Social Security retirement benefits are based on a pay-as-you-go system, paid out in the form of employer payroll taxes. In contrast, private pensions invest your contributions into money-earning assets, ideally creating substantial growth in your retirement funds during your working years. The Social Security system was born out of the Great Depression of the 1930s, and the Social Security Act was passed in August 1935.
A private pension is a retirement plan in which employers and employees make regular contributions into a retirement account. The funds contributed are invested on behalf of the employees, are typically tax-deferred, may have defined contributions, benefits or both and allow employees to build a substantial nest egg for their retirement years. Individual retirement accounts (IRAs) and 401ks are examples of private pensions.
According to the CATO Institute, the design of the Social Security public pension system is fundamentally flawed and will prevent many members of today’s workforce “from enjoying financial security in their later years.” Your Social Security benefits will depend upon the number of workers in the workforce when you reach retirement age. In other words, there exists a support-benefit ratio of workers per retiree, and with life expectancy growing and birthrates falling for the past several decades, there will be fewer workers to support retirees.
The fact that most employees are legally required to pay into Social Security taxes with every paycheck they earn prevents workers from investing the money in assets with higher earnings, such as IRAs, 401ks, mutual funds, stocks and bonds. Your costs to invest in these investment vehicles (private pensions) would be a fraction of that required for Social Security, and your financial returns could be three to six times greater.
Allowing workers to invest their Federal Insurance Contributions Act (FICA) taxes into financial instruments such as stocks and bonds would be known as privatization of the public pension system. Chile has implemented the successful privatization of its public pension system, which requires workers to put 10 percent of their wages into their own retirement accounts with a pension fund company. The funds are invested in various securities and contributions and dividends are tax-free, but withdrawals upon retirement are not.
In its present form, the Social Security system is not a sustainable system. Whereas private pensions consist of assets held in trust for their beneficiaries (future retirees), the Social Security system operates quite differently. The federal government spends any excess Social Security funds on various unrelated expenses (defense, food stamps or bridge repairs) and issues itself an IOU in the form of interest-paying bonds.
When Social Security needs to cash out the IOUs to pay benefits, the federal government has no assets set aside to pay the bill, so it is forced to obtain the funds by raising taxes or issuing additional debt. So in contrast to a private pension plan that not only stores but seeks to build your wealth, Social Security is simply a tally of the government’s debt.