The decision on when to begin collecting Social Security is one where I find the greatest divide between what is in the best financial interest for most people and what they are inclined to do. Lately I have seen articles in the press arguing for taking Social Security early — and ignoring the conventional wisdom that it is better to wait. But as I read through the articles I don’t find any math that supports the argument for early withdrawal. My sense is that these articles are appealing to what many people want to hear, not what the actual math would suggest is best for them.
The government provides an incentive to delay collecting on Social Security by increasing the amount of the annual benefit by approximately 8% a year every year between age 62, when Social Security is first made available, and age 70, when the benefit stops increasing. As a result, the benefit at age 70 is over 70% higher than the benefit at age 62.
Of course, if you delay taking the benefit you will receive fewer payments. For that reason, many people ask about the breakeven age—the age at which you collect more by waiting. The growth of the benefit by waiting was initially determined so that benefits collected would be actuarily “equivalent” based on average life expectancy no matter what your age when you start collecting. The increase in the benefit would offset the fact that you were receiving fewer payments. While average life expectancy has been steadily increasing, the growth factors have not been adjusted down to compensate. Thus, in today’s world the breakeven point for someone deciding between taking Social Security at age 62 and age 70 might be age 79, whereas the life average life expectancy for someone age 62 might be age 84. Looking at it from a breakeven perspective, most would benefit by waiting all things being equal.
But I don’t believe breakeven is the right way to think about this decision. Planning for retirement is about making sure you have adequate resources to support your desired lifestyle no matter how long you live. The financial “penalty” for taking Social Security early and living well beyond your life expectancy is far greater than the penalty for waiting to take Social Security but dying at a relatively young age. This fear of potentially dying early causes many people to want to start collecting early. They have paid into the system all those years and fear that they will drop dead at age 72 after having only collected for two years. But from a purely financial perspective, if someone has a reasonable retirement plan there is little risk to running out of resources if they were to die well before their average life expectancy. While it is true that this person would not have collected as much in Social Security as they would have if they had started to collect earlier, their retirement plan was a “success” in that they had sufficient resources to fund their retirement. On the other hand, taking a significantly lower social security benefit by filing early but then living well into your late eighties or nineties might put significant pressure on the retirement portfolio and force a reduction in retirement spending to avoid depletion of the portfolio.
Married couples need to coordinate the timing of claiming their Social Security retirement benefits based on their ages and individual earnings record and consider carefully when to being collecting. If both spouses file for Social Security early, taking substantially reduced benefits, when one passes away it leaves the surviving spouse living on one small Social Security income stream. It is generally wise for the higher earning spouse to delay taking Social Security as long as possible since their benefit will determine what a surviving spouse collects for the rest of his or her life. So you not only have to think about your own life expectancy, but also the probability that either spouse will live into their 80s or 90s.
But waiting is not what most people do. More than half of those receiving Social Security benefits started claiming at age 62 (the earliest possible date). Most of the other half start claiming between 62 and 66, with the biggest cluster claiming Social Security around the full retirement age, now age 66. Only 5% wait until age 70. Additionally, if a person continues working while collecting benefits before full retirement age, the Social Security benefit amount can be temporarily reduced.
I am not suggesting you need to continue working until age 70. The timing of retirement does not have to coincide with the decision of when to claim Social Security benefits. What is optimal for many people is to retire during their 60s and then draw from their retirement portfolio to fully cover cash flow needs until age 70 when full Social Security kicks in. Intuitively people think it is safer to collect Social Security early and preserve their retirement portfolio, but for most it is better to draw from the portfolio first while letting Social Security grow. Let me give you an example. Let’s say that a couple wishes to live on $75,000 per year in after-tax dollars during retirement. Their combined Social Security after-tax benefit if they wait until age 70 is $50,000. Thus they would need their retirement portfolio to provide $25,000 per year after tax. Using a safe withdrawal rate of 4% means that their retirement portfolio at age 70 would need to be about $750,000 to support their lifestyle. But if they started collecting Social Security at age 62, their after-tax Social Security benefit would be about $26,000, meaning they would need their portfolio to provide $49,000 after tax. This would require a portfolio of $1.5 million at age 70. In most cases, even if they have to draw down the full $75,000 from the portfolio for a few years until age 70, they would still be better off.
This example illustrates is that Social Security is much more valuable than many people give it credit for. Even for the affluent, Social Security will likely make up a significant portion of their retirement income. A professional couple both with incomes over $100,000 will collect something like $80,000 per year from Social Security if they wait until age 70 to collect.
This brings up the next issue: many are worried that Social Security, particularly the Social Security trust fund, will run out of money. But I’m confident that is not going to happen. Social Security is a pay-as-you-go system, which means that the majority of the benefits being paid out are funded by Social Security taxes collected that year from people who are working that year. The Social Security trust fund, which was established in the 1930s, has been building up ever since and is there to cover any gap between funds collected and funds paid out. It has not yet been tapped.
The current projection is that it will be first tapped in 2024 and if nothing changes would be depleted by 2045. But given that most benefits are covered by taxes by those currently working, even if the trust fund were to be depleted entirely, the worst-case scenario is that benefits would be reduced by 30%. But I do not believe that the trust fund will be depleted. The fixes needed are known and will eventually be enacted. Options include increasing the full retirement to age 70 to reflect how much longer we are living and lifting or eliminating the income cap (right now, Social Security taxes are collected only on wages up to $128,400). Changes like this would not be popular and thus will not be passed until Congress has no other choice. But if the alternative is lowering benefits by 30% for everyone, I suspect it will eventually happen.
Having said all this, there are situations where filing early make sense. Someone in poor health or someone without the resources to survive without Social Security may have no other choice than to take it early. But I do believe that many make the decision without fully considering its implications. You will want to evaluate the decision of when to claim Social Security in the context of your overall retirement plan.
As always feel free to reach to Jim or I if you have any questions.