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February 13, 2005

Elrod Q. Public

You can get some background from my below post, but I decided to open up Excel and run some numbers for an "average" employee, born in 1938, that started working in 1954 and retired in 2003 at the age of 65. For his wages, I used the Social Security Administration's National Average Wage Index. In his first year of employment he made $2,800 and in 2003 he took in $34K. Very average.

According to the Social Security administration, his monthly retirement benefit is $1,142. How does that compare? Well, if he had invested his entire payroll tax in the S&P 500 once a month and was never charged any commissions or fees (unlikely!) he might have enough money to purchase an annuity worth $1,899. That's better, but he should have retired in 1999, when he could have pocketed $2,421 a month -- live and learn.

If he had just invested his money in an account that paid the same interest rate as the federal funds rate, he'd be collecting an annuity of $1,292. This is the safest option, of course, and the value of the annuity that he could purchase never goes down, just up a little every year. If he invested in stocks every month and then, twice a year balanced his portfolio so that 2/3 would be in stocks and 1/3 would be in treasuries, he'd be looking at a $1,620 / month annuity.

Of course, one thing to remember is that unlike Elrod's social security, the annuity above runs out of money in 25 years. In the unlikely but possible event that he lives to age 91 it is unlikely he will make it to 92 under the private scenario -- he'll have no money.

Now, Elrod was lucky that he wasn't disabled or killed -- where would his heirs have been? It depends a lot on when it happened. Most of the growth in his private account occured in the last years he was working, and actually if he had died in 1999, at the top of the market, his heirs would be better off having purchased an annuity then than now.

Remember, though, that Social Security is not merely a retirement portfolio but also a disability insurance program and a survivor's benefits program. I assume that Elrod would need to divert about 3% of his 12.5% payroll taxes into some sort of disability/survivors insurance in order to fully protect his family and purchase the type of insurance that social security already provides.

So what happens when he's just investing 9.5% of his salary instead of 12.5%? This is more realistic, assuming that any government privitization plan will mandate that workers either still be part of the current system or they will be forced to purchase this supplemental insurance.

Now the S&P 500 retirement portfolio purchases a $1,443 annuity -- a little better than social security. The safe treasury option produces $982 -- worse than social security, and the balanced fund (which given the limited choice you will actually get in your "private" account is probably similar to the type of investment you'll end up making) is $1,231 -- which is slightly better than what social security is doing.

But, pick your retirement date carefully. Retire in September instead of December and the S&P plan only pays $1,289 while the balanced fund goes down to $1,138 -- $4 less than Social Security. What if Elrod decided that volunteering for Saxby Chambliss's Senate campaign was his mission in life and he retired a year early in September 2002 to devote his life to politics? Oops! Now the S&P 500 annuity pays only $1,044 and the balanced fund pays $981 -- only $30 more than the treasury retirement plan pays at this point. All three retirement plan options would pay less than social security at this point -- retiring at age 64 gets him $1,047 a month.

In summary, if Elrod chooses to strictly invest in stocks and is very disciplined about it -- contributing once a month and never trying to play the market, he could retire with $300 more a month than social security or $3 less, depending on the date he chooses. If he sticks with treasuries that pay the fed funds overnight rate, he's out of luck, making less. And if he sticks with a highly disciplined balanced approach he could come out about $100 ahead or $100 behind, depending on his luck.

If you accept that the current program is not in trouble and doesn't need drastic cuts to fix it -- which I do and which the facts clearly demonstrate, then why would you want to mess with a program that is working to guarantee a non-poverty retirement for all able bodied and disabled working Americans? It must be because you hate the idea of government helping its citizens, that's the only reason I can think of.

As you can see, a highly disciplined employee, sometimes comes out a little ahead, sometimes a little behind. This example also assumes that investing is free -- no commissions, no annual fees, no fund management expenses -- which is true in Microsoft Excel but not in the real world.

The fact is, however, that this example, as neutral outcome as it sounds, is unlikely. What happens when Elrod freaks out and puts all of his money into bonds when the market dips and does the reverse when it's going up? Decreased return. And what about that $10,000 he took out to purchase a house or pay for college for his kids? That also decreased greatly his return. If you're a conservative economist, you're familiar with risk and return. In the no risk world of Excel, there's very little return as an incentive for changing the system. When you introduce real risk to the equation, equal returns don't justify the expense. Why bother?

Posted by Chris at February 13, 2005 04:10 PM

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Posted by: Mark Wade at February 15, 2005 10:50 AM

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