Welcome to Hidden Value, the column where Joe Elsasser, CFP, addresses common financial planning issues with insights advisors and their clients may not have considered.
The Social Security program has been a frequent topic of discussion lately. According to the annual report published by the Social Security trustees, it is projected that right now 100% of promised retirement benefits will be payable through 2034. (The number can fluctuate based on interest rates, contributions to the system, how many people actually elect, when they elect, and other factors.)
Additionally, new legislation has been introduced to try to address some of the current issues affecting the program, and there are lot of questions among those who are nearing retirement. The Social Security program is complex and can be difficult to navigate, but there is hidden value for advisors who can shed light on some of the biggest misconceptions and help clients make the best claiming decision for their particular situation.
Misconception: Benefits will no longer be paid out once Social Security is out of money.
Many people think benefits will cease to be paid out once Social Security is out of money. However, even if Social Security was totally broke, and the only thing coming in was tax dollars, Social Security would still be able to pay 77 cents of every promised benefit dollar, even without any Social Security reform.
If an immediate payroll tax increase were implemented to fully fund both the retirement and disability programs, the increase would need to be approximately 2.7% (a 1.35% increase on the employee, and a 1.35% increase on the employer). If no changes were made until 2035, the increase to fund both programs would need to total 3.65%.
The fear of losing out on their benefits can make many retirees want to claim their benefits early, “why they still can.” However, you know that by claiming early they forfeit what they could be making if they delayed. By explaining that benefits will continue to be paid out, even without new legislation, and that the amount will be significantly higher if they delay, you can help prevent your clients from making a costly mistake.
Misconception: Social Security will be means tested.
Social Security benefits are already calculated to provide a higher replacement of pre-retirement earnings for a lower income wage earner than for a higher wage earner.
The progressive nature of Social Security benefits is based on a calculation that uses “Bend Points” to benefit those with lower income over those with higher income. The wage replacement rate is only 15% for average lifetime wages that fall into the highest income range and is 90% for lifetime average wages falling into the lowest income range.
Additionally, the recently proposed Social Security 2100 Act suggests an additional bend point. Simply charging a higher tax rate on pre-retirees would fund those benefits. Higher wage earners would end up paying more Social Security tax, and a smaller percentage would come back to them in the form of benefits. It’s simply a different way of calculating what the retirement benefit would be. While this is similar to means testing, it’s not taking benefits away from a retiree.
Misconception: There will be benefit cuts for current retirees. (Chained CPI and Increasing Full Retirement Age)
The passage of the sweeping tax overhaul in December of 2017 marked a widespread incorporation of a different measure of indexing for tax brackets. Historically, tax brackets were indexed using the Consumer Price Index (CPI-U) for all urban consumers. That is the same measure of inflation that is currently used to index Social Security benefits. The tax law changed the indexing of tax brackets from CPI-U to a newer measure of inflation called the Chained Consumer Price Index. The major difference between CPI-U and Chained CPI-U is that the new measure incorporates switching behavior among consumers. When a good or service experiences high inflation, consumers tend to identify lower cost alternatives. As a result, the Chained CPI-U increases more slowly, and using it as the measure of inflation will cause tax brackets to increase at a slower rate than the historical CPI-U measure of inflation would have.
A switch to Chained CPI-U for Social Security benefits has been discussed for many years, and it would be a benefit cut for current retirees. However, it’s a tiny benefit cut in terms of how people will experience it. Historically the difference between C-CPI-U and CPI-U has been about .2% per year. So, if the cost of living adjustment would have been 3% under the CPI-U, then under chained CPI you might expect a 2.8% cost of living adjustment. It does represent a benefit cut, but it’s not one that people will feel dramatically. The incorporation of this measure in the tax bill foreshadows that this measure will likely be used in any future Social Security legislation.
I also expect full retirement Age (FRA) to continue to increase. The 1983 legislation began increasing full retirement age because life expectancy has continued to increase. An increase in full retirement age is effectively a benefit cut. For someone whose full retirement age was 65, electing at 62 years of age would yield 80% of their full benefit, for someone whose full retirement age is 66, electing at 62 years of age would yield 75% of their full benefit. Electing at 62 for someone whose full retirement age is 67 represents only 70% of their full benefit amount.
At the same time, if future legislation does further increase full retirement age, you could also expect that Delayed Retirement Credits would be expanded past age 70. For example, if FRA were raised to 68 or 69, it would be reasonable for Delayed Retirement Credits to continue to accrue until age 72 or 73. Additional, phased-in increases in FRA are to be expected, as life expectancies have continued to increase. The relationship between early and late claiming has not changed, only the underlying scale on which it’s measured. It’s important to explain to clients that this sort of change is highly unlikely to impact those on the edge of retirement.
The vast majority of Americans begin collecting Social Security earlier than their full retirement age — a decision that often means they’re losing out on tens of thousands of dollars. One of the biggest opportunities in the marketplace is for advice on Social Security. You can position yourself as a helpful resource and make a measurable difference for the financial well-being of your community by offering your Social Security expertise.
— Related on ThinkAdvisor:
- Roth IRA Conversions: How Much Is Too Much?
- Think You Know the Capital Gains Tax Rate? Think Again.
- Beware the Social Security ‘Tax Torpedo’
Joe Elsasser, CFP, RHU, REBC, developed his Social Security Timing software in 2010 because, as a practicing financial advisor, he couldn’t find a Social Security tool that would help his clients make the best decision about when to elect their benefits. Inspired by the success of Social Security Timing, Joe founded Covisum, a financial tech company focused on creating a shared vision throughout the financial planning process.
In 2016, Covisum introduced Tax Clarity, which helps financial advisors show their clients the hidden effective marginal income tax rates that can significantly impact cash flow in retirement. In early 2017, Covisum acquired SmartRisk, software that allows advisors to model “what-if” scenarios with account positions and align a client’s risk tolerance with their portfolio risk.