For years, many retirees have considered their 401(k)s untouchable until mandatory withdrawals kick in at age 70½. But a trend toward delaying Social Security claims, coupled with Congressional action to close Social Security “loopholes,” could change all that, while creating new opportunities for 401(k) specialists.
Filing Strategies Disappearing
In November, Congress passed its new budget law, lesser-known provisions of which mandated phase-out of two Social Security claiming strategies: “file and suspend” and “restricted application for spousal benefits.” Combined, these strategies enable both members of a couple, at age 66 or older, to delay benefits on their own earnings records, while one spouse—usually the lower earner—collects spousal payments based on the earnings record of the other.
Under this arrangement, each spouse can continue to earn delayed credits on his or her own record, with the account growing by up to 8 percent each year to age 70. These strategies, now slated to end April 29, 2016—six months after President Obama signed the budget into law—provide many middle class families financial support while waiting to maximize their eventual benefits. File and suspend has also been used by individual filers so that they can claim a future lump sum, and by families claiming dependent or disabled child benefits who wish to allow individual credits to grow to age 70.
Those currently receiving benefits will not be affected by the changes Congress made. Those at full retirement age, or who will be by the deadline, may still take advantage of file-and-suspend. Additionally, if you turn 62 this year (or are older), you may still file a restricted application for spousal benefits at 66.
“I think the Congress had no idea what they were doing, and it was just awful,” says Laurence J. Kotlikoff.
Kotlikoff, author and professor of economics at Boston University, is also president of Economic Security Planning Inc., which specializes in financial planning software.
“If this induces people to take their (Social Security) benefits early, at 66 rather than at 70, on a lifetime basis, that’s a huge shift—could be a couple hundred thousand dollars for a couple,” he says. “It’s a balancing act between trying to save taxes but also trying to have a smooth living standard. I would say what (Congress) just did is make that a more challenging task.”
The Congressional decision underscores the value of Social Security, which William Meyer believes will dominate retirement planning over the next five years. Meyer, whose Social Security Solutions Inc. provides consulting and software for claiming strategies, says he and William Reichenstein, CFA, the company’s head of research, found that delaying Social Security benefits to age 70 extends portfolio life an average of seven years, in some cases up to 10 years.
According to Reichenstein, Social Security is especially useful in extending the portfolios of middle class retirement investors. “If you have a low financial portfolio—the lowest example we had was $200,000—that additional Social Security benefit is huge by comparison to somebody with $1.5 million,” he says.
But to fully take advantage of delayed Social Security strategies, advisors must turn the traditional withdrawal sequence on its head.
Tapping 401(k)s First
“The rules of thumb about how to draw down are completely backwards,“ says Meyer. He says retirees have learned to take withdrawals from taxable accounts first, from tax-deferred savings such as a 401(k) second, and from tax-exempt sources such as Roths last. “The new rule of thumb always has you tapping your 401(k) (first). If you’re Middle America, you’re tapping all of it; if you’re rich, you’re tapping a little bit to get to the top of a tax bracket. The reason why you should take your tax-deferred first is most people should delay Social Security.” He adds, “It’s better to liquidate your 401(k) and delay Social Security than it is to maintain your 401(k) and take Social Security early. That’s the shocker.”
Meyer says withdrawing from 401(k)s first reduces the retiree’s required minimum distribution after age 70, the latest point at which to file for Social Security benefits.
“You’re also going to reduce your taxation on your Social Security because withdrawals from your 401(k) or an IRA are part of the formula for what percentage of Social Security is taxed, he adds.“ Meyer is not alone in his assessment.
“For anyone who anticipates—or wants to hedge against—living a long time, the most efficient risk-adjusted returns will come from spending down the 401(k) first and delaying Social Security to the max,” says Michael Kitces MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, partner and director of research for Pinnacle Advisory Group, in Columbia, Md. “At the most basic level, the key takeaway to me is simply that delaying Social Security in exchange for higher future payments is like buying a mini-annuity—but with one that has far better risk-adjusted returns than one can obtain in any traditional investment or annuity product.”
In his Nerd’s Eye View blog, Kitces wrote, “For those whose greatest retirement ‘risk’ is living far past life expectancy, the decision to delay Social Security can actually be a highly beneficial investment, with a real return that dominates TIPS, is radically superior to commercially available annuities, and even generates a real return comparable to equities but without any market risk.” He added, “Ultimately, the decision to delay Social Security delivers the best results when there is either unexpected inflation, unusually long longevity, or especially bad market returns—three scenarios that traditional portfolios are least effective at managing.”
“If you’re going to live much beyond 80, it pays to delay,” Reichenstein says. “For somebody to live till 92 they’re going to get … 29 percent higher lifetime benefits if they wait till 70 instead of starting at 62.”
Opportunities for Advisors
“The Social Security component just got more valuable within the 401(k) arena,” Meyer says.
He urges 401(k) specialists to offer Social Security advice and retirement income planning to differentiate their practices and capture assets under management that would otherwise be lost when clients make 401(k) withdrawals. “No one’s doing that now, and I predict over the next five years, that’s going to be the category killer.” Fielding Social Security questions is a great way to generate leads, Meyer says.
Meyer suggests that 401(k) specialists offer plan participants reports that go beyond the sparse information on their Social Security statements. Social Security Administration personnel are prohibited from offering advice, and human resources generalists often lack the expertise to answer relevant questions.
Meyer concedes that the 401(k)-first withdrawal strategy could undercut assets under management for advisors. Clients might also be resistant, as most Americans seem to undervalue Social Security benefits. He blames parental “brainwashing” and media predictions about the Social Security system’s insolvency. “Social Security’s an asset, just like your 401(k). It doesn’t matter from a household perspective how you put them together to make your total household assets last longer,” he insists.
Facing the April Deadline
With Congress’ six-month deadline, won’t the window of opportunity for 401(k) specialists close soon? “No, not at all,” says Meyer. “Many people are calling in now because they want to know how it impacts them, but 10,000 baby boomers retire every day.”
Kotlikoff agrees the loss of popular claiming strategies is creating a lot of anxiety: “Our software’s selling like hotcakes right now,” he says. “We’re selling more than ever. I think a lot of people are saying, ‘I fit under this grandfather clause; I just want to see what I should do under the old law.’”
After Congress shuts down file and suspend, some people will likely experience fallout for three or four years, Kotlikoff says. Those born in 1953 or earlier still have an option to file for spousal benefits at age 66. So, consider the example of a married, higher-earning individual, eligible to be grandfathered in, who manages to file and suspend before the upcoming deadline. If that individual’s spouse is, say, 63 now, he or she will be eligible to start collecting a spousal benefit by itself. The spouses of filers who miss the deadline will not be so lucky.
“There are two kinds of ‘notch babies’ here,” Kotlikoff says. “There’s the people that are born an hour too late beyond six months, and there are people who are born an hour too late and they’re not going to be 62 by the end of the year. The difference in treatment is going to be essentially $60,000.”
Overlooked Strategies
Meyer says it would be a mistake to think eliminating a couple of claiming strategies has suddenly made Social Security decisions simple. Many strategies remain. “There are some scenarios where it’s better to claim at full retirement age than to wait to 70,” he says. ”Given how it all played out with the politicians, if you’re married, it’s better to claim at 66, your full retirement age, not delay till 70.”
Widows or widowers face a choice between two scenarios, Meyer points out. Scenario 1: take survivor benefits as early as age 60, let your own benefits grow, and at age 70, switch to your own benefits if they’re greater. Scenario 2: take your own benefits early at 62, then claim your widow benefits at age 66, your full retirement age. How a claimant chooses could make a difference of hundreds of thousands of dollars.
“You or a spouse is going to die at some point, so everyone in America should look at those two scenarios,” Meyer says. He adds that saving a plan participant $100,000 is a great way to start a discussion about your retirement income planning services.
What would it take for Congress to reinstate the doomed strategies? Kotlikoff says the strategy phase-outs had some unexpected heavyweight support from quarters such as AARP and Alicia Munnell, director of the Center for Retirement Research at Boston College. He believes it would be unlikely to reverse AARP’s support for the budget act unless many of the organization’s members threatened to defect. “I’m really calling for a nationwide boycott of AARP,” he says.
“(Phasing out strategies) is all being portrayed as closing a loophole for the rich,” says Kotlikoff. Overlooked in the budget act is the story of a secretary with whom he works. She’s 64 and works 80 hours a week to support a disabled child and her husband, who takes care of that child. She was planning to cut back to 40 hours per week at age 66 and use the file and suspend/spousal benefit strategy to ease the family’s financial burdens until she retires. “People like Alicia Munnell—I’d like her to come over and talk to my secretary,” Kotlikoff says. “Please quote me on that.”