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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?”

In my view, the most appropriate rate of return to assume is that from Treasury Inflation-Protected Securities (TIPS), because:

  1. They are the investment with the most comparable level of risk to Social Security benefits, and
  2. TIPS or other low-risk holdings are usually the part of the portfolio that should be spent down in order to delay Social Security.

For reference, at any given time you can find current TIPS yields here. (Right now, the yield on TIPS of comparable duration is just shy of 1%.)

Comparing Risk Level

TIPS and Social Security are both backed by the federal government, and they are both inflation-adjusted. Taken together, those two things mean that they have a very similar level of risk — more similar to each other than to most other things.

That said, the risk characteristics of Social Security and TIPS are not identical. With TIPS, the rate of return is as close to certain as you can get. In contrast, the rate of return that you get from delaying Social Security is uncertain, because you don’t know how long you will live.

However, that uncertainty is actually helpful for most people, because it precisely offsets a type of risk that you face.

By way of analogy, consider the purchase of term life insurance by a 30-year-old single mother with two young children. It’s uncertain whether the policy will pay out. And as such we cannot calculate a rate of return from her insurance purchase. But that uncertainty is good. We don’t know whether the policy will pay out, but we do know that it will pay out in exactly the scenario in which it is needed (i.e., if the mother dies).

The same thing goes for delaying Social Security (or buying any other lifetime annuity). We don’t know whether the decision will pay off, but we do know that it will pay off in a scenario in which you live a long time, which just so happens to be the financially scary retirement scenario. So the uncertainty here is actually reducing your overall financial risk level.

On the other hand, Social Security has a degree of political risk that TIPS do not have. As we’ve discussed before, that political risk doesn’t necessarily weigh in favor of claiming early. But there’s no question that that source of uncertainty is undesirable.

So, relative to the return from TIPS, the return from delaying Social Security (or, if you prefer to think of it this way, the return from selling some of your holdings in order to “buy more” Social Security) has one helpful source of uncertainty and one unhelpful source of uncertainty. Without any way to quantify the political risk, I generally consider TIPS and Social Security to have roughly similar overall risk levels — more similar to each other than to anything else.

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, the necessary rate of return that would make claiming Social Security at 62 as good as claiming at 70 is about 1.7% above inflation. For an unmarried female, the necessary return would be about 2.9% 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).

*These rates of return use the SSA’s 2014 period life table for life expectancies. This understates the average life expectancy somewhat. As a result, the necessary rates of return would actually be somewhat higher. 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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