Social Security: A good deal? It depends.

A friend posted a link to an article with the title:  “When Soda Was a Nickel and Social Security Wasn’t Much More.” The premise to the author’s article is that Social Security is a bad deal for a variety of reasons. But their analysis very much simplifies the complex calculations of Social Security and reviews one particular case: A high wage earner who is single. The link to the article is at the end of this one.

What about the rest of us and what assumptions are made for that single, high wage earner?

This is a simplified analysis with the following conservative, critical assumptions:
1) Single person, who remains single from a social security and tax perspective for the whole life.
2) Starting salary of $33,000 at age 21 for a college graduate (source: CNN/Money)
3) 2% for average annual salary growth (source: assumption)
4) Age 21 start for contributing to the Social Security Trust Fund or contributing the same amount (12.4% of gross salary) to a pre-tax investment account.
5) Contribute the 12.4% every year without stopping.
6) Age 67 end-of-year retirement (source: Social Security requirement for 100% payout).
7) Age 78 year life expectancy (source: World Bank)
8) 5% annual compounded rate of return on investments pre-retirement
9) 0% annual compounded rate of return on investments after retirement
10) Inflation: All values in 2010 dollars, no adjustments for inflation.

Critical Assumptions:
The assumptions that affect the results the most are:
1) The age in which you retire. By retiring early, you receive a significantly lower payout from Social Security as a built-in penalty. Although not as severe, retiring early also adversely affects investment incoming from a private pre-tax account.
2) Your life expectancy. The longer that you live, the greater the benefit of the Social Security program since it is basically a defined benefit plan. Private pre-tax investment accounts are not defined benefit plans.
3) The length of time that you contribute. The longer that you contribute to either program, the more funds you’ll have available during your retirement although Social Security does have a cap.
4) Inflation. Social security payments are adjusted based on Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), a measure of inflation. A private pre-tax investment account is not adjusted for inflation.
5) Continuous contributions. Starting and stopping contributions is not beneficial for either plan.

Due to the significant changes that occur in the results if the above five assumptions change, for the sake of simplicity, all calculations are based on a contribution start age of 21, retirement age of 67 and life expectancy of age 78. To make the comparison between the two plans similar, inflation is artificially set to zero %. Also, a key assumption is that you work and contribute to the two plans continuously throughout your career.

With these five assumptions fixed, the greatest variables become:
1) Your starting salary
2) Your ability to continuously increase your salary by 2% average per year (unlikely)
3) Your marriage status
4) The amount of money that your spouse earns

Calculations for Social Security are complex, and this first analysis is very simplistic in order to illustrate one particular scenario.  “Complex” as in: The Annual Social Security Supplement 09, which is the basis for calculating benefits is 551 pages long.

Results from this analysis:
Social Security: You pay more into the Social Security trust fund than you receive back during your 11 years of retirement. If you get the maximum annual payment (unlikely) you’ll receive $27,876 per year (source: Bloomberg)

Your own investment account (assuming that Social Security goes away and you contribute the same 12.4% per year of gross salary to an pre-tax investment account): $95,000 per year in pre-tax funds if you draw down 100% of your investment.

There’s no question that for high wage earners, Social Security is a bad deal. Comparing the capped maximum Social Security benefit with contributing the same amount (12.4% of gross income) to a pre-tax retirement plan at 5% would yield in the range of 3 to 4 times more pre-tax money at retirement for the person contributing to a pre-tax retirement account if they were able to opt-out of Social Security.

But this is just one case of a complex act that was put into place in 1935 and amended by congress, the executive branch and even the courts many times. The act is based on the philosophy of social engineering and is presently biased in favor of those who make little money and those who are married. Depending on your viewpoint, this may or may not be a good thing.

Comparisons between the two plans is problematic since Social Security is basically a guaranteed insurance program (defined benefit) with minimal risk to the participants while funds contributed to a pre-tax investment program, such as an IRA or 401(k), are inherently at risk based on underlying stock and bond price and yield fluctuations. The risk with a pre-tax investment program is further exaggerated, when compared to Social Security due to timing risk. For example: If a significant recession occurs during the years available prior to and during retirement, the value of a pre-tax investment program could significantly decline while Social Security suffers no such risk.

From a percentage return on investment perspective, Social Security is biased in favor of married couples, who are the same age and earn in the middle of the income spectrum. This is a bias that is presently inherent in the amended Old-Age, Survivors, and Disability Insurance (OASDI) program, which forms the basis of Social Security. Since the program was started in 1935, biases based on race and gender have been incorporated into the program and gradually removed while the present biased system has been developed by the executive office, congress and the court system over the ensuing years.

Finally, the history of saving for retirement by Americans is traditionally poor. For example, many people do not save sufficient funds in their company sponsored 401(k) or 403(b) plans for retirement. Considerable research has shown that a significant number of people don’t opt in to even the most basic forms of company sponsored retirement plans (source: “Opt-in and Opt-out Pension Design. Does using the opt-out mechanism cause more saving?” Psychology Today, 2009 August 30).

Bottom Line:
In a near perfect society, the waste and social engineering associated with the Social Security program would not be needed. People would opt-in to retirement plans and begin to reduce their investment risk as they approach within five-years of their retirement. We don?t live in a perfect world and the availability of un-biased investment information for the average person is not easy to find, let alone act on.

Social Security absolutely needs reform to rid it of as much waste and social engineering as possible. However, without significant resources spent on continuously educating people on how and when to save for retirement, the likely outcome of not having any type of program like Social Security will cause long-term financial disaster for retirees.

Of course, an argument can be made that the whole concept of “retirement” is an artificial construct of the 1900′s and perpetuated by President Roosevelt’s “New Deal” in 1935.
Americans need to decide if they want to continue to pay for a retirement safety net or if they’re willing to go back to the ideology of taking care of themselves.

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