How to understand high yield/junk bonds


The high yield fixed income market, also known as “junk bonds” is often one of the most misunderstood asset classes by many investors.   In recent years with interest rates at historically low levels, many investors have attempted to look at different investments to enhance the cash flow generated from their portfolio.   One such area has been the high yield marketplace.


 High yield bonds by definition are bonds that pay a coupon (interest payment) in excess of the normal interest rate environment as a result of their lower credit quality.  They are typically below investment grade debt instruments.  There are several different rating agencies that rate fixed income credit quality. One such agency is Standard & Poors (S&P).  S&P ratings indicate any fixed income position with a rating below BBB is classified as below investment grade or “junk” status.


 The term “junk” can sound quite derogatory in nature, and may insinuate that it is something to stay away from.  This is not necessarily the case. There is almost always a place for lower quality fixed income within the confines of a longer term investment plan. The first thing to understand is how high yield bonds correlate to other assets.  Most fixed income investments are inversely correlated to interest rates.  That means that when interest rates are rising, an existing bond offering a lower interest rate declines in value.  The relationship here is simple to understand. Imagine that you hold a bond issued by a corporation that matures in 10 years and pays 5%.  If rates rise to the point that the 5 year treasury pays 6%, why would anyone want to buy your bond paying 5% when they have to wait twice as long to get their investment back?  The answer is that they likely wouldn’t.  As a result, if you attempted to sell your bond early, it would sell at a discount (loss) from your original purchase, if you bought it as a new issue.  This is known as interest rate risk.


Yet, high yield bonds generally function in the opposite manner.  As a result of the substantially higher rates paid, the emphasis of concern in pricing these instruments is rooted in the issuer’s ability to pay back the original principal payment due to the lower credit quality of the issuer. High yield bonds are classified as below investment grade because the underlying company is perceived to have a less stable set of financial conditions.   The reason for the positive correlation with interest rates is based on this concept of solvency.    If interest rates are rising, this is generally perceived as the result of the Federal Reserve increasing rates to slow the growth rate of the economy and prevent higher inflation.    Since the economy is theoretically expanding, the probability of a company surviving through more prosperous economic times has therefore likely increased.   Hence, their ability to repay their debt obligations has also likely increased.   Likewise when rates are declining, that is usually indicative of some concern of an economic contraction, and perhaps even a recession.    While in a period of contraction, the earnings of Fortune 500 companies may decline.   However, it is typically unlikely that these large multinationals will go bankrupt.  In the case of less credit worthy companies, a company that already has financial concerns will likely find it much more difficult to weather the economic storm.   Therefore the ability to satisfy their debt obligations will be called into question.  It is for this reason that the high yield bond market tends to move most often with interest rates rather than against them.


High yield bonds also tend to get issued withoutcall protection” on the individual bonds.   A callable feature is an aspect of a bond issuance that permits the issuer to redeem the bond early if the economic environment of the company improves.   In such a scenario where the growth of the company is so strong that they are no longer considered to be a credit risk, or of junk status, they may opt to call in some bonds, and then issue newer debt at lower rates based on their improved financial condition.  However, this means you as the investor will not see the return you anticipated had you been able to hold the issue until its full maturity.



What about buying individual High Yield Bonds?


In general, it is not prudent for the average investor to buy high yield bonds individually.  The risk of repayment can be enormous. The key to buying into this market is typically diversification.  The majority of retail investors will not likely have the capital to broadly diversify this portion of their portfolio across hundreds of holdings.   Furthermore, the likelihood that the average investor has completed the necessary financial analysis in each individual company’s financials is also improbable.   Most investors will be served far better by capturing exposure to these areas through mutual funds and ETF’s.


When should you buy High Yield Bonds?


The purpose of buying into this area of the market is that it serves as a potential hedge against interest rate risk.   Should an investor have a fixed income portfolio of treasuries, government agencies and good quality corporate bonds, they will be exposed to the negative/inverse correlation when rates rise over time.   As a result, having a small portion of your fixed income portfolio allocated to this area of the market will offset a portion of that risk, while simultaneously paying a higher income.   Such a holding simply balances the risk associated with the better quality debt holdings.  It is important to note that these positions are typically a much smaller percentage of the overall holdings than that of traditional fixed income.  In cases where a portion of your portfolio is exposed to stocks or stock funds, it should also be noted that high yield bonds may correlate closely with them as well.  The correct percentage exposure in an individual’s portfolio is going to be specific to that person’s financial goals and time frame. The same can be said of any asset class, as each situation must be addressed in a unique manner.


While their performance is often dictated by different economic environments, it is still not prudent to attempt to time these cyclical trends.  As is the case with any asset class, pricing is often reflected in anticipation of a changing environment, and exploiting shorter term price inefficiency can be very difficult, and even more challenging to accomplish on a consistent basis.


High yield bonds are generally classified as a higher risk investment, and should be treated as such.   Yet, from a financial planning perspective, when used appropriately in the proper proportion of an individual portfolios overall asset allocation, they will likely bring down the overall risk of your investment strategy by reducing the correlation across portfolio holdings.   As with any asset class, it is advisable that an investor discuss this with their financial advisor and complete their due diligence before taking a position.


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Should you worry about market volatility?


How often have we heard that markets are volatile, and you simply need to stay invested rather than panic? To the average investor, the answer is likely countless times. So how reliable are such cliché like statements about investing? The answer is; extremely reliable, so long as you don’t attempt to out think financial markets.


Novice investors sometimes equate the stock market with some form of a casino in which only the “house” can win. Nothing could be further from the truth. As it pertains to the stock market, there is no independent “house” as is the case with a stay at a casino in Las Vegas. Ownership in a stock is no different than ownership in any business, large or small. If you as an investor were to invest your own dollars into a bakery, you may be highly successful, or perhaps not. Hopefully, before you made the decision to invest in this bakery, you evaluated the local marketplace, the cost to run the store, the insurance coverage required, etc. If you failed to address these necessary concerns adequately, the business venture may not be as successful as you had initially hoped. The novice observer would likely simply equate the failure and corresponding financial loss to either poor planning, or some unlucky set of circumstances. However, the “house” is never to blame for some reason.


Investing in the stock market is simply investing in a business as a silent partner. You the investor will take a minority stake in a company, and in return you share in the success or failure. Aside from the tax treatment a small business owner realizes, the only fundamental difference between the publicly traded stock and the bakery investment is you exercise no operational control. Like investing in the bakery, it is prudent to complete your own due diligence before placing your hard earned dollars into any investment.


Investing in the stock market offers far greater opportunity in the way of risk diversification via various solutions. An investor can utilize mutual funds for professional investment management, or simply gain broad access to financial markets via index funds/ETF’s which invest directly into a broad market index at once.

It should be noted that investing in actively managed equity mutual funds have most often consistently underperformed direct investments into their corresponding index fund counterparts.


So how risky is the stock market? Looking at the S&P 500 index (The 500 largest public US companies), we actually see that market volatility is quite the norm. A recent JP Morgan analysis showed that from 1980-2016 the S&P 500 posted positive price returns in 28 out of 37 years. That is roughly 3 out of every 4 years. When dividend yields from the underlying companies are included, three of the nine negative years turn positive. Across that time frame, there was an average intra-year decline of -14.2% from the peak of the market to its worst point each year. As an example, the S&P 500 Index closed up approximately 26% in 1980, yet at its worst point in the year had fallen by about -17%. Seeing these types of swings in pricing is quite normal and expected.


What is NOT predictable is specifically when such swings will take place, in what direction, and how long they will last. Financial markets are highly unpredictable in the short term. There are thousands of variables that impact the value of a specific company at any given point in time. Some of them are specific to that company, and others can be related to larger indirect economic or geopolitical concerns. Attempting to predict short term prices movements in a specific company, or the stock market as a whole is most often an exercise in futility. In the end, what makes a company, or group of companies more valuable over the long run is profit growth. No different than the bakery, if the business generates more profits over time, it is more valuable. Considering the resources available to diversify a stock market portfolio, and the fact that the vast majority of small business ventures fail within a few years, there is a strong case to be made that the stock market as a whole poses much less risk than investing in the bakery.


Looking across various market indices, you will see varying degrees of volatility. Small Cap stocks are generally more volatile than Large Cap stocks. Investing into a Small Cap fund will offer greater potential returns, with likely greater volatility. Investing in fixed income investments/funds will typically offer you lower potential returns, with lower exposure to short term volatility.


A recent paper put out by the NYU Stern School of Business demonstrated that from 1928-2016 the 10 year US Treasury Bond posted average annual returns of 5.18%, with only 15 years in which returns were negative. During the same time frame between 1928-2016, the S&P 500 index posted and average return of 11.42% when including annual dividends. During that time there were a total of 24 negative years.


While this is just a simple snapshot of two of the most widely quoted benchmarks, there are various measures of financial markets. What’s important to note is that over time, all asset classes continue to appreciate. Ultimately, there is NOT a finite amount of wealth that exists. New products and services come to the market place all the time. In addition, new dollars are created and enter the global economy all the time. Given enough time, everything will cost more money due to inflation. That means given these consistent variables, a gallon of milk, the price of a car, and value of the S&P 500 Stock Index will all likely continue to increase in price. If the proper balance of money creation and new productivity is not maintained over time by policy makers, the risk of inflation can be even more impactful. This means that by not maintaining a constant allocation in some form of investing, you are subject to what amounts to a guaranteed loss through the erosion of your purchasing power.


What we find fairly consistently in the financial planning field is that investors behave emotionally far too often. What drives down returns across portfolios over the long run is the lack of a consistent strategy and discipline. Dalbar, an independent financial services research organization has been providing for many years an annual report on individual investor results versus the market as a whole, known as the Quantitative Analysis of Investor Behavior. In their 2015 report which looked back 20 years, they found the average equity mutual fund investor had a 20 year return of 4.67% vs 8.19% for the S&P 500 Index. The average fixed income mutual fund investor produced annualized returns of 0.51%, while the Barclays Aggregate Bond Index posted an average return of 5.34%. Most of this lag in performance is driven by emotional responses to market conditions in which investors attempt to time financial markets. This often leads to selling into market declines, and buying into market strength.


As an investor, market volatility is only relevant to the specific goal an investor has with a specific pool of dollars. If an investor has a goal of using a specific amount of money for a pending new home purchase that is only a few months away, neither the stock market, or the bakery venture is an appropriate us of those funds. Investing requires time to serve as your ally. In general, any goal of less than 3-5 years is not appropriate for even a conservative portfolio of investments. As it pertains to retirement savings for anyone who is a good distance from retirement, or even throughout their retirement, an investment strategy that does not maintain some exposure to equity investing is unwise.


What all of this data tells us is that markets are highly unpredictable over the short term and very predictable over the longer term. A well-constructed investment plan will gain exposure to various different asset classes to help to minimize the inherent short term volatility. However, no investment plan can be expected to work without the commitment to stay invested across different market conditions. In order to accept that, investors must first accept that market volatility is quite normal. It should be regarded as an opportunity rather than a cause for concern.

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Back Door Conversions: A Tax-Free Growth Opportunity


Many investors find the thought of using the ROTH IRA for tax-free growth as a very attractive option, but ultimately never participate. This is typically due to their income, which can phase out an investor from making a contribution to a ROTH IRA if it exceeds certain thresholds. However, investors are offered the opportunity to convert from a traditional IRA to a ROTH IRA without limitations on annual income.

Doing a conversion triggers an immediate tax liability on the pre-tax amount that is converted from the traditional IRA to the ROTH IRA. In order for this to make financial sense, there are many factors to consider. One significant concern is the investor must presume that they will be in a higher tax bracket in the future, which is most often less likely in retirement. Additionally, if they satisfy the tax liability from the funds in the account being converted rather than paying the taxes with other, post-tax, funds, they lose the tax-free growth shelter on the tax amount, which negates a reasonable portion of the intended benefit by reducing the total amount invested.


In order to make a contribution to any IRA, an investor must have earned income or have a spouse with earned income. The maximum contributions are $5,500 per individual under age 50, and $6,500 per individual over age 50 in the 2018 tax year.


The IRS rules state that for the tax year 2018, IRA contributions to a ROTH IRA are limited to the following income caps:

Single Filers can contribute the maximum if they earn up to $120,000 in adjusted gross income. Above $120,000 the contribution is reduced until you are fully phased out at $135,000 in adjusted gross income.


Joint Filers can contribute the maximum up to $189,000 in adjusted gross income. Above $189,000 the contribution is reduced for each until you are fully phased out at $199,000 in adjusted gross income.


Furthermore, the IRS places limits on contributions to traditional IRAs in order to obtain a tax deduction. Those limits are also based on income, and whether or not you and/or your spouse are actively participating in a qualified employer retirement plan.


Yet many investors are unaware that the IRS places no income limit on a non-deductible traditional IRA contribution. Regardless of whether or not you exceed the income cap or participate in an employer plan, you can make the maximum contribution to the traditional IRA. All that is required is that in the year of the contribution, IRS form 8606 is completed in order to designate to the IRS that these are previously taxed dollars and no deduction was taken against your income. Therefore there will be no taxes due on the contribution portion at the time of the withdrawal. Only the gains will be subjected to income taxes.


This creates an opportunity that many investors are unaware of, sometimes called the Backdoor Conversion. If you make a non-deductible IRA contribution to a traditional IRA, and then subsequently convert that dollar amount to the ROTH IRA, you have effectively made the ROTH contribution. It is important to remember that since you made the contribution to the traditional IRA and never took the deduction, these are after-tax dollars. As a result the conversion to the ROTH does not trigger an income tax liability. Presuming you completed these steps simultaneously, there would be no gains yet realized, so there would again be no taxes on the conversion.


While this sounds simple enough, there are some additional complications that can limit this strategy for many investors. The primary issue is what is known as the pro-rata rule. The IRS states that the conversion must look not specifically at the after-tax dollars that were converted, but the sum of all the IRAs an investor owns. So if you had an IRA made up of $500,000 in pre-tax funds, and then simply opened a separate IRA to use this strategy, the value of the larger account would be taken into account and negate virtually the entire benefit, making nearly the entire transaction a taxable conversion. 



So who might this strategy make sense for?


Generally speaking, investors who have little to no money in traditional IRAs, but are actively contributing to an employer sponsored retirement plan such as a 401k/403b. Or perhaps in the case of a couple in which one spouse has a traditional IRA, but the other spouse does not. The pro-rata rule applies only to the individual, and not the spouse. The existence of an IRA in the husband’s name will not limit the wife from applying this strategy should she not have an IRA with pre-tax funds.


In the case of investors who have already maximized employer sponsored plans, and wish to further contribute discretionary cash flow to a tax free shelter, the backdoor conversion can be an excellent opportunity.


It is also important to note that tax laws are constantly changing. Rules, phase outs and limitations will likely be altered over time. So it is advisable that any investor consults with both their financial advisor as well as their tax advisor before applying any strategy to ensure it is permissible.



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Rising Interest Rates and the Bond Market: What is the Risk?

By lwmdemo4,

As many investors have started to take note, interest rates have begun to rise.   The Federal Reserve Board (Fed) has signaled at least three interest rate hikes for the calendar year 2018.    As the additional concerns of rising inflation begins to mount in the eyes of many forecasters, it is entirely possible that the Fed will act even more aggressively in raising their target rate.

Differing economic conditions can pose challenges to various different asset classes, as well as investment vehicles within a given asset class.  A rising interest rate environment is generally perceived to be a poor environment for fixed income investments.  This tends to be true in a broad sense, although not exclusively true in all areas of fixed income.   Certain types of fixed income investments tend to do well in a rising interest rate environment.  One such example would be High Yield bonds, which tend to benefit from expanding credit.

In a more broad sense, rising interest rates are a challenge for bonds.  The simple reason is that existing bonds are priced based on a number of metrics such as credit quality, maturity, callable features and the coupon of the bond.  The coupon is the stated interest rate the bond pays when it was issued.  If you purchased a bond paying 3%, and new bond offerings of a similar profile are offering 5%, this makes the bond you hold less attractive and will devalue that bond in the eyes of the current marketplace should you wish to sell it prior to maturity.   Even if you have no intent on selling a bond prior to maturity you may suffer from some “statement shock” when you notice the reduction in value.

The fixed income markets in general have benefited from a period of primarily declining interest rates since the middle of 1981.  Since then, according to Ibbotson Associates the SBBI U.S. Government Treasury Index has averaged better than an 8% annual return.   Much of this performance was frontloaded in the early 1980’s as rates began to decline from unusually high levels in which the intermediate treasury was yielding in excess of 16%.   As an example the 7-10 year Treasury index managed to post only an average return of 1.53% for the 5 year period ending in December of 2017, as rates have remained at historic lows for a decade.

More importantly, the concerns relating to fixed income markets is often centered on how will fixed income investments fare should we see a sustained environment of rising rates.   Much of this is likely dependent on numerous factors such as the timing and pace of Fed policy.    After all, much of the Fed’s policies such as the multiple rounds of Quantitative Easing and its rapid expansion of the Central Bank’s balance sheet are unprecedented.  So it remains to be seen how successful the unwinding of such policy positions will be.

However, there is some historical data to reference regarding fixed income and prolonged rising rate environments.   During the period between 1941 until the peak of interest rates in 1981, there was a longer term trend of fairly consistently rising rates bringing the yield on the intermediate U.S. Treasury from about 0.51% to a peak of 16.4%.   During this period in time the intermediate Treasury market still posted average returns of about 3.3%.    So while the returns over this 40 year period where less than half of that the next 37 years posted for the Treasury market, it was still a net positive performance.   During this period of rising rates there were some negative years.   Yet, negative for fixed income tends to be far less impactful than its equity market counterparts.  According to the NYU Stern School of Business, the single worst year for the 10 year US Treasury bond was in 1969 in which the total return inclusive of dividends was a decline of -5.01%.    Interestingly, the worst years posted for the 10 year treasury were actually during the great bull market in bonds over the last 37 years, which were 1999  which was a decline of -8.25% and 2009 which was an -11.12% decline.  During both of those years the stock market countered this downturn in fixed income with the S&P 500 stock index which was positive by 20.89% & 25.94% respectively.

So while to a certain extent we are in some uncharted territory as pertains to Fed policy, there is a reasonably good track record of rising rates and the impact on the bond market.  Yet, it is still important to distinguish between the historical impact of rising rates on Treasury securities versus other areas in the fixed income markets.  Treasury bills have historically been representative of a risk-free rate of return.  It is fair to say that there is no true risk-free asset when one accounts for other forms of risk, such as inflation.  It is fair to say that treasuries do not pose a default risk.   Unfortunately, this is not true of all fixed income investments.  Corporate debt can in fact default, and even municipalities can go bankrupt altering their repayment of debt obligations.   It should be noted that municipal bankruptcies historically have been an extremely rare event.  

An investor should understand the relationship between changes in rates and their bond portfolio in total.  Each bond has what is known as Duration Risk.  Duration is a complex calculation involving present value, yield, coupon, final maturity and call features of a bond.  This can be measured by examining an individual bond or the average across a portfolio of bonds, or bond funds to assess an average duration.   The simplest way to understand duration is that for each 1% change in interest rates, the price of the bond or bond portfolio should approximately move inversely by the percentage amount of its duration.

As an example, if a bond portfolio had an average duration of 4.5, then a 1% increase in interest rates would indicate a theoretical decline of 4.5%.   The opposite is true in a declining interest rate environment.   Understanding this risk is paramount in building a fixed income portfolio.

It is also imperative to understand that when building a truly diversified investment plan, fixed income is not measured exclusively by your short or long term forecast of the bond market.  It must also be measured in relation to other asset classes you own.  While bonds can and do have negative years, those years are not nearly as poor as the volatility and single year declines associated with stocks.   Due to the fact that stocks and bonds do not always move in tandem, bonds serve the purpose of diversification, a consistent income stream, and the dampening of volatility during periods when stocks can contribute significant amounts of volatility and downward pressure on an investment portfolio.  This becomes particularly important as it pertains to those investors who are either retired or approaching retirement and in need of generating a consistent cash-flow from their investments.

While the forecasts made by many of a challenging investment environment for fixed income may in fact come to fruition, it is difficult for any investor truly interested in a diversified approach to eliminate an entire asset class.   Often times, even in a challenging environment for any asset class there may be many areas of opportunity within in the bond market.  Perhaps that will be in international markets or varying degrees of credit risk.  No matter what the outcome, it is likely that bonds still serve an important role for the majority of investors to some degree.

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When Should You Collect Social Security Benefits?

By lwmdemo4,

Among the most consistent questions my colleagues and I have received as financial planners from investors relates to the timing of when they should take their Social Security (SS) benefits.  Social Security is a relatively complex system with many rules that pertain to various circumstances.  Let me first emphasize that there are no absolute answers, and each individual’s situation should be assessed on its own merits.  Unless of course you can tell me precisely when you will die, in which case I can provide you with a far more precise answer.

I would venture to guess that the majority of articles and publications on this topic will suggest that you wait as long as possible to collect.   I will attempt to defy what may be the conventional wisdom, because in my experience the conventional wisdom is often wrong.   Let me first say, none of this is based on the known actuarial problems facing the SS trust fund, which begins to run a shortfall projected around the year 2033.  The SS trust fund is made up of intragovernmental debt (US Treasuries).  The funding sources for SS have been merged with the general taxes collected for many decades.  Since the United States operates as a fiat currency, “running out of money” is essentially impossible.   I say this not to minimize the challenges that such entitlement programs face, as they can have many other substantial economic consequences on the nation beyond the scope of this article.  However, the fear of the government “running out of money” should play no role in determining when you should collect your benefit.

SS benefits allow under normal circumstances that you can collect your benefits prior to your full retirement age (FRA) as early as age 62, or past your full retirement age as late as age 70.  Full retirement can be differing ages as defined by SS depending on when you were born.  Each year you delay the benefit, it increases by 8% using a simple interest calculation rather than a compounding calculation.

The first thing to understand is that SS is actuarially designed so that when you reach your statistical average life expectancy you will have received the same exact total amount of dollars regardless of whether you began at age 62, age 70, or anytime in between.  Each day you live past your average life expectancy, the total amount of dollars received is greater for someone who delayed collecting their benefits versus someone who collected earlier.   Additionally, the term “average” life expectancy is quite misleading.   In financial planning we also study “longevity” planning, which is different than the average.   The average can be misleading because averages are impacted by unfortunate events such as infant mortality or a teenager killed in a car accident.  When we look at longevity, a couple that actually reaches age 65 has better than 75% chance that at least one of them will reach age 92 years old.   So, if you live long enough to qualify it would seem statistically highly probable that you will surpass the average, and therefore you are better off delaying your benefit.   While it may seem that way, here is why it may not.

The majority of examples that illustrate when an individual should opt for their SS benefits will look in isolation at the SS benefit, and often not enough at the details surrounding an individual or couples overall financial picture.  This approach will most often encourage you to wait as long as possible.   Let’s first look at the most common example, which is a married couple.   Many people are unaware that unlike a traditional retirement plan, SS does not offer a traditional survivor benefit.   This means that if Spouse A is earning $2,600 at full retirement, and Spouse B is earning $1,800 at full retirement, upon the death of either of the spouses, the survivor will receive the higher of the two benefits and lose the lower benefit permanently.

Let’s imagine a common example.  Client A is born in 1955 and their full retirement benefit at age 66 and 2 months.  The annual benefits offered are as follows:

Reduced benefits at age 62:                $25,181

Full retirement benefits at age 66:    $33, 933

Delayed benefits at age 70:                 $44,792

For the sake of these illustrations we are going to discount the annual inflation increases on the SS payments because they would be applied at the same rate linked to the consumer price index regardless of what age you opted to begin collecting your benefit.

Client A’s benefit of $25,181 between the age of 62 until 70 is an aggregate income of $201,448 over the 8 year period.   If client A does not receive this annual benefit because they waited until age 70, then we might presume that they needed to spend down the $201,448 from another source such as a 401k, IRA, savings or another investment account in order to meet their income needs.   So how much is the time value of money on the $201,448 spent down to replace the SS benefit that was not collected because Client A waited until age 70 for the enhanced benefit?

Let’s be conservative.

If the same $201,448 remained invested earning an average return of 5% (which is well below historical long term market averages), that would compound into $297,630.    It is widely accepted based on countless financial planning studies that a properly balanced investment portfolio can sustain a 4% withdrawal strategy for 30 years increasing with inflation without depleting assets to zero.  If you were to wait until age 70 to begin withdrawals, a 4% withdraw should be more than sustainable and quite reasonable.  Even a 5% withdrawal at age 70 is highly plausible.  In the interest of remaining conservative in the assumptions used, we will use the 4% withdrawal approach.

The pool of investment dollars has compounded to an additional $297,630 because Client A did not need to draw on these assets due to the early SS benefit supplementing their income, how much is this worth as an income?  Using a 4% withdrawal strategy annually from $297,630 beginning at age 70, you have an annual income in year one of $11,905.   This figure is still smaller than the difference between your age 70 benefit and the age 62 benefit ($44,792-$25,181=$19,611).  That is a difference of $7,706 annually.   So why would it be better to realize the lower income?

Let’s remember that you don’t receive more in total benefits by waiting until you reach your average life expectancy, (currently approximately 81 for women and 76 for men).  What happens if Client A did not live to their statistical average and were to pass away at age 70?  Remember that the survivor benefit to the spouse is the higher of the two benefits, but they lose the smaller benefit.   In such a case the surviving spouse would lose not only the smaller income (which is at least 50% of the larger income), but the benefit of inheriting the $297,630 that was never realized because the assets were spent down rather than saved and grown via an investment portfolio during the 8 year period while waiting to collect the higher benefits.  The result of the combined loss in many cases can be dramatically impactful, if not financially catastrophic on many surviving spouses.

It is sometimes argued and entirely possible to insure this risk by buying a term life insurance policy on the amount of the lost savings.  However, term insurance typically ends at age 80.  In the event the insured died at age 81, the surviving spouse never receives the death benefit, nor do they have the accumulated additional dollars saved by collecting earlier.  Additionally, they lost the cost of the life insurance premiums they paid for 18 years, which negates some of the benefit of having just barely passed the breakeven point at their average life expectancy.    This strategy also presumes the individual is in fact insurable, which is not always the case depending on their past medical history.

What if Client A waits to collect at age 70 and both spouses live to the ripe old age of 95?  

With the average life expectancy for a man being approximately age 76, that is an extra 19 years with an additional $7,706 per year past the breakeven point.  That is a total of an additional $146,414 ins SS income.

So while Client A may have collected a total of an additional $146,414 in total benefits by delaying benefits, we cannot ignore the investment capital that was spent down between ages 62-70, which we established earlier was equal to $297,630 with a 5% return for 8 years.   While this capital using the 4% withdrawal strategy is presumed to be generating less income, it does not necessarily mean it will be spent to zero.

In fact, according to research done by Michael Kitces, if you spend at a rate of 4% per year over a 30 year period in a balanced portfolio (defined as 60% stocks & 40% bonds), statistically 2/3rds of the time you’ll have more than 2 times the amount of assets at the end of a 30 year period.

More than ½ the time the value will nearly double.

More than 1/3rd of the time the retiree ends up with 5 times the amount of principal they started with at the end of 30 years.

90% of the time retirees finish with more than their starting principal at the end of 30 years.

That is equal to between $595,260 $892,890 at the end of retirement.  So while Client A may have collected an additional $146,414 from their delayed SS benefit, they likely lost somewhere between $595,260 -$892,890 due to 38 years of missed compounding.

From a legacy perspective, Client A’s estate is greatly enhanced by collecting early.  While an estate is more of a benefit to Client A’s heirs, either way the bills were paid to support their lifestyle during retirement, and their total net worth is higher at the end of their life.

Many of the above assumption are very conservative growth estimates.  However, it is still worth noting that in order for this to work, Client A must stick to an investment plan in a disciplined manner.  While many retirees certainly do just that, others have a tendency to panic during periods of market volatility which then undermines the above assumptions.

There are other variables worth considering such as taxes.  If the funding source for the theoretical investment capital is a retirement account subject to income taxes on withdrawals, this must be compared with SS income which has some additional tax benefits.  SS income is exempt from State income tax, and at least 15% of the benefit is exempt from Federal income taxes.    While that is a slightly greater benefit for SS, it is not enough to offset the benefit of collecting early in many circumstances.

What if you had no need for your Social Security Income at all?

If you and your spouse have no need for the SS income or the assets you have saved to generate a cash flow because perhaps you have a large pension benefit that more than pays for your lifestyle, then that SS income possibly becomes discretionary investment capital.

Assuming you live to age 95 and the income was invested annually compounded at 5%.

Collecting $25,181 at age 62 would compound at age 95 to $2,116,895

Collecting $44,792 at age 70 would compound at age 95 to $2,244,685

In this example, if you never needed the funds and invested them at the same rate of return, and lived to age 95, it paid to wait.   However, you would need to live until at least age 82 to have benefited from waiting.   Once again, if either you or your spouse pass away prior to that, the lack of a survivor benefit on the lower income is a substantial difference.

As we referenced earlier, there are no absolutes, and circumstances do exist in which it certainly does not pay to collect early.  In the event that you are still working, you want to delay benefits until at least your full retirement age in order to avoid penalties that would negate a substantial portion of the income, if not all of it.

If you and your spouse are in a position where you have not saved an adequate amount of money to support your lifestyle and you are likely to run out of money no matter what you do, it likely pays to delay the benefit as long as possible since you will not have investment capital to produce any compounded growth.   If you are essentially running out of liquid assets anyway, you are likely spending all of the SS benefit every month, and no wealth is accumulated no matter what happens.  Therefore, the larger lifetime payment makes sense.   If you died well before your average life expectancy, you never reached your breakeven point.  But either way there is no legacy of assets left to heirs.

Each situation must be examined independently in order to make an educated decision.  However, it is wise to be cautious of software programs, or any form of advice that measures only the metrics of the SS benefits formula without accounting for all the other moving parts that make up your personal financial profile.

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