3 Essential Facts You Need To Know About Social Security
Social Security was formed in 1935 during the Great Depression. It was initially meant to serve a dual role. First, it was meant to alleviate poverty among the elderly. Second and more importantly, it was meant to allow older Americans to quit the workforce and make room for hiring the massive amount of unemployed younger workers. Today, Social Security is arguably the most important, but also least understood, government program. According to the Social Security Administration, 63 million Americans (including 43 million retirees) will be receiving benefits in 2018.
The Social Security Administration just published its annual report on the status of a program that has important implications for the retirement plans of all Americans. So let’s take a look at three critical facts, while also debunking some dangerous myths about this crucial program. Along the way, we can hopefully help you better plan for your own retirement to maximize the chances of prosperous golden years.
Social Security Isn’t Supposed To Replace All Your Income
According to the 2018 OASDI Trustees Report (the people overseeing the program), on average Social Security Benefits make up 33% of retiree income. The program’s original goal was to replace 40% of your working income during retirement. Since the average person spends about 80% of what they did after retirement, this means that social security was originally intended to provide about half your income in retirement. So you’d think that with the average retiree relying on the program for just 33% of their income, things should be going well for the program and America’s elderly. However, that is not the case.
According to the Social Security Administration, 23% of retired couples and 43% of retired individuals rely on their social security for 90% or more of their total income. Given that the average 2018 monthly benefit will be $1,404 per month ($16,848 per year per person), this means that roughly 14 million Americans will be forced to live extremely frugally. This is largely because of three connected historical trends.
First, private pensions have largely been a thing of the past. According to a 2017 report from analyst firm Willis Towers Watson in 1998, 59% of Fortune 500 companies offered new workers a pension. In 2017, that figure was down to 16%. Instead, companies have switched to 401Ks, in which individual employees are responsible for saving for their retirements. In theory, this isn’t a problems since many companies even offer to match your contributions (usually between 3% to 6% of your salary). This represents free money to help people build their nest eggs. However, there are three major problems in reality. First, Americans are notorious for a low savings rate.
Currently the US savings rate is 3.1% and has been falling for several years. Financial advisors usually recommend a savings rate of 10% to 15%, invested in low cost stock and bond index funds. It’s been roughly 33 years since the US savings rate has been at even the low end of the recommended range. Thus the US retirement crisis is a problem that’s been a long time coming, but one that’s not purely the fault of Americans not saving enough.
Source: Ycharts
Another issue is that the mutual funds offered by companies in their 401Ks are actively managed, with high expense ratios that means 95% of them will underperform the market over time. Often HR directors receive kickbacks from fund companies to exclusively offer certain funds to a company’s employees.
Finally there’s investor psychology. Simply put, most people are absolutely terrible at market timing, yet due to risk aversion (it hurts twice as much to lose a dollar as make a dollar), most people simply can’t help themselves. This means pulling money out of one’s 401K when stocks are falling, and increasing contributions when stocks are rising. Or to put another way, most investors are experts at buying high and selling low.
This is why, according to a study by JPMorgan Asset Management (4th largest asset manager on earth), over the past 20 years the average investor generated total returns of 2.6% annually. That’s worse than every other asset class and just 0.5% above the rate of inflation.
This combination of low savings, poor mutual fund options, and terrible market timing, is why, according to the Economic Policy Institute, the average family aged 56 to 61 has just $163,577 in retirement savings. That might sound like a lot but in reality it’s nowhere near enough to live comfortably on during retirement, even factoring in Social Security. How much does the average person need to have saved up? The answer is rather shocking and a bit depressing.
You Need Substantial Personal Savings To Augment Social Security
According to the Bureau of Labor Statistics, older households, defined as those run by someone 65 and older, spend an average of $45,756 per year, or roughly $3,800 a month. This is why a 2017 report by Merrill Lynch estimates the average retirement costs $738,400 ($275,000 of which is out of pocket medical expenses not covered by Medicare). Or more specifically, the amount the average couple needs to have in retirement savings (assuming withdrawing 4% of your savings each year), is $738,400.
That’s factoring in the average Social Security benefit, a 20 year retirement (starting at age 65), and the risk weighted healthcare costs (senior living expenses can run up to $120,000 per year, per person). In other words, a retired couple needs a nest egg of nearly $750,000 in order to enjoy a safe and comfortable retirement. In reality, most households are far short of that goal. Which brings us to the most important fact of all…
Social Security Isn’t Going Broke…BUT It Is In Trouble
As a tool for combating poverty among the elderly, Social Security has been a roaring success. According to the Center on Budget and Policy Priorities, thanks to Social Security the poverty rate among Americans 65+ is about 9%. Without the program, it would soar to about 40%. In effect, Social Security has reduced poverty among retirees by about 75%.
However, the program is in deep trouble, which is why there is a common misperception that “Social Security is bankrupt”. This stems from the fact that by 2035, according to the Social Security Administration, the number of Americans aged 65 or over will increase from 49 million to 79 million. This means the ratio of workers/retirees will fall from 2.8 today to 2.2. Social Security is a “pay as you go” system funded by 12.6% payroll taxes. According to the latest trustee report, “Over the program’s 83-year history, it has collected roughly $20.9 trillion and paid out $18.0 trillion, leaving asset reserves of $2.9 trillion at the end of 2017 in its two trust funds.”
As the number of retirees rises over the coming years (about 10,000 per day), the Social Security Trust fund will begin to decline in 2018 as the total benefits exceed program income (including interest on the trust fund’s special Treasury bonds). By 2034, the fund will be completely depleted because at present the program’s unfunded liabilities are $13.2 trillion (through 2092). This means that in 2034, if nothing is done, then Social Security will run out of reserves and have to be fully funded only out of payroll taxes. Assuming the current 12.6% remains in place, this means a roughly 25% cut to benefits.
The good news is that this means that Social Security, as its currently constructed, literally can’t “go bankrupt”, since payroll taxes will continue flowing in as long as Americans are working. The bad news is that for tens of millions of retirees that will be a huge blow to their income. For millions of those, it will mean plunging into poverty. Fortunately this is a worst case scenario that will only happen if Congress (who last tweaked Social Security in 1983) does nothing. There are several ways to fix the program, as well as ways for you to prepare yourself to better meet your likely retirement funding needs on your own. Those solutions will the the topic of my next article.
Note: This article originally appeared at Dividend Sensei.
Category: Personal Finance
