Social Security: The Perfect Investment Hedge

Social Security retirement income provides a lifetime income and has tax, inflation and survivorship benefits no other income stream has available.

Social Security performs well under all economic conditions but it performs best at times when investment portfolios may perform worst

These are during periods of high inflation, high tax environments and when the retiree ends up living longer than average. This dynamic creates what is known as a financial hedge.

A true hedge is a financial position intended to offset the potential losses of a companion financial position. Pairing Social Security Retirement Income and an investment portfolio creates the perfect hedging strategy for any retiree.

There are three factors that drive the relative benefit, or lack of benefit, of delaying Social Security.  These factors are:

• The growth rate of the portfolio (time value of money),
• Inflation (the Cost Of Living Adjustment on the higher benefits), and
• Life expectancy (the time horizon for the benefit to compound).

Delaying Social Security works best when growth rates are low because there is little lost when spending down assets while you wait, when inflation is high because of the increased benefit of the larger cost-of-living adjustment, and when life expectancy is long which allows more years for the benefits to compound.

These are also the three worst situations for a portfolio-based retirement.  In other words, the scenarios that are best for delaying Social Security are the exactly the opposite of the best for investment portfolios.

This means that deciding to delay Social Security income actually functions as a hedge against those adverse factors affecting the portfolio.

Of course, the reverse is also true.  When market returns are good, inflation is under control, or retirement turns out to shorter than hoped, then the value of delaying Social Security declines.

Again, this is simply how diversification and hedging strategies work – what is good for one is not good for the other, and vice versa.

Since this is the way hedging and diversification works, delaying Social Security, even if it requires spending down some of the portfolio while waiting, is a good way to hedge against poor investment performance and volatility.

This up and down roller coaster effect investments can experience can make a retiree feel uneasy if income is based on a portfolio-withdrawal strategy.  I discuss the risks of in my book Why the Stock Market which you can download for free.