Social Security is a hot topic in the economic and political landscape these days. Many reports indicate that Social Security’s finances are getting worse as the economy continues to struggle and as the “Baby Boomer” generation begin to retire. To add to the confusion, Texas Governor Rick Perry is standing by his assertion that Social Security is a Ponzi scheme—a fraud being perpetuated on today’s young people by old people. While I’m not sure this is necessarily true, I recently came across a fascinating history of the Social Security program that will help us understand how we got to where we are in the first place.
Social Security: That was Then
The idea of a government-sponsored source of retirement income in the United States was largely a result of the industrial revolution. With an increasing percentage of the workforce employed in factories (rather than family farms), the traditional family-based social model for taking care of the elderly eroded. There were a variety of political and social groups that endeavored to come up with some sort of centralized source of support that would help to keep the elderly from living in poverty, but none of the support groups truly succeeded. In addition, the average lifespan increased substantially with industrialization—many years beyond the point at which it was efficient or possible to have people continue working in heavy industry.
The Social Security Act (SSA) was signed by President Franklin D. Roosevelt in January of 1935 and promised to provide retired workers (age 65 and older) an income for life.
Social Security: This is Now
Fast forward to current day and the challenge that we find ourselves facing is that Social Security is simply unsustainable as currently designed. The Social Security system will not be able to fulfill its financial commitments beyond 2037.
Now, this doesn’t mean that the system will stop functioning. This means that in 26 years from now the Social Security trust fund will only have enough in its coffers to fund 75% of promised retiree benefits (assuming nothing is done to increase the payments into the system).
Social Security: So What Happened?
Why are our Social Security benefits drying up for future retirees? Here’s what happened. Current retirees have been receiving (on average) retirement benefits that have far exceeded what they have paid into the system during their working years (this is based on analysis by the Urban Institute, among others).
To make up for this shortfall, the Social Security tax has increased substantially through time. In 1965, workers paid a 3.6% Social Security tax. Today, the current tax rate is 6.2% (notwithstanding the current temporary tax cut to 4.2% for 2011). Employers pay a matching amount.
Today, workers and employers pay 12.4% (6.2% is paid from employees’ wages and the other 6.2% is paid by employers) of wages to Social Security vs. 7.2% back in 1965.
While paying 12.4% in Social Security taxes each and every paycheck sounds like a lot to involuntarily contribute into a system that won’t necessarily pay you back when you retire, we have to put these percentages into context—and that can be done by comparing the increase in Social Security tax over the past 45-plus years or so to the increase in real median household income.
American Families Made More and Got Taxed More
Over the past 45-plus years, our real median household income has increased by 25%, from $40,000 in 1967 to $49,777 in 2009 (both measured in current dollars). The problem with comparing Social Security contributions over the years to household income, however, is that this measure doesn’t take into account the mass entry of women into the full-time workforce since the 1960s. A range of data show that real wages for men have plummeted. Over the past forty years, the real wage of the median American male declined by 28%.
Why Social Security Doesn’t Add Up
The Urban Institute, a non-partisan policy think tank, has put together an estimate of the lifetime payments into the Social Security system and the lifetime benefits that recipients of Social Security can expect to receive.
Their analysis assumes that the taxes collected are invested so that they will earn a 2% real rate of return (2% beyond inflation). The question of why they use a 2% real rate of return is an important one.
The Urban Institute study argues that this is a plausible return for a very low-risk portfolio. In my opinion, a more realistic comparison would be to look at the yield on inflation-protected bonds as the basis for very low-risk investments that keep pace with inflation. Right now, long-term inflation-protected bonds are yielding well below 2%, so the Urban Institute’s projections of the lifetime value of contributions are likely to be too high.
The Urban Institutes estimates of payments in and benefits paid from Social Security are worthy of note. An average single working male who turned 65 in 1980, would have contributed $96,000 (in current dollars, including the investment gains) but would likely receive an average total benefit of $203,000.
That same average working male retiring at age 65 in 2010, would have contributed a total (including investment gains) of $294,000 and can expect to receive a total of $265,000 in benefits. And the same average working male who retires in 2030, will have contributed a total of $398,000 (including investment gains) but will expect to receive a total of $336,000. In other words, Social Security is creating an “inter-generational wealth transfer” from younger people to older people: Older people are taking out more than they paid in and the difference is being made up by younger workers who are paying more into the system than they can expect to receive when they retire.
These are the sort of results that might be cited to support Rick Perry’s ‘Ponzi scheme’ metaphor, but I trust that the reader can see that the reality is somewhat nuanced. It is undeniable, however, that the current promises are being fulfilled on the basis of a long-term plan that is unsustainable.
Future Implications for Social Security
So, what does this all mean for individuals trying to plan for their future working and post-employment years?
Younger generations are to correct to think that they’ll receive a lot less from Social Security relative to their contributions when they retire, as compared to those currently receiving Social Security benefits. Social Security is acting as an inter-generational tax, with younger generations subsidizing older generations.
There are only three solutions that I can see that will make up for the short fall in Social Security:
(1) Increase the Social Security tax
(2) Reduce current benefits, or
(3) Reduce benefits for future retirees
Needless to say, none of these solutions will be politically popular.
While we don’t know how the policy issues will be resolved, it’s clear that the Social Security system has made promises of future benefits to younger generations that it can’t deliver (at current funding levels).
What Can We Do Today?
So what can we all do today? Take control of our own retirement.
Individuals need to learn how to save and invest for their long term financial futures. They need to start saving more today so they can live a comfortable life tomorrow.
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