Social Security in the US (and the equivalent in Europe and Japan), as well as some pension plans, might be in far worse shape than you think. And the reason may be very good news for you, and almost certainly will be for your kids. Potentially very good indeed. Today we take a look at one potential pitfall in the future of Social Security that no politician is talking about.

I had told myself that with so many people writing about Social Security that I should just go on to another topic. That changed this morning. While dropping off my 16 year old son at school, he turns off his brand new MP3 player (shock!) and turns to me and asks, "So what do you think of this Social Security thing? I mean, like private accounts and all? Isn't there some kind of risk in that?"

"Well, yes, Chad there is. Investing and saving for retirement is definitely risky. There's lots of risk all around us. For instance, letting you drive is a risk," I pointed out. "Not hardly!" he said. "I know what I am doing!" (Dad sighs.)

But there is great risk, at least for elected officials, involved in messing with Social Security. But there is even greater risk to Chad (and his six siblings) in doing nothing. So today I write a letter to my kids, looking at a future retirement for them that will almost certainly be far different than the one they think (when the young do think about retirement) they face today. (As long-time readers know, I am not interested in personally retiring, so the issue is hopefully merely academic for me at this time.)

But before we deal with the heavy lifting, let me start with a lighter note. Everyone knows that Republicans and Democrats do not agree on what to do about Social Security. The atmosphere in Washington is poisonous, as some of the recent Senate confirmation hearings demonstrated. We wonder how anything can get done. But it has been worse. A lot worse. Art Cashin (of UBS and on CNBC daily) does a daily letter which always starts off with a historical reference. Today he wrote:

"On this day (+2) in 1858, that august deliberative body, the U.S. House of Representatives was calmly discussing a matter of import to the nation. Well.....maybe 'calmly discussing' misses the point. The House was in mid- debate/mid-filibuster on the topic of admitting Kansas to statehood.....and whether such admission should be as a free state or slave state.

"The debate had been going since the prior day and as it moved into the wee small hours of February 6th the tension, partisanship and weariness began to show. Since night-time in February, in Washington, in the Capitol building, in the 1850's tended not to be too warm, several members of Congress were said to have sipped (or gulped) some alcoholic beverages.....just to stave off the chill.

"Rep. Keitt of S.C. made a rather uncomplimentary remark about Rep. Galusha Grow of PA. (who had the floor at the time). Rep. Grow responded with an equally unkind assessment of Keitt. Keitt went for Grow's neck, but was knocked to the ground. Soon most of the House was wrestling, spitting, kicking and punching their worthy and distinguished colleagues. Spittoons and inkwells flew through the air. The Speaker gaveled for order with no success. The Sergeant at Arms beat members with his staff (in a non-partisan way, of course).

"Rep. Grow was being pummeled by Barksdale of Mississippi when Washburn of Wisconsin rushed to Grow's defense. Washburn's intention was to grab Barksdale by the hair with his left hand and knock him out with a right uppercut. But when he grabbed Barksdale's hair, it came off in his hand. Shocked, Washburn screamed. The rioting representatives looked up and saw a suddenly bald Barksdale.....and Washburn waving his wig. 'My God, he's been scalped!' shouted someone and the riot broke up in riotous laughter.

"To mark the day suggest to the bipartisan leadership that as they begin to debate Social Security consider appointing someone from the Hair Club as doorkeeper."

The Union has survived worse political climates and partisanship than we see today. My guess is that it will continue to survive.

I will get to the unspoken problem (and good news for us) with Social Security at the end of the letter, but let's first quickly assess the problem. In just 10 years, spending on the elderly in the US will total nearly $1.8 trillion, almost half the federal budget, according to new Brookings Institution and Congressional Budget Office projections. That is up from 29% in 1990 and 35% in 2000. The bulk of that growth is spending on the federal government's two largest health care programs, Medicare and Medicaid. Their combined costs are projected to more than double, to a combined total of $1.2 trillion in 2015 from $473 billion last year. Social Security spending is expected to rise to $888 billion from $492 billion in that span. (Source: Washington Post).

It gets worse of course. Douglas Holtz-Eakin, the Congressional Budget Office director, notes that "Medicare and Medicaid spending triples, maybe quintuples by 2050, while Social Security spending goes up by 50%."

Social Security Do Nothing Act

There is a great essay at The American Enterprise Magazine website. After listing all the "new" innovations of 1935, as well as the then current conditions, essayist Karl Zinzmeister takes us back to that period and writes:

"... Admittedly, the U.S. economy has seen better days. The human disruption of the Dust Bowl storms is just beginning to subside. A quarter to a third of today's U.S. population is quite poor.

"And amidst our economic disappointments, life's other ancient maladies continue to sting. Doctors still have no effective medicines to stop biotic infections. Tens of thousands of American children will be crippled by polio this year. U.S. life expectancy averages only 59 years and some months.

"That last figure explains why another of the year's milestones produced only a mild ripple among the public: This August 1935, Franklin Roosevelt pushed through Congress a program for universal government-paid pensions. Checks will begin to mail as soon as this new "Social Security" plan takes hold. But full benefits don't commence until age 65--and, as a plain fact, most of us will be gone before then.

"So: Do you want to base your security in old age on a program engineered at the same time as the Model A and the vacuum-tube radio? Has work changed much since the era when slopping pigs for Auntie Em was a typical job? Does the boundary between state and individual look different now that the USSR has gone from progressive polestar to oppressive flop? Has American finance advanced from the decades when the only choices for ordinary savers were the passbook, the mason jar, or the mattress? Are the retirement goals of Americans still the same as in the days when the Bambino retired? Or is it time for Social Security to enjoy a major-league update?

"The answer, I think, is obvious. Nothing but a government welfare program could ever last this long in unimproved form. Our transportation networks, our medical services, our economy are all light-years better than they were in 1935. So why are we still stuck with a gramophone/Hupmobile/fountain pen system of public pensions?

"Two reasons: First, sentimental Democrats have flatly refused to let go of their FDR/New Deal glory days, and have repeatedly gone nuclear on anyone who suggested we could do better than blue paper cards, musty claims offices, $420 monthly checks, and payroll taxes headed over 20 percent. Reactionary, backward- looking politics has been reform blocker number one.

"Reform blocker number two has been the ability of crafty administrators and legislators to prevent the public from understanding the demographic and economic contradictions that doom old-style Social Security in a modern era. Apologists have shamelessly employed dishonest terminology (from "Trust Fund" to "insurance" to "employer contribution" to "lockbox"). They have relied on repeated tax increases (from 2.0 percent of the worker's first $3,000 in the early years to 15.3 percent of the first $90,000 today--with all of that withheld from your paycheck before you even see it, so what's to miss?). They have used a succession of "blue ribbon commissions" to paper over problems rather than face them (I know--as a junior staffer I worked with the Greenspan Commission that cobbled together the 1982 Social Security patch).

"But the days of being able to punt Social Security's glaring faults to the next political generation are nearly at an end. With the aging Baby Boomers due to start collecting checks in just three years, Social Security's finances will soon head south in a big way. And then, just a few years later, an even worse hemorrhaging commences in the other half of the Social Security Act: the Medicare program that pays the doctor and drug bills of America's oldsters....

"...Two more honest politicians, Democrat Bob Kerrey and Republican Warren Rudman, warned the nation a couple years ago where this would lead: "Suppose a member of Congress introduced legislation called the Social Security Do Nothing Act. Under this bill, promised retirement benefits would be cut...by 35 percent for today's newborns. Alternatively, payroll taxes would go up by roughly 40 percent.... These are the choices under the Do Nothing Plan."

So Many Promises, So Few Answers

The sad fact is that we have made promises as a nation (this includes most of Europe and Japan) that we simply cannot keep. Or more correctly, we have made promises on behalf of our kids that they will not be able to keep. The Center for Strategic and International Studies notes that if the increases needed for our current programs comes entirely from tax increases, our taxes would rise to 33% of GDP by 2040. Except that such a tax rate would kill all growth in the economy and cripple wage growth and increase unemployment. Or if we cut spending on other unnecessary items like defense, parks, research and education, we would see the national share of funds going to the elderly rise to 56%.

(By the way, if tax increases were the answer, not one European country would pay less than 50% in taxes and France would pay 62% of GDP! Japan would see rates rise to 40%. Germany today has 10% unemployment with a tax regime not as bad as what the US (meaning our kids) will face if we do not act now.

Kerrey and Rudman noted above we could pay for increased Social Security promises with a mere 40% increase in taxes. Of course, that leave the far larger problem of Medicare unresolved.

We have simply promised too much of our children's future income to ourselves. That worked when there were 30 or 15 or even 3 workers (as now) to every retiree. It will not work when there are two. There are really only two unpalatable choices: we can either cut benefits or raise taxes, or some combination in between.

Of course, we could put off a decision for a few decades and make the situation worse. Yes, I know we could make changes. We could lower the cost of healthcare (not likely, as I will point out in a few paragraphs) or radically reduce the size of government so that we could devote large amounts of our budget to caring for retirees. Imagine the screams if we simply put a freeze on every government program except for Social Security and Medicare?

At the end of the day, we are still going to have to raise taxes or cut benefits or cut other spending.

If we do not tackle Social Security this year, I am pessimistic it will not happen for another 8 years. If Congress cannot muster enough courage to do it this year, then almost certainly it will not happen next year. Then Bush will be a lame duck, the presidential campaign will be upon us and nothing will happen for the next two years. Then we get a president who will want to "study" the problem for another four years, and if we are lucky and he/she gets re-elected, then maybe we get around to it in 2013. If not, then we start the cycle again, and it is 2017 before something becomes politically possible.

Of course, the funding goes negative in 2018. But what's a few years among friends?

The simple way to fix the Social Security problem involves several steps. First, we need to increase the age of retirement gradually over time (see more below). Secondly, for future retirees (not current retirees) we need to slow the growth of increases to a rate that grows with inflation. We made a deal and should not ask current retirees and those close to retirement age to have to make changes. As Bush noted, if you are over 55, your deal will not change.

As an offset for lower future payments, we should fund private accounts that not only have the potential to grow but will be able to be passed down to future generations. As far as the $2 trillion dollars Bush wants to borrow over time? We now owe $7 trillion, and will have to borrow it anyway if we do not act. Pay me now or pay me later.

We must balance the budget and begin to pay down the debt. And then we need to take a breath and tackle Medicare. But if we cannot do Social Security, there is no way we can do Medicare.

And now let me speak a heresy. We need to recognize that Social Security is not a retirement program, like a pension or 401k plan. It is a welfare program. It transfers money from one group to another group. We need to means test Social Security payments at some point in the future on a graduated scale.

One more note: a major study has found that approximately 50% of all bankruptcies were due to medical bills, and that 76% of those were with people who had insurance.

Fantastic Voyage

The bad news is that the estimates for Social Security liabilities may be seriously under-estimated. The good news is that the reason is that we may all be living a lot longer.

Life expectancy was 37 years of age only 150 years ago. When Social Security was introduced, it was just 60. Today it is 77.2 years. Life expectancy is increasing 1 year for every 4 years we progress through time. The prospect for a further increase in life expectancy may be accelerating.

I have just finished a rather remarkable book by Ray Kurzweil and Dr. Terry Grossman called "Fantastic Voyage," sub-titled "Live Long Enough to Live Forever." I picked it up because I am a fan of Kurzweil, who is one of the world's truly brilliant scientists and inventors and futurists. He is the author of the best-selling book "Spiritual Machines." Ray Kurzweil was the principal developer of the first omni-font optical character recognition machine, the first print-to-speech reading machine for the blind, the first CCD flat-bed scanner, the first text-to-speech synthesizer, the first music synthesizer capable of recreating the grand piano and other orchestral instruments, and the first commercially marketed large-vocabulary speech recognition. Ray has successfully founded and developed nine businesses. (http://www.kurzweiltech.com/aboutray.html)

He developed type 2 diabetes at 37 (he is now in his mid-50's). His Dad died from a heart attack at the age of 55, and Ray decided to change his lifestyle to try and avoid the same end result. Now free of all symptoms, he has become quite the authority on living and eating healthy. Since I am also interested in being healthy, I decided to see what research Ray had dug up. As it turns out, quite a lot.

Understand, Ray is a little on the edge in his optimism about the future of medial advances. But his research is top drawer.

There can be little doubt that great change is upon us. As the authors note, "As interesting as the first two decades are likely to be, subsequent decades should lead to even more dramatic changes. Ray has spent several decades studying and modeling technology trends and their impact on society. Perhaps his most profound observation is that the rate of change is itself accelerating. This means the past is not a reliable guide to the future. The 20th century was not 100 years of progress at today's rate but, rather, was equivalent to about 20 years, because we've been speeding up to current rates of change. And we'll make another 20 years of progress at today's rate, equivalent to that of the entire 20th century, in the next 14 years. And then we'll do it again in just 7 years."

Their thesis is that science is advancing rapidly enough that at some point in the future we may be able to slow down or even reverse the aging process. They think that point is 30 years (or so) from now, so it behooves you to take care of your body today. I am not certain I buy the live forever (or at least very long) part is in my lifetime, but "Fantastic Voyage" is a great book of detailing the latest research on living a healthy life today, interspersed with brief stories on what is happening with the latest in bio-tech and nanotech research. Warning: this is at heart a science book, and while well written, is not light reading. But if you want to understand why certain things are bad for you and why you need other foods and want to learn why in great detail, you will enjoy the book.

Let's considerably cut back the rate of progress they project. Let's forget their premise of living long enough to live forever, and think about the more realistic prospect of simply living longer. There are medicines and procedures available in the near future that are going to help you do it. For instance, my Dad's family generally made it to their mid-80's and then developed a form of dementia and had small strokes and died. I may get hit by a truck tomorrow, but it is unlikely that I will be afflicted as was my Dad. There are drugs in the pipeline, which will be available this decade, which will deal with the memory issues, and soon thereafter with dementia. As noted below, in a few decades when I start to be at risk, strokes will be a rare event.

(My mother is still going strong at 87, although she does have two new knees and two new hips, as well as a hearing aid and a few drugs. All of her family seemed to lose their hearing, though many of her ten older brothers and sisters, as well as her parents, made it to their mid-90's.)

Let me thumb through Fantastic Voyage and mention a few facts and areas of research that will come to be in our future.

GlaxoSmithKline has a drug in phase 1 clinical trials that will benefit type 2 diabetes and also help weight loss. They think of it as a "chemical Adkins diet." It blocks sucrose and glucose from being absorbed in the body, and if effective it will essentially reduce the effective calories of what you eat. It is the bad stuff you eat that causes much of the heart disease and other medical problems. Maybe this one fails, as do many experimental drugs, but you can bet thousands of people are working on a drug like this. Eli Lilly has a drug in phase 3 which does something similar.

The company which develops a drug which allows me to eat ice cream and pie and stay healthy will have the hit drug of all time.

Speaking of thousands of people, there are now over 50,000 engineers and scientists working on some aspect of research on the human brain. This is not some process where 5-10 guys sit around and work on the steam engine at leisure over decades. Breakthroughs are happening at an increasing pace.

There are 700,000 people who have strokes each year, the third leading cause of death behind heart disease and cancer. Most of them are caused by blood clots traveling to the brain. "A drug in human trials, Desmoteplase, has been developed from a protein in vampire bat saliva; it breaks up the brain blood clots associated with strokes but does not prevent a patient's blood from clotting elsewhere in the body, such as a scratch on the arm. An Israeli team has built a mesh device like a tea strainer that blocks clots larger than 300 micrometers from traveling up the carotid artery in the neck into the brain."

There are a number of approaches that are starting to show promise in regenerating nerve tissue. They now have the ability to have paraplegics control robotic arms simply by mapping the neuron patterns in the brain. Georgia State University is working on ways to link to a human brain and allow people to surf the Internet by the power of thought alone.

Inflammation plays a critical role in every step of plaque formation in the heart, as well as the final eruption of plaque that causes a heart attack. Pfizer has developed a new leukotriene-blocking drug called CP-105,696 that caused artery plaques in mice to shrink dramatically in a mere 35 days, and the control group had no shrinkage. They list pages of new drugs currently in the pipeline that will dramatically lower heart disease, the leading cause of death in the US.

Specific drugs to attack cancer are being developed. Scientists are growing arteries and regenerating cells. Although it seems quite sci-fi, there are serious research groups working on the aging process itself.

The Flaw in Social Security Projections

In short, nothing is going to change overnight, but in 20 years, it is not unreasonable to speculate that the average age at death will be far north of the current 77. Many, instead of dying at 60 or 65 or 75 will live a long and full life. We will be dodging the bullet on Alzheimer's, heart disease, many forms of cancer and strokes that take far too many of us at an early age. That is a wonderful prospect.

But it will blow to pieces the current mortality projections that Social Security is built on. There will be lots of baby boomers who will be collecting their checks a lot longer than currently thought. And forget about how long our kids will live.

Of course, if we can use drugs to avoid long expensive stays in the hospital that will actually cut medical costs. But on the other hand, the demand for a drug that can remove heart plaque or blood clots will be monster. Care to suggest those won't be eligible for Medicare?

And as the cost of scanning, gene tests and other forms of disease detection comes down, everyone is going to want it, and then want the therapy to cure what is found. Market rule #1: the cheaper something is, the greater the demand. Re- generating nerves and some of the really gee-whiz technology in 20 years are not going to be cheap. The longer people live, the more new knees and hips they are going to need.

In short, projecting Medicare costs in 20 years based upon current trend lines is probably about as accurate as projecting the NASDAQ based upon 1990-2000 performance. Things are changing so rapidly. But as more and more technology becomes available, you can bet more and more people are going to want to get access.

The cost in the future is likely to be higher unless we re-structure the system now to contain costs. This may take some creative thinking like rewarding people with tax incentives for living a healthy lifestyle and thus costing the system less money.

Of course, this means that at some point in the future, we will have yet one more effort to "Save Social Security for the Future Generations."

Next week, we will look at the economic factors which will skew the actual outcome of how baby boomers will experience retirement. Will your savings be enough to keep you in the lifestyle you want? Will you be able to retire at the age you now plan?

London, Copenhagen and Puerto Vallarta

Toronto and New York were a whirlwind this week, and it is good to be back home. If anyone up there is missing a cold, let me know and I will be glad to return it. I am going to have to go to London in mid-March to take an English securities regulatory exam. Looking at the material, I am quite nervous about it. It is over English rules and regulations, and some of it is quite arcane to this Texas boy. The rules seem so completely, well, foreign. It will be at least 10-12 days of my life studying, but it is the cost of doing business.

I will probably speak at least once in London, and will post places and times later if it will be open to the public. Then my London partners are arranging a meeting or two in Copenhagen (which will be my 42nd country to visit) and then back to Texas. But next week my bride and I jump down to Puerto Vallarta for a few days of well-deserved holiday. Oh, and the next week I am off to Connecticut for a conference on inferential thinking with those really smart guys from the Williams Inference Group. Remember, I told you this was the year I was going to travel less. It's looking more and more like the last few years. (Sigh) That should probably lay to rest any ideas you have that I have a clue about the future.

The next day or so is set aside for family, watching my youngest play basketball and being with my twins in Tulsa at school (yet another plane, but it is a short hop), and then back for a quiet Super Bowl party with family and friends.

Finally, I would like to thanks my associate, Harry Ward, who every week gets my copy late on a Friday evening and goes over it for errors. Given the sometime late schedule, he does show remarkable flexibility.

Your looking forward to seeing the changes analyst,