Discussion: (2 comments)
Comments are closed.
The public policy blog of the American Enterprise Institute
Over at the Wall Street Journal’s Encore Blog, Alicia Munnell of Boston College warns of “Missing Data” in the new 2014 Social Security Trustees Report. The “data” she warns are missing are the “replacement rates” paid by Social Security, which Social Security’s actuaries claim measure retirees’ benefits as a percentage of pre-retirement earnings. In fact, though, there’s no data missing – there’s actually been data added. And that new data shows why the actuaries’ replacement rate figures are highly misleading.
SSA states that “Most financial advisors say you’ll need about 70 percent of your pre-retirement earnings to comfortably maintain your pre-retirement standard of living. Under current law, if you have average earnings, your Social Security retirement benefits will replace only about 40 percent.” These commonly-known factoids shape how we view Social Security’s generosity and Americans’ overall readiness for retirement.
But as Syl Schieber and I showed recently in the Wall Street Journal, SSA mixes apples and oranges: financial advisors measure replacement rates relative to a worker’s final earnings prior to retirement, while SSA’s actuaries measure them relative to the wage-indexed average of their career earnings. (What this means will become clearer below.) If you calculate Social Security replacement rates as financial advisors do, the typical replacement rate isn’t 40%. It’s around 60%.
Apparently Social Security’s trustees saw the same problems. In 2013 they warned that SSA’s “method of calculation produces percentages that may differ significantly from those that would be produced by comparing benefits to these representative workers’ recent average earnings levels or to other more common measures of pre-retirement income.” In 2014, the Trustees removed the actuaries’ replacement rate figures entirely.
Munnell blames “a concerted effort by a band of critics who argue that all is right in the world: People will have plenty of money in retirement.” This straw man argument refers to me, though wrongly: in my National Affairs article with Syl Schieber, we cited studies concluding that roughly 25% of Americans are undersaving. That’s not “all is right in the world,” it’s just less than the flawed figures coming from other sources.
But back to the “missing data”: in reality, the Trustees Report contains more data this year than last. Namely, they included figures on:
a) Social Security benefits in any given year for new retirees at different earnings levels
b) the average wages of workers in the workforce that year
And guess what? If you divide the benefits of today’s retirees by the wages of today’s workers, you get the same figure the SSA claims is replacement rate for today’s retirees, which supposedly measures their benefits relative to their past earnings. Compare the two figures, as I did using data from the 2013 Trustees Report, and you’ll see they’re almost exactly the same. For instance, the 2013 Trustees Report states that a medium earner retiring at the full retirement age in 2012 received an annual benefit of $19,112 and a replacement rate of 43.7%. The 2013 Trustees Report also reports the Average Wage Index for 2012 as $43,716. Divide the two and the medium earner’s benefit is equal to 43.7% of the AWI. Leaving aside some technicalities, the same is true every year: the figure that SSA claims to be the replacement rate of new retirees relative to their past earnings is almost precisely equal to those new retirees’ benefit as a percentage of today’s average earnings.
How can this be? If wages rise over time, then the average wage paid to workers today will be higher than the past wages earned by today’s new retirees. What gives? That’s where SSA’s “wage indexing” comes in: SSA’s actuaries increase the value of a new retirees prior wages, beyond just compensating for inflation, in such a way that an average retirees’ past wages are made equal to the average wage paid to workers today.
So here’s a question: why should retirees care about how their incomes compare to the incomes of today’s workers? The answer is they shouldn’t: in the standard “life cycle model,” what individuals care about is how their retirement income compares to their pre-retirement earnings, not the earnings of people who are working at the time they’re retiring. This life cycle approach has been dominant in academic economics for, oh, the past 60 years or so. But I guess the wheels of actuarial progress grind slowly.
Now, some other countries do measure replacement rates by comparing pension benefits to the average economy-wide wage (Munnell cites an OECD study that does). But in most cases they’re clear that what they’re measuring is simply the standard of living of retirees relative to the standard of living of workers. The OECD in other papers is clear on what it’s calculating, as are studies from the World Bank and the IMF. What these groups don’t generally do – which SSA’s actuaries do – is mix and match this measure of replacement rates with how financial advisors measure them, since they’re just different animals.
So why do SSA’s actuaries measure replacement rates differently than financial advisors and economists? Stay tuned.
Follow AEIdeas on Twitter at @AEIdeas.
Comments are closed.
1150 17th Street, N.W. Washington, D.C. 20036
© 2014 American Enterprise Institute for Public Policy Research