Retirement's First Leg: Social Security

By Robert Brokamp
The Money Fool
July 1, 2004

Over the next century, which event do you think is more likely:

You will receive more from Social Security than you paid in.
Earth will be visited by extraterrestrials.
Dick Clark will age.
You may have heard of surveys using a version of this question (such as this one -- except for the Dick Clark part), and heard about the results: Many people believe more in aliens than they do in the long-term viability of Social Security. While that's kind of funny (in a sad sort of way), how much you'll actually receive for the tens of thousands you've contributed to Social Security's coffers is no laughing matter.

Since the launch of the Motley Fool Rule Your Retirement service, we've been helping subscribers evaluate their resources and make some projections. When it comes to retirement, those resources are usually in the form of the proverbial three-legged stool: Social Security, traditional pensions, and personal savings.

This is the first of a three-part series that will discuss the strength of each leg. Today, we'll start with the biggest item in the federal budget: Social Security. So sit back and get ready to face some reality -- and opportunity.

Social Security basics
Social Security and its younger cousin, Medicare, are funded through your Federal Insurance Contributions Act (FICA) taxes. You pay 6.2% of your salary (up to $87,900) for Social Security and 1.45% for Medicare (no salary limit). Your employer kicks in another 7.65%; if you're self-employed, you pay the entire 15.3%. Many people don't think too much about their FICA taxes, since they're taken out automatically by employers, and we don't have to file FICA tax returns every year. But the amount we pay is substantial. In fact, approximately 80% of American workers pay more in FICA taxes than they do in income taxes.

So what will you get for all that money? That's a good -- and hotly debated -- question.

Social Security is a pay-as-you-go system -- today's FICA taxes pay today's benefits. This worked fine when Social Security was created in 1935; there were 16 workers for every beneficiary. Plus, the average person didn't even live long enough to get too many Social Security checks. In 1940, life expectancies were just 61.4 years for males and 65.7 years for women.

Today, there are just 3.3 workers for every beneficiary. (I think all those 0.3 workers are customer service reps for the phone companies.) In 20 years, there will be just 2.3 workers per retiree. On top of that, retirees have the gall to live longer. Life expectancies have increased to 74.4 years for men and to 79.5 for women. In 2000, 12.4% of the population was older than 65, up from 5.4% in 1930. That percentage is projected to reach 20% by 2030.

Anticipating that there would be fewer workers to pay benefits, the 1983 National Commission of Social Security Reform -- formed by President Reagan and chaired by a then-private citizen named Alan Greenspan -- recommended (and Congress approved) an increase in payroll taxes so that more money would be collected than was needed to pay benefits. The excess collections were put in trust funds -- piggy banks Uncle Sam could break open when the baby boomers retire.

However, there's a whole debate about whether that money will really be available since the government actually borrows from these funds to pay current obligations. So instead of real money, these funds contain IOUs from the government in the form of special Treasury bonds. When it comes time to use that money, Uncle Sam will be holding out one hand while digging through his pockets for loose change with the other. It's sort of like borrowing from your 401(k) for years, and then expecting the money to be there when you retire.

Social Unsurety
So how does all this shake out when it comes to real numbers? Every year, the Trustees of the Social Security program -- folks such as Treasury Secretary John Snow, Health and Human Services Secretary Tommy Thompson, and an economist with the ironic last name of "Saving" -- release a report. According to the most recent version, retirement benefits to retirees will exceed taxes paid by workers in 2018, which is when the Social Security trust fund will need to be tapped. By 2042, the trust fund will be depleted.

As for Medicare, current expenses already outpace current taxes paid into the system, and the Medicare trust fund is projected to be depleted in 2019. This is due to the rapidly rising cost of health care and the prescription-drug benefit passed last year.

In the words of now-Federal Reserve Chairman Alan Greenspan:

The dimension of the challenge is enormous. The one certainty is that the resolution of this situation will require difficult choices and that the future performance of the economy will depend on those choices. No changes will be easy, as they all will involve lowering claims on resources or raising financial obligations. (Feb. 24, 2004)

In other words, get ready for higher taxes and/or lower benefits.

What this means to you
While all this sounds rather grim, the fact is that people who are in retirement and near retirement (i.e., in their mid-50s or so) shouldn't worry about their retirement benefits. As the Trustees estimate, there will be money until 2042. Plus, as recently as 1999, that depletion date was 2034, so you can't put too much stock in the specifics of such long-range estimates. (Imagine economists in the 1960s making projections about retirement in 2004, knowing nothing of IRAs, 401(k)s, the Internet, Viagra, and other inventions of the past few decades.)

Medicare is a far more pressing problem, since that program is already facing difficulties, and the coverage will change drastically over the next few years. Keeping up with these changes -- and knowing how to get the most benefits -- are topics we'll cover regularly in the Rule Your Retirement newsletter.

For those who are in their 40s and younger, it is estimated that you will receive approximately 70% of currently scheduled benefits. While that certainly doesn't qualify as good news, it is much preferable to receiving zilch, which is what some prognosticators might have you believe.

For financial-planning purposes, keep an eye out for your estimated benefits statement, which the Social Security Administration sends out three months before your birthday. Or visit the online Social Security benefits calculator. If you're in or close to retirement, you can plan on getting your benefit. If you're younger, use just 50% or less of your calculated benefit in your retirement planning, just to be safe.

Check back next week to find out how much you can expect from your pension.

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