Social Security vs. Private Retirement

Antony Davies,

Release Date
May 2, 2012


Gov't Debt & Spending

A large part of your Social Security taxes goes towards a forced savings plan intended to provide Americans with money for retirement. Economics professor Antony Davies looks at the Social Security system, and discusses alternatives that may provide Americans with more retirement money and more financial security.
To evaluate the merits of Social Security, Professor Davies examines how much average Americans will earn in social security benefits relative to how much they will contribute. As it turns out, social security is a very poor option: the average worker will earn an annual return of only 1.2% percent on his social security taxes.
Imagine, however, if workers weren’t required to pay into social security. If a worker took the money that would have gone to social security taxes and invested it in the stock market himself, he could expect to earn a lot more; upwards of $500,000 dollars more.
According to Davies, phasing out Social Security would enable government to honor its obligations to current retirees, shut down a program that costs half a trillion dollars each year, and allow Americans to transition to a system that would provide more safety and a better return on investment.

Social Security vs. Private Retirement
Your Social Security taxes pay for insurance in case you’re disabled and insurance for your survivors in case you die. The largest part of your Social Security taxes go to a forced savings plan that provides income when you retire. It is reasonable that we ask what sort of return one can expect from this forced savings plan.
To answer this, let’s look at what the average American worker pays into and receives from Social Security. We’ll filter out inflation, so the figures you will see are all in today’s dollars. To be conservative, let’s assume that our average worker doesn’t start working full time until age 22.
Economists generally agree that employers pass on their halves of Social Security tax to workers in the form of lower wages. This means that our worker pays 12.4 percent of his wages in Social Security taxes, but only 63 percent of those taxes go to paying for retirement benefits. So the total amount of Social Security tax the worker can expect to pay toward his retirement is just over $216,000 in today’s dollars.
Our average worker can expect to pay that amount from age 22 to age 66. According to the Social Security Administration, our worker can expect to receive retirement benefits of almost $25,000 per year in today’s dollars, starting at age 67. The average 22-year-old can expect to live to age 78, so he can expect to receive just under $300,000 in retirement benefits.
Now, to evaluate Social Security as a retirement plan, we combine the worker’s expected Social Security tax payments and his expected Social Security retirement benefits. Our average worker pays $216,000 toward retirement, receives almost $300,000 in retirement benefits. That’s the equivalent of an annual real return of 1.2 percent on his Social Security taxes.
In other words, the Social Security taxes that went toward the worker’s retirement earned him an interest rate that is about 1 percent better than inflation. How does this rate compare to other interest rates? Over the past 50 years, stocks in the S&P 500 have generated a return that is 5.1 percent higher than inflation. If our worker were able to invest his Social Security taxes in a private account then invest it in stocks, he could expect to collect over $950,000 in retirement, or more than three times the return that Social Security provides.
The counter argument is that stocks are risky and that the whole point of Social Security is to provide guaranteed retirement benefits. This is in fact false. The only thing that is “guaranteed” is that the Social Security Administration will invest the taxes it collects in government-issued Treasury bills. There is no guarantee that Social Security will give you the money back. At any time, Congress can change the rules and reduce your Social Security benefits.
If a person truly wants safety, one can use a private retirement account to obtain an investment that is safer than Social Security: Treasury bills. By investing privately in Treasury bills, the retiree gets the same safety of government-issued securities that Social Security claims to provide but without the risk of the Congress changing the rules and reducing Social Security benefits.
Historically, one-year Treasury bills have paid an average of 1.7 percent more than inflation. If our worker were able to invest his Social Security taxes in a private account that invested in one-year Treasury bills, he could to expect to collect more than $345,000 in retirement, or about 17 percent more than Social Security provides.
Today, Social Security retirement benefits cost the federal government about half a trillion dollars a year. And under current law the program is projected to be insolvent within 25 years. If the government started a 20 or 30 year phase out of Social Security today, the government could honor its obligations to current retirees, shut down a program that cost half a trillion dollars a year, and allow Americans to transition to private accounts that would yield more safety and better returns than Social Security provides.