December 14, 2006
Most of our political leaders are aware that our Social Security system faces challenges similar to Germany's. Many of them endorse the German model of raising taxes and cutting benefits, others support a saving and investment system. Given Germany's projected taxes and benefits, it is worthwhile to compare the two approaches, says the Cato Institute:
- Assume a 21-year-old German worker earns $38,696 this year (the U.S. 2006 average wage), works for 44 years and then retires in 2049.
- This year he'll pay a 19.5 percent payroll tax or $7,546, which includes the tax his employer pays on his behalf.
- Assuming his wages rise, including inflation, at the same annual rate they have in the United States over the last 44 years, his last wage will be about $340,573.
- His last tax will be $74,926; under the proposed new law, he'll receive $146,446 in his first year of retirement, 43 percent of his last wage.
- We'll assume he lives another 25 years, longer than expected.
How would he fare if he could get out of this arrangement and save just half of his payroll tax and invest it in capital markets, while still paying the other half to the government? The answer depends, in part, on how capital markets perform throughout his working career and retirement. But as a starting point, assume he invests in a U.S. balanced fund of 70 percent stocks and 30 percent bonds:
- During the last 44 years the average annual return on this portfolio was 10.86 percent, almost exactly the same as the long-run average.
- By saving half the tax and receiving this annual return, while earning just 5 percent during retirement, he would accumulate enough wealth to replace 43 percent of his last wage, and increase his yearly benefit at our historical 3.1 percent inflation rate.
- In other words, at just half of the cost of the government system he would do as well.
Source: William Shipman, "Retirement Trendsetter," Cato Institute, December 7, 2006.
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