Social Security or Personal Retirement Accounts

Members of the baby boomer generation have toiled away for perhaps 40+ years with retirement on the horizon. For all of those years most of us have been paying into the social security system which was signed into law in 1935. To qualify for benefits, one needs to accumulate 40 “credits.” Currently, 1 credit is earned for each $1,260 in earnings, with a maximum of 4 credits earned per year. Hence, one needs at least a 10 year work history to qualify for Social Security benefits. The level of benefits is based on one’s best 35 years of inflation adjusted annual earnings. Full retirement age for those in the baby boomer generation ranges from 66 to 67 years old. As most are aware, one may take reduced benefits as early as age 62, or delay benefits to as late as 70 with an accompanying increase in benefits. The Social Security Administration actually publishes a nice summary of the benefits titled “Understanding the Benefits”.

Employees currently pay 7.65% Federal Insurance Contributions Act (FICA) on their earnings. Of this 7.65%, 6.2% represents Social Security tax and 1.45% represents Medicare tax. The 6.2% Social Security tax is paid on earnings below a threshold of $117,000 (in 2016). The wage threshold on Medicare tax was removed in 1993 so that all earnings are subject to this tax. Employers contribute an equal amount, hence the effective Social Security tax is 12.4%. Self-employed people pay a Self-Employment Contributions Act (SECA) tax at the same rates as the total FICA tax. That is 12.4% into Social Security and 2.9% into Medicare.

Prior to 2010 Social Security’s income exceeded expenses. When Social Security’s sources of income exceed its expenses, the resultant surpluses are deposited into the Social Security Trust Fund. By law, the Trust Fund must invest its assets in special non-marketable securities issued by the U.S. Treasury. The government then spends these loaned funds on ongoing government obligations not related to Social Security. At the end of 2014 the Trust Fund was owed $2.79 trillion which was collecting interest payments at a rate of about 3.5%. The logic for this borrowing by the Treasury from the Trust Fund is that it decreases the amount that must be borrowed from the public through the issuance of marketable Treasury Bonds. You will find many financial writers and economists that have no problem with this. They liken the arrangement to a bank loaning a customer funds to purchase a house. Not really true though as the value of the house secures the bank loan whereas the Trust Fund’s loan to the Treasury is secured only by the “full faith and credit” of the federal government.

To this point, the Clinton administration’s year 2000 budget proposal includes the following paragraph on page 337 when referring to the Social Security Trust Fund:
“These balances are available to finance future benefit payments and other trust fund expenditures—but only in a bookkeeping sense. These funds are not set up to be pension funds, like the funds of private pension plans. They do not consist of real economic assets that can be drawn down in the future to fund benefits. Instead, they are claims on the Treasury that, when redeemed, will have to be financed by raising taxes, borrowing from the public, or reducing benefits or other expenditures. The existence of large trust fund balances, therefore, does not, by itself, have any impact on the Government’s ability to pay benefits.”

Since Social Security expenses exceed income through payroll taxes, the Social Security Administration needs to draw on interest collected from the Trust Fund. The only means by which this can happen is for the Treasury to issue marketable bonds to the public to redeem the interest owed. As these bonds reach maturity new bonds will need to be issued. This process simply adds to the public debt and transfers the responsibility of paying for current Social Security obligations from current workers to future generations. Perhaps we should set the Social Security tax rate annually at a level sufficient to fund current benefits. At least this way, it would actually be a pay as you go system, rather than pay most/borrow the rest.

Unfortunately, we all know Social Security is considered a “third rail” of politics and is hence untouchable. Any politician proposing benefit cuts or tax increases faces political turmoil. Hence the lack of any substantial discussion of the future of Social Security by any of the current candidates, except to perhaps increase benefits.

You may recall that in President Bush’s 2005 State of the Union address he proposed that we allow the establishment of voluntary personal retirement accounts. Democrats were uniformly opposed to this and by early summer support for the plan had plummeted. By fall it was clear the initiative had failed. But would it have been such a disaster for those who chose to open an account? Likewise, how well has the current system worked out?

I wanted to answer the second question for myself rather than listening to the pundits, using my own payroll tax contributions since 1975. Towards that end, I developed a Windows-based computer program to calculate the balance accumulated if all my contributions were invested in a “non-touchable” personal account. This program is available for downloading on the Software page. The user simply enters their taxable Social Security income for each year of work, which is available by logging into a personal account on the Social Security Administration website. Annual OASI rates are then used to convert this to an annual OASI tax (which is doubled to account for the employer match). Note that the Medicare Hospital Insurance (HI) component is not included. The program has options to use as a rate of return the actual annual S&P 500 stock market returns from 1937 to 2015, a constant user defined rate of return, or more generally, user input rates of return for each year of contribution.

The idea is to compute your balance to date using whatever rates of return desired and then to look at what an immediate or deferred annuity purchased with that balance would yield. This may then be compared with your estimated social security payout available from the Social Security retirement estimator or available on your own Social Security account page. This should yield a reasonable comparison since the OASI trust fund provides monthly benefits to retired-workers, their spouses and children, and to survivors of deceased insured workers. Immediate annuities can be configured to provide similar benefits.

My personal results? From 1975 to 2015 contributions to OASI by myself and my employers have totaled approximately $200,100. If these contributions had been invested in a fund achieving the same rate of return as the S&P 500, the value of the contributions would have grown to approximately $750,000. Since it’s not likely, over the long, to equal the S&P 500 returns, I have also computed values for lesser, constant rates. In particular, a 6% annual rate of return would result in a balance of approximately $450,000, and a 3% annual rate, $292,000.

Checking on the value of a deferred annuity, beginning at 66.5, or full Social Security age, I find that a $750,000 premium would provide $4,864 per month as a single person “life with cash refund” annuity, or $4,013 per month with a second person. A premium of $450,000 would return $2,913 and $2,404 for single and two person annuity, respectively. The $292,000 premium would return $1,892 and $1,561. These calculations assume the annuities are purchased immediately, but payouts delayed for about 7 years. Of course the values would be larger if the balances were allowed to accumulate for another 7 years, but it’s difficult to predict the future.

What is my expected monthly payment from Social Security, assuming I retire at full retirement age, and continue to contribute to my account similar to levels? The Social Security Administration website estimates a payment of $2,798. Early retirement at 62 would provide a payment of $1,892 per month. However, one benefit of the Social Security payout is that it is adjusted for inflation. The estimated annuity payouts listed above are not. After adding a 2% COLA adjustment to the $750,000 premium, the two-person annuity would pay about $3,100 per month. That is a significant decrease, and it would take about 13 years for the inflation adjusted annuity to reach the value of the non-adjusted annuity. One pays a hefty price for the COLA.

These are my numbers. I leave it to the reader to draw conclusions, realizing that is not exactly an apples-to-apples comparison. Nevertheless, I suspect most people opposed to personal retirement accounts have never actually run the numbers. I’d welcome others to use their own numbers and comment on the results.

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