Early Retirement and Social Security - Island of Sanity

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Early Retirement and Social Security

Social Security sets a "full retirement age", or "FRA", which is the age you have to be to start collecting the "standard" social security benefits. If you retire earlier than this, you get less. If you retire later than this, you get more.

For people born in 1960 or later, full retirement age is 67 years old. For people born earlier, it's younger, because at one point they increased the retirement age but they didn't want to change it retroactively on people. If you were already retired, they didn't want to say, "Oh, sorry, you've got to un-retire." But for this article we'll use 67 for the examples just to keep it simple.

If you do retire early, the amount you get is reduced permanently. If you retire, say, 3 years before FRA, (that is, 64 if your FRA is 67) you get 20% less. It doesn't go up when you get to 67. You stay at that 20% less for the rest of your life. The idea is to let people retire early, but give them an incentive to wait. If you got the same amount if you retired at 62 that you got if you retired at 67, why would anyone wait until 67? Or if the amount went up when you reached 67, that would mean that someone who retired early would collect money for those extra years, and then when he hit 67 get the same amount as someone who collected nothing before reaching 67.

So if you retire early, you get a smaller amount each month, but you collect that amount for a longer period of time. Namely, for the time between when you start collecting and when you reach full retirement age.

So for example, suppose your social security benefits at FRA came to, say, $20,000 per year. (Just using a round number. That's a little bit above the average.) If you retire 3 years early, at age 64, you get 20% less or $16,000.

So if you lived to, say, 70, then by retiring at 67 you would collect $20,000 per year for 3 years, or a total of $60,000. If you retire at age 64 you would receive $16,000 per year for 6 years, or $96,000. In that scenario, you get more total benefits by retiring early.

But suppose you live to be 90. Then if you retire at 67, you would receive $20,000 per year for 23 years, or a total of $460,000. If you retire at 64 you would receive $16,000 per year for 26 years, or a total of $416,000. You get more total by retiring later.

So think about the total that you will collect in each case. If you retire early, you start collecting sooner but build up your total at a slower pace. You get a head start but don't run as fast. If you retire later, you start collecting later, but you build up the total at a faster pace. So if the late retiree lives long enough, he'll eventually catch up to the early retiree and pass him.

Here's agraph showing how it works for person A retiring at 67 and person B retiring at 64. In each case, I assume that the FRA benefit is $20,000 per year.

So at what point does the full retirement line catch up to the early retirement line?

The actual formula for social security is that if you retire early, your benefits are reduced by 5/9 of 1% for each month you retire before full retirement age up to 36 months, and then 5/12 of 1% for each month for the next 24 months. (The earliest you can retire is 62, which is 60 months before 67, so that's as far as the formula has to go.)

So for example if you retire 3 years early, your benefits will be reduced by 3 years x 12 months/year x 5/9% = 36 x 5/9% = 20%.If you retire 5 years early, your benefits will be reduced by 36 months x 5/9% + 24 months x 5/12% = 20% + 10% = 30%.

We can calculate the break-even point with a little algebra. Feel free to skip to the conclusion if you don't understand the algebra or find it boring.

Let b=annual benefit at full retirement age and t be the number of years between your full retirement age and when you die.

Then your total benefits if you retire at full retirement age = b x t. Your total benefits if you retire 3 years early = 0.8b x (t + 3). The break-even point is when these two numbers are equal.

t=0.8(t+3)        Divide through by b. Note that the break-even point does not depend on the FRA benefit amount, this cancels out.

So the break even point is 12 years after full retirement age, or 67+12=79 years old. If you expect to live to be older than 79, then you will collect more by delaying retirement. If you expect to die before you reach 79, then you will collect more by retiring early. Of course no one knows just how long they will live, so you can only guess.

Inflation should be mostly irrelevant to this calculation. Social security benefits increase every year with inflation, so that should just cancel out.

You might want to consider the future value of money. If you're not familiar with this concept, let me explain.

Suppose you did some special project at work and your boss offered you a bonus. But he gives you a choice. Get $1000 today, or get $1000 a year from now. Which would you take? Most people would choose $1000 today. Why wouldn't you? If you have something you want to spend the money on, you'd get it a year sooner. If you don't have any particular use for the money right now, you could just put it in the bank and you'd still have it a year from now anyway.

But suppose your boss offered you $1000 now or $1200 a year from now. Now the choice is harder. It would be nice to get the money sooner, but by delaying you get more money.

If he offerred you $1,000 now or $10,000 a year from now, the rational person would almost always wait the year. Unless you had some desperate need for the money right now, the reward for waiting is too good to pass up. If he offerred $1,000 now or $1,010 a year from now, you'd probably still take it now. So there's some number where you would be truly torn, where the reward for waiting just balances the inconvenience of having to wait. Of course that number isn't the same for every person and every situation. But there would be some number. That is the future value of money.

(Economists usually calculate future value based on average return on investments. Like if the stock market is growing at 7% per year, then the future value of money is 7% per year more than the present value.)

The point being, collecting $1000 from social security 20 years from now is not as good as collecting $1000 today. So we should adjust the break-even point based on future vs present value. This will push it out further.

On the other hand, in real life, you don't normally start collecting social security until you retire. At that point you are no longer making income from your job. So if you're deciding when to retire, you really need to consider not just how much you will get from social security, but how much you will lose by not working.

© 2022 by Jay Johansen


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