The mid- to late-20th century model of the three-legged stool of Social Security, pensions and individual savings no longer applies to many retirees. Despite Social Security providing the lion’s share of retirement income for many, the thousands of rules surrounding Social Security claiming are poorly understood by the average retiree. Interpreting and internalizing all these complex rules strains the ability of even experienced financial advisors.
Lack of Social Security education, claiming strategies
The conventional wisdom until just a few years ago was that it didn’t matter when you started claiming Social Security – and for good reason. When Social Security was last overhauled in 1983, the benefit adjustments from delaying past your retirement age were calculated to be what’s called “actuarially fair.” By design, the intention was to avoid providing a strong incentive to claim benefits early or late. Thus, the standard advice from the Social Security Administration representatives was that it didn’t matter. Since most people prefer to have money earlier than later, the natural inclination was to claim sooner. As long as you didn’t face any clawbacks (whereby money already paid out must be returned) while still working, it made sense to claim as soon as you retired.
But as time went on, circumstances changed. Life expectancies kept improving and interest rates fell substantially and stayed low for a long time. These factors meant that the delay credits, which used to be actuarially fair, become very strongly actuarially titled to favor delaying.
The most common mistake made related to Social Security
Taking Social Security too early is the most common mistake. The vast majority of retirees file for benefits within a few months of retiring. Unfortunately, they don’t realize they’re likely foregoing tens or even hundreds of thousands of dollars of expected lifetime benefits by doing so.
Factors to consider when claiming Social Security
First, recognize that Social Security is often your most valuable financial asset. People don’t see a total dollar figure, so it’s easy to lose sight of the value of a lifetime stream of guaranteed income. Doesn’t it make sense to pay more attention to how you use your biggest asset in retirement?
Second, if you are the sole or primary earner in your household, the incentives for delaying claiming past full retirement age are very strong. If you are in poor health or have reasons to expect a shorter-than-average lifespan, that could change the picture.
Third, if you are a married couple, keep in mind that delaying the main earner’s benefit has dual benefits: The primary earner’s benefit increases and the surviving spouse’s benefit also increases. The increase in the main earner’s benefit is already better than actuarially fair, and the increase in survivor benefits adds an even stronger reason to delay claiming for many households.
Key features of the Edelman Financial Engines free* Social Security optimizer tool
Our Social Security Optimizer tool starts with basic household information that participants have often already shared to develop their retirement strategies. In the case of a married couple, it may be information such as each spouse’s birthdate and salary. Salaries are used to estimate earned and/or spousal benefits. If participants have access to their estimate from the SSA, then that is used instead.
The tool illustrates how much their monthly benefit would be by claiming at different ages, which is often eye-opening. Next, we highlight what would happen under a simple claiming strategy: Claim when you retire or at age 62, whichever comes later. Participants can see their monthly benefits as well as their expected lifetime benefits under this approach, which many would probably choose if deciding without professional guidance.
We then optimize their claiming ages, considering all the possibilities for each spouse’s claiming age. Our goal is to maximize the household’s expected lifetime benefits. Participants can quickly see how much our recommendation improves their lifetime benefits, compared to the simpler strategy of claiming at retirement.
Participants can customize the strategy to reflect their specific needs. For example, if our recommended strategy requires the retiree to draw down other sources of income more quickly than they are comfortable with, then they can request a new strategy with a constraint such as “spouse claims no later than age 65.” Then we’d reoptimize around that requirement and determine the best strategy obeying that constraint.
Finally, we illustrate how the recommended claiming strategy fits into a broader retirement income picture. This is important because participants need to see that by delaying Social Security, they are not left without income during those early years. Our retirement income solution shows them how much income can be generated from their accounts, adapting to Social Security income starting a few years into retirement.
What makes our tool unique?
One factor that we pay a lot of attention to is the uncertainty about how long people might live. Most other tools assume death occurs at a specific age. We felt it was important to acknowledge the significant uncertainty surrounding how long each spouse might live. For example, if you have a married couple who are currently age 55, their life expectancies would be 86 and 89 for the husband and wife, respectively. How informative are those numbers? What’s the likelihood that both will die within +/- two years of those ages? Surprisingly, there is only a 2% chance of that happening! Most of the time, one or both will die a good number of years before or after their life expectancy.
Therefore, instead of running our analysis over just one assumed lifespan, we model all the combinations. For example, what if the husband dies at 75 and the wife lives until 93, or the husband dies at 90 and the wife dies at 82? We allow for possible death ages out to age 120, giving more weight to more likely lifespan combinations (using actuarial mortality tables). Additionally, we go a step further and allow both spouses to customize their longevity assumptions. They can each tell us whether they expect to live shorter or longer than average for their age group. And we’ll factor that into our recommended strategy. For example, if one person is in poor health, and as a result doesn’t expect to live as long as would be typical, then we might not recommend delaying benefits as much as we normally would.
All this work has the benefit of developing a recommended strategy that is stress-tested against the many different things that could happen. This is a natural extension of our long-standing philosophy of showing participants the impact of uncertainty when it comes to their investment strategies. In the context of Social Security claiming, they are getting a risk-free income, but we shouldn’t ignore the uncertainty in how long they might live, which affects the payoff to delaying benefits.
The evolution of Social Security over the next five to 10 years
Four factors should be considered in the evolving landscape: declining private pensions, required minimum distribution rules, participant financial education and Social Security reform.
A significant fraction of recent retirees have private pensions. Going forward, this will decline in importance, and participants will pay more attention to Social Security since it will be their sole source of steady income that’s guaranteed for life.
The SECURE Act pushed out the RMD age to 72, and at the time of writing, the SECURE Act 2.0 looks like it could push it out further to 75. While many will welcome the option to further defer taxes, there may be an unintended consequence. Studies have shown that many people use that RMD age as a mental reference point for starting withdrawals. We should worry if people think, “I shouldn’t start my account withdrawals until 75, which means I can’t afford to delay Social Security until age 70 because that’s too big a gap.”
The behavioral bias we just described can be combated with better financial education and advice. Fortunately, more retirees are starting to realize that taking Social Security as early as they can isn’t the best move. We still have a lot of room to help participants develop the answers that fit their particular situation, since there isn’t a simple rule of thumb that works for everyone.
Finally, it’s anyone’s guess as to how Congress will address the looming funding crisis for the Social Security program. We could see benefit reductions, changes in full retirement age, modifications in the effect of delaying, changes in how benefits are taxed or a combination of changes. There’s a high likelihood that the optimal strategies under current rules would need to be modified under a new set of rules.
* This tool is offered for free to all employees enrolled in Edelman Financial Engines Workplace services. If you are an organization interested in learning more about how we can help your employees, contact us for more information.