For many, the monthly social security check is a welcome sight.  Part of the social contract for ages, it helps pay rent and grocery bills, put some gas in the Cadillac, and provide for the occasional trip to Florida.  With all of the press about the underfunding of the Social Security trust, it still takes in more in employment taxes than it pays out, and is part of retirement planning for the majority of future retirees

Like many retirees (early and otherwise), we paid no Social Security tax in 2013 (and don’t plan to ever again*.)  This raised a great question on the recent post where we shared our 2013 taxes.

“The one downside to not paying social security tax going forward is that your payout when you retire will be lower than a person paying as they continue to work….am I correct about this? If so, then the loss of a “annuity product for life” can be a major problem.”

Let’s see if this is a major problem, or even a problem at all.

To be eligible to receive future Social Security payments, an individual needs to earn 40 credits.  For most people this means working for a decade, which is a convenient number since it is also possible to save enough to retire in just 10 years.  The Social Security payout is determined by a formula based on the average of your 35 highest income working years.  If you work less than 35 years, your payout will be lower.  Seems reasonable

The Social Security Administration provides a (not very good) calculator to estimate your future benefit.  You just enter your date of birth, your earnings history, and an estimate of your future earnings, and the calculator provides a benefits estimate.

Based on our working history and no additional taxes paid past 2012, if we elected to receive Social Security benefits at the age of 62, we would receive $1312 a month in “Today’s dollars.”  If instead of early retirement and world travel, we had elected to work until age 62 , we would be eligible to increase that monthly check by $617.

Work another 25 years to get an extra $617 a month?!  Does it seem worth it?  Let’s investigate

The 4% rule states we would need a portfolio worth $185k to provide $617 in monthly spending.  By comparison to the $363k that would be paid in taxes during an additional 25 years of employment, $185k looks pretty reasonable

Our 2013 spending of $33.5k can be sustained by a portfolio of $836k.  Savings an additional $185k certainly would have taken less than 25 years.

Clearly Social Security isn’t the most efficient option for funding a retirement.  What other options do we have?  Since Social Security is a complex instrument, it is somewhat difficult to completely estimate alternatives.  No direct replacement exists in the private market, but we can get similar if not equivalent coverage by purchasing:

  • An inflation-adjusted annuity with survivor benefits
  • Disability insurance
  • Term life insurance (to buy an annuity for our descendents upon an untimely death)

An annuity is a contract with an insurance company.  In exchange for an up-front payment, they will manage your funds and provide a monthly income for life.  In exchange, they get to keep the remainder of your money when you die.  With a higher cost, the annuity can provide survivor benefits, which provides income to a surviving spouse

Most insurance companies want you to speak to an agent to get a quote for one of these, but one online calculator (UK based) estimated an inflation adjusted annuity with 50% spousal benefit with payments starting at age 62, would cost $298k.  Since this is 25 years from now, adjusting for present value allows for a much more affordable price of between $70k (Do it yourself investment at 6% return) and $125k (insurance company invests for you at the “safe rate” of 3.62%.)

Disability Insurance provides income if for some reason a person becomes disabled and can’t work in the same capacity.  Usually this is to provide income during recovery or to allow training for a new vocation.  Social Security benefits are fairly generous in this case, sometimes providing income for life.  The closest equivalent would be disability insurance with a 2 year payout, for which I found an online quote for a $2k/month policy for $40 a month ($480/year.)

In the event of an untimely death, a life insurance policy provides financial support for our family.  A $150k term life insurance policy could be used to purchase an immediate annuity at a cost of $43 a month ($516 per year.)

While these solutions aren’t an exact equivalent of what Social Security offers, it comes close.  And while Congress could change Social Security at any time (for better or worse), these contracts are a known entity.

We could either work for another 25 years or (as closely as possible) substitute private market solutions with a total cost of about $83 a month and a bit of savings for an annuity.

The closer one comes to financial independence, the less necessary these insurance options are.  Without a job, there is really no need to have disability insurance, and with a sizable nest egg there is really no need to have life insurance.  For that matter, the annuity is starting to look like a bad deal.

So while it is true that working fewer years will provide for a lower Social Security payout, it looks like Social Security isn’t such a great deal in the first place.  Better to focus on saving and use private market solutions until savings grow to sufficient size to become independent.  Consistent with our general attitude that it is better to self insure when you have the means to do so, we will neither work 25 more years nor purchase private insurance.

* Odds are that in 25 years we will also elect to not receive Social Security.  Having more income won’t make us any happier, and since Social Security is considered Earned Income it would mess with our tax planning