Could your retirement fund use an extra $175,000?

I thought so.

How about $350,000? Possibly even $400,000 if you swing for the fences. Well, it might have happened--- if you had invested a portion of your payroll tax instead of sending it to Washington to support Social Security.

I don't mention this to be rude.

It's just bothersome that the chairman of the Federal Reserve has now suggested twice that it would be a good idea to reduce future Social Security benefits for people who will be retiring in the future. After all, these are the people who are paying the benefits for those currently retired. Maybe it's time to change Social Security, instead. Maybe Retirement Income should be completely privatized.

Yes, I know that's a big change.

But think about it. The payroll tax has done nothing but grow. From 1.5 percent on the first $3,000 of income in 1950 it has grown to 5.3 percent of the first $87,900 of income in 2004. Add disability insurance and Medicare and the total tax rate for employees is now 7.65 percent. And that's just the employees' portion.  Employers take the same amount straight from our pay and send it to Uncle Sam. It's just not labeled that way.

  Worse, the tax will continue to grow. According to Social Security Online's frequently asked questions (see URL below), the benefits people who are now 25 will receive will have to be cut by 27 percent in the year 2042, when they are 63, if the financing of the system isn't improved.

Current payroll tax "contributions," in other words, may do far less for future retirees than they have done for current and past retirees. That's not exactly fair, is it?

So lets ask and answer two questions.
  • First, how much money could you accumulate if payroll tax contributions were invested?
  • Second, if the money is invested, how will benefits promised under the current system be fulfilled during a transition period?
To get an approximation of the first question, I calculated how much you would have accumulated if only half of the payroll tax money that went toward retirement security was invested in a stock index, a bond index, or a 60/40 pension fund-like index. Assuming that you always earned at the maximum income--- $37,800 in 1984 rising to $87,000 in 2003---and that you invested your payroll tax portion regularly, you would have accumulated about $199,000 in the Standard and Poor's 500 Index, $175,700 in a 60/40 domestic stock/bond mix, and $132,700 in Intermediate Government bonds. (The figures for a balanced portfolio are shown below.)

 
Twenty Years of Payroll Tax Investing
In each year the employee share of the Old Age Security Income tax is calculated and given a return equal to the return on a 60/40 domestic portfolio mix of stocks and bonds. The returns are cumulated; tax free, as if in a 401k account.
Year Wage Base OASI Tax Rate Employee Payroll Tax $ 60/40 Return Growth Year End

1984

37800

0.052

$1,965.60

9.38%

$92

$2,058

1985

39600

0.052

$2,059.20

27.44%

$847

$4,964

1986

42000

0.052

$2,184.00

17.14%

$1,038

$8,186

1987

43800

0.052

$2,277.60

4.28%

$399

$10,863

1988

45000

0.0553

$2,488.50

12.52%

$1,516

$14,867

1989

48000

0.0553

$2,654.40

24.22%

$3,922

$21,444

1990

51300

0.056

$2,872.80

1.96%

$448

$24,765

1991

53400

0.056

$2,990.40

24.50%

$6,434

$34,189

1992

55500

0.056

$3,108.00

7.50%

$2,681

$39,978

1993

57600

0.056

$3,225.60

10.48%

$4,359

$47,562

1994

60600

0.0526

$3,187.56

-1.26%

-$619

$50,131

1995

61200

0.0526

$3,219.12

29.16%

$15,087

$68,437

1996

62700

0.0526

$3,298.02

14.70%

$10,303

$82,038

1997

65400

0.0535

$3,498.90

23.40%

$19,606

$105,143

1998

68400

0.0535

$3,659.40

21.24%

$22,721

$131,523

1999

72600

0.0535

$3,884.10

11.88%

$15,856

$151,263

2000

76200

0.053

$4,038.60

-0.42%

-$644

$154,658

2001

80400

0.053

$4,261.20

-4.10%

-$6,428

$152,491

2002

84900

0.053

$4,499.70

-8.10%

-$12,534

$144,457

2003

87000

0.053

$4,611.00

18.18%

$26,681

$175,749

Source: author calculations; return figures from Ibbotson Associates; Social Security Trustees
 

It is important to realize that we are not taking any money from the disability fund or from Medicare. It's also important to realize that this was a period of relatively high returns. Large common stocks returned 13.0 percent annually during the period and Intermediate bonds returned 8.9 percent. Future returns might not be so good. On the other hand, this is only the results of 20 years, not a 40 or 45-year career of work.  Also, most workers would have paid in less. Only 7 percent of all workers earn more than the Social Security wage base.

Then again, you could double the accumulation simply by investing the other half of the money.

Caveats not withstanding, real people could have accumulated a good deal of real money if they had invested the money for their own future. Instead, Social Security paid it to those who were already retired. With future prospects for both Social Security and corporate pensions getting worse by the moment, a private Social Security plan is starting to make real sense.

Unfortunately, a private retirement plan for future retirees would leave current recipients of Social Security hungry. And there are 40 million of them. The only way to go private is to create an alternative source of support for the retired, a transition fund that would keep the promises already made. It would have to promise that no one would go hungry or suffer lower benefits.

The solution co-author Laurence J. Kotlikoff and I suggest in "The Coming Generational Storm: What You Need To Know About America's Economic Future" (MIT Press, www.mitpress.edu, $27.95) is simple: a national sales tax. The tax would decline as promises were fulfilled and the liability was paid off. The tax would be applied to all consumer purchases, from food to bed sheets. People who don't work would contribute through their spending. Rich people would support the elderly with their luxury purchases, including mega yachts. The rest of us would know that we were supporting retirees every time we filled our gas tanks or went to the movies.  Only the elderly poor would be spared, because their Social Security benefits would be automatically adjusted as the sales tax inflated prices.

There is no ideology behind this suggestion. We simply want a fair shake for young people and a retirement income system that works.  The current system doesn't work in a world of rising life expectancies.

Frequently Asked Questions about Social Security, including estimates of benefit cuts for 25 and 35 year olds.

History of the Employment Tax