When teaching principles of economics to university freshmen and sophomores, I always give what I call my “Prozac lecture.” I warn them it is coming so they can bring their coping powers to class, prescriptions and otherwise.
You’re probably thinking the lecture has something to do with economics being known as the “dismal science.” Not so.
The lecture, rather, offers students a personal application of Albert Einstein’s observation that “compound interest is the eighth wonder of the world.”
The lecture topic is the effect the federal government’s Social Security program will have on students’ future financial well-being. The lesson extends to all Americans, but as we age, it turns into a “what might have been” story instead of “what your future holds.” Either way, psychoactive medication or counseling might be in order.
The first thing I’ve noticed about students — and something I assume extends to many Americans — is their ignorance about the Social Security tax rate. The rate is currently 12.4 percent. Congress cleverly splits this between a 6.2 percent deduction from employee paychecks and having their employers send Uncle Sam an additional 6.2 percent.
While the 50/50 split supposedly connotes “fairness,” the economics of the labor market guarantee that employers’ 6.2 percent comes primarily from employees’ wages being another 6.2 percent lower. In other words, employees shoulder close to the entire 12.4 percent. The tax is currently levied on the first $127,400 of an individual’s annual income, a limit that is of minimal concern to students but of more concern to many other Americans.
The discussion is organized around the following question: What if students, instead of being legally obligated to pay Social Security taxes, had the option of putting and holding those funds in the stock market?
To this end, it should be noted that the average annual return in the stock market since 1928, as measured by the S&P 500 index, is 9.8 percent (not that the return every year is 9.8 percent, mind you — just that over the last 90 years, annual returns average out to 9.8 percent). Then pick an annual starting salary students might earn. Say it’s $35,000, and assume it rises by 3 percent a year. Under this latter assumption, the salary never rises above the current $127,400 maximum taxable annual income.
Assume the person intends to work 41 years. Then at the end of the first year of employment, his/her $4,340 Social Security tax for the year ($35,000 x 12.4 percent) is invested in an S&P 500 index fund and held for the following 40 years at the 9.8 percent average return. What will it equal at the end of 40 years? Believe it or not, $182,634. That’s right; just the first year’s tax will grow to $182,634. The second year’s tax ($4,470), held for 39 years, will grow to $171,316, and so on.
Making these calculations by hand is tedious, to say the least. For example, the growth in the first year’s tax is the answer to $4,340 x (1.098)40. The second year’s tax follows from $4,470 x (1.098)39 and so on. Don’t despair; there are websites that will enable you to make the calculations quite easily by plugging in the numbers.
Thus, if the student never saved another penny in his/her whole life, just the first two years of Social Security taxes invested under the above conditions would grow to $353,950, more than one-third of a million dollars, when they retired 41 years after graduation.
If the student’s Social Security taxes for the first 10 years of working life were invested at the S&P 500’s 9.8 percent return, he/she would have a $1,391,844 portfolio at the end of 41 years; the first 20 years of taxes would grow to $2,126,777; the first 30 years of taxes grows to $2,514,569; and for the entire 40 years, it’s $2,718,713.
Einstein’s comment about compound interest being the eighth wonder of the world is illustrated by the fact that investing just the first 10 years of taxes produces more than 50 percent of the amount obtainable by investing 40 years of Social Security taxes.
Now, there are obviously many configurations one can assume for 1) salary experience, 2) rates of growth for the S&P 500 index for each year, 3) Social Security tax rates, and 4) maximum income subject to the tax. The above experiment is intended to be as simple as possible to convey what is at stake as far as a graduating college student is concerned.
Needless to say, we now know why Americans do not have the option of choosing when it comes to Social Security. Younger Americans would surely opt out. Those “pie in the sky” articles one reads in financial magazines about how people can, through stringent measures, retire early — even in their 40s or early 50s — would not be so attractive in the popular press.
One final comment: Am I suggesting that the federal government invest peoples’ Social Security taxes in the stock market? No. Not at all. If the federal government were to obtain ownership positions in the S&P 500, Adam Smith’s “invisible hand” would eventually be replaced by Uncle Sam’s “deadening hand.”
Surely a cure worse than the disease, if you please.
T. Norman Van Cott, Ph.D., an adjunct scholar of the Indiana Policy Review Foundation, was head of the Ball State University Economics Department from 1985 until 1999. The foundation is a non-profit education foundation focused on state and municipal issues. It is free of outside control by any individual, organization or group. It exists solely to conduct and distribute research on Indiana issues. Send comments to [email protected].