Taking Social Security to the Max

A friend who plans to retire soon asked me recently whether he should delay filing for Social Security. He's reached full retirement age (66) but doubted it would make sense to wait longer--he's been a high earner most of his career and assumed he had already "maxed out" his "full" benefit.

Not so. Social Security's filing rules are designed to be actuarially "fair," which means the credits for delayed filing--and penalties for early filing--should give us all roughly the same lifetime income--at least, according to the actuarial tables. You get about 8% less for every year you file early (starting at 62), and the same increase for every year you wait until 70--the last year for which additional credits are available.

And most probably, my friend should delay. Social Security plays a surprisingly large role in supplying retirement income to affluent households. Since high-income people tend to live longer, they stand to benefit from delayed filing. For example, the new mortality tables from the Society of Actuaries shows that average life expectancy for a 65-year-old male is 3.16 years longer in the highest income quartile than in the lowest band; for women, the gap is 1.52 years.

So, a delayed filing makes sense for the affluent. How much is that worth?

I ran the numbers with SocialSecuritySolutions.com, a service that helps people maximize their benefits. We looked at a hypothetical single man, "Sam," who will turn 62 in January 2015. Sam has earned the maximum in Social Security earnings every year since he turned 22 (unlikely, I know, but remember, we wanted to max him out).

Sam's benefit at his full retirement age (FRA) of 66 is $2,685.50. Let's say Sam thinks that he will live only to age 82--numerous studies show that most people underestimate their own longevity.

The table below shows Sam's cumulative benefit payout at different ages under three scenarios: if he claims early (starting at age 62), if he claims at full retirement age (66), or if he delays filing until age 70. Sam's monthly (or annual) benefit will be higher the longer he waits to file. But notice that in the "max" scenario (the right column) his cumulative lifetime benefit is a bit lower than the second scenario (filing at full retirement age)--that is, if he fulfills his own prediction and lives only until age 82.

If he lives even one year longer (until age 83), the story changes: His best plan is to delay filing until age 70. Sam receives not only the highest monthly benefit but $5,147 more in cumulative income. If he lives to 87, he gets $46,393 more. The cumulative difference between filing at age 62 and age 70 is $119,000.

The sensitivity to longevity in this scenario is due only to the fact that Sam is single. In the case of married couples, joint filing strategies are even higher percentage wins, since the odds that one spouse will beat the mortality averages is very high: the Social Security Administration reports that for a couple with above-average health, there's a 60% chance one of them will live to age 90.

"I like to say to wealthier people--this is over a $700,000 decision where you can typically find an additional $100,000," says William Meyer, SocialSecuritySolutions.com's co-founder. "Most wealthy people would say that is a figure worth analyzing."

Indeed. A Vanguard study released earlier this year found that 28% of aggregate wealth of older households (age 60-79) with at least $100,000 in retirement savings comes from Social Security. Traditional pensions provide another 20%, and tax-deferred retirement accounts came in third among those who have them, at $13,000 (11%).

Vanguard did the study because it wanted to better understand why so few affluent households were drawing down much of their savings in retirement. That is reflected in data from Vanguard's own account holders, as well as in a separate study of retired households not yet required to take RMDs (age 60-69), which showed that just 20% were taking withdrawals from IRAs or 401(k) accounts.

Prolonging Portfolio Longevity
Higher Social Security income also can prolong portfolio life significantly. In an earlier column, I described research by William Meyer and William Reichenstein detailing how higher Social Security income impacts portfolio longevity. Their research concluded that portfolios ranging from $200,000 to $3 million in size can be extended by two to 10 years in retirement. Delayed filing creates a much larger annual annuity income that continues as long as you are alive, which reduces pressure to draw from portfolios. At the same time, a smaller portion of Social Security benefits are taxed because of the reduction in withdrawals from tax-deferred accounts.

(Social Security benefits are taxed using a complex "provisional income" formula that is determined by adding together your adjusted gross income, tax-exempt income, and half of your Social Security benefit. If that total exceeds $25,000 for individuals--$32,000 for married couples--then 50% of the excess must be included in your income for tax purposes; if it's over $34,000--$44,000 for couples--then 85% of the excess is included in your income.)

High earners certainly can expect to pay taxes on their benefits. The only question is the size of the tax bite. Meyer and Reichenstein call for a tax-efficient portfolio plan that begins well ahead of retirement, focused on drawing down savings in tax-deferred accounts--just enough to fill up your current tax bracket.

If your marginal tax bracket will increase in the future, it makes sense to combine both taxable and tax-deferred account withdrawals up to the top of a dedicated tax bracket. This approach upturns traditional wisdom, which outlines solely taking taxable money at the beginning or your retirement. (Meyer and Reichenstein will illustrate this approach in a research paper to be published in the March 2015 edition of Financial Analysts Journal.)

Says Meyer: "Conventional 'rules of thumb' don't always apply, and coordinating withdrawals from both taxable and tax-deferred accounts can make your money last longer."

Re-Thinking Allocations
Affluent households may also want to rethink their stock/bond allocations in light of high Social Security income.

Meyer has argued that Social Security should be regarded as a bond in retiree portfolios, despite the fact that it isn't a permanent asset, and that portfolios should be adjusted accordingly. And he has some impressive company: Vanguard founder Jack Bogle pointed to this in a recent Morningstar interview. Morningstar's head of retirement research, David Blanchett, makes a similar argument in an August 2013 research paper and in this video interview with Christine Benz.

That thinking also ties back to Meyer's portfolio longevity argument. A recent paper by Wade Pfau and Michael Kitces argues that the risk of portfolio failure in retirement is lower for investors who start retirement with a relatively low equity allocation and then increase stock allocations to 70% or 80% over time.

Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work, and Living. The views expressed in this article do not necessarily reflect the views of Morningstar.com.