More on the “new Social Security notch”

I've been meaning to flesh out what I wrote last week in Forbes regarding a new "Social Security notch," in which individuals who turned 62 in 2009 are disadvantaged because – while they did not receive the over-large 5.8 percent COLA paid in January of this year – they will be subject to the "no COLA" years in 2010 and 2011. (See this new AEI paper for details on the COLA.)

This seems to be a good time to discuss it more, since SSA's Chief Actuary Steve Goss has circulated a memo on the Hill (available here) discussing the notch issue. (Steve's been very helpful to me in understanding a really tricky issue.) Since the memo is short I'll paste in the text and then give a quick response.

Social Security Benefits for Those Born in 1947

October 14, 2009

Andrew Biggs recently noted (Forbes Commentary, October 9, 2009) that retired workers who were born in 1947, and will reach age 62 in 2009, did not receive the 5.8 percent cost of living adjustment (COLA) awarded to Social Security beneficiaries eligible in December 2008. This is true. However, the workers born in 1947 did receive a 4.54 percent increase in their benefits through the wage-indexed benefit formula. And this increase will not be applied for retirees born before 1947. Therefore, the difference of about 1.2 percent is the amount by which benefits will be lower for life for a worker 62 in 2009, compared to a similar worker reaching 62 in 2008.

Is this a "notch", and is it unusual? Unfortunately, consumer prices and the average wage level do not rise smoothly over time. The increase in the CPI that caused the 5.8-percent COLA for December 2008 just happened to be bigger than the 4.54-percent increase in the average wage that retired workers age 62 in 2009 will receive instead of the COLA. So yes, this is a small "notch". Is this unusual? Actually, the COLA received by existing beneficiaries has been larger than the average wage increase applied for newly-eligible beneficiaries in 9 of the 30 prior years. And in 5 of these years the difference was greater than it is for 2009. So the 1.2-percent difference between benefits for those age 62 in 2008 and those age 62 in 2009 is neither very large nor very unusual.

Steve Goss, Chief Actuary

Social Security Administration

The first thing to remember is that I didn't argue that a notch existed because individuals in the 1947 cohort would receive lower dollar benefits than individuals in the 1946 cohort (although they may). I argued that unusual changes in prices over the course of 2008, interacting with the benefit formula, mean that individuals aged 61 in 2008 will receive lower benefits than they otherwise would have.

However, comparing two cohorts may nevertheless be useful so long as we bear in mind how Social Security intends benefits to change between cohorts. Social Security is a wage-indexed program, meaning that initial benefits rise from cohort-to-cohort along with average wages. This maintains a roughly constant replacement rate – the ratio of initial benefits to average pre-retirement earnings. (Social Security calculates pre-retirement earnings as the wage-indexed average of the highest 35 earning years.) As a result, we'd expect the 1947 cohort to receive higher benefits than the 1946 cohort, assuming they had higher average lifetime earnings. The fact that benefits are lower is notable.

Typically the replacement rate for a medium wage earner is around 40 percent; since the retirement age isn't currently increasing, let's assume the replacement rate would ordinarily be 40 percent for both the 1946 and 1947 birth cohorts. To make things simpler still, let's think of the numerator and the denominator of the replacement rate separately; in other words, imagine as if a person received a benefit of $40 (say, per day) and had pre-retirement earnings of $100 (again, per day).

OACT's memo points out that a typical person in the 1947 birth cohort received benefits 1.2 percent lower than a similar person in the 1946 birth cohort. So, using our simplified formula, that $40 daily benefit falls to $39.52. The memo also notes average wage growth of 4.54 percent in 2007, the year the 1947 birth cohort turned 60. This, in turn, increases the wage-indexed average of lifetime earnings by around 4.54 percent, since the Social Security benefit formula indexes past earnings to wage growth through age 60. So that $100 daily pre-retirement earnings for the 1946 birth cohort increases to around $104.54 for the 1947 cohort. Divide it out and you get a replacement rate of 37.8 percent.

Now calculate the percentage differences in replacement rates: 1 – 37.8%/40% = 5.5%. In dollar terms, benefits for the 1947 cohort are around 5.5 percent lower than needed to maintain the same replacement rate received by the 1946 cohort. This was the point I attempted to make in the Forbes article.

Now, there are many possible "notches" that can be created by the benefit formula and there are other things going on that might reduce the cut for the 1947 cohort a little. I'll get into them as I write on this more.