Today I came across a great article on The Dough Roller about Social Security. The post includes a great table that shows how much people at different incomes can expect to reap during retirement from everybody's favorite entitlement program. I have always resented the amount taken out of each check for social security, but today I learned something new. It really isn't all that bad for most people. The average person can expect to get $15,570 each year. This is is equivalent to buying an annuity which would cost $225,000. So at least you get something for all of the money that disappears from each check. Based on the present numbers it seems the social security isn't quite as big a rip off as I had thought. As it stands now, paying 6.2% of your gross earnings over your career gives a high earner 28% back every year for life.
I ran some of my own numbers assuming both no investment returns and an 8% return on contributions. An important thing to remember, which I originally forgot to include, is that your employer contributes an equal amount to Social Security in addition to the employee amount. My salary projections started at $97,500 (the Social Security ceiling for 2007) and, adjusted for inflation of 3% per year, topped out at $299,000 by 2045. I will pay $437k into social security before I hit retirement at age 62 (and my employer will match that amount). Assuming an 8% return that money would compound to $4.37 million dollars. That is equal to $1.42 million today. Wow! How does that compare to what Social Security actually pays out?
If I get 28% of my final salary in social security payments it would be approximately $83,000 per year. An equivalent annuity, would pay $83 per year for life starting at retirement and would cost $2.09 million dollars. In other words, I loose about half of the [$4.37 million] compounded contributions . Social security also includes disability and life insurance benefits, however these amount for only a tiny fraction of the $2,280,000 that disappeared.
The actual annual rate of return on contributions made to social security is around 4.75%. This is slightly below the historical average for government bond yields. If you factor in the tax deduction (SS taxes are deducted from gross income), assuming the 25% bracket, the return moves to a slightly more respectable 6%. This rate does indeed beat government bonds by a small margin so I'd consider it to be only a moderate rip off.
I am still young (24 years old) so I fully expect social security to change A LOT from now until I retire. Current projections indicate that there will be a shortfall of funding for the program of about a quarter of promised benefits starting in 2041 (4 years before I plan to retire). A 25% reduction in benefits seems almost certain but the cut may be even more by the time I retire.
If benefits are cut 25% and I only get 21% of my final salary I could take home $63,000 each year in retirement. Even in the best case, with a 25% tax deduction included, it would add up to a mere 4.7% annual return. That is a pretty sad return when you consider government bonds have averaged ~5.75% since World War II. If benefits get rolled back and no change is made to the payroll tax rates, it will dramatically reduce the value of Social Security to the middle and upper middle class.
Creating private accounts is one solution which could allow for returns of better than 4.7%. It may be a free market solution to the poor performance of Social Security. I would suggest taking a fixed percentage from all employees paycheck (tax free) and placing it into a fund similar to the government employees Thrift Savings Plan. It would offer a limited selection of broadly diversified index funds in which retirement money would be invested. The additional risk will need to be counter-balanced with a true insurance program that protects against market failures. This system would then replace our our current fixed check-a-month system of entitlement.
For now, Social Security is not as big a rip off as I had thought, even for those at the top end of the earning scale like I am. However, the 25% reduction in benefits would hurt the fairness of the program a great deal and drop rates to an intolerable level. We need to recognize now how unfair it would be to our workers to force them to earn below market returns on their contributions because we do not have the political will to make the needed changes. A free market return on all of their retirement investments, including Social Security, is the only fair way to fund retirement.
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