The Big Reveal on Minimum Social Security

Transcription

1 The Big Reveal on Minimum Social Security Mark Buis F.S.A. Louise Gates A.S.A. NCPERS 2013 Public Safety Employees Pension and Benefits Conference Copyright 2013 GRS All rights reserved.

2 Outline Background Minimum Social Security Benefits FICA Replacement Plan Examples 2

3 Chronology of Significant Events 1935 Social Security (SS) Act signed into law State & local government employees excluded 1951 Section 218 of the SS Act becomes effective Voluntary agreements between states & SSA Provide SS coverage to state s public employees Agreements between the state and its subdivisions agreements cannot be terminated 1990 OBRA amends the SS Act Mandatory SS participation for public employers 3

4 Minimum Social Security Benefits Mandatory Social Security coverage Social Security reform Minimum Social Security benefits Why minimum SS benefits are important Retirement planning Satisfy legal requirements Labor negotiations 4

5 Labor Negotiations Battle over resources Result is often reduced pension benefits Typically for new hires Sometimes for current employees Reductions may be extreme Minimum benefits apply if there is no SS coverage 5

6 Labor Negotiations Erosion of retirement security Defined benefit plans are dwindling Defined contribution pension plans are growing Concerns about a reasonable standard of living after retirement Replacement ratios Considerations Employer sponsored retirement plans SS coverage Supplemental plans Availability of ancillary benefits 6

7 Retirement Planning In the Past Retirement Income Employer Sponsored DB Plans Prevalent All employees participated in 1 plan Social Security Coverage Provided through: Primary employment Part-time employment Supplemental Retirement Income 457 plan Savings / Investments 7

8 Retirement Planning The New Reality Covered by Social Security No Social Security Coverage DC Plan(s) / Savings DC Plan(s) / Savings Social Security 8

9 Considerations for Public Safety Even with a 3-legged retirement plan there are challenges The Windfall Elimination Provision (WEP) Government Pension Offset (GPO ) Disclosure requirements for employees hired on/after January 1, 2005 (Form: SSA-1945) Even more challenges with a 2 or 1-legged plan The individual bears virtually all of the risk in a DC type pension plan Can be many years between retirement and Social security benefit commencement 9

10 Considerations for Public Safety Is retirement even possible without Social Security coverage? 10

11 Minimum Social Security Benefits About 25% of government employees are not covered by Social Security Don t pay FICA tax on earnings from government jobs CA, CO, IL, LA, MA, OH, TX have nearly 70% of the non-covered government employees After July 1991, employers are responsible for providing appropriate coverage SS benefits may be provided through a FICA replacement plan Plan must provide certain minimum benefits Both DB and DC plan types are permisable 11

12 Minimum Social Security Benefits Described in IRC Section 3121 Mandatory benefits Comparable to those provided in the Old Age portion of OASDI SS benefits Benefit must be payable on or before the individual s social security retirement age DB and DC safe harbor benefit formulas IRC (b)(7)-2 12

13 Safe Harbor DB Benefit Formula Benefit Multiplier (%) Service Credit Years (SVC) Final Average Compensation (FAC) Monthly Benefit Payable for Life 13

14 Safe Harbor DB Benefit Formulas 1.50% x svc x month FAC 1.55% x svc x month FAC 1.60% x svc x month FAC 1.75% x svc x month FAC 2.00% x svc x 120+ month FAC Definition of Compensation used in Final Average Compensation Must be at least equal to base compensation Can exclude overtime etc. Revenue proc

15 Safe Harbor DC Benefit Formulas Contribution must be at least 7.5% of pay May be satisfied by 100% employee contributions Benefit must be payable on or before the individual s SS retirement age Vesting conditions are permisable DC plan account must be credited with Actual earnings and losses or, A reasonable rate of interest 15

16 Social Security Fun Facts 16 Originally called the Economic Recovery Act of 1935 to provide supplemental income to seniors at age 65 Male life expectancy in 1940 was 61.6 years Male life expectancy now is around 83 years First recipient was Ernest Ackerman who received a lump sum benefit of 17 cents (he paid in 5 cents) Not so fun fact In 1940, tax rate was 2% (employee and employer) Tax rate has climbed to 12.4% by 1990

17 The City of Redville Example The City of Redville never participated in Social Security Following the 1987 Stock market drop, Jacob Marley, the City manager, decided to reduce benefits for new hires in the police and fire plan The new tier provided benefits that complied with Revenue Procedure that were payable at age 50 17

18 Minimum DB Benefit Example Solomon (Sol) is a Police Officer in Redville His brother Mortimer (Mort) is a Firefighter Both were hired after the new benefit tier was installed 18

19 Sol s Data Sol was hired at age 25 in 1988 Pay at hire is $25,000 Assume 4% pay raises Assume he retires at age 50 in 2013 It is difficult to estimate the true minimum benefit because the PIA cannot be determined until the person is older 19

20 Minimum DB Benefit Using a reasonable technique to estimate the PIA, the minimum benefit would be $16,889 per year- probably most plan designs would use a safe harbor, and Redville did just that The safe harbor benefit would be $23,119 based on the 1.5% x 3 year average earnings formula But Sol needs to provide for his spouse, so he elects the 50% joint and survivor benefit, and his final pension after the reduction is $20,807/yr which is about $1,734 per month 20

21 What About the Next 33 Years? Sol s life expectancy is to age 83 His retirement savings are minimal He has paid to put three kids through college Since the plan does not provide a COLA, he decides he needs to get another job that is covered by Social Security. Then he will ultimately get both the pension and Social Security 21

22 The Next 33 Years Sol knows a little about how Social Security works. He knows that his average earnings for Social Security will be low, but that the benefit is weighted toward lower income. He figures he will be fine. So he gets a job paying $30,000 per year and works until he is

23 The Next 33 Years Lets figure out his Social Security benefit assuming: Sol gets 3% pay increases each year Social security values go up 2% per year after

24 Step 1: Figure His Total Indexed Social Security Earnings Age Year Wage Base Actual Indexed $113,700 $ 30,000 $ 36, ,974 30,900 36, ,293 31,827 37, ,659 32,782 37, ,072 33,765 38, ,533 34,778 38, ,044 35,821 38, ,605 36,896 39, ,217 38,003 39, ,881 39,143 39, ,599 40,317 40, ,371 41,527 41, Total $ 464, Example: $30,000 x 138,599/113,700=$36,

25 Now Get His Average Earnings Sol s favorite brother-in-law told him Social Security would be based on the average of the 5 best indexed years. So Sol thinks his average earnings will be $40, But his best friend said No, that s wrong, it will be the average of all the years, so it is $464,103.49/12=$38, Who is right, the brother-in-law or the friend? 25

26 The Answer is Neither The Average earnings is based on the 35 highest years. At this point, no one except Sol thinks adding in a bunch of zero s is a problem (i.e., Social Security covered earnings were $0 during the years when he was serving as a Police Officer) The answer is $464,103.49/35=$13,260!!!!!! That figure is then divided by 12 to produce his Average Indexed Monthly Earnings or AIME which is $1,

27 Now Lets get Sol s Social Security Benefit Sol checked on the Social Security website late in 2024 and found that the bend points in 2025 are $1,003 and $6,047. Based upon his brother-in-law s explanation, Sol figures he will get 90% of the first $1,003 of his AIME and 32% of the excess. Relieved, he thinks that he will get 90% x $1, %x($1,105-$1,003)=$ (after rounding). 27

28 Wrong Again Poor Guy His PIA actually becomes 40%x$1,003+32%x($1,105-$1,003)=$ after rounding This is due to the Windfall Elimination Provision WEP The WEP lowers the 90% in the calculation to 40% for people with less than 20 years of substantial earnings Now Sol expects 80% of that amount or $347 per month since he is retiring at 62 28

29 Wrong Yet Again Since Sol was born in 1958, his normal retirement age is 66 years and 8 months. He is retiring 56 months early. The early retirement reduction is 5/9 of 1% for the first 36 months and 5/12 thereafter. His actual reduction is %, so his Social Security benefit is $433.80x( )=$ per month (after rounding). 29

30 Where Does This Leave the Poor Guy? Since his original pension at time of retirement was not cola d, the $20,807 of purchasing power he started with has declined to $16,406 per year in the 12 years since he retired (based upon 2% annual inflation). If we add his $310.89/month Social Security benefit, his purchasing power at age 62 becomes $20,135 compared with $20,807 at original retirement. 30

31 He Will Live Longer with Less In spite of all of his planning, (and his brotherin-law s advice), Sol is slightly worse off than when he retired. Since his pension is not cola d, his purchasing power will continue to erode. Unfortunately, he did not die during the last 12 years, so his life expectancy is now to age 85 (two years longer than when he retired from Redville). 31

32 Sol s Brother Mort He (thought he) was wiser. He married a person who worked in a Social Security covered position. Mort knew about the WEP, and even the early retirement reduction. He thought he would just sit back and draw a spouse benefit equal to half his spouse s PIA, and avoid this mess. 32

33 He Wasn t Wise Enough The spouse benefit also gets reduced for early retirement of the spouse, and Mort did not know that. So he did not get half the PIA. He got a reduction similar to but larger than Mort s. Then Mort found out about the Government Pension Offset GPO the hard way, when his wife retired. The GPO ends up taking away 2/3rds of the pension for most people in Mort s situation. 33

34 What About a Replacement DC Plan Suppose Jacob Marley had set up a replacement DC plan in Redville with a 7.5% contribution. Based on Mort s earnings, if the account had earned 6% per year, it would have contained just over $157,000 when he turned

35 The DC Benefit Sol might be able to annuitize the lump sum to about $850 per month. Recall that the 1.5% DB benefit was $1,734 per month. So if Sol matched the 7.5% employer contribution, he could get back to the DB benefit. 35

36 The DC Benefit That is not really surprising (but to tell the truth, the way the numbers worked out was mostly coincidence). The minimum DB benefit is modeling the entire Social Security benefit. The minimum DC benefit is only modeling the employer contribution. 36

37 Conclusions Even if you are not covered by Social Security it is worth understanding how it works. Social Security is complicated. There are some real surprises, especially for people in non-covered employment. Don t put a lot of stock in what brothers-in-law or friends tell you. 37

38 Conclusions Both Sol and Mort might have planned things differently if they had known these things. But now you do! 38

39 Retirement Think Carefully, Choose Wisely 39

40 Disclaimers Circular 230 Notice: Pursuant to regulations issued by the IRS, to the extent this presentation concerns tax matters, it is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) marketing or recommending to another party any tax-related matter addressed within. Each taxpayer should seek advice based on the individual s circumstances from an independent tax advisor. This presentation shall not be construed to provide tax advice, legal advice or investment advice. Readers are cautioned to examine original source materials and to consult with subject matter experts before making decisions related to the subject matter of this presentation. This presentation expresses the views of the authors and does not necessarily express the views of Gabriel, Roeder, Smith & Company. 40