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Social Security vs. Private Retirement Accounts

Prof. Antony Davies analyzes Social Security in the United States through the lens of a typical 22 year old American. Assuming that Social Security is completely solvent, the expected return on investment (ROI) of Social Security is far lower than the expected ROI of a private account. Further, if an individual could hypothetically opt out of Social Security payments and invest the funds entirely in Treasury Bills, the Treasury bills would even yield a greater ROI.

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Social Security vs. Private Retirement Accounts

We know Social Security is going bankrupt. The question is, even if it weren’t going bankrupt, is this a good deal? What you see here is what the average 22-year-old college graduate can expect to pay into and receive from Social Security, assuming that Social Security is around.

From age 22 onward, this 22-year-old starts to pay into the system and the payments get larger and larger as the 22-year-old starts to accrue a greater and greater salary. At age 67, our 22-year-old retires and, according to Social Security, the 22-year-old can expect to get $80,000 a year in Social Security benefits. Now, keep in mind, that number is not adjusted for inflation, so that’s about approximately the same as $25,000 a year today.

Our 67-year-old now starts to pay, starts to receive from Social Security, and the amount that the person could expect to receive from Social Security drops down. It drops down because of the probability of the person being alive. Social Security, unlike private retirement funds, is subject to a 100 percent estate tax. What that means is, whatever money you have put into Social Security, once you die, the remainder that would have gone to you had you lived is now gone. It does not go to your estate.

So the drop down that you see here is due to the likelihood of our 22-year-old, now aged, retiring. In total, this 22-year-old can expect to pay into Social Security about $840,000, not adjusted for inflation, and pull back out about $1.2 million, for a 1.6 percent rate of return.

Now, suppose that our 22-year-old, instead of paying the tax money into Social Security, instead was allowed to divert those Social Security taxes into a private retirement account, made up of a mix of stocks and bonds. And let’s suppose this private retirement account makes 3 percent more than inflation. Over time, our 22-year-old pays in this money to the private retirement account and when the 22-year-old retires, now gets to draw down these red bars. In total, our 22-year-old paid in $840,000 and gets to pull back $6.8 million, or about five times what he or she could have expected to receive from Social Security.

Now, the counterargument to this is, yes, we understand that private markets provide a greater rate of return than Social Security, but our money in Social Security is safe, whereas the private markets are subject to risk. That’s not entirely true. It’s not entirely true because you’re only guaranteed that the money you pay into Social Security will be invested in Treasury Bills. You are not guaranteed that the government will then pay you back the money that is invested.

In fact, in 1983, the government changed the rules regarding Social Security tax benefits. Prior to that time, Social Security retirement benefits were not subject to income taxes. Starting in 1983, they became subject to income taxes. That’s the same thing as the government reneging on 15 percent of the Social Security retirement promises it made to you.

If you really want the safety of Treasury Bills, you can get this yourself. Individuals are free to purchase Treasury Bills just like the Social Security Trust Fund purchases Treasury bills, and in fact, if you invested your money privately in Treasury Bills, the return would exceed the return that you can expect to get from Social Security and you would have actually more safety than you have with Social Security.

Here’s our 22-year-old diverting these Social Security taxes into a private fund that invests only in Treasury Bills. Here’s the return that our 22-year-old can expect to obtain, or about $3.3 million. That’s around three times what the person could expect to obtain from Social Security. What this information suggests is that not only is Social Security a bad investment, but if you want the safety that Social Security purports to give you, you’re much better off investing in Treasury Bills yourself.                                                  

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