In the financial advisory world, too much emphasis is often placed on the investment side of the conversation and not enough on issues like when to start collecting Social Security, which can have a significant impact on the potential success of a client’s retirement.
The decision on when to begin collecting Social Security is one where I find a great divide between what is in the best financial interest for most people and what they are inclined to do. The government provides a great 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. Furthermore, the recipient will receive that higher level of benefit (adjusted for inflation) for the rest of their life. And if there is a spouse also eligible for Social Security, it opens up options for advanced claiming strategies such as file-and-suspend, which increases the benefit even more.
Someone in relatively good health who has a source of retirement income to draw upon during their sixties (i.e., a retirement portfolio, pension, part-time wages) will almost always be better off waiting until age 70 to begin drawing Social Security. But that is not what most of these individuals actually do. More than half of those receiving Social Security benefits started claiming at age 62 (the earliest possible date). Most of the other half started claiming between 62 and 70, with the biggest cluster claiming Social Security around the full retirement age, now age 66. Only 5% wait until age 70.
Retirement Doesn’t Have to Coincide with Collecting Social Security
I believe one reason for this is that many people equate beginning to collect Social Security with their retirement date. But those two events don’t have to happen at the same time. You can choose to retire and delay collecting Social Security. However, many people don’t consider this option and its benefits. Once people do retire, most believe it is safer to begin drawing their Social Security, and try and minimize the amount they draw against their retirement portfolio. But in most instances, the opposite is true. The safer strategy is to live off the retirement portfolio exclusively during your sixties in order to lock in the higher Social Security benefit.
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.
What this example illustrates is that Social Security is much more valuable than most 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.
Social Security is not Going to Run out of Money
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 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. The Social Security trust fund is there to cover any gap between funds collected and funds paid out. If the trust fund were to be depleted entirely, the worst-case scenario is that benefits would be reduced by 30% but would not stop.
But I do not believe that the trust fund will be depleted. Fixing Social Security may require that the full retirement age be increased to age 70 to reflect how much longer we are living and that the income cap be raised or eliminated. Right now Social Security taxes are collected on wages only up to $118,500. Neither change would 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 collecting Social Security, it will eventually happen.
A Higher Social Security Benefits Helps Protect Against the Financial Risk of Living a Long Life
Another reason I hear for justifying taking Social Security early is that people are worried about not living past their seventies and thus not getting the money back that they paid in over the years. This is certainly a possibility. But there is also the possibility of living well into your nineties and having to live on a much lower benefit level for many years. I like to think about it as a decision matrix. If you knew you were going to live only until your seventies, you would want to start collecting at 62. And if you knew you were going to live well into your eighties or nineties, you would wait until 70 to begin collecting (the breakeven for waiting to collect is usually around age 80). But we don’t know how long we are going to live.
So let’s consider the two scenarios where we make the “wrong” choice. First let’s say a woman waits to collect until age 70 but lives until age 72. No one who has planned well for retirement is going to run out of money at age 72. While it is true she did not collect all that is possible from Social Security, she certainly had enough money to fund her short retirement and there will still be a larger than expected estate to be passed onto heirs since not much of the portfolio was drawn upon. On the other hand, let’s assume she takes Social Security at age 62 but lives to age 97 (this situation is increasingly common and is a big part of the retirement crisis, primarily for women). Having to fund a bigger income gap from her retirement portfolio for thirty-five years could easily cause her retirement portfolio to be depleted well before age 97 creating the worst-case scenario for both the retiree and her family.
Of course, someone in poor health or someone without the resources to survive without Social Security will need to draw early. But I do believe that many make the decision without fully considering the implications.
The analysis in the example above is essentially the core of what I do in my financial planning sessions with my clients. We calculate the income gap between Social Security (along with any other pension) and what clients would like to live on during retirement. We then use financial planning software to do scenario planning related to their retirement portfolio, adjusting factors such as retirement age, level of savings and asset allocation, to come up with a plan that maximizes the probability of the clients meeting their goals.