Friday, July 20, 2012

Pascal's Wager and Social Security Retirement Benefits

by Dirk Cotton

With many of my friends approaching their 60th birthday, I frequently hear conversations about when to claim Social Security retirement benefits. The earliest age to collect those retirement benefits is 62, but postponing your claim can substantially increase your annual benefit and provide insurance against running out of money before you run out of time.
Break-even ages are often recommended as a tool for deciding whether to claim your retirement benefit at the earliest age of eligibility or to postpone your claim so you can receive a higher benefit later.
That’s the choice with Social Security retirement benefits: less now or more later. If you are able to postpone your claim to the maximum benefit age of 70, for instance, you can nearly double your benefit. Of course, you will receive that larger benefit for eight fewer years.
The break-even argument is misleadingly attractive. It asks what might happen if you don’t live past your 70’s, but ignores what might happen if you do live to 95 or 100.  A 65-year-old couple has a 31% chance of at least one of them making it to 95. 

Pascal's Wager

Let’s take a brief detour to seventeenth century France. Blaise Pascal, a mathematician, physicist, inventor, writer and Catholic philosopher, created a philosophical argument we call “Pascal’s Wager”. Pascal argued that either there is a God or there isn’t, and that we can either choose to live a righteous life or not.
Pascal noted the following four possible after-life scenarios:

Avoid Mortal Sins
Commit Mortal Sins
God Doesn’t Exist
God Exists

If we commit mortal sins, Pascal noted that the possible outcomes are Nothing, if God does not exist, and Hell if he does. No big winners in that column, but a really big loser.
If we live a righteous life instead, the possible outcomes are Nothing and Heaven. Like Pascal, I’d prefer to draw my ticket from that box. 
We can avoid the possibility of spending eternity in Hell if we bet there is a God and live a righteous life. If we are wrong and it turns out there is no God, we have lost nothing except the opportunity cost of a life of debauchery.
Pascal concluded that it is best to not sin and to wager that God exists. In other words, eliminate the worst-case scenario.
What does Pascal’s Wager have to do with Social Security retirement benefits? Actually, it is a useful tool for all kinds of risk analysis. The lesson is to avoid unacceptable outcomes whenever possible and particularly when the cost of doing so is low.
The worst-case financial scenario for retirement is running out of money before you die and spending your dotage in the poorhouse. Your decision of when to claim your Social Security benefits can have a significant impact on the possibility of that happening.
Now, let’s return to the 21st century and see how the Social Security break-even analysis works.

When Do You Break-Even After Postponing?

Assume you were born in 1950 and can claim Social Security retirement benefits at the earliest age of 62 in 2012. You earned $50,000 a year in 2011 and learn from the Social Security Administration website's QuickCalculator that you are entitled to the following benefits:

Claim Benefits at Age:
Monthly Benefit Claimed at this Age for Life:
Annual Benefit
Approximate Break-Even Age for Postponing Claims from Age 62


(I rounded these numbers to simplify the explanation, but they’re in the ballpark. Also, the break-even ages vary somewhat depending on your specific situation.)
In this example, you would have the choice of receiving $1,000 monthly starting at age 62. You would also have a choice of waiting until age 66 to claim a benefit of $1,400 monthly, but you would receive no benefits at all before age 66.
If you postponed claiming until age 66 and began receiving that benefit, you would receive $4,800 per year more than if you claimed at age 66, but you would need to replace the four year’s worth of benefits of $1,000 per month ($48,000) you lost from ages 62 to 65 before your decision to postpone would begin to pay off. It would take ten years to recover those benefits you passed up, and that would occur when you were 75.
The “break-even age”, then, for postponing your claims from age 62 to age 66 would be age 75. If you die sooner than age 75, claiming at 62 will have worked out better for you. If you live longer, postponing claims would have been the more lucrative decision.
Many people look at the break-even analysis and say, “I’m not sure I’ll live to age 75 so I’ll take the sure thing, even if it’s smaller.”

If You Die Before Break-Even. . . And If You Don't

Let’s overlook for the moment the fact that healthy people have no idea when they are going to die, though I believe that is a very strong argument against break-even analysis. By the same token, having a terminal illness would be a strong argument to claim at the earliest age.
They’re essentially asking, “What if I die before the break-even age”, but they also need to ask, “What happens if I don't and I live to 95 or 100?” Here’s where our friend, Blaise, comes in, because we want to avoid the unacceptable outcome of dying broke, the “Hell” of retirement finances.
Here are the potential outcomes:

Die Before Break-Even Age (Mid-70’s)
Die Soon After Break-Even Age (Late 70’s)
Live to 95 or Longer
Claim SS Benefits at 62
You maximized benefits
You nearly maximized benefits
Condemned to decades of the lowest possible benefit
Postpone Claim as Long as Possible
You lost all SS benefits, but had other income
You maximized benefits
You maximized benefits

Note that there are only two scenarios in which you will not have maximized your Social Security retirement benefits, or nearly so. The first is when you die soon after age 62 and receive no benefits because you postponed claiming, but this isn’t as bad as it might initially sound. Presumably, you made the decision to postpone claiming because you could afford to do so. You had enough savings or could work longer, so you didn’t do without.
The worst-case scenario, the one Pascal warns us to avoid, is living to a very old age after claiming at age 62 and locking in your lowest possible benefit for the next 33 years or more. There are many older retirees, mostly women, who will now tell you that claiming Social Security benefits early was the worst financial decision they (or their spouse) ever made.

A Widow May Receive Far More Survivors Benefits than Retirement Benefits

The case for postponing claims is even more compelling for a higher-earning spouse of a married couple1. When you choose to claim your retirement benefits will impact the amount of your spouse's survivors benefit should you be the first to die. For widows who live long after their spouse dies, survivors benefits will be much more important than retirement benefits.
Imagine a couple of the same age who retire at the same time at age 62. The husband passes away at age 70 but the wife lives to 95, not an uncommon scenario. The wife will receive 8 years of retirement benefit payments, but 25 years of survivors benefits. And the amount of her survivors benefit check will be determined by when the husband claimed his retirement benefits.
The lower-earning spouse is entitled to his or her own benefit or up to half the other spouse’s full retirement benefit, whichever is larger. In the example above, a spouse would be eligible for half of the full retirement age (66) benefit of $16,800, or $8,400 per year. If the spouse’s own benefit was greater than $8,400 a year, he or she would receive his or her own, instead.
Spousal benefits do not depend on when the higher-earning spouse claims his or her benefit. They are based on the spouse’s full retirement benefit in all cases. However, Social Security survivors benefits are up to 100% of the retirement benefit the deceased spouse received, compared to 50% of the full retirement age benefit for spousal retirement benefits2.
In the example above, the surviving spouse's survivors benefit would be $12,000 a year if the deceased spouse claimed retirement benefits at age 62, while the largest possible survivors benefit would be $24,000 if the deceased spouse had postponed claiming until age 70. That’s double the annual Social Security benefit for a widow who might need them for two or three decades.

For Most Households, Postponing Won't Be an Option

It’s time to inject a bit of reality, however. More than half of U.S. households about to retire have no retirement savings at all.  The median balance of a 401(k) account for those who have one was just $78,000 a few years ago and it would generate only about $3,000 a year of income for a retiree. The vast majority of U.S. households will need Social Security benefits just to meet living expenses and postponing claims will not be a viable option.
If it is an option for your household, because you have adequate savings to fund your first few years of retirement or because you can work past age 62, I strongly recommend that you pay little heed to break-even ages. The Social Security Administration used to have a break-even calculator on their website but took it down a few years back because they felt it was providing poor guidance.
I recommend that you consider all the possible outcomes and the value of longevity insurance that postponing claims as long as feasible can provide, especially if you are a higher-earning spouse. We should be more afraid of living out our old age in poverty than of dying sooner and not getting every penny of Social Security benefits we earned.
It is especially important that you understand the impact your Social Security claiming decision might have on your spouse's survivors benefits.
Your surviving spouse might be thanking you for decades after you learn how Pascal's wager turned out for him.

1I omitted discussion of two additional reasons to delay claiming retirement benefits until at least full retirement age, which will be 66 for the next decade or so of retirees, so as not to confuse an already complex topic. If you claim your own retirement benefit and become eligible for a larger spousal benefit later (or vice versa), you can switch to the larger benefit, but only if you waited to claim until your full retirement age. Claiming before full retirement age permanently locks in that benefit. Also, if you claim benefits before full retirement age and continue to work, part of your income will offset Social Security benefits until you reach full retirement age.

2If the spouse dies before receiving his or her own benefits, survivors benefits are based on the deceased's full retirement age benefit.