The phase-out of Social Security’s file-and-suspend loophole has sparked a scramble among companies that offer benefit-optimization software to rewrite their programs and advisors to rethink client retirement plans.
The Bipartisan Budget Act signed into law by President Obama in November shuts down two Social Security claiming maneuvers that can boost benefits substantially for married couples -- "file-and-suspend" and "restricted claims."
The legislation will simplify Social Security planning. But the timeline for phasing out the maneuvers introduces some near-term complexity for those who are closer to retirement and can still benefit from the strategies.
The loopholes offered a way to for married couples to manipulate Social Security’s primary insurance amount (PIA) rules, which govern how much of the benefit is paid out at various ages. A claimant receives 100 percent of PIA if they file at full retirement age (FRA), currently 66; every 12 months beyond that point--until age 70--tacks on an additional eight percent. Conversely, filing for benefits at 62--the first age of eligibility--PIA is reduced by 25 percent; that’s a lifetime reduction.
Under the loophole, the spouse with the higher benefit--typically the husband—could file for his benefits at full retirement age and then suspend them and accrue the delayed retirement credits. The lower-benefit spouse would file but "restrict" the application to a spousal benefit only (equal to 50 percent of her spouse's payment). The restricted application effectively delayed the filing for her benefit, thus earning delayed credits on her benefit.
The total lifetime gain varied depending on a couple’s PIA, but it ranged from $35,000 to $65,000, according to Michael Kitces of Maryland-based Pinnacle Advisory Group and author of the Nerd's Eye View Blog.
The budget act prohibits new file-and-suspend claims, starting 180 days after the legislation's enactment (November 2, 2015). And it disallows restricted applications for anyone who has not reached age 62 by the end of calendar-year 2015.
Since file-and-suspend is only available to workers who have reached full retirement age, the maneuver remains available to workers who either already have turned 66, or will do so by the end of April next year. Couples who already have executed the strategy are unaffected by the new law.
The grandfathering language means that there will be some level of restricted application activity through 2019. The restricted application is available only for people who have turned 62 by the end of calendar-year 2015, which means an end to the practice of filing for a spousal benefit at full retirement age and shifting to a (larger) individual benefit later on.
The new law also impacts rules for divorced couples. Before the phase-out, it was possible for a divorced individual who had reached full retirement age, and who met the other divorced filing criteria, to file a restricted claim on the benefit of an ex-spouse. That right will be phased out under the same set of rules applying to everyone else.
The restricted claims will be possible only for those who have turned 62 by the end of calendar year 2015 - and they will need to wait until they are full retirement age to do it. A divorced spouse will receive their own benefit or a spousal benefit - whichever is higher - when they claim.
At this writing, there is uncertainty about one other point related to divorced spouses. Before the new budget law, it was possible to collect a benefit on an ex-spouse’s record even if that spouse wasn’t receiving benefits. Now, it is not clear how Social Security will handle such a claim if the other spouse has suspended his benefit. The Social Security Administration says that its “legislative and policy staffs are diligently working with Congress to analyze the intent of the legislation and update our instructions.”
Online Optimization Tools
Online optimization services built on the obtuse mathematics of file-and-suspend scrambled to update their tools after the new act was signed. T. Rowe Price took its optimization tool offline in November pending an update; AARP and Financial Engines both were working to update their software in November. Several already have updated their software, including Social Security Solutions, Maximize My Social Security and SS Analyze.
Many of these companies relied on file-and-suspend strategies to generate their most eye-popping benefit gains, and advisors sold clients on the wisdom of the tactic. The end of file-and-suspend could hurt their business.
“We were right in middle of evaluating three software products,” says Helen Modly, president of Focus Wealth Management in Middleburg, Virginia. “Since this happened, we decided against it because the application is too limited.”
But Modly also views the six-month window of opportunity on file-and-suspend as an opportunity. “We have about 15 clients who could still take advantage of it,” she says.
William Meyer, co-founder of Social Security Solutions, has been hearing two reactions from advisers to the news of file-and-suspend’s demise. “Some advisers just have their heads under water. They’re getting called by clients who have a lot of questions and don’t know where to start. The other group sees a tremendous opportunity. They are looking to identify people who are candidates to do this and using it as a marketing opportunity.”
It still makes sense to optimize Social Security for your clients - whether you choose to use third-party software or not.
“The new law does take away some of the obscure strategies that add quite a bit of value,” says Wei-Yin Hu, vice president of financial research at Financial Engines. “But having said that, even for younger people who get a couple options taken away, there is still a significant opportunity to improve on what they would have done by themselves.
“Most people start claiming when they retire or when they reach 62 - whichever is later. And even for single people, there is an incentive to delay taking benefits.”
Married couples can consider other options. Should one start benefits early, should both delay, or should both file early? Most often, couples are better off if the higher-benefit spouse delays filing to earn the credits.
Social Security's rules are designed to be actuarially "fair," which means the credits for delaying (and penalties for early filing) should give us all roughly the same lifetime income--at least, according to the actuarial tables. You get about eight percent less for every year you file early (starting at age 62), and the same increase for every year you wait until age 70--the last year for which additional credits are available.
Higher-income people tend to live longer and so stand to benefit more from delayed filing. The most recent mortality tables from the Society of Actuaries show that average life expectancy for a 65-year-old male is 3.16 years longer in the highest-income quartile than in the lowest band; for women, the gap is 1.52 years.
Moreover, the eight percent credit is a great deal when considered in the context of today’s marketplace. Says Hu: “It’s more than actuarially fair, because the rules were written back in the 1980s, when interest rates were quite a bit higher, so you had to pay people more for putting off their benefit. And since people are living longer now, they are likely to get more years of those higher benefits.”
Meyer argues the new optimal strategy will focus on a break-even age analysis - that is, how many years both spouses need to live to make up the foregone benefits from a delayed filing. The longevity hurdle will be higher because of the extra benefits delivered through a file-and-suspend and restricted application. “Under the old rules, the break-even age for filing early or not might have been 82, but now, it might be 89.”
Role of the Advisor
“So, the role of the adviser is larger because clients need to consider the decision in light of their current health and family history.”
Of course, none of us really can know how long we’ll live. A simple approach is to think of each year of foregone early benefits as an investment in a longevity annuity with an eight percent payout. This approach works especially well in the case of married couples, since odds are high that one spouse - usually the woman - will live well past the actuarial averages. Those years of advanced age often are years when savings have been exhausted, so a higher Social Security benefit – one tied to a cost-of-living adjustment - can be a financial lifesaver.
Roger Wohlner, a financial planner based in Arlington Heights, Illinois, thinks the closing of the file-and-suspend loophole will reinforce the importance of planning basics.
“Social Security claiming decisions will be less complicated, but it may make retirement planning in general a bit more complicated,” He says. “It will make us look more closely at other things for someone 10 years from retirement. Has she max’d out her 401(k) and health savings account? Is she a candidate for a phased retirement down road?”
The old strategies may have been complex mechanically, but they gave advisors and clients a simple answer to handling retirement decisions that might now be a lot more complicated.