How To Handle Social Security Benefit Cuts


Special Report: Race To Retirement

In addition to the investment and health risks that people must weigh in planning retirement, government decisions are now becoming a bigger part of the equation.

While Washington remains in a state of denial about Social Security's finances -- Democrats campaigning in 2014 are calling for increased benefits for all -- the bad news has continued to pile up.

Congressional Budget Office projections now show that the Social Security Trust Fund will be fully spent by 2031, when today's 55-year-olds are turning 72.

At that point, Social Security will be able to pay only about 75% of benefits, which would result in a 25%-across-the-board cut to annual benefits if Congress doesn't act.

Assuming recipients live to the average life expectancy of 85, that would mean the equivalent of three lost years' worth of benefits. For those who live longer, those losses will not only accumulate, they'll come during very old age, when seniors tend to depend more on Social Security if health bills rise or the other legs of their retirement stool start to seem a bit wobbly.

Limited Options

Surely, Congress will act at some point. Yet there is only so much it can do to change Social Security's basic math, especially since protecting lower-income workers, the disabled and those already retired from benefit cuts is sure to take precedence.

To the extent Washington does do something to limit benefit cuts for the broad middle class and higher earners, you should expect that fix to involve higher taxes.

Whether it's more tax dollars funneled through the government or more money tucked away in a personal account, setting aside extra savings will have to be an important part of the response to Social Security's dwindling resources.

The other way to make up for less support from Social Security is by working longer. At present, workers who claim benefits at the earliest eligibility age of 62 face an early retirement penalty that amounts to a 25% benefit cut each year for as long as they live. (That penalty will ramp up to 30% in steps as the official retirement age rises from 66 to 67 for people between the ages of 54 and 59.)

Reward For Waiting

In contrast, workers who wait to claim benefits until after the official retirement age will get an 8-percentage-point benefit boost for each year they wait.

Thus, an extra three to four years of work could fully offset the approximate 25% benefit reduction that would be needed to put Social Security on sound financial footing.

More work may be the best fix for Social Security because it's good for both government and individual finances, but it may not be wise to depend on more work alone.

That's because, depending on one's profession and skill level, and for reasons of health and the economic cycle, plans to work full-time to age 70 or beyond may not be something you can take to the bank.

For a career-average earner ($47,000 in 2014) who claims benefits at the official retirement age, Social Security will replace about 41% of pre-retirement income ($19,000 in 2014). As career earnings rise, Social Security's replacement rate falls -- to 34% ($25,500) for a $75,000-earner and 27% ($31,000) for someone earning the maximum amount subject to Social Security taxes ($117,000).

While Social Security sometimes gets criticized for providing meager returns on tax contributions, the upside is its inflation-protected lifelong benefit.

To the extent those benefits are eroded by measures to make the program solvent, Social Security actuaries have provided some idea of how much personal savings would be needed to compensate.

An average earner would have to set aside 2.5% of pay each year over a full career, investing it in Treasurys, to cover 25% of his Social Security benefit (if the proceeds were annuitized).

Because of lower replacement rates, higher earners wouldn't have to save quite as much. Today's $75,000-earner would have to save 2% of pay over a full career and a top earner 1.5% to offset the same 25% benefit cut.

Yet for workers already halfway through their careers, the necessary savings would be more than twice as high. That's why one would expect policymakers in Washington to propose only very gradual changes to benefits once they finally get around to shoring up Social Security.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , Mutual Funds

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