November 6, 2024
By Gary Konwinski and Christian Lewton
All working Americans look forward to the “golden years” of retirement. While some have crafted detailed plans to secure a steady income stream during their retirement, many have not. One constant that retirees have traditionally relied upon is Social Security—or so they thought.
Current recipients of Social Security are not receiving a direct return on their contributions. Instead, the benefits being paid today come from the FICA taxes collected from current workers and their employers, who each contribute 6.2% of the first $168,600 of paid wages. Additionally, these payments are supplemented by the Social Security Trust Fund, which the Congressional Budget Office projects will be depleted by 2035. Alternate investment strategies and savings plans are essential to assure a secure financial stream beyond 2035, a mere eleven years in the future.
It is highly unlikely Social Security, as a program, will be discontinued. However, it is highly likely that the cost of the Medicare benefit will increase for recipients and the age for receiving Social Security benefits will rise. These two likely modifications to the program will result in smaller benefit payments being made later in life. How do you prepare?
The Social Security program was proposed by President Franklin D. Roosevelt and became active in 1935. The deductions that employees see on their paychecks are labeled as FICA, an acronym for the Federal Insurance Contributions Act. These FICA contributions were initially placed in an independent trust fund, separate from the general operating fund. Originally, when individuals became eligible for monthly benefit payments, those payments were not subject to income tax. This setup appeared to prioritize individual welfare. Alternatively, it could be argued that the program was established because the government believed that individuals might not set aside sufficient savings for retirement on their own. Regardless of the motivations, wage earners and employers were mandated to contribute to the program.
Over the years, the Social Security program has undergone numerous modifications. The most significant and impactful of these changes was the decision to make benefit payments subject to income tax. In 1993, the percentage of Social Security benefits subject to income tax was increased from 50% to 85% for recipients exceeding certain income thresholds. Additionally, individuals in higher income brackets are charged more for Medicare coverage, and therefore receive a smaller monthly Social Security check.
Today, Social Security is more critical than ever for a significant portion of the population. For approximately 40% of retired Americans, it’s their only source of income—a reality that wasn’t necessarily by choice but rather a reflection of the times. As the workforce became more mobile, with people frequently changing jobs, companies began to retreat from offering retirement plans. Small businesses and large corporations alike faced rising costs, regulatory demands, and administrative burdens, from fiduciary responsibilities to managing third-party administrators and the Pension Benefit Guarantee Corporation. The growing complexity and costs of maintaining pension plans forced many companies to discontinue them.
In this shifting retirement landscape, individual retirement plans have become increasingly important. While they don’t fully replace the security that pensions once offered, they provide essential flexibility and are a vital tool for many seeking financial stability in retirement.
Client A was continually employed from 1968 to 2023. During these 55 years, total contributions to the Social Security fund—comprising both Client A’s and their employer’s contributions—amounted to $376,098.73, as depicted in Chart 1 below. Based on Client A’s average indexed monthly earnings (AIME) over their career and their Primary Insurance Amount (PIA), their projected monthly Social Security retirement benefit is $3,263 in 2024. Assuming Client A has a life expectancy of 20 years and receives an annual inflation adjustment of 2%, the present value of their Social Security benefits is approximately $630,000.
While Social Security provides a reliable income stream in retirement, it may not fully cover the lifestyle Client A desires. Additionally, it’s important to recognize that Social Security offers no residual value—there is no principal to pass on. The only financial benefit is the monthly check, and upon death, there are no remaining funds for heirs. Therefore, Social Security functions as a source of income during retirement but does not contribute to an estate or provide generational wealth transfer.
Now, let’s consider Client B, who had the same earnings as Client A. In addition to paying Social Security taxes, Client B also contributed an equivalent amount—$188,049 in total or an average of $285 per month—into an individual retirement account (such as a 401(k) or IRA). Assuming these contributions were invested in the S&P 500, the account would have grown to $930,651 by the end of 2023, as shown in Chart 2.
This means Client B enjoys both the guaranteed monthly Social Security payments and the flexibility to access their retirement account. If Client B chooses to maximize their income and fully deplete their retirement account, they could withdraw around $6,150 per month for 20 years, assuming a conservative 5% return. This would bring Client B’s total monthly income in 2024 to $9,413, approximately 188% higher than Client A’s monthly income.
Alternatively, if Client B prefers to match their Social Security payment with withdrawals from their retirement account—doubling their monthly income—they would still retain over $947,000 in the account after 20 years, assuming the same 5% rate of return (see Chart 3). This strategy would provide increased income while preserving a large asset base for future needs or inheritance.
Unlike Social Security, which offers no residual value, Client B’s retirement account would still hold a substantial balance after 20 years. This underscores the advantage of supplementing Social Security with individual retirement savings, enhancing financial security in retirement while allowing for wealth transfer.
While Social Security provides a safety net, it is clear solely relying on social security may not be enough to sustain your desired lifestyle in retirement. The uncertainty surrounding the future of Social Security, coupled with the relatively modest returns it offers compared to other investment options, underscores the importance of saving outside of Social Security. By investing in additional retirement accounts, such as IRAs or 401(k)s, and exploring other long-term savings strategies, you can better ensure a more comfortable and financially secure retirement. Saving even modest amounts over a long period of time, in a tax deferred retirement account, will reap the benefits of compounded interest. Start planning and saving now to supplement Social Security, which is almost certain to come with higher participant costs, lower monthly benefits, and a later retirement age in the future.
The GHP Investment Advisors Financial Concierge Newsletter is published as a service to our clients and other interested parties. This material is not intended to be relied upon as a forecast, research, investment, accounting, legal or tax advice and is not a recommendation offer or solicitation to buy or sell any securities or to adopt any investment strategy. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only. Past performance is no guarantee of future results.
