No 46,000% Return for Social Security Recipients

Published September 1, 2005

The Social Security system, also known as Old Age, Survivors, and Disability Insurance (OASDI), was enacted in 1935. In 1940, the first benefit check, for $22.54, was paid to Ida May Fuller. She ended up collecting $22,889 in benefits after paying only $49.50 in taxes into the system.

That 46,000 percent return was a fabulous deal for Fuller. Such large returns compared to payments have cemented support for the program among beneficiaries.

However, those large returns were made possible only by the Ponzi features of the system. When Fuller received her first Social Security check in 1940, there were 42 workers paying into the system for each retiree drawing funds out of it. Today there are just more than three. With fewer workers to pay the taxes to support Social Security benefits, future retirees face dwindling returns.

Intergenerational Transfer

Anyone who knows anything about Social Security knows it is an intergenerational income transfer program. The transfer is largely from the working young to the retired old. Though there is a so-called Social Security Trust Fund, it is not truly operated as a trust.

Those who pay into this fund have no ownership rights to any benefits. In 1960 the U.S. Supreme Court ruled in the case of Flemming v. Nestor that Social Security benefits were not contractual in nature. The government can bestow the benefits on whomever it chooses, without regard to how much, if anything, that individual may have paid into the system.

Recipients of Social Security benefits have generally received more than they paid into the system. This has not been due to astute investment of the monies paid in payroll taxes. It has been due to the robust growth in wages of those still in the workforce.

Paying benefits to early participants by extracting the money from later participants is a classic “Ponzi scheme.” This type of scheme works only if the number of those paying increases at a faster pace than the number of those receiving. Given the slowing population growth in the United States and increases in longevity, the Social Security Ponzi scheme cannot survive.

Untenable Demographics

In the 1930s average life expectancy in the U.S. was 57 years. Setting the age for retirement benefits at 65 years meant the majority of people would die before becoming eligible to collect. Today, the average life expectancy is 76 years. By the middle of this century, the average American will live to be 82.

A system that was financially feasible when only a minority survived to collect benefits is infeasible when a majority is expected to live a decade or more collecting benefits.

Because Social Security cannot continue as currently structured, we must choose which type of change is most palatable. The approaches fit into the following categories: (1) personal accounts, (2) means testing, (3) increasing the retirement age, (4) increasing population growth, or (5) raising taxes.

Personal Accounts

Investing a portion of the payroll taxes collected from workers in stocks and other income-producing assets would generate new revenue to keep Social Security viable for a longer time or to supplement retirement benefits. Individuals could be put in control of their own investments through a system of personal retirement accounts.

The long-term history of the U.S. stock market lends credence to the idea that personal accounts would work as suggested. Over the past 80 years, shares of stock in U.S. companies, on average, have grown in value by more than 10 percent per year compounded. The inflation-adjusted compound rate of return has been 7.6 percent per year.

If these types of historical returns on investment are repeated in the future, personal Social Security accounts would grow into enormous sums. If the current Social Security taxes for a person who worked at minimum wage for his or her entire working life (about 45 years) were invested at these historical rates of return, it would grow to nearly $500,000. This would be sufficient to purchase a lifetime annuity paying about $37,000 per year.

If the current Social Security taxes for a person who worked at the average wage for his or her entire working life were invested at these historical rates of return, it would grow to more than $1.1 million. This would be sufficient to purchase a lifetime annuity paying about $90,000 per year.

Both of these figures compare quite favorably to both the average ($11,460 per year) and the maximum ($22,500 per year) Social Security benefit over the same timeframe.

Means Testing

Means testing would focus on the insurance aspect of the original Social Security plan. In the 1930s, few workers had pensions from private employers. A person too old to work faced destitution.

Insuring against destitution, like insuring against fire, is a feasible concept. If the only persons eligible to collect Social Security were those who would otherwise be poor, there would be no crisis. It is the attempt to pay everyone benefits that is infeasible. Imagine how expensive fire insurance would be if everyone had to be paid regardless of whether they suffered fire damage.

Perhaps the simplest method of introducing a means test would be to make Social Security benefits taxable income. Those in high tax brackets because of large annual incomes would give back a large share of what they receive in Social Security benefits. Those in low tax brackets would keep almost all of the Social Security benefits they receive.

The existing Internal Revenue Service could serve to enforce this rule. No new bureaucracy would need to be established.

Increasing the Retirement Age

When the Social Security system was first implemented, the normal retirement age to receive benefits was 65 years old. Starting in 1961, retirees could opt to start taking reduced benefits at age 62. In 1983, the retirement age for full benefits was boosted to 67 for those born in 1960 or later. That hike in the age for eligibility for full benefits was aimed at adjusting for longer life expectancies. The adjustments, though, were paltry considering the substantial changes in life expectancy since 1935.

To put Social Security on an actuarial par with the life expectancy change since the 1930s, the age for full retirement benefits would need to be somewhere in the 80s.

People who live longer can be expected to work longer. Medical care is better. People stay healthier longer. Work is less physically demanding. Fewer jobs entail backbreaking manual labor in harsh environments. More jobs are behind desks in air-conditioned comfort.

Raising the retirement age would be one way of heading off the crisis by adapting to changed life expectancies.

Increasing Population Growth

If each new generation were larger than the previous one, more workers would be paying into the Social Security system. That could enable the Ponzi scheme to continue.

There are two ways to achieve this: (1) raise the birthrate or (2) increase immigration. Raising the birthrate would require a reversal in the downward trend of births per fertile female. Given the high cost of rearing a family in an increasingly urban environment, it is difficult to see what would induce people to take on such a burden.

Taking in more young adults from other countries would be less costly. The costs of raising children from birth to adulthood would be borne elsewhere. People would be entering the country as they entered the workforce. They would be paying Social Security taxes for decades before becoming eligible to collect.

Whether we boost the population by increasing the birthrate or the immigration rate, we would have to accommodate exponential population growth to keep Social Security running as an intergenerational income transfer system.

An exponential population growth rate, however, especially one consisting of increasing numbers of foreign-born immigrants, might pose its own problems. Assimilating the necessarily large influx of persons from divergent cultures might require many adjustments.

Raising Taxes

We could try to keep Social Security running by increasing the payroll tax rates. In the beginning of the program, the Social Security tax was 2 percent. Currently it is 12.4 percent. According to the Social Security and Medicare Boards of Trustees, the program could be brought into actuarial balance over the next 75 years with an immediate increase in the tax rate to 17 percent of payroll earnings up to $90,000.

Analyst Peter J. Ferrara has estimated that by the middle of this century the tax rate necessary to keep Social Security solvent would rise to about 26 percent.

The downside of the tax increase option, though, is its negative impact on economic growth. Whatever is taxed is discouraged. Increasing the payroll tax will increase the cost of employing American workers. Outsourcing production to other countries will become more attractive. In the long run, the economy will grow more slowly.

Depending on which side of the Laffer curve we are on, an increase in Social Security taxes may even result in lower revenues for the program.

Necessary Choice

We must choose one of the five approaches outlined above. We cannot continue “as is.” Given the relative impacts of the options, personal accounts may offer the best long-term solution. All of the other options rely upon reducing benefits as the means for overcoming the insolvency of the current system. Only personal accounts offer gains.

And unlike the other options, personal accounts offer an additional benefit: They are more compatible with individual freedom.

John Semmens ([email protected]) is an economist at the Laissez Faire Institute in Tempe, Arizona.