Privatizing Social Security, Part II

Comparing Returns

Usually, any opposition to Social Security privatization will use some kind of emotional argument about the risks of stock investing versus the absolute certainty of the safety net embodied by Social Security. They never seem to produce numbers to back up the claims, unless they cite specific days when the stock market performed especially poorly (i.e., any market crash day). You can just as easily pick days when the government performs poorly (e.g., missed someone’s paycheck). That one event doesn’t reflect on all future Social Security payments for all beneficiaries. Let’s try to put some numbers to the argument to compare Social Security to the stock market.

The real return on social security “contributions” was determined by the Social Security Administration by running simulations for beneficiaries born between 1920 and 2004. The return for an individual is difficult to determine because it is based on lifetime earnings and the length of time drawing benefits. That said, the highest return was earned by single-earning couples born in the 1920s: 6.52%. Everyone else will get less. Younger workers have paid higher payroll taxes, so their returns will be lower. Single beneficiaries will earn less because they don’t receive Social Security’s generous spousal benefits. For example, a middle-income single-earning couple born in 1943 will get a 4.59% return, while a single earner with similar income will only earn a 2.49% return. Of course, the returns improve the longer the beneficiaries live, but the simulations show you have to live beyond 85 years old to guarantee a positive return (only half of the people who die between 75 and 84 earn a positive return).

How does that compare to the stock market? The minimum 45-year after-tax average annual return for the S&P 500 index since 1927 is 4.4% (1963-2008). The average is 6.4%, and the standard deviation is 1.1% (based on return data from Aswath Damodaran and inflation data from the Minneapolis Fed, as credited in my book, Basic Personal Finance). So you’re earning a positive return the moment you start saving. Unlike Social Security, this return is not dependent on marital status or longevity, and the proceeds can be passed on (increasing returns to future generations). Under Social Security, if you are single and have no dependent children under 18, your contributions produce zero benefits if you pass away. If you put your money in the stock market, that money could be bequeathed to anyone you specify.

Bonus: It turns out that minimum return of 4.4% is the magic return to ensure ANYBODY saving 12.4% of their income for 45 years could earn his or her salary for 31 years after retirement. Ask anyone drawing Social Security benefits how those checks compare to their salaries when they worked. According to the National Academy of Social Insurance, those benefits will be between 26% and 53% of career-average wages. (The higher number is for lower income earners.)

This is significant because whenever retirement advisors suggest people save at least 10% of their income, detractors say something like, “Easy for you to say. The poor can’t afford to save 10%.” Well, if they were allowed to save their Social Security contributions, that’s 12.4% (including the employer portion).

Let’s look at a worst-case scenario of an individual who makes minimum wage for their entire 45-year working career. We’ll use $7.25/hr with a 40-hour work week and 50 weeks per year. That’s only $14,500 a year. If this person’s 12.4% Social Security tax were invested at 4.4% for 45 years, the retirement account balance would be $242,836. That doesn’t sound like a lot of money, but if the account continued to grow at 4.4%, this individual could live on that money for 31 years and draw $14,500 in each year, the equivalent of the minimum wage salary. (The cool thing is that this works for any annual salary.)

That’s just using basic time-value of money calculations with average returns. A more thorough analysis would simulate real returns to capture the variabilities which could hurt (or benefit) the portfolio. Maybe someone with one of those many university research grants could do that. It would be nice of the proponents and detractors of privatizing Social Security would actually do SOME analysis rather than just regurgitating the tired talking points.

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