Sensible Perspectives

The Other One Percent – Part II

Posted by on February 29, 2016

This is Part 2, of a 3-part series, read the other parts here: Part 1, Part 3.

In my previous article, I noted the (surprising) fact that although most financial planners recommend people delay filing for Social Security until age 70, when the benefit will be highest, only about 1% of Americans actually do this. In this article, I’ll answer the common question “How long will I have to have lived in order for delaying Social Security to pay off?” using a breakeven analysis. I’ll then explain why I think this method is flawed.

A breakeven analysis example

Delaying Social Security retirement benefits is a trade-off. In exchange for waiting until some future point (age 70 will maximize your retirement benefit), you will receive higher payments for life. If those higher benefit payments continue for long enough (the Social Security breakeven point), you will have been better off waiting. If you die before the breakeven point, you would have been better off taking your benefit early.

Let’s take  a simple example. Dana will retire when she turns 66 on June 1st of this year. She will be entitled to a monthly Social Security retirement benefit of $2,639 (the maximum for 2016) if she files for her retirement benefit when she turns 66. Alternatively, she can delay taking her benefit until 70, which would allow her benefit to grow 32% (or 8% per year) in addition to the annual inflation adjustment. If she waits, her monthly benefit at 70 will be $3,483.

SS Breakeven graph

The graph shows Dana’s cumulative lifetime benefits as a function of her filing age. To calculate this benefit, I’ve assumed a real rate of return of 1% (this is about equal to what you could receive today from Treasury bonds).

You’ll notice that Dana’s breakeven point is her age 83. At this point, the cumulative benefit she would receive from waiting until age 70 is greater than the cumulative benefit she would have received had she filed for benefits at age 66. Importantly, every year she lives past 83, the better off she is for having waited. If she lives to 100, she will have been better off by approximately $125,000.

The pitfalls of a breakeven analysis

Many people see the above analysis and conclude that taking an early benefit is in their best interest (remember, only ~1% of Americans delay their benefit until age 70!). Below are some of the more common arguments along with my thoughts.

  1. I’ll never live that long, so why should I wait until 70? If you have health issues or if your family does not have a history of longevity, it’s true that you might be better off claiming your Social Security benefit sooner than later. However, if you are of average health and you do not need the income immediately, you should strongly consider delaying. (Society of Actuaries Retirement Participation 2000 Table). Once you retire, the real danger is not dying too early, it’s outliving your savings. The best way for most people to insure against that risk is to delay Social Security.
  2. “A bird in the hand is worth two in the bush”. The idea that taking Social Security “now” rather than “later” is somehow safer is another common argument I hear. Let’s be clear: Social Security is fantastic insurance. It’s an inflation-adjusted annuity that has zero default risk. There is simply no substitute for it in the market. And although the Congressional Budget Office estimates that changes will have to be made by 2033 to prevent a shortfall, that’s a long time from now and there are many options for shoring up the system. I think people who make this argument are not really worried that Social Security won’t be there in another couple years. They are worried about losing money. Statistically speaking, people feel twice as bad about a loss as they feel good about an equivalent gain. It follows that if you focus on the potential loss that would occur by delaying your benefit and dying prematurely, you are more likely to file early. This is another failure of breakeven analysis. Instead of viewing Social Security as an investment, I suggest you think about it as insurance against the worst-case financial scenario, i.e., living a very long time. I’ll bet you didn’t run a breakeven analysis when you bought life or homeowner’s insurance (if you did, you’d never buy it!). Instead, you probably focused on the worst-case scenario, e.g., dying prematurely or your house burning down in a fire, and decided it was in your best interest to transfer that risk to an insurance company. The same thought process applies to Social Security.
  3. If I take my benefit early, I can do better in the stock market than I could otherwise. In my analysis, I used a real rate of return of 1% to calculate Dana’s cumulative lifetime benefit. If I increased this rate to something higher, let’s say 4%, Dana’s breakeven point changes from her age 83 to 89. That’s because as the discount rate increases, the present value of your Social Security benefit decreases. So while it’s true that if stocks were to yield consistently high real rates of return, you might be better off taking Social Security early and investing the rest. But comparing Social Security benefits to stock returns is a mistake. Social Security is a government-guaranteed, inflation-adjusted annuity. There is no guarantee that stocks will have a positive return. Frequently, their returns are negative. The proper comparison is Treasury bonds, which are government-guaranteed and yield approximately 1% real today. Using this rate, most people would be better off delaying their benefit if they live to their early 80s.

Conclusion

In sum, a breakeven analysis is a flawed way to analyze Social Security. Nevertheless, it’s awfully prevalent. Try typing “social security break even” into a Google search and see how many results it yields. When I did this myself, I got about 11 million results, including articles from major publications such as U.S. News and Forbes.

But if analyzing Social Security based on your lifespan isn’t a sound method, how can you measure the value of delaying Social Security? In my next article I’ll explain how you can compare Social Security to a comparable product, in this case an inflation-adjusted annuity from an insurance company, to better quantify Social Security’s retirement benefit.

  • Bill E

    Two other things occur to me:
    1. Some folks might rather have more money to spend when they are younger and although this may be financially unsound to some extent, the delta doesn’t seem enough to me to make it a big deal to not have some fun.
    2. For high net worth individuals, this doesn’t matter one way or the other really.

    Bill

    • Frank Napolitano

      Bill, two thoughts: 1. Assuming someone has savings, they could spend just as much money as if they had taken social security early. You would just withdraw from your IRA the same amount that you would have received in SS. The question’s not whether or not to spend money, it’s from which source should you spend. I think my next article will clarify this point. 2. Actually, for high net worth individual’s, social security typically makes up a smaller amount of guaranteed income in retirement than for the average American. From that perspective, delaying Social Security might be even more important.

  • A simple breakeven analysis not including investing would be 82.5 years for delaying from 66 to 70.(4 years divided by .32 increased payments) In my case, since my wife didn’t work, and file and suspend is no longer an option, we would also have to make up 4 years worth of her 1/2 spousal benefit. This would require adding(1/2 * 4/.32)= 6.25 years to the breakeven point making the breakeven 86.75 years old. I have looked at many websites and none of them show this scenario.
    What is your opinion based on this length of time to breakeven?

    • Frank Napolitano

      Pat,
      Let me begin by saying I don’t know your situation, so please don’t take my thoughts here as advice. The laws pertaining to Social Security are quite complex.
      To your question: you’re correct that YOUR breakeven is simply 4/.32 (or solve for the equation 100x = 132(x-4), where 100 is full retirement benefit and 132 is 32% higher than the benefit 4 years later). This tells you how long you’d have to live before the higher benefits you’d receive by waiting until 70 to claim would equal the benefits you’d receive had you filed at 66.
      Your wife, however, doesn’t have a comparative breakeven analysis. There are no delayed retirement credits for spousal benefits. So there’s nothing to compare. You could calculate how much money you’ve lost due to the changes in the law, but since there’s no benefit to delaying past full retirement age, there’s no analysis.
      Hope that was helpful.

  • Down the Shore

    Hi Frank, trying to help my sister calculate the rate of return she needs for a side account if she banked her SS payments when taken as soon as possible. She is extremely well off so she doesn’t need the money but it just galls her that if she delays and dies before she receives any benefit she feels she paid all that money in for nothing. She’s born Oct 1957 and her FRA is 66 1/2 years. Next year when she turns 62 she is tempted to take the money. Reason being her husband died at age 65 and he never received a penny from SS as he was still working and made the decision to delay personally. She is uniquely situated to literally have the benefits paid to a brokerage account and invested for her. It looks like her breakeven point is around age 77 without the benefits being invested. My dad lived til 80, my mom 85. Is there a calculator available for breakeven with side account? 62 $1657 mo, 66 1/2 $2333 mo
    Thank you
    Rich

    • Frank

      Rich, I’m not sure a breakeven analysis works for this situation. Comparing social security to social security based on filing dates and life expectancy is comparing two streams of income. As I mention above this analysis has serious flaws. Comparing Social Security (an inflation adjusted annuity) to an investment account such as a brokerage account is very difficult. I try to do something similar in my follow up article, but even there I assume the investment account will be used to buy an inflation adjusted annuity to maintain as much as possible an apples to apples comparison.
      I think the bottom line in your sister’s situation, assuming she really doesn’t need the money, is that she can afford to take an early benefit if she wants. There will be some combination of circumstances, for example she lives a very long time and market returns are below-average, that would have made waiting until 70 better, but ultimately it’s a risk she may be able to take.
      I wrote another article recently, located here, about when it makes sense to delay filing. Although the factors I identify can also be used to see when it might make sense to take an early benefit.

      • Down the Shore

        Thanks Frank, seems like her break even point without even investing the early withdrawal is 77, so with a modest theoretical return, that 77 gets longer and longer.

        Appreciate it.

        Love the new article