Social Security Clawback Nightmare Hints at Far Bigger Problems: Kotlikoff

More and more financial advisors may be speaking with their clients about Social Security claiming and the overall effort to organize retirement income, but relatively few are doing so in an effective manner.

Meanwhile, a stream of “horror stories” of the Social Security Administration demanding clawbacks from retirees who were mistakenly paid benefits they weren’t entitled to is indicative of deep, possibly irreparable dysfunction in the system.

So suggested Laurence Kotlikoff, a Boston University economics professor who is well-known in the retirement industry for advocating an “economics-first” approach to financial planning and for his at-times scathing analysis of the Social Security program, in a new interview with ThinkAdvisor.

During a frank and wide-ranging discussion, Kotlikoff did not pull any punches when asked about the performance of the financial advisor industry when it comes to helping Americans navigate the transition from wealth accumulation to “decumulation.”

Kotlikoff — who was a senior economist for President Ronald Regan’s Council of Economic Advisers and has consulted for the World Bank and the International Monetary Fund, among others — also called once again for the full-scale scrapping of Social Security, to be replaced by government-managed individual investment accounts.

While advisors do a relatively good job helping their clients accumulate wealth by taking (potentially excessive) risk in the equity markets, the level of planning for the income phase remains “woefully inadequate,” according to Kotlikoff.

“You have to take what I say with a grain of salt, because I offer my own investment and income planning solutions to the industry, but I think the industry would get an F on the income planning front,” Kotlikoff said. “So much of the industry is geared towards making product recommendations, in general, and the income planning question is so much bigger than that.”

Kotlikoff suggested more advisors need to “put the economics first” in both the wealth generation and spending effort. If they continue to fail to do so, he argued, they will continue to fail to meet the needs of their clients, especially when it comes to the retirement phase.

Kotlikoff also spoke at length about the continued emergence of Social Security “horror stories,” wherein the underfunded and understaffed Social Security Agency mistakenly pays out benefits to retirees (at no fault of their own) and then seeks to claw the money back years in the future, often to the tune of tens or even hundreds of thousands of dollars.

“This is a terrible situation, and its coming on top of the fact that the Social Security program itself is beyond broke,” Kotlikoff said. “When you put all this together, our retirement system as a whole is clearly broken.”

From his point of view, Kotlikoff sees all these problems as intertwined, and he warns that America has a serious retirement readiness problem on its hands — one that is set to get a lot worse before it gets any better.

An ‘F’ in Income Planning

Kotlikoff admitted that his point of view may sound harsh, but he said he has good reason for being skeptical of the “planning work” many advisors are doing on behalf of their retirement-focused clients. Lest anyone think he is merely trying to drum up business for his own planning solutions to line his own pockets, Kotlikoff emphasized that he doesn’t take a salary from the company.

“I recently took a call from a financial advisor at a prominent firm who is considering changing the software they are using to do this planning, and this person stepped me through their process and platform,” he said. “Because of the licensing protections on the platform, this was actually the first time in some years that I had seen the planning program up close, and I was shocked by some of the inadequacies.”

According to Kotlikoff, the program in question fails to incorporate what he called “some of the most basic economic principles that should underlie true financial planning,” including foundational discounting principles. He said there were also clear issues with the treatment and integration of survival probabilities and assumptions made about interest rates and inflation.

While these shortcomings are concerning enough, Kotlikoff said, they are just one part of a bigger planning problem that he sees across the advisor industry.

“Look, if you are an economist like me, you don’t come at planning from the assets under management and sales perspective,” he suggested. “The industry today is just obsessed with running Monte Carlo simulations and using these to encourage people to take more investment risk and keep money in the portfolio, because the projections show they aren’t currently saving enough to meet their projected income needs.

“The typical advisor will just simulate that the client who has an income shortfall can just put a higher percentage of their wealth in stocks and presto, the success probability shoots up to 90%,” Kotlikoff continued. “The client sees this increase and thinks they are all set for retirement.”

The problem is that such projections, Kotlikoff said, fail to demonstrate to the client (and to the unwary advisor) that this approach raises the probability that the plan will fail sooner in life and that the failure will be more painful.

“It’s a basic economic principle that so often gets ignored in the planning process. Greater returns are simply never free,” Kotlikoff said. “You just can’t have a higher upside probability without a bigger downside. The risk here is that, should the plan fail, it will fail worse and it will fail earlier, potentially leaving the client completely destitute in retirement.”

The other big problem beyond excessive risk taking, according to Kotlikoff, is the risk of under-consumption when clients are told to follow an antiquated spending approach, such as the 4% withdrawal rule.

“This is not an income plan. It’s a way for advisors to keep as much money in the portfolio as possible during the retirement period so that they can continue to collect fees on it under the AUM model,” Kotlikoff said. “A true plan will involve investments, yes, but it will also consider the role of annuities and protection from the worst possible outcomes. It will mean planning truly for the individual and their maximum potential lifespan — not like an insurance company that can pool longevity risk.”

Social Security Clawback Horror Stories

During the discussion, Kotlikoff also took time to spotlight an issue that he said is making himself and other like-minded economists in the planning community “mad as hell.”

“Right now, an unknown number of Americans, conceivably in the tens to hundreds of thousands, are receiving clawback letters each year from Social Security, demanding they return benefits received in the past due to Social Security overpayments,” he warned. “Social Security’s steadfast rule is that ‘our mistakes are your mistakes.’”

According to Kotlikoff, unless a person has proof they were actively misled by Social Security Administration staff while filing for benefits, any Social Security overpayments or underpayments are the individual’s responsibility.

“At the same time, large numbers may be receiving lower benefits for years because Social Security has mistakenly underpaid them,” he explained. “Unless you discover such underpayments on your own, you’ll likely never learn you have been defrauded, however innocently, of what’s yours. Moreover, unless you check your benefit amount is accurate, you and the other 70 million current Social Security beneficiaries must live in fear of having past benefits received clawed back.”

Kotlikoff encouraged all advisors to study up on this issue, and to see it for what it really is: a clear sign that the Social Security system is “beyond broken.” To that end, he encouraged advisors and the public at large to think carefully about the idea of cutting funding directed to the SSA’s administration and operations — whatever one thinks about the long-term future of the program.

A New Retirement Deal

For his part, Kotlikoff advocates for a wholesale reset of the retirement contract that America makes with its citizens. His plan includes scrapping Social Security and starting a fundamentally new system based on government-managed individual investment accounts.

To do that, he recommends freezing the current Social Security accounts of those, for example, currently at age 40. When these workers retire, they would get Social Security benefits based on their earnings up to age 40.

Kotlikoff would maintain the payroll tax — “we need the revenue” — but recommends that people put 10% of their pay into a personal retirement account. The government would make progressive matching contributions on behalf of the poor, he says.

These accounts would then be government-invested “by a computer in a global index fund of stocks, bonds and real estate investment trusts” of major markets. Everyone would get the same rate of return, and the government would guarantee a return on contributions.

Each person could augment their account accordingly with added contributions. Kotlikoff said Wall Street “wouldn’t and shouldn’t get a penny” in managing these accounts.

“In short, our politicians have constructed a fiscal monster,” Kotlikoff concluded. “Its economic damage can’t be eliminated piecemeal, for a simple reason. Each of our fiscal system’s programs contribute to all or most of the system’s problems. … In short, all aspects of the system need to be reformed in unison.”

(Pictured: Economist Laurence Kotlikoff)