Delaying Social Security benefits: A real options perspective
March 3, 2007 (original: February 21, 2007)
December 2010 update: On December 8, 2010, the Social Security Administration established a 12-month, one-time limit on the ability to reverse an early election of benefits by repaying the benefits received without interest.
(Notes are at the end.)
Every year millions of people become eligible to receive Social Security retirement benefits, and they face an important decision: Should I elect to receive a reduced benefit now, or should I wait to receive a greater benefit later?
Different methods of analysis can lead to different conclusions. In particular, you are more likely to elect a reduced benefit if you treat the decision as a one-time-only choice than if you treat it as an option.
Under current law, you are eligible to receive Social Security retirement benefits at age 62, but you can choose to postpone the starting date until any time up to age 70. There is no deadline for making a decision; your retirement benefits will begin when you notify the Social Security Administration that you want to begin receiving benefits.
The reward for postponing the starting date is that you will receive a higher monthly benefit. The benefit increase depends upon your year of birth, which determines the age at which you are eligible to receive a full retirement benefit. This age, called the full retirement age, varies from 65 (for people born before 1938) to 67 (for people born after 1959). You can elect to receive your full retirement benefit at that age, and it will be adjusted for inflation each year.
If you want to receive Social Security payments before your full retirement age, you will receive a permanently reduced benefit that is a percentage of the full benefit amount. That percentage depends upon your year of birth and your starting age. For the minimum starting age (age 62), it varies from 80% (for people born before 1938) to 70% (for people born after 1959). The percentage reduction declines each month between age 62 and your full retirement age.
If you want to postpone the starting date for Social Security retirement benefits beyond your full retirement age, you will receive a permanently increased benefit that is a percentage of the full benefit amount. That percentage depends upon your year of birth and your starting age. The monthly rate of increase varies from 0.4583% (5.5% annual) for people born before 1935 to 0.6667% (8.0% annual) for people born after 1942. The delayed retirement credit levels off at age 70, so there is no incentive to delay receiving retirement benefits beyond age 70.
One disadvantage of receiving benefits before your full retirement age is that benefits are reduced by employment income above an annual exempt amount, although lost benefits may be recovered at your full retirement age. Employment income does not cause any reduction in Social Security retirement benefits after you reach your full retirement age.
If you are married, you and your spouse also have to make a decision about your spouse’s benefit, and you have to consider how your decisions affect the survivor’s benefit.
Income taxes also enter the picture. Up to 85% of Social Security retirement benefits can be subject to income tax. The taxable amount depends on your other sources of income.
Given all of these details to consider, and assuming that you do not need to rely on Social Security benefits for basic living expenses, how can you decide when to start receiving benefits?
The breakeven approach
The usual method is to estimate how long you will have to live in order to be better off by waiting to receive benefits. You can then compare this breakeven age with your own guess about how long you expect to live.
The Social Security Administration’s website (www.ssa.gov/retire2/delayret.htm) gives a simple example. Suppose your monthly benefit at age 62 is $758, and your monthly benefit at full retirement age (65 years, 10 months) is $1,000. Your breakeven age would be 77 years, 10 months, because the sum of the benefits received from age 62 through the breakeven age (190 months x $758) would be almost the same as the sum of the benefits received from full retirement age through the breakeven age (144 months x $1,000). Because retirement benefits are adjusted for inflation, this calculation implicitly assumes that you can earn a 0% before-tax real rate of return on your investments (or that your before-tax real discount rate is 0%).
Breakeven analyses can be refined by selecting appropriate discount rates and mortality probabilities and by measuring expected present value rather than breakeven age. (Note 1)
The real options approach
The breakeven approach answers this question: If I have only one opportunity to choose between receiving benefits now or later, what should I do? However, this is not the situation that people actually face. The Social Security Administration does not require you to specify a starting age when you reach age 62.
What people really need to know is this: What should I do now, given the fact that I will have many opportunities to choose again later? This is a more difficult question to answer, and it requires a more powerful method of analysis.
Three features of the Social Security decision are worth noting. First, it is generally irreversible; although some post-decision changes are allowed, they may be impractical to implement. Second, the gain from choosing one alternative over another is uncertain; it depends on many factors, including your life expectancy and your discount rate. Third, you have the option to wait to decide, each month until age 70.
Financial decisions that involve irreversibility, uncertainty and the ability to delay can often be understood more clearly by using real options analysis, which applies option-pricing theory to a wide range of investment situations. Real options analysis provides a way of thinking about the value of flexibility; in this case, the flexibility to wait to decide when to receive Social Security benefits.
You can find a detailed explanation of the use of real options analysis in personal finance in “Should You Convert to a Roth IRA? A Real Options Perspective” (www.glenndaily.com/documents/rothira.pdf) and “Decision Making Under Uncertainty: A (Second) Wakeup Call for the Financial Planning Profession” (www.glenndaily.com/documents/wakupcall.pdf). Briefly, the goal is to restate the Social Security decision as a decision about whether to exercise an option, and then to use option-pricing techniques to solve the restated problem.
The table below shows the analogy between owning a call option on a dividend-paying common stock and having the option to receive Social Security benefits early.
|Analogy between a call option on common stock and the option to receive Social Security benefits early|
|Call option||Option to receive Social Security benefits early|
|Financial option, associated with an underlying financial instrument||Real option, associated with an underlying investment project|
|Option price (the value of an exchange-traded or over-the-counter option)||Total value of the early election option: dynamic net present value = static net present value + value of timing option|
|Shares of common stock||Difference between early and delayed Social Security benefits|
|Stock price||Expected present value of difference between early and delayed Social Security benefits|
|Volatility of stock price||Uncertainty about the advantage of receiving Social Security benefits early, due to uncertainty about life expectancy, future tax laws, Social Security benefits, investment returns, inflation and other factors|
|Intrinsic value||Expected present value of difference between early and delayed Social Security benefits|
|Expiration date||Age 70|
|Dividend||Forgone Social Security benefits due to delay|
|Risk-free interest rate||Risk-free interest rate|
In this framework, your default choice is to start receiving benefits at age 70. However, the option to start receiving benefits as early as age 62 gives you a claim on the expected gain from choosing early benefits. If there is no expected gain from an early starting age, your option is analogous to an out-of-the-money call option, and the decision is obvious: you delay receiving benefits.
On the other hand, if there is an expected gain from an early starting age, your option is analogous to an in-the-money call option, and you have to decide if it is wise to exercise the option. The breakeven approach implicitly says that every in-the-money call option should be exercised, but economists have known since the 1970s that this is bad advice. Sometimes it is smart to exercise the option, and sometimes it is a blunder.
Options are valuable because they let you enjoy good outcomes while walking away from bad ones. If you own a stock, you will make money if the price goes up and lose money if the price goes down. If you own a call option on the stock, you will make money if the price goes up, but you won’t lose money if the price goes down. The more uncertainty there is about the future price of the stock, the more valuable the option is.
When you exercise the option, you give up the opportunity to wait to see how the future unfolds. On the other hand, if you hold the option instead of the stock, you miss out on receiving stock dividends. Conceptually, you need to weigh the cost and benefit of waiting. The basic rule for handling call options on common stock is that you should exercise the option if the option price immediately after the stock pays a dividend will be less than the intrinsic value of the option (that is, the difference between the stock price and the exercise price) immediately before the dividend payment. This will depend on the length and in-the-moneyness of the option and the size of the dividend.
How can you apply real options analysis to make a decision about when to receive Social Security benefits? There are 96 months from age 62 to age 70, so you have 96 chances to decide if you want to receive benefits before age 70. Applying the basic rule for handling call options, the optimal time to start receiving Social Security benefits is the month in which the expected gain from an early election (the intrinsic value of the option) is greater than the value of the delay option if you wait.
That’s the theory. However, it is very difficult to calculate the value of the delay option, as you can for a call option on common stock, and that means that you are missing a necessary piece of information to determine the optimal starting month. So is all of this just a waste of time? Not at all. The real options perspective encourages you to show respect for uncertainty by considering the possibility that receiving benefits early might not look as good tomorrow as it does today.
In the Social Security Administration’s example, you would forgo $758 at age 62 by delaying the starting date by one month. Is it worth $758 (before taxes) to have another month to compare the value of early versus delayed Social Security benefits? Suppose you expect to die at about age 76. If you start receiving benefits now, the sum of benefits until age 76 will be $127,344 (168 months x $758). If you wait a month, your benefit will increase to $761 (in real dollars). The sum of benefits until age 76 will be $127,087 (167 months x $761). Two months from now, your benefit will be $764, and the sum of benefits until age 76 will be $126,824 (166 months x $764).
By forgoing $1522 now, you can wait a month to see if new information will make delay look better. For example, new medical research or a lifestyle change might persuade you that you could live beyond age 76, or you might decide that having a higher inflation-adjusted lifetime income is a good hedge against longevity risk, or you might want to take advantage of new planning strategies, such as income bridge products. (Note 2)
This simple calculation understates the value of the option to wait, because it ignores the value of being able to wait beyond two months. To value the option properly, you would have to start at age 70 and work backwards to age 62, looking at all of the possible scenarios that could occur (including changes in life expectancy, discount rates, tax rates, employment, Social Security laws and financial planning strategies) and your election decision at each point.
If your Social Security election option is deep-in-the-money — that is, if early election appears to provide a much greater total benefit than delay — it will be hard to think of plausible scenarios that make delay work to your advantage. In that case, the real options perspective will simply confirm the guidance provided by a breakeven analysis. However, when the advantage of receiving benefits early is not so decisive, the real options perspective leads you to think more carefully about plausible scenarios that would favor delay.
This suggests a research project: interview people who elected early benefits and find out if subsequent events vindicated their decisions or provided reasons for regret.
- For recent examples of breakeven analyses, see Kathy M. Kristof, “Social Security Now — Or Later?”, Los Angeles Times, February 16, 2007; Christine Fahlund, “Invest or Delay? Strategies for Taking Social Security Benefits,” AAII Journal, February 2007; John J. Spitzer, “Delaying Social Security payments: a bootstrap,” Financial Services Review, Fall 2006; Kathryn Garnett, “Social Security: What’s the Magic Age?”, Journal of Accountancy, July 2006; Robert Muksian, “Calculating Break-Even Ages for Delaying Social Security Beyond Normal Retirement Age,” Journal of Financial Planning, March 2006; Alicia H. Munnell and Mauricio Soto, “Why Do Women Claim Social Security Benefits So Early?”, Center for Retirement Research, October 2005; Robert Muksian, “The Effect of Retirement Under Social Security at Age 62,” Journal of Financial Planning, January 2004; Thomas G. Walsh, “Spousal and Survivor Elections of Normal Versus Early Retirement Benefits,” TIAA-CREF Institute, July 2003; Thomas G. Walsh, “Electing Normal Retirement Social Security Benefits Versus Electing Early Retirement Social Security Benefits,” TIAA-CREF Institute, July 2002; and Thad W. Mirer, “The Optimal Time to File for Social Security Benefits,” Public Finance Review, November 1998.
- For reasons to wait, see Scott Burns, “Deferring Your Social Security Benefits Can Yield a Big Gain,” Boston Globe, September 30, 2006; and Jonathan Clements, “Delayed Gratification: When Postponing Social Security Payments Is a Smart Move,” Wall Street Journal, May 10, 2006.