By Laurence Kotlikoff
Here’s a critical question confronting the 10,000 baby boomers retiring daily, each of whom must decide when to take Social Security.
How much are my future Social Security benefits really worth?
The answer matters. If we place very little value on future benefits, we’re going to take our benefits as soon as possible. But doing so comes at a price – a permanently reduced level of benefits. The reduction is substantial. Social Security retirement benefits starting at 62 are, on an inflation- or purchasing-power adjusted basis, only 57 percent as large as retirement benefits starting at 70.
Waiting eight long years without collecting a single penny isn’t easy. Think of all the bills and vacations those Social Security checks could cover between 62 and 70. On the other hand, collecting early can fill our “golden years” with regret. Imagine living to 100 and spending 30 years – from 70 to 100 – knowing that your monthly check would have been 76 percent larger had you waited until 70 to collect. (Note, 1 divided by 1.76 gets you to the 57 percent.)
Soooo, you don’t want to undervalue or overvalue future Social Security benefits. Doing either will lead to all kinds of mistaken financial, housing, and retirement decisions. It can also lead you to take the wrong benefits at the wrong time.
Unfortunately, valuing your future Social Security benefits isn’t straightforward. Uncle Sam is promising to give us money in the future. But there’s a catch. We have to be alive to collect it. If we croak, well, we’re plain out of luck. Yes, there is a measly death benefit and substantial survivor benefits for our spouses and children, but that makes valuing future benefits even more complicated. Let’s just stick for the moment to the problem of valuing the future retirement benefits of Joe, the orthodontist, who never married, never will marry and neither has nor will have kids.
Valuing something means determining its current price – what you can sell it for today. Thus, in principle, pricing Joe’s future Social Security benefits – finding what they are worth today -- is no different from pricing other things Joe owns – his house, his car, his golf clubs, etc. In practice, though, neither Joe nor anyone else can sell his claims to future Social Security benefits.
Joe’s situation is not much different from trying to value, say, a newly discovered painting by a well-known painter, which had never been sold. An appraiser would compare the painting with others by the painter that were similar in various ways, but that had been sold and come up with a price by what amounts to analogy.
With Social Security benefits, the closest analogous financial products are inflation-indexed Treasury bonds, known at TIPS, which stands for Treasury Inflation-Protected Securities. Like Social Security benefits, the payment on TIPS is adjusted for inflation and is being made by Uncle Sam.
By buying the right amounts of TIPS bonds of various maturities (dates at which the bonds come due), Joe can, with three buts, secure an income stream that is insulated against inflation and that matches what he’ll get from Social Security. The buts aside, the cost of buying these TIPS provide a valuation of Joe’s Social Security benefits.
The first but is that the longest maturity TIPS extend out only 30 years. If Joe is now 60 and could possibly live to 100, he has claims to Social Security benefits that extend out 40, not 30 years. One can get around this problem, however, by inferring from the price of 30-year TIPS what TIPS of longer maturities would likely sell for.
The second but is that Congress can change Social Security benefits, whereas it can’t change the return on TIPS unless it defaults on this and, presumably, other forms of its official debt. The likelihood that Social Security benefits would be cut for current or near term retirees seems quite remote. The America Association of Retired Persons has some 38 million members who can easily be galvanized to keep Congress’ paws off “their” Social Security.
The third but is that with TIPS, Joe’s receives payment regardless of whether he’s dead. In contrast, his Social Security check stops when he dies. If Joe has potential heirs that he cares about, the same income coming from TIPS will be more valuable than coming from Social Security benefits because the former will make payments to heirs.
This third but suggests that Joe value Social Security benefits based on the value of a portfolio of TIPS that deliver the same annual income stream as his benefits, but with the valuation reduced to reflect the lack of payment to heirs.
In my company’s Social Security software, Maximize My Social Security, we set a default value for valuing future benefits. Specifically, we assume that users will discount, as in value less, future inflation-adjusted Social Security benefits by 2 percent for each year these benefits lie further in the future. But users are free to set higher or lower real (inflation adjusted) discount rates.
Those who place no value on their heirs should use a discount rate of about 1 percent, which reflects how, roughly speaking, the market is now discounting TIPS across all their maturities in setting its market price (with extra weight on longer term issues since most benefits will be paid over the long term). For these people, TIPS are just like Social Security benefits, in terms of securing extra spending in old and old old age, so they value Social Security benefits just like TIPS, i.e., they use the prevailing market price of TIPS to value their benefits.
For those who place a high weight on their heir’s future spending capacity, Social Security benefits are less valuable than TIPS because TIPS provide something for their heirs. So they value their Social Security benefits at less than they’d have to pay for TIPS, which is another way of saying they discount their benefits at a higher rate, like 2 or 3 percent, than the market now discounts future income from TIPS.
Finally, there are those who aren’t interested in securing more future spending either for themselves or their heirs. Such people would, instead, borrow against their future Social Security benefits if only they could. For these people Social Security benefits aren’t worth what they’d have to pay for TIPS. Consequently, they too would want to discount their benefits (make less of them) at a high rate.
The bottom line is that a real discount rate of at least 1, 2, 3 percent or even higher seems appropriate for valuing future Social Security benefits. But the right discount rate to use is household-specific.
Unfortunately, many of the other available web tools that “help” you decide when to take Social Security overvalue these benefits to a very considerable extent by assuming a zero discount rate. They treat $1 of purchasing power received in 30 years and only if you are alive as equal in value to having $1 of purchasing power today.
Yes, proper Social Security planning can mean very big bucks. But by not discounting, these tools overstate the value of future Social Security benefits and advise some people to wait for benefits longer than is appropriate. They can also lead married couples to take spousal and retirement benefits in the wrong order. The same is true for widows and widowers in taking survivor and retirement benefits.
Laurence Kotlikoff is an economist at Boston University, co-author of "The Clash of Generations." His software company markets Maximize My Social Security.