Many workers aren't factoring Social Security into their retirement plans, fearing a massive cut to benefits, but how likely is such an event, and what would it mean for retirees?
Christine Benz: Hi, I’m Christine Benz for Morningstar.com. Social Security plays a significant role in many retirees' plans, but younger investors may wrestle with how much to factor it into their own retirement planning. Joining me to discuss that topic is Mark Miller, he is a Morningstar contributor. Mark thank you so much for being here.
Mark Miller: Hi, Christine.
Benz: This is a hot topic Mark, very much in the news today. People are talking about the future of Social Security, whether there will be changes to the plan. Let's start with the current crop of retirees, people who are already retired or maybe getting close to retirement. How should they think about Social Security in relation to their retirement planning?
Miller: Most people who are in retirement or let's say within the 10-year window of filing for Social Security shouldn't expect to see any big changes in their benefits, with one exception. There is the possibility of a change in the annual cost-of-living adjustment, or COLA as people refer to it. People have probably heard in the news this debate about, so called "chained" CPI, which is a technical-sounding description of a change in the way that that automatic cost-of-living adjustment is calculated. The net effect of it would be a reduction in the inflation formula of roughly 3/10 of 1% per year at the beginning, but then that compounds over time. So, if it were put in place today, some projections say that, for example, somebody who retired at 65, by the time they're 80 could be looking at a cumulative loss of about $8,000 in benefits, likewise $19,000 at age 90. So, it's a significant cut, and that's the only thing that's being discussed that could impact people who are close to or on the Social Security program now. And it's something that keeps getting batted around in Washington as something that could happen as part of some grand bargain on deficit reduction.
Benz: So that possible change in the inflation calculation is the big thing to watch if you're someone who is retired currently or getting close to retirement.
Let's discuss the younger set. I've talked to a lot of people, maybe of my age band who are saying, "You know what, I don't factor Social Security into my retirement planning at all." Let's talk about that group, and specifically how they should think about their benefits. Should they factor in the program?
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Miller: And likewise I often hear financial planners say, "Well people should be discounting whatever their projected benefit is by some amount."
Benz: Because there will be cutbacks.
Miller: Exactly. So, from a fact standpoint here is what we do know. Social Security is basically set up as a pay-as-you-go program. It generally is structured to pay out benefits based on what it's collecting in current payroll taxes. But right now we're in kind of a historically unusual period where we've been building up an enormous trust fund reserve, and that's been happening since the early 1980s as a result of some reforms that were put in place basically to anticipate the boomer age wave that everybody knew was coming. So, we have this enormous trust fund. It's about $2.7 trillion, and we're starting to draw that down now as more boomers retire.
Here is the issue: That trust fund is on schedule to be exhausted around 2033. We'll get a new projection on that shortly from the Social Security trustees, but as of right now what we know is it will be gone in 2033. When that happens, if nothing else changes between now and 2033, Social Security benefits will be cut about 25% because we'd only be able to pay out the money that's coming in at that time for payroll taxes, so that's the projection. So, the number-one thing to say to this question of--"Well I don't expect Social Security to be there for me at all"--I would say the worst-case scenario is that your benefits could get cut 25% at that point.
I actually think that's highly unlikely to occur for a couple of reasons. One is, there is such strong political support for Social Security in the country that to me a far more likely outcome is, at some point, between now and then Congress gets its act together and enacts a reform package to keep benefits whole going forward.
An interesting side note on this is that the Congressional Budget Office actually assumes that even in the event that the fund was exhausted in 2033, their long-term budget assumption is that Congress would opt to continue to pay benefits and just borrow money to pay benefits. So, what I am saying is nobody seems to really think that [the worst-case scenario is] going to occur. How do we get to the point where that fix occurs? We don't know for sure.
Benz: So, let's say it is a worst-case scenario though and you're doing some planning, maybe you are 20, 25 years from your retirement. Let's talk about the implications, say, in a worst-case scenario and we were to get that 25% cutback in benefits. There has been some recent data that show some of the knock-on effects if benefits were to get cut back to that extent. Let's talk about what that might mean for retirees?
Miller: I was interested in this question, so I actually worked with a financial planner for a recent column that I wrote looking at what would happen to people who born in the 1960s and '70s if down the road that 25% cut occurred. And we looked at what I'll call sort of mass affluent and more affluent households since that's the crowd that planners tend to work with. The surprising result was that we know Social Security is terribly important for people in lower-income brackets. For many people it's everything in retirement.
Benz: It's all they have.
Miller: It's all they have. But for more affluent households who do have savings and portfolios, the surprising finding of this, we ran some hypothetical couples [when we ran] through some of the typical planning software. We found that under that scenario, people would exhaust their portfolios anywhere from three to five years earlier than they would have because the benefit cut on Social Security comes in and you start drawing down more quickly from the portfolio. Then you get to a point where you've exhausted your savings, and generally this is occurring for people in the general age range of the mid-80s, 85 years old. Now, you have exhausted your savings and Social Security benefits get cut, so you're looking at net cut in your income, both from withdrawal rate and Social Security, anywhere from 40% to 60% at that very advanced age.
That implies a sharp cut in your lifestyle at that point, and what it doesn't include at all is any kind of possible emergency expense need, health-care emergency or let's say a long-term care need that isn't insured. So, what it suggests is that even for more affluent households, the risk, the retirement of security risk of such a cut in Social Security is pretty sizable.
Benz: So, did you factor in simultaneously scaled-back Medicare benefits
Miller: We strictly looked at Social Security for this exercise.
Benz: So, another question, Mark, is that cost-of-living changes would also affect this cohort as well, so assuming that there are some adjustments to the cost-of-living.
Miller: Absolutely. In fact the impact of that COLA change, the cost of living is even bigger for younger people, because again, you're looking at it affecting more years in your retirement.
Benz: Well, thanks so much for sharing this research, Mark, definitely something that we all need to stay plugged into as the years go forward.
Miller: My pleasure.
Benz: Thank you.
Miller: Thank you.
Benz: Thanks for watching. I’m Christine Benz for Morningstar.com.
