The CBO weighs in on the “replacement rates” debate

On December 18 the Congressional Budget Office released its latest report on Social Security. In addition to updating its projections for system financing – which has worsened considerably in recent years – CBO touched on the debate over how to measure Social Security “replacement rates.”

Back in July, Syl Schieber and I wrote in the Wall Street Journal that the Social Security Administration’s method of calculating replacement rates understates the adequacy of Social Security benefits. A replacement rate is designed to measure the degree to which retirement income can “replace” working-age earnings and thus allow retirees to maintain their pre-retirement standard of living. Most financial advisors recommend a replacement rate from total retirement income of about 70%, while SSA’s actuaries calculate a typical replacement rate from Social Security benefits of about 40%.

But SSA’s actuaries use a method that overstates individuals’ pre-retirement earning and thus understates their replacement rates from Social Security. SSA compares Social Security benefits to the wage-indexed average of the retiree’s highest 35 years of earnings. This “wage indexing” adjusts past earnings for substantially more than the rate of inflation and thus understates the degree to which Social Security benefits help retirees maintain their pre-retirement standard of living. Here’s how we put it back in July:

“Say you are retiring at age 65 this year and earned $20,000 in 1985. The purchasing power of that 1985 salary in 2014 dollars is $43,640. But in calculating replacement rates, SSA wage indexes that $20,000 for the growth of the economy, and so under that model you earned $53,281. Replacing 70% of $53,281 is a lot more difficult than replacing 70% of $43,640. SSA’s wage indexing of past earnings in effect credits retirees with salaries that they never had, then deems retirement income inadequate if it fails to replace that nonexistent past salary.”

In its new report, CBO seems to grasp these points. CBO calculates replacement rates relative both to wage-indexed earnings (its previous practice) and inflation-indexed earnings. In both cases, CBO calculates replacement rates using the 35 highest years of pre-retirement earnings.

Moreover, the language CBO uses makes clear they understand what we were getting at:

“Indexing earnings to prices better captures the real amount of resources available to a worker over his or her lifetime, whereas indexing earnings to wages may overstate those amounts.”

How much does this matter? A lot. CBO’s wage-indexed replacement rate for a typical worker born in the 1980s is 46%, while that person’s price-indexed replacement rate is 61%, about one-third higher.

A replacement rate is merely a shorthand for a much more complex “life cycle” calculation in which individuals try to maximize their standard of living over their full lifetime, while accounting for changing family sizes, uncertainty regarding their life expectancies and the return they can receive on their savings, their attitudes toward risk, and other factors. No shorthand will be perfect.

But CBO’s use of the inflation-adjusted average of the highest 35 years of earnings isn’t a bad shorthand. It will tend to reflects earnings from the individual’s late 20s through retirement, a period in which he or she has paid off some debts, established a career path and begun to anticipate the standard of living they will enjoy through their working life, which is the standard of living they will seek to replicate through their retirement savings. If you want a single measure that’s easy to understand while being consistent with the more sophisticated life cycle approach to retirement saving, CBO hasn’t chosen a bad one.

By contrast, SSA’s “wage-indexed” measure isn’t consistent with a life cycle approach. In the life cycle model, for which Franco Modigliani won the Nobel Prize, individuals care about smoothing their own standard of living from year to year. SSA’s actuaries, by contrast, assume that individuals want their standard of living to rise each year with the average wages of other workers in the economy. But they don’t present any research or data to back this “Keeping up with the Joneses” theory, they merely assert it. Personally, I’ll stick with the guy who’s got the Nobel Prize…

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Smith: Social Security deal of 1983 was a punt

Writing in The Hill, Brenton Smith of Fix Social Security Now argues that the 1983 bipartisan deal to fix Social Security, which some have cited as a blueprint for current reformers to follow, was in fact a “punt” that pushed most of the costs of reform onto future generations.

Check it out here.

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New working papers from the Center for Retirement Research at Boston College

The Center for Retirement Research at Boston College has recently released seven working papers:

Do Tax Incentives Increase 401(k) Retirement Saving? Evidence from the Adoption of Catch-Up Contributions Matthew S. Rutledge, April Yanyuan Wu, and Francis M. Vitagliano Are Retirees Falling Short? Reconciling the Conflicting Evidence Alicia H. Munnell, Matthew S. Rutledge, and Anthony Webb Lifetime Job Demands, Work Capacity at Older Ages, and Social Security Benefit Claiming Decisions Lauren Hersch Nicholas Who Is Internationally Diversified? Evidence from 296 401(k) Plans Geert Beckaert, Kenton Hoyem, Wei-Yin Hu, and Enrichetta Ravina The Causes and Consequences of Financial Fraud Among Older Americans Keith Jacks Gamble, Patricia Boyle, Lei Yu, and David Bennett New Evidence on the Risk of Requiring Long-Term Care Leora Friedberg, Wenliang Hou, Wei Sun, Anthony Webb, and Zhenyu Li Why Do SSI and SNAP Enrollments Rise in Good Economic Times and Bad? Matthew S. Rutledge and April Yanyuan Wu

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New papers from the NBER

Does Front-Loading Taxation Increase Savings? Evidence from Roth 401(k) Introductions

by John Beshears, James J. Choi, David Laibson, Brigitte C. Madrian - #20738 (AG)

Abstract:

Can governments increase private savings by taxing savings up front instead of in retirement? Roth 401(k) contributions are not tax-deductible in the contribution year, but withdrawals in retirement are untaxed. The more common before-tax 401(k) contribution is tax-deductible in the contribution year, but both principal and investment earnings are taxed upon withdrawal. Using administrative data from eleven companies that added a Roth contribution option to their existing 401(k) plan between 2006 and 2010, we find no evidence that total 401(k) contribution rates differ between employees hired before versus after the Roth introduction, which means that the amount of retirement consumption being purchased by 401(k) contributions increases after the Roth introduction. A survey experiment suggests two behavioral factors play a role in the unresponsiveness of contribution rates to their tax treatment: (1) employee confusion about or neglect of the tax properties of Roth balances and (2) partition dependence.

http://papers.nber.org/papers/W20738?utm_campaign=ntw&utm_medium=email&utm_source=ntw

4. The Long Reach of Education: Early Retirement by Steven Venti, David A. Wise - #20740 (AG)

Abstract:

The goal of this paper is to draw attention to the long lasting effect of education on economic outcomes. We use the relationship between education and two routes to early retirement - the receipt of Social Security Disability Insurance (DI) and the early claiming of Social Security retirement benefits - to illustrate the long-lasting influence of education. We find that for both men and women with less than a high school degree the median DI participation rate is

6.6 times the participation rate for those with a college degree or more. Similarly, men and women with less than a high school education are over 25 percentage points more likely to claim Social Security benefits early than those with a college degree or more. We focus on four critical "pathways" through which education may indirectly influence early retirement - health, employment, earnings, and the accumulation of assets. We find that for women health is the dominant pathway through which education influences DI participation.

For men, the health, earnings, and wealth pathways are of roughly equal magnitude. For both men and women the principal channel through which education influences early Social Security claiming decisions is the earnings pathway. We also consider the direct effect of education that does not operate through these pathways.

The direct effect of education is much greater for early claiming of Social Security benefits than for DI participation, accounting for 72 percent of the effect of education for men and 67 percent for women.

For women the direct effect of education on DI participation is not statistically significant, suggesting that the total effect may be through the four pathways.

http://papers.nber.org/papers/W20740?utm_campaign=ntw&utm_medium=email&utm_source=ntw

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New papers from the Social Science Research Network

"Individual Account Retirement Plans: An Analysis of the 2013 Survey of Consumer Finances"
EBRI Issue Brief, Number 406 (November 2014)

CRAIG COPELAND, Employee Benefit Research Institute (EBRI)
Email: COPELAND@EBRI.ORG

This paper assesses the status of American families’ accumulations in individual account (IA) retirement plans, both through the incidence of ownership and the amounts accumulated, using the Federal Reserve Board’s triennial Survey of Consumer Finances (SCF). Building on previous research by the Employee Benefit Research Institute (EBRI) using prior SCF surveys, this paper investigates the percentage of families who own various types of retirement plans, including IRAs. Next, it provides both median and average estimates of the value of the assets in these accounts, as well as the proportion of total financial assets represented and their relative percentages within the IA retirement plan universe. It then focuses on the value of IRA rollovers as part of the total IRA market, in order to glean a sense of the full contribution that the employment-based, retirement-plan system makes to total retirement assets. The percentage of all families with an employment-based retirement plan from a current employer decreased from 38.8 percent in 1992 to 36.2 percent in 2013. While retirement plan ownership from a current employer among families declined from 2010-2013, the percentage of family heads who were eligible for defined contribution (DC) plans and chose to participate held essentially stable at 78.2 percent in 2010 to 78.7 percent in 2013. The percentage of families owning individual retirement accounts (IRAs) or Keoghs was also unchanged from 2010 (28.0 percent) to 2013 (28.1 percent). Furthermore, the percentage of families with an individual account retirement plan from a current employer or a previous employer or an IRA/Keogh declined from 50.4 percent in 2010 to 48.2 percent in 2013. However, when including defined benefit (pension) retirement plans, the percentage with any retirement plan was unchanged from 63.8 percent in 2010 to 63.5 percent in 2013. While ownership of employment-based plans and IRAs was unchanged to declining in 2013, the median (mid-point) account balance of those families owning an individual account retirement plan increased in 2013: The value was $22,992 in 1992, reached $38,608 in 2001, and increased to $59,000 in 2013. Individual account retirement plan assets were a clear majority of families’ total financial assets (among those owning such plans): 70.3 percent in 2013 at the median, unchanged from 2010. Across all demographic groups in 2013, these assets’ share at the median of total financial assets was at least 49.2 percent (when these accounts were owned). By IRA type, regular IRAs accounted for the largest percentage of IRA ownership, but rollover IRAs had a slightly larger share of assets than regular IRAs in 2013.

"The Gap Between Expected and Actual Retirement: Evidence From Longitudinal Data"
EBRI Notes, Vol. 35, No. 11 (November 2014)

SUDIPTO BANERJEE, Employee Benefit Research Institute (EBRI)
Email: banerjee@ebri.org

This EBRI paper compares the expected and actual retirement for the same group of workers. It finds a majority (55.2 percent) of these workers retired within three years (before or after) of their expected retirement. Specifically, the longitudinal findings show that 38.0 percent retired before they expected, 48.0 percent retired after they expected, and 14.0 percent retired the year they expected to retire. It also shows that more people (35.9 percent) actually retired after 65 than expected (18.9 percent), and among those who expected to retire after 65, 56.6 percent did so. The study also shows that these longitudinal findings (comparing one cohort at different times) differ from cross-sectional findings (comparing different cohorts at the same time), which are reported more frequently. It shows that in 2012, the expected probability of working full-time after age 65 was 48.7 percent and 46.0 percent, respectively, among men and women working full-time. But only 12.7 percent of men and 6.0 percent of women worked full-time after age 65 in 2012. EBRI also found that people who have a retirement plan tend to retire closer to when they expected, compared with those without a plan. It also found that the gap between expected and actual retirement among those with defined benefit plans and defined contribution plans is generally very small. A large difference exists in later-than-expected retirement between pre- and post-September 2008, when the markets crashed. Pre-September 2008, 83.9 percent retired either earlier or no later than three years after their expected retirement, but only 59.3 percent did so post-September 2008. Clearly, the economic recession delayed the retirement of many people. The EBRI study uses data from the University of Michigan’s Health and Retirement Study (HRS), which is sponsored by the National Institute on Aging, and is the most comprehensive national survey of older Americans.
The PDF for the above title, published in the November 2014 issue of EBRI Notes, also contains the fulltext of another November 2014 EBRI Notes article abstracted on SSRN: “Views on the Value of Voluntary Workplace Benefits: Findings from the 2014 Health and Voluntary Workplace Benefits Survey.”

"Insights from Switzerland's Pension System"
Pension Research Council WP 2014-16

MONIKA BUTLER, University of St. Gallen, CESifo (Center for Economic Studies and Ifo Institute)
Email: Monika.Buetler@unisg.ch

This chapter takes Switzerland's much praised three-pillar system to illustrate some of the challenges pension system reforms face in an aging society. It shows that policymakers are confronted by some individuals with behavioral anomalies, and by others who strategically exploit the system. The trade-off between providing incentives and adequate retirement income limits policy options, especially if reformers do not want to impose too many restrictions on individual choice and avoid excessive burdens for the young generation. Pension reforms can also be seriously challenged by political constraints, in particular, when voters have a direct say on proposed changes.

"Lifetime Job Demands, Work Capacity at Older Ages, and Social Security Benefit Claiming Decisions"
CRR WP 2014-15

LAUREN HERSCH NICHOLAS, University of Michigan at Ann Arbor - Institute for Social Research (ISR)
Email: lnichola@umich.edu

We use Health and Retirement Study data linked to the Department of Labor’s O*Net classification system to examine the relationship between lifetime exposure to occupational demands and retirement behavior. We consistently found that both non-routine cognitive analytic and non-routine physical demands were associated with worse health, earlier labor force exit, and increased use of Social Security Disability Insurance. The growing share of workers in jobs with high levels of cognitive demand may contribute to growth in DI use.

"Are Retirees Falling Short? Reconciling the Conflicting Evidence"
CRR WP 2014-16

ALICIA H. MUNNELL, Boston College - Carroll School of Management
Email: crr4381@bc.edu
MATTHEW S. RUTLEDGE, Boston College
Email: rutledma@umich.edu
ANTHONY WEBB, Boston College - Center for Retirement Research
Email: webbaa@bc.edu

This paper examines conflicting assessments of whether people will have adequate retirement income to maintain their pre-retirement standard of living. The studies that it examines use data from the Survey of Consumer Finances (SCF), the Health and Retirement Study (HRS), and the HRS supplement Consumption and Activities Mail Survey (CAMS). Critical components of the analysis are behavioral assumptions about household consumption patterns when children leave home and when households retire. A key limitation is that the behavioral assumptions in the different studies are based on incomplete knowledge of actual household behavior.
The paper found that:
*A simple – assumption-free – calculation of wealth to income by age clearly indicates that households retiring in the future will be less prepared than those in the past.
*Studies showing that households are saving optimally hinge crucially on assumptions that people are willing to accept declining consumption as they age and that they sharply reduce their consumption when the children leave home.
*While other studies have found consumption does not decline early in retirement, new analysis suggests that many will be unable to maintain this pace over their full retirement.
The policy implications of the findings are:
*Households are more likely than not to be falling short in their retirement preparedness.
*Such shortfalls should be taken into consideration as policymakers discuss options for reforming Social Security.
*To bolster retirement preparedness, policymakers may want to consider ways to encourage more private saving, such as requiring 401(k)s to adopt auto-enrollment and auto-escalation policies and to apply these policies to current workers as well as new hires.

"Causal Effects of Retirement Timing on Subjective Physical and Emotional Health"

ESTEBAN CALVO, Universidad Diego Portales - Facultad de Economía y Empresa - Instituto de Políticas Públicas, Boston College - Sociology Department - Center for Retirement Research
Email: estebancalvo@gmail.com
NATALIA SARKISIAN, Boston College, Department of Sociology
Email: natalia@sarkisian.net
CHRISTOPHER R. TAMBORINI, U.S. Social Security Administration
Email: Chris.Tamborini@ssa.gov

Objective: This article explores the effects of the timing of retirement on subjective physical and emotional health. Using panel data from the Health and Retirement Study (HRS), we test four theory-based hypotheses about these effects — that retirements maximize health when they happen earlier, later, anytime, or on time.
Methods: We employ fixed and random effects regression models with instrumental variables to estimate the short- and long-term causal effects of retirement timing on self-reported health and depressive symptoms.
Results: Early retirements — those occurring prior to traditional and legal retirement age — dampen health.
Discussion: Workers who begin their retirement transition before cultural and institutional timetables experience the worst health outcomes; this finding offers partial support to the psychosocial-materialist approach that emphasizes the benefits of retiring later. Continued employment after traditionally expected retirement age, however, offers no health benefits. In combination, these findings offer some support for the cultural-institutional approach, but suggest that we need to modify our understanding of how cultural-institutional forces operate: Retiring too early can be problematic, but no disadvantages are associated with late retirements. Raising the retirement age, therefore, could potentially reduce subjective health of retirees by expanding the group of those whose retirements would be considered early.

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New paper from the Social Science Research Network

"Lifetime Job Demands, Work Capacity at Older Ages, and Social Security Benefit Claiming Decisions"
CRR WP 2014-15

LAUREN HERSCH NICHOLAS, University of Michigan at Ann Arbor - Institute for Social Research (ISR)
Email: lnichola@umich.edu

We use Health and Retirement Study data linked to the Department of Labor’s O*Net classification system to examine the relationship between lifetime exposure to occupational demands and retirement behavior. We consistently found that both non-routine cognitive analytic and non-routine physical demands were associated with worse health, earlier labor force exit, and increased use of Social Security Disability Insurance. The growing share of workers in jobs with high levels of cognitive demand may contribute to growth in DI use.

Read more!