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Social Security Benefits and the Time Value of Money: An Example

Occasionally, someone asks me for an explanation of the mechanics of discounting future values to get present value equivalents. In this post, I provide an illustration of those mechanics. You can find some additional discussion on our main website.

Suppose that Mary, a single female, is turning 62. She will receive $25,000 a year if she claims at that age. Over a normal life span, up to age 86, she will receive a total of $625,000 (ignoring any COLAs).

A serious problem with this total amount is that it assumes that the $25,000 received 25 years from now has the same value to Mary today as the $25,000 she will get over the next year. Clearly, these two amounts don’t have the same present value: $25,000 25 years from now is worth a lot less than $25,000 received over the next 12 months.

The conventional method for translating future values into present value equivalents is to discount those future values by a discount rate (or discount factor). For our calculations, we use a 3% real discount rate (that is, 3% over and above any inflation).

So, the present value of $25,000 to be received next year would be calculated as: $25,000/1.03 = $24,272. In other words, at a 3% discount rate, $25,000 received next year is worth $24,272 to you today.

From an investment perspective, discounting is the twin of compounding. If you could invest $24,272 today at 3% (above inflation), you would have $25,000 in one year (= $24,272*1.03).

The calculations for the entire 25 year period used in this example are shown below:

Calculating Present Values

The undiscounted annual benefits ($25,000) are shown in the second column. The appropriate discount rate is shown in the third column. And the discounted amounts are shown in the last column.

Our measure of Social Security Wealth is the sum of the last column: $448,389 in this instance. Compare that amount to the undiscounted amount of $625,000. The discounted amount is about two-thirds of the undiscounted amount. (We have found this two-thirds relationship to be a fairly reliable rule of thumb in many instances.)

One useful way to think about the discounted total amount is as follows: $448,389 invested at 3% above inflation will yield a time stream of annual payments of $25,000, for a inflation-adjusted total of $625,000 by year 25.

Now, you may wonder why we use a 3 percent discount rate. That is an issue for a future post.

T Rowe Price Social Security Benefit Calculator: A Broken Tool

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T Rowe Price recently rolled out a new Social Security benefit calculator. Unfortunately, their calculator is not ready for prime time. In fact, in its current state, it is not ready for any time. It gives incomplete and misleading advice that, if followed, could cost some married couples $100,000 or more.

I will illustrate some of the problems with the T. Rowe Price (TRP) Social Security calculator with data for a hypothetical married couple, John and Mary. I assume John and Mary were born in 1952 and 1954, respectively. John’s life expectancy is 83; Mary’s is 95. John’s Social Security benefit at his full retirement age (FRA) is $2000 a month, while Mary’s is $100 a month.

Example #1

For this example, I selected the following as this couple’s goal: “We want to maximize the survivor benefit and also receive income early, if possible.” (The TRP calculator allows a user to select among several goals.)

Here is the set of recommendations from the T. Rowe Price calculator:

Mary claims retirement benefits at 62, receiving approximately $900 per year.
When John turns 66, he files a restricted application for spousal benefits, receiving approximately $600 per year.
When John turns 70, he claims his own retirement benefits, receiving approximately $31,680 per year.

And that’s it.

Do you see a problem here–a really big problem?

The T. Rowe Price Social Security calculator has failed to include a recommendation that Mary should claim a spousal supplement as soon as John turns 70. At that point, she could pick up an extra $10,800 a year in spousal benefits. These spousal benefits would continue until John’s expected death at age 83, implying that the T. Rowe Price Social Security calculator has mislaid about $140,000 in this case!

That’s an amazing–really, inexcusable–oversight.

Example #2

For this second example, I assume that Mary’s retirement benefit at her FRA is $900 per month. Other personal characteristics remain unchanged.

For the couple’s goal, I assume that John plans to retire at age 66 and that Mary plans to retire at 70.

Here is what the TRP calculator recommends:

John should file for his retirement benefits at age 66, receiving approximately $24,000 per year.
Mary should file for her retirement benefits at age 70, receiving approximately $14,256 per year.

Again, that’s it.

And, again, I ask: do you see a really big problem here?

The TRP calculator fails to mention that Mary can claim spousal benefits at age 66, using a restricted application and letting her retirement benefits grow until age 70. These spousal benefits would equal $12,000 a year, or $48,000 between age 66 and 70 Mary.

I have not yet thoroughly investigated the TRP calculator. But, from what I have seen, it is easy to conclude that this calculator is seriously broken.

For an example of a calculator that actually works, go here.

How to Calculate the Social Security Supplemental Spouse Benefit

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A client recently asked me: “Should I claim my modest Social Security retirement benefit early, say at 62, and then switch to my larger spousal benefit later on?” This question shows a serious misunderstanding of the relationship between retirement benefits and spousal benefits.

One can never switch from retirement benefits to spousal benefits. If a person is receiving retirement benefits (or they have filed and suspended receipt of those benefits), then the spousal benefit becomes a supplemental benefit, not a substitute benefit. In other words, when a person is eligible for both retirement and spousal benefits, the Social Security Administration first calculates their retirement benefit, and then adds their spousal supplement. While this distinction may appear trivial, it can nevertheless have significant implications for Social Security claiming decisions, as I will show below.

Just to keep things reasonably simple, I limit the following discussion to those circumstances in which a person claims retirement benefits early and then claims spousal benefits at their full retirement age (FRA). Note that if a person claims retirement benefits before FRA and they are eligible for spousal benefits at the time of claiming, then the SSA “deems” that both benefits are being claimed. So, the case I discuss here applies only to those who could not claim spousal benefits at the time they claim retirement benefits. A person cannot claim spousal benefits unless their spouse has claimed his or her own retirement benefits. (This restriction does not apply to ex-spousal benefits, but that is a topic for another time.)

Let’s look at an example to see how this works. Consider a hypothetical couple: Karen and Burt, who are both 62. Karen’s retirement benefit at age 66, her full retirement age (FRA), is $400 a month. Burt’s age 66 (his FRA) benefit is $2,000. Karen’s maximum spousal benefit is $1,000 at 66 (that is half of Burt’s age 66 retirement benefits). Burt plans to file for retirement benefits at 66, at which point Karen will be eligible to claim spousal benefits.

Karen knows that she can claim retirement benefits early at age 62 and get $300/month (75% of the $400 she could get at her FRA). She also believes that at her FRA she can switch to her spousal benefits and get $1,000. She is wrong on this last count. By claiming spousal benefits at her FRA, she can get the full spousal supplement, but that will not bring her up to $1,000.

Here is how the full spousal supplement is determined. It equals 1) a person’s maximum spousal benefit at their FRA ($1,000 for Karen) minus 2) that person’s retirement benefit at FRA ($400 for Karen). By claiming spousal benefits at her FRA, after claiming $300 in retirement benefits at 62, she gets a full spousal supplement of $600 (= $1,000 – $400). This brings her total benefit, at FRA, up to $900, not the $1,000 she was expecting.

Claiming retirement benefits early results in a significant reduction in those benefits. Karen thought she could claim retirement benefits early and then dodge that penalty by “switching” to spousal benefits. But, that is simply not possible, as the above example demonstrates. The early retirement penalty will stick with Karen until she dies (or until she switches to widow’s benefits— a topic for another post).

A final point: just as early claiming of retirement benefits is penalized, so is early claiming of a spousal supplement. But, just to add to the complexity, the SSA uses different early claiming penalties for the two benefits.

For much more information about benefits available to married couples, go here.

Social Security and the Fiscal Cliff

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As negotiations have continued to avert the ‘fiscal cliff”, there have been attempts to balance increases in taxes with reductions in projected entitlement payments. Press reports indicate that the Obama has offered to change the way that Social Security cost-of-living adjustments (COLAs) will be measured. The projected savings from using an alternative measure of inflation are projected to save the government substantial outlays over the coming decades.
AARP and other organizations have objected strongly to these changes since they could bring down benefits that seniors will receive in their retirement. These organizations are also correct in arguing that Social Security’s long-term financial problems can be fixed with less radical changes.
An important consideration in evaluating these arguments is whether the changes that are being proposed are fair to seniors who have paid their Social Security taxes and have been promised reasonable benefits from Social Security when they retire.
Economists generally agree that the present cost-of-living measure that is used by the government in adjusting Social Security benefits and other government programs overstates the actual changes in the cost-of-living. They have adopted a different measure called a chained-index which better represents the changes in the cost-of-living. This chained-index is what Obama has now agreed to use for calculating benefit increases in the future. So in this sense the change in the inflation measure seems fair to seniors.
There is a basic problem, however, with using either of these measures. These inflation measures are based on the consumption profile for the average American urban wage-earning household. To the extent that seniors consume different goods and services than the average urban American household, the proposed adjustments to Social Security might overstate—or understate–the rise in the cost- of- living for seniors or put their future finances in jeopardy. If the COLA adjustments understate the cost-of-living, our oldest seniors would be the most vulnerable since they would suffer repeated annual loses in their purchasing power.
When people retire, financial planners generally suggest that household expenses will be about three-quarters of what was needed before retirement. This calculation alone suggests that the items that seniors consume could be very different from what non-retirees purchase. Increased need for healthcare and the different housing situations seniors generally face suggest that these two elements of their ‘market basket’ could be quite different from younger people. Energy price changes also have a smaller effect on seniors since they drive less. (The recent COLA adjustments to Social Security benefits have been very erratic due to energy price spikes.)
What is needed, therefore, is an inflation measure which is based on the goods and services that seniors actually consume and uses the new chained-index methods for calculating price level changes. Then the adjustments to Social Security would be fair.

Social Security COLA Watch: October 2012

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The CPI-W for September 2012 was released this morning by the Bureau of Labor Statistics, and, just as in August, the index increased considerably from last month, moving up from 227.056 to 228.184. The average of the July, August, and September CPI-Ws is 226.936 which is 1.65% higher than the third quarter 2011 average (the baseline for COLA calculations). In fact, the SSA has announced that beneficiaries will see in increase in their benefits of 1.7% starting in January of 2013.

As has been the case for the past few months, the increase in the CPI-W was mainly due to energy prices, but food prices, as well as the prices of all goods excluding food and energy ticked up slightly as well.

On this blog, we’ll keep an eye out for issues that may impact COLAs going forward. As we get closer to the third quarter of 2013, we’ll resume regular posts on the topic.

Presidential Debate: Romney and Obama on Social Security

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During the first Presidential Debate the two candidates were directly asked to address the issue of Social Security. Here is what they said:

LEHRER: All right? All right. This is segment three, the economy. Entitlements. First — first answer goes to you, two minutes, Mr. President. Do you see a major difference between the two of you on Social Security?

OBAMA: You know, I suspect that, on Social Security, we’ve got a somewhat similar position. Social Security is structurally sound. It’s going to have to be tweaked the way it was by Ronald Reagan and Speaker — Democratic Speaker Tip O’Neill. But it is — the basic structure is sound.

….(digression on Medicare)…..

When it comes to Social Security, as I said, you don’t need a major structural change in order to make sure that Social Security is there for the future.

LEHRER: We’ll follow up on this.

First, Governor Romney, you have two minutes on Social Security and entitlements.

ROMNEY: Well, Jim, our seniors depend on these programs, and I know anytime we talk about entitlements, people become concerned that something’s going to happen that’s going to change their life for the worse.

And the answer is neither the president nor I are proposing any changes for any current retirees or near retirees, either to Social Security or Medicare. So if you’re 60 or around 60 or older, you don’t need to listen any further.

But for younger people, we need to talk about what changes are going to be occurring. Oh, I just thought about one. And that is, in fact, I was wrong when I said the president isn’t proposing any changes for current retirees. In fact he is on Medicare. On Social Security he’s not.

What can we learn from this exchange?

First, Social Security is not the problem that Medicare is. While Social Security is underfunded, it can be fixed whereas there is much less agreement on how to fix Medicare.

Secondly, neither candidate is anxious to say that they will lower benefits for people who are 60 or older. This constituency votes is large numbers, and politicians are loath to change the Social Security benefit structure in a way that will affect them adversely. This does not mean that younger people will be so lucky. As we have pointed out in an earlier post, http://www.socialsecuritychoices.com/blog/?p=93, Orszag and Diamond have analyzed the Romney proposals and have calculated that, because Romney’s proposal does not raise taxes, benefits would fall significantly for today’s young people.

“That’s exactly what’s going to happen,” Senator Bernie Sanders (Ind – Vt) said of Social Security being on the proverbial table, “Unless someone of us stops it — and a number of us are working very hard on this — that’s exactly what will happen. Everything being equal, unless we stop it, what will happen is there will be a quote-unquote grand bargain after the election in which the White House, some Democrats will sit down with Republicans, they will move to a chained CPI.”

Chained CPI, or consumer price index, is an alternative measure of calculating inflation that would lessen the cost of living increases for Social Security payments. When the president and Speaker John Boehner (R-Ohio) attempted to craft a deal on the debt ceiling last summer, Obama offered the chained CPI as a concession.

Sanders is one of 29 Senators who have signed a letter to “oppose including Social Security cuts for future or current beneficiaries in any deficit reduction package.” In addition Sanders has supported legislation that would enact the proposal that Obama put forward as a candidate for president in 2008, which entails putting in place a payroll tax on income over $250,000, in the process creating a gap between the current cap of $110,100 and that new level.

Obama’s openness to the tax proposal at the AARP forum prompted Sanders to call The Huffington Post to try and get the president’s commitment to that approach.

“When he says that he’s willing to look at changing the cap, that’s not good enough,” said Sanders. “Four years ago, he told us that, in fact, that was a proper solution, and he was right. I’ve introduced legislation to do just that … I think we’ve got to make sure that we reduce the wiggle room for the president, and he has got to make a very simple statement that, ‘If reelected, I will not cut Social Security.'”

By Monday morning, the Obama campaign had moved slightly in the opposite direction, with top adviser David Axelrod refusing to unveil any specifics about what the president had planned for Social Security reform.

“[T]he approach has to be a balanced one,” Axelrod told MSNBC’s “Morning Joe.” “We’ve had discussions in the past. And the question is, can you raise the cap some? Right now Social Security cuts off at a lower point. Can you raise the cap so people in the upper incomes are paying a little more into the program? And do you adjust the growth of the program? That’s a discussion worth having. But again, we have to approach it in a balanced way. We’re not going to cut our way to prosperity. We’re not going to cut our way to more secure entitlement programs — Social Security and Medicare. We have to have a balance.”

“So what is the president’s proposal?”, asked Time magazine’s Mark Halperin.

“Mark, I’ll tell you what: When you get elected to the United States Senate and sit at that table — this is not the time,” replied Axelrod.

How Important are Social Security Spousal Benefits?

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Many people do not know about Social Security spouse benefits. There may be a good reason for this. There is no mention of spousal benefits in the Your Social Security Statement that the Social Security Administration is again sending out annually to people 60 and over.

Spousal benefits are important for just about everyone who is married or, in the case of divorcees, has been married for more than ten years. Spousal benefits provide additional income for families where one spouse does not qualify for benefits on their own record. If the person claiming spousal benefits waits until full retirement age (66 for most people claiming benefits now), the spouse will receive half the full retirement benefits of the working partner. Thus a family, where one person worked and the other did not, can receive 150% of the retirement benefit of the working partner (if they both claim at full retirement ages)

There are three aspects of the spouse benefit that are important to remember: (1) To claim a spousal benefit, the working spouse must claim their retirement benefit first. (2) Claiming a spousal benefit has no effect on the benefits received by the working partner. The working partner will still receive a benefit which will depend on when they claim their benefit. This benefit will increase every year between 62 and 70. (3) The size of the spousal benefit only depends on when the spouse claims a benefit. The spousal benefit will increase every year between 62 and full retirement age. Unlike the retirement benefit of the working partner, the spousal benefit does not increase after full retirement age so there is no reason to delay claiming spousal benefits beyond full retirement age.

These same general conditions apply to divorcees who have been married for ten years and are not presently married to someone else. A divorcee can claim a spousal benefit based on the earning record of their ex. Claiming a spousal benefit on the record of your ex will have no effect on their retirement benefit or, if they have remarried, the spousal benefit of their new spouse, Indeed, several people can claim benefits on the earnings record of one person, if that person has been married several times. The present spouse and every ex-spouse who was married to that person for ten years and is not presently married to someone else can claim a spousal benefit. Unlike the situation for a married couple, a divorcee does not have to wait for their ex to claim their retirement benefits before claiming a spousal benefit, but their ex has to be 62 before a spousal benefit can be claimed.

Spousal benefits can also increase the income of couples where both work. For a discussion of the strategies that duel earner couples can use to take advantage of the spousal benefit go to our discussion of Secret Strategies. We also provide a custom analysis for married couples so they can best exploit these strategies.

How Do I Maximize My Social Security Benefits?

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There are two answers to the question expressed in the title.

First, if you are interested in maximizing your monthly Social Security retirement benefits, all you need to do is wait until age 70 to claim your benefits. If you are looking to maximize your monthly spousal benefits, then you should wait until your full retirement age to claim them. (Spouse benefits include ex-spouse and surviving spouse benefits.)

Second, if you are seeking to maximize your lifetime Social Security retirement or spouse benefits, then answering this question can be vastly more complicated than answering the first one.

Let’s consider married couples, the group that faces the most difficulty in finding the claiming strategy that maximizes lifetime Social Security benefits: they face literally hundreds of possible claiming options. At www.SocialSecurityChoices.com we have found the following factors to be the principal underlying determinants of optimal claiming strategies for married couples:

Length of planning horizon (e.g., do you and your spouse have a relatively short life expectancy because of poor health; or, do you expect to live well into your 80s or even 90s?);
The discount rate for converting future values into present value equivalents (for the details about this factor, see our discussion on the main website).
The ratio of the wife’s primary insurance amount, or PIA (that is, retirement benefit at full retirement age) to the husband’s PIA;
The age differences between the husband and wife.

For ex-spouses and widow(er)s, determinants (3) and (4) above are irrelevant because only one spouse is directly involved in claiming decisions for this group. The optimal claiming determinants for these two groups include (1) and (2) from above, plus (3′)

3’. The ratio of the person’s PIA to their maximum ex-spouse or widow(er)’s benefit.

For singles, the problem is much simpler in that the optimal choice depends only on factors (1) and (2) above.

If you need help in solving your claiming puzzle, check out our separate benefit calculators for married couples, singles, and widow(er)s. (The calculator for ex-spouses is under development and should be available soon.)

A Misleading Tool: Social Security Break-Even Calculator

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Those thinking about whether to claim their Social Security benefits now or later often ask the following question: “If I delay claiming and give up benefits now in return for greater benefits later on, how many years must I wait to get those forgone benefits back? This is known as the “Social Security breakeven time period” question.

In this post, I discuss why concentrating on this breakeven question alone may well lead to poor decisions about one’s claiming strategy. Notably, the Social Security Administration agrees with my view. For some years, the SSA website had a Social Security break-even time-period calculator. It was removed about three years ago because the SSA concluded the information generated by the calculator was misleading many people into making poor claiming decisions.

Here is a simple example of how a Social Security breakeven calculator works. Suppose that Don, a single person, could get $9,000 a year in Social Security benefits if he took them at age 62. If he waited one year, his benefits would go up to $9,600. So, he gives up $9,000 for a year in order to get an extra $600 a year for the rest of his life. The breakeven period for Don is 15 years (= $9,000/$600), or when he reaches age 77. Had I discounted future benefits to account for the time value of money, the breakeven age could be several years past age 77.

Delayed claiming is a form of investment: you give up money today in return for more money in the future. Wise investors consider at least three factors when contemplating an investment: 1) how risky is the investment? 2) what is the expected rate of return on the investment? and 3) how liquid is the investment? Breakeven time-period analysis focuses exclusively on the third question: when will I get my money back?

When confronted with a payback time period of 15 to 20 years, many people decide that is too long to wait to get their “investment” back. So, they claim as early as possible. Yet, by ignoring the implied rate of return to delayed claiming, such decisions are usually poorly informed. On our main website,we show that delayed claiming can offer high rates of return, even extraordinarily high rates of return in some circumstances. And these rates of return are inflation protected. A breakeven calculator tells you nothing about this important factor.

Breakeven analysis also says nothing about risk. Delayed claiming essentially provides a risk-free payoff in the form of inflation-protected higher future benefits. The only investments that approach this extremely low level of risk are federally insured forms of savings, like bank CDs.

In this era of low interest rates, it seems impossible to beat delayed claiming as an investment, unless perhaps you want to assume a lot of risk. Of course, the problem with high risk investments is that you might lose everything you invested.

If you are interested in maximizing your Social Security benefits, you should investigate our Social Security calculator, which provides step-by-step guidance as to how to get the most out of Social Security.

Can I Double My Monthly Social Security Benefit by Claiming at 70?

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Answer: Maybe

In a recent posting on Reuters, Lynn Brenner writes about an example provided by T Rowe Price’s Christine Fahlund where someone who claims at 70 can double the monthly benefit that they would have received if they had claimed at 62. This is a surprising result. The usual calculation is that the difference between claiming at 62 and 70 is 76%. This calculation reflects the fact that at 62 a person will get three quarters of the benefit at 66 (full retirement age) and a benefit 32% higher at age 70.

Where then does the idea come from that the benefit can double when someone waits until 70? Ms Fahlund uses The Social Security Quick Calculator to get her result. The reason that the benefit doubles is that the Quick Calculator assumes that claiming occurs at the time a person stops working. Since the benefit at any age depends on work history, continuing to work from 62 to 70 can increase the benefit that someone claiming at 70 will receive.

The calculator does this calculation for a hypothetical person. It does not know the actual work history for any particular individual. How much your benefits will increase from 62 to 70 will depend on your actual work history. Because your work history is almost certainly different from the work history of a hypothetical person, the increase in your benefits will be different from the calculation provided by the Social Security Quick Calculator. So your benefit may double if you work until 70 and then claim, but then again it may not.

Fortunately, it is not hard to find out what your situation actually is. Social Security does a similar calculation in Your Social Security Statement. (If you do not have a statement you can go either go to www.ssa.gov/estimator/ or www.socialsecurity.gov/mystatement and get the same information.) Look at what the statement says about the benefits you will receive at 62 and 70, respectively. Divide one into the other and you will see whether your benefit will double. Mine is 86% higher.

Whatever the increase, you may not want to wait as long as 70 before claiming your benefit. Every year you wait, you will lose benefits that year. To determine the best strategy for you and your wife, order a report from www.socialsecuritychoices.com. Our calculator takes these trade-offs into account so you can determine the best time to claim your benefits.