Mr. Money Mustache (MMM) might be the “Paul the Apostle” of the financial independence / FIRE movement, a relentless missionary spreading the Lord’s word far and wide. If MMM hasn’t converted more people to FIRE than anyone else, he’s got to be near the top of the list.
Perhaps his most famous sermon is The Shockingly Simple Math Behind Early Retirement. I can attest – it steered me down a path that led me to where I am today. Hallelujah.
MMM is great. Thank you, MMM.
But with an audience of…millions?…comes a big responsibility to share accurate advice.
But, lest I blaspheme, I think his recent work is dead wrong.
False Profit
MMM recently wrote a post called, The Shockingly Simple Math Behind Social Security.
While the article has a few different subtle points, the main thrust is that taking Social Security at age 62 is better than at any other age because, in short, stock index funds grow faster than Social Security benefit increases.
…Am I really telling you that it’s actually less valuable to work longer so you can get the higher [Social Security] benefits? The answer is yes, for people who understand the concepts of “investing” and “the time value of money.
To really understand this, just imagine what would happen if you started taking those payments as early as possible (age 62) and tossed them into an index fund, earning 6% after inflation on average. After the first year, you’d already have about $24,300 and you’d still be piling in that extra two grand per month and the whole snowball would be starting to compound.
By the time your more patient friends started drawing $2796 payments five years later, you’d already have over $137,000. It’s such a big lead that the 67-year-old will never catch up.
MMM is but the latest victim of a fatal logical flaw in Social Security analysis.
“They Repeat Their Folly”
In MMM’s defense, he’s far from the first and won’t be the last person to make this mistake.
What mistake?
The discount rate.
Discount rates help us compare present values to future values (or past values). Warren Buffett would say that discount rates started with Aesop – a bird in the hand is worth two in the bush.
MMM’s discount rate is flawed. It’s that line where he says, “…earning 6% after inflation on average.” He’s actually using ~9%, because the 6% is inflation-adjusted (6% + 3% for inflation = 9% nominal index fund returns).
“But Jesse! Stock index funds DO earn something like 9% per year over long periods of time!”
That’s correct. But it’s incorrect to use that as your discount rate here.
Why?
Because when choosing a discount rate, it’s important to match the risk of the cash flows. In simple terms, that means our discount rate must reflect the “risk” built into Social Security. A common phrase in discount rate discussions is “your next best option of similar risk.”
Does the risk of the stock market reflect the risk of Social Security? No.
The Social Security increases you earn by delaying your benefits are guaranteed by the full faith and credit of the U.S. government. That’s as “risk-free” as it gets. Stock index funds (which I own a ton of!) do not come close to meeting that high bar.
After all, why not use a 20% discount rate? That’s Berkshire Hathaway’s annualized return for the past 70 years.
Or a discount rate of 230%? That’s Bitcoin’s annualized return since inception.
It’s because those comparisons clearly are not apples-to-apples with Social Security. We recognize that on its face. Using stock market returns might be less egregious, but it suffers the same flaw.
What Discount Rate Makes Sense Instead?
How do we correct this error? What discount rate makes sense instead?
Let’s go back to thinking about the risk of the cash flows. Or our next best option of similar risk.
Social Security behaves like a government-guaranteed annuity, with inflation-protection built in.
The “next best option of similar risk” here would be TIPS (Treasury Inflation-Protected Securities). And the current TIPS yield curve ranges from 1% to 2.5%. That is a real, inflation-adjusted return.
Where MMM uses 6%, the right answer is ~2%.
MMM’s calculations come to this conclusion:
[…showing that collected a lesser amount of $1968 per month at age 62 has a greated net present value than collecting $2798 per month at age 67 or $3467 per month at age 70.]
But using more accurate inputs (a 2% inflation-adjusted discount rate, a la TIPS), the actual numbers are:
- $1968/month from age 62-90 is like having $506,000 today
- $2796/month from age 67-90 is like having $618,000 today
- $3467/month from age 70-90 is like having $685,000 today
The “shockingly simple math of Social Security” is shockingly wrong.
PS – if you really want to learn more about Social Security, read these:
- When Should I Take Social Security?
- Should You Take Social Security Early and Invest It?
- Spouses, Survivors, and Exes: Your Relationships Affect Social Security
- Should the Higher-Earning Spouse Delay Social Security?
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