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How to View Social Security vs. a Long-Term Stock Portfolio

Originally posted at MarketWatch

MarketWatch columnist and colleague Robert Powell recently shared an intriguing question with me from one of his readers on the merits of the Social Security retirement payout versus the returns on a conservative, long-term stock portfolio.

The question is below, followed by my thoughts and analysis:

“I realize Social Security was designed as a safety net and isn’t an investment vehicle. However, most advice is to wait as long as possible to start collecting Social Security to increase the ‘return’ or payout. My most recent Social Security Statement shows how much I have paid over my working career ($122,270) and how much my employers have paid on my behalf ($136,076.) I am 61 and I started working in 1972. Just for argument’s sake, what if I were able to invest that money myself over the years and picked relatively conservative investments with the majority in stocks or stock mutual funds or ETF’s. What would be the estimated value of my investments at age 66 and a couple of months? Assuming an annual withdrawal percentage of 5% how would that compare to my potential Social Security payment of $2,500 a month? Assume I live until age 85. The key advantage I’d like to evaluate with this ‘pretend’ scenario is that I would get a payout over the years but still have a residual estate instead of nothing as is the case with Social Security. Thank you.”

If someone ends up dying early in retirement, they would be better off claiming early, but it doesn’t really matter anyway in these cases. The real value comes from the protection in cases where someone’s retirement lasts for a long time. So the 62 versus 70 decision is an independent issue from whether or not the Social Security system should exist in the first place.Now, on to the question on the investment prospects of participating in Social Security. The Social Security Administration has produced a series of interesting studies on the topic of money’s worth measures. Dean Leimer provided a good overview about this. A basic summary is that Social Security is generally not a good “investment” in terms of its implied returns.

The problem is that the first recipients in the 1940s received a great deal of benefits relative to their small contributions — and so the rest of us are forever paying off this debt. Ida May Fuller provides an illuminating example, as she was the very first Social Security beneficiary in the program’s history and she lived to age 100. Her total contributions added up to $24.75, and her total benefits added up to $22,888.92. What a great investment for her! Well, someone has to pay for that.

Nevertheless, due to the risks related to the specific market returns we experience over our careers, some people will end up with a better “return” from Social Security while others would have been better off investing on their own.

As for the reader’s case, I have to make some major simplifying assumptions to avoid spending a week trying to back out a precise answer since payroll tax rates, maximum taxable earnings and the like have changed so much over time. Without the reader’s Social Security statement, I can’t be precise.

So to simplify, I’ll assume that the reader’s Social Security contributions were spread out evenly over each month from January 1972 through December 2014. That’s 42 years, or 504 months. I assume $512.59 is invested each month. Assuming that the reader held a portfolio with 80% in the Standard & Poor’s 500 Index SPX, -1.69% and 20% in a fund with 10-year Treasurys, rebalancing monthly and paying 0.5% as a portfolio management fee each year, I calculate that the reader would have accumulated $1.17 million. With a 5% withdrawal rate, that would be $58,500 a year, or $4,875 a month.

But I think a 5% withdrawal rate is extremely risky with interest rates so low. A 3% withdrawal rate (which I think is much more realistic) would support $2,925 a month.

And let’s not forget about the luck of the draw. Had your career started and ended six years earlier, so that we were doing this same analysis in early 2009 for a 42-year career, you would have only had about $640,000. That would have left you at about the same position relative to your Social Security benefit if you used a rather risky 5% withdrawal rate.

Find out your Funded Ratio for retirement.