Saving Social Security - Island of Sanity

Island of Sanity



Wealth & Poverty

Saving Social Security


Democrats and Republicans regularly vie with each other over who has the best plan to save Social Security. Each claims that the other is driving the system into bankrupcy or gutting essential benefits or whatever, while only they have a proposal that will keep it going.

But this debate completely skips over what would seem to be the first question we should ask: Is Social Security worth saving?

What you pay into Social Security

Let's make an elementary calculation. According to the census bureau, the average American makes about $40,000 per year. Social Security taxes are presently 6.2% of your gross income. So if you're making $40,000, you will pay $2,480 per year. In addition, your employer is required to pay an equal amount in your name. So $4,960 per year are paid into your Social Security account. If you start working at your first "real" job when you are, say, 21, and continue until Social Security's "full retirement age" of 67, you will pay this amount for 46 years, for a total of $228,160.

(Of course most people start out making much less than $40,000 and their income increases as they gain experience in their field, but this is an average amount. Presumably you make less and thus pay less in taxes in the beginning, and make more and thus pay more in taxes late in your career.)

What you get out of Social Security

With this income, you would qualify for a Social Security retirement benefit of $1352 per month. According to the US Centers for Disease Control, the average American lives to be a little under 77. So you could expect, on the average, to collect these benefits for ten years. $1352 per month times 12 months times 10 years gives a total benefit you would receive of $162,240.

That is, under the present rules and formulas, the average American who begins working in 2001 will pay $228,160 into the system, and receive $162,240 back. You will lose over $60,000 for the privilege of loaning your money to the government for 40 years.

Note: I am not taking inflation into account in these calculations, but that is pretty much irrelevant: Social Security automatically adjusts all the numbers involved for inflation each year.

I have to wonder: If a private company offerred its customers such a deal, would they be investigated by the authorities for fraud? Interestingly enough, even running a scam like this the government is losing money: the Social Security system is projected to go bankrupt in the year 2038. That may sound like a long time away, but if you were born after 1971, you won't reach Social Security's full retirement age until after that date, that is, you're paying into a system that is projected to be bankrupt before you can expect to receive a dime in return. Even if you were born before then, if you're still alive and receiving benefits at that time, it's not at all clear that they'll continue. How can you go bankrupt by taking $220,000 from someone, keeping it for 40 years, and then giving him back $160,000? I don't know -- ask the government.

Note: For the mathematically inclined -- or the skeptical -- my calculations are all given at the end of this article.

Consider an alternative

Suppose instead you were permitted to put that same amount of money into an IRA or 401k or some other type of retirement fund, and your employer paid the same matching amount into such a fund. I have several such accounts that are generating returns between 10% and 20%. Over the past 30 years the stock market has averaged 14% per year annual growth. These numbers should be adjusted for inflation, but I think it is fair to say that one could get a return of 10% over inflation without a great deal of difficulty. Suppose you get just 5% over inflation.

Over the course of 46 years you would pay in that same $228,160. Through the power of compound interest, you would earn an additional $608,518, for a total of $836,678. Suppose you then withdraw only the returns on this money, and don't touch the principle. You would have $3,486 a month to live on for as long as you lived.

That is, if instead of putting money into Social Security, you were permitted to put exactly the same amount of money into a mutual fund or similar retirement account, you would be able to retire with over 250% of the monthly income that Social Security provides! And when you died, you would leave over $800,000 to your children or whomever, as compared to Social Security's death benefit of $255.

Remember these calculations are all based on your retirement fund getting a return of just 5% over inflation, which would make it one of the worst-performing retirement funds in the country. You could almost certainly do better than this.

Suppose they pulled the plug

Suppose that tomorrow the government announced that Social Security was abolished. No more benefits will be paid. Any money you have already paid into the system is simply lost. But you are no longer required to pay taxes into the system.

This would, of course, be devastating for someone who is already retired and living on his Social Security, or someone who was planning to retire soon. I'm certainly not suggesting that the government do this.

But here's an interesting fact: Under these circumstances, anyone who is less than 50 years old would still collect more when they retired then they would have under Social Security! That is, you would be better off to just throw away 29 years of payments into Social Security and start over again with a private plan at age 50, then to continue with Social Security. (This assumes you put the money into a retirement fund paying that same paltry 5%, and lived that same average ten years after retirement.)

A Thought on Fairness

I've based all the above calculations on statistics about the "average American". Let's break this down racially: The average African-American male makes only $26,600 per year, and so in 46 years will pay about $151,800 into the system, significantly less than a white person. His benefits are also less, about $1030 per month. But the average African-American male lives to just over 67 1/2. Thus, a black man can expect to collect Social Security retirement benefits for a little over six months, or about $6,180. The remaining 96% of what he paid in goes to white people.

Therefore, every year, Social Security takes billions of dollars from poor black people and gives it to rich white people.

Objections

I have heard several objections to what I say here. Let's deal with a few:

Objection: You are assuming that a person will only live to the average life expectancy and thus collect benefits for only 10 years. But many people live longer than this.

My reply: Sure. But many people don't live this long, too, which is why it's an "average". Many people pay into Social Security all their lives and then die before reaching retirement age, and never receive a penny in return. If they were in a private plan, they would at least have money to leave to their children.

Objection: Private investments are risky. Okay, for the past few decades the stock market may have been averaging 14% returns, but there is no assurance that it will continue to do this well in the future. And any given retirement fund may do much more poorly than any large-scale averages. Social Security benefits, on the other hand, are guaranteed.

My reply: Social Security benefits are only "guaranteed" in the sense that the government has written a number on a piece of paper and said that this is the amount that they will pay. Congress can change the formulas at any time. Indeed, Congress has tinkered with the formulas a number of times in an attempt to remedy various claims of unfairness or to keep the system solvent. For the average mutual fund to do worse than Social Security would require the stock market to take a beating far worse than anything that has happened in US history. If that were to happen, sure, people who relied on mutual funds would not get anything like the retirement income they expected. But if the economy were to suffer such a severe downturn, it is not at all clear that the government would be able to continue to pay Social Security benefits at the current levels. After all, that money has to come from taxes, and if the economy is going down the tubes, tax revenues are going to fall.

With a private retirement account, there are risks, but the money belongs to you, and the only risks are those you choose to accept. With Social Security, the money belongs to the government, and you are totally dependant on the government's decisions about how much you need and it can afford to give you.

Objection: It may be that the AVERAGE peson would do better with a private retirement fund than with Social Security, but surely there would be some people who would choose funds that end up losing money or going broke. Social Security insures that every American gets at least a minimal retirement income.

My reply: People suffer misfortune because they make poor decisions or simply have bad luck all the time. I think a reasonable solution to this problem is to provide assistance to those who get into trouble. Social Security protects some number of people who would have made poor investment choices from the losses they would have sufferred, but it does this by also "protecting" the vast majority of people who would have made good or even mediocre choices from the benefits they would have gained. In practice, Social Security has proven to be one of the absolute worst investments in the world. Yes, there are some investments that are even worse, but far more people are being protected from success than are being protected from failure.

Objection: If people were not required to pay into Social Security, some number will not bother to save for retirement at all, and will end up on welfare. People who DID save for retirement will then have to pay twice: once when they put away for their own retirement, and again when they pay taxes to support those who failed to save. The fair thing to do is to require everyone to pay into the system to prevent anyone from freeloading.

My reply: Yes, it can be tricky to construct a system that encourages responsibility while providing compassionate assistance to people who make poor decisions. But it is not at all clear that the best way to solve this problem is for the government to force all the citizens -- presumably under threat of imprisonment -- to do what governments burocrats consider responsible. Especially in a case like this, where simple arithmetic shows that the plan put together by the burocrats is far worse than what most people would do on their own. Many people grumble about welfare, how people who are lazy sometimes take advantage of the system. Surely there is validity to these complaints, but just as surely, society has managed to survive the problem. It is not at all clear that we would be better off if the goverment took over all employment and forced everyone to work at some big government-run labor camp to prevent free-loading.

Objection: Your comparisons are unfair. Social Security is not just a retirement program, but also provides benefits to handicapped and disabled people. Some of the money you pay in Social Security taxes goes to provide these disability benefits, while all of the money you pay into a retirement fund goes to retirement.

My reply: I concede, there is indeed some validity to this objection. According to the Social Security Administration, about 15% of Social Security taxes go to pay disability benefits. Of course any money a person put away for retirement could also be used if that person became disabled, but if someone was disabled early in life they might well not have had a chance to put away very much money before they were no longer able to work. To make this comparison fair we should assume that an amount of as much as 15% of what you are presently paying into Social Security would have to go to some sort of disability program -- whether it was private disability insurance, a government-run program, or some combination of the two.

So take my alternative calculation and subtract 15% from it. Instead of having $836,768 when you retire, you would have "only" $711,253, and you would only be able to make monthly withdrawals of $2,964. This is still 219% of what Social Security would pay with the same contribution.

Note that this assumes that the 15% is simply lost. To be truly fair to the private plan, somwhere we would have to factor in the probability that you would become disabled and receive benefits in return for this 15%.


Calculations

Taxes

gross income $40,000
employee's tax at 6.2% 2,480
employer's matching tax 2,480
total annual tax per employee 4,960
times 46 years 228,160

Any income above $84,000 [check this number] is not taxed and is not counted when computing benefits.

Benefits

The basic formula is: List your gross income each year since you started working. Adjust the amount for each year for inflation. Then take the average of these adjusted incomes for your 35 best years. (If you do not have income for a full 35 years, average in as many zeros as are necessary to bring the total to 35.) Divide this by 12 to get a baseline monthly income. Then calculate the monthly benefit as follows:

from thru multiply by
$0 $531 90%
532 3202 32%
3202 15%

The maximum benefit is $1,536 per month.

If you retire early, this amount is reduced. For example, if you retire at the earliest possible retirement age, 62, benefits are reduced by 20%.

Various other special rules apply to various other special situations.

An Alternative

This table assumes 5% per year return on inventment.

Year Returns New investment Ending balance
1 4960 4960
2 248 4960 10168
3 508 4960 15636
4 782 4960 21378
5 1069 4960 27407
6 1370 4960 33737
7 1687 4960 40384
8 2019 4960 47364
9 2368 4960 54692
10 2735 4960 62386
11 3119 4960 70466
12 3523 4960 78949
13 3947 4960 87856
14 4393 4960 97209
15 4860 4960 107030
16 5351 4960 117341
17 5867 4960 128168
18 6408 4960 139537
19 6977 4960 151473
20 7574 4960 164007
21 8200 4960 177167
22 8858 4960 190986
23 9549 4960 205495
24 10275 4960 220730
25 11036 4960 236726
26 11836 4960 253523
27 12676 4960 271159
28 13558 4960 289677
29 14484 4960 309121
30 15456 4960 329537
31 16477 4960 350974
32 17549 4960 373482
33 18674 4960 397116
34 19856 4960 421932
35 21097 4960 447989
36 22399 4960 475348
37 23767 4960 504076
38 25204 4960 534239
39 26712 4960 565911
40 28296 4960 599167
41 29958 4960 634085
42 31704 4960 670749
43 33537 4960 709247
44 35462 4960 749669
45 37483 4960 792113
46 39606 4960 836678

Pulling the Plug

How much would you need to match what Social Security would pay? You would need a sum of money at retirement such that, if you withdrew an amount equal to what Social Security would pay each month, you would run out of money on the day you died. We can calculate this amount based on life expectancy. Again, we will assume the same 5% rate of return as you are withdrawing money.

The actual calculation is a bit complex, so rather than going into some tedious mathematics, let me just give you the result and demonstrate that it is correct.

The answer is: You would need about $126,000.

To match Social Security, you must withdraw $1352 per month for ten years. $1352 per month is $16,224 per year. Thus:

Year Returns Withdrawal Ending balance
0 126000
1 6300 16224 116076
2 5804 16224 105656
3 5283 16224 94715
4 4736 16224 83226
5 4161 16224 71164
6 3558 16224 58498
7 2925 16224 45199
8 2260 16224 31235
9 1562 16224 16572
10 829 16224 1177

To see how long it would take to accumulate this much, we need only look at the "Alternative" table and see when it first passes $126,000. This occurs in year 17.

Thus, it would take 17 years of saving for retirement to accumulate enough money to match what Social Security is likely to pay you. If you are going to retire at 67, then you would need to start such a plan by age 50.

It would, of course, be risky to plan your retirement so that you run out of money on the day you reach the average life expectancy. What if you are so unfortunate as to live longer than average? You would be broke. So I am not suggesting the above as a good retirement plan. I am just calculating the amount of money you would have to have to exactly match what Social Security would pay, assuming that you were average in all relevant respects. In real life I would certainly encourage anyone to have a plan that would have them not run out of money until well beyond any reasonable life expectancy, or better yet, a plan where you live purely on the returns and never dig into the principle at all.

© 2001 by Jay Johansen


Comments

Hamdani Jul 24, 2014

1)Do you think you'll have enough money for a colroftabme retirement?Does not apply. I love my career as an artist and hope to die with the tools of the trade in my hands.2) Do you plan on receiving the social security benefits that have been promised to you?Sure, I'm a boomer. I plan to tap in at 62. But my intent is to pass it along every month to someone in one of the following generations. There's some delicious irony there.3) What % of your income do you save today for retirement?When I work my savings rate is usually around 40-50%. But let me say that life so far has been like a long summer vacation. I have taken as much as a year to enjoy myself and recharge my batteries several times in my adult life. I rarely reject an offer to go river rafting or fishing (which are very low cost and high enjoyment activities). On the financial side, I sold my suburban home four years ago and rent a small farm now. The cash is well invested (I hope) since it has more than doubled in that time. To buy in my locale would cost me at least triple what I now pay in rent. 4) Where would you like to retire?I'm an avid, no, really I'm a compulsive food gardener and tree grower. Soil, water, four real seasons and open spaces blow my skirt up. I'll stay in the USA and take my chances with the coming times since my tribe is here. 5) How old are you, and what age do you plan on retiring?The answer to part one is that I'm just about to turn 61. For part B see the above.A little rambling: The real goal is to have a good life. Keep it simple and full of heart. Be joyful doing vigorous work. Eat healthy food not poisonous crap. My key to having enough money has been to tighten down the outflow spigot rather than exert myself in the mind numbing quest for big bucks. Oh yeah, exchange goods and services with others because the return is much greater (though a bit difficult to quantify). You have all seen pictures of some ancient and very wrinkled peasant in bib overalls holding a bunch of grapes with a twinkle in his eye and a wise smile on his face. This is not a bad goal. Finally, it is better to die deservedly well loved than rich.

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