The Social Security Hedge
Most readers of this blog are pre-retirees who probably haven’t given much thought to Social Security. For the majority of us, other than the hefty 6.2% of every paycheck that goes towards FICA, Social Security is an afterthought. But even if Social Security planning isn’t in your immediate future, there’s a good chance that somebody you know will be dealing with it soon. For that reason, I wanted to illustrate a few simple concepts that are important to understand.
What is Social Security?
Social Security is an entitlement program. The benefits are established based on a broad class of individuals who have a legal right to claim those benefits, and anyone who meets the eligibility requirements will be “entitled” to receive them (and not necessarily in proportion to the dollars/taxes they may have paid in to begin with).
Accordingly, under the Social Security program, anyone who works for at least 40 calendar quarters (10 years), receiving earnings that are/were subject to Social Security (payroll or self-employment) taxes, will be entitled to a Social Security benefit . When eventually claimed sometime in our sixties, Social Security benefits are paid out each month until death.
When to Claim
One of the biggest financial planning questions about Social Security involves the optimal age a person should begin taking his or her benefit. The earliest a person can claim benefits is when they reach 62 years of age. However, in many situations, delaying the benefits can be advantageous and, as we’ll see below, the timing of a claim can make a huge difference in long-term financial outcomes.
Full Retirement Age (FRA), as defined by the Social Security Administration, is the age when an individual is eligible for a maximum Social Security benefit. For those of us born after 1959, FRA is 67 years old. At 62 years old, individuals can opt to begin receiving their benefits early, albeit at a reduced rate. The earlier one elects to receive benefits, the lower the benefit payment will be.
Let’s say I plan on claiming my benefits when I turn 67, the Full Retirement Age, and my monthly benefit will be $2,000. All else being equal, if I instead decide to claim early, at 62 years old, the monthly benefit payment would be reduced to $1,400 or 70% of the original amount.
On the other hand, the longer I wait to claim my benefit, the larger the benefit payments will be. In fact, I can even choose to delay my benefit beyond the FRA. By delaying beyond age 67, my annual benefit amount would increase by 8% annually for a maximum of 3 years. At 70 years old, increases to the potential benefit amount will cease. If I decide to delay my claim until I turn 70, my monthly benefit would be $2,480, 24% higher than at my FRA ($2,000).
The difference in monthly benefit amounts from earliest possible claim date to latest is 77% ($1,400 vs. $2,480)!! This alone makes careful consideration of claim timing a worthwhile activity. For those with the financial means to do so, delaying can have big benefits.
The Ultimate Hedge
Three major factors drive the relative benefit of delaying: portfolio growth rate, inflation, life expectancy. The ideal scenario for delaying benefits would be an environment with low expected portfolio growth, high inflation (social security benefits are inflation protected) and a long life expectancy (the longer you live the more you can take advantage of higher payments). Ironically, this same combination is horrible for retirement portfolios! As Michael Kitces points out, the true value of delaying Social Security may be its triple-benefit of hedging longevity, poor returns, and high inflation.
“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.”
The decision of when to claim social security benefits can’t be made in isolation. There is plenty more to discuss on this topic beyond the scope of this post. Health, spousal situations, disability, divorce and total portfolio allocation will all factor into optimal claim timing decisions. For now, I hope I helped you understand a few basic Social Security planning concepts that those approaching retirement should be considering! The New World of Social Security Planning – Michael Kitces
At Ariadne, I work closely with families and individuals to organize their finances and utilize their resources to design a life they love. If you are interested in a straightforward, no-gimmick approach to financial planning that focuses on you and your needs, don’t hesitate to get in touch. I’d be happy to have a conversation.