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Social Security — Try to Calculate Your Benefits! June 27, 2007

Posted by federalist in Economic Policy, Government, Retirement, Taxation.
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I would invite anyone who believes in Social Security to try to calculate their expected benefits based on what they have paid in.  This is actually an amusing exercise which I recently undertook to answer the following question: If you haven’t paid any social security taxes in your life, what is the least you can pay in to get the maximal return from the Social Security system?

First, we must remember that there are two components to the social security system: welfare and pensions.  Anyone is eligible for the former based on circumstances like disability.  In order to earn the pension benefit — what retirees typically think of as “social security” — you must earn eleven “Years of Coverage,” which are defined as calendar years in which you paid social security taxes on at least a magic number of earnings.  What is that magic number?  It’s the middle column on this page, and it’s indexed to inflation.  The magic number for earnings this year to qualify as a YoC is $10890.

So in today’s dollars you need to pay FICA taxes of 15.3% on 11 years of $10890 per year, which means a total of $18328 in taxes paid into the system.  (You can’t pay just the social-security portion of FICA.)

But how can you maximize your payout from the system?  Social security is very regressive, which means that as you pay more money in you get less in return.  The payout function is piecewise linear, with the maximum payout available only on the first $680 of Average Indexed Monthly Earnings (AIME).  AIME is a very complicated calculation.  In principle it considers your 35 highest-earning-years (based on wages on which you paid FICA taxes), adjusts each for inflation, and then takes the average.  If my calculations are correct then paying FICA taxes on $300k (present dollars) would lead to an AIME of roughly $700 in today’s dollars, which is about the optimal AIME.  Doing this over 11 years will result in $45900 in taxes.  Assuming you’re paying the taxes in equal amounts over 11 years with a 5% discount rate you will actually lose $62234 in taxes.

Having accumulated an AIME of $700, the monthly benefit you will receive at “Normal Retirement Age” (say, 67 years old) is 90% of AIME, or $612 in today’s dollars.  How good is that?  Well a 67-year-old can buy an immediate annuity that pays out that monthly benefit for $98k.  Getting that annuity through social security cost $62k in taxes.  So in the best case social security will give you a modest pension at a 36% discount over what you could get privately.

However, if you pay taxes any more slowly, or accumulate a higher AIME, your payout will be much worse.  Since the next AIME payout rate is just 32% (instead of 90%), and since earnings are compounded by the rate of inflation instead of the risk-free rate of return — which is almost always higher — these figures go downhill quickly, making the private annuity a lot more attractive.

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