Clients struggle with making right the Social Security claiming decision. This article provides a six-step process to guide clients through the complexity of Social Security.
1. Obtain the client’s Social Security statement
The first step is to understand where your client stands with Social Security. This information is contained in the Social Security statement. The statement includes the earnings history up to the maximum taxable limit for each year, which the client should double-check for accuracy, as well as estimates for benefit amounts. These estimates include retirement benefits if claimed at 62, full retirement at age 70, as well as disability, family, and survivor benefits if claimed in the current year due to disability or death. The Social Security statement is mailed every five years, and then annually after age 60. But you should encourage your clients to signup up here to view the statement online and to prevent fraudsters from opening an account in their name.
2. Understand the assumptions used in the statement and how to make adjustments
The benefits shown on the Social Security statement are based on numerous assumptions. The first, which is very important to recognize, is that the benefits are expressed in today’s dollars. That makes them straightforward to understand in terms of current income and spending. The actual benefits received will be adjusted for future inflation and cost-of-living adjustments.
More generally, the benefits shown on the statement do not consider inflation or wage growth. Future inflation and economy-wide wage growth, as expressed through the average wage index, are assumed to be flat. As well, future earnings are assumed to match the value shown on the statement, which is based on the earnings from the most recent one or two years shown.
These earnings are assumed to continue until the year or month before one reaches the age for which the benefit is shown. Whether earnings are assumed through the month or year before claiming appears to be random. For example, I was born in May, and when I calibrated the calculations shown on my statement for the age 62 and age 70 benefits, the assumption that the Social Security Administration made is that I had earned 4/12ths of the earnings in the years I reached those ages, representing work through the end of April. But for the full-retirement-age benefit to match, the Social Security Administration assumed I had stopped working on December 31 in the year before reaching full-retirement age. This seems arbitrary, but it is worth noting.
Economy-wide wage growth is important, because if wages grow faster than inflation in the future then this will increase future benefits relative to today when calculated in today’s dollars. Future benefits (as well as payroll taxes) will grow in real terms by the amount of future real wage growth. Growth of the average wage index is used to calculate the primary insurance amount, and inflation assumptions are used to translate that future dollar value into today’s dollars. This distinction did not matter on the Social Security statement because inflation and wage growth are assumed to be zero. But that also means for clients who are still some years away from turning age 60, their statement is underreporting what the benefits will be. Age 60 is the important year for indexing past wages for their wage growth.
The intermediate assumptions in the 2021 Social Security Trustee’s Report include growth of the Average Wage Index at 3.55% and Consumer Price Index-W growth at 2.4%. This implies a 1.15% real growth rate for benefits in the years before the client turns 60, which is not reflected in the benefits shown on the statement for clients younger than 60. Younger clients who are worried about a future benefit cut may find that the present law’s wage-indexing could offset such a cut, such that the benefit statement may be about right after all.
Without having a more sophisticated spreadsheet with the Social Security formulas, one easy adjustment that can be made with the Social Security statement is to calculate what the benefit would be if one claims at age 70 but stopped working at age 62. To determine this, you could take the age-62 benefit and multiply it by 124/70 if the client’s full retirement age is 67, or by 132/75 if the full retirement age is 66. Unless one already had 35 years of their highest indexed earnings by age 62, this calculation will lead to a smaller age-70 benefit than shown on the statement. The difference would reflect the impact of an additional eight years of work on the benefit amount.
One final point is that Social Security statements do not account for any potential benefit reductions caused by the Windfall Elimination Provision or the Government Pension Offset. The statement assumes these do not apply, leaving you with more work to do to adjust for their impacts. The Social Security Administration does have calculators at their website to help with matters like this. This includes a “detailed calculator” that can be downloaded and does the same types of calculations I mentioned for adjusting future earnings, wage growth, or inflation.
3. Familiarize yourself with the basic claiming philosophies
Social Security can be viewed as a form of insurance protecting against longevity, market, and inflation risk. Delaying the start of benefits can increase the value of this insurance. Alternatively, Social Security can be viewed in terms of a breakeven analysis, in which it generally pays to delay if one lives beyond their early 80s. Though the breakeven age falls below average life expectancies, framing the decision in this manner can lead to people viewing Social Security as a gamble in which they are cheated if they delay and die early.
Beyond these basics, it is also important to have a basic understanding about worker benefits, spousal benefits, survivor benefits, benefits for divorced spouses, and benefits for other dependents. Having dependents be eligible based on one’s earnings record can change considerations regarding claiming. The calculation of survivor benefits often rewards delayed claiming for the high earner, since the delay credits will translate into larger survivor benefits as well. But spousal benefits do not receive delay credits, and some dependent benefits, such as for minor children or for spouses caring for minor children, may be permanently lost with delay.
Other considerations for claiming include the earning test that applies when claiming and working before full-retirement age, the windfall elimination provision and government pension offset for those spending part of their careers and earning a pension outside of the Social Security system, interactions with disability benefits, and rules around suspending benefits at full retirement age to benefit from some delay credits if one had claimed earlier.
4. Collect the relevant information for making a claiming decision
With an understanding of how to think about the claiming decision, the next step is to collect the relevant information to determine claiming so that your client does not unintentionally overlook an important matter.
A starting point for this is to consider the potential benefits one will have available, both from other individual’s earnings records, and the benefits that others can receive based on one’s own earnings record. For the former, one can consider spousal benefits from a current spouse, survivor benefits from a deceased spouse, and spousal or survivor benefits from an ex-spouse when the marriage lasted at least 10 years. As for the latter, one’s own earnings record can generate benefits for spouses, dependent minor children, disabled children whose disability occurs before age 22, and dependent parents. Spouses can receive benefits when caring for eligible minor children and then later receive the spousal benefit again in retirement. Often your client will need to inform the Social Security Administration about eligible dependents and previous marriages, as it will not necessarily uncover your eligibility for such benefits without prompting.
Other important issues to consider include whether a client is currently collecting disability benefits, as this can also create implications for retirement benefits. As well, if one is still working, when will work stop and will the earnings test apply if collecting benefits before the full retirement age? You should also identify whether the windfall elimination provision or the government pension offset will apply for any members of the client’s household.
Another set of issues extends more broadly beyond just Social Security rules. For instance, if the client decides to delay benefits, do they have the resources available to support the delay? As well, how reliant are they on the Social Security benefits to support their spending needs? Those who are not dependent on Social Security have greater risk capacity, which could allow them to claim earlier and “gamble” on the notion that they could earn a higher rate of return by investing their benefits. But such behavior requires accepting the risk of the stock market over the protections of Social Security. The client’s risk tolerance also speaks to how willing they are to accept such risk. As well, Social Security delay suggests internal rates of return that can easily dwarf what other bond investments could provide.
Finally, the optimal Social Security claiming decisions determined by software will depend on both assumptions about longevity and interest rates. Greater assumed longevity and lower interest rates will both push strategies toward delay, everything else being this same. Armed with this information, one is ready to then determine a claiming strategy.
5. Use software to calculate the optimal claiming strategy and compare with other options
Because of the complex rules, special cases, and other “gotchas,” it is important to test a Social Security claiming strategy using a high-quality software program. A free open-source program on the Internet is Mike Piper’s Open Social Security. Financial advisors also have numerous other commercial software options for testing Social Security strategies. Different programs may not provide the same claiming answer, and reasons for this will relate to different longevity assumptions (most important), different interest rate assumptions, or that the software is not as comprehensive when it comes to some of the more obscure aspects of Social Security. Generally, the differences in near-optimal strategies are small, but the difference between good and bad strategies can add up to several hundred thousand dollars over a long retirement horizon.
6. Build a strategy to support deferring benefits when applicable
Finally, Social Security claiming decisions must be made as part of an overall financial plan that considers the personal characteristics of the retiree, the importance of reliable income for the retirement balance sheet, the tax considerations for any decisions, and the ability to create a Social Security delay bridge when delaying is found to work best. When delaying benefits, options for replacing the missing benefits before claiming include working part-time, a carve-out of fixed income assets from the investment portfolio, the use of a buffer asset such as a reverse mortgage or cash value life insurance, or a decision to just spend less before Social Security starts.
Conclusion
Though Social Security claiming is just one step in building a retirement income plan, the value of lifetime Social Security benefits can dwarf many other retirement assets. A thoughtful analysis should be taken to determine how to claim Social Security in the most effective manner for the household. The six steps outlined here provide such a framework. My Retirement Planning Guidebook provides a deeper dive into these important planning issues. The book includes detailed action plans for decision making that can assist advisors and their clients. It is available at Amazon, Barnes & Noble, Target, and other leading retailers.
Wade D. Pfau, Ph.D., CFA, is the curriculum director of the Retirement Income Certified Professional program at The American College in King of Prussia, PA. He is also a principal and director at McLean Asset Management and RetirementResearcher.com.
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Clients struggle with making right the Social Security claiming decision. This article provides a six-step process to guide clients through the complexity of Social Security.