Tuesday, November 6, 2012

Claiming Social Security Retirement Benefits - Part 1

I promised to provide some useful retirement funding advice for people who aren’t wealthy. By my definition, that’s anyone who hasn’t saved enough for retirement to avoid a significant decline in their standard of living after retiring. As I showed in my blog on retirement savings balances, that’s at least 50% of all Americans. I suspect the percentage is much larger.

Claiming Social Security benefits is a complicated issue, particularly if you are married or divorced. In many cases, it’s an emotional one, so I will need a few posts to even cover the basics. 

But this I can tell you up front: Social Security is the most reliable source of retirement income most Americans will have and when you decide to receive benefits is, unless you are quite wealthy, the most important retirement funding decision that you will make.

There are three primary ways to pay for retirement: 1) pensions, 2) personal retirement savings in 401(k) and other savings accounts, and 3) Social Security retirement benefits. Many studies include home equity by assuming that retirees will take out reverse mortgages to generate income, but I find that troublesome. First, most people simply don’t take out reverse mortgages for various reasons and second, studies show that about 85% of Americans want to retire in their current homes. Many want to pass their home to their children.

Nonetheless, a Boston College Center for Retirement study found that taking out a reverse mortgage would add about 10% to the number of Americans who have saved enough for retirement. In other words, for many households, successfully funding retirement will require tapping home equity with a reverse mortgage or by downsizing.

Pensions work fairly well, but they have all but disappeared since the early 1980’s. Mostly public workers like teachers, firemen and the military have them now.

Pensions were largely replaced by 401(k) accounts beginning in the early 1980’s, transferring the risk of retirement financing from businesses to individuals. As I pointed out in an earlier post, the personal savings approach (401(k)’s, IRA’s, etc.) has only worked for a very small percentage of American households. That leaves Social Security benefits to serve as the backbone for retirement financing.

Regardless of how you feel about Social Security as a social safety net, it is unquestionably the most secure component of retirement income. Without Social Security retirement benefits, most of our elderly would live in near poverty. About 14% of all Social Security recipients derive more than 90% of their income from those benefits. For about half or recipients, it contributes 50% or more of their income.

If you qualify for these benefits because you paid FICA taxes for 40 quarters or more, or because you are married to someone who did, deciding when to claim them may well be the most important retirement financial decision you make. That’s because the amount of your benefit will depend on when you choose to receive it.

You can receive these benefits as early as age 62, but every year you postpone receiving them, they will increase about 8% in value. They stop increasing after age 70, so there is no gain from postponing them past age 70.

For example, you might receive a benefit of $1,000 a month for the rest of your life if you claim benefits at age 62. If you forego those payments for twelve months, though, you might receive $1,080 a month for the rest of your life.

On the other hand, it may turn out that you have no decision to make. 

Nearly half of retirees recently surveyed (45%) say they were forced to retire earlier than they had planned, typically because of layoffs, health problems, or the need to take care of a spouse. You may plan to retire later than age 62, but life won’t necessarily oblige.

If you can postpone claiming, however, it will be the most effective way possible to improve your retirement income. It helps in three separate ways. First, it increases your benefit, as I explained above, by about 8% each year that you postpone claiming. Second, it delays the date when you will need to draw down your personal retirement savings to pay living expenses, so your savings will last longer. And third, it gives you a few more years of work income to contribute to your retirement savings.

Assuming you’re in the 55% of workers who actually get to make this choice, why wouldn’t you choose to wait?

First, you might need the income at age 62, in which case claiming early is a no-brainer.

Second, you might be persuaded by the “break-even” argument that says you have to live 10 years or so before you are paid back for the years you elected not to receive benefits. This is a specious argument and one that I will explore in my next post.

Third, you might believe that the entire Social Security program will go away before you can take advantage of it, so you should grab what you can get while the grabbing is good.

I don’t buy the latter argument for two reasons. First, conservatives have been trying to eliminate the program since its inception in the 1930’s without success. People love Social Security and it has proven politically disastrous to recommend ending the program. Second, eliminating Social Security would create a massive elderly poverty problem, and so would be self-defeating as a way to cut the federal budget. Americans aren’t going to let their elderly starve.

Still, if you feel strongly that the program will go away, claiming early would be a rational choice, though I don’t recommend it. The reality is that only very wealthy people can afford retirement without Social Security.

So, here’s my first bit of retirement advice for people who won’t accumulate several hundred thousand dollars in retirement savings by their early sixties. 

Postpone claiming Social Security retirement benefits as long as you can up to age 70.

This is especially true if you are the higher earner of a married couple. If you are the lower earner, it may make sense to claim as early as your full retirement age (66 for people retiring soon), and have the higher earner postpone his benefits as long as possible, but that is a more complicated decision that I’ll address subsequently.

Social Security retirement benefits are a deferred joint lifetime annuity. Those benefits are paid to you and your spouse for as long as you live. You could purchase an annuity that is equivalent to your Social Security benefits from several insurance companies, though it would be expensive.

Social Security retirement benefits are a single premium immediate annuity with inflation protection. You could buy one of those from an insurer recently with a 3.875% payout, meaning it would pay $38.75 per year for every $1,000 of annuity you purchased. 

The average household Social Security benefit in 2012 is about $14,000 a year. Divide that by .03875 and you get $361,290. That’s the amount you would have had to save to purchase an annuity equivalent to the average Social Security benefit in 2012.

You can divide your own annual Social Security benefit by .03875 to see what your benefit is worth. In fact, I suggest that you head over to the Social Security website and use their calculator to estimate your benefits and calculate how much you would have had to save to buy those benefits. (Remember to multiply the monthly benefit by 12 and then divide by .03875.)

I recommend that you consider your benefits as longevity insurance, guaranteeing that you will have substantial income if you live a very long time. If you do so, the value of postponing claiming benefits will be obvious.

The best argument for delaying benefit claims as long as possible is the sentiments expressed by many elderly women who have outlived their spouses by two decades and now suffer with a benefits check that could have been as much as 85% larger. Their biggest financial regret is that they and their spouses claimed Social Security benefits at too early an age.

In my next post, I’ll explain why break-even analysis is a poor way to decide when you should receive your benefits.

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