Germany’s response has been to increase workers’ taxes and decrease retirees’ benefits. We’ve done the same. These government responses have not solved the problem in Germany, nor have they here. And now the German Conservatives and Social Democrats have agreed to a major, and new, reform of their Social Security system: Raise taxes further and cut benefits more. Will America follow once again?
Under the new proposed German agreement, the payroll tax that finances retirement income will rise from the current 191/2 percent to 20 percent in 2020 and then 22 percent in 2030. Full state pension benefits are scheduled to drop from 54 percent of former salary to 46 and then 43 percent in 2020 and 2030, respectively. Also, the age at which one can receive full benefits will rise from 65 to 67 over the next 23 years. Another benefit cut.
To cushion the blow, workers will accrue benefits even when they take time off from work to care for their children and their elders. The government will also provide incentives to employers who hire workers over age 50.
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.
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 191/2 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 U.S. 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. But there’s more.
After 25 years of retirement he’d still have money left over, about $12.7 million ($3.3 million in today’s dollars). This provides him options. He could double his payout to 86 percent, increase it for inflation, and still have about $2.7 million left over. He could start the whole process later, save less, or he could invest in a more conservative portfolio.
On the last point, the common convention of using the historical average rate of return to estimate future wealth masks the fact that the yearly returns that make up the average tend to jump all over the place. For instance, this 70/30 portfolio lost 17.9 percent in 1974, gained 34.8 percent in 1995, and lost money 12 out of the 44 years. Volatility is the real world, and it is unsettling.
One way to dampen the volatility is to dramatically reduce the stock exposure, say to 40 percent, and invest the remaining 60 percent in bonds. This reduces the volatility by about 20 percent, but also reduces the amount available for retirement. By investing in this portfolio, which returned 9.64 percent annually, our German friend would still be able to replace 43 percent of his wage, index it to inflation, receive benefits for 25 years, and still have about $8.3 million left over. Or he could increase his replacement rate to 78 percent and hope he doesn’t live longer than 25 years. He still has options.
Using different but reasonable assumptions for market returns, life expectancy, inflation, working years and the like doesn’t qualitatively alter the outcome. Our German worker is significantly better off by saving for retirement than by paying taxes to the government and receiving his scheduled benefits.
One major obstacle confronting him, however, is that all this is illegal. He’s not allowed to save part of his payroll tax. It’s also illegal here. But that may change.
Germany’s latest proposed reform gives our political leaders the opportunity to revisit the Social Security debate. The overwhelming benefit of saving for retirement instead of being taxed for it is crystal‐clear when the two models are compared in a highly taxed country such as Germany. The differences are striking.
If we don’t reform our system along market‐based principles, we will continue to follow Germany and raise taxes and cut benefits. But should we seize the opportunity and reverse course, America will lead. Then, Germany may follow.