There are numerous articles pointing out that Social Security Retirement Benefit (SSRB) is designed to replace 40% of income – at most. See https://www.fool.com/retirement/2017/04/24/social-security-is-designed-to-replace-this-much-o.aspx, or https://humbledollar.com/2018/08/ten-commandments-2/). Even the Social Security Administration (SSA) estimates an average income replacement rate (RR) of 40% (https://www.ssa.gov/planners/retire/r&m6.html).
Interestingly the calculation of RRs is not without controversy. Generally speaking, the RR is some measure of the yearly retirement benefits divided by some measure of the yearly income prior to retirement. While this sounds straightforward, there are several possible values for each that can be used.
Most (but not all) of the argument centers on calculating income prior to retirement. There are several ways to measure the income: Final year, average of final 5 years, average indexed earnings, earnings indexed by CPI etc. (see https://www.ssa.gov/policy/docs/ssb/v68n2/v68n2p1.html). For this analysis I shall start using average indexed earnings (AIE). This, generally speaking is the number that SS believes represents the income associated with the individual’s lifestyle. It is the income that SS purports to replace.
What I intend to do here is show what is meant by this 40% replacement figure and show just how wrong it really is. Once we see the real RRs, we may begin to understand how 10,000 people a day somehow mange to retire – despite all of the “expert” opinion that they are unprepared and unable to retire comfortably. However, that (understanding how they manage) is beyond the purpose of this article, which is merely meant to show that the 40% RR figure significantly understates the experience of the majority of retirees.
How SSA might calculate the average RR
The current average SSRB is $1422. The National Average Wage Index (NAWI) is $50,322. The simple calculation is 12*1422/50321 = 34%. That is not even 40%. Further, it uses the 2019 SSRB and the 2019 NAWI – which is based on average salaries in 2017.
Using the NAWI, one can calculate a PIA equal to 1879 using the 2019 bend points. That RR is 12*1879/50322 = 45%. If we use the NAWI (which is based on 2017 salaries) and the 2017 bend points (885 and 5336), we find a PIA equal to 1855 or a 44% RR.
I suspect the difference between SSRB and PIA comes from benefits that tend to be claimed earlier rather than later than at Full Retirement Age (FRA). For analysis purposes here we will assume PIA as the SSRB for comparison purposes. Public policy addressing RRs should not be made based on the propensity of people to retire early.
Calculating Income and SSRB
All calculations of income shall start with an assumed final year salary that has kept pace with the NAWI throughout the workers lifetime (or at least for 35 years). Then the AIE will look pretty much identical to the last year’s salary. While this may overestimate his true AIE (due to significant salary increase late in his career) it also over estimates his SSRB.
I believe in order to fairly calculate an income RR requires that we look at income – not gross salary, but at a minimum, income after FICA withholding. A $100,000 salary cannot result in a paycheck greater than $92,350. RRs should be concerned with the latter figure, not the gross figure. If I received $92,350 with no withholding (there is no FICA withholding of SSRB) I would think that 100% of my income was replaced.
Subtracting FICA withholding from gross income is the minimum correction necessary. Federal income taxes are also withheld (and or paid at the end of the year). These taxes too are unavailable to spend. Of course there are taxes in retirement, and SSRB are often subject to tax.
According to the SSA trustee report https://www.ssa.gov/oact/TRSUM/ , total taxes collected on OASI payments were 36 Billion on benefit payments of 799 Billion. That is Overall SSRB were taxed at just under 5%. That would be essentially slightly less than half of the benefits being taxed at the lowest marginal rate – 10%.
Whether income taxes should be considered is debatable. Again, the availability and quality of public pensions is a separate issue from tax policy. However, I will use PIA, not accounting for possible taxation, because SSRB alone have no tax consequences. The maximum SSRB (at FRA) in 2019 ($2861/mo) would have no tax liability for a single individual. The same is true for a married couple filing jointly even if each had the maximum SSRB.
SSRB is calculated using the 2019 bend points and assumes that claimant is FRA using Salary as indicative of the AIE for the individual.
RR is calculated using three variations of income:
- Salary – the gross salary before any deductions
- Salary less FICA
- Salary less FICA and federal taxes – referred to as After Tax Income (ATI)
Given that the goal of SS is to help people maintain their lifestyle in retirement, the important feature is how much of an individual’s ATI is replaced – it is ATI that people spend (or save) and it is spending that maintains the lifestyle. The difficulty lies in determining ATI as federal taxes differ from one person to another.For comparison purposes here I shall use singly or Married filing jointly tax rates assuming that the standard deduction is used.
The RR is then simply SSRB/income. (as calculated three separate ways)
I shall calculate RR for single and for married couples with one person working. I will also discuss RRs for married couples with two incomes. Given the disparity of incomes and benefits I shall show the results for a variety of salaries.
Results: RR for various incomes and marital status.
The RR for single individuals is shown in Table 1 for various salaries. Listed are the salaries, salary less FICA withholding, salary less FICA and federal income tax, SSRB, and RR using the three income variations.
Table 1. RR for various incomes for a single individual
|Salary less FICA||9235||18470||36940||46175||64655||92350|
|RR vs ATI||93%||73%||57%||54%||51%||43%|
|RR vs Salary less FICA||98%||69%||52%||49%||44%||36%|
|RR vs Salary||90%||64%||48%||45%||40%||33%|
It is readily apparent that RRs are significantly higher than 40% for a vast majority of the single population – regardless of the comparison income chosen. In fact when compared to replacing ATI – the comparison that I think is appropriate – it exceeds 40% for essentially all of the population.
SSRB replaces more than half of ATI for 85% of the working population (those with salaries under $70,0000/yr.).
For married couples that have had only one income there is a significant spousal benefit. The spouse (at FRA) can claim a spousal benefit equal to one half the PIA of the qualified worker. This comes at no increase in FICA withholding but generally a decrease in federal taxes. Table 2. shows the results for one income couples at the same salary levels. It is assumed that each of the couple has reached FRA.
Table 2. RR for One Income Married Couples
|Salary less FICA||9235||18470||36940||46175||64655||92350|
|RR vs ATI||138%||104%||82%||77%||71%||59%|
|RR vs Salary less FICA||146%||104%||78%||73%||66%||53%|
|RR vs Salary||135%||96%||72%||67%||61%||49%|
For married couples that have lived on one income, the RR is significantly higher than 40%, without exception. For those at the low end of income, RR near or greater than 100% is achievable.
For two income married couples, differing claiming strategies and the soon to be discontinued restricted application may affect the RR. Also, age differences may cause differing claiming ages. We will not consider these strategies.
For a working couple that has essentially the same incomes and claims at FRA – the RR is essentially the same as shown in Table 1 for a single individual. There are some small differences at the very low-income end due to the phase out of earned income credits. The results are shown again in Table 3.
Table3. RR for two equal income Married Couples.
|Salary less FICA||18470||36940||73880||92350||129290||184700|
|RR vs ATI||97%||73%||57%||54%||51%||43%|
|RR vs Salary less FICA||97%||70%||52%||49%||44%||36%|
|RR vs Salary||90%||64%||48%||45%||40%||33%|
Basically, each individual claims a single benefit and thus the RR is unaffected by the presence of a second income in the marriage.
Finally, what happens when there are significant salary differences? The first thing to note is that half a salary generates an SSRB of more than half of the SSRB for the full salary. E.G. a $40,000 salary has an SSRB of $19,245. A non-working spouse is eligible for half of that benefit at FRA. However, if he worked and earned half of that salary, $20,000, his benefit would be $12,845 – significantly more than half of the higher benefit. However, because of the increased income, the RR may be less than that for Married couples with one income. Some results are shown Table 4.
Table 4. RR for Married Couple with Unequal Income
|Salary less FICA||36940||46175||55410||73880||92350||129290|
|RR vs ATI||71%||66%||62%||57%||54%||46%|
|RR vs Salary less FICA||68%||63%||58%||52%||49%||40%|
|RR vs Salary||63%||58%||53%||48%||45%||37%|
Mostly the result of two different salaries is only slightly lower than two identical salaries with the same total value. Note that a 100,000 salary split 60/40 (Table 4.) is identical to the split 50/50 (Table 3.). The same is true for 80,000 split 60/20 versus 40/40. But 40,000 split 30/10 is slightly lower than if the salaries were evenly split (20/20). The same is true for 140,000.
Still there is but one comparison where the actual RR is less than 40%.
The major item of note in all of the RR listed data is that SSRB replaces about 60% of ATI for all salary levels up to 40,000/yr. This is true for single individual and married couples with 80,000 dollars of income – regardless of how that income is split. The idea that social security replaces but 40% of your income is totally inaccurate.
Until recently, many “experts” suggested that people needed 70% of their gross income in retirement. This figure was meant to estimate the idea that ATI was about 70% of your gross salary. I believe a more reasonable goal is that you will need 100% of ATI.
Clearly, SS replaces nowhere near 100% of ATI for the vast majority of people. The very poor have RR near or higher than 100%. As much as these people are poor while working, they will continue to be poor in retirement. They will likely need assistance with housing and health costs that will continue to rise.
Single income married couples will receive the best benefits. Even those with total salaries up to 100K will have RR greater than 60%.
Those with individual salaries in the 30,000 – 40,000 (60K-80K total married) range can expect SSRB to replace about 60% of their ATI.