One of the most important and popular "sub-specialties" in financial planning is "Retirement Income Planning". As baby boomers approach retirement many are fearful of that nagging question, "do I have enough savings to ensure that I do not outlive my money in retirement?". Unfortunately, many financial planners are ill prepared to do a comprehensive retirement income plan for their clients because they lack in-depth knowledge of the 2,700 rules which govern social security and the many filing strategies available to maximize benefits.
For most retirees, social security will typically make up 30-60% of their income in retirement. Therefore it is critical that individuals seek expert advice on the optimal filing strategy to maximize the value of their social security benefits as part of their overall retirement income plan.
When it comes to retirement income planning strategies, American's are not as knowledgeable as they need to be. Only 20% passed The American College's recent "Retirement Income Literacy Quiz". On that quiz, only 30% of people age 60-75 recognized that deferring Social Security by two years or working two years longer would have more impact on their retirement security than saving 3% more in the five years prior to retirement. The following are some tips which may help retirees with their retirement income planning.
For starters, selecting the right investments is NOT your most important decision in retirement income planning. Surprised? For approximately two-thirds of retirees, more than half of their retirement income comes from Social Security! That means that for the average American, choosing when and how best to claim Social Security benefits (as well as when to retire and how to use home equity) has a much greater impact on retirement security than how to invest financial assets.
Another fundamental misconception by many individuals approaching retirement is that they mistakenly believe that choosing "when to retire" and "when to start Social Security benefits" are a single decision. They don't realize that there may be enormous value in deferring the start of Social security benefits and that you can, and in many cases should, commence benefits sometime after retiring and not necessarily when you retire from your job.
If you defer Social Security benefits from age 62 to 70, your benefits increase by 7-8% each year (the benefit at age 70 is 76% more than at age 62). Too few Americans know this. In the Retirement Income Literacy Survey, only 54% realized that deferred benefits increase each year up to age 70.
Furthermore, Social Security is an inflation-adjusted annuity which will pay you as long as you live. Unlike probably all the other investments in your retirement portfolio, Social Security is likely the only asset which offers annual cost of living adjustments to help you keep up with inflation throughout your retirement.
Certainly, unless your other retirement income assets are generating 7-8% guaranteed annual returns, it would probably be optimal to draw down from those other assets in order to defer the start of your Social Security benefits. However, the challenge in retirement income planning for those who retire prior to receiving Social Security benefits is how best to fill the "income gap" until Social Security benefits commence.
Some possible strategies to consider include working part-time in retirement, using other retirement assets, possibly tapping into home equity through a reverse mortgage or taking the lower of the two spouse's social security benefits first and deferring the larger of the two benefits. By deferring the larger of the two Social Security benefits you are also maximizing the Social Security survivor benefit, which is a critical consideration in retirement income planning.
As is commonly seen in financial literature, the base of "The Retirement Pyramid" is composed of your guaranteed income sources (Social Security, pension income and annuities) and for good reason. The more guaranteed income you have in retirement the lower the risk of out living your money, which is the most common fear of most retirees. Deferring the start of Social Security benefits is generally the least expensive way, and often the optimal strategy, to acquiring more guaranteed lifetime income throughout retirement.
There is no question that one of the most polarizing and sensitive words in our political landscape these days is the word "entitlement". But when it comes to social security, is it fair to call social security an entitlement?
I was recently giving a continuing education class to a group of CPA's when the topic of entitlements came up. In our group discussion one of the CPA's lashed out saying "...how can anyone call social security an entitlement when you pay into it your entire working life...it's not an entitlement but rather a promise to pay back in retirement what workers funded during their working years".
Although he makes a compelling argument, literally and legally speaking, social security is in fact an entitlement. For example, social security is Title II of the Social Security Act and Medicare is Title XVIII. So that's where the root of the word "title" comes from. Once you meet all the qualification requirements for social security then you are "eligible" for benefits. However, it's not until you actually file for and get approved for benefits that you become legally "entitled" to those benefits.
But popular culture and political rhetoric have given the term "entitlement" a bad name. It is often being connoted as some kind of government handout, like welfare and food stamps. These latter two programs are quite different than social security but, since all three are legally defined as "entitlement programs", social security also tends to bear the social stigma often afforded all entitlements programs.
It is correct to think that, although you did contribute into the social security system, you will likely end up getting more out of the system than you put it. Could you have generated a larger benefit if you had invested your social security contributions on your own over your working years? Perhaps, but it's important to remember that social security was never set up to be an investment scheme. The system was originally set up to achieve a number of objectives, with a goal of balancing the benefits that individuals got out of the system along side what the country as a whole got out of the system.
For example, one of the major goals of "social" security was to raise the standard of living of lower income workers. To this day, social security uses a retirement benefit formula that is skewed to give lower income workers a higher rate of return (when comparing taxes "paid in" to benefits "received") than that received by higher income workers. By doing so, this has helped lift millions of seniors out of poverty. When FDR started the program in 1935, it was estimated that 80% of seniors in the U.S. lived below the poverty line. In large part because of social security that figure is less than 10% today.
There is no question that in many circles "entitlement program" has become a pejorative phrase, with the insinuation that people are getting something that they didn't earn or even deserve. The fact is, the use of the phrase "entitlement program" in government is simply a legal term for any government program guaranteeing certain benefits to a segment of the population who qualify for benefits under specific terms and conditions. In short, it has nothing to do with whether recipients are deserving, nor is it linked to a cost-benefit analysis on taxes paid versus benefits received. But in the highly politicized world that we live in, what words actually mean and the meaning given to words are often very different indeed.
The majority of eligible filers do in fact file for social security benefits prior to "full retirement age" (FRA), which is age 66 for most filers. Approximately 40% of filers take their benefits at age 62 and 75% take their benefits prior to full retirement age. Frankly, the majority of early fillers do so because they have little choice; they need the money. However, a large percentage, who would otherwise have the option to delay the start of benefits, do so having given little thought to the opportunity costs of filing early. In fact, many early filers later regret their decision once they learn of the financial repercussions of filing early.
By filing early, you permanently reduce your benefit amount by 25% as compared to your eligible benefit amount at age 66. Furthermore, you also miss an opportunity to increase your benefit amount by 8% per year by further delaying the start of your benefits from FRA to age 70. These represent permanent lifetime increases in your benefits. Delaying the start of benefits can also increase the size of all future cost of living adjustments (COLA) since these COLA adjustments will apply to your now higher benefit amount.
It is true that delaying the start of your benefits means that it will take some time in order to "recoup" the benefits that you could have obtained by filing earlier. From my experience, however, most break-even points range from age 78-81. So, if you think you are likely to live beyond that age range then you may be better off deferring the start of your benefits.
From a financial planning perspective, it is often more important to treat social security benefits as "insurance" versus an "investment". In other words, since social security is a pension (it will pay you as long as you live), it is an invaluable retirement asset that can protect you from "longevity risk"; the risk of outliving your money. Given that social security provides for COLA, it is a powerful tool in addressing potentially higher cost of living expenses later in retirement such as health care costs and long-term care expenses.
Another disadvantage to filing for benefits prior to FRA results from the "earnings test ". If you file for social security prior to FRA and you are still working, if you earn over $15,720 per year, social security will claw back $1 of benefits for every $2 in earnings above $15,720. In the year you turn 66, social security will allow you to earn $41,880 but will claw back $1 of benefits for every $3 you earn above that amount. Any benefits that are clawed back will be included in the recalculation of your benefit amount at FRA. The point being that filing early when you are still working may result in some or all of your benefits being clawed back.
Another disadvantage to filing early is that, by doing so, you are also reducing the survivor benefit for your spouse. If your own benefit is higher than your spouse's benefit then, assuming you pre-decrease your spouse, she will be eligible to switch from her lower benefit to your higher benefit amount at your death. Conversely, if your spouse pre-deceases you, then you would simply continue to receive your own higher benefit. By filing early you may be significantly reducing this survivor benefit.
When deciding whether to start benefits early or not, numerous other factors should be considered including your life expectancy, health status, other retirement assets, how low you plan to work, your spouses benefit amount (if any), divorced spouse benefits (if any), survivor benefits (if any), etc.
In addition to those factors, you now also have to consider the impact of the "new social rules" and "upcoming deadlines" resulting from the recent Bipartisan Budget Bill. In navigating your way through this complex decision making process it would be prudent to engage the assistance of a financial advisor who specializes in social security and retirement income planning. You may have an opportunity to obtain tens of thousands of dollars (even hundreds of thousands of dollars) of additional lifetime benefits from social security. Do your homework and make sure you are not unnecessarily leaving money on the table by filing for social security benefits too early.
Ash Ahluwalia, NSSA, CCSCA, MBA