Monday, August 20, 2012

Kotlikoff on Social Security

One follow-up point from my previous post on ESPlanner: Prof. Kotlikoff also provided a brief and clear explanation about the value of waiting to begin Social Security.

To paraphrase, one should not think about Social Security from the perspective of a breakeven investment analysis for how long it will take for Social Security pay off. That missed the point of the insurance value which Social Security provides. Using the breakeven analysis, one would not buy any insurance. On average, insurance is never expected to pay off. Insurance companies need to make a profit and cover their expenses. But the reason insurance is valuable is that it pays off in the low probability states of the world when outcomes are bad.

People cannot rely on the average outcome for their personal situation: either things work out or they don't. With Social Security, you won't feel regret by delaying Social Security and then dying before collecting benefits, because you won't be around anyway. Regret comes when you live a long life and think about how your situation would have been improved through delay. By waiting from 62 to 70 to start benefits, your benefits will be 75% larger for the rest of your life. That is a valuable safe and real annuity based on an implicit real return of 2.9%. The premiums for that annuity are the 8 years of missed Social Security benefits between 62 and 70, but all in all it can be a pretty good deal and it protects your lifestyle in the event of living a particularly long life.


  1. The decision to wait assumes that Social Security will remain essentially intact, at present payout levels, without means testing, far enough into the future to cover everyone pondering this issue.

    Given current levels of federal spending and taxation this seems unlikely.



    1. What do you see as the implication of this? Are you suggesting to get out what you can before it's too late?

  2. Sir -

    I'm cynical; for my retirement planning I assume that I'll pay into Social Security until I stop working and I assume that I'll draw nothing out i.e all cost, no benefit. This is a 'worst case' so anything else with any benefit will be a pleasant surprise.

    I *expect* a future Congress change the rules (higher payroll taxes, delayed eligibility, means testing, etc).

    Since I plan for the worst case, waiting to start benefits that may not be there doesn't have a down-side for me.
    I can't rue the loss of something I never had.

    However, if someone needs the money, getting a smaller benefit today is much better than no benefit tomorrow.



  3. Hopefully your view about Social Security is too pessimistic, but it is always good to use conservative assumptions when doing your planning.

    Assuming you will get nothing is fine for planning purposes for younger people.

    However, for people already at 62, I think it is a tougher call to then use that assumption as a justification to start Social Security. The likelihood of benefits being dramatically cut for people who are already 62 does seem rather low.