There is quite a lot of controversy and politics concerning Social Security. In this post, I take on some issues concerning Social Security (SS) with a balanced take and from an investor point of view.
Myth or Truth: Is SS an Investment?
The supporters of SS generally claim that the program is an insurance policy and not an investment. Critics would generally agree it’s not an investment. Therefore, participants should not expect a ‘return on investment’ in the same way one would on a stock/bond portfolio or even a savings account. The structure of the program suggests that it in fact has components of an investment when it concerns the determination and funding of the retirement benefits.
Here’s how it works, with an indicator to each point as to whether or not it qualifies as an investment:
- You earn credits each year that eventually count towards your retirement benefit. These credits are based upon your earnings, not your taxes paid. So, increases in the payroll tax rate that have occurred do not offer a higher benefit because it’s not based upon a direct link to taxes paid. (Investors normally like to calculate an investment return based upon actual money contributed). Not an investment.
- To determine your initial retirement benefit, your historical earnings are brought forward using the historical growth rate of average wages. Wages tend to increase faster than inflation so this calculation offers a real rate of return. It’s an investment.
- Once in retirement, your benefit level increases each year at the inflation rate. This is unique, nearly all investments do not have this feature.
- An investment has a few basic features, including an asset value that can be measured and a legal right to ownership by the holder. SS benefits do not have an asset value and citizens do not have any legal ownership to an asset or benefits for that matter. Not an investment.
Myth or Truth: Is the SS Trust Fund Real?
Payroll taxes collected are immediately used to pay benefits for current retirees. For the past 25 years or more, the payroll taxes collected have been greater than benefits paid. This surplus has been invested in a Trust Fund that contains special issue Treasury Bonds that SS can use to pay for future benefits. Supporters of SS point out that the trust fund contains real assets that can be used to pay future benefits. Detractors note that the Trust Fund is a fiction because its claim against the Treasury is simply the money it owes itself, which does nothing to insure future benefits. Who is right?
It depends upon your point of view.
All sorts of people and institutions all over the world lend the U.S Treasury money. If you believe that lending the U.S. government is a worthwhile investment (meaning that they can spend the money efficiently to create future economic growth and opportunities), then the money that is lent through the Trust Fund could improve the ability to pay future SS benefits by higher taxes collected from future economic growth. If you do not believe that this a worthwhile investment, then you likely believe that this spending won’t improve future growth and therefore the Trust Fund may seem like a fiction.
Regardless of where you come across on this question, it is more important to realize that the existence of the Trust Fund (whether real or fictional) does not tie directly to your benefits. Congress can decide to change benefit levels independent of the Trust Fund; its existence does not insure your benefits. Far more important is the near and long term expected cash flow of the U.S Treasury.
Myth or Truth: Will You Get SS Benefits At All?
Most people can probably agree that it is unlikely you won’t get any benefit. The program is too large and has a large enough of a support base that would prevent the program from being dismantled.
The real question is how much will you pay in taxes during your working years and how much will future retirement benefits be reduced. Getting any benefit does not mean it will be a benefit at the same level of past generations. It is safe to say that taxes will likely go up and benefits will be reduced in the future to bring the system into balance.
A very rough estimate for SS retirement benefits for middle income workers is to multiply your income from your final working years by .25. This means that you will likely get about 25% of your working income in retirement benefits. There are rules that can further reduce your benefits (e.g., if you work prior to normal retirement age your benefits can be reduced).
It is prudent to add in a margin of safety to your expected benefits, depending on how far in the future you expect to get benefits. People who are perhaps less than 10 years away from retirement age will likely get their expected benefits in full. If you have more than 10 years to go, I would apply a discount of 25% or more.