Social Security benefits are becoming less adequate for today's and tomorrow's retirees, due to changes already enacted into law, changes in family work patterns and the likelihood of future financial problems. Some of the forces affecting Social Security have already happened; others are more speculative. But the trend is clear.

Measures of Adequacy
A common measure of retirement–income adequacy is the replacement rate – that is, retirement income relative to pre–retirement earnings (sometimes adjusted in some way to reflect inflation). The philosophy underlying the use of replacement rates is that retired people should be able to maintain their pre–retirement standard of living (although the relationship to adequacy per se may be legitimately questioned). Retirees need to receive a determinable percentage of pre–retirement earnings in order to accomplish this goal. The lifestyle–maintaining replacement rates, which vary by income level for a variety of well–known reasons such as varying marginal tax rates and declining work–related expenses, are not too difficult to compute, and many analysts have done this. The generally accepted figure is around 70 percent for middle–income people. Social Security provides only about half of this target figure.

Projection Models
While we can determine fairly easily the replacement rates of yesterday's and today's retirees, determining the corresponding figures for tomorrow's retirees depends to some extent on the projection model used. Of course, computer models can be only as good as the assumptions on which they are based (if they are even that good!). In this situation, the assumptions should be regarded with considerable skepticism, simply because they necessarily extend several decades into the future.

Because demographic experience is not very volatile, demographic assumptions may be forecast with considerable confidence. Replacement rates, however, do not depend very much on demographics, except for the fairly predictable life expectancy – and even that can be ignored when examining defined–benefit plans like Social Security (meaning Old–Age, Survivors and Disability Insurance, or OASDI). Economic assumptions are an entirely different matter.

Analyses of short–range economic forecasts by even the most highly respected economists demonstrate the great uncertainty that exists in this field. Economists (and everybody else, for that matter) have demonstrated limited ability to forecast many years ahead. Even so, some well–known economic models attempt to forecast the situation 30 or 40 years into the future. Actuaries at the Social Security Administration (SSA) top them all, attempting the perhaps impossible task of projecting economic and demographic variables for the next 75 years, as required by law! And in 2003, Social Security's trustees decided to add infinite–time–horizon projections to their annual report on the program's financial condition. No comment on the reliability of such assumptions seems necessary! (If you don't have anything good to say...)

Very long–range projections can be put into perspective in the following way: Consider an economist (or actuary) sitting in his office in 1970 and trying to predict what the United States economy would be like 35 years hence, in 2005. How close to reality would he (or she) have been? Then make the enormous leap to an economist in the year 1930, at the very beginning of the Great Depression, trying to forecast 75 years down the road to the present time. Obviously, none of these people – no matter how brilliant – would have had any chance of coming even close to projecting what actually occurred. Because today's economists are probably not much better at predicting the far–distant future than their predecessors were, since there are a lot of elements that are unforeseen we need to take all of these projections simply as that, projections. The use of computers really should not give us unwarranted confidence in the results. No systems can predict the future only the likelihood of what can happen.

Social Security's Contribution to Retirement Income
The magnitudes of the most likely future sources of retirement income are quite difficult to project. We have no way of accurately estimating future investment income, for example, because we cannot project with any real confidence how much people will save during their working years or what future earnings rates will be on invested assets. One item that seems to be an exception to this general rule, however, is Social Security.

Social Security has been regarded for almost 70 years now as the "floor of protection" for working Americans. It is the foundation on which other retirement programs are built. Thus, Social Security's contribution to the typical retiree's replacement rate is a matter of considerable interest. That contribution increased for the first several decades of the program's existence but has been declining slightly since about 1979. It is expected to decline much more in the future, for three reasons:

1. Changes already enacted into law will reduce the adequacy of Social Security benefits, especially for workers born after 1959.
2. Changes in family work patterns will reduce or eliminate certain "free" spousal benefits that have historically been provided to married couples.
3. Future financial problems are likely to require additional reductions in Social Security benefits.

The present–law OASDI benefit formula produces absolutely stable and predictable replacement rates under any economic conditions. Very briefly, a worker with average earnings in every year (about $34,000 in 2003) who retires at his or her normal retirement age (NRA) will receive benefits at retirement that are about 41 percent of earnings in the last year before retirement. Similarly, an otherwise identical worker with maximum OASDI–covered earnings ($90,000 in 2005) will, in the long run, receive benefits at retirement that are about 25 percent of the last year's earnings.

These replacement rates, and the continuum of replacement rates for workers at other earnings levels, were essentially locked into place by the Social Security Amendments of 1977 (Public Law 95–216). Absent changes in the law, Social Security's contribution to future retirement income can be predicted with greater confidence than any other source. Still, Social Security has some surprises in store for the unwary retiree.

Changes Already Enacted Into Law
The stable replacement rates cited above are for workers retiring at NRA. The NRA was age 65 when Social Security began, and it remains 65 for workers born before 1938 (who first became eligible in 2000 for Social Security's early–retirement benefits). For workers born in 1938 and later, however, the NRA rises, under provisions enacted into law as part of the Social Security Amendments of 1983 (Public Law 98–21). Eventually, for workers born after 1959, the NRA reaches 67. Thus, to get the same replacement rate from Social Security that a worker got through 2003 at age 65, retirees in 2027 and later will need to wait 2 years, until age 67.

The fact that the increase in NRA is a benefit reduction, which may be obvious enough, becomes much more obvious when considered in light of the overwhelming percentage of beneficiaries who claim early–retirement benefits from Social Security. Currently, about three–fourths of the non–disabled eligible population claim Social Security retirement benefits at age 62 or shortly thereafter. At exact age 62, the early–retirement reduction required by law is 20 percent for those with NRA of 65; therefore, these early retirees receive 80 percent (or slightly more) of the benefit that they could receive if they waited until age 65 (ignoring the usually small effects of additional earnings). Their replacement rates are therefore lower. For example, the hypothetical average earner described above could receive 41 percent of his or her last year's earnings from Social Security at NRA; at age 62, the replacement rate would be only 33 percent.

Under current law, early–retirement benefits continue to be available at age 62, but because the number of years of early retirement will increase (from 3 to 5), the early–retirement reduction factor also increases. Starting in 2022, workers who retire at exact age 62 will receive just 70 percent of the benefit that would be payable at NRA, instead of 80 percent today. This represents a 12½ percent relative reduction in benefit amount. The replacement rate for our hypothetical average earner who retires at age 62 would be just 29 percent in 2022, instead of 33 percent today. Clearly, unless retirement behavior changes, Social Security will contribute less toward the adequacy of retirement income in the future than it does today.

The question of whether retirement behavior will change is worth investigating. Everyone knows that Americans have been retiring earlier and earlier for many decades, although the decline seems to have stopped in the mid–'90s. Of course, Americans have been living longer, too, and we might anticipate that some of this extra longevity will be reflected in longer working lives, rather than going entirely to more leisure time. On the other hand, we could speculate that greater affluence will allow the trend toward earlier retirement to continue. Perhaps most Americans do not like working so long and will retire as soon as they can afford to do so. This issue raises questions that we simply cannot answer, and it serves to emphasize the uncertainty of all long–range projections.

The fairness of Social Security's early–retirement reductions is worth considering, too. Most people understand that early retirees choose to get benefits for a longer time – their age at death presumably doesn't change – and therefore should get less each month. The actuarially fair reduction depends on the assumed mortality rates. Higher mortality should translate into larger actuarial reductions for early retirement; lower mortality means smaller reductions. Because the Social Security law is totally gender–neutral today, one set of reduction factors is applied to both men and women, even though men have significantly higher mortality experience (and shorter life expectancies). Thus, the reductions factors tend to be too low for men and too high for women, but the "errors" are small. As mortality continues to decline, the reduction factors will eventually become too large for both men and women, but that won't happen for many decades.

So the early–retirement reduction factors are roughly fair, but only for people who have no "special" knowledge of their own mortality. What does that mean? Well, consider a 62–year–old worker who is thinking about retiring and claiming Social Security immediately but might work until NRA instead. If he (or she) has average mortality, then the decision is actuarially neutral in that regard – although maybe not with respect to other factors, of course. However, if this hypothetical worker goes to the doctor and finds that he is terminally ill, that changes everything. With this new information, waiting until NRA to claim Social Security seems foolish, because the worker expects to be dead by then. If he wants any Social Security benefits, he must claim them immediately. The actuarial reduction is the least of his worries.

But he needs to consider something else. If he is married, his spouse's benefit as a widow will be limited to the benefit that he received as a retired worker. If he never claimed benefits before his death, then she can get an amount equal to his unreduced benefit (although possibly reduced based on her age). If he claimed early–retirement benefits, her widow's benefit would be limited to what he had been receiving (plus cost–of–living adjustments, of course). In other words, his reduction could affect her for many years, costing her much more than the few months of benefits he received. The decision to claim early–retirement benefits from Social Security is not so easy!

Even that's not the end of the analysis. If a beneficiary is working, the amount of his or her benefit can be reduced on account of earnings from employment or self–employment, even in employment that is not covered by Social Security. This "retirement earnings test" is designed to ensure that early–retirement benefits are not paid to workers who have not substantially retired. Benefits are not reduced on account of pensions, interest, dividends, capital gains, etc., because these are not attributable to current work. For beneficiaries who have not yet reached NRA in 2005, the benefit reduction is $1 for every $2 by which annual earnings exceed $12,000. A special monthly test applies only in the first calendar year of benefit receipt. For beneficiaries who will reach NRA in 2005 but have not yet reached it, the reduction is $1 for every $3 by which earnings in the months preceding attainment of NRA exceed $31,800. Beneficiaries can earn any amount without affecting their benefits starting with the month in which they reach NRA.

Workers who claim Social Security retirement benefits before they have fully retired have to consider whether those benefits will actually be paid, taking into consideration their anticipated level of earnings. At the same time, however, Social Security benefits are automatically recomputed at NRA to "give back" actuarial reductions for months in which no benefits were received on account of the retirement earnings test. In other words, a worker who claimed benefits 36 months before his or her NRA would have a 20–percent benefit reduction imposed initially, but if he or she had benefits withheld for 18 of those months due to excess earnings, the benefit would be recomputed at NRA to reflect just a 10–percent reduction, which would continue for life. The benefit amount would also reflect any increase due to the additional earnings, of course.

Changes in Family Work Patterns
In one–earner families, which were the norm years ago and are still predominant in today's retired population, the non–employed spouse (usually, the wife) receives a benefit roughly equal to half of the retired worker's benefit, depending on their respective ages. In other words, if our hypothetical average earner who retires at NRA has a non–employed spouse exactly the same age, then their combined replacement rate is not 41 percent, but 62 percent of the worker's last year's earnings.

When today's predominantly two–earner couples retire, they will ordinarily not be eligible for any such spousal supplements, because each worker's own retired–worker benefit will offset any potential spouse's benefit, reducing it to zero in most cases. The point at which reduction to zero occurs depends on many factors, but it almost always happens when one spouse has average indexed monthly earnings of one–third of the other spouse's average indexed monthly earnings. Without supplemental spouse's benefits, the combined replacement rate for a retired couple, both with average earnings in every year, would be just 41 percent at NRA, a huge reduction from 62 percent today.

Let's look at an example: A married couple, both at NRA (for simplicity), retire and claim their Social Security benefits. The man gets $1000 per month, roughly the average benefit. The woman is entitled to $500 per month simply for being his spouse, regardless of whether she ever worked. But what if she did? We can look at three cases:

1. She worked very little, but enough to get a Social Security benefit based on her own work record of $300 per month. A worker's own benefit is always paid, but it reduces any benefit payable as a spouse dollar–for–dollar. So her spousal benefit is reduced to $200 per month. Her total benefit is the same $500 that she could have received without ever having worked. But as a worker, she can retire independently of her husband. If her husband dies before she does (as three–fourths of husbands do), she'll get a widow's benefit of $1000 per month.
2. She worked a moderate amount, enough to get a Social Security benefit of $600 per month. She'll get that amount, and it will reduce her spousal benefit to zero. But she can still get a widow's benefit of $1000 if her husband dies first.
3. She worked a lot and earned a Social Security benefit of $1200 per month. Again, she'll get that amount, and it will reduce her spousal benefit to zero. If her husband dies first, she will not get a widow's benefit, because her own benefit is larger. Does her husband get a spousal benefit? No, his own benefit is too large to allow payment of a $600 spousal benefit, but he will get a widower's benefit of $1200 per month is his wife dies first.

Today's retired population looks mostly like case 1. Lots of spouses receive benefits based on their – usually – husbands' earnings records. But when today's workers retire, they will look more like cases 2 and 3. No spousal benefits will be payable until one spouse dies.

The reductions in future Social Security benefits resulting from changes in family work patterns will continue even after one spouse dies. As described in the above examples, the surviving spouse receives a benefit essentially equal to the benefit that had been received by the higher–earning spouse. If the higher earner dies first, then the survivor gets a widow(er)'s benefit equal to what the decedent had been receiving; if the lower earner dies first, then the survivor simply continues to get whatever benefit had been payable before the first death, and the decedent's benefit ends. For the traditional one–earner retired couple that we see today, this means that the benefit reduction at the first spouse's death is about 33 percent relatively. For our hypothetical average earner with a non–employed spouse the same age, the replacement rate while both are alive is 62 percent; after the first spouse dies, the replacement rate drops to 41 percent.

For today's two–earner working couples, the reductions will be more severe. When our hypothetical married average earners retire at NRA, each will receive a retired–worker benefit replacing about 41 percent of his or her last year's earnings. The overall replacement rate for the couple is therefore 41 percent, also. When one spouse dies, that person's benefit will end, reducing the overall replacement rate to 21 percent of the couple's pre–retirement earnings, as compared to 41 percent today. This is a 50–percent relative reduction – even larger than when both were living.

Finally, the percentage of one–person families has been increasing. When these people retire, they obviously can receive no spousal supplements – having no spouse – and consequently will have lower–than–average replacement rates.

Future Financial Problems and Their Effects
The Social Security program will begin to have problems meeting its financial obligations in the year 2017, just 13 years from now (based on the intermediate assumptions of the 2005 OASDI Trustees Report). At first, the problem will be manageable, as the program begins drawing down funds accumulated since 1983. In 2041, however, these funds are expected to run out. At that time, the program's income will cover only about three–fourths of its outgo, preventing benefits from being paid on time. The law will need to be changed sometime before then, and the changes might well include benefit reductions.

All Social Security benefits and administrative costs are paid from the program's "trust funds." When the trust funds have more income than outgo, the excess is retained by the Treasury and used to meet the government's non–Social Security expenses. In return for using Social Security's extra revenue, the Treasury issues to the trust funds special U.S. government bonds. When the trust funds have less income than outgo, the difference must come from bond redemptions. In practice, this means that the Treasury cancels some of the bonds and provides cash, which comes from other sources. The cash is used to meet the revenue shortfall.

Since 1983, Social Security's trust funds have grown rapidly, because revenue has greatly exceeded outgo. The revenue that was not needed immediately to meet the program's obligations was automatically used to purchase special–issue government bonds, which totaled more than $1.7 trillion at the end of 2004. For many years, some policymakers have justified higher–than–necessary Social Security tax rates on the grounds that large trust funds need to be accumulated to meet future needs.

How will the Treasury redeem such huge amounts of bonds? Its choices are limited:

1. Sell bonds to the public. The Treasury always has the option of selling bonds one place to make redemptions another place. Whether the public has sufficient appetite to buy additional bonds at an average rate of $400 billion per year, even in the inflationary dollars of the 2030s, remains to be seen.
2. Raise taxes. Policymakers can raise taxes to provide the Treasury with the necessary money. More directly, they could raise Social Security taxes, reducing the need for bond redemptions in the first place.
3. Print money. The Treasury is in the unique position of being able to print money. It could redeem Social Security's bonds that way, but not without increasing inflation. Because Social Security benefit increases are tied to changes in the Consumer Price Index, inflation would result in even higher benefit costs and the need to redeem bonds more rapidly, not to mention causing other deleterious economic effects. No Administration could prefer this solution.

Because bond redemptions on such a massive scale would be so difficult – perhaps even impossible – we have to ask whether they would happen at all. Policymakers could avoid questions involving how to redeem the accumulated bonds and whether the amounts are really available by simply leaving the trust funds' bonds untouched. They could say that a large trust fund needs to be maintained forever, as a contingency fund for the future. They could accomplish this by enacting into law a package of revenue increases and benefit reductions, as was done in 1983, and matching Social Security's income and outgo as soon as the imbalance would otherwise occur, in 2017.

The following "big–ticket" items might be included in such a package:

1. Increases in FICA tax rates. Virtually every major piece of Social Security legislation since 1950 has included increases in payroll–tax rates. Tax increases are easy to explain, and workers and their employers pay the additional amounts largely through withholding from wages and salaries. This sort of change is not likely in today's political climate, but the climate in 2017 may be different. (Note that substantially increasing revenue from taxation of Social Security benefits is essentially impossible, because the increases enacted into law in 1993 will already result in 85 percent of benefits being subject to tax in the distant future.)
2. Reductions in COLAs. Social Security's cost–of–living adjustments were delayed 6 months by the 1983 legislation, but the annual increases were maintained at 100 percent of the change in the Consumer Price Index (CPI–W). In 1986, Congress enacted a smaller COLA – so–called "diet COLA" – for Federal employees covered by the then–new Federal Employees' Retirement System (FERS). This new retirement system will eventually cover all members of Congress – it almost does so today – who may be inclined to apply their COLA procedure to the general population under Social Security.
3. Increases in normal retirement age. As discussed earlier, 1983 legislation raised the NRA – the age at which unreduced retirement benefits are first available – from the historical age 65 to age 67. Congress has therefore demonstrated that it knows how to reduce benefits through changing the NRA; it could easily do so again. Age 67 is no more special today than age 65 was before 1983.
4. Price–indexing. Under the 1977 formula, all benefit parameters except the COLA change every year based on changes in the national average wage. Many have proposed indexing initial benefits by prices, which historically have risen more slowly. This can be done many different ways. Some would cause a one–time reduction in replacement rates; others would result in continuing reductions. Either way, replacement rates would be lower.

Some policymakers reject these traditional solutions in favor of individual accounts. These accounts would radically change the nature of Social Security, resulting in less risk pooling. They could raise or lower replacement rates, depending on the exact specifications of the plan and the investment performance of participants.

We know enough details about the president's Social Security reform plan to make some observations about it. The primary solvency–related change is some form of price–indexing, probably proposal #2 of the 2001 President's Commission to Strengthen Social Security. That change would reduce the percentages in the benefit formula by the difference between the wage increase and the price increase, expected to be 1.1 percent per year. This would continue forever, causing replacement rates to decline more and more every year. (Other forms of price–indexing would be less harsh.)

In addition, the president proposes allowing workers born after 1949 to set up individual accounts. They would be completely voluntary, although two–thirds of eligible workers are expected to opt in. Participating workers could divert exactly 4 percent of their earnings, but limited initially (in 2009) to $1000 per year. This limit would rise slowly over time. Investment choices would be quite limited, like under the existing Federal Thrift Savings Plan (for Federal employees). Funds could not be touched before retirement for any reason. This will be interesting politically, when workers with legitimate needs such as health care (or even terminal illness) demand access.

A new governmental "central administrative agency" would be created to keep track of workers' accounts. It would also have to set up "phantom," or offset, accounts that would be used to determine the reductions in government–paid Social Security benefits for those who decide to participate in voluntary accounts. These offset accounts, which would be simply notional accounts, not real assets, would be credited with (a) amounts equal to workers' actual contributions and (b) investment earnings at a 3–percent real rate (about 6 percent nominal). This crediting rate is controversial; the 2001 Bush Commission proposed using 2 percent real interest for purposes of determining offsets. Workers would have to earn more than 3 percent real (6 percent nominal) on their actual accounts to come out ahead of the offset account. That would be a high hurdle for many workers. And even if the average worker could earn this rate, individual accounts have an inherent volatility of investment performance that does not exist in the current system. Some workers will do better, but clearly some will do worse.

At retirement, each worker's offset account balance would be converted into an annuity that offsets, or reduces, the government–provided benefit (after price–indexing as described above). Reduction to zero is possible in the long run. Meanwhile, the worker's actual account would be required to be annuitized only to the extent necessary to bring total Social Security benefits up to the poverty level. Leftover funds could be taken in lump sums for a variety of purposes, such as health care, education and buying a home. Individual accounts of workers who die before retirement and unspent (probably unannuitized) funds of workers who die after retirement could be left to heirs. Many unanswered questions include the effects of this proposal on the disabled and family members, including survivors. Smooth transitions may be impossible.

Because of the significant diversion of payroll taxes, the government would have to borrow additional funds to pay benefits in full to the 48 million current beneficiaries. Borrowing would be roughly $1 trillion in the first 10 years of the new program.

Conclusion
Already scheduled changes in law and the way that it functions in the context of changing family circumstances will cause Social Security's replacement rates to decline substantially from today's levels. Thus, everything else being equal, retirement income can be expected to be less adequate in the future than it is today.

The additional reductions in Social Security benefits that may be required due to anticipated financial difficulties just exacerbate the need for workers to save more if they want to maintain their pre–retirement standard of living. The necessary amounts cannot be saved during the last few working years; they must be accumulated over much longer periods of time. If Social Security benefits will be substantially lower than workers anticipate as soon as 2017, they need to know now so that they can take appropriate actions and increase their retirement savings.

The public needs to know that Social Security will begin to have serious problems in just 12 years, when tax revenue is expected to first become inadequate to meet obligations. The trust fund assets that are accumulating, because of the unnecessarily high Social Security taxes levied on today's worker, are not sufficiently real to meet the revenue shortfall. The program will have to change, and the sooner workers know about it, the better.

This information is general and has been gathered from sources believed to be reliable. Neither New York Life, its agents nor subsidiaries provide tax or legal advice. Please consult your own advisors for tax and legal advice.

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