Last week's landmark tax deal sharply changes the financial outlook for Social Security. That has huge implications for your retirement. And most people don't have a clue what's coming.
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The deal, by cutting payroll taxes for one year, weakens Social Security's funding. It puts those payroll taxes "in play" as a political football for the first time. And by freezing federal taxes at today's low rates, it will add at least $900 billion — and probably much more — to our spiraling national debt. That threatens the ultimate financial stability of the federal system.
Note that while Social Security is called a "trust fund," that is largely a matter of internal accounting. Your Social Security checks ultimately come from the same flow of tax dollars as all other federal spending. Social Security can't stay solvent unless Uncle Sam does.
Ten years ago, the national debt was about $3.5 trillion. By 2020, Congressional Budget Office calculations suggest it could be well over $20 trillion. No kidding.
The latest tax deal appears to rule out tax increases, possibly for good. Federal taxes currently account for about 15% of the gross domestic product — lower levels than we ever saw under Eisenhower or Reagan, and the lowest since 1950.
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If we don't raise taxes, we are left with two options: a financial crisis, or deep spending cuts. Assuming we embrace the latter, that would mean going after Social Security and Medicare. After all, that's where the money is. These two programs already account for a third of the entire federal budget, and that proportion is set to rise dramatically, as the population ages and the baby boomers retire.
To consider what this means, let's look at the case of Social Security — in particular what it is, what it means for your retirement, and what it would take to replace those benefits from other sources. (Medicare, and medical costs, are a separate story and a complex one.)
Social Security is a lifetime income annuity. It sends you a check every month till you die. That one feature addresses the biggest financial challenge any retiree faces — making sure you don't outlive your savings, even by a single year.
According to government data, a 65-year-old man can expect to live, on average, another 17 years. A woman can expect to live on average another 20 years. But these are only averages, and they are widely misunderstood. Some people will die at 66. Others will live to 100.
What are your odds? According to federal data, someone who is 65 has around a 25% chance of living to 90 and nearly a 10% chance of living to 95. For women the figures are even higher. Of women age 65, one in eight will live to 95. If you're making a pile of savings last, you need to plan for all contingencies. The only way to make sure of that is to buy an "immediate annuity," the kind that most closely mirrors Social Security's steady stream of regular payments.
Social Security also offers something most annuities don't: inflation protection. Very few insurance companies offer anything similar.
To see what this is worth, think about the dangers that inflation poses to a retiree.
Over time, even small amounts of inflation will gradually wear away the purchasing power of your money. Let's say at 65 you buy a lifetime annuity paying you $1,000 a month. Let's also say that inflation runs at a pretty modest 3% a year over the next couple of decades. That's a pretty benign inflation scenario. Yet by the time you turn 85 your monthly checks will have lost almost half their purchasing power. You thought you were buying security. Instead, you may now be struggling to pay the rent or buy groceries or pay medical bills. And you may have another 10 or 15 years still to live.
Social Security offers a third benefit as well. It's an annuity guaranteed by the federal government.
It's easy to forget how valuable this can be. During the financial crisis, I got a lot of anxious emails from readers who held annuities from stricken insurance giant AIG. If the company went bankrupt, they asked, would their checks stop? For a 75-year-old widow, this was no joke. So an annuity backed by the federal government provides a lot of peace of mind.
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Once upon a time, many middle-class Americans were beneficiaries of company pension plans. Not anymore. For most people, Social Security is the only inflation-adjusted annuity they know.
If your Social Security payments are scaled back, or worse, what would it cost you to buy something similar in the private sector?
We can do some math.
According to ImmediateAnnuities.com, a 66-year-old man would have to pay $128,000 for an annuity providing him with income of $10,000 for life. A 66-year-old woman would have to pay even more, about $138,000.
That's for an income of $10,000 a year. If you think you'll need $40,000 a year to live on, naturally you'd need to set aside four times as much, or about $550,000.
And this would only be for a straight annuity, with absolutely no inflation protection at all.
Few life insurers provide inflation-protected annuities. New York Life offers something close: an annuity that increases payments by a certain percentage each year. This won't protect you from runaway inflation. But at least an annual increase of, say, 3% will give you some cushion.
I asked the company how much a 66-year-old would have to pay for an annuity paying $10,000 a year, with a 3% annual increase.
The answer? About $180,000. It's about the same for men and women.
Right now, the average retiree is getting about $14,000 a year from Social Security. To buy a similar income stream on the open market, a 66-year-old would have to pay about $250,000. Someone getting the maximum benefit, $28,000 a year, would need to pay about $500,000.
It's something to bear in mind as we debate cutting Social Security. Most Americans are already grossly underprepared for retirement and have saved far too little.
According to the most recent survey by the Employee Benefits Research Institute, a think tank specializing in the topic, fewer than half of workers have even saved $25,000, and only a third have saved as much as $50,000. Forty-four percent have saved less than $10,000, and a quarter have basically saved nothing at all.
To put these numbers in context: Someone with $25,000 can buy an annuity (with the 3% annual bump) paying maybe $1,400 a year. Someone with $50,000 can raise that up to $2,800 a year. That works out to an income of $54 a week. Good luck with that.
If we want to cut Social Security, even prosperous middle-class Americans need to save much, much more. Starting about 20 years ago.
- Social Security