Understanding the importance of pension contributions

 

Earnings from tea expected to prevail in the first half of this year. Photo/FILE 

By SCOLA KAMAU Special Correspondent

By Christian Gaya Business Times March 8-15 2013

Social security benefits are an important part of most retirees’ income. Overall, it is important for workers to consider the effect of these choices on their retirement well-being, and ensure that consideration of social security benefit factors are part of the retirement planning process. There is need to examine the factors that affect a young person’s net social security benefit and the decision of when to begin benefits.

Healthy workers should work at least 35 years in covered employment in order to maximize the base benefit. However, any additional year beyond 15 years may attract 1.5 of the average monthly earnings a person’s Social Security benefits, particularly if an individual works less than full-time. When determining when to begin benefits, a worker should consider several threshold factors, including immediate income needs, the availability and size of other retirement assets, and the decision of whether to continue working.

If there is no immediate need for benefits, it is generally a poor decision to begin early benefit receipt while still working. The combined effects of the permanent early retirement reduction, the temporary earnings test reduction, the income tax on social security benefits, and the payroll tax on earnings can seriously erode net benefits received, even for workers with modest lifetime earnings.

Break-even life expectancy analysis suggests that people with lower than average life expectancies or high discount rates should begin benefits earlier. Individuals with greater than average life expectancies should defer benefit receipt until at least their full retirement age.

Retirement planning is a complicated process, fraught with uncertainties about how much money will be needed in retirement and the related issues of how much to contribute to retirement savings, how to invest retirement assets, and how to take distributions (draw down) from retirement assets. The consequence of making a poor decision increases the likelihood of inadequate retirement resources, resulting in either a lower standard of living in retirement or a need to delay retirement in order to accumulate additional assets. Fundamental to making sound decisions is understanding how the mixture of social security, employer pensions, Individual Retirement Arrangement assets, life insurance, after-tax stocks, bonds, and money market accounts, and housing wealth interact to determine available resources and potential retirement consumption.

Some of the key questions that young people workers may have as they near retirement are: When should I begin receiving social security benefits? What is the value of an additional year of work? Should I work and receive social security benefits? At a minimum, any analysis needs to consider the value of additional benefits over the retired life relative to additional taxes and foregone benefits during additional working years. Consider that each additional shilling of total covered earnings adds at most about 1.5 of the average monthly earnings (AIME). When applied to the progressive benefit formula, the marginal effect on PIA is as large as one-fifth of a penny and as small as one-twenty-fifth of a cent, but the tax effect is 10.6 cents per shilling. This trade-off provides a strong incentive to leave covered employment after 15 years.

There is need to examine the factors that affect a person’s net benefit and the decision of when to begin benefits. We demonstrated that healthy workers should work the maximum of 35 years in covered employment, but that additional years of work may not increase social security benefits. When determining when to begin benefits, a worker should consider several threshold factors, including need, other retirement assets, and the decision of whether to continue working while collecting benefits.

We demonstrate that in the case of no immediate need for benefits income, it is generally a poor decision to begin early benefit receipt while still working and receiving even moderate labor income. Using break even life expectancy analysis, we find that workers with lower than average life expectancies should begin benefits earlier, while those with greater average life expectancies should defer benefit receipt until at least full retirement age.

Pension contributions or social security benefits are an important component of almost everyone’s retirement security. Therefore Individuals should control a number of factors that affect their social security benefit. For the base benefit, a person has some control over the number of years in social security covered employment as well as the earnings used in calculating the base benefit. For adjustments to the base benefit, a person controls whether a permanent early retirement reduction or delayed retirement credit is applied, if benefits are temporarily reduced by the earnings test, and how other income impacts the net benefit through the income tax on social security benefits.