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.
6 comments:
That's a very good analysis. What changes would you propose be made to Social Security that don't involve killing the program and that Congress would actually try to do? What could the government do to get a better ROI?
Too many people, especially on the poorer end, rely on Social Security for retirement and they can't be counted on to save for themselves. Is that the government's responsibility? Should savvy savers be forced to pick up the slack? I don't necessarily think so, but the program is already set up. How long it stays properly funded and all that is another thing. Assuming Social Security sticks around in a form similar to what it is now, how is it made to be sustainable?
Unless I misunderstand the system, Social Security is not meant to be a retirement investment for an individual, but rather it is meant to provide some means of subsistence for all persons above a certain age. Accordingly, while for an individual it is not necessarily a return maximizing investment, the theory underlying the system is not to obtain a return maximizing investment. Social Security serves as a forced mechanism for saving, but also a forced mechanism for assistance to others. The problem, as I see it, is not that Social Security provides a poor ROI, but rather that the government dipped into the coffers of Social Security while more workers were paying in that payments were going out (baby boomer generation working), and now the inverse is true (baby boomer generation retiring) and there is no money in the fund to account for the discrepancy.
@B: Thanks! As for your excellent questions...stay tuned: those are the themes of my next post!
@McTwo: I think you're right that the original intent of Social Security was not to provide retirement income, but to cover subsistence expenses.
The original inception of Social Security simply involved a lump-sum payment for workers. Widows and a few others were entitled to monthly payments beginning in 1940. That system evolved into the one we have today.
The original system also had much, much lower tax rates. From 1937 until 1949, only 1% of the first $3000 of your income was taxed (about $45,000 in current dollars). In other words, each year, the most any one individual would have to pay was the equivalent of $450. From that standpoint, Social Security was a great deal: you're basically buying a really, really cheap insurance policy every year that guarantees you won't starve in old age! I think we can all agree that is a laudable program.
Then the Great Society happened. Social Security's scope widened enormously. Both benefits and tax rates skyrocketed. (Consider that in 1939 the most a worker could pay was the equivalent of $450 -- in the example I created, Bob paid about $3255, or over 700% as much.)
At that point I think it became less about insurance against starvation and became, as you put it, "a forced mechanism for saving."
Combine that with the other phenomenon that Mr. Arends described: Baby Boomers have simply not saved anything else up for retirement. Rightly or wrongly, intended or not, Social Security has become the de facto retirement plan for most Americans.
As for your comment about raiding the Trust fund, I've always been curious about the truth of that. Republicans accused Democrats of it in the 80s, Democrats accused Republicans of it in the 90s, and then we were back to the Democrats accusing the Republicans of it under President Bush.
Here's what the Social Security Administration itself says about it: "The assets of the larger trust fund (OASI), from which retirement benefits are paid, were nearly depleted in 1982. No beneficiary was shortchanged because the Congress enacted temporary emergency legislation that permitted borrowing from other Federal trust funds and then later enacted legislation to strengthen OASI Trust Fund financing. The borrowed amounts were repaid with interest within 4 years." emphasis added
It's probably more complicated than that, but it sounds like the funds were raided but were later repaid.
CRAP I left a big thoughtful comment and it disappeared. Ah well. The point was this: I agree SS stinks, but it is unwise for individuals to assume average returns (from stocks or elsewhere) of 7-11% for retirement planning. There's no such thing as the "average" -- no one has 2.2 children. Be old school: Earn more than you spend, save, avoid debt. You can't predict the future.
My comment was much warmer and more humorous than that, but it's gone so you get this short cranky version.
PS -- If Bob personally gets 5% ROI from SS, that's not bad compared to my 0.4% savings account or 0.9% CDs. Thank you Alan and Ben!
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