FRBSF Economic Letter
99-34; November 12, 1999
 Economic
Letter Index
Rates of Return from Social Security
Under the current Social Security law, 10.7% of nearly every U.S. employee's
gross annual wage (up to a maximum of $72,600) must be "contributed" to
the Old Age and Survivor's Insurance (OASI) program. For many individuals,
these contributions represent the most important (and perhaps only) investment
they will make to provide financial support for themselves during retirement.
In 1997, OASI payroll tax contributions totaled $350 billion, or 4.3%
of GDP. By comparison, contributions to private retirement plans (pensions,
401ks, and IRAs) totaled about 2% of GDP. Given the huge flow of funds
into Social Security, it is natural to wonder about the return that today's
workers can expect to receive from the program in the form of post-retirement
benefits. This Economic Letter summarizes the findings of some
recent studies which show that the investment deal offered by Social Security
varies significantly across distinct groups of individuals depending on
age, income, gender, family status, race, education, and country of origin.
In light of the ongoing debate over reform of Social Security (see Daly
1999 and Lansing 1998 for a discussion), these results serve to remind
us that in addition to being a retirement program, Social Security includes
some important redistributional features.
Internal rate of return
on contributions
One way to assess the investment deal offered by Social Security is to
compute the internal rate of return on contributions. This is the rate
of interest that a worker would have to receive on contributions to a
hypothetical savings account in order to accumulate a balance at retirement
that is sufficient to finance a stream of benefits exactly equal to those
promised by Social Security. In reality, of course, no such saving account
exists. Social Security operates primarily on a pay-as-you-go basis, which
means that the vast majority of workers' contributions are neither saved
nor invested--the money is simply transfered to current retirees to pay
benefits. To be sustained, the program requires an ever-expanding payroll
tax base which comes from a growing labor force and productivity-driven
wage gains. Despite the fiction of the savings account, the internal rate
of return is a useful concept because it allows us to compare Social Security
to other types of investments that could provide retirement support.
Effect of income level and birth year
By design, Social Security redistributes income by means of a progressive
benefit formula. Low-paid workers are awarded a greater fraction of their
pre-retirement income than high-paid workers. This progressive benefit
structure is more than enough to offset the regressive nature of the OASI
payroll tax whereby income above a specified maximum level (currently
$72,600) is not subject to the tax. Caldwell, et al. (1998) compute internal
rates of return on contributions for several categories of OASI participants
(see Figure 1, Panels A-D).
The authors find that, under current OASI rules, today's lowest paid workers
(those in the bottom 20% of the income distribution based on lifetime
earnings) can expect internal rates of return between 4% and 5% after
adjusting for inflation (Panel A). Today's middle income workers can expect
real rates of return between 1% and 2%. Today's highest paid workers can
expect real rates of return below 1% and may even face negative rates
of return if born after 1975.
Within each category of income, rates of return generally decline with
birth year. This is due to the historical rising trend of OASI tax rates
combined with legislated increases in Social Security's normal retirement
age. The OASI payroll tax rate in 1963 (when those born in 1945 began
to enter the work force) was 6.75% on income up to $4,800. By 1980, the
tax rate had risen to 9.04% on income up to $25,900. The tax rate now
stands at 10.7% on income up to $72,600. Under current OASI rules, workers
born between 1945 and 1954 can retire with normal benefits at age 66.
Workers born between 1955 and 1959 must wait an additional two months
for each year beyond 1954. Workers born after 1959 must wait until age
67. Hence, compared to today's older workers, today's younger workers
must contribute a larger fraction of their paychecks to qualify for benefits
that start later in life.
Effect of gender
Women receive a higher rate of return on contributions than men (Panel
B). Three factors account for this result. First, women generally have
lower earnings than men. This causes Social Security's progressive benefit
formula to award a greater fraction of pre-retirement income to women.
Second, women tend to live longer than men. This allows women to collect
benefits for more years following retirement. Third, women are more likely
to receive spousal and survivor benefits computed on the basis of their
spouse's higher earnings record. For example, a woman who has been married
at least ten years is entitled to receive benefits equal to one-half that
of her husband's benefits even if she has never contributed a dime to
Social Security. If the husband dies, the widow is entitled to the husband's
full benefits. In this way, Social Security redistributes income away
from single individuals and two-earner couples toward one-earner couples.
Effect of race and education
There is very little disparity between the rates of return received by
whites versus non-whites (Panel C) and the college-educated versus the
non-college-educated (Panel D). Two offsetting factors account for this
result. On the one hand, whites and the college-educated have longer life
expectancies and hence more years of collecting benefits. On the other
hand, non-whites and the non-college-educated have lower earnings which
implies more favorable treatment under Social Security's progressive benefit
formula.
Effect of foreign vs. U.S.-born
Another issue of some interest is Social Security's treatment of immigrants
versus U.S.-born workers. This point is not addressed by Caldwell, et
al. (1998) but is the subject of a separate study by Gustman and Steinmeier
(1998). These researchers find that immigrants receive a higher rate of
return on Social Security contributions in comparison to U.S.-born workers
even when their earnings are identical for all years the immigrant has
been working in the U.S. This is because Social Security's benefit formula
assigns a value of zero earnings to all years the immigrant spends outside
the U.S. The effect is to make the immigrant worker appear to have a lower
lifetime earnings history in comparison to a similarly paid U.S.-born
worker. As noted earlier, workers with lower earnings receive a better
deal from Social Security due to the progressive benefit formula. Despite
the better deal received by immigrants who stay in the U.S., the participation
of immigrant workers in the Social Security program is a net plus for
U.S.-born workers. Gustman and Steinmeier (1998) find that taxes received
from immigrants who subsequently emigrate from the U.S. without collecting
benefits serve to reduce the financing burden on workers who remain in
the program.
Conclusion
Social Security has evolved from humble beginnings in 1935 as a program
of "forced saving" intended to ensure retirement income for the elderly
into its present form: a complex, resource-intensive program that redistributes
income across individuals and households based on a wide variety of characteristics.
In general, Social Security favors low-wage earners over high-wage earners,
older workers over younger workers, women over men, and immigrant workers
over U.S.-born workers. The "average" U.S. worker faces a rate of return
on contributions that is quite low--less than 2% after adjusting for inflation.
By comparison, the real yield on a 10-year inflation-indexed Treasury
Bond is currently around 3.5%. In addition to being low, rates of return
from Social Security must be viewed as risky because they are subject
to change from future political actions that will be needed to ensure
long-term solvency of the program. Under intermediate demographic and
economic assumptions, Gokhale (1998) reports that the OASI payroll tax
rate must be increased by about 4 percentage points (from 10.7 to 14.6%)
to pay for projected benefits on an ongoing basis, i.e., for 75 years
and beyond. Alternatively, long-term solvency could be achieved by cutting
benefits by 25%. Either action would reduce the real rate of return for
the average U.S. worker to around 1%. A tax increase would be disproportionately
borne by young workers (who are further from retirement) whereas a cut
in benefits would penalize young and old workers in a more even-handed
way. While numerous ideas for reforming Social Security exist, none have
yet to be formally proposed in the U.S. Congress. Continued delays in
addressing Social Security's long-term financing problem will only lead
to more painful adjustments in the future.
Kevin Lansing
Economist
References
Caldwell, Steven, Melissa Favreault, Alla Gantman, Jagadeesh Gokhale,
Thomas Johnson, and Laurence J. Kotlikoff. 1998. "Social
Security's Treatment of Postwar Americans." National Bureau of Economic
Research, Working Paper 6603. <http://www.nber.org/papers/w6603>
(accessed November 2, 1999).
Daly, Mary. 1999. "Understanding the Social Security
Debate." FRBSF Economic Letter 99-20 (June 25). <http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-20.html>
(accessed November 2, 1999).
Gokhale, Jagadeesh. 1998. "Social
Security's Treatment of Postwar Generations." Federal Reserve Bank
of Cleveland Economic Commentary (November). <http://www.clevelandfed.org/Research/com98/index.htm#1101>
(accessed November 2, 1999).
Gustman, Alan L., and Thomas L. Steinmeier. 1998. "Social
Security Benefits of Immigrants and U.S. Born." National Bureau of
Economic Research, Working Paper 6478. <http://www.nber.org/papers/w6478>
(accessed November 2, 1999).
Lansing, Kevin. 1998. "Can the Stock
Market Save Social Security?" FRBSF Economic Letter 98-37
(December 11). <http://www.frbsf.org/econrsrch/wklyltr/wklyltr98/el98-37.html>
(accessed November 2, 1999).
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