Building a Social Safety Net: Part II
Money Makes Money
Time and Compound Interest Build Wealth
Albert Einstein is said to have observed that compound interest was the “eighth wonder of the world.”1 It is an incredibly powerful tool to build wealth and it should be utilized to craft a robust social safety net. For compound interest to have a powerful effect it must be given time to work. The longer you use it the greater the return. In my previous post I proposed a thought experiment: what would it be like for every American to have access to $1.65 million of their own money at age 30 with another $250,000 as a starter fund in a Roth IRA? Now I will illustrate what this might look like and how it is quite possible. This situation is achievable by leveraging compound interest over long periods of time.
Picking up where I left off, suppose that under my notional Social Security IRA system the Federal Government invests $250,000 into a modified Roth IRA for a newborn US citizen. This newborn’s parents would be allowed to contribute up to $500, per parent, each month until the child reached age 30. We could also say that contributions would simply be capped at $1,000 a month since most people find work before they turn 30 and thus the individual could make the contribution themself at a certain point. At or after age 30 the child (now adult) could make a one-time, tax free withdrawal from their Social Security IRA with the stipulation that a minimum of $250,000 must remain in their account with no further withdrawals permitted until retirement. How much money would this withdrawal yield and what would their IRA look like by retirement (let us say age 70)? As you read further you will realize the power of compounding interest.
[If you have not read Part I of this series I suggest you review it before reading further].
The Withdrawal
Assuming a person’s parents make zero contributions to their Social Security IRA and using market index funds with a return rate of 7%, a regular American’s Social Security IRA would be valued at approximately $1.9 million when they turn 30.2 Under the above withdrawal stipulation this American, now an adult at age 30, would have access to $1.65 million dollars of their own money, tax free. If the individual’s parents consistently made the maximum contribution, then their account would be worth approximately $3.03 million and they would have access to about $2.75 million of their own capital at age 30. Bear in mind that this would be fully their own money, withdrawn tax-free from their Social Security IRA—zero deductions of any kind. Every American under this system is looking at a withdrawal option somewhere along the lines of the following:
Possible Withdrawals:
Withdrawal (No Contributions) — $1.65 million
Withdrawal (Maximum Contributions) — $2.75 million
Withdrawal (Median Value) — $2.20 million
Under this system it is unlikely that everyone’s parents will have the means to make the maximum contributions possible to their Social Security IRA. However, it is also likely that withdrawal amounts would exceed $1.65 million as even partial contributions over a 30 year period would compound to a person’s benefit given enough time. I have therefore shown the median withdrawal value of $2.20 million. Under this system, most Americans would likely be able to withdraw about $2 million. However, to be conservative most of the calculations moving forward will make the assumption that, for whatever reason, a person had zero contributions entered into their Social Security IRA and therefore would only have about $1.65 million available to withdraw at age 30.
So, what could be done with this money?
This capital could be leveraged for a variety of benefits to include repaying student loan debt, mortgages, car purchases, health and life insurance and a great many other boons. At age 30 many Americans would either be several years into their working lives (but still generally at entry level employment) or just finishing up advanced academic degrees. The advantage of using age 30 as the earliest withdrawal date is that it allows sufficient time for the Federal Government’s $250,000 of seed money to grow to a value in excess of $1 million. Also, it leverages the fact that by age 30, most members of the American workforce display a level of maturity that is often not matched when they are in their twenties. They are therefore, less likely to squander their money—although this cannot be entirely ruled out.
That aside, the $1.65 million withdrawal at age 30 could be leveraged for two purposes. The first would be to allow your standard worker to pay off or significantly reduce personal debt. The second use for this money could be to generate a reasonably steady, passive income stream—a Basic Income.
Paying-Off Personal Debt
Many Americans face personal or household debt of varying sorts. This debt ranges from credit card debts to financing major purchases such as vehicles, mortgages or student loans. Other personal debts might be linked to large medical bills, disaster recovery or even small business expenses. The types of debt Americans hold are legion. Thus, a good many American workers could leverage a portion of their $1.65 million Age 30 withdrawal to significantly reduce or even pay-off all outstanding debts. Emerging debt-free at 30 years old would posture most workers for future financial success as it allows them to leverage their incomes to build wealth.
For simplicity’s sake, suppose that your standard American worker decided to use $650,000 of their withdrawal money to pay down debt and make other significant financial moves. Examine the following possibilities:
Possible uses for $650,000:
$250,000 - repaying student loans for professional or advanced academic degrees
$50,000 - purchasing a new vehicle
$50,000 - major consumer purchases (new computer, washer, dryer, fridge, etc…)
$300,000 - purchase a new house outright or significant down-payment on home
Simply using $650,000 of Age 30 withdrawal money a worker would place themself in a robust financial state. As illustrated above, most of the daunting expenses that plague young people could be covered by $650,000 from the $1.65 million withdrawal. This frees the worker to leverage wage income for wealth creation by investing or financing more generous health and life insurance policies versus paying off debt over many years. At the very least it would allow them to achieve their short or mid-term financial goals.
This proposal also offers significant financial stability to young families. For example, a married couple could use the husband’s $650,000 to pay off all debts while the wife’s $650,000 could be leveraged to purchase vehicles and furnish a new home as well as posture that couple to have children (if they do not already have some by their thirties).
What other significant purchase might a married couple or single worker face? Keep in mind that a single worker would also have $1 million left to invest. A married couple would be looking at $2 million. This leads us to consider the second function of the Age 30 withdrawal money. This is where a Universal Basic Income (UBI) or “living wage” of sorts could be generated.
A Universal Basic Income
After having paid off all debts outstanding, our average American worker could place their remaining $1 million into investments which would yield monthly stipends thus providing a Basic Income, a UBI for all society. For example, the worker could place their $1 million in a 5 or 10 year Certificate of Deposit (CD) with, say, an annual interest rate of 2%. This investment would yield approximately $20,000 per year.3 A regular worker could withdraw from their earnings $1,500 a month and yet have their CD grow by $2,000 per year! Add this income stream to their wages and that person’s standard of living is greatly improved.
The average worker could know that regardless of their employment status, they would have approximately $1,500 a month available to live on. This $1,500 provides a valuable safeguard for those whose jobs might get replaced by automation in the incipient digital economy. Also consider that a worker would benefit from having no debt. Thus, the $1,500 a month would go towards cost of living expenses as they transition to new lines of work versus paying off debt.
This dynamic presents significant value to the “gig” economy where laborers often work a “gig” for a few months before bouncing to the next project. A worker could transit between jobs knowing they have a Basic Income from the money accrued by the investment of their $1 million. This liberates workers from having to tap retirement savings or other funds to sustain them as they alternate between jobs. The Age 30 withdrawal provides the flexibility and modularity necessary for America’s future workforce as it shifts skills and jobs due to the dynamism and disruptions caused by rapid technological change. This allows for a flexible workforce and affords workers a level of margin in their lives. It provides a social safety net that generates a minimum income stream even when Americans cannot find work.
The benefits of this system are even more numerous for young families. A young couple would have significant financial stability with at least $2 million in growing CDs and a $3,000 per month income stream in addition to their wages. When the couple is employed they could leverage this supplemental income towards generous health and life insurance policies for themselves and their children. Additionally, it could also go towards investing in their own or their children’s Social Security IRAs thereby posturing themselves for a solid retirement or preparing their children for a more robust one-time withdrawal when they, in-turn, become 30.
As with the single worker, a married couple could rest secure knowing that they will always have a guaranteed income stream regardless of their employment status. This situation offers greater flexibility to the couple should, say, the wife wish to reduce her working hours or even stay at home full time for child-care. Would this notional couple or their children require Federal funds for anything else? Their need for any Federal assistance would be minor. Their children would already be cared for through Social Security IRAs of their own.
It is also important to remember that there are other investment tools besides CDs. In fact, a worker has many options for their $1 million. It would come down to how much risk a person is willing to assume when they are parking this money. However, the bottom line is that with an Age 30 withdrawal a single worker or married couple will be able to set themselves into a very advantageous financial situation. They would enter their thirties largely debt-free while enjoying a kind of Basic Income through investing much of their withdrawal.
This, however, is not the end of the benefit. We must also consider retirement. After all, I am advocating that we alter the Social Security program. We want to ensure that reforms lead to a superior retirement system than the one currently in place. So, does my proposal offer this? It certainly does. Let us examine the remaining $250,000 left in the Social Security IRA. How well would it posture a person for retirement?
The Remaining $250,000
The $250,000 remaining in an individual’s Social Security IRA after their Age 30 withdrawal would be left to grow, untapped, for the next 40 years. Let us say a worker is authorized to make up to $500 per month in contributions and their employer can add up to $1,000 per month as part of an employee retirement plan. At an age 70 retirement their account would be valued at $7.3 million assuming a 7% compounding growth rate. Were zero contributions to be made the account would still be valued at $3.7 million.
Possible Social Security IRA Valuations at Age 70 (single worker):
Valuation (No Contributions) — $3.7 million
Valuation (Maximum Contributions) — $7.3 million
Valuation (Median Value) — $5.5 million
For the sake of conservatism, I will reference the lowest likely valuation—$3.7 million. A 70 year old retiree could withdraw $185,000 a year for 20 years before depleting their $3.7 million. To break it down further, that retiree is looking at approximately $15,417 a month as a monthly budget! Not bad for retirement.
A married couple would be valued at $7.3 million having made no contributions to their retirement or they could be worth $14.6 million having leveraged the maximum contributions possible. Consider the range of valuations, it is quite remarkable:
Possible Social Security IRA Valuation at Age 70 (married couple):
Valuation (No Contributions) — $7.3 million
Valuation (Maximum Contributions) — $14.6 million
Valuation (Median Value) — $10.95 million
Would this couple be secure in their retirement? I would think so.
A retired married couple would have, in effect, an annual budget of $370,000 for at least 20 years! Would that cover health insurance? We are talking about $30,800 a month budget for your average, retired married couple. Not bad! If the retired couple had made the maximum contributions over their careers we are talking about an annual joint income of $730,000 or $60,800 per month! Could you even spend that much money in a month?
Consider that their children and grandchildren would also be covered under this program with their own, respective Social Security IRAs.
This is all possible if we dispense with the petty partisan gutter-sniping of our present moment and think long term. Let us use multi-generational thinking! Who wouldn’t want their grandkids to benefit from this system?
Counting the Cost
In fairness, I have painted a very rosy picture and by now, I am sure you are wondering, “how do we pay for all of this” or “what is the catch?” The market is certainly not consistent. There are recessions and even depressions which can momentarily deplete IRAs. However, long term trends generally show the market growing, overcoming depressions and recessions to build fantastic wealth. Again, we must think in the long term, not in the short-term. Consistent savings over the course of 30 or more years in conjunction with compound interest grows wealth in a wondrous way.
You may also be thinking, “if this is so beneficial why has it not been attempted before?” The answer lies in the fact that this proposal relies upon delayed gratification. Any politician who champions such a reform would not see the fruits of his labor until at least 30 years after implementation. That is a lot of forward thinking for a politician. Most people simply do not think 30 years ahead. It is difficult to do so. President George H. W. Bush was in office 30 years ago—how likely is it that he gave much thought to the year 2021? However, in the life of a nation, 30 years might as well be a breath in the wind. Would the architects of the present Social Security system have imagined that it would still be in place in the year 2021 (and likely to continue for many years hence)?
There is a lot of cost associated with implementing this proposal. These costs will be enumerated in my next post. However, we must consider that in this proposal, the US Federal Government will have advanced a one-time investment of $250,000. After 30 years it would collect tax revenue on a worker worth at least a million dollars. In addition to this, much of the Federal burden for unemployment, WIC payments, Pell Grants or FAFSA could be reduced over time as the costs for these would eventually transfer back to workers who can leverage their Age 30 withdrawals to fund many of the things
Interestingly, there is another part to Einstein’s quote. He is alleged to have actually said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”4 If we pay attention to compound interest and leverage it, we can earn it. If we do not, we will end up paying it and bequeath to our children and their children, a failing and insolvent social safety net.
In my next post I will discuss the implementation of this proposal.
Albert Einstein as quoted by R. B. Matthews and Doug McCutcheon, “Compound Interest May Not Be Einstein’s Eight Wonder, but It Is a Powerful Tool for Investors,” The Globe and Mail, November 12, 2019, https://www.theglobeandmail.com/investing/investment-ideas/article-compound-interest-may-not-be-einsteins-eighth-wonder-but-it-is-a/.
Note to Reader: all computations were done utilizing the US Securities and Exchange Commission’s Compound Interest Calculator which may be accessed at the following link: https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator. Furthermore, this study utilizes the 7% growth rate since, historically, S&P 500 Index Funds have yielded this rate adjusting for inflation (see Adam Levy, “Average Roth IRA Returns,” The Motley Fool, November 30, 2020, https://www.fool.com/retirement/plans/roth-ira/returns/).
Matthew Amster-Burton, “Can You Live Off the Interest of a $1 Million Dollar Investment?” MintLife Blog, Intuit MintLife, June 18, 2013, https://mint.intuit.com/blog/investing/can-you-live-off-a-1-million-dollar-investment-0613/.
Albert Einstein as quoted by R. B. Matthews and Doug McCutcheon, “Compound Interest May Not Be Einstein’s Eight Wonder, but It Is a Powerful Tool for Investors.”