In many ways, Social Security is just like any other asset you hold in your retirement nest egg. Yes, it's a key asset -- one that promises a lifetime, inflation-adjusted payout to everyone who vests into the system, based on their age, salary, and years of contributions. But, as with any holding, you need to consider what role it plays in your savings plan.
The first step is to calculate how much it will be worth when you need to begin tapping into it. One way to do that is to estimate what the equivalent lump-sum value of your Social Security payment would be.
Once you have that figure, you can more accurately estimate how much you need to save to cover the gap between how much Social Security will pay you and how much you'll need in total to cover your lifestyle.
The 4% Withdrawal Rule
One of the easiest ways to estimate the lump-sum value of your Social Security check is to use what's known as the 4% rule.
Social Security conveniently pays every month a consistent amount that increases by the rate of inflation and has the potential to last the rest of your life. Using the 4% rule you can:
- Take 4% of the value of a well-diversified portfolio during your first year of retirement.
- Increase that take by the rate of inflation every year.
- Have a very good chance of seeing your money last as long as you do.
So, for example, if you're expecting $1,000 a month from Social Security, that would work out to $12,000 a year. Dividing that $12,000 by 4% gives you a lump-sum value of $300,000.
If you anticipate needing $50,000 worth of annual income during retirement, that same 4% rule works out to a lump sum of $1,250,000. Subtract out the $300,000 estimated value of that Social Security benefit, and it means you'd need to save an additional $950,000 on your own to cover your retirement lifestyle.
So all you need to do is make sure you've got $950,000 on hand by the time you're Social Security eligible, and then call it a career. Easy as pie, right?
Don't Panic: Five Tips for Supplementing Your Social Security
Of course, in reality, those numbers are moving targets. Your Social Security benefits depend on your earnings record and your age when you start taking them. Your investment account balance can vary daily, depending on mood swings in the stock and bond markets. Even the currency market can throw you for a loop if you own international stocks or American stocks with significant overseas operations.
As this week's market plunge so brutally reminded us, stock returns are certainly not guaranteed. Yet since Social Security will cover only a small portion of what you'll likely need to retire, you're left with little choice but to invest. Here are some options to help mitigate the risk:
1. Over-save for your target. Over the long haul, the S&P 500 index has returned an average of around 8.9% annualized. If you invested in an index tracker like SPDRs (SPY) to accumulate your nest egg, one additional "average" year (though there are no guarantees) would take you from $950,000 to $1,034,550. Waiting until as late as age 70 to collect Social Security will also increase that payment.
2. Directly protect yourself against inflation. Treasury Inflation-Protected Securities are government bonds that rise in value in response to inflation. An investment in iShares Barclays TIPS Bond Fund (TIP) should help preserve your purchasing power.
3. Look beyond Treasuries for bond income. General Electric (GE) and Wells Fargo (WFC) each have AA- or better rated bonds with yields to maturity above 5%. That's a good combination of financial strength on their part and protecting your current income, though if rates rise, the bonds can still lose value.
4. Consider growing dividends for additional income and inflation protection. Diebold (DBD) has increased its dividend every year for the past 58 years, Emerson Electric (EMR) for 54, and 3M (MMM) for 53. While there's no guarantee those trends will continue, that's a heck of a set of track records.
5. Prioritize your spending and know where you'd cut back if you had to. If your house is paid for, your kids living independently, and your health insurance subsidized by Medicare, do you really need that full $50,000 to cover your basic costs of living? With an advance plan for what you'd be willing to live without, such choices become easier.
Balance Your Risks and Build Your Plan
Ultimately, there's no such thing as a risk-free retirement plan. But by considering your total financial picture, you can build a plan that balances the risks and potential rewards to improve your chances of retiring successfully. Using the 4% rule to figure out what that Social Security check is worth as part of that plan can help you see the total picture much more clearly.
At the time of publication, Motley Fool contributor Chuck Saletta owned shares of General Electric. The Fool owns shares of and has created a ratio put spread position on Wells Fargo. Motley Fool newsletter services have recommended buying shares of 3M and Emerson Electric.