- Delaying commencement of Social Security
- Buying an immediate life annuity (Single Premium Immediate Annuity or SPIA)
- Buying a deferred life annuity (or Qualified Longevity Annuity Contract (QLAC))
- Electing the life annuity option under defined benefit pension plan
Most of the above options address investment, longevity and cognitive decline risks, but generally only Social Security (and therefore the delay commencement of Social Security strategy) addresses inflation risk as well. As a follow-up to our recent posts and our post of April 16, 2015, in this post we will update our previous comparison of Strategies 1 and 3 and add Strategy 2 for those individuals who may be considering building their floor portfolios with extra low-risk investments. In summary, because Social Security provides inflation protection as well as spousal and survival benefits, we believe the delay commencement of Social Security strategy is still generally more robust than the other extra low-risk options for most individuals at this time, even though it is subject to some political risk. If this option is not available to you, because, for example:
- You are Canadian (or live in some other non-US country),
- You are otherwise not eligible for Social Security,
- You have already commenced your Social Security benefits and received them for longer than a year, or
- You are over age 70,
Because of their longer life expectancies, delaying commencement of Social Security benefits will generally be more effective at reducing retirement risk for single females than for single males when compared with the QLAC and SPIA alternatives. For this reason, we will show example comparisons for both a single 65-year old male and a 65-year old female. We will not show comparisons for married couples.
Data and Methodology used in the Comparisons
Our two hypothetical individuals are both age 65. One is a single male and the other is a single female. They both have accumulated savings at the beginning of 2019 of $600,000. They are both eligible to receive an immediate early Social Security benefit of $18,667 (reduced for one year from the $20,000 primary insurance amount payable at their full normal retirement age of 66). They estimate that if they delay commencement until age 70, they each will be eligible to receive $29,148 per year ($20,000 X 1.32 and further increased for 5 years of inflation estimated at 2% per year). For comparison purposes, they are assumed to have no other assets and no future spending liabilities other than their expected annual recurring spending. They estimate their annual recurring essential expenses to be $25,000 per year and would like their floor portfolios to consist of extra low-risk assets to cover these expenses.
Base case—in the base case situation, they are assumed to commence Social Security immediately. They enter their information in the Actuarial Budget Calculator (ABC) for single retirees and the male determines his annual recurring spending budget for 2019 to be $45,465, while the female’s is $44,180. They note that their floor portfolio in this base case (the present value of their Social Security benefits) is insufficient to fund the present value of their assumed essential expenses of $25,000 per year based on the default assumptions used in the workbook. Based on these assumptions, the present value of their essential expenses would be $559,745 ($25,000 X 22.3898) for him and $587,943 ($25,000 X 23.5177) for her. As a result, they decide to explore options that may increase the size of their floor portfolios.
#1—Delay Commencement of Social Security until age 70—They input the estimated age 70 Social Security benefit and 5 years of delay in the workbook and see that their current year recurring spending budget increases to $47,525 for him and $46,512 for her. By looking at the run-out tab of the workbook, they see that withdrawals from accumulated savings during the first five years under this option would be much greater than under the base case. The present value of the additional withdrawals for the first five years under this option is $99,725 for him and $101,035 for her. They decide to set aside these amounts and invest them in very low-risk cash equivalent investments. They consider the amounts set aside for these Social Security bridge payments to be part of their floor portfolio under this option. Therefore, the present value of their floor assets (including the present value of amounts set aside to replace deferred Social Security benefits) would be expected to cover the present value of their future essential expenses under this option.
#2 and #3—SPIA and QLAC annuity purchases. Instead of using the present value of Social Security bridge withdrawals to fund recurring expenses for the next five years, Options #2 and #3 assume that this same amount is used to purchase either a single premium immediate annuity commencing at age 65 or a deferred annuity commencing at age 85, with no payment if death occurs prior to that date. The following monthly rates per $100,000 of premium were obtained several days ago from Immediateannuity.com:
Results. The two tables below show results for the base case and the three options. As discussed above, the total floor portfolio in these tables consists of only extra low-risk investments.
In these examples, the delay commencement of Social Security option increased the male’s base case spending budget by about 4.5% and the female’s by about 5.3%. This is consistent with results discussed in previous posts (most recently in our post of December 11, 2017), where we indicated that retiring and deferring commencement of Social Security benefits (but not past age 70) is expected to increase one’s annual recurring spending budget by about 1% for each year of deferral. By comparison, we noted in that post that continuing to work in full time employment was expected to increase one’s spending budget by about 8% for each year of additional employment and Social Security deferral, so deferring actual retirement is much more powerful than retiring and simply deferring commencement of Social Security.
Many retirement experts indicate that deferral of commencement of Social Security benefits is a “no brainer”, at least for those who are reasonably healthy. It should also be noted that the calculations above assume the male lives until 94 and the female lives until 96. They also assume that the Social Security bridge assets set aside to meet spending for the first five years of retirement (and considered as “floor assets”) will earn 4% per annum. So, it can be argued that the actual increase in recurring spending budgets expected as a result of this option may be even less than 1% per year of deferral. Further, the few opponents of this option point out that Social Security benefits can be amended with the stroke of a pen and, given its current financial situation, future benefit cuts are likely. In addition, those who expect higher future returns on equities argue that this option (as well as the annuity purchase options) costs individuals too dearly in terms of lost returns on the assets used to fund the bridge period (or buy annuities). Therefore, not everyone believes that this option is necessarily a “no-brainer.”
All of the above extra low-risk options are expected to increase our example individuals’ annual recurring spending budget and increase their total floor portfolios above the level expected to fund their essential expenses. Based on recent annuity quotes, it appears that the QLAC option is a little more efficient than the SPIA option in increasing current spending budgets and floor portfolios than the base case option. The QLAC option appears to be a little more efficient than Social Security delay option for the male and a little less efficient for the female. Note, however, that the QLAC is subject to inflation risk and, as discussed below, possible cash-flow risk.
Caveats/ other items to consider
The comparisons in this post are based on deterministic assumptions about longevity, investment return and inflation. It is certainly possible that more robust comparisons can be obtained using stochastic assumptions. Before actually changing your investment strategy, you may wish to consult a financial advisor who employs a reasonable Monte Carlo model that can provide you with probabilities under various strategies of future spending exceeding specified levels.
As discussed above, while the extra low-risk investments discussed above provide certain guarantees, they are not entirely risk-free and therefore will not 100% guarantee any specific level of future real spending. Life annuities and pension annuities are generally paid in fixed dollars and are therefore subject to inflation risk and other possible financial risks. Also note that both the delay commencement of Social Security option and the QLAC option can involve potential cash flow risks, as accumulated savings may run out (or be significantly diminished) before Social Security or the QLAC benefits commence. Given the longer potential period of deferral under the QLAC option, this “cash-flow risk” is greater under the QLAC option than under the delay commencement of Social Security option. For example, while the total floor portfolio exceeds the present value of our example male’s expected essential expenses of $25,000 per year under Option 3, he must rely on his Social Security of $18,667 (increasing each year with inflation) and his riskier investments to fund the twenty years prior to commencement of his QLAC benefit of $42,543 per annum (or $28,630 in today’s dollars based on an inflation assumption of 2% per annum). Therefore, there is some risk that his total spending could fall below his “essential” $25,000 target level during this 20-year deferral period under the QLAC option. These potential cash flow issues are generally not a problem with SPIAs.
Annuity purchase rates can and do change frequently. These changes will affect future comparisons of the various options. We encourage you to use our workbooks to do your own calculations (and/or consult a financial advisor) if you are interested in exploring these options (or if you are considering a lump sum buy-out offer with respect to your defined benefit pension as we will discuss in our next post).
Conclusion
One of the more important tasks involved in retirement planning is to determine how much of your assets to allocate to your boring and less-risky floor portfolio and how much of your assets to allocate to your sexy, potentially more lucrative but more-risky upside portfolio. Complicating this task is the question of which assets to consider as part of your floor portfolio—those that simply reduce investment risk or those that also reduce longevity or inflation risks (extra low-risk investments). Finally, this task is further complicated by the fact that even the extra low-risk investments can still carry some (or different) risks. This post compares some of these extra low-risk investments for two example single individuals and shows you how you can use our workbooks to do your own comparisons.
