Whether you’re approaching retirement or already in it, you probably have questions about Social Security and how it impacts your retirement plan. Social Security is as complex as it is important. The income stream can be an integral part of a well-thought out financial plan and the myriad of options often lead to sub-optimal elections by otherwise well-informed folks. Social Security goes beyond retirement income and provides workers and their families with disability and survivors insurance benefit as well; however, this post will focus on the following key points of Social Security as part of retirement planning:
- How benefits are calculated
- Solvency of the program
- Recent changes to popular claiming strategies
- Social Security as part of your retirement plan
How are my benefits calculated?
- A beneficiary’s retirement benefit is based on their covered earnings over a career and a minimum of 10 years (or 40 quarters) of work history is needed to qualify
- Benefits are adjusted to account for price of living increases
- You will receive 100% of your benefit at your Full Retirement Age (FRA is 66 for those born before 1954)
- Qualified beneficiaries have the option of beginning withdrawals as early as 62 and as late as age 70
- For a married couple, each spouse is entitled to their own benefit or 50% of their spouse’s benefit, whichever is greater
Patience is a Virtue
If so inclined, you may choose to receive your benefit at age 62 but at 75% of your FRA benefit. For those that wait, delaying until age 70 increases your benefit to 132% of your FRA amount. As the chart below shows, every year you defer your benefit past age 66, it will increase 8% until age 70. In other words, you receive an 8% “risk-free” return year over year for waiting—for perspective, the current yield on the only other “risk-free” asset (3-month treasury bill) is 0.28%. So, easy decision, right? Not quite. As of last year, 72% of retired workers elected early to receive reduced benefits. Does this make any financial sense? No, but let’s review why many Americans knowingly elect to receive benefits early.
Source: https://www.ssa.gov/pubs/EN-05-10147.pdf - “When to Start Receiving Retirement Benefits”
Social Security Solvency – Can I rely on this benefit?
One of the main concerns we hear from our clients is about the solvency of the program: Will this benefit be there in 30 years? Will it be reduced? The fear that their benefit will be lost or reduced often leads individuals into opting early and forgoing their optimal strategy. While this emotion is understandable, for those entering retirement right now, all the data and evidence suggest the funding for current retirees shouldn’t be an issue, but it’s worth a deeper look.
Social Security’s Demographic Challenge
Social Security is a pay as you go system, meaning the current work force pays for the retired folks. As of 2014, roughly 86% of Social Security revenues came from payroll taxes. The other 14% came from taxation on benefits and interest from the bonds held in the trust fund. Because of the heavy reliance on the current work force, the mass exodus of baby boomers from the work force into retirement is a long-term issue. Per a recent Trustees Report, the population of retirees is projected to double over the next 50 years. To compound the matter, birth rates are low and modern medicine is helping people live longer. Simply put, there will be too few workers to support too many retirees.
How long can this last?
Per the Social Security Administration, under the current tax rates and benefit calculations, Social Security is not sustainable over the long term. As the chart above indicates, the steady decline of the work force is the primary issue. You’ll notice that in 2034, the projected worker/beneficiary ratio is 2.1, down from 2.8 in 2014. For this reason, the current Social Security Trust fund is projected by the Social Security Administration to be depleted by 2034. After that, payroll taxes are expected to pay 75 cents on the dollar.
While this is cause for concern, it’s highly unlikely that current retirees or even those 10 years out will be impacted. The Social Security Administration has committed to not cutting current benefits and Congress has already begun addressing the long-term issue (see recent changes below). The solution is yet to be determined and may be in the form of increased payroll taxes or reduced benefits to future generations, but the general consensus is the current program is fully funded and can be counted on by today’s retirees.
Recent Changes to Social Security
So, any funding issues will be my kid’s problem, not mine? Not so fast. While it’s very likely that funding will not impact those near retirement, government has begun taking steps to ensure solvency for future generations. By enacting the Bipartisan Budget Act of 2015, the government has eliminated the popular claiming strategies discussed below. The government’s basis for eliminating these strategies was that they were “actuarial loopholes”, and not in the spirit of the program. Read on to find out if these changes affect you.
Elimination of Strategies for Married Couples
File and Suspend
This strategy allows the higher earning spouse to file for their benefit at FRA, and immediately suspend receiving benefits until they reach age 70, thus capturing the increased benefits. Because the higher-earning spouse filed for the benefit, the other spouse is allowed to receive 50% of the spousal benefit.
As of April 30th, 2016, if a spouse “files and suspends” their benefit, all other benefits paid from their record will be suspended as well, which disallows the spouse from claiming spousal benefits. For those that initiated this strategy prior to the April cut-off, there will be no retroactive measures.
Restricted Applications for Spousal Benefits
A similar strategy to the one discussed above, “Restricted Application” strategies work best for couples with large discrepancies in their earning history. In this scenario, the higher earner would apply for a restricted application at FRA, begin taking the 50% spousal benefit and defer their own benefit until age 70, capturing the 8% increase. Once the higher earning spouse switched back to their own benefit, the other spouse could then switch to the spousal benefit.
Starting January 2nd, 2016, Social Security will restrict an individuals benefit to the higher of their benefit or their spouse’s, thus eliminating the ability to ‘restrict’ one’s application. Anyone who was born in 1953 or earlier is grandfathered in under the old rules.
Elimination of claiming strategies for Individuals
File and Suspend with Retroactive Lump-Sum
Similar to married couples, a single individual that is only eligible for their own benefit could file at age 66 and suspend their benefits until age 70. However, if they suspended their benefit prior to April 29, 2016, at any point between then and age 70, they could retroactively request a lump-sum payment. This strategy allowed individuals to earn delayed credits but gave them the option to recoup their delayed benefits in case an emergency expenditure came up or their life-expectancy was unexpectedly shortened.
Going forward, anyone who suspends their benefit will no longer be able to retroactively claim a lump-sum benefit.
Social Security and Retirement
Too often we get very tactical planning or investment questions from family, friends or airplane seat companions - “What should I invest in?” or “Should I do a Roth Conversion?” We would be breaking the cardinal sin of financial planning by making concrete recommendation without understanding your situation and circumstances. Determining the appropriate Social Security strategy is no different and should be made in light of the bigger picture—not in isolation.
At Cordant, we believe the first step to understanding your “bigger picture” is to get strategic. Once your goals & objectives have been identified and modeled properly in a financial plan, determining the appropriate withdrawal strategy can be accomplished.
What factors need to be considered?
- Age - Delaying the age you begin withdrawing your benefit can increase your benefit up to 57%.
- Life Expectancy - The takeaway is straight forward – the longer you live, the less you can spend now. For planning purposes, factors to consider include date of birth, race, gender, education level, health and family longevity history.
- Resources - Do you have the assets to support your lifestyle while delaying benefits? It’s possible that the optimal strategy may actually be sub-optimal when incorporated with your financial plan. For retirees with small taxable pools, supporting your cash flow needs by withdrawing from your tax-deferred accounts (e.g. 401(k) or IRA) may lead to additional taxes.
- Employment - If you elect to to receive your benefit before reaching your FRA and are still working, any earned income that exceeds set annual thresholds may reduce your benefit. Once you reach FRA, your earned income no longer impacts your benefits.
When should I begin taking benefits?
Generally speaking, the longer your life expectancy, the more it pays to delay Social Security benefits. For individuals with little financial resources or poor health, electing to receive your benefit early may make sense. However, as the chart below details, in all other situations it’s straightforward, if you expect to live longer than the average life expectancy, it almost always makes sense to delay.
For retiring couples, the optimal strategy isn’t always that simple. Because there are two income streams and endless timing combinations between the two, the analysis is more complex. Discrepancies between spouse’s age and earning history allow for more creative timing combinations, despite the demise of the aforementioned timing strategies. For most couples where both people have earned a benefit (i.e., not taking the spousal benefit), it typically makes financial sense to defer at least one income stream until age 70. However, determining the optimal strategy requires the use of advanced planning software and a thorough understanding of your financial situation.
There are many factors to consider when determining your withdrawal strategy and it can be easy to get overwhelmed with the details. For this reason, many people simply default to taking the benefit early or at their FRA. However, understanding the magnitude that Social Security benefits play in your financial plan (i.e., how much of your spending in retirement are you counting on from Social Security) is crucial and may determine your desire to optimize. For those that do wish to optimize, we recommend you follow the steps below. Good luck!
- Create a customized financial plan that reflects your current situation as well as your path forward
- Obtain your Social Security statement - https://www.ssa.gov/myaccount/
- Utilize online planning calculators or work with an advisor to determine withdrawal strategies
- Incorporate optimal strategy into your financial plan
- Enjoy retirement!