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,¹ 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.²

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.³

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.⁴ 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.⁵ Census Bureau data from 1996 suggest that the average union family paid $6,878 (in 1998 dollars) in OASI taxes alone.⁶

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.⁷ 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.⁸ 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. ⁹

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.¹⁰ 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.¹¹ 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.¹²

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.¹³

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,¹ 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.²

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.³

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.⁴ 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.⁵ Census Bureau data from 1996 suggest that the average union family paid $6,878 (in 1998 dollars) in OASI taxes alone.⁶

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.⁷ 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.⁸ 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. ⁹

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.¹⁰ 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.¹¹ 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.¹²

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.¹³

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.

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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.¹⁴

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.¹⁵ Data from the National Institutes of Health are used to adjust these mortality tables by occupation and industry.¹⁶

Components of The Heritage Foundation
Social Security Rate of Return Microsimulation Model

1. 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 [T_i]) equal to the discounted stream of income from the system (that is, benefits [B_i]). r is the rate such that:

 

 

 

2. 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.¹⁷

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, L_i, equal to the actuarial present value of Survivors Insurance:

T_i = x_i*W_i - L_i

in which x is the OASI tax rate for year i; W_i is the total taxable wage, salary, and self-employment income for year i; and L_i 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.

3. 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.¹⁸

4. 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.

5. 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 2075.¹⁹ 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 1980-1981.²⁰ 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.²¹

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.²² 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.²³

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.²⁴

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

2. Based on life table for all males and females and real interest rate on annuity of 2.8 percent. An administrative fee equivalent to 20 percent of the value of the sum being annuitized is included. See Burtless, "The Role of Individual Personal Saving Accounts in Social Security Reform," and Aaron, "Social Security Reform."

3. See Daniel J. Mitchell and Robert P. O'Quinn, "Australia's Privatized Retirement System: Lessons for the United States," Heritage Foundation Backgrounder No. 1149, December 8, 1997.

4. Social Security Administration, Social Security Bulletin, Annual Statistical Supplement for 1997 (December 1997), p. 34.

5. Data on average family consumption expenditures from U.S. Department of Labor, Bureau of Labor Statistics, Consumer Expenditure Survey for 1995 (Washington, DC: U.S. Government Printing Office, June 1997), Table A. This report estimates average family income before taxes to be $36,918 in nominal dollars.

6. Based on average earnings for a union-affiliated household in 1996 as estimated from the U.S. Bureau of the Census, 1997 Current Population Survey. According to these data, mean earnings in 1996 for a family with at least one union-affiliated member was $61,798 in nominal dollars ($65,395 in 1998 dollars).

7. See William W. Beach and Gareth G. Davis, "Social Security's Rate of Return," Heritage Foundation Center for Data Analysis Report No. CDA98-01, January 15, 1998; Beach and Davis, "Social Security's Rate of Return for Hispanic Americans," Heritage Foundation Center for Data Analysis Report No. CDA98-02, March 27, 1998; and William W. Beach, Gareth G. Davis, and Sarah Youssef, "A State-by-State Analysis of the Returns from Social Security," Heritage Foundation Center for Data Analysis Report No. CDA98-05, July 30, 1998.

8. 1998 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors and Disability Trust Funds, Tables II.F13 and Table II.F19. The ratio of workers to beneficiaries includes Disability Insurance recipients.

9. For a survey of the overall pattern in death rates see Paul E Zopf, Mortality Patterns and Trends in the United States (Westport, CT: Greenwood Press, 1992).

10. Report of the 1994-1996 Advisory Council on Social Security, Volume I, p. 219.

11. C. Eugene Steuerle and Jon Bakija, Retooling Social Security for the 21st Century (Washington, DC: Urban Institute, 1994), p. 290.

12. David Koitz, "Social Security Reform: How Much of a Role Could Private Retirement Accounts Play?" CRS-96-195 EPW, March 4, 1998, Tables 1-21.

13. 1998 Annual Report of the Board of Trustees of the Federal Old Age and Survivors and Disability Trust Funds, Tables II, F13 and Table II, F19.

14. See Daniel M. Garrett, "The Effects of Differential Mortality on the Progressivity of Social Security," Economic Inquiry, July 1995, pp. 457-475; and Gareth Davis, Ethnic and Racial Differentials in the Return from Social Security, unpublished manuscript available on request from the author.

15. Felicitie C. Bell, Social Security Area Population Projections: 1997, Actuarial Study No. 112, Social Security Administration Publication No. 11-11553, August 1997.

16. Eugene Rogot, Paul Sorlie, Norman Johnson, and Catherine Schmidt, A Mortality Study of 1.3 Million Persons by Demographic, Social and Economic Factors: 1979-1985 Follow-Up, National Institutes of Health Publication No. 92-3297 (July 1992).

17. These tax rates are calculated using the intermediate assumptions in the 1998 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds.

18. Ibid.

19. Bell, Social Security Area Population Projections: 1997.

20. Ibid. The ratios of the mortality rates of the selected groups are assumed to remain constant.

21. See National Center for Health Statistics, Monthly Vital Statistics Report, Vol. 45, No. 11 (S)2, June 12, 1997.

22. Rogot et al., A Mortality Study of 1.3 Million Persons.

23. Richard Singer and Louis Levinson, Medical Risks: Patterns of Mortality and Survival, A Reference Volume Sponsored by the Association of Life Insurance Directors of America and The Society of Actuaries (1976).

24. See Dean Leimer, A Guide to Social Security Money's Worth Issues, Social Security Administration Office of Research, Evaluation, and Statistics Working Paper No. 67, 1995.