Thursday, October 6, 2016

Calculating Required Retirement Savings Rates: Part 3

In Part 1 of this series I outlined a method for estimating how much you need to save to have a good shot at a financially secure retirement. I put this in terms of a retirement savings rate, calculated as your required annual savings divided by your gross (before tax) annual income. For example, if your gross annual income is $50,000 and you estimate that you must save $7,500 annually, your required savings rate is 15% (7,500 / 50,000).

In Part 2 I discussed how to estimate living expenses in retirement, and gave a few examples of how this affects the retirement savings calculations. In this post I'll discuss how to estimate your Social Security retirement benefit, since this can have a significant impact on how much you need to save for retirement.

The Social Security Administration (SSA) website provides several ways to estimate your Social Security retirement benefits. The best thing to do is to create a "my Social Security" account, which you can use to get customized benefits estimates whenever you want. This enables you to easily use your actual earnings history to estimate your benefits.

The SSA website also provides a variety of calculators you can use to estimate retirement benefits and other related things. These calculators do not require creating a my Social Security account, but some of them either access your earnings record or allow you to enter detailed earnings.

To get some rough estimates of Social Security benefits for purposes of illustration, we can use the Social Security retirement benefit Quick Calculator. I'll start by using this calculator for our hypothetical 25-year-old with an annual income of $50,000 who plans to retire at age 65. You might learn more if you click the Quick Calculator link and follow along by entering the numbers yourself.

I make the following entries into the Quick Calculator:
  • Birth date: 10/6/1991. This is 25 years before today. 
  • Current salary: $50,000. 
  • Last year and amount of covered earnings: 2016 and $50,000
  • Month and year of retirement: 10 and 2056. This is 40 years from now. 
  • Leave the default of "today's dollars" selected for the benefit estimate, because we are calculating our retirement savings numbers in real dollars (which is the same as today's dollars). 
Then I click Submit request, and a results page is displayed that says my estimated monthly benefit amount is $1,585 (in today's dollars).

I also see a button labeled "See the earnings we used", so I click it. On the earnings page I see that some earnings were assumed starting in 2009, when I would have been age 18. There are other things you can do on this page to change the assumptions, but for now I'll just delete the earnings before 2016 to see what the impact is. I leave the default "Enter the amounts you want to change ...", delete all earnings before 2016, then click "Submit earnings information".

There is no change in the benefit estimate of $1,585 per month. This is because the Social Security retirement benefit is based on the 35 years with the highest earnings, so years before 2016 aren't included. This also means that even though the benefit calculation assumes no earnings in the year of retirement, the retirement benefit would be the same if earnings in the retirement year were included, since the earnings over the 35-year period used in the benefit calculation would be the same.

I multiply by 12 to get an annual benefit amount of $19,020 (1,585 x 12). This is is 38% of my assumed annual earnings of $50,000.

In Parts 1 and 2, I assumed an annual Social Security retirement benefit of only $14,000, so based on the calculator, this estimate is too low. However, some people are pessimistic that they'll actually receive the full benefit, with SSA itself warning that only 79% of the estimated benefit will be covered by payroll taxes by 2034. If we are slightly more pessimistic, and assume only 75% of the benefit will be received, we get $14,265 (19,020 x 0.75), which I rounded down to $14,000.

You can make any assumptions you want to develop estimates for different scenarios. Personally I think that laws will be changed to keep Social Security solvent, and able to pay 100% of estimated benefits beyond 2034. Changes could include increasing the cap on salary that is subject to Social Security tax, increasing the Social Security tax rate, and increasing full retirement age. Legislative changes like this have been made in the past, which is why, for example, full retirement age for people born in 1967 or later is 67, while it was age 65 for those born in 1937 or earlier (see this chart to determine your full retirement age).

As a more recent example, legislation was passed last year that reduces the amount of benefits that a married couple can receive by using certain claiming strategies (this actually affects my spouse and me, reducing the benefits we could have received before the change). Note however that this legislation has no impact on the Social Security benefit of each person based on their own earnings, so it would not affect the calculations we're doing here.

Now let's rerun the Quick Calculator assuming annual earnings of $100,000. We can do this quickly by clicking "See the earnings we used" on the SSA web page showing the estimated benefits we already generated, changing the 2016 earnings amount to $100,000, then clicking "Submit earnings information". This generates an estimated monthly retirement benefit of $2,273, which is an annual benefit of $27,276 (2,273 x 12). This is about 27% of our assumed $100,000 annual earnings (27,276 / 100,000).

Note that a much smaller percentage of earnings is covered at $100,000 (27%) than at $50,000 (38%) of annual earnings. This is due to the progressive nature of the Social Security retirement benefit, which is intended to provide a higher percentage of replacement income for people who have lower incomes. If we rerun the calculation assuming annual earnings of $25,000, the estimated monthly benefit is $1,007, which is $12,084 per year--an even higher replacement income of about 48% (12,084 / 25,000).

The implication is that people who make more money must save a higher percentage of their incomes to be able to maintain a comparable lifestyle in retirement, assuming that our other assumptions also are the same. Of course using the same assumptions for lower incomes and higher incomes may not be reasonable. For example, we saw in Part 2 that buying a home and paying off the mortgage before retirement can reduce the required retirement savings rate, and a higher income could make doing this more feasible.

With these caveats in mind, let's redo the calculations we did in Part 1 for annual incomes of $50,000 and $100,000, using the retirement benefit estimates generated by the Quick Calculator.

Plugging the estimated annual Social Security benefit of $19,020 for annual earnings of $50,000 into my spreadsheet, with a little trial and error I get a savings rate of about 13%. As expected, since we are assuming a higher Social Security retirement benefit, the calculated savings rate is slightly lower than the 14% we calculated in Part 1.

Plugging the estimated annual Social Security benefit of $27,276 for annual earnings of $100,000 into my spreadsheet, with a little trial and error I get a savings rate of about 15%. This is a slightly higher rate than the 14% we calculated in Part 1,  but in Part 1 we assumed that Social Security retirement benefit would cover 35% of our retirement living expenses regardless of income. By using the Quick Calculator, we've learned that our Social Security retirement benefit will be a smaller percentage of our annual earnings at higher incomes, and thus cover a smaller percentage of our retirement living expenses if we keep all other assumptions the same.

Of course there are many other variables you can play with when it comes to Social Security. You can begin collecting retirement benefits as early as age 62, but will receive more the longer you delay, until age 70 at which point your retirement benefit reaches it's maximum value. If you can afford to do it, it's probably a good idea to wait as long as possible to start collecting your Social Security retirement benefit, since this provides you with about the best inflation-adjusted longevity insurance you can get; i.e., if you live longer than predicted by the expected-lifetime tables used by the Social Security Administration, you will be very happy that you're collecting a much larger monthly retirement benefit that is guaranteed to keep pace with inflation.

In the next post in this series I'll discuss how to come up with a range of reasonable estimates for the real rate of return you can expect on your investments. The higher the rate of return, the lower the required savings rate, and vice versa.

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