Social Security is political dynamite. Since people between the ages of 55 and 74 have the highest levels of voter turnout, many politicians are scared to death of doing anything to alienate them by suggesting changes to a program from which they either currently receive benefits or anticipate receiving benefits in the near future.
Meanwhile, the demographic shift represented by the aging baby boom generation has led to strong debate about the financial problems facing the program and what actions people and government should take to resolve them.
Given this, some commentators -- including the Fool's own Rule Your Retirement newsletter editor, Robert Brokamp -- have questioned whether we really need Social Security at all. After all, it's expensive, since employees have more than 6% of their paychecks taken away from them, and self-employed individuals pay nearly 12.5% in taxes. In exchange for these contributions, the relatively modest benefits appear to many to be meager and disproportionately small. Advocates of personal retirement savings accounts argue that many people would be far better off if they could choose blue-chip stocks like Johnson & Johnson (NYSE:JNJ) and 3M (NYSE:MMM) for their own accounts.
It's too easy to get lost in all the propaganda and emotion surrounding the Social Security debate. When discussions become heated, it's time for rational Fools to get out their calculators and do the math to find real answers. Luckily, the Social Security Administration makes it fairly easy to estimate what your retirement benefits will eventually be. Every year, the SSA sends you a statement containing a history of your earnings for every year you earned income. The statement then analyzes your earnings data and tells you the amount you would receive under various provisions of Social Security, including retirement benefits for you and your spouse, survivor benefits for your spouse and children, and disability payments if you were unable to work.
If you don't want to wait for your annual statement, you can go to the SSA website and use one of a number of online calculators to estimate your benefits. A very basic calculator asks you just a few simple questions and responds by giving you a general ballpark estimate of what your benefits will be. Another, more sophisticated calculator, on the other hand, requires a great deal more input from your earnings history, but the answers the calculator comes up with are much more precise and rely on fewer assumptions.
Because the future of Social Security is shrouded in uncertainty, it makes sense to analyze Social Security returns in light of the decisions that currently retiring workers must make. The SSA provides a fairly simple worksheet specifically for 62-year-old retirees to use to help them decide whether to take benefits immediately or wait until full retirement age to receive a larger monthly payment.
Running the numbers
Anyone who has ever filled out their own income tax returns knows how complicated government explanations involving mathematical calculations can be. Some calculations take a page of line-by-line figuring before the form finally spits out the final answer. Although you might fairly conclude from such a lengthy process that the calculation is complicated, the contrary is often true: The logic behind the calculation is often quite simple.
The process of determining Social Security benefits provides a good example of this phenomenon. Although the worksheet for 62-year-olds involves a full page, a 55-line table, and seven multi-part calculation steps, the logic behind calculating your benefits is fairly straightforward. First, you enter in the amount of wages you earned each year throughout your career. After you make an adjustment to each year's wages to take wage inflation into account, you take the 35 years in which you were paid the most and add up those wages. For many people who work 35 years or less during their lifetimes, this gives you an estimate of your total career earnings as valued by present-day dollars. For instance, if you earned $5,000 in 1972, that's roughly equivalent to earning $25,000 today.
Because Social Security benefits are based on average monthly earnings, you then take your total earnings during your 35 highest-paid years and divide that figure by the number of months in 35 years, which is 420. This figure is an inflation-adjusted average of what you earned each month during your career.
Using your average monthly earnings, you can then calculate the amount of your monthly benefit. The benefit calculation has three parts that are roughly analogous to the way different tax brackets apply to various taxpayers. For average monthly earnings up to $656, you receive $0.90 in benefits for every dollar of average earnings. From $656 to $3,955, you receive $0.32 for every dollar. Above $3,955, you receive $0.15 for every additional dollar. Add up these three amounts, and you have the base amount for your total monthly benefit.
Once you have your monthly benefit, you have a decision to make. If you want to start taking payments immediately at age 62, you can, but you only receive 75% of the base benefit. To get the full base amount, you have to wait until your full retirement age, which for 62-year-olds this year is age 66.
By looking at various examples of earnings and benefits, you can determine the implicit rate of return retirees get from their "investment" in Social Security. The second part of this article presents a number of examples and draws conclusions about how well Social Security treats its recipients.
Related articles:
- Is Social Security a Rip-Off?: Part 2
- Dueling Fools: Social Security
- Demystifying the Social Security "Crisis"
- What to Expect From Social Security
Need some help evaluating Social Security and other retirement issues? Take a closer look at Robert Brokamp's Rule Your Retirement newsletter, which you can try for free. There you'll find lots of helpful advice to prepare to live your golden years in style.
3M is a Motley Fool Inside Value pick, while Johnson & Johnson is a Motley Fool Income Investor selection.
Every dollar Fool contributor Dan Caplinger eventually gets from Social Security is an unexpected gift in his eyes. He doesn't own any shares of companies mentioned in this article. The Fool's disclosure policy is one of your basic entitlements.
