Today, we’re going to talk about two retirees, Pilot Pete and Chef Steve. Each plans to retire next year when they turn 62. Their financial situations are exactly the same; they have the same amount saved and expect to spend the same amount in retirement.
However, there’s one difference in their retirement plans: Pilot Pete will immediately apply for Social Security when he retires at age 62, while Chef Steve plans to wait until age 70.
Will the timing of their Social Security make a difference? Who’ll come out better? Let’s find out. And be sure to stay until the end where I discuss the long-term prognosis of Social Security in general.
How Applying Early Reduces Your Benefits
The amount you’ll receive from Social Security depends on both the amount you earned over the course of your career and when you choose to start receiving your benefits. Your “Full Retirement Age” – or FRA – is the age at which you are eligible to receive your full retirement benefits. Your FRA depends on when you were born, but for most people trying to make this decision today, Full Retirement Age is 67 years old.
So, what happens if you want (or need) to start your benefits before your FRA? You can start receiving your benefits early, but, of course, it wouldn’t be fair to just let you have your full benefit amount. Thus, Social Security reduces your benefits depending on how early you apply.
If your Full Retirement Age is 67 and you apply at the earliest possible date – when you turn 62, your benefits will be reduced by 30%. So, if your full retirement benefits are $1,000 per month at age 67, you’ll receive $700 per month instead if you begin at the earliest possible date.
Of course, this is a government program, so if you begin your benefits somewhere between 62 and 67, your benefits will be reduced by a smaller fraction. The actual formula is this:
- Benefits are reduced by 5/9 of 1% per month for the 36 months preceding your FRA, and
- If you apply more than 36 months before your FRA, benefits are then reduced by 5/12 of 1% per month.
Makes total sense, right? Well, of course not, but them’s the rules.
How Delaying Increases Your Benefits
Conversely, if you delay your benefits beyond your Full Retirement Age, it’s only fair to expect a higher monthly benefit since you’ll be receiving fewer checks over your lifetime. If you delay retirement one year beyond your FRA, your monthly benefit increases by 8%.
So, based on our last example, if you expect to receive $1,000 per month at your Full Retirement Age of 67, delaying a year to age 68 means that you’d receive $1,080 per month instead.
The formula for increasing benefits by delaying is a bit simpler. For every one month you delay, your benefits increase by 2/3 of 1%. That adds up to a total of 8% every 12 months. These benefit increases stop at age 70, so you can’t delay beyond then.
Notice that none of these fractions are the same. 2/3 is greater than 5/9. 5/9 is greater than 5/12. Once you throw in Social Security’s annual cost of living increases (COLAs), it creates an incentive to try and optimize your benefits as much as possible.
But does optimizing your benefits make a material difference? To understand how impactful the timing of Social Security can be, let’s catch up with our friends, Pilot Pete and Chef Steve.
For simplicity and consistency, we’ll continue to use the same assumptions we’ve made in prior blog posts in all our calculations. Inflation will be 3% and our expected portfolio returns are 7%. I know these numbers may not seem feasible in today’s environment, but they’re round numbers close enough to historical data for the purposes of our discussion here.
For income, we’ll assume they make $90,000 per year. To estimate their Social Security, we’ll simply input Pete’s and Steve’s income into the Social Security online quick calculator to arrive at a monthly benefit. In this case, their benefits at Full Retirement Age would be $2,304 per month. We’ll also assume their stay-at-home spouses are eligible for spousal benefits.
Of course, Social Security benefits will increase annually with a cost-of-living adjustment. For simplicity, we will assume that Social Security payments increase at the rate of inflation as well.
For both Pete and Steve, we’ll assume they plan to spend $6,000 per month in retirement.
To see how the differences in timing Social Security change things for Pete and Steve, we’ll also need to make some assumptions about what they’ve saved up to this point. Let’s assume they both have the following saved:
Cash Accounts: $ 50,000
Stocks & Mutual Funds: $ 250,000
Retirement Accounts: $ 700,000
Total Investments: $ 1,000,000
The only difference between Pete and Steve’s retirement plans will be the timing of their Social Security benefits.
Retirement Projections: Apply at 62
With retirement living expenses of $6,000 per month, both Pete and Steve have solid probabilities of retirement success. For Pilot Pete, we find that he has a 78% probability of success, according to our Monte Carlo analysis. Chances are pretty good that Pete will not have to reduce his spending over the course of his retirement. However, let’s dive into the numbers.
Because Pete applies early, he’ll only receive $1,613 per month at age 62. We’re also assuming that Pete’s wife Sally will apply for spousal benefits at age 62, reducing her benefits as well.
Assuming Pete and Sally live to their full life expectancies of 92 and 94 respectively, they’ll receive a total of $917,222 in Social Security retirement payments over the course of their lifetimes. This total is in today’s dollars to make comparison easier.
So, Pilot Pete is in good shape. But how does he stack up against Chef Steve? After all, Steve will be applying eight years after Pete. Until then, he’ll have to fund all his retirement expenses from his investments. Will it make a difference?
Retirement Projections: Apply at 70
As it turns out, timing does make a difference – and a significant one at that. By delaying Social Security until age 70, Chef Steve sees an 85% probability of retirement success, based on his Monte Carlo results. Going from a 78% probability to an 85% probability may be the difference between feeling comfortable about retirement and not.
At age 70, Steve will begin receiving $2,857 per month due to the benefit increases from delaying. Steve’s wife, Suzie, will see her spousal benefits increase as well. Here, we assume she also applies for benefits at 70.
By delaying as long as possible, Steve and Suzie will receive the maximum possible total benefits over their lifetimes. Assuming they both live to their respective life expectancies of 92 and 94, they’ll receive a total of $1,175,040 in Social Security payments over that time.
Even though Chef Steve will need to rely on his investments to fund retirement before Social Security kicks in, he still has a higher probability of success than Pilot Pete. Why is this the case? It all comes down to the cost-of-living adjustments. The benefits of delaying get compounded over time as Chef Steve’s larger payments increase every year with inflation.
By the way, Chef Steve and his wife will have to live until age 78 before their delaying strategy finally hits the break-even point. Beyond then, they’ll have received more in total benefits than Pilot Pete and his wife Sally.
Retirement Projections: Apply at FRA
You may be wondering how our pilot and chef friends would fare if they applied at their Full Retirement Age of 67. As it turns out, this is the optimal age for them to apply. If they did, they’d see their Monte Carlo probability of retirement success jump to 88% – a full 10% increase over applying at age 62.
By delaying to their Full Retirement Age of 67, they get the benefit of delaying – and they don’t rely completely on their investments to pay for their living expenses until age 70. It turns out that neither of them chose the optimal age to apply.
Timing Social Security: Other Factors
There are other factors to consider when timing Social Security retirement benefits. Our scenarios with Pilot Pete and Chef Steve are over-simplified, of course.; there are a lot of details missing from their financial plans.
An important assumption we’ve made is that we’re expecting them to live well into their 90s. As I mentioned earlier, the break-even age for Chef Steve and his wife, Sally, was age 78. If either of them has health issues or any other reason to believe they’d need to shorten their life expectancy, that would change the calculus.
Over the years, I’ve also seen that Social Security timing doesn’t move the needle as much when clients already have a 90% or greater Monte Carlo probability of retirement success. It can make a difference, but only marginally. It all depends on the circumstances – everyone is different.
Of course, all of this assumes that Social Security will be with us in its current form throughout Pilot Pete’s and Chef Steve’s retirements.
Will Social Security Survive?
According to the Social Security Board of Trustees’ 2022 annual report, the Social Security trust fund will be depleted by 2035. Demographic trends are driving the depletion of the trust. Today, we have more retirees collecting benefits and living longer. Birth rates have also decreased, leaving fewer workers to pay into the system.
Even if the Social Security trust fund does run out, it doesn’t mean benefits go to zero. Right now, about 6.4% of Social Security’s total outflows come from the trust. The other 93.6% come from taxes, including – not amusingly – the taxes that retirees pay on the Social Security benefits they’re currently receiving.
If the trust fund runs out in 2035 as projected, Social Security would only be able to pay out around 80% of the benefits that would be entitled to everyone. So, planning to reduce your Social Security benefits by 20% in 2035 would be a great stress test for your financial plan – and a great idea for a future blog post.
If you need help figuring out optimizing your Social Security benefits, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.
As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.