## Wednesday, September 15, 2010

### Social Security Part 2 - Comparison To The Market

This is Part 2 of a 2-part series on Social Security.  In Part 1, we took a look at how the harder you work, the less you get on a percentage basis from Social Security.  In Part 2, we will take a look how your "return" on your Social Security "investment" compares with what you could get in the market.
Continuing our example from Part 1,  over the 35 years of the lesser-working person, they will have paid about \$566.18 * 35 = \$19,816.30 (in today's dollars) into the Social Security system.  When they retire, they will receive a payment of 90% of their yearly earnings, or \$8,218.8/year.

Now, let's see how much it would cost in the open market to get that pension benefit and compare it to what the lesser-working person paid in to Social Security to see if they are getting a good deal.  Keep in mind that Social Security is inflation adjusted, as opposed to most immediate annuities sold today.  There are a few places you can buy inflation adjusted immediate annuities, but their pricing is not as transparent as regular annuities.  However, here is an article in Forbes that can give us a ballpark estimate of how much an inflation-adjusted immediate annuity would cost.  The article cites the example of a 65-year-old retiring woman. If she had \$1MM to buy an annuity with, it would get her \$83K/year if it were a regular annuity or \$59K/year for an inflation-adjusted annuity.  You can see that the inflation-adjustment aspect is really pretty costly!

Applying these numbers to our desired yearly benefit of \$8,218.8/year means that the lesser-working person is being awarded with an annuity valued at \$139,302 at their retirement - as compared with only putting in \$19,816.30 (in today's dollars) over their working lives.

However, let's see what rate of return they would have had to earn on their \$566.18/year "investment" to get to \$139,302 in 35 years assuming monthly payments of \$47.18.  Also recognize that we have to adjust for inflation, so it's not just how long it would take to save the 139K, but how long it would take to save that amount when that amount is adjusted upward at say, 3%/year for inflation and the contributions are also adjusted upward at 3%/year.  However, using this calculator, we can see that the lesser-working person is effectively earning a 12.6% return on their Social Security contributions.  That's a very good rate of return for the taxes paid by the lesser-working person.

What about the harder-working person?  Well, they will have paid \$6,621.60 * 35 = \$231,756 (in today's dollars) into the Social Security system.  When they retire, they will receive a payment of only about 28.7% of their yearly earnings, or \$30,672/year.  They could match that with an inflation-adjusted annuity for about \$519,866.  We find that this represents a 7.3% return on the Social Security payments.  That's not a great return, but not bad, either.

So even at the low end, the SS system seems to be providing a pretty good "return" on the tax dollars paid.  However, therein lies a problem.  SS is effectively promising a minimum 7.3% return on your tax "investment" - up to 12.6%, at least under the currently promised benefits.  Unfortunately, they don't have the money.  Our tax base is just not growing at that rate.  That rate of return is just too high.  For decades, the SS tax collected has exceeded the amount the government was obligated to pay out.  However, instead of setting the money aside, the government immediately spent the money and left an "IOU" in the "Social Security Trust Fund".  Unfortunately, the necessary spending on SS now exceeds the amount of payroll tax collected, so the Trust Fund has to call in its IOUs with the government in order to pay out the benefits it promised.  This is going to get worse as the years progress and more people retire.  As a further unfortunate aspect, the government would typically try to raise the additional needed money by raising taxes.  However, we are in a recession and raising taxes typically causes the GDP to go down - further exacerbating a recession, so they can't raise taxes now.  The result is massive borrowing.  Borrowing on a scale that we have never before seen - and as a percentage of GDP that we last saw during World War II.

The bottom line is that although the current benefits promised by SS represent a pretty good return on your tax dollar, they don't represent the reality of what you will receive.  Frankly, Social Security just represents another bubble - much like the housing bubble.  Similar to the housing bubble, people are paying their mortgage (SS taxes) and being told that they will have large equity (value of the promised annuity), but the value of their equity is not possible to sustain, so prices will come crashing down (the actual provided benefits will be drastically reduced - in line with what the nation can actually afford.)  The fact that people don't see this as a bubble I think relies more on the fact that they don't view SS's promises as an annuity with a cash value and less on the fact that they think that the government will actually fulfill its promises.