Academic journal article Economic Commentary (Cleveland)

Social Security: Are We Getting Our Money's Worth?

Academic journal article Economic Commentary (Cleveland)

Social Security: Are We Getting Our Money's Worth?

Article excerpt

Consider the following investment scenario. You turn over 10 percent of your salary each year to an investment manager who pools your contributions with those of others to form something that looks like a mutual fund. The manager assembles a portfolio that ends up earning a meager rate of return--less than 1 percent after adjusting for inflation.

Next, you learn that before you ever joined the fund, the manager made some unwise promises to the early investors. In particular, he guaranteed that they would receive very high rates of return--far exceeding the fund's ability to pay, given its less-than-spectacular investment performance. Moreover, he handed out all sorts of cash bonuses along the way to keep the early investors happy. To maintain investor confidence, the manager used incoming cash from the new investors to make direct payments to the early investors.

This precarious setup actually worked for awhile. Now, however, like all pyramid schemes, the fund is on the brink of collapse because the supply of new investors has begun to dry up. Indeed, the manager informs you that you will have to increase your annual contribution to keep the fund solvent, and that you should reduce your expectations about future payoffs from this investment.

Although the possibility of becoming entangled in such a financial mess is probably not foremost in many people's minds, it may already be a reality for the majority of American wage earners. As it turns out, the U.S. Social Security Trust Fund has many features in common with this hypothetical scenario. Today's workers may wonder whether Social Security will be able to deliver the benefits that have been promised for their retirement, and if so, how these benefits compare to those that might be provided by alternative investments. In this Economic Commentary, we examine Social Security from an individual investment perspective and discuss whether current and future workers are likely to receive their money's worth from the program.

* A Dramatic Rise in Social Security Contributions

Similar to the hypothetical scenario, 10.52 percent of every U.S. employee's gross annual wage (up to a maximum of $61,200) must be "contributed" to the Old Age and Survivor's Insurance (OASI) trust fund under the Federal Insurance Contribution Act of 1939. These contributions are collected via a payroll tax on employee earnings.(1) The payroll tax rate has risen dramatically and is now almost six times its original level.

As tax rates have risen, so too has the maximum level of earnings subject to the tax. At its inception, the OASI tax rate was 2 percent on earnings up to $3,000, implying a maximum annual contribution of $60 per employee. Today, the average contribution is more than $2,000 per year--an increase that has far outpaced the growth of worker compensation per hour (figure 1). (all figures and tables omitted) Hence, compared to earlier generations, today's workers must turn over a much larger fraction of their paychecks in order to qualify for benefits.

* A Dramatic Fall in Rates of Return

High Returns for Older Generations

The enormous amount of workers' earnings being channeled into OASI has raised concern about the nature of the investment "deal" they may expect to receive.(2) Assuming that the return from participation consists of post-retirement benefit checks alone, one can compute the "internal rate of return" on contributions made over an individual's working years.(3) Figure 2 shows the internal rates of return for different generations according to birth year. Early participants, especially those born before 1900, have received extremely high returns--12 percent or more after adjusting for inflation.(4)

The high returns paid to these early participants can be traced in part to the conversion of OASI from a fully funded system into a "pay-as-you-go" plan in 1939. At that time, it was decided that early participants would receive full benefits (retirement, spousal, dependent, and survivor) regardless of the number of years, or the amounts, of their prior contributions. …

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