Cost-of-Living Increases Don't Come Cheap
When Social Security announced its latest cost-of-living increases, you could hear the yawns coming from all over. The benefit is going up 3.3 percent on Jan. 1, an average of $33 a month for single retirees, $55 for couples. Seems like no big deal.
But if you crunch a few numbers, you see that it's a very big deal. No, not the 3.3 percent increase itself -- but the fact that Social Security retirees have a benefit that's tied to the consumer price index and goes up every year. In fact, you can make a case that the inflation adjustment adds at least a third to the value of Social Security benefits for today's newly minted retirees.
Sure, Social Security checks may not seem like a big deal to people with seven-digit retirement accounts. And living on Social Security alone isn't much fun. But let me show you how valuable Social Security benefits actually are. For starters, it would cost you well over $700,000 to buy a benefit to match what Social Security pays a married couple with one high lifetime earner and a stay-at-home spouse. That's some serious jack.
No, I'm not getting this from some bleeding-heart Social Security lover. It's from the financial markets. To be precise, it's from Vanguard and AIG, which together last year began offering lifetime income protection annuities that let you buy an inflation adjustment similar to Social Security's. Please note that I'm not pushing this product. I'm using it because its inflation adjustment is very close to Social Security's, I can run scenarios on Vanguard's Web site to my heart's content, and its fees, from what I can discern, are rather low.
Before we proceed, a brief primer on annuities. Stop that! Stay awake! I'm talking about a straightforward lifetime annuity -- you fork over dough and you get a monthly check for life. Think of it as the opposite of life insurance. With annuities, you win if you live longer than the insurance company expects. With life insurance, you win -- in the financial sense only, of course -- if you die early.
People rarely equate Social Security benefits with a big pile of dough. But if you're going to survive in the new world of on-your-own retirement, you need to think this way to figure out how much you need to save. You should also put a value -- which may be quite large -- on pensions that you stand to get from your employer, if you're lucky enough to have such an employer.
Here's a for-instance. Take $100,000. Seems like a lot. But if you're a single male born in 1941 -- which lets you retire on full Social Security on Jan. 1 -- it will produce only $703 of lifetime monthly income from Vanguard/AIG. Buy the inflation-adjusted version, and you get only $501 to start.
Let's look at it another way. Social Security says that the average monthly check for single people retiring at full benefits on Jan. 1 will be $1,361. It would cost you $263,000 to buy an inflation-adjusted annuity (if you're a male) to match that benefit, which will rise along with the CPI. A fixed $1,361 monthly payment would cost about $71,000 less.
If you've maxed out on Social Security tax for 35 years and are retiring at full benefits on Jan. 1, your monthly check will be $2,121, plus future CPI adjustments. Matching that would cost you a cool $410,000. If you've got a nonworking spouse, your monthly check would be $3,181, which would drop to $2,121 when the first of you dies. Vanguard doesn't sell this package but priced it for me. The number: $738,234.
Inflation adjustments cost so much because people are living for a surprisingly long period. For instance, if you're 65, you've got a 50 percent chance of living to 82. If you and your spouse are both 65, there's a one-in-four chance that one of you will live to 92. If inflation runs at 2.8 percent a year, as Social Security projects, by the time you're 92, today's dollar will be worth less than 50 cents. If inflation runs at the 3.7 percent built into Vanguard and AIG's figures, a dollar will lose half its value in only 20 years.
Patricia Colby, head of Vanguard's annuities and insurance business, says only about 10 percent of customers are buying the inflation adjustment. "People are reluctant to make that trade-off because there is a cost to it," she says. Or a benefit, depending on your point of view.
I've rounded and simplified throughout this column, and the numbers may have changed some since I wrote it -- annuity prices are tweaked constantly. But the one thing that won't change is that lifetime inflation-adjusted income is really expensive to buy. If you have any, cherish it.
Correction: Harris Associates doesn't run a London-based fund of hedge funds, as I wrote last week. It's run by Harris Alternatives, which split off in 2003.
Sloan is Newsweek's Wall Street editor. His e-mail address firstname.lastname@example.org.