When should you take social security benefits?
It is one of the most common questions people ask me when they are getting ready to retire. There have been innumerable posts written about when you should take benefits. None of the ones I saw seemed very robust. So, I decided I needed to hit the Excel spreadsheets and crunch some numbers.
For those who are not familiar, I will offer the basics. First of all, the calculation of the benefit is beyond the scope of this writing. However, a formula is used to come up with a ‘Primary Insurance Amount’ which becomes your benefit at ‘full retirement age’. ‘Full Retirement Age’ “FRA” is considered 67 for anyone born after 1960. You are allowed to start taking benefits as soon as age 62, but in exchange for taking your benefits early, you need to take a reduced amount. You are also allowed to delay taking benefits until the age of 70. By doing so you will receive a larger amount. Below is the table that shows the amount of benefit you receive at each age:
Figure 1: Percentage of full benefit received at each age (for those born after 1960)
If you start taking benefits at the age of 62 you will only get 70% of your fully calculated benefit. If you wait until 70, you will receive 124% of the benefit, but you have waited 8 years for that privilege.
The question then becomes, what is the optimal age to start receiving benefits?
When I looked this online most of the sites I came across try to find the age at which you will ‘break even’. That is, when does it pay to wait? Imagine your FRA benefit is $24,000 per year. At age 62 you can start taking $16,800 (70% of FRA benefit) and at age 70 you can take $29,760 (124% of FRA benefit). By the time you start taking $29,760 you would have already collected $134,400 if you would have started taking the benefit at 62. Your break-even age then is 80 years old.
Figure 2: Straight dollar cash flow tracking shows breakeven at age 80.
The analysis these sites take is that if you think you have a good chance of living past the age of 80, it makes sense to wait to age 70 to take your benefits. Seems pretty straight forward but there is something not quite right.
Most of the time in finance, a series of cash flows will be compared based on a discounted present value method. That is, each of the cash flows will be discounted by the opportunity cost of those funds. No analysis of Social Security benefits I came across attempts to use that analysis. They use straight dollar figures.
While many advisors will argue that the cost of living adjustment (COLA) cancels out the inflation effect, that still doesn’t consider that you can invest those funds for some amount above the level of inflation. Let me explain:
First of all, if you take the cash at 62 and invest it in an account that earns 5% you will have more than 151,200 at age 70. You would actually have $185,246 as your $16,800 per year also earned an additional 5%. This would push back your break-even age to 90!
– But Keith! This money usually gets spent, not invested!
That could be true; however, if you are 62 and decide not to take social security benefits you do need to pull money from somewhere. The likely source that people would draw from would be retirement savings where money is currently invested! This is why I think putting a small discount rate on these cash-flows makes sense. Even if you are spending the funds, there is an opportunity cost that should be accounted for.
I also do not like the idea of setting a break-even age and trying to make a decision based on whether or not you think you will live longer than that long. What if instead we adjusted each of the cash flows based on the probability of surviving to each subsequent age. In this way we value the cash you receive at age 65 much higher than the cash you receive at age 100. The odds of a man living to 100 is less than 1%, so it only makes sense to discount its value to someone who is age 62.
So, to summarize, here is how I ran my analysis.
1) I assume a $2,000 per month benefit at FRA
2) I used a conservative 3% discount rate for each cash flow to capture the opportunity cost of those funds
3) I probability-adjusted all of the cash flows by the odds of surviving to each subsequent year using the mortality tables published on the SSA.gov website.
4) I assume COLA adjustment of the benefits cancels out any inflation adjustment
What did the analysis tell us?
It turns out that for men, your most likely better off by taking your benefit ASAP. The probability-adjusted present value is the highest by taking your benefit starting at age 62. This would be reinforced for single men, since single men have a lower life-expectancy than married men.
Figure 3: Probability-adjusting the cash flows for men and discounting by 3% make it look more advantageous to take benefits early
Women, on the other hand, due to their longevity, do see some benefit in waiting. The highest present-value in this analysis occurs at age 66. Those women who have a history of longevity in the family can even benefit by waiting past 66 to 67 or even 70.
Figure 4: Women’s probability-adjusted discounted PV is higher than men’s due to longer expected lives
The trick comes with married couples. I will probably run a follow up to this piece with some of those numbers, but as with all of these scenarios, NONE of this should be construed as financial advice. Seriously, talk to your advisor before making any decisions, though if he tries to tell you to wait until 70 to start taking your benefits, just ask why.
In closing, here are the main points to consider about social security benefits.
1) It has been said that most people take their benefit as soon as they are eligible. I agree that many make this decision with imperfect information, but I would submit that for many, it is a perfectly rational one.
2) Advisors often say that “by waiting to take benefits, you can get 8% more. It’s hard to find an investment that makes 8%” – This is completely illogical. This statement totally disregards the fact that you are giving up the cash-flows from earlier years, whether those are spent on movies, race-cars, or lottery tickets, there is a cost to getting that extra 8%. One should not compare waiting for a higher annual cash-flow with an investment return.
3) A bird in the hand is worth two in the bush – No one knows what the future holds. Whether you are worried about the solvency of the social security trust (it just went cash flow negative, like, last week), or acknowledging that we cannot know how much time we are blessed on this planet, there should be a premium placed on cash flows received sooner.
When I teach my finance class I talk about how a business should approach valuing cash-flows on three levels.
1) More cash is better than less cash
2) Cash today is better than cash tomorrow
3) More certain cash is better than less certain cash
It seems funny that we do not apply these same tenants when we are analyzing cash for our personal use. Instead of suggesting that most people are making a mistake by taking social security benefits early, we should acknowledge that this is a very rational decision to make.
Let me know what you think. I’m curious what other advisors are doing, and I happen to love getting better by getting corrected.
Until Next Time….
“While money can’t buy happiness, it certainly let you choose your own form of misery.” – Groucho Marx
Feature photo credit: taxcredits.net via flickr.com