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Minimum Wage Millionaires

Thursday, June 1, 1995

Suppose you are 20 years old and earning $10,000 a year. You and your employer are paying $1,240 a year in Social Security taxes. That's 12.4 percent of your hard-earned income, for benefits that you will never see.

Suppose instead you could invest that same $1,240, as well as an additional $2.50 a week. By the time you are 65, thanks to the magic of compound interest, you would be a millionaire. You would be assured a comfortable retirement.

This isn't a game-show fantasy. This isn't a lottery jackpot. It is a realistic goal. But unlocking this economic opportunity means revolutionizing Social Security. Every American who earns $10,000 a year or more can become a millionaire over the course of one working lifetime—45 years. By the year 2000, there will be over 100 million Americans who fall in this category.

In a recent survey, Americans between the ages of 18 and 34 reported they are more likely to see a UFO (46 percent) than their Social Security benefits (28 percent). They're right. The Social Security trust fund starts running out of money, under current projections, in the year 2013. If you're 20 today, that's when you turn 38. By the year 2030, when you turn 55, the fund will be short $200 billion a year and be unable to meet one quarter of its obligations. By the year 2042, when you turn 67 and reach your so-called normal retirement age, the fund will have an accumulated debt of $4.7 trillion. I'm not making this up. This isn't science fiction. These numbers come from the 1994 report of the trustees of the Social Security system.

You could get all your benefits, of course, if there were an enormous tax increase for your children and grandchildren. According to the Social Security trustees, honoring existing promises for Social Security and Medicare benefits will require a rise in payroll taxes from the current level of 15.3 percent to 25.7 percent in 2030. But that simply isn't going to happen. Americans are already overtaxed. Do you think they'll put up with 25 percent payroll taxes, and federal income taxes, plus state and local taxes on top of that?

Some politicians will tell you not to worry: Social Security is building up a big trust fund that will take care of all those promises. By the end of this year, the trust fund will have $475 billion in assets—on paper. By 2020, there will be $3 trillion on paper. The trouble is, when the program needs the money, the money will already have been spent on everything the federal government spends money on. To redeem its IOUs to the trust fund, the federal government will have to borrow money or raise taxes—by over $36,000 per family—just as if the trust fund had no assets at all.

So you and your employer are now paying one eighth of your income to pay for the Social Security benefits of current retirees, and to build up an illusory trust fund. Meanwhile, your own retirement is in jeopardy.

No wonder younger Americans fear they are on a treadmill. No wonder there is so much trepidation about the future of the country. No wonder we have a savings crisis: our savings are being spent. No wonder most Americans now say their children will enjoy less opportunity than they do.

It doesn't have to be this way. Social Security can be saved without raising taxes, and without lowering the benefits or cost-of-living adjustments of existing retirees. Social Security can be saved in a way that will open up opportunity for younger people—so that their standard of living will be better than that of their parents and grandparents. If we use the principles of democratic capitalism to reform Social Security, the 20-year-old making the minimum wage can become a millionaire by the time he or she retires.

Most Americans are on a treadmill because they have but one source of income: wages. The way to get ahead is to earn income from capital. Money makes money. With capital, you can retire in comfort and bequeath a nest egg to your children.

Here is the beauty of capitalism. Any American currently earning $12,580 or more pays $30 a week, or $1,560 a year, into Social Security. Imagine that, beginning at age 20, you invest that $30 a week at market rates. When you retire, you'll be a millionaire. Whoever earns at least the minimum wage can become a millionaire in 45 years.

The secret is compound interest. Let's assume a long-term return on your investments of 8 percent a year. (This is a prudent assumption; the annual return on the Standard & Poor's 500 over the past 70 years, including the Great Depression, is actually 10.19 percent.) If you can save $30 a week ($1,560 a year), after 10 years the value of your portfolio is $29,000. After 20 years, it is $110,000. After 30 years, it is $318,000. Forty years—$822,000. And 45 years—the normal working lifetime—$1.3 million. After 50 years, if you work until age 70, the value of your portfolio crescendoes to an estimated $2 million.

You wouldn't exactly be a millionaire in today's dollars. If we adjust for inflation of about 4 percent a year, your portfolio of $1.3 million after 45 years would be closer to $230,000. That's still a larger nest egg than most working Americans even dream of. With that amount of capital, you could purchase an annuity at age 65 that would give you $18,256 a year (in today's dollars) during your retirement years.

The way to save Social Security is to make the magic of compound interest work for its beneficiaries. I've been developing a proposal that will save Social Security—and enable 100 million Americans to become millionaires. The plan keeps Social Security as a mandatory, redistributive savings program, but it converts the program from the current pay-as-you-go system to a funded system, in which individuals own retirement portfolios at Social Security and choose private investment managers. Individuals would be allowed to set aside portions of their Social Security payments, together with additional voluntary contributions, in their own personal accounts. They could use their accounts for retirement income and pass on the capital tax free to their children. The plan has four basic elements:

Pay existing obligations to all current retirees. Social Security benefits would be paid to all existing retirees, as promised, without changes, and without reductions.

Divide Social Security into two tiers. If you are working now, you and your employer would continue to pay existing Social Security taxes of 12.4 percent on the first $61,200 of your income. Some of that would go to pay the benefits of existing recipients. Some of your payments would go into your own personal account. Payroll taxes would not rise from their current level. They would be cut by 2 percentage points around the year 2040.

The benefits of current retirees would be paid out of the first tier—current payroll taxes. When they retire, current workers would draw benefits from two Social Security sources: income from future payroll taxes and income from their personal retirement accounts.

Create personal investment and retirement accounts for the second tier of Social Security. Every worker who earns at least $4,000 would have his own IRA-like account with Social Security. (Unlike an IRA, you could use your account only for retirement, and could not withdraw from it earlier.) The first $500 that you and your employer pay into Social Security every year would be automatically deposited in your personal retirement account. You could increase the deposit in your personal retirement account by up to $3,000 per year by making voluntary contributions that would be matched by Social Security taxes you are already paying. The size of the match would vary according to income.

Here's an example: If you earn $10,000 a year and you contribute $1,240 per year, the first $500 of this money would be paid into your personal account. If you add a savings match of $130, the Social Security program will deposit an additional $610 of tax money you are already paying into the fund into your personal retirement account, for a total of $1,240 per year. In 45 years, your portfolio will be $1,026,524 and you're a millionaire.

If you are making $50,000, you might wish to put the maximum of $3,000 per year into your personal account at Social Security; $1,500 of the $3,000 comes from taxes you are already paying, and $1,500 comes from additional funds you save from your income, that is, from a personal-savings match. In 45 years, your portfolio would be $2.5 million.

This money would be in your name, you would own it, and you would be in charge of picking an investment manager to invest it for you. Social Security would set up a corporation whose only purpose is to certify and approve private-sector money managers. (Criteria would include performance and experience in money management, years in business, and certfiably good character.) You would pick your investment manager from this list, and could switch to a different one any time you wanted. This sort of system is already working well in Chile.

Use your capital account to increase your retirement income, and pass on your assets tax free to your children. When you retire, you would have two attractive choices of what to do with your capital account. One would be to use income from your capital (5 percent a year) for your retirement benefits—and then, when you die, to pass on your entire capital account tax free to your children or heirs. The second would be to purchase an annuity with your capital account, and receive higher retirement benefits during your lifetime but not pass any assets on to your children or heirs.

Based on current life-expectancy charts, when you reach 65 you can expect to live, on average, to age 83, an additional 18 years. With an annuity you could currently receive an estimated 7.9 percent return per year.

If you have a small portfolio when you retire, your Social Security benefits would be paid as promised out of the income from your capital (5 percent a year), as well as payroll taxes from future workers. Suppose, for instance, you have $100,000 in your personal account, and promised Social Security benefits of $10,000 a year. You would receive $5,000 in Social Security income from your capital, and $5,000 through the regular payroll-tax base. When you die, you would then be able to pass your retirement assets on to your children or heirs.

As portfolios grow through compound interest, however, tens of millions of retirees would have the opportunity to increase their benefits. Twenty-year-olds today earning $10,000 a year will retire at age 65 in 2040. If the wages keep up with expected inflation, their final wages will be $15,236. Their promised present-law Social Security benefits will be $9,121 per year (a 59.9 percent replacement level). If payroll taxes are not increased, Social Security benefits would be reduced 24.4 percent—from $9,121 to $6,892 per year.

Under the Beard system, these retirees would have $1,026,524 in their personal accounts with Social Security ($182,769 in today's money). If they choose an annuity, their Social Security benefits will be $14,511 per year—$5,390 higher than present-law Social Security promises. If they wish to pass the $1,026,524 tax free onto their children or heirs, their benefits will be $9,138.

It would be enormously expensive to move from a pay-as-you-go to a funded Social Security system. Annual deposits into personal capital accounts would begin at over $100 billion per year and climb to over $200 billion per year (in today's dollars) by 2040. And this would be in addition to the massive deficits already projected for Social Security beginning in 2013. How can America possibly afford these expenses? The money would come from five sources.

Over time, the largest increase in Social Security revenue would come from the income of the new capital accounts. By 2040, after 45 years in operation, the estimated value of retirees' capital accounts in today's dollars would be $8 trillion, almost double the current value of the private pension system. If we assume 5 percent income from capital to pay retirement benefits, retirees would receive over $400 billion every year from their capital (in today's dollars).

Social Security payroll taxes currently exceed payments by about $25 billion a year. This surplus would go into the personal capital accounts. So would the $475 billion in assets that have supposedly accumulated in the Social Security trust fund. Those assets don't really exist, but workers have paid extra taxes on the federal government's promise that the surplus would go to a trust fund. Amortized over 20 years, the trust fund could be drawn down at the rate of $30 billion a year. In practice, this will mean that other federal expenditures will have to be cut by the same amount, bonds of $30 billion will have to sold to the public, or taxes will have to be raised by $30 billion.

Some $60 billion a year would be saved through a special debt instrument we call the Liberty Bond. The Liberty Bond would be a voluntary 30-year interest-paying instrument. After 30 years, heirs and designees would receive principal and interest tax free. It would be marketed to retirees who do not need all their benefits to enjoy a comfortable retirement, and would gladly forego some of their benefits if they were sure this would help their children.

I anticipate that five to 10 million Americans would purchase Liberty Bonds. Millions of retirees would gladly set aside $1,000 per year to create a $25,000 tax-free education fund for their children and grandchildren. Many would even set aside their full benefits—$10,000 to $15,000 a year for their remaining lifetime—to build a nest egg for their children. The government could create a cap of $95 billion per year on the sale of Liberty Bonds, so that no more money is deferred than necessary.

To make the numbers work, benefits will also have to be reduced for future retirees. There are two fair ways to do this. One is to raise the normal retirement age from the current 67 to 70, a change that can be phased in gradually. We are all living longer and we are in better health as we age. It is fair to extend the normal retirement age as our own lifetimes are extended. And in any case, with individual capital accounts in Social Security and the power of compound interest, Americans will want to work longer—because they'll have the opportunity to build up even larger nest eggs.

The second way to reduce Social Security benefits fairly is to reduce indexation for real wage growth. It is important to index Social Security for inflation. Once you retire, the cost of living continues to rise as a result of inflation. Without cost-of-living adjustments, the purchasing power of your benefits will decrease an estimated 4 percent per year. But Social Security is indexed again for real wage growth—about 1 percent a year. This is icing on the cake for retirees. It is not necessary, and it could be reduced by 50 percent.

The current pay-as-you-go system is an economic, political, and cultural dead end. It will force us to raise taxes, and then raise taxes again to pay promised benefits, or to cut benefits and then cut benefits again to avoid mammoth tax increases. It will create no new capital opportunities. It will drain a growing amount of America's resources—our savings and investment—out of the private sector. A shrinking private sector damages our ability to create new jobs and new industries—our future strength.

The current system is also a recipe for conflict. If America is a shrinking pie, the young generation and older generation will fight over the crumbs.

Under a funded, two-tier system, we would cut payroll taxes 2 percentage points in 2040 and then cut them again. As the system matures, we would increase retirement benefits by 25 to 35 percent. We would create 100 million millionaires. We would amass unprecedented savings and investment in America by opening the doors of capital ownership to most Americans. We would create a capital pool that no other nation in the world can equal, and use this investment to finance the high-paying jobs and new industries of tomorrow.

By making every American a capitalist, a funded Social Security system would unleash new economic growth, raise the standard of living of our children, and return America to its historic role as the country of tomorrow, with its best days yet to come.

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