How does the amount that current workers can expect
to receive in future Social Security retirement benefits vary by
state? This Heritage Foundation analysis shows that future
retirement benefits will vary greatly from state to state. It also
shows that typical workers in every state can expect to receive
returns on their lifetime Social Security payroll taxes that are
much lower than those they could expect to have earned from
investing those same retirement taxes in even an ultra-conservative
portfolio of U.S. Treasury Bonds.
Using
federal government data on life expectancy and earnings in each
state, Heritage analysts found that:
-
Average young double-earner families in
every state are likely to experience lifetime losses of potential
income that run into hundreds of thousands of dollars. If
workers in every state had been allowed to invest the retirement
portion of their Social Security taxes in 401(k)-type investment
plans, they could expect to accumulate by retirement significantly
more income than they can expect to receive under Social Security.
Based on a comparison with a portfolio of 50 percent equities and
50 percent U.S. Treasury Bonds, pre-tax losses under Social
Security in 1997 dollars for an average two-earner couple born in
1967 with two children range from more than $1.09 million in the
District of Columbia to $335,000 in South Dakota. Even when
compared with a conservative portfolio composed entirely of U.S.
Treasury Bonds, losses in 1997 dollars range from $592,133 in the
District of Columbia to $98,517 in North Dakota. The 15 states with
the largest dollar losses for young married couples under Social
Security are shown in Table
1.
- Social Security pays a very low rate of return to
almost all families born since 1945. Average families in
every state can expect inflation-adjusted (or real) rates of return
from Social Security that fall well below the 7 percent long-term
real rate that the Social Security Administration's 1994-1996
Advisory Council found to exist on equities. Real rates of return
from Social Security range from 3.83 percent for single-income
couples in South Dakota born in 1945 with two children down to a
negative 0.77 percent for an average double-earner couple in the
District of Columbia born in 1975.
-
Single workers fare particularly
badly under Social Security. Single workers, who do not benefit
from Social Security survivors or spousal benefits, have
particularly low rates of return. Returns for single males range
from 2.14 percent for a single male in Hawaii born in 1945 down to
a negative 2.95 percent for single males in the District of
Columbia born in 1975. Because of longer life expectancies, single
females fare slightly better under Social Security with returns
ranging from 2.78 percent for South Dakota females born in 1945
down to 0.27 percent for single females in the District of Columbia
born in 1975. The 15 states with the lowest returns for single
males born in 1975 are shown in Table
2
It is important to note that low life expectancies depress Social
Security's rate of return by reducing the period during which
retirees collect benefits. States with higher earnings levels also
tend to have lower rates of return because Social Security is
designed to transfer money from high-income to low-income retirees.
Why Do Rates of
Return from Social Security Matter?
Social
Security's rate of return measures the ultimate effect of the
program on the lives of American workers and families. If the rate
were nearly to equal what one could achieve from stocks and bonds,
then it might make sense to devote current savings to other things
besides retirement. But retirement rates of return from Social
Security that are significantly poorer than returns from bonds or
stocks, even after adjusting for inflation and risk, mean that more
savings need to be allocated to future retirement needs.
The
ability of individuals to make this important decision depends on
seeing clearly their retirement rate of return from Social
Security. Knowledge about Social Security's rate of return is
especially important for low-income workers, who generally are less
able to save additional dollars for retirement than higher-income
workers.
Key Assumptions and
Methodology
(for details, see Appendix)
-
In order to focus just on the
individual retirement issues surrounding Social Security, the
estimated insurance cost of pre-retirement survivors
benefits is subtracted from Old-Age and Survivors Insurance payroll
taxes. Thus, only retirement income taxes and benefits are
compared. Likewise, the Heritage Social Security model assumes no
change in disability insurance. Holding disability insurance
payments constant means that the rates of return in this paper
reflect only the retirement portion of Social Security's many
programs. Likewise, the Heritage Social Security model holds
constant the pre-retirement survivors benefits and taxes that
support this program.
-
Future increases in life expectancy and
wages are taken into account and, unless otherwise stated, are
consistent with the intermediate assumptions of the Board of
Trustees of the Social Security trust funds.
-
"Rate of Return" is a statistic widely
used to measure the income performance of an investment. It
represents the annual rate of increase in the value of an
investment and usually is expressed in percentage terms.
-
All calculations are adjusted for
inflation. Both the employee's and employer's share of payroll
taxes are included in the calculations.
- Unless otherwise indicated, the "private" investment
alternatives described in this study are based on tax-deferred
IRA-type accounts, but with initial contributions not
tax-deductible. These accounts may be subject to post-retirement
income taxes.
The Heritage estimates of the rate of return help
low-income workers to determine whether Social Security will
provide them the retirement income they expect by referring only to
that portion of Social Security that provides retirement income.
The non-retirement components of Social Security are removed from
consideration by subtracting pre-retirement survivors benefits and
the taxes that support this separate insurance program from the
retirement rate of return calculations. Similarly, the Heritage
analysis does not include disability insurance taxes or benefits in
its retirement rate of return estimates. The study assumes that
both the survivors and disability programs will continue unaffected
by privatization of the retirement portion of payroll taxes. (See
Appendix, Basic Assumptions and
Methodology, for a more complete explanation of the methodology of
this calculation.)
Until
now, debate on the future of Social Security has focused mainly on
the future financial solvency of the system. However, to focus only
on the future balances of the trust funds ignores the key problem
faced by the Social Security program: In its present form, Social
Security acts to reduce the potential lifetime wealth of the great
majority of current participants. In theory, it would be possible
to ensure the program's financial viability by preserving its
current form while cutting benefits or raising payroll taxes.
However, such solutions, while balancing the trust funds, would
reduce Social Security's rate of return even further below its
current level.
Defenders of the current Social Security
system argue that its rates of return are not a pressing concern
because the program was intended to provide a basic retirement
income and stopgap benefits for the spouses of deceased workers.
Such an argument might be persuasive if Social Security taxes were
a minor burden, but Social Security taxes are not low. The Social
Security program began in 1937 with a 2 percent payroll tax rate.
By 1972, workers were being taxed for the Social Security Old-Age
and Survivors Insurance (OASI) program alone at 8.1 percent on the
first $21,500 (in 1997 dollars) of earnings. In 1997, workers paid
10.7 percent on the first $65,400 of employment income.1 According to U.S. Department of
Labor data, the average American family now spends a higher
proportion of income on Social Security taxes than on
housing.2
These
high payroll taxes mean that many American workers, especially
those at low income levels, have few dollars left over for private,
supplemental retirement savings. Many low- and moderate-income
families are forced to rely on Social Security as their major, if
not sole, form of "wealth." Thus, the key criterion by which the
Social Security system should be judged is this: Do workers receive
an adequate return from the large amount of taxes they are forced
to pay into the system?
Since
an understanding of the returns from the current system is
necessary to ensure a productive national dialogue on Social
Security, economists from The Heritage Foundation's Center for Data
Analysis examined the pattern of returns for various groups of
Americans. Heritage analysts calculated the rate of return from
Social Security for the population as a whole and for workers by
income level, family structure, race and ethnicity, age, and
gender.3 The publication of
Social Security rates of return by geographic area offers still
additional information on Social Security to the American public
and will better enable them to decide on the best reform.
What Do These
Figures Mean?
Table
3 illustrates the foregone income effects of Social Security
using the example of a married couple, both of whom were born in
1967, who now have two children, and who both earn the average wage
prevailing in their state. The table compares Social Security's
retirement benefits for this couple with amounts that they could
expect to accumulate by retirement if they were permitted to invest
the retirement portion of their payroll taxes in either 30-year
U.S. Treasury Bonds or a conservative portfolio composed of 50
percent U.S. Treasury Bonds and a broad equity index that follows
the Standard and Poor's 500. The dollar differences between Social
Security's benefits and the amounts that could be saved through the
private investment of payroll taxes are shown under the heading
Loss Under Current Social Security Compared with Private
Investment in columns 5 and 6.
The
differences in columns 5 and 6 measure the absolute dollar amount
that such a family loses under Social Security in each state and
the District of Columbia compared with what they could expect to
receive had their taxes been placed in private investment accounts.
All amounts in Table 3 are
expressed in terms of 1997 dollars, which means that taxes paid,
projected Social Security benefits, and investment alternatives
have been adjusted for inflation.
States
with the largest dollar losses under the current Social Security
system tend to be highly populated and heavily urbanized, with
relatively high earnings and substantial minority populations. The
large dollar differentials also reflect the comparatively high
taxes that young workers now pay to obtain their future Social
Security retirement benefits. The states with the lowest dollar
losses tend to be comparatively rural and to have low average
earnings combined with relatively high life expectancies.
As can
be seen in Map 1,
there is a geographic concentration of such states with relatively
low absolute-dollar losses from Social Security in the upper
Midwest.4 There is a
concentration of states with large absolute-dollar losses in highly
urbanized Eastern, Midwestern, and Western states.
Map 2
illustrates differences across states in Social Security's rate of
return for single males.5 As
can be seen from Map 2, single male workers in Southern states who
were born in 1975 have generally low rates of return from Social
Security. Single males in a number of large urban states also have
low rates of return from Social Security. Higher rates of return
for males are found in the upper Midwest and in certain Western
states.
Map 3
shows Social Security's rate of return for single females born in
1975.6 As is the case with
male workers, single female workers in rural Western and upper
Midwest states have comparatively higher rates of return than the
national average. However, in contrast to the case of single men,
single women in heavily urbanized Eastern and Midwestern states
tend to fare worse than single women in the South.
Tables
4,
5,
6, and
7
show the real rate of return from Social Security for all family
types born between 1935 and 1975. In all states, single workers and
dual-income married couples fare worse than single-earner married
couples who pay tax on only one earner's wages while collecting
benefits for both the worker and the spouse. Single males have the
lowest rates of return because of shorter life expectancies. In all
cases, the real rate of return on Social Security declines sharply
for workers born between 1935 and 1975, with young workers facing
the lowest returns. In five states and the District of Columbia,
typical single male workers born in 1975 have negative rates of
return, which means they can expect to get back less in
inflation-adjusted dollars than they pay into the Social Security
system.
Conclusion
Social
Security's original aim was to help low- and moderate-income
workers provide for themselves during their retirement years.
However, as this and other Heritage studies have shown, the current
Social Security system actually works to decrease the lifetime
income of most participants by driving retirement income below what
could be achieved through private investments.
What
is true at the national level about Social Security's rates of
return can be seen in each state, but the degree of permanent
income loss varies significantly between states. Social Security
imposes particularly heavy burdens on workers in states with low
life expectancies or above-average incomes. In general, Southern
and heavily urbanized states have the lowest rates of return on the
retirement portion of the current Social Security program.
This
analysis of the Social Security system probably underestimates the
total costs of the current system. It makes no attempt, for
example, to include the economic benefits to states that most
likely would flow from privatizing all or a portion of Social
Security's retirement. Substantially increasing private savings
improves the chances for faster economic growth, higher wages, and
increased employment.
The
superior returns available in bond and stock funds also raise the
probability that retirees will be able to leave cash estates to
their children or other heirs. Such estates constitute direct
infusions of cash into local communities that can be used to open a
grandchild's own retirement savings account, expand a local
business, or pay for someone's educational or medical expenses.
Although debate on Social Security at times
has focused entirely on obscure technical terms (such as
"replacement ratios" and "long-range actuarial balance") that mean
little to people busy with making a living and raising a family,
there is little doubt that the outcome of the debate will be
profoundly important to families in every one of the 50 states and
the District of Columbia. For example, whether the current system
will continue to exist in its present form is a matter of great
concern to a young Ohio couple struggling to accumulate enough
wealth to give themselves and their children a better life. It is
equally crucial to the single Mississippi male who must watch as
his biggest source of retirement wealth yields him a negative
return.
For
almost every type of worker and family in every state--from Alaska
to Florida and from Connecticut to New Mexico--retiring under the
current Social Security system means having less retirement income
and passing on fewer dollars to the next generation than would be
the case if that family were allowed to place their Social Security
taxes in private retirement accounts.
William W.
Beach is John M. Olin Senior Fellow in Economics and
Director of the Center for Data Analysis at The Heritage
Foundation.
Why Do Social Security Rates of
Return
Differ Between States?
The two main factors that drive differences in the return from
Social Security are:
-
Earnings. Social Security
retirement benefits are based on a worker's taxable earnings.
During retirement a low-income worker will be paid a monthly Social
Security benefit that is a larger share of his taxable earnings
than the benefit paid to a similar high-income worker.
-
Life Expectancy. If life
expectancy in a state is low, workers will tend to die sooner and
collect fewer Social Security Old Age benefits. In states with
longer life expectancies, beneficiaries will live longer and
collect more benefits during their lifetimes.
APPENDIX:
BASIC ASSUMPTIONS AND
METHODOLOGY
The
authors used The Heritage Foundation's Social Security Rate of
Return Microsimulation Model to compare the benefits that different
types of families can expect to receive from Old-Age and Survivors
Insurance (OASI) with the Social Security taxes they pay during
their working lives.
The
Heritage model treats taxes paid over a worker's lifetime as a
series of investments. Social Security's rate of return is the rate
of return on these payroll taxes that would buy an annuity equal in
value to the Social Security benefits payments. This yield is the
difference between OASI benefits payments (after subtracting any
applicable income taxes) and the amounts paid to the Old-Age and
Survivors Insurance trust fund through payroll taxes. In the model
and this paper, all amounts are adjusted for inflation and
expressed in terms of 1997 purchasing power.
The
Heritage Foundation model includes both portions of OASI taxes: the
share paid by employers and the share paid directly by the
employee. However, in calculating the return, an amount is removed
from taxes paid that is equal to the premium on a term life
insurance policy which has the same value as benefits that are paid
to children of workers (and the spouse caring for their children)
who die before retirement. This means the calculations do not
unfairly include the cost of the spousal benefit when figuring the
rate of return in terms of retirement income.
Heritage analysts also assume that, from
2015, tax rates will increase by the amount that the Board of
Trustees of the Social Security Trust Funds considers to be
necessary to finance the OASI benefits contained in current
law.
The
earnings to which OASI tax rates are applied are based on a
proportion of the Social Security Administration's Average Wage
Index. Past values of this wage are taken from historical data
contained in the 1997 Annual Report of the Board of Trustees of
the Federal Old-Age and Survivors Insurance and Disability
Insurance Trust Funds, and future wage growth is based on the
Trustees' best guess of what the rate of increase in the average
wage will be.
All
workers are assumed to begin work on their 21st birthday and to
continue to work right up to the age at which they become entitled
to Social Security's full Old-Age and Survivors benefit. For those
retiring in 1997, this is age 65; but under current law, this
retirement age is scheduled to increase gradually until reaching 67
for those born in 1960 and later. Earnings are adjusted to reflect
the average wage earned in each state as a proportion of the
national wage.
The
model calculates post-retirement Old-Age and Survivors benefits to
individuals according to formulas stipulated in current law and the
"best guess" economic assumptions contained in the 1997 Trustees'
Report, up to the date on which their life expectancy expires.
Neither Disability Insurance taxes nor benefits are included in the
model.
The
model uses life expectancies drawn from the National Center for
Health Statistics' 1992 Life Tables for the United States.7 The 1979-1981 Decennial Life
Tables produced by the National Center for Health Statistics are
used to calibrate life expectancy on a state-by-state basis.8
Throughout this study, comparisons are made
between what families could accumulate during their working lives
if they were able to invest their Social Security Old-Age and
Survivors taxes (less the life insurance premium equal to the value
of pre-retirement Survivors Insurance benefits) and what they can
expect to receive, on average, in Old-Age and Survivors benefits.
Different assumptions are entertained regarding the composition of
the worker's portfolio of private investments.
For
years prior to 1997, the historical inflation-adjusted rates of
return on long-term U.S. Treasury Bonds9 and U.S. equities10 are used to determine,
respectively, the rate of return on bonds and the rate of return on
equities. For the period 1997 onward, Heritage analysts used
forecasts of the real rates of return on 30-year long-term U.S.
Treasury Bonds to estimate returns on bond investments.
These
forecasts were made by WEFA, Inc., an economics consulting firm,
and published in its Long-Term Macroeconomic Forecast for October
1997.11 The eventual
long-run average of these forecasts is a 2.8 percent real rate of
return. The annualized real rate of return on equities is assumed
to be 5.7 percent, which lies at the lower boundary of professional
estimates of the long-run returns to equities.12
The Heritage
Foundation Social Security Rate of Return Microsimulation
Model
The
Heritage Foundation Social Security Rate of Return Microsimulation
Model computes the annualized rate of return from Social Security
on the basis of the taxes that individuals or couples are projected
to pay and the benefits they can expect to receive during their
lifetime. The focus of the model is not to provide estimates of the
"average" rates of return to existing populations, but rather to
use data to construct representative individual and family types
and to estimate the rates of return that those representative types
will enjoy.
Internal Rate of
Return
The
internal rate of return is defined as the rate which will set the
discounted value of the stream of Social Security Old-Age and
Survivors Insurance tax payments (i.e., taxes
[Ti]) equal to the discounted stream of income
from the system (i.e., benefits [Bi]).
Discount Rate:
r is the discount rate such
that:
Taxes
The
taxes paid by an individual are calculated by multiplying the
individual's taxable earnings and self-employment income in a given
year by the OASI tax rate in that year. Each individual is assumed
to begin work on his or her 21st birthday and to cease working on
the date on which he or she is entitled by law to collect the full
Social Security Old-Age benefit.13 The OASI tax rate remains at the
current law level until the year 2015, after which tax rates are
adjusted annually so that income and expenditures of the Old-Age
and Survivors Insurance program are equal.14
The
tax revenue in a given year is calculated by means of multiplying
the earnings for that person by the OASI tax rate
Ti =
xi*Wi -
Li
where
x is the OASI tax rate for year i;
Wi is the total taxable wage, salary, and
self-employment income for year i; and Li
is an amount equivalent to the value of a life insurance premium
equal to the actuarial value of pre-retirement Survivors Insurance
coverage.
Earnings
Earnings for workers in each state are
assumed to be a proportion of Social Security's Average Wage
Index15 for employed and
self-employed workers. This proportion is calculated using the
state's average wage as a percentage of average U.S. wages for 1996
as measured and reported by the U.S. Bureau of Labor
Statistics.16
For
periods after 1996, the average wage index is assumed to grow at
the rate assumed under the "intermediate" projections made by the
Social Security Trustees in their 1997 Annual Report.17 In the case of the Single-Earner
Married Couple scenario, it is assumed that one spouse pays no OASI
taxes during his or her lifetime. In the case of the Double-Earner
Married Couple scenario, each earner is assumed to pay OASI
taxes.
Post-Retirement
Old-Age and Survivors Benefits
OASI
benefits are calculated on the basis of the "bend point"
formulas--the earnings levels from which benefit amounts are
calculated--as specified under current law. For example, in order
to calculate the monthly benefit amount for an individual who first
becomes eligible for full Social Security Old-Age Benefits in 1995,
the individual's Average Indexed Monthly Earnings (AIME) is
calculated according to the formulas contained in current law.
Individuals receiving benefits for the first time in 1997 are paid
90 percent of their AIME up to the $437 bend point, 32 percent of
any earnings between the $437 and $2,635 bend points, and 15
percent of any amount in excess of $2,635 (up to the maximum amount
of earnings which are taxable).
For
years after 1997, these bend points are indexed at rates in the
"intermediate" range projections made in the 1997 Trustees' Report.
Benefits are paid up to the point of the individual's life
expectancy. These tables are adjusted to incorporate fully the
effect of changes in life expectancy that are estimated by the
Trustees of the Social Security Trust Funds to occur over the
period 1993-2070. These Social Security benefits may be subject to
income taxes.
Survivors
Insurance
For
married couples, the value of pre-retirement Survivors
Insurance--paid to children of deceased covered workers and the
spouse taking care of them--is approximated by subtracting from
taxes (Ti) the premium required to buy an
equivalent term life insurance policy. Covered individuals are
assumed to carry two 10-year term life insurance policies over 20
years between the ages of 35 and 55.
For
each covered worker turning 35 in 1997 who has two children and
earns the national average wage, the Survivors Insurance policy is
estimated to be equivalent to a 10-year term life insurance policy
worth $295,000. For each average-wage covered worker with two
children who turns 45 in 1997, the Survivors Insurance policy is
assumed to be equivalent to a 10-year term life insurance policy
worth $194,700.
The
market insurance annual premiums required to buy every $250,000
worth of insurance (in 1997) were estimated, respectively, to be
$167 and $345 for a male and $150 and $230 for a female.18 The estimates of the life
insurance component are indexed to changes in the earner's Primary
Insurance Amount,19 which is
used to calculate the worker's retirement benefit.
In the
case of the single-earner married couple, each spouse is assumed to
be the same age. After retirement, the couple is paid 150 percent
of the benefit amount payable to a single beneficiary during the
lifetime of the husband. During the period between the death of the
husband and the death of the wife, the wife is paid 100 percent of
the benefit amount payable to a single recipient.20
Life
Expectancy
Life
expectancy by worker's age is estimated based on life-expectancy
data contained in the National Center for Health Statistics'
1979-1981 State Life Tables.21 However, these estimates reflect
only the demographic conditions that prevailed in 1979-1980 and do
not reflect the long-term upward trend in life expectancy that
factors such as improved health care and better nutritional
standards will cause.
The
Board of Trustees of the Social Security Trust Fund, for example,
estimates that between 1997 and 2070, life expectancy at birth will
increase by 5.8 years for males and 4.6 years for females and that
life expectancy at age 65 will increase by 3 years for females and
2.9 years for males.22 In
order to create life expectancy projections that embody these
projected trends, it is necessary to adjust the 1979-1980 Life
Tables. For workers in each state, these data were adjusted to
conform with life expectancy estimates contained in the 1997
Annual Report of the Board of Trustees of the Federal Old-Age and
Survivors and Disability Insurance Trust Funds.
First,
Heritage analysts made a slight adjustment in the 1979-1981 Life
Tables by applying to them an age-weighted index that adjusts for
the estimated national increase in life expectancy for each gender
over 1979-1981 to 1997:
Q = E + J, and
J = ((O/65)*S + ((65 -
O)/65)*X)
where
Q = 1997 "adjusted" static life
expectancy;
J = age-weighted increase in life
expectancy age between 1992 and 1997;
E = life expectancy based on
1979-1981 "static life tables";
O = age in 1979 (ranges from 5 to
49); and
S and X = respectively, the
increase in life expectancy at birth and age 65 over 1979-1981 and
1997.
Second, Heritage analysts recognized that
the gains in life expectancy in the post-1997 period will not be
uniform across the age distribution. The Social Security
Administration estimates that life expectancy at birth will
increase much faster than life expectancy at age 65. In order to
calculate the gain in life expectancy for individuals between these
two points (birth and 65), an age-weighted index is used:
G = ((A/73)*B + ((65 -
A)/73)*x')
where
G = overall gain in life expectancy
for a particular age group over 1979-1981 to 2070;
A = age in 1997 (ages in the model
range from 21 to 65);
B = gain in life expectancy at birth
between 1997 and 2070; and
x' = gain in life expectancy at age
65 between 1997 and 2070.
G can be used to construct a
projected life table for the single year 2070, where L is
life expectancy for each age group in 1997 and G is the gain
in life expectancy expected to occur for that particular age
between 1997 and 2070:
L = Q + G.
However, this projection must also take
into account the fact that life expectancy gains will be
distributed over time as well as across the age distribution. The
gains in life expectancy projected to occur will be spread across a
period between now and 2070. The later a cohort is born, the
greater the proportion of this increased longevity will be from
where the cohorts can be assumed to benefit. In order to estimate
the degree to which a given cohort will benefit from this increase
in life expectancy, the following linear weighting equations were
used:
"Dynamic" Life Expectancy = Y +
R*(G)
where
Y = Q, or life expectancy in
1997;
R = ((2070 - V)/73); and
V = year in which the individual's
life expectancy expires.
Endnotes