Social Security: A Bad Return

Author: Vale

social securityWe all know what social security is, so I will be brief with the introduction to highlight the key points. Essentially, it is a required government program that taxes earnings 7.65% (including Medicare) below a cap (currently $113,700) and 1.45% of all earnings above that. They also require your employer to contribute the same amount.

With the new Obama-Care law that passed, 0.9% is taken from investment income for those with earnings above $200,000 per year (one simplifying assumption for the analysis below is that the new investment tax or the 1.45% on earnings above the maximum dollars subject to the social security tax are not considered). Social Security currently comprises 25% of the Federal government spending, but it is set to rise in the future.

Social Security is akin to a forced savings program, but you have no control over those savings, and it is a one size fits all solution. Here are the facts:

  • The money you contribute doesn't go into an account, but instead goes directly to workers who are currently retired today.
  • When you die, nothing you contributed to the system that wasn't taken out goes to your heirs.
  • You could pay into the system your whole life and die before ever taking out a payment and the government doesn't even bother to send your family a thank you card for the optimal outcome.
  • You cannot set your asset allocation to change your rate of return.
  • The whole system depends on a promise built with IOUs from an overly indebted government.
  • With each generation, the benefits are reduced and the tax rate increased, which means that each successive generation obtains a worse return than the previous.
  • Things are only scheduled to get worse as the 'trust' (an accounting book) is scheduled to be exhausted in 2033 according to the official report by the Social Security Administration (SSA) [page 29].
  • The current unfunded liability of social security is $8.6 trillion [page 27].


It's always bad policy to create a new government program that will last until the end of time (or until collapsing) based solely on the current economic conditions. Social Security started out as a government spending program right in the middle of the Great Depression in 1935 to alleviate the poor economic conditions for seniors. The first generation of benefits paid out to retirees were not paid for by taxes collected over their careers. This created a legacy debt and then the program turned into a giant wealth transfer program as taxes were collected from the young and paid to the old. For example, the first monthly retirement check was issued to Ida May Fuller who contributed $24.75 to the system over three years but pulled out $22,888 over 35. It was a fantastic return for her, but not for future generations. Moreover, back in 1945, the ratio of workers paying into the system to beneficiaries drawing from the system was 41.9. By 1955, it had already dropped sharply to 8.6 and today it is about 2.8 [page 61]. The Ponzi scheme started to unravel from the moment of inception because more "investors" could not be added to the system as families got smaller (but at least in a Ponzi scheme, you can choose not to participate!). As the baby boomers begin to retire, the ratio of retirees to workers will be the highest it has ever been. It was bad government policy then and it is even worse policy today.

Eased In
When the program was first introduced, the government implemented the usual tactic for pushing through a new social program and sold it as having a small tax impact. Back then, the Social Security tax was 1% on income up to $3,000, but it has steadily increased nearly 8 fold from its onset. Congress would never be able to push through a double digit tax (including employer contribution) from inception, which is why they resort to the usual tactic of creating a new tax with an insignificant starting rate, but then increase the rate slowly over time. Taxes of all kind start out small and insignificant, and as the populous gets used to it, politicians tweak it a little higher to cover 'new costs' or 'fund a new project' or 'cover a deficit'. Taxes never seem to have an upper bound. At the margin, any increase is pretty insignificant, but over time, the absolute rate can be quite large. When the government claims that the introduced rate is "the most you will ever pay," don't bank on it. It's the proverbial boiling frog.

The Contribution is Actually Double
Before continuing, I just want to emphasize one part of the discussion that doesn't get enough attention and that is the fact that your employer has to pay a matching contribution to the system. Usually businesses mark this down as part of your compensation or as a cost of doing business, but have you considered how much extra money you could instead be paid if they were not forced to pay the government the extra 7.65% on top of your compensation? The employer has to pay this money regardless as the law stands, so wouldn't it be better if some or all of it went to you instead? There are those who think that the employer contribution doesn't count because the line item doesn't show up on their paycheck, but they should keep in mind that they are, in fact, the ones working for it, so they are indeed the ones paying for it. It doesn't really matter who is the one dropping the check in the mailbox to the government.

Rate of Return on Investment
So key to the discussion is that most people will never know what their rate of return is from being required to participate in the SS system. This is a serious lack of information for taxpayers. Many people also do not realize that Social Security has some welfare characteristics to it and it might be better aptly named "Socialist Security" because of its redistributive properties. The higher your income is, the worse of a return you receive and the lower your income is, the higher the return you will receive. Of course, in both situations the return is dismal, as I show below. But perhaps if more people knew if they were getting a poor deal, there would be more pressure for an opt-out option, or pressure for an option to allow participation in Private Retirement Accounts (PRA). Twenty eight countries have PRAs as part of their Social Security plans. A lot of them are considered "third world," so why are their retirement systems so much more advanced than ours?

Your Estimated Return
Would you like to know what your rate of return is? Your actual rate of return won't be known until you die, because the number of years drawing from the system is critical to the valuation: how much money did you put in versus how much money did you pull out? The Social Security Administration occasionally publishes return figures for several scenarios, but they use "simulations." They've been running the system for 78 years, so why can't they publish some statistics related to actual outcomes? Well, the first reason is because taxes have increased a lot over the time since inception and benefits have been reduced, so any historical figures would overstate returns of today. And the second is because with simulations, they can alter the assumptions to improve the resulting outcome. The critical assumption is the interest rate used to value the annuity of future payments that results from the value of benefits. If the SSA wants to increase the apparent value of the benefits, then they would use a lower interest rate to decrease the loss in the time value of money. They do indeed use low yielding Treasury rates, but it is a defensible assumption if considering that it is the 'risk-free' rate. Aside from the obvious disbelief for most people about Social Security being risk-free, or our government debt for that matter, an alternative rate to use would be the opportunity cost rate - the rate that one could receive in the marketplace by investing in a diversified portfolio.

Modeling Overview

In my analysis below, I also use the risk-free rate so as not to "cook the books," but if I really wanted to destroy the results then all I would have to do is usetableI the opportunity cost rate. I compare the Social Security annuity value to the value one could have had in a PRA had they been allowed to invest the same amount of money in a diversified portfolio. More modeling assumptions are at the bottom of this page for those interested. However, the end result is that over a 10+ year career time span, the private diversified portfolio is almost certain to be a better deal.

Poor Outlook

tableIIFor those retiring in the future it is almost a near certainty that the rate of return is going to be poor. This is before even considering the trust fund path to exhaustion scheduled to hit in two decades that will reduce the return even further because of changes that will be required! If the government does nothing, the Social Security Administration has said that the 'trust' will be exhausted by 2033 and then they can continue paying benefits at 75%. If they raise taxes, the rate of return goes down. If they reduce benefits, the rate of return goes down. The only scenario that would improve the health of the trust fund is if lots of retirees started dying off at a younger age. Fortunately for families, but unfortunate for the health of the trust, we have the opposite situation with people living longer! All roads point to a dismal future for the money you pay into the system.

So here is what I found*: for those retiring today or the near future, the real rates of return are at least halfway acceptable because they are all positive for those with an average life expectancy (highlighted in green: 16 years expected after age 66 for a man). However, as mentioned before, the rate of return goes down the higher one's income is. I say that the returns are halfway acceptable because they are not stellar by any means, but at least they aren't negative. There is one caveat, however, because this analysis assumes that 2033 doesn't happen and benefits are never reduced. Therefore, this table can be thought of as a best case scenario. On the contrary, if one had been able to invest in a PRA earning a diversified market rate (to calculate the PRA rate, I use a modest interest rate of 6% that one could obtain with a balanced portfolio), the value of the SS benefit would have increased for all income levels for those with an average life expectancy. For example, for someone whose career ended with an income of $50,0000 a year, his monthly benefit with a PRA could be almost double what SS would provide to him. It is in both the government's and retiree's best interest to have PRAs because the government could capture additional money when the retiree died (the trust becomes more solvent), and the retiree could have a much larger annuity to live off as well.

Champions of the status quo hate the idea of PRAs for many reasons, but their points lack validity in a number of ways. Because higher income people pay more tax dollars, they would stand to benefit the most from the higher returns of PRAs. But the key point here is that everyone would be better off, even lower earning people. It is unfortunate that if a higher income person stands to benefit some way from a break in the status quo (even if it leads to more fairness or efficiency), this tends to bring out the nay saying, soak-the-rich crowd who will resist change at all fronts. Their mindset is that they would rather be worse off, so as long as someone else is not better off than them. It is not logical.
Another criticism of PRAs is that the investment industry would stand to profit somewhat from managing the funds.  One could respond that managing money is not free, and if the fees are not onerous and you are getting a much higher rate of return, then what is the problem? Do you also not invest in mutual funds because a fund might charge 0.30% even though it had an average return of 10%? Furthermore, since the SSA has trillions of dollars assets in the 'trust', this would make them the largest asset manager in the world. Are you telling me that the SSA would not have the ability to manage the PRA accounts themselves?

More Bad News


The future is much more bleak for people set to retire in the future. Current retirees will get a higher rate of return because the taxation and wage cap were lower throughout their careers and benefits started a couple of years earlier. You can estimate what your rate of return will be from the results in the table to the left. You have to know what your maximum career earnings will be and how long you will live. Both are unknown at this point, but if you assume you will live an average length of time and estimate what your maximum earnings will be based on your industry and experience, you have the approximate information you need. The first year's income cap is using the one effective today, but as long as your highest 35 years of earnings started after 1990 (when the top tax rate was implemented) and earnings were less than the income cap throughout your career, the results are applicable. I find that the real rates of return are only positive for the lowest earning citizens and negative for everyone else. For most people, SS will turn out to be a bad deal and this is a very unacceptable outcome. I use an average 3% rate of inflation expectation, even though since 1962 it has averaged 4%. If the rate of inflation increases substantially between now and your retirement date, your rate of return will decrease substantially. But remember that 'positive' rate of return is not synonymous with 'good' rate of return. Every earning bracket could have had more assets with a PRA because on average a diversified portfolio would earn more, especially over a period of time involving a career span.
But it gets worse. Remember the SSA concluded that the fund will be exhausted in 2033 and will have to reduce benefits by 25%. How does that change the returns? The table below shows that for every scenario the annual rate of return is negative. This is a dire situation. Would you knowingly put money into an 'investment' that will give you less than you put in? It would be better deal to put your money in a tin can and bury it in your backyard with inflation eating away its value than putting it into the hands of the government.tableV


So what can be done about Social Security? Liberals want to raise the tax rates without reducing benefits so that the entitlements remain the same (win over the senior citizen vote; the young vote is already locked up), whereas conservatives would prefer not to raise taxes again. Any young person should resist the call to raise taxes to cover Social Security shortfalls since the rate of return is worse than what they can get anywhere else in the marketplace. The system is broken. Throwing more money at the problem does not create a solution. A combined tax rate of 15% is too high already. The real iconoclasts should take it a step further and push their government representatives to introduce an opt-out option. They would be telling the world that they don't need big government to hold their hand and that they can accept some personal responsibility to cover their own affairs. For those worried about moral hazard (such as never saving a dime and then jumping on welfare during retirement), opting out could be conditioned on a yearly requirement to contribute the same amount of money to a 401(k) or IRA account (the tax would be collected, but refunded at the end of the year when the condition is met), and this is what I would recommend. Saving for retirement should be encouraged, but providing savers with a negative rate of return is not saving at all, it does not provide the right kind of encouragement, and it just takes away money that they could be saving in a 'real' retirement account. The failed government program needs to start winding down and this would be the step moving in the right direction. Call your representatives today.



*The career path is modeled with a sigmoid function to simulate a career development where earnings start off small, but grow rapidly through the mid-career and taper off towards the final maximum salary (I also compared it to a linear interpolation and found similar results). To calculate the monthly benefit, I use the formulas available on the SSA website. I next take the present value of the annuity for the five levels of drawing periods and 5 levels of income listed in rows of the table. And finally, I compute the interest rate that the compounded tax contributions would require to equal the present value of the annuity.


+2 # kwarner 2013-10-09 11:27
Wasn't it funny when Bush suggested privatizing only 1-2% of social security. The intent was one could direct his or her own money and live with the consequences. Additionally, it was your money to pass to your heirs upon death. The liberals and democrats realized that would mean less money to steal and less control over the populous, and started screaming about the idea. They said the average American would not invest the $$ correctly and would lose it. HOLY COW, what is happening sending all the $$$ to the gov. Talk about unable to manage the money. This belief of always increasing tax and spend more approach of the democratic party is bleeding and destroying this country.
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-5 # known 2013-03-06 02:29
The objective of Social security is to prevent race to the bottom and promote
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+5 # Vale 2013-03-06 19:28
So what you are telling me is that someone is supposed to wait until they are retired to become socially mobile? And then they are going to do that with $20,000 a year ($30,000 max benefits currently)? Try again.
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-3 # known 2013-03-07 01:16 Reply | Reply with quote | Quote
+1 # Self Reliance 2013-06-29 16:22
@ known,
That is covered by family, charitable organizations, humanitarian efforts. These will do a better job than the government in providing
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