To take advantage of retirement savings plans and the tax savings that accompany them, you must first spend less than you earn. Only then can you afford to contribute to these retirement savings plans (unless you already happen to have a stash of cash from previous savings or inheritance).
BROADENING STOCK OWNERSHIP WITH SOCIAL SECURITY CHOICE
Many Americans (by some estimates around 40 percent) don’t own stock. That’s unfortunate because stock ownership is one of the best proven long-term methods for folks of all means to build wealth over the long term. Average annual stock returns in the U.S. have been above 9 percent. That may not sound like a lot, but stocks returning that average yearly rate (combined with the magical powers of compounding) would double in value every 8 years without any newly added capital. (Anyone can achieve these solid long-term returns through regular buying and holding of a broadly diversified stock index fund, which tracks a broad stock market average.)
There’s a simple and powerful way to broaden stock ownership to include virtually all households, especially and including folks working at low and moderate pay jobs. My idea for change is that the U.S. Social Security system could be modified so that workers can elect to have a portion of the large amount of money they are paying into the system be invested in a highly diversified portfolio of stocks. What I am suggesting would be voluntary for workers and for just a portion of their payments going into Social Security. And, simple safeguards would ensure that investors couldn’t do risky things that caused them to lose most or all their money.
This is a case where other countries are ahead of us. Both Japan and the United Kingdom have systems that allow for workers to voluntarily invest a portion of the government retirement taxes into individual investment accounts. Chile, Mexico, and Sweden have mandatory plans.
Working folks are paying a lot into the current U.S. Social Security system. For people who work for an employer, the employer withholds Social Security taxes of 7.65 percent of a worker’s pay and then adds to that another 7.65 percent (out of their own coffers) for a total of 15.3 percent of the worker’s compensation. Of that amount, 2.9 percent is earmarked for Medicare — the federal government health insurance program for people age 65 and older. The remaining 12.4 percent goes toward Social Security. So, for a worker being paid $50,000 per year, that amounts to $6,200 that gets sent to the federal government and used for the Social Security system.
Given that the bottom 41 percent of workers pay no federal income tax, it’s safe to say that most American workers pay more in Social Security taxes than they do in federal income taxes. The vast majority of those Social Security tax payments (81 percent) go to funding the most well-known Social Security (“old age”) program, which pays monthly retirement income benefits just like an old-style employer pension plan based upon years of service. Think of the Social Security retirement income benefits program as a forced savings plan because that’s what it really is.
Far smaller amounts of your Social Security taxes (the remaining 19 percent) go toward survivor benefits and disability payments. The overall program’s acronym is “OASDI,” which stands for the three programs: Old-Age, Survivors, and Disability Insurance.
So, returning to our example of the worker earning $50,000 per year, he and his employer are paying about $5,022 into the Social Security retirement/pension program. Imagine if just half of this money (say $2,500 per year in today’s dollars) could be invested in a highly diversified, low-cost U.S. stock market index fund — such as Vanguard’s Total Stock Market Index fund, which invests in thousands of U.S. publicly traded companies of all sizes. (The institutional share class of this fund, which the non-profit Vanguard provides on an at-cost basis, has a management fee of just 0.02 percent per year, which translates into just $2 per $10,000 managed!)
I call this new program Social Security Choice because it would give workers an actual choice. Invested money would remain in this diversified U.S. stock fund during a worker’s decades of employment. The federal government Social Security program began in 1935 during the depths of the Great Depression and ultra-low-cost mutual funds and the technology to facilitate everyone’s investment in such a vehicle didn’t exist back then.
Over a 45-year working career, this worker’s stock-fund invested Social Security money would have grown to more than one million dollars — $1,377,870 assuming an average annual rate of return of 9 percent. Of that, just $112,500 is the amount paid in by the worker, and the vast remainder, more than $1,265,300, represents the investment returns!
Now, remember that in my example, I suggested that the worker be able to invest half of his Social Security retirement account contributions. So, he would still qualify for half of the normal Social Security retirement income benefit when he reaches the retirement age based upon his year of birth. Full retirement age is 67 for those born in or after 1960. A person who has been making about $50,000 per year (in today’s dollars) throughout their adult years and retiring at their full retirement age today would receive a monthly benefit amount of about $1,800 from Social Security. So, if they instead got half of that amount, they’d be receiving about $900 per month from Social Security. But they would also have well over one million dollars in their Social Security Choice investment account, as I explain earlier.
Now, what about the money in this person’s investment account that we previously calculated to be $1,377,870? At age 67 when Social Security kicks in for this person, he could elect to convert his Social Security Choice investment account balance into a monthly stream of income, which is called annuitization. For a single person, Vanguard’s annuity program would agree to pay $7,520 monthly for life! If this account holder were married, the couple would get $6,160 per month for the lives of both spouses.
These are simply stunning amounts and demonstrate the power of providing a mechanism for modest income workers to build wealth by investing in a diversified portfolio of stocks over the long term. And, please remember that this would be an optional choice-based system. Folks could choose to remain fully in the traditional Social Security system, or they could choose to direct a modest portion (in my example, half) of their Social Security tax payments into a highly diversified stock investment account. Workers could be provided with the option of directing smaller portions — like 25 percent — of their Social Security payments into the Choice investment account.
Also, the investment balance could be used in other ways. The account holder could choose to take some of the money and buy a home for their retirement, help pay for their grandkids’ education costs, etc. They could help their kids with a down-payment to purchase a home. They could annuitize part of the account.
The beauty of Social Security Choice, especially for lower income earners, is that it retains the best aspect of the Social Security system — forced savings — but provides a much better investment option that enables real growth.
To make Social Security Choice work, there is an important funding detail to work out. Social Security is a “pay as you go” system, which means that the benefits going to today’s retirees are funded by current workers’ Social Security tax payments. So, if some percentage of workers are choosing to send a portion of their Social Security taxes into private investment accounts, those amounts need to be made up somehow in the short term. (Longer-term, those workers putting money into a Choice account would be drawing lower Social Security benefits once they retire.) One idea is to limit access to Social Security Choice, at least initially, to those making less than a certain income — say $100,000 — with the logic being that