FA Playbook

What you don't know about Social Security can hurt you

Social Security: 'Politics' third rail
Social Security: 'Politics' third rail

Love it or hate it, Social Security is the foundation of retirement in America, but what people don't know about the system can hurt them.

The benefits from the public pension system initiated by President Franklin Delano Roosevelt in 1935 account for more than half the retirement income of more than 75 percent of retired Americans.

For many millions of people, Social Security benefits will be their only source of income after they stop working. And with the inexorable decline of private defined-benefit pensions in America, Social Security's guaranteed income will only become more important in the future.

"Social Security has become absolutely key to the retirement of Americans," said Alicia H. Munnell, director of the Center for Retirement Research at Boston College.

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"It's a source of income adjusted for inflation that keeps going for as long as you live," she said. "You want to have as much of this income as possible."

A man reads through a Social Security Benefits Application.
Jim McGuire | Getty Images

But for too many Americans entering retirement, the knee-jerk reaction is to file for benefits at 62, as soon as they are eligible. That decision can cost them hundreds of thousands of dollars through their retirement years.

"The most important financial decision that 99 percent of Americans will make about their retirement is how to claim their Social Security benefits," said William Meyer, founder and managing principal of Social Security Solutions.

His firm uses software to help people assess potential claiming strategies for their benefits.

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The easiest way to get the biggest bang for your buck is to wait to claim benefits.

The Social Security Administration bumps benefit payments up 8 percent for every year that an individual postpones filing a claim after the full retirement age of 66.

Wait until 70, when filing is mandatory, and the check will be about 32 percent bigger every month. Social Security is adjusted for inflation.

For example, a single woman who would receive a $2,000 monthly benefit at the full retirement age would instead get about $2,640 if she waited until 70 to claim her benefits. Conversely, if she were to claim her benefits when first eligible, at 62, she would get about 25 percent less than her full retirement age benefit, or $1,515.

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If she were to live until her late 80s, delaying her Social Security claim could increase her overall income during retirement by six figures.

The break-even point when the waiting strategy surpasses the advantage of collecting benefits early is typically about 10 years, financial advisors contend.

How to reduce retirement needs
How to reduce retirement needs

"I don't care what equation you use; you can't beat the rate of return on delaying your Social Security benefits," Meyer said. "It's a killer deal."

The decisions get more complicated for married couples because of considerations of spousal and survivor benefits.

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Spouses of at least 10 years of a beneficiary are entitled to 50 percent of the spouse's benefit. Surviving spouses of beneficiaries get the full benefit.

"With couples, the strategies usually boil down to maximizing the higher wage earner's benefits because it lives beyond the death of the first spouse," said Jim Blankenship, a certified financial planner who is the founder and principal of Blankenship Financial Planning.

A popular strategy for couples is for the higher wage earner to file for benefits and then suspend the claim, allowing his or her spouse to claim spousal benefits.

Meanwhile, the higher-earning spouse's benefits can continue to grow by 8 percent annually until age 70. At that point, the other spouse can either continue to receive the spousal benefit based on the early filing or claim their own benefits if they are larger.

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If either spouse was previously married for more than 10 years, there is also the option of claiming benefits derived from that beneficiary if they are greater.

There are also limited opportunities to undo decisions about Social Security claims if family, health and financial circumstances change.

"There are so many variables to consider, especially if there's a big difference in age between spouses," Blankenship said. "The optimal strategies may change over time."

In almost all situations, it makes sense to delay filing for Social Security, even to the point of drawing on a 401(k) plan account or other savings to support yourself until filing for benefits later, Blankenship said.

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Not all advisors are apt to recommend drawing down the nest egg that they make their fees on, but it is usually the far better strategy.

"We recommend whatever makes the most sense economically for the client," Blankenship said.

There may be nothing wrong with claiming benefits early, however.

An individual who is unable to work and/or is in poor health may have no alternative. If a person has a family history of early death, they may wish to claim their benefits as early as they can.

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The key is understanding the financial consequences of different strategies.

Free analytical tools offered by organizations such as AARP and companies such as T. Rowe Price are a good place to start.

Social Security is one of the things you can control, and you must control it well.
Mark Cortazzo
senior partner at MACRO Consulting Group

Meyer's firm offers customers a report based on basic personal data for $20, while $50 allows access to an interactive tool to model different assumptions, and $125 provides someone who can speak on the phone about it.

"As long as people are making informed decisions, there are no wrong answers," said Mark Cortazzo, a certified financial planner and senior partner at advisory firm MACRO Consulting Group.

"Social Security is one of the things you can control, and you must control it well," he said. "The financial impact of it is enormous over an individual's life expectancy."