Optimizing Social Security Benefits for Couples

Married couples in which both people have paid into social security have a distinct advantage when it comes to benefit payments. This advantage comes from the ability to optimize the total payments they receive over time with an appropriate combination of retiree and spousal benefits.  The optimal approach is determined based on a number of factors including life expectancy, the interaction of spousal benefits, and your cash flow needs.

Note that this article focuses on married couples only because the federal government does not recognize domestic partnerships or any other non-marital arrangements.

Disregarding spousal benefits and assuming you live to the average mortality used by the Social Security actuarial tables then you would receive the same amount of total payments over time regardless of when you began taking benefits. (This also assumes you are not subject to a reduction due to other earned income). If you started taking benefits earlier you would receive a greater number of smaller payments. If you started later you would receive a smaller number of larger payments.

If you have a shorter life expectancy there is a point as which you maximize the total benefits paid by starting social security payments sooner. And as you would expect if you have a longer life expectancy you maximize the total benefits paid by starting later. In practice our financial plans are usually assume that people will live into their 90’s. So delaying receiving benefit until age 70 is the better approach if your budget prior to that allows it.

A couple can improve on this approach while also providing partial benefits at retirement by taking advantage of spousal benefits. The main approaches for optimizing retiree and spousal benefits are listed here. Which one is the best will depend on benefit amounts and the age of each person.

·         Wait until Full Retirement Age (FRA)

o   Claiming social security benefits before FRA  (66 to 67 depending on your age) means locking in lower lifelong benefits. As mentioned earlier this may only make sense if you have a short life expectancy or have immediate cash flow problems.

o   Even if your life expectancy is low, claiming early also means locking in lower spousal survivor benefits. At death the surviving spouse is eligible to receive the higher of their own benefits and survivor benefits. If the survivor benefit would be significantly higher it may make sense to delay claiming until your FRA.

o   Your budget must allow you to forgo any social security income until FRA.

·         Wait until Age 70

o   Each spouse waits until they are age 70 until they claim and start receiving their social security benefits. The benefits are approximately 137% - 140% more (depending on your age) than if they had taken them at their FRA

o   Your budget must allow you to forgo any social security income until age 70.

·         Claim and Suspend:

o   You start receiving a spousal benefit at FRA, and still get both of your enhanced benefits when you each reach age 70.
The older spouse

§   claims his benefits when the younger spouse reaches their FRA or retires, whichever is later.

§  Immediately suspends receiving benefits

o   Starts taking own enhanced benefits at age 70

o   The younger spouse

§  Takes spousal benefits based on the older spouse’s benefits at the same time the older spouse claims and suspends, which is also her FRA or retirement date.

§  Starts taking own enhanced benefit at age 70

o    

·         Claim Spousal First

o   You start receiving a full benefit and a spouse benefit at FRA, and one enhanced benefit starting at age 70.

o   Younger spouse takes her full benefits at FRA

o   The Older spouse claims spousal benefits at the same time.

o   The Older spouse claims his own full benefits at age 70

Notes:

·         Claim and Suspend is not an option before reaching FRA. Until FRA, if you file you are deemed to be filing for both worker and spousal benefits. You will receive the higher of the two. You do not have the option to do otherwise until you reach FRA when you can choose which one you want

·         If either person qualifies for a government pension and they did not pay into social security while earning that pension, there retiree and/or spousal benefits may be reduced . This deduction is due to the Government Pension Offset (GPO) and  the Windfall Elimination Provision(WEP). In this situation the annual social security statement you receive is not accurate!  A complex set of calculations is required both to determine your benefits and the most optimal approach for a couple.

·         CONSULT YOUR ADVISOR BEFORE TAKING ANY ACTION! At retirement your situation and the available options should be analyzed before making any decision as the IRS may have changed the rules.

Vanguard Funds Reduced Fees with Admirals and ETF’s

Vanguard made an incredible announcement in October 2010: The minimum investment requirement for their Admiral Class shares were lowered from $100,000 to $10,000 for index funds and to $50,000 for actively managed funds. The lower minimum investment requirement makes the Admiral Class accessible to a large number of investors previously locked out. This is effectively a fee reduction as the Admirals’ expense ratios are from 0.07% to 0.17% cheaper than the investor class.

There are over 50 Vanguard funds with Admiral Class shares, all of which are included in this change. For example, the Vanguard Intermediate-Term Bond Index Fund Investor Class (VBIIX) expense ratio is 0.22% while the Admiral Class (VBILX) is 0.12%. Similarly the Vanguard 500 Index Fund Investor Class (VFINX) expense ratio is 0.18% while the Admiral Class (VFIAX) is 0.07%.

However as with many good things, this change comes with conditions. The Admirals shares are now almost exclusively available from Vanguard Brokerage. Looking at other retail brokerages such as Schwab, Fidelity, Scottrade and E*Trade you will find the Admiral Class of shares either not available or only open to existing owners. They are also not available on Advisor platforms such as Pershing. I suspect that they may be available for certain institutional or qualified plan arrangements, though I do not know for sure.

 

Admiral or ETF?

This change can be seen as another step in Vanguard’s long history of dropping investor expense ratios. It is also a very smart marketing strategy providing another incentive for investors to move their assets to the Vanguard Brokerage. Or is it? It turns out that almost all of the index funds with Admiral Class shares also have ETF class shares. And guess what the expense ratio is for these ETF’s? Almost all are the same as the Admiral Class shares with some ETF’s even lower!

So in reality every investor can share in the lower expense ratio of Vanguard Index Fund Admirals regardless of their brokerage by buying ETF’s. In addition to the lower costs ETF’s typically have no capital gains distributions. Although there were capital gains distributions with some ETF’s for the first time at the end of 2010 they were still lower then for most mutual funds.

.You might have noticed that I said “ETF Class”. That is because due to Vanguard fund’s unique structure, the ETF’s are actually just another share class of the Fund. This means that they share in the economies of scale of the existing assets in other fund classes and so are able to be offered at the lowest expense ratio.

Conversion Considerations

Should you switch you existing Vanguard Shares to Admirals or ETF’s? If your funds are held at Vanguard, they should have been automatically converted to Admiral Class shares at the end of 2010 if you met the minimum investment requirement. For investors at other brokerages (or those at Vanguard with less $10,000 in an index mutual fund) the decision and timing to move to the ETF class should be based on an analysis of management fee savings, your holding period, transaction fees and tax consequences.

Example

Let us look at an example to understand the potential benefits. Assume an investor owns $20,000 of the Vanguard 500 Index Fund Investor Class (VFINX) at Charles Schwab with a cost basis of $15,000 in a taxable account:

VFINX Fund annual expense (0.18%) = $36

VOO ETF annual expense (0.06%) = $12

Online Fund sale transaction fee: $49.95

Online ETF purchase transaction fee: $8.95

There would be a $24 annually by converting to the ETF. However it would cost $58.90 to do so. It would take about 2 1/2 years to breakeven. If the ETF was going to be held longer than this than changing to the ETF would make sense if the tax consequences were acceptable.

In our example there would be a $5000 capital gain. Assume it is a long term capital gain and that the owner has $6000 in long term capital losses. In this case the fee reduction could be achieved with no income taxes being paid.

Conclusion

If you are an investor now holding the investor class of Vanguard Mutual Funds which have an ETF’s class you should evaluate whether a move would be beneficial to you. The decision and timing to move to the ETF class should be based on management fee savings, your holding period, transaction fees and tax consequences.