Over the years there have been numerous calls to privatize Social Security. The primary argument used is that an investor could get a much better return if his contributions, along with employer contributions, were managed and invested in the workers own account. To see if this argument has merit, we need to look at what the ‘return’ the Social Security system is giving you.
To do this analysis, we need to make some assumptions. Per the Social Security’s website, a man reaching age 65 today can expect to live to age 84.3 while a woman reaching 65 can expect to live to 86.6. I think most people want to make sure they can continue their income if they beat the averages so I used a life expectancy of 92.
I then added up what a person would have paid into the system, plus the amount their employer contributed, if they had started working at 21 and worked up to age 66. Based on the Social Security benefit formula, I then had them start their benefit at 66 and had them receiving this benefit until death at 92. I then solved for the annual rate of return needed to meet the distributions. Throughout the analysis, I used an inflation factor of 2.6% which is the average Cost of Living Adjustment (COLA) of Social Security benefits. The chart below outlines the results.
The Minimum Qualifying Worker is a worker who earned in the least amount each year to receive Social Security credit for his work. The Median Worker earned $51,939 in 2016 and averaged the same earnings, adjusted for COLA’s, through his career. The Maximum Wage Worker earned the maximum wages subject to Social Security withholding each year since age 21.
Looking at these numbers, it appears that the Minimum Qualifying Worker is getting a great deal and I agree with that. The Median Wage Workers looks to have done ‘okay’ while it looks like the Maximum Wage Worker got a bad deal. The argument higher wage earners tend to make is that they could have done much better investing the money on their own when they compare their
return to market averages.
According to Dalbar, an analytical company, the S & P 500 index averaged 10.35% over the past 30 years. The Barclay’s Aggregate Bond Index averaged 6.73% over the same period as of 12/31/2015. It is understandable why the Maximum and even the Median Wage Workers think they are getting a bad deal. Dalbar also tracks how mutual fund investors performed over the same period based on inflows and outflows of funds. Not surprisingly, the average investor invests when funds have had good performance, and takes money out when performance has been poor, resulting in a cycle of buying high and selling low. The calculated annual performance of an average investor in equity (stock) mutual funds was 3.66%, an investor in fixed income funds (bonds) got 0.59% and an investor in asset allocation funds got 1.65%. Their conclusion is that average investor, investing his own money, tends to underperform the market. Based on these numbers, Social Security provides a better return than the average investor gets.
That, however, isn’t the full story. Social Security benefits continue for life, no matter how long you live. Social Security also provides disability benefits to injured works as well as survival benefits to families. When you adjust for the ‘insurance’ you received that was covered by contributions, your total rate of return is even higher than shown in the chart.
From a retirement income planning perspective, I like clients to have access to Social Benefits and/or some other form of pension benefit. Having a baseline income stream coming in that has a COLA adds some certainty to a total income plan.
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