The Downside Risk of Postponing Social Security Benefits

Abstract The point that only live participants may initiate or receive Social Security benefits is typically overlooked. Thus, a postponement of benefits at any eligible retirement age may be likened to participation in a game of chance in which the participant is subject to a variant form of gambler's ruin at death. The typical assumption, therefore, mat a participant should automatically opt for a postponement if the present value of the resulting benefits, discounted to breakeven age, higher than the present value of the opportunity costs, carries with it the implication of risk neutrality in relation to the consequence of dying before reaching breakeven death age. While this implication of risk neutrality is sometimes correct, it is more likely not. In marked contrast to conclusions reached in previous studies, this paper shows that a single Social Security participant, who is risk averse as regards the chances-and contingent consequences-of dying before reaching breakeven death age, would be well advised to initiate benefits at the earliest age at which he or she would not be subject to earned income tax penalties. © 2010 Academy of Financial Services. All rights reserved. Keywords: Social Security; Social Security benefit initiation; Social Security benefit postponement; Social Security benefit optimization; Retirement annuities (ProQuest: ... denotes formulae omitted.) (ProQuest: ... denotes text stops here in original.) 1. Introduction Under current law, the normal retirement age [NRA] for Social Security participants born between 1943 and 1954 is 66. Participants may claim benefits as early as early as age 62, which is the presently designated early eligibility age [EEA], or at any age thereafter - but there is no financial incentive to postpone benefits beyond age 70. ' Participants who elect to start receiving benefits at the NRA receive a full retirement benefit [FRB] amount initially, with subsequent monthly payments increased by an annual inflation adjustment factor. The FRB is determined by a Principal Insurance Amount [PIA], which the Social Security Administration calculates on the basis of the number and amount of payments made into the system before the initiation of Social Security Benefits. The Social Security Administration [SSA] adjusts benefit payments for participants who initiate Social Security benefits before or after reaching NRA relative to the FRB, using adjustment factors that vary by age. The maximum discount is 25% if benefits are initiated at age 62 and the maximum premium is 32% if initiation takes place at age 70. The delay of benefits by postponement at any eligible age x, between 62 and 70, therefore, is tantamount to the forfeiture of a single benefit payment, in exchange for a incremental Social Security benefit annuity (amount) that will begin one month later and terminate at death. It is generally assumed that a participant's decision to initiate benefits or postpone may result in just two mutually exclusive outcomes: lower lifetime annuity payments for a longer period of time in the case of initiation or higher benefit payments for a shorter period of time in the case of postponement. Though mutually exclusive, these outcomes are not collectively exhaustive. In the case of postponement there are at least two other possible outcomes: * A participant may die before initiating benefits, in which case the effective yield on his or her cumulative postponement investments is -100%. * A participant may eventually initiate benefits but not live to his or her breakeven death age, in which case the yield on his or her cumulative postponement opportunity costs must, by definition, be negative. Unlike standard life annuities offered by many private insurers that guarantee a minimum number of benefit payments regardless of when an annuitant dies, Social Security benefit payments terminate at death. From the SSAs point of view, benefit payouts may be averaged over the individual lifetimes of the population of participants presently alive and receiving benefits. …