• Should I Consider Social Security Benefits in My Retirement Plan?

    When developing a financial plan for retirement, you need to decide what to assume about future Social Security income. Social Security benefits significantly impact most people’s retirement calculation.

    To be conservative, many younger investors simply assume Social Security won’t be around when they retire. Although this approach is certainly conservative, it’s unlikely Social Security will entirely disappear, even for the affluent.

    If future Social Security benefits are eventually curtailed, the value of this “guaranteed” income is still substantial. Not including any Social Security income in your retirement plan will cause you to over-save for retirement and sacrifice current consumption.

  • But Wait, Isn’t Social Security Going Broke

    Now don’t get me wrong, Social Security is broken. Regardless of the nonsense you hear from politicians about the Social Security Trust Fund (specifically the “Old-Age and Survivors Insurance (OASI) Trust Fund” which pays benefits to retirees) being funded until 2034, the system is broken and unlikely to return to positive cash flow unless painful changes are made.

    Annual benefit payments have exceeded payroll taxes collected for many years. Starting in 2020, total payments will exceed total Trust Fund income—which includes both payroll taxes and interest the government pays to itself on the Trust Fund balance—and the negative cash flow will continue indefinitely.

    The shortfall is ultimately covered by the Treasury issuing more debt—just as it would if the Trust Fund didn’t exist. The Social Security Trust Fund basically holds IOUs from the Treasury, as Social Security redeems these IOUs to pay out benefits, the Treasury must borrow more from the general public—increasing both the annual budget deficit and total government debt.


    Social Security Is A Valuable Retirement Asset

    Although changes must inevitably be made—in all likelihood—benefit payments will continue, even if at reduced levels. But even a reduced benefit is highly valuable.

    To replicate the income provided from Social Security, you could buy an annuity with inflation protection. An annuity is basically an agreement with an insurance company that for an upfront premium payment, the insurance company agrees to pay you a fixed amount every month.

    To get an annuity somewhat similar to the promised benefits from Social Security, you could buy an inflation-indexed annuity with lifetime monthly payments (or joint life annuity with your spouse if both claim benefits on a single earnings record). This is still not the same as the package of benefits and payments promised from Social Security but can serve as a proxy.


    Social Security Reduces Needed Retirement Savings

    A 66-year old today would need to pay an insurance company over $250,000 to buy such an immediate fixed annuity providing the average retiree’s Social Security benefit (~$17,500 per year for 2018 [2]). For a retiree receiving the maximum Social Security benefit (~$34,500 per year [3]), the figure jumps to over $500,000.

    These are just rough cost estimates from online annuity calculators based on a single-life annuity with fixed payments. Including the inflation adjustments and getting a joint life contract—if you need payments to continue for a spouse following your death—would further increase the cost.

    To put this in perspective, if you are 40 years old—and just starting to save for retirement—you would need to save an extra $4,500 per year toward retirement for the next 27 years to accumulate savings approximately equal to the value of the typical Social Security benefit. This assumes your investments earn 5% above inflation and the value of the Social Security benefit increases with inflation.

    Considering the median household income in the United States is around $61,000 per year, Social Security is clearly a critical asset in most people’s retirement plan.


    High Earners at Risk

    High earners—like employees at technology firms—are probably most at risk for seeing their Social Security benefits reduced.

    To a degree, this has already happened.

    If you collect Social Security and have other “substantial income” from wages or interest/dividends, up to 85% of your Social Security benefits may be taxed. For those in the top income tax brackets, this effectively reduces your benefits by over 30%.

    To bring Social Security payments back in line with taxes collected, it seems likely high earners will continue to see their promised benefits scaled back in some form.

    Promised benefits for the “rich” could simply be reduced, taxed even more than today, or “means tested” based on wealth or income. In addition, payroll taxes could be increased by upping the income cap (currently $132,900 in 2019) or increasing the Social Security (OASDI) tax rate (currently 12.4%—half paid by the employee and half by the employer).

    And although we can’t predict what will ultimately happen, it also seems likely that Congress would never reduce benefits for current retirees in absolute terms. The annual growth rate might be reduced (by using a lower inflation adjustment factor) for the typical retiree, but the actual dollar amount will likely persist.


    Adjusting for Longer Life Span

    What Congress might do is decide to reduce the value of future retiree benefits by increasing the age one becomes eligible for full benefits, known as the “full retirement age.”  The lifetime value of Social Security benefits is effectively reduced by about 8% for every year the retirement age is increased.

    For retirees today (those born between 1943 and 1954), full retirement age is 66. Scheduled to increase to age 67 for those born in 1960 or later.[1]

    Retirees can start claiming Social Security benefits as soon as age 62, but payments are reduced for each month benefits are claimed prior to full retirement age.

    If the current full retirement age was increased by two years from 66 to 68—and you still claimed benefits at age 62—your payments would likely be reduced by ~35% compared to claiming benefits at full retirement age (vs. about a 25% reduction today for claiming at 62).


    Planning for the Future of Social Security

    So back to the original question: how should Social Security factor into your retirement planning?

    Here are some guidelines for consideration. Ultimately it depends on how conservative you want to be with your retirement savings.

    • If you are over 55 or so, assume you will receive Social Security benefits more or less equal to what is projected in your annual Social Security Statement (perhaps assuming a 5-10% haircut in inflation-adjusted payments if you want to be conservative).


    • If under age 55, assume you will receive 70-80% of projected benefits (Social Security Trustees estimate payroll taxes will equal 77% of promised benefits in 2034[4]).


    • If you are under age 55 and believe your annual retirement income (in 2019 dollars) will exceed $50,000 before Social Security, assume a 40-50% reduction in projected benefits.
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