Early Retirement Benefits: A Lose/Lose Situation

Early Retirement Benefits: A Lose/Lose Situation

It seems very likely that the National Commission on Fiscal Responsibility and Reform is going to recommend an increase in the age to qualify for full Social Security benefits. Already, the AARP and liberal groups are pushing back, labeling any retirement age increase as a de facto benefit cut. In fact, the true retirement age for most Americans these days is actually 62, which severely limits the potential for achieving budgetary savings by raising the “normal” retirement age.

There is still some mystery as to where the original age of 65 came from in the first place as an appropriate age to cease work. According to the Social Security Administration, half of state pension plans in the 1930s set 70 as the retirement age. This was quite a high age at the time, given that life expectancy at birth in 1935 was just 59.9 years for men and 63.9 years for women. In short, a goodly number of people would never live even to 65, let alone 70, in those days.

Of course, by the time one reaches age 65 one has already outlived many of those born the same year. In 1940, only 53.9 percent of men and 60.6 percent of women who lived to age 21 had survived to age 65. The important question, therefore, is how many years did one likely have left at that point? According to the Social Security Administration, a man turning 65 in 1940 was expected to live another 12.7 years and a woman would have 14.7 years left.

In the years since, there has been a substantial increase in longevity. According to the Centers for Disease Control and Prevention, a male born in 2006 could expect to live to age 75.1 and a female to age 80.2, about a 15-year increase since Social Security was established. A man turning 65 in 2006 was expected to have an additional 17 years of life and a woman had 19.7 years, an increase of about five years since 1940.

Assuming that the purpose of Social Security is to give people roughly the same number of years in retirement, it would seem reasonable to raise the age to qualify for benefits by the increase in longevity. This would suggest a normal retirement age of 70 today. And given projections of increasing longevity in the future, we would have to continue raising the retirement age by about one month per year forever, according to Stanford economist John Shoven.

The Creation of ‘Early Retirement’
But Congress made an important change to Social Security in 1961 by lowering the minimum age at which one can begin to draw benefits to age 62. This action appears to have been motivated more by a desire to help unemployed older workers than a desire to fundamentally change the nature of retirement. Nevertheless, that is what happened.

In 1955, only about 30 percent of men began drawing Social Security benefits at age 65; about the same percentage waited until age 70 or later. The average age at which men began drawing benefits was 68.4.

However, once early retirement became possible, more and more workers have taken advantage of it. In 2008, the average age at which men began drawing Social Security benefits was just 63.6. Some 58 percent of men retired before age 65 and less than 4 percent waited until age 66 or later.

This trend is a bit puzzling for two reasons. First, in 1983 Congress raised the normal retirement age to 67 for those born in 1960 or later. The increase was phased-in for those born between 1938 and 1960. Second, those retiring before the normal retirement age pay a substantial penalty in terms of lower monthly benefits. As the table below demonstrates, those retiring at 62 this year will get 25 percent less per month than those who wait until 66, the normal retirement age for that birth cohort.

Social Security Retirement Benefits By Year of Birth
Compared to monthly benefits at the full retirement age
Year of BirthFull Retirement Age% Reduction in Benefits at Age 62*
1937 & earlier6520.00
193865 & 2 months20.83
193965 & 4 months21.67
194065 & 6 months22.50
194165 & 8 months23.33
194265 & 10 months24.17
195566 & 2 months25.83
195666 & 4 months26.67
195766 & 6 months27.50
195866 & 8 months28.33
195966 & 10 months29.17
1960 & later6730.00
*Compared to monthly benefits at full retirement age
Source: Social Security Administration

At least theoretically, it doesn’t make any difference to Social Security’s finances when one begins drawing benefits. The difference in benefit levels is actuarially calculated so that the average retiree gets the same aggregate lifetime benefits whether one retires at 62, the normal retirement age or later. Indeed, one’s benefits continue to rise the longer one delays retirement past the normal retirement age until age 70.

Something called the delayed retirement credit raises monthly benefits by 8 percent per year that one delays drawing Social Security benefits. Someone born between 1943 and 1954, a typical baby boomer, will get 32 percent more per month by waiting until age 70 to begin drawing benefits than they would get at the normal retirement age of 66, which are 25 percent larger than that person would get at age 62. Thus someone in this birth cohort would get almost 60 percent more per month at age 70 than at age 62.

The Drawbacks of Early Retirement
The big problem is that many people have a use-it-or-lose-it attitude and may not be aware that they will suffer lower lifetime Social Security benefits by retiring early. Those that end up living longer than they expect may end up in poverty late in life as a consequence.

Another problem is that those taking Social Security benefits before the normal retirement age are subject to an earnings penalty that reduces their benefits by $1 for every $2 of earned income above $14,160—less than someone would make working full-time at the minimum wage. (The test does not apply to pensions or income from saving; only wages.)

The earnings penalty originally applied to all those drawing Social Security retirement benefits regardless of age. The purpose was to keep retirees out of the labor force so as to create job openings for younger workers. In 2000, it was abolished for those above the normal retirement age, but retained for those taking early retirement.

Thus early retirement encourages many workers to leave the labor force well before it may be in their best interest to do so. And if they try to re-enter the labor force, they are severely penalized for taking a full time job paying as little as the minimum wage.

There is, however, a loophole that few retirees are probably aware of. Social Security will allow beneficiaries to pay back all their benefits without interest and in effect reset their benefit level. Since, as noted earlier, benefit levels are substantially greater the higher one’s age, an early retiree with the cash to spare may be able to buy a much higher Social Security benefit at a later date. (Here’s the form.)

Of course, it’s doubtful that very many of those who took early retirement can afford to cough up tens of thousands of dollars to take advantage of this loophole, since in many cases the decision to take benefits early was the result of a job loss and dismal prospects for finding a new one. Nevertheless, it is an option that people should be aware of.

In a recent article, Urban Institute economist Eugene Steuerle says that the impact of instituting early retirement in 1961 was to change the nature of retirement itself. It sent a powerful signal to workers about the appropriate age to withdraw from the labor force. And it’s bad for both workers and the economy. Early retirement reduces economic output and lifetime incomes, and causes workers to build up less retirement saving, to draw down what they have faster and pay less into the Social Security system by spending fewer years working.

Ultimately, whatever changes are made to Social Security must grapple not only with the system’s finances, but also the changing nature of work and retirement. Consequently, it may make more sense to concentrate on raising the early retirement age than the normal retirement age. Even if the benefit formula was restructured to give people the same lifetime benefits they get today, encouraging workers to stay in the labor force longer will benefit both them, by reducing the number of years they will depend on retirement savings and giving them more time to build up those savings, and Social Security by having people pay more taxes into the system over their lifetime.