2020 has been full of surprises and challenges for all of us, and those who recently retired and those planning to retire soon are no exception. Career instability, volatile markets, and the uncertain futures of so many business owners have shaken the foundations of their retirement plans. Some are doubting the reliability of what had been safe assumptions as recently as January. For all of us there are any number of variables in a retirement plan. Social Security benefits factor in for almost everyone, with varying degrees of impact. Regardless of one’s wealth, it’s important to integrate Social Security benefits with asset allocation and portfolio withdrawal strategies to efficiently finance living expenses in retirement.
Deciding exactly when to claim the Social Security benefit isn’t always obvious. Too many don’t even know their options, not to mention the pros and cons of various strategies. There are myriad rules governing claiming strategies which we are not attempting to detail or diagnose here. But generally speaking, Social Security can be claimed as early as age 62 (for those that qualify). However, this locks in a lower monthly benefit than the benefit received if claimed at Full Retirement Age (somewhere between 66 and 67 depending on year of birth). On the other side of Full Retirement Age, the benefit can be delayed as far out as the 70th birthday. The benefit grows about 8% for each year the claimant delays the benefit beyond Full Retirement Age.
According to the Social Security website this means a retiree would see their benefit increase to 132% of their full retirement benefit if they hold out to age 70. For those with sufficient retirement assets, this sounds like a no-brainer. But there are several issues to consider before making this decision. Most have to do with families’ specific goals, assumptions, and what brings peace of mind, not just math. Like most wealth-planning issues, the numbers can’t be analyzed in a vacuum, and the solution doesn’t always neatly fit into a spreadsheet.
If we could know our lifespan the answer could be found with a simple calculation. Claiming earlier makes sense with shorter life expectancies, and waiting until age 70 can possibly make sense if one lives into their late-seventies or early-eighties (depending on their benefit amount). It really comes down to a break-even analysis, but the most impactful variable (life expectancy) is unknowable! Still, we can make some reasonable assumptions based on current health, family history, and lifestyle choices. Unless one is very confident they will live beyond age 80, delaying until 70 to claim is not clear cut. Social Security benefits are use-it-or-lose-it and can only be passed to a surviving spouse. For couples the health of both spouses must be considered.
The Benefit/Growth Comparison
The question is commonly framed as an arbitrage question with respect to the growth of the benefit (8% per year, not compounded) compared to the growth of the assets in the portfolio. On the surface, it appears that a “guaranteed” (by the federal government) 8% growth rate compares favorably to the potential return on the assets that would need to be taken from investment accounts. But there are two factors that reduce this return advantage:
- The 8% growth rate of the benefit is not compounded, but the investment return in a portfolio is compounded. The portfolio could go down but the four-year effect of compounding does reduce the advantage on average. Factoring compounding, the portfolio would need to return 7.2% per year for four years (not 8%) to match the 32% benefit increase.
- Taxation also needs to be considered. If a retiree is taking money exclusively from tax-deferred assets to replace what they would have received in Social Security benefits, those distributions are fully taxed as ordinary income. However, only a maximum of 85% of Social Security benefits are taxable as ordinary income, creating a tax advantage for Social Security benefits over tax-deferred withdrawals.
Taken together, this means the “hurdle rate” for the portfolio when comparing the growth of the Social Security benefit is lower than what was typically considered to be the “rule-of-thumb” 8% annual benefit increase by waiting to claim.
The claiming decision is also driven by a family’s goals for passing wealth to the next generation. Children and grandchildren can’t inherit future Social Security benefits from their parents, but they can inherit investment accounts in full. If Mom and Dad’s investment accounts were drawn down for living expenses as a result of delaying Social Security until 70, the inherited account balances would likely be lower.
Do the Math to Assess Return on Sleep
It can be helpful to actually do the math on the differential of claiming strategies. There are many software tools that can accurately accomplish this task using the full earnings record (from the Social Security statements). The results can then be put in context. For example, if the total life-time advantage of one strategy or another is insignificant, it may be worth choosing the one that provides the most peace of mind. Factoring return on sleep (ROS) can be more valuable than the purely number-driven return on investment (ROI).
Social Security analysis is complex, and even sophisticated software struggles to capture all the variables, especially return on sleep. Making a decision based on a Google search and rules of thumb is usually a recipe for regret. Doing the math helps but it’s just one factor in the context of a personalized wealth plan. We will only know after the fact which option is best. After evaluating the variables and making reasonable assumptions, we can at least make an informed decision and move forward with a sense of confidence.