Why Social Security is a Terrible Retirement Plan
While it has its uses elsewhere, Social Security is a woeful excuse for a retirement savings plan. Participants receive a fraction of the value that they should for a lifetime of contributions. We propose giving the retirement portion of Social Security back to workers so they can have more control over their own futures.
I prefer not to get off on diatribes all that often. You’ll usually offend someone if you do.
Instead, I’m a peacemaker. I try not to rock the boat too much and am trying to create a website where people feel welcome and confident that the subject matter won’t be offensive or venture too far off-topic.
So, as a financial “expert,” I’m going to explain to you why Social Security is such an awful retirement plan and why it should be put out of our collective misery.
However, while doing so I’m not going to point out how it is an unsustainable, legalized, government-run Ponzi-like scheme.
I’m not going to get into how the program is in major financial trouble and won’t survive through most of our lifetimes without some major reform.
I won’t discuss how, despite it being touted as a program to help low-income households, it unintentionally benefits wealthier people who tend to live longer and thus, receive more benefit from the program.
I’ll also restrain myself from pointing out that the federal government pays out billions (yes, BILLIONS, with a ‘B’) to fraudulent claimants each and every year ($8.3 Billion in 2020).
Finally, I’m not even going to touch the fact that we’re unlikely to have leadership in Washington with the necessary backbone or mental wherewithal to correct these issues before Social Security fails spectacularly. (Sorry, no link. You’re just going to have to trust me on this one.)
How’s that for passive-aggressive?
In summary, Social Security is trying to do far too much for an aging country with a shrinking workforce, a struggling economy, and not enough personal savings to weather retirements that are lasting longer and longer and becoming more and more expensive.
Furthermore, it is operated by politicians and bureaucrats who use Social Security as a bargaining chip and political eye candy in their quest for power while the rest of us just hope we eventually get something back out of the program for ourselves.
Yes, I think there’s a better way, but we’ll get into that in a minute.
The Personal Finance Mathematics of Social Security
Whether you’ve ever paid attention to it or not, a portion of your income is withheld each quarter or pay period as your personal contribution to Social Security (also seen as FICA on your pay stub).
Currently, this amount is 6.2% of your gross income.
That may seem like a lot, but 6.2% isn’t really an adequate savings rate to provide income for a very lengthy retirement.
Good thing that’s not all of it.
In addition to the 6.2% of your income that YOU contribute to Social Security, your employer is required to contribute the same amount themselves on your behalf.
If you’re self-employed, I’m sure you already know that you get to give a double portion of FICA, one as the recipient of the income and the other as the payer of said income.
This brings the total to 12.4% per person, per pay period.
In Milestone 5 of the Next Dollar Roadmap, we suggest that you save 15%-25% of your income for retirement through tax-advantaged accounts like 401(k)s and IRAs.
Between Social Security taxes for you and your employer, that 12.4% would cover 82%-50% of that goal by itself.
However, given the shaky financial ground Social Security is standing on, I wouldn’t count on any of it for your retirement. The younger you are, the stronger I feel about this.
Even if the system itself has enough cash to continue making payouts for years to come, congress can change the rules at any point.
For example, it’s possible that they push the retirement ages out further, limit payments based on personal income or wealth, or any number of other adjustments that could leave you with less than you expected when you retire.
I’d rather just eliminate the risk altogether and save for retirement myself instead of depending on Social Security.
For kicks and giggles though, let’s look at an example of what a 12.4% contribution rate should provide for you in retirement.
Average J and Social Security
If you haven’t met our friend Average J before, you can learn more about him or her here.
For this exercise, let’s assume Average J has just completed college at age 22 and will begin working for the first time in 2023.
Because Average J is a college graduate, his/her starting income is currently $55,260.
Instead of contributing to social security, how much money do you think Average J could accumulate if 12.4% of his or her income was invested in a tax-deferred Traditional 401(k)?
We did the math.
After 40 years, when Average J is 62 and at “full retirement age”, Average J would have $2,077,897.40 in a 401(k) assuming an average annual rate of return of just 8% (not inflation adjusted).
No bad. And that’s the number if Average J never gets an increase in pay. Seems unlikely, so let’s press on, shall we?
Assuming just a modest annual wage increase of 3% (the average was actually 6.68% annually since 1960 when I wrote this in November 2022), Average J would have $2,975,351.02 when he or she reaches age 62.
The total amount invested by Average J over that time (Average J’s contributions) would be $539,019.79. Hang on to this number for a second because we’re going to need it later.
If Average J waits until age 70 to retire, he or she will be sitting pretty with $5,797,665.95 in savings!
Those last years of compounding really are the best.
What Average J Actually Gets
Now let’s compare this to what Social Security actually provides.
Currently, the average monthly retirement benefit for a 62-year-old is $2,572.
With an average life expectancy at age 79, Social Security is basically a 17-year annuity with a $2,572 monthly payout.
And how much would such an annuity be worth in terms of present value?
If you bought such an annuity and used the 20-year bond rate for interest (currently 3.74%), the present value of such an annuity would be $387,833.79.
So, instead of saving 12.4% of Average J’s income for him or herself, Social Security requires Average J to pay $539,019.79 for an annuity that is worth $387,833.79. That’s a difference of $151,186 that gets lost or spent somewhere else while in the control of Uncle Sam.
And that doesn’t even include the additional $2,436,331.23 of lost opportunity cost from the funds that are paid out to current retirees instead of being invested on Average J’s behalf.
Clearly, Average J could do better on his or her own.
What About Disability?
Many will be quick to point out that Social Security does more than just provide retirement income as American workers age.
This is an excellent point.
Honestly, I don’t have a problem with the disability or survivor benefits social security provides. I think taking care of widows, widowers, orphans, and disabled people are hallmarks of a good society.
What I would suggest, however, is that we continue to support these people out of a separate tax. Heck, keep calling it Social Security if you want, but for goodness’ sake, there’s no reason to blend a retirement account for the whole country with benefits for these people who need our support.
As you can see in the yummy pie chart below, about three-quarters of payouts made by Social Security each year go to retirees.
So, for the sake of not over-complicating this post, I propose that we drop the cumulative FICA withholding to 3.1% and leave survivors and disabled people with the same benefits they already have.
That’s one-quarter of the 12.4% currently withheld; 1.55% for the employee and 1.55% for the employer.
Even if we drop Average J’s savings rate from 12.4% to 9.3% to account for this disability and survivor portion, Average J will still have $2,231,513.26 upon reaching age 62. Still not too shabby.
With that said, let’s jump into my personal suggestion for social security’s replacement.
Let’s Try Something Different
In the interest of full disclosure and total transparency, I’d rather kick Social Security to the curb completely and let everyone take responsibility for their own retirement saving.
I’ve just shown how we could give everyone 9.3% of their income back so they can save and invest it themselves for a golden retirement, without hurting disability and survivor benefits.
Looking at our case study with our friend Average J, even saving just 9.3% would provide a sufficient nest egg for life’s later years.
Not only that, but I believe freedom is one of the most superior human ethics after love. Face it, we all prefer to have control over our own decisions and no one likes to be told what to do.
This is especially true for our hard-earned money.
I’m not suggesting that government and taxes aren’t necessary, they just aren’t necessary for everything, including retirement savings.
Furthermore, I personally believe the retirement system would be more stable if people had to learn how to engage and plan for themselves as opposed to just blindly expecting Uncle Sam to take care of them when they’re old.
With all of that said, my primary plan wouldn’t work. ☹
I’m not so naïve as to expect people to actually save any money they suddenly received in lieu of the Social Security taxes they formerly had to pay.
You shouldn’t be either. I mean, you’re spending your free time reading an article about Social Security.
Face it, you and I are not wired like most people. You’re a little weird, but probably wealthier than the average Joe too.
No, given the opportunity, most Americans will spend and consume nearly all of any extra dollars that come their way.
Even without a Social Security safety net to fall into at retirement, I’m just not hopeful most people will have the self-discipline to set aside enough savings to support themselves when their working years have reached an end.
With that in mind, I think the government should do a total reboot on the horribly complex system of retirement saving that we’ve built our tax code and employment culture around.
At a macro level, retirement in the United States is a Frankenstein assemblage of tax legislation that has gradually morphed into a collage of retirement strategies, growing and shrinking in popularity, as economic, social, and cultural forces exerted their will upon them.
Over the years, I think the government has meant well. They just haven’t been exemplary in execution.
For example, when 401(k) legislation was first introduced in 1978, its primary purpose was to protect employees from having to pay income tax on deferred compensation.
Then, in 1980, a guy named Ted Benna came up with a “scheme” to allow employees to save pre-tax income in a retirement account that employers could then match all or some portion of as a benefit for their employees.
Apparently, the IRS thought it was a good idea. So, to encourage saving even more, they tweaked 401(k) rules a bit in 1981 allowing employees to fund their 401(k)s through payroll deductions.
This accidental retirement strategy was off and running. A little over 40 years later, over 60 million Americans participate in 401(k) plans with total assets of around $7.75 Trillion!
That’s quite an accident.
But 401(k)s are just one example. There’s an alphabet soup full of other retirement focused plans like IRAs (all 5 types), 457s, 403(b)s, deferred compensation plans, pensions, etc., etc., etc.
And in many cases, these plans have drifted far from their original intent as Americans seek out strategic places to save for retirement.
It’s not that options are bad, but to be knowledgeable in this broad spectrum of plans you need spend a lot of time researching, learning, and maybe even visiting a financial website or two.
Worse yet, you may be tempted to trade a portion of your savings just to get some expert advice on how best to save in this complex system.
Personally, I think we’d all benefit from a bit of simplification.
My Humble Proposal
At a very, very high level, I propose that in lieu of the current social security retirement pension system, we adopt the 401(k), or some new form of it, as the nation’s preeminent retirement plan.
Instead of making contributions into a large, mixed bag of taxpayer contributions, each account owner would have their own savings account.
Contributions could be made to the account by anyone (employee, employer, grandma, anyone) and would be tax deferred (Traditional) or pretax (Roth) as they are now, but there would be a required minimum deposit as a percentage of each account owner’s income.
“Whoa, Curt. This is starting to sound like a tax.”
Yes, I suppose it is. But going back to my point above, requiring contributions is the only way I know to ensure people actually use the accounts. Besides, as you’ll see, you’ll maintain control over the money you contribute.
Employers would be able to continue making contributions on behalf of their employees and receive tax deductions for those contributions.
Banks and investment companies would continue to serve as account custodians as they are for 401(k)s now. The only difference now is that they would be required to follow legal guidelines designed to provide similar costs and benefits for all account owners.
The custodians would still be entitled to profit from the management of the accounts, but they should also be able to keep costs much lower since legal requirements will ensure features won’t vary any from account to account.
For example, Fidelity manages over 440,000 401(k) accounts for all sorts of companies nationwide. Can you imagine how much of an administrative burden they have in managing such a broad portfolio of client retirement accounts?
I suppose in a lot of ways it would work similarly to the Affordable Care Act. 401(k) custodians would make their offering to potential account owners in an exchange where they’d compete for business.
Many of the existing tried and true rules for contribution limits, early withdrawal penalties, and RMDs could remain or be adjusted as needed from time to time.
Of course, there are a lot of finer points that would have to be worked out, but the key thing is you as a taxpayer get a direct benefit from your contributions to retirement savings without it being subjected to the deterioration in value that happens to your social security dollars now as you wait your turn to claim benefits.
I’ll admit, this is high-level and there are sure to be issues working through something like this, but Australia already has a well-tested version of this called Superannuation or “Super” for short.
It started in July 2002 and is still running strong. Initially, employers were required to contribute 1% to 2% of their employee’s income into the plan which has slowly grown to 10% in 2021 and will cap out at 12% in 2025. Employees can also make contributions to the account.
We wouldn’t need to follow this exactly. It just serves as a model, in my view, for us to consider as we remodel our own retirement approach.
Conclusion
Y’all can probably tell I’m no fiscal socialist. I prefer to keep things simple, educate people on how things work, and give them the freedom to make choices that best suit their needs.
As a retirement program, social security does a terrible job on all three of these points.
It’s time for us to quit pretending social security is a suitable retirement plan and put it down. Nearly anything would be better and it the best time to start working on it is now.
