U-M economist: Collecting Social Security

April 3, 2015
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FACULTY Q&A

About 10,000 Americans retire every day, putting increasing pressure on the solvency of Social Security.

Although projections show that Social Security will be exhausted sometime after 2030, University of Michigan economist Donald Grimes believes that during the next 15 years the federal government will fix the problem, resulting in, at most, a small cut in benefits.

Grimes is available to discuss the importance of understanding how Social Security benefits are calculated and lessons learned from his own experience.

Q: In calculating how much to withdraw from Social Security and the best methods for doing so, what advice would you give new retirees?

Grimes: As an aging baby boomer unfortunately nearing the end of my working life, I have been thinking about how much money I will need in retirement. While the details for any particular individual (or couple) will vary, there are three really important lessons that I learned from this exercise.

My first lesson is that as long as your health is reasonably good you should put off collecting social security as long as possible, to age 70, if possible. It is especially important to do so for at least one earner in a married-couple, two-earner household. When one of the parties dies, the other spouse will collect the higher of the two individual’s Social Security benefits, so having one earner put off benefits until age 70 ensures that the surviving spouse collects the highest benefits possible.

Second, people will need to be flexible in how much they withdraw from their retirement savings account. My calculation assumes that they should withdraw 4-to-5 percent of their retirement balance each year. If the value of the retirement account goes down, for example, when the stock market goes down, then you would have to reduce the amount you are withdrawing to stay at the 4-to-5 percent rate. If you have about two-thirds of your money in stocks, then you can withdraw 5 percent from your portfolio each year. If you have more money in fixed-income securities, including bonds, then presumably that value of the portfolio will fluctuate less each year, but you will also get a lower return over the long run and thus must withdraw a lower percentage of your assets each year.

Since the dollar amount you can withdraw from your retirement savings will vary by year, this reinforces the idea of waiting as long as possible to collect Social Security since that benefit will not vary by year, other than increasing along with the inflation rate.

And third, since the amount of income will vary with the value of your portfolio, it is important to minimize any fixed expenses each year. Pay off your mortgage, and purchase cars with cash when your car replacement fund has enough money in it. That way, when you are forced to withdraw less money when the market goes down, you can more easily make the spending adjustment by eliminating travel, eating out less often or postponing that vehicle replacement.

Q: Why is it important to delay receipt of Social Security benefits, especially if married?

Grimes: Spouses married at least 10 years are entitled to either their own Social Security benefit or one-half of the benefit of their spouse. Lower-wage income households collect more benefits if one spouse has earned all of the money, whereas among higher income households, the total benefits are higher if the two married partners have been earning roughly the same amount over the years.

Many two-earner married couples can maximize their combined Social Security benefits by claiming the spousal benefit once they reach full-retirement age while letting their own benefits grow to the maximum when they turn 70. This is a complicated calculation, so all two-earner married couples should carefully evaluate their own situation before one of them temporarily claims the spousal benefit. It is especially important not to claim the “temporary” spousal benefit before that person reaches full-retirement age.

Q: In addition to making Social Security calculations, how should retirees calculate how much other income they will need?

Grimes: I have assumed that people will need about 85 percent of their pre-retirement wage income. This is a fairly conservative assumption, reducing your needed income only by your social insurance taxes (and the income tax you pay on those taxes) and the money you are saving for retirement (assumed to be about 6 percent of income). Most people will probably need less income than this, but a few who have expensive retirement plans will need more.

The amount of money that is necessary to generate your future non-Social Security income depends on how much money you expect your retirement portfolio will earn each year. In my simple (and conservative) calculation I assume that people have two types of assets: bonds earning 3 percent a year and stocks earning 6 percent a year. If you have a two-thirds stock, one-third bond portfolio then the average return should be about 5 percent a year, and if you have a one-third stock, two-thirds bond portfolio then the average return should be about 4 percent a year.

Why have money in bonds since bonds have a much lower return than stocks? Because bond funds tend to be less volatile year to year, and thus the value of your portfolio will fluctuate less year to year. And, less volatility is important because under my retirement plan you are only allowed to withdraw a certain percentage value of your portfolio each year, not a fixed dollar amount that most retirement planners aim for.

Traditional retirement plans that attempt to provide people with a certain dollar value per year in income have to make very conservative assumptions to ensure that people don’t run out of money before they die. So they will frequently say that people should withdraw 3.5 percent or, at most, 4 percent of their initial portfolio value in dollar terms. Immediate annuities are another way to generate a fixed dollar of income per year, although at the cost of the ultimate loss of principal.

If you have a flexible dollar withdrawal rate, by using the fixed percentage approach you will be able to withdraw, on average, a higher dollar value than a traditional retirement plan, and probably leave an estate at least as large as the initial value of your portfolio. Since my assumptions with respect to the return to stocks and bond are probably too conservative, the dollar value of your withdrawals, on average, will probably also increase over time as the value of the portfolio increases. But, you will have to make downward adjustments in spending during years when the stock market declines—thus my third lesson about minimizing fixed expenses once retired.

 

Contact: 941-225-1304 (cell), dgrimes@umich.edu. Bio: myumi.ch/J229J