Journal of Financial Planning: December 2015
Wade D. Pfau, Ph.D., CFA, is a professor of retirement income at The American College and a principal at McLean Asset Management. He is a two-time recipient of the Journal’s Montgomery-Warschauer Award. He hosts the Retirement Researcher website, RetirementResearcher.com.
One of the hottest topics in retirement income planning over the past several years has been how to help clients strategize on their Social Security claiming decisions. These discussions generally delve into the intricacies of approaches like “file and suspend” or “file a restricted application.” The general theme emerging from these discussions is that at least the spouse with higher lifetime earnings should delay taking their benefit until age 70.
This message may be getting through to the public, at least partially. Using numbers reported in the 2015 Annual Statistical Supplement to the Social Security Bulletin, I find that the percentage of nondisabled Social Security retirement beneficiaries who claimed benefits at 62 fell from 58 percent in 2005 to 44 percent in 2014. Meanwhile, those who delayed claiming until past their full retirement age was still just 5 percent as late as 2008, increasing to 11 percent in 2014.
Not everyone agrees, however, that delaying Social Security is worthwhile. And the data does demonstrate that few are willing to do it. I will review the main philosophical justifications for delaying Social Security, as well as review some of the reasonable and not-so-reasonable opposing arguments.
Social Security Is Insurance
Blaise Pascal was a seventeenth century French philosopher whose “Pascal’s wager” was an argument that it is best to believe in God. If God does not exist, then a misplaced belief in God will have relatively minor consequences. However, if God does exist, then the impact of belief in God becomes much more consequential: eternity in heaven for believers and eternity in hell for non-believers. The consequences of the decision weigh toward a belief in God.
Pascal’s wager, as it relates to Social Security, is a matter of the consequences of longevity risk. Think of the four general outcomes for Social Security: (1) claim early and experience a short retirement; (2) claim early and experience a long retirement; (3) claim late and experience a short retirement; and (4) claim late and experience a long retirement.
What are the consequences of these different outcomes? It is surely unfortunate to experience a short retirement. In relation to Social Security, claiming early would have gotten the most out of the program. But claiming late would have resulted in minimal harm. Less would be obtained from Social Security, but there would have been less pressure on the portfolio anyway, and a decent amount may still remain for heirs.
Consequences become more severe with longer retirements, and this is where decision-making should be focused. When claiming early, a retiree is setting up conditions for a permanently reduced standard of living in retirement. A long retirement combined with Social Security delay supports a permanently enhanced lifestyle. The point is that greater emphasis should be placed on what happens in longer retirements, because the financial consequences are more severe, and this is when delaying Social Security will have a clear positive impact.
Pascal’s wager points to the idea that Social Security should be viewed as insurance, rather than as an investment. Social Security retirement benefits are inflation-adjusted and government-backed. With lifetime cash flows, they mitigate longevity, inflation, and market risk for retirees. For risk-averse retirees who would otherwise invest more heavily in bonds, which do not provide longevity protection, the insurance value of Social Security becomes even stronger, because there would otherwise be less potential for upside growth. Social Security also provides spousal and survival benefits, as well as benefits for dependent children.
Social Security as an Investment
The alternative to treating Social Security as insurance is to view it as an investment or as a gamble on how long one lives. This can be problematic. The investment approach focuses more on the break-even age for when it finally pays off to delay benefits. With inflation-adjusted discount rates of 0 to 2 percent, the break-even age is 80 to 84. Though these ages are within the range of life expectancies for 62-year-olds, they appear to be high, and clients start to worry that they may not live long enough for delay to pay off.
As well, sometimes it is the advisers who get ahead of themselves, thinking that they can invest the early Social Security benefits better and provide more lifetime wealth to their clients. I’ve seen advisers write that it doesn’t make sense to delay Social Security, because the adviser can invest that money and earn their clients a 10.5 percent compounded return. Certainly, if realized returns are this high, then claiming early is advantageous. But the odds are not in favor of getting that sort of investment return over the eight-year delay period, especially in our current low-yield world.
Nevertheless, although I prefer thinking of Social Security delay as insurance, it can be viewed as a rather attractive “investment” proposition. This involves understanding the additional credits provided by delaying Social Security benefits, which were meant to be “actuarially fair.” What this means is that for someone living to their life expectancy, it should not matter what age they claimed their benefits. The increase in benefits from delay should precisely offset the fewer number of years that benefits will subsequently be received.
However, these calculations about actuarial fairness with the delay credits were made as part of the 1983 amendments to Social Security. The calculations are 32 years old, and changes since that time suggest that delaying benefits can now provide net advantages.
First, Social Security actuaries calculated the delay factors assuming that the real interest rate is 2.9 percent. In October 2015, the yield on 30-year TIPS was only about 1.2 percent, and it was even less for shorter-term TIPS. Lower interest rates today mean that we should expect lower returns on other types of investments, which favors delaying Social Security as a way to actually obtain higher overall returns for the household assets.
The other change relates to longevity. Longevity continues to improve and retirees are now living longer than they were in 1983. This, as well, favors delaying Social Security, as it improves the odds of living long enough to enjoy positive net benefits from delayed claiming. Also, actuaries considered aggregate longevity for the population of Social Security participants, and the more highly educated and higher-earning clients of financial advisers represent a subgroup of the population with longer lives.
A simple example can help illustrate how delaying Social Security can work as an “investment” that helps to improve portfolio sustainability for retirees. Consider a 62-year-old who has already retired. We will consider the case of a single individual with no dependents; this leaves out additional complications, although having a spouse entitled to survivor benefits would further strengthen the case for delay. This individual is simply thinking about the decision between claiming Social Security at 62 or at 70.
In this example, the client has an annual spending goal of $120,000 in today’s terms. Future spending grows with inflation. Her full retirement age is 66, and her PIA is $2,500 per month or $30,000 per year in today’s dollars (all dollars are expressed as their age-62 values, though in subsequent years cost-of-living adjustments would be applied to the overall spending goal and to Social Security benefits). If she claims at 62, her benefit would be reduced by 25 percent to $1,875 per month or $22,500 per year. If she delays until 70, her benefit grows by 32 percent from the PIA to $3,300 per month or $39,600 per year. Inflation-adjusted Social Security benefits are 76 percent larger when claimed at 70 relative to 62.
To meet her $120,000 spending goal, any amount above what is provided by Social Security will be funded by withdrawals from an investment portfolio worth $2.35 million. This creates two lifetime spending scenarios. By claiming at 62, Social Security provides $22,500 of income, and $97,500 is withdrawn from the investment portfolio. When claiming at 70, $120,000 will have to be supported by the portfolio for the first eight years of retirement. Starting at 70, Social Security then provides $39,600 with the remaining $80,400 coming from the portfolio.
One way to compare these strategies is the implied withdrawal rate needed from the portfolio after accounting for Social Security. By claiming at 62, the inflation-adjusted withdrawal rate needed to meet the spending goal is:
Withdrawal rate = ($120,000 – 22,500) / $2,350,000 = 4.15 percent
When claiming at 70, there could be two different withdrawal rates for before and after 70. However, it would not be wise to use a volatile investment portfolio for the full spending amount when Social Security is delayed, as that would magnify sequence risk. Instead, I use a conservative assumption that eight years of age 70 Social Security benefits will be set aside at age 62 and earn a 0 percent real interest rate (building an actual eight-year TIPS ladder would provide a positive yield).
At age 62, this means that $39,600 x 8 = $316,800 will be set aside as a Social Security bridge, leaving the other $2,033,200 for withdrawals. The required withdrawal rate to meet the spending goal throughout retirement is now:
Withdrawal rate = ($120,000 – $39,600) / ($2,350,000 – $316,800) = 3.95 percent
In this example, Social Security delay allowed the withdrawal rate to drop from above 4 percent to below 4 percent. This improves retirement sustainability. The investment portfolio is less likely to be depleted and more income remains available through the higher Social Security benefit in the event that the portfolio is depleted.
Allowing for the same probability of portfolio depletion, spending could be increased to more than $126,000 to match the withdrawal rates. The magnitude of the difference would be larger if the client’s spending goal and asset base were smaller.
Arguments for Claiming Early
I’ve already attempted to counter the argument justifying an early claim that it is reasonable to expect an adviser to earn outsized returns on Social Security benefits. This uncertain quest for upside growth means giving up a valuable lifetime inflation-adjusted income stream.
Another common argument for claiming early is that the Social Security program is about to be dramatically overhauled in a way that leaves clients attempting to get a little out of the system before it’s gone. It seems rather unlikely that any impending reforms would leave near retirees with significant reductions to their benefits.
Legitimate arguments for claiming Social Security early, though, include that clients simply need the funds to survive and do not have other alternatives. They do not have sufficient assets to cover the loss in benefits until age 70. Using the previous example, if the financial portfolio was only about $300,000, then there is not a way to build the bridge for delay (really, the $120,000 spending goal would not be feasible with a $300,000 portfolio). Delaying retirement would be a better option, although it is not always possible. Claiming early in these circumstances may be unavoidable with the consequence of a permanently reduced lifestyle.
The other reasonable argument is for individuals and spouses who have legitimate medical reasons to believe they will not live to age 80. Then, claiming early is better justified.