Wednesday, November 7, 2012

Social Security Part 2 - Breaking Even?

 Would you be willing to bet a large portion of your retirement income, perhaps a hundred thousand dollars or more, on whether or not you will die before you’re 75? If you are married, would you bet that neither you nor your spouse will live past 75?

Assuming you’re not in seriously poor health, that seems like a pretty dumb bet, huh? Risking all that money on the belief that you can guess when you and a spouse will die? Nonetheless, that’s the bet people make when they decide to claim Social Security benefits at the earliest possible age (62).

Surveys show that people tend to underestimate their longevity. A married couple age 65 today has a 25% probability that at least one spouse will live to 90. If the couple claims at age 62, the surviving spouse — if he or she is the lower earner — will receive far less income from Social Security. (It might make sense for the lower earner to claim early, but that’s a topic for its own post.)

Still Willing to Make That Bet?

Perhaps the crux of the decision process is how you frame it. If you consider Social Security benefits an investment, then you might concern yourself with when it becomes profitable, as in the break-even analysis. For example, “I’ll receive more benefits from Social Security by claiming at age 62 unless I live past age 75.”

But, don’t forget what you’re betting. If you lose the bet, you’ll have a lot less income when you’re old. Postponing benefits can increase them by as much as 85%.

Social Security Is an Insurance Policy

Social Security is not an investment; it’s an insurance policy. The actual title of the program is Old Age and Survivors Insurance. It’s an inflation–protected lifetime annuity insurance policy. And “break-even age” and “profitability” don’t make sense with an insurance policy.

Do you decide whether to purchase homeowners or auto insurance based on the number of years to “profitability”? Imagine thinking, “I’m better off not buying car insurance if I can just avoid having an accident for three years”, or “I’m better off not buying homeowners insurance if my house just doesn’t burn down.”

We don’t buy insurance to make a profit or to break even. We buy it to protect against the risk of a catastrophic financial loss.

Deciding to claim Social Security benefits at age 62 because it takes a dozen years to break-even compared to delaying benefits to age 66 is equivalent to thinking, “I can make more money if I can just die before I’m 75.”

Kind of a weird thought process, isn’t it?

I’ve been paying homeowners insurance since 1975 and, true, I’ve made a few claims along the way. On balance, though, I’ve paid a lot more in premiums than they have paid in claims. In other words, it would have been more profitable to me to skip homeowner’s insurance and pay the claims myself.

But I don’t buy insurance hoping to make a profit. I buy it to protect myself against the risk of a catastrophic loss, like my house burning down. I paid for risk protection and I received it whether or not my house burned or my car crashed.

Social Security is an insurance policy, too. When you claim benefits at age 62, you receive protection against the risk that you will run out of money before you die. With Social Security, however, you can “buy” more insurance against going broke in old age, referred to as longevity insurance. You pay for it by foregoing those benefits until you are older.

If you claim Social Security retirement benefits at age 62 and die before you reach your early 70’s (the break-even age varies by individual circumstances), then you will receive more benefits before you die than you would have had you postponed claiming.

The thing is, I don’t think wringing the most out of your benefits if you die early is the best goal. A better goal is to provide for you and your spouse should you live to a very old age, in other words, to provide longevity insurance.

Not maximizing your benefits if you die at an early age would not be a catastrophe but living two decades of old age with inadequate income would be. Postponing benefits helps you insure against the worst-case outcome, which is what insurance is intended to do.

Four Scenarios

Let’s consider four scenarios in which you claim retirement benefits at 62 and 66, and die before and after your break-even age of say, 70, as depicted in the following table.

Die Before Break-Even Age
Die After Break-Even Age
Claim at 62
1. You maximized income and have the least chance of outliving your savings
2. Delaying benefits would have provided more income and you may run out of savings
Claim at 66
3. Claiming at 62 would have provided more income, but you have the least chance of outliving your savings
4. You maximize income when you have the greatest chance of outliving your savings

Scenario 1 is not a bad financial outcome, though you might have wanted to live longer.

In scenario 3, you left some benefits on the table, but had the least chance of depleting your personal savings and you were better insured against scenario 4. You purchased an insurance policy and it turns out you didn’t get to file a claim, but you had coverage and more peace of mind about the future and that’s the purpose for insurance.

The worst-case outcome is scenario 2. You limited your Social Security income for the rest of your life (and your spouse’s) by claiming early and then lived a long time, possibly depleting your personal savings. You and your spouse are at risk of growing old with too little income.

A basic principle of personal finance is that we protect ourselves against worst-case outcomes when we can.

Delaying Benefits Helps Married Couples Even More

The advantage of delaying your claim is magnified if you are married and are the higher earner. Your spouse is entitled to half your full retirement age benefit as a “spousal” benefit. If your full retirement age benefit is $1,000 per month, your spouse is entitled to a spousal benefit of $500 per month, regardless of when you actually claim your benefit. In other words, if you claim early it will not reduce your spouse’s spousal retirement benefit, nor will delaying your claim increase their benefit.

Your spouse’s survivors benefit, however, is up to 100% of whatever retirement benefit you were receiving at the time of death. Your spouse will receive a larger survivors benefit if you delay receiving your retirement benefit. (In either case, the spouse’s benefit will be reduced if he or she claims it before reaching his or her own full retirement age.)

Let’s look at an example. Assume you and your spouse are the same age and claim retirement benefits at age 62. You were earning $45,000 a year before retiring and your retirement benefit is $11,892 per year. Your spouse will receive a $5,946 annual spousal benefit.

Your spouse’s survivors benefit will be up to $11,892 per year after you die, assuming she claims it after her full retirement age. Should you die at age 75 and should she live to 95, she will receive 20 years of payments of $11,892, totaling about $238,000.

If you claimed at age 66 instead, your retirement benefit would be $16,428 per year and her spousal benefit would be $8,214 per year, but her survivors benefit would be $16,428 per year. You would forego four years of benefits between the ages of 62 and 66. If you then died at age 75 and she lived until age 95, she would receive 20 years of payments worth nearly $329,000, or 38% more than if you had claimed early.

Single retirees will “buy” longevity insurance by delaying receiving Social Security benefits, protecting themselves against inadequate income should they live a long life. Married retirees will also protect their spouse from inadequate income in old age.

If you can’t live without your Social Security retirement benefits, then claim them when you need them. But, if you have the option to postpone receiving your Social Security benefits, by working longer or by paying for a few years from your retirement savings, then do so. You’re purchasing insurance against becoming very old and very poor.

You don’t have to delay claims to age 66 or 70 to purchase more longevity insurance. Even postponing a single year increases benefits by about 8%.

Receiving benefits at age 62 because you don’t want to die while leaving some benefits money on the table makes about as much sense as skipping homeowners insurance and simply hoping you never need it.

Your goal should be to protect yourself and your spouse from running out of money in your dotage and you increase your protection every year you delay receiving your Social Security benefits.

 Social Security benefits are tricky and your claiming decisions are typically irreversible. You want to get it right the first time. Check out my book, Retiring When Your 401(k) Fails, for more information.


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