In our first discussion about Social Security, we discussed Break-Even Analysis. It’s a good place to start as it is fundamental to understanding when to claim Social Security. However, it’s exactly that, a starting point. If that’s where your research stops, then you are missing the bigger picture. Unfortunately, that is where many studies, commentary, and analysis done by individuals begin and end.
So, what is the bigger picture? Professional financial planning is the integrated, coordinated, and ongoing management of one’s finances. Deciding when to claim social security can impact when and how much you withdrawal from your investment portfolio. The most significant limitation with linear breakeven calculations is that they do a terrible job representing reality and significantly understate the risk of an adverse sequence of returns and portfolio volatility.
Linear calculations, like the ones most people do in Excel, assume a constant rate of return. For example, 5% a year every year. However, how often does the market earn an average rate of return? Not often. In reality, you tend to have years that are much better or years that are much worse than the average. The impact of sequence and the volatility of those returns matter in the outcome you actually experience.
Here’s an example: you start with a $1,000,000 portfolio, withdraw $50,000 per year and earn a 5% rate of return every year for 20 years. The linear calculation below indicates you can do this indefinitely, and your ending value is the same as what you started with.
| Year | Beginning Value | Withdrawal | Return % | Return | Ending Value |
| 1 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 2 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 3 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 4 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 5 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 6 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 7 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 8 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 9 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 10 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 11 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 12 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 13 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 14 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 15 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 16 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 17 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 18 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 19 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
| 20 | 1,000,000 | (50,000) | 5.0% | 50,000 | 1,000,000 |
What happens if you experience a favorable sequence of returns? Let’s make the same assumptions as before, but now the first ten years you experience a 10% rate of return annually and the last ten years a 0% rate of return annually. The average return over the 20 years is still the same, 5%. All that has changed is the sequence of returns. As you can see, the outcome is better.
| Year | Beginning Value | Withdrawal | Return % | Return | Ending Value |
| 1 | 1,000,000 | (50,000) | 10.0% | 100,000 | 1,050,000 |
| 2 | 1,050,000 | (50,000) | 10.0% | 105,000 | 1,105,000 |
| 3 | 1,105,000 | (50,000) | 10.0% | 110,500 | 1,165,500 |
| 4 | 1,165,500 | (50,000) | 10.0% | 116,550 | 1,232,050 |
| 5 | 1,232,050 | (50,000) | 10.0% | 123,205 | 1,305,255 |
| 6 | 1,305,255 | (50,000) | 10.0% | 130,526 | 1,385,781 |
| 7 | 1,385,781 | (50,000) | 10.0% | 138,578 | 1,474,359 |
| 8 | 1,474,359 | (50,000) | 10.0% | 147,436 | 1,571,794 |
| 9 | 1,571,794 | (50,000) | 10.0% | 157,179 | 1,678,974 |
| 10 | 1,678,974 | (50,000) | 10.0% | 167,897 | 1,796,871 |
| 11 | 1,796,871 | (50,000) | 0.0% | 0 | 1,746,871 |
| 12 | 1,746,871 | (50,000) | 0.0% | 0 | 1,696,871 |
| 13 | 1,696,871 | (50,000) | 0.0% | 0 | 1,646,871 |
| 14 | 1,646,871 | (50,000) | 0.0% | 0 | 1,596,871 |
| 15 | 1,596,871 | (50,000) | 0.0% | 0 | 1,546,871 |
| 16 | 1,546,871 | (50,000) | 0.0% | 0 | 1,496,871 |
| 17 | 1,496,871 | (50,000) | 0.0% | 0 | 1,446,871 |
| 18 | 1,446,871 | (50,000) | 0.0% | 0 | 1,396,871 |
| 19 | 1,396,871 | (50,000) | 0.0% | 0 | 1,346,871 |
| 20 | 1,346,871 | (50,000) | 0.0% | 0 | 1,296,871 |
If we reverse the sequence of returns, which represents an adverse sequence, the outcome is quite worse.
| Year | Beginning Value | Withdrawal | Return % | Return | Ending Value |
| 1 | 1,000,000 | (50,000) | 0.0% | 0 | 950,000 |
| 2 | 950,000 | (50,000) | 0.0% | 0 | 900,000 |
| 3 | 900,000 | (50,000) | 0.0% | 0 | 850,000 |
| 4 | 850,000 | (50,000) | 0.0% | 0 | 800,000 |
| 5 | 800,000 | (50,000) | 0.0% | 0 | 750,000 |
| 6 | 750,000 | (50,000) | 0.0% | 0 | 700,000 |
| 7 | 700,000 | (50,000) | 0.0% | 0 | 650,000 |
| 8 | 650,000 | (50,000) | 0.0% | 0 | 600,000 |
| 9 | 600,000 | (50,000) | 0.0% | 0 | 550,000 |
| 10 | 550,000 | (50,000) | 0.0% | 0 | 500,000 |
| 11 | 500,000 | (50,000) | 10.0% | 50,000 | 500,000 |
| 12 | 500,000 | (50,000) | 10.0% | 50,000 | 500,000 |
| 13 | 500,000 | (50,000) | 10.0% | 50,000 | 500,000 |
| 14 | 500,000 | (50,000) | 10.0% | 50,000 | 500,000 |
| 15 | 500,000 | (50,000) | 10.0% | 50,000 | 500,000 |
| 16 | 500,000 | (50,000) | 10.0% | 50,000 | 500,000 |
| 17 | 500,000 | (50,000) | 10.0% | 50,000 | 500,000 |
| 18 | 500,000 | (50,000) | 10.0% | 50,000 | 500,000 |
| 19 | 500,000 | (50,000) | 10.0% | 50,000 | 500,000 |
| 20 | 500,000 | (50,000) | 10.0% | 50,000 | 500,000 |
And, if we increase the volatility of the portfolio coupled with an adverse sequence of returns, the outcome becomes even more dismal.
| Year | Beginning Value | Withdrawal | Return % | Return | Ending Value |
| 1 | 1,000,000 | (50,000) | -5.0% | (50,000) | 900,000 |
| 2 | 900,000 | (50,000) | -5.0% | (45,000) | 805,000 |
| 3 | 805,000 | (50,000) | -5.0% | (40,250) | 714,750 |
| 4 | 714,750 | (50,000) | -5.0% | (35,738) | 629,013 |
| 5 | 629,013 | (50,000) | -5.0% | (31,451) | 547,562 |
| 6 | 547,562 | (50,000) | -5.0% | (27,378) | 470,184 |
| 7 | 470,184 | (50,000) | -5.0% | (23,509) | 396,675 |
| 8 | 396,675 | (50,000) | -5.0% | (19,834) | 326,841 |
| 9 | 326,841 | (50,000) | -5.0% | (16,342) | 260,499 |
| 10 | 260,499 | (50,000) | -5.0% | (13,025) | 197,474 |
| 11 | 197,474 | (50,000) | 15.0% | 29,621 | 177,095 |
| 12 | 177,095 | (50,000) | 15.0% | 26,564 | 153,659 |
| 13 | 153,659 | (50,000) | 15.0% | 23,049 | 126,708 |
| 14 | 126,708 | (50,000) | 15.0% | 19,006 | 95,714 |
| 15 | 95,714 | (50,000) | 15.0% | 14,357 | 60,071 |
| 16 | 60,071 | (50,000) | 15.0% | 9,011 | 19,082 |
| 17 | 19,082 | (50,000) | 15.0% | 2,862 | (28,056) |
| 18 | (28,056) | (50,000) | 15.0% | 0 | (78,056) |
| 19 | (78,056) | (50,000) | 15.0% | 0 | (128,056) |
| 20 | (128,056) | (50,000) | 15.0% | 0 | (178,056) |
How do you go from a linear calculation showing you will have $1 million remaining to showing a potential range of outcomes from $1.3 million to running out of money entirely in 17 years? This is explained by sequences of returns and volatility. In other words, the linear calculation understates the potential upside and downside risk. Therefore, the sequence of returns and portfolio volatility matter.
So, what does all of this have to do with Social Security? By claiming earlier, you could potentially reduce the risk of an adverse sequence of returns by reducing the withdrawal from your portfolio. If you need $50,000 to meet your spending needs and $20,000 of it comes from Social Security, then your net withdrawal from your portfolio is $30,000. The lower the portfolio withdrawal, the better prepared you are to withstand an adverse sequence of returns. On the other hand, this could also potentially result in more upside if you have a favorable sequence of returns.
These examples assume a constant withdrawal. In reality, Social Security benefits vary. If you claim early, you get a smaller benefit. If you delay, you get a larger benefit. The real question is, does the increased benefit of delaying offset the potential compounding effect of a favorable or adverse sequence of returns?
Stay tuned for future articles on how we evaluate when to claim Social Security and how we put it all together. If you would like to discuss it sooner, give us a call. We are always happy to serve!
Have any questions? We’re here to help!
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