It has become standard practice that risk tolerance questionnaires are completed for almost every client during a financial planning or investment planning process. But risk tolerance isn’t just insightful for investing, it could be helpful with Social Security decisions, too. Advisers can use risk tolerance for guidance on how to approach Social Security planning with their clients.
In most cases, financial advisers present Social Security as a break-even proposition—if you live for X years, you win. That strategy requires people to essentially take risk now to get a gain later. Instead of thinking about it that way, let’s flip this problem on its head.
If we know a client is risk averse, we might want to get the client to agree to a claiming strategy years in advance of age 62. Research has shown that when you have no choice but to wait for cash flow, even a more risk-averse client will be willing to wait longer for a higher payout. But, on the other hand, if one option is to get money today, they won’t be willing to wait the same timeframe for the larger payout.
Risk-averse people are willing to take risk in order to avoid loss, but they won’t take on risk to chase gains. Presenting Social Security as a “you get a higher payout if you wait” situation to a risk-averse client isn’t effective. A better way to introduce it would be to focus on what they could lose by claiming today.
Let’s look at the maximum loss potential if you claim at age 62 and live until age 95. The worst-case scenario is that you could lose $215,509—which is the present value difference of claiming at age 62 and at age 70 with 2% inflation and a 3% discount rate. According to Social Security data, you have a 10.5% chance of living to age 95—almost identical as the risk of dying between ages 62 and 70. But what if we reframed the situation and you knew there was a 10.25% chance you’d lose $94,602 by waiting until age 70 to claim and a 10.5% chance of losing $215,509 by claiming at age 62? When laid out like this, the “rational” answer should leap off the chart. Why take on a higher rate of risk to lose more money? It isn’t logical.
While people like to gain money, they like the sure bet. They’re willing to chase risk to avoid loss. However, they need to realize that with deferring Social Security, they aren’t chasing risk and return, they’re just avoiding loss.
You can find the full article at Kiplinger.