Despite its nearly 80-year history, and its status as one of the two largest government programs in the world (the other is Medicare), Social Security remains an enigma to many of us. Some say it’s going bankrupt and you shouldn’t count on receiving anything. Others believe they can count on Social Security and other government programs alone to care for them in retirement, so they don’t bother, or aren’t able, to build their own savings.
The once-conventional advice that Social Security is one leg of the 3-legged retirement stool (the other legs being private pensions and personal savings) can also be misleading. Fact is, private pensions are going away, personal savings are minimal on average, and Social Security can easily be most of the stool, depending on the retiree.
In the end, it is hard to know what Social Security means to you, until you know what it’s worth to you. So let’s explore the actual dollar value behind your Social Security benefits. How much are you due in the future? What does that equate to in the present? What does that value mean to you? How certain can you be of it all?
Once you know how much your Social Security is really worth, you can begin to assess how it will contribute to your retired lifestyle, and what other steps you’ll need to take to ensure freedom and comfort in your later years….
Doing It Yourself
Make no mistake: assessing your Social Security benefit is primarily up to you. Don’t expect the average financial advisor to get very interested in this issue. He or she may even recommend that you "ignore" Social Security. (Mine once did.)
Why aren’t some advisors interested in helping you understand Social Security? Because, it’s not in their interest.
First of all, Social Security is an extremely complex program, one subject to political and economic winds. In other words, anything that can be said or computed about Social Security today is subject to change and dispute tomorrow.
Second, Social Security represents a pool of assets that is purposefully shielded from the financial services industry, which can’t draw management fees or commissions based on what you do with your benefits.
Third, to the extent you receive those benefits (and I believe the majority of us will receive most of ours), they offset other potential investment assets. So relying on Social Security, to some extent, is a disincentive to your slaving and saving madly into the coffers of the financial services industry….
Estimating Your Monthly Benefit
So let’s get started assessing your Social Security by finding your future monthly benefit. Valuing Social Security is easy to start: just go to the Social Security Administration’s retirement estimator. There you will enter some identifying data, and receive an estimate of your monthly benefit at various retirement ages: 62, full retirement age (67 for me), and 70. That estimate will be based on your earnings during the 35 years when you earned the most.
The calculator assumes that you continue to work until retirement, making about the same amount as you do now. If you know that won’t be the case, you can add different retirement scenarios to be calculated.
The essential tradeoff in claiming your Social Security benefit is that you can get lower benefits starting sooner, or higher benefits starting later — in both cases lasting until the end of your life. There is a crossover age, often around 80, when it will have made more sense to delay taking benefits, because you’ll end up getting more over your lifetime. (That’s predicated on your having enough other assets to live on, that you can delay your Social Security benefit in the first place.)
That’s as far as I’m going to go here in discussing the claiming decision, which can be frightfully complex. For much more, including handy rules of thumb, see Mike Piper’s excellent new book Social Security Made Simple.
Will You Get It All? Gauging The Odds…
Death and taxes may be certainties, but, as reliable as it’s been historically, Social Security is regrettably not. Prominently displayed throughout the Social Security Administration’s publications is the fact that "by 2033, the payroll taxes collected will be enough to pay only about 75 cents for each dollar of scheduled benefits." Changes must be made.
The reality is that either taxes will go up, or benefits will be reduced or delayed — and it would be wise to plan on some of both. On the benefit side of the equation, reductions could made directly, or as a function of income. Or, very likely in my opinion — because baby boomers will have substantial political clout and it will be less politically painful – reductions will be embedded in your benefit’s inflation adjustment. That could happen directly, by a reduction in the adjustment itself, or indirectly via real inflation outpacing the government’s official inflation indexes.
So, the big question will be, even though Social Security is "inflation adjusted," just how much will those future dollars buy? Nobody can answer this, though it is another reason not to count on receiving your entire Social Security benefit. Still, don’t despair. Realize you have substantial ability to manage your personal inflation rate.
Whatever happens, you must assess the impact of future economic cycles and future political processes on your Social Security benefits. Not an easy call! My own, conservative, personal rule of thumb has been to assume I’ll receive only 50% of my projected benefits. But for somebody nearing retirement now, I don’t think it would be unreasonable to assume a portion as high as 75%. After all, that much is projected to be available even if the government takes no action.
Calculating the Present Value of that Benefit as a Lump Sum
Knowing your monthly Social Security benefits at some point off in the future is one thing. Knowing how much money that could represent to you today is quite another, potentially useful value. For instance, it can help you estimate the impact of your current savings and fine-tune your investment asset allocation.
So how much is your expected lifetime Social Security benefit stream really worth to you, as a lump sum, in today’s dollars? Turns out this isn’t a simple or precise calculation. It requires some guesses about the future, and must be performed in stages. However, without too much work, you can generate a number that will give you a rough feel for the role Social Security plays in your retirement. Just keep in mind that any figures based on speculation about the future are suspect, and these are no exception.
I’ve used two different formulas to assess the value of Social Security. Neither is right or wrong. There is slightly different input data, results, strengths, and weaknesses. Neither formula can be called "precise." Both are imperfect models of an uncertain, distant future.
The first formula I’ve used, copied directly from my Excel spreadsheet, looks like this:
=PV(rateOfReturn, yearsUntilRetirement, 0, -(12*benefit)/swr)
And here’s what that formula does in words: it first multiplies the expected Social Security benefit by 12 to get the annual amount. Then it divides that amount by the Safe Withdrawal Rate — which I set as the traditional figure of 4%. That produces the lump sum of money we’d need at retirement to generate the expected benefit for approximately 30 years. Then the spreadsheet formula "discounts" that value into the present, given the number of years until retirement, and some conservative investment rate of return. Note that latter rate probably should be a real rate of return — meaning how much you expect to earn on your investments after inflation.
The end result is the sum of money you would need now, to duplicate your Social Security benefit in the future.
The second formula I’ve used, again copied directly from my Excel spreadsheet, looks like this:
=PV(tipsRate, yearsUntilRetirement, 0, -PV(tipsRate, yearsInRetirement, -(12*benefit)))
And here’s what that formula does in words: it again multiples the expected Social Security benefit by 12 to get the annual amount. It then computes the lump sum at retirement that would produce that annual benefit, for a given life expectancy (which I guessed based on family history and IRS Publication 939). Then, similar to the first equation, it discounts the future lump sum into the present, given the number of years until retirement.
Importantly, for the discount rates, this formula uses the yield for Treasury Inflation Protection Securities (TIPS) with maturities closest to your retirement date, and to your life expectancy. This is an important point: you’re basically leveraging the TIPS market to predict a conservative real (inflation-adjusted) investment return for your lifetime. Is that certain? No way. It’s still a long time into the future. But it’s a defensible number.
Given the input parameters for our own early retirement scenario, both equations yielded present values in the low to mid six digits, with the second equation producing a value about 30% larger than the first. That was close enough for my purposes.
Which formula should you use? Try both, or a hybrid. Just remember that the first formula is based on the validity of Safe Withdrawal Rate research, and your ability to guess at a real investment rate of return. The second formula assumes the market is guessing properly at that rate of return — via the rate on long-term TIPS.
That second formula also requires you to pick a life expectancy. That’s the kind of minor detail that many retirement calculators are comfortable passing over, but that I consider a serious limitation for any critical retirement decisions. Any retirement planning that requires you to know the exact time of your death is, by definition, an abstract, academic exercise — fine for insurance companies, which can rely on the laws of statistics governing large groups of people, but potentially dangerous for an individual.
Why the Present Value Matters, or Not: Your Asset Allocation
Once you have that present value, a single number representing your Social Security benefits in the future, what should you do with it?
For starters, ask whether that value represents an actual vested amount that belongs to you and will pass to your heirs after your death. Social Security and most pensions do not fall into that category. Since this value won’t survive you, don’t think of it as an addition to your net worth.
But, since that present value represents income that you can rely on for retirement living expenses, you should definitely consider it part of your income-producing assets. It would be foolish to ignore the positive impact on your lifestyle from the extra income. But how should that affect your investing strategy or asset allocation?
Various investing and retirement luminaries argue that Social Security or a pension is like a bond issued by the government or your former employer, because it pays a very safe and predictable stream of income for a long period of time. Thus, they argue, you can safely increase your allocation to stocks, to compensate for this large bond that you already effectively own. In other words, you can choose to make a given asset allocation more aggressive, if you consider Social Security and pensions to be fixed income, like a bond.
Should you do that?
Here is my experience: I think it’s helpful to understand this principle, take it into consideration, and nurse whatever peace of mind it offers in offsetting your riskier assets. But, having experimented with the idea myself for a few years, I’m against adjusting your asset allocation based on a typical Social Security or pension benefit.
First, as mentioned, this will contribute to a more aggressive portfolio. And, especially in your later years, and during these trying economic times, seeking out rationales for a more aggressive portfolio is not advisable for most people. Just remember that your Social Security’s value is not going to be shown on your brokerage statements to dampen the swings in your investments!
Secondly, it is unconventional to adjust your asset allocation based on typical Social Security benefits. Though it’s theoretically a "good" idea, few people actually do it, to my knowledge. Thus if you choose that route, then any time you read about or analyze investment portfolios, you will be comparing apples to oranges. The recommendations and statistics for asset allocations won’t apply to you, because you will be making different assumptions from the rest of the world. And it may be hard to normalize published data against your own portfolio.
So my advice is to monitor the present value of your Social Security and pensions, and take the income into account for your budgeting, but, in general, don’t let it affect your asset allocation. The one exception might be if you fall into that ever-diminishing group whose entire retirement expenses are covered by a private pension plan. In that case, you might be justified in a more aggressive stock allocation, since your living expenses are fully insulated from the market.
Social Security Does Matter…
So I’ve laid out some answers to the question of how much your Social Security is worth. I’ve discussed how to find your future monthly benefit, and presented some formulas for determining its present value. I’ve also discussed a few of the many issues with these, or any, calculations that attempt to model the future. And I’ve explored one of the main reasons to be interested in the results anyway — your asset allocation.
Computing the present value of your Social Security benefit will pay you one large dividend: it will force you to be realistic about the size of Social Security relative to your other retirement income. For example, if your retirement plan account balance is well below $100K, like the average, and you compute that your Social Security is worth $200K or more, it will be readily apparent just how critical that benefit is to your retirement.
Regardless, I hope you’ll take away one point. Social Security matters. It will likely represent a non-trivial portion of the retirement income stream for most of us. Only multi-millionaires can afford to ignore it, and even they might appreciate seeing that government check every month. That’s especially true now, with historically low interest rates and dividend yields making predictable, inflation-adjusted Social Security benefits significantly more valuable. That’s the only such income stream most of us will ever enjoy….