By Bruce D. Schobel, Corporate Vice President and Actuary, New York Life Insurance Company
Measures of Adequacy
A common measure of retirement-income adequacy is the replacement rate: retirement income relative to pre-retirement earnings (sometimes adjusted in some way to reflect inflation). The philosophy underlying the use of these rates is that, as a matter of fairness, retired people should be able to maintain their pre-retirement standard of living. They need to receive a determinable percentage of pre-retirement earnings to accomplish this goal. These 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. A generally accepted figure is around 70 percent.
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 extend several decades into the future.
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. The Social Security Administration tops them all, attempting the perhaps impossible task of projecting economic and demographic variables for the next 75 years!
Such very long-range projections can be put into perspective in the following way: Consider an economist (or actuary) sitting in his office in 1972 and trying to predict what the United States economy would be like 30 years hence, in 2002. How close to reality would he (or she) have been? How about another expert in 1962 trying to look ahead 40 years? Then make the enormous leap to an economist in the year 1927, just before 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 a 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, we need to take all of these projections with at least a few grains of salt. The use of computers really should not give us much more confidence in the results.
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 interest rates will be. One item that seems to be an exception to this general rule, however, is Social Security. (By this term, I refer to the Old-Age, Survivors, and Disability Insurance, or OASDI, program.)
Social Security has been regarded for more than 60 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 it has been declining slightly since about 1979. It can be expected to decline much more in the future, for three reasons:
- Changes already enacted into law will reduce the adequacy of Social Security benefits, especially for workers born after 1959.
- Changes in family work patterns will reduce or eliminate certain "free" benefits that have historically been provided to married couples.
- Future financial problems will 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 2001) who retires at his or her normal retirement age (NRA) will receive benefits at retirement that are about 41 percent of the earnings in the year before retirement. Similarly, an otherwise identical worker with maximum OASDI covered earnings ($84,900 in 2002) will, in the long run, receive benefits at retirement that are about 25 percent of the last year's earnings.
These figures, and the continuum of replacement rates for earnings between average, maximum, and below the average, 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 that of probably 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 there for workers born before 1938 (who first became eligible for Social Security early-retirement benefits in 2000). 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 Social Security replacement rate that a worker gets today 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 large percentage of beneficiaries who claim early-retirement benefits before reaching NRA. Currently, about three-fourths of the non-disabled eligible population claims Social Security retirement benefits at age 62 or shortly thereafter. At exact age 62, the early-retirement reduction required under the 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 effects of additional earnings, which are relatively small in most cases). 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.
In the future, early-retirement benefits will 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 increases, also. 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 12 1/2-percent relative reduction in benefit amount. The replacement rate for our hypothetical average earner who retires at NRA 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 around 1996. Of course, Americans have been living longer, and we might anticipate that some of this extra longevity will be reflected in longer working lives, rather than going entirely to longer periods of leisure. 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 their jobs very much 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.
Changes in Family Work Patterns
In one-earner families, which were the norm years ago and are predominant in today's retired population, the non-working spouse (usually, the wife) receives a benefit roughly equal to half of the retired-worker spouse's benefit, depending on their respective ages. In other words, if our hypothetical average earner who retires at NRA has a non-working spouse the same age, then their combined replacement rate is not 41 percent, but 62 percent.
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 the retired couple, both with average earnings in every year, would be just 41 percent at NRA, a huge reduction from 62 percent today.
These reductions in future Social Security benefits resulting from changes in family work patterns will continue after one spouse dies. Under Social Security law, the surviving spouse receives a benefit essentially equal to the benefit that had been received by the higher-earning spouse. (If that spouse dies, the other spouse gets a widow(er)'s benefit equal to what the deceased spouse had been receiving; if the lower-earning spouse dies, the higher earner simply continues to get whatever benefit had been payable before the other spouse's death, and the deceased spouse'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. For our hypothetical average earner with a non-working 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.
When today's two-earner working couples retire, they will have less survivor protection, because of the absence of spousal supplements. When our hypothetical married average earners retire at NRA, each will receive a retired-worker benefit replacing about 41 percent of that person's last year's earnings. The overall replacement rate is therefore 41 percent. When one spouse dies, that person's benefit will end, reducing the overall replacement rate to 21 percent of the couple's previous wages, as compared to 41 percent today. Again, this is a huge reduction. Finally, the percentage of single-person families has been increasing. When these people retire, they obviously can receive no spousal supplements 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 15 years from today. At first, the problem will be manageable. The program will need to begin drawing down funds accumulated since 1983. In 2041, however, the bonds are expected to run out. At that time, the program's income will cover only about three-fourths of its outgo. The program 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 now total more than $1 trillion. 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:
- 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 2025-40, remains to be seen.
- 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.
- 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 claim 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:
- 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 pay the additional amounts largely through withholding from wages and salaries. (Note that increased taxation of Social Security benefits will probably not be a possible source of revenue, because the increases enacted into law in 1993 will result in nearly all the benefits being subject to tax in the future.)
- Reductions in COLAs. Social Security's cost-of-living adjustments were delayed six months by the 1983 legislation, but the annual increases were maintained at 100 percent of the change in the Consumer Price Index (CPI). In 1986, Congress enacted a smaller COLA so-called "diet COLA" for Federal employees covered by the new Federal Employees' Retirement System (FERS). This new retirement system will eventually cover all members of Congress, who may be inclined to apply their COLA procedure to the general population under Social Security.
- Increases in normal retirement age. The 1983 legislation raised the "normal retirement age" (NRA) the age at which unreduced retirement benefits are first available from the historical age 65. The Congress has demonstrated that it knows how to reduce benefits through changing the NRA; it could easily do so again. Age 67 is no more special than was age 65 before 1983.
Already scheduled changes in law and the way that it functions in the context of changing family circumstances will cause Social Security benefits to fall substantially from today's levels, relative to previous earnings. 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 will be required due to earlier-than-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 savings.
The public needs to know that Social Security will most likely begin to have serious problems in just 15 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.
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