Is Social Security a good return on the investment?

Last updated on: August 16, 2016 at 9:52 am by Jane the Actuary

Is Social Security a good return on the investment? 2016-08-16T09:52:50-06:00 Jane the Actuary

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That’s the usual argument, from the conservative side, about why Social Security reform is needed: pundits either run the numbers on the benefits at retirement vs. the contributions over the years, and calculate a “rate of return” or they take the contributions and calculate an account balance if they received an average rate of return for a diversified equity/bond portfolio, and determine how much Social Security falls short of this ideal “Defined Contribution” benefit.

But it’s not a helpful approach.

Social Security has an intentionally progressive benefit. Here’s the formula:

Each year’s earnings up to that year’s wage base are indexed to reflect wage growth, and the highest 35 years are averaged. Then, the following formula is applied:
– 90% x first $767 of indexed earnings, plus
– 32% x remaining indexed earnings up to $4,624, plus
– 15% of remaining indexed earnings up to the ceiling.

This means that individuals at very low income levels are subsidized by earners at middle and, to a lesser extent, high income levels (since the high earners pay less, as a percent of pay, once they hit the annual ceiling).

All single or dual-income workers also subsidize low-earning spouses, who get benefits (that is, half their spouse’s benefit) even without contributing to the system at all.

This means that comparing Social Security to account-based systems produces winners and losers, and really just doesn’t make sense. (To state the obvious, the same metric for Medicare isn’t any more worthwhile, since rich and poor pay in different amounts over the years but receive the same benefit at retirement). (And one of the things that bugged me about various account proposals in the past was that there was never any clear explanation of how the “regular” Social Security benefit was to be reduced — a simple percentage reduction? A reduction in the index earnings that feed into the formula? A different formula altogether?)

Social Security intentionally serves multiple purposes — providing (modest) pay replacement for middle-class workers, as well as aiming to keep lower-paid workers out of poverty (though SSI is targeted at the poorest retirees), and providing for dependent spouses — and any replacement has to keep these mutliple functions in mind. Hence, account-based programs abroad (and some proposals in the U.S.) generally have a minimum benefit or an additional fixed amount.

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