New Ways to Think About Social Security Claiming

The classic way to analyze the Social Security claiming decision has been to focus on the breakeven age—that is, the age at which total benefits from later claiming begin to exceed total benefits from earlier claiming. When comparing the claiming ages of 62 vs. 70, the breakeven age is about 80, or 78 if COLAs are taken into account. When interpreting this mathematical result to clients, you would say something like, “if you think you’ll live beyond age 78, you should claim Social Security at 70.” Clients would then consider their health status, the ages of their parents and grandparents, and try to get an idea of how long they might be expected to live. Married couples would need to look at the respective life expectancies of each spouse; if at least one spouse could be expected to outlive the breakeven age (highly likely), the higher-earning spouse, at least, should claim at 70, since that higher benefit will keep going after the death of either spouse. You could say to a high-earning husband, “It almost doesn’t matter how long you live. What matters is how long your wife lives because she’ll take over your benefit if you die first.”

More recently the focus has been on Social Security as longevity insurance. Here, it doesn’t matter how long you think you’ll live. You can’t know that anyway. Rather, the idea is to maximize Social Security by claiming later just in case you do live a long time. After all, if you die before your breakeven age and realize on your deathbed that you won’t live long enough to recoup the lost benefits you could have received by claiming early, it reallys won’t matter at that point. What would matter, though, to anyone still alive and healthy, is living to a ripe, old age and wishing you had maximized your Social Security income in order to keep up with high and rising health care costs and other general expenses. Viewed this way, Social Security is like an insurance policy that pays out if you live too long.

Another way to think of the Social Security income stream is to convert it to net present value. This is an effort to translate all the future payments into one lump sum amount so it can be compared to other similar assets as of today. Some people think it is a better way to measure the breakeven age because it takes opportunity costs into account. The concept of net present value is indisputable: it acknowledges that a payment received in the future is worth less than a payment received today. If you had the payment today, you could invest it at some assumed rate of return and have that much more in the future. So when calculating net present value you have to take that future payment and discount it by the assumed rate of return to make it equivalent to a payment received today. What’s up for debate is what discount rate is appropriate for Social Security.

Michael Finke of the American College makes the case for a 0% discount rate. The reason is that Social Security is already adjusted for inflation. Any given future payment, because it will have been adjusted annually for inflation, is worth exactly the same as a payment made today. No discounting necessary. In other words, if you had all those COLA-adjusted future payments today, they would be worth the same as a lump sum that could be invested at a rate equal to the COLA. Whereas some have argued that you could get much more than the COLA rate by investing in a portfolio of stocks and bonds, Finke argues that for a true comparison you have to assume a rate of return equivalent to what you would get on an investment with the same risk profile as the Social Security formula, which is virtually guaranteed. He refers to TIPS (Treasury Inflation Protected Securities) as the equivalent investment and looks to their current market price, which, at the time of his writing (June 2021) suggested a negative discount rate. Round up and you’re at a 0% discount rate.

A new Kitces article by Derek Tharp broadens the discount rate discussion beyond expected value to include expected utility, which brings subjective pleasure or happiness into the equation. That is, when people can’t do the math in their heads or if some critical piece of information is missing (life expectancy in the case of Social Security), they make the decision that they think will bring the most happiness, even if it might carry less monetary value. This is reflected in people’s tendency to take $50 now rather than a coin flip that could pay $100, even though the theoretical value of both is the same. We all see this in the “I’m going to take my Social Security now so I can enjoy it while I’m young” claiming rationale.

Many of us work to refute these seemingly irrational decisions. Why would you take Social Security early when it’s clear from the software that if you live beyond your breakeven age—which, given your education and income level you are likely to do—you would receive more total dollars if you delay? This argument ignores the expected utility of the early-claiming decision: that the client will simply be happier if he takes Social Security now.

Tharp attempts to monetize this expected utility, along with other unknowable factors, by adjusting the discount rate. Michael Kitces has always argued that the discount rate should not be zero but rather reflect the rate an investor could earn on their actual investments (i.e., a 60/40 portfolio of stocks and bonds) rather than the theoretical Social Security equivalent (i.e., TIPS). This would suggest a discount rate of 4.89% based on average historical real returns (i.e., after inflation) from 1901 to 1922.

If claiming later carries the risk that you could have had more money if you’d taken benefits early and invested them, and if this risk can be quantified by discounting the future income stream by the assumed rate of return on invested assets, are there any other risk factors that might be quantified by adjusting the discount rate? For example, we all know that the sequence of returns carries real risks: your portfolio may end up averaging a 5% return after inflation over 20 years, but if it drops by 20% your first year, you’ll end up with less money in the end. In an example Tharp adds 2% to the discount rate to account for sequence of returns risk. He lists a number of other risks (mortality risk, regret risk, longevity risk) and shows how the discount rate might be adjusted up or down to account for them. In the example the base 4% discount rate based on the expected investment returns ends up being 8.5% after these other risks, unique to this client, are taken into account. This high a discount rate would probably lead clients to claim early as it would raise the breakeven age considerably.

News briefs

Social Security Claiming Reform Moves Past House Committee
“The House Committee on Ways and Means has advanced legislation that would make changes to Social Security terminology utilized in rules, regulation, and guidance. The bill, named the “Claiming Age Clarity Act,” was advanced in a vote of 41-1. If passed, it would substitute terms like ‘full retirement age’ and ‘normal retirement age’ to ‘standard monthly benefit age.’ It would also replace the term ‘early eligibility age’ with ‘minimum monthly benefit age,’ and reject the term ‘delayed retirement credit’ to be swapped with ‘maximum monthly benefit age.’ … If passed, the bill would begin making changes to the terminology no later than Jan. 1, 2027. Studies show that while confident, individuals remain confused over when they can begin claiming Social Security benefits. Financial professionals in a July report from Protective Life Corporation say they’re clients have felt confused, skeptical, and anxious when devising a plan to claim benefits, and one-third of individuals admit feeling unsure on when they can claim.” (401k Specialist)

Your Medicare Costs Are Set to Soar: What to Expect Over the Next Decade
“The 2025 Medicare Trustees Report projects a steady increase in Medicare Part B premiums and IRMAA surcharges over the next nine years. The projections are based on expected rises in healthcare costs, particularly for outpatient hospital services and physician-administered drugs. It’s crucial for retirees and those approaching retirement to understand these projections for proper financial planning. It’s essential to note that these projections are subject to change, and the official figures may vary. The Centers for Medicare and Medicaid Services (CMS) will release the official numbers this fall. The projections in the 2025 report show a significant increase compared to last year’s report. The largest year-over-year jump is expected between 2025 and 2026, with a projected increase of $21.50, setting the 2026 Part B premium at $206.50, up from $185.00. The 2024 report projected a 1% increase from 2025 to 2026, with premiums rising to $186.90, only $1.90 more. The report estimates that the standard monthly premium for Medicare Part B will potentially reach almost $350 by 2034. If the estimates are accurate, the Part B premium is expected to increase by 188% by 2034.” (Kiplinger)

Public Sector Workers Not Covered by Social Security: Implications for Their Retirement Security (PDF)
“Public sector entities seeking exemption from Social Security must demonstrate that they comply with the requirement that they sponsor a pension plan whose benefits are ‘comparable’ to Social Security. The most common method of demonstrating compliance is to show that the plan benefits are equal to or greater than a safe harbor that was established in 1991. But does the safe harbor truly ensure that benefits are comparable? This policy paper will attempt to answer that question. For career employees, the initial safe harbor benefit will typically be larger than the corresponding Social Security benefit at all but the lower salary levels. However, this may not be true in the long run because the safe harbor does not require cost of living adjustments, as does Social Security.” (American Academy of Actuaries)

More than Half of Older Workers Are Enrolled in High-Deductible Health Plans
“HDHPs appear entrenched as a coverage option under ESI. Not only have employers consistently offered HDHPs to employees, many of which are HSA-qualified plans, but workers, including those ages 50 to 64, continue to enroll in HDHPs at high rates. Furthermore, myriad factors continue to affect enrollment in HDHPs. Among them are high health care costs that put pressure on employers to trim health care spending, the attraction of HDHPs’ low premiums to workers, and the evolving landscape of ESI plan offerings. Whether these factors portend continued enrollment or further growth is unclear. The benefits and risks of health insurance plans with high deductibles vary among older workers. For example, people with higher incomes may be more likely to see benefits of having an HSA, which is available to them if they enroll in an HDHP. Meanwhile, a lower-income worker may find even moderate deductibles financially challenging and make health care choices, such as forgoing or delaying care, to avoid incurring predeductible expenses.” (AARP)

Rethinking Retirement A Four-Pillar Framework for Security and Sustainability
“Reforming the retirement system requires redefining the three traditional pillars to reflect today’s realities, as well as adding a new pillar.

• Mandatory state benefit: A minimum guaranteed benefit that provides income redistribution and replacement (Social Security).
• Secure income from retirement accounts: Savings funded by employers, individuals, or both (401(k), IRA, etc.) that are converted into predictable income to supplement Social Security. This income could come from annuities, laddered bonds, or other low-risk options. Secure income is financed from a retirement account, funded either by an employer or individual or both.
• Market-based savings: Retirement accounts and other savings invested in riskier, liquid assets, which can fluctuate with markets but help cover discretionary expenses such as travel or dining; the balance between pillar two (secure income) and pillar three (market assets) will vary by individual, depending on preferences and needs.
• Part-time work: Continued participation in the labor force, in flexible or reduced roles, in order to supplement retirement savings and Social Security.” (Manhattan Institute)

How Much Could Taxing Health Benefits Help Social Security?
“The brief’s key findings are:

• To fix Social Security’s finances, broad support exists for increased revenue to be at least part of the solution.
• This study focuses on one way to expand the payroll tax base: including the value of employer-sponsored health insurance (ESI).
• The results suggest adding ESI would raise payroll taxes by about $400 per year on average and reduce Social Security’s 75-year shortfall by about 25 percent.
• This option is somewhat regressive—as it would collect no additional taxes from earners above the wage cap—but it could be part of a larger reform package.” (Center for Retirement Research at Boston College)

Elaine Floyd, CFP®
Director, Retirement and Life Planning
Horsesmouth, LLC