The Social Security Mistake Risk-Averse Folks Make

It has become standard practice that risk tolerance questionnaires are completed for almost every client during a financial planning or investment planning process. Risk tolerance questionnaires serve two purposes:

1. Bluntly speaking, it is a “COA” instrument — which stands for a “cover our…” (You can fill in the blank.)
2. Partially driving No. 1 is the belief that a client’s plan should be built around his or her unique situation and risk tolerance level.

While I have been outspoken about the usefulness — or lack of usefulness — of many risk tolerance questionnaires, understanding a client’s risk tolerance level or risk aversion is valuable because people react differently when information is presented as a loss or a gain.

When used correctly, risk tolerance levels likely can be helpful not just as an investment guide or asset allocation guide, but perhaps even to guide the savings strategy or retirement income approach used. For instance, a more risk-averse client might be better suited for a flooring approach that relies on “safe” investments and income sources in retirement. A more risk-tolerant investor might prefer a higher equity and systematic withdrawal approach to income planning.

But risk tolerance isn’t just insightful for investing, it could be helpful with Social Security decisions, too. Advisers can use risk tolerance for guidance on how to approach Social Security planning with their clients. For instance, most advisers talk about deferring Social Security as a way to get an increase of benefits — a boost that comes with the downside of giving up income now. A risk-averse client is unlikely to want to give up a sure bet today, and may end up claiming early instead of waiting for a higher payout later.

When presented with the decision of “Do I take benefits at age 62 at a lower amount or wait for a higher payout?” many Americans choose to claim benefits early. Granted, some decisions are out of necessity, but not all.

In most cases, financial advisers present Social Security as a break-even proposition — if you live for X years, you win. That strategy requires people to essentially take risk now to get a gain later. Instead of thinking about it that way, let’s flip this problem on its head.

Social Security advice for the risk averse

If we know a client is risk averse, we might want to take a different approach to discussing and planning around Social Security. First, we might want to get the client to agree to a claiming strategy years in advance of age 62. Research has shown that when you have no choice but to wait for cash flow, even a more risk-averse client will be willing to wait longer for a higher payout. But, on the other hand, if one option is to get money today, they won’t be willing to wait the same timeframe for the larger payout.

Overcoming this immediacy bias with Social Security could be extremely beneficial by locking in a plan years ahead. Granted, a client can always change his or her mind, but getting them to agree in writing to a wait-to-claim Social Security strategy years before age 62 might help.

Risk-averse people are willing to take risk in order to avoid loss, but they won’t take on risk to chase gains. Presenting Social Security as a “you get a higher payout if you wait” situation to a risk-averse client isn’t effective. A better way to introduce it would be to focus on what they could lose by claiming today.

Loss Scenario No. 1: Waiting to Claim Social Security – but dying before getting it

Let’s look at two decisions — waiting to claim at age 70 and claiming at age 62 – to see what the maximum loss could be. We’ll start with an average benefit of $1,400 for a 66-year-old, which will be reduced down to $1,050 when claimed at age 62 and increased to $1,848 at age 70.

How much would this person stand to lose if they waited until age 70 to claim and died the day before receiving a benefit? In this situation the individual received nothing and missed out on eight years of payments. Using a present value calculation,* a discount rate of 3% and an inflation adjustment of 2%, the maximum loss would be the eight years of no payments: a present value of $94,602.

According to Social Security there is a 10.27% chance of dying between the ages of 62 and 70.

Loss Scenario No. 2: Claiming Social Security at 62 – and losing a LOT more

Now, let’s look at the maximum loss potential if you claim at age 62 and live until age 95. The worst-case scenario is that you could lose $215,509 — which is the present value difference of claiming at age 62 and at age 70 with 2% inflation and a 3% discount rate.

According to the same Social Security data used above, you have a 10.5% chance of living to age 95 — almost identical as the risk of dying between ages 62 and 70.

But what if we reframed the situation and you knew there was a 10.25% chance you’d lose $94,602 by waiting until age 70 to claim and a 10.5% chance of losing $215,509 by claiming at age 62? When laid out like this, the “rational” answer should leap off the chart. Why take on a higher rate of risk to lose more money? It isn’t logical.

The present value approach used here can be challenged – although I’d argue that I downplayed the present value of deferring benefits in my analysis. And it’s by no means the only way to view Social Security claiming or the only factor to consider. Taxes, funding status, cash flow, necessity, personal health issues, and an overall retirement income plan also need to be considered. But, if those factors still support deferral, presenting it in a way that resonates better with a risk-averse client could make sense.

The bottom line:

While people like to gain money, they like the sure bet. They’re willing to chase risk to avoid loss. However, they need to realize that with deferring Social Security, they aren’t chasing risk and return, they’re just avoiding loss.

*Present value formulas are used in finance to calculate the present day value of an amount that is received at a future date. It strives to define the “time value of money,” showing that an amount received today is worth more than the same amount in the future.