Social Security Benefits Seem Anything But Secure

Social Security Benefits Seem Anything But Secure

Higher taxation and reduced inflation protection are widely expected.

That makes retirement planning difficult.

By Donald Jay Korn

Jump to mention of Sharon
12/01/97
Financial Planning
Copyright 1997 Securities Data Publishing

In October, as the world was pondering the 10th anniversary of the stock market crash, Social Security's annual announcement slipped under the radar screen. For 1998, benefits will increase only 2.1%, the lowest since 1987. Was this good news? The trifling increase reflects low inflation, which is bullish for stocks and bonds. Was this bad news? Social Security recipients will receive only modest boosts in their monthly checks next year. Or was this no news? For some financial planners, Social Security plays a declining role in their clients' future. "Social Security used to be the third leg of the retirement planning stool, along with pensions and investment income, but that leg is withering," says Robert "Buzz" Law, a financial planner in Atlanta.

Indeed, a phone survey indicates that many planners are deeply skeptical about the outlook for Social Security benefits: Higher taxation and reduced inflation protection are widely expected. "For my clients under age 35, I don't plan for Social Security at all," says Elissa Buie, a planner in Falls Church, Va. "Over the years it will play a decreasing role in their retirement plans."
Although the future of Social Security is certainly questionable, the present is not. Millions of people-including many financial planning clients-receive billions of dollars in benefits each year. Those benefits can be surprisingly large, in some circumstances, and many clients rely upon them. Therefore, planners need some knowledge of the system in order to answer clients' questions. In addition, Social Security benefits should be factored in to investment planning, especially for the pre-baby boomers who'll be retiring within the next 15 years.

As clients near retirement, they should be encouraged to call the local Social Security office and get a "Personal Earnings and Benefits Statement." This will show a record of taxes already paid as well as estimated benefits at age 65, at a "full retirement age" (which will start to exceed 65 in 2003) and at age 70. Remaining Vigilant "It's important to check on estimated benefits every few years," Law says. "You can catch mistakes sooner rather than later, when it's easier to correct them. Recently, I discovered that Social Security had lost the records of a client's contributions for several years. We provided tax returns and other information to straighten things out."

Planners and clients need to be especially vigilant about 401(k) and similar plans. If a client earning $60,000 elects to contribute $6,000 to a 401(k), for example, the full $60,000 is subject to Social Security and Medicare tax in the current year while the employer is responsible for withholding the full amount. Therefore, Social Security's records should show that this client earned $60,000 that year, not $54,000. If the lower number is recorded and unchallenged, retirement benefits may be reduced. To correct any error, documents relating to the 401(k) plan may have to be supplied.

Assuming that clients' records are in order, they may have queries about Social Security. Most planners say the question they most commonly hear is, When should I start taking benefits? Under current law, a full retirement benefit is available at age 65. Recipients can start as early as 62 (widows at 60), but the earlier one begins, the smaller the monthly check: A client who starts on his 62nd birthday would get only 80% of his full benefit. Thus, a client who would be entitled to a $1,000 monthly check at 65 would get only $800 per month at age 62.

Is it worth starting 36 months early-and receiving 36 extra checks-in return for locking in a lower level of monthly benefits? "Generally, starting earlier is better," Buie says. "It takes a long time to catch up, even with the greater payments you receive for starting later." Going through the math, a person who starts at 65 will take 12 years to receive as much in total benefits as the person who starts at 62, assuming the same earnings history. Factoring in a time value of money, true break-even takes even longer. Unless clients are certain of living until age 80-and who is?-starting at 62 seems like a better choice.

However, Kevin Condon of Baltimore-Washington Financial Advisors in Ellicott City, Md., has a different view. "One of the main concerns of retirees these days is outliving their money. An annuity such as Social Security benefits can help address this concern. I tell my clients to wait as long as they can, in order to receive a larger benefit. The greater the percentage of their income that comes in the form of an annuity, the less chance they'll have of running short of money as they grow older." Bizarre Rules Advising clients when to retire may be tricky because of some bizarre rules regarding earnings and benefits. From ages 62 through 64, individuals can earn only $9,120 (in 1998) and collect full benefits. Over that limit, they'll lose $1 of benefits for every $2 of earned income. Thus, a client who is entitled to $10,000 per year in Social Security benefits would not receive anything if he earns $29,120 or more in 1998. Obviously, such a client should not start to receive benefits. Suppose, though, that a client works part time and earns $15,000 or $20,000 per year. He'll get some benefits but not full benefits. Is it worth locking in a low benefit rate by starting before age 65, if a client won't actually receive full benefits? "You need to look at the numbers carefully," says Sharon Rich , a financial planner in Belmont, Mass. "We advised one of our clients to stop working at a certain point during the year because we calculated he would take home only 20% on the extra dollars he would earn, after taxes and lost benefits."

The situation is a bit better for clients who have reached age 65. In 1998, they can earn up to $14,500 per year without losing any benefits, and they lose only $1 for every $3 of incremental benefits. Thus, someone entitled to $10,000 in Social Security benefits could earn up to $44,500 before losing all benefits. Even so, the decision about whether to start benefits at age 65 is not automatic. If clients continue to defer benefits they're entitled to a "delayed retirement credit," which is essentially a bonus for not taking benefits. This bonus escalates from 5% per year to 8% per year (for everyone born after 1942). What's more, the bonus compounds. For clients who continue to earn substantial amounts, the end of the game comes at age 70, when Social Security benefits won't be reduced, no matter how much the recipient earns. Therefore, the decision on whether or not to apply for benefits is one that needs to be constantly analyzed between ages 62 and 69.

As might be expected, some taxpayers attempt to play games with these tradeoffs. While "earnings" reduce benefits, unearned income doesn't-a client could receive $1 million in investment income at age 65 and still collect full Social Security benefits. "Some strategies are legitimate," Buie says. "Clients who are self-employed might defer billing from age 69 to age 70. However, there are also some people who try to manipulate the system improperly." Business owners receive a great deal of scrutiny in this regard. Some attempt to maximize benefits while in their sixties by cutting their salaries yet taking money from their company via "loan proceeds," "rents," "dividends" or a huge "expense account." Still others try to shift their compensation to a spouse. As a result, Social Security frequently makes special demands upon "retired" owners of family businesses. Such individuals may have to furnish corporate records and complete a Self-Employment Corporate Officer Questionnaire, in order to receive retirement benefits. In essence, the Social Security Administration will look hard at how much work a client actually performs and how he's compensated. If there's a suspicion of excess earnings, he may be called in for an interview to prove that he's truly retired. Nevertheless, there are appropriate techniques for re-casting income yet staying within the letter and the spirit of the law. Such preparation might begin a few years ahead of time, with the creation of a special class of dividend-paying preferred stock, owned by Joe Business Owner. If Joe actually works less, he might take a reduced salary, in his sixties, yet still receive substantial income from dividends. (An S corporation election can ease the problem of double taxation for his company.) Retirement plans can be pushed to the max, in order to provide more unearned income. Joe might even sell some of his shares to the company each year, if he needs still more income. As long as he is the majority shareholder, he'll be able to make decisions as an owner rather than as a full-time, highly paid executive. Deferred compensation is another tactic that can work for business owners or corporate employees as well. For calculation of Social Security benefits, deferred compensation is counted when earned, not when received. Therefore, if a client has been in a deferred compensation plan prior to age 62, that client can receive payments from 62 to 69 without losing benefits. On the other hand, deferring income from 62 to 69 to age 70-plus won't help because the income will count as current earnings, offsetting Social Security benefits.

Extra planning may be needed for clients who retire with unexercised stock options. "When a client exercises a nonqualified stock option," Law says, "that shows up on a W-2 form, so Social Security thinks income has been earned. Actually, this type of income enjoys an exemption so it won't affect Social Security benefits, but planners need to be prepared to help clients provide the required paperwork in order to keep their benefits." Just to make planning for Social Security even more intricate, taxes on Social Security benefits may need to be considered. "You start out by calculating 'provisional income,' which is the total of adjusted gross income, tax-exempt interest income and one-half of your annual Social Security benefits," says Sidney Kess, an attorney and CPA in New York. "If provisional income is well over $50,000, 85% of Social Security benefits likely will be taxed. If provisional income is under $25,000, no benefits will be taxed. In the middle, some techniques to reduce provisional income may reduce taxes substantially." Planners' Strategies What are some of those techniques? Working less, which also can reduce lost benefits due to "excessive income." Focusing on growth rather than income in an investment portfolio. Investing in deferred annuities. Tapping lines of credit when cash is needed. "If you're withdrawing from an IRA or liquidating appreciated investments for retirement income," Kess says, "you might increase sales and withdrawals one year, biting the tax bullet, and build up enough funds so you can minimize those activities the next year, reducing provisional income." Such concerns may be most important to clients who expect moderate incomes (say, $25,000 to $50,000) in retirement. But another issue concerns virtually all clients, even the wealthiest: How should future Social Security benefits be factored in to investment strategies?

In 1998, while the average Social Security benefit is more than $9,000 per year, retiree who has always earned the maximum amount subject to Social Security benefits will receive more than $16,000. Some retirees receive as much as $22,000, thanks to delayed retirement credits. A married couple might receive twice as much, if both spouses had careers; assuming one spouse provided most of the income, the other spouse is entitled to 50% of that spouse's benefit, calculated before any delayed retirement credits. (Divorcees and widows are entitled to benefits after 10 years of marriage.) Thus, it's not unusual for upper-income retired couples to be collecting more than $20,000 per year in Social Security benefits today. Even assuming modest cost-of-living adjustments in the future, a couple planning to retire in 10 years could receive $25,000 to $30,000 a year or even more. What's more, that's a lifetime income (after one spouse dies, the other will collect the survivor's full benefit, including any delayed retirement credit). Under present law, this lifetime annuity is fully indexed to inflation and partially tax-exempt.

In other words, Social Security benefits are hardly insignificant: A client would need $500,000 in 6% Treasuries to earn $30,000 per year. How should this future income stream be factored into retirement planning? "When we work with older clients, we project that Social Security benefits will be 100% taxable," Buie says, "and we project increases in annual benefits at one-half the inflation rate rather than the full rate. The longer the time until a client will begin receiving benefits, the greater the difference this adjustment will make. When it comes to clients 35 or younger, we just ignore Social Security. The system might change dramatically in the next 35 years." For Buie's clients who are older than 35, a discounted, fully taxable Social Security benefit is included in projected retirement income. "If we project that a client will need $6,000 a month in retirement, and Social Security will provide $2,000 per month, then the other $4,000 has to come from somewhere. So we develop a strategy aimed at building up enough of a fund to generate enough income to bridge the gap."

Is it fair to say that $2,000 per month from Social Security is the equivalent of $400,000 in bonds and adjust a client's portfolio accordingly, shortening the fixed-income side and devoting more assets to equities? "That's the type of the thing I'll do with a military or a corporate pension," Buie says. "I'm more skeptical about Social Security." In practice, though, the result winds up being about the same: Buie says her younger clients tend to be fully invested in equities while even the older ones have at least 50% in stocks.
Richard Vodra, another planner in Falls Church, does equate anticipated Social Security benefits to a lump-sum invested in securities. "I assume 100% taxability of benefits, at a 25% average tax, rather than a marginal tax-rate. Then I capitalize this income stream at 2%, the after-inflation yield on municipal bonds, and factor in the number of years the client can expect to receive these benefits. For a client receiving $1,500 per month from Social Security, the present value might be about $340,000." This number is presented to Vodra's clients to give them a better idea of their actual financial picture. "Clients who are not super rich have to save money for their retirement," he says. "Generally, they have to save an amount equal to seven times their income, which is difficult enough. If you tell those clients that they're going to live until age 98 and they shouldn't count on Social Security, these clients might need to save 10 times their income. Encouraging over-saving may be good for asset managers but not necessarily for their clients."
Although various methods may be used, anticipated future Social Security benefits should be factored in to investment plans, especially as clients approach and reach retirement. Condon says that Social Security benefits are "a given, like air. You start with Social Security and retirement planning goes on from there." Near-term, at least, this breath of air can keep cash flowing and provide clients with the assurance they may need to maintain their exposure to equities. FP