Why Chained CPI Matters to You

I’ve previously spoke about the value of saving today. Why? Because Social Security will be practically non-existent by the time Gen Y’ers reach retirement age. However, it looks the Baby Boomers may soon experience – at least partly – the diminishing promise of Social Security benefit payments.

What the heck am I talking about? Chained CPI. In the current budget talks, our government is considering modifying the annual increase (cost of living adjustments) in Social Security benefit payments. Right now, Social Security payments are adjusted for inflation. This ensures that Social Security benefit recipient's purchasing power is maintained over time. For example, while a retiree benefit may currently receive $1000 month in benefits this year, that same retire will receive $1030 a month next year. The increase compensates for the effect of inflation on the dollar.

"...Social Security benefit payments will fail to keep up with inflation."

The rate at which Social Security benefit payments increase every month is a reflection of the Consumer Price Index (CPI) – a metric that calculates the average cost of a particular basket of goods. As prices rise, the chained CPI - unlike the conventional CPI - substitutes particular goods for less expensive alternatives, The specific mechanics behind the two indexes are less important than the consequences of a switch from the conventional CPI to the chained CPI: increases in Social Security payments will fail to keep up with inflation. Compound interest will magnify the consequence of this over time. Said another way, the dollar amount of Social Security benefit payments will be able to purchase less and less as years go by.

Now, the Social Security Administration has yet to officially switch over to the chained CPI. That will be determined by the coming budget talks. Feel free to contact your Congressperson if you feel strongly about the switch.

"...the importance to not count on government subsidies in retirement remains. It is on the individual, to save and invest wisely, so as to ensure adequate funds for retirement."

My point, however, is this: The government is already making its move to cut Social Security benefit payments. Hence, Social Security benefits will be a token gesture when Gen Y’s reach retirement - not to mention what current recipients of benefit payments may expect. Thus, the importance to not count on government subsidies in retirement remains. It is on the individual, to save and invest wisely, so as to ensure adequate funds for retirement.

When to Get Paid

This week’s post is inspired by one of my financial planning textbooks, which states that, “93% of all individuals retire between the ages of 62 and 65.” Very interesting. Why so interesting? Because, Social Security (SS) retirement benefit payments increase the longer they are deferred – by 8% annually.

While individuals are eligible to begin receiving benefits payments as early as age 62,¹ total money paid out by the Social Security Administration (SSA) increases with age and deferral of payments. Said another way, the longer you live and the longer you wait to start receiving SS benefit payments, the more money you’ll get over the course of your lifetime. It’s the classic case of giving up something now, so you can have more later on – the basic principle of saving.²

Running the numbers, our average Joe will net the most money from Social Security benefits if he defers receiving benefits until age 70 – assuming he lives long enough to make up for the delay in receiving income. (While the SSA increases the amount paid in benefits the longer one defers payments between ages 62 and 70, there is no increase in benefit payments past age 70.) If average Joe lives to age 85, he will more than break-even, despite not receiving income for several years. (If he dies before age 85, he may have been better off electing to receive benefit payments earlier.)

For explanatory purposes, consider an example. Let’s say, I offer to pay you $1 a day for the rest of your life, starting today. You could take that offer, or you could a second offer: $1.25 a day for the rest of your life, starting tomorrow. Which offer would you take? Well, the answer depends upon how long you think you will live. If you think you will die tomorrow, then the offer of $1 day is your best bet. But if you think that you will live for at least six days, the second offer is more lucrative.

Back to the issue: If you’re retiring between ages 62 and 65, (assuming you’ll be receiving SS benefit payments at the same time) – you may not be getting as much money as you could if you postpone receiving payments. How does one determine the optimal time to begin receiving SS benefit payments? See the chart below.

To use this chart, begin by selecting your estimated lifespan on the vertical axis (left-most column). Now, move to the right until you hit the high-lighted green cell. Move up to find the ideal age at which to begin receiving Social Security benefit payments.

For example, one set of my grandparents lived to the ripe old ages of 95 and 91. On that basis, I may conservatively estimate that I may live until at least 85. Therefore, the ideal age for me to start receiving Social Security payments is age 70.

Assuming a long lifespan, it would appear that people are retiring (or rather choosing to start receiving SS benefit payments) prematurely - at with least with respect to the maximum amount of money that one receives in benefits over the course of their lifetime. The solution, then, is a simple one: Average Joe should defer receiving Social Security benefit payments until age 70. This way, average Joe will more than break even by the time he reaches age 85. 

"...the longer you wait for the government to pay you retirement benefits, the more money the government eventually gives you."

BUT! What if average Joe doesn’t make it 85? Well, according to the actuarial tables provided by the Social Security Administration, he won’t. If average Joe is not already in retirement, that is, if average Joe is between ages 0 and 61, average Joe will most likely only make it to age 78 (or 82 for average Jane). 

If you’ve gotten this far, you may be thinking, “according to this table, if I’m only going to live until 78 (or 82 for females), then I should claim benefits at age 66 (for males, 68 for females), because this will get me the most money, right?”

Well, not really. You see, actuarial table data is dynamic: life-expectancy changes with age. This is to say that the older one gets, the more likely one will keep on living. (Funny how that works.) 

Yet, we are not even concerned with pre-retirement ages. The only actual age that matters is the age of the individual who has the option of receiving SSA benefit payments: 62. Interestingly, if you are 62, your expected life span shoots up from 78 for men and 82 for women, to 82 and 85, for men and women respectively. According to our table above, given that longer lifespan, deferring Social Security benefit payments until age 68 and 70 (for men and women respectively) nets the greatest amount of wealth over time.

For women, the issue is clear – defer SSA benefit payments until age 70. For men, the issue of when to start receiving SSA benefit payments gets a little more interesting. As a man, you turn 68 and now you are ready to start receiving SSA benefit payments. BUT WAIT! Remember how the actuarial tables declare that the older you are the, longer you’ll live? Well, now that you are 68, your life expectancy moves up from 82 to 83. And if you look at the table above, you’ll notice that deferring benefits payments until age 69 (no longer 68) is the most lucrative option. At age 69, life expectancy increases to age 84, but the most lucrative SSA payment deferral age remains age 69.

If you’ve been following along this entire time, you’ve come to the conclusion, “OK. I’ll start receiving benefits at age 69 (or 70 for females).” I’m afraid it’s not that simple. The reason being is that you are not a perfectly representative sample. That is – you are not average. And you need to consider specific variables that will influence how long you will live: personal health, family history, and advancing medical science.

"...you need to consider specific variables that will influence how long you will live: personal health, family history, and advancing medical science."

Feel free to use the above – 69 for men and 70 for women – as a starting point. Then consider your health. If you are healthy, consider tacking on a few extra years to the table above. This may push you towards further deferring benefits another year – to age 70 if you’re male (and makes no difference if you are female). Are you terminally ill? Then consider electing to receive SS benefit payments immediately. 

Next, consider family history. Did your parents/grandparents/great-parents live to 90? If so, consider deferring SSA benefit payments until age 70. Or is your average family lifespan shorter? If so, remove a few years off your estimated lifespan and see where that puts your ideal retirement age (with respect to the table above). Lastly, consider that all life spans are increasing as medical technology progresses. (This will push your life span a little farther to the right on the table above.)

Naturally, there are always other considerations. If you are still working before achieving full retirement age (FRA), consider that your benefit payments can reduced as part of the SSA’s the earnings test. The option to defer receipt of SS benefit payments to a given date is a luxury. If you absolutely need the income provided by SS benefit payments, and cannot delay receiving income because of a deficit in other sources of income/savings, it absolutely makes sense to elect receiving benefit payments right away.

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[1] While you could elect to receive benefit payments early, and then invest that money for growth, it is not possible to find a guaranteed real rate of return of 8%. The return is real, not nominal, because SSA benefits payments are adjusted to increase with inflation.

[2] Assuming no discount rate. SS benefits increase with inflation. (In today’s low interest rate environment, just keeping up with inflation in a risk-free asset is an accomplishment.)

Shop-lifting Grandmas

Today's post is less about actual practical applications of investing, as it is an argument for saving. Two recent events caught my eye, both of which stress the importance of saving, then investing those assets yourself or via a financial fiduciary.

If you've been listening to the news recently, you have learned that the city of Detroit is having severe financial problems. A portion of those problems stems from the city’s obligations to it pensioners. In the end, those pensioners may not end up getting what they were promised, most especially younger employees. It's bad news for the pensioners of Detroit, but we can learn something from this event. What is the lesson? The critical nature of self-sufficiency.

...if you have a pension, save and invest as if you do not.

Across the lake, another very interesting thing is happening that speaks to the value of savings. In Japan, there is a proliferation in the increase of senior citizens shop-lifting – for groceries. Yep. You read that right. The article in Bloomberg Businessweek states that “more elderly are turning to crime, often out of hunger.” Why? The Japanese government has cut pension benefits in an effort to curb the national debt. Can you think of any other governments with outsized debt? I’ll give you a hint: You’re living in it.

The moral of the story is that you must save your own money and invest those assets yourself. Depending on someone else to do is mistake. Why? Because that someone else has a lot less interest in your comfort during retirement than you.

Save and invest as if Social Security may never materialize – because that just may be the case.

One could make the argument (I do) that any sort of future payments should not be considered in retirement planning. That is, if you have a pension, save and invest as if you do not. The same applies to Social Security – most especially for younger individuals. Save and invest as if Social Security may never materialize – because that just may be the case. In the event that the pension or Social Security does come through, that’s terrific. And it’s likely that’ll you be taking some extra vacations during your golden years. In a worst case scenario, you will have your own assets to rely on.