As peculiar as such a statement may appear at first glance it is a question that I hear repeatedly from my clients when I do their social security income maximization planning. In order to do any type of retirement income planning you have to make a number of assumptions including expected rates of return on investments, cost of living adjustments (COLA), withdrawal rates, anticipated tax rates and of course life expectancy. How long do you and your spouse expect to live?
As it turns out, most American's "underestimate" how long they expect to live. In fact, four in ten underestimate their life expectancy by more than five years. Based on current mortality statistics, if a man reaches age 65 he can expect, on average, to live to approximately age 87. If a woman reaches age 65 she can expect to live, on average, to approximately age 89.
Clearly, your individual life expectancy is affected by your personal health, family history, lifestyle and numerous other factors. The implications of life expectancy on retirement planning, however, are significant. Mortality risk in retirement is not the risk of dying young and not being able to enjoy your money but rather the risk of living too long and outliving your money.
With respect to social security retirement income planning, faulty life expectancy assumptions can have a significant affect on deciding what would be the best age to file for social security benefits. By filing too early, you may significantly reduce your eligible social security income in retirement. For example, simply by deferring the start of your social security benefits from age 66 to age 70 you can receive a guaranteed increase in your social security income by 32% plus COLA, which has historically added an additional 2.5% per year to social security income. The compounded effect of COLA adjustments significantly increases your annual and cumulative benefits in retirement.
The effects of underestimating life expectancy, however, can be potentially devastating to your retirement plan. Most social security recipients who filed early say they regret that they did. Unfortunately, once you file, very few options are available to improve your benefits.
Most people approach retirement longing for the day that they can walk away from work for good and start enjoying life. However, when you stop working, not only does your paycheck stop but the likelihood of re-entering the workforce later on, in any meaningful financial way, becomes extremely difficult as well.
Many retirees regret retiring from work to early. They realize later on that a couple of extra years of work not only allows for additional savings it also shortens the number of years needed to finance retirement. It also allows you to defer the start of your social security benefits and therefore provides for a permanently higher lifetime benefit.
When reviewing your retirement assets and their ability to protect you against the risk of living too long, there are some fundamental risks inherent in these assets which are not shared by social security. For example, if you had a substantial balance in your 401(k) account, and it was invested in a diversified portfolio of stocks and bonds, you have to make a number of assumptions regarding that portfolio's performance over the life of that investment. Looking at historical average rates of return is not enough to identify the likelihood that these assets will last a lifetime.
For example, one factor that must be considered is "sequence of return risk". Simply put, if you start your retirement in a period when the stock market experiences a sharp decline then you run a much greater risk of outliving your money. Say you retired in 2008 and your account value fell by 50%. To bring your account value back to it's original value you would have to have a 100% increase in your account. That's because your account is now worth half of what it was. Furthermore, you are now retired and drawing down monthly on this account value in order to provide income in retirement. That will put added pressure on the ability for your portfolio to recover.
This however highlights yet another advantage that social security provides that many other retirement assets do not. Social security is a pension plan that's guaranteed to pay you for as long as you live, insulated from the risks of the stock market. In addition, the COLA adjustments built into the program help provide for protection against inflation in retirement.
As such, it may be prudent to consider drawing down on other retirement investments in order to delay the start of social security thereby increasing this guaranteed lifetime income check. Social security may provide one of the strongest hedges against longevity risk when compared to your other retirement assets. Certainly you should consult with your financial advisor regarding other investments such as SPIA's (single premium immediate annuities) and other annuities which may also provide guaranteed lifetime income.
The many risks that individuals face in retirement (market risk, inflation, health issues, interest rates etc.) are all magnified by longevity risk. As modern medicine continues to improve at an increasing rate, the likelihood is that life expectancy will also continue to increase. With that, we have to be even more diligent in managing and structuring our retirement assets to meet the financial challenges of living a long life. A properly designed social security income maximization plan can provide a strong foundation on which to build your overall retirement.
Ash Ahluwalia, NSSA, CCSCA, MBA