When people think seriously about retirement, they often wonder if their savings are going to be sufficient to support their lifestyle in retirement. Few people are able to rely on pensions, and most young people assume Social Security may help their parents, but will be of no value to them. Obviously some things need to be done to fix the Social Security System for the long term, but for those of us approaching retirement in the next ten to fifteen years, Social Security payments will be an important part of the retirement income picture. More important than many people realize.

A recent study from the Center for Retirement Research at Boston College (Brown et al., March 2015) suggests that people find it difficult to value a lifetime income stream, and yet the value of Social Security may be as important, or even more important than savings, in determining financial security in retirement.

The researchers asked people to put a value on a $100 change in their Social Security monthly benefit. Participants were asked, if they could write a check now for an increase of $100/month in their lifetime income, how much would they be willing to pay? Most respondents were only willing to do this when the price was very low. The median price they were willing to pay was $3,000, which could be recovered in the first two and half years of higher payments! By way of reference, the actuarial value reported by the researchers is $16,855. Even more dramatic, to replace $100/month with a 4% withdrawal rate, you would need an investment portfolio of $30,000, but of course your heirs would keep the remaining principal in that scenario.

Helping clients decide how much investment risk is right for them may be the most important thing we do as investment advisors. We can provide advice, but the decision must be the clients’ own if they are going to remain committed in the face of adversity.

That decision can be difficult, but may be made easier when framed properly, or put in an appropriate context. Understanding the value of Social Security may be critical to making good investment decisions, yet this recent study points to how difficult that can be.

As an example, for a typical couple who has accumulated a million dollars by the time they retire, their savings could provide $40,000 per year at a 4% withdrawal rate. If they need $80,000 per year to support themselves in retirement, the $40,000 or so they may get in annual Social Security benefits are in one way equal to the income they may take from their savings (assuming a 4% withdrawal rate).   The payment stream from Social Security is not really worth $1 million, because there is no residual value for heirs, but it is an important part of the retirement portfolio.

Conclusions:

  1. Social Security is more valuable than many people think.
  2. The value of Social Security is important in the investment risk decision as the guaranteed stream of income provides stability, which may provide the confidence to take a higher level of investment risk in the rest of the portfolio.
  3. Better investment decisions can be made in a portfolio context, where all sources of wealth and income are taken into consideration.

When thinking about the risk of your investments, be sure to take a step back and look at the whole picture. Maybe you can take more risk than you thought!