James Mahaney heads the Thought Leadership practice at Prudential and writes on topics impacting the financial wellness of Americans. This material is provided for educational purposes only. It is not intended to market or sell any specific products or services.
The stock market has been volatile so far in 2020, dropping sharply into bear-market territory in the first quarter and then recovering some of its lost ground in April. While many 401(k) or 403(b) investors have seen their account balances go down, their total retirement wealth may actually be up.
How is this possible?
The explanation lies with interest rates, which have declined considerably this year. As rates have fallen, the intrinsic value of future Social Security benefits has increased. The same is true for other guaranteed lifetime income streams such as payouts from annuities or pensions. This doesn’t mean anyone’s monthly Social Security or pension check is going to be any higher, only that it is worth more in today’s dollars. Let me explain.
Economists estimate current Social Security wealth by calculating the expected present discounted value of the benefit a person can anticipate, assuming an expected claiming age and population mortality risk, as well as a “discount rate” that depends on current interest rates. When the discount rate falls, estimated Social Security wealth goes up. Why? Because lower rates mean that if you will rely on interest income to generate a certain amount of wealth, you need to start with more money today.
Think of it this way. Let’s say you want to invest a sum of money so that it will be worth $1,000 five years from now. If your investment could earn interest at a steady rate of 10% annually, you will only need to invest $621 today. But if your investment can only earn a 5% return, you will need to invest $784 at the outset. Simply put, the current cost—or value—of your future $1,000 has gone up because your interest rate has gone down.
As of this writing, the yield on 10-year Treasury notes has plunged below 1% for the first time in history. As interest rates, and therefore the discount rate, plummeted, in turn, the expected value of Social Security benefits has risen.
Estimate your own Social Security wealth
You can easily estimate the present discounted value of your own Social Security wealth. Start by going to the Social Security website’s Quick Calculator. There you can enter your personal information to see your projected monthly benefit in future dollars at your Full Retirement Age. Then, since Social Security is effectively an annuity, and insurance companies price annuities using current interest rates, you can get a quote from an insurance company for a single premium annuity that would produce a monthly payout comparable to your Social Security benefit.
Actually, there’s no need to call an insurance company. Just go to an annuity shopping website like immediateannuities.com and enter your current age and the number of years remaining until your Full Retirement Age. If you are age 50, for example, you can state that you want income to begin in 17 years, when you would reach your Full Retirement Age of 67. Insurance companies that partner with immediateannuities.com will then quote a price to purchase the annuity.
Because your Social Security benefit features an annual cost-of-living adjustment, which adds to its estimated value, you should also take that into account. As it happens, there are no single-premium immediate annuities sold in the U.S. today that offer a cost-of-living adjustment. However, one was available at the beginning of 2019. At that time, David Blanchett, head of retirement research at Morningstar, found that the insurance company offering it was charging an extra 40% for the cost-of-living adjustment. Using that figure, we can estimate the value of Social Security’s inflation adjustments for your annuity by adding 40% to its cost.
Let’s see how this exercise would play out for a 55-year old female earning an annual $120,000. Using the Quick Calculator, we can see that her Social Security benefit beginning at age 67 is projected to be about $4,060 per month. Next, using the immediateannuities.com calculator, we plug in a $4,060 monthly benefit starting in 12 years and see that it would cost approximately $575,000 to buy it. Increasing this by 40% for the annual inflation adjustment feature would boost the total cost to $805,000. Put another way, an annuity paying $4,060 per month starting 12 years from now is worth $805,000 today.
While we don’t know exactly how this annuity would have been priced before interest rates started falling so precipitously, we do know it would have cost less than today. We should also note that if our future Social Security recipient is married and has a higher Social Security benefit than her spouse, her spouse will be entitled to a 100% survivor benefit, which adds even more value to her overall Social Security benefit. And if she used age 70 as her claim age, instead of her Full Retirement Age, this would boost her monthly benefit and her spouse’s survivor benefit substantially.
You can estimate the value of any annuities you own, or any future pension income you’re entitled to, in a similar fashion, albeit without adjusting for inflation since these income guarantees are most likely nominal rather than inflation protected dollars (unless you work in the public sector, where many payouts do have at least partial inflation protection).
The bottom line
The bottom line is that Social Security delivers multiple benefits. It can provide peace of mind during your working years, since you know that your payout will not be impacted by fluctuations in the financial markets. It provides longevity and inflation protection when you are retired. When financial markets and interest rates are falling, you can take comfort knowing that the present discounted value of your benefit is going up.
This perspective may help you better handle your 401(k) or 403(b) losses, and perhaps keep you from panicking the next time a bear market hits.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.