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ATLANTIC HIGHLANDS HERALD |
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SECRETS OF SOCIAL SECURITY Since President Bush’s reelection the hills have been alive with the sound of Social Security reform. Mr. Bush and many others say reform is essential because:
For a long time Social Security was called the “third rail of American politics” because any politician who dared touch it would instantly die, politically. Barry Goldwater was an early victim. In the 1964 campaign he talked incautiously about reforming or even dismantling the system. He was buried by Lyndon Johnson in an epic landslide. The “third rail” reality was because older voters guarded the system jealously. They loved it because it was a terrific deal. The system is really an elaborate “pyramid scheme”. A pyramid is a scam where the founder collects, say, $100 from each of 100 other people. Each of them, in turn, collects $100 from each of 100 other people who do the same; etc. All is well as early “investors” find their 100 people and happily collect $10,000. But mathematicians know that by the fourth layer you need a million people, and by the sixth layer you need 10 billion people. This exceeds earth’s population. Such schemes always collapse because of the simple arithmetic of exponential growth. A 1920s scam artist named Charles Ponzi made pyramids so infamous that they are now called Ponzi Schemes. They are illegal under current law – except when the government runs them. Social Security was designed by FDR’s Brain Trust to help people who had lost their life savings in the bank failures of the Great Depression. Early beneficiaries made out great. My grandparents retired in 1952 under a 1950 law that extended SS coverage to self-employed farmers. When the law was passed my grandfather was already 68. He died in 1959; my grandma lived until 1971. They probably drew $30,000 in benefits – not a bad return on less than $200 in taxes paid. Other retirees in those early years prospered similarly. Later retirees fared less bountifully, but still very well. By 1964, when Mr. Goldwater incinerated himself on the third rail, the system was only 29 years old. At that time, no SS retiree had paid FICA taxes for his entire working life. It was all gravy for them. Not until 1977 did workers begin retiring who had paid FICA taxes all of their working lives. It is not a coincidence that major FICA tax revisions were enacted the very next year. Someone finally did the math. In 1949 the FICA tax rate stood at 2%. Thereafter, Congress modified that rate twenty-one times, until the current rate of 12.4% was reached in 1990. My own records show that I paid FICA taxes on the maximum FICA-taxable income every year from 1965 through 2002. In 1965 my FICA tax was $348. In 2002, $10,528. President George W. Bush is the first politician to have survived after openly running on Social Security reform. Polls suggest he actually benefited among younger voters by advocating private investment accounts. He has a real mandate to move the system toward fiscal soundness. All the reform talk made me wonder what return new retirees can expect on the taxes they have paid. The algorithm for calculating benefits is still very mysterious, but I have some data. My wife retired early this year, so we know her benefit. I will retire next year, and I know what my benefit will be. The SSA helpfully sends a record of how much FICA-taxable income you earned each year (although not a record of how much tax you paid each year). I decided to tabulate the data for my working lifetime – 1960 through 2003. For each year I wanted to calculate what I paid in FICA tax, and what that amount would have grown to if invested at prevailing rates through 2004. This would let me estimate what I might have accumulated, had I been able to invest those taxes instead of simply paying them to the government. I also wanted to measure the rate of return my pension represented. To construct this table, I needed the historical FICA tax rates. (Found on the Internet.) I also needed historical investment interest rates for those years. I settled on the Prime Rate as a reasonable rate for serious investing. Those data were also readily available. The completed table had the following form (only a few years shown because of space constraints):
Columns 2, 3, and 5 are historical data, although for many of the years the prime rate shown is an average. (In 1980 the Prime Rate was adjusted 39 times – in case anyone is nostalgic for the Carter years.) Column 4 was computed by multiplying columns 2 and 3. Column 6 involves a more complex calculation. For the year 1960, the Cumulative Factor = Prime Rates compounded for each year, 1960-2003; for 1961, CF = Prime Rates compounded for 1961-2003; etc. Thus, the $20 tax I paid in 1960 would have grown to $619 by 2004, if re-invested at the Prime Rate each year. (i.e., Column 7 = Column 4 x Column 6.) Thus, the $168,751 of FICA taxes I paid on $1,438,557 of taxable income, over those years, would have grown to $596,247 by 2004, if so invested. This (virtual) amount, if invested in preferred stocks and bonds, at 7.5% (realistic because I have funds actually invested at that rate), could produce an annual income of nearly $45,000 – not princely, but a reasonable amount that would support many people in retirement. Unfortunately, my Social Security pension is less generous than this. The official report sent to me by the SSA indicates that my monthly benefit will be $1394 when I retire next year, at age 62. This is not quite $17,000 a year – an apparent return of about 2.8%, when only the interest is used, protecting the entire principal until my death. But a Social Security pension is like an annuity. Nothing remains at your death. If the $596,247 were real, it could be used up over 25 years only by drawing $23,850 a year ($1987 a month), without earning any interest. On the plus side, the SS pension is inflation-adjusted each year. For 2005 the increase will be 2.6%. For 2004 it was 2.1%. If my retirement lasts 25 years (taking me to age 87), and inflation is 2% a year, my pension would increase to $2242 a month. Under these assumptions, my total SS benefits would be $535,800 – i.e., as though I had received no interest on my virtual accrued amount, but instead paid a 10% “fee”. If my retirement lasts only 20 years, I’ll receive benefits of $406,000 (assuming annual 2% inflation), and the “fee” would be 32%. Only if inflation is 2.5% or more would my benefits actually exceed my virtual accrued taxes. If inflation is 2.5% and I live 22 years, my benefits would exceed my accrued virtual taxes by just $7275 (1.22%). Inflation confuses the issue, however. It looks like your income is growing, but the dollars buy no more. If inflation were zero, and my benefit remained static, my monthly benefit of $1394 would represent a negative return – like an annuity paying zero interest where a 2.8% fee is extracted yearly, for 25 years. Over a retirement of 20 years the “fee” would nip away 5.3% per year. No one in his right mind would put his money into such investments. For comparison, I duplicated these calculations for my wife’s Social Security data. (Table not listed.) Her earnings picture is less robust, since she spent many years of her working lifetime raising our children. She paid FICA taxes of $11,931 on $106,770 of income. By the same compounded Prime Rate calculations, those taxes would have grown to $57,682 by 2004, when she retired. Her annual SS pension is $5,064, which represents a return of +8.8% on $57,682, if the principal is untouched. If the principal is used up in 20 years, her benefit of $422 a month (no inflation) is an apparent yield of +6.3%. For a 25-year retirement, the yield is +7.4%. With inflation of 2% a year factored in, she stands to come out ahead, over 20 years, by 181%. With inflation of 2.5% a year, she comes out 275% ahead over 25 years. It’s a fabulous deal. Obviously the system is tilted toward low-income earners. (Remember, “Social” is part of the name.) It is very unlikely that any private investment could produce a pension as generous as Social Security gives to lower earners. But for people who consistently earn the maximum FICA-taxable income each year, the benefit is very poor. Changes in the system can’t help me now, but my children and grandchildren need a fair shot at building retirement wealth. They will pay hundreds of thousands of dollars in FICA taxes over their working lifetimes. There is no way they could live on the “benefits” they would receive under the current system. The “pyramid” has gone bust. A new New Deal is needed. If they understand the current system, higher earners will want the proposed reform. Lower earners won’t. Both sides will try to argue for or against reform without letting the other side know how unbalanced the system is. Should be a real scrap. But beyond the entertainment value, the financial futures of millions of people will be riding on it. All my readers, my age and younger – especially those making good money – can read the numbers and weep. This New Deal Dinosaur will gyp you, big time. I urge you to push your Congressmen for major restructuring without delay. Even if you can put into private accounts only a few points of the 12.4% FICA tax you now pay, that will amount to hundreds of billions a year, nation-wide. Those investments would electrify the securities markets and send values soaring. Your future will be made. There will never be a better time to do this.
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