In Wisconsin, a brewing battle between the state public workers union and the Republican-controlled Statehouse and Legislature erupted into open warfare when Democratic lawmakers literally fled the state to derail the legislative process and prevent a vote on modest reforms to teacher's pensions.
Wisconsin, like many states, faces tough budget challenges. The current decifit is $3.4 billion, and, unlike its neighbor Illinois or big brother the Federal Government, Wisconsin is trying to do the right thing and get out ahead of the problem.
Gov. Walker, who swept into office by soundly beating his incumbent opponent, and the State Legislature -- which saw absolute shallackings for the Democrats, who lost control of both houses -- are beginning a series of reforms to get the budeget under control. One of their first targets is reforming public workers pensions. His proposals would save the state about $300 million per year.
The teachers' union, of course, cried foul and has staged large protests and the equivalent of boycotts. They argue it is a question of fairness.
I agree: this is 100% a question of fairness.
Wisconsin pension law determines the overall amount of money that must be set aside for pension contributions. Currently, the law mandates a cost of 5% of a teacher's salary plus 6.6% in employer contributions. That seems to make sense.
But here's the rub: that law only proscribes the cost required. In practice, teachers pay absolutely nothing to their pensions. The entire cost is borne by the school system, aka the taxpayer.
Gov. Walker submitted a relatively modest proposal that, heaven forbid, teachers should contribute something to their own defined benefit plan. He suggests the 5% that is allocated to the employee but is actually now paid for by the employer. In exchange, he promises no layoffs or furloughs.
For your average teacher, who makes $48,000 per year in salary (and about twice that in total compensation), this amounts to about $100 out of every paycheck. But, I'm always curious as to whether or not something like this a good long-term deal or if, in fact, the teachers are getting treated unfairly on this one.
I used the Wisconsin Pension System's online calculator to figure out what my monthly pension would be if I worked in the system for the minimum 25 years, retired at age 65, and my highest three years of salary were around $75,000 (which are fair estimates, according to other data). My total pension: $2,500. (Keep in mind I also get Social Security on top of this, for total retirement income of about $4,000.)
Using our handy calculator from ImmediateAnnuity.com, we find that this annuity has a cash value of about $400,000.
So what is the rate of return if I contribute $200 per month, for 25 years, and end up with $400,000?
12.75%
Seeing as how that rate of return is almost double what the average person with a 401(k) can expect to get in the market, this is a pretty great deal. The state -- aka, the taxpayers -- are still picking up 57% of the pension cost. And the teacher's union has filled the streets, howling protest that they might have to accept this horribly burdensome arrangement.
Meanwhile, an average person without a defined benefit package (e.g. most of us), would have to save about $500 per month -- or, if we made the same $48,000 salary, the equivalent of 12.5% of our paycheck -- to end up with the same $400,000 to purchase a comparable annuity.
This debate about pensions is, most definitely, a question of fairness.
Friday, February 18, 2011
Wednesday, January 12, 2011
Brady Hoke? Seriously?
I hate Michgian football. I mean, I really despise them. Losing to them eats away at my soul for the next 12 months.
That being said, college football is undeniably better when Michigan has a good team. It's good for the sport to have good teams in the Midwest, especially since the northeast has more or less stopped playing football, and 90% of the focus during the season is on teams from the SEC and PAC-10.
As far as I'm concerned, Michigan going 11-1 every year would be a great thing for everyone involved.
Rich Rodriguez was never going to work out. Never, ever hire someone who leaves their employer in the way he did to come work for you. Although he probably didn't expect to be named the Michigan coach while he was renegotiating his contract with WVU, the fact that he had just signed a contract means he should have passed. If that's how he treated his alma mater, what did you expect him to do to your program?
Michigan's AD, David Brandon, however, seems to have botched this one pretty good. First, it was obvious to everyone that, regardless of what Rich Rod did in the bowl game, the chances of him surviving until the following season were about zilch. Brandon should have done a lot more groundwork early on with Harbaugh or Miles (if those are the guys he was interested in). As it was, it looked like the search didn't get underway until the first week of January. And, of course, those two candidates ended up passing on the job. This was sloppy work by the folks at Ann Arbor -- just plain sloppy.
Second, enough of this "Michigan Man" nonsense. Heck, the guy who coined the phrase, the legendary Bo Schembechler, was himself not a Michigan Man. (He played and coached at Miami of Ohio before coming to Ann Arbor.) If you can get the right person for the job who also happens to be an alum, fantastic. But just because you are from the same place doesn't mean you are going to be a success (see: Charlie Weis). It is more important to get the right person than the right pedigree.
So that raises the question: why Brady Hoke? Near as I can tell, his leading qualification is that he was an assistant coach in Ann Arbor for several years. Other than, there is little to recommend him.
His greatest achievement was almost winning something at Ball State. In 2008, he took his team to 12-0 and a #12 ranking...before getting absolutely used and abused against Buffalo in the MAC Championship (42-24) and then suffering an even worse defeat against Tulsa in the GMAC Bowl (45-13).
Almost winning something is no reason to hire or extend a coach. (See: Charlie Weis)
His next best year was this year, taking a San Diego State team to 9-4 and a victory in the Poinsetta Bowl. It was a pretty good season to be sure, and it could have been even better: their 4 losses all came by 5 points or less. Still, we have no idea if that was simply a fluke or if he really did turn around SDSU.
His short-term accomplishments, therefore, are somewhat suspect. And his long-term record -- 47-50 -- is nothing to brag about. Plus, he has never been subject to the kind of intense pressure and scrutiny that comes with the Michigan job, both on and off the field.
Hiring Hoke seems like a complete leap of faith by a program that was so desperate to get a Michigan Man that they really limited who they considered. By the time things didn't work out with Harbaugh and Miles, they had to offer the job to Hoke.
I hope Hoke succeeds, I really do. But if I were a Michigan fan, I would be very leary of this hire...
~Go Irish
That being said, college football is undeniably better when Michigan has a good team. It's good for the sport to have good teams in the Midwest, especially since the northeast has more or less stopped playing football, and 90% of the focus during the season is on teams from the SEC and PAC-10.
As far as I'm concerned, Michigan going 11-1 every year would be a great thing for everyone involved.
Rich Rodriguez was never going to work out. Never, ever hire someone who leaves their employer in the way he did to come work for you. Although he probably didn't expect to be named the Michigan coach while he was renegotiating his contract with WVU, the fact that he had just signed a contract means he should have passed. If that's how he treated his alma mater, what did you expect him to do to your program?
Michigan's AD, David Brandon, however, seems to have botched this one pretty good. First, it was obvious to everyone that, regardless of what Rich Rod did in the bowl game, the chances of him surviving until the following season were about zilch. Brandon should have done a lot more groundwork early on with Harbaugh or Miles (if those are the guys he was interested in). As it was, it looked like the search didn't get underway until the first week of January. And, of course, those two candidates ended up passing on the job. This was sloppy work by the folks at Ann Arbor -- just plain sloppy.
Second, enough of this "Michigan Man" nonsense. Heck, the guy who coined the phrase, the legendary Bo Schembechler, was himself not a Michigan Man. (He played and coached at Miami of Ohio before coming to Ann Arbor.) If you can get the right person for the job who also happens to be an alum, fantastic. But just because you are from the same place doesn't mean you are going to be a success (see: Charlie Weis). It is more important to get the right person than the right pedigree.
So that raises the question: why Brady Hoke? Near as I can tell, his leading qualification is that he was an assistant coach in Ann Arbor for several years. Other than, there is little to recommend him.
His greatest achievement was almost winning something at Ball State. In 2008, he took his team to 12-0 and a #12 ranking...before getting absolutely used and abused against Buffalo in the MAC Championship (42-24) and then suffering an even worse defeat against Tulsa in the GMAC Bowl (45-13).
Almost winning something is no reason to hire or extend a coach. (See: Charlie Weis)
His next best year was this year, taking a San Diego State team to 9-4 and a victory in the Poinsetta Bowl. It was a pretty good season to be sure, and it could have been even better: their 4 losses all came by 5 points or less. Still, we have no idea if that was simply a fluke or if he really did turn around SDSU.
His short-term accomplishments, therefore, are somewhat suspect. And his long-term record -- 47-50 -- is nothing to brag about. Plus, he has never been subject to the kind of intense pressure and scrutiny that comes with the Michigan job, both on and off the field.
Hiring Hoke seems like a complete leap of faith by a program that was so desperate to get a Michigan Man that they really limited who they considered. By the time things didn't work out with Harbaugh and Miles, they had to offer the job to Hoke.
I hope Hoke succeeds, I really do. But if I were a Michigan fan, I would be very leary of this hire...
~Go Irish
Sunday, January 9, 2011
Social Security: Poor Rates of Return are Just the Start
In a previous post, I argued that Social Security is a terrible investment for workers. Simply, workers would do a lot better by purchasing 30-year Treasury bonds throughout the course of their careers to attain more value than what they derive from Social Security. My original intent was to have this next post contain proposals for fixing the system. However, I wanted to elaborate on the additional problems confronting Social Security. Next time I'll throw out some solutions, I promise.
Social Security is a program facing enormous systemic problems: not only does it produce poor returns, but the future entails negative returns for many workers; it is a wealth redistribution system that actually transfers money from the poor to middle class and even affluent people; and bankruptcy looms for right around the time today's children are going to their mailboxes looking for a check.
And those are just the major issues.
Before identifying possible solutions, it is worth looking at how Social Security actually works. Importantly, Social Security is a type of program called "pay-as-you-go." In other words, taxes that are collected today are used to pay benefits tomorrow. Today's workers are paying for today's retirees. Bernie Madoff went to jail for a similar business model.
Fewer Workers, More Retirees
Still, pay-as-you-go was not necessarily a problem when Social Security was created. In fact, it made a lot of sense: in 1950, there were 16 workers for every retiree. Also, the retirement age was 65 and the life expectancy for someone born in 1930 was 60. Not only were there more workers to support the system, but also retirees were unlikely to receive benefits for more than a handful of years (if ever).
But then the Greatest Generation decided to have babies. And boy did they have a lot of them. This baby boom would not in itself cause a problem if the Boomers had maintained a similar birth rate as their parents, but they did not. Fewer babies meant fewer workers. By 1960, the worker-to-retiree ratio had fallen to 5:1. Today the ratio is 3.3:1. By 2050, that ratio will have fallen to 2:1.
Think about that for a second: each married couple will essentially have the responsibility for providing for most of the retirement income of an elderly Baby Boomer because Boomers have been horribly irresponsible at saving for retirement.
Higher Taxes or Lower Benefits?
Even the folks at Social Security acknowledge that either taxes will have to go up or benefits will have to go down. Right now, the Social Security Administration is planning on benefits going down. As the Trustees report states, benefits for future retirees will only be about 70% of what they are today. They say this like it's a good thing and we should be grateful that there will be anything left at all.
Of course, this reduction in benefits just makes a bad deal worse, kind of like when Darth Vader threatens Lando in The Empire Strikes Back:
Negative Returns (or how I lost money in Social Security)
Remember Bob? Bob was our fairly typical worker. He has a bachelor's degree and worked from age 25 to age 65. When Bob could expect to receive 100% of his benefit, his ROI for his Social Security taxes was 2.5%.
However, according to the Social Security Trustees, those benefits are going to have to be slashed to 70% of what they are today. Let's re-run the ROI calculator with those new numbers:
Average Salary: $52,500
Years Worked: 40
Taxes Contributed: $6,510 (annually -- includes both employee & employer contributions)
Monthly Benefit: $1,526
Value of Annuity: $288,150
New ROI: 0.525%
That's right. If benefits are slashed to 70% of what they are currently, then Bob will be earning the equivalent of about one-half of one percent on his taxes. Of course, since inflation is expected to dramatically increase in coming years, this means his real rate of return will be negative. What a system!
Punishing Minority Working Couples (or How I transferred wealth from black workers to white stay-at-home moms)
Social Security is very effective at transferring wealth -- from young black men to old white women. There are two primary reasons: life expectancy and the so-called "two-earner bias."
Life Expectancy
A black male born today has a life expectancy of 70 years. A white female has a life expectancy of 81 years. A black male, therefore, is less likely to receive benefits for more than a handful of years after retiring. A white female, however, can quite easily receive benefits for more than 20 years.
As a study by the Urban Institute found, when one accounts for mortality rates and other factors, black males have a real internal rate of return of 1.99%; white females, by contrast, have a rate of return of 3.2%.
That might not sound like much, but let's consider what that means in real numbers. Say a black male and a white female both invested $50,000 for 40 years at their different rates of return. At the end of 40 years, the black male has $110,000; the white female has $176,000. These rates of return really do matter.
Two-Earner Bias
This benefits disparity is complicated by differences in earnings and whether or not both individuals in a family are working. As Washington & Lee Law School professor Dorothy A. Brown explains it in a truly fantastic paper ("Social Security and Marriage in Black and White"):
"Social security benefits will generally be lower for a two-earner couple than a single-earner couple with the same total household income. In addition, for two-earner couples, the greater the wife's contribution to household income, the less she receives in spousal and survivor benefits."
The reasons for the benefits disparity are complex, and for the details I recommend you read Prof. Brown's excellent analysis, but the 30-second version is that Social Security treats spouses differently depending on whether they have worked or not.
For example, say both Couple A and Couple B earn $60,000 total household income. Couple A is a single-earner, and therefore the wife receives a benefit calculated on his income. Couple B is a two-earner family, and each person earns $30,000. The wife receives a benefit based on each individual's lower earnings (compared to the single-earner), and her own benefit is limited because of what is known as the "dual entitlement limitation."
Prof. Brown cites a quote from the Social Security Administration itself on the impact this has on two-earner families: "In some cases, a two-earner couple can receive total benefits that are one-third less than an otherwise identical one-earner couple's benefits."
What a system!
Don't Worry -- It Won't Be Around Too Much Longer Anyway
This section does not require a whole lot of elaboration. Even though Social Security is running a surplus right now, that won't last. According to the Trustees, the Trust Fund will become insolvent (that is, start paying out more than it is taking in) by 2040.
By 2084, it will be broke. I will most likely be dead by then, so it won't matter a whole lot for my personal finances. But it does mean that anyone born in 1990 or later would watch the funds run out unless we dramatically revamp the program.
What a system!
Social Security is a program facing enormous systemic problems: not only does it produce poor returns, but the future entails negative returns for many workers; it is a wealth redistribution system that actually transfers money from the poor to middle class and even affluent people; and bankruptcy looms for right around the time today's children are going to their mailboxes looking for a check.
And those are just the major issues.
Before identifying possible solutions, it is worth looking at how Social Security actually works. Importantly, Social Security is a type of program called "pay-as-you-go." In other words, taxes that are collected today are used to pay benefits tomorrow. Today's workers are paying for today's retirees. Bernie Madoff went to jail for a similar business model.
Fewer Workers, More Retirees
Still, pay-as-you-go was not necessarily a problem when Social Security was created. In fact, it made a lot of sense: in 1950, there were 16 workers for every retiree. Also, the retirement age was 65 and the life expectancy for someone born in 1930 was 60. Not only were there more workers to support the system, but also retirees were unlikely to receive benefits for more than a handful of years (if ever).
But then the Greatest Generation decided to have babies. And boy did they have a lot of them. This baby boom would not in itself cause a problem if the Boomers had maintained a similar birth rate as their parents, but they did not. Fewer babies meant fewer workers. By 1960, the worker-to-retiree ratio had fallen to 5:1. Today the ratio is 3.3:1. By 2050, that ratio will have fallen to 2:1.
Think about that for a second: each married couple will essentially have the responsibility for providing for most of the retirement income of an elderly Baby Boomer because Boomers have been horribly irresponsible at saving for retirement.
Higher Taxes or Lower Benefits?
Even the folks at Social Security acknowledge that either taxes will have to go up or benefits will have to go down. Right now, the Social Security Administration is planning on benefits going down. As the Trustees report states, benefits for future retirees will only be about 70% of what they are today. They say this like it's a good thing and we should be grateful that there will be anything left at all.
Of course, this reduction in benefits just makes a bad deal worse, kind of like when Darth Vader threatens Lando in The Empire Strikes Back:
Negative Returns (or how I lost money in Social Security)
Remember Bob? Bob was our fairly typical worker. He has a bachelor's degree and worked from age 25 to age 65. When Bob could expect to receive 100% of his benefit, his ROI for his Social Security taxes was 2.5%.
However, according to the Social Security Trustees, those benefits are going to have to be slashed to 70% of what they are today. Let's re-run the ROI calculator with those new numbers:
Average Salary: $52,500
Years Worked: 40
Taxes Contributed: $6,510 (annually -- includes both employee & employer contributions)
Monthly Benefit: $1,526
Value of Annuity: $288,150
New ROI: 0.525%
That's right. If benefits are slashed to 70% of what they are currently, then Bob will be earning the equivalent of about one-half of one percent on his taxes. Of course, since inflation is expected to dramatically increase in coming years, this means his real rate of return will be negative. What a system!
Punishing Minority Working Couples (or How I transferred wealth from black workers to white stay-at-home moms)
Social Security is very effective at transferring wealth -- from young black men to old white women. There are two primary reasons: life expectancy and the so-called "two-earner bias."
Life Expectancy
A black male born today has a life expectancy of 70 years. A white female has a life expectancy of 81 years. A black male, therefore, is less likely to receive benefits for more than a handful of years after retiring. A white female, however, can quite easily receive benefits for more than 20 years.
As a study by the Urban Institute found, when one accounts for mortality rates and other factors, black males have a real internal rate of return of 1.99%; white females, by contrast, have a rate of return of 3.2%.
That might not sound like much, but let's consider what that means in real numbers. Say a black male and a white female both invested $50,000 for 40 years at their different rates of return. At the end of 40 years, the black male has $110,000; the white female has $176,000. These rates of return really do matter.
Two-Earner Bias
This benefits disparity is complicated by differences in earnings and whether or not both individuals in a family are working. As Washington & Lee Law School professor Dorothy A. Brown explains it in a truly fantastic paper ("Social Security and Marriage in Black and White"):
"Social security benefits will generally be lower for a two-earner couple than a single-earner couple with the same total household income. In addition, for two-earner couples, the greater the wife's contribution to household income, the less she receives in spousal and survivor benefits."
The reasons for the benefits disparity are complex, and for the details I recommend you read Prof. Brown's excellent analysis, but the 30-second version is that Social Security treats spouses differently depending on whether they have worked or not.
For example, say both Couple A and Couple B earn $60,000 total household income. Couple A is a single-earner, and therefore the wife receives a benefit calculated on his income. Couple B is a two-earner family, and each person earns $30,000. The wife receives a benefit based on each individual's lower earnings (compared to the single-earner), and her own benefit is limited because of what is known as the "dual entitlement limitation."
Prof. Brown cites a quote from the Social Security Administration itself on the impact this has on two-earner families: "In some cases, a two-earner couple can receive total benefits that are one-third less than an otherwise identical one-earner couple's benefits."
What a system!
Don't Worry -- It Won't Be Around Too Much Longer Anyway
This section does not require a whole lot of elaboration. Even though Social Security is running a surplus right now, that won't last. According to the Trustees, the Trust Fund will become insolvent (that is, start paying out more than it is taking in) by 2040.
By 2084, it will be broke. I will most likely be dead by then, so it won't matter a whole lot for my personal finances. But it does mean that anyone born in 1990 or later would watch the funds run out unless we dramatically revamp the program.
What a system!
Tuesday, January 4, 2011
Social Security: A Bad Investment for Workers
Social Security is often described as the "third-rail" of American politics: touch it, and you get zapped. Even more deadly than its effect on politicians' careers, however, is Social Security's effects on the ability of workers to retire comfortably.
There have been several studies over the last several years analyzing Social Security's so-called Return on Investment (ROI). ROI is simply a measure of how well your money has performed over a given amount of time. For example, say you invest $1000 for 6 years. At the end of six years, your investment has grown to $1400. Your total ROI is 40% or your annualized ROI is about 6.7%.
Measuring Social Security's ROI is tricky business. First, Social Security is not a retirement account like an IRA or 401(k). Those accounts are simply investments that have different tax advantages. The idea is to grow them as large as possible before you retire. Once that money is spent, it's gone forever. There is also no survivor benefit, aside from what your heirs would stand to inherit normally.
Social Security, on the other hand, provides perpetual income and insurance. Regardless of how much you paid into the Social Security system during your career, you are entitled to receive payments as long as you are alive. Additionally, there is a small cash benefit provided to your surviving spouse after you die, and your spouse may be entitled to receive a portion of your benefits after your death. Finally, Social Security is protected against inflation.
For these reasons, studies that compare Social Security to simple retirement accounts are hopelessly flawed. They undervalue the worth of Social Security benefits -- and as a result make it appear that the ROI for Social Security is exceptionally low.
A more reasonable approach is to value Social Security the same way one would value an annuity. While there are many types of annuities -- some good, some bad -- a basic, run-of-the-mill annuity functions similarly to Social Security. After you purchase the annuity, the carrier has an obligation to pay you a defined benefit each month (based on the size of the annuity), plus a survivor's benefit if you have purchased that option.
Using this approach, the Wall Street Journal's Brett Arends calculated that the value of the annual average Social Security benefit would be worth about $250,000 as an immediate annuity with inflation protection. This seems a fair valuation. It is simply based on what it would cost a 66 year-old retiree to purchase an immediate annuity that pays out $14,000 per year for the rest of the individual's life.
Mr. Arends also points out that Baby Boomers have been notoriously bad at saving for retirement: "[F]ewer than half of workers have saved even $25,000, and only a third have saved as much as $50,000. Forty-four percent have saved less than $10,000, and a quarter have basically nothing saved at all."
Now that's scary.
But workers have been saving for retirement, in a way. First, they pay 6.2% of their wages into Social Security (matched by an employers contribution of 6.2% as well). Second, many families have mistakenly bought into the notion that "your house is your biggest asset" and consequently have most of their wealth tied up in where they live.
The burst housing bubble should hopefully put to rest forever the notion that continuously rising housing prices will be enough to finance your retirement. That leaves us with a return to the first savings option of most workers: Social Security.
So what is the Return on Investment in Social Security? And how does it compare to other options?
First, let's take an average worker, Bob. Bob started working full-time at age 25 after receiving his Bachelor's degree. According to the US Census Bureau, Bob can expect to earn $2.1 million from the time he is 25 until he is 64. That translates to an average annual salary of $52,500 per year over 40 years.
Bob himself pays 6.2% each year of that salary, and his employer makes a matching contribution. Each year, Bob and his employer pay $6,510 toward his Social Security benefit. When Bob retires at age 66, the Social Security Administration estimates that his monthly benefit will be $2,181. His annual benefit will be $26,172.
What would that cost as an annuity? According to ImmediateAnnuity.com, Bob would need to pay about $425,000.
We now know how much Bob and his employer have paid into Social Security, as well as the real value of his Social Security benefit. We can do some fancy arithmetic to find the ROI Bob would need to earn on his $6,510 annual contribution to Social Security to reach $425,000.
The answer? 2.25%
Yes, Bob and the employer are getting ripped off. What this number means is that in order for Bob to have the equivalent in 40 years of $425,000, he would only have to invest his money in instruments that genererate a palty 2.25% in interest each year.
Even if we just base our calculations on Bob's contribution and ignore the cost to his employer, the ROI only goes up to around 5%. Even in this era of historically low interest rates, a 30-year Treasury bond is yielding around 4.25%.
In other words, the ROI for Social Security really, really stinks.
How much monthly income would Bob get if he were left to his own devices and were able to purchase an immediate annuity with the money he otherwise would be paying to Social Security?
Let's assume that Bob were able to invest his money at an average annual return of 7%. While this is a respectable return, it is well below the S&P historical average of about 9%. Of course, Bob -- being a savy investor -- is going to make his portfolio more conservative as he gets older, so he's OK with the lower yield.
After 40 years, Bob would have saved approximately $700,000 -- not including his employer contributions. With that $700,000, Bob purchases an annuity with survivors benefits.
His monthly income? $3,700 per month, or $44,400 per year. For those keeping score, that's 1.7 times the amount of his Social Security check. And at half the cost to the private sector.
Social Security reform is coming, one way or another. Regardless of the social merits of Social Security, as a financial proposition, the program stinks. If we want to preserve the legimitate positives of a social security system, our elected leaders must get away from the current Ponzi scheme-inspired business model.
Stay tuned for a future post outlining my suggestions to create a viable, durable system that makes sense for America's workers.
There have been several studies over the last several years analyzing Social Security's so-called Return on Investment (ROI). ROI is simply a measure of how well your money has performed over a given amount of time. For example, say you invest $1000 for 6 years. At the end of six years, your investment has grown to $1400. Your total ROI is 40% or your annualized ROI is about 6.7%.
Measuring Social Security's ROI is tricky business. First, Social Security is not a retirement account like an IRA or 401(k). Those accounts are simply investments that have different tax advantages. The idea is to grow them as large as possible before you retire. Once that money is spent, it's gone forever. There is also no survivor benefit, aside from what your heirs would stand to inherit normally.
Social Security, on the other hand, provides perpetual income and insurance. Regardless of how much you paid into the Social Security system during your career, you are entitled to receive payments as long as you are alive. Additionally, there is a small cash benefit provided to your surviving spouse after you die, and your spouse may be entitled to receive a portion of your benefits after your death. Finally, Social Security is protected against inflation.
For these reasons, studies that compare Social Security to simple retirement accounts are hopelessly flawed. They undervalue the worth of Social Security benefits -- and as a result make it appear that the ROI for Social Security is exceptionally low.
A more reasonable approach is to value Social Security the same way one would value an annuity. While there are many types of annuities -- some good, some bad -- a basic, run-of-the-mill annuity functions similarly to Social Security. After you purchase the annuity, the carrier has an obligation to pay you a defined benefit each month (based on the size of the annuity), plus a survivor's benefit if you have purchased that option.
Using this approach, the Wall Street Journal's Brett Arends calculated that the value of the annual average Social Security benefit would be worth about $250,000 as an immediate annuity with inflation protection. This seems a fair valuation. It is simply based on what it would cost a 66 year-old retiree to purchase an immediate annuity that pays out $14,000 per year for the rest of the individual's life.
Mr. Arends also points out that Baby Boomers have been notoriously bad at saving for retirement: "[F]ewer than half of workers have saved even $25,000, and only a third have saved as much as $50,000. Forty-four percent have saved less than $10,000, and a quarter have basically nothing saved at all."
Now that's scary.
But workers have been saving for retirement, in a way. First, they pay 6.2% of their wages into Social Security (matched by an employers contribution of 6.2% as well). Second, many families have mistakenly bought into the notion that "your house is your biggest asset" and consequently have most of their wealth tied up in where they live.
The burst housing bubble should hopefully put to rest forever the notion that continuously rising housing prices will be enough to finance your retirement. That leaves us with a return to the first savings option of most workers: Social Security.
So what is the Return on Investment in Social Security? And how does it compare to other options?
First, let's take an average worker, Bob. Bob started working full-time at age 25 after receiving his Bachelor's degree. According to the US Census Bureau, Bob can expect to earn $2.1 million from the time he is 25 until he is 64. That translates to an average annual salary of $52,500 per year over 40 years.
Bob himself pays 6.2% each year of that salary, and his employer makes a matching contribution. Each year, Bob and his employer pay $6,510 toward his Social Security benefit. When Bob retires at age 66, the Social Security Administration estimates that his monthly benefit will be $2,181. His annual benefit will be $26,172.
What would that cost as an annuity? According to ImmediateAnnuity.com, Bob would need to pay about $425,000.
We now know how much Bob and his employer have paid into Social Security, as well as the real value of his Social Security benefit. We can do some fancy arithmetic to find the ROI Bob would need to earn on his $6,510 annual contribution to Social Security to reach $425,000.
The answer? 2.25%
Yes, Bob and the employer are getting ripped off. What this number means is that in order for Bob to have the equivalent in 40 years of $425,000, he would only have to invest his money in instruments that genererate a palty 2.25% in interest each year.
Even if we just base our calculations on Bob's contribution and ignore the cost to his employer, the ROI only goes up to around 5%. Even in this era of historically low interest rates, a 30-year Treasury bond is yielding around 4.25%.
In other words, the ROI for Social Security really, really stinks.
How much monthly income would Bob get if he were left to his own devices and were able to purchase an immediate annuity with the money he otherwise would be paying to Social Security?
Let's assume that Bob were able to invest his money at an average annual return of 7%. While this is a respectable return, it is well below the S&P historical average of about 9%. Of course, Bob -- being a savy investor -- is going to make his portfolio more conservative as he gets older, so he's OK with the lower yield.
After 40 years, Bob would have saved approximately $700,000 -- not including his employer contributions. With that $700,000, Bob purchases an annuity with survivors benefits.
His monthly income? $3,700 per month, or $44,400 per year. For those keeping score, that's 1.7 times the amount of his Social Security check. And at half the cost to the private sector.
Social Security reform is coming, one way or another. Regardless of the social merits of Social Security, as a financial proposition, the program stinks. If we want to preserve the legimitate positives of a social security system, our elected leaders must get away from the current Ponzi scheme-inspired business model.
Stay tuned for a future post outlining my suggestions to create a viable, durable system that makes sense for America's workers.
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