03/12/2012 07:31 pm ET Updated May 12, 2012

Taking Social Security's Best Deal

I have a good friend, Paul. He's has a good education. He earned a Ph.D. in engineering at MIT and then received a law degree at the University of Pennsylvania, after which he went into patent law.

Over lunch the other day, he told me, out of the blue, that I wouldn't believe how complicated Social Security benefit-taking rules are. He then told me he'd figured out how to get the most from the system for himself and his wife Karen.

Paul's 68 and Karen's 65.

"What's your strategy, Paul?" I asked. Well, I just started taking my retirement benefits and I had Karen take her spousal benefit. When she's 70, I'll have her take her retirement benefit.

"Paul," I said. "Learning Social Security's provisions is just about as hard as learning Chinese. Social Security's Handbook has 2,728 separate rules, virtually all of which are indecipherable unless you have spent years studying the system's parsing of terms. And almost all of the rules are incomplete, so there's something called the Program Operating Manual System (POMS), which has thousands upon thousands of additional rules to clarify the Handbook's rules. And the POMS is harder to understand than the Handbook."

"And, by the way, Paul. I think you blew it in your Social Security strategy."

"What do you mean?"

"Well, for starters, you should have waited until 70 to collect your highest Social Security benefit. You're not living hand to mouth, so you can afford to wait."

"I disagree. I looked at life tables and made an actuarial calculation that showed taking the benefits now beat waiting."

"Paul, you're looking at this like you are an insurance company. Insurance companies do such breakeven analyses. But you are just one person who will die only once. You can't plan to die on time. In fact, you need to plan to live not until your expected age of death, but until your maximum age of life for one very simple reason - You might!"

"Paul, if people did actuarial analyses in deciding whether to buy home owners insurance, auto insurance, health insurance, or life insurance, no one would buy any of those products. The premiums are always above the average payout on the policy because of the fees/loads the insurance company pays. But when we're exposed to risks, taking averages isn't appropriate because the bad event, like our house burning down, will either happen or not. If we have 10,000 houses, taking averages would be fine in deciding whether to buy homeowners insurance. But with one house and no others to average against, we take a huge risk in not buying homeowners coverage."

"When it comes to longevity insurance you don't have multiple lives to average over. You will either die early, on time, or late and the big risk is dying late with no money."

Here, we're talking about your giving up a couple of years benefits to get a higher annuity (an inflation-indexed one) starting at 70 that will continue right through you maximum age of life if you live that long. So by deferring benefits for two years, you buy more longevity insurance -- at the cheapest rate available."

"OK, Larry, I got you. But did I blow the decision on Karen as well."

"Yew, you did. You should have had Karen wait until full retirement age at which point she'd be able to apply just for her spousal benefit on your record. When you had her apply for her spousal benefit, you forced her to apply for her retirement benefit as well based on Social Security's deeming provision that applies only when people are under full retirement age."

"So here's what you should do, Paul. Neither you nor Karen have received your benefits for more than a year. So you can go repay all the benefits you and she received and do the following. When Karen reaches full retirement age -- when she turns 66, go into Social Security and file for your retirement benefit, but suspend its collection. This will let Karen apply just for her spousal benefit based on your earnings record. When you're 70, you'll tell Social Security you want to start collecting your retirement benefit and it will be 16 percent larger than you are now getting. When Joan's 70, she'll start tell Social Security to start paying her her own retirement benefit. Given what I know about your earnings, this may well be worth $50,000 in present value."

Paul did as I suggested. He went back to Social Security, where the people at the office tried to talk him out of this strategy based on actuarial considerations. But he persisted and was able to fix the mistakes.

Social Security is our nation's most important saving vehicle, but it's a user nightmare. At and at I point out how it should be fixed so that people don't end up randomly losing massive amounts of benefits because they don't speak Social Security. My software company also has a $40 tool -- that can help people get the most from the system.