You can stop worrying about cuts in Social Security benefits after 2040 due to unfunded liabilities.

Why?

Something worse will happen before then. Medicare will start to cut into your retirement benefits the day you retire.

You can understand this by considering the fate of workers who retired at age 65 only five years ago. Retirees receive their basic monthly benefit, which is calculated at retirement. Before the check is mailed out, however, a monthly premium for Medicare Part B insurance is deducted.

In 2000 that premium was $45.50. Since then it has risen at an 11.4 percent compound rate, reaching $78.20 a month this year. During the same period the annual cost of living adjustment (COLA) for the basic benefit has been only 2.46 percent a year. As a consequence, the Medicare Part B premium is taking a bigger and bigger slice out of the basic benefit.

This is not a minor problem.

While the 2004 Trustees report estimated a 2006 monthly premium of $80, the 2005 report estimates $87.70, and more recent reports estimate an increase approaching 15 percent.

A low-income worker who retired in 2000, for instance, has seen his actual purchasing power (net of the insurance premium) shrink by nearly 4 percent in only five years. If major premium increases continue, a low-income worker/retiree will lose 15 percent of purchasing power in the next ten years and 26 percent in the next 20 years.

Without cutting benefits in nominal dollars, a low income worker who retires this year could lose about as much purchasing power over the next 15 years---26 percent--- as the Social Security Trustees are warning may occur in 37 years.

Medicare, the elephant in the government liability closet, is "crowding out" Social Security. The lower your Social Security benefit, the bigger the impact. Even workers at the highest benefit rate will suffer a significant loss of purchasing power if Medicare premium growth continues to leave COLAs in the dust.

The Social Security Trustees, for instance, regularly project the retirement benefits that four different income categories will receive--- low-income workers, average income workers, high-income workers, and highest income workers. The recently released report for 2005 shows that a typical worker who retires at 65 this year will receive $14,833 in annual benefits or $1,236 a month. This will replace 42.2 percent of her $2,929 pre-retirement earnings.

The $78.20 monthly Medicare Part B premium takes only 6.3 percent of the monthly benefit. If premium costs continue to rise at the 11.4 percent rate of the last 5 years, typical workers will lose 3 percent of their purchasing power in 5 years, 8 percent in 10 years, nearly 14 percent in 15 years, and 25 percent in 20 years.

Since the inception of Medicare in the late sixties, Medicare Part B premiums have risen at a compound annual rate of 8 percent. At that rate, typical worker retirees will still lose 10 percent of their purchasing power in 20 years. The table below shows the impact on four different income groups at two different premium growth rates, assuming annual COLA increases of 3 percent.

 
How Medicare Premiums Reduce Retiree Purchasing Power
These figures are based on growing the original retirement benefit at 3 percent a year while growing the Medicare Part B premium at 8 or 12 percent a year. The percentage figures in each yearly column represent the portion of original purchasing power that remains at the end of each period, assuming the retirees living expenses and the COLA adjustments rise at the same rate. The initials RR below refer to Replacement Rate.
… If Medicare Part B Premiums rise at 8 percent a year, net purchasing power will be:
Income Starting Monthly Benefit (RR%) 5 years 10 years 15 years 20 years
Low $  750.25  (56.9%) 96.9% 92.9% 89.0% 81.6%
Medium $1,236.08 (42.2%) 98.2% 95.9% 93.6% 89.3%
High $1,630.67 (35.3%) 98.7% 96.9% 95.3% 92.0%
Highest $1,877.08 (29.7%) 98.8% 97.4% 95.9% 93.1%
… If Medicare Part B Premiums rise at 12 percent a year, net purchasing power will be:
Income Starting Monthly Benefit (RR%) 5 years 10 years 15 years 20 years
Low $  750.25  (56.9%) 93.9% 84.7% 74.0% 49.5%
Medium $1,236.08 (42.2%) 96.5% 91.1% 84.9% 70.7%
High $1,630.67 (35.3%) 97.4% 93.4% 88.8% 78.1%
Highest $1,877.08 (29.7%) 97.7% 94.3% 90.3% 81.1%
Source: Social Security and Medicare Trustees, Scott Burns on-line calculator
 

What's the bottom line?

Social Security benefits may be nominally adjusted for inflation but retirees don't live on a "fixed income." They live on a declining income. Continue the premium growth of the last 5 years into the next 15 and low-income workers will have lost 26 percent of their purchasing power--- a disaster. The highest income workers will have lost 10 percent of their purchasing power---a major squeeze.

  Some 65 year olds, of course, won't live to experience this. But most will. Sixty percent of all men and nearly 74 percent of all women can expect to survive at least another 15 years from age 65.

  If you're 30 or 40 and think this doesn't apply to you, think again. Proposals to change from wage based growth of Social Security benefits before retirement to inflation based growth of Social Security benefits, if they become law, could have your entire Social Security benefit absorbed by your Medicare premium--- that's the power of compounding working against you.

  Want to explore how this may affect you and your retirement? Then check out my online Medicare Versus Social Security Calculator. It allows you to type in your Social Security benefit and pick a growth rate for the annual COLA and the annual Medicare premium increase. Then it calculates your monthly benefit, monthly premium, and adjusted purchasing power for each of the next 25 years.


Medicare Part B premium expected to rise at least 12 percent in 2006 

Table VI.F10 from the 2005 Social Security Trustees Report

History of the Social Security Cost of Living Adjustments

Expected 2006 Medicare Part B Premium

History of Medicare Part B Premiums  (on page 160 of the PDF file)