Last week’s post made the point that Social Security isn’t simply an entitlement program and is instead a deferred income annuity (“DIA”) payable for life. As discussed, the primary difference between Social Security and a commercial DIA is the organization from which the investment is purchased and payments are guaranteed. In the case of Social Security, it’s the federal government while DIA’s are purchased from, and payments guaranteed by, individual life insurance companies.
It turns out that in today’s low-interest rate environment, Social Security is inarguably the ultimate DIA. To illustrate this, I will use my current Social Security benefits statement that includes the following information about my projected monthly retirement benefit beginning at various ages:
Age 62 $1,870
Age 66 and 2 months (full retirement) $2,559
Age 70 $3,385
In addition to projected monthly retirement benefits, my statement also shows that through 2011, I have paid Social Security taxes totaling approximately $149,000 and my employers (including myself and my two corporations for the last 23 years) have paid approximately $94,000, for a total of approximately $243,000.These taxes have been paid over the last 40 years beginning with part-time employment when I was in high school, with the vast majority paid over the last 25 years.
In addition to my Social Security retirement benefit, my wife is entitled to receive a monthly benefit equal to one-half of my full retirement benefit, or $1,280 (50% x $2,559) if she starts receiving benefits at her full retirement age. This is referred to as a spousal benefit and is independent of any benefit to which she may be entitled based on her earnings record. Assuming my wife has no significant earnings and further assuming that I predecease her, she will receive her spousal benefit for the rest of my life at which time she will receive my higher monthly benefit for the remainder of her life.
Ignoring my wife’s spousal benefit in order to minimize complications, let’s demonstrate the value of my Social Security retirement benefit by calculating the single premium required today at my age 57 to purchase a DIA that will pay my projected monthly retirement benefit beginning at various ages with a 2% annual increase for the remainder of my wife and my lives. Per the November 12, 2012 The Smooth COLA post, Social Security cost-of-living adjustments (“COLA’s”) have averaged 2.6% over the last ten years; therefore, an assumed 2% annual increase is probably conservative.
The following is the range of DIA single premiums required to pay various joint lifetime income amounts assuming an annual 2% increase beginning at various ages using illustrations from three highly-rated life insurance carriers:
While it’s obvious that the above single premium amounts are significantly greater than the total Social Security taxes of $243,000 paid through 2011 by my employers and myself, it’s important to keep in mind the following facts when doing a cost/benefit analysis of Social Security compared to commercial DIA’s:
- In order to receive the projected Social Security monthly income beginning at various ages, it’s assumed that my current earnings will continue until my full retirement age.
- In order to receive the projected Social Security monthly income beginning at various ages, Social Security taxes paid by my employers and myself are projected to total $314,000 – $381,000 or greater depending upon my annual earnings, actual taxable Social Security wage bases, and when I retire.
- Although my Social Security tax payments haven’t been segregated and invested in an account in my name and they have been used to fund Social Security benefits for other individuals, my employers and I have been paying into the Social Security Trust Fund for 40 years.
- My projected Social Security monthly income beginning at various ages doesn’t include COLA’s between now and my Social Security starting age.
- The DIA assumed annual increase of 2% may be greater or less than the actual Social Security COLA’s for the remainder of my wife and my lifetime.
- Although it isn’t likely, it’s possible that my projected Social Security benefit amounts may change if Social Security law changes.
- As previously stated, my projected Social Security benefits and the single premium DIA calculation both exclude my wife’s Social Security spousal benefits.
- While it’s possible that less than 50% of my Social Security benefits will be taxable, under current law, it’s likely that 50% – 85% of my benefits will be taxable, depending upon the amount of my other income.
- Depending upon when I would start receiving payments from a DIA, approximately 40% – 60% of my payments would be taxable as a result of favorable tax treatment associated with nonqualified annuity payments.
- The required DIA single premium amounts are on the high side since they were calculated assuming that I’m a California resident when I receive my payments and, as such, take into consideration California’s nonqualified annuity premium tax of 2.35% which isn’t applicable in most states.
As you can see, a number of factors must be considered when comparing Social Security as a DIA to purchasing a commercial DIA. Despite these various factors, in today’s low-interest rate environment, it’s clear that Social Security is the ultimate DIA.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.