Social INSecurity: Why We Shouldn't Be Panicking
I’ve stopped counting the number of people who tell me they’re starting Social Security as soon as they turn 62--the earliest age possible--because it's become too frequent of an occurrence. For most people, this is a poor financial decision since their Full Retirement Age (FRA) is 66, and taking benefits four years early will reduce their monthly benefit by 25%.(1)
But here's the thing: They know their decision will lead to a permanent reduction in their payouts, but they don't care. They're more worried about Social Security's future than they own, and think that they should get what they can, when they can. This is not smart financial planning.
Studies show that neither socio-economic status or education level has much bearing on making this decision. If anything, the tendency is somewhat higher among people who could afford to wait until FRA and have adequate resources to draw from in order to generate the income they’d need in order to wait until their 66th birthday.
Even if you show them the amount of Social Security income they’re giving up by claiming benefits early, some aren't persuaded. For instance, assume that Margie and Frank have each earned a Social Security benefit of $2,550 a month. Let’s say Frank files to begin benefits at 62, reducing his monthly check to roughly $1,660. Margie waits until age 66 to start Social Security. The chart below illustrates the cumulative amounts each will have received at key ages.
*Assumes annual Cost-of-Living Adjustment (COLA) of 2.5%
By approximately age 75, Margie’s cumulative income has surpassed Frank’s benefits amount and from that point on, he is steadily losing ground. Nonetheless, the "Franks" of this world are adamant about starting Social Security as soon as they become eligible. Logic has no impact on these folks because their decision is emotional. They’re afraid Social Security is going broke and they have the mentality of: I’d better take it while I can.
This phenomenon is so prevalent I’ve come up with a name for it: Scary Headlines = Stupid Claiming Decisions
As I wrote last week, the Social Security trustees reported that for the past three years, largely due to the lousy economy, the amount of payroll tax collected from workers has not been enough to cover the benefits the program has paid out. This gap in inflow vs. outflow has been bridged by using some of the assets (special Treasury bonds, plus the interest they pay) that have built up in the Trust Fund, but unless changes are made, by 2033 all of the bonds will have been cashed in. Since Social Security can only pay out what it takes in, that would trigger an across-the-board 25% benefit cut
Despite this, Andy Peterson, a specialist in pension and retirement issues at the Society of Actuaries, says not to panic.
“The changes needed to get Social Security into balance are among the easier challenges that our policy makers in Washington, D.C. are facing. A combination of a slight adjustment to the [full] retirement age, raising the earnings cap, changing the CPI, a slight increase in the payroll tax…could put it back into actuarial balance without a great amount of difficulty.”
According to this year’s Trustees Report issued to Congress earlier this month, if we only wanted to attack this from the tax side, we could solve Social Security’s funding issues for the next 75 years by increasing the payroll tax from 12.4% to 15.12%. Since employers and workers split this tax, this would amount to each side paying about 1.3% more.
1.3%!
In fact, it wouldn’t take much more than this to permanently put Social Security on firm financial ground. “From where we are now, if we increased the payroll tax by 4%,…then you could finance it into eternity,” says Alicia Munnell, director of the Center for Retirement Research at Boston College. This approach has the advantage of avoiding any other changes to the program- such as raising the Full Retirement Age or adjusting the cost-of-living formula.
Though the beauty of this approach lies in its finality and simplicity, it’s more likely that Congress with take the usual route and tinker with a number of factors that put a “patch” on the problem for a limited period of time. Peterson predicts that “any solution will be a combination of things both sides of the aisle will not like. [Such as] an increase in the taxable wage base, so you get more revenue, plus a benefit cut” achieved by adopting a new method of measuring inflation.
At the risk of stating the obvious, I would like to point out that 2033 is 20 years away. In other words, we’ve got time to address this, provided we’ve got elected officials who are willing to do so. Because the longer this uncertainty about the future of Social Security lingers, the more insecure Americans become. And the more bad decisions they make about when to claim benefits. Such as focusing on how many years it takes to “break even” if you start an early versus at a later age.
“How do I get my money’s worth?” is the wrong way to go about deciding when to start benefits, says Peterson. Instead you should be asking yourself: "How do I insure against a potentially long life?,” something that, as an actuary, he is acutely aware of. Retirement is no longer a 20-to-25 year period; these days you need to assume it will last 30 to 35 years.
“Personally, I would encourage working as long as you can. The longer you wait, the bigger your benefit becomes. It’s the only retirement income that has an automatic inflation adjustment built in. So your buying power doesn’t erode as you age. By waiting, in effect you’re buying a [larger] cost-of-living-adjusted annuity.”(2)
If continuing to work isn’t an option, Peterson says you’re better off taking withdrawals from your 401(k) rather than starting Social Security before Full Retirement Age. According to his calculations, even if you include the four years of reduced benefits you receive, it’s more expensive to start collecting at 62 and then buy an inflation-adjusted annuity at age 66 to replace the income you’d get if you had simply waited until then to start Social Security.
At the very least, do the math before you pull the trigger to start your benefit. The Social Security website has some great calculators that allow you to see how your monthly check will change based upon when you begin. In fact, if you go here you can set up an account that only you can access so you can tap into your actual earnings history. You can also go to your local Social Security office and have the folks there run the numbers under different assumptions. Talk with an experienced financial advisor who understands Social Security.
But above all, don’t worry about Social Security disappearing. As Peterson points out, “Social Security is such a popular program. And we know that seniors vote. It would be legislative suicide for policymakers to scale it back in any material way.”
1. Filing to begin receiving Social Security before you reach your Full Retirement Age always results in a smaller benefit amount. For those born from 1943 through 1954, FRA is age 66. Starting with individuals born in 1955, the Full Retirement Age increases by 2 months per year until it reaches a maximum age of 67 for those born in 1960 or later. Increasing the FRA is one option being considered to help bring Social Security’s long-term financial situation into balance. See http://www.socialsecurity.gov/retire2/agereduction.htm.
2. It is increasingly rare that a defined benefit, i.e. “pension,” plan provides an inflation-adjusted benefit.