Social Security provides a key source of retirement income for tens of millions of Americans, and one of the biggest financial decisions that older Americans have to make is when to start taking their Social Security benefits. Faced with a choice between larger benefits later in life and smaller benefits immediately, many choose to take their Social Security retirement benefits right at age 62, the earliest claiming age.
The Social Security Administration (SSA) has said that its intent in offering larger payments to those who delay taking benefits is to make the choices actuarially equivalent -- meaning that for the average person, when you claim shouldn't have an impact on how much you receive in benefits. But that's an overly simplistic summary of what's actually a complex mathematical question.
Fortunately, analyst Brian Alleva, with the Office of Retirement Policy and the Office of Retirement and Disability Policy at the SSA, did a much more thorough research project a couple of years ago that took a much closer look at the claiming decision. The study's conclusions make it clear that the ideal claiming decision varies depending on the investment strategy that a retiree follows. For stock market investors, that generally favors claiming as early as possible.
Discount rates and Social Security benefits
Most analyses of Social Security claiming ages focuses on looking at how much money you'll get from Social Security over the course of your lifetime. Claim early, and you'll get smaller payments but for a longer period of time. Wait, and your payments will be larger, but you'll get fewer of them. Guess how long you expect to live, and you'll be able to compare outcomes and decide which choice is likely to pay you more in the long run.
Strangely, though, most analyses of Social Security benefits ignores the time value of money. In order to keep the math as simple as possible, you'll typically find comparisons based on current-value benefit payments. In the language of the SSA study, this analysis assumes a real discount rate of zero, incorporating only the rate of inflation in valuing earlier payments more highly than ones further into the future.
Some analysts have argued that using the real discount rate for bonds is the better way to analyze the claiming decision. Because Social Security payments resemble what investors can get by purchasing an immediate annuity from a private insurance company and because Social Security is a financial obligation of the U.S. government, the argument goes, using the inflation-adjusted long-term bond rate makes the most sense.
However, the Alleva study sought to look at how different assumptions about the discount rate can lead to different optimal choices for when to claim Social Security. For investors, the results are eye-opening because they shed light on how aggressive and conservative investors can come to different conclusions about which decision is smartest.
Aggressive investors should claim earlier
The most important part of the SSA study's analysis looks at how choosing a discount rate affects the claiming age at which you can maximize your benefits. For an ultra-conservative investor who uses a real discount rate of zero, claiming at 62 pays the most until your life expectancy reaches around age 77. Then, the ideal claiming age rises to 66 by age 80 and hits 70 at around age 86. Those figures are almost identical to what traditional breakeven analysis typically gives.
However, the more aggressive an investor is, the higher those ideal claiming ages go. When you use a 2.4% real discount rate -- roughly equivalent to the typical return on long-term bonds -- the entire decision curve is shifted up about two to four years. In other words, in order to justify waiting beyond age 62 using the higher discount rate, you'd have to be confident in living until nearly age 80 rather than age 77.
For those who invest primarily in stocks, the real discount rate of 6.7% produces a scenario in which it never makes sense to wait until age 70 to claim Social Security. Indeed, unless you expect to live beyond age 95, waiting even until full retirement age is inferior to claiming as soon as possible. Once you hit a real discount rate of 7.5%, it's always smartest to claim at 62.
What the SSA study means for you
Few people use this sort of analysis in justifying taking their Social Security benefits early. That's appropriate, because despite the initial intent of Social Security not to be a primary income source, most people don't have substantial retirement nest eggs that they invest.
But for those who do have outside investments, the SSA analysis provides useful information in gauging this key claiming decision. Wait to claim, and you'll have to tap into your other financial resources earlier, forcing you to sell off investments that would likely have produced positive returns. Claim earlier, and you can let those investments grow longer. The more they grow, the smarter it will have been to allow them to do so by using Social Security to cover your living expenses instead.