Note: This article is part of Morningstar's September 2016 Retirement Matters Week special report.
This video has appeared previously on Morningstar.com.
Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Social Security is a valuable asset, but should you consider it part of your household balance sheet? Joining me to discuss that topic is financial-planning expert Michael Kitces.
Michael, thank you so much for being here.
Michael Kitces: Great to be here. Thanks.
Benz: This topic of how to consider Social Security as part of your total wealth portfolio is really a hot one among Morningstar.com readers. You recently did a blog post about this topic. I'd like to talk about some of the attributes that you mentioned in your posting that make Social Security so valuable and, in a lot of ways, quite unique relative to traditional portfolio assets.
Kitces: I find this to be an interesting dynamic. The reality is that we use assets to produce income streams, and Social Security really functions the same way, just in reverse. It is the income stream; we don't ever see the asset. And pensions work the same way. But there is an asset. Not only is there classically an asset that funds pensions, but in something like Social Security, we can actually value what that asset equivalent would be--what kind of asset we would need to replace the income stream of Social Security over our life expectancy or over our lifetime. The interesting phenomenon is that when you actually try to value that as an asset--[essentially, the amount of money] I would actually need in order to produce that kind of retirement cash flow--it's an impressively valuable asset.
The math will vary a little depending on what your rates are or whether it's just your benefit or also pushes out a survivor benefit. But we see a lot of client situations where the value of Social Security could be $200,000, $300,000, or $500,000--sometimes even as much as $600,000 or $700,000 for married couples when we get both benefits going. That's a big asset for a lot of people to have on their balance sheet. We don't really think about it that way because we never see the Social Security account balance that's there. But it is an asset, and it's a really material one.
Benz: So, in a lot of ways, it's like a TIPS--a Treasury Inflation-Protected Security. But in some ways, it's even more valuable.
Kitces: Yes. Because those Social Security payments have that cost-of-living adjustment attached to them, they really do function like an inflation-adjusting government bond. And frankly, if you were to try to value it on your balance sheet and watch the value over time, that's essentially how it would behave. So, if inflation ticks up, your inflation-adjusted payments are going to be higher, and so it becomes more valuable as an asset. If interest rates go higher, the discount rate gets a little bit higher; it gets a little less valuable as an asset. So, it really does actually function very much like a TIPS--with the caveat that because all of the Social Security payment formulas haven't changed since the Greenspan Commission in 1983, it's frankly a really nice TIPS. That's because it's based on payouts that we calculated back in 1983, with those mortality tables and those interest rates. Obviously, things have gotten a little bit different in today's environment.
Benz: Right. One thing that has been written about a lot recently is the value of delaying Social Security. You say that, in the current low-yield environment for bonds, that's a particularly attractive strategy right now.
Kitces: It really is. There's been more buzz about Social Security delay over the past couple of years--which I think, in part, has to do with more baby boomers reaching retirement. There are more of us that have to make this decision, so we're facing it more regularly. But the value of delaying Social Security truly has changed from where it was just 10 years ago. Part of that is that interest rates are lower right now. So, if I think of the decision to delay Social Security as hinging on where I'm going to get my money, either I can draw it from a portfolio and delay Social Security or I can take Social Security now and let my portfolio stay invested.
Well, Social Security is like a giant bond, but it's a bond that has this really appealing return attached to it. You'd rather spend the bonds in your portfolio and let Social Security grow than spend Social Security first and let the fixed-income portion of your portfolio grow. And when we look at it with that kind of trade-off, it looks even better in low-rate environments because now the bond portfolio is doing worse and the Social Security asset is doing better. And frankly, it looks even better because the delayed retirement credits that you earn for delaying Social Security only recently got to the point where it's an 8% annual increase for everyone. If you go back 10 or 15 years, it was only about 5%. If you go back to the early stages of the Social Security system, it was only 3%.
So, we've actually shifted the system to make it more beneficial to delay Social Security benefits. In a low-rate environment, it becomes exponentially more valuable. So, it's literally like your asset appreciates more rapidly. Social Security, as an asset, appreciates more rapidly when you delay it. Certainly, [it appreciates more rapidly] than the bonds in your portfolio and, frankly, I can even make the case it's got a better risk-adjusted return than equities in today's environment.
Benz: Another thing worth thinking about, though, is that perhaps in a more normal interest-rate environment, for people who aren't close to retirement at this point, in fact, that decision to delay may not be the slam-dunk fit that it is today. Let's talk about that.
Kitces: As with any asset, as you are trying to manage the asset and figure out how to invest it or how to use it, when we get to a higher-rate environment, that delay decision may not look as compelling relative to maybe a bond portfolio or blended portfolio that might be looking a little bit better on the return side. It will be, I think, a little bit of a dynamic formula; that's why planning around retirement and Social Security is sort of the puzzle that it is, because the efficient strategies for it really do depend on the outlook for the different assets on your balance sheet. Social Security is one of those assets, and how good or bad it is really does vary from one to the next.
And frankly, if at some point in the coming years, we change the Social Security system a little bit (we know we need to make some changes--we can all see where the projections are going in 15 years), changes to the Social Security system may or may not further tinker with that formula [for deciding] whether you are delaying or not. So, frankly, I guess it's not the most uplifting thing [to hear]. If you're in your 40s today or younger, I don't know whether you are really going to be delaying Social Security by the time you get there or not. We are going to have to see what the rules look like when we get there--not to mention interest rates and the rest of the environment. If you're in your 50s, you probably are still going to delay, but you'll have to see exactly what things look like when you get there. If you are already in your 60s, and you compare essentially the supercharged-TIPS return that you get off of delaying Social Security versus your other assets, it becomes really compelling to delay Social Security in this environment.
The question I always get is, "But do I really want to spend my portfolio down for my Social Security to grow bigger?" The answer is yes--you really do. The growth of your Social Security asset is giving you a better risk-adjusted return, in most cases, than what most people are getting off their portfolios--especially if they are fixed-income heavy in their portfolio at today's rates.
Kitces: Obviously, the caveat is life expectancy. If you know your life expectancy is short--you are in poor health--take your money while you can get it.
Benz: Take it and run.
Kitces: Yes, take your money and run. But if you have even just an average life expectancy, it becomes pretty compelling because, again, Social Security's formulas were balanced based on life expectancy in 1983. Our life expectancy has gotten better. So, merely average health today means you are actually winning the life-expectancy mortality table relative to where Social Security was priced.
Benz: The big question is if I've got this investment portfolio and I've also got this Social Security asset, should I consider the Social Security piece part of my kitty and let it affect my asset allocation? Jack Bogle has said that target-date funds are doing it all wrong because they're not factoring in the role of Social Security as a bond-like asset. Where do you come down on that question? Specifically, I'd like to hear from you as a practitioner; how would this work in a real-world-client environment--telling them that their Social Security is effectively a bond?
Kitces: This is a funny challenge because I have to come at this with two different hats. If I put on my academic-researcher hat for a moment, frankly, I think absolutely Social Security should be an asset; you should be looking at it on your balance sheet. You should be comparing it with the rest of your balance sheet, because not only is it an asset--a very material one for a lot of retirees--it's an asset with really unique characteristics. And frankly, I think if we put Social Security on the balance sheet and you said, "It's like a TIPS that gets better returns than other TIPS." And then you say, "Here's this big Social Security asset with a great fixed return and then here is your portfolio with low bond returns--would you rather spend from your portfolio first or Social Security first?" It actually becomes quite obvious.
Well, of course, you'd spend from the lower portfolio return first and let the Social Security asset grow; that becomes very obvious when you view them as assets. And Social Security is also unique because it's an asset that really behaves differently from every other asset in your portfolio. It effectively gets more valuable in low-return environments because the discount rate we use to calculate its value looks better. It gets more valuable in high-inflation environments because it's inflation-adjusting. And it gets more valuable the longer that you live because it's a payment stream for life. When we compare that with the rest of the assets on your balance sheet, such as the portfolio, the portfolio is basically the opposite. The portfolio does worse when you get bad returns, high inflation, and you live longer than you expected. Social Security does best when you get low returns, unexpected inflation, and you live longer than you expected. So, if you're trying to manage risk for your whole balance sheet to make your retirement work and you put Social Security there as an asset, I think a lot of that those trade-offs actually become clear as to why it's so good to delay Social Security and [draw from] your portfolio.
Now, I take off my academic-research hat, and I put on my practitioner hat as an adviser who sits across some clients. This gets messy really fast. If you imagine a married couple: They were both working; they've accumulated a really healthy Social Security benefit. Married couples could see [situations] where the present value of their Social Security could be $600,000 or $700,000--even more sometimes in today's low-rate environment. They've got this nice $750,000 401(k) retirement nest egg that they've built up. We sit down and say, "OK, you are relatively conservative; you only want to be about 40% or 50% in equities overall; you've got a $750,000 portfolio and almost $750,000 of Social Security."
The Social Security clearly has to be a bond--I can't change that. So, if I want you to be 50-50, I'm going to take your entire 401(k) and I'm going to put 100% in stocks. You will be all in on equities for your portfolio. Now, again, wearing my academic hat: "No, no--you're 50-50. Your Social Security is just a little bit less liquid; your portfolio is a little bit more liquid. You've really got to look at this whole thing as you've got $1.5 million net worth, including the Social Security bond and this portfolio of stock." In the real world, when you're sitting there and you're looking at the only thing you get a statement on--which is the 401(k) or the IRA--and you watch real-world equity volatility and you go through a scenario like 2008, it's going to be terrifying. I just sat across from some clients and said, "I know what this looks like." We mentally account for things [by dividing them] into buckets; we don't really mix the Social Security bucket in our head with the portfolio bucket.
So, when you look at a portfolio bucket that's 100% in equities and the kind of volatility that produces, it's going to get a little scary. So, I don't know if there is entirely a workaround for that. We truly get in and out of thinking in the hyper-logical, rational world versus what we do in the real world and the way that we think about our money. It's tough. The good news is, as you draw on your Social Security over time, that bond asset basically depletes itself because you are getting the payments and your life expectancy is getting shorter. So, we actually slowly get there over time, as our Social Security spends down and our portfolio stays even--or even grows in the early stages of retirement. We're actually shifting to be a little bit more equity-centric, and that's actually a good thing. So, as we've talked about in the past, we did some research that found that portfolios that drift higher in equities in retirement is actually OK.
So, you get there over time as your Social Security assets spend down naturally and your portfolio grows--or at least stays even--and your percentages of net worth shift. But academically, you really should invest around [Social Security]. In the real world, that's harder. I think, certainly, we can invest around it to the extent of saying, "This Social Security asset that we delay really has unique investment characteristics that are very compelling--especially in today's environment--so we're going to delay Social Security and draw from the portfolio first." We can get that far. But to actually say, "No, your portfolio should be 100% in stocks because it's being counterbalanced by this 100% bond position in Social Security, even though you'll never see that account balance," that's hard. In the real world, what's it going to be like when you're looking at that statement? That's hard.
Benz: Michael, such an important set of questions here. Thank you for being here to share both your practitioner's perspective as well as the academic perspective.
Kitces: My pleasure. Thank you.
Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.