Social Security

There is a Social Security email making the rounds. Much of it is a rant against perceived government excesses, but here is the relevant part, the part with numbers.

… not only did you contribute to Social Security but your employer did too. It totaled 15% of your income before taxes. If you averaged only $30K over your working life, that's close to $220,500. If you calculate the future value of $4,500 per year (yours & your employer's contribution) at a simple 5% (less than what the govt. pays on the money that it borrows), after 49 years of working you'd have $892,919.98. If you took out only 3% per year, you'd receive $26,787.60 per year and it would last better than 30 years (until you're 95 if you retire at age 65) and that's with no interest paid on that final amount on deposit! If you bought an annuity and it paid 4% per year, you'd have a lifetime income of $2,976.40 per month.

Could these numbers be right?

The email says your social security taxes “totaled 15% of your income before taxes.” And, “If you averaged only $30K over your working life, that's close to $220,500.”

Averaging $30K over your working life is not the same as earning $30K each year of your working life. So right away we need to address that.

The email writer assumes his hypothetical “Mr. Average” paid a Social Security tax rate of 15%. But 49 years ago Social Security taxes were 6.625% combined employer and employee contribution. Social Security taxes have inched upward over the years until hitting 12.4% combined contribution in 1990 and have remained at that level. In order to pay a 12.4% social security tax rate for his entire career, a wage earner would have to begin working no earlier than 1990.

I created a spreadsheet using Social Security tax rates from the Social Security website (here). Note that your entire earnings are not necessarily taxed. Only an amount called “base earnings” are taxed. Those base earnings can be found here. I also used more realistic earnings numbers. My spreadsheet assumptions were:

1. Mr. Average turned 18 on Jan 1, 1964, and immediately began working.

2. Mr. Average began his career earning $5000 per year. This is a realistic number for a high school graduate in 1964 with no college degree and no experience.

3. His pay increases by 6.364% every year until it reaches $90,848 in 2011. That rate of increase is necessary to make his average annual earnings equal to $30,000, the number specified in the email.

4. On January 1, 2012, after 48 years of working, Mr. Average turned 66 years old, the age at which he can collect full Social Security benefits, and he retired.

5. All his Social Security taxes were put into a fund earning 5%, compounded annually.

6. Beginning in 2012 he withdraws an amount from the fund each month equal to what he would have gotten from Social Security. I used an initial monthly withdrawal of $1950 with an annual cost-of-living increase of 3%.

Question: How much money would accumulate in the fund, and how long will the fund last? (It continues to earn interest until it is depleted.)

Answer: The fund peaks at the end of 2011 with a total of $377,158 and it will be depleted when Mr. Average is 84. If Mr. Average lives longer than 84 years, he will be better off with Social Security.

But let’s be more realistic. A high school grad with no college education probably won’t be earning $90,000 today. Let’s assume he began his career in 1964 earning $5000 and his pay increased by 5% every year. Then he would be making $49,530 in 2011. That seems reasonable. If he begins withdrawing $1568 per month (smaller lifetime earnings = smaller retirement check) and his withdrawal amount increases by 3% per year, his private fund will be depleted when he is 82. At that point the private fund pays nothing, but social security would continue to pay.

The Future

But we’ve been talking about history. What about people who have entered the job market since 1990?

Consider a wage earner who began working Jan 1, 1990, at age 23 with an advanced degree. Assume he pays the maximum tax he can pay. Increase the base wage by 3.13% annually, which is the average rate of increase from 2000 - 2012. Keep the tax rate at 12.4% – I don’t see how it can go significantly higher without wage earners demanding to be allowed out of the system.

Let’s assume his retirement age for full benefits will be 68, which he reaches on Jan 1, 2035. On that day he retires. 

Question: How much money would accumulate in the fund, and how long will the fund last?

Answer: His private fund will peak at $1,876,892. He will withdraw $4960 per month beginning in 2035, and with an annual increase of 3% his private fund will last until he is 115 years old. Yikes! Not a good deal – for him. (But his heirs might be happy.)

Of course, I’ve set up a kind of “best case” scenario. It assumes our taxpayer never finds himself unemployed, and that he gets a raise in pay every year regardless of how the economy is performing. It assumes you can invest money at 5% every year for a half century and not only earn guaranteed interest but also never lose value on the principal amount.

And tweaking the numbers just a little can have a dramatic effect on the outcome. What happens if your private fund earns 3% instead of 5%? What happens if your income goes down dramatically? What happens if you spend a year or two out of work, here and there? What if your working life is interrupted or cut short because of illness or injury? The real world is not a tidy spreadsheet.

Social Security was not intended to be a money-making investment for the contributor. It’s like an annuity for society, not for the individual. Still, the “return on investment” is plainly trending from something that is not unreasonable for people retiring today to a very questionable proposition for people who are at the mid-point – or earlier – in their careers.