The current hot debate about proposed changes in health care financing has sparked concern for many about how such changes will affect Medicare benefits. Also looming in the background: the unresolved question of how Social Security might be changed to ensure the program’s solvency as more than 75 million Baby Boomers retire over the next 15 years.
Legitimate concerns about these issues have been inflated by much careless rhetoric from both sides of the political aisle. The upshot is that many people believe the “return” in benefits they personally are getting relative to the Social Security taxes they paid is a poor one. In fact, many age groups or “cohorts” still living have gotten a much greater sum of benefits from these programs than they paid in, when adjusted for inflation and interest. This adjusted figure is called the actuarial present value.
The problem is that many people are hazy about the sum of Social Security taxes they pay in over their working lives, and few have the skills to make the financial calculations to determine the actual value of their benefits relative to the actuarial value of what they paid in. (These taxes are sometimes called FICA, for the Federal Insurance Contributions Act that instituted them.)
The resulting misunderstanding accentuates people’s fears about the fairness of any proposed changes in either Social Security or Medicare and how they might be affected personally. This makes already-thorny issues more intractable.
Detailing how to calculate benefits received relative to taxes paid is beyond the scope of this column. But a discussion of some of the factors that go into such calculations may be helpful to understanding important, but often overlooked, considerations in the process.
Amounts paid in: The amount anyone pays in depends on the FICA tax rates that applied in different years of their working life, their actual income and if any of that income exceeded the ceiling amount to which FICA taxes applied. The initial tax level was 2 percent of wages up to $3,000 per year. It is now 12.4 percent of the first $106,800 for traditional Social Security and another 2.9 percent for Medicare, with no upper limit on income.
Everyone now gets an annual statement from the Social Security Administration detailing their taxed earnings over their entire working life. The SSA Web site has information about how these withholding rates and applicable income ceilings increased over time. Combining the two allows one to tabulate exactly how much one paid in taxes. Many older people will be surprised by how little they paid in, relative to their current benefits. For example, back in 1960, the maximum amount of tax for one earner was $288, and in 1975 it was $1,650.
Value of nonretirement benefits: Most people think of Social Security as a retirement program, ignoring the program’s benefits to their survivors in case of death or to themselves and dependents if they become disabled. Yet, more than a third of all Social Security benefits paid falls under these two categories. Moreover, most people drastically underestimate what it would cost to obtain private term life or disability insurance that would provide equal benefits. Subtract these amounts from the taxes paid each year, and much less is left to fund retirement benefits.
Exact calculations are difficult, because of the difficulty of obtaining data on insurance costs from decades ago. But one can make good estimates. I found that the cost of such policies would have exceeded the amount I actually paid into Social Security until I was in my 30s. I earned little as a soldier, student, farmer and small-college teacher. Moreover, I was married and had two children in my 20s, so the survivors’ benefit was important to me.
Such dramatic returns have dropped over time as more retirees passed larger fractions of their working lives in the years since FICA rates and earnings limits were boosted in the late 1970s and early 1980s. But my experience is typical for many.
The upshot is that many of my cohorts have gotten retirement benefits several times larger than what they paid in. For example, by 1990, a typical couple that retired in 1980 had not only gotten back the value, with interest, of what they had paid into Social Security and Medicare over their lifetime, but also that of all the federal taxes they had ever paid. Yet, most such couples probably thought they were “just getting their own money back.”
Such dramatic returns have dropped over time as more retirees passed larger fractions of their working lives in the years since the mid-1980s when FICA rates and earnings limits were boosted. Because of the way benefits are calculated relative to inflation-adjusted average earnings, the return is greater for low-income earners than high-income ones. Some future cohorts may receive an actuarial value of benefits that is less than the taxes they paid, but that is not yet true for many recipients.
The actuarial value of Medicare benefits received by current retirees generally also exceeds that of Medicare taxes paid. Again, it varies by specific age cohort and by income, but in most cases the excess of benefits over taxes paid ranges from $80,000 to more than $250,000. In this category, unless tax rates increase or benefits are cut, the excess of benefits over taxes paid increases for succeeding cohorts rather than declines.
The money has to come from somewhere for current retirees to receive, as they do, more out of Social Security and Medicare than they pay in. It comes from the younger cohorts that are still paying FICA taxes. This constitutes a transfer payment from younger to older and, on average, from poorer to richer, because the average household income of those paying into the system is less than the average income of retirees. Much of the benefits current retirees get is simply the “income redistribution” so scorned by conservative politicians.
Under current law, the younger you are and the fewer children who might qualify for any survivors’ benefits you have, the worse a financial return you can expect for the taxes you pay. For many, the return indeed will be negative. But for most current retirees, including many convinced they are “only getting their own money back,” the returns are far higher than they would have gotten making their own insurance and retirement provisions in a free market.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.