Importance of Using Future Value When Determining a Claiming Strategy for Social Security
Social Security is one of the bigger decisions most retirees will make when it comes to their retirement. It can be an intimidating decision because it’s a permanent decision. And a decision that has lasting impacts.
The desire to start benefits right away and be able to enjoy that income early in your retirement clashes with the fear that your 85-year-old self will have troubles because your income isn’t high enough to keep up with your rising health care costs.
Everyone wants to maximize their Social Security benefits. We all want to get the most out of it. As someone who oversees a lot of retirements, I’ve heard / seen every strategy out there from:
· “I want to start my benefits as early as possible, because I don’t know how long I’ll live, and I want to enjoy it while I can”
· “I want to delay my benefits as long as possible. It’s an automatic 8% return.”
· “We’re just going to start when we retire”.
You may be able to relate to these statements. And in many ways Social Security is a personal preference. You may be completely fine if you don’t maximize your Social Security as long as it meets your needs now.
There are too many unknown variables to be able to perfectly assess your Social Security situation. The big one being: How long will you and your spouse live? You’ll only know if you got it right when it’s near the end.
But there is a way to properly assess your Social Security claiming decision to help put you and your household in the best position to maximize your benefits.
And while I see households attempt to calculate this maximum strategy, I often see it done with one, rather large, mistake. That is that most people will analyze their Social Security benefits on a $ for $ basis. Meaning, they simply look at how many $’s will they receive from Social Security over the length of their retirement. They’ll compare the total dollars they’d receive if they start at age 62, versus 63, versus 64, and so on. Then they’ll decide based on the starting age that provides the most total dollars received.
This will often misguide you. The proper way to calculate the optimal claiming strategy for Social Security is to calculate the Future Value of Benefits. This brings time value of money and opportunity costs into the equation.
Why this is important:
Say you retire at age 65 and you require $7,000 / month to live your lifestyle. You are deciding if you should start your benefits right at retirement or wait until age 70. If you start at retirement, you’re expecting to receive $3,000 / month. If you wait until age 70, your estimate is $4,230 / month.
Attracted by the higher payout, you decide to delay. Because you have delayed Social Security, you now find yourself funding your entire $7,000 / month in expenses from your retirement savings. Should you have started Social Security benefits right at retirement, you would only be needing to withdraw $4,000 / month, since the other $3,000 is covered by your Social Security. Over the course of the year, starting Social Security right away at retirement would’ve potentially saved you from withdrawing $36,000 out of your retirement portfolio.
Say your retirement portfolio is growing at an average annual rate of 5%. Being able to keep that $36,000 invested leads to that $36,000 growing to $37,800 ($36,000 x 1.05) by the end of the year.
That’s the Opportunity Cost.
So, after 1 year, the decision to start at age 65 instead of age 70 provided value of $37,800, not $36,000.
Alternatively, say you don’t need that $36,000 to help with expenses. Maybe you have a pension that covers your expenses. Or an annuity that covers everything. You could still start receiving your Social Security benefits and invest that $36,000 since you don’t need it. Again, assuming you earn 5% on your investments, that $36,000 would have a future value of $37,800 after 1 year. $1,800 may not seem like much. But considering the long-term picture, compound this by 5% for 20 years, and the future value of that $36,000 becomes $95,519.
Cost-of-living Adjustments (COLA)
Additionally, when analyzing your Social Security claiming strategy, it’s important to remember Cost-of-living Adjustments. Social Security benefits are designed to keep up with inflation. You receive a COLA each year based on the year-over-year % increase of the CPI-W from the third quarter of last year to the third quarter of the current year.
Why this is important:
A COLA is a % increase in your benefit. Take 2023’s COLA for example. With 2022 being an extreme inflation year, the COLA going into 2023 for Social Security was 8.7%.
That means everyone’s Social Security benefit increased by 8.7%. But that does not mean everyone’s increase was the same. If your benefit is $2,000 / month. An 8.7% increase is $174. Your new benefit would be $2,174 / month. That’s an increase of $2,088 for the year.
If you have a higher benefit, say $4,000 / month because you delayed your starting age, an 8.7% increase for you would be $348. Your new benefit would be $4,348 / month. That’s an increase of $4,176 for the year.
Person 1 & Person 2 both received an 8.7% COLA. But Person 1’s annual income went up $2,088, while Person 2’s annual income went up $4,176.
Again, may not seem like too much to consider over one year. And 8.7% was an anomaly of a year. The average Social Security COLA over the last 10 years has been 2.6% annually. But compound this over a 20- or 30-year retirement, and it makes a big difference.
The charts above are from our Social Security software, and they help illustrate what we just discussed. In each of the three charts above, the dark green squares are the more favorable starting ages, while the lighter, tanner squares are the less favorable starting ages. The Optimal Claiming Strategy is noted by the “star” icon. You can ignore the “target” icon, which remains on their Full Retirement Ages of 67 for each grid.
Chart on Left: The chart on the far left is not considering a Rate of Return on Investments, nor is it considering any Cost-of-Living Adjustments. It is simply calculating the total $’s this couple would receive between now and age 85. As you can see, the star is in the very top right corner, signifying that both of them delaying till age 70 would be the Optimal Strategy. This is how I see most people analyzing their Social Security.
Middle Chart: The chart in the middle enhances upon the analysis from the chart on the left. The middle chart is now including a Rate of Return into the analysis. So, this chart is calculating for the Future Value of Benefits as we discussed in the beginning. You can see now the star is located towards the bottom left, signifying an Age 63 starting age as optimal. But this analysis still isn’t complete. It’s not including the estimated COLAs your benefits are going to receive. Which leads us to the third chart.
Chart on Right: The chart on the right is now calculating the whole picture. It is including both the Rate of Return from your portfolio, plus the annual COLAs. And as you can see, the star is now located at age 68.
So, while calculating $ for $ did help this couple to delay their benefits, they actually would’ve delayed too long had they followed their original analysis. Because of the Future Value of their Benefits, starting a couple years prior to age 70 would’ve led to a higher value received. Not in total $’s received. But from total value received.
This is how to properly analyze your Social Security Benefits when determining a claiming strategy for your retirement.
As mentioned above, we do utilize Social Security software to help with this analysis. It allows us to quickly compare various claiming strategies and various assumptions (life expectancies, rates of return, COLAs, etc.). However, assuming you don’t have access to this type of software, you can run these calculations on your own. It can be a little extensive from a time perspective, but if you’re comfortable working in Excel, that’ll really help.
I’ve created another blog, How to Calculate Your Breakeven Analysis for Social Security, that demonstrates how to properly complete this type of analysis on your own, as well as create your own Breakeven Analysis.
Everyone’s retirement situation is different. Claiming Social Security is not a “one-size-fits-all” deal. That’s why there are numerous options. It tries to be flexible to accommodate differing situations. For example, you may have intended on delaying Social Security, but then the market takes a huge dive, so you determine its better to draw Social Security now instead of sell investments from your portfolio after they’ve just sunk in value. Or you may have a spouse who is significantly less in age than you, and you want to make sure they’re taken care of well after you’re gone. Or maybe you have a health issue, and you don’t see a normal life expectancy for yourself. Whatever it may be. Everyone’s situation is different. But understanding how to properly analyze Social Security using Future Value of Benefits will help you make the best decision for yourself and your family.
I hope this blog is helpful in feeling more confident in your Social Security strategy and overall retirement plans. If you have any questions, please don’t hesitate to reach out. I’m a financial planner who helps people navigate retirement. You can get in touch with me through the contact page or by scheduling an appointment.
Thank you,
Drew Schaffer, CFP®
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