September 5, 2023 – Welcome back to a new blog post in the Safe Withdrawal Rate Series! It’s been a while! So long that some folks were wondering already if I’m all right. Nothing to worry about; we just had a busy travel schedule, spending most of our summer in Europe. First Italy, Switzerland, Austria, and Germany. Then, a cruise through the Baltic Sea from Sweden to Finland, Estonia, Latvia, Poland, Germany again, and Denmark. But I’m back in business now with a fascinating retirement topic dealing with Social Security timing: What are the pros and cons of deferring Social Security? If we set aside the ignorant drivel like “you get an 8% return by delaying benefits for a year” and look for more serious research, we can find a lot of exciting work studying this tradeoff. Earlier this year, in Part 56, I proposed my actuarial tool for measuring the pros and cons of different Social Security strategies, factoring in the NPV/time-value of money consideration and survival probabilities. A fellow blogger, Engineering Your FI, has done exciting work studying this tradeoff using net present value (NPV) calculations. And Open Social Security is a neat toolkit for optimizing joint benefits-claiming strategies.
But those calculations are all outside of a comprehensive Safe Withdrawal Rate analysis. How does Social Security timing interact with Sequence Risk? For example, can it be optimal to claim as early as possible to prevent withdrawing too much from your equity portfolio during a downturn early in retirement? In other words, if you’re interested in maximizing your failsafe withdrawal rate, you may feel tempted to pick a potentially suboptimal strategy from an NPV point of view. Sure, you underperform in an NPV sense on average if you claim early. But hedging against the worst-case scenarios may be worth that sacrifice.
Let’s take a look…
Before we even get started, I like to perform some preliminary calculations. Sometimes, folks in the FIRE community ignore their future Social Security benefits, whether out of laziness or excessive caution, due to potential future policy changes. Depending on your retirement age, you could leave a lot of money on the table! Let’s put that to the test. Assume that we have a retired couple, both 35 years old, with a $2,000,000 portfolio. I assume a 60-year horizon and capital depletion, a 75% stocks and 25% bonds portfolio (10-year Treasury benchmark bonds, and no supplemental benefits in the future. I calculate a safe consumption amount (=retirement budget) of $65,073, i.e., the safe withdrawal rate is about 3.25%.
Assuming a $10,000 supplemental annual income ($833.33/month) at age 67 (as always, in today’s dollars) would raise the safe withdrawal rate to $66,444 or about 3.31% of the initial capital if we assume we reduce the withdrawals later in retirement 1-for-1 when Social Security kicks in. Almost $1,400 a year more; that’s better than nothing! Also, the effect on the sustainable retirement budget is approximately linear (within bounds, of course). So, for example, for a $30k/year retirement income at age 67, we’d bump up the retirement budget by more than $4,000 per annum.
Once you get closer to age 67, supplemental income will have larger benefits on your retirement budget. In the table below, I list the results for different retirement ages and retirement horizons. If you retire in your mid-to-late-40s, like most folks in the FIRE community, don’t ignore future Social Security benefits! First, you will likely have accumulated significant Social Security credits with a long enough work history, and you will bump up your retirement budget by about 30-35% of the future expected income, equivalent to raising your SWR by 0.15 to 0.18 percentage points. Don’t leave that on the table! But maybe apply a small haircut to account for the likely policy uncertainty. But it is certainly true that for extremely young retirees, say, at 30 years old, future Social Security benefits don’t make a huge benefit.
Social Security Timing for Early Retirees
I established that early retirees should certainly incorporate future benefits into their safe withdrawal rate calculations. But should they worry about the exact Social Security timing, too? Sure, at age 45, you would not lock in your retirement age. You can defer that decision until at least age 62. But will a change in the timing of benefits make a meaningful difference in the sustainable retirement budget? Without running explicit simulations, we can already suspect the answer is no. If you retire 20 years before your eligibility age, you don’t get much of a hedge from Sequence Risk because Sequence Risk arises from large portfolio drawdowns during bear markets in your first 10-15 years. But we can certainly study how much of an impact different claiming strategies would have.
So, let’s assume we now have a 45-year-old couple, $2,000,000 in their portfolio, a 50-year horizon, and no bequest target (i.e., capital depletion is OK). They expect combined monthly benefits of $2,500 at age 67, i.e., $30k a year. How much would we alter the retirement math by claiming early ($1,750 at age 62) or late ($3,100 at age 70)?
Before I dig into the details, let me first report the safe consumption amounts for this 45-year-old couple for the different claiming strategies.
- Age 62: $74,862
- Age 67: $74,412
- Age 70: $74,049
It turns out that claiming earlier, at age 62, will give us a slight edge. Not by much; we’re talking about $400 annually in additional retirement budget when claiming at 62 instead of 67. That’s about a 0.5% increase in the budget or a 0.02 percentage point rise in the sustainable withdrawal rate. The range between the best timing (62) and worst timing (70) is about $800 a year or 0.04 percentage points. Not much, but better than nothing.
I want to understand what’s going on here and whether the superiority of claiming as early as possible is generally valid for all cohorts. I plot the advantage of claiming at 70 vs. 62 in a time series chart below. The blue line is the advantage of deferring benefits (plotted using the left axis), and the orange line is the safe withdrawal rate when claiming at age 62, using the axis on the right. There have been historical cohorts where deferring benefits would have been advantageous, namely between 1933 and 1955. Still, all historical worst-case cohorts, like 1929 and the mid-to-late-1960, when the SWR dropped below 4%, were all instances where claiming earlier would have been advantageous.
Side note: Social Security wasn’t even around in 1929. So, why would I simulate that cohort planning for future benefits? It is very simple: think of my simulations as thought experiments where today’s retirees who enjoy today’s government programs want to model safe withdrawal strategies that could withstand a replay of past asset returns. Just because you believe that 1929-1932 could happen again doesn’t necessarily mean that we would also lose Social Security and go back into the 1920s in all other respects.
And again, just for reference, not modeling the Social Security income at all would give you a safe retirement budget of only $66,986. Generally, modeling future benefits is essential for 45-year-olds in early retirement. But it’s likely too early for most of us in the FI community to worry about the precise Social Security timing, at least from a Sequence Risk perspective. I recommend deferring that decision until you get closer to the eligibility age. But eventually, that day will come, which brings me to the next section…
Social Security Timing for a 62-year-old
Now assume that we’ve reached the earliest possible benefits-claiming age, currently 62. Assume that our retired couple has a 33-year horizon up to age 95, a $2,000,000 portfolio, and monthly benefits at age 67 of $2,500. As before, claiming at age 62 would imply $1,750 in monthly benefits (30% reduction), while deferring until age 70 would give you $3,100 or a 24% benefits boost.
Here are the safe consumption amounts when claiming at different ages:
- Age 62: $95,840
- Age 67: $96,198
- Age 70: $96,858
Remember that when claiming at age 62, the $95,840 annual safe consumption level already includes the $21,000 Social Security benefits. That’s one of the reasons why I prefer the term “Safe Consumption Rate.” You are withdrawing only $74,840 from the portfolio, while the rest comes from Social Security!
It’s intriguing that the order is reversed relative to the 45-year-old retriees; you do better deferring benefits. Clearly, there may be a benefit to claiming early and preventing portfolio withdrawals when prices are down. But the worst-case scenarios in past retirement cohorts faced very long portfolio drawdowns, sometimes 15-20 years. Thus, getting those higher benefits at age 70, only eight years into retirement, ensured that your portfolio recovered eventually. Below, I plot the same style plot again as before. Notice how the blue line is consistently above zero around the historical worst-case cohorts (1929, 1964-1968).
But also note that for some cohorts with very high SWRs, say post-1980, when SWRs would have been 10+%, it would have been reversed: You were better off claiming early, at age 62, to avoid drawing down the portfolio during the roaring 1980s bull market. That’s very intuitive.
Even the cohort that retired at the 1937 market peak would have been roughly indifferent between claiming at 62 vs. 70, indicated by the blue line being close to the zero line around that time. That makes sense because the 1937 bear market was much shorter than the market drawdowns starting in 1929 and the 1970s and 80s.
Social Security Timing Case Study: September 1929
I want to drive home the point from the previous section and showcase how deferring benefits until age 70 would have improved the retirement experience. Assume that our 62-year-old couple had retired right before a replay of the stock market crash preceding the Great Depression, i.e., in September 1929. This was indeed the historical worst-case scenario, so a retirement budget of $95,840 (the fail-safe amount quoted above) would precisely deplete the $2,000,000 portfolio after 33 years. What if we had used the same $95,840 retirement budget but deferred Social Security benefits until age 70, then? Let’s plot the portfolio value of the two strategies in the chart below. I plot the two portfolio values as well as the difference (70 vs. 62). Claiming benefits at age 70 would have drawn down the portfolio even more for the first eight years, but eventually, our retirees would have come out ahead by about $126k after 33 years. The crossover point occurs after 317 months, i.e., more than 26 years into retirement.
Summary so far: A replay of the Great Depression market event is long enough for you to find it advantageous to defer your benefits rather than claim Social Security early at age 62. The larger benefits starting in year eight will help during the recovery period. In fact, the higher benefits would have kicked at precisely the right time in 1937 when the stock market took another severe nosedive.
Social Security Timing Case Study: December 1968
Next, let’s do the same exercise for the December 1968 cohort. Again, I set the retirement budget to exactly deplete the portfolio after 33 years, implying a slightly higher budget ($95,983 p.a.) than in 1929. I apply the same retirement budget but defer benefits to age 70 and plot the portfolio time series in the chart below. This time, deferring benefits beats claiming at 62 by about $432k after 33 years, though we’d again draw down the portfolio during the first eight years. The crossover point is now 232 months, about 19 years into retirement.
Again, the higher benefits starting in year eight would have been well-timed when the stock market was still down in the mid-70s and facing another two recessions and accompanying bear markets in the early 80s.
A Social Security “Bridge Strategy”
Notice that if you are 62 years old and would like to defer benefits until age 70, it doesn’t necessarily mean that you must suffer through Sequence Risk for the first eight years of retirement. You could, of course, create your own quasi-Social-Security payments. Simply set aside a portion of your portfolio to build a bond ladder, or even better, a TIPS ladder, to bridge the years until you can claim your maximum benefits. Especially with bond interest rates back to multi-year highs again – around 2% for real-inflation adjusted TIPS – that plan looks more attractive now.
Let’s assume our retired couple, aged 62, defers benefits until age 70 but sets aside enough money to bridge the first eight years with $3,100 of monthly (real, CPI-adjusted) income from a TIPS ladder. I assume the real interest rate is 2% p.a. How much money would we shift from the 75/25 portfolio? We can use the Excel PV function…
… which is about $275,000.
(Side note: some folks prefer the compounding formula for the monthly interest, i.e., 1.02^(1/12)-1, but it makes no noticeable difference for small enough interest rates.)
Your $1.725m portfolio plus $3,100 monthly in supplemental income from the bond ladder in years 1-8 and Social Security after that affords us a safe consumption level of, get this, $101,739. That’s significantly higher than the $96,858 in the model without the bond ladder.
But make no mistake! The bond ladder would have been effective only for the cohorts that retired at or close to the historic market peaks, right before your retirement portfolio would have tanked and returned significantly less than the 2% real return in the TIPS ladder. Most of the time, the TIPS ladder would have underperformed your 75/25 portfolio. But of course, that’s the nature of this Sequence Risk hedge: you do better in the worst-case scenarios, but you lose a little bit and leave a slightly less spectacular inheritance to your heirs when the market rallies during your first eight years of retirement. Most retirees are willing to pay this “insurance premium.”
After 7+ years of blogging and 50+ posts in the SWR Series, I’ve finally looked deeper into the Social Security timing question. Contrary to popular belief and my initial intuition, claiming benefits early will not necessarily hedge against Sequence Risk. That’s because some of the historical bear markets were far too long, and getting benefits at age 62 instead of 70 would not have made much of a difference from a Sequence Risk perspective. Quite the opposite, claiming at age 70 proved to work better around the historical worst-case scenarios like 1929 and 1968. Also, to effectively hedge some of the Sequence Risk, it’s best to defer Social Security (maximize the monthly benefits) and rather use a bond ladder to fund retirement between ages 62 and 70.
But of course, timing Social Security is not exactly an urgent issue for me personally. It’s best to defer the exact timing decision until we reach our earliest benefit-claiming age, likely 13 years from now. But as an academic exercise, it’s still helpful to run the math. I hope you enjoyed it, too!
Thanks for stopping by today! Please leave your comments and suggestions below! Also, check out the other parts of the series; see here for a guide to all parts so far!
All the usual disclaimers apply!
Picture Credit: Wikimedia