In almost every financial situation that we deal with on a regular basis, there is the idea of an “account”. For example, when you put money into a bank, it is understood to be “your money” and it goes into an account with your name on it. The same thing happens when you contribute to your 401(k) plan at work — you have an account with your money in it, and if you change employers the money in the account is yours. You also have accounts for your credit card, mortgage, car loan, and so on. In any of these accounts, you add money to the account and take money out of it, and whomever holds the account keeps track of how much you have or you owe.
The Social Security system is nothing like that. In the Social Security system, the money you pay into the system gets immediately paid back out to the people who are currently getting Social Security checks. This arrangement came into being because of the way the system started. In 1935, when Roosevelt signed the Social Security Act into law, there were a lot of people who needed benefits (because of the Great Depression), but there was no money to pay those benefits with. The idea at the time was that people currently working would pay into the system, and their money would immediately go back out in the form of benefit checks. Each generation of retiring workers would get paid by the people currently working, and therefore the system would fund itself forever despite the fact that the system had no money to start with.
This clever idea worked great in 1935 (and for many years after that), but it is going to have a problem in the future for two reasons:
In 1935, there were many more people paying into the system than those receiving benefits. The ratio of workers to retirees meant that workers did not have to pay much into the system in 1935 to support the retirees, up through 1950, only 2% of income (1% employee, 1% employer) was withheld for Social Security, compared to 15.30% (7.65% employee, 7.65% employer) today). In the future, the retirement of millions of baby boomers will hurt the ratio — there will be so many retired people that the working people will not be able to support them. If the population had grown steadily this would not have been a problem, but there is no good way for the design of the Social Security System to handle a population spike like the baby boomers.
Many people have become so used to the idea of a 401(k) plan (where your money belongs to you and grows to a large sum over time through investment compounding), that the idea behind the Social Security system becomes hard to swallow. Currently a worker pays 7.65% of his or her gross income into the Social Security system (with a cap at a gross income of around $70,000), and the employer pays another 7.65% for the worker as well. If you could take that 15.30% of gross income and invest it in a 401(k) plan for the same period of time, it would generate an immense sum of money based on historical returns — far more than a person with average income (or greater) would get from Social Security. A retiree’s Social Security benefit is calculated using a complex formula rather than an account balance, because there is no “account” in the traditional sense.
In finance, the rule of 72, the rule is methods for estimating an investment’s doubling time. The number in the title is divided by the interest percentage per period to obtain the approximate number of years required for doubling. Although scientific calculators and spreadsheet programs have functions to find the accurate doubling time, the rules are useful for mental calculations and when only a basic calculator is available.
For instance, if you were to invest $1000 with compounding interest at a rate of 9% per annum, the rule of 72 gives 72/9 = 8 years required for the investment to be worth $2000; an exact calculation gives 8.0432 years
Assume that when you are born your parents or the government invest for you only $1,000 in a savings account that yields 8 or 10% per year. The table below will show you what this modest investment can do for you in later years.
The first column is for reference, the second is the number of years to take to double your money at a yield of return of 10% or 72/10 = 7.2 or approximately = every 7 yrs. The third column is the number of years to take to double your money at a yield of return of 8% or 72/8 = 9 yrs. The fourth column shows the total compounded investment. Notice that a yield of return of 10% will yield 512K at age 63 and for a yield of return of 8% will yield 128 K at age 63. Notice that such a small difference in yield (10% vs 8%) makes such a huge difference in compounded return.
1 7 9 2K
2 14 18 4K
3 21 27 8K
4 28 36 16K
5 35 45 32K
6 42 54 64K
7 49 63 128K
8 56 72 256K
9 63 81 512K
10 70 90 1,024K
Thus, an investment of $1000 when you are born with a yield of return of 10% per year, will give you 512K at age 63, or one time investment of 15% of your salary at age 28, say you make 60K or $16.8K will give you 537.6K at age 63.
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