Saturday, October 24, 2015

Does New Math Clearly Demonstrate that People Should Delay Commencement of Social Security Benefits When Possible?

Apologies to my non-US readers as I will once again take on the subject of when to commence US Social Security benefits.  This post is in response to the October 23 article in The Wall Street Journal entitled, "The New Math of Delaying Social Security Benefits”, in which Dr. Pfau concludes, “the math is clear:  People should delay claiming when possible.”

As I have discussed in several prior posts (most recently in posts of September 25, 2015, April 16, 2015 and August 9, 2014) and based on the “old math” built into the simple Social Security Bridge spreadsheet on this website, deferring commencement of Social Security benefits can be a reasonably good strategy for many individuals, but it may not be all that it is cracked up to be by the media experts. 

I’m going to use the same example person in this post as Dr. Pfau used in his article (which I suggest that you read because I’m not going to repeat the entire example here).  His example person sets aside assets of $316,800 in a non-interest bearing account to pay herself $39,600 per year (the age 70 Social Security benefit without CPI increases) during the eight year bridge period (from age 62 to age 69) during which no Social Security benefits are paid.  He then determines that the initial withdrawal rate at age 62 from remaining assets necessary plus the withdrawals from this artificial Social Security replacement account to meet a $60,000 annual real dollar total income level is only 4.22% vs. a 4.69% initial withdrawal rate necessary to meet the $60,000 total income level if she commences her Social Security benefits at age 62.  From this comparison of initial age 62 withdrawal rates, Dr. Pfau concludes that it is financially advantages for everyone to defer commencement of Social Security from age 62  until age 70.

If we assume inflation of 2.5% per year and we assume that the example retiree wishes to pay herself the expected age 70 Social Security benefit in real dollars each year during the bridge period, she will need to set aside assets of $345,951.  Under these assumptions, the initial age 62 withdrawal percentage to achieve the $60,000 income target will be 4.49% ($60,000 – $39,600)/ ($800,000 - $345,951) vs. the 4.69% withdrawal rate if she commenced Social Security at age 62.  This example still favors the deferral strategy, but not by quite as much.

If we also assume investment return of 4.5% per annum on the example retiree’s assets not set aside for bridge purposes, at age 70, she will have remaining assets of $428,583 to go with her Social Security benefit of $48,249 ($39,600 plus eight years of CPI increases of 2.5% per annum).  By comparison, if she commenced benefits at age 62, she would have $738,560 of remaining assets at age 70 and a Social Security benefit of $27,414.  Thus, under these assumptions, she effectively spends $309,977 ($738,560 - $428,583) of her expected assets at age 70 ($35,974 less than the $345,951 she set aside) to obtain an additional $20,835 ($48,249 - $27,414) of fully CPI-indexed Social Security benefits commencing at age 70. 

As noted in prior posts on this subject, deferring commencement of Social Security can increase total retirement income under most reasonable assumptions.  This strategy also adds inflation protection and can provide larger benefits to your spouse.  If you want to retire and adopt the commencement deferral strategy, you have to be willing to dip into your accumulated savings to make it work (and therefore this strategy may involve loss of some spending flexibility).  The degree of success of the commencement deferral strategy will depend on the investment return you could have earned on the "bridge payments" you withdraw from your accumulated savings, the rate of future inflation, how long you live and how much of your accumulated savings you spend during the bridge period.  Assuming Social Security law remains unchanged, it can be an effective way to mitigate inflation risk, investment risk, and longevity risk.  In a very real sense, the decision to defer is analogous to using your savings to purchase additional longevity insurance/real annuity income.  However, under most reasonable assumption scenarios, you aren’t likely to see the increases in total retirement income that you might have expected from reading articles on this subject by the retirement experts. 

I recommend that retirees who are reasonably comfortable spending a significant portion of their accumulated savings up front during the bridge period consider the commencement deferral strategy.  On the other hand, I am also sensitive to retirees who could have made this decision but didn’t or who are just not comfortable with this strategy.  To them I say, Don’t listen to those experts who say that not deferring until age 70 is one of the biggest mistakes you can make in retirement.  Move on with your life based on the decision you made (or will make).  If it is indeed a mistake not to defer, it is probably not the biggest mistake you will make in retirement. 

As with all my prior posts on this subject, I (and Dr. Pfau in his article) looked at non-married individuals.  The factors involved in a decision to defer can be different for a married individual under current law.