Monday, July 13, 2015

Early Retirement and Social Security Benefits

In my first post on this topic, The Risk of Retiring (or Being Retired) Early, I noted that retiring early means a longer and more expensive retirement. In my second installment, Retiring Early: Lost Savings, I reviewed the risk of saving less. And in the third, Early Retirement: Spending Sooner, I considered the combined consequences of simultaneously stopping savings and starting spending. Another major financial risk of retiring early is not optimizing Social Security benefits.

I recommend that most retirees delay Social Security benefit claims as long as possible, but there are some people I just cannot convince. They're afraid that fiscal conservatives who have tried to dismantle the program since its inception in the 1930's will soon have more success than they have had in the past 80 years, or that they will not live long enough after retiring to "break even." But, I suspect a lot of it is addressed by a recent Forbes piece entitled, Most Americans Can't Pass This Basic Social Security Quiz, and they just don't understand how Social Security works.

The basic problem we try to solve by delaying Social Security benefits is the mitigation of longevity risk (growing very old and outliving all our savings) and delaying benefits is the single most cost-effective way to achieve that.

Here's the problem we hope to mitigate by waiting. John can retire at age 70 and receive benefits of $36,000 a year, he can retire at full retirement age of 66 and collect $27,600 a year, or he can retire at age 62 and receive $21,000 a year.  John's wife, Martha, will be entitled to spousal benefits of $13,800 a year, assuming she claims at her full retirement age. Her spousal benefit, like his retirement benefit, is reduced if she claims early, but her spousal benefit, unlike her survivors benefit, isn't dependent on when John claims.

If John claims at 70 and dies first, which is more often than not the case, Martha's spousal benefit will be replaced by a survivors benefit equal to John's retirement benefit. If John claims at age 70, Martha's survivors benefit will equal (his) $36,000 a year but if he claims at 62, her survivors benefit will only be $21,000 a year for the rest of her life.

If John claims at 62 and dies at 71 but Martha lives to 96, Martha is stuck with a $21,000 benefit for two and a half decades when she might have enjoyed $36,000 a year.  (Whether your Martha begrudges the extra $375,000 after you're gone is between you and your spouse.) It really all boils down to whether you view Social Security retirement benefits as insurance against a very poor financial outcome or you view it as a game you are trying to win against the Federal government. But, be forewarned that the government doesn't care who wins and that you generally "win" when you claim early by not living long.

Here's the problem the "claim early" crowd hopes to mitigate. John, or John and Martha, plan to delay claiming, but both die in their late 60's and never receive a penny of their benefits. From a purely financial perspective, this isn't as severe an outcome as living to 100 with inadequate funds for the last decade or so. While we would all probably hope to live longer, a short retirement means we are far less likely to outlive our wealth.

Some of those arguments made by the "claim early" crowd are valid. Maybe you and your spouse won't live a long time, who knows? Maybe benefits will be reduced in the future. But living long enough to regret claiming early is a far more common event than reductions in Social Security benefits have been. Don't protect yourself from sharks and ignore heart disease.

Nearly all academics in the field and economists, some Nobel laureates, recommend delaying benefits as long as possible. If they can't convince you, I certainly can't. If you do, however, agree that delaying claims for Social Security benefits is a good idea, then it becomes a consideration for early retirement.

Retiring early often means that you will need to live completely off retirement savings until Social Security benefits kick in, unless you are lucky enough to have a pension. That may put pressure on your retirement plan, unless you are quite wealthy, to claim benefits sooner than you otherwise would and to forgo the most effective longevity insurance available.

Next time, I'll talk about my own decision to retire early in Early Retirement: Would I Do It Again?

Before I do, let me say that I really appreciate your questions and comments and I hope you won't feel constrained to the topic of the post you are reading. Feel free to ask any retirement finance question anytime. If I don't know the answer, I'll find it. Sometimes your questions spawn an entirely new post. If you have a question, there is a good chance that several others have the same one. I prefer that you log in any leave your name, but do so anonymously if it makes you more comfortable.

I hope you're enjoying your summer as much as I am mine!




19 comments:

  1. Can you please comment on my case? I am eligible to receive Social Security. My wife is a school teacher in Maine. She paid into social security before becoming a teacher, but has not paid in for the last 20 years under the Maine Public Employees Retirement System. Thus her Social Security will be offset/eliminated by the Government Pension Offset and the Windfall Elimination Provision. If I die before her she will also not be able to collect any Social Security survivors benefit. I can understand her not being able to collect her own Social Security, but it does not seem right that she cannot collect mine if I die before her since I have been paying into Social Security for 40 years. I plan to start collecting Social Security at 62 since my wife cannot collect any Social Security if I die before her.

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    1. I know a lot of school teachers who are angry about the WEP and GPO. Public employees were left out of Social Security in 1935 because it wasn't clear if the Federal government had the authority to tax state employees. That has long since been resolved, but teachers primarily in 15 states (including your Maine and my home state of Kentucky) have these issues because their state governments have not chosen to switch from public pensions to Social Security. Many of these teachers have the same issues as you.

      The GPO became law because "In the absence of the GPO, the spouse or survivor of a covered worker would be treated more favorably if he or she had worked in noncovered government employment than if he or she had worked only in covered employment." You can read more about it here, if you are interested.

      On the positive side, my elderly father-in-law was a farmer who paid FICA taxes and his wife was a teacher with a pension. His survivors benefits and medical care from her pension have been far better than he would have received from Social Security.

      Regardless, your wife's survivors benefits aren't the only consideration. If you claim at 62 and live to an old age, you will eventually regret the decision. You will have locked in a low benefit for a very long time. I can't offer an opinion on claiming at 62 in your case because I'm not aware of the provisions of your wife's pension. Her pension and your Social Security benefits need to be considered together.

      These decisions are perhaps the most important retirement financial decisions you will make and you really need to get it right. I strongly suggest that you find an adviser well-versed in both Maine public pensions and Social Security benefits. If you will e-mail me at jdcplanning@gmail.com, I may be able to help you find someone.

      Good luck and thanks for writing.

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  2. I'll turn 70 this fall, and will begin receiving SS benefits. My wife is almost 8 years younger, and is the lower-earning spouse. I read an article this past week which argues that she should claim SS benefits as early as possible. The reasoning is that I'm likely to die before she would reach her break-even point if she were to delay. And at that time, she'll receive my full benefit. Agree?

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    1. Otto, congratulations on holding out until 70. I think that's a wise choice. I would need a lot more information to address your specific case, but I can tell you that I don't care for the argument. I don't believe that financial arguments based on guessing when some healthy person might die are sound. Yes, the odds favor your spouse outliving you, but I know a 97-year old man who has so far outlived his decade-younger and much healthier wife by nearly a decade. You should be planning to protect yourself from longevity risk, not guessing when you will die.

      Having said that, I think there are probably better arguments that do support her claiming early in your case. For one, she gets no increase for claiming past her full retirement age. (There are no delay credits for spousal benefits).

      I have a couple of suggestions. First, you might want to read a recent post by Michael Kitces entitled, "Why It Rarely Pays For Both Spouses To Delay Social Security Benefits" (emphasis mine).

      My second suggestion is to invest $40 in Laurence Kotlikoff's MaximizeMySocialSecurity software. It will download your family's actual earnings from SSA.gov and show you how to maximize benefits. This is a decision you really need to get right and $40 pales in comparison to the cost of getting it wrong.

      Short answer, given the limited facts you have provided, is that it sounds like a reasonable strategy in your case. If it were me, I would confirm that with MMSS software.

      Thanks for writing!

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  3. In my experience as an adviser (and with my Father as well), the decision to take benefits early is emotional. For many people, especially middle and lower income types, SS represents a significant marker in their life. They also feel like they are "ready" to receive it. They have worked a long time, many in work that has not been satisfying or frustrating, and finally want to get paid from a plan that they have paid in to forever. The numbers and risk evaluation, as it were, are just not as interesting to people that feel this way.

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    1. I've seen that, too. Unfortunately, many financial decisions get made more on the basis of emotion than logic, including this one. Thanks, Mark!

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  4. Many thanks to Mike Piper, whose OblivousInvestor.com blog is among the very best finance resources on the web, for catching an error in my example regarding spousal benefits. Martha's spousal benefit would be $13,800 a year instead of $10,500 and is not dependent upon when John claims. Her spousal benefit is reduced if she claims early. (Her survivors benefits are dependent on when he claims, so the outcome of the argument remains the same.)

    Mike provided the following additional information on spousal benefits:

    "Regarding your most recent post about Social Security, I believe there is an error in your example regarding spousal (rather than survivor) benefits.

    Martha's benefit as John's spouse (i.e., her benefit while he is still alive) is unaffected by the date at which he claims. If she claims her spousal benefit at her FRA (and she has no retirement benefit of her own), she gets 50% of his PIA rather than 50% of what he is getting.

    Here is the relevant Code section.

    Alternatively, on the SSA.gov page you linked to here, this is why they state that the spousal benefit is "one-half of your spouse’s full retirement amount."


    I apologize for the oversight but, fortunately, I have a number of knowledgeable readers who usually find them quickly.

    Thanks, Mike!

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  5. We are still a few years out from being eligible for claiming Social Security, but my understanding is that the higher earning spouse would be eligible to collect a full spousal benefit based on the lower-earning spouse's benefits once FRA age is reached for both spouses while the higher earning spouse would still be able to file and suspend his benefit to age 70 to get the increase in his benefit. I don't see this discussed in the Kitces article. This spousal benefit could potentially be a quarter to a third of the final delayed benefit which is not insignificant in breakeven calculations.

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    1. I believe Michael is trying to simply show that it rarely makes sense for both spouses to delay claiming until age 70 and not to consider the full range of claiming options. There are many.

      I believe the strategy you suggest is viable, but there are several restrictions to consider. A spouse need not wait until FRA to claim spousal benefits, for example, but he or she can't claim early and switch later. Spouses can't claim spousal benefits simultaneously. It might be profitable for the lower earning spouse to claim-and-suspend, or better for the higher-earning spouse.

      I'm probably sounding like an ad for MaximizeMySocialSecurity at this point, but for $40 can you buy software that considers hundreds of strategies for you and lets you try your own if you think you can do better. The alternatives are paying an expert or studying SSA.gov while you build complex spreadsheets.

      Been there. Done that.

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  6. I have appreciate this series, as I am planning to retire early in a couple of years at age 55 +/-. I am concerned about sequence of returns risk, and have considered purchasing an annuity with a fixed term of 5-10 years using my non-retirement investment account (which is a little less than half of my portfolio). This would carry me through the years before my retirement funds are available and perhaps beyond, and allow me to invest income from potential part-time work in my Roth IRA. The rationale behind the fixed term is consideration of the effect of inflation on the annual payment over a potential 45-year retirement. I have not seen much discussion of fixed term annuities at all in the various blogs that I follow, and none in the context of 'market-proofing' an early retirement income stream. Any thoughts or comments much appreciated!

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    1. A fixed-term annuity is essentially a certificate of deposit issued by an insurance company instead of a bank. A 5-year CD might pay 2.25% today, while a 5-year FTA might pay 2.75%.

      FTAs pay higher interest rates for a couple of reasons, both having to do with greater risk demanding a higher rate of return. First, banks typically don’t sell CD’s with maturities greater than 5 years and if you are willing to lock in today’s interest rate for longer, you can do so with FTAs. You would, however, be taking on greater inflation risk and greater interest rate risk by doing so.

      Second, bank deposits are insured by FDIC, while FTAs are insurance policies and protected by state insurance funds. Federal insurance is significantly less risky.

      Neither CD’s nor FTAs are likely to keep up with inflation over 5 to 10 years, so they aren’t your best bet for a retirement portfolio. And, investing in both bonds and cash is a better way to “market-proof” your portfolio than investing in cash alone. (Both CD's and FTAs are "cash equivalents".)

      It sounds like you want minimal risk for these investments. Instead of locking in today’s historically low interest rates for 5 to ten years with no inflation protection, you might want to consider short and intermediate TIPS bond funds or ETFs that will take advantage of future interest rate increases and offset inflation.

      Good question. Thanks for writing!

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  7. Thanks so much! You noted a number of points that I would not have thought of, and it all makes sense to me. I will definitely take your device to consider TIPS funds.
    Abby

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  8. Thanks so much! Your analysis is very clear and I can see why this may not be the best strategy. I will definitely take your advice and consider TIPs funds.
    Abby

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  9. Dirk, if I understand you correctly; are you recommending buying annuities after the Fed has hiked interest rates since that will result in a greater amount annually?

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    1. Before I respond, out of curiosity, what gave you that impression?

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  10. I find it interesting that most Americans misunderstand social security. For the last 80 years it's been an every day part of working in America. Thanks for helping me to understand what happens once social security benefits are claimed early. I'd rather play it smart instead of looking for the quick reward.
    http://www.duffandassociates.com/Our-Services.2.htm

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    1. In fairness, Social Security programs are quite complex and go well beyond retirement benefits. But, I agree it's disheartening that most Americans don't even understand the basics when most families will need it just to stay out of poverty.

      Again, I recommend this booklet from EBRI for households that need to start with the very basics.

      Thanks for writing!

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  11. Dirk: I'd like to wait until I'm 70 (65 now expect to retire at 66)) to collect max SS, which would be $40,000 a year. To do so, I'd like to take interest only from my portfolio ($1.3m) and augment that with careful withdrawl from my home equity line (at prime for life) , then pay that back over a few years at age 70. Or,. I could whittle down some of my portfolio to mitigate the RMD. What do you think.

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    1. I would need a lot more information to answer those questions for your specific situation, but you do raise some interesting issues.

      Postponing Social Security benefits I highly recommend to anyone who can afford to do so. It's the most cost-effective longevity insurance you can buy.

      I'm not sure what spending interest only from your portfolio buys you. Maintaing your portfolio allocation is more important and spending only interest from the bond portion might significantly change your allocation. I'd suggest that you spend the assets that need rebalancing.

      If you delay Social Security and live off your portfolio for a few years, you may find that you have more tax deductions than you can use. You may be able to use part of the deductions to offset Roth conversions, which will whittle away at your RMDs.

      I assume you plan to borrow and repay from home equity to fix some sort of liquidity problem? I would try to find a cheaper way to accomplish that than paying interest. Unless you have thoroughly investigated the liquidity issue, I would suggest that you invest in $ESPlanner. It does a really good job at solving liquidity issues.

      Better yet, you might consider finding a good, fee-only financial planner to help. My guess is that you may be able to significantly improve on your current plan.

      Good luck, Steve, and thanks for writing.

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