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Social Security Once Again Takes a Central Role in Retirement Planning

The only issue remaining is the amount.

Helen Modly, 08/13/2009

Just a few short years ago, clients would tell us to ignore any Social Security benefits in their retirement planning analysis. "I don't expect it will exist 10 years from now," or "I don't want to have to count on it" were some of the comments we heard. Planners often acquiesced because clients presented with such rosy employment forecasts. Three percent to 5% cost-of-living raises annually plus increasing salaries and bonuses of 5% to 10% a year were common planning scenarios. Oh, and remember those investment projections showing linear growth of 6% to 8% year-in, year-out for decades? My first year in the business I actually saw--I won't admit to using--12% linear return projections for variable insurance products.

Those Were the Days
Fast-forward to today's retirement planning exercise where employment is considered as great a blessing as good health, investment returns are playing serious catch-up, and social security has once again become the cornerstone of retirement income.

The primary planning issue concerning Social Security was usually only "how much?" Workers worked, they retired at 65, and they began receiving their Social Security checks right away. Widows usually took their benefits early. Every year they got a little bit of a raise due to cost-of-living adjustments, and that was about the end of the planning implications.

Timing Is Everything
In today's planning, the question of when to begin Social Security is the real issue. For people born in 1955 and later, the actual full retirement age (FRA) gradually increases from 65 to 67 years old. If they begin taking benefits before that, they lose a percentage of their Primary Insurance Amount (PIA), which is the amount they would receive if they waited until reaching FRA. When clients postpone collecting benefits, they will receive an increased benefit based upon how many years they delay (up to age 70) and their year of birth.

Break-Even Point
We used to be concerned about calculating the break-even point, which was the age when the smaller checks clients receive now would be equivalent to the larger checks they would start to receive later. Just a few years ago, this was the primary consideration. In essence, we were asking clients whether they thought they would live longer than age 82 or 84, which were common breakpoints for people whose FRA was age 65. As the FRA has crept up, so has the amount of benefit reduction retirees will see when they begin taking benefits earlier. At age 62, the reduction in benefits is between 25% and 35%, for each and every check for the rest of their life. Widows whose late husbands were eligible can begin taking benefits as early as age 60, but they will also see a steep reduction in benefits.

On the other hand, delaying the start date increases the PIA by 7% to 8% for each year delayed until age 70. This is a huge planning opportunity that is often dismissed without really understanding the implications. By delaying the start date from age 65 to age 70, clients could see their benefits increase by as much as 40% for the rest of their life, plus cost-of-living increases based upon the higher amount.

Keep Working
Most people earn more in their later working years than in their earliest years. The PIA amount is calculated using the most recent 35 years of earnings history, so working an extra few years at a high salary will cause earlier, lower-paid years to drop out of the calculation.

Even if you are already receiving benefits, clients still have planning choices. If they have not yet reached full retirement age, they will see their Social Security benefits reduced by $0.50 for every dollar earned over the threshold of $14,160 in 2009. In the calendar year that full retirement age is reached, the threshold increases to $37,680 for 2009 and the reduction drops to $0.33 for every dollar over. After that, there is no income threshold.

These dollars lost are not lost forever. Once full retirement age is reached, the benefit level is recalculated to reflect the additional work record.

Pay It Back
If your client has already begun receiving a reduced benefit and later decides that postponing to age 70 would have been a better option, he or she can pay back the total benefits received--without interest. This could be a good deal if your client was able to invest the reduced benefits and then pay back the principal, keeping any earnings. The only caveat here is that your client would need to feel comfortable about living into his or her 80s to break even.

Two Is Better Than One
For couples where both spouses are eligible based upon their own earning records, there may be even more flexibility. Each spouse is able to collect his or her own benefit, or 50% of the spouse's benefit, whichever is greater. Traditionally, the spouse with the lowest earnings record is the wife who is usually a few years younger than her husband. If she has reached her Full Retirement Age, she can elect to receive benefits based upon her earnings record (presumably lower) while she waits for him to reach his full retirement age.
At his Full Retirement Age, she could switch to collecting her spousal benefit, if higher than her own benefit. NOTE:  This only works if she has reached her FRA. Otherwise, she will receive the greater of the two benefits and not be able to switch later. Since her Spousal Benefit is calculated based upon her husband's Primary Insurance Amount, it does not increase because of his deferral past full retirement age. At his age 70, she would switch to collecting the higher 50% delayed spousal benefit, if it is higher than her own benefit.

If there is only one spouse eligible, there is an option for that spouse to claim benefits early but immediately suspend payment. That allows the other spouse to begin collecting the 50% spousal benefit while the eligible spouse keeps working and delays benefits for a higher payout later. In the case of divorced spouses, as long as the ex-spouse is at least 62 and eligible, the other ex-spouse can receive benefits based upon his work record as long as the divorce occurred more than two years ago.

Surviving spouses have the most flexibility of all. They can collect a reduced benefit at age 60 if they have not remarried by then, based upon the amount the deceased spouse was eligible for when he died. If a widow/widower remarries after age 60, she can continue to receive the survivor benefit until eligible for her own benefit, or a spousal benefit based upon the new husband's record, if greater.

The eligibility rules for divorced or widowed spouses, and spousal benefits in general, are often confusing. On the Social Security Web site is a great resource publication, "What Every Woman Should Know About Social Security".

A Partial Answer to the Three Biggest Risks
Instead of an afterthought, Social Security is once again becoming the cornerstone of many retirement income plans. It is designed to provide an income stream that clients cannot outlive, and it does that--at least to some extent. It is guaranteed--at least for now, by the U.S. government, so market volatility is no longer a risk for this income source. It will also respond to inflation--as measured by the consumer price index, so the purchasing power of these benefits is protected. The only issue remaining is the amount. The highest possible benefit available to someone at full retirement age is $27,876. If we translate that to a prudent withdrawal amount from a portfolio, it reflects about a 4% withdrawal off of a $700,000 portfolio.

However, for this person to be eligible for the full benefit, he would have been earning at the highest limit for Social Security taxes for 35 years. This year, that limit is $106,800, meaning that at full retirement age, Social Security will replace only about 25% of earned income for the highest wage earners. If workers delay claiming benefits until age 70, this replacement ratio gets better, but it clearly is not sufficient to provide the level of retirement income needed. But, it is a start.

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