Friday, October 19, 2012

What’s Your Social Security Rate of Return?

Writing for Reuters, Mark Miller runs through a SSA Office of the Actuary analysis of rates of return paid to different types of people from Social Security. You can check out the SSA study directly here.

Miller states “[The SSA analysis] showed that some workers might beat Social Security's returns in some years if they took risks in the stock market. But over a lifetime, Social Security's consistent, risk-free and inflation-adjusted returns would be very tough to beat.”

I’m not so sure.

One mistake Miller makes is to look at “current law” benefits, which assumes that Social Security can pay full benefits forever without raising taxes. In other words, it overlooks the multi-trillion dollar funding shortfalls that are the main reason we think about Social Security reform.

A more accurate analysis, and one that is truly reflective of current law, assumes that full benefits will be paid through the early 2030s, when the trust fund is projected to run out. Following that, benefits are reduced to the level that can be paid through payroll tax receipts alone, a cut of around one-fifth. That obviously would reduce returns from Social Security.

While there are other (and better) ways to fix Social Security’s finances, no matter how we do it, rates of return paid by Social Security will on average be consistent with this “payable benefits scenario.” We might raise taxes rather than cut benefits, or we might cut benefits gradually rather than all at once, or we might cut benefits for some but not for others, but the net effect on rates of return will on average be the same.

And under this realistic baseline rates of return aren’t exactly staggering. For instance, a typical couple retiring today would receive a return of less than 3.2 percent, which is about what you’d get on government bonds. But considering the political risk of Social Security, my guess is people would consider government bonds to be a better deal. Going forward returns will be lower. And for single individuals or higher-earning couples, returns can be well below the government bond rate.

Is Social Security a terrible deal? For a low-risk investment, no. But is it a good deal? Not really.


WilliamLarsen said...

It is amazing that the SSA or those doing this analysis COMBINE two separate programs OASI and DI into one analysis. The writers state;

"We consider all types of retirement, disability, and survivor benefits, except for benefits to student children, disabled-adult children, and parents based on caring for a disabled-adult child. Omission of these benefits results in a very small understatement of the theoretical internal rate of return."

First, the OASI tax rate is 10.6% and the DI tax rate is 1.8%. They have different criteria for each. Combining non normal distributions into one is not mathematically correct. The worker to beneficiary ratio for OASI is much different than the ratio for DI (which is much lower).

The DI return will be zero for the majority who pay SS-DI taxes because the majority never collect. This is more like insurance where if you have a loss, you file a claim; house burns down.

The OASI is not insurance but as the analyzer has stated PAY-GO, which was never FDR's plan. Over the years in order to avoid the term "PONZI", PAY-GO was used.

Michael Clingman, Kyle Burkhalter, Alice Wade, and Chris Chaplain have left out some detailed information and used some incorrect assumptions.

Incorrect assumptions are;
"for the Payable Benefits scenario, annual benefit reductions begin in 2036 and generally increase each year thereafter. Projected program income, using present-law tax rates, pays 76.5 percent of scheduled benefits in 2037 and 74.4 percent of scheduled benefits in 2085.?"

If the payroll tax does not increase, then it is mathematically impossible to pay 74.4% of schedule benefits in 2085. The current worker to beneficiary ratio for OASI is 3.8 to 1. In 2085 it will be around 2.4 to 1 according to the SSA intermediate population file the SSA sent me. Now it could be they believe in 2085 that the current 18% of those between 18 and full retirement age will who are not working due to being unemployed, women who take time off for children/birth, early retirement, etc will work. I do not think this will be the case and it would be a bad assumption to make without identifying it.

2nd, the SSA web site identifies the precise rates of returns earned each year. However, I have not found any reference to these rates.

3rd "The maximum steady worker is assumed to be born on January 2 and to start working on his/her 22nd birthday." This is not a correct assumption. Fully over 1/3 of the population begins full time work at age 19. A better assumption is to use age 20 to 21 which would be a weighted average of those who go to college and those who work full time after high school. In my own case, I began work at age 17, though I only worked summers I find that these early years impact my IRR.

4. It is fairly easy for anyone to calculate their own IRR.

benefit formula -

Tax rates -

Treasury Rates -

I calculate the IRR for those born after 1985 between a -1.0% and 2.0% depending on wage history. If you add in non working spouses, it will generally double.

"The payroll-tax rate increases from the present law amount of 12.4 percent beginning in 2036. The payroll-tax rate increases to 16.21 percent for 2037 and continues to increase year-by-year, reaching 16.64 percent for 2085."

From 12.4 to 16.64 without any increase in benefit, yet a 25% increase in tax, how does this not affect IRR?

Arne said...


1) I think you are right to note that combining OASI and DI is odd. They are very different types of insurance, but they are still insurance.

An ROI analysis on a PAYGO system is inherently flawed since your money does not earn interest until you get it back. Your money goes to keep your parents generation out of poverty. A meaningful analysis would need to determine how much you would spend for that purpose if SS did not exist.

FDR may have envisioned less PAYGO, but that is not what the 1935 Act implemented. Starup costs prevented it. (And Congress did not listen to Altmeyer.)

"The current worker to beneficiary ratio for OASI is 3.8 to 1"
No, the current ratio is 2.8 and is produces very close to cost balance. Paying 75% of benefits at a ratio of 2.4 is entirely consistant.

2) Take a look at Table V.B2

3) The "hypothetical steady maximum worker" is not meant to represent a real situation. No one really starts a $100K job at age 22, much less 17.

4) As Andrew observes, Table 1, Present Law, is not the right one to use. Comparing Table 1 to Table 2 or 3 produces the decrease in ROI that you expect. In fact, the 25% increase in taxes means you go from Table 3 to Table 2, which produces an increase in ROI. The incremental increase in ROI associated with increasing the taxes to meet scheduled benefits is about 3 percent for a single male. Not bad, except that the whole ROI analysis is flawed from the beginning.

Andrew G. Biggs said...


Regarding your point 4, I think the increase in returns due to the tax increase is a statistical illusion. Returns are affected equally whether we raise taxes or reduce benefits, but raising taxes pushes out the date at which returns fall. If we cut benefits today then IRRs for people retiring today will fall; if we raise taxes today, current IRRs will be unchanged but will fall once today's workers retire.

Arne said...


Since I think the whole ROI analysis is a statistal illusion, I am loathe to disagree, but I often find mathematical illusions interesting for themselves.

For instance, the whole concept of backwards transfer is another illusion. Every year the backwards transfer increases. This increase goes on forever, whether you decrease benefits or increase taxes. However, if you increase taxes, the backwards transfer also increases. Increasing the backwards transfer MUST increase the ROI.

Of course, all of this interesting math has very little to do with whether SS is a good idea or how best to deal with the upcoming shortfall.

WilliamLarsen said...

The only way the Internal Rate of Return of a cash outlay over 10 to 45 years balanced with a cash inflow of 1 to 30 years can increase is for one of two things to happen:

1 The cash inflow (benefits) must increase while the cash outflow (Taxes) stay constant.

2. The cash inflow (Benefits) stays constant while the cash outflow (taxes) decrease.

I have run millions of iterations using current OASI law for benefits at early and full retirement age v numerous wage levels from low to high, unsteady to steady and it is very difficult to get the rates in this paper.

One way to determine the magnitude of the problem is what is the theoretical tax rate of a cohort? Period cohort life tables exist and are helpful in determining the number of years a cohort will collect benefits. Like wise SSA population files from 1940 through 2000 clearly show the number of people at each age there were in the US. The SSA US Wage for each year is known up till 2010. We also know that future benefits for a cohort grow at the exact same rate as the SSA US wage rate up till age 60 for that cohort. since benefits are indexed by COLA which is generally different from SSA US wage, we have a compound gradient.

see formula

Using the above formula and the targeted OASI benefit 42% of life time indexed wages, we can calculate the savings rate (same as the tax rate) that is needed to sustain this benefit based on the period cohort tables at full retirement age.

Using this formula and changing the replacement rate while working (Same as SSA US wage Growth) it is clear that assuming a higher wage growth increases the need to save more (increase tax) in order to pay future benefits at full retirement age.

Assuming SSA can pay 75% of benefits makes it easy to determine what the tax rate is to pay this benefit. 75% payable x 42% benefit is 31.5% of life time indexed wages. based on a 10.6% payroll tax requires 3.7% Treasury rate, but this assumes COLA is paid at 2.5%. But since the trust fund is exhausted and under current law COLA is suspended, the US Treasury rate needed to pay this future 75% benefit falls to a tad over 3.1%. But this is not the entire story. As each year passes beyond 2033, the worker to beneficiary ratio continues to drop, which means the cost per worker (taxes) must increase or the benefits paid to beneficiaries must decrease. This is purely a mathematical problem. Since benefits are indexed by the change in the SSA US Wage, benefits are directly dependent on US wage growth. Since the Treasury rate in the past generally rose and fell in relation to inflation, the effective rate of return (1+Treasury) divided by (1+COLA)- 1 did not vary much, thus making projecting future costs fairly constant. The difference is relative size (smaller wage growth makes future benefits smaller), higher inflation tends to push wage growth as well as inflation as well as treasury rates.

In 2085 the IRR of the OASI cash flow (Taxes/benefits) is around 2.5%. The problem is in normal terms this is 50% less than normal treasury rates.

Insurance works when there is a low risk of a high dollar loss. Home owners insurance works well because few homes of the insured are damaged, thus the cost is spread out over everyone. However, with OASI the risk of living to full retirement age from age 21 is very high. In the case of OASI the loss is living and that means there is a high risk of paying out to many while each payout is high. Social Security OASI is not insurance. The "Insurance" was added to the program title in order to keep the supreme court from ruling it unconstitutional. Congress also state in the legislation that they reserved the right to alter, change or repeal any portion without liability.

Actually, the backward transfer cannot continue on forever in the case where birth rates continue to fall steadily over time.

Bill Woessner said...

The CBO does a similar analysis every year and reaches a drastically different conclusion. The CBO analysis concludes that only those in the lowest quintile of lifetime household earners can expect to receive more from Social Security than they pay in. Everyone else will receive less, with the average person getting back about 87% of what they pay in to Social Security.