Increasingly, financial advisers are helping their clients realize that when they retire and when they begin to collect Social Security benefits are two separate decisions. Stopping work does not necessarily mean it's time to claim Social Security, particularly if clients can rely on other sources of income while they wait to collect a bigger retirement benefit later.
Still, many advisers wonder how they can quantify the value of those future Social Security benefits, as estimates are based on the assumption that a worker continues to work and earn about the same salary through retirement age. But what happens if there are several years of reduced earnings — or even no earnings — between the end of work and the beginning of benefits?
Luckily, there is a handy tool on the Social Security website that can help you and your clients tinker with several “what if” scenarios. For example, clients can use the Retirement Estimator to alter the dates when they plan to stop working or to create multiple scenarios about future earnings. However, the Social Security Administration cautions that the projected benefits are merely estimates and it can't provide actual benefit amounts until an individual applies for benefits.
The tool works for anyone who has acquired at least 40 quarters of covered earnings needed to be eligible for Social Security benefits and who is not yet collecting benefits on their own or another's earnings record. It won't work for public-sector employees who are entitled to a pension from work not covered by Social Security. Due to privacy restrictions, advisers can't use calculator for clients, but you can ask your clients to use the calculator and share the information with you.
“The older you are and the closer you are to retirement, the more accurate the retirement estimates will be because they are based on a longer work history with fewer uncertainties such as earnings fluctuations and future law changes,” Social Security spokeswoman Nicole Tiggemann wrote in an email. “Generally, if an individual has already accrued at least 35 years of covered earnings, the benefit amount should not be less than the estimated benefit amount that appears on the Social Security statement.”
I put my own Social Security benefit estimates to the test. Assuming I continue to earn the maximum amount of wages or net self-employment income subject to FICA taxes ($118,500 in 2015 and indexed for inflation in future years) over the next six years until I reach my full retirement age of 66, the estimator projects my benefit at $2,515 per month.
But if I stopped working today and earn nothing for the next six years, the Retirement Estimator projects my monthly benefits would drop to $2,383 if I claim at 66. Presumably the difference between the two estimates is based on the missing six years of maximum taxable wages that would not be available to replace six years of lower earnings.
Laurence Kotlikoff, an economics professor at Boston University and creator of Maximize My Social Security software for consumers and financial advisers, cautions that the agency's Retirement Estimator seriously underestimates the value of future benefits, whether or not you continue to work until your full retirement age.
Using his own software, Mr. Kotlikoff ran several scenarios for a 50-year-old individual. He said the SSA's Estimator tool underestimates future Social Security benefits by about 20% because the agency ignores future increases in average wages, which distorts the indexing factors used to estimate future Social Security benefits.
Social Security benefits are based on your top 35 years of earnings. Actual earnings are indexed to account for changes in average wages since the year the earnings were received. A separate index factor is applied to each year of earnings. Any earnings received after age 60 are recorded at face value.
Social Security adds the top 35 years of earnings and divides the total amount by 420 — the number of months in 35 years. Then it divides that number by 12. The result is the worker's average indexed monthly earnings, or AIME. The AIME is used to compute the worker's full retirement age benefit, known as the Primary Insurance Amount.
Bottom line: Your future Social Security benefit could actually be larger than your official SSA estimate benefit suggests. Mr. Kotlikoff urges consumers and advisers to use third-party software to generate a more precise benefit projection by entering each year of your earnings history. And don't worry about all that data input. With Mr. Kotlikoff's Maximize My Social Security, for example, you can cut and paste your earnings history from your SSA statement.
(Questions about Social Security? Find the answers in my ebook.)