More money, poorer return
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April 03, 2000 01:00 AM

More money, poorer return

Kevin Lansing
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    Every year Social Security takes bigger bite out of payroll compared to private retirement contributions, yet earns a lower return.

    In 1997, Social Security's Old Age and Survivor's Insurance payroll tax contributions totaled $350 billion, or 4.3% of gross domestic product. By comparison, contributions to private retirement plans (defined benefit, 401(k)s, and IRAs) totaled some 2% of GDP. Given the huge flow of funds into Social Security, it is natural to wonder about the return that today's workers can expect to receive from the program in the form of post-retirement benefits.

    The "average" U.S. worker faces a rate of return on contributions that is quite low -- less than 2% after adjusting for inflation. By comparison, the real yield on a 10-year inflation-indexed Treasury bond recently was around 3.5%.

    In addition to being low, rates of return from Social Security must be viewed as risky because they are subject to change from future political actions that will be needed to ensure long-term solvency of the program. Under intermediate demographic and economic assumptions, a study published by the Federal Reserve Bank of Cleveland reports the OASI payroll tax rate must be increased about four percentage points, to 14.6% from the current 10.7%, to pay for projected benefits for at least 75 years. Alternatively, long-term solvency could be achieved by cutting benefits 25%. Either action would reduce the real rate of return for the average U.S. worker to around 1%. A tax increase would be disproportionately borne by young workers (who are further from retirement) whereas a cut in benefits would penalize young and old workers in a more even-handed way.

    Under the current Social Security law, 10.7% of nearly every U.S. employee's gross annual wage (up to a maximum of $72,600) must be "contributed" to the OASI program. For many individuals, these contributions represent the most important (and perhaps only) investment they will make to provide financial support for themselves during retirement.

    The investment deal offered by Social Security varies significantly across distinct groups of individuals. In general, Social Security favors low-wage earners over high-wage earners, older workers over younger workers, women over men, and immigrant workers over U.S.-born workers. These discrepancies remind us that, in addition to being a retirement program, Social Security includes important redistributional features.

    One way to assess the investment deal offered by Social Security is to compute the internal rate of return on contributions. This is the rate of interest that a worker would have to receive on contributions to a hypothetical savings account in order to accumulate a balance at retirement that is sufficient to finance a stream of benefits exactly equal to those promised by Social Security.

    In reality, of course, no such savings account exists. Social Security operates primarily on a pay-as-you-go basis, which means that the vast majority of workers' contributions are neither saved nor invested -- the money is simply transferred to current retirees to pay benefits. To be sustained, the program requires an ever-expanding payroll tax base, which comes from a growing labor force and productivity-driven wage gains. Despite the fiction of the savings account, the internal rate of return is a useful concept because it allows us to compare Social Security to other types of investments that could provide retirement support.

    A recent study published by the National Bureau of Economic Research finds today's lowest paid workers (those in the bottom 20% of the income distribution) can expect returns between 4% and 5% after adjusting for inflation. Middle-income workers can expect real returns between 1% and 2%. Highest paid workers can expect real returns below 1% and may even face negative returns if born after 1975.

    Returns generally decline with birth year. Compared to today's older workers, today's younger workers must contribute a larger fraction of their paychecks to qualify for benefits that start later in life. The OASI payroll tax rate in 1963 was 6.75% on income up to $4,800. The tax rate now stands at 10.7% on income up to $72,600. Plus, the retirement age for workers who receive full Social Security benefits is gradually being raised to age 67 from 65.

    Women receive a higher rate of return on contributions than men. Immigrants receive a higher return on Social Security contributions in comparison to U.S.-born workers, even when their earnings are identical for all years the immigrant has been working in the United States.

    Social Security has evolved from a humble start to a complex, resource-intensive porgram that redistributes income.

    Kevin Lansing is an economist with the Federal Reserve Bank of San Francisco. His commentary is adapted from a piece he wrote for the bank's monthly Economic Letter. His views don't necessarily reflect those of the Federal Reserve.

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