I received a question from a reader that sort of dovetails with the post from last week about payback from Social Security, so I thought I’d run through the numbers on his question here. As you may have noticed, I never met a spreadsheet I didn’t like!
Here’s the question from the reader, verbatim:
started work at age 20 retire at age 70.
Over 50 years of work I average $50,000 a year.
If I put 10% of my income away every month from age 20 to age 70 how would I come out versus depending on the government social security checks I would receive after retirement.
My initial reaction to this question was that you’d be much better off with the savings option, since you’re saving at a much greater rate (10%) than the withholding, and for fifteen more years than the Social Security system takes into account. However, that’s not altogether correct, since the Social Security system includes both your withholding and your employer’s withholding, for a rate in 2010 of 12.4%. But this rate is much lower in the earlier years of the calculations. So let’s go ahead and run the numbers.
There are a few assumptions that we have to make in order to complete this problem:
- In order to come up with an average of $50,000 per year, I first looked at the maximum Social Security withholding. By calculating the average from 1961 to 2010, we come up with an average of $43,804. This is a little less than the average that the reader suggested, but it will work for our purposes and keep the calculations a bit simpler.
- Putting aside 10% each year requires that we come up with a rate of return for this investment account. I used a simple 5% return, which is reasonable over that period of time.
- I assumed that the side account is an IRA or a 401(k), so taxes have not been factored into the equations.
As we saw in the previous post, earning the Social Security maximum over the final 35 years of your working career will give you a monthly benefit of $3,204 in 2011.
Saving 10% of your earnings (using the maximum Social Security wage base) over 50 years at 5% will bring you to a total in your IRA or 401(k) of $443,969. Unfortunately, just running a few simple quotes from single premium annuity websites indicates that a joint and survivor annuity paying a $3,200 monthly payment will cost a total of $584,830 or $610,909 depending on the website you choose. And that’s a fixed payment, not a COLA-adjusted payment like your Social Security benefit is.
However, upon the death of both you and your spouse, there is nothing left over – so the question becomes one of longevity. If you both live long, full lives, the Social Security option works out much better. If you and your spouse die earlier, any time before about age 85, there will be something left over for your heirs in the savings option.
Of course, the Social Security benefit could be taxed, up to 85% depending upon your other income. Since the savings option is in a qualified account or an IRA, 100% of the disbursements will be taxed. If it was a non-qualified account, just a regular savings or investment account, the taxation would be considerably less.
In the end result, it seems that the Social Security benefit option is a pretty good deal, especially since we all hope to live a long, full life. The savings option works better if you die earlier than (roughly) age 85, providing a residual amount to your heirs. This is a little different from what I’d originally thought, but when you consider that the average life expectancy of a male age 70 is roughly 84 (86 for females), there’s a high probability that you won’t outlive your savings, although there’s a similarly high probability that you will outlive your savings.
And finally, since you don’t really have a choice in the matter, the entire question is really moot – but an interesting exercise, nonetheless.