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Save Soc. Sec. for Later, When You Need It Most

Tim Maurer, Director of Personal Finance

I think we’ve been looking at Social Security retirement benefits all wrong. In the long-running debate about when to take Social Security — as early as age 62 or as late as age 70 — the focus has been on timing your claim to get the most money, in total, out of the social safety net.

This is a circular argument that will never be fully decided until the Social Security recipient in question dies. So let’s shift the focus from the question “How do we get the most out of Social Security?” to “How do we get Social Security when we need it most?”

Simply put, you’re more likely to run out of money at the end of retirement than at the beginning.

Behavioral science explains why we are all so prone to preferring money today over tomorrow. It’s called “hyperbolic discounting,” and behavioral economists plead that we meaningfully overvalue money now, unfairly discounting money later.

But the risk of making less money in your early retirement years is dwarfed in comparison to the risks of longevity and inflation in the latter stages of retirement. And the probability you will outlive your money meaningfully decreases if you wait to take Social Security.

Prove it!

Let me show you through an example that, while hypothetical, is no doubt close to reality for many.

We’ll consider three couples, the Earlies, the Fullers and the Laters. Each couple:

  • Retires with $1 million in tax-deferred retirement savings.
  • Has an identical 50 percent equity, 50 percent fixed-income portfolio.
  • Has a pretax retirement income need of $90,000 per year.
  • Will supplement their Social Security income with the retirement savings necessary to fulfill their income needs.
  • Includes one household member who will receive the maximum in Social Security benefits and one who will receive 50 percent of the maximum.

The only difference is that the Earlies retire and begin taking Social Security retirement benefits at 62, the Fullers at 67 and the Laters at 70.

This hypothetical case study is designed to result in an academic probability that each couple will not run out of money, and applies more than 3,000 iterations of randomized historical market returns for the respective retirees’ portfolio allocations.

Then, we show the likelihood that each couple will have at least one dollar left in retirement savings at the end of four different time periods — 20, 25, 30 and 35 years into retirement.

Therefore, if you see a result of 47 percent in the 25-year column of the table below, it means the couple represented still had at least one dollar left in their retirement savings at the end of that period in nearly half of the thousands of iterations run. In other words, that couple had a 47 percent chance of not running out of money 25 years into retirement. Statistically, a probability of 85 percent or better is favorable.

The findings

What did we find? If you die early enough — within 20 years of your retirement date — you have a reasonably good chance to outlive your money regardless of when you take Social Security. The Earlies hit the golf course fully five years before the Fullers, but it’s not clear that they’ve suffered for it at the 20-year mark.

At 25 years, however, there’s a greater than 50 percent chance the Earlies have run out of money and now must ask their kids to pay their greens fees. At 30 years their probability of solvency has dropped to 30 percent, and at 35 years they’re likely relying on their reduced Social Security benefit for all of their income.

Why do the Earlies fail? Because in order to meet their income needs with a reduced Social Security benefit, they put too much pressure on their portfolio to pick up the tab. They were forced to take an effective withdrawal rate of 5.62 percent in their first year of retirement.

How do the Fullers look? Pretty good. Buoyed by a Full Retirement Age (FRA) Social Security benefit and beginning with a reasonable 4 percent effective rate of withdrawal from their portfolio, at 20 and 25 years into retirement, they’re in the 90 percent-plus range. But if they plan on seeing their faces on a Smucker’s jar, their probability of success declines to 67 percent when they’re 35 years into retirement.

As you’d guess, the Laters are solid. Because of their increased Social Security benefit, they require only a 3.26 percent portfolio withdrawal rate in year one. Statistically, they ride off into the sunset and should have the funds to test the boundaries of science in their pursuit of longevity.

If you suspect you’ll die early — and have lineal or medical justification for that belief — you might justify taking Social Security as early as you can (although a lesser-earning spouse could still benefit from your higher benefit when you’re gone). And please forgive the inherent insensitivity in this analysis, which presumes the Earlies, Fullers and Laters all have a choice in taking their benefits at various points in time. Many retirees don’t, and if you need to retire and take early Social Security for any number of valid reasons, of course you should do just that.

But if you hope to have a longer retirement — 30 or 35 years, especially — your chances of not outliving your retirement savings improve greatly if you delay Social Security. Waiting is like purchasing longevity and inflation insurance for what will hopefully be a long and prosperous retirement.

This commentary originally appeared January 1 on CNBC.com

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

Glasses on newspaper

Can Your 401(k) Impact Your SS Benefits?

By Claire Boyte-White | Updated June 26, 2017 — 6:00 AM EDT

Reposted from Investopedia

While income you receive from your 401(k) or other qualified retirement plan does not affect the amount of Social Security retirement benefits you receive each month, you may be required to pay taxes on some or all of your benefits if your annual income exceeds a certain threshold.

Why Doesn’t 401(k) Income Affect Social Security?

Your Social Security benefits are determined by the amount of money you earned during your working years for which you paid Social Security taxes. Since contributions to your 401(k) are made with compensation received from employment by a U.S. company, you have already paid Social Security taxes on those dollars.

This holds true even for traditional 401(k) accounts. Contributions to traditional accounts are made with pretax dollars, but this tax shelter only applies to income taxes, not Social Security. While you don’t pay income tax on traditional 401(k) funds until you withdraw them, you still pay Social Security taxes on the full amount of your compensation in the year you earned it.

“Contributions to a 401(k) are subject to Social Security and Medicare taxes, but are not subject to income taxes, unless you are making a Roth (after-tax) contribution,” notes Mark Hebner, founder and president of Index Fund Advisors, Inc., Irvine, Calif., and author of “Index Funds: The 12-Step Recovery Program for Active Investors.”

The Tax Impact of 401(k) Savings

Though the amount of your benefit is not affected by your 401(k) savings, you may have to pay income taxes on some of your benefits if your combined annual income exceeds a certain amount. In fact, about one-third of benefit recipients must pay taxes on a portion of their benefits.

The income thresholds are based on your combined income, which is equal to the sum of your adjusted gross income (AGI) – which includes withdrawals from any retirement savings accounts – any non-taxable interest earned and one-half of your Social Security benefits. If you take large distributions from your 401(k) in any given year that you receive benefits, you are more likely to exceed the income threshold and increase your tax liability for the year.

In 2017, if your total income for the year is less than $25,000 and you file as an individual, you won’t be required to pay taxes on any portion of your Social Security benefits. If you file jointly as a married couple, this limit is raised to $32,000. You may be required to pay taxes on up to 50% of your benefits if you are an individual with income between $25,000 and $34,000, or if you file jointly and have income between $32,000 and $44,000. Up to 85% of your benefits may be taxable if you are single and earn more than $34,000 or if you are married and earn more than $44,000. If you are married but file a separate return, you are likely to be liable to for income tax on the total amount of your benefits, regardless of your income level.

Other Types of Retirement Income

In some cases, other types of retirement income may affect your benefit amount, even if you collect benefits on your spouse’s account. Your benefits may be reduced to account for income you receive from a pension based on earnings from a government job or from another job for which your earnings were not subject to Social Security taxes. This primarily affects people working in state or local government positions, the federal civil service or those who have worked for a foreign company.

If you work in a government position and receive a pension for work not subject to Social Security taxes, your Social Security benefits received as a spouse or widow or widower are reduced by two-thirds of the amount of the pension. This rule is called the government pension offset (GPO). For example, if you are eligible to receive $1,200 in Social Security but also receive $900 per month from a government pension, your Social Security benefits are reduced by $600 to account for your pension income. This means your Social Security benefit amount is reduced to $600, but your total monthly income is still $1,500.

The windfall elimination provision (WEP) reduces the unfair advantage given to those who receive benefits on their own account and receive income from a pension based on earnings for which they did not pay Social Security taxes. In these cases, the WEP simply reduces Social Security benefits by a certain factor, depending on the age and birth date of the applicant.

How Your Is Benefit Determined?

Your Social Security benefit amount is largely determined by how much you earned during your working years, your age when you retire and your expected life span.

The first factor that influences your benefit amount is the average amount that you earned while working. Essentially, the more you earned, the higher your benefits will be, up to the maximum benefit amount of $3,538. The Social Security Administration (SSA) calculates an average monthly benefit amount based on your average income and the number of years you are expected to live.

In addition to these factors, your age when you retire also plays a crucial role in determining your benefit amount. While you can begin receiving Social Security benefits as early as age 62, your benefit amount is reduced for each month that you begin collecting before your full retirement age. Full retirement age varies between 65 and 67, depending on your year of birth. Conversely, your benefit amount may be increased if you continue to work and delay receiving benefits beyond full retirement age. For example, in 2017, the maximum monthly benefit amount for those retiring at full retirement age is $2,687. For those retiring early, at age 62, the maximum drops to $2,153, while those who defer collection until age 70 – the latest age at which collection can commence – can collect a benefit of $3,538 per month.

“Delaying Social Security until age 70 can be beneficial since you will receive an 8% gain every year after reaching your full retirement age,” says Carlos Dias Jr., wealth manager, Excel Tax & Wealth Group, Lake Mary, Fla.

Eligibility Requirements

To receive Social Security benefits, you must have accrued 40 credits, which you earn by working and paying into the Social Security system. Each year of work is worth a maximum of four credits, so you must work a minimum of 10 years to be eligible. However, each credit is equivalent to $1,300 of taxable earnings in 2017. Once you’ve earned $5,200 in any given year, you have already earned the maximum four credits. This means you could elect to stop working for the rest of year without endangering your eligibility, though this is not a very sustainable strategy. For one thing, a lower income will mean your benefits will be lower.

 

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Guide to Retirement Planning

Guide to Retirement Planning

Section 1: Determining How Much to Save and Spend

Estimating a Retirement Spending Amount

If you are 10 years or less away from retirement, you may be able to estimate retirement spending based on your current spending. Be sure to exclude expenses that may not continue in retirement, and remember to include expenses that may be higher in retirement. In determining how much of these expenses need to be funded by your portfolio, subtract any income you’ll receive in retirement from Social Security or pensions.

If you are more than 10 years away from retirement, it may make sense to estimate retirement spending as a percentage of your current pretax income. A starting point you can use is to assume that 50 percent of your pretax salary needs to be funded from your portfolio. While 50 percent may seem low, keep in mind that in addition to this level of spending, you’ll likely have Social Security or pension income on top of this. In addition, after retiring, you no longer have to save for retirement or pay FICA taxes.

Estimating How Much to Save

If you are 10 years or less away from retirement, we recommend working with a financial advisor to develop a savings plan using Monte Carlo analysis. Monte Carlo simulation is a statistical method for analyzing issues that involve randomness, like the returns of different asset classes. The inputs used in the simulation include the return, volatility and correlation of the asset classes. The simulator provides thousands of “versions” of each year in the future, and then reports back how the portfolio held up in each of these versions of the future. This simulator can help determine when you can retire and how much you’ll need to save for retirement.

If you are more than 10 years away from retirement, Monte Carlo may not be as useful due to uncertainty surrounding retirement expenses and the limitations surrounding the number of years you can run a Monte Carlo simulation. This simulation is useful for up to about 30 years, but analyses that are run much longer than that become unreliable. As a replacement, you can use the table below:

 

Savings Schedule

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The rows of this table are your current age while the columns are how much you have saved for retirement. The percentages show the pretax income you should save annually. The assumptions behind this chart are a 50 percent replacement rate, a retirement age of 65, a 30-year retirement and a 60-40 portfolio. As an example, if you are 35 years old and you’ve saved 1x your annual salary (as indicated by the shaded box above), you would need to save 10 percent per year going forward. The table, which was created by Professor Wade Pfau, looks at a worst-case scenario using historical data back to 1871.

Plan for Potential Early Retirement

The above chart assumes a retirement age of 65, but it is wise to plan for the possibility that you might retire earlier than planned. There can be positive and negative surprises. For example, the investment returns you experience may be higher than expected, your earned income may be higher than expected or you may receive a large unexpected inheritance. On the other hand, you may retire earlier than expected due to negative surprises. For example, you may have a health issue that forces you into early retirement. It is important to have a “Plan B” for this possibility, which could include reducing annual spending or downsizing your home.

Section 2: Portfolio Management

Deciding on an Asset Allocation

Selecting an appropriate asset allocation is largely a function of your ability, willingness and need to take risk.

Your ability to take risk is largely a function of your time horizon. The longer your horizon, the greater is your ability to wait out the virtually inevitable bear markets. In addition, the longer the investment horizon, the more likely equities will provide higher returns than fixed income investments.

Your willingness to take risk is determined by the “stomach acid” test. This is the degree to which you’ll be able to stick with your plan during bear markets.

Your need to take risk is determined by the rate of return required to achieve your financial objectives. We discuss estimating future returns in the next three subsections.

Do Not Assume Constant Rates of Return

When planning for retirement, it is common to plan for the average returns you hope to achieve. However, actual returns will vary from one year to the next. Even if you could predict the actual average return in your retirement, the sequence of returns is also very important when it comes to retirement planning.

For the period of 1926–2014, a portfolio invested 70 percent in the S&P 500 and 30 percent in five-year Treasuries returned an average of 10.1 percent. In real terms (adjusted for inflation), the return was 7.0 percent. You might conclude that it would be possible to withdraw $70,000 per year from a
$1 million portfolio and maintain the same real income over the long term, increasing the $70,000 by the future rate of inflation.

The problem with this approach is that inflation rates and investment returns vary each year. If you retire before the start of a bull market, you may be able to withdraw 7 percent per year and maintain a portfolio in excess of $1 million. However, retiring at the beginning of a bear market can produce very different results.

For example, an individual who retired in 1972 and withdrew 7 percent of his or her original principal and adjusted that figure each year for inflation would have run out of funds within 10 years, or by the end of 1981. This is because the S&P 500 Index declined by approximately 38 percent in the
1973–74 bear market.

Systematic withdrawals during bear markets exacerbate the effects of the market’s decline, causing portfolio values to fall to levels from which they may never recover. For instance, if you withdraw
7 percent plus 3 percent for inflation in a year when the portfolio declines by 20 percent, the result is a decline in the portfolio of 30 percent in that year. A 43 percent increase is then required the following year just to return to the previous value.

Given the possibility that a market decline might occur at a very early stage of your retirement (when it tends to cause the most damage to long-term portfolio outcomes), consider remaining conservative as you determine how much money you can withdraw annually and still minimize the risk that you outlive your assets. We recommend consulting with a financial advisor who uses a Monte Carlo simulator to determine a prudent spending rate in retirement.

Estimating Equity Expected Returns

There are two primary ways of estimating expected returns, either using historical averages or using current valuations to forecast returns.

From 1926–2014, the annual average real return on the S&P 500 was 8.9 percent (not compounded). If you use current valuations, you can use the dividend discount model (which uses dividend yields), the Shiller CAPE10 model or a combination of the two. As of June 30, 2014, the Gordon model yields a real return estimate of 4.5 percent. The Gordon model is calculated using the dividend yield on the MSCI All-Country World Index (2.5 percent) plus an estimate of future growth of 2 percent. The Shilller CAPE10 model yields an estimate of 5.1 percent by taking a 60 percent U.S., 30 percent developed international and 10 percent emerging markets weighted average of the CAPE10 ratios and then multiplying by 1.075 to normalize for growth in earnings.

As you can see, the various methods can yield very different results. Further, all methods of calculating the expected return have flaws. Historical returns are subject to survivorship bias and changes in valuations. The dividend discount model doesn’t account for alternative ways of getting cash to shareholders. Also, not all firms pay dividends, and this model uses current dividends as a proxy for future dividends. As for the Shiller model, it doesn’t account for changes in accounting practices.

We generally prefer to err on the conservative side for these estimates, so we use an average of the result from the Gordon and Shiller CAPE10 models. If you plan for returns that are higher than what actually occur, this could result in you falling short of your goal.

Estimating Fixed Income Expected Returns

On the fixed income side of the portfolio, you are also able to use historical averages or current valuations in the form of current yields.

From 1926–2014, the average real return on five-year Treasuries was 2.5 percent. In looking at current valuations, the yield on a five-year TIPS is 0.2 percent.

Again, the method you use can yield very different results. We prefer to use long-term TIPS rates for determining the highest real return you’d be able to earn over the period. For example, if your horizon is 20 years, we’d recommend using the yield on a 20-year TIPS as your real return estimate on fixed income.

Equity Portfolio Construction

The first step to building a solid equity portfolio is to invest in a globally diversified portfolio. Investing in international stocks, while delivering expected returns similar to domestic stocks, provides the benefit of diversifying the economic and political risks of domestic investing. There have been long periods when U.S. stocks have performed relatively poorly to international stocks. The reverse has also been true.

The logic of diversifying economic political risks is why you should consider allocating at least
30 percent and as much as 50 percent of your equity holdings to international equities. To obtain the greatest diversification, your exposure to international equities should be unhedged from a currency perspective.

Fixed Income Portfolio Construction

The main role fixed income assets play in a portfolio is to reduce its volatility. Therefore, we generally recommend investing in high-credit-quality fixed income. This can include AAA/AA rated corporate bonds or municipal bonds, bank CDs under FDIC limits, agency bonds or bonds issued by the U.S. Treasury. Along the same lines, short-term and intermediate-term bonds have the benefit of less volatility and lower correlation to equities than long-term bonds. As a result, we think most individual investors are best served by avoiding long-term nominal bonds.

Section 3: Risk Management

Long-Term Care Coverage

According to the U.S. Department of Health and Human Services, roughly 37 percent of people turning age 65 today will need long-term care in a nursing home or assisted-living facility. The average cost of a private room in a nursing home is $229 per day or $83,580 per year. The average cost of a room in an assisted-living facility is $3,293 per month or $39,516 per year.

These costs are quite high and many people have turned to insurance to protect against the risk of needing long-term care. The process for determining whether you need long-term care can be complex. We recommend consulting with a financial advisor to determine if it is appropriate in your situation.

Protecting Against Longevity

It is important to consider the “risk” of living longer than expected. This “longevity risk” is the risk that you outlive your financial assets. In certain cases, it can make sense to buy a form of insurance against longevity risk.

This insurance is either a single premium immediate annuity (SPIA) or a deferred income annuity (DIA). In a SPIA, you pay an upfront premium to an insurance company in return for an income stream that starts immediately. This income stream can be either fixed or adjusted for inflation. In a DIA, you pay an upfront premium to an insurance company in return for an income stream that starts at some date far into the future. For example, you could buy the DIA at age 65 in return for income starting at age 85.

The process for determining whether you should insure against longevity risk or self-insure is complex, and we recommend consulting an advisor to determine if it is appropriate in your situation. We generally prefer deferred income annuities over immediate annuities because we’ve found the deferred option leads to higher levels of success in Monte Carlo simulations.

Section 4: MaximizING Social Security Benefits

According to the Social Security Administration, Social Security benefits represent about 40 percent of the income for the elderly. Social Security benefits are essentially guaranteed income that:

  • Is adjusted for inflation
  • Is free of investment risk
  • Is protected against longevity risk
  • Comes with a death benefit for married and qualifying divorced individuals

These benefits often are a significant source of retirement income and unlike any other income or investment vehicle. It is important to know how to optimize lifetime benefits. Benefits are determined by birth year, retirement age and lifetime earnings. Once workers reach full retirement age (FRA), they are eligible for full retired worker benefits, also known as the primary insurance amount.

Workers who claim benefits prior to reaching FRA will receive a reduced benefit of up to 25 percent of the primary insurance amount. Delaying a claim until age 70 results in a benefit of up to
32 percent more than the primary insurance amount due to cost-of-living adjustments and delayed retirement credits.

The optimal strategy for claiming Social Security benefits might not be obvious because of various rules for how those benefits are paid. For instance, a husband who earns high wages but does not expect to live long may still want to delay filing because, at his death, his benefit will go to his lower-earning wife. If he claims early, she will have a lower benefit for the rest of her life.

Strategies for claiming Social Security benefits can get incredibly complex, so we recommend consulting a financial advisor to help you make this decision.

Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.