Monday, November 27, 2017

Social Security Benefits: the Big Picture

In a previous post, Income Annuities: Immediate and Deferred, I discussed the problems that single-premium immediate annuities (SPIAs) and deferred income annuities (DIAs) can solve and I included the two charts below. These two problems are also considerations in deciding when to claim Social Security benefits.

The first chart demonstrates the use of an immediate annuity to increase the floor of safe income for retirees with otherwise inadequate Social Security benefits or pensions. (By “safe”, I mean income generated by assets that are not subject to market volatility. No asset is completely safe.) These are households that need safe income as soon as they retire.

Chart 1. Inadequate safe income throughout retirement.

The second chart demonstrates the use of a DIA to mitigate the risk of declining wealth late in retirement, should the retiree live that long.[3] This declining wealth could be the result of a failing portfolio, for instance, though as this chart shows, portfolios rarely fail before age 80.

Chart 2. Portfolio Depletion Risk in Late Retirement
Loss of standard of living can also result from an increase in expenses late in retirement even if the portfolio is successful, or it can be the result of a combination of portfolio losses and increased expenses. In either case, the DIA can mitigate the risk of a loss of standard of living later in retirement.

What does this have to do with Social Security benefits? A lot – Social Security retirement benefits are a deferred income annuity, the premiums for which are effectively paid from our FICA taxes. We can begin the benefits payout at age 62 or defer those benefits up to age 70.

I discussed the trade-offs between deferring benefits or claiming them early in Delaying Social Security Claims (or Not), but here’s a quick review.

We can increase our monthly Social Security retirement benefits by about 8% for each year we defer them up to age 70. This can ultimately result in receiving a check that is 32% larger when claimed at age 66 rather than age 62 and up to 76% larger when benefits are postponed from age 62 to 70.

However, there are risks to postponing. Single retirees who decide to postpone benefits to age 66, for example, and die before that age, would receive no benefits, at all. (A lower-earning spouse would receive survivors benefits as if the deceased had claimed retirement benefits at full retirement age.) In fact, the retiree would need to live several years past age 66 for the larger payments to repay the benefits that were skipped. (This isn't as unlikely as it sounds.)

If we spend from an investment portfolio to provide additional income while postponing benefits (instead of working longer, for example), we may increase sequence of returns risk at the worst time, early in retirement. Over-savers might not see a significant increase in sequence risk but retirees with smaller portfolios probably will.

In exchange for taking these risks, we can receive much higher total lifetime benefits, perhaps hundreds of thousands of dollars more, in the event that we live to an old age. In this way, we are mitigating the risk of scenarios shown in Chart 2 above (declining wealth and/or increasing expenses in late retirement). By claiming benefits at age 62, we are mitigating the early-retirement risks of scenarios with inadequate safe, floor income as shown in Chart 1.

There are a few common strategies for claiming Social Security benefits. One, the “break-even” strategy, suggests that a retiree claim benefits early if they don’t believe they will live past the age when the total of the (fewer) larger benefits overtakes the total of more, smaller benefits.

There are several problems with this strategy, the largest being that many healthy people seem to believe they know how long they will live with very little evidence to support that belief. (They are overconfident.) The second problem with break-even analysis is that it doesn't consider life expectancies and it's easy to underestimate the probabilities of surviving to the break-even age.

Here's an example from Brian O'Connell at US News and World Report.[1]
"The breakeven point, when the total dollars received by waiting until age 66 begin to exceed total dollars received by beginning at age 62, is approximately age 77," he adds. "Life expectancy tables show that a person who has attained age 62 will live to be 85.5, and a person who has attained age 66 will live to be 86.2. This means that if you have a normal life expectancy, you will end up with less dollars received [by claiming at 62]."
I often hear retirees say things like, "But I'd have to live 15 more years just to break even!"

In fact, the probability that a 62-year old male will live 15 more years to age 77 and profit by delaying claiming is about 72%, meaning that there is a 72% chance that he would lose the break-even bet by claiming at age 62.

A second common strategy, advocated by many Social Security optimization tools, is to postpone claiming benefits as long as you can to maximize lifetime benefits in the event that you live a long time. This is a “safety first“ strategy and one I prefer to guessing how long I will live.

Claiming Social Security retirement benefits: the big picture.
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Although I prefer the second strategy to the first, both are missing critical elements of the decision by proposing that we claim Social Security benefits as an isolated exercise. In reality, the correct claiming decision is largely influenced by the composition of the remainder of our retirement plan.

A retiree with limited savings, for example, probably cannot afford to delay claiming Social Security benefits except by working longer. In that case, the claiming decision is strongly influenced by the retiree’s opportunity to continue working (her "human capital") and the amount of her retirement savings.

A household that has accumulated several million dollars in retirement savings, at the other extreme, won’t rely heavily on Social Security benefits, at all. It might be wise to claim late as longevity insurance. These households might even claim benefits early and invest them in the stock market since losses there would be unlikely to reduce standard of living. A household with marginal savings would risk their standard of living with this strategy.

Retirees with a significant pension and eligibility for Social Security benefits (those with "public" pensions are probably not eligible for both) would be less dependent on Social Security benefits for either immediate income or for mitigating the risk of loss of standard of living late in retirement. So, the availability of pension income is also a factor in claiming Social Security benefits.

Households that choose to fund retirement primarily with safe income assets like government bonds and income annuities avoid the risk (and rewards) of market volatility late in retirement. The more safe income they have, the less risk of depleting wealth late in retirement. The extent of the presence of these assets in the household retirement portfolio is a factor in the Social Security benefit-claiming decision.

I simulated a large number of retirement scenarios randomizing several of these factors including claiming benefits at age 62 and at age 70. I noticed an increase in the number of scenarios that did not meet spending demand throughout retirement when claiming at age 70.

Upon further analysis, I found that delaying claiming benefits increased spending from the investment portfolio in the failed scenarios for those early years of retirement, when sequence of returns risk is at its peak, and in marginal market return scenarios. In these specific scenarios, the additional portfolio spending was enough to deplete the portfolios a few years earlier than claiming at age 62 would have. The impact of increased portfolio spending on portfolio survival when delaying benefits is yet another factor not typically considered by claiming strategies.

Retirees may work longer to delay Social Security benefits, in which case there would presumably be no adverse impact on portfolio spending. In fact, portfolio spending would be delayed, reducing the risk of premature portfolio depletion.

On the other hand, retirees who claim Social Security benefits before Full Retirement Age (currently aged 66 for those about to retire) and continue to work will see their benefits reduced until they reach full retirement age.[2] 

In other words, your Social Security-claiming decision will be affected by how long you plan to work after you claim benefits before Full Retirement Age, the decision again depending on the human capital component of your retirement plan.

Perhaps the most challenging consideration is the risk of spending shocks. Even retirees with significant retirement savings face the risk of large unexpected expenses after they retire.

Retirement plans that contain long-term care insurance policies, umbrella liability policies and the like are at less risk of losing standard of living, though the risk is always non-zero. Not every retiree will be eligible for an LTC policy or will be able to afford one, and for those retirees postponing Social Security benefits will help mitigate that risk. The presence and extent of insurance policies in the retirement portfolio will, therefore, influence the claiming decision.

Marital status is another consideration. Claiming early not only limits one's own lifetime retirement benefits, it also limits survivors benefits for a lower-earning spouse. (When a spouse dies, the surviving spouse's survivors benefit will become the larger of the two previous retirement benefits.)

Deciding when to claim Social Security benefits is much like deciding when to purchase immediate annuities, deferred income annuities, neither or both. Claiming early mitigates the inadequate floor income problem and claiming late mitigates the risk of lost standard of living in late retirement.

One last consideration is the cost of retirement, which is largely dependent on how long we live. Retirees who postpone claiming and don't live long will indeed "leave money on the table." Then again, they will have had a relatively inexpensive retirement that they could probably still afford. Retirees who live a long time will have a very expensive retirement and will likely need the extra income later in life. In other words, postponing claiming Social Security benefits will reduce income for retirees who don't live long, but their cost of retirement will be lower, too.

The decision isn’t as simple as guessing how long you will live or figuring how to maximize lifetime benefits in the event that you live a long time. The best claiming decision depends on the retirement problem(s) you’re trying to solve and how Social Security benefits will work with the rest of your retirement plan. Following is a table of conditions that suggest claiming early and those that suggest claiming later.

Social Security benefits can solve the same problems as immediate and deferred annuities with even greater economic efficiency. The nature and extent of those problems, however, will be determined by other interrelated retirement plan decisions.

The key point is that a retirement plan is a portfolio of income-generating assets that interact with one another in much the same way as do stocks and bonds in an investment portfolio. Choosing a Social Security benefits-claiming strategy in isolation from the other decisions of the retirement portfolio excludes critical considerations and is likely to provide sub-optimal choices. It's like trying to pick a stock investment without considering what's already in your portfolio.

The same goes for setting an equity allocation, choosing an annuity allocation, implementing a tax strategy and most other major decisions. They're all interrelated. They work as a team.

The retirement financial model is so complex that I don’t see an obvious alternative to simulation to make the best decision. It's extremely challenging to look at one change to a spreadsheet and understand how it will affect other components. Without simulation, I would never have noticed, let alone have been able to measure, the impact that delaying claiming Social Security benefits might have on portfolio survivability.

If neither you nor your planner is able to perform the simulations, then my original recommendation stands: postpone claiming benefits for the higher-earning spouse as long as you can. Weight your decision using the factors in the table above. If you need the income right away, the decision has been made for you.


[1] The Pros and Cons of Taking Social Security Early | Investing | US News, U.S. News and World Report.

[2] What happens if I work and get Social Security retirement benefits?,

[3] Competing Risks: Death and Ruin, Cary Cotton, Alex Mears and Dirk Cotton, Journal of Personal Finance Vol 15 issue 2, Aug 24, 2016, page 36.

Tuesday, November 7, 2017

Income Annuities: Immediate and Deferred

Annuities are insurance contracts that you can purchase to provide a stream of income for as long as you live. Think of them as life insurance in reverse. With life insurance, you pay premiums periodically while you are alive and your beneficiaries receive a large lump-sum payment when you die. Annuities are just the opposite — you pay a large lump sum to the insurance company up front and they make periodic payouts to you until you die, no matter how long that might be.

The following diagrams show the cash flows for life insurance, single-premium immediate annuities (SPIAs) and deferred income annuities (DIAs). Blue cash flows go to you and red cash flows represent payments you make to the insurance company.

The difference between an immediate annuity and a deferred income annuity is that immediate annuities begin payouts in less than one year, while deferred income annuity (DIA) payouts can be deferred for many years.

I can purchase a $500,000 single premium immediate annuity today and begin receiving payouts next month if I wish. I can purchase a $100,000 single premium deferred annuity today and elect to not receive those payouts for ten years, for example, if I prefer.

Why would I want to defer an annuity’s payouts? Because deferred annuities and immediate annuities solve two different retirement problems.

Immediate annuities can be purchased at the beginning of retirement to help provide a lifetime of safe "floor" income. Retirees with little secure income may want to augment that safe income with an immediate annuity. Retirees with significant Social Security benefits and a pension may have plenty of safe income and not need an immediate annuity.

The following diagram shows the problem an immediate annuity can fix. The retiree has only a small portion of income generated from pensions and Social Security and may be exposed to a good deal of market risk in the red area. The green "floor" of safe income can be raised throughout retirement with an immediate annuity.

Some households may feel that they have adequate income in early retirement but worry that they might not have enough remaining wealth to fund their desired standard of living late in retirement should they live a very long time. Deferred annuities, also referred to as "longevity insurance", can solve that problem.

An immediate annuity (SPIA) provides income beginning in less than a year and continues those payouts for as long as the annuitant(s)[1] live. A deferred annuity (DIA) begins payouts at some contracted date in the future if and only if the annuitants survive to that date. At that time, DIA payouts also continue for as long as the annuitants live, but because the insurer will make fewer payouts with a DIA, and none at all if the annuitants don't survive until the future date, DIAs are a less expensive way to fund late retirement than SPIAs and much less expensive than spending from an investment portfolio.[2]

A good candidate for a DIA might be a household that relies on spending from an investment portfolio and is confident that the portfolio will fund early years of retirement but concerned that it will be prematurely depleted. A study my son and I conducted found that depleting a portfolio before age 80 should be quite rare.[3,7] A DIA is a good way to insure income after age 80 or so in the event of a failed portfolio.

See how portfolio survival rates begin to decrease sharply (risk of ruin increases sharply) once we reach age 80 to 85? Deferred income annuities can provide cost-effective protection against that increasing risk in late retirement for retirees who depend on an investment portfolio for income.

Why buy a deferred income annuity now and defer payments 20 years instead of just waiting 20 years to buy an immediate annuity? Because the DIA will be much cheaper and because there is no guarantee we will still have enough remaining savings to afford an immediate annuity when that time comes.

Assuming 3% annual inflation, a 65-year old man could buy a DIA today that would generate $10,000 of income per year in 2017 dollars ($15,580 in 2032 dollars) beginning at age 80 for a one-time purchase of $41,560.

An 80-year old could purchase an immediate annuity today that will generate $10,000 of immediate annual income for $91,070. It's much cheaper to buy the late retirement income in advance.

The immediate annuity would generate significantly more lifetime income, of course, but it requires more than twice the initial outlay. For households that only expect to need additional income in the event of a very long life, the DIA is the better choice.

This is not an apples-to-apples comparison. This assumes that life expectancies and interest rates will remain roughly the same over those 15 years. I have figured in 3% inflation, which could be high or low. The SPIA purchaser will almost certainly receive some income while the DIA purchaser will receive nothing unless she survives to age 80.

Nonetheless, the annuitant who does live to 80 will fund income the least expensive way. The DIA is longevity insurance and that's how insurance works. We accept a certain loss (premiums) to protect us from a potentially very large loss (running out of money in late retirement). We pay someone else to accept our risk.

Deferred annuities, like retirement finance in general, have an accumulation phase and a distribution phase. But, the phases might be easier to understand if we describe them as two different products.

When to buy a deferred or immediate annuity and when you probably don't need one, at all.
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Imagine that the accumulation phase of a deferred income annuity (DIA) is like having a fixed-interest rate savings account. The money invested in this savings account is illiquid because the insurer can charge high surrender fees if the annuitant makes withdrawals sooner than the annuity contract allows. Taxes on earnings are deferred until they’re withdrawn, so sort of like a savings account held in a traditional IRA but without a tax break on the contributions.

The value of this account grows until the DIA is annuitized, or converted into a stream of lifetime income, or until the annuitants die, in which case the account value becomes zero. If the annuitants die during either phase, even if payouts have not begun, the results are pretty much the same as with an immediate annuity. That means that unless riders are purchased to guarantee some payout to your beneficiaries, the deferred income annuity will have no residual value.

The second product (the distribution phase) is a life annuity that you will choose to purchase with funds from the “savings account” if you survive the deferral period.  If the annuity is funded from an IRA or 401(k) — a “QLAC”, described below — you must begin annuitization by age 85. Funded outside a retirement account, you can often delay annuitization until age 90.

An annuitant might reach the age they expected to convert to an annuity, not need the income, and elect to delay annuitization until they do. Or, they might find they need the income sooner and move back the annuitization date a few years.

Inflation is a greater concern with deferred annuities than immediate annuities. While most deferred annuities don’t offer inflation protection, those that do offer it don’t provide inflation protection during the accumulation phase. The inflation protection kicks in only when the account is converted to an annuity. Since the deferral period can last a long time, inflation can become a significant issue as your axccount compounds during the accumulation phase at bond-like interest rates.

Another advantage of DIAs compared to immediate annuities is that they require a smaller cash outlay because they only provide income if you survive until late in retirement. According to researcher David Blanchett, "The cost of a DIA, for example, that would provide $10,000 a year of income, if you buy it at age 65, it would cost about 20% of what it would cost to have a SPIA starting today at age 65 to provide that same level of income." [4]

Wade Pfau wrote a column entitled Why Retirees Should Choose DIAs over SPIAs[5]. The short answer is that deferred annuities are the most economically-efficient way to finance the latter years of retirement should a retiree or spouse live a long time. The more technical answer is that DIAs "expand" the retirement income efficient frontier and create opportunities with higher expected returns for a given level of risk.

There is a special type of DIA worth mentioning, a qualified longevity annuity contract (QLAC). A QLAC is a deferred annuity that you can purchase with qualified funds from your retirement accounts with payouts deferred to as late as age 85.

According to Motley Fool[6], “a QLAC allows the insured to withdraw 25% — up to a maximum of $125,000 for single folks and $250,000 for married couples — from their qualified retirement accounts and exempt these funds from being considered in their RMD calculation from age 70½ onward.

I recently recommended a QLAC to friends. They plan to annuitize it at age 82, but if they reach that age and their portfolio has held up well, they can choose to defer payouts up to three more years and receive larger checks then. On the other hand, if their portfolio underperforms, they can choose to annuitize a few years earlier and receive slightly smaller checks sooner.

Annuities are not particularly popular although interest in DIAs has recently grown.

One of the problems, I believe, is that retirees often consider annuities in isolation and not as part of an integrated plan. True, the money used to purchase an annuity cannot be left to your heirs. (Unless you buy special riders to continue payouts to your beneficiaries for some guaranteed minimum number of years. Those essentially offset mortality credits and defeat much of the purpose of buying the annuity.)

On the other hand, if you purchase an annuity and die early in retirement, the good news (financially) is that you will have had a relatively brief and inexpensive retirement. That may mean you had plenty of savings apart from the annuity to leave your heirs.

If you live to an old age, an annuity might help you avoid spending other savings that you can leave to heirs. Owning an annuity may give you more confidence (or may not, depending on your personal risk aversion) to invest your portfolio more aggressively and improve your odds of earning a greater return. As Pfau’s research shows, annuitants often end up with greater terminal wealth.

The point is that you need to consider annuities as an integrated part of a retirement plan and consider the entire plan’s terminal wealth instead of focusing on the fact that the annuity has no value at death. If the annuity ultimately becomes worthless but it has preserved other assets, it will have done its job.

This isn’t a thorough treatment of deferred annuities. My goal is simply to explain their salient characteristics for comparison with immediate annuities and Social Security benefits. If you want more information — and certainly if you are considering purchasing one — please see the references below.

The most important takeaway is that deferred income annuities (DIAs) are the most economically-efficient way to fund late retirement by providing "longevity insurance." Single-Premium Income Annuities (SPIAs) are a better way to provide income throughout retirement for retirees with an inadequate "floor" of safe income. The correct choice depends on the problem or problems you are trying to solve — you might even need one of each.

As I have mentioned often, I believe that retirees should plan retirement in a way that makes them happy. Some people hate annuities; some won't invest in the stock market. If you understand the pros and cons of each and can't be persuaded, buy what lets you sleep at night.


[1] An annuity can cover a single life (annuitant) or joint lives (annuitants).

[2] The 4% Rule-At What Price?, Scott, Sharpe, Watson.

[3] Competing Risks: Death and Ruin, Cary Cotton, Alex Mears and Dirk Cotton, Journal of Personal Finance Vol 15 issue 2, Aug 24, 2016, page 36.

[4] Pros and Cons of 2 Key Annuity Types, David Blanchett interview video.

[5] Why Retirees Should Choose DIAs over SPIAs - Articles - Advisor Perspectives, Wade Pfau, 2013.

[6] What Is a QLAC, and Why Might You Want One?.

[7] Note that these curves show the cumulative conditional probability of portfolio survival. Most studies show the probability, for instance, that a 65-year old's portfolio will survive to age 95. A Kaplan-Meier curve shows the probability that a retiree who actually lives to 80 and has not depleted her portfolio, for example, will experience portfolio failure at later ages. Retirees who have already died or already depleted their portfolios are not included in the Kaplan-Meier calculation of future probabilities.