Resetting Social Security -- An Annuity That Actually Makes Sense

Last Updated Jul 24, 2009 10:38 AM EDT

Over the years, I've written a word or two (million) about the irrationality of buying annuities. They're generally pitched as earning market returns with great downside guarantees. The irrationality of believing that an insurance company can take your money, pay commissions, cover their costs, make a profit and still pay you market returns without risk has caused me to grind down many a molar. Nonetheless, it is possible for investors to create an annuity-like product by repaying Social Security and resetting the benefit.

I'll give you a recent example, using a real client, to illustrate how it works. Paul is 65 years old, in good health, and married. He had elected to take social security at age 62. Three years later, he has collected a total of $51,500 in Social Security benefits.

Paul has the option of doing something called double dipping on Social Security. Larry Kotlikoff, author of Spend 'til The End, explains that Paul would be allowed to repay those benefits, without any interest whatsoever, and then immediately reset Social Security as if he had elected it at his current age of 65.

For Paul, this meant that for $51,500, he could get an additional $466 a month and have that amount increase with inflation. That increased payment would not only continue the rest of his life, but also have a survivor benefit for his wife should he die first.

Two ways to look at it
The first way to look at this option is to determine the number of years Paul or his spouse would need to live to breakeven. If you take into account the time value of money (the cash today is worth more than cash in the future), Paul would need to live about 10 years before the increased benefits would exceed the cash he is paying today. Actuarial tables predict that he will live an additional 17 years, making this a good bet.

A second way to look at this is that the client is buying longevity insurance. He is buying a cash stream that is very similar to an insurance product known as an immediate inflation adjusted annuity. This product, in return for a lump sum that you pay today, gives you a monthly cash payment that is adjusted annually for inflation.

How much would it cost Paul to buy a low cost annuity on the open market? According to Vanguard, an inflation adjusted lifetime annuity of $466 a month would cost about $107,000, with his spouse having the right to collect 50 percent of the payment after his death. I used 50 percent because that approximates the amount of the survivorship benefit for his particular circumstances. Thus, for only $51,500, Paul is getting a product that would cost about $107,000 in the open market, and likely more than that for an annuity paying agent commissions.

The comparison to the annuity is close but not quite perfect. It's possible the feds may decide at some date to lower Social Security benefits. An insurance company, however, would be contractually obligated to make those payments for as long as they are in business. That would tend to imply the insurance annuity has more value. On the other hand, the U.S. government has a much lower default risk than an insurance company. Yes, insurance companies can go out of business; and there is no assurance that state guarantee funds can make policy holders whole if they default systematically and the federal government decides not to bail them out, as they did recently. All told, I'd rather have my cash stream supported by the only entity legally entitled to print money -- the U.S. government.

My advice
Resetting Social Security is a complex analysis which involves several factors such as amount to repay, increased benefit amounts, health, tax rates, and political climates. Regardless, it may also make good sense for someone who took Social Security early and has the cash to repay it. Larry Swedroe, who writes Wise Investing, points out that fixed annuities can make sense in certain circumstances and disucsses it in his book on alternative investments. Maybe so, but I'd explore this avenue first.
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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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