Social Security recently celebrated its 79th birthday, and over the decades, hundreds of millions of Americans have received payments under the program. Most people consider their benefits to have been well paid for by the payroll taxes they've paid throughout their careers. But no matter how valuable Social Security benefits will be to them, today's workers won't get anywhere near as big a payoff as their parents got in return for the money they paid in payroll taxes.
Where Social Security benefits come from
Many people believe their Social Security benefits are linked to the amount they paid in Social Security payroll taxes during their careers. In essence, they see Social Security the same way they'd look at a company pension or 401(k) retirement plan account, comparing what they put into the system with what they took out. If they end up with more money than they put in, then they figure that they got a reasonably good deal. The more excess they take out of Social Security, the better they feel they fared under the system.
But in reality, Social Security taxes play no direct role in the benefits that you receive. Social Security's benefit calculation formula takes average earnings into account, using your work history to produce a primary insurance amount that the Social Security Administration uses in turn to determine how much your monthly Social Security benefits will be. But the benefits that the formula produces are specifically designed not to be directly proportional to average earnings: There's a level of progressivity built into the formula that helps lower-income earners replace more of their past income through retirement benefits than higher-income workers.
The rising tax burden under Social Security
Beyond the progressive nature of Social Security, the other big variable that has changed over the years is the amount people pay in Social Security taxes. When the program first started, the payroll tax rate was a meager 1%, and it only applied to the first $3,000 of income someone earned. Over time, payroll taxes climbed, but it was only in the 1990s that they reached their current rate of 6.2% for the employee contribution toward Social Security.
What that means is that those who worked much of their careers during the 1950s, 1960s, and 1970s ended up getting the best of all possible worlds. Many of them earned retirement benefits calculated similarly to the way that benefits get paid today. Yet by paying tax rates of 1.5% to 5%, they put far less money into the system -- and so their return on the taxes they paid will be far greater than those who put the full 6.2% toward Social Security throughout their working lives.
Demographics will never be the same
The big factor that made low tax contributions possible was that early in its history, Social Security had far more workers paying into the system than it had recipients collecting benefits. According to the Social Security Administration, the ratio of covered workers to beneficiaries in 1950 was 16.5, falling to 5.1 in 1960 and 3.7 in 1970. Today, it's below three, and the ongoing retirement of the baby boom generation is projected to keep that number shrinking well into the future.
As fewer workers support Social Security, it takes higher tax rates to maintain benefit levels. That means that if anything, the trend will be for current workers to pay more into Social Security, thereby reducing their eventual return even further.
Social Security is still a valuable program, and you can expect to rely on it for at least a portion of your income during retirement. But when it comes to comparing payroll taxes to your eventual benefits, you'll only be able to look back longingly at the big payoffs that your parents and other Americans of past generations got from Social Security.