Thursday, April 16, 2015

Delaying Commencement of Social Security vs. Buying a QLAC—Which Is the Better Strategy?

May 28, 2015 Note: This post has been revised to correct some minor errors.

There is no shortage of articles out there advocating delaying commencement of Social Security as a no-brainer strategy to increase spending in retirement.  Several experts have indicated that delaying commencement of Social Security is hands down the best long-term investment money can buy. These articles encourage individuals who have retired to spend what may be a significant portion of their accumulated savings during the period of deferral in order to collect a much larger Social Security benefit down the road (typically at age 70). While I have agreed in prior posts (see the post of August 9, 2014 for example) that this deferral strategy can increase annual retiree spending budgets, it does come with its own set of risks and does not always live up to the hype used to sell it. In this post, I will compare the Social Security deferral strategy to the strategy of using roughly the same amount of accumulated savings to purchase a Qualified Longevity Annuity Contract (QLAC), which I have also discussed in prior posts (see the post of February 25, 2015 for an example).

In our post of February 25, 2015, we took a look at a hypothetical retiree, Mike, a single 65-year old male with a 401(k)/IRA balance of $750,000 and a potential Social Security benefit payable immediately of $16,800 per year.  Using the Excluding Social Security spreadsheet in this website and the recommended assumptions, Mike developed a first year spending budget of $49,427. Using the Social Security Bridge spreadsheet and the same assumptions, Mike determines that if he defers commencement of Social Security until age 70, his Social Security benefit will increase to about $26,880, and his spending budget, starting at age 65 and remaining constant in real dollars for the next 29 years, will increase from $49,427 to $51,412, an increase of $1,985 per year. He also determines that he must effectively spend a present value of $114,329 of his 401(k)/IRA balance in order to implement this strategy.

Yesterday Mike went to to check out the amount of annual payments he could receive under a deferred annuity contract commencing at age 85 (with no death benefit) with a premium of $114,329 (the same cost as the Social Security deferral strategy). The website said that his annual benefits commencing at age 85 would be almost $60,000.  Mike is a little bit skeptical of this result as it is significantly higher than the benefit amount shown on this website just a couple of months ago. He knows that the QLAC market is not yet robust, but he decides to see what the effect on his spending budget would be if he spent $114,329 on a QLAC that gave him a benefit of $52,000 (not $60,000) starting at age 85. So he enters $635,671 ($750,000 - $114,329) as accumulated assets, an annual deferred benefit of $52,000 starting in 20 years (by entering 21 in the spreadsheet) and the recommended assumptions. The Excluding Social Security spreadsheet tells him that his spending budget under these input items would be $35,409 to which he adds his non-deferred age 65 Social Security benefit of $16,800 to get a spending budget of $52,209, or $2,782 higher than his base spending budget and $797 higher than the Social Security deferral strategy spending budget. So, based on realization of all the assumptions in these spreadsheet calculations (and the slightly lower assumption for the QLAC benefit payable at age 85), the QLAC strategy appears to be the better strategy for Mike.

But, not so fast here. We know that future experience will deviate from our assumptions. Future interest rates will change, future investment returns will not be 4.5% per annum, future inflation will not be 2.5% each year, Social Security benefits may be reduced, QLAC pricing may become more robust, etc.  There is a great deal of uncertainty about the future that makes comparison of these two approaches difficult.

Both strategies involve generation of mortality credits by virtue of mortality risk pooling that you don’t get when you self-insure.  These mortality credits are used to pay larger benefits to individuals who live longer (the winners, if you will) and come from payments not made to individuals who die earlier (for lack of a better term, the losers). The bet inherent in both of these strategies is won only if the individual lives longer than average. The QLAC strategy is a bigger bet in this regard than the Social Security deferral strategy with a potentially bigger mortality credit payoff for those who live past age 85. This larger mortality credit is the reason the QLAC approach appears to be the better strategy for Mike under the spreadsheet assumptions.

On the other hand, Social Security provides survivor benefits and inflation protection not provided by the QLAC. If annual inflation is 4.5% rather than 2.5%, the Social Security deferral strategy becomes the better strategy (in terms of increasing the spending budget) as QLAC payments are fixed and Social Security benefits are indexed to inflation (under current law).

There is another hand, however, with Social Security. To digress a little here, this reminds me of the old actuary joke about the actuary who used the phrase, “on the other hand” so frequently in explaining the plusses and minuses of different approaches that her client asked her firm to replace her with a “one-handed” actuary. Anyway, like it or not, there is nothing in the current Social Security law that prevents Congress from changing Social Security law with negative effects on individuals, even those who may have elected to defer commencement of benefits. As I indicated in my post of March 1, 2015, Social Security actuaries predict that benefit payments will have to be reduced by about 23% across the board if no action is taken by Congress prior to 2033. There are experts who say that the Social Security deferral approach is still a good option even if benefits are reduced by 23%.  Of course, there is nothing that guarantees the reduction will be 23% across the board. It is possible that Congress could decide that the benefits payable to retirees with lower levels of retirement income should be protected.  In that event, reductions for more affluent retirees would have to be greater than 23%. Just yesterday, for example, Chris Christie made headlines by proposing to phase out Social Security benefits for those with retirement incomes in excess of $80,000. So an individual who chooses the Social Security deferral strategy needs to be aware that there is a possibility that future Social Security benefits could be reduced or eliminated, thus negatively affecting the expected benefits of the deferral strategy, even for individuals with greater than average longevity. 

As discussed above, the QLAC market is not yet robust. There are far too few insurers in the market at this point. In addition, if you believe that interest rates are going to rise in the future, now may not be the best time to purchase a product which essentially combines long-term bond investments with mortality credits. Higher future real interest rates will favor the QLAC strategy (assuming purchase takes place in the future) relative to the Social Security deferral strategy unless the law is changed to increase actuarial adjustments for benefit deferral.

Bottom line:
Both the Social Security deferral strategy and the QLAC strategy can be used to increase retiree spending budgets. The strategy that is more effective in this regard will depend on what actually happens in the future.  Not knowing what the future holds, it is just too difficult for me to proclaim a “no-brainer” winner at this time. I do believe that both strategies are worthy of consideration by retirees and/or their financial advisors, and that those interested in pursuing the QLAC strategy should keep a watchful eye on QLAC pricing in the months ahead.