Deferring Commencement of Social Security Benefit is OK, Deferring Retirement is Better

There have been a number of articles recently touting the benefits of deferring commencement of one's Social Security benefit.  For example, in my post of December 8 of last year, I quoted the author of one such article who said, "Rather than annuitizing retirement wealth, participants can get a much better deal by spending down retirement assets and deferring Social Security."  This post will examine a hypothetical situation in an attempt to quantify how much more retirement income a person could have by deferring commencement of his Social Security benefits.

Let's look at a 65 year old male with accumulated savings of $800,000 in 2014.  His Social Security Normal Retirement Age is 66.  He is eligible for a Social Security benefit of $2,000 per month (plus an inflation adjustment) if he retires at age 65 and commences his Social Security benefit at age 66, or $1,867 per month (.9333 X $2,000) commencing immediately if he retires at age 65 and commences at age 65.  Assuming annual inflation increases of 3% per annum, retirement at age 65 and deferral of his Social Security benefit until age 70, he would receive a benefit of about $3,060 per month (1.32 X $2,000 plus 5 years of assumed 3% per annum inflation increases).

The table below shows total spendable income available to the individual from accumulated savings, Social Security and, in the third scenario from a life annuity developed by using the simple spending spreadsheets found in this website and the assumptions recommended for use with the spreadsheets.  Readers are reminded that the spreadsheets provided in this website are designed to provide level real dollar total spendable retirement income from year to year over the expected payout period.

(click to enlarge)

Under Scenario 1, the individual retires at age 65 and commences Social Security immediately.  He uses the actuarial approach in this website (Excluding Social Security 2.0 spreadsheet) to determine his annual withdrawals from accumulated savings.

Under Scenario 2, the individual retires at age 65 but defers commencement of his Social Security benefit until age 70.  He uses the Social Security Bridge spreadsheet to determine the extra withdrawals from his accumulated savings that will, when combined with deferred Social Security benefit, provide level real dollar spendable income from year to year.  In this instance, the present value at 5% interest of those extra "bridge" payments is $152,480.

Under Scenario 3, the individual retires at age 65 and commences Social Security immediately.  He takes $152,480 of his $800,000 retirement nest egg and buys a life annuity.   I used a purchase rate of $14.03 per each dollar of annual income obtained from Incomesolutions.com to determine the immediate life annuity payable at age 65.

As the table shows, total retirement income is comparable for the first three scenarios with the deferral strategy (Scenario 2) being somewhat better than the immediate commencement and no annuity purchase strategy (Scenario 1) but only slightly better than using the same amount of money to purchase a life annuity (Scenario 3) at current annuity purchase rates.

But, if this person really wants to get a significant increase in retirement income, he needs to work another five years.  Scenario 4 assumes that he continues to work until age 70 and retires at that point.  His accumulated nest egg in 2014 is assumed to earn 5% per annum and he is assumed to contribute $10,000 each year and his employer is assumed to contribute $2,000 each year.  While his Social Security benefit should increase somewhat as a result of five additional years of earnings and tax payments, we have assumed it would remain the same.  Under these assumptions, his benefit at age 70 is at least 35% higher than the benefits payable at age 70 under the other strategies.

Take Away:  Deferring receipt of Social Security may be able to get you a little more retirement income (depending on assumptions employed and actual experience), but if you really want more retirement income, you need to defer both your retirement and Social Security benefit commencement date.  This strategy works for you in two ways--it should increase your accumulated retirement nest egg and it reduces the expected payout period. 

Back to How Much Savings is Needed

The primary focus of my posts is on how much accumulated savings can be spent each year in retirement.  But since that amount is generally linked with how much accumulated savings one has, readers will forward me articles aimed at pre-retirees looking for advice on how much they need to have saved at retirement. 

I have addressed this issue somewhat in this article and most recently in my post of May 31 of last year where I concluded that if you don't have sources of retirement income other than Social Security, you probably shouldn't be too worried about over-saving until you have accumulated at least 10 times your annual salary. 

This past week, I read "Have You Saved Enough to Retire?" and "Why not even $1 million may not be enough for retirement".

The first article references Fidelity's very optimistic "8 times" rule, which claims that if you are an "average worker", retire at age 67, die at age 92 and accumulate savings of 8 times your pay at retirement, you can enjoy total retirement income (Social Security and withdrawals from accumulated savings) of approximately 85% of your gross pre-retirement pay.  Based on the recommended assumptions in this website (5% investment return, 3% inflation and payments until age 95), I come up closer to a 70% replacement rate.  Of course, Fidelity assumes that you will earn an average nominal rate of return of 7.5% per annum with 2% inflation (a real rate of return of 5.5% per annum).  If I input Fidelity's assumptions in the "Excluding Social Security 2.0" spreadsheet on this website, I do get a replacement rate of 88%, so, at a minimum, I can confirm Fidelity's calculations, if not the reasonableness of their assumptions.

The second article argues that $1 million in accumulated savings at retirement may not be enough.  Whether it is enough will depend on many things, but I can provide some spending numbers associated with having $1 million in accumulated savings and you can make up your own mind.  If Social Security income is around $30,000 per year (about the maximum in 2014) and no other retirement income sources exist, then total annual gross retirement income (Social Security and withdrawals according to the approach outlined in this website) for an individual retiring at age 67 with $1 million of accumulated savings will be about $75,000 to $80,000 depending on how much of the $1 million is used to purchase an immediate annuity (based on current annuity purchase rates) and/or whether the retiree delays receipt of Social Security benefits.  This level of retirement income will probably be enough for many individuals who retire in the near future.  Keep in mind, however, that it assumes retirement occurs at age 67 with $30,000 in annual Social Security income.   

As an actuary, I tend to be fairly conservative.  I wish I could tell pre-retirees that you don't need to accumulate all that much to afford to retire, but in all good consciousness, I just can't.  If you want, you can certainly plan your retirement by assuming that you will earn a 5.5% real rate of return on your retirement assets, there will be no reductions in Social Security benefits, or you will retire later than age 67, etc.  Or, you can follow the more conservative path and save more now for your retirement. 

Delaying Commencement of Social Security--Internal Annual Real Rate of Return Calculations

Dr. Wade Pfau has produced another fine article of interest to individuals who are in a position to delay commencement of their Social Security benefits.   As discussed in several of our previous posts (most recently December 8, 2013), there are at least two ways to delay commencement of Social Security benefits.  One can keep working, or one can retire prior to age 70 and use their accumulated savings to "bridge" the period of delay by paying themselves what they would have received had benefits commenced earlier than age 70.  We have a spreadsheet to enable individuals to see how such a bridging approach could affect their total retirement spending budget.

In Dr. Pfau's article, he has determined internal annual real rates of return assuming death occurs at various ages for individuals with a Social Security Normal Retirement Age of 66 assuming commencement at age 62 vs. delaying commencement until age 70 and subsequent death at a later age.  He also assumes no changes in current Social Security law.  So, for example, he has determined a 3.2% internal annual real rate of return for an individual who dies the day before his 85th birthday (at age 84) resulting from his decision to delay commencement until age 70.  So, if inflation is 3% per annum, this example individual who elects to delay commencement of Social Security until age 70 and use his accumulated savings to bridge the payments he would have received will be financially better off provided he does not earn more than approximately 6.2% per annum (3.2% real) on his accumulated savings and the Social Security benefits he receives.

As shown in the article, internal annual real rates of return are lower than 3.2% if the individual dies earlier than age 84 and higher for deaths occurring after 84.  So, if you definitely know that you are going to live past your mid-80s, the delay strategy appears to be a good one unless you anticipate earning relatively high real rates of returns on your investments or changes in the Social Security law. 

Several Wade Pfau Posts

A first for me this week--An individual actually asked me why I hadn't posted on this site in over two weeks.  Of course it was just Bob, a fellow Baritone in my singing group, but I will take his comment as encouragement (which is unusual for Bob as he is usually all over me for singing the wrong notes and/or the wrong dynamics).  

Readers of this blog will know that I frequently refer them to Wade Pfau's Retirement Researcher Blog for excellent discussions of retirement income issues.  This past week, Wade posted two more such discussions.

In his March 27 post,   he has listed and classified known retirement income strategies.  Readers with good eyes will see that the Actuarial Approach recommended in this website resides in the bottom box as a Variable Spending strategy residing under the general classification of Probability-Based Approaches.

In his March 24 post, Wade refers to two of his articles discussing risks in retirement and presents a Taxonomy (classification) of Retirement Risks.  I would add "not spending enough" to the lower right hand quadrant of his chart as this risk can be almost as problematic as spending too much.

As I have mentioned several times in this blog, it would not be unreasonable for a retiree to manage these risks in retirement by diversifying their sources of retirement income.  For many retirees, I believe the best approach involves combining Social Security, life insurance annuity (or long-term care) products or pensions, with a good systematic withdrawal strategy.   

Shopping Around for Withdrawal Strategies That Will Give You a Higher Withdrawal Rate?

As discussed in our post of March 1, the JP Morgan withdrawal strategy produces a higher withdrawal rate than the withdrawal strategy recommended in this site when our recommended assumptions are used.  Several readers commented that this was a big plus in the JP Morgan column, especially for individuals who want to front-load spendable income earlier in retirement or for others who have lifestyle spending goals that simply aren't achieved by using more conservative withdrawal strategies.  We caution retirees against selecting a withdrawal strategy simply because it produces a higher initial withdrawal rate.

The withdrawal approach set forth in this website produces a total retirement spending budget that is designed to remain constant in inflation-adjusted dollars if all input assumptions are correct and the spending budget is actually spent each year.  That part of our approach is just simple math.  Our approach also gives the retiree a recommended process for dealing with the inevitability that the input assumptions will not be correct or actual spending will differ from the budget amounts.  To make it a little easier for some to use our approach, we have recommended what we believe to be fairly conservative input assumptions:  currently 5% nominal investment return, 3% desired increases/inflation and an expected payment period until age 95 (or life expectancy if later).

If the withdrawal rate using our approach with recommended assumptions is lower than desired,  a retiree is free to change the recommended input assumptions to reach a higher withdrawal rate using any kind of rationale the retiree chooses (i.e., I can earn an annual investment return greater than 2% real, I won't live longer than my life expectancy, I can live with retirement income that decreases in inflation-adjusted dollars, etc.).  The retiree can also simply choose to spend more than the budget amount and live with the consequences.  Retirees should of course note that higher initial withdrawals will mean lower subsequent withdrawals, all things being equal, and there are no guarantees when you choose to fund some or all of your retirement through periodic withdrawals from accumulated savings, irrespective of the withdrawal strategy you use.  

Follow-Up to JP Morgan Post

Several individuals took me to task for criticizing JP Morgan's conclusion that "greater lifetime income through... pensions and/or lifetime annuities allows individuals to increase both their withdrawal rates and equity allocations."  While this may appear to be a "logical" conclusion, particularly for investment allocations, the math just doesn't support this conclusion as it applies to withdrawals rates.  Retirees who desire reasonably constant spendable income in retirement, should decrease, not increase, withdrawal rates from accumulated assets as the amount of their fixed immediate life annuity/pension income increases, all things being equal.

As an example, Let's go to the "Excluding Social Security 2.0" spreadsheet on this site.  If we enter $1,000,000 in accumulated savings, $0 immediate life annuity, 5% annual investment return, 3% per annum desired annual increases, 30 year payout period and $0 bequest, we get an initial withdrawal rate of 4.34%.  If we assume 3% inflation, the inflation-adjusted run out tab shows that annual withdrawals are expected to remain constant over the expected 30-year payout period.

However, if we input a fixed immediate payment of $20,000 per year, the initial annual withdrawal rate drops from 4.34% to 3.75% to keep total annual spendable income (withdrawals from accumulated savings plus annual annuity payment) constant in real dollar terms over the expected 30-year payout period.

Finally, if instead of $20,000 per year fixed annuity payment, we input $40,000, the initial annual withdrawal rate drops from 3.75% to 3.15%.

JP Morgan's Dynamic Withdrawal Strategy

JP Morgan has recently released its research on dynamic retirement income withdrawal strategies entitled, "Breaking the 4%Rule". 

As someone who has frequently ranted on this website against the 4% Rule and encouraged the use of a dynamic retirement income withdrawal strategy, I recommend this paper to readers of this blog.  In many ways, the expressed goals of the JP Morgan withdrawal strategy are similar to the goals of the withdrawal strategy suggested in this website.  The JP Morgan paper also combines its withdrawal strategy with an investment allocation strategy, which I do not address in this website as I have no investment expertise.

In addition to attempting to carefully balance lifestyle risk and longevity risk, JP Morgan also attempts to "maximize how much utility value investors receive from their withdrawals."  This utility value maximization is also not something that I address in my recommended withdrawal strategy.

Some concerns I have with the JP Morgan Strategy:

The withdrawal schedule is significantly more aggressive than withdrawal rates recommended in this website.  For example, JP Morgan specifies an initial 5.9% withdrawal rate for a 65 year old with $1,000,000 in accumulated savings and $50,000 in "lifetime income".  Based on the assumptions recommended in thiswebsite and zero bequest, I get a withdrawal rate of 3.45% using the Excluding Social Security 2.0 spreadsheet if I assume $30,000 of the $50,000 of lifetime income is in the form of a fixed immediate annuity (with the remaining $20,000 payable from Social Security).  The main reasons the JP Morgan withdrawal rate is so much higher is that their model assumes higher future investment returns, lower future inflation, a shorter payout period and does not anticipate using accumulated assets to provide for future inflation adjustments to fixed payment "lifetime income."  If comparable assumptions are used for both models, I would anticipate results to be very similar for the initial year's withdrawal.

Additionally, the JP Morgan strategy does not appear to have relatively constant inflation adjusted retirement income as a goal.  Therefore, all things being equal, their withdrawal strategy would be expected to be more volatile from year to year than the approach recommended in this website when measured in inflation adjusted dollars.

Because the JP Morgan paper was critical of the performance of the 4% Rule in volatile markets, "especially when a portfolio loses significant value during the early years of retirement" I decided to calculate spending budgets and remaining assets under the JP Morgan strategy and the Steiner Actuarial Approach (using recommended assumptions and smoothing methodology) for a hypothetical retiree where asset returns are somewhat unfavorable.  The two graphs below  compare retirement spending budgets (withdrawals from accumulated savings + Social Security + fixed pension) and remaining assets under the JP Morgan Dynamic Strategy with the Steiner Actuarial Approach for someone retiring at age 65 with $1,000,000 in assets, $20,000 in annual Social Security and $30,000 in fixed pension/life annuity income (for a total of $50K) of "lifetime income". 

I assumed about a 0% average annual rate of return for this hypothetical retiree's first five years of retirement with the following randomly chosen rates of investment return:  year 1: -15%,  year 2: 2%, year 3: 5%, year 4: -5% and year 5: 15%.  I also assumed 3% inflation each year.  I used the withdrawal rate table included in the JP Morgan article to determine withdrawal rates and I interpolated between relevant wealth and age factors.  I ignored the fact that inflation increases in the retirees Social Security benefit would increase the retirees "lifetime income" and thus perhaps slightly increase the retiree's withdrawal rate under the JP Morgan approach.  I also assumed that the JP Morgan withdrawal rate tables (and the Steiner recommended assumptions) would remain unchanged for the entire 5 year period.  For each approach, I assumed that the annual budgeted amount determined under the relevant approach would be spent during the year.

Comparison of Budget Amounts In Inflation-Adjusted Dollars

Comparison of Remaining Asset Amounts

The graphs show that based on this assumed investment experience,  the JP Morgan strategy produces a spending budget that is somewhat more volatile (when measured in inflation adjusted dollars) than the Steiner Actuarial Approach.  Because it is more aggressive than the approach in this website (based on recommended assumptions), it produces higher spending budgets each year and therefore lower remaining assets at the end of the five year period.  Is the JP Morgan strategy better than the Steiner Actuarial Approach?  I don't believe its use of Monte Carlo simulations or utility value maximization necessarily make the JPMorgan strategy superior.  If comparable assumptions are used, results under the two methods can be comparable, and the smoothing algorithm in the Steiner Actuarial Approach results in more real dollar stability in the retiree's spending budget from year to year.   The Steiner approach is also readily available on this website.  

The Actuarial Approach and Withdrawal Policy Statements--Its in There!

In his February 26 post, Michael Kitces encourages the use of a written Withdrawal Policy Statement to ensure that retirees have a plan for dealing with market declines.

The Actuarial Approach described in this website automatically adjusts spending not only for market declines (or spending more than the budget) but also for favorable experience (or spending less than the budget).  So like the slogan in the old Prego commercial goes--"Its in There!"

Anticipating "Lumpy" Expenditure Needs

As indicated in previous posts, I believe it is not unreasonable to manage risks in retirement by diversifying sources of retirement income.  This article discusses research that explains why individuals are "more likely to select an annuity option when a 'partial' option is offered instead of an 'all or nothing' option."  I especially liked the comment from one of the researchers who said, “If you anticipate lumpy expenditure needs in retirement (e.g., out-of-pocket medical expenses), you want some liquid wealth to cover those expenses."

Comparison of Four Withdrawal Strategies Based on Recent Experience

In my previous post of January 16, I stated my belief that each of the three systematic withdrawal options examined in the Stanford/SoA study was inferior to the actuarial approach advocated in this website.  While I was critical of the three approaches for not even attempting to focus on total retirement income by coordinating with annuity income that the retiree may currently have or expect to have in the future, I think that each of the three approaches have shortcomings even if the retiree has no other sources of income.  In this post, I will illustrate those shortcomings with an example that uses historical investment and inflation experience from 1998 to the present. 

Let's assume that Rachel retired on her 65 birthday on January 1,1998.  At that point, she had $500,000 in accumulated savings in addition to her Social Security benefit.  Since she was single with no children, she had no desire to leave money to heirs.  She wanted to maximize her income in retirement, particularly in her younger retirement years (when she wanted to travel more).  On the other hand, she did not want to outlive her savings.  She decided to invest the assets not budgeted for spending each year 25% in large cap equities, 25% in mid-cap equities, 25% in mid-term bonds, and 25% in short-term bonds (which she rebalanced at the end of each year).  Unfortunately, Rachel died in a car accident on January 1, 2014.  She had just turned 81. 

The graph shows withdrawals under the three different strategies discussed in the previous post compared with withdrawals under the actuarial approach advocated in this website.  All amounts are shown in 1998 dollars.  In using the actuarial approach, Rachel looked at annuity purchase rates in 1998 and decided to determine her first year's withdrawal assuming 7% investment return, 4% inflation and death at age 95.  In 2004, when interest rates had decreased somewhat, she changed the assumptions to 6% investment return, 4% inflation and in 2009 she changed to the now recommended assumptions of 5% investment return, 3% inflation.  She also used the recommended smoothing algorithm. 

None of the four strategies would have been successful in meeting Rachel's objective to die with only a small amount of assets remaining.  She expected to live well past age 81 and her investments did much better than she assumed (on average).  Following the actuarial strategy, she would have died with $626,635 remaining.  But this approach was better than the other three approaches in meeting Rachel's objective, as she would have $786,436 remaining under the IRS Required Minimum Distribution approach, $804,358 under the Constant 4% approach and $827,504 under the 4% Rule.

And while the 4% Rule produces a ruler-flat inflation adjusted withdrawal pattern, it failed to maximize Rachel's desire to maximize spending.  The other two approaches also failed to maximize spending and their withdrawal patterns were much less stable from year to year than under the actuarial approach.  Based on experience from 1998 to 2014, the clear winner of the four approaches in terms of meeting Rachel's objectives is the actuarial approach.