Early Retirement improves the ROI of Social Security

[climber1]

I was curious about how an individual's Social Security benefit was calculated so I did some Googling. I think the results are quite interesting so I thought I would share my conclusions.

For a full rundown of how the benefits are calculated, you should check out http://www.ssa.gov/oact/COLA/Benefits.html. This is Social Security Office of the Chief Actuary's website which is fantastic, just straight numbers and facts. However, I will give a summary.

1. First, you calculate the average indexed monthly earnings (AIME). This is calculated by first taking all of your previous years of income (subject to an per year income cap that changes yearly), adjusting them to the present day for inflation via a specified index. You then add the highest 35 years of this inflation adjusted income and divide by 420 (=35*12) to get your AIME.

2. Your monthly Social Security payment is you retire at full retirement age, called the Primary Insurance Amount (PIA), is calculated by a piecewise linear function of your AIME. For 2014, the PIA is the sum of

• 90% of the first $816 of your AIME
• 32% of the portion of AIME between $816 and $4917
• 15% of the portion of AIME above $4917

The values $816 and $4917 change annually for inflation, but the 90%, 32%, and 15% figures are set by statute.

The first thing to realize is that the Social Security tax paid on the 36th highest year of income and below don't increase your payment at all. Definitely a bad ROI there.

However, what is more interesting is what happens when you retire early. Say you have a 20 year career. Then, when they calculate the AIME they are averaging in 15 $0s. This obviously brings the AIME down. However, since the AIME is proportional to the amount you have paid into Social Security this isn't necessarily a bad thing. What is important is that the ratio of PIA to AIME goes up! The ratio of PAI to AIME is 0.9 for low AIME and decreases all the way to 0.3 for someone who had an income of at least the income cap in all 35 years.

The return that an individual gets from Social Security is based on 2 things, the ratio of PIA/AIME and lifespan. Given that lifespan isn't something we have much control over, it is clear that an individual with a higher PIA/AIME has a higher ROI. Thus, individual who retire early have a higher ROI from Social Security.

[mxt0133]

That is some great research!  It is definitely food for thought along the lines of why it can be more efficient to lower expenses than to increase income at a certain point.  All the benefits of that extra income is marginal because of tax rates, time constraints, and now social security benefits.

[UnleashHell]

I have no idea what my figure will end up looking like. I worked in the Uk for the first part of my working life - if I get out of the rat race by the time I'm 50 then i'll only have 18 years in the system here. I thought I needed 20 as a minimum..

[climber1]

I have no idea what my figure will end up looking like. I worked in the Uk for the first part of my working life - if I get out of the rat race by the time I'm 50 then i'll only have 18 years in the system here. I thought I needed 20 as a minimum..

In order to be eligible for Social Security, you need to have earned 40 social security credits. You can earn up to 4 credits per year and assuming you don't make an absolute pittance, you will earn all 4 credits (in 2014, you only need wages of $4,800 to get all 4). So you only need 10 years.

[UnleashHell]

I have no idea what my figure will end up looking like. I worked in the Uk for the first part of my working life - if I get out of the rat race by the time I'm 50 then i'll only have 18 years in the system here. I thought I needed 20 as a minimum..

In order to be eligible for Social Security, you need to have earned 40 social security credits. You can earn up to 4 credits per year and assuming you don't make an absolute pittance, you will earn all 4 credits (in 2014, you only need wages of $4,800 to get all 4). So you only need 10 years.

Nice...
naturally i'll check before I FIRE. Or not - and if it doesn't work out I can sue you for giving me improper advice :D


Or I could just accept that by then anything I get is a bonus..

I'm also due a pension from the uk... which , due to tax treaties, the USA will offset against the amount they pay me.. that's a real incentive to collect that one!!

[ender]

This is good to know!

You can get the number of credits you have from the Social Security Administration estimator site, too.

[Another Reader]

The important difference between Social Security and many defined benefit pension plans is that your PIA continues to rise from the time you leave work until two years before the year in which you turn 62.  If you turn 62 in 2014, the PIA is indexed through 2012.  The National Average Wage Index ratio for each year is applied to those 35 highest years to get an indexed wage on which your PIA is based. 

Many government defined benefit plans base the annuity on an average of two or three highest years, with no indexing for wage inflation.  You may receive COLAs after you start the annuity, but the base amount of the annuity is set, even if you left the employer decades before.  If you retire later, you may get a higher benefit, but it's based on age.

For those of you that are confused by the claims of 8 percent increase in the benefit for every year you delay, it is helpful to look at this chart.

http://www.ssa.gov/oact/ProgData/ar_drc.html

The percentage increases after FRA are not compounded.  Each year gets you another 8 percent of your original PIA.  Most of the folks here are younger and the last line of the table applies to them.

[TreeTired]

I am not sure what you think you have discovered.   When you say "early retirement" are you talking about the often debated starting benefits at 62  vs 66 vs 70?   where 62 would be early,   or have you discovered the feature of the Social Security program that was designed in to the program to give people disproportionately large benefits to those who barely qualify.  People who only have 40 quarters (the minimum) of qualifying earnings stand to receive benefits far in excess of what they paid in.   This is a well known and intentional design of the Social Security system, and yes those folks will have a higher ROI than someone who earns the maximum amount and works for 30 or 40 years.   The idea is to supplement the lowest wage earners, not to encourage people to work for 10 years and retire.

[climber1]

I am not sure what you think you have discovered.   When you say "early retirement" are you talking about the often debated starting benefits at 62  vs 66 vs 70?   where 62 would be early,   or have you discovered the feature of the Social Security program that was designed in to the program to give people disproportionately large benefits to those who barely qualify.  People who only have 40 quarters (the minimum) of qualifying earnings stand to receive benefits far in excess of what they paid in.   This is a well known and intentional design of the Social Security system, and yes those folks will have a higher ROI than someone who earns the maximum amount and works for 30 or 40 years.

I am not addressing the first point of what age to take Social Security. From the financial perspective of maximizing benefit, this is solely a question of lifespan.

What I am discussing is closely related to your point that those who barely qualify have the highest ROI. Many of the people on this forum expect to have shorting working careers than the average. While many of them are very well compensated during that period (coming close to it or exceeding it), averaging in the $0s from the years they weren't working makes it look like they were far lower on the income scale and so as designed, Social Security gives these individuals a higher ROI.

The idea is to supplement the lowest wage earners, not to encourage people to work for 10 years and retire.

I understand why the US government created Social Security and what its goals for the program are. However, my analysis asks what is the actual impact of those laws. During the beginning of a high compensated individual's career, the ROI of their Social Security taxes is quite high. However, it drops once their AIME reaches a certain level. Thus, Social Security can actually be viewed as a negative tax for the first few years (you pay some now, but get a lot back in the future) and then a positive tax once your AIME gets higher.

Social Security may not be intended to encourage people to work for 10 years and retire, but it does increase the marginal tax rate after a certain point which in practice does give an incentive to retire early.

[Emilyngh]

I am not sure what you think you have discovered.   When you say "early retirement" are you talking about the often debated starting benefits at 62  vs 66 vs 70?   where 62 would be early,   or have you discovered the feature of the Social Security program that was designed in to the program to give people disproportionately large benefits to those who barely qualify.  People who only have 40 quarters (the minimum) of qualifying earnings stand to receive benefits far in excess of what they paid in.   This is a well known and intentional design of the Social Security system, and yes those folks will have a higher ROI than someone who earns the maximum amount and works for 30 or 40 years.   The idea is to supplement the lowest wage earners, not to encourage people to work for 10 years and retire.

Ummm are you aware of what of what forum you're on?   Early retirement here is usually defined as retiring at much younger than 62, and regardless of what you interpret the "idea" of SS to be, the facts remain as the OP stated, one gets a much larger ROI retiring early (eg., only working for 10 years-which is the premise behind much of what's on this forum).

[flashpacker]

I've been thinking about this too, as I'm new perm resident in the US and I'm planning on making sure I pay into SS for the 40 quarters so those payments aren't completely lost. Since I'm self-employed it would be a massive amount of tax to pay if I was short of the 40 quarters and got nothing.

I have also looked up the New Zealand pension rules since that's my home country and those require living in NZ for 10 years with 5 of those years being when you're aged over 50. Therefore, even if some had paid in for 35 years between 19 and 54 but wasn't living in NZ for 5 years after 50, they'd get nothing. It definitely pays to check the rules of this stuff.

[Beric01]

My problem is that MOST of my years will be big fat zeros! (I plan to retire very early 30's).

But I expect Social Security to be bankrupt by the time I'm eligible to collect it (probably at least 50 years from now, as there is no way the qualifying age isn't getting pushed out). I expect to pay a ton of Social Security taxes I'll never see back, so I'm just viewing my payments as straight taxes. That's why my investment planning is not counting on ANY SS.

I wish we could invest our money as we willed. But since most Americans are too irresponsible to save money for retirement themselves, the government had to force them to do so while putting the money in a poorly-performing investment... but I digress.

[Exflyboy]

I have no idea what my figure will end up looking like. I worked in the Uk for the first part of my working life - if I get out of the rat race by the time I'm 50 then i'll only have 18 years in the system here. I thought I needed 20 as a minimum..

In order to be eligible for Social Security, you need to have earned 40 social security credits. You can earn up to 4 credits per year and assuming you don't make an absolute pittance, you will earn all 4 credits (in 2014, you only need wages of $4,800 to get all 4). So you only need 10 years.

And you'll get a pension from the UK if you have 10 or more working years there too..:)

Frank

[climber1]

My problem is that MOST of my years will be big fat zeros! (I plan to retire very early 30's).

But I expect Social Security to be bankrupt by the time I'm eligible to collect it (probably at least 50 years from now, as there is no way the qualifying age isn't getting pushed out). I expect to pay a ton of Social Security taxes I'll never see back, so I'm just viewing my payments as straight taxes. That's why my investment planning is not counting on ANY SS.

I wish we could invest our money as we willed. But since most Americans are too irresponsible to save money for retirement themselves, the government had to force them to do so while putting the money in a poorly-performing investment... but I digress.

I can understand taking a conservative approach to Social Security in your planning for early retirement, but I think entirely discounting it is unrealisitic. Let me walk through the financials of Social Security to explain why.

Fundamentally, Social Security isn't an investment, but rather a transfer program. It transfers income from the currently working population to the elderly. If the US population and age distribution were is steady state, every month the US government would collect a certain amount of money and pay out the same.

However, this assumption does not hold. Due to the baby boom, the ratio of workers to retirees will change over time. In order to keep the Social Security tax rate and payment per retiree constant over time (for intergenerational fairness), the Social Security program has built up a large buffer while the worker/retireee rate was high, that will now decrease as that ratio decreases. At present, Social Security has reserves of $2.764 trillion.

Now, this would work fine if the baby boom was a one time event changing the worker/retiree ratio temporarily. The Social Security fund would get drawn down and then it could continue at parity with monthly receipts and payments equal. However, the continuing increase in life expectancy, changes this ratio permanently. Under this circumstance, the Social Security fund still has revenue from the working population, but that works out to less per retiree than currently promised. Even if there is no change in Social Security taxes or the qualifying age, at the time of reserve depletion, Social Security could still pay out 77% of the expected amount from current receipts. This discrepancy can be resolved by a slight increase in the Social Security tax rate, a slight increase in qualifying age, and/or a slight decrease in payments.

In any case, by being a very early retiree, you will do better than most under the current model (I am also planning on retiring around age 30) and shouldn't worry too much about proposals to increase tax rates or the qualifying age. What you should be more concerned about is a complete overhaul in how the payments are determined. For instance, replacing the average of top 35 years with average of top 10 years would hurt us severly. Similarly, any consideration of net worth in determining the amount received would have a very negative effect.

[MooseOutFront]

My problem is that MOST of my years will be big fat zeros! (I plan to retire very early 30's).

But I expect Social Security to be bankrupt by the time I'm eligible to collect it (probably at least 50 years from now, as there is no way the qualifying age isn't getting pushed out). I expect to pay a ton of Social Security taxes I'll never see back, so I'm just viewing my payments as straight taxes. That's why my investment planning is not counting on ANY SS.

this is a naive view of our nation's #1 security blanket. Sure there will be changes, but it's not going anywhere.