One of the most important decisions a retiree faces is when to apply for Social Security benefits. This is not a decision to be made lightly; the guaranteed lifetime inflation-adjusted income promised by Social Security makes it one of a retiree's most significant assets.
If you were to calculate the present value of a client's Social Security income stream, it would rival the lump sum many people have in their 401(k) plans at retirement. While the Social Security "asset" may not be managed in the traditional way, pre-retirees can enhance its value by building a strong earnings record and applying for benefits at the optimal time.
The basic choices for applying for Social Security are these:

• Apply at age 62 and receive a reduced benefit for life
• Apply at full retirement age and receive full benefits for life
• Apply at age 70 and receive an additional credit for life

As full retirement age rises with the phase-in of 1983 amendments, the penalty for taking early benefits is increasing while the credit for delaying the onset of benefits is rising. These adjustments, combined with longer life expectancies, are making it more and more advantageous for today's retirees to delay benefits to age 70.

For example, here's what a 60-year-old client with $100,000 in earnings would receive under the following scenarios:

Source: Social Security Administration

The traditional way of deciding when to take benefits has been to calculate the break-even age. This is the age the client must live beyond in order for delayed benefits to provide a higher lifetime income. Here are the break-even ages for today's 60-year-old:

Source: Social Security Administration

However, it seems the break-even method of determining the onset of Social Security benefits leaves out several factors that can influence the age at which benefits should begin. A new paper titled "Rethinking Social Security Claiming in a 401(k) World" highlights, among other things, cost-of-living adjustments (COLAs), taxes, and spousal benefits. A key premise of the paper is that today's retirees face major risks in managing their accumulated retirement funds, which generally end up in an IRA rollover account. These include investment risk, longevity risk, inflation risk, and the financial risk caused by the death of a spouse.
Two additional risks that are rarely discussed are expense risk and tax risk. Authors James I. Mahaney and Peter C. Carlson argue that Social Security benefits will become increasingly valuable due to their longevity protection, inflation protection, survivor protection, and tax-favored status (only a portion of benefits is taxable and only if income is over a certain threshold). In light of the risks retirees face in managing their own retirement assets, it behooves them to maximize Social Security benefits to the extent possible.

COLAs
COLAs are the annual increases in Social Security benefits that enable retirees to keep up with inflation. In a low-inflation environment, they may not seem like much—2.3% for 2008, for example (compared with 14.3% in 1980)—but annual compounding creates a snowball effect, making COLAs very significant over a person's retirement years.
According to authors Mahaney and Carlson, most break-even analyses ignore the impact of COLAs. But when COLAs are applied to the higher benefit available at age 70, the breakeven age falls further. The longer a retiree lives, the higher the lifetime benefit will be due to the impact of COLAs on the higher starting amount.

Taxes
If a client retires at age 62 and has the choice of applying for early Social Security benefits vs. delaying benefits and drawing income from an IRA rollover during the "bridge period" (the years between retirement and age 70), many advisors would recommend leaving the rollover intact (so it can continue to grow tax-deferred) and taking reduced Social Security benefits to meet current spending needs.
However, Mahaney and Carlson argue that when taxes are factored into the formula, the opposite strategy is recommended. The reason is that taxes on Social Security benefits raise the effective tax rate on whatever IRA distributions the client does take. Since Social Security income counts at only a 50% rate in the combined income formula, much larger amounts of Social Security can be received before the combined income thresholds are met.
They give the example of a 72-year-old retiree who has two options for receiving pretax income of $69,000. In Strategy #1 he applied for early Social Security benefits and now receives $24,000 per year; in Strategy #2 he delayed benefits and now receives $39,000 per year. The balance of the $69,000 comes from IRA withdrawals: $45,000 in Strategy #1 and $30,000 in Strategy #2. Because the higher IRA withdrawals in Strategy #1 raised his combined income for the purpose of calculating the income tax on Social Security benefits, more of his Social Security benefits are taxed. Strategy #1 produces an after-tax income of $61,703 vs. $65,321 for Strategy #2. Over a 30-year period the taxes saved in Strategy #2 amount to more than $100,000.

Spousal Benefits
When the combined benefits for a married couple are taken into consideration, the analysis becomes much more complex. You must take into account each spouse's age, their combined life expectancies, the benefit based on each spouse's own earnings record as well as the spousal benefit (if higher), and the amount the surviving spouse would receive after the spouse dies. Believe it or not, even with all these variables, there are some rules of thumb that can help you advise clients on when to apply for Social Security benefits.
For one thing, it's important to know that spousal benefits may be taken as soon as the primary worker reaches full retirement age. There is no advantage to delaying spousal benefits.
However, a primary worker need not apply for benefits in order for a spouse to begin receiving spousal benefits. Under the Senior Citizens' Freedom to Work Act of 2000, a primary worker can "file and suspend" his own benefits upon reaching full retirement age in order to initiate spousal benefits while continuing to build delayed retirement credits for his primary benefit. Many people do not understand this relatively new rule, but it can provide the optimal solution for married couples where the spousal benefit (one-half of the primary worker's benefit) is higher than the benefit based on the lower-earning spouse's own earnings record and where the lower-earning spouse is younger than the primary working spouse.