Executive Summary
Despite a growing body of research suggesting that most retirees would benefit by delaying the onset of Social Security payments, the majority who are eligible still elect to begin receiving them as early as possible. In no small part, this appears to be attributable to a "take the money and run" mentality from retirees, who simply don't see the value of delaying as being worth the risk of foregoing benefits. And without a doubt, there is a material risk that the retiree will not live to the so-called "breakeven point" where the delay in benefits is worthwhile.
However, what most retirees fail to recognize is that while there is a risk to delaying benefits and never fully recovering them, the upside for living past the breakeven point isn't just that the money is made back; it's that the retiree can make exponentially more. And in fact, these asymmetric results - where the retiree only risks a little by delaying, but stands to gain far more in the long run - are further magnified in situations where the client lives dramatically past life expectancy, experiences high inflation, and/or gets unfavorable portfolio returns - which are, in fact, three of the greatest risks to almost every retiree.
As a result, the reality is that delaying Social Security benefits may actually be one of the best triple-hedges available to any retiree - simultaneously protecting against poor returns, high inflation, and longevity!
The inspiration for today's blog post is the recent Journal of Financial Planning article entitled "How the Social Security Claiming Decision Affects Portfolio Longevity" by William Meyer and William Reichenstein, which was covered in our recent Weekend Reading column. The article shows how delaying Social Security benefits can increase the overall longevity of a retirement strategy that includes Social Security income and a portfolio.
The Impact of Delaying Social Security
The primary reason that delaying Social Security can have such a benefit on increasing the longevity of a portfolio is because of the asymmetric nature of delay decision.
For example, let's look at a scenario where a 66-year-old - currently at Full Retirement Age - with a PIA of $1,000/month, chooses to delay benefits by 1 year, earning a delayed retirement credit of 8%. As a result of the delay, the client will receive a monthly payment of $1,080/month beginning one year from now, at a "cost" of not receiving $1,000/month for the next 12 months. Thus, the client essentially starts out $12,000 in the hole, and makes it up $80/month at a time.
In reality, though, the client recovers the cost of foregone payments slightly more rapidly over time, because the client doesn't merely receive an extra $80/month. The client actually receives $1,080/month increased by annual cost-of-living adjustments, in lieu of receiving $1,000/month payments now, also increasing by annual COLAs. At the margin, this means the client is actually recovering the $12,000 of foregone payments at a pace of $80/month, where the $80/month itself is increasing by COLAs each year thereafter.
How Delaying Social Security Compounds Over Time
Assuming a moderate 8% growth rate on the available funds (e.g., the $1,000/month collected for the first year, compared to the extra $80/month for the client who delays for a year) and a 3% annual COLA, the chart below reveals that it takes just over 20 years for the client to come out ahead due to the delay decision.
However, note what happens in the final years of the chart. While it takes approximately 20 years for the client to initially dig out of the $12,000 hole created by delaying initially, it takes only 6 more years thereafter for the client to go from even to up $12,000. And it takes only another 4 years after that to make another $12,000, and then just over 2 more years to add yet another $12,000. In other words, as the client lives longer, the client doesn't just come out ahead; the client comes out exponentially ahead. Dying 20 years before the breakeven period costs the client $12,000; living just 14 years past the breakeven period brings the client ahead by nearly quadruple that amount, to just shy of $48,000.
Sensitivity to Assumptions
Notably, the value of delaying Social Security benefits is sensitive, both to the level of inflation (which impacts the COLAs) and the growth rate on the investments. Notably, even if the client's plan is to spend the early Social Security benefits, that means other investment funds won't have to be spent down, so the growth rate is relevant regardless of whether the actual Social Security funds will be saved or spent.
As it turns out, the lower the growth rate, the shorter the breakeven period and the greater the value of delaying Social Security benefits (because that initial year's worth of benefits won't have as much time to grow). In addition, the higher the inflation rate, the shorter the breakeven period and the greater the value of delaying, because the higher payments catch up and compound faster.
According, the graph below shows the original benefit delay (at 3% inflation and 8% growth), and an alternative scenario with 4% inflation and only 6% growth. In this case, it takes only 15 years to breakeven, instead of 20; in fact, by year 21, the client is already up over $12,000 in the higher-inflation-lower-growth scenario, and ultimately turns $12,000 at risk into almost $80,000 by the end of the 34-year time horizon. With just a 2% decrease in the growth rate and a 1% increase in the inflation rate, the economic value in the long run nearly doubled.
The True Value of Delaying Social Security
Notably, living 34 years past the starting point to harvest the full value illustrated in these charts is no trivial task. This example assumes an individual who is age 66 at full retirement age (thereby earning an 8% delayed retirement credit for waiting one year), which means reaching age 100 to get the full value shown here.
But on the other hand, that's the whole point to the value of delaying Social Security retirement benefits. The upside for outliving the breakeven isn't just to recover the amount at risk or to make it back again; it's to make exponentially more than the original amount at risk, if the client is fortunate enough to live a long time. Yet for a client who's seeking to hedge against the risk of outliving his/her money and increase the longevity of the portfolio, that's precisely the most desirable outcome; like any other lifetime-annuitized payment, it creates the most value when the client lives the longest, which is exactly when the client needs that upside value the most.
In addition, it's notable that delaying Social Security not only hedges longevity, it also hedges two other adverse scenarios that are otherwise harmful to the retiree: unexpectedly high inflation, and unexpectedly low returns. As noted in the charts above, an adverse outcome with either, or both, can go even further to leverage the value of delaying Social Security, decreasing the breakeven period and increasing the upside for materially outliving life expectancy.
Which means in the end, the true value of delaying Social Security is a triple-benefit of hedging longevity, poor returns, and high inflation, because of the asymmetrical way that delayed higher benefits compound in the later years. It won't necessarily win for every client, but as any good hedge should, it wins the most in the times the client will need it the most.
So what do you think? Have you ever framed the value of delaying Social Security as a longevity, inflation, and bad return hedge for clients? Do you typically recommend that clients delay their benefits? Do you think clients would be more receptive to delaying benefits given all the risks that delaying can hedge?
(Editor's Note: This blog post was featured in the 17th edition of the Carnival of Retirement on Young Cheap Living.)
