Wade Pfau's Retirement Researcher blog received a disquieting question from a reader last week. The reader asked Wade how he, the reader, would have done had he invested his FICA payments over the years in the stock market instead of paying into Social Security. We assume the reader knew that wasn't legally possible.
Wade researched the question because well. . . because he's a researcher, and responded along the lines that in the reader's personal situation it would have been roughly a draw, but that investing in the market would have exposed him to far more risk to achieve similar results. In other words, the reader would have done about as well with investments but largely because he had chosen a good time to be born. (He was lucky.)
Wade later noted that his analysis didn't include spousal benefits. Spousal, survival, and other Social Security benefits are huge, so if the reader is married then he would have been worse off investing his FICA taxes. Significantly worse off.
The question is disquieting because it suggests that the reader may not appreciate the difference between insurance, like Social Security Retirement Benefits, and investments. They aren't apples and apples.
Social Security retirement benefits, officially named Old Age and Survivors Insurance (OASI), are insurance against longevity, or living a very long time and running out of wealth. It was passed into law in the 1930's because Americans felt that old people who couldn't work any longer shouldn't live in poverty. We pay the premiums for this insurance with FICA taxes. OASI is available not only to Americans but to anyone who works legally in the U.S. and pays FICA taxes. Benefits are based on how much we pay in FICA taxes over the years.
Insurance is a contract that pays us when bad things happen in our lives but typically pays nothing if we don't suffer a loss. An investment is something we buy with the hope of selling at a higher price in the future.
If you live a long time after retiring, you will be better off buying insurance like fixed annuities or more Social Security benefits, which you can effectively do by delaying claiming. If you live less than an average lifespan, you may well be better off investing – or maybe not, since investments can lose as well as gain. Investing seeks to maximize spending in retirement but guarantees nothing, while insurance guarantees that you will have at least some income no matter how long you live. If you are healthy, you cannot predict how long you will live, which makes it a lot harder to choose between the two. Theirs are two very different promises.
When you buy stocks and bonds you “sell cash and buy risk.” Cash includes things like actual cash and short- to intermediate-term Treasury bonds. Risk means risky assets, like stocks and riskier bonds. When you buy an annuity or increase Social Security longevity insurance by delaying your claiming age, you are buying safety from longevity risk. Another way to say this is that you are paying an insurer to accept your longevity risk.
Your total household balance sheet, as RIIA likes to say (download PDF, should include all social, financial and human capital.
The risk you buy when you invest in stocks and bonds is market risk, or capital market risk, and this is a risk to your financial capital. When you buy an annuity, increase Social Security benefits by delaying claiming age, or buy disability or life insurance, you're protecting your human capital.
Claiming Social Security benefits early and investing them would mean accepting more longevity risk in addition to increasing market risk. Investing FICA taxes in the market would mean increasing your financial risk in hopes of mitigating your human capital risk, which is all perfectly fine if your overall financial situation in retirement calls for more risk. If you have a huge private pension and little savings to invest, for example, that might be the case.
Increasing your Social Security benefits by delaying claiming them would decrease both your financial risk, because you would be investing less, and your longevity risk by making sure that you or a surviving spouse will have more income guaranteed if one of you lives a long time.
When we ask if we would be better off with stock investments than Social Security benefits, we're asking if it is better to gamble that our investments will do well and we won't live a long time or to buy insurance that will increase our income if we do live a long time. The ideal answer is to have enough wealth to do some of each. This is the basis for a floor-and-upside income strategy.
When I read the question, my first thought was why not invest my homeowners insurance premiums in the market instead of handing them over to an insurance company? If my investments do well and my house never floods or burns down, I'll be way ahead of an insurance policy. (Please don't try this at home.)
But what if it does? What if my house burns down? What if I live to an old age? What if my widow lives to a very old age? Some risks, like long-term care costs, home insurance, and living to 95 are, as my cousin in the insurance industry likes to say, not easy to out-save. When there is a low-probability, high-magnitude risk and insurance is affordable to protect against it, then insurance is the most effective way to deal with that risk.
The next question might be, “I’m wealthy and don’t need Social Security, so why should I have to participate?”
The answer is adverse selection. If only people who really need insurance buy insurance, any kind of insurance, that insurance is doomed to failure. Successful insurance only works when claims are random and uncommon.
Adverse selection increases the price of life annuities (SPIAs and DIAs), as well. People who don’t expect to live long buy life insurance, not annuities. Those who buy annuities are those who think they will live longer, so the price goes up. If only poor people or old people enrolled in Social Security, it couldn’t work.
So, why am I bothered by someone asking if investing is better than insuring? Because they are not the same thing, so “better” depends on what you are trying to achieve. Is an umbrella better than sunscreen? It is if it rains.
Investing and buying insurance are two very different propositions. Even if your personal preference is to bet everything on the market, you should do so understanding this difference.
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