Social Security was every bit as controversial when it was passed in the 1930’s as Obamacare is today. When it started, it was a very small tax (a couple percent of pay) that provided a very small benefit – just enough to keep people from starving to death. Over time the benefit remained low but the cost increased. Today individuals pay 6.2% in Social Security taxes and their employers pay 6.2%, for a total of 12.4% of your paycheck. If you are self-employed, you pay both sides. Actually, you pay both sides in either case since you would receive higher pay if your employer didn’t need to pay Social Security taxes, but you pay it directly if you are self-employed.
When Social Security was first being debated back in the 1930’s, there were two options. The first option – the one chosen – was to have individuals pay into a big kitty and then have the government pay out of that kitty to those receiving benefits. Anything left over could be spent as the government saw fit, so long as they left an IOU. The second option was to have individual accounts where each person would have a private account to which he/she would contribute and then withdraw from at retirement, kind of like the 401k of today. The issue with the second method was that it would take a few years to get going – those who were retiring immediately would still need to find a way to make ends meet. With the first option, they received a windfall since they paid in almost nothing and then got benefits for the rest of their lives (lucky folks).
The issue with the first option is that it ends up being a giant Ponzi scheme. Initial investors are paid by later investors with the left-over money going to those running the scheme. This works fine until you don’t have enough money coming in to pay the earlier investors. This happened in the past, which is why the rates have risen so dramatically over the years. Even still, the fund is running out of money, so benefits have been cut – by raising the retirement age – and there is talk about raising taxes yet again. Of course, taxes were raised in the 1980’s to “save Social Security” with the goal to pile up more money for the retirement of the babyboom generation now retiring, but the extra money was just spent leaving the solvency of the program in doubt. There is absolutely no reason to believe this would not just happen again.
There is a much better option and that is to return to the private accounts. I was wondering how long it would take and how difficult it would be to transition today’s workers to such a plan. I found out the answer was: not that hard. Here’s some of the math:
1. I estimated the average amount an individual living in retirement from age 65 to 85 would collect in Social Security payments, assuming a monthly payment of $1500. They would receive about $179,331. Assuming a 5% interest rate over that period ( Social Security would actually be closer to 1 or 2%, so I’m being generous here), the total benefit would be about $230,000.
2. I assumed an 8% rate of return for money invested in private accounts. This would be a good estimate for the after-inflation rate of return for a mix of index mutual funds held for a period of ten or more years.
3. I assumed a steady paycheck of $60,000 per year and then assumed different savings rates (paycheck deductions) and determined how long it would take to amass $230,000 at the different savings rates. The results are as follows:
|Savings Rate||Monthly Payment||Years to $230,000|
So, if you were making $60,000 per year started putting away 5% of your paycheck in a private account, you would amass enough money to replace your Social Security payments in just 24.5 years. That would only be a payment of $250 per month. If you contributed 13% – close to the 12.4% rate you pay now – it would take just 15 years. We could phase out Social Security right now for everyone 50 or younger without paying any more just by directing payments to private accounts instead of the public system. Today’s 56 year-olds could contribute 20% of their paycheck, which they would probably be able to do with the kids gone and the mortgage paid, they would be able to replace Social Security by the time they reached 65.
No what about the young people? I wanted to find out how much a person starting today at age 20 would need to put away each month to replace Social Security payments by the time they were 65. This is how much people should be paying today for the benefit they receive, instead of the 12.4%, or almost $650 per month for someone earning $60,000 per year. And the answer (drum roll please): $45 per month! Yes, that’s right. You’re paying $600, $700, or even $800 per month for a benefit that is worth at most $45 per month. And that is assuming that you retire at age 65. Today’s workers actually won’t be eligible for full Social Security benefits until they reach age 70, so it is even worse.
It is possible to unroll the system we have and stop paying $650 per month for something worth $45 per month. In fact, if we had private accounts instead of the public system, there would be no need to fund an IRA or a 401K because you’re contributing enough to fully take care of your retirement already through Social Security. The problem is just that the trustees – Congress – are spending the money instead of investing it. If this doesn’t sound like a good plan to you, perhaps your Congressman needs to hear about it.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.