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.
- Internal rate of return on contributions
- Effect of income level and birth year
- Effect of gender
- Effect of race and education
- Effect of foreign vs. U.S.-born
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.
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.
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.
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.
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.
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.
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.
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). (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). (accessed November 2, 1999).
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