Count Social Security in Your Retirement Portfolio

The average married couple can expect to receive about $20,000 a year in Social Security benefits.  Top earners now can expect to receive around $25, 000 a year, assuming they retire at their full retirement age, between 65 and 67.

If a top earner is married and his or her spouse receives a 50% spousal benefit, the couple’s total Social Security benefits would be just over $38,000 a year.  If the earner decides to postpone benefits, the total will be higher still:  One gets a greater monthly benefit for waiting, up until age 70.

Those Social Security benefits have two advantages:

Taxes.   Under current law, no more than 85% of benefits will be taxed.  The range can be from zero up to 85% of the Social Security benefits being subject to taxation, depending on other income.  Suppose, for example, that you and your spouse have an income that’s well into six figures and you receive $38,000 per year from Social Security.  Of  that $38,000, no more than $32,000 (85% of $38,000) will be included in your taxable income.

Inflation adjustments.  Each year, monthly benefits are indexed to inflation.  Benefits for 2007, for example, are 3.3% higher than they were in 2006.  At that rate, the monthly benefit would just about double in 22 years.

Part of the picture.  For many people, receiving between $20,000 and $40,000 per year in Social Security benefits won’t provide their desired retirement lifestyle, even with the tax benefits and inflation adjustment described above.

Therefore, one should invest for one’s own retirement and not rely solely on Social Security.  At the same time, though, the process of structuring a retirement portfolio should not ignore future Social Security benefits

Take the hypothetical case of Harry and Janet Black, both aged 60.  Their financial adviser suggests that they split their investment portfolio 50-50, between stocks (for growth and inflation protection) and bonds (for current income and stability).

Further assume that Harry and Janet’s Social Security checks, when they begin to arrive in a few years, will be above average but not at the maximum levels.  Assume they can expect to receive around 30,000 per year in combined Social Security retirement benefits.

That’s the equivalent of owning a $540,000 bond portfolio:  as of this writing, investment-grade corporate bonds pay around 5.5% interest.  If you owned $540,000 worth of such bonds, yielding 5.5%, you’d receive around $30,000 in annual interest, which is what our hypothetical couple will get from Social Security.

As mentioned, $30,000 per year from Social Security beats a $540,000 bond portfolio because your retirement benefits rise every year.  With a bond portfolio, interest payments are fixed until the bonds are redeemed.  When new bonds are bought, your new interest rates might be higher or lower. 

Balancing act.  Nevertheless, many investment plans for retirement do ignore Social Security benefits, which provide a stream of steadily rising income.  As a result, such plans may be overweighed in bonds and underweighted in stocks, a formula likely to deliver underperforming investment returns over the long term.

Going back to Harry and Janet Black, you can see the impact.  Their financial adviser estimates that their total portfolio, investments, inside and outside of tax-deferred  retirement accounts, will be around $1.2 million.

Based on the advisor’s recommendations, Harry and Janet are aiming to hold 50% in bonds and 50% in stocks.  Such a portfolio might look like this:

Thus, they would have $45,000 in retirement income from their portfolio,

pretax.  In addition, $600,000 of their assets would be in stocks, likely to grow.

However, that’s not really an accurate view of their portfolio.  As mentioned, they expect to receive $30,000 per year in Social Security benefits when they retire in  six years.  Counting those benefits, their retirement portfolio will look like this:

By looking at their finances from this perspective, their total portfolio tops $1.7 million, of which only about 35% is invested in stocks.  Because Harry or Janet (or both) could live another 40 years, they might need more growth potential – more stocks – than they have in their current portfolio.

For example, they might restructure their holdings in this manner:

With this portfolio, their retirement income drops by $8,750 because they switched $250,000 from bonds to stocks.  However, the after-tax difference will not be the full $8,750 because they’ll be receiving less fully taxed bond interest and more dividend income, which is lightly taxed under current law.  What’s more, nearly half of their income will be coming from Social Security, which probably will increase each year.

In this revised allocation, Harry and Janet have added $250,000 to their equity holdings.  Even if they use the dividend income for retirement spending, the stocks or stock funds may increase in value over the long term.

Their dividend income can grow, too, if the companies boost their payouts.   In addition, Harry and Janet may be able to cash in some stock market gains to supplement their income.  Thanks to Social Security benefits, Harry and Janet can plan on having enough cash flow to allow them to tie up more money in lower-yielding stocks that increase their chances of realizing long-term gains