Social Security is one of the most contentious government programs ever created. Although millions of past and current retirees have relied on it for a big part of their income, others have criticized the program as a Ponzi scheme that's doomed to eventual failure.
Recently, Social Security reached a milestone that's sure to add fuel to the highly charged policy debate. For an increasing number of new retirees, the amount that Social Security will pay out in benefits will end up being less than the payroll taxes they paid into the program over the course of their careers.
Moving Down the Scale
For some retirees, this is nothing new. High-income earners have been in this negative-return situation for quite a while.
According to analysis from the Associated Press, though, many middle-income retirees now face the same situation. Moreover, even if nothing happens to reduce benefit levels going forward, the trend is likely to continue and affect more retirees with even lower incomes.
The Push and Pull of Social Security
A few factors go a long way toward explaining exactly why this shift is happening. On one hand, with the exception of the past few years, the amount of payroll taxes that workers pay has steadily risen. During the initial years of the program, from 1937 to 1949, the portion of payroll taxes earmarked for Social Security was locked at 1%. That amount steadily rose during the ensuing decades, hitting 2% in 1954, 3% in 1960, 4% in 1969, and 5% in 1978. The current rate of 6.2% held steady since 1990, although the temporary payroll-tax cut reduced that rate by 2 percentage points. So today's retirees have had more of their earnings subject to high rates than those in earlier generations.
In addition, the amount of wages on which the government collects payroll taxes has marched inexorably upward. As recently as 1972, Social Security taxes applied only to the first $9,000 in annual wages that a worker earned. This year, that figure has climbed above the $110,000 mark.
On the other side of the equation, the formula that determines monthly payments from Social Security doesn't match up in a straight line with average career earnings. Instead, Social Security has what it calls "bend points" above which every additional dollar of earnings yields a smaller increase in your monthly benefit. For instance, in 2012, the first $767 of average monthly earnings produces a benefit of $0.90 per dollar, while additional earnings up to $4,624 boosts monthly payments by $0.32 and income above that increases a payment by $0.15.
The bend points in the benefits formula explain why higher-income retirees fell below the breakeven point earlier than middle-income retirees. Because taxes rise at a constant rate but benefits provide diminishing returns as income levels go up, the redistributive effects of the program hit those with higher incomes first.
It's important to remember that Social Security covers a lot more than just retirees directly. With spousal benefits, as well as payments to a surviving spouse and minor children after your death, many payments from Social Security go to other people. Moreover, with disability insurance coverage, you may get benefits long before reaching retirement age if something happens to you.
Worse to Come?
Perhaps the scariest part of this analysis is its assumption that benefits will continue at their current levels. In the latest report from Social Security's trustees, projections indicated that, left unchecked, benefits would have to drop by about a quarter in the year 2033 because of shortfalls between the amount of payroll taxes collected and benefits owed to retirees.
In this election year, most politicians have been afraid to tackle Social Security head-on. But with increasing pressure to justify the benefits of the program, you may see reform efforts appear once the election is over -- especially if more members of the public start seeing the program as a bad deal.
10 Secrets to a Secure Retirement
Is Social Security Becoming a Bad Deal for American Workers?
Take five ways to boost your income and five ways to reduce your expenses and debts and you have USA Today's 10 secrets to a financially secure retirement.
Click through our gallery to see the steps you should be taking, including why you should not start collecting Social Security checks at age 62 (Slide No. 5).
"The decision to retire is sometimes made for superficial reasons," Alicia Munnell, director of Boston College's Center for Retirement Research, says. She's heard many stories of older workers quitting suddenly because they had been stuck on airplanes too long during business trips. She heard of a woman recuperating from a sprained ankle who decided she really liked to watch daytime television, so she retired. Some quit because they were peeved at younger bosses. Leaving in a huff without developing a solid exit strategy, though, can be financially foolhardy.
Plenty of investors turn timid as they age, so it's no surprise that many retirees consider stocks off-limits. What they fail to realize is that an ultra-conservative portfolio stuffed with bonds and certificates of deposit can't keep up with inflation. It may be hard to imagine, given the current bloodbath on Wall Street, but over the long run, returns from stocks and stock mutual funds tend to surpass the returns on other investments. Adding stocks to a retirement portfolio can boost your returns without exposing you to reckless risk.
Those lucky enough to retire with a pension must often decide whether to take a lump sum or a lifetime of monthly checks. Grabbing that huge chunk of change all at once is exceedingly tempting, but retiring workers should consider consulting a pension actuary before making such a momentous decision.
You can start collecting Social Security checks at age 62, and most Americans go for it. But their eagerness can curtail their retirement income. If you delay Social Security past age 62, your benefits will increase significantly. Crunch your own numbers, using various retirement scenarios, by visiting the Social Security Administration's website at www.ssa.gov.
What's required to be a successful investor hasn't really changed from the days when stock prices were ripped off ticker tapes. "The whole purpose of investing for the long term is to make your money grow faster than inflation deteriorates it, " says author Lewis Schiff. "For those investors who take the long view and practice the simple arts of diversification, compound returns and dollar-cost averaging, and especially those who do so in tax-advantaged accounts, this growth is well within reach." If you're not confident in your own investing skills, consider using low-cost target retirement funds offered by big mutual fund companies. Next: 5 Ways to Reduce Expenses
People need to remember that it's after-tax returns that matter," says author Taylor Larimore. The after-tax performance of mutual funds can look shockingly different from their posted figures. During the decade that ended in 2007, for instance, Lipper estimated that fund investors lost anywhere from 17% to 44% of their returns to taxes. Many retirees woefully underestimate their tax hit because they incorrectly assume that their tax burden will plummet once their paychecks dry up. A great way to stanch the tax hemorrhaging is to invest in tax-efficient index and exchange traded funds. Next: Secret No. 2
Obviously, carrying a credit card balance is a no-no, but if you haven't managed to erase your debt, there's a painless way to tackle the problem: Call your card issuer. "If you have good credit -- a 700 FICO score or better -- you have a ton of leverage with credit card companies, which are scared and worried about their profit margins," observes author Liz Pulliam Weston. Card issuers hate losing customers, so they're generally willing to negotiate. If you enjoy good credit, you should be able to capture a rate below 10%.
No one's asking you to deny yourself a $4 latte, but if you're living beyond your means, it makes sense to root out the budget-busters. "You have to know where the money is going in order to know where to cut back," Weston says. Recording your purchases for a week can prove a tremendous help.
Investment fees are a natural enemy of retirement portfolios. But many investors are oblivious to this predator. Why? Because investors of mutual funds and annuities aren't billed for these expenses. Instead, the fees are automatically deducted. You can see for yourself the damage that even average expenses can wreak on a mutual fund by using the U.S. Securities and Exchange Commission's mutual fund cost calculator at www.sec.gov/investor/tools.shtml. Try sticking with mutual funds that charge an annual expense ratio of 1% or less.
Regardless of your age, take care of your health and you'll probably save money. "Eat right, exercise and care for your teeth, eyes and ears," says Henry Hebeler, the creator of AnalyzeNow.com, a financial website geared toward retirees. "By the time we get to retirement age," Hebeler adds, "health care costs are the single largest item in most of our budgets, and early prevention of health problems pays huge financial dividends."