Random musings: Social Security

Since Friday is Social Security Day, this seemed like a timely topic. Today's blog post is based on two articles, both from The Motley Fool

The first article is on how much income you'll need in retirement:

Here's an often-misunderstood retirement concept: Being ready to retire isn't necessarily about how much money you have in savings. The much more important factor is how much sustainable income you'll have.

For example, if you have a pension, Social Security, and an annuity, all of which are inflation-adjusted each year, and this combination is more than enough money to live on, it doesn't matter too much if you have a million-dollar 401(k). On the other hand, if your only guaranteed source of income is Social Security, having a stockpile of savings that you can use to create income becomes much more important.

With that in mind, here's a quick overview of the basic retirement income rule of thumb and how to modify it to determine how much income you will need in retirement.

I'm sure most of you are familiar with the 80% rule:

Financial planners (myself included) often tell clients that they should anticipate needing about 80% of their pre-retirement income after they retire in order to maintain the same standard of living they're used to. The number varies slightly, but is generally between 70% and 80%, depending on who you ask.

You may be wondering: "Where does that 80% figure come from? Wouldn't I need 100% of my pre-retirement income to sustain the same lifestyle?"

Well, not really. The idea behind the 80% rule is that there are some expenses you naturally won't have after retirement. For example, if you commute to work now, you'll probably have lower expenses for things like gasoline and auto maintenance or won't have to pay as much for public transit if you go that route.

And don't forget about the expense of retirement savings itself. The average worker contributes just over 6% of their salary to retirement savings, which will be unnecessary after retirement for obvious reasons.

The point is that after subtracting expenses you will no longer need to worry about, the 80% figure is generally accurate for the average American.

So, if you're happy with your current standard of living, you'll only need about 80% of your current income to maintain it. But as we get older, our health care expenses will tend to increase.

I'm pretty healthy right now, so hopefully my health care expenses will stay low for awhile, but I intend to do more traveling so that expense will probably go up

Since we only need 80% of our current income when we retire, where will we get the money from?

The second article from The Motley Fool is about how much you can expect from Social Security:

It's worth noting that the Social Security Board of Trustees has projected that the Social Security Trust will have completely exhausted its more than $2.8 trillion in spare cash by the year 2034, necessitating what it estimates will be a 21% across-the-board cut in benefits. In other words, if you're heavily reliant on Social Security, your monthly income could take a substantial hit in less than two decades. Worse yet, if you've claimed benefits before reaching your full retirement age (the age where the SSA deems you eligible to receive 100% of your monthly benefits), your already permanently reduced payout could be slashed even more.

Data from the Social Security Administration (SSA) shows that 61% of retired workers count on their benefits to provide at least half of their monthly income. For unmarried elderly individuals this figure jumps to 71%.

Yet according to the SSA, Social Security benefits are only truly designed to replace about 40% of the average worker's wages during retirement. Based on the $1,363.66 that the average retired worker receives each month (as of Feb. 2017), or $16,364 a year, this means around $24,000 in additional annual income (approximately 60%) should be derived from other sources aside from Social Security (e.g., a pension, 401(k), IRA, or some other retirement or investment account).

Understand that this figure has some leeway based on what a worker earns during his or her lifetime. An individual who earned an average of $150,000 a year is capped by how much they can receive monthly from Social Security ($2,687 in 2017). Thus, higher-income individuals will see around 25% of their income replaced by Social Security and, in some instances, they may not even be reliant on this added income at all. Conversely, low-income individuals could see around 55% of their working wages replaced by Social Security income during retirement.

What isn't OK, based on the SSA's recommendation, is relying on Social Security to provide a significant portion of your monthly income (60%+). Doing so runs the risk of being at the mercy of a possible benefits cut in the not-too-distant future.

The most recent numbers, according to U.S. News, is:

The average Social Security benefit was $1,503 per month in January 2020. The maximum possible Social Security benefit for someone who retires at full retirement age is $3,011 in 2020. However, a worker would need to earn the maximum taxable amount, currently $137,700 for 2020, over a 35-year career to get this Social Security payment.

Calculating your SS payment isn't very straightforward (again from U.S. News):

Social Security payments are calculated using the 35 highest earning years of your career and are adjusted for inflation. If you work for more than 35 years, your lowest earning years are dropped from the calculation, which results in a higher payment. Those who don't work for 35 years have zeros averaged into the Social Security calculation and get smaller payments.

"When it's time to calculate your benefits, the Social Security Administration will look at your highest 35 years of earnings, and earnings before your 60th birthday are indexed for inflation – meaning that while your earnings may have crept up over your career, the money you earn this year may not be one of your highest earnings years after indexing," says Jim Blankenship, a certified financial planner at Blankenship Financial Planning in New Berlin, Illinois, and author of "A Social Security Owner's Manual."

For a worker who becomes eligible for Social Security payments in 2020, the benefit amount is calculated by multiplying the first $960 of average indexed monthly earnings by 90%, the remaining earnings up to $5,785 by 32%, and earnings over $5,785 by 15%. The sum of these three amounts, rounded down to the nearest 10 cents, is the initial payment amount. Cost-of-living adjustments and delayed retirement credits can boost your payments above this amount.

This article from Investopedia tells exactly how to calculate your social security payment...it's not easy!

To see the steps involved, check out these instructions from Investopedia:

Using a recent Social Security Statement, list in spreadsheet Column A your taxable Social Security earnings year by year.
List in Column B the most recently published NAWI adjustment factors (year by year) as published by the SSA.
Multiply Columns A and B and output the result to Column C.
Identify in Column D the 35 highest values in Column C. Add these together and divide the sum by 420 (420 months in 35 years). This will approximate your AIME.
Use the most recently published bend points to convert your AIME into a PIA.

The PIA (Primary Insurance Amount) is your actual computed monthly benefit.

If Social Security pays approximately 40% of your pre-retirement earnings, and you only need 80% of that amount to live on, then SS should provide half of what you need to live on. Where will the other half come from?

Take the total amount you have accumulated in your retirement accounts...401k, IRA, etc. and divide that amount by 200. That's how much you can withdraw from your accounts every month and not touch the principal, if you earn 6% interest per year. If that amount isn't at least equal to half of your projected monthly expenses, then you need to either save more (if you have enough time) or to come up with some additional income. Or you could just keep working!

Now that you know how much you'll earn, let's talk about how much you pay into Social Security.

You pay 6.2% of your wages and your employer matches it for a total of 12.4%. (12.5% would be 1/8, so basically one eighth of your income gets paid into Social Security).

I'll probably write some more on the payroll withholding next week,