Archives for August 2020

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How Do Social Security Inflation Adjustments Work?

A reader writes in, asking:

“I’d be interested in an article on the specifics of Social Security inflation adjustments. I have a vague awareness that my wages are indexed so that my wages from early years count for more than just the actual dollar amount earned. And I also know that the SSA publishes a COLA figure every year for people already receiving benefits. Are those the same thing? And does a person have to file for benefits in order to start getting the COLA?”

The indexing of prior-year earnings is completely separate from the annual cost-of-living adjustments. Let’s discuss how each works.

Wage/Earnings Indexing

Wage indexing occurs at one point in time: in the year you turn 62 — or the year in which you die or become disabled if such happens before you reach age 62.

All of your wages (and net earnings from self-employment) up to 2 years prior to the year in question are indexed based on the national average wage index (NAWI) — sometimes just referred to as the average wage index (AWI). This can be roughly thought of as adjusting your old earnings for “wage inflation” up to age 60.

Example: Bob (alive and not disabled) turns 62 in 2020. All of Bob’s historical earnings up to 2018 are indexed based on the ratio of NAWI in 2018 to NAWI in the year of the earnings in question. So for example if Bob’s earnings in a given earlier year were exactly twice the NAWI figure for that year, then his earnings for that year would essentially “count for” twice the 2018 NAWI.

In the year 2000, NAWI was $32,154.82. If Bob earned twice that amount (i.e., $64,309.64) in the year 2000, then his 2000 earnings would be adjusted to twice the 2018 NAWI when originally calculating his benefit. In 2018, NAWI was $52,145.80, so Bob’s year-2000 earnings would count for $104,292 in 2018 dollars.

Earnings after age 60 are not indexed. In most cases this means that earnings after age 60 actually count for more than they would if they were indexed — because if they were indexed, they’d have to be indexed downward to age-60 dollars, given that NAWI usually grows over time. (There are exceptions of course. NAWI shrank in 2009 with the recession, and it’s certainly going to be lower for 2020 than it was for 2019.)

Another relevant point here — one you may have seen discussed in the news lately — is that your Social Security benefit is ultimately rather dependent on the NAWI figure in the year you turn age 60. If NAWI is low in that year, all of your prior earnings will be multiplied by the low age-60 NAWI. While we won’t know 2020 NAWI until (roughly) September 2021, it’s clear that the figure will be unusually low, given the dramatic amount of earnings loss this year. This is not a good thing for people born in 1960. (And to the extent that it doesn’t recover by 2021, this is not a good thing for people born in 1961.)

Cost-of-Living Adjustments (COLA)

The second type of indexing is the annual cost-of-living adjustment based on actual price inflation. Beginning with the year you turn 62 (or, if earlier, the year you die or become disabled), each year, your primary insurance amount is indexed upward based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).

Specifically, the COLA for a given year is based on the average of the CPI-W for the third quarter of the prior year, divided by the average of the CPI-W for the third quarter of the year before that. For example, the average CPI-W from July-Sept of 2019 was 1.6% higher than the average CPI-W from July-Sept of 2018, which is why we had a 1.6% COLA in 2020.

If the calculated figure is negative (i.e., CPI-W went down), then there is no COLA rather than there being a negative COLA. And in the following year, the denominator in the calculation will be the third quarter CPI-W from the last year for which there was an inflation adjustment. For example, in 2015, the third quarter average CPI-W was lower than in 2014. So there was no COLA for 2016. Then, in 2017, the COLA was calculated based on the ratio of average CPI-W from third quarter 2016 relative to third quarter 2014 (rather than being compared to 2015 as would typically be the case).

Finally, to answer the reader’s second question, a critical point about Social Security cost-of-living adjustments is that they do not depend on whether or not you have claimed your retirement benefit. That is, you will get the applicable COLAs beginning age 62 onward, regardless of the age at which you file for your retirement benefit.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security cover Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

Investing Blog Roundup: Downsizing, How to Get Rid of Stuff

Over a lifetime, we accumulate a lot of stuff. If you’ve lived in the same home for many years — and it’s therefore been quite a while since you’ve gone through the forced purge of moving — it’s probably a lot of stuff.

At some point, all of that stuff will have to go. Maybe that job will be yours if you do end up moving, or maybe the job will ultimately fall to your children or some other designated party. But, eventually, none of your stuff will remain in (what is currently) your home.

This week I encountered an interview of David Ekerdt about the findings from his new book, Downsizing: Confronting Our Possessions in Later Life. For the book Ekerdt conducted extensive interviews with people ages 50+ about their experiences getting rid of their stuff. The interview below shares many of the lessons and insights gained from that research.

Other Recommended Reading

I hope you’re well, and thanks for reading!

How Does the Fed “Prop Up” the Stock Market? (Interest Rates and Stock Prices)

A reader writes in, asking:

“I’ve read over and over this year that the Fed is ‘propping up’ the stock market by keeping interest rates low. How does that work?”

Broadly, there are two ways in which low interest rates help to keep stock prices high.

Firstly, to the extent that corporations are borrowers, keeping interest rates low reduces their costs and therefore directly improves their profitability, which of course helps keep their share prices higher. In the case of a struggling corporation, having access to low-cost capital can even make the difference between declaring bankruptcy or not. And of course avoiding bankruptcy proceedings is good for shareholders.

The second effect has to do with the way stocks are priced. (I think it’s actually easier to understand this effect from the perspective of increases in interest rates. So we’ll start with that.)

Stocks are quite a bit riskier than Treasury bonds. So why do you own stocks at all, rather than just buying Treasury bonds with all of your savings? Presumably, you own stocks because you hope to earn additional returns beyond what Treasury bonds earn. That additional return that you hope to earn is known as a risk premium (i.e., additional return to compensate you for the additional risk).

The price of a stock reflects the (market’s consensus as to the) present value of the future cash flows from the stock. And the discount rate used in that present value calculation is usually something along the lines of “whatever we could earn from bonds, plus a risk premium.”

So when interest rates go up, the necessary discount rate goes up. A higher discount rate means a lower present value, which means stock prices go down.

Or you can think of it this way: imagine that TIPS yields suddenly went way up to 3%, rather than the roughly -1% range where they are right now. Maybe you had been estimating that stocks would earn a 4% real return going forward. Before, that was a 5% risk premium. But with TIPS yielding 3%, a 4% real return would only be a 1% risk premium. Maybe you decide that a 1% expected risk premium isn’t high enough to justify the additional risk from owning stocks, so you sell your stocks to buy TIPS.

Collectively, lots of people would be selling stocks to buy bonds in such a scenario. So the price of stocks would fall. When the price falls, the expected return going forward goes up (because a new buyer is paying a lower price for a given amount of dividends/earnings). And the price would continue to fall (i.e., people would keep selling stocks) until the price was low enough that the expected return was high enough to earn whatever the market collectively decided was a sufficient risk premium over bonds.

So that’s what happens when interest rates go up: it has a downward effect on stock prices.

When governments or central banks make efforts to keep interest rates low, the opposite occurs: it exerts an upward pressure on stock prices. That is, low interest rates make the alternatives to stocks not look very appealing — and that helps keep stock prices high.

To be clear though, while low interest rates have an upward effect on stock prices (i.e., they make stock prices higher than they would otherwise be, all else being equal), they do not prevent stock prices from falling. When events occur that worsen the outlook for corporate profitability, stock prices will still fall.

Investing Blog Roundup: Why the Market Doesn’t Care that the Economy Stinks

This week Barry Ritholtz tackled the question of why the stock market is doing reasonably well when the economy, clearly, is not.

One critical point, as we discussed recently, is that the stock market and the economy are not the same thing. The stock market isn’t even supposed to reflect the economy. (Rather, the market’s value at any time is a prediction, not a reflection of current status. And it only reflects a prediction regarding publicly traded companies, which are only a piece of the broader economy. Further, it only reflects how profitable those companies are predicted to be, not anything regarding how well their employees — or, ahem, former employees — are predicted to fare.)

Ritholtz also points out that it’s easy to overestimate how badly publicly traded companies, on the whole, are doing. Many very visible sectors (e.g., airlines) are doing horribly, but if such sectors make up only a small portion of the overall market capitalization, how well/poorly they perform doesn’t have a very large impact on the overall market performance.

Recommended Reading

I hope you are well, and thanks for reading!

Social Security and Tax Planning

A reader writes in, asking:

“I think there is more to deciding when to file for SS income than just the maximum benefit. I plan to coordinate SS with regular IRA, Roth IRA, and portfolio income in order to avoid as much taxes as possible. Any recommendations for how to optimize for the total portfolio?”

The tax aspect side of Social Security planning is very case-by-case (just like any tax planning, really). In a majority of cases I have looked at though, it has turned out to be a point in favor of delaying — for two reasons.

The first reason is that Social Security is taxed favorably relative to most other types of ordinary income such as distributions from tax-deferred accounts. So it’s usually advantageous to spend down tax-deferred accounts in order to delay Social Security — with the effect being to reduce the percentage of lifetime income that’s made up of tax-deferred distributions (which are normally fully taxable) and increase the percentage of lifetime income that’s made up of Social Security (which is not fully taxable).

The second reason is that, once you start receiving Social Security benefits, your marginal tax rate on other types of income could increase significantly. (Not only because you have a new source of income, but also because of the way Social Security is taxed, in which one additional dollar of ordinary income can cause not only the normal amount of income tax, but also cause 50 or 85 cents of Social Security to become taxable.)

Delaying Social Security gives you some years with a relatively lower marginal tax rate prior to that higher marginal tax rate kicking in. It’s often advantageous to spend down tax-deferred accounts (and often do Roth conversions as well), thereby making use of the relatively lower marginal tax rate in the pre-Social Security years. In some cases, this has the additional benefit of allowing your Social Security to remain nontaxable once it does begin, because your “combined income” is below the applicable threshold due to having done conversions.

To summarize, there are multiple mechanisms that point in favor of the same exact plan: delaying Social Security and using that pre-Social Security period of time to spend down tax-deferred accounts and make some Roth conversions.

But again, tax planning is case-by-case. Basically anything that appears on your Form 1040 could be a relevant factor, and some of them could point in the opposite direction (i.e., in favor of filing for benefits earlier rather than later).

Working with a financial planner can provide a lot of value here.

For anybody taking a DIY approach, I would caution that attempts to actually do the tax calculation on your own (e.g., with just a spreadsheet) are as likely to be harmful as helpful. DIY tax calculations frequently fail to account for all of the various income-threshold-based tax provisions that can apply to a person. A better method is to use tax-prep software (which can account for the phaseouts/phase-ins of every applicable tax provision) to run hypothetical year-by-year calculations in different scenarios. Then record those results in a spreadsheet (or other software of your choosing) and factor them into a broader analysis.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security cover Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."
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