Why Middle Class Private Sector Workers Are NOT “Ripping Off the Next Generation”

A few months ago we published an editorial entitled “Social Security is Healthy Compared to Public Sector Pensions.” The highlights offer compelling evidence of two very distinct categories of “middle class workers” in America:

“According to the U.S. Census Bureau, in 2030, when Social Security will be supposedly approaching insolvency, there will be 99.4 million citizens over 58 years old, and 59.5 million citizens over 68 years old. This means that by 2030 (assuming no public employees also participate in Social Security – which many of them do) there will be 19.9 million government retirees collecting pensions that average $60,000 per year, and there will be 47.6 million private sector retirees collecting Social Security benefits that average $20,000 per year. Using these assumptions, the total pension payouts to government retirees, who were only 20% of the workforce, will be $1.2 trillion, more than the total Social Security payouts to private sector retirees, which will be $952 billion.

As for solvency, assuming government’s share of the workforce remains at around 20%, in 2030 we will have 247 million citizens over the age of 25. On a pay-as-you-go basis, to pay $1.2 trillion annually to 19.9 million government pensioners, 29.6 million active government workers would each require $40,343 per year withheld from their paychecks; to pay $952 billion annually to 47.6 million retired Social Security recipients, 150 million private sector workers would require $6,337 per year withheld from their paychecks – one sixth as much.”

These facts, stupefying all by themselves, don’t go far enough to counter what has become an irritating meme: That the baby boomers, to fund their retirement security, are passing massive debts onto the younger generation.

That really depends on which baby boomers you are referring to. The remainder of this post will illustrate exactly why middle class private sector workers are not stealing anything from the next generation, and if anything, are making noble financial sacrifices for their fellow citizens.

The chart below compiles benefit data for three hypothetical retirees, one who receives Social Security, one who has a Defined Contribution plan, and one who has a Defined Benefit plan. To make the examples consistent, each participant begins working at age 25, works 43 years, and retires at age 68. All three of them retire at a final salary of $70,000 per year. Using the Social Security Administration’s “Quick Calc,” it is simple enough with these assumptions to determine the annual Social Security benefit due – $25,824 per year, as noted in the “Retirement Benefit” row in column 1, “Social Security.”

And with this data, using a declining balance annuity spreadsheet (to see detailed calculations, download here), determining the imputed annual rate of return for the Social Security participant’s 12.5% of total earnings contribution each year is simple and precise; these middle-income workers earn exactly 2.68% per year on their retirement investment. Hardly a gargantuan ripoff.

Comparing Social Security, Defined Contribution, and Defined Benefit Plans

SS-DC-DB_comparison_chart-4In order to fully appreciate the comparison between Social Security (column 1) and a Defined Benefit (column 3), refer to the row “Pension Formula” to see the imputed annual pension accrual (all imputed numbers are highlighted in yellow). For a Social Security recipient who retires at age 68 earning a final salary of $70,000, their pension formula – to provide an “apples to apples” comparison – is “0.85% at 68.” Not exactly “2.5% at 55,” or “3.0% at 50,” is it?

The information in column 3, “Defined Benefit” is fairly straightforward, although ridiculously conservative in order to maintain the “apples to apples” comparison. Ridiculous, because very few people spend 43 years in public service and wait until age 68 to retire. And few of them have a pension accrual that is only 2.0% per year. But let’s suppose they do. This would mean their “pension formula” is “2.0% at 68,” and even under these hideously crammed down terms they earn a pension of $60,200 per year, 2.5x more than they would have gotten through Social Security.

The point of this post isn’t to attack the defined benefit, by the way. Column 2 clearly illustrates the problem with defined contribution plans as the sole source of retirement security – refer to the row “Max Life Expectancy.” As can be seen, the defined contribution participant has an individual account, which means they need to make sure they have money to live on if they have a longer than average lifespan. Hence, in order to not be broke if they make it to age 90, they have to contribute 11.1% of payroll for their entire lives, instead of 7.3% if they were in a defined contribution. That’s a lot more money. And if you think this example is ludicrous, go talk to an 87 year old in reasonably good health who planned for their 401K to sustain them for ten years beyond an average lifespan, and ask them how they sleep at night.

The only thing wrong with defined benefits – and yes, this is our understatement of the year – is they make no provision to adjust benefits downwards when returns fail to meet expectations. Perhaps, to turn the tables in a most representative way, we shall permit private sector workers to invest their individual 401K contributions with the pension funds, and if those 7.5% returns falter, tax public sector pensioners to make up the difference! Would the public sector unions, to keep this topical, support such a magnanimous gesture? Would it be “constitutionally protected?”

The older generation is indeed passing on troubling levels of debt and unfunded liabilities to younger Americans. But don’t blame middle-income Social Security participants. To do so is not merely inaccurate, it is scurrilous, demagogic, opportunistic drivel.

*   *   *

Ed Ring is the executive director of the California Public Policy Center.

2 replies
  1. Tough Love says:

    Ed, Again, nice demonstration. Too bad 90+ of the population doesn’t have sufficient smarts to follow what your showing.

    It might be a good idea for you to run such future workups by a reasonably bright high school student before posting. If they can’t follow it without great effort (or without additional explanation from you), you need to dumb it down a bit for the masses. Great work serves little purpose if it isn’t easily understood.

    And just for the sake of completeness, SS is a bit MORE generous than you are stating in your comparisons because you ignored the incremental value of Spousal benefits paid to non-working (non-contributing) spouses.

  2. Editor says:

    Tough Love – Hopefully there is something for everyone in that piece. The suggestion at the end, that maybe we should be allowed to invest in pension funds and have our 7.5% returns guaranteed by special new taxes on public employees, ought to be visceral enough. And we are writing for a diverse audience, including public officials and fully engaged activists on both sides of the debate. If they can’t understand this stuff, they should resign.

    As for Social Security, I suppose you’re right, but only for married retirees whose spouses didn’t earn as much as they did. That narrows it down considerably. Pensions, as you know, have survivor benefits which increases their present value.

    What would have been a great additional point, which you will readily understand, is Social Security’s imputed return-on-investment on the marginal income someone might earn if they take on a 2nd job to earn in excess of $70,000, but less than the max (which goes up to $117,000 in 2014). Because as you know, Social Security pays less and less back as a percentage of final salary, the more you make. So that 2nd job that requires you pay 12.4% to Social Security, translates, at the margin, into a return that is FAR less than 2.8%. This is particularly cruel, considering many of us take on 2nd jobs specifically so we can save for retirement.

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