For many Americans Social Security benefits are an extremely important source of retirement income. Four reasons Social Security is so valuable are:
• The monthly payments continue for life.
• Benefit payments can’t be reduced (market downturns and deflation don’t change benefits).
• Benefits are usually adjusted annually for inflation (in financial terms, Social Security is like owning a lifetime annuity with an inflation rider).
• The worker’s spouse may also claim benefits, and spousal benefits may continue after a worker’s death for the remainder of the surviving spouse’s life.
Social Security benefits vary from person to person. They are based on a complex formula that considers the age benefit payments begin and an individual’s “work record” (earnings from employment over a working career). Because people earn different amounts at different times over their working lives and begin taking their benefits at different ages, Social Security benefits will vary from person to person.
How much is a Social Security benefit worth? Of course that depends on the worker’s benefit and potential benefits payable to a surviving spouse. Take the example of a 66-year-old man who retires with a $2,500 monthly Social Security benefit. It would cost him more than $499,000 to purchase a single premium immediate annuity that would pay $2,500 per month as long as either he or his spouse is living. The ability to increase the payments annually for inflation brings the value of this Social Security benefit to more than $500,000.
Social Security Favors Married Couples
Social Security was designed to give married couples extra benefits. They have more flexibility in claiming their Social Security benefits and multiple options for maximizing them. Benefits for single individuals, on the other hand, are simple, straightforward and (once begun) inflexible.
Most married people who are 62 or older probably qualify for a Social Security benefit. At age 62 spouses can elect to receive either a personal benefit based on their own work record, or a spousal benefit based on their spouse’s record.1 The spousal benefit is capped at 50 percent of the other spouse’s benefit amount at the electing spouse’s full retirement age (currently age 66). The ability of both spouses to receive separate monthly benefit payments can be very important to their retirement standard of living.
Spousal Survivor Benefits
Unfortunately, when one spouse dies, his Social Security benefits end. The surviving spouse must then deal with two losses: (1) the emotional loss of the partner and (2) the financial loss from the termination of the deceased spouse’s Social Security benefits. The surviving spouse may get some partial relief from the financial loss. After the first spouse’s death, the surviving spouse gets to choose between two benefits going forward. The surviving spouse may elect to receive either the benefit available under his own record or can decide to “step into the deceased spouse’s shoes” and receive the monthly benefit the deceased spouse was receiving at the time of death. This is an important election, and surviving spouses should consult with their financial advisors to determine which alternative is best for them.
Regardless of which Social Security benefit the surviving spouse elects, he will experience a significant reduction in overall family Social Security income. The loss of one Social Security benefit will likely result in a loss of several thousand dollars per year for the surviving spouse. In addition, future benefit increases from inflation adjustments will be smaller.
John and Joan Smith
The Smiths have been married for 30 years and are retiring at age 68. They are electing Social Security benefits based on their individual work records. John’s benefit is $2,000 per month and Joan’s is $3,000 per month. Thus, together they have a combined household Social Security income of $5,000 per moth. For simplicity, we won’t consider the inflation adjustments to their benefits. If Joan dies in five years at age 71, John will probably elect to receive a spousal survivor benefit of $3,000 (Joan’s benefit) and give up his benefits from his own work record. As a result, the total Social Security income available to John drops by $2,000 per month (from $5,000 to $3,000), creating a total income reduction of $24,000 per year.
If John dies first, Joan will suffer the same financial loss. She will continue to receive her $3,000 per month benefit (taking over John’s $2,000 monthly benefit won’t make financial sense because it is less than her current $3,000 monthly benefit). As a result, total monthly Social Security income will drop from $5,000 to $3,000. The resulting annual loss will still be at least $24,000 per year for the balance of Joan’s life. Thus it doesn’t matter whether John or Joan dies first. The income reduction will be the same, and it will be significant.
The permanent reduction in combined benefits at the first spouse’s death may have a serious long term impact on the surviving spouse’s financial security. Household expenses after the first spouse’s death may be smaller, but the reduction may not be enough to offset the reduction in total Social Security payments. In the Smiths’ case, living expenses probably won’t decline by $2,000 per month. Unless both spouses die simultaneously, there is sure to be a reduction in Social Security income. The ultimate amount of the total loss depends on how long the surviving spouse lives. Without replacement assets or a new source of income, the surviving spouse could be forced to liquidate assets or reduce his standard of living.
Life Insurance May Offset Some of the Loss
Since death is certain, the risk of reduced Social Security benefits is real. When the first spouse dies, total Social Security income will be reduced. The question is: What’s the best way to deal with this loss of income? One alternative is to use life insurance to make up for the lost Social Security benefits.
Although they may not have thought about it, every married couple has this risk. Those who aren’t doing anything about it are essentially self-insuring. If they are in good health they may have the option to transfer some of the risk to a life insurance company. A life insurance policy could give them an extra margin of safety by transferring the portion of the risk they don’t want to retain.
Cash value life insurance could give the Smiths the potential to protect the surviving spouse’s standard of living. Statistically, Joan is likely to survive John by 3 to 5 years.2 If that happens, the $2,000 per month reduction in lost Social Security benefits at John’s death would lead to an income loss of $72,000 over three years and $120,000 over five years. If Joan survives John by 10 years her income loss will be $240,000 (without factoring in lost inflation adjustments). A life insurance policy on John could replace all or part of the lost benefits. If Joan dies first, John faces the same loss. A policy on Joan would replace all or part of the reduction in benefits he would face. If the non-insured spouse dies first, the policy remains in force and the surviving spouse may access available policy cash values to replace the lost benefits.
Joan and John could assess how healthy they are and decide to purchase a cash value policy on the one most likely to die first. Or they could purchase two policies—one insuring each of them. This two-policy approach would provide a death benefit to protect the survivor’s standard of living no matter which of them dies first. The surviving spouse would then still own a policy insuring his own life, which could be used to supplement other sources of retirement income (through cash value withdrawals and policy loans) or to provide a family or charitable legacy at death.
Conclusion
Many people focus their retirement planning on the first few years of retirement. They are focused on accumulating enough assets and generating enough income so they can afford to stop working. In their planning they need to look further down the retirement road. They also need to anticipate threats to their retirement income and adopt a viable strategy to defend it. Once they retire, maintaining their retirement income in the face of unexpected and inevitable events may be difficult.
This is especially true for married and committed couples whose standard of living is based on their combined Social Security and pension benefits. They need to plan for a retirement that will last for two lives, not just one. Smart couples look down the road and envision what their retirement situation could be 10 or 20 years into the future and the problems that could emerge over that time. They structure their retirement plans with a margin of safety to protect their lifestyles. It is inevitable that one of them will die first and that the survivor will suffer a reduction in Social Security income. If the survivor’s standard of living will be threatened without that income, they need to have a workable strategy to replace it. Cash value life insurance is a planning option they should consider. It can be a flexible way to help protect their retirement income.
Footnotes:
1. For spousal benefits to be paid, the worker must have filed for his own benefits or “file and suspend” the payment of benefits.
2. Centers for Disease Control and Prevention, National Center for Health Statistics, National Vital Statistics Report, October 2012.
These materials are not intended to and cannot be used to avoid penalties and they were prepared to support the promotion or marketing of the matters addressed in this article. Each taxpayer should seek advice from an independent tax advisor. The ING Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws change frequently and the strategies suggested may not be suitable for everyone.
