Should You Claim Your Social Security Early and Invest It?

Today a client sent me a link to Don't Need Your Social Security? 1 Reason You Should Claim It Early Anway, by Dan Caplinger of Motley Fool. (I love it when clients forward articles because it helps keep me apprised of what's out there that's catching their attention.)

In the article, Caplinger suggests that "successful investors" who don't need their Social Security to live on should consider claiming it early at 62 and investing it instead.

Now in fairness, Caplinger mentions various caveats: that this is for successful investors, assumes aggressive investment returns, disregards taxes, and disregards potential Social Security clawback if drawing benefits early while still earning income.

My contention is that the slice of population for which this strategy maybe could work is miniscule. And that'd be no big deal, except without better explanation in the article, there will almost certainly be a lot of readers who dangerously elect themselves as this unicorn "successful investor" thinking it applies to them.

So let's run through some issues....

"Successful Investor"

The first issue is how to define "successful investor." For the article's purposes, this is someone who's done well enough investing in financial markets (and accumulating other assets) that they don't need Social Security to live on. Fair enough.

But determining if someone is a successful investor is, by definition, bound to a time frame and valuation context. Are you measuring it at the bottom of the financial crisis in March 2009 after stock prices had crashed or in June 2017 when US stocks are 8 years into a bull run (second longest in history) and stocks, bonds, and real estate all have bubblicious valuations?

From what I see, there are a lot of investors who've been floating along with the herd thinking they're a lot better off financially than they really are. Like Garrison Keiler's fictional Lake Wobegon: "...where all the women are strong, all the men are good-looking, and all the children are above average." Let's add: "...and all the investors are successful."

When we (finally!) get the next sizable downturn, the supposed investment success will vaporize for so many and they'll get a chance to see what real wealth remains. There'll be a lot of folks who discover they needed that Social Security after all.

Bubblicious Valuations

About 9 months ago, I blogged This is How Far Central Banks Have Goosed Asset Prices and included this chart.

Valuations have only gotten even more stretched since then, by a broad number of measures.

GMO, which regularly puts out their 7-Year Asset Class Real Return Forecasts projects that, after inflation (real returns), the various asset classes will post negative average annual returns over the next 7 years, except for emerging market stocks and bonds.

Research Affiliates has a fantastic interactive online tool where you can test expected returns over the next 10 years. And the results are similar to GMO's and a number of others.

But the Motley Fool article runs a projection with a nominal (pre-inflation) return of 8% per year. My response: "From current valuation levels? Over the next 10 years? Please be serious." At least not with the standard buy-and-hold approach. Investors and portfolio managers who use a tactical approach (there aren't many of us) and make portfolio adjustments as we go may do okay.

Research shows that when starting investment valuations are low, returns tend to be comparatively high over the next 10 years. And when starting investment valuations are elevated, then returns tend to be low over the next 10 years. Common sense tells us this, but we also have plenty of studies to back it up.

And yet, there just seems to be something in the investment psyche that naively latches on to an 8-10% average annual return for stocks, regardless of where valuations are at the start.

Plus it ignores the very real behavior gap where investors constantly shoot themselves in the foot by buying high when the crowds are all ga-ga (a bit like today) and then dumping their investment after the damage is done in the next round of carnage. Most investors don't even get anything close to the market returns because they buy and sell at the wrong times.

But maybe that's not the case for the article's "successful investor" because they have patience and staying power? No matter...barring a miracle, what's the likelihood of anyone getting an average annual 8% buy-and-hold return in stocks over the next 10 years: Not. Gonna. Happen.  

Tax Savings

Again, in fairness to Caplinger, he indicated that income taxes were not considered in the article's projections. In my view, a wise Social Security claiming decision requires that income taxes be considered.

Once a single filer reaches $32,000 or a married couple filing jointly reach $44,000 of provisional income, then up to 85% of their Social Security benefits become federally taxable. But that means at worst 15% is still federally tax-free. And there are about 37 states that don't even tax Social Security.

So continuing to work or spending other assets now and deferring Social Security claim for a larger future tax-free benefit may result in substantial tax savings over your lifetime.

And with traditional retirement going the way of the dinosaur, many folks (perhaps even our hypothetical 62 year old successful investor) may want to stay engaged and continue earning an income even though they don't need it. Claiming early and earning over the annual limits results in temporarily reduced Social Security benefits, which would then thwart the strategy of investing those benefits.

Are You Married?

The article discussed Social Security and breakeven analysis from the standpoint of an individual. This is common and it works fine if you're single. But if you're married, you need to make the Social Security claiming decision as a couple--and particularly if there's a substantial difference between your benefits.

A surviving spouse is entitled to the higher of their own benefit or their deceased spouse's, but not both. If you're so wealthy that Social Security doesn't matter, fine. But if you think you're wealthy (because of current valuations) and a 40% +/- hit to your portfolio plus the death of one of the spouses would leave the surviving spouse in a bind, be sure to factor in those kinds of scenarios before pulling the trigger on claiming Social Security early.