While the vast majority of Americans will receive Social Security benefits at some point during retirement, relatively few understand the ins and outs of the system.
Do you qualify for benefits? If so, how big will your monthly check be? And finally, when should you elect to receive them? Let's address these three questions, arguably the most important when it comes to Social Security.
1. How do you qualify for Social Security benefits?
When the Social Security program was enacted in 1935, it provided benefits to a relatively small share of the American population. Generally speaking, only workers who earned wages in the private sector were eligible. But as time went on, it became more inclusive by adding farm, domestic, self-employed, and government workers to the pool of eligible beneficiaries. Today, an estimated 96% of American workers are covered by the system.
To determine whether you qualify for benefits, the Social Security Administration uses a system of credits, which, in turn, derive from your earnings and duration of employment. In 2014, workers receive one credit for every $1,200 of earnings, up to a maximum of four credits per year. Once workers accumulate 40 credits, they become eligible for Social Security retirement benefits. This typically follows approximately a decade of employment.
As may be obvious, most people earn more than 40 credits over their lifetime. For instance, let's say that you begin full-time work at age 22 and then retire at 62. In this case, you would have accumulated somewhere in the neighborhood of 160 credits, or four times the requisite amount. Unfortunately, the extra 120 credits have no bearing on the size of your monthly benefit. This is because the 40-credit requirement is nothing more than a binary threshold -- that is, you either satisfy it or you don't.
2. What determines the size of your Social Security benefits?
The size of your monthly Social Security check is principally a function of your primary insurance amount, which is the hypothetical amount one receives if applying for benefits at full retirement, which is currently 66 years of age.
To calculate your primary insurance amount, the Social Security Administration takes an inflation-adjusted average of your 35 highest earning years and then divides the number by 420 (the number of months in 35 years). It then applies a three-tiered framework. For the first $816 in average monthly earnings, you get credit for 90%. From $816 to $4,917, you get credit for 32%. And for any income above that, you get credit for 15%. Add these together and round down to the nearest dollar; that's your primary insurance amount.
It's probably obvious that calculating this figure is easier said than done. In the first case, few people have a complete record of their lifetime annual earnings. In the second case, figuring out how to index your past earnings for inflation can be a challenge to even the most financially astute retiree. The good news is that the Social Security Administration keeps a running tally of your estimated benefits. To access your own, simply go to www.ssa.gov, open an account, and access your estimated monthly benefit.
Beyond this calculation, it's also important to appreciate that the age at which you apply for benefits will affect their size. Under the original framework, only people who had reached age 65 were eligible. In the 1950s, however, the age threshold was lowered to 62. The catch was that the benefits were "actuarially adjusted" -- that is, the monthly benefit one received decreased the earlier it was applied for.
3. When should you claim Social Security benefits?
The question of when to claim Social Security benefits is one of the most contentious in retirement literature. The conventional wisdom is that you should wait as long as possible, and at least until reaching full retirement at age 66. But this flies in the face of reality, given that 62 remains the most prevalent age for Americans to take benefits.
The conventional wisdom is based on the fact that waiting longer will increase your chances of maximizing lifetime benefits -- i.e., the total amount paid to you over your lifetime. As I've already explained, the longer you wait to begin receiving benefits, the bigger the monthly payment will be. If you take them at 62, the monthly check will be 25% less than your primary insurance amount. If you take them at your full retirement age of 66, then it will be 100% of your primary insurance amount. And if you wait until turning 70, it'll be 32% larger.
From this perspective, the benefit from waiting is obvious. Let's say, for example, that your primary insurance amount is $1,000 (which is decidedly below average but simplifies the calculation) and that you live to age 84.3, which is the average life expectancy of an American male upon reaching 65. In this case, had you elected to receive Social Security at 62, your cumulative lifetime benefits would add up to $199,500. Had you waited until 66, they would be $218,000. And had you waited until turning 70, your benefits would be $224,400.
Even though this analysis is accurate, however, it makes a fundamental mistake. Namely, the conventional wisdom assumes that maximizing lifetime benefits is the primary objective of most retirees. But there are at least two other reasons that seem to factor into the equation before this strictly quantitative goal.
The first is that taking benefits before age 66 can facilitate an earlier retirement. You can deduce this from the fact that "[c]ompared to all other occupations, those who held a blue-collar job at age 60 through 62 were 55% more likely to claim early," according to a study by the Government Accountability Office. That's because "61% of those who held a blue-collar job at age 60 through 62 reported their job was physically demanding and/or involved heavy lifting most or all of the time compared to 25% of those in all other occupations."
The second reason is that many people in their 60s need the income to survive. According to the Social Security Administration, "51% of the workforce has no private pension coverage [and] 34% of the workforce has no savings set aside specifically for retirement." Or consider this: Among elderly Social Security beneficiaries in particular, almost a quarter of married couples and just under half of unmarried people rely on Social Security for 90% or more of their income.
It's worth pointing out, moreover, that the Social Security benefit formula is structured to yield the same in lifetime benefits to the typical retiree irrespective of when that person retires. As the same GAO report I cited explains, "The Social Security benefit formula adjusts monthly payments so that someone living to average life expectancy should receive about the same amount of benefits over their lifetime regardless of which age they claim."
The point is that the decision about when to take Social Security benefits is a highly personal one. If you have the luxury of waiting, then you should do so -- and particularly if you have a spouse who will be eligible for spousal or survivor's benefits. For people who don't have said luxury, however, then there's absolutely no reason to regret taking them early. They are, after all, your benefits to do with as you please.
The bottom line on Social Security benefits
No government program -- or private program, for that matter -- is perfect. And the Social Security system is no exception. It's nevertheless the backbone of America's retirement infrastructure and is bound to continue playing this role for decades to come.