Wednesday, January 2, 2008

Social Security Thought Exercise

While working on a blog post about taxation (not yet finished), I started looking into social security. I made a spreadsheet to calculate what would have happened if instead of paying social security taxes to the government, individuals had been required to invest that money in a private retirement account. Note, I am not advocating mandatory retirement accounts, but I think it is a useful exercise to show just how bad our current system is.

Let's take the case of an individual born in 1941, retired in 2007, and made the median family income from 1959 to 2007. If he had invested 7.5%, the amount taken out of wages by the government for social security, of his income into an account that made 7% per year (pretty conservative), he would have had $477K in savings in 2007. The same person would now be entitled to $23K per year in social security benefits. Now let's say instead his employer also was required to contribute 7.5% (which is required under social security). In that case, he would now have $955K in savings. This would result in a much higher standard of living than the amount currently received under social security.

This is a somewhat simplistic model though. A typical person doesn't start off at 18 making the median income. It takes many years to reach the medium income. Let's say he started off at age 18 making half the median income and didn't reach the medium income until age 35. In this case, he would have $862K saved for retirement. This would still afford a much higher standard of living than the amount currently received under social security.

The result though is that social security is a pay-as-you-go system. There is a myth that social security is a savings plan, but in reality, the people paying taxes today fund the people receiving benefits today. The surplus is "lent" to the government, which really means it's spent.

I am not advocating mandatory retirement accounts, but I do think we would be much better off today had we had them instead of the current system. Nobody knows what the average performance of those accounts would have been because adding those trillions of dollars of investments would have impacted the economy in a very different way than what actually happened where the government spent the money. But in general, I believe the free market would have used that capital to create some amazing innovations that we can't possibly imagine today. Instead we probably spent the money on subsidies, special interests, and weapons that did not increase the longterm wealth of the country.

We could have still provided a safety net to people who made bad investment choices through a welfare program for the elderly at likely a much lower cost. Instead, we now have saved very little as a country and have over $60 trillion in unfunded liabilities, My generation and the next generation are going to have to live well below our means in order to pay for the retirement of the baby boomers and our other debts.

Data for these calculations
Median income data
Social Security Calculator

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