Early retirement and social security

Suppose you retire early. How much does this reduce your eventual social security benefit? Generally not as much as you might expect if you were well paid. This is because social security is front loaded, in other words you tend to earn a disproportionate share of your benefit in your first years of work. Traditional private pension plans are often back loaded.

Social security benefits are based on your average monthly earnings (from jobs that paid into social security) over your 35 highest earning years prior to age 62. When computing your average monthly earnings, your earnings are scaled to account for inflation. So for example if you were born in 1947 (so you would be 62 in 2009) your earnings in 2008 are multiplied by 1.00 but earnings from 2000 are multiplied by 1.26, earnings from 1990 are multiplied by 1.92, earnings from 1980 are multiplied by 3.23 etc.

Your average monthly earnings are then converted to a monthly social security benefit via a formula that gives greater weight to the first dollars earned (thereby favoring low income workers). So for example if you were born in 1947 your benefit will be 90% of your average monthly earnings up to $744 plus 32% of any additional average monthly earnings up $4483 plus 15% of any average monthly earnings exceeding $4483. The formula for other dates of birth will have different break points but the same general nature, your first dollars earned will count for 6 times as much in figuring your benefit as the last dollars earned (assuming you earn enough to get your average earnings above the second break point).

So in my case I can make the following rough estimates. I currently have 26 years of maximum earnings. If I hadn't been laid off I could have expected another 6 prior to age 62 (I started working too late to get in the 35 years of maximum earnings required to get the maximum benefit). So my current average monthly earnings are about 26*102000/(35*12) = 6314 (note 102000 is the 2008 earnings limit) which corresponds to a monthly benefit of .90*744+.32*3739+.15*1831 = 2140.73. Another 6 years of maximum earnings would increase my average monthly earnings by 6*102000/(35*12) = 1457 and my monthly benefit by .15*1457 = 218.55. Hence increasing my average monthly earnings by 23% by working another 6 years would only increase my benefit by about 10%. This is a very rough estimate (for example each year of maximum earnings does not actually contribute exactly the same amount to your average monthly earnings) but illustrates the point.

Note the combined social security tax rate is 12.4% so each additional year of maximum earnings represents $12648 of additional tax paid into the system. Over 6 years this is about $75000 for an added monthly benefit of $218 not a terrific deal.

See here for more on how social security is calculated.

Added 1/12/2014:  The general point of this post, that social security is front loaded,  is correct but a detail is wrong.   Your 35 highest earning years which are used for computing your benefit can include years in which you are 62 (or older).  So by continuing to work I can increase my benefit by a bit more than indicated above.  See here for more.