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 sum it all up and move on to a new topic.

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!