It's no secret that the average American is ill prepared, financially speaking, for retirement.
On the one hand, that shouldn't be too surprising: the very idea of retirement is almost brand new to humans. On the other hand, it doesn't change the fact that as we're living longer lives, we'll need to provide for ourselves for decades after exiting the workforce.
While current retirees are well aware of how important Social Security is in their finances, many younger workers don't have a firm grasp on just how important the program is. They look at the average monthly benefit of about $1,350 and think, "That's a pittance."
When put in perspective of most Americans' retirement income, however, it is enormously important. And I've got the graph to prove it.
Some information about income in retirement
We'll get to that graph in a second, but first we need to calibrate expectations for retirement. One of the biggest misconceptions out there is that your spending will go up after you claim Social Security. While every household will have its own unique experience, on the whole, this simply isn't true.
For proof, let's look at the 2016 Consumer Expenditure Survey from the Bureau of Labor Statistics. Below, I've picked out the five largest categories in household spending and how they change in the 20 years leading to -- and including -- retirement.
|Category||45-54 Years Old||55-64 Years Old||65+ Years Old||Change Over Time|
|Total (5 categories)||$56,545||$49,042||$36,976||(35%)|
As you can see, while healthcare costs do, in fact, increase, those increases are dwarfed by falls in spending on all other major categories. Think about it for a minute and it all makes sense:
- Many have paid off their mortgage by the time they retire -- or downsize to a smaller house.
- Not having to drive to work anymore cuts down drastically on transportation costs.
- Retired couples often have fewer mouths to feed and have the time to cook at home.
- No longer is such a large cut of income being taken out to pay for Social Security and/or pensions.
Some might retort that these spending reductions are forced because of a lack of income and not the result of choice. Those people might be right. But my response would be simple: As long as basic needs are being met, who cares?
We know that hedonic adaptation works both ways -- meaning that as long as basic needs are met, we can adjust to fewer physical comforts in our life quickly. And study after study shows that levels of contentment spike -- and stay high -- once people enter retirement.
The main reason I highlight this is to put the amount that Social Security provides in perspective.
Using the 4% rule
In financial planning circles, there's an all-important tool called the 4% rule. In the most basic sense, it states that whatever your nest egg is, you can take out 4% of it in year one and take out the same amount every year thereafter -- adjusting for inflation -- without having to worry about running out of money.
According to TransAmerica, the median baby boomer has retirement assets -- including IRAs, 401(k)s, and the like -- of $164,000. Using the 4% rule, this means that the nest egg can be safely relied upon for $6,560 per year in retirement, or about $550 per month.
This rule will come in handy below when we examine the massive importance of Social Security.
The declining role of pensions
According to New Retirement's annual report, the typical pension can be worth as little as $9,262 for private employees and as much as $22,172 for retirees from the government. A January 2018 report from the Pension Rights Center estimates that 12.9% and 10.4% of all workers currently have privately funded or government pensions, respectively.
Obviously, if you are one of the few who gets this income, you can count yourself lucky. But if we look at the pension's effect on American retirement as a whole -- which factors in the reality that more than 75% of current workers will not receive pension income -- the average annual pension income comes out to just $3,500 per year.
Using the 4% rule, this is equivalent to a nest egg of about $87,500.
The vital graph to understand Social Security's importance
In June 2018 (the most recent month with data available), the typical retired worker received a monthly Social Security benefit of $1,413. The typical spousal benefit clocked in at $737 per month. When we do the math for the blend between retired worker (43 million recipients) and spousal (2.4 million recipients), the typical household of retirees gets monthly Social Security benefits of about $2,009.
Again, it's easy to look at that $2,000 and think, "That's really not much." But we need to remember what we've covered above: you won't need nearly as much in retirement, and -- if you're like the median American household -- you won't get more money from any other source.
To really drive the point home, let's consider that $2,009 per month rounds to $24,108 per year. That's almost two-thirds of what the average retired household spends in a year.
But here's the really important part -- if we viewed this benefit as if it were a nest egg, using the 4% rule, it would come out to almost $603,000.
Let's put that in perspective:
Perhaps, then, it's not surprising that two of every three retirees count of Social Security for most of their income. More to the point, the program provides over 90% of income for one of every three retirees. Social Security advocates also point out that if the program disappeared tomorrow, the poverty rate for this demographic would jump from 10% today to as high as 45%.
Keep in mind, there are definitely key pieces missing. Many retirees continue to do part-time work, and others can count on things like rental real estate for income. And, as I stated above, if you actually do get a pension, it has a much bigger effect.
But if we back up to look at the situation from a societal level, this chart proves something beyond a shadow of a doubt: Social Security is massively important, and while it may not be enough for many retirees to live on alone, most would be devastated if it disappeared overnight.
That's important for all of us to remember as changes are debated to make the program sustainable moving forward. Your future retirement will no doubt be affected.