How to help clients maximize Social Security benefits

When should individuals claim their Social Security income benefits? According to a recent report by the Bipartisan Policy Center, more than one-third of Americans still claim at age 62 and two thirds claim before their full retirement age (FRA).

Nearly a quarter of men claim at FRA, many without considering that by doing so they are making an active choice to receive less income than they could receive by claiming later. Others fail to consider the implications claiming may have on their spouse’s benefits.

While many without adequate savings aren’t able to choose when to claim if they retire involuntarily, everyone else has a choice. An analysis of actual claiming decisions by retirees made by United Income Inc., a wealth management software firm owned by Capital One, found that suboptimal claiming decisions cost households an average of $68,000 in lost wealth.

Sophisticated analyses take into account the tradeoff of receiving no income during the deferral period and more income later in retirement. The losses are particularly acute for women and healthier Americans (often those with higher incomes) who receive the same annual income increase from deferral but can expect to receive this income over more years than the average American, as they tend to live longer.

Claiming early can be tempting for retirees who are worried about the solvency of Social Security. As Boston University economics professor Larry Kotlikoff has pointed out, if Social Security income is eventually cut (which is unlikely), the income of those who claim early will be cut by the same percentage as those who claimed later.

If benefits get a 23% cut in 2034, the average present value (or PV) of payments for a man claiming at 62 is $678,124, and $764,084 if he claims at 70. Cutting benefits earlier than 2034 will only increase this difference. Without a benefit cut, the difference between claiming at 62 and 70 is $131,951 ($818,747 vs. $950,698).

Advisors and present value

As Kotlikoff’s present value calculations demonstrate, getting the claiming decision right can add the equivalent of a six-figure windfall to a retiree’s balance sheet.

Advisors who cling to less accurate methods, such as the breakeven age, to evaluate the benefits of various claiming options may shortchange their client by tens of thousands of dollars if they fail to consider the value of larger income payments made later in life.

Insurance companies price the cost of creating an annuity based on the present value of mortality weighted future payments. If the probability that a healthy woman will be alive at age 90 is 50% (according to the Society of Actuaries table for annuity buyers), then the value of a $30,000 payment will be $15,000.

Discounting the current rate on inflation-protected U.S. government Treasury bonds (TIPS), which recently was -0.5%, the present value of this payment is exactly $17,000. In a market that prices inflation-adjusted payments with a negative discount rate, the value of Social Security is higher than when TIPS rates are positive.

An advisor evaluating deferral strategies should think like an insurance company when estimating the value of claiming at different ages. How healthy is my client compared to the average American? If they’re healthy, this increases the present value of any claiming strategy that increases future income.

How healthy (and what age) is their spouse and how much will the deferral affect the spouse’s income? What is the current market rate of return on inflation-protected securities? Higher Social Security income is worth more when the market places a greater value on inflation protection and nominal interest rates are low.

Effective claiming often means overcoming the biggest barrier — clients’ behavioral biases. Common objections include “it’s my money and I want it now,” “Social Security is going bankrupt,” or “my mom/dad/grandparent died at 72 so I want to get some of my money back.”

Advisors can overcome these biases by using an objective fact-based process that recognizes that Social Security is an asset and that the goal is to maximize the asset’s value.

Claiming decision & retirement security

Social Security provides not only income, but also crucial protection against the risk of outliving one’s assets. This is particularly important today since people are living longer than ever, and rising health care costs often lead to unexpected expenses that can drain savings.

Higher-income workers have made the biggest gains in longevity in recent decades, so planning horizons for higher-income clients should be longer than for the average American.

An important aspect of Social Security planning is evaluating whether the individual is likely to be alive in their 80s and 90s.

A question used in the University of Michigan’s Health and Retirement Study, which asks respondents how likely it is that they will live beyond age 75, does a reasonable job of predicting actual longevity. A client in poor health, who smokes, is obese or carries another risk factor associated with reduced longevity, will see less benefit from delayed claiming.

Remember that the income increases calculated by Social Security are fair for an American of average lifespan and during a period with positive real interest rates. For healthy Americans today, delayed claiming provides an (actuarially) increase in total wealth.

While benefits are available as early as age 62, claiming later permanently raises monthly benefits with the maximum benefits available to those who claim at age 70. There’s a 6% reduction in monthly benefits for each year one begins receiving benefits before full retirement age.

For someone whose full retirement age is 67 but decides to begin benefits at 62, that means approximately 30% less per month than if waiting until age 67.

If your client is able to wait, delaying claiming past the full retirement age means they will gain about 8% more in monthly benefits each year, up to age 70. For someone with a full retirement age of 67, delaying Social Security retirement benefits until age 70 would result in a 24% increase in the monthly benefit amount.

Here’s another way to think about the financial impact of early claiming. Assume the initial monthly benefit is $1,000 if a client claims benefits at the full retirement age of 67. If the client begins collecting benefits at 62, the monthly benefit would be $700 — that’s a 30% reduction.

But if the client can wait to begin collecting benefits until age 70, the monthly benefit would be about $1,240 — 24% more than the $1,000 he client would get at age 67, and 72% higher than the monthly benefit amount the client would have collected if you began at age 62.

Only about 4% of retirees make the optimal Social Security claiming decision. This results in a loss of wealth of roughly $2.1 trillion for current retirees that made a suboptimal claiming decision.

Additional United Income estimates demonstrate that future retirees could lose an estimated $3.4 trillion in potential income that could be spent in retirement due to suboptimal claiming decisions.

Optimal claiming

Many advisors have become accustomed to using a breakeven calculation to evaluate claiming strategies. This generally involves telling a client the age at which increased payments from waiting a couple of years will eclipse the payments received by claiming early.

This method may cause a client to dismiss delayed claiming as a gamble that they’ll be alive at that age to benefit from the strategy.

Other advisors may discount future payments using the expected historical rate of return on portfolio assets. This would result in placing significantly less value on payments occurring 25 or 30 years in the future.

Social Security income payments are far more valuable than a hypothetical risky return that is not adjusted for inflation. The market values $1 of inflation-protected income 20 or 30 years in the future higher than $1 today.

Advisors who believe that investors are placing too high a price on future real income are free to bet against the market by trading inflation swaps, but clients should use a discount rate based on current pricing.

By delaying claiming from age 69 to age 70, the healthy client may forego $30,000 in income for one year in order to receive an additional $2,400 in annual income for life starting at age 70. What is the value of this income?

Simply multiply the survival probability by the present value of the payment. The value of a monthly payment during the 75th year of age for a man is about $2,250. It’s about $1,500 for his 85th year and $470 for his 95th year. In total, the present value is $44,700, or nearly 50% higher than the income he gave up.

For a woman, the present value is $48,500, or 62% higher. Put another way, the healthy female client can gain $18,500 in expected retirement wealth by simply waiting a year to claim.

Women vs. men

The previous example also illustrates an important point — Social Security income is more valuable for women than it is for men. Why? Women live longer.

On average, they can expect slightly more than two years of additional payments in retirement. Women benefit more from delayed claiming and, conversely, suffer a greater loss in wealth from claiming early.

Many of the more advanced claiming strategies were eliminated in 2016 to limit opportunistic behaviors that impacted the solvency of Social Security.

However, differences in spousal incomes still present an important opportunity to increase expected lifetime income for lower-earning spouses.

The benefit is even greater for lower-earning women who can expect to receive more in future benefits.

If couples have similar incomes, delayed claiming should be based on a present valuation calculation. If they are healthy, both should likely delay to 70, although the calculation is made more complex by the surviving spouse’s ability to claim the other spouse’s full benefit after death. If a spouse is unhealthy, it may make sense to claim earlier.

A lower-income spouse has the option to receive half of the benefit of a higher-earning spouse when he or she claims their benefit at full retirement age. This increases the present value benefit of delayed claiming for a higher-income worker, especially if the lower-income spouse is expected to live longer.

Claiming early can be particularly harmful for a higher earner because it reduces income for both spouses over a lifetime, and harmful for a lower-earning spouse because he or she forgoes the ability to receive the full 50% spousal benefit. Upon the death of the higher-earning spouse, the surviving spouse can receive the other spouse’s full benefit amount.

In a negative real interest rate environment, these expected benefit payments for a surviving spouse can have significant value. The calculations move from a single mortality table to a joint mortality table in which the increased Social Security earnings continue until the death of the surviving spouse.

There is about a 50% chance that a spouse in a healthy opposite-sex couple will still be alive at the age of 95. Benefit increases tied to delayed claiming are spread over a greater number of expected life years, further increasing the present value.

Helping clients make better choices

Many retirees suffer from a behavioral phenomenon known as narrow framing. They aren’t easily able to disentangle the decision to claim Social Security from the decision to retire. Many also express discomfort at the prospect of spending down savings in order to fund early retirement expenses before Social Security kicks in.

One way to encourage clients to accept Social Security deferral is to focus their emotions on something they may dislike more than spending down savings — paying higher income taxes on future required minimum distributions.

Estimate a sustainable annual retirement spending path given the client’s current wealth and make a plan to withdraw funds from a traditional individual retirement account to bridge lifestyle expenses before Social Security begins.

Explain that by withdrawing the IRA assets when their income taxes are lower, this allows for a reduction in the tax impact of required minimum distributions later in life; withdraw more before age 70 and less after Social Security begins, while paying attention to tax brackets.

Keep in mind, waiting until age 70 may not be the optimal claiming decision for everyone.

Jason Fichtner is the associate director of the Master of International Economics and Finance Program at the Johns Hopkins School of Advanced International Studies.

Michael Finke, Ph.D., CFP, is a professor of Wealth Management and Frank M. Engle Distinguished Chair in Economic Security at The American College of Financial Services.