In the first part of this article, you saw how Social Security retirement benefits are calculated for 62-year-olds who are now becoming eligible to receive them. To evaluate whether Social Security is a good deal for workers, it's helpful to compare it against an alternative. One alternative to consider is what would have happened if workers had taken the taxes that they paid into the Social Security Old Age and Survivors Insurance (OASI) Fund and instead had invested it themselves in a private account. Using the retirement benefit calculations and historical information about OASI tax rates, one can build a model to compare the two methods.
To keep things relatively simple, the model makes some basic assumptions. Most advocates of replacing Social Security with private accounts argued that the private accounts should be tax-deferred, so the model does not account for any taxation of Social Security benefits or private account investments or withdrawals. In calculating the present value of Social Security benefits, the model uses a life expectancy for 62-year-olds of 23.4 years, or 281 months, and a discount rate of 3% is used to reflect the fact that Social Security benefits are adjusted upward each year for cost-of-living increases. Once the present value of the Social Security benefits is calculated, one can then determine what rate of return would have been necessary for a private account to reach the same value.
A good deal for short careers and modest wage-earners
The results of running various scenarios through the model were extremely interesting. Because of the way that the SSA calculates benefit amounts, certain categories of workers got better returns on their taxes than others.
For instance, people who earned relatively modest wages over brief periods of time did pretty well. If, for instance, you earned $20,000 during each of the last 10 years before retiring, you would receive the equivalent of nearly a 12% average return on the money you paid in Social Security OASI taxes. People who earned similar wages earlier in their adult lives did fairly well but not as well. For example, if you earned $12,500 during each year between 1986 and 1995, which is roughly equivalent to $20,000 today, then your benefits would be the equivalent of about a 6.5% average return on your OASI taxes.
Although short careers tended to do well, you had to work a minimum length of time. Because Social Security requires workers to have 40 quarters of work experience before becoming eligible for retirement benefits, anyone who worked for a shorter period of time saw no return at all on their taxes.
Unattractive for most other workers
For the most part, Social Security benefits were not a great deal for most workers. For most modest wage-earners who worked the majority of their adult lives, the returns on their taxes were relatively low. For instance, a worker who earned $8,000 a year from 1976 to 1985, $12,500 from 1986 to 1995, and $20,000 from 1996 to 2005 would see a return of less than 4% on their taxes.
Workers who earned higher levels of wages also fared poorly. People who earned $60,000 per year from 1996 to 2005 earned just 1.5% on their tax contributions, while those who earned $80,000 during the last decade actually lost money, with an equivalent return of about -0.5%. Even middle-class workers got a low return: If you earned $16,000 a year from 1976 to 1985, $25,000 from 1986 to 1995, and $40,000 from 1996 to 2005, your equivalent return was less than 2%.
A very big caveat
From these numbers, it's tempting to conclude that Social Security is a bad idea for many people and should be scrapped in favor of private accounts. It's true that over longer periods of time, well-established companies like IBM
The most important thing that this model leaves out is the fact that Social Security benefits don't just go to you. In addition to your own retirement benefits, your spouse may receive retirement benefits based on your earnings history. In general, if your spouse's benefit would be less than half of your benefit based on your spouse's earnings history, then SSA will pay an additional amount to your spouse to bring it up to the one-half amount. In addition, after your death, your spouse is usually eligible to receive up to the full amount of your retirement benefit for the remainder of your spouse's life. While it's extremely difficult to make simple assumptions about spousal retirement and survivor benefits, it's obvious that they substantially increase the amount of money paid out by Social Security, and therefore any return from private accounts would have to rise accordingly to make up for those additional payments.
In addition, although this model specifically looked solely at OASI-related taxes, other models that look at the full Social Security tax of 6.2% sometimes fail to consider the value of Social Security disability insurance benefits. Private account plans that eliminate Social Security entirely but do not include provisions for obtaining private disability insurance coverage make a fundamental error in their calculations.
As with most government programs, Social Security has winners and losers. The differences in returns among various categories of workers suggest that the program involves some redistribution of wealth, a fact that's suggested by the way in which benefits are calculated. Although many workers would be better off investing their own money for retirement, Social Security provides at least basic subsistence-level benefits for most retired workers regardless of their income level, and that's a good thing.
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Every dollar Fool contributor Dan Caplinger eventually gets from Social Security is an unexpected gift, in his eyes. He doesn't own any shares of companies mentioned in this article. The Fool's disclosure policy is one of your basic entitlements.