The Growing Wealth Gap: Thank Social Security

by JT McGee

I have no intentions to sugarcoat any of the following, and I will not make mincemeat of logic solely for the purpose of glamorizing the supposed protector of the middle class (government). The rich get richer and the poor get poorer thanks to none other than Social Security.

FICA taxes create the poor, and have little effect on the rich

The Poor Aren’t Saving

From the top of the working middle class to the bottom-rung of the socio-economic ladder, the average American simply isn’t saving a single dime. I covered this in depth in another article titled “Solving the Retirement Crisis.” You needn’t read it as I’ll be talking about the most important stuff here.

Basically, the middle class has no money for retirement. On average, the middle class has saved $29,000 to retire. Oh yeah!

Thirty years ago (with the cost of hiring rising due to FICA increases) we realized that things had changed, especially the cost of hiring, and that placing both your current income and retirement plan in the hands of one entity isn’t such a good diversification strategy. So, employers started promoting “defined-contribution plans” in lieu of “defined benefit plans.”

In theory, it’s a great idea to let everyone run their retirement; savers get to plan according to their own personal needs, and the company can provide a reasonable amount of benefit to the employee for saving. The shift, however, resulted in more people taking home their money and spending it than taking it home and investing it.

We see even now that the best way to get people to save is to force it–Opt-out 401ks see multiples more participation than non-opt out 401ks–but in the 1980s we forced companies to swap forced defined benefit plans in exchange for unforced defined contribution plans.

FICA Tax: It Makes the Poor, Poor

Let’s examine the data, because it really shows the full picture:

US FICA tax rates over the history of Social Security and Medicare
Source: http://www.ssa.gov/oact/progdata/taxRates.html

Now compare that to another timeline surrounding the popularity of defined benefit plans. Thanks to BankRate for this information:

  • Defined benefit plans (pensions) grew in participation through the 1960s and 1970s, before topping in the mid-1980s. The mid-1980s was a time when FICA jumped considerably.
  • Where 40 percent of workers were offered a pension in the mid-1980s, only 20 percent of private sector workers receive them today.
  • Those who still have access to pensions are finding that companies are cutting or freezing the benefits, or limiting benefits to protect from longer-living workers.

Who would have thought? Pension programs and their benefits have been cut as the cost to employ workers steadily rises due to rising FICA tax burdens. It was Reagan actually, the supposed supply-sider, who enacted the most antisupply-side/trickle down economics policy history has ever seen.

But why is this bad for John Q. Public?

  1. It isn’t as if there are any assets in the Social Security trust, but we will pretend there are. (Note: The Social Security trust holds US Treasuries, so basically, inside the “lockbox” are just IOUs, which the government says are worth trillions.)
  2. There is a very big difference between the performance of your average pension plan—pensions can own a variety of assets ranging from stock, to corporate debt—and your average Social Security holdings, which are US Treasury-exclusive.

If I wanted to make someone poor—and I mean, really, really poor—I would require that they invest 15.3% of their income into the lowest yielding asset class in the world: US Government debt.

Where pensions might earn 6% in any given year in triple-A corporate debt, Treasuries yield maybe 3-4% per year.

So, in effect, the Middle Class is forced to save 15.3% of their income in the lowest yielding asset classes. On the other hand, the rich, who don’t feel quite the same pinch in terms of tax rate regression, save a smaller percentage of their assets in that joke of a program called Social Security. Thus, they can save a larger amount in other, higher-yielding asset classes.

But wait, there’s more! Look what happened when FICA taxes trudged higher in the 1980s; not only did investors pile into US Treasuries, but they did so right before the largest and longest bull-run in the history of the US financial markets!

Social security is making you poor

This shouldn’t even be a debate. Social Security is not making anyone better off, and it certainly isn’t the benefactor to the poor that politicians purport it to be. The program is, in many ways, the best way to make sure that no one from the working class ever has a shot to live the American dream. Incentives still matter.

Summary:

  1. Decline of pensions is directly related to the rise in FICA taxation. As with all tax changes, there was a period where pensions declined with no substitute.
  2. The middle class invests a greater percentage of their disposable income into low-yielding US debt (Social Security) than do the rich. Thus, the rich grow their money faster than the poor.
  3. The rise in FICA taxes, and subsequent fall of defined-benefit programs, came at a time just before the largest bull-run in equities in recent American history.

Want to read more about the decline in pensions? Weakonomist has a great read on the subject: The problem with pensions.

{ 16 comments… read them below or add one }

Ravi Gupta April 25, 2011 at 08:09

Great post! One question I have is how would you define “the rich”? I think social security is pointless, and many people see it as a way of retiring instead of saving money themselves. I don’t think the government will ever come to a solution on what to do with social security. Should we continue on the track that it’s on with just investing in Government debt which supposedly has AAA rating or should we let it invest in different assets that could suffer during a bear market? It’s one complicated question if you ask me.

-Ravi Gupta

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Edwin @ Cash The Checks April 27, 2011 at 03:22

America is built on putting things on credit, not on saving money.

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JT McGee April 27, 2011 at 14:57

@ Ravi – For the purposes of this article, rich is mostly defined as people who earn an income beyond the cut off for FICA taxation. If you earn $150,000 for example, you pay less in percentage of your income to FICA than someone who earns $25,000.

I still think the best solution is private accounts–allowing people to roll their side of the 15.3% in FICA taxes into a 401k, IRA, or other retirement account.

@ Edwin – Shame, isn’t it?

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Invest It Wisely April 30, 2011 at 17:55

JT, if this is true, then why is anyone who is against social security also against the poor? Funny how politics is so full of doublespeak.

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JT McGee April 30, 2011 at 20:44

Warren Buffett says it far better than I can, “A public opinion poll is no substitute for thought.”

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LaTisha @FSYAonline April 30, 2011 at 20:53

It really is up to the individual to decide how they want to meet their retirement plans. It’s a capitalist society and if they want to retire on $29,000 then that’s their choice. The real problem is the lack of education.

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Amanda L Grossman May 1, 2011 at 09:17

I just can’t believe that Americans think $29,000 is sufficient to retire on. They need to take charge of their finances and learn to save instead of spend.

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JT McGee May 1, 2011 at 11:32

@ LaTisha – It is definitely someone’s choice to retire on $29,000, but unless personal savings start creeping up, the lingering threat of entitlements on the public trust will only become a larger problem. The fact that people aren’t saving beyond their contributions to social security is alarming to me. And yes, I totally agree, financial literacy needs improvement.

P.S. Maybe I’m just bitter–I’d prefer to be allowed to “opt out” of social security and instead invest my 15.3% how I see fit, even if that means higher marginal tax rates in the future. That percentage I plow into Social Security is both low-yielding, and less “risk-free” than other debt instruments, even though yields are tiny.

@ Amanda – Me either. Actually, the study found that 56% of middle class workers were confident in their retirement. The median savings was $29,000, so in the best case scenario, 6% of middle class workers 45-59 had saved less than $29,000 but were still confident about their retirement outlook. Scary!

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Invest It Wisely May 1, 2011 at 11:36

If everyone thinks Uncle Sam is going to take care of them, then why would you be surprised? In Canada we’re about to have an election, and most of the politicians talk about how they’re going to spend money on this or that to “make life better” and the way they speak it’s as if the money is theirs or it fell from heaven, and that there are no costs to this sort of spending. Do people not realize that the government only has what it was able to obtain through taxes or debt? More spending means more of either one.

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Invest It Wisely May 1, 2011 at 11:37

(ignoring printing and seignorage)

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JT McGee May 1, 2011 at 12:07

If I were to show my true political bias on this blog, I’m afraid I’d attract all the wrong people, to say the least.

The problem in the States is that we don’t let anyone fail. We don’t let people learn from their mistakes. Instead, we subsidize bad decisions at the cost of good decisions, and to this day, we have a tax system that encourages consumption and punishes investment.

If you have, for example, $20,000 in cash, you could invest it, but the returns would be taxed (at the best possible rate) at 15% for long-term investment. You could also spend it, and pay only 7-8% (I can’t remember my state’s sales tax…). So if you want to maximize your tax loss in the short-term (humans are mostly short-term thinkers) you go spend your money.

My generation is the most entitled of any. We expect a free education, a job, a home in the suburbs with a white picket fence and 2.2 kids. For the most part, my generation has never had to make decisions with their money, and we don’t take care of our finances like we should. We borrow without consequence, and we project that the future, naturally, will only shine as bright as the past. Nowhere else is this made more evident than in student loans, which I’ve profiled on this blog, and will continue to make a major portion of my blog posts on economic institutions.

The failure is systemic. Those who save diligently, work hard, and seek to better themselves will be inappropriately labeled “the rich,” taxed into oblivion and used as a pawn in the game of class warfare. It should come to no surprised that the tax code has been toyed with so that 50% of Americans do pay Federal Income Taxes and 50% do not. It makes for very simple political victories, with independents ultimately voting for the same policies, just from different parties.

Save for serious financial or health difficulties, no one should be impoverished in the United States. This country has the world’s best leaders, the best businessmen, and the best opportunity for anyone to make their lives and their family’s lives exponentially better.

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Hunter May 1, 2011 at 16:32

Even if people invested 15% of their income in their 401(k), most workers are not aware of how to allocate teir assets, and end up with a poor return. It’s going to be sad seeing more and more people working through retirement because they have been poorly advised, or made bad decisions wit their retirement planning. Social security alone doesn’t buy much of a lifestyle.

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David M May 4, 2011 at 20:56

JT,

You do not have your fact correct! First of all about 4% of the 15.3 goes to pay for Medicare.

Then, part of the Social Security money is an insurance policy against you or your spouse dieing or becoming disabled. If a 30 year old father with 3 kids 5, 3 and 2 dies – his family is going to get back WAY more than he ever put in. Also if the 30 year old become disabled they will get back way more.

Also, there are break points in social security and the lower your income the more you get back. It is 90% of the lowest amount, 34% of the next amount and 15% of the highest income. Thus, low wage earners will most likely get back much more than they put in.

The are invested in NOTHING – the amount you get back is based upon your earnings and inflation and has nothing to do with earnings.

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JT McGee May 4, 2011 at 22:17

I’m aware Medicare is included; I could have named it “blame FICA” but that just didn’t have the ring to it that Social Security did.

There was a section that I removed that discussed the “insurance” or “disability” feature, which I happily left out. Useless tangent, for the most part, and it was such a small percentage of the annual payouts that I removed it so this wouldn’t spill into 1200 words.

“Also, there are break points in social security and the lower your income the more you get back. It is 90% of the lowest amount, 34% of the next amount and 15% of the highest income. Thus, low wage earners will most likely get back much more than they put in.”

Wouldn’t that only create a bigger wealth gap? 😉

Techinically, Social Security does hold US Treasuries in the trust fund. I realize that it is mostly a cash flow program, but at the end of the day the average middle class FICA taxpayer is going to get a return roughly equal to the rate of US Treasuries, which the revenue from taxes are “invested” in.

In summary, if I went on to explain every little facet of the Social Security program, this post would have been 10,000 words longer, and still come to the same conclusion: Social Security makes people poor.

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David M May 5, 2011 at 03:41

Thanks for your reply!

We will have to agree to disagree on this one!!!! IMHO – companies still would have decreased defined benefit plans and lower income people would still not save money – even if Social Security Taxes were lower.

And – whether Social Security HOLDS US Treasuries or NOT is totally irrelevant – they have ZERO impact on the amount you receive back from Social Security.

Again, thanks for replying and keep on blogging,

David

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Travis@TradeTechSports May 6, 2011 at 22:08

This is a great socio-economic argument. Many people believe America grew such a strong middle class out of World War 2 with everyone working and working hard. With labor going over seas, the US is losing that part of the economic battle to the rest of the world. I think the US needs to continue growing its education so we dont get left behind some Asian countries and continue to move forward on technology and creating new markets. Education and innovation is the key to a growing middle class. My 2 cents 🙂

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