Friday, July 27, 2012

Delaying the Start of Social Security Benefits

I was one of the youngest in my 1968 high school graduating class, which means I’m one of the last of those who have already retired to face the decision of starting Social Security payments at our earliest eligibility, age 62. This decision involves many considerations; I advise talking with an experienced financial advisor to help make sure you understand all the ramifications of early retirement.

I was an actuary and understand the mathematics involved in determining the exact retirement age to maximize the present value of Social Security payments. However, that calculation does not include a crucial perspective: reflecting your risk profile relating to outliving your money.

Unfortunately, because you are a single individual the actuarial mathematics of optimizing when to start Social Security doesn’t apply. It relies on the law of large numbers to provide rational results. You and I are single numbers. We only get to die once (reincarnation is not reflected in Social Security earnings records) and you will either die before or after the actuarially expected time—throwing off the results.

A factor people who have significant retirement assets other than Social Security should give significant weight to is the financial effect if you die “too early” compared to the results if you live much longer than anticipated.

Unless you are already living month-to-month (in which case you probably didn’t have significant retirement assets), if you die “too early” you probably didn’t spend all the money you had available. Your beneficiaries will get more than you hoped they would (you hoped you would spend it not your children or church or whatever). You could have lived a bit higher off the hog. That’s your loss.

If you live “too long,” at some point your standard of living takes a rapid decline. In determining how much you can spend each year, you include Social Security, retirement plan payments and dipping into savings based on a reasonable expectation of how long your savings must last. Unless you are lucky enough to have retired from government, your defined benefit plan payments (if any) are not linked to inflation so over time their purchasing power decreases in value. With good planning, you took that into consideration when you determined how much you could pull out of savings each year.

All of which works fine until you live longer than your plan allowed. Savings can no longer hold up its end of the bargain; the pension plan payments buy less and less each year. Only Social Security keeps up with living costs.

By deferring the Social Security payment start until normal retirement age (66-67 depending on your year of birth) you maximize the portion of your assets indexed to inflation. Let’s say your Social Security normal retirement benefit starting at age 66 is $1,000 a month. If you begin payments at age 62, you will receive only $750 a month. Assume inflation runs at 3% every year (that won’t happen, but it could average out to about that). Here’s what you would get at various ages:

With Age 62 Retirement
With Age 66 Retirement

With Age 62 Retirement
With Age 66 Retirement






During the first four years you are unambiguously better off if you start your Social Security benefits at age 62. Over those four years you will receive around $37,500 in benefits. Assuming a risk-free return equal to the inflation rate, those payments would have an accumulated value of approximately $39,000. You’ll need that money to reimburse yourself for the greater normal retirement benefits you could have been receiving had you delayed your Social Security retirement. Your accumulated pot of money (continuing to grow with interest but shrinking with the make-up payouts) runs out around age 77. From then on you are less well off compared to deferring Social Security retirement.

From a risk standpoint, these later years are just the time you’ll need the extra money because your chances of outliving your life expectancy are now much greater.

For me the choice is easy. I can afford to die “too early” and I won’t be living to regret my decision. However, if I live longer than expected, I’ll have to suffer (or not) the consequences of that decision. Having a larger guaranteed income will be a welcome cushion.

I’m not sure most baby boomers will agree with my logic. The majority of my generation has preferred purchasing perishable consumer goods over saving for retirement. I suspect these people will start collecting Social Security as soon as they can. Many will rue their decision after they’ve run out of money and all they have left are their toys that no longer work.

~ Jim

Thursday, July 19, 2012

Libor Rate Fixing – What’s the Big Deal?

When the Barclay’s scandal about reporting lower-than-actual costs of borrowing to those who compile the Libor rate (London Interbank Offered Rate) I thought, “Isn’t this old news?” Sure enough, Calculated Risk, a blog I follow, posted a bunch of links that reminded me why I had indeed come to believe Libor was something of a fiction.

For the record, let’s back up a bit and describe what Libor is—and it’s not one thing; it’s actually 150 things: Libor rates are set for fifteen maturities and ten currencies. Every day around 11:00 a.m. major London banks report the rates they “expect” to pay to borrow for various lengths of time. The compiler ignores the top and bottom 25% of reported rates and averages the middle 50% to determine the Libor rates, which are released to the public at 11:30. Banks, insurance companies, credit card companies (and maybe even loan sharks for all I know) use these rates to determine the interest rates they charge on loan balances. If you check your loan agreement you may find that it calls for something like the 3-month Libor rate plus 2.75%.

The first thing to note is that if only one bank was misstating their rates by substantially over- or under-reporting their borrowing costs, it would make little or no difference to the Libor rate since the high and low outliers are excluded from the calculation. To make a difference to the reported rate requires malfeasance on the part of a significant portion of the reporting banks.

From documents reported so far, it appears that especially in the midst of the 2008 financial crisis many banks understated their reported Libor rates. People began to use the Libor rate as a proxy for understanding each bank’s health, which explains why a bank might report a lower rate than their real borrowing cost. No CEO wants others to view their bank as vulnerable. If no one will lend to a given financial institution, it will soon have to shut down. (See Lehman Brothers for example.)

As a consumer, this chicanery might actually be good news. If your loan agreement ties your interest rate to an understated Libor rate, you aren’t charged as much as you should be. You win; your lender loses. That is a zero-sum game. Holy financial boondoggle, Batman, the banks screwed themselves? Well, for sure they screwed those brethren not able to offset the losses from preternaturally lowered Libor rates. However, some banks have trading arms that take financial positions on (among other things) the movement of Libor rates. If you knew the rates weren’t going to move as much as the economics of the time suggested, perhaps you’d be a wee bit tempted to place a bet given your inside knowledge.

Perish the thought anyone in the financial industry might use inside information. The fools who took the other side of the Libor bets thought they knew better—but what does that say about them when someone like me, a simple retiree with a bit of time on his hands, was convinced the banks were not reporting accurate figures.

As individuals we need to keep in mind that we should never invest in something we don’t understand. That includes not investing money with someone who buys and sells financial instruments you don’t understand—it’s just as likely they don’t understand those financial instruments either. As further proof, just look at the hedging operation that has already cost JP Morgan Chase billions and they haven’t completely unwound their position.

As usual, the lawyers will make out the best since they represent both sides of all suits (and they have already started over the Libor mess) and always figure a way to be paid.

Oh, and if you want a way to fix the problem of the phantom reporting, here’s my solution. Forget about publishing an expected rate. Have the banker boys tell us the highest rate they actually paid during the last 12-hours. There might be a bit of a lag in the data, but we can audit the results and put behind bars those who lie. Which would you prefer, fresh lies no more than 30-minutes old or half-day-old truths? I’ll take the truth, thank you.

~ Jim