Early Retirement and Social Security

"It does not do to leave a live dragon out of
your calculations, if you live near him."

- J.R.R. Tolkien

Calculating your Social Security benefits is complicated, and determining the effect that early retirement will have on those benefits is even more difficult. In an effort to avoid the complexity of the problem, much of the conventional wisdom tends to fall to the extremes: either blindly assume Social Security will take care of all your retirement needs, or ignore it altogether because of potential solvency issues with the program.

For the typical person contemplating early retirement, however, Social Security benefits are far too important to be casually dismissed. Compared to most traditional pension plans, the Social Security program is considerably more favorable toward the early retiree. The reasons for this good fortune will be apparent as we consider the details of exactly how the retirement benefits are calculated.

Let's examine the effect of early retirement on these key items:

• Qualifying for benefits
• Indexing of earnings
• Calculating average indexed monthly earnings
• Calculating your benefits
• Determining spousal benefits

(The above items are all linked to their relevant sections in the Social Security Online website. There you can find out almost anything you want to know about Social Security in excruciating detail.)

1. You need 40 credits to qualify for Social Security retirement benefits, and you can receive up to 4 credits per year that you work. You need about $1,000 of earned income for each credit, so if you have wages of at least $4,000 for the year, you receive your maximum of 4 credits for that year.

Implications for early retirement: It does not matter when you earn the credits. If you work for 10 years and have at least $4,000 in wages in each of those years, then you qualify, regardless of whether you work any more years. In my case, I already have the necessary 40 credits, so I will always qualify for benefits even if I stop working at 45.

2. Your wages for each year are indexed to their current value, based on the average wage increase in the United States during that time period. All your wages up to age 60 are indexed. (Wages after age 60 are not indexed.)

Implications for early retirement: This one is huge! Most employer pensions are based on your final salary when you stop working. The basic idea is that you will receive raises throughout your working career, so that basing your pension upon your final salary has the effect of compensating you for the inflation that occurred throughout your career. However, this only happens if you are working for that employer right up until the time that benefits can be paid. Otherwise, you are not compensated for inflation.

For example, suppose you work from age 25 to 45 for Company A, which has no pension plan. You then leave Company A and work from age 45 to 65 for Company B, which has a typical pension plan based upon final salary. Further assume that both Company A and Company B treat you reasonably well by giving you the average wage increases for your line of work. When you turn 65 and retire, your pension is roughly based on your salary at age 65. The wage increases throughout your career compensate you for all the inflation that occurred throughout your career.

However, suppose you worked for Company B first for 20 years, and then worked for Company A for the remaining years. Assume your salary for each year was always the same as the first scenario. In the second scenario, your pension will be based on your final salary 20 years ago at Company B. It will likely be less than half of the first scenario! The bottom line: A typical employer pension is worth much more if you work for that employer right before you draw benefits.

I have a pension plan with my current employer. Assuming I retire early at 45, it will be based on my final salary at age 45, but won't be payable until 65. This means inflation will eat up that pension value for 20 years. This is in stark contrast with my Social Security retirement benefit calculations. If you work 40 years, your benefits will obviously be greater than if you only work 20 years. However, the point is that with Social Security, it doesn't matter that my 20 years of work occurred early in my life, rather than right before I start receiving benefits. Social Security can be very important for many early retirees because it doesn't have the same penalty for early retirement that is built into most pensions.

3. The amount of your retirement benefits is based on your highest 35 years of income. All other years are ignored!

Implications for early retirement: First of all, if you have always been a high wage earner, your last few years of working may not increase your Social Security benefits at all. For example, suppose you start working at 25 and are over the maximum every year for 35 years. At that point, you are 60 years old, and your Social Security wage base is essentially maxed out. If you continue working until you are 65, you will pay into the Social Security system for 5 more years, but it will not increase your benefits at all.

Second, it's clear that the inclusion of a lot of years with zero wages will have a considerable effect on your retirement benefits. However, it may not be as bad as you imagine. If you start working at age 22 and you are eligible for full retirement benefits at 67, it's not true that 45 years of wages contribute toward the calculation of your benefits. Only the top 35 years will be included. Thus, if you retire at 45 with 23 years of wages, only 12 years of zeros will be averaged into your calculations -- not 22 years.

4. Your retirement benefits are calculated relative to two "bend points". (The bend points are adjusted each year for inflation.) You receive 90% of your income up to the first bend point, 32% of your income from the first bend point to the second, and 15% of your income from the second bend point up to the taxable maximum amount.

Implications for early retirement: The amount of your retirement benefits benefits are not linear with respect to your wages. Higher and higher total career wages result in smaller and smaller increases to your retirement benefits. Thus, eliminating one half of your career will not result in your benefits being cut in half. The effect will typically be much less.

5. If your spouse also qualifies for retirement benefits, your spouse can choose the higher of his/her benefits or half of your benefits. If your spouse doesn't qualify for benefits, he/she is still entitled to half of your benefits!

Implications for early retirement: The spousal benefit does not seem to be widely understood. Don't assume that because your spouse never earned a lot of income, there won't be much coming from Social Security. Your spouse will at least get half of your benefits, even if your spouse never paid into Social Security! The only restriction is that your spouse must be of retirement age (or is caring for a child of yours under the age of 16).

(Disclaimer: I do not work for the Social Security Administration, nor am I an authority on Social Security matters. This article is merely a brief description of my best understanding of how Social Security works and how it relates to my personal situation. For the purposes of making any real financial decisions, please make sure to get your Social Security information directly from the Social Security Administration.)