Should You Include Social Security in Your Clients’ Financial Plans?

The future of Social Security in the United States is hotly contested. Both current and future retirees are concerned that the Social Security benefits they’ve been promised won’t be there and should be excluded from their financial plans.

The future of Social Security in the United States is hotly contested. Both current and future retirees are concerned that the Social Security benefits they’ve been promised won’t be there and should be excluded from their financial plans. We’re going to examine some of the popular notions of Social Security reform and whether financial planners should include Social Security in their clients’ plans.

First, let’s examine some of the popular proposals to remediate the failing Social Security system.

1.) Increase the age of full retirement for younger workers.

Many people are living longer and healthier lives, enabling them to work longer and still have a lengthy retirement. When Social Security was first enacted in 1935, the average life expectancy of a newborn was 61. In 2017, the average life expectancy of a newborn in the U.S. is 78.5 years. Perhaps a more meaningful statistic is the change in life expectancy of someone at full retirement age (FRA). In 1935, a 65-year-old had a life expectancy of 78 years. In 2016, a 67-year-old (full retirement age for those born after 1960) had a life expectancy of 84. Therefore, the eligible age for full retirement has only increased by two years (from 65 to 67), while the average life span for a 65-year-old has increased by six years (from 13 to 17), meaning only one-third of the increase in life expectancy is being accounted for. In 1983, the full retirement age of 67 for Social Security benefits was officially enacted after a gradual implementation over 22 years. This was done slowly to protect those getting close to retirement with only a small impact for those a few more years away from retirement.

2.) Increase the cap on wages on which Social Security is taxed.

While this would increase revenues for Social Security, it would also increase future expenses, as benefits have historically been limited by the same cap. However, the Social Security benefit formula only includes 15 percent of the wages earned above $5,397 a month which is far below the cap of $10,700 a month in 2018. Eliminating the tax cap would solve approximately 30 percent of the anticipated shortfall in Social Security over the next 75 years, according to The Social Security Fix-it Book: A Citizens Guide.

3.) Increase the percentage taxed on wages to pay for Social Security.

Covering the shortfall would necessitate an increase now of 2 percent, according to The Social Security Fix-it Book: A Citizens Guide. If we wait until 2034, the increase in taxes would have to be 3.3 percent to reach a total of approximately 15.7 percent, as the current 12.4 percent rate is only projected to cover 79 percent of Social Security’s expenditures when its reserves run out.

4.) Decrease current or future planned benefits.

13 percent overall benefit cut would solve 75 years of the shortfall, or the government could wait until 2033 and then slash benefits by 21-23 percent, also according to The Social Security Fix-it Book: A Citizens Guide.

5.) Means test benefits.

Reducing benefits for those with a high income in retirement is a popular proposal among some, who believe that those with greater income in retirement don’t need Social Security. This is a complex proposal for several reasons. First, some legal experts believe that the implied covenant between workers contributing to Social Security and the U.S. government is that they would receive those benefits upon retirement. Some believe that not providing the stated benefit would violate this agreement. Now, one could make a similar argument that simply delaying full retirement could also constitute a breach of agreement. So, let’s look at the practical impact of means testing. If those with retirement income above the cap of $256,800 (2018’s wage base cap x 2; married couples) received no benefit, this would equate to approximately 1 percent of retirees whose taxable income exceeded the taxable wage cap. Because of the small population of high-income retirees, this is expected to only cover approximately 10 percent of the shortfall if it were enacted immediately, and the impact if enacted years down the road would be even smaller.

What Should Advisers Actually DO When it Comes to Clients’ Financial Plans?

Some potential things to plan for include delaying the expected age of full retirement for clients under 50 without increasing expected benefits (note that in 1983 individuals with fewer than 20 years until full retirement were spared any delays). Delaying a year for every 6 years younger than 50 is both practical (2 months for each year later someone was born was the formula used in 1983, although there was a hiatus for those born between 1943 and 1954) and realistic. For example, expect a 44-year-old would have full retirement age of 68 and a 38-year old would be delayed to 69, while those 32 or under would have a full retirement age of 70. This adjustment to a client’s financial plan is simple to implement and most consistent with historical responses to an expected failure of the system.

Albeit conservative, it may also be prudent to exclude Social Security for those with likely taxable income of $250k (present value) or more in retirement. This is likely a client with $10 million-plus in taxable assets or $5 million-plus in traditional IRA/401k assets, or substantial defined benefit pension income or other taxable income sources. Don’t forget to adjust for inflation, meaning in 28 years (at 2.5 percent inflation) that annual income threshold would likely be more like $500k a year. For those clients in this situation, likely roughly the top 1 percent of retirees, it may be reasonable to exclude Social Security benefits to ensure that they can sustain their lifestyle, even if their benefits have been eliminated in the future.

For most of America, the absolute worst case regarding Social Security would be if nothing is done and they received only 79 percent (decreasing to 73 percent over 75 years) of their promised benefit. The most recent figures from the Social Security Trustees’ Report puts that figure at 77 percent. Since there are a number of seemingly reasonable alternatives to this scenario, it appears that situation is unlikely. However, clients looking to be extremely conservative in their planning could choose to plan for only 77 percent of their stated benefit. It seems clear that removing Social Security altogether from the plan would be too conservative for all but the wealthiest Americans.

Journal of Financial Planning tax planning columnist Randy Gardner, J.D., LLM, CPA, CFP® professional, said to project clients will receive only 77 percent of their benefits after 2034 based on the Social Security Trustees’ Report.

The bottom line is that the Social Security system may be in dire need of reform, but it’s not going away. Making one or more of the suggested adjustments above can achieve the right balance between prudence and practicality to ensure that your financial plans best help your clients achieve their goals.

For a more comprehensive look at the current state of the Social Security system, please visit the Tolerisk Blog.