Private Annuities vs. Social Security

Social Security provides security – at least as long as Congress can pay its bills – but at what cost? When conservative investments rise faster than wages, a pay as you go system is theoretically inferior to a fully invested annuity. And as we have already seen, even during the nadir of the Great Recession, a conservative portfolio did grow faster than wages over a 35 year time span.

How does this translate in real world investment options? Would the working class be better off with a Chilean style forced savings plan? This is not to say we advocate such here; we do not. But the comparison can teach us whether Social Security is progressive overall, or whether it penalizes the more diligent members of the working class. As we shall see below, Social Security is a good deal for those making average adjusted wages below the first bend. For those above the first bend, the question becomes more interesting. By comparing Social Security with a forced savings plan, we can determine whether or not Social Security widens the gap between the professional class and the truly rich.

With some pretty easy sleight of hand, we can make Social Security look either terrible or wonderful. We shall demonstrate a bit of both and then iterate our way towards the truth.

The private sector equivalent to Social Security is an annuity which continues until death. But not just any annuity! Social Security provides survivor’s benefits, so we much include such when comparing Social Security to the private sector options for a married couple – unless both spouses worked. In that case, we can treat each spouse as single and use his/her income history. For a couple where one spouse works full time for an entire career while the other takes off significant time for raising children, we might compare Social Security to an annuity with partial survivor’s benefits. Finally, we must compare Social Security with an inflation protected annuity! Any other comparison would be dishonest. (This is not to say that an inflation protected annuity is the best retirement option. But if an inflation protected annuity is not a good option for you, then neither is Social Security, for that is what it is.)

Comparing Social Security with a fixed annuity without inflation is the first cheat for those who want to make the case against Social Security. The second cheat is to choose a good year for retirement, say after the year 2000:

Comparing Social Security @66 with saving 10.6% over 35 years (1966 to 2000). For the first 34 years, putting the money in as S and P 500 based index fund, and for the remaining 1 years, in cash while cashing the fund savings over the same period. Finally the funds are used to buy an inflation adjusted annuity priced for a 66 year old.
Career Adjusted Annual IncomeTotal SavingsAnnuity with Survivor's BenefitAnnuity with 75% Survivor's BenefitAnnuity for Single FemaleAnnuity for Single MaleSocial Security Monthly Income
10000.00116035.48414.14457.32480.75536.23708.05
20000.00232070.95828.28914.64961.491072.47974.71
30000.00348106.431242.431371.961442.241608.701241.38
40000.00464141.911656.571829.281922.992144.941508.05
50000.00580177.382070.712286.592403.732681.171774.71
60000.00696212.862484.852743.912884.483217.411971.00
70000.00812248.342899.003201.233365.233753.642096.00
80000.00928283.813313.143658.553845.974289.882221.00
90000.001044319.293727.284115.874326.724826.112346.00
100000.001160354.774141.424573.194807.475362.352471.00
10000.000000 to 20000.000000167483.82597.77660.09693.90773.99841.38
20000.000000 to 40000.000000334967.631195.531320.171387.801547.991241.38
30000.000000 to 60000.000000502451.451793.301980.262081.712321.981641.38
40000.000000 to 80000.000000669935.272391.072640.352775.613095.971971.00
50000.000000 to 100000.000000837419.082988.833300.443469.513869.962158.50

If your career over 35 years is above the median family income, or if it is significantly lower and you are single, investing in a fund that matches the S&P500 (with no dividends) over 35 years beats Social Security. For those below, the progressive nature of Social Security provides a better return. Social Security transfers wealth from the upper middle class to the lower classes. The rich get a free ride. The upper middle class pays incomes taxes and gets a bum deal on Social Security.

The numbers are even worse for Social Security if we look at 45 year careers: people who work starting at age 21 and retire at 66.

Comparing Social Security @66 with saving 10.6% over 45 years (1956 to 2000). For the first 44 years, putting the money in as S and P 500 based index fund, and for the remaining 1 years, in cash while cashing the fund savings over the same period. Finally the funds are used to buy an inflation adjusted annuity priced for a 66 year old.
Career Adjusted Annual IncomeTotal SavingsAnnuity with Survivor's BenefitAnnuity with 75% Survivor's BenefitAnnuity for Single FemaleAnnuity for Single MaleSocial Security Monthly Income
10000.00147861.35527.73582.75612.60683.31708.05
20000.00295722.701055.461165.501225.211366.62974.71
30000.00443584.051583.201748.251837.812049.941241.38
40000.00591445.402110.932331.002450.422733.251508.05
50000.00739306.752638.662913.763063.023416.561774.71
60000.00887168.103166.393496.513675.634099.871971.00
70000.001035029.453694.124079.264288.234783.182096.00
80000.001182890.804221.864662.014900.835466.492221.00
90000.001330752.154749.595244.765513.446149.802346.00
100000.001478613.505277.325827.516126.046833.122471.00
10000.000000 to 20000.000000216989.61774.46855.20899.011002.77871.68
20000.000000 to 40000.000000433979.211548.921710.401798.022005.551301.99
30000.000000 to 60000.000000650968.822323.372565.602697.033008.321732.29
40000.000000 to 80000.000000867958.423097.833420.803596.044011.102027.82
50000.000000 to 100000.0000001084948.033872.294276.004495.055013.872229.52

Under these conditions everyone who averages at least $20000 per year in 2000 dollars is better off investing in stocks than with Social Security!

Before we expose the sleight of hand, let’s make sure everyone understands the numbers in the charts above. The Career Adjusted Annual Income is the nominal income for the year 2000. For previous years, we scale using thethe Social Security Administration’s index factors. These factors represent increases in wages over time due both to inflation and real wage increases. A wage of $15000 in 2000 means a wage of $15000 * 1.29 / 8.37 = $2312 in 1966. A constant adjusted wage means your wage stayed the same relative to wages in general. For careers where wages vary with respect to others over the course of a career, we model with a simple linear ramp model. We linearly interpolate between the two values for each year and then apply the Social Security Administration’s index factor.

The second column is the total savings should one take 10.6% of your wages each year and invest the money in a portfolio that exactly matches the S&P 500. (Of the 6.2% employer and employee FICA tax, only 5.3% goes to retirement. The rest goes to disability. Currently the employee payroll tax rate is even lower as part of what I assume to be a temporary stimulus, so for this study I stick with 5.3% for each.) I realize that the rates and the wage adjusted contribution limits were lower in earlier years, but in these charts I used the non-stimulus numbers retroactively for a reason: the windfall today’s beneficiaries are experiencing is not available for future retirees. The purpose of this exercise is to compare private savings going forward with the windfall-free pay-as-you-go system.

To model the S&P500, I took the month end data from Yahoo Finance and averaged it over each year. An investor who dollar cost averages over the year would do better. For the last year we put the 10.6% in a cash account and sell our portfolio to date at the year’s average price.

The next four columns represent the monthly income you could get from buying an annuity using the aforementioned savings. To arrive at these numbers I used this table of annuity prices from the Principal Financial Group (taken early May 2011; the numbers vary with time). I did a quadratic interpolation of the charts to estimate the price for someone buying an annuity at age 66 to compare with the standard retirement age for Social Security of 66.

The second sleight of hand comes from selecting 2000 as the year to cash out. Do the same calculations for the year 2009 and Social Security looks like a much better deal:

Comparing Social Security @66 with saving 10.6% over 35 years (1975 to 2009). For the first 34 years, putting the money in as S and P 500 based index fund, and for the remaining 1 years, in cash while cashing the fund savings over the same period. Finally the funds are used to buy an inflation adjusted annuity priced for a 66 year old.
Career Adjusted Annual IncomeTotal SavingsAnnuity with Survivor's BenefitAnnuity with 75% Survivor's BenefitAnnuity for Single FemaleAnnuity for Single MaleSocial Security Monthly Income
10000.0052455.81187.22206.74217.33242.41708.05
20000.00104911.61374.44413.48434.66484.83974.71
30000.00157367.42561.66620.22651.99727.241241.38
40000.00209823.23748.88826.96869.32969.661508.05
50000.00262279.03936.101033.691086.651212.071774.71
60000.00314734.841123.321240.431303.981454.481971.00
70000.00367190.651310.541447.171521.311696.902096.00
80000.00419646.451497.761653.911738.641939.312221.00
90000.00472102.261684.981860.651955.972181.732346.00
100000.00524558.071872.202067.392173.302424.142471.00
10000.000000 to 20000.00000071523.98255.28281.89296.33330.53841.38
20000.000000 to 40000.000000143047.96510.55563.78592.66661.071241.38
30000.000000 to 60000.000000214571.93765.83845.67888.99991.601641.38
40000.000000 to 80000.000000286095.911021.101127.561185.321322.141971.00
50000.000000 to 100000.000000357619.891276.381409.451481.651652.672158.50

Everyone except high income singles and high income two wage earner households does better with Social Security than with a private annuity. Defenders of the New Deal are entitled to a neener dance at this point. But keep it short, for this chart biases our results against the investment option. For starters, many people work for more than 35 years. For 45 year careers we have:

Comparing Social Security @66 with saving 10.6% over 45 years (1965 to 2009). For the first 44 years, putting the money in as S and P 500 based index fund, and for the remaining 1 years, in cash while cashing the fund savings over the same period. Finally the funds are used to buy an inflation adjusted annuity priced for a 66 year old.
Career Adjusted Annual IncomeTotal SavingsAnnuity with Survivor's BenefitAnnuity with 75% Survivor's BenefitAnnuity for Single FemaleAnnuity for Single MaleSocial Security Monthly Income
10000.0068502.89244.49269.98283.81316.57708.05
20000.00137005.77488.99539.97567.63633.14974.71
30000.00205508.66733.48809.95851.44949.721241.38
40000.00274011.55977.971079.931135.261266.291508.05
50000.00342514.431222.471349.921419.071582.861774.71
60000.00411017.321466.961619.901702.891899.431971.00
70000.00479520.211711.461889.891986.702216.012096.00
80000.00548023.091955.952159.872270.512532.582221.00
90000.00616525.982200.442429.852554.332849.152346.00
100000.00685028.872444.942699.842838.143165.722471.00
10000.000000 to 20000.00000096962.50346.07382.15401.73448.09871.68
20000.000000 to 40000.000000193925.00692.14764.30803.45896.191301.99
30000.000000 to 60000.000000290887.501038.211146.451205.181344.281732.29
40000.000000 to 80000.000000387850.001384.281528.591606.901792.372027.82
50000.000000 to 100000.000000484812.501730.341910.742008.632240.462229.52

Those who sustain a high income over the course of a 45 year career are better off with the private option. For the rest, however, Social Security still wins.

You can pause your neener dance now. All the charts up to this point are exaggerated compared to a conservative investment strategy. Putting money into stocks while you are young is a sound strategy. Keeping your money in stocks right up to retirement age is not! A conservative strategy entails selling off your stock (or mutual fund) portfolio over time. Let’s see what happens when we impose a five year selloff strategy. For a 35 year career, buy a stock/mutual fund portfolio that tracks the S&P500 for the first 30 years. For the next five years put the savings in cash and cash out 1/5 of the total portfolio. The results for 2009 are now:

Comparing Social Security @66 with saving 10.6% over 35 years (1975 to 2009). For the first 30 years, putting the money in as S and P 500 based index fund, and for the remaining 5 years, in cash while cashing the fund savings over the same period. Finally the funds are used to buy an inflation adjusted annuity priced for a 66 year old.
Career Adjusted Annual IncomeTotal SavingsAnnuity with Survivor's BenefitAnnuity with 75% Survivor's BenefitAnnuity for Single FemaleAnnuity for Single MaleSocial Security Monthly Income
10000.0068101.52243.06268.40282.15314.72708.05
20000.00136203.05486.12536.80564.30629.44974.71
30000.00204304.57729.18805.21846.45944.151241.38
40000.00272406.10972.241073.611128.611258.871508.05
50000.00340507.621215.311342.011410.761573.591774.71
60000.00408609.151458.371610.411692.911888.311971.00
70000.00476710.671701.431878.811975.062203.022096.00
80000.00544812.201944.492147.212257.212517.742221.00
90000.00612913.722187.552415.622539.362832.462346.00
100000.00681015.252430.612684.022821.513147.182471.00
10000.000000 to 20000.00000092768.29331.10365.62384.35428.71841.38
20000.000000 to 40000.000000185536.58662.20731.24768.70857.421241.38
30000.000000 to 60000.000000278304.87993.301096.861153.041286.131641.38
40000.000000 to 80000.000000371073.151324.401462.471537.391714.841971.00
50000.000000 to 100000.000000463841.441655.501828.091921.742143.552158.50

Hmmm, Social Security still wins! (In an earlier version of this article, the S&P to annuity strategy still beat Social Security for high income earners because I was assuming that all of FICA taxes went to retirement. “Pnwgy” correctly noted in the comments below that I should have used 5.3% instead of 6.2% for retirement. Oops!) But this leaves us with a mystery: how can Social Security win across the board when in the previous article we saw that even for this bad year the S&P500 grew faster than wages. Is it because illegal immigrants are contributing without hope of collecting? Or is Social Security still handing out an unsustainable windfall? Or perhaps the private inflation adjusted annuities I found are a bad deal? It does seem like the conservatives and libertarians who call Social Security have been lying, or at least need to crunch some more numbers. Maybe they need to stabilize the money and financial systems so that private annuities become a good deal first, and then call for privatization. Or maybe the game is rigged against private inflation adjusted annuities, and they are inherently a bad deal. See below.

Anyway, let’s move on and look at Social Security vs. private annuities for those with longer careers, 45 years to be precise:

Comparing Social Security @66 with saving 10.6% over 45 years (1965 to 2009). For the first 40 years, putting the money in as S and P 500 based index fund, and for the remaining 5 years, in cash while cashing the fund savings over the same period. Finally the funds are used to buy an inflation adjusted annuity priced for a 66 year old.
Career Adjusted Annual IncomeTotal SavingsAnnuity with Survivor's BenefitAnnuity with 75% Survivor's BenefitAnnuity for Single FemaleAnnuity for Single MaleSocial Security Monthly Income
10000.0088971.36317.55350.65368.62411.16708.05
20000.00177942.72635.10701.31737.23822.33974.71
30000.00266914.07952.641051.961105.851233.491241.38
40000.00355885.431270.191402.621474.471644.651508.05
50000.00444856.791587.741753.271843.092055.821774.71
60000.00533828.151905.292103.922211.702466.981971.00
70000.00622799.512222.832454.582580.322878.142096.00
80000.00711770.872540.382805.232948.943289.312221.00
90000.00800742.222857.933155.893317.563700.472346.00
100000.00889713.583175.483506.543686.174111.632471.00
10000.000000 to 20000.000000125854.97449.19496.02521.43581.61871.68
20000.000000 to 40000.000000251709.95898.38992.041042.861163.231301.99
30000.000000 to 60000.000000377564.921347.571488.061564.291744.841732.29
40000.000000 to 80000.000000503419.891796.761984.082085.722326.452027.82
50000.000000 to 100000.000000629274.872245.952480.102607.152908.072229.52

Still, Social Security looks good under a worst case scenario for the S&P500. A switch over to a pure forced savings plan appears to entails unacceptable risk! Pity those born on the wrong years! But before we opt to keep Social Security as is, let us consider that there are also good years, such as 2000. Even if we blunt them with a more conservative 5 year selloff period we get for a 35 year career:

Comparing Social Security @66 with saving 10.6% over 35 years (1966 to 2000). For the first 30 years, putting the money in as S and P 500 based index fund, and for the remaining 5 years, in cash while cashing the fund savings over the same period. Finally the funds are used to buy an inflation adjusted annuity priced for a 66 year old.
Career Adjusted Annual IncomeTotal SavingsAnnuity with Survivor's BenefitAnnuity with 75% Survivor's BenefitAnnuity for Single FemaleAnnuity for Single MaleSocial Security Monthly Income
10000.0087823.61313.45346.13363.86405.86708.05
20000.00175647.23626.90692.26727.72811.72974.71
30000.00263470.84940.351038.391091.591217.581241.38
40000.00351294.461253.811384.521455.451623.441508.05
50000.00439118.071567.261730.651819.312029.301774.71
60000.00526941.691880.712076.782183.172435.161971.00
70000.00614765.302194.162422.912547.032841.012096.00
80000.00702588.922507.612769.042910.903246.872221.00
90000.00790412.532821.063115.173274.763652.732346.00
100000.00878236.143134.513461.303638.624058.592471.00
10000.000000 to 20000.000000126688.71452.16499.31524.88585.47841.38
20000.000000 to 40000.000000253377.43904.33998.611049.771170.931241.38
30000.000000 to 60000.000000380066.141356.491497.921574.651756.401641.38
40000.000000 to 80000.000000506754.851808.661997.222099.542341.871971.00
50000.000000 to 100000.000000633443.562260.822496.532624.422927.332158.50

Social Security was a bad deal for successful single professional and two income professional couples. And for a 45 year career Social Security was a bad deal for all but those at the lowest income levels:

Comparing Social Security @66 with saving 10.6% over 45 years (1956 to 2000). For the first 40 years, putting the money in as S and P 500 based index fund, and for the remaining 5 years, in cash while cashing the fund savings over the same period. Finally the funds are used to buy an inflation adjusted annuity priced for a 66 year old.
Career Adjusted Annual IncomeTotal SavingsAnnuity with Survivor's BenefitAnnuity with 75% Survivor's BenefitAnnuity for Single FemaleAnnuity for Single MaleSocial Security Monthly Income
10000.00111983.98399.68441.35463.96517.51708.05
20000.00223967.96799.36882.70927.921035.02974.71
30000.00335951.941199.051324.051391.881552.531241.38
40000.00447935.931598.731765.411855.842070.051508.05
50000.00559919.911998.412206.762319.802587.561774.71
60000.00671903.892398.092648.112783.763105.071971.00
70000.00783887.872797.773089.463247.733622.582096.00
80000.00895871.853197.463530.813711.694140.092221.00
90000.001007855.833597.143972.164175.654657.602346.00
100000.001119839.813996.824413.514639.615175.122471.00
10000.000000 to 20000.000000164254.22586.24647.36680.52759.07871.68
20000.000000 to 40000.000000328508.431172.481294.721361.041518.141301.99
30000.000000 to 60000.000000492762.651758.721942.082041.562277.201732.29
40000.000000 to 80000.000000657016.872344.962589.432722.093036.272027.82
50000.000000 to 100000.000000821271.082931.203236.793402.613795.342229.52

Conversely, at the very bottom Social Security was still better than forced savings coupled with private annuity.

Why not Keep Social Security?

It appears that for tens of millions of people Social Security is competitive or clearly superior to a conservative retirement portfolio even under good market conditions. That 90% of adjusted average wages you get below the first bend beats out most markets. The lower rates above the bend are another story. (We shall look at private investing plus free money money equal to the first bend value in a future article.) Some of the advantage of Social Security is real; some is a cheat, however.

Social Security is an inflation adjusted annuity that you have to buy whether it is a good deal or not. If you have poor health and are likely to die soon after retirement, then a generic inflation adjusted annuity is a bad deal. Social Security subsidizes the long lived at the expense of the short lived. A private annuity plan that applies to everyone will experience adverse selection; only the likely long lived would buy the product unless there are discounts available for the unhealthy. This is why Social Security appears competitive with the private investment option even though conservative investments on average grow faster than wages. With Social Security, those who die young subsidize the rest. With Social Security, you pay into the annuity even before your reach retirement age, vs. the private immediate annuities I quoted. Given current life expectancies, Social Security is currently a welfare program that takes away from black males and transfers to white females. (This may change over time.)

We leave it as an exercise to the reader to shop around as to what discounts the market currently provides for being an overweight smoker or have a life shortening preexisting condition. Good luck finding an African American discount.

Free Money, the Simple Alternative

We propose providing free money for seniors equal to at least the first bend in Social Security and letting the younger generations invest as they see fit for any money above this value. The reasons for doing so are several:

Dishonesty abounds in this debate from all sides. Choose the right data points and you can make Social Security look great or terrible. The answer is somewhere in between. If we don’t figure in the annuity value of Social Security benefits, we can overstate the gap between rich and poor. If we fail to account for the transfer between the upper middle class and the poor via payroll taxes, we can make the truly rich look overtaxed since they “pay most of the income tax.” The rich can also appear overtaxed when the government runs a cash surplus while actually running an actuarial deficit. Somebody has been undertaxed to the tune of over 13 trillion dollars! Either that, or the government has been spending money it shouldn’t have been spending. Which is it? And then we have the short lived and the illegal aliens who are paying for a retirement annuity they will never receive. They are paying federal taxes even if they don’t pay income tax.

For all these arguments against Social Security, the forced savings plan option also has problems:

  1. As we have seen in this study, except for lucky circumstances combined with risky investing, the poorest are better off under Social Security as is. (Though if the forced savings program required annuity purchase upon retirement, the rates would be better than those I quoted here.)
  2. People who “invest” in lottery tickets cannot be trusted to save for retirement and invest it conservatively without being forced to.
  3. Government directed forced savings plans put the government in charge of where investments go. This is in some ways more socialistic than Social Security.
  4. If most people invest in index funds, then we magnify herd effects. The system loses information and bubbles could be even worse.
  5. If forced savings accounts are limited to conservative investments, we may end up favoring established corporations over new corporations and large corporations over small corporations.
  6. In bad years, forced savings accounts followed by inflation adjusted annuities are worse than Social Security for some of the population. (Though once again, if annuity purchase upon retirement was mandatory, annuity rates would be better than those I quoted.)

Our plan to simplify payroll, reduce the responsibility of Congress, create an ownership society and provide an ample safety net is as follows:

  1. Stabilize the financial system by eliminating tax incentives for excessive leverage.
  2. Slowly reign in maturity transformation on the part of banks, which would make bank based IRAs a decent, if not spectacular investment.
  3. Honor existing Social Security promises for the retired and nearly retired.
  4. Merge payroll taxes into the income tax and/or replace them with tariffs and excises.
  5. Eventually replace Social Security with free money for all seniors, at a level at least as high as the first bend (currently $761/month). For a couple this sets a minimum retirement income equal to twice this amount even if only one spouse worked.

In subsequent articles we investigate how much people would need to save in order to beat today’s Social Security if they had the free money safety net in addition. We shall look at both stocks and more conservative investments.