My Social Security IRR

IRR (internal rate of return) was the common term for the percentage rate of return on an investment until the early 1990s, when CAGR (compound annual growth rate) gained popularity. Today, CAGR is typically used for simple annualized returns of regular cash flows, while IRR is reserved for more complex cases involving variable cash flows and irregular compounding periods. CAGR can be considered a simplified subset of IRR. IRR is typically backward-looking (based on present value), whereas CAGR is typically forward-looking (based on future value). These distinctions are observations of usage more than strict definitions.

To Dr. Quinn’s chagrin, I’ve always viewed Social Security and Medicare deductions as pure taxes I’d never see again. It appears I was wrong. Pessimists enjoy pleasant surprises more often than optimists.

Some argue that comparing self-investing to Social Security is apples-to-oranges because government benefits are “risk-free annuities.” I disagree. Politicians have repeatedly reduced or delayed benefits, and more changes seem almost certain. Such a comparison may be closer to apples-to-apples than many want to admit.

I calculated the IRRs required for the Social Security taxes I paid to grow into the benefits my wife and I are currently promised, across four scenarios defined by age of death and whether a 3% COLA is applied (a close average over the past decade). My speculation is that my IRR is unusually high due to my limited participation in the system—most of my income was “unearned” (investment income, per the IRS) and therefore not subject to payroll taxes.

I haven’t seen this calculation performed elsewhere, so I thought it might be interesting. I’ve attached tables with my complete data set starting in 1975, when I was 16. They’re boring, but included for completeness. The SSA earnings report lists annual earnings, but only a total for taxes paid, so I estimated annual Social Security taxes (the investment outflows) using the current rate of 12.4%. This slightly overstates taxes in the earliest years, but the cumulative total closely matches my official SSA record.

All IRR figures are annualized. I’m 66, 15 months older than my wife.

• We both shuffle off our mortal coils at my age 83, no COLA: 6.1%
• We both shuffle off our mortal coils at my age 83, 3% COLA: 6.6%
• I shuffle at age 83, wife shuffles at 95, no COLA: 6.6%
• I shuffle at age 83, wife shuffles at 95, 3% COLA: 7.3%

Real (inflation adjusted) break-even points using a 3% IRR:

• No COLA: After 59 monthly payments (4.9 years)
• 3% COLA: After 56 monthly payments (4.7 years)

Isn’t it remarkable how little impact money received decades in the future has on the overall rate of return?

IRR Calculation Tables

Planned Social Security Receipts (Blue Traces)

(Graph is high-resolution and should be viewed full screen. You can download it.)