Social Security Versus Private Retirement Plans

If you look at your pay stub you will see a significant deduction for FICA.  This FICA contribution (which stands for the Federal Insurance Contribution Act) is the tax paid to fund your Social Security and Medicare benefits.  Let’s focus on our governmental pension program, Social Security, even though I could take up a chapter discussing the flaws in the Medicare program as well.

For most working Americans the FICA tax is the single most significant federal tax paid.  It is a flat tax levied on every dollar of wage income up to approximately $88,000 per year.  The rate of tax is a flat 7.65% – with 6.2% going toward the Social Security part and 1.45% going toward the Medicare part.  Let's look at the Social Security element.  If your wage income for the year were $50,000, your Social Security tax would be $3,100 ($50,000 x 6.2%).  But the picture is worse still.  Your employer pays a matching 6.2% contribution.  Most people probably think this is a great deal until they scrutinize things a little closer.  The employer isn’t making a gift here.  The employer is paying its 6.2% contribution out of your gross wages.  Like your regular wages, it is simply another cost of doing business from the employer’s viewpoint.  Therefore, in a very real sense, the entire 12.4% combined employer and employee Social Security tax is coming out of your gross wage income.  Thus, your real Social Security tax if you make $50,000 of wage income a year is more in the neighborhood of $6,200 ($50,000 x 12.4%).

What does this very high pension cost get you?  Depending on which poll is consulted, younger Americans are more likely to either believe Elvis is still alive or to believe in UFOs than that they will reap a meaningful benefit from the Social Security program.

For older Americans retiring nowadays who have 40 years or so of work history, Social Security provides approximately $1,200 per month for life.  This might also sound like a great deal if you don’t think a little more deeply about what is actually going on.  Most retirees would literally have hundreds of thousands of dollars more of wealth accumulated by retirement if they were allowed to put their FICA contribution into an Individual Retirement Account type investment (discussed below) rather than in the traditional Social Security program.

This concept is popularly referred to as “privatization.”  There are many reasons for doing this in modern America.  The most significant is that it would allow Americans to obtain a stock market rate of return which has averaged better than 11% over the last four decades while being investing in relatively safe stock mutual funds.  Even an absolutely safe U.S. Treasury Bond or Note rate of return of 5% would significantly beat the current rate of return on Social Security benefits which is only about 1½%.  Despite the fact that privatization is such a hot political issue, the current privatization proposals will only partially privatize Social Security (only about 15% of a worker's Social Security tax could optionally be privatized).

Maybe an even better reason, however, would be that such a privatized program would be self-funding like the private retirement system I will discuss below.  By self-funding I mean that each retiree’s benefits are funded out of his or her trusteed account and reservoir of wealth.  Even though most people think that under Social Security there is similarly a pot of money with their name on it, nothing could be further from the truth.  Social Security is a pay-as-you-go system which means that the Social Security benefits being paid now to retirees are coming out of contributions that workers are currently making to the same system rather than from the retiree’s Social Security account balance.

An additional extreme negative associated with the Social Security pension is that the benefits die with the retiree whereas with self-funded private retirement plans there will be a death benefit equal to the remaining account balance in the private plan.  In other words, you could incur the significant Social Security tax each year for 40 to 45 years, die at the age of 65 and not have anything to leave to your family.  In a private retirement plan situation where you were socking away comparable amounts of money each year, you might have an account balance of hundreds of thousands of dollars to leave to your family if you died at age 65.

A common argument against privatization is that the privatized Social Security benefits would not be guaranteed as they are under the current system.  However, a privatized system could be structured in a way that allowed for a safety-net rate of return (higher than what the current system is now paying) at the cost of giving up a percentage point or two on the stock market rate of return yield.  This would be a good compromise and, again, would assure that the whole system would be self-funding and safe.

Another extraordinary fact pertaining to this issue, and one that is relatively unknown by most Americans, is the fact that many federal and state employees already have fully-privatized retirement benefits.  In other words, many federal and state employees have the equivalent of their entire Social Security tax go into an individual account plan that can earn a real market rate of return like in a Section 401(k) and the other private retirement plans discussed below.  So the politician who is telling you that privatizing a small portion (about 15%) of your Social Security contributions would be a risky scheme is himself participating in a 100% privatized plan (more hypocrisy from the status quo-and an excellent example of what happens when we let the government help us too much).

Despite all of the fundamentally sound arguments for privatizing the Social Security system, privatization is fought tooth and nail because it is such a political hot potato.  Therefore, for purposes of this book, we simply cannot count significantly on Social Security to build our retirement nest egg.  The only prudent thing to do is build our own retirement through the many tools available to us under the private retirement system discussed below.  If Social Security is ever meaningfully reformed so as to provide a more significant source of retirement income, that will be welcome icing on the cake.

We need, therefore, to have a good understanding of what is available to us under the private retirement system.  This private retirement system allows us various choices and different types of plans: pension, profit-sharing and Section 401(k) plans and Individual Retirement Accounts (IRAs).  Another advantage to retirement benefits paid from private retirement plans (except those voluntarily contributed under Section 401(k) Plans or Individual Retirement Accounts (discussed below)) is that such benefits are never taxed under the Social Security FICA tax.  That is, neither the contributions to such plans nor the distributions from such plan are subject to Social Security taxes.  I will describe each of these private retirement plans below and then we will discuss strategies for investing the wealth we build-up in these plans.