The Future of Social Security

The Future of Social Security

In 1935, Social Security (the Old-Age, Survivors and Disability Insurance program) was introduced through the Social Security Act. Since then, retirees have used this as a reliable source of income to supplement retirement savings. The retirement age in which full social security benefits are payable is currently between the ages of 65 and 67, depending on your year of birth, while those who have reached age 62 are eligible for partial benefits. While the program has changed significantly since it was introduced, its goal has always been to provide a more stable income outlook for those that are retired or affected by disability.

Baby Boomers

The generation of Americans born from 1946 to 1964 has historically been called Baby Boomers. This generation will have a tremendous impact on the economy, strategy for investments and the future of social security. Beginning on Jan. 1, 2011, and every day for the next 19 years, it is projected that 10,000 baby boomers will reach the age of 65. In addition to the sheer number of baby boomers, the increase in life expectancy over the past few decades has caused the projected benefit obligations of the social security system to substantially increase.

 

Revenue and Expenses

While Social Security is not a business, the same concepts apply. For the system to continue operating functionally, it must generate a sufficient amount of income to cover the benefits that are paid out. In 2010 and 2011, Social Security expenditures exceeded non-interest income for the first time since 1983. This is expected to continue for at least the next 75 years under current circumstances. Thus, to continue the ability to fully pay all scheduled benefits, congress will have to either increase the revenues generated by social security taxes, decrease projected expenses or both. To generate income for Social Security funding, Congress enacted the FICA tax. Until recently, the income has been greater than payments, generating a surplus. This surplus has then been held in a trust fund, earning interest income. Any future funding shortfalls will be drawn from this trust fund.

Each year, the Trustees of the Social Security trust fund report on the financial status of the program. In 2012, the actuarial deficits were made worse because of updated economic data and assumptions. The Trustees determined that legislative modifications will be necessary in order to avoid disruptive consequences for beneficiaries and taxpayers. The primary goal of the report was to warn lawmakers not only about the extent of the issue of long-term projected shortfalls, but also that changes should not be delayed. Any additional delay will only make the problem worse and will reduce options available to lawmakers. One of the biggest issues with the program is that growth in program expenses is forecast to be substantially larger than GDP growth due to the aging population of baby boomers. Additionally, social security will be strained by the increasing life expectancy of its participants and growing health care costs in excess of GDP, and Social Security costs as a percentage of GDP are projected to increase from 4.2 percent in 2007 to 6.4 percent in 2035. With projected future shortfalls, the trust fund is projected to run out in 2033 (three years earlier than in 2011). While this is alarming, FICA tax is still projected to cover roughly 75 percent of schedule benefits after the fund is depleted.

Future

Changes to Social Security that would help solve future funding shortfalls (increasing income, decreasing expenses or both) are difficult, but necessary. Further complicating this issue is political matters. Neither political party would like to be seen as responsible for raising FICA taxes or extending the retirement age. However, changes to the system are necessary in order to extend the availability of fully funded benefits and therefore appear inevitable. While no material discussions are ongoing regarding changes to the system, the simplest change to help combat future shortfalls would likely be an increase in retirement age. The main reason for this is that changes have not been made to the Social Security retirement age since the early 1980s. Life expectancies have continually increased, rising above 78 years in 2011. Additional possible changes could include raising the FICA tax to higher levels, raising/eliminating the income limit for FICA taxes, introducing means testing and many more.

Effect on Financial Planning

The effect of the uncertain future of Social Security on financial and retirement planning is tremendous and should be taken into account by everyone, regardless of age. Based on the projections outlined by the Social Security Board of Trustees, there is a marked difference in the effect this uncertainty will have on different generations. For those already in retirement, while it is possible that benefits could be changed to reduce expenditures, it is highly unlikely that changes would be made for anyone already retired. With benefits still projected to be fully provided through 2033, any potential benefit shortfalls are relatively unlikely to affect individuals that are already retired. With a high likelihood that Social Security will be changed to solve funding shortfall problems, it is reasonable to rely on this income source for the rest of your life. 

Individuals near retirement have less certainty about the future of social security, as the projected future shortfall in the Social Security trust fund in 2033 will likely be within your planning time frame. The high likelihood that some Social Security regulations will change in the near future will make it extremely likely that this projection will change for the better. If you are near retirement, most of your investment decisions related to retirement have already been made. As a result, future changes in social security may have little impact on your retirement plan. However, it may be beneficial to analyze the potential scenario (however unlikely) that no changes are made and only 75 percent of projected income is realized from this source after 2033.

For people who are far from retirement, any future changes to the structure of social security will alter the projections for the viability of future payouts. This uncertainty means that a contingency plan to cover cash flow shortfalls should be in place, just in case Social Security benefits are reduced. It is important to remember that even if no changes are made and the Social Security trust fund is entirely depleted, 75 percent of benefits are still projected to be paid from ongoing taxes. Projecting cash flow under the assumption that only 75 percent of benefits are paid would be helpful to determine whether your savings will be enough, even in this scenario. An increased focus on saving personal funds would decrease the risk of not having enough resources to achieve retirement goals.

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Retirement

Retirement

Life is full of unanswerable questions, like knowing exactly how much you’ll need to live comfortably during your retirement years. Though difficult to determine, the following article highlights some useful strategies and tools to help you get a step closer to a dollar amount you can feel confident about.

Retirement Age

The first step is determining your desired retirement age, keeping the following in mind: Medicare is available to you when you reach age 65, but you are eligible for early Social Security benefits at age 62. Those who retire at age 62 will receive Social Security benefits at a 30 percent reduction from the full amount that they would receive if they waited until their “full retirement age,” which ranges from age 65-67, depending on birth date. In general, the longer you wait to retire, the larger your Social Security benefits will be, up until age 70. If you have the desire, ability and health to work until age 70, your social security benefits will be significantly larger than if you chose retirement at age 62. Similarly, your company’s retirement plan may have specific early, normal and deferred retirement ages to be aware of.

You might have a specific age in mind, and plans for what you’d like to do when you do retire. That’s great, as long as you’ll have sufficient funds to live the life you envision. For those with a desire to travel, start their own business or spend more time on their favorite hobbies, they may want to retire earlier. Others may want to delay their retirement as long as possible because they enjoy their work. Similarly, some choose semi-retirement, taking a step back from their careers to help out on a part-time basis. Keep in mind, your goals and health may change as you get closer to retirement, so it’s important to adjust your planning accordingly.

Lifestyle Goals and Familial Responsibilities

Whether you plan to shave strokes off of your golf game, rack up the mileage on your personal odometer by traveling, or simply maintain your current lifestyle, your plan will alter the amount of money you will need. Similarly, it may be beneficial to take your family’s financial situation into account. By the time you retire, chances are your dependents will be off on their own, supporting themselves financially. However, it is not uncommon for retirees to want to help their children with mortgages on their homes or grandchildren with their college tuition. In other unfortunate situations, retirees may be in a position to continue to financially support disabled dependents. Each individual’s goals and obligations may vary, but taking them into account when planning for retirement is crucial.

Life Expectancy

Like planning for retirement, life expectancy is never certain. Life expectancy rates are only an estimate based on averages, but useful when planning for retirement. While it is positive news that life expectancy rates continue to rise, this may have a negative effect on your retirement funds – living up to or even past life expectancy may mean outliving your retirement funds. In addition, life expectancy rates continue to rise, so the average life expectancy age may be even higher by the time you retire than it is today. Take increasing life expectancy rates and personal and family health history into account when planning for retirement.

The Replacement Ratio Method

For those who wish to maintain their current standard of living, the replacement ratio method is often a useful strategy when drawing up your retirement blueprint. In general, this method suggests taking between 60 and 80 percent of the average of the assumed salary of the three years prior to retirement. The replacement ratio method is typically supported by the assumption of common changes in your financial routine and situation. For example, the fact that you will no longer be working also means that many employment-related expenses – such as the costs of commuting, parking, proper clothing and even food for work – will decrease when you retire. In addition, retirement brings important changes to your taxes, such as the halt in Social Security taxes, plus typical increases in medical expenses, and also typical decreases in debt, vehicle and homeownership expenses.

 

The Expense Method

The expense method focuses primarily on the typical increases and decreases of common expenses. For example, expenses that tend to increase or remain the same in retirement are utility bills, medical expenses, recreational activities, and house and vehicle maintenance. On the other hand, expenses that tend to decrease in retirement are mortgage payments, income and property taxes, transportation costs, debt repayments and household furnishings. The use of the expense method varies by an individual’s financial situation, goals and obligations. The expense method will require you to spend some time considering the many potential changes to your expense patterns upon retirement – but when it comes to feeling confident about your future financial security, every second is worth it.

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A New Way to Look at Annuities

A New Way to Look at Annuities

Retirement is about trust. When we choose to give up our careers, we all trust that the money we’ve put away is enough to get us through the rest of our lives. We have faith that our investments will continue to do well.

Seeing the need for guaranteed income, insurance companies have devised an investment strategy to remove some of the risk to retirees. Annuity plans are investment contracts that promise a certain level of income for purchasers. When used as part of a retirement plan, annuities become something retirees can trust for an uncertain future.

How does it Work?

Insurance companies have created many types of annuity contracts, all designed to provide regular income for their owners. Though each type has its own complex details, the concept behind them is very simple. An investor hands over a large sum of money to an insurer. The insurer then professionally invests it and makes regular payments back to the investor over a given period of time. The additional money gained through the investment is used to benefit both the investor and the insurer.

Annuities have become popular with many diversified retirement portfolios because they are able to promise income. Even if a retiree’s investments drop and he or she loses all other assets, an annuity will always be there to provide some form of payment. Despite this guarantee, the rigidity of an annuity’s payment cycle makes it less than the ideal vehicle for the entirety of a retirement fund.

Different Types

There are two major factors used in determining the type of annuity available to a person: funding and return on investment. During the accumulation phase, annuities can be funded with the intention of either immediate or later use. Annuities used immediately are typically funded with a large lump sum payment. An annuity that will be used later is usually funded through smaller regular payments, much like an IRA or 401(k).

The other factor, return on investment, is much trickier to judge when choosing an annuity. Agreements on income are usually made by selecting one of three major types of investment return systems: fixed, variable and equity-indexed.

  1. Fixed annuity – These are annuities that earn a fixed rate of interest. No matter how good or bad the market is, the insurer will always pay out at the rate it has guaranteed.

  2. Variable annuity – The hallmark of variable annuities is the account value is largely swayed by the success of the investment option. The contract owner takes on the risk of market performance.

  3. Equity-indexed annuity (EIA) – A hybrid of fixed and variable annuities, EIAs, also known as fixed-index annuity, provide a minimum interest rate along with minimum payout guarantees. The insurer promises that this set growth will occur but also credits additional interest if the EIA index outperforms the minimum.

Your selection of one of the above types of annuities may influence the type of payouts available to you during the second phase of the annuity, which is the distribution phase. During the distribution phase, the owner typically has two choices for receiving distributions from the contract. One choice is to withdraw earnings and principal from an annuity contract in either a lump sum, or over a period of time through regular or irregular payments. A second choice is to annuitize the contract. Annuitizing a contract will generate a guaranteed income stream from the annuity as defined under the terms of the annuity contract. The contract might provide payments to be made on a periodic basis in either a fixed amount or a variable amount. Most annuity contracts provide that payments can be made over a lifetime, a specific term of years or a combination of both. The amount the contract owner will receive for each payment depends upon how much money is in the annuity, and the annuitant’s age and gender when the contract is annuitized.

Customizations and Exchanges

Though the major characteristics of annuities are described above, insurers have created a competitive market with dozens of specialized features that can be added to any given annuity plan. These features allow for investors to get exactly what they want but can also raise the cost of an annuity. Investors shopping for annuity plans must be careful to judge what they need and what is unnecessary.

In Section 1035 of the Internal Revenue Code, the IRS allows for an investor to exchange their annuity for a new one without incurring any income taxes. Though the option exists to let investors back out of a bad annuity plan, it should only be exercised in situations when a different annuity is obviously better. An exchange may not incur a tax penalty, but it could still be subject to fees and adjustments from the insurer.

Annuities and Investment Plans

Because of their rigidity, annuities are best used as a support to other retirement plans. Annuities can provide for skeleton costs, while a managed IRA fund can provide the flexible cash needed to travel or handle sudden expenses. Even if the market plummets or an accident drains other funds, depending upon the annuity selected, it can continue to provide a fixed or variable income stream.

Take the first step toward achieving your goals.

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