Most Americans give little thought regarding when and how to file for social security benefits and the negative impact it could have on their lifetime retirement benefits. Making the wrong filing election could cost tens of thousands or even hundreds of thousands of dollars in missed but eligible benefits.
There are a number of reasons for the lack of social security income planning starting with the sheer complexity of the program. With over 2700 rules governing social security, a typical couple has over 567 possible filing options. How are they supposed to determine which would be their best filing option?
Another, perhaps more common reason for electing a sub-optimal filing strategy is that many people have pre-conceived ideas regarding the best time file. Often, these notions are not based any detailed analysis of benefit options but rather are determined through discussions with various family members, friends, colleagues at work or other sources who are not qualified experts in social security planning.
So what's the big deal anyway. Does it really matter when you file? Well, if maximizing your lifetime social security retirement income is important to you then yes it sure does matter.
For example, assume a couple had both earned income at the maximum social security wage base level throughout their 35 years of employment. If they had applied for benefits at age 62 then their expected lifetime benefits would be about $1.2 million. If instead they had delayed filing until age 70 (and also used some little known enhanced filing strategies) their lifetime benefits would be approximately $1.6 million. That's an additional $400,000 in lifetime benefits!
But what if you have already filed for your benefits? Do you have any options to change your filing election? Generally speaking, the answer is no. Your filing election is all but permanent. However, here are a couple of possible remedies.
One strategy is called "The Do-Over". If less than 12 months have passed since you filed, you are allowed to pay back all the social security benefits that you received to date and social security will undo your election as if you had never filed. If other auxiliary beneficiaries (eg. spousal or child beneficiaries) also received benefits as a result of your filing, then they too must pay back any benefits received. Note, you are only permitted one "Do-Over" but it may allow you to change to a new filing strategy that will provide you with thousands of dollars of additional benefits in retirement.
But what if 12 months has already passed since you filed for benefits, do you have any other options? There may be one other possible option for you to consider. If you, for example, filed at age 62 (taking a 25% reduction in benefits as compared with to your age 66 benefit) then, once you reach full retirement age (66 for most filers) you are eligible to "suspend" your benefits. If you suspended payments from age 66 to 70, your benefit amount will increase by 8% per year (guaranteed!) plus any cost of living adjustments declared by social security. That means your benefit amount could increase by 32% plus cost of living adjustments by your age 70. It's important to note, however, that you are not allowed to suspend benefits prior to full retirement age.
Given the limited options available to filers to change their filing options once they have made them, it is critical that they review as many possible filing options "before" locking themselves into one. One's haste to start collecting social security benefits may result in the permanent loss of thousands of dollars in eligible benefits.
The decision you make on when to file for social security benefits may be the most important financial decision you make regarding retirement. In addition, your filing election is permanent. Should you take your benefits early (the earliest being age 62) or late (up to age 70)? What analysis or methodology should you use in analyzing your decision?
Many people race in to take their benefits early without doing any analysis at all but rather for emotional reasons. They feel that "I've paid into this @#$%& system for my entire working life and now I want my money!". What if I die young and never get my money back?
My response to that thinking is twofold. One, it will on average take a person only about 5-6 years to recoup all the money that they have paid in social security taxes over their lifetime. After that, it's all "free money" from the government. Secondly, if you happen to die young before you can recoup your money then, from a financial planning perspective, "all is good". More specifically, you avoided what we consider to be the real risk in retirement which is "the risk of outliving your money" as opposed to the "risk of dying with money".
Another popular method used in analyzing when to take social security benefits is a "break-even analysis". In simple terms, you would try to determine how long it would take you to recoup monies that you could have received early in exchange for taking a larger payout later. Without going into a detailed analysis here, what I have found is that a typical break-even age range is approximately ages 78-80. By that age you will have recouped all the money that you could have obtained by electing benefits early. So, if you think you are likely to live past ages 78-80 then you will get more money by deferring the start of benefits versus filing early.
Finally, some people try to analyze their filing decision by considering how much more money they would get if they took their benefits early and invested that money in the stock market. There are a number of flaws with this analysis the least of which is determining a reasonable rate of return (adjusted for inflation) on your investments.
Ultimately I think all of the various analytical tools we have discussed so far are fundamentally flawed as tools in analyzing when to start taking social security benefits. The reason is that we should not be viewing social security as an "investment" but rather as "insurance". The insurance you get from social security covers the risk of "living too long and outliving your money". This is known as "longevity risk". This risk is real and a growing concern for most retirees.
Virtually all insurance (homeowners, car insurance, term life insurance) are bad "investments" in the sense that you are not statistically likely to recoup the years of premiums that you paid into these policies because the likelihood of you filing for a claim is very small. On the other, you would not go without homeowners insurance, for instance, because if your house burned to the ground that could be a financially catastrophic event. Similarly, I would suggest that the risk of outliving your money would also be a financially catastrophic event that you would want to insure against.
Social security not only provides "longevity insurance", this "policy" also comes with a myriad of "policy riders" including inflation protection, creditor protection (Federally guaranteed), spousal protection, survivor protection, divorce protection, child care and child-in-care protection, disability protection and more...and it's cheap! Where else could you go to obtain such a policy? How much would a policy with all those features and benefits cost you? Could you even find such a policy?
Social Security: A good "investment"? I think so. An outstanding "insurance policy"? Definitely!
When it comes to trying to figure out the best way to file for social security benefits, without leaving money on the table, even brilliant economists, financial experts and seasoned financial journalists need help too. As pointed out in a New York TImes (NYT) article on March 13, 2015 entitled, "The Social Security Maze and Other U.S. Mysteries", the social security system is enormously complex and difficult to figure out, even for so called "smart people".
In this NYT article, Larry Kotlikoff (a Boston University Economist) describes how he made a game of approaching smart people whom he knows and convincing them that they were leaving tens of thousands of Social Security dollars on the table.These friends included an M.I.T. economist as well as a veteran writer and retirement expert.
In these two cases, Mr. Kotlikoff was able to show them, through the use of relatively simple but little known social security filing strategies, that one was eligible to receive an additional $50,000 and the other an additional $100,000 in benefits. They were both shocked and amazed that such rules existed to provide these additional benefits.
And there in lies the problem. Like most government programs, the level of complexity in the social security systems is so substantial that you need specialized knowledge in order to figure out how to maximize your benefits. There are 2,728 rules that govern social security and the typical couple has over 567 possible filing strategies.
Mr. Kotlikoff and two of his colleagues felt compelled to write a new book, as mentioned in the NYT article, to assist people in trying to sort their way through this maze of social security rules and regulations. I have read the book and it is very good but, like Larry, I felt that there is something fundamentally wrong with a system that requires us to seek specialized assistance just to obtain the benefits that we have earned and are entitled to receiving. Books and software are useful, if not necessary, but for many the likelihood that you will obtain your maximum social security benefits may end up to be, as Mr. Kotlikoff put it, "...simply based on their (perhaps random) access to those who have a deep understanding of the rules".
Like Mr. Kotlikoff, we at NSSP started our firm to meet the growing demand by baby boomers to understand their options regarding social security benefits. We look to identify filing strategies that provide our clients with maximum benefits as well as customized strategies that integrate their social security benefits into their overall retirement plan in a tax efficient way.
We also saw the value in working with our client's CPA, attorneys, wealth managers, insurance professionals and the other professional advisors so that we are all on the same page and coordinating our advice to develop an overall retirement plan for the client.
For the vast majority of Americans, social security is their largest (and often only) retirement asset. Your decision on when and how to file for benefits may be your most important retirement decision. As Mr. Kotlikoff has clearly pointed out, even "smart people" need advice when it comes to social security due it's enormous complexity.
As millions of baby boomers approach retirement the need for them to obtain a better understanding of their social security benefits and how to optimize them becomes increasingly important, if not critical. For most Americans, social security is their only pension plan and typically represents about 30-60% of their income in retirement.
So how are social security retirement benefits calculated? An individual's benefits are based on their highest 35 years of averaged indexed monthly earnings (AIME). You also need a minimum of 40 quarters (10 years) of earned income in order to qualify for any benefits. So, for example, if you have only 8 years of earned income and then stopped working in order to stay home with the kids, it may prove valuable to obtain 2 more years (8 quarters) of earned income as soon as possible. Even part-time work would suffice as you only need to earn $1,220 in a quarter for you to earn a qualifying quarter of social security earnings.
Please note however that if you, for example, had 10 years of earned income then social security would include a zero value for the remaining 25 years when calculating your highest 35 years of averaged indexed monthly earnings. Therefore, any opportunity you have to replace a zero income year with some earned income will result in an increase to your social security benefit.
In fact, if you have already started to receive social security benefits, but continue to work, each of those additional working years will also be eligible to be included in the calculation of your AIME. Therefore you have an opportunity to possibly increase your social security benefits even after you have started to take benefits!
The age at which you elect to take your benefits also has a significant impact on the benefits you receive. If you were born between 1943-1954, your "full retirement age (FRA)" would be age 66. If you chose to take your benefits at age 62 (your earliest eligible filing age) you would receive 25% less than your FRA benefit amount. If you instead elected to take benefits at ages 63, 64 or 65 you would receive 80%, 86.7% and 93.3% of your FRA benefit amount respectively. It's important to note, however, that these are permanent lifetime reductions in benefits when you decide to take your benefits early.
In contrast, if you delay in taking benefits, you can increase your benefits substantially. For each year after FRA, your benefits will increase by a guaranteed 8% per year plus any cost of living increases (COLA). Therefore, for example, if you defer taking your benefits until age 70 your benefits will increase by 32% guaranteed plus any COLA. This is a permanent increase in your lifetime benefits. Furthermore, all future COLA will be based on your now higher benefit base.
The impact of COLA should not be understated. For example, if your monthly benefit amount at FRA is say $2,000 and COLA averages 2.8% (the historical social security COLA) then your benefit amount will increase to $2,636 in 10 years, $$3,474 in 20 years and $4,580 in 30 years. On a cumulative basis this translates to total benefits of $304,246 in 10 years, $673,622 in 20 years and $1,160,479 in 30 years. It is also important to note that these totals represent values for one spouse only!
Clearly, there are a number of opportunities that individuals have to potentially increase their social security benefits. Understanding how your benefits are calculated and managing your earned income accordingly can help you to maximize your eligible benefits.
As millions of baby boomers approach retirement a nagging question persists. Can we count on social security being there when we retire? This is a critical question for the majority of retirees as social security often represents 30-60 of a middle class couples retirement income and 90-100% for lower income families.
In addition, with 90% of pension plans being shut down and replaced by 401K's and IRA's, social security is the only "pension plan" that the vast majority of retirees have.
It's important to note that 401K's and IRA's are not true retirement plans. They should be more accurately characterized as "tax advantaged savings plans". You could outlive your 401K or IRA but you can't outlive social security. It is guaranteed by the federal government to pay for as long as you live. It also offers annual cost of living adjustments (although not guaranteed), spousal benefits, survivor benefits, divorced spouse benefits, children's benefits etc. which are unique benefits when compared to most pension plans.
The question remains, however, will social security be there when I retire. Contrary to the gloom and doom pervasive in the general media, social security is highly likely to survive, especially for individuals who are currently age 55 or older.
The social security trust fund is currently valued at over $2.7 trillion dollars and it is still growing. If no changes are made to the social security program, by 2021 the trust fund is expected to peak at $3.1 trillion. Then, as the giant waive of baby boomers course through the system, the social security trust fund is expected to be depleted by 2033. At that time, tax revenues will still allow social security to pay out 77% of it's obligations.
The reality is, however, that changes will need to be made to ensure the survival of the system. It's not a matter of "can" the system be saved but rather "how" should it be saved. The solution is a political one not an economic one.
For example, estimates have shown that increasing the social wage base from $118,500 to say $130,000 or deferring full retirement age to ages 68 or 69 for people in their 30's and 40's could extend the viability of the fund past 2080! There are numerous options available as we speak but, once again, a political solution is not easy to come by.
It appears however, based on the rhetoric from the previous federal election, that both parties held a position of not making any changes to benefits if you were over age 55. Too many voters, especially in swing states like Florida.
Will changes be made to the system? Yes, it is highly likely that some changes will be made, after all it's a government program. The impact of any changes for those currently age 55 and older will likely be minimal, so include social security in your retirement planning and feel confident that this substantial government pension plan will be there for you.
Ash Ahluwalia, NSSA, CCSCA, MBA