Tuesday, December 31, 2013

Why Bonds?

Wade Pfau recently posted a nice piece on how to build a TIPs ladder for retirement. A discussion ensued on the topic of whether one should build a ladder of individual TIPs bonds or instead buy a fund of TIPs bonds.

I'll chime in on the topic, but first let's talk about why a retiree should own bonds at all.

There are three basic alternatives for investing your savings after retirement. You can buy a life annuity from an insurance company that will pay you periodic amounts (let's assume monthly) for as long as you live. You will continue to receive these payments if you live to age 150, but you will stop receiving them when you die, even if that's next year. 

The best thing about a life annuity is that you will never run out of money. The worst thing may be that you could end up with nothing left for your heirs.

(There are options you can buy to protect yourself against losing your investment if you don't live at least 10 years, to continue payments to a surviving spouse, and you can even purchase inflation protection, but let's not get into the weeds at this point.)

The second major alternative is to buy bonds. As William Sharpe and Jason Scott showed in "A 4% Rule -- At What Price?", you can invest in a ladder of TIPs bonds and, if interest rates follow long-term average returns of 2%, you can spend 4.46% of your initial portfolio value every year and your capital should last exactly 30 years. In other words, you can withdraw a constant $44.60 adjusted for inflation every year for 30 years for every $1,000 invested.

There are at least two major differences between these alternatives. First, the TIPs ladder will last exactly thirty years, at which time your account balance will be zero.  The annuity pays for the remainder of your life, which could be significantly more or less than 30 years.

Second, you give your principal to the insurance company up front for an annuity, but you always own the bonds in your bond ladder. If you live less than 30 years, you can leave the surplus bonds to heirs. Depending on the options you choose, there may be nothing left of an annuity to bequeath.

The third major alternative for your post-retirement investment dollars is a stock portfolio. You could invest in stocks and spend from the portfolio each year. Maybe you could pay your annual expenses and end up with a large portfolio to leave your heirs. Or maybe you will completely run out of money long before you die. There's a lot of upside potential with this approach, and a roughly equal downside.

A commenter on the Pfau thread suggested that he prefers investing in dividend-generating stocks, with a goal of spending dividends of around 4% and, unlike the annuity or TIPs ladder approach, being able to preserve his capital. Preserving capital is, in fact, one possible outcome. Going broke in old age is another. Stocks don't always go up.

Another commenter on the Pfau thread asked why you would invest in risky stocks and spend 4% a year when you could invest in a TIPs ladder and spend 4.5%. Part of the answer is that at the end of 30 years, the TIPs ladder is completely spent, principal and all. The value of the stock portfolio, on the other hand, could be enormous after 30 years, or it might not last 20 years.

The other part of the answer is that 4.5% is a pretty predictable spend rate for the TIPs ladder, while 4% for the stock portfolio is merely a guess.

Of course, you can bet some of your retirement on a combination of two or three of these alternatives, and that is probably the more common strategy.

So, back to why a retiree should own bonds. If you decide to go the stock portfolio route, you should probably also own some bonds. As Modern Portfolio Theory predicts, bonds can decrease the risk of a portfolio a lot while lowering its return just a little. Deciding how much of your portfolio should be held in bonds at what age is still hotly debated.
(from Young Research & Publishing)
As an example, Index Fund Advisors calculates that the long term average return for a portfolio of 50% stocks and 50% bonds is 8.15% with a standard deviation (risk) of 11.42%. Lowering the stock allocation from 50% to 40% reduces the expected return to 7.39% (9.33% lower) but reduces the standard deviation to 9.28% (an 18.7% reduction of risk).

Another reason to own bonds is that they can provide a safe, predictable amount of future income. Let's say you predict that you will need $30,000 in 2019, five years from now, and you can find TIPs bonds in the market that mature in 2019 that currently offer a real yield-to-maturity of 2%. Let's simplify matters by assuming that the TIPs bond you find is a zero coupon bond (there aren't any, for some reason). If you invest $27,172 in such bonds, you can be pretty sure that the bond will be worth $30,000 in 2013 dollars when it matures in 2019.

Do that for the next 30 years (or any number of consecutive years) and you have a bond ladder. You also have a safe, predictable, inflation-protected income stream.

Why buy bonds, then? Because they improve your risk/reward profile if you decide to go the stocks route and they can provide safe, predictable, inflation-protected income if you decide to go with a TIPs ladder. Remember these two benefits, because which you desire will be a determinant of whether you should buy a fund or individual TIPs. More on that later.

Go the annuity route and you probably don't need bonds. In fact, a fixed annuity is a lot like a bond, issued by an insurance company, with a lifetime coupon and no remaining value when you die.

Unless you annuitize all your retirement savings, you're probably going to want to own some bonds to reduce your stock portfolio volatility, or to ensure income for living expenses for some future years.

Probably both.

Wade's original question, though, was whether to build a TIPs ladder or to buy a fund, but we're not there, yet. Now that we've discussed why to buy bonds at all, the next question is "Why TIPs bonds"?

Sunday, December 29, 2013

Saving Excess Tax Deductions at the Last Minute

I’m not a tax specialist. I have my taxes done by an expert IRS-enrolled agent. Keeping track of tax laws is a full time job and one I'm delighted to outsource.

I do have a tax idea to pass along that sometimes works for retirees. Please discuss this with a tax expert if you’re interested. 

Retirees can find themselves in the position of not only owing no federal taxes (because they’re no longer working), but actually having more deductions than they can use. Health care and health insurance costs, for example, can generate far more tax deductions than you might have considered when you were budgeting for retirement. 

Health care costs have been the second largest financial shock of my retirement (right after learning that kids don’t actually grow up, go to college and then support themselves, anymore).

This may especially be the case if you’re spending first from your taxable accounts, and thus not generating taxable income from IRA’s and 401(k)’s. You might just find that you have no taxable federal income and, in fact, you have more itemized deductions than you can use.

Here's an example. Joe retired at the beginning of 2013 and paid his living expenses from his taxable retirement savings. $10,000 interest and dividends from his taxable accounts makes up his only taxable income. He has no taxable income from Social Security (he hasn't claimed, yet) and no taxable withdrawals from IRA's or 401(k) accounts.

Joe has $30,000 in mortgage interest and deductible property taxes and paid another $30,000 for deductible medical costs and private health insurance, and of course, exemptions for himself and his spouse.

According to the TurboTax online tax estimator, Joe should expect to report $10,000 of taxable income, $59,250 deductions and $15,600 exemptions. He should expect to pay no federal taxes.

No federal taxes sounds good, but Joe could have had another $65,000 of taxable income and still paid no federal taxes because he has unused tax deductions.

Now, you can carry forward capital gains losses and net operating losses to future years when you do owe taxes, but you can’t carry forward unused itemized deductions.

So, how can a retiree make use of all those deductions? By generating more income. And, how do you do that the last week of the year when you didn’t do it for the previous 51?

Convert a traditional IRA to a Roth. The conversion amount will be reported on IRS Form 8606 and claimed as an IRA withdrawal in the Income section near the top of IRS Form 1040. The amount will be taxed as regular income, so the trick is to convert the amount of your IRA account to a Roth account that will be offset by your excess deductions and leave your taxes at zero, or thereabouts.

The TurboTax estimator tells us that if Joe converts $75,000 from his traditional IRA to a Roth IRA, increasing his taxable income from $10,000 to $75,000, he will still pay no taxes. (The estimator says $4, but let's not quibble.)

You don't pay income tax on Roth IRA withdrawals, but traditional IRA withdrawals are taxed as ordinary income. Leave the money in an IRA and you will eventually be taxed when you take it out. The funds you convert to a Roth will no longer be subject to income tax when you spend them and you will have achieved this by paying the current taxes dues on the IRA withdrawal, which, if you do it right, will be zero.

The amount you convert doesn’t need to be exact because, should you convert too much, you can undo all or part of the conversion in 2014 with a Roth recharacterization. I suggest you estimate your taxes, guess the amount of excess deductions you will have, and convert that amount or a little more. (You can put money back into your IRA in 2014, but you can’t take out more.)

Let's say Joe converts $75,000 by the end of 2013 but his tax preparer points out another $10,000 in taxable income that Joe didn't realize would be treated as taxable income. Joe can simply put $10,000 back in his IRA through a recharacterization.

As I said, you can undo all of this in 2014, but the conversion has to be done by the end of 2013 to offset taxes this year.

There are deadlines for the recharacterization, the earliest of which is the day your 2013 taxes are due but this can be extended to October 15.

What happens if Joe only converts $30,000 and finds out after his taxes are prepared next April that he could have converted $75,000? Too bad. You can put converted dollars back after the end of the tax year, but you can't take out more.

Of course, there are many reason to do a Roth conversion, or not to, and retirees aren't the only potential beneficiaries. Maybe you were unemployed for part of 2013, but still had high medical bills and deductible mortgage interest. You still might find yourself with more deductions than you can use.

I can’t say this enough: I am not a tax expert. Roth conversions, like many tax maneuvers, have subtleties that need to be considered.  I am not suggesting that you do this, I am suggesting that you might want to discuss this with a tax expert.

You'll have to act quickly to do it this year. You have until close of business Tuesday to convert. It 's pretty easy at websites like Fidelity's. It takes just a few minutes.

Of course, there's always next December.

Happy New Year to all my fellow (and future) retiree readers.

Wednesday, December 4, 2013

Does Retirement Get Cheaper as We Age?

A reader noted last week that living expenses tend to decline as we age and suggested that tendency offers some comfort as we look at the cost of a long retirement. That is true in one respect, but there are a couple of important considerations to keep in mind.

First, let’s look at the true part. Expenses typically decline with age, even when we include health care costs.

According to a 2012 study, Expenditure Patterns of Older Americans, 2001‒2009 by Sudipto Banerjee, Employee Benefit Research Institute, "Household expenses steadily decline with age. With the age 65 expenditure as a benchmark, household expenditure falls by 19 percent by age 75, 34 percent by age 85, and 52 percent by age 95.

Here’s a chart of household expenditures by age from the study1. It's almost linear.
What doesn’t get cheaper as we age? Health care. The cost of every other category in the study (home, food, clothing, etc.) decreased with age.

According to Banerjee, “Health-related expenses are the second-largest component in the budget of older Americans. It is the only component which steadily increases with age. Health care expenses capture around 10 percent of the budget for those between 50–64, but increase to about 20 percent for those age 85 and over.

Health care expenses probably won't steadily decline with age. They're more likely to come in bunches. Studies have shown that many retirees will spend most of their total lifetime medical expenses near the end of their life.

So, yes, living expenses tend to decline as we age but growing healthcare expenses offset those savings to some degree. 

The real wild card among retirement expenses is long term care. 

It is estimated that about 60% of Americans will need some form of long term care in their lifetime and this care is not covered by Medicare. That’s the scary number LTC insurance providers use to sell insurance policies but, in reality, the costs of long term care range from several thousand dollars that might be easily covered out of pocket all the way up to "catastrophic".

As I showed in a previous blog on Long Term Care Insurance, more than 40% of retiree’s can expect no long term care costs at all and another 19% can expect costs less than $10,000. An additional 8% can expect costs between $10,000 and $25,000. So, arguably about 70% of retirees will have LTC costs that might well be managed without insurance.

Still, that leaves 30% of retirees that can expect to have very large, perhaps catastrophic long term care costs.

The following chart shows the percentages for those who will need long term care at various cost levels.
You may not have long term care needs at all, or you may only need care for a short time and experience manageable costs, but the possibility remains that you or your spouse might have catastrophic long term care needs that will destroy your financial plans for late retirement. 

LTC insurance is available, but costly. Wealthy people can self-insure. Those with scarce resources won’t be able to afford it. That leaves a group in the middle with a decision to make about purchasing insurance.

There is another major unknown factor in the cost of our retirement, of course: how long we will live. A shorter retirement will cost less, perhaps far less, than one that takes us into our late nineties. While you might derive some consolation from the fact that expenses tend to decline as we age, the factor that really increases or decreases the cost of retirement is longevity. 

Given the possibilities of a very long life and catastrophic LTC costs, expenses in retirement can be wildly unpredictable. Part of that risk depends on how you choose to finance it. Those who choose to forgo (or cannot afford) LTC insurance and choose to fund retirement with a stock and bond portfolio will have little control over those risks. The range of potential outcomes is quite large.

Households that insure against LTC and longevity risk by purchasing LTC insurance and life annuities will have less money to spend elsewhere, but will avoid the worst-case outcomes and have more predictable expenses.

So, will your total expenses decline as you age? If you stay healthy they probably will.

If you have high health care costs and uninsured long term care costs, expenses can explode.

1A lot of retirement income calculators treat income and expenses as static throughout retirement. "You need to replace 70% of your pre-retirement income." As this chart shows, expenses are not static, and income isn't typically static, either. A good retirement plan takes these changes over time into consideration. I prefer a consumption-smoothing tool like E$Planner.

Tuesday, November 19, 2013

The $241,000 Kid (College Not Included)

I often wonder how the more than 95% of American workers who aren’t able to save enough for retirement will get by and what other strategies might be available to households who recognize that they probably won’t win the “Save 22 Times Your Required Income after Social Security Benefits 401(k)” Lotto1.

A few weeks back, I asked readers for their thoughts on the subject and I received some interesting comments.

A fellow financial planner, Mark Zoril, responded eloquently with what might be an obvious potential outcome, even if you don’t think of it as a strategy:
"I have been a financial advisor for 17 years and worked with many people that have very modest accumulations for retirement. However, what I have found is that over the years, their lifestyle, what they need to spend, has adapted to their limited income and modest means. They simply do not lead, in any way, extravagant lifestyles.
Mark identifies an outcome (a “strategy” in the game theory or evolution sense) that is important because it will be the most common scenario for families that can’t save enough: their standard of living will decline considerably after they retire.

Another strategy for funding retirement if you can't save enough is to limit your family size. This is not a strategy that I readily recommend, but then neither is the one that Mark notes.

I'm simply pointing out that having children may have a large impact on your ability to save enough for retirement. I also want to reinforce the thread that the decisions you make and your life experiences before you retire largely determine your standard of living after you retire.

I have three grown children and I can tell you two things about child-rearing: it’s expensive beyond belief and it’s rewarding beyond belief. 

How much does it cost to raise a kid? According to a 2013 U.S. Department of Agriculture report, it will cost an estimated $241,080 for a middle-income couple to raise a child born in 2012 for 18 years. That's up almost 3% from 2011.

But wait, there's more.

Despite this study's assumption, kids don’t leave home and support themselves at 18, anymore, like my wife and I did. Jobs are hard to find and a lot of kids "boomerang". Bump up that price tag a few more years.

Second — and this one is going to break your heart — the Dept. of Agriculture estimate of over $240,000 per child doesn’t include college costs. Add in an average $22,261 per year for a four-year public college and that $241,000 climbs to $330,000 per child.

(I’d personally feel blessed with these costs. One of mine is in med school and the others are taking the scenic route through college. Does any kid graduate in four years, anymore?)

If you’re interested in a cost more tailored to your specific household, the Dept. of Agriculture provides a “childcare cost calculator” with which you can further ponder the dollar cost of parenthood, but if you don’t have Internet access, you can achieve roughly the same experience by shaving your head with a cheese grater.

I had an economics professor in college who said that the ultimate form of birth control would be to show young couples the lifetime cost of raising a child.

(That’s how economists think. I’m pretty sure he had 2.3 children.)

So, the average cost of raising a single child far exceeds the typical retirement savings for 95% or more of American households. It's easier to fund retirement with a spare $330,000 or two lying around the house than it is with a couple of twenty-somethings lying around the house.

I’m not suggesting that you forego children to secure retirement, but you need to understand that there is a correlation. If you weren't able to save enough for your golden years but raised a happy, successful family of children and grandchildren, then pat yourself on the pack. Yours was the nobler accomplishment.

And every time someone writes me that they were able to save plenty of money for retirement and anyone who didn’t is one of those 47% slackers, I know the odds are quite good that the writer never had a family medical or other financial catastrophe.

And he probably doesn’t have children.

1If you can generate a 4.5% payout from your savings, through TIPs ladders, annuities, or stock and bonds portfolios, for example, you will need to save about 22 times (1 / .045) the amount of retirement income you will need less any income you will receive from Social Security benefits or pensions. For example, if you will need $40,000 a year to retire on and Social Security benefits will total $25,000, you will have a "gap" of $15,000. With a 4.5% payout, you will need to save about $333,000. If you will only be able to generate a 3.5% payout, you would need to save about $429,000.

Friday, November 15, 2013

Deep Risk, Discipline and a Punch in the Mouth

William Bernstein’s new e-book, Deep Risk: How History Informs Portfolio Design (Investing for Adults), is introduced with the story of Lucie White and Mark Villa, a couple who sold at the bottom of the market in 2009 and bought back in after missing the great run-up that followed. Sadly, not an uncommon story.

The passages that caught my eye in the first few pages of Deep Risk describe the couple’s plight:
“This story speaks volumes about risk. All investors experienced it during 2008–2009; if you did not lose sleep then, you’re not human. But the outcomes varied greatly from investor to investor, depending on their individual level of discipline
and. . .
“For the rest of this booklet, I’m going to assume that, like all investment adults, you’re disciplined and thus not vulnerable to the routine but serious buy high/sell low loss of capital.”
Let me repeat that. “You’re disciplined and thus not vulnerable.”

Notice how sweetly that rolls off the tongue.

Bernstein seems to say here that investment discipline is independent of context, but I know from his previous writings that he understands just how difficult that discipline is in bad times.  It's unbelievably difficult.

I have been young and old, dirt-poor and well off, through incredible booms like the 1990’s and horrendous crashes, like Black Monday and the Great Recession, and through the grinding stagflation of the 1970’s and, when it comes to decision-making, context matters.

Investment discipline is a function of risk tolerance and we know that our risk tolerance isn’t constant.

How difficult it is to maintain investment discipline depends on what’s going on around you, how much you have to lose and your prospects for earning it back and not just on some personal level of discipline you might have been born with or developed over the years.

Stock market discipline came easy throughout the nineties, but was a far different story come the end of 2007.

Bob is 25 and has $10,000 in his retirement portfolio. Discipline isn’t that hard to come by. His standard of living for the rest of his life isn’t at risk from a market crash and he has decades to recover from losses. Frankly, Bob doesn’t really expect that retirement day will ever come, so retirement savings aren’t quite real to him. In the words of that great finance sage and rolling stone, Bob Dylan, “When you got nothing, you got nothing to lose.”

Sam is 50 and his retirement savings account holds a lot to lose. On the other hand, he still has a decade and a half to recover from a loss and his salary is probably as high as its ever going to be. He can still save a lot. A big loss probably won’t change his lifetime standard of living. Discipline is more difficult for Sam than for Bob, but not as difficult as it will become.

At 64, Joe is about to retire. The prospects for earning back your losses are quite attractive when you’re young and have a lifetime of human capital on your balance sheet, less so when retirement is a year or two away. As I wrote in Even Your Portfolio Heals More Slowly as You Get Older, rebuilding your wealth is far easier when you’re earning a lot of money and saving for retirement than when you retire, have no earnings, and are spending 4% or so of your portfolio every year.

Donald is 70 and has been retired for three years. Returning to the workforce at anywhere near his old salary isn’t in the cards. His standard of living for perhaps the next 30 years depends on his retirement savings. Patiently waiting out a bear market and wondering if his standard of living is permanently declining before his very eyes requires more discipline from Donald than from all the others combined.

The salient point, I believe, is not that discipline comes cheap for 25 year-old Bob but dear for retired Donald, or easier for Sam in his fifties than for Joe at 64, but that you are, at various times in your life, Bob and John and Sam and Joe and Donald.

That discipline you found when you had twenty years until retirement and were packing away a large percentage of your peaking salary might not carry the day when you are 70 and watching your lifestyle flow into the black hole of a bear market, perhaps permanently.

Bernstein’s point about portfolio risk is that it will remain shallow risk — usually — if the investor doesn’t panic. The insurance against shallow risk becoming deep risk in this scenario, he says, is simple. Don’t panic. Adult investors don’t panic.

Getting out is usually the wrong decision. Of course, you never know. Maybe it's 1929 and getting out is the right move. If it were always the wrong decision, it wouldn't require much discipline.

My point is that avoiding panic is easier in some circumstances than others, and your capacity to avoid it before you retired may not suffice after you retire and have far less capacity to rebuild wealth. I suggest you rely on something safer than self-discipline.

If you have one safe “standard-of-living” portfolio that generates enough income to live on  and a separate risky “wealth” portfolio to possibly improve your standard of living or leave a bequest, you will be less likely to panic in a market crisis than if you depend on self-discipline. Your standard of living won’t be at risk.

Planning on self-discipline for protection is over-rated.

As that other great financial sage, Mike Tyson famously said, “Everyone has a plan 'till they get punched in the mouth.”

Tuesday, November 12, 2013

Deep Risk: Wealth versus Standard of Living

Standard of living and wealth are closely related but they aren’t exactly the same thing.

You can buy the same standard of living at dramatically different prices, for example, depending on which city you choose to live in. Your current standard of living in Manhattan would cost you less in San Francisco, much less in Wichita.

Even if you retire in place, you will no longer pay FICA taxes or need to save for retirement, so you can have exactly the same standard of living at a significantly lower cost without even relocating.

If you play around with consumption smoothing at E$Planner.com, you begin to see a number of things that can raise or lower your standard of living (discretionary spending) with a given level of wealth. You can delay Social Security benefits, for example, or pay off your mortgage and perhaps be able to spend more with the same amount of wealth.

That’s the benefit of consumption smoothing, arranging all your assets, borrowing power, and income streams to provide the highest consistent discretionary spending level, though these might not be the optimum strategies to maximize your portfolio value.

Consumption smoothing has convinced me that standard of living is a better metric for retirement planning than wealth. That thought hit home as I was reading William Bernstein’s new e-book, Deep Risk: How History Informs Portfolio Design (Investing for Adults).

(If you want to understand retirement finance, read this book. Then read the rest of Bernstein’s books, magazine articles and his posts from long ago at http://www.efficientfrontier.com. When you finish, you will know more about the subject than 99% of the population. Heck, you’ll know more than 99% of financial planners.)

Bernstein distinguishes between “shallow risk” and “deep risk” based on the amount of the potential loss and its duration, or how long it would take the investor to recover that loss. Normal portfolio variance is shallow risk, for example, and a major depression would be a deep risk.

I think of it a little differently. I think of shallow risk as financial risk that won’t impact my long-term standard of living, while deep risk can.

Bernstein identifies four major types of deep risk: long-term inflation, deflation, confiscation and destruction. He notes that deflation is actually a symptom of economic depression and not the disease. A year or two of deflation probably won’t destroy you, but long term deflation associated with an economic collapse (think Japan) might well do the trick.

Confiscation refers to the government seizing your assets. While taxation always does this to some extent, Bernstein is thinking more along the lines of Russia and Argentina. Massive confiscation is pretty unlikely in a developed nation like the U.S. and as Bernstein points out, it’s difficult, expensive and perhaps felonious to protect yourself against it.

Destruction is loss due to a war or a natural disaster and again, there is no reasonable way to protect yourself, unless you are ridiculously wealthy.

(I’m not sure where Bernie Madoff fits among the four horsemen, but theft and fraud have cost more retiree’s their life savings in the U.S. over the past 75 years than deflation, confiscation and destruction combined. Not covered in Deep Risk, it certainly warrants your consideration as a major risk to your standard of living.)

If you're a long-time reader of Bernstein, you know that he believes a retiree can't expect more than an 80% probability of successfully funding retirement. That's not because he thinks the safe withdrawal rates math is wrong, but because he thinks there are larger risks, like these four, that may render the withdrawal rate moot.

What actionable information did I take away from Deep Risk?  Perhaps not a lot, but then I was pretty much a Bernstein guy to begin with.

Perhaps I feel a little better knowing that, while I have done nothing to protect myself against destruction and confiscation, there is little I could do. Stashing gold bars in various banks around the world or buying real estate in those places probably isn’t in the cards for me. These are highly unlikely events in the U.S., anyway.

Since most countries moved away from the gold standard, instances of deflation around the world have greatly diminished. Still, deflation in the U.S. is possible and far more likely than losses due to war or a cataclysmic natural disaster.

The problem with protecting against deflation risk, as Bernstein explains, is that the solution (long term bonds) is a really bad one if we experience inflation, instead, and that is a far more likely possibility. Bernstein estimates that the likelihood of destructive, pervasive inflation is an order of magnitude greater than that of a depression.

That leaves inflation as the most likely of the four risks and not the 3% or 4% we typically see, but a long, grinding period like we experienced in the seventies. Deep Risk suggests two solutions, depending on whether you’re trying to protect yourself for the next 10 to 20 years, or the next 20 to 30. TIPs work better for the former, but Bernstein believes a globally diversified stock portfolio better protects us against inflation for money we probably won’t need in the next two decades.

Bernstein also writes that shallow portfolio risk can turn into deep risk if an investor chooses (or is forced) to sell assets at low prices during a market crash. In fact, he believes it is the most common way that people experience a real loss of standard of living.

And that brings me back to my initial thought about a standard of living metric. Bernstein often suggests two retirement portfolios, along the lines of Life Cycle Finance Theory, with one to provide the income we need to maintain our standard of living (he refers to this as a “liability matching portfolio”) and the remainder of our assets, if we are so fortunate to have any, allowed to grow in a risky portfolio.

This approach secures your standard of living while perhaps giving up some potential to grow your overall wealth. In essence, you have a “standard of living” portfolio that you don’t put at risk and a “wealth” portfolio in which major losses won’t impact your standard of living.

And, here’s the actionable information I gleaned from Deep Risk. Instead of thinking of my retirement assets as two portfolios, I’ll think of three. My risky portfolio will remain the same, but I may start thinking of my 20-30 year standard-of-living liabilities as being met by a larger stock allocation to mitigate the risk of a long bout of inflation and as a better solution than long bonds.

Thinking of wealth and standard of living as two separate but closely related financial metrics brings me greater clarity when I think about retirement planning.

So does reading Bernstein.

Thursday, November 7, 2013

How Much Does a $10 Office Visit Cost?

In my last blog, Retirement and the Affordable Care Act, I stepped through my reasoning for buying the cheapest health insurance policy I could find (it lowers my total healthcare costs) and explained how important it is for retirees to be able to buy private health insurance (you never know when your employer might retire you.)

Let’s take a quick look at what I could buy if I spent more.

Blue Cross Blue Shield of North Carolina, the only carrier offering policies in my half of the state for 2014, offers policies other than the $5,500-deductible Bronze Value plan I chose. I might have chosen their Silver Zero plan, Gold 1000 plan or Platinum 500 plan, among several other options. The numbers represent the individual deductible amounts and family deductibles are twice the individual amount.

Here are the key data points for each policy for my family of four.
Silver Zero. With this plan, I’d have no deductible to meet. Then again, I’d have to pay 50% of every covered medical claim until we reached the $12,700 family deductible amount. That doesn’t happen until we’ve spent $25,400. I’d get a break on prescriptions, paying 50% of their cost. My cheaper Bronze 5000 Value plan requires me to pay the full cost of prescriptions until I reach my overall deductible. Same with office visits. 

I’d get the larger doctors network with this plan, but as I mentioned in my previous blog, our doctors are mostly all available in the limited network.

So, I’d pay more for drugs and doctors in years with low total family claims with Bronze 5500, but I’d pay $8,628 more in annual premiums with Silver Zero. You can pay for a lot of doctors visits with $8,628 a year.

Our family out-of-pocket maximum would actually increase with the more expensive Silver plan.

Here’s a comparison of policies excluding the premium cost.
Gold 1000. I’d get small copayments for drugs and office visits and just 20% coinsurance. I’d also get the larger doctor network.

The family out-of-pocket maximum drops from $11,000 to $8,000 — if you ignore premiums.

Platinum 500. What would going platinum get me? I mean, besides an additional $14,592 a year in premiums? A $500 deductible, $10 office visits and $4 generic drugs.

The family out-of-pocket maximum drops all the way to $3,000, if you ignore premiums.

Gold and Platinum coverage are the kinds of policies people think they like. Ten dollars for a prescription, $15 for a doctor visit, $30 for a specialist. A huge list of in-network doctors. How do you beat a deal like that?

You beat it with lower premiums. Moving up another notch to Gold 1000 increases my premiums by $11,184 a year. (I love the way insurers only quote monthly rates. An extra $932 a month sounds a lot more attractive than an extra $11,184 a year, doesn't it?) 

Bankruptcy Protection

The most important number is the cost of annual premiums plus the out-of-pocket maximum. That’s your bankruptcy protection, or the most you would have to pay in any given year. As the bottom line of the table shows, that protection doesn’t increase by buying more expensive insurance in most cases. It decreases. You will pay more in a year with catastrophic medical expenses with more expensive policies.

Finally, here’s a graph of costs including premiums. You will notice what looked to be the least expensive policies are the most expensive when you consider all costs.
While my total costs for the Bronze Value 5500 plan will range from $16,296 per year to $27,296, depending on my medical costs, Platinum 500 is basically an “all-you-can-eat for $33,880 a year” deal. 

I hope you're hungry.

I’m liking my Bronze Value 5500 policy more and more.

These examples are specific to my family of four in North Carolina. Your mileage, as they say, may differ depending on specifics. In particular, NC hasn’t embraced ACA, so we have no real competition to lower rates here. Also, the premiums you see are for a family of four adults.

The basic principles will probably be consistent anywhere, though.

So, how much does a $10 office visit cost?

In our case, $14,592 a year.

Tuesday, November 5, 2013

Retirement and the Affordable Care Act

I read in the New York Times a few days ago that about 150 million Americans get health insurance from their employers and only about 10 million buy private policies. I’m one of the latter and have been since I retired in 2005. (That leaves a large part of America’s 314 million population without health insurance, but not my point.)

I still have five years to go before I am eligible for Medicare, but even then I’ll need a Medigap policy. Before the Affordable Care Act (ACA), I had a difficult time buying insurance. I ended up in North Carolina’s high-risk pool, which is going away at the end of 2013 because ACA policies will be available.

If you have health insurance from your employer, as I used to, then none of these things has much impact on you personally. If you retire before you’re 65 and eligible for Medicare, it would have become an issue for you without ACA. Trying to find affordable private health insurance when you retire (voluntarily or involuntarily) in your sixties before the Affordable Care Act was a bear.

The enormous amount of money I have had to pay for healthcare has been the biggest financial surprise of my retirement. I knew it would be burdensome.

I just wasn't prepared for this.

Over the past eight years I have spent just shy of $18,000 a year for health insurance to cover my family and I can't recall that I ever met a deductible on my $5,000-deductible policies or that a claim was ever paid. In fairness, I was protected against catastrophic medical expenses all that time, had I been so unfortunate, so the premiums weren't for naught.

I just spent a harrowing week trying to decide on a new ACA health insurance policy for my family and I’d like to share some of my findings. It seemed like an amazingly complex problem. I created a Space Shuttle Program-sized Excel spreadsheet, but was eventually able to narrow my choices to a handful.

Two things made the process simpler, one good, one not so much. The good part is that ACA forces all insurers to cover essential services in every policy, so I didn’t have to read each one closely to see what was not covered and how and why the insurer could rescind my coverage or cancel my policy if I made a large claim. ACA weeded out the junk policies for me.

Of course, being able to buy a policy at all with my pre-existing conditions helped. Prior to ACA, finding so many potential policies to consider that I needed a spreadsheet was never a problem. I was diagnosed with cancer in 2000, but Blue Cross Blue Shield of North Carolina (BCBSNC) claimed they refused to cover me because I took medication for a migraine headache one time back in the 1980’s. At least that’s what they wrote to me when I demanded an explanation.

The bad thing that made my selection process simpler was a lack of insurance carriers in North Carolina. BCBSNC actually ended up with a larger monopoly than they had before ACA. I read recently that Kentucky now has 180 policies available at Kynect. Carolina has Blue Cross Blue Shield.

I didn’t need HealthCare.gov. With one carrier in the state, you can just go straight to their website.

Their only real competition in North Carolina was Coventry Health before ACA and they had a small market share. As recently as a few months ago, Consumer Reports provided information on four or five carriers in NC and perusing their websites back then showed that competition was lowering prices. Then, just before the ACA marketplace opened up in October, they all pulled out of my area except for BCBSNC. (Coventry does offer policies in western NC.)

A story in the Raleigh News and Observer reported that the competition left after the state refused to expand Medicaid. That apparently signaled insurers that there might be lots of poor people here who would otherwise be on Medicaid applying for policies and, since poor people are usually less healthy, we no longer fit into their profit plans.

Ultimately, I found myself reviewing about a dozen or so policies, all from BCBSNC. My wife and two college-aged children each had separate pre-ACA policies from BCBSNC, since they refused to cover me. The kids’ policies were grandfathered under ACA; my wife’s was not.

I spoke with an independent agent for BCBSNC about the grandfathered policies and she told me they were better than new policies. I should keep them and get a family policy to cover my wife and me.

The main thing you should look for in a health insurance policy is not whether a $200 prescription will cost you the full price or a $25 copayment, but whether a major illness can bankrupt your family. Medical expenses are the leading cause of personal bankruptcy in the U.S. In insurance parlance, the most important factor is the “Out-of-Pocket Maximum”  (which I will call OOP Max for short), or the most you will ever owe in any one year of the policy.

Most policies describe OOP Max as the sum of your deductibles, copays, and coinsurance. I don’t know about you, but premiums also come out of my pocket, so I include them in the OOP Max. 

When I looked at the agent’s advice, insuring with three policies instead of one by keeping the grandfathered kids’ policies, the OOP Max became a problem. Each policy has its own OOP Max. A single family policy’s OOP Max added to the OOP Max’s for two more individual policies quickly becomes a very large number (near $40,000 in our case). The family policies covering all four of us topped out at around $30,000.

I rejected the agent’s suggestion and vastly simplified the selection process by deciding we would best be covered in the worst-case scenario by a single family policy.

I generated 5,000 random annual total claims and scatter plots for the four policies I was considering. The x-axis shows possible total claims in a single year for our family and the y-axis shows what the total out-of-pocket cost would be under each of the four policies. The numbers in the policy names indicate the individual deductible amounts (e.g., Silver 3000 has a $3,000 individual deductible. Family deductibles for the policies were twice the individual deductible.)

Costs would be about the same under all four policies for claims totalling up to about $10,000, but for larger claims, the OOP Max begins to kick in. Two of the policies limit OOP costs to $11,000 and two limit them to $12,700. Without premiums included, it looks like the four policies have only one of these two OOP Max levels.

Notice I am using the insurance carrier’s definition for OOP Max. Now, see what happens when I use my definition, which includes premiums.
As you can see from the graph above, the policies have four distinct maximum annual costs when their premiums are included. Also, it becomes more obvious that the true out-of-pocket maximums you might have to pay range from $27,608 to $38,616. Those are the worst-case scenarios you need to plan for, not the $11,000 to $12,700 range in the first chart that ignores premiums.

Big difference.

By the way, more expensive “Silver” and “Gold” policies don’t lower your OOP Max and give you more protection against bankruptcy. They do get you more doctor visits and lower cost prescriptions, but they have higher premiums. While it might feel good to pay a $25 copay for that $200 prescription or visit your doctor with no copay, saving several hundred dollars a year on premiums ultimately feels better.

Another question I needed to answer was whether to pay BCBSNC more money for access to their larger network of doctors. All of our doctors but one are available in the Limited plan and the Large Network plan costs about $1,300 more per year. You can pay for a lot of out-of network doctor visits with $1,300 a year, so I decided on the Limited network to lower premiums.

The next choice I needed to make was whether to pay a larger premium for a lower deductible. As I mentioned, over the past eight years we have never had a claim paid. In most years, then, we pay large premiums and get only negotiated doctor rates and catastrophic-risk protection in return. Smaller premiums are better if there are only small claims, of course.

What happens if one of the four of us has a large claim one year, say $10,000? My analysis shows that, for the worst policy of this group I considered, that would have to happen every two years for the lower deductible to be a better deal than lower premiums every year.*

My decision was to select the highest possible deductible policy ($5,500) with the lowest premiums and that made me realize that I could have come to the same conclusion with a much simpler analysis.

The more you self-insure, through higher deductibles and higher coinsurance, the lower your insurance policy costs. That’s obvious, of course, since you’re buying less insurance. So, the highest deductible and highest co-insurance policies will be cheapest.

The most important factor in selecting a policy is making sure that the Out-of-Pocket Maximum won’t bankrupt you. More expensive policies lower cost when your claims are low, but they don’t make much difference when claims are extremely high.

You have to make a purchase decision on doctor network access, but if you expect only a reasonable number of out-of-network visits to a particular doctor, the cost savings on your premiums may save you more than your out-of-pocket costs.

To select a policy, you have to decide what is important to you. Is it more important that you not pay a doctor $150 instead of a $25 co-pay, or that your total costs for the year is hundreds of dollars lower? What is the worst-case annual medical cost you can tolerate? Is it important that every doctor you see be “in-network”, or would you rather pay extra for a few out-of-network visits if your total annual costs were lower?

Had I thought through these basic issues, I suspect my analysis would have been much simpler than I made it, and I would’ve ended up with the same decision. I would have selected the lowest total cost (including premiums) policy, not with the highest deductible I could afford each year, but with the highest Out-of-Pocket Maximum I could handle in the worst imaginable year.

Focus on total costs for the year including premiums, not individual costs for an office visit or a prescription.

I think a lot of people search for a policy like an all-you-can eat buffet. They want to make sure any doctor they might wish to see is in-network, and prescriptions and office visits never cost more than $30.

That's an expensive way to buy health insurance, retired or not.

*To calculate the break-even in years, divide the additional OOP Max from the second policy by the increase in premiums. Often, you will find that an increase in premiums provides no increase in OOP Max and you will never be better off (from an OOP Max perspective) to pay the higher premium. For example, if paying an additional $1,000 a year for a policy with an OOP Max that is $2,000 lower, you would need to have large claims at least every two years to justify the higher premiums from an OOP Max perspective. Of course, the additional premium might provide other benefits.

Friday, November 1, 2013

Trick or Treat

Last night was Halloween. We rarely get more than a handful of trick-or-treaters, sometimes none. Last night we had just one group, but it was a group of twelve, so now I only have to eat half a large bag of mini-size M&M packets before Christmas candy shows up on the shelves.

In the “spirit” of the holiday, I was feeling a bit mischievous this morning when a friend called with a finance question.

“You recommended a 60/40 stock allocation for our retirement portfolio, right?” she asked.

“Well, my husband is rolling over his 401(k) and he says he will feel better with a 50/50 allocation of his part of our savings. Will that work?”

I told her a true story about myself from around 2000. (If you’ve read LocallyGroan.com, you know how I like to tell stories about myself. Inherited the weakness from my grandfather.)

I went to see a well-known and quite capable money manager on the West Coast during the Tech Boom about managing a large sum of money I had made on stock options. I told his managers that I wanted 40% of the portfolio invested in bonds and cash.

“We don’t do that,” they told me. “Holding bonds significantly reduces your expected return. We buy them on occasion and use other hedges when we anticipate a bear market, but in general, you can trust us to get you out of the market before a crash.”

We're market timers. We don’t need no stinking bonds.

I said “fine” and subsequently turned over 60% of my portfolio for them to invest in stocks and I invested all of the remainder in bonds. They were happy with their 100% stock allocation and I was happy with my 60/40 portfolio. While I was with them, the combined stock and bond portfolios outperformed the stock portfolio.

“So, if I increase the stock allocation of my part of the savings so it averages out to 60/40, should I tell my husband?” my friend asked.

“Whoa!” I told her. “I’m not going there. You know the NSA is listening to this, right?”

I can imagine times when you might treat a husband and wife’s retirement portfolios separately, but if the pool of funds belongs to both of you, one of you can’t invest in Russian ruble futures without affecting the other.

I stayed with that money manager for a few years and did OK. Ultimately, I was unhappy with the “exceptional manager” theory and decided to manage my own money with index funds and ETF’s.

And bonds, of course.

I read a letter a few years ago from the exceptional manager apologizing for not foreseeing the 2007 market crash and getting his investors out in time.

Sorry, kids. We ran out of candy.

Tuesday, October 29, 2013

Safe Withdrawal Rates: Is 60 the New 95?

Safe Withdrawal Rates (SWR) strategies, spawned by the so-called Trinity Study1 in 1998, are based on a dangerous assumption — that the future will look like the past.

Now, most everyone knows that is a ludicrous assumption. Nonetheless, in finance we sometimes pretend that is it not, and in our closets we Baby Boomers hang on to our plaid bellbottoms, just in case.

The widely-publicized interpretation of those studies is that retirees can withdraw 4½% of their nest egg the first year of retirement and continue to withdraw that constant dollar amount, increased for inflation, every year and have a 95% probability of funding at least thirty years of retirement. (That's the widely-publicized interpretation, not mine.2)

More and more, researchers are raising serious doubts about that "history repeats itself" assumption. Dr. Wade Pfau studied withdrawal rates in other countries and found that the U.S. was an exception. The widely-advertised 4% to 4½% withdrawal rates weren't safe globally. In subsequent studies, Dr. Pfau concluded that more frugal withdrawals would probably be needed for today’s retirees to achieve a 95% chance of their portfolio lasting 30 years or more in this country. Maybe closer to 3%.

A recent study by Pfeiffer, et. al., entitled The Benefits of a Cash Reserve Strategy in Retirement Distribution Planning, investigated the benefits of maintaining a one-year cash reserve account, but I found the results of the Reverse Dollar Cost Averaging (RDCA) scenarios most interesting. RDCA is another name for constant-dollar withdrawals, or Safe Withdrawal Rates (SWR).

The study (excellent video explanation by Dr. Pfau here) compared monte carlo simulations of RDCA and a similar strategy that held one year’s expenses in a cash account to minimize having to sell stocks when prices were low. A major difference between the Pfeiffer study and the Trinity and William Bengen studies earlier is that Pfeiffer considers transaction costs and taxes and “a future of lower investment returns than seen in the historical data” based on recent capital market projections (that's current predictions of future stock market returns for those of you who speak English).

The results? In a tax-deferred environment (401(k), IRA, etc.), with a 4% withdrawal rate the cash reserve strategy improved 30-year portfolio survivability by nearly 5% from . . . wait for it . . . 55% to 59.4%. 

Not 95% to 99%.

55% to just under 60%.

In a taxable environment, cash reserves increased 30-year survivability with 4% withdrawals, but from a very risky 60% to a still risky 66%.

The following chart is a summary from the Pfeiffer study. The first pair of columns represents an unrealistic environment with no taxes or transaction costs. The second pair represents a ROTH IRA scenario with only transaction costs. The third pair represents a tax-deferred (IRA, etc.) environment and the fourth pair a taxable environment.

95% isn't even on the y-axis.

What happened to 95% survival rates and 4½% withdrawals? If Pfau and Pfeiffer are correct, history won’t repeat itselPf. . . sorry, itself . . . and 4½% won’t work. If history does repeat itself and the U.S. stock market continues to outperform the rest of the world, Bengen was correct and 4½% will work.

Who’s right?

It’s unknown. And unknowable. Check back with me in thirty years. But, the newer research nowadays seems to point to significantly lower sustainable withdrawal rates.

Maybe they’ll all be wrong. In his early writing at EfficientFrontier.com, William Bernstein wrote that retirees shouldn't expect any rate of success greater than 80%.

That "everyone being wrong" thing happens a lot with financial projections. A quite successful money manager used to predict the coming year’s market returns by waiting for other money managers' predictions and then picking the range that no one else picked. It worked amazingly well until the others caught on and they all started waiting.

If you’re basing your retirement funding primarily on portfolio withdrawal strategies, you should heed the words of the authors of the Trinity study that started it all:

"The word planning is emphasized because of the great uncertainties in the stock and bond markets. Mid-course corrections likely will be required, with the actual dollar amounts withdrawn adjusted downward or upward relative to the plan. The investor needs to keep in mind that selection of a withdrawal rate is not a matter of contract but rather a matter of planning."

95% survivability of your investment portfolio with 4½% annual withdrawals isn’t carved in stone somewhere.

In fact, 60 may be the new 95.

1Retirement Savings: Choosing a Withdrawal Rate That is Sustainable

2I think the studies show that your probability of success is a function of the value of your portfolio at any point in time (not its initial value when you retire) and the number of years remaining in retirement. In other words, you have to reassess the safe withdrawal amount periodically, and the safe withdrawal rate increases as retirement progresses.

Friday, October 25, 2013

A Retirement Plan Begins at the End

A lot of retirement planning revolves around your expectations for the end of retirement.

You need to begin with the end in mind, as they say.

There are two basic schools of thought regarding retirement financing. The first, explained by Zvi Bodie in The Theory of Life-Cycle Saving and Investing, is often referred to as the life-cycle approach, or sometimes the "safety first" approach. It is based on the principle that you should first secure your minimum acceptable lifestyle by investing in safe bonds, life annuities and the like, and only then risk what's left of your savings in the stock market in hopes of improving your lot.

The other school is represented by Safe Withdrawal Rates (SWR) and refinements of that strategy and is predicated on making a stock portfolio "safe enough" to minimize the chances that you will go broke late in life. No one, including SWR advocates, will tell you that this strategy will work 100% of the time. In fact, they shoot for about 95%.

So, the bulk of retirement planning revolves around how important it is to you and your spouse to be financially secure if one or both of you live long lives.

For retirees like me who want as close to a zero percent probability of going broke in their nineties as they can possibly arrange, betting on how long we will live or counting on a wonderful next thirty years of market returns isn't good enough. We know that we might live to 95 or 100 and that the market might not bail us out.

But not everyone feels that way. Some feel that a 5% chance of running out of money is an acceptable risk for the opportunity to improve their standard of living. Or maybe they're convinced that longevity isn't their fate.

Neither of us is right or wrong. We safety-first people are simply less willing to take that risk than are the SWR crowd.

The group that worries me are retirees who believe they can have both a perfectly safe retirement and invest the bulk of their savings in the stock market. They hope to find a magic withdrawal rate, buy equity-indexed annuities that promise stock market returns with no downside, or some other such "spending strategy".

You can't have both. If you choose the stock market route, understand that you risk suffering a permanent reduction in your standard of living. If you opt for the safety-first route and the market goes straight up for the next 30 years, understand that you risk missing out on a huge, long-term bull market.

With either choice, in the worst case outcome you'll need to feel good about saying, "I knew the risk. It was a wise decision. I'd do it again." If you don't think you would be able to say that, you're probably making the wrong choice.

My personal feeling is that I would be happier with my current standard of living and missing out on a grand bull market than going broke late in life. Thinking that probably won't happen doesn't work for me. But, that's a personal decision.

Knowing which school of thought suits you can be a huge help when you begin planning retirement. If you're a safety-first kind of person, your plan will include strategies like saving a lot for retirement, spending less after you retire, claiming Social Security benefits as late as possible, buying TIPS bond ladders and maybe even fixed annuities.

A safety-first retiree ignores life expectancy and plans for the worst-case financial outcome living a long time and going broke.

If you're willing to risk financial safety in your later years, your available strategies will include stock and bond portfolios, perhaps saving less and spending more, maybe claiming Social Security benefits sooner. Perhaps you consider the probability of living a very long time an acceptable risk. You may do better or worse than the safety-first strategies and you might go broke. That's the risk.

Most of the clients I work with spend the bulk of our time together struggling with the risks and rewards of these two approaches, generally trying to convince themselves that there is some way to have both maximum financial security in old age and the maximum opportunities possible with stock investments.

There isn't a way to have both, but I'm not sure I have ever completely convinced a client of that.

Tuesday, October 22, 2013

Need Help with Your Social Security Claiming Decision?

In my last post, I'm Not Ready for Social Security, I promised to provide an actual case study that I ran through the MaximizeMySocialSecurity.com (MMSS) website. That post listed several good free and paid websites to help you decide when to claim Social Security benefits. MMSS is the one I chose, in large part because I also use E$Planner.

Joe and Sally (real people, fake names) are approaching their minimum age of 63 to receive (also minimum) Social Security retirement benefits. They are both relatively high earners in their current careers, though Joe earns quite a bit more, so his benefits will be higher.

For various reasons, some wise though most unwise in my opinion, many people choose to claim Social Security retirement benefits at the earliest possible date, even though these benefits would increase about 8% a year for every year they waited.

I asked Joe and Sally to send me earnings histories copied from SocialSecurity.org and I plugged them into MMSS. I then ran the software with the assumption that both would live to age 70.

This is the worst case for claiming late, because if Joe waited until age 70 to claim and died sooner, he’d receive no retirement benefits at all. (Sally would, however, receive larger survivors benefits because Joe had postponed his own retirement benefits[1].)

If both Sally and Joe had claimed their own retirement benefits at age 63 and died at age 70, their lifetime benefits would have totaled $282,712.

(MMSS found 42,209 possible claiming options to consider. Want to work that out by hand?)

Now, let’s look at the other extreme and assume that both live to age 100. MMSS shows that claiming at the earliest possible age would have generated $981,232 in lifetime benefits, but claiming optimally would provide $1,246,962 in benefits, or $265,694 more. It recommends the following claiming strategy:

  • Joe should take retirement benefits in Jan 2023, the year Joe turns 71.
  • Joe should take spousal benefits in Jan 2019, the year Joe turns 67.
  • Sally should file and suspend[ii] in Dec 2018, the year Sally turns 68.
  • Sally should take retirement benefits in Dec 2020, the year Sally turns 70.
Complicated, right?

A million two is a pretty impressive number, but according to Michael Kitces, "the probability of a joint life expectancy of 30 years for a 65-year-old couple (to age 95) is already as low as 18%. A 35-year life expectancy for that same couple (to age 100) has a mere 3.7% likelihood.”

So, what happens if Sally and Joe live to 95 instead of 100? MMSS recommends the same claiming strategy and forecasts lifetime benefits of  $1,101,411. Still a nice number and $205,657 more than they would get from claiming early.

I ran several scenarios for different longevities for Joe, but always assuming Sally would live to 95, which in my experience is not an unusual outcome. MMSS recommends in every scenario that Joe claim spousal benefits based on Sally’s earnings history when he reaches age 67 and delay receiving his own benefits until he reaches age 71. Sally’s recommendation is to always claim her own benefit (not her spousal benefit), but the best age for her to claim those benefits varies depending on how long she expects Joe to live.

The rightmost column shows the additional benefits the two would receive compared to claiming at the earliest opportunity. (Click table to enlarge.)

Now, I would never recommend that you base claiming benefits on how long you guess you will live, unless you have firm medical reasons to expect a less-than-average life span. If you guess wrong, you can be really screwed.

Absent that kind of poor medical prognosis, I would suggest that Sally wait to at least age 68 to claim if she can afford to.

The free AARP site provided similar advice, but not as detailed. That’s because the site uses life expectancy rather than allowing you to choose a planning horizon. It also uses income averages instead of actual lifetime earnings records from Social Security.

There are several points to take away from this analysis:

1.     Social Security benefits claiming can be very complex (42,209 possible choices in this analysis), especially if you are married or divorced or one of you can claim a public pension. You need to consult a professional financial planner or use a reliable web-based tool. There are many possible strategies and the best websites, including SocialSecuritySolutions.com and MaximizeMySocialSecurity.com, will consider them all. Forty bucks seems a small price to pay with a hundred grand at risk. A qualified financial advisor would be a good investment, too.

2.     The specific scenario in my example cannot be generalized. You might receive different advice if you were single, divorced, eligible for a public pension, a different age, or if your earnings during your career were significantly different than these. Don’t trust magazine articles that provide general Social Security advice. No single strategy fits all. That includes "always claim as soon as you can" and "always wait as long as you can." Tailor your strategies to your households’ specifics.

3.    Your benefits claim can have a dramatic effect on lifetime benefits and your benefits may be the most important component of your retirement income if you weren’t able to save enough for retirement.

There are two additional recommendations that I would make.

First and foremost, think of Social Security benefits as longevity insurance to make sure you have income when you are very old, or that your surviving spouse does. If you were the higher earner, your spouse's survivors benefits will depend on when you claim retirement benefits. If you claim early, you not only lower your retirement benefit, you lower benefits for your surviving spouse for the rest of his or her life.

Second, consider your claiming strategy within your overall retirement financing plan. It is difficult to identify the best claiming strategy without understanding when you will need that income the most. If you have a lot of savings or can work part time to cover your spending requirements for the first few years after you retire, claim later to receive greater benefits. Consumption smoothing software like E$Planner, or a financial advisor, can help you integrate Social Security benefits with the rest of your retirement plan.

Claiming Social Security retirement benefits is very complicated and it is extremely important that you get it right. A lot of money is at stake. Unless you're an expert, get help.

Claiming early might ensure that you squeeze every penny out of Social Security should you die early, but that’s like buying home or car insurance that only pays the small claims that you could afford to pay out of pocket. 

A short retirement won't cost much.

It’s the big claims that can destroy your finances, and living to age 90 or older is a very, very big claim.

[1] Your spouse’s survivors benefits equal your retirement benefits, if you have begun receiving them. Limiting your own retirement benefit consequently limits your spouse’s survivors benefit.

[2] “File and Suspend” is a strategy for claiming your retirement benefits and immediately suspending them so you spouse can claim spousal benefits and you can keep the meter running on your own retirement benefit. You can read more here.