Do Not Take Social Security Benefits Early Just Because You Think You Can Invest Them at a Profit

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Larry Kotlikoff’s Social Security original 34 “secrets”, his additional secrets, his Social Security “mistakes” and his Social Security gotchas have prompted so many of you to write in that we now feature “Ask Larry” every Monday. We are determined to continue it until the queries stop or we run through the particular problems of all 78 million Baby Boomers, whichever comes first. Kotlikoff’s state-of-the-art retirement software is available here, for free, in its “basic” version.

Once again, I’m posing a question to myself this week.

Question: Dear Larry, I’m having trouble explaining to my friend Fred that thinking about Social Security from a break-even perspective is inappropriate.

Answer: Dear Larry, man, you ask the best questions. The proprietor of the Business Desk, Paul Solman, surely whispered this one in your ear.

I’ve come across many, indeed, far too many people who are absolutely convinced that the break-even period is relevant for thinking about when to take Social Security benefits. Many software programs, including “leading” commercial ones, display break-even analysis.

“Breakeven” refers to the number of years and months you need to receive extra benefits (which arise from waiting to collect) before you get back more benefits from waiting to collect than you gave up by not taking reduced benefits early.

Associated with the focus on breakeven is the notion that “I can take my Social Security benefits early and invest them in stocks and make more money than I’ll get from Social Security.” And yet, a third proposition is that we should run Monte Carlo computer simulations to see the chances of doing better on the stock market by taking our benefits now.

As Paul would be the first to tell you, this way of evaluating Social Security is just plain nuts. (Paul, by the way, is an economist by acclamation. He’s interviewed so many boring, pompous economists about so many fantastically dry economic issues, yet retained his marvelous sense of humor, that we’ve had no choice but to make him an honorary member of our tribe.)

Anyway, I digress.

Viewing Social Security as an investment rather than as an insurance policy leads one to think about breakeven, but doing so is actually beyond nuts. It’s out-and-out stupid. Don’t do it!

If you feel obliged to think about an insurance product as an investment and consider breakeven, do so with your house. In other words, think about whether it makes sense to buy homeowners insurance on a break-even basis. How? Just compare the money you are giving up in premiums to buy the policy with the very small chance your house will burn down. Next, multiply this small chance by the cost of rebuilding your house. If this expected payoff from the policy is less than the premium, the insurance “investment” fails the break-even test.

Now, I guarantee that the expected payoff from “investing” in your homeowners policy is less than the premium the insurance company charges you. In other words, I guarantee that you can’t break even buying homeowners insurance. The reason is that the premiums insurance companies charge on their various policies include “loads” to cover administrative and other underwriting costs. Thanks to these loads, the payoffs from homeowners insurance, life insurance, car insurance, health insurance or any other type of insurance we normally buy always are less than the premiums we’re charged for the policies. Therefore, if we are just focused on breakeven, we should never buy these or any other forms of insurance.

But that would be crazy. We don’t analyze standard insurance this way because we are focusing, properly so, on the worst case scenario: our house burning down, our car getting totaled, developing cancer.

For better or worse, we aren’t insurance companies. We don’t have millions of homes that may or may not burn down, we don’t have millions of cars that we might or might not crash, we aren’t Bill Murray in the movie “Groundhog Day,” able to restart our lives every morning. Very few of us can afford to play the odds. And we’re in no better position to play the odds when it comes to Social Security’s longevity insurance.

In the longevity sphere, the worst case scenario is, frankly, living too long — living to our maximum possible age of life, and, as a result, outliving our savings and income. Social Security provides insurance against this worst case scenario. This insurance is safe against inflation and against default. It’s also dirt cheap. There is no close substitute for it in the market.

So Larry, tell Fred to forget about breakeven, Monte Carlo simulations and any other actuarial analysis. Instead, have him focus on the worst case scenario because worst cases happen and we can’t assume them away.

As ever,