Social Security provides an important foundation for most Americans' retirement. Still, you pay dearly for that foundation. The retirement benefits Social Security offers cost you 10.6% of your salary (half paid by you, half paid by your employer), up to the first $117,000 earned each year.
Source: Social Security Administration.
While Social Security's assets haven't exactly been robbed, they have been invested in very low-risk, low-return investments: special-issue U.S. Treasury bonds. That arrangement helped finance the national debt, but it does little to help ensure you a comfortable retirement. Here are three reasons why:
1. The principal is dropping. Despite that substantial tax rate, Social Security is running dry. According to its most recent trustees report, the Social Security trust fund will be empty by around 2033, forcing it to cut benefits by about 23%. Absent a change in the law to shore it up, the foundation that Social Security provides is crumbling, and the money you're paying toward it simply isn't enough to stop that cut.
2. The money you put into it isn't really yours. When you pass away, your Social Security check generally stops. While some survivor benefits go to surviving spouses or minor children, the money put into the program on your behalf remains with the program. Contrast that with an ordinary investment -- in which the principal would pass to your heirs and get a step up in tax basis upon your death -- and the unsung benefits of an ordinary investment become clear.
3. The returns are pathetic. Even if Social Security were healthy, long-term Treasury bonds currently yield roughly 3.1%. That just about covers what has been long-run inflation, but it does nothing to provide a real return. The stock market, on the other hand, has returned something in the neighborhood of 9%-10% per year on average, albeit with its share of ups and downs. That's enough not only to cover inflation but also to provide real growth over time.
How bad is it?
In January 2013, the average Social Security check awarded to a first-time retiree was $1,380.96. That retiree likely worked and paid Social Security taxes for his or her whole career to earn that benefit. But what if that retiree had the opportunity to invest that money instead?
While it's hard to compare results across recipients, consider a retiree who began working in January 1973 and had a 40-year career before retiring in December 2012. Let's say that person started out earning half the median household income but was earning twice the median household income by retirement. This treatment gets the person near the average over his or her career (acknowledging that people senior in their careers tend to earn more than entry-level workers).
If that person had been able to invest the money that instead was taxed just to cover the retirement benefit portion of Social Security, he or she could have wound up with a nest egg of $621,497, assuming 8% annual returns.
There's a rule of thumb popular among financial planners called the "4% rule" that estimates how much you can take from your nest egg each year and still have a decent retirement. In essence, it suggests that if you take 4% from a diversified portfolio the year you retire and increase your withdrawals by inflation every year, there's a good chance you won't run out of money in a retirement that lasts three decades.
Using the 4% rule as a guide, that $621,497 nest egg could produce $24,859.88 per year -- or $2,071.66 per month -- in income. That's substantially better than the average Social Security check for a January 2013 retiree, even though it invested about the same amount of money and assumed a rate of return below what the market actually delivered over the long haul. And if that person were to die an unfortunate early death, every penny left in that nest egg could still go his or her survivors.
For younger people, the news is worse
When this hypothetical worker started contributing to Social Security, the tax rate for the retirement part of the program was only 8.6%, fully 2 percentage points below today's rates. The January 2013 retiree is also likely to get his or her full expected Social Security benefits for about two decades before the program's trust fund runs out and benefits are cut.
People just entering the workforce now -- or virtually anyone in their mid-40s or younger -- will likely put more than 10% of their salary into Social Security retirement for most, if not all, of their careers. Despite all that, by the time they're eligible to collect, the program is on track to see its trust fund emptied and its benefits slashed by nearly one-quarter.
Still, even though Social Security is lousy as an investment, it serves a purpose as a safety net against extreme poverty during retirement. As a prospective retiree, you should treat it as such and not count on it to provide you with anything more than it's on track to do. But... you can do better elsewhere.
