SOCIAL SECURITY: RETURN ON INVESTMENT
by reader coberly
SOCIAL SECURITY: RETURN ON INVESTMENT
We often hear claims that the “rate of return on investment” of Social Security is less than what a person could realize by investing “in the market.” So much so that some authors claim that Social Security has created a “legacy debt” that amounts to a “backward transfer” of wealth from future generations to past generations.
This claim is as bizarre as it sounds. No future taxpayer will be giving money to his long dead grandparents. But it is also fundamentally wrong headed. Social Security is not an investment club in which returns paid to some subscribers result in less money available to earn interest to pay other subscribers. Social Security is an insurance policy, and the costs and “returns” of an insurance policy must reflect the real world costs of the insured event. They cannot be a simple expression of an arbitrarily chosen interest rate.
Calculations of “rate of return” usually leave out important complications like fees, taxes, inflation, and market variations. And they never refer to the insurance function whereby Social Security protects you from disability and your family from your early death. And no consideration whatever is given to the accidents of health or employment that could leave you unable to save enough through market investments to pay for even a marginally adequate retirement.
And finally, these comparisons always ignore the fact that as an insurance policy, there is no one “rate of return” that adequately describes the facts of Social Security. My purpose here is to make a beginning to addressing that lack of understanding. Ultimately there are too many complications for a short essay to address all the possibilities, but here is a start:
I’ll explain the method below, but here are the results.
An employee earning a below average wage of 26000 per year (adjusted for inflation and average real wage growth), in order to get the benefits Social Security will guarantee to him and his wife, would have to invest his 6.2% payroll tax and get a steady 12% return on investment per year every year above taxes and fees.
That same employee without a wife would have to get 10%.
A self employed person, investing the entire 12.4% payroll tax, would have to get 8.5% if married, 6.3 % if single.
An employee earning the average wage of 44,000 per year, adjusted, would have to get 10.4% married, 8.5% single; self employed married 6.7%, self employed single 4.5%.
An employee earning 70,000 per year, adjusted would have to get 9.2% married, 7.3% single; self employed married 5.5%, 3% single.
I assumed an average wage equal to the “average wage index” given in Table V.C1, page 98 of the 2007 Trustees Report, for each year from 1975 through 2009. This is nearly equivalent to starting at $8600 per year in 1975 and increasing 5% each year after that. For the low wage worker, I assumed 60% of the average. For the high wage worker I assumed 160% of the average. In each case I assumed an investment each year equivalent to either 6.2% of the wage for “employee” or 12.4% for the self employed.
I calculated benefits based on the average adjusted wage, which is the same as the final wage in this exercise, using the bend points in Figure V.C1, page 100 of the 2007 Trustees Report. I assumed the retiree would be able to buy an annuity using all of his savings plus return on investment calculated above. I assumed that annuity would earn 8% and pay the Social Security calculated benefit plus 3% inflation adjustment each year for a life expectancy of 15 years following retirement. I assumed that a married retiree would receive an extra 50% spouse allowance.
Since I looked at only the required 35 years for the Social Security calculation, some would argue that I neglected the money the employee would have earned, and paid taxes on, over a greater number of years. On the other hand, since early wages tend to be lower in relation to the average wage than later wages, by holding the wage constant, as a function of the average wage, I very likely overestimated the earnings from the early years, those that would have the greatest increase due to compounding. I did not count wages earned by the spouse, but neither did I count taxes and fees, possible inflation surges and market dips. Nor did I consider that actual life expectancy is even now somewhat longer than 15 years after retirement.
The largest source of contention, I suspect, would be whether or not the employer’s share of Social Security taxes would be available for the employee to invest if there was no tax. My view is that while it is reasonable to guess that they would be, obviously for the self employed, probably for high earners with bargaining power, or unionized employees with bargaining power, it is extremely unlikely they would be for low wage workers who have no bargaining power. And it is even more unlikely that if those taxes magically turned into a 6% wage hike for the low wage earner, that he would save and invest them. A worker making 400 dollars per week is not going to invest 50 dollars on the market even if you give him a 25 dollar raise. In any case according to the law, and in historical fact, the employer’s share does NOT come out of the employee’s earnings. I prefer to deal with reality rather than the woulda shoulda coulda of even the best economists’ imaginations.
And the whole point of Social Security is to provide retirement security for those workers who, for whatever reason, end up after a lifetime of work without enough money saved to pay for a retirement that includes a roof and groceries. Since this could be you… even now… if you are currently enjoying high expectations, instead of obsessing about what you “could have” earned “if only,” let me suggest you pour a glass of good wine and rejoice that you are going to at least get your money back adjusted for inflation. And all in all it is better to pay a little for insurance you don’t “need” than to not pay for insurance you end up wishing you had. In fact, if the universal mandatory automobile insurance requirements are a guide for thinking, there is some reason to suppose that it is better for you that other people have insurance, even if you yourself will never need it.
A low wage employee with a stay at home wife would have to get more than 12% “rate of return” from investing his Social Security tax to get the same retirement income that Social Security guarantees him. This is based on current tax and benefit schedules and historical data that reflect roughly a 3% inflation rate and a 2% real income growth. An unmarried, self employed, average earner would have to earn 4.5% every year on his savings of 12.4% of his income in order to get the retirement income that Social Security guarantees him. The rate of return is highly dependent on income level, with rates of return being much higher for people whose lifetime earnings fall below average. But even a single, self employed, high earner will at least get his taxes back adjusted for inflation. Social Security is insurance, not an investment, but its “rate of return” is quite competitive with real world investments.
by reader coberly
Wow. This entire converstation is facinating. I just read every post. Thank you so much for having this open dialogue. I was born in 1964, the last year of the baby boomers, and I’ve been worried for years that I wouldn’t get to collect Social Security. I see more balanced view of how it all works now, even if the “rates of return” are debated. I work with many people on SSI and SSD, and I can tell you that this “insurance” is so needed by most of those that have it. To think that it only costs about 2% or our wages to ensure this exists seems like a humane bargain to me. Both of my long term relationships in my life have been with partners from countries without a public safety net (Brazil and Mexico). I so appreciate knowing that our country has this public saftey net built in. Even though there are huge flaws, it shows how far we’ve come.
I wonder about the amount of money contributed to SS by undocumented aliens who will never recieve benefits. Is this significant?
In your conclusion you refer to “the benefits socoal security guarantees him”; a supreme court decision in the 40’s said that SS guarantees you nothing…that the government can decide who gets what however they please.
Thanks for an informative discussion. I think your numbers were very instructive on why it’s a good idea for a PERSON to take advantage of social security. But is it a good idea for the government/taxpayers/society? I think you missed the point about “grandchildren paying their grandparents”. You pay money now, but that money is not saved until you retire as you would think of your 401K. It’s being used…right now… to pay for the people who are currently retired (or it’s put into Al Gore’s “lock box” to save for when Boomers retire). That is a Ponzi scheme … or if you prefer it is a tax on your grandchildren.
If a person can really make a 12% return from their social security investment, the question is, does the government make a 12% return on our investment to cover that payout? I don’t have the numbers, but I think it unlikely. Thus SOMEBODY is subsidizing that 12% return, and I submit to you that it is your grandchildren.
I’ve run the numbers and SS pays anything from -1% to a 2% annual growth rate on the individuals investment over their total employment years. Your defending these numbers????? Are you a damn fool? Oh – why did I ask – I know the answer to that just like I know real returns when I caculate them properly. If I invest the money on my own the annual growth rate on a bad day could be estimated at 4% and the annual return on investment in retirement years would be over 200% higher than what the Gov. return would be (each year my friend). And if someone happens to have an average annual growth rate of 8.0 percent the numbers go through the roof – compared to the pathetic return from the Government. BTW: this factors in inflation and leaves ample money for someone to buy proper insurance and still vacation in tahiti whenever they like.
How could anyone in this recent era claim that the return on Social Security is not a good one? With the average benefit check from SS being about $1,500 per month, I think, one would need to have a bond fund of about $1 million in the bank to get this return. Essentially, no one can claim to have contributed $1 million to SS over their working career.
In fact, SS is providing a fantastic return in this era of low fixed-rate-investment returns. This is exactly what the doctor ordered. It keeps seniors/retirees above the poverty level, despite what they may be getting from their other investments. What a great system SS is for Americans. It is the envy of the world!
Real life. I’m in my late 50’s. A teacher with Texas Teacher Retirement. Paid SS decades ago and off and on for various self-employment jobs, part-time jobs, etc. I can look at my annual statement from SS Admin. and figure 8% return from time of payment until retirement, year by year, cumulative. Comes to about $225,000. Statement says I will get about $10000 a year starting at age 65. However, they will reduced that by 40% because of my teacher retirement (it’s law – they say teachers’ employment history fools the formula). So, $6000 a year for 20 years (assuming age 85). Roughly, $120,000. Rough but close – doesn’t account for taxes on SS, changes in formula, etc.
How is that a good deal?
And if your subject dies tomorrow, the return is Zero.
Actually, less than zero, because the principal from ‘investing’ about 14% of income per year is not returned except for an extremely small death benefit.
the business that employs robots or over-seas workers pays less SS employer contribution tax than the business who employs Amercian workers.
Employment of US workers is dis-incentivized.
This does not include the amount contributed to Social Security by the employer on the employee’s behalf, however, does it?
Fact is the original intent of SS was to provide a safety net in old age. The payout far exceeds the paid in capital. That is a ponzi scheme that cannot be sustained. Sure it is a great investment until we are all broke.
I would like to see this compared to what the returns and benefits would be from systems such as those advocated by http://www.bankonyourself.com which use the right kinds of life insurance policies. Banks and corporations and rich families have used these for generations, and anyone can. I think this would be the best way to go but I’m not sure.