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

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:

  1. Mary claims retirement benefits at 62, receiving approximately $900 per year.
  2. When John turns 66, he files a restricted application for spousal benefits, receiving approximately $600 per year.
  3. 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:

  1. John should file for his retirement benefits at age 66, receiving approximately $24,000 per year.
  2. 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.

 

 

 

 

On Social Security, Birds, Bushes, and Hands: The Time Value of Money

Many people we encounter are dead set on claiming their Social Security retirement benefits immediately when it becomes available. They often use some variation of the well-known proverb: a bird in hand is worth two in the bush. In citing this proverb, these individuals are expressing a rational preference for money now over money later. A quick web search suggests that the bird in hand phrase dates to the 13th century, so its originator certainly never had to worry about when to claim Social Security benefits. It’s worth thinking about how this proverb applies to the Social Security claiming decision.

Taken literally, the statement suggests an exchange rate of one bird in hand for every two birds in the bush. We can think of this exchange rate between bird in hand and birds in the bush in terms of the “discount rate.”

Instead of birds, let’s talk about something we’d rather have in our hands: $100 bills. Furthermore, let’s assume that $100 bills currently in the bush will be in our hands one year from today. With these assumptions, our proverb becomes: $100 today is worth $200 next year. This represents a 100% discount rate, because it implies that a 100% return on the initial $100 is needed for one to break even. Needless to say, this is a very high rate, and most people would be willing to accept far less than $200 next year for $100 today. So, the bird in hand proverb may not provide the best guidance, at least when taken literally.

When taken figuratively, though, the proverb illustrates the reasonable preference for money now rather than money later. To most people, money received today is indeed worth more than money received next year, because they may wish to spend it now, or if not, they can invest it for a positive return. While almost everyone would give up $100 this year for $200 next year, almost no one would give up $100 this year to receive only $100 next year. The question of how much money one demands next year in order to give up $100 today will elicit different responses from different individuals, even if we ignore inflation, and there is absolutely no risk of next year’s payment not being made on time. Some people might be willing to trade $100 today for $101 next year, while others might demand $110 or more. For our Social Security reports, we settled on $103 as the amount that the typical person would demand next year in return for $100 today, which represents a 3% discount rate. We chose 3% because it is the approximate return on long term U.S. treasury bonds, which are considered to be an extremely safe investment (like Social Security). In our analyses, our 3% annual discount rate accounts for a moderate preference for receiving money in the present.

The discussion gets more complex when one is dealing with multi-year trade-offs. For example, a single person claiming at 70 instead of 62 gives up benefits for years 1 – 8, and then gets a larger payment in each subsequent year. A married couple might have to decide between claiming at 62 or implementing one of many special strategies, which would result in them giving up all benefits for a few years, getting smaller benefit payments for a few years, and then getting larger benefit payments in each subsequent year. Invoking our proverb, we’re now trying to determine whether two birds in hand is worth more than a bird in a nearby bush and a four birds in a slightly more distant bush!

The relative values and proximities of these “birds” will vary from situation to situation, but the takeaway point is that the birds in the bushes are sometimes considerably more desirable than the bird in hand under standard discount rates. By implementing special strategies, it is often possible to get considerably more from Social Security, even after incorporating the discount rate. Some may choose the bird in hand in spite of considerable returns on strategies that involve delayed claiming, but no one should make this choice blindly. Everyone has their tipping point. For example, what those two birds in the bush are geese that lay golden eggs? Do you still prefer that seagull in your hand?

Getting the Most Out of Social Security while Meeting your Needs

For many retirees, Social Security benefits make up a large portion of retirement savings. Often, these people can only follow a limited set of strategies to optimize their benefits because they may not have the financial resources to wait as long as the mathematics of their situation would suggest. This is why our custom reports provide more than just the “optimal strategy.” Rather, we show you the optimal strategy, as well as a wide range of alternative strategies, how to implement them, and how they compare in dollar terms to the optimal strategy. In many cases, one can find a strategy that, while not quite the best from a mathematical standpoint, is far superior to the default (claiming immediately) and better meets financial goals in retirement.

Sometimes, situations even change after a Social Security plan has been partially implemented. In the case of a married couple, sometimes steps can be taken to alter the strategy to get larger SS checks sooner than planned, such as by having one spouse claim earlier than expected. However, beneficiaries and advisors should be aware of the repercussions of changing plans, especially when complex strategies are involved.

Recently, a client wrote to ask the following: “I’m over 66 and still working. Can I apply for my full benefits for a few months to temporarily increase my current income for some bills and then go back to the ‘free spousal’ benefit later on?” In this case, as recommended by our report, the client had filed a restricted application for a “free spousal” benefit on his wife’s record while allowing his own retirement benefit to grow. His financial situation changed, and he was hoping to temporarily increase his benefit by switching to his own benefit and then switching back (by suspending his benefit and going back to the spousal benefit) when he had paid his bills. Unfortunately, this option isn’t available.

When a beneficiary files a restricted application, he can end the restriction by filing for his own benefit at any time. Additionally, a beneficiary can suspend his benefit at any time (as long as he is at or above full retirement age). However, for calculating spousal benefits, a suspended benefit is treated differently than one for which an application was never filed. When my client originally claimed his free spousal benefit, he had never filed for his own benefit, so the spousal benefit is not reduced by the amount of his own benefit. However, if he were to file and then suspend later, he is still “entitled” to his own benefit even after suspending. The spousal benefit he was receiving would be lower, at best, or completely eliminated, at worse, depending on the size of his benefit relative to his wife’s.

Fortunately, our client wrote to ask about his proposed plan. Had he implemented it, he would’ve been stuck with his early claim and may have given up thousands of dollars over his lifetime. His strategy makes intuitive sense, but the way the SSA defines entitlement to benefits is one of the many nuances that claimants need to account for. Our software takes these nuances into account, and if you have questions that our software doesn’t answer, we’re always happy to help our customers.

How to Calculate the Social Security Supplemental Spouse Benefit

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

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

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

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.

Social Security COLA Watch: September 2012

New data have been released. Check here for more!

The CPI-W for August 2012 was released this morning by the Bureau of Labor Statistics, and, as we predicted in our last post, the index increased considerably from last month, moving up from 225.568 to 227.056. The average of the July and August CPI-Ws is 226.312 which is 1.4% higher than the third quarter 2011 average (the baseline for COLA calculations). The September index, which will be released on October 16, is the last piece to the COLA puzzle. If the September number exceeds 226.312, the COLA will be greater than 1.4, if it is less than 226.312, the COLA will be less than 1.4. It is all but certain that SS recipients will receive a COLA this year.

Let’s look at a few scenarios:

  • If the increase in CPI-W is wiped out, and the index returns to its July value for September, the COLA will be just under 1.3%.
  • If the CPI-W is unchanged between August and September, the COLA will be about 1.5%
  • If the CPI-W increases at the same rate as it did between July and August, the COLA will be about 1.7%

I think it’s likely that the COLA will be somewhere in the range of 1.4 to 1.6 percent next year. The CPI-W increased at a very high rate in August, and I don’t expect the change in September to be as great. The biggest driver in the August increase was energy prices, so they will likely dictate the final COLA. Check back on October 16 for a look at the September numbers!

Social Security COLA Watch: August 2012

New data have been released. Check here for more!

The CPI-W for July 2012 was released this morning by the Bureau of Labor Statistics, and the index continued its decline from last month. The CPI-W index fell from 226.036 to 225.568, which is only 1% higher than the third quarter 2011 average (the baseline for COLA calculations). Once again, energy prices appear to be the culprit, as food prices and other prices increased slightly or were unchanged.

The July report is the first one that factors into the 2012 COLA calculation (recall that the COLA is based on the 3rd quarter only). If the CPI-W doesn’t change over the next two months, Social Security beneficiaries will receive a COLA of approximately 1%. If the downward trend in CPI-W continues, the COLA will be smaller. However, I would expect the CPI-W to actually increase, rather than decrease over the next few months. First, one very transparent element of energy prices – gasoline prices – have been increasing rapidly since the end of July. Gasoline prices have been a big contributor to the decline in CPI-W in recent months, so a reverse in that trend should contribute to an increase in CPI-W. Second, the impact of the drought in the midwestern US has been putting pressure on food prices.

Increases in food and energy prices are certainly not beneficial to US consumers. However, if they occur during the third quarter of the year, they may result in a higher COLA for SS recipients. The analysis in this post is far from conclusive, but the beauty of a blog is the ability to speculate a bit (our custom reports are comprised of much more careful analysis). The August CPI report will be released on September 14, so check back then for an updated analysis.