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A recent post by Dan Smith took a crack at evaluating at the often heard statement that we would all be better off if the FICA taxes we paid into the Social Security (SS) trust fund were instead invested in individual accounts. The idea is that by investing our payroll taxes in something like an S&P 500 fund, we would be better off at retirement. This strategy has the benefit of long-term compounding, since many of many us will work upwards of 50 years. My first FICA payroll taxes were collected in 1973, 51 years ago.
Dan performed a calculation using his actual SS earning record to calculate his yearly FICA taxes. He then calculated how much each year’s contribution would have grown if invested at an assumed rate of return, and then added them up to come up with a total amount he would have had at retirement. Assuming a 10% average yearly return (based on the S&P 500), he calculated he would have a tidy sum, over $2M dollars. Using a 4% withdrawal rate, he would have generated a monthly benefit about 40% greater than he was collecting from SS.
I had started a similar calculation a while ago, and Dan’s post encouraged me to complete the analysis. I built a spreadsheet using my actual SS earnings to calculate how much my payroll taxes would be worth today if they had been invested instead. At 10%, I also would have accumulated over $2M, which could produce over $90,000 per year at a 4% withdrawal rate.
While that sounds great, there are some real caveats. The first consideration is that by embracing this strategy, we are trading safe asset for a risky asset. It might be more reasonable to assume an investment return equivalent to what is often considered a risk-free return – a 10 Year Treasury. The long-term average return is about 4.25%. Using the 4.25% return, the accumulated amount drops to about $480,000. This would generate about $19,000 per year at a 4% withdrawal rate. This is about 41% of my 2025 SS benefit. I also looked at a few other scenarios, as show in the table below.
Scenario | Assumed Return | % of Actual Benefit |
S&P 500 Investment | 10.0% | 198% |
150 % Spousal Benefit | 9.0% | 150% |
Equivalent Benefit | 7.6% | 100% |
Risk Free Return | 4.3% | 41% |
The table shows that I would need to earn an average 7.6% yearly return to accumulate a sum able to generate a yearly withdrawal, at a 4% withdrawal rate, equivalent to my SS benefit. SS also provides a spousal benefit of up to 50% of the higher earning spouse’s benefit. Suppose my wife had not earned her own SS benefit? She would be eligible for 50% of my benefit. The table shows I would need a 9% return to generate the 150% combined benefit.
This analysis is obviously very idealized, assuming consistent average rates of return, and it’s hard to draw specific conclusions. The 4% rule is a good rule of thumb, but has no tie to how SS benefits are calculated. It might be better to look at what kind of annuity could be purchased with an accumulated sum. There are also other important considerations, such as disability and survivor benefits. But I think this demonstrates that SS retirement benefits are more valuable than many believe.
As I have said several times, fixing SS is not that difficult- if the issue is properly explained to people and we are honest about the cost and funding.
Many people still accept the myth Congress stole the money.
For example, taxing cafeteria plans for SS closes 10% of the funding gap. How many Americans benefit from Section 125 of the IRC?
You can try various scenarios using the Committee for a Responsible Federal Budgets modeling tool. Give it a try and see for yourself.
Proceed at your own risk when projecting SS benefits. For past SS recipients SS benefits were solid. In 8 years the SS reserve is depleted. Future benefits will be based on actual SS taxes collected resulting in a 21% or so reduction of benefits, $3,000/mo becomes $2,400/mo. Won’t happen?
My optimism is challenged considering the Federal government spends roughly $6.5 trillion, collects $4.5 trillion and borrows $2.0 trillion. Interest on the debt is the 3rd highest expense category after SS and Medicare. SS has been a “safe” asset but change appears to be on the horizon.
Would we be better off investing SS tax in a private account is an interesting hypothetical question. In the example Rick Conner outlined, 4% was spent from the $2.0 million account. Using the equivalent return of 7.9%, the income was greater and the principle was not touched. In fact it grew 3.9%/yr. doubling in 17 years. With a private account I’m better able to match my financial life with personal life. If only I could put that horse back in the barn…
JC commented that SS has a demographic problem. I concur. More people paying into the system will continue to float SS. In the meantime, SS benefit reduction is something I’m paying attention to, 8 years may/may not be a long time.
The federal government spending and debt is not a problem for the Social Security Trust (for us, yes). When the Trust is depleted all the Treasury bonds owned by the Trust will have been redeemed. There is no excess revenue to invest more.
The most frustrating part is that minor changes in funding and a bit of creativity could make the Trust sustainable for the next 75 years.
Thanks to everyone for the lively comments. I’m getting the sense that this is not one of my better written pieces. I should have stated that I have never been in favor of replacing SS with private accounts, and have never promoted such a plan. As Mr. Quinn so kindly pointed out, this was a hypothetical calculation, narrowly focused, to see if the claims of some that we’d be better off with private accounts holds water. I was not trying to save SS, or propose government policy. I used Dan Smith’s much clearer article as a starting point, and see if I got similar results. I also then attempted to calculate what return would generate a withdrawal amount equivalent to my current actual benefit. My point was that SS is not nearly the bad deal that proponents of private accounts make it out to be, especially when one considers a risk-adjusted return. My last sentence seems to have failed in that endeavour. Mea culpa.
Rick, your post was well written and a great extension of the subject. At the end of the day it’s clear that neither you nor I are in favor of individual accounts, but those with other opinions deserve the benefit of a respectful conversation. Isn’t that at least part of the HumbleDollar mission.
Now for something totally different. Today is my first day as an AARP tax volunteer. Hope you have a good season Rick.
Thanks Dan. Have a great first day. We start a week from today. I’m still learning NJ’s newest property tax rebate program!
Rick, It still all boils down to “what if they did this instead of that?”. No one has the political will to make any substantive changes, be they good or bad, to the status quo. For once I’d like to hear a politician say out loud “I plan to kick the can down the road as far as Social Security is concerned” because at least he would be honest about it.
I hate to sound like a broken record, but we can’t fix a demographic problem with an investment solution. Sure, we can all imagine scenarios where our privatized Social Security accounts earn great returns. But why use our imagination? Let’s just promise all retirees $1 million at age 62. The question is, what happens when folks go to spend those dollars? Where will the goods and services demanded by society come from? What we need is a strategy to encourage folks to stay in the workforce for longer. Absent that, we’re just rearranging the deckchairs on the Titanic.
Maybe jobs need to be made more likeable, employees less subject to burnout. I think we Americans work too hard.
But if more goods were mass produced more cheaply, it seems to me the supply of goods would be available without the demand increasing the price.
On the other hand, if government just mailed everybody $1 million tomorrow then what you say would seem correct to me.
Jonathan, if this is a broken record, keep singing. Some 20 years ago I attended a lecture by Dr. Jeremy Siegel of the Wharton School, discussing his book Stocks for the Long Run. In the lecture he went into a detailed discussion of the demographic issues facing the returning baby boomers. He looked at SS, Medicare, and the transfer of the boomer’s saved retirement assets to the next generation. He made the same point as you’d id above, that we needed people to provide the goods and services that retirees purchase. He also pointed out that we needed a next generation of investors that would purchase the assets that the boomers had saved and needed to sell to fund their retirement. To make the equation work, he said we needed to look beyond our own shores to international workers and investors.
Alternatively, it could also be more workers via immigration…..
Agreed. Rather than reciting which taxes you’d raise or which benefits you’d cut to shore up Social Security, what I’d love to hear are the policies that readers would favor to encourage labor force participation. That’s the solution to Social Security funding and so much else. More folks working means more taxes collected. But more fundamentally, you have more people producing the goods and services that society needs and wants.
A valid point Jonathan, but it’s quite amazing that workforce participation needs to be encouraged. Could it be encouraged to the extent offsetting the demographic changes and birth rates? I don’t know.
Change SS ER to 63 perhaps but I can’t see that going over well. Increase to SS bend point percentages for work past age 65?
i favor adjusting (up or down) all funding aspects annually based on the actuarial projections to meet the solvency goal. If demographics improve, such as from immigration, rates might go down.
The problem may be that funding is a separate tax low and Congress controls taxes. Could it approve auto tax adjustments? I don’t know.
Forget sticks, like raising the age to claim Social Security. Instead, think of the tax carrots that could be used to encourage folks to stay in the workforce for longer and to encourage employers to retain older workers. Whatever the tax cost incurred with these policies would be more than offset by the additional tax revenue collected.
Publishing, the social security benefits of staying in the workforce until age 70 helps.
I understand some jobs would be difficult to do as we get older though.
True that JC, more workers working longer is paramount. Sadly, in the industrial blue collar circles that I run in, no one wants to keep working.
My take: the employer’s portion should be added to fairly make the comparison.
The analysis also fails to mention that after a lifetime of withdrawals at 4% you’d also have $2-4MM to leave to your heirs instead of $0.
Any sensible person would take the money instead of SS, but that’s not the deal that’s on offer. It never was offered and there is no indication that it ever will be. One can go mad theorizing about what could have been.
Ben, thanks for reading and commenting. I agree that the employer portion should be included, but not everyone agrees with that. It’s certainly possible that a 4% withdrawal rate could still leave a large chunk to pass on, but it’s not a guarantee. There are plenty of stories of folks – certainly not HD readers – getting a windfall and blowing through it a short period of time.
Your last sentence is very true.
I’d like you to imagine a different scenario. Suppose that in 1983, when SS was “fixed” with increases in the retirement age and increases in the SS tax so that SS Trust Fund generated a surplus every year until 2021, that the surplus funds were invested in the US stock market instead of special non-negotiable treasury notes?
I am not going to run the numbers, but a typical 7% average equity return is better than 4%. And, the US government would not have had those funds to spend forcing different choices about taxation and other spending.
Given a capitalistic economic system and human proclivities, left to themselves, a large chunk of the population will never end up with enough funds saved to pay for their retirement and certain other needs of the elderly. Therefore, more funds have to be committed to the goal. The easiest way to do this is to gradually increase the employer payroll tax and over time let the cost of this ripple through the economy. Some of these funds might be invested in the US stock market making everyone a capitalist.
Thanks for reading and commenting. It will be interesting to see what, if any, direction any changes to SS will be enacted in the future.
Such analysis is an interesting exercise, but theoretical only.
Even if it were 100% certain of the outcome, not only is SS much more than retirement income after a lifetime of work, the assumption that a person would exercise the discipline to consistently invest wisely is highly suspect.
SS is insurance against early death, disability, retirement, various spousal benefits and even individuals who never were able to work from birth.
I see no value in isolating a retirement benefit to compare taxes paid with individual investing, something which most Americans not only don’t do very well, but don’t even understand.
Dick, thanks for the reminder that SS is more than just a retirement benefit.
Thanks Rick, for making the comparison. Would adding the employee match change the investment returns? Also, with the current income tax load on Social Security, for most of us, the calculations might swing to Roth investments early in our employment years.
Thanks for reading and commenting fleeb. Adding the employer portion would dramatically alter the analysis. If you counted the employer taxes, the “break-even” rate of 7.6% drops to 5%, pretty close to the risk free rate.
As Dan mentioned, it is controversial whether you should include it in any calculations attempting to measure SS’s return. I recall years ago some of the senior engineers at work arguing this point. I think there are two points in favor of including it (even though I didn’t).
1) Employers are required by law to pay the tax. If we moved to a system where citizens could invest their taxes, the law could be written so that employers are required to continue paying their half of the FICA tax, with the same tax incentives.
2) More importantly, anybody who has ever been self-employed knows that both halves of the tax get paid. My father started his own business in the 1970s. I remember him talking about having to pay the full tax for the first time in his life. I experienced the same feeling when I started a consulting business after retiring from my employer.
You are correct that I ignored the structure of the proposed personal accounts. Would they be pre-tax like and IRA, or post-tax like a Roth? Nobody knows.
I also did not mention that taxation of SS benefits is limited to a maximum of 85% of your benefits, giving it a bit of an advantage over traditional qualified retirement plans.
Great post Rick, I considered using treasury bonds and a SPIA. Honestly, I didn’t even think about the spousal benefit, but that must be considered as well. Instead I decided to stay with the anti-SSers argument that they could easily best the system. David Lancaster asked what would happen if a near retiree suffered a decade similar to 2000 to 2009. Let’s call that question rhetorical.
A few people have made the “I could do better” claim to me. I simply asked them how much money have they managed to save on their own so far. They didn’t answer; apparently that question was rhetorical as well.
Dan, thanks again for initiating a great conversation. It’s a very complicated topic, and goes beyond any simplistic calculations I’m capable of making. There are so many considerations that would need to be considered. One that intrigues me is how would we transition from our current system to a system of personal investment accounts.
Yes, what happens to current beneficiaries when current workers cease their support.