Archives for May 2018

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Claiming Social Security Early to Invest It: What Rate of Return (Discount Rate) Should We Assume?

A reader writes in, asking:

“In your social security talk at the White Coat Investor conference, you mentioned that when considering whether to delay social security or claim it early and invest it, the appropriate rate of return to assume is the rate of return from TIPS bonds. But I didn’t catch the reason for that. Would you consider discussing that for an article?”

As a bit of background for other readers: when deciding whether to delay Social Security or claim it now and invest the money, you have to make some assumption about the rate of return that you would earn on invested benefits. The higher the rate of return you assume, the more advantageous it is to claim benefits early.

Alternatively, you can think of the analysis as, “what part of my portfolio would I spend down in order to delay Social Security? And what would be the rate of return that I’d be giving up by no longer having those assets in my portfolio?”

For most people, the relevant rate of return is the expected return on the bond portion of their portfolio. The primary exception would be the household that has a 100%-stock allocation and wants to take on even more risk. (Relatedly, by default the Open Social Security calculator uses the current 20-year TIPS yield as the discount rate, but you can select a different discount rate by checking the box at the top of the page for additional options.)

By way of analogy, imagine that your portfolio currently has a 70/30 stock/bond allocation. And imagine that Vanguard releases a new bond fund tomorrow. When evaluating the new fund to determine whether to add it to your portfolio, would you want to know whether the fund’s expected return is:

  1. At least as good as the expected return of the stock portion of your portfolio,
  2. At least as good as the weighted average expected return of your 70/30 portfolio, or
  3. At least as good as the expected return of the bonds fund(s) in your portfolio with similar risk?

Question #3 is the relevant question. If the new fund had, for example, a 0.5% higher yield than a given bond fund in your portfolio with a similar level of risk, it would probably merit inclusion — even if the new fund’s expected return is considerably lower than the expected return for stocks and lower than the weighted average expected return of your 70/30 portfolio.

Same thing with Social Security.

If your portfolio is currently 30% bonds and you are currently considering filing before 70, you can instead choose to swap some of those bonds for more Social Security. In practice, that usually looks like spending more quickly from bonds than you otherwise would have done — “selling” bonds in order to “buy” Social Security.

For somebody who isn’t spending from their portfolio because they have income from other sources, it means shifting the allocation of the portfolio toward stocks. Counterintuitive, but because money is fungible it’s the same concept.

That is, if you have, for example, decided that filing at 62 and using a 70/30 portfolio is an appropriate level of risk, what about instead filing at 70 and using an 80/20 portfolio? (To be clear, I’m just making up the 80/20 figures here. The actual percentage would depend on the size of your Social Security benefit relative to the size of your portfolio. The idea is to keep the same level of risk, but have more Social Security and less bonds.)

Spending Down Bonds to “Buy More” Social Security

As financial planner Allan Roth has been arguing for years (here for example), it doesn’t usually make sense to own bonds earning a certain rate of interest while simultaneously paying a higher rate of interest on your mortgage. It’s generally advantageous to sell the bonds and pay down the mortgage.

A similar concept applies for Social Security.

For an unmarried male in average health (as reflected by the SSA’s 2020 period life table), the necessary rate of return that would make claiming Social Security at 62 as good as claiming at 70 is about 1.2% above inflation. For an unmarried female in average health, the necessary return would be about 2.6% above inflation. If delaying Social Security provides such an expected return, with a low level of risk, it doesn’t usually make sense to forgo additional Social Security in order to continue owning bonds that have a lower expected return (or a similar expected return and a higher level of risk).

For an unmarried male in better than average health (as represented by the 2017 CSO Nonsmoker super-preferred life insurance table) the necessary rate of return would be about 3.2% above inflation. For an unmarried female in such health, the necessary real rate of return would be about 4% above inflation.

*For a married couple, the “breakeven” rates of return will vary based on their difference in earnings history and difference in age. In general though, the breakeven rate of return for the higher earner will be significantly higher than for an unmarried person (meaning it’s usually super advantageous for this person to delay) and lower for the lower earner (meaning it’s less advantageous for this person to delay).

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Investing in Your Earning Potential

A reader writes in, asking:

“Does it ever make sense to slow down the rate at which I’m saving for retirement, or even put it on hold completely, in order to direct money toward expenditures that could increase my income? I suspect that putting money toward additional education in my field would have a good payoff. But I also know that saving and investing is particularly powerful when I’m young. How would one actually go about doing such an analysis?”

To the first question: yes.

Investing in your own earnings potential is often a very good idea (e.g., by getting a particular certification, license, or degree in your line of work, or by putting money into a business that you’re starting), even if it means putting off saving for retirement for a brief period. This is especially true for people early in their career, because the increased earnings will be in effect for many years.

I did this myself, a little over 10 years ago. There was a period of almost two years (around age 23-24) when my wife and I saved nothing for retirement, because we were putting money into my publishing business. The business was growing, and it seemed likely that additional funding would pay off — and it has. The resulting increase in our income has significantly exceeded the return that we would have achieved via additional 401(k) savings. (Plus, now I get to do work that I find much more enjoyable than what I was doing before.)

How to Calculate a Projected Return

If you want to actually make a comparison of rates of return, you first need to come up with a year-by-year estimate of the cost and the payoff from the investment you’re considering. In some cases you may be able to find good statistics on the topic (e.g., how much more, on average, do people in your field with a particular certification earn than people without that certification?).

Then you can use the IRR function in Excel to calculate the rate of return from the projected cash flows. The tutorial in the previous link explains how to use it, but it’s pretty straightforward. You type the projected cash flows in a column of cells, with the cash outflows (i.e., the money you expect to spend) as negative values and the cash inflows as positive values.  Then, in another cell, you use the “IRR” function, selecting the range of cells that includes your projected cash flows (e.g., “=IRR(A1:A17)”).

Then you can compare the calculated return from your projection to the return you would expect from additional investment in your portfolio. (Important note: in each case, you want to adjust the cash flows to account for taxes. For example if you expect an additional $10,000 per year of income, and you have a 25% combined state/local marginal tax rate, you’d enter $7,500 as the expected cash inflow in each cell.)

It varies quite a bit from one case to another, but it’s not at all rare for the rate of return from career-related expenditures to greatly exceed the rate of return you could expect from regular stock/bond investing.

How Risky Is It?

It is important, however, to recognize that comparing a projected rate of return from career-related spending to the rate of return you would expect from additional retirement savings isn’t an apples-to-apples comparison, as the risk level may be quite different.

For instance, if you’re a 23-year-old accountant, getting your CPA certification is very likely to substantially improve your earnings over the course of your career. Frankly, this is probably less risky than putting money into a stock index fund.

Conversely, investing a lot of money into an entrepreneurial endeavor can be super high-risk. You’re essentially buying a single stock (i.e., an undiversified investment), and it’s a riskier stock than your typical publicly traded company. (See, for instance, this cautionary tale I recently encountered of a man whose failed restaurant endeavor cost him his house.)

But, in summary, yes, investments in your own earnings potential are worth considering, even if they would require you to put saving for retirement on pause for a brief period. And this is especially true if:

  1. You are early in your career, and
  2. The hoped-for increase in earnings is very likely to actually occur (i.e., it is not especially speculative).
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