What can union members, from miners to school
teachers, expect to receive from Social Security after a lifetime
of contributing payroll taxes to the Old-Age and Survivors
Insurance (OASI) program? And how does this compare with the
returns they reasonably could expect if the taxes were placed in
private investments? A new study by the Center for Data Analysis,
using real-world data from the federal government's own databases,
shows that inflation-adjusted rates of return on retirement payroll
taxes paid by unionized workers are lower. In fact, many unionized
workers are losing hundreds of thousands of dollars in potential
retirement income because of their inability to invest payroll
taxes in U.S. Treasury Bonds or stock index funds.
A
careful examination of the experiences of a diverse selection of 20
union households, with principal beneficiaries aged between 25 and
45 years who earn the average union wage prevailing in their
industry, reveals that all would be better off in a system based on
the personal investment of payroll taxes. For most of these
unionized workers, losses under the current retirement portion of
the Social Security system (which consumes 10.6 percent of their
annual pay up to the maximum taxable income limit, or $68,400 in
1998) run into hundreds of thousands of dollars, compared with what
they would have received had their payroll taxes been placed in
conservative 401(k)-type assets. For example:
-
Because they have
shorter-than-average life expectancies and do not benefit from
Survivors Insurance and spousal benefits, single male union workers
are hit particularly hard under the current system. Among
the 20 households examined in this study, negative returns range
from -1.7 percent for a 35-year-old union miner to -0.3 percent for
a 40-year-old single male unionized truck driver. For every dollar
that he pays into the Social Security system, the single miner
analyzed in this study will receive back only 68 cents. Single
males employed as unionized police officers and utility workers
also suffer negative rates of return.
-
Even after the associated
administrative costs are included, private investment accounts
yield higher returns than Social Security for all workers included
in this study. When these costs are included, a cautious
investment portfolio made up of 50 percent U.S. Treasury Bonds and
50 percent large company equities generated returns for all workers
that were at least 2 percentage points, and in most cases more than
3 percentage points, above the yield on Social Security. Table
1 shows the annualized inflation-adjusted rates of return for
Social Security and for private accounts.

Lifetime losses under Social
Security, when compared with private investments, range from
$37,124 for a 30-year-old single father employed in the hotel
industry to $754,056 for a 40-year-old married couple employed in
the transport, communications, and public utilities industry (in
terms of 1998 inflation-adjusted dollars). Table 2
shows the additional income that would have been generated by a
private account. The results of this analysis suggest that union
leaders should support reforms to Social Security that would
provide their members with hundred of thousands of dollars of extra
retirement income.

-
The existing Social Security
system has hurt successive generations of ordinary union
families. Currently, the Social Security program does not
allow for the transfer of any wealth from parents to children.
Unless they are under 18 years of age when their parent dies, the
children of those who pay Social Security taxes receive nothing
from the large investment made by their parents. Under a system of
private accounts, workers would be able to gift or bequeath part of
their retirement account to their heirs. If they died before
reaching retirement age, the money in their account would belong to
their survivors. In this analysis, for example, a 30-year-old
married couple employed as teachers would be able to give up to
$270,000 in inflation-adjusted 1998 dollars to their children at
retirement--and still have enough left over in their account to
purchase an annuity equal to the initial value of their Social
Security retirement benefits.
An
examination of the returns from Social Security suggests that union
leaders should support worker-controlled investment of payroll
taxes. In other countries, unions and other employee organizations
have been quick to grasp the potential of the returns offered by
worker-directed retirement investments. Unions in Australia, for
example, took the lead in helping to create a retirement system
based on worker-directed savings.
How Private Investments Are
Assumed to Be Structured for Rate of Return
Comparisons:
-
Workers are allowed to keep all their
Social Security OASI payroll taxes. Social Security Disability
Insurance taxes and benefits remain unchanged. This analysis
focuses only on the rates of return from the payroll taxes workers
pay for their retirement or OASI benefits.
-
A portion of the taxes devoted to
retirement is used to purchase life insurance equal to the value of
Social Security survivors benefits, and the remainder is invested
in a worker-controlled investment account that will provide income
during retirement.
-
Workers invest 50 percent of their
remaining taxes in long-term U.S. Treasury Bonds; they place the
rest in a broad market equity index fund.
-
Returns on these private investments
prior to 1998 are based on historic rates of return since 1929. For
1998 and after, the Treasury Bond is assumed to yield a real return
of 2.8 percent per annum and the equity index is assumed to yield
7.0 percent per annum.
-
These returns are consistent with the
federal government's best estimates of future asset returns. The
Social Security Administration has projected a rate of 2.8 percent
on long-term U.S. government bonds 1.
The Social Security Administration's Advisory Council found a
long-term real rate of 7.0 percent on equities 2. Between 1926 and 1997, a period that
includes World War II and the Great Depression, large company
equities yielded an average annual real return of 7.7 percent, and
small company equities yielded 9.3 percent after inflation.3
-
The initial setup cost of each
retirement account is assumed to be $1,000 in 1998 dollars. To this
is added an annual fixed fee of $100 in 1998 dollars plus an annual
charge equal to 1 percent of all assets. In cases in which a worker
chooses to purchase an annuity, a fee equal to 20 percent of the
value of the principal is applied.
1. 1998 Annual Report of the Board of
Trustees of the Federal Old-Age and Survivors and Disability Trust
Funds (Washington, DC: Social Security Administration,
1998).
2. Report of the 1994-1996 Advisory
Council on Social Security, Volume I: Findings and
Recommendations (Washington, DC: Social Security
Administration, 1997), p. 35.
3. 1998 Stocks, Bills Bonds and
Inflation Yearbook (Chicago, IL: Ibbotson and
Associates, 1998), Table 6-8.
WHY RETURNS FROM
SOCIAL SECURITY MATTER
The
rate of return on Social Security measures the ultimate effect of
the program on the lives of ordinary American workers and families.
High rates of return mean that Social Security is serving its
objective of boosting retirement income and providing an adequate
safety net for union families. Low rates of return are an indicator
that the Social Security program is harming workers by reducing
their retirement incomes below the amount they could have received
by investing their taxes privately.
So
far, the debate on the future of Social Security has focused mainly
on the financial solvency of the system. To attend only to the
future balances of the Social Security trust funds, however,
ignores the key problem the Social Security program faces: In its
current form, it acts to reduce the lifetime wealth of the great
majority of today's 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.
Although such solutions may balance the trust funds, they also
would hurt ordinary Americans--especially union members--by
reducing Social Security's rate of return even further below its
current dismal level.
The
defenders of the current Social Security system argue that rates of
return on Social Security are irrelevant: The program was intended
merely to provide a basic retirement income and stopgap benefits
for the spouses of deceased workers. Such an argument might be
legitimate if Social Security taxes were a minor burden. But Social
Security taxes are high. The Social Security program began in 1937
with a 1 percent payroll tax rate. By 1972, workers were being
taxed for the Social Security OASI program alone at 8.1 percent on
their first $21,500 (in 1997 dollars) of earnings. In 1997, workers
paid 10.7 percent on the first $65,400 of employment income. According to
data from the U.S. Bureau of the Census, the average American
family now spends a higher proportion of income on Social Security
taxes than on housing. Census Bureau data from 1996
suggest that the average union family paid $6,878 (in 1998 dollars)
in OASI taxes alone.
These high payroll taxes mean that
workers--especially those at low-income levels--have few dollars
left over for private savings. Many union families are forced to
rely on Social Security as their major, if not sole, source of
retirement income and mode of "saving" for retirement. Whether
workers receive an adequate return from the large amount of taxes
they are forced to pay into the system is the key criterion on
which the Social Security system should be judged.
An
honest dialogue on Social Security requires knowledge about the
rates of return from the current system. To advance that dialogue,
The Heritage Foundation's Center for Data Analysis began examining
the pattern of returns for various groups of Americans in a series
of papers beginning in January 1998. Heritage analysts presented
rates of return for Social Security for the population as a whole
and for workers by income level, family structure, race and
ethnicity, age, geographic area, and gender. This paper
continues that series.
WHY SOCIAL
SECURITY RATES OF RETURN VARY
A
family's rate of return from Social Security will vary depending on
the age, marital status, life expectancy, work history, and income
of the persons within that family unit.
Age: Returns for older
workers tend to be higher than they are for younger workers. This
difference stems largely from payroll tax rates that have increased
because of the steady rise in the ratio of retirees to workers. In
1950, there were 16.5 workers per beneficiary, and the OASI payroll
tax rate was a mere 3.0 percent. By 1998, there were 3.4 workers
per beneficiary, and the OASI tax rate was 10.6 percent. By 2048,
the Social Security Administration estimates there will be only 2.0
workers per retiree; if the benefits currently promised are to be
paid, then OASI payroll taxes will have to increase by 41
percent--to 15 percent of a worker's wage, salary, and
self-employment income. Because of a long-term increase
in the share of the population made up of retirees (due to
increasing life expectancies and declining birth rates), only a
system that uses a worker's own savings to fund his or her
retirement, rather than one that relies on the taxes of younger
workers, can allow younger generations of workers to escape
continually declining rates of return.
Marital Status: Social
Security's rates of return tend to be especially low for single and
childless workers. Even though they face the same payroll tax
rates, single workers do not receive the spousal benefits Social
Security pays to the husbands and wives of retired workers. Social
Security also provides survivors benefits to the children under age
18 of deceased workers and to the spouse who cares for these
children.
Life Expectancy: Life
expectancy differentials can lead to large differences in returns
from Social Security. Workers in high risk occupations are more
likely to die before reaching retirement age. Even if they do reach
retirement age, such workers are likely to draw benefits for a
shorter period of time than workers who experience lower mortality
rates. Life expectancy differs widely across groups on the basis of
such characteristics as ethnicity, gender, income, occupation, and
marital status. Generally, African-Americans have lower life
expectancies than other racial groups; single persons face higher
mortality rates than married persons; individuals with lower
incomes have higher death rates; and men have shorter life
expectancies than women. Occupational, gender, and marital
differences in mortality are illustrated by Chart
1, which shows the risk of dying before reaching age 67 for two
occupational groups, manufacturing workers and teachers, by marital
status.
Income and Work History:
The Social Security benefits a worker and his spouse and survivors
will receive are paid on the basis of his earnings record.
Generally, a worker's retirement benefits are calculated on the
basis of his 35 years of highest earnings. This can mean that
workers with a non-steady work record can receive a higher rate of
return. For example, if an individual works for only 35 years
between the ages of 20 and 65, his old age benefits will the same
as those for a worker with identical annual wage rates who worked
all of the 45 years between ages 20 and 65. This means that the
worker who worked only 35 years receives a higher rate of return
from Social Security: He receives the same benefits as a worker who
has been employed for 45 years even though the latter has paid
taxes for ten more years. Higher-income workers, too, tend to
receive lower returns from Social Security. Although all workers
must pay a fixed proportion of their earnings in taxes, the
benefits paid to high-income workers will be a lower proportion of
their wages than those paid to lower-income wage earners.
SOCIAL
SECURITY'S RATES OF RETURN FOR A CROSS-SECTION OF TYPICAL UNION
FAMILIES
To
examine the impact of the current Social Security system on their
lifetime incomes, the authors drew from federal government data to
look at the returns that a collection of 20 diverse union families
aged 20 to 45 will receive from Social Security. Some work on
Social Security's return draws on aggregate average cases that may
not fully reflect the experiences of individual families. Although
the case studies contained in this paper may not include the entire
universe of union families, they do represent a large proportion of
the types of families with members affiliated to unions. In
selecting these cases, particular attention was paid to sectors of
the economy in which unions have a strong presence.
To
ensure that the households examined in the Case Studies section are
as typical as possible, workers are assumed to have earnings equal
to the total average earnings for all unionized workers in their
industry/occupation earned by persons of their gender and marital
status. These earnings data come from the U.S. Bureau of the Census
March 1997 Current Population Survey. Workers and spouses also are
assumed to live until the average life expectancy for individuals
with their occupation/industry, age, gender, and marital
status.
As
can be seen from the details of the case studies, each household
also experiences a variety of events consistent with what happens
to many ordinary families, both union and non-union. Within this
set of examples, there are periods of unemployment, marriage, both
single and married parenthood, career breaks, and early retirement.
The only characteristic shared by all these families is that each
would have been better off had they been allowed to invest their
own payroll taxes in private assets.
Assumptions and
Methods
(For complete methodology, see Appendix 2)
-
All estimates are made on the basis of
the intermediate assumptions of the 1998 Annual Report of the
Trustees of the Federal Old-Age and Survivors and Disability
Insurance Trust Funds.
-
In every case, life expectancy is
adjusted for gender, marital status, age, and occupation. For
example, life expectancy for a 25-year-old ranges from 72.4 for all
single males to 84.9 for all married females. All life expectancy
projections include projected future increases in longevity and are
based on data from the Social Security Administration and the
National Institutes of Health.
-
The total earnings of each worker are
estimated from the U.S. Bureau of the Census 1997 Current
Population Survey. Earnings are based on the average for union
members in the worker's industry or occupation in 1996. These
averages are adjusted for the worker's gender and marital
status.
-
The actuarial value of Social Security
Survivors Insurance benefits are calculated and fully included in
Social Security's rate of return. In calculating the rates of
return and the value of retirement accumulations that are generated
under a system of private accounts, it is assumed that workers are
required to purchase life insurance exactly equivalent to the value
of the Survivors Insurance coverage provided by Social Security
OASI taxes.
-
Private rates of return take full
account of administrative expenses. The returns from private
accounts are adjusted for a flat setup charge of $1,000 and an
ongoing flat yearly charge of $100 per account. To these basic
charges is added an annual fee of 1 percent of all account assets.
In addition, where a lump sum is annuitized it is assumed that a
one-time fee of 20 percent is paid to cover the costs of
transforming the account into a series of payments for the duration
of the person's life.
-
Unless noted otherwise, all dollar
amounts are stated in pre-tax 1998 inflation-adjusted dollars and
do not have discount rates applied to them. A number of discounted
amounts are contained in Appendix 2, and
the interested reader is directed toward them. All rates of return
are net of inflation.
CONCLUSION
When
Social Security began, its aim was to help ordinary Americans, and
especially those in disadvantaged positions, to enjoy financial
security in their old age. As this analysis (as well as other
analyses) has demonstrated, however, the Social Security system as
it currently exists acts to decrease the lifetime income of union
families. Even when workers chose to place half their savings in
ultra-safe low-yield Treasury Bonds, and when the administrative
expenses associated with private accounts were included, typical
union families would receive hundreds of thousands of dollars more
from private investments than they would have received from Social
Security.
The
results of this analysis mirror the results of many other studies,
all of which conclude that the Social Security system as it
currently exists offers relatively low returns for program
participants. A recent study conducted by the Social Security
Administration's own Office of the Chief Actuary concludes that an
average-income couple born in 1964 can expect a return of only 1.97
percent under the current system. C. Eugene Steuerle of the Urban
Institute has determined that an average-income single male born in
1975 can expect a real return of only 1.0 percent from Social
Security. A study by David Koitz, of
the nonpartisan Congressional Research Service, concludes that
an average wage worker born in 1980 who invests in stocks and
receives the same rate that the Standard & Poor's 500 has
yielded historically needs to invest only 3.1 percent of his wages
to generate the same retirement benefits that he will receive from
Social Security. Under the current Social Security system, the same
worker would have to invest over 10 percent of his income to
receive these benefits.
When
an intergenerational perspective is taken, the current system's
costs for union families are even greater. As it is currently
structured, Social Security leaves many parents unable to pass on
any substantial wealth to their children. For example, in a system
of individual accounts, the couple composed of two teachers could
give their two children over $270,000 (in inflation-adjusted 1998
dollars) and still have enough money left over to purchase an
annuity equal to the initial value of their Social Security
benefits. Long-term demographic trends mean that continuance of the
status quo will subject the children and grandchildren of today's
workers to an ever-increasing payroll tax burden. According to
Social Security Administration projections, payroll tax rates must
be increased by 40 percent between now and 2040 if the current
system is to be maintained.
Even
though ideology may lead union leaders to support the continuation
of Social Security in its present form, there is little doubt that
doing so runs contrary to the interests of millions of ordinary
union families. By forcing millions of union workers to pay taxes
into a retirement and insurance program that yields them dismal
rates of return, the current Social Security system acts to reduce
the lifetime income of typical union workers by thousands of
dollars. Moving to a system that allows workers to place their
payroll taxes in individual investment accounts while protecting
the benefits paid to existing retirees would enable ordinary
workers to reap the higher returns that have been available
historically from equities and bonds. The effects of such higher
returns would boost the retirement incomes and the levels of wealth
held by union families.
William W.
Beach is John M. Olin Senior Fellow in Economics and
Director of the Center for Data Analysis at The Heritage
Foundation. Gareth G. Davis is a former Policy Analyst in
the Center for Data Analysis at The Heritage Foundation.
What can union members, from miners to school
teachers, expect to receive from Social Security after a lifetime
of contributing payroll taxes to the Old-Age and Survivors
Insurance (OASI) program? And how does this compare with the
returns they reasonably could expect if the taxes were placed in
private investments? A new study by the Center for Data Analysis,
using real-world data from the federal government's own databases,
shows that inflation-adjusted rates of return on retirement payroll
taxes paid by unionized workers are lower. In fact, many unionized
workers are losing hundreds of thousands of dollars in potential
retirement income because of their inability to invest payroll
taxes in U.S. Treasury Bonds or stock index funds.
A
careful examination of the experiences of a diverse selection of 20
union households, with principal beneficiaries aged between 25 and
45 years who earn the average union wage prevailing in their
industry, reveals that all would be better off in a system based on
the personal investment of payroll taxes. For most of these
unionized workers, losses under the current retirement portion of
the Social Security system (which consumes 10.6 percent of their
annual pay up to the maximum taxable income limit, or $68,400 in
1998) run into hundreds of thousands of dollars, compared with what
they would have received had their payroll taxes been placed in
conservative 401(k)-type assets. For example:
-
Because they have
shorter-than-average life expectancies and do not benefit from
Survivors Insurance and spousal benefits, single male union workers
are hit particularly hard under the current system. Among
the 20 households examined in this study, negative returns range
from -1.7 percent for a 35-year-old union miner to -0.3 percent for
a 40-year-old single male unionized truck driver. For every dollar
that he pays into the Social Security system, the single miner
analyzed in this study will receive back only 68 cents. Single
males employed as unionized police officers and utility workers
also suffer negative rates of return.
-
Even after the associated
administrative costs are included, private investment accounts
yield higher returns than Social Security for all workers included
in this study. When these costs are included, a cautious
investment portfolio made up of 50 percent U.S. Treasury Bonds and
50 percent large company equities generated returns for all workers
that were at least 2 percentage points, and in most cases more than
3 percentage points, above the yield on Social Security. Table
1 shows the annualized inflation-adjusted rates of return for
Social Security and for private accounts.

Lifetime losses under Social
Security, when compared with private investments, range from
$37,124 for a 30-year-old single father employed in the hotel
industry to $754,056 for a 40-year-old married couple employed in
the transport, communications, and public utilities industry (in
terms of 1998 inflation-adjusted dollars). Table
2 shows the additional income that would have been generated by
a private account. The results of this analysis suggest that union
leaders should support reforms to Social Security that would
provide their members with hundred of thousands of dollars of extra
retirement income.

-
The existing Social Security
system has hurt successive generations of ordinary union
families. Currently, the Social Security program does not
allow for the transfer of any wealth from parents to children.
Unless they are under 18 years of age when their parent dies, the
children of those who pay Social Security taxes receive nothing
from the large investment made by their parents. Under a system of
private accounts, workers would be able to gift or bequeath part of
their retirement account to their heirs. If they died before
reaching retirement age, the money in their account would belong to
their survivors. In this analysis, for example, a 30-year-old
married couple employed as teachers would be able to give up to
$270,000 in inflation-adjusted 1998 dollars to their children at
retirement--and still have enough left over in their account to
purchase an annuity equal to the initial value of their Social
Security retirement benefits.
An
examination of the returns from Social Security suggests that union
leaders should support worker-controlled investment of payroll
taxes. In other countries, unions and other employee organizations
have been quick to grasp the potential of the returns offered by
worker-directed retirement investments. Unions in Australia, for
example, took the lead in helping to create a retirement system
based on worker-directed savings.
How Private Investments Are
Assumed to Be Structured for Rate of Return
Comparisons:
-
Workers are allowed to keep all their
Social Security OASI payroll taxes. Social Security Disability
Insurance taxes and benefits remain unchanged. This analysis
focuses only on the rates of return from the payroll taxes workers
pay for their retirement or OASI benefits.
-
A portion of the taxes devoted to
retirement is used to purchase life insurance equal to the value of
Social Security survivors benefits, and the remainder is invested
in a worker-controlled investment account that will provide income
during retirement.
-
Workers invest 50 percent of their
remaining taxes in long-term U.S. Treasury Bonds; they place the
rest in a broad market equity index fund.
-
Returns on these private investments
prior to 1998 are based on historic rates of return since 1929. For
1998 and after, the Treasury Bond is assumed to yield a real return
of 2.8 percent per annum and the equity index is assumed to yield
7.0 percent per annum.
-
These returns are consistent with the
federal government's best estimates of future asset returns. The
Social Security Administration has projected a rate of 2.8 percent
on long-term U.S. government bonds 1.
The Social Security Administration's Advisory Council found a
long-term real rate of 7.0 percent on equities 2. Between 1926 and 1997, a period that
includes World War II and the Great Depression, large company
equities yielded an average annual real return of 7.7 percent, and
small company equities yielded 9.3 percent after inflation.3
-
The initial setup cost of each
retirement account is assumed to be $1,000 in 1998 dollars. To this
is added an annual fixed fee of $100 in 1998 dollars plus an annual
charge equal to 1 percent of all assets. In cases in which a worker
chooses to purchase an annuity, a fee equal to 20 percent of the
value of the principal is applied.
1. 1998 Annual Report of the Board of
Trustees of the Federal Old-Age and Survivors and Disability Trust
Funds (Washington, DC: Social Security Administration,
1998).
2. Report of the 1994-1996 Advisory
Council on Social Security, Volume I: Findings and
Recommendations (Washington, DC: Social Security
Administration, 1997), p. 35.
3. 1998 Stocks, Bills Bonds and
Inflation Yearbook (Chicago, IL: Ibbotson and
Associates, 1998), Table 6-8.
WHY RETURNS FROM
SOCIAL SECURITY MATTER
The
rate of return on Social Security measures the ultimate effect of
the program on the lives of ordinary American workers and families.
High rates of return mean that Social Security is serving its
objective of boosting retirement income and providing an adequate
safety net for union families. Low rates of return are an indicator
that the Social Security program is harming workers by reducing
their retirement incomes below the amount they could have received
by investing their taxes privately.
So
far, the debate on the future of Social Security has focused mainly
on the financial solvency of the system. To attend only to the
future balances of the Social Security trust funds, however,
ignores the key problem the Social Security program faces: In its
current form, it acts to reduce the lifetime wealth of the great
majority of today's 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.
Although such solutions may balance the trust funds, they also
would hurt ordinary Americans--especially union members--by
reducing Social Security's rate of return even further below its
current dismal level.
The
defenders of the current Social Security system argue that rates of
return on Social Security are irrelevant: The program was intended
merely to provide a basic retirement income and stopgap benefits
for the spouses of deceased workers. Such an argument might be
legitimate if Social Security taxes were a minor burden. But Social
Security taxes are high. The Social Security program began in 1937
with a 1 percent payroll tax rate. By 1972, workers were being
taxed for the Social Security OASI program alone at 8.1 percent on
their first $21,500 (in 1997 dollars) of earnings. In 1997, workers
paid 10.7 percent on the first $65,400 of employment income. According to
data from the U.S. Bureau of the Census, the average American
family now spends a higher proportion of income on Social Security
taxes than on housing. Census Bureau data from 1996
suggest that the average union family paid $6,878 (in 1998 dollars)
in OASI taxes alone.
These high payroll taxes mean that
workers--especially those at low-income levels--have few dollars
left over for private savings. Many union families are forced to
rely on Social Security as their major, if not sole, source of
retirement income and mode of "saving" for retirement. Whether
workers receive an adequate return from the large amount of taxes
they are forced to pay into the system is the key criterion on
which the Social Security system should be judged.
An
honest dialogue on Social Security requires knowledge about the
rates of return from the current system. To advance that dialogue,
The Heritage Foundation's Center for Data Analysis began examining
the pattern of returns for various groups of Americans in a series
of papers beginning in January 1998. Heritage analysts presented
rates of return for Social Security for the population as a whole
and for workers by income level, family structure, race and
ethnicity, age, geographic area, and gender. This paper
continues that series.
WHY SOCIAL
SECURITY RATES OF RETURN VARY
A
family's rate of return from Social Security will vary depending on
the age, marital status, life expectancy, work history, and income
of the persons within that family unit.
Age: Returns for older
workers tend to be higher than they are for younger workers. This
difference stems largely from payroll tax rates that have increased
because of the steady rise in the ratio of retirees to workers. In
1950, there were 16.5 workers per beneficiary, and the OASI payroll
tax rate was a mere 3.0 percent. By 1998, there were 3.4 workers
per beneficiary, and the OASI tax rate was 10.6 percent. By 2048,
the Social Security Administration estimates there will be only 2.0
workers per retiree; if the benefits currently promised are to be
paid, then OASI payroll taxes will have to increase by 41
percent--to 15 percent of a worker's wage, salary, and
self-employment income. Because of a long-term increase
in the share of the population made up of retirees (due to
increasing life expectancies and declining birth rates), only a
system that uses a worker's own savings to fund his or her
retirement, rather than one that relies on the taxes of younger
workers, can allow younger generations of workers to escape
continually declining rates of return.
Marital Status: Social
Security's rates of return tend to be especially low for single and
childless workers. Even though they face the same payroll tax
rates, single workers do not receive the spousal benefits Social
Security pays to the husbands and wives of retired workers. Social
Security also provides survivors benefits to the children under age
18 of deceased workers and to the spouse who cares for these
children.
Life Expectancy: Life
expectancy differentials can lead to large differences in returns
from Social Security. Workers in high risk occupations are more
likely to die before reaching retirement age. Even if they do reach
retirement age, such workers are likely to draw benefits for a
shorter period of time than workers who experience lower mortality
rates. Life expectancy differs widely across groups on the basis of
such characteristics as ethnicity, gender, income, occupation, and
marital status. Generally, African-Americans have lower life
expectancies than other racial groups; single persons face higher
mortality rates than married persons; individuals with lower
incomes have higher death rates; and men have shorter life
expectancies than women. Occupational, gender, and marital
differences in mortality are illustrated by Chart
1, which shows the risk of dying before reaching age 67 for two
occupational groups, manufacturing workers and teachers, by marital
status.
Income and Work History:
The Social Security benefits a worker and his spouse and survivors
will receive are paid on the basis of his earnings record.
Generally, a worker's retirement benefits are calculated on the
basis of his 35 years of highest earnings. This can mean that
workers with a non-steady work record can receive a higher rate of
return. For example, if an individual works for only 35 years
between the ages of 20 and 65, his old age benefits will the same
as those for a worker with identical annual wage rates who worked
all of the 45 years between ages 20 and 65. This means that the
worker who worked only 35 years receives a higher rate of return
from Social Security: He receives the same benefits as a worker who
has been employed for 45 years even though the latter has paid
taxes for ten more years. Higher-income workers, too, tend to
receive lower returns from Social Security. Although all workers
must pay a fixed proportion of their earnings in taxes, the
benefits paid to high-income workers will be a lower proportion of
their wages than those paid to lower-income wage earners.
SOCIAL
SECURITY'S RATES OF RETURN FOR A CROSS-SECTION OF TYPICAL UNION
FAMILIES
To
examine the impact of the current Social Security system on their
lifetime incomes, the authors drew from federal government data to
look at the returns that a collection of 20 diverse union families
aged 20 to 45 will receive from Social Security. Some work on
Social Security's return draws on aggregate average cases that may
not fully reflect the experiences of individual families. Although
the case studies contained in this paper may not include the entire
universe of union families, they do represent a large proportion of
the types of families with members affiliated to unions. In
selecting these cases, particular attention was paid to sectors of
the economy in which unions have a strong presence.
To
ensure that the households examined in the Case Studies section are
as typical as possible, workers are assumed to have earnings equal
to the total average earnings for all unionized workers in their
industry/occupation earned by persons of their gender and marital
status. These earnings data come from the U.S. Bureau of the Census
March 1997 Current Population Survey. Workers and spouses also are
assumed to live until the average life expectancy for individuals
with their occupation/industry, age, gender, and marital
status.
As
can be seen from the details of the case studies, each household
also experiences a variety of events consistent with what happens
to many ordinary families, both union and non-union. Within this
set of examples, there are periods of unemployment, marriage, both
single and married parenthood, career breaks, and early retirement.
The only characteristic shared by all these families is that each
would have been better off had they been allowed to invest their
own payroll taxes in private assets.
Assumptions and
Methods
(For complete methodology, see Appendix 2)
-
All estimates are made on the basis of
the intermediate assumptions of the 1998 Annual Report of the
Trustees of the Federal Old-Age and Survivors and Disability
Insurance Trust Funds.
-
In every case, life expectancy is
adjusted for gender, marital status, age, and occupation. For
example, life expectancy for a 25-year-old ranges from 72.4 for all
single males to 84.9 for all married females. All life expectancy
projections include projected future increases in longevity and are
based on data from the Social Security Administration and the
National Institutes of Health.
-
The total earnings of each worker are
estimated from the U.S. Bureau of the Census 1997 Current
Population Survey. Earnings are based on the average for union
members in the worker's industry or occupation in 1996. These
averages are adjusted for the worker's gender and marital
status.
-
The actuarial value of Social Security
Survivors Insurance benefits are calculated and fully included in
Social Security's rate of return. In calculating the rates of
return and the value of retirement accumulations that are generated
under a system of private accounts, it is assumed that workers are
required to purchase life insurance exactly equivalent to the value
of the Survivors Insurance coverage provided by Social Security
OASI taxes.
-
Private rates of return take full
account of administrative expenses. The returns from private
accounts are adjusted for a flat setup charge of $1,000 and an
ongoing flat yearly charge of $100 per account. To these basic
charges is added an annual fee of 1 percent of all account assets.
In addition, where a lump sum is annuitized it is assumed that a
one-time fee of 20 percent is paid to cover the costs of
transforming the account into a series of payments for the duration
of the person's life.
-
Unless noted otherwise, all dollar
amounts are stated in pre-tax 1998 inflation-adjusted dollars and
do not have discount rates applied to them. A number of discounted
amounts are contained in Appendix 2, and
the interested reader is directed toward them. All rates of return
are net of inflation.
CONCLUSION
When
Social Security began, its aim was to help ordinary Americans, and
especially those in disadvantaged positions, to enjoy financial
security in their old age. As this analysis (as well as other
analyses) has demonstrated, however, the Social Security system as
it currently exists acts to decrease the lifetime income of union
families. Even when workers chose to place half their savings in
ultra-safe low-yield Treasury Bonds, and when the administrative
expenses associated with private accounts were included, typical
union families would receive hundreds of thousands of dollars more
from private investments than they would have received from Social
Security.
The
results of this analysis mirror the results of many other studies,
all of which conclude that the Social Security system as it
currently exists offers relatively low returns for program
participants. A recent study conducted by the Social Security
Administration's own Office of the Chief Actuary concludes that an
average-income couple born in 1964 can expect a return of only 1.97
percent under the current system. C. Eugene Steuerle of the Urban
Institute has determined that an average-income single male born in
1975 can expect a real return of only 1.0 percent from Social
Security. A study by David Koitz, of
the nonpartisan Congressional Research Service, concludes that
an average wage worker born in 1980 who invests in stocks and
receives the same rate that the Standard & Poor's 500 has
yielded historically needs to invest only 3.1 percent of his wages
to generate the same retirement benefits that he will receive from
Social Security. Under the current Social Security system, the same
worker would have to invest over 10 percent of his income to
receive these benefits.
When
an intergenerational perspective is taken, the current system's
costs for union families are even greater. As it is currently
structured, Social Security leaves many parents unable to pass on
any substantial wealth to their children. For example, in a system
of individual accounts, the couple composed of two teachers could
give their two children over $270,000 (in inflation-adjusted 1998
dollars) and still have enough money left over to purchase an
annuity equal to the initial value of their Social Security
benefits. Long-term demographic trends mean that continuance of the
status quo will subject the children and grandchildren of today's
workers to an ever-increasing payroll tax burden. According to
Social Security Administration projections, payroll tax rates must
be increased by 40 percent between now and 2040 if the current
system is to be maintained.
Even
though ideology may lead union leaders to support the continuation
of Social Security in its present form, there is little doubt that
doing so runs contrary to the interests of millions of ordinary
union families. By forcing millions of union workers to pay taxes
into a retirement and insurance program that yields them dismal
rates of return, the current Social Security system acts to reduce
the lifetime income of typical union workers by thousands of
dollars. Moving to a system that allows workers to place their
payroll taxes in individual investment accounts while protecting
the benefits paid to existing retirees would enable ordinary
workers to reap the higher returns that have been available
historically from equities and bonds. The effects of such higher
returns would boost the retirement incomes and the levels of wealth
held by union families.
William W.
Beach is John M. Olin Senior Fellow in Economics and
Director of the Center for Data Analysis at The Heritage
Foundation. Gareth G. Davis is a former Policy Analyst in
the Center for Data Analysis at The Heritage Foundation.
APPENDIX I:
CASE STUDIES
1. Miners' Retirement
Benefits
2. Construction
Workers' Retirement Benefits

3. Manufacturing Workers'
Retirement Benefits
4. Transport, Communications,
Public Utility Workers' Retirement Benefits
5. Public Administration Workers' Retirement
Benefits
6. Teachers' Retirement Benefits
7. Truck Drivers' Retirement Benefits
8. Hotel Workers' Retirement Benefits
9. Firefighters' Retirement Benefits
10. Police Officers' Retirement Benefits
APPENDIX
II:
BASIC ASSUMPTIONS AND
METHODOLOGY
The authors used The Heritage Foundation's
Social Security Rate of Return Microsimulation Model to compute
Old-Age and the Survivors Insurance (OASI) benefits and Social
Security taxes. The Heritage model treats taxes paid over a
worker's lifetime as a series of investments for which a rate of
return can be calculated. The rate of return for Social Security is
the rate of return on payroll taxes that would buy an annuity equal
in value to the person's Social Security benefits payments. This
yield is the difference between OASI benefit payments (after
subtracting any applicable income taxes) and the amounts paid in
OASI payroll taxes. Throughout the model and this paper, all
amounts are adjusted for inflation and expressed in terms of 1998
purchasing power.
The focus of the model is not to provide
average estimates of the return to a specified group of workers and
families, but rather to use data to construct representative or
"typical" individual and family types and to estimate the rates of
return they will receive. Information about the individuals and
families presented in thus study are based on the characteristics
of union workers, including average amounts of earnings and mean
life expectancies.
The Heritage Foundation model includes
both the share of the OASI taxes paid by employers and the share
paid directly by the employee. The rate of return is estimated by
constructing a time series of the cash flows that the family will
experience as a result of their participation in the system. Taxes
are treated as negative cash flows and OASI benefits are treated as
positive cash flows.
The actuarial value of Survivors Insurance
is calculated by multiplying the probability of death for a worker
in a given year by the discounted value of the survivors benefits
that are payable to the worker's spouse and children in the case of
his or her death. It is then added to the family's time series as a
set of positive cash flows.
The Heritage model assumes that current
law benefits will continue to be paid. It also assumes, however,
that payroll taxes will have to rise because, according to the
Clinton Administration's 1998 Annual Report of the Board of
Trustees of the Federal Old-Age and Survivors Insurance and
Disability Insurance Trust Funds, the Social Security system
as it is currently structured will be unable to fund the benefits
that have been promised. In 2015, the OASI program is projected to
begin taking in less money than it needs to pay benefits. It then
will have to begin drawing from the Social Security "trust fund" (a
series of IOUs written to the Social Security system by the rest of
the federal government). By 2035, the OASI trust fund will be
exhausted. Payroll taxes are assumed to have to rise from 2035
onward to cover the cost of promised benefits. By 2045, OASI
payroll taxes are assumed to have increased by 4.28 percent above
current law levels.
The earnings to which these payroll taxes
are applied are calculated on the basis of data for unionized
workers obtained from the U.S. Bureau of the Census Current
Population Survey for March 1997. Earnings are calculated for
each worker on the basis of his occupation/industry, gender, and
marital status. Mean earnings are estimated for 1996 and adjusted
to 1998 inflation-adjusted dollars. During the period of analysis,
these earnings are assumed to grow at the same rate as the Social
Security Administration's Average Wage Index. The limited number of
observations precludes the use of an age-earnings profile; however,
analyses of a number of other studies suggest the use of life-cycle
income profiles will not materially affect the outcome
materially.
The model calculates post-retirement OASI
benefits to individuals according to formulas stipulated in current
law and the intermediate economic assumptions (widely regarded as
the Social Security Administration's "best guess" about future
demographic and economic conditions) contained in the Annual Report
of the Board of Trustees of the Federal Old Age and Survivors
Insurance and Disability Insurance Trust Funds, up to the date on
which their life expectancy expires. Neither Disability Insurance
taxes nor benefits are included in the model.
The core life expectancies used in the
model are calculated on the basis of the intermediate projections
of the Social Security Administration's 1998 Annual Report of the
Board of Trustees of the Federal Old Age and Survivors Insurance
and Disability Insurance Trust Funds. These are adjusted for
marital status on the basis of the same mortality data used by the
Social Security Administration's Office of the Chief
Actuary.
Data from the National Institutes of Health are used to adjust
these mortality tables by occupation and industry.
Components of The Heritage
Foundation
Social Security Rate of Return Microsimulation Model
-
Internal Rate of Return
Calculator
The internal rate of return is defined as
the rate that will set the discounted value of the stream of Social
Security OASI tax payments (that is, taxes
[Ti]) equal to the discounted
stream of income from the system (that is, benefits
[Bi]). r is the rate
such that:

-
Tax Calculator
The taxes paid by an individual are
calculated by multiplying the individual's taxable earnings in a
given year by the OASI tax rate in that year. Earnings amounts are
calculated on the basis of average characteristics (see section 3
below). The OASI tax rate is based on current law until the year
2035, after which tax rates are adjusted annually so that income
and expenditures of the OASI program are equal and the OASI Trust
Fund maintains a non-zero balance.
The tax payment in a given year is
calculated by multiplying the taxable earnings for that person by
this OASI tax rate and subtracting an amount,
Li, equal to the actuarial present value of
Survivors Insurance:
Ti =
xi*Wi - Li
in which 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 actuarial present value of pre-retirement Survivors Insurance
coverage. Pr(Dr) is defined as the probability of death in
year i:

in which
S is the Survivors Insurance benefit payable in year
n. A real interest rate of 2.8 percent was used to
discount the stream of Survivors Insurance benefits. The
methodology used to calculate the probability of death for a worker
is shown in the section on Life Expectancy.
-
Earnings
Profile
Taxable earnings are based on the mean
salary for workers of the individual's occupation/industry, gender,
and marital status and for year ending 1996 as reported in the U.S.
Bureau of the Census March 1997 Current Population Survey.
Table
A1 shows the sample population for each of the estimates of
mean earnings:

Because of data limitations, the earnings
estimate for hotel workers is based on a mean for the entire
population of hotel workers. The small size of a number of the
samples should serve to emphasize the point that the profiles
contained in this study are not estimates of industry-wide
"average" returns to Social Security but rather a compilation of
representative cases that are made as typical as possible,
considering the available data.
For periods subsequent to 1996, the
average wage index is assumed to grow at the rate assumed under the
"intermediate" projections made by the Social Security Board of
Trustees in its 1998 Annual Report.
-
Old-Age and Survivors Benefit
Calculator
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 that are taxable). For years after 1997,
these bend points are indexed at rates in the "intermediate" range
projections made in the Trustees' 1998 Annual Report.
Benefits are paid up to the point of the individual's life
expectancy. These tables are adjusted to incorporate the effect of
changes in life expectancy that are estimated by the Trustees of
the Social Security Trust Fund to occur over the period 1998-2075.
In the case of early retirement, benefits are adjusted in
accordance with current law. In the case of the single-earner
married couple, each spouse is assumed to be of the same age, and
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 a spouse and the death of the remaining
spouse, the survivor is paid 100 percent of the benefit amount
payable to a single recipient according to current law.
-
Life Expectancy
Calculator
In this analysis, life expectancy is
defined as the cohort life expectancy of an individual in 1998.
This life expectancy is adjusted on the basis of the person's
occupation/industry, age, gender, and marital status.
Cohort life expectancies are derived from
a mortality table, which is calculated on the basis of the Social
Security Administration's 1994 period life table for program
participants published as Table 4.C6 of the Annual Statistical
Supplement, 1997, to the Social Security Bulletin. The
age-specific mortality rates in this table are adjusted by the
age-specific changes in mortality that the Social Security
Administration's Office of the Chief Actuary projects to occur from
1995 to 2075. Projections by the Office of the
Chief Actuary are available on a period basis at five-year
intervals, so a geometric interpolation is used to compute values
for intervening years.
The computed mortality rates then are
adjusted for marital status using ratios computed from the data for
1980-1981. Although more recent data on
mortality recently were published by the National Center for Health
Statistics, the Social Security Administration has not used them
yet, so they are not utilized in this study. Analysis of this more
recent data reveals, however, that the presence of a large
mortality differential between married and non-married persons has
persisted from the early 1980s to more recent years.
The cohort-specific mortality tables
generated for the general population next are adjusted by
occupation/industry using data from the National Institutes of
Health Mortality Study of 1.3 Million Persons by Demographic,
Social, and Economic Factors: 1979-1985 Follow-Up. This study
contains Standardized Mortality Rates by occupation and industry by
race and gender. In this study, aggregate Standardized Mortality
Ratios are calculated for all males, and for all females aged 25
through 64 and 65 and above. The sample size in this study for
firefighters and police officers is considered too small to yield
an accurate estimate of the Standardized Mortality Ratio for this
group, so data for this group come from the Society of Actuaries'
Medical Risks: Patterns of Mortality and Survival.
These mortality ratios are applied to the
cohort mortality tables for the general population and are used to
generate life expectancies for workers in 1998 that took into
account the worker's occupation/industry, marital status, age, and
gender. The cohort mortality tables also are the source of the
probabilities that are used in calculating the actuarial value of
Social Security pre-retirement survivors benefits.
Accounting for the Time Value of
Money
Unless stated otherwise, all money values
are presented in terms of 1998 inflation-adjusted amounts. The
consumer price index, as projected by the Social Security
Administration in the Trustees' 1998 Annual Report, is
used to deflate nominal dollars to 1998 dollar amounts. In general,
discount rates are not applied to dollar amounts for two reasons:
First, the use of discount rates can lead individuals to
underestimate the magnitudes of differences in terms of purchasing
power; second, the net present value of a stream of values can be
altered drastically by the use of alternative discount rates that
can be selected arbitrarily.
One exception to this general rule is the
calculation, in Table
A2, that shows the present value of participation in Social
Security OASI program for each of the families included in this
analysis. A discount rate of 4 percent is used to calculate these
net present values. This discount rate represents a reasonable
proxy for the opportunity cost of Social Security in terms of the
rate of return on a conservative investment portfolio. The amounts
below refer to the present value of program participation in terms
of 1998 inflation-adjusted dollars discounted back to the date on
which the family first begins to work.

Endnotes