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Putting Social Security Back Into the Plan

In today's reality, Social Security has once again become the cornerstone of retirement income planning.

Helen Modly, CFP, ChFC, 07/18/2013

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: 3%-5% cost-of-living raises annually plus increasing salaries and bonuses of 5%-10% a year were common planning scenarios. Oh, and remember those investment projections showing linear growth of 8%-10% year-in, year-out for decades?

Those Were the Days
Fast forward to today's retirement planning reality where secure 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 planning.

The primary planning issue concerning Social Security was usually only how much? Workers worked, they retired at 65, and 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 environment, the question of when to begin Social Security payments 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. Another important planning point is how to optimize Social Security for couples, widows, and divorced spouses.

Break-Even Point
We used to be concerned about calculating the break-even point, which is the age at which the sum of the smaller checks initially claimed age 62 falls below the sum of the larger Social Security checks initially claimed at age 65 or 70. Just a few years ago, this was the primary consideration. In essence, we were asking clients whether they thought they would live past 82 or 84, which were common breakpoints for people whose FRA was age 65.

As the FRA has creeped up, so has the amount of benefit reduction they will see if they begin taking benefits earlier. Taking Social Security at age 62 reduces the actual benefit by 25% of the amount a client would receive if they waited until their FRA. Widows whose late husbands were eligible for Social Security can begin taking benefits as early as age 60, but if they do, they will see a 30% reduction in their benefits for life.

On the other hand, delaying the start date increases their benefit by 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% (5 years X 8% increase each year) for the rest of their lives. There are no further increases after age 70, so there is no point in delaying any longer.

Don't Underestimate the Power of a COLA
2010 and 2011 were the first years that we did not see an increase in Social Security benefits due to inflation since the Cost Of Living Adjustment (COLA) was added in 1975. In 1980, the increase was a whopping 14%.

Regular increases of even modest amounts compound over time to create a significant increase in monthly payments decades out. The trustees of Social Security project an annual COLA of 2.8%. Over just 10 years, this would create a 30% increase in your monthly payment. The adjustment for 2012 was 3.6%, and is 1.7% for 2013.

This was the missing piece in traditional break-even analysis of taking benefits early vs. at FRA or age 70. Factoring in a 2.8% COLA will extend the break-even age by a few years, for example from age 79 to age 83; however, the cumulative benefit received could be $150,000 or more by age 90. Where we once used to hear, "I don't plan to live that long," now we are hearing, "I am afraid of outliving my money." The break-even age is becoming less important to many clients than providing for the highest possible guaranteed, inflation-protected income for life.

Keep Working
Most people earn more in their later working years than in their earliest years. Social Security's Primary Insurance Amount (the basic monthly benefit) is calculated using the highest 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. Conversely, being out of work or working part-time for several years may hurt a client's benefit. This is the dilemma that many women face when they exit the workforce to care for children or elderly family members. Another advantage to working longer is that once clients reach FRA, there is no benefit offset for earned income, regardless of the amount.

Two Is Better Than One
For couples where both spouses are eligible for benefits based upon their own earnings record, there may be even more flexibility. Most clients are aware that from age 62 up to their FRA, they can collect their own benefit or 50% of their spouse's benefit, whichever is higher, provided that their spouse has filed to claim his or her own benefit. If they start receiving benefits before their FRA, they must continue with whatever benefit was higher when they began.

However, it they wait until their FRA to begin receiving benefits, they have the choice of claiming their own benefit or 50% of their spouse's benefit. This choice allows some couples of similar age to take advantage of the File and Suspend strategy, whereby the spouse with the lowest benefit files at his or her FRA and requests that benefits be suspended. This allows the other spouse to receive a 50% spousal benefit (provided that he or she is also at FRA), and then switch to their own, higher delayed benefit at age 70. In this example, both spouses end up with a higher, delayed benefit at their age 70, while still collecting some income between FRA and age 70.

Another example is an older spouse who begins collecting benefits at full retirement age, allowing a younger spouse with a higher earnings record to claim a spousal benefit at his or her FRA and switch to his or her own higher benefit at age 70.

This level of couples planning has become much more commonplace with more women having built their own significant earnings histories. There are several software programs available to help planners determine the most advantageous claiming strategy given the ages and earnings records of the spouses.

Divorced or Widow-Benefit Planning
In the case of divorce, a former spouse can claim on his or her divorced spouse's record provided:

> the former spouse is at least 62 and unmarried

> the marriage lasted at least 10 years

> the divorced spouse is eligible to claim benefits, regardless of whether he or she has filed for them, and the divorce occurred more than two years ago.

It does not matter if the divorced spouse has remarried; however, if the former spouse has remarried, the second marriage would have to be ended by death or divorce in order for him or her to collect on the first spouse's record.

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.

This is only a generalized overview of the benefits for divorced or widowed spouses. The eligibility rules for divorced or widowed spouses, and spousal benefits in general, are often confusing. For more information, consult What Every Woman Should Know About Social Security, a great resource publication on the Social Security website.

It's Worth More Than You Think
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 exactly that. It is guaranteed--at least for now--by the U.S. government, so market volatility is not a risk for this income source. It will also respond to inflation--as measured by the CPI--again, at least for now, so the purchasing power of these benefits is protected.

The only issue remaining is the amount. Currently, the highest possible monthly benefit for 2013 is $3,350 for a claimant with a sufficient earnings record claiming at age 70. That equals $40,200 annually, which, if it were an annual withdrawal of 4% from an investment portfolio, would require a portfolio of just over $1,000,000. While that may not be enough, it is certainly a good start.  

Helen Modly, CFP, ChFC, is executive vice president and director of investment services for Focus Wealth Management, a fee-only registered investment advisor in Middleburg, Va. Modly has more than 20 years of experience providing wealth-management services. She is a member of NAPFA and FPA. She can be reached at info@focus-wealth.com. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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