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Social Security: The Best Annuity Money Can Buy

February 16, 2019

Wade Pfau, Ph.D., CFA

A final frame for viewing the Social Security claiming decision is as an annuity purchase. By starting at age 70 instead of 62, the retiree misses eight years of receiving a benefit of $22,500. But starting at 70 provides the retiree a net increase in benefits of $17,100 per year for as long as he or she lives. The eight years of lost benefits could be viewed as a premium payment for a $17,100 inflation-adjusted lifetime income starting at age 70.

By not claiming until 70, the eight-year loss of Social Security benefits comes to $180,000 (this is a slight overestimation, as it assumes a 0% real interest rate. Positive real rates are available from TIPS). This may seem like a big loss, but the $180,000 can be viewed as a premium for a deferred income “annuity” with inflation-adjusted income of $17,100 annually beginning at age 70. The implied payout rate on the “annuity” provided by delaying Social Security is 9.5%.

This is quite attractive when compared to commercial annuities – a deferred income annuity like this offers a valuable additional provision which cannot even be purchased commercially as no company offers a product with inflation protection for the initial payment amount. Though inflation protection is available as an option after income begins, today’s marketplace demands you calibrate real expected income from a deferred income annuity by using an assumed inflation rate (which will probably turn out to be a little off in the end).

As of 2015, the best available deal for an eight-year deferred income annuity for a 62-year-old male was for $180,000 to generate $1,323.09 of monthly income, which would then adjust for inflation. If we assume that compounded inflation will average 2% over the next eight years, real monthly income is $1,120.24, or $13,550.93 per year – a payout rate of 7.53%. For a 62-year-old female with the same average inflation, the payout rate is 6.89%. For the higher earner in a couple whose benefit is comparable to a joint and 100% survivor income annuity, the payout rate is only 5.49%.

With an implied payout rate of 9.5%, Social Security delay provides a higher payout rate, stronger inflation protection and less credit risk than commercially available annuities. Delaying Social Security should be the first step for anyone considering income annuities as part of their retirement income plan. But there’s no need to mix the two – starting Social Security early and buying an income annuity would be wasteful and inefficient.

The “investment” value of delaying Social Security can also be seen through internal rates of return. As with an income annuity, the internal rate of return from these cash flows depends on how long they last.  We can get some ideas by looking at the remaining life expectancy of 62-year-olds.

A healthy 62-year-old male has a 50% chance of living beyond age 84, while a healthy 62-year-old female can expect to live to almost 87. For a 62-year-old couple who are both healthy, one of them will likely live beyond age 90.

The real compounded returns provided at these ages by delaying Social Security are 3.2%, 4% and 5.2%, respectively. For government-backed, inflation-adjusted income, this can be compared to TIPS yields under 1.2%. The following figure highlights internal rates of return provided by delaying Social Security (on a real and compounded basis) at life expectancy.

Internal Rates of Return

Though it depends on survival, delaying Social Security offers attractive investment returns compared to safe alternatives available today. It can really pay to spend down other assets more quickly until age 70. Though the portfolio will be smaller at 70, the reduced spending needs after 70 – because Social Security is paying 76% more in real terms – will leave you increasingly better off forever after. Those lucky enough to live far into retirement will preserve more of their portfolio for their heirs and be thankful they delayed Social Security.

Jay Kaplan profile picture
Jay Kaplan
This is the place to share. Share news, updates and opinions. The reverse is the most misunderstood item in the lending and financial home ownership arena; we need more exchange of ideas. This area is for questions and, I hope; answers. Please keep the dialogue going in the name of education, and that goes both ways. Please see that I have added two categories from The Educated Retirement show for Nostalgia and Wisdom
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