Weighing benefits: would a private retirement fund yield far more benefits for workers than the current Social Security system, even during years when the stock market is down?
In response to the Bush proposal, leftists across the nation have shrieked in horror that investing in stocks is too "risky" compared with investing in the federal Social Security program. Boston University Professor Alicia Munnell opined in the Boston Globe that "using historical rates of return on stocks, without any adjustment for risk, is clearly improper and overstates the contribution of private accounts to retirement security." In the New York Times, Swarthmore University Professor Barry Schwartz called pro-privatization arguments "dubious, or disingenuous, or both."
Countering the notion that allowing private investment would be too risky, Vice President Dick Cheney claimed on January 13: "The answer to this concern, of course, is simply to set guidelines, basic standards of safety and soundness when it comes to investment choices." That is, the private stock fund would be limited to government-approved investments. But to what extent? Would the federal money managers be able to manipulate the market by which investment choices they approve or reject? Would the so-called private stock fund really be private?
Regardless of the still-to-be-announced details of the president's plan, the public perception is that President Bush is calling for privatizing Social Security, and that perception is fueling a welcome debate as to whether it should be privatized. Specifically, would a private fund yield a higher rate of return than Social Security? And would a private fund pay as much as Social Security during a major downturn in the stock market?
THE NEW AMERICAN first answered these questions in 1994 ("America's Retirement Rip-off," April 18, 1994), when it published a study contrasting the benefits of Social Security with that of a stock fund annuity for four hypothetical families.
In 1994, 65-year-old retirees who derived their retirement income from Social Security enjoyed roughly the same monthly payments as those who derived their retirement income from a private stock fund, but the ones relying on Social Security payments would lose more than $160,000 in death benefit in 1994 dollars. Assuming that an average 65-year-old worker retiring in 1994 had a spouse who never entered the paid workforce, Social Security actually paid nearly $100 more every month than a stock fund--as long as both spouses survived. But the analysis also revealed that younger workers had to contribute more to Social Security for a decreasing benefit.
Eleven years later, it is now very clear that young people in the workforce would be better served by being allowed to invest their own money for retirement rather than relying upon Social Security. Private funds pay out far more to the average worker--both in monthly benefits as well as death benefits--than Social Security does.
An Average Couple: Wendell and Anna Quinlan
Consider the case of Wendell and Anna Quinlan, an imaginary couple who turned 65 years old on January 1,2005. Like many men in his generation. Wendell served as the primary breadwinner in the family, earning an average income. Anna served as a full-time homemaker. Therefore, Anna stayed out of the paid workforce and didn't contribute to Social Security (or the private stock fund) and won't be able to collect on her own policy. She will, however, qualify for half of Wendell's Social Security benefits. Their first monthly checks from Social Security this year, $1,298 for Wendell and $649 for Anna, for a total of $1,947, amount to about $702 less per month than they would have collected if their Social Security contributions had been invested in a private stock fund (see Figure 1).
Wendell and Anna would also lose out on the $370,905 in capital they could have accumulated in a private fund (the interest and dividends that they would derive from this capital is what would pay their retirement salary). They won't be able to pass on this nest egg to their children because they have been forced to invest in Social Security instead.
Being statistical averages, Wendell will live until shortly after his 81st birthday, leaving Anna the primary Social Security beneficiary (and cutting the total family check to $1,298 per month). Anna will live another four years, and the pair will collect a total of $433,523 from Social Security over their lives, or $557,220 less than a private stock fund. In all, the private fund pays out more than twice as much as Social Security.
Worst Case Scenario: James and Martha Quinlan
Of course, panic-mongers argue that the stock market fluctuates too much to be able to rely on it to generate retirement income. The January 5 New York Times published Swarthmore College Professor Barry Schwartz's op-ed column warning that downturns in the stock market make private stock funds a bad deal compared to Social Security:
Perhaps equities and other types of investments will outperform Treasury bills in the long term but that doesn't mean that they will be outperforming Treasury bills at the specific moment you retire. For example, a person who retired in 2000 after a lifetime of investing in half stocks and half in bonds would have had 50 percent more in his account than a person making the same investments who retired in 2003. A difference like this could mean that the lucky retiree can afford both food and medicine while the unlucky one must choose between them.
The argument appears to make sense, even though it is not backed up by any figures or statistics comparing the stock fund to Social Security benefits. So let's take a look at a second average-income retiring couple, James and Martha Quinlan. James is the older brother of Wendell by two years and retired at 65 years old on January 1,2003--at the very bottom of the recent three-year bear market. Their stock fund would indeed have lost about 40 percent of its value between January 2000 and January 2003 (from nearly $503,000 to $305,000), even though James would have continually added 10.6 percent of his wages to the fund during those years.
But (as Figure 2 reveals) the stock fund would still have generated, upon retirement, $361 more per month than they'd have gotten from Social Security. And by investing in the stock fund, the couple could pass on their $305,203 nest egg to their children when they die, compared with the meager $255 the couple will each get at death from Social Security. In all, the couple would still get more than twice as much money from a private stock fund as from Social Security.
If it's true that a private stock fund would make a person who retires at the end of a bear market choose between either buying food or buying medicine, as Professor Schwartz says, Social Security would make medicine altogether unaffordable and limit food menu choices to only 25-cent boxes of macaroni and cheese.
One lesson to be learned from the examples shown is that downturns in the market are highly unlikely to bring private funds as low as Social Security. A second lesson is that young wage-earners are increasingly penalized by having to pay into Social Security.
But why is it that retirees just 11 years ago were able to get monthly Social Security payments that approximated those of a private fund when such a payout is not possible now? The answer can be found in Social Security tax rates. Retirees in 1994 began their working careers paying only two percent of their income into Social Security, and they didn't pay more than 10 percent until 1982, just 12 years before they retired. By way of contrast, those retiring in 2005 generally began work in 1958, when taxes were four percent. Congress repeatedly raised Social Security taxes during the period that these retirees worked, leveling off the taxes at just over 10 percent in 1982. These retirees then paid at a rate over 10 percent toward Social Security for over 20 years. If this larger deduction for Social Security was put toward a private fund, the payout for the private fund would vastly outstrip the payout by Social Security because of compounding interest on the money.
With the Social Security retirement age already in the process of being backed up from 65 to 67, the Social Security vs. stock fund benefit gap will widen further.
Younger Couples Lose More: Thomas and Julia Caine
Perhaps there is no better way to illustrate the principle of "the younger you are, the more you lose under Social Security" than to take a statistical couple of 24-year-olds. Thomas and Julia Caine are a traditional middle-class couple with an average income (see Figure 3). Like our first two couples, Thomas is the primary breadwinner, and Julia is a full-time homemaker. Thomas entered the workforce in the year 2000, when the Social Security OASI tax was permanently set at 10.6 percent. (This fund does not include the 1.8 percent for Disability Insurance and the 2.9 percent for Medicare, which would account for a total tax of 15.3 percent.)
Projecting average income figures over the same career length as the first two couples, we can generate a Social Security benefit and a stock fund benefit in current 2005 dollars using the 10.6 percent salary investment in both programs.
The results are dramatic. At 65 years old, Thomas and Julia Caine can expect to receive only 87 percent of the monthly Social Security benefit that Wendell and Anna receive this year (because the full retirement age has been pushed back to 67 years). If they'd invested in a stock fund, their retirement next egg would be almost half again as large as Wendell and Anna's, $523,263 compared to $370,905. Thomas and Julia's monthly check from the stock fund is more than twice the size of Social Security ($3,737 compared with $1,727). The stock fund pays out nearly four times as much as Social Security over their expected lifetimes, and Thomas and Julia will in total lose more than $l million (in current, 2005 dollars) if they are forced to invest in Social Security instead of investing in the stock fund.
Of course, these figures are likely to become even more striking because life expectancy is likely to be longer when the couple retires in 2048. When the Social Security program began in 1935, less than six out of ten Americans even lived to collect their first check; more than eight out of ten survive to 65 today. A large part of the reason full retirement benefits are being postponed to age 67 is because more people are living longer to collect more benefits.
Longevity is not a friend of Social Security. The longer Americans live, the more financially endangered the Social Security program becomes--unless benefits are cut or taxes increased--because the Social Security program does not rely upon interest and accumulation of dividends. It relies upon money collected each year from taxpayers. By way of contrast, the financial viability of a private stock fund has no relationship to longevity because stock funds create their own wealth through compound interest.
Robbing Two-income Families: Henry and Alison Sebastian
Another damaging part of Social Security, one that is robbing working families under Social Security, is the two-tiered effect of the Social Security program, whereby two-income families get reimbursed at a lesser rate than single-income families. Consider the case of Henry and Alison Sebastian, who are identical to the Caines except that both Henry and Alison are employed full-time and earn average incomes (see Figure 4). Both, therefore, contribute to Social Security and will qualify for their own Social Security accounts.
The Sebastians, like all other two-income families, receive 33 percent less in monthly Social Security benefits per worker compared to one-income families. Henry and Alison get less in benefits because they each have their own Social Security account, but neither will be able to take advantage of the spousal benefit (half the wage-earner's check) when they retire. Yet the couple contributes twice as much money as the Caines to the Social Security fund. As a result, their monthly Social Security check will be only $575 more than the Caine's check.
In a private fund, however, when the contribution doubles, the benefit doubles. The Sebastians' private fund would increase their monthly check by an additional $3,737 every month over the Caine's private fund. The Sebastians would also have a nest egg of over $1 million to pass on to their children with a private fund, versus a measly $510 from Social Security. Social Security would pay less than one-fifth as much money as a private stock fund.
The bottom line: Social Security cannot compete with a private stock fund for benefits. But what are the prospects of getting a genuine private plan?
As mentioned earlier, the Bush administration has yet to release details of the proposal. The only way that Social Security will be preserved over the long haul is if a phony "privatization" program is proposed by the Bush administration and implemented. Poorly managed privatization, or phony privatization, has discredited genuine privatization across the globe in recent decades. Several Eastern European nations have re-embraced socialism after false privatization schemes were laid out after the "fall" of Communism.
Americans would be best-served in retirement by being allowed to invest their own money in private stock funds. Americans must demand full privatization, real privatization.
Figure 1--Wendell and Anna Quinlan (One income, 65 year-olds in 2005) Social Security Private Fund Accumulated capital $0 $370,905 Permanent monthly $1,298 $2,649 benefit check: (plus $649 for spouse) Lifetime monthly payments: $433,013 $619,838 Death benefit: $510 $370,905 Total benefits: $433,523 $990,743 Difference $557,220 Social Security pays 44 cents on the privately invested dollar. Figure 2--James and Martha Quinlan (One income, 65-year-olds in 2003) Social Security Private Fund Accumulated capital $0 $305,203 Permanent monthly $1,212 $2,179 benefit check: (plus $606 for spouse) Lifetime monthly payments: $404,323 $509,820 Death benefit: $510 $305,203 Total benefits: $404,833 $815,023 Difference $410,190 Social Security pays 50 cents on the privately invested dollar. Figure 3--Thomas and Julia Caine (One income, 24-year-olds in 2005) Social Security Private Fund Accumulated capital $0 $523,263 Permanent monthly $1,151 $3,737 benefit check: (plus $576 for spouse) Lifetime monthly payments: $383,987 $874,452 Death benefit: $510 $523,263 Total benefits: $384,497 $1,397,715 Difference $1,013,218 Social Security pays 28 cents on the privately invested dollar. Figure 4--Henry and Alison Sebastian (Two incomes, 24-year-olds in 2005) Social Security Private Fund Accumulated capital $0 $1,046,527 Permanent monthly $1,151 $7,474 benefit check: (plus $1,151 for spouse) Lifetime monthly payments: $498,631 $1,748,903 Death benefit: $510 $1,046,527 Total benefits: $499,141 $2,795,430 Difference $2,296,289 Social Security pays 18 cents on the privately invested dollar.
RELATED ARTICLE: How do you figure?
by Thomas R. Eddlem
Many skeptics would naturally ask how one could calculate comparison figures between Social Security and a private fund. Calculating Social Security benefits is simple because the Social Security Administration provides a computer program called "AnyPIA" on the web to calculate benefits. All you need to do is to plug income figures into the program, and it makes the benefit computation. The U.S. Social Security Administration annually publishes "average income" figures for Social Security.
To calculate Social Security benefits, we used these average income figures and adjusted them by age, according to historic income levels by age as reported in the federal government's Statistical Abstract of the United States. The age adjustment accounts for what is a fact of life: income of Americans is low for the young, peaks during middle age and trails off as workers near retirement. The age-adjustment is not only a practical adjustment for economic reality, it is also necessary to be fair to Social Security. Allowing an "average income" level for young workers without an age adjustment would increase contributions to the private fund earlier in their careers and, because of the impact of compound interest, increase the size of the stock fund nest egg and income at retirement.
Calculating the benefits of a private fund is somewhat more complicated, but the U.S. government publishes all of the Statistics needed to make a comparable stock fund figure. We used the same age-adjusted "average income" figures provided by the U.S. Social Security Administration, and computed the contribution amount to the private fund by taking the Social Security, or FICA, tax each worker would have paid during the year. The worker's "contributions" are then put into a stock fund to earn (or lose) interest according to the Standard and Poor's 500 stock index (published in the Statistical Abstract of the United States), minus a 0.75 percent fee that is similar to what most private stock fund managers would charge.
When Social Security began in 1935, the tax was only two percent of a worker's income (one percent each paid by the worker and his employer). Today, the total tax is 15.3 percent (7.65 percent each for employer and employee). In this study, we use only that portion of the FICA tax that is designated for the Old Age and Survivor's Income (OASI) fund of Social Security, which is currently set at 10.6 percent of a worker's income. The Social Security Administration also sets aside 1.8 percent for Disability Insurance and 2.9 percent for Medicare.
Because Social Security's OASI fund also has a survivor's benefit if the worker dies, the cost of a 30-year term $300,000 life insurance policy is deducted from the amount of earnings generated by the stock fund. A $300,00 life insurance policy subsequently invested in stocks would generate the same permanent income as the Social Security survivor's benefit for a wife and three children. A permanent stock fund income is taken from the average S&P 500 stock index increase from 1949 through 2004, minus the average inflation rate (about three percent) and the 0.75 percent management fee.