Approximately 65 million Americans receive a monthly Social Security check and it remains a major source of income for the elderly. However, Social Security was never meant to be the only source of income for people when they retire.
Social Security only replaces a percentage of a worker’s pre-retirement income based on lifetime earnings, so it’s worthwhile to understand how the Social Security program works, the problems it’s facing and the importance of personal savings.
[See: 35 Ways to Save Money.]
Social Security’s Funding Shortfall
Social Security has primarily been known as a pay-as-you-go program. Workers pay Social Security taxes based on their earnings, up to a certain amount, which then goes directly to beneficiaries. Over the last 40 years, there’s been more money left over from payroll taxes than what was needed to pay out current benefits. This extra cash goes to the Social Security trust funds.
“Those surpluses now total $2.9 trillion,” says Kathleen Romig, Senior Policy Analyst at the Center on Budget and Policy Priorities. These reserves are now being used to pay current benefits, which are estimated to be depleted by 2034, according to the most recent Social Security Trustees’ report.
However, it’s important to point out that if the trust funds run out of money, it only means that Social Security will go back to a pay-as-you-go system unless lawmakers take action.
“Payroll tax revenues coming in at that point would only be sufficient to cover about three-quarters of promised benefits,” explains Romig. “I think we have every reason to expect that policymakers will act before something like that happens.”
Considering the Social Security Trustees anticipate a 22% benefit cut if there’s no reform, it means that instead of collecting $1,500 per month in benefit, you would only receive $1,170. This would add up to a loss of $330 a month, or $3,960 a year.
How Rules Could Change
Although the last time there was an overhaul to Social Security was in 1983, Congress can propose a reform at any time. To stop potential benefit cuts within the next 13 years, lawmakers will have no choice but to take action. “When you’re talking about a shortfall like this, it’s money going in and money going out,” Romig says. “There are all kinds of ways to get more money into the program and all kinds of ways to have less money going out.”
Many potential fixes have been brought forward to help improve the program’s solvency. “The most likely potential changes would be increasing the full retirement age, increasing the proportion of income subject to payroll taxes and reducing benefits for retirees with higher levels of total income,” says Christopher Jones, Chief Investment Officer at Edelman Financial Engines. “There are many combinations of changes that would allow Social Security to operate much as it has before, but some of these changes become more expensive the longer Congress delays taking action.”
While lawmakers are expected to take action to address Social Security solvency, their decision could significantly impact your retirement plans. Jones adds that those close to retirement can remain fairly confident that the law will not change much for them. However, it is more likely that benefit policies will change for younger people. “People in their 20s, 30s and 40s should take into account the possibility that benefits under current law could change for them. For example, a possible increase in the full retirement age.”
Loss of Buying Power
Changes are made to Social Security every year and it remains one of the few sources of retirement income that is adjusted for inflation. According to research conducted by The Senior Citizens League over the past decade, benefits lose buying power over time. “That’s in large part due to the fact that the annual cost-of-living adjustment doesn’t accurately reflect the rising prices faced by most older and disabled Americans,” says Mary Johnson, Social Security and Medicare policy analyst for The Senior Citizens League.
For example, Johnson references the Consumer Price Index for Urban Wage Earners and Clerical Workers, or CPI-W, which assumes that consumers spend roughly 7.6% on medical costs. However, the Consumer Price Index for the Elderly, which uses expenditure weights for households with individuals age 62 or older, assumes medical expenses cost significantly more, at 12.2%.
“This means that in the years when medical costs rise more rapidly, the CPI-W, which is used to calculate the COLA, doesn’t reflect the full scope of those price increases,” Johnson explains. “The result is COLAs that don’t keep pace with health care costs and a loss of buying power over time.”
Over the last 12 months, the Consumer Price Index for all items rose 6.2% while Social Security recipients are receiving a 1.3% COLA for 2021. “That works out to prices rising almost four times faster than the 1.3% COLA,” Johnson adds.
Because retiree costs are rising at a faster rate than the COLA, beneficiaries would require a higher benefit amount to maintain the same level of buying power.
The Importance of Saving Early
Social Security only replaces about 40% of earnings, or even less. Saving for retirement as early as possible will help to ensure that you have enough money to enjoy a comfortable level of living when you stop or reduce the number of hours you work. However, a report released by the Federal Reserve found that 31% of survey respondents have no retirement savings or pension and plan to completely rely on Social Security benefits.
“The earlier you start, the easier it is to accumulate sufficient assets to fund your retirement,” says Jones. “Don’t make the mistake of assuming it is too late — it is never too late to get started. It helps to model your situation with a realistic projection of your spending and investment return assumptions to see where you stand.”
Romig advises everyone to take all the prudent steps that financial advisors recommend, such as contributing to retirement accounts and, if your employer offers a match for those retirement accounts, to contribute enough to get the full match. “The main thing to do is to save and also to learn more about Social Security and its rules,” Romig says. “When you take your benefit is really important. The longer you wait to take your benefit, the bigger that benefit is.”
Jones also recommends that most Americans delay their benefit start age unless there’s reason to believe that your expected lifespan is much shorter than average. For example, if your full retirement age is 66, but you decide to claim your Social Security benefit at age 62, then your monthly benefit is reduced by 25%.
By knowing how Social Security works, you can better understand how you and your family’s benefit could best be optimized.
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