New paper: Can 401(k) Plans Provide Adequate Retirement Resources?

The Investment Company Institute has released a new paper by Peter J. Brady titled "Can 401(k) Plans Provide Adequate Retirement Resources?" which simulates the benefits and replacement rates individuals could expect to receive through a combination of Social Security benefits and participation in a 401(k) investment account. Brady's paper can be seen in the context of the recent debate over the effectiveness of 401(k) accounts in furthering retirement preparation. Here's the summary:

Despite only having been in existence for 27 years - less than a typical working career - some analysts seem to have concluded that 401(k) plans are a failure. For example, Munnell and Sundn (2004, 2006) argue that the 401(k) is "coming up short" due to, among other factors, low contribution rates among those participating. A recent government report concludes that "low defined contribution plan savings may pose challenges to retirement security" (GAO, 2007). In addition, Ghilarducci (2006, 2008) has proposed to replace 401(k) plans with Guaranteed Retirement Accounts, in part due to belief that 401(k) plan participants will not be adequately prepared for retirement. This paper illustrates that moderate 401(k) contribution rates can lead to adequate income replacement rates in retirement for many workers; that adequate asset accumulation can be achieved using only a 401(k) plan; and that these results do not rely on earning an investment premium on risky assets. Using Monte Carlo simulation techniques, this study also illustrates the investment risk faced by participants who choose to invest their 401(k) contributions in risky assets, or who choose to make systematic withdrawals from an investment account in retirement rather than annuitize their account balance.

Brady's paper is very interesting and worth checking out.

For what it's worth, I should have an AEI Retirement Policy Outlook coming out next month which examines some similar issues. The table below shows combined Social Security and private pension replacement rates for the 1960 birth cohort as of age 70 (meaning, in the yea 2030). Replacement rates are adjusted for efficiencies of scale in household size, meaning that both pre- and post-retirement income is assumed to go further for couples living together with kids than for singles. (This adjustment process is one of the central points of the upcoming paper, and was inspired by recent work by Scholz and Seshadri and by Skinner). The simulations were conducted using the Policy Simulation Group models; they assume payment of current law Social Security benefits, and the assumptions regarding pension benefits are similar to those used in a recent GAO report.

Table 5: Distribution of Adjusted Total Pension Replacement Rates, 1960 birth cohort
	Replacement rate percentile
Earnings decile	10th	25th	50th	75th	90th
10%	61%	77%	100%	131%	171%
20%	54%	69%	87%	113%	146%
30%	50%	64%	83%	109%	143%
40%	49%	63%	82%	109%	142%
50%	48%	62%	82%	109%	142%
60%	47%	62%	82%	109%	141%
70%	46%	61%	83%	112%	145%
80%	45%	60%	83%	111%	144%
90%	43%	61%	84%	113%	150%
100%	33%	50%	72%	99%	130%

While there's much more to be said than can be outlined here, the main point is that – even assuming declining replacement rates from Social Security and the imperfections of the 401(k) system – projected replacement rates for most future retirees aren't bad, particularly since this analysis excludes other sources of retirement income (e.g., earnings, non-pension savings, implicit rent from housing). For reference, most financial advisors recommend a retirement income equal to around three-quarters of income during pre-retirement years.

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Problems with Guaranteed Retirement Accounts

The New York Times calls Teresa Ghilarducci's proposal for Guaranteed Retirement Accounts one of the "ideas of the year." Here's some background, and then in later posts I'll look at a number of problematic issues regarding the proposal. The following summary of the GRA plan is pulled from this paper Ghilarducci wrote for the Economic Policy Institute:

How Guaranteed Retirement Accounts work

Structure. Guaranteed Retirement Accounts are like universal 401(k) plans except that the government, as befits a large and enduring institution, will invest and manage the pooled savings.

Participation. Participation in the program is mandatory except for workers participating in equivalent or better employer defined-benefit plans where contributions are at least 5% of earnings and benefits take the form of life annuities.

Contributions. Contributions equal to 5% of earnings are deducted along with payroll taxes and credited to individual accounts administered by the Social Security Administration. The cost of contributions is split equally between employer and employee. Mandatory contributions are deducted only on earnings up to the Social Security earnings cap, and workers and employers have the option of making additional contributions with post-tax dollars. The contributions of husbands and wives are combined and divided equally between their individual accounts.

Refundable tax credit. Employee contributions are offset through a $600 refundable tax credit, which takes the place of tax breaks for 401(k)s and similar individual accounts and is indexed to wage inflation. Eligibility for the tax credit is extended to part-time workers, caregivers of children under age six, and those collecting unemployment benefits. If an individual's annual contributions amount to less than $600, some or all of the tax credit is deposited directly into the account in order to ensure a minimum annual deposit of $600 for all participants.

Fund management. The accounts are administered by the Social Security Administration and funds are managed by the Thrift Savings Plan or similar body. Though funds are pooled, workers are able to track the dollar value of their accumulations, as with 401(k)s and other individual accounts.

Investment earnings. The pooled funds are conservatively invested in financial markets. However, participants earn a fixed 3% rate of return adjusted for inflation, guaranteed by the federal government. If the trustees determine that actual investment returns have been consistently higher than 3% over a number of years, the surplus will be distributed to participants, though a balancing fund will be maintained to ride out periods of low returns.

Retirement age. Participants begin collecting retirement benefits at the same time as Social Security, and therefore no earlier than the Social Security Early Retirement Age. Funds cannot be accessed before retirement for any reason other than death or disability.

Retirement benefits. Account balances are converted to inflation-indexed annuities upon retirement to ensure that workers do not outlive their savings. However, individuals can opt to take a partial lump sum equal to 10% of their account balance or $10,000 (whichever is higher), or to opt for survivor benefits in exchange for a lower monthly check. A full-time worker who works 40 years and retires at age 65 can expect a benefit equal to roughly 25% of pre-retirement income, adjusted for inflation, assuming a 3% real rate of return. Since Social Security provides the average such worker with an inflation-adjusted benefit equal to roughly 45% of pre-retirement income, the total replacement rate for this prototypical worker will be approximately 70%.

Death benefits. Participants who die before retiring can bequeath half their account balances to heirs; those who die after retiring can bequeath half their final account balance minus benefits received.

In following posts, I'll look at several aspects of the GRA plan that I think are worth considering more carefully before moving ahead.

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New Paper: “Are There Opportunities to Increase Social Security Progressivity despite Underfunding?”

The Tax Policy Center has released a new paper by the Urban Institute's Melissa Favreault and Gordon Mermin titled "Are There Opportunities to Increase Social Security Progressivity despite Underfunding?" Here's the abstract:

This paper reviews why Social Security fails to lift more aged low-wage workers and people of color out of poverty. It examines the payroll tax and benefit formula and reviews literature about OASDI outcomes by race, gender, and earnings level. It describes how mortality, earnings, disability, childbearing, immigration and emigration, and marriage patterns all differ across U.S. racial/ethnic groups, and highlights the importance of these differences for program outcomes. The paper then uses the DYNASIM model to examine lifetime OASDI redistribution under current law and a trust fund-neutral reform package that would enhance system progressivity and improve outcomes for some vulnerable to retirement poverty.

In addition to being a good summary of existing research on who does well and who does poorly under Social Security – and why – Favreault and Mermin present a number of potential reforms to Social Security to reduce poverty among seniors. Definitely worth a read.

Here's my quick take, based on forthcoming work for AEI: while Favreault and Mermin's paper is very good, the emphasis on whether Social Security should be more or less progressive actually misses the point a bit. The problem Social Security faces is that it isn't consistently progressive, meaning that there is too much disparity in treatment among people with the same lifetime earnings. Poor people get higher average replacement rates than higher income people, but that average hides a lot of disparity: many poor folks do really well, but a lot also do pretty poorly. The reason, as Favreault and Mermin point out, is that Social Security redistributes based on a lot of factors other than the person's lifetime earnings. (E.g., length of marriage, relative earnings between spouses, length of working career, etc.)

The chart below illustrates. As can be seen, average replacement rates decline as lifetime earnings increase – this shows that Social Security is generally progressive. However, the distribution of replacement rates at any given level of lifetime earnings can be pretty wide, especially for low earners. Some do really well, others do pretty poorly.

If Social Security is to be successful as social insurance, it needs to pay off consistently. There are a number of ways, including those discussed by Favreault and Mermin, to improve the targeting of Social Security benefits by earnings level. If Social Security's progressivity were better targeted, the same amount of average progressivity could produce better protections for low earners in old age.

Update: An anonymous commenter asks, "The problem you note may be related to the disparate way benefit formulas apply to couples in general. The chart would probably look more equitable for wage earners only. Is the way we treat couples still as relevant as it was in the 1930's?"

It's a logical point but turns out not to be the case. Social Security benefits are better targeted at a household level than an individual level. The chart below differs a bit from the one above (it shows data points rather than interquartile ranges), but the dispersion in replacement rates by lifetime earnings is significantly higher at the individual than the household level.

One way to look at is to measure the R-squared values of a regression of replacement rates on lifetime earnings. At the household level the R-squared value is around 0.55, which indicates that around 55% of differences in replacement rates can be accounted for by differences in lifetime earnings. (Given that Social Security is designed to redistribute by lifetime eranings, this strikes me as a lower value than you'd want.) At the individual level, however, the R-squared is only around 0.3; this indicates that 70 percent of differences in replacement rates between indivduals are due to things other than differences in their lifetime eranings. This again strikes me as very haphazard given that we're trying to target low earners.

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New paper: Estimated Retirement Benefits in the Social Security Statement

The Social Security Administration Office of Retirement and Disability Policy has released a new Research and Statistics note "Estimated Retirement Benefits in the Social Security Statement," by Glenn R. Springstead, David A. Weaver, and Jason J. Fichtner. The paper examines the accuracy of the social security statement in projecting individuals' future retirement benefits. Here's the summary:

Since 1999, the Social Security Administration (SSA) has mailed an annual Social Security Statement to individuals aged 25 or older showing their reported earnings history. The Statement also provides workers with estimates of benefit amounts available under the Social Security programs. This note focuses on estimates of retirement benefits in the annual Social Security Statement.

Estimated benefits are adjusted for economy-wide average wage growth from about the time of Statement issuance to about the time of retirement. In addition, the Social Security Statement uses certain assumptions about current and future individual earnings to estimate retirement benefits. This note evaluates whether the Statement's assumptions produce accurate estimates, using data from a sample of recently eligible retired workers in SSA's Modeling Income in the Near Term (MINT) microsimulation model.

Here are some of the paper's findings:

• Examining statistics based on differences measured at the individual level, we find the median differences are highest at the earlier Statement ages. For example, the median percentage difference between Statement PIAs and deflated retirement PIAs is minus 16 percent at Statement age 25, but narrows considerably at later ages (around minus 1 percent to minus 2 percent at Statement ages 40 or older). Note that these are median differences, not differences in medians.
  
• A majority of sample members (57 percent) would have received Statements at age 55 with benefit estimates based on PIAs very close (plus/minus 5 percent) to their deflated retirement PIAs. Over three-quarters (78 percent) had values that were within 10 percent. Considering a 10 percent difference to be "fairly close," we note that by Statement age 40 a majority of persons have Statement PIAs fairly close to their deflated retirement PIAs.
  

I did some work in this area several months ago and I believe the new SSA findings match fairly well with my own analysis. Both find that the projections are reasonably accurate on average, and the accuracy of the projects improves as individuals approaches retirement.

(The principal issue I had with the Social Security Statement was not in how future benefits were estimated, but the way in which the estimated future benefit was converted to today's dollars. The Social Security statement "wage indexes" the nominal retirement benefit back to today. That is, if the nominal future benefit is b, the rate of nominal wage growth g, and the number of years until retirement n, then the wage-indexed benefit is equal to b/(1+g)ⁿ. The more conventional way to convert future dollar amounts to current dollars is through inflation-indexing, in which the value for wage growth g is replaced by a value for price inflation, p. If g is greater than p, as it generally is, then the Statement's wage indexed benefit under understate the better inflation-indexed estimate by and amount equal to the compounded differences between g and p. If real annual wage growth (g-p) equals 1.1 percent, then the Statement will underestimate the "true" benefit amount by roughly 1.1 percent for each year between now and the time of retirement.)

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New paper: Alternate Measures of Replacement Rates for Social Security Benefits and Retirement Income

I have a new paper out in the Social Security Bulletin co-authored with Glenn Springstead, of the Office of Retirement and Disability Policy at SSA. The paper is entitled "Alternate Measures of Replacement Rates for Social Security Benefits and Retirement Income" and looks at the ways in which we measure retirement income adequacy. Here's the summary, followed by some notes:

Discussions of retirement planning and Social Security policy often focus on replacement rates, which represent retirement income or Social Security benefits relative to pre-retirement earnings. Replacement rates are a rule of thumb designed to simplify the process of smoothing consumption over individuals' lifetimes. Despite their widespread use, however, there is no common means of measuring replacement rates. Various measures of pre-retirement earnings mean that the denominators used in replacement rate calculations are often inconsistent and can lead to confusion.

Whether a given replacement rate represents an adequate retirement income depends on whether the denominator in the replacement rate calculation is an appropriate measure of preretirement earnings. This article illustrates replacement rates using four measures of preretirement earnings: final earnings; the constant income payable from the present value (PV) of lifetime earnings (PV payment); the wage-indexed average of all earnings prior to claiming Social Security benefits; and the inflation-adjusted average of all earnings prior to claiming Social Security benefits (consumer price index (CPI) average).

The article then measures replacement rates against a sample of the Social Security beneficiary population using the Social Security Administration's Modeling Income in the Near Term (MINT) microsimulation model. Replacement rates are shown based on Social Security benefits alone, to indicate the adequacy of the current benefit structure, as well as on total retirement income including defined benefit pensions and financial assets, to indicate total preparedness for retirement.

The results show that replacement rates can vary considerably based on the definition of preretirement earnings used and whether replacement rates are measured on an individual or a shared basis. For current new retirees, replacement rates based on all sources of retirement income seem strong by most measures and are projected to remain so as these individuals age. For new retirees in 2040, replacement rates are projected to be lower, though still adequate on average based on most common benchmarks.

Here's a quote from a SSA publication that motivated this paper for me:

"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."

Here's the problem: financial advisors measure replacement rates by dividing your retirement income by your income immediately preceding retirement; say, income at age 65 divided by income at age 64. Social Security defines the replacement rate as the Social Security benefit divided by the wage-indexed average of your lifetime earnings. These are two different animals, so comparing Social Security's 40 percent average replacement rate to the 70 percent recommended replacement rate is apples and oranges.

In the paper we discuss the pros and cons of various ways of defining replacement rates. In the process, though, we also use the Social Security Administration's MINT microsimulation model to measure Social Security and total retirement income replacement rates for current retirees. This is cool because MINT is the best, most detailed model available for running these kinds of numbers. The table below shows the distribution of Social Security replacement rates compared to various definitions of pre-retirement income.

Table 4: Median Shared Benefit Replacement Rates for Retired Beneficiaries age 64-66 in 2005
	Lifetime earnings quintile
	Lowest	2nd	3rd	4th	Highest
Final Earnings	137%	77%	69%	53%	42%
PV Payment	62%	47%	42%	40%	36%
AIME	70%	52%	45%	41%	36%
CPI Average	82%	60%	53%	48%	42%
Source: MINT model, authors' calculations; N = 3,604. Numerator is shared benefit; denominator is shared value as defined in the text.

The next table shows replacement rates for total retirement income, which includes Social Security, pensions, asset income, earnings and co-resident income.

Table 5: Median Shared Total Retirement Income Replacement Rates for Retired Beneficiaries age 64-66 in 2005
	Lifetime earnings quintile
	Lowest	2nd	3rd	4th	Highest
Final Earnings	381%	210%	185%	161%	143%
PV Payment	160%	111%	98%	108%	115%
AIME	176%	120%	106%	112%	112%
CPI Average	204%	141%	124%	130%	130%
Source: Authors' calculations, MINT model. Numerator is shared total retirement income; denominator is as defined in the text.

This last table is interesting, because it provides some perspective for those who are afraid that we're facing a crisis in retirement income. For instance, the median household has a total retirement income equal to 124 percent of their inflation-adjusted average income during their working years. (This may or may not be the best replacement rate measure to use, but it's easily understandable.) We find relatively few households with very low replacement rates, indicating that concerns over retirement income – while not invalid – may be overstated.

There are a few other interesting results as well, including the finding that – contrary to some views – replacement rates don't tend to decline as people age. Anyway, I hope folks will read this and find it interesting.

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More on Social Security and poverty…

It seems one of my comments from yesterday struck a nerve, both here and over at Arnold Kling's blog. Here's the offending passage:

Sen. Obama says, "Social Security has lifted millions of seniors and their families out of poverty. Without it, nearly 50 percent of seniors would live below the poverty line." This is a common talking point, but let's be clear on what it means: if we forced people to pay Social Security taxes all their lives but didn't pay them any benefits, yes, nearly 50 percent of seniors would live below the poverty line. But this is a silly standard. If we were truly "without" Social Security, we would also be without Social Security taxes, which individuals could then save on their own for retirement. So the better question would be, "Without Social Security taxes and benefits, what would the poverty rate among seniors be?" The answer is, about the same as the current rate.

I made two points:

First, saying that a system that collects an eighth of people's wages all their lives and pays them a benefit at retirement reduces poverty versus an alternate system that collects the same amount of taxes but doesn't pay them a dime at retirement is a silly comparison. This was my main point, but it's also one that you either accept or you don't. To me, it seems so obviously a silly comparison that if you don't understand that I'm not sure what else I can do.

Second, I said that in the absence of Social Security the senior poverty rate today would be around the same. This I'm willing to concede is too strongly stated, though it's worth considering the range of issues pro and con (see below). That said, what I'm conceding is that the elderly poverty rate would be higher than the current rate (officially around 9.5 percent), not that "nearly 50 percent of seniors would live below the poverty line." That I believe is simply wrong. In any case, here are some things to think about:

Individual saving: Would people most at risk of poverty in retirement save as much in the absence of Social Security? Probably not, which is the strongest reason to believe Social Security reduces poverty (if not by 50 percent…). That said, I'm not convinced that run of the mill low earners (meaning low skilled, versus due to health or social reasons) simply wouldn't or couldn't save.

Progressivity: The Social Security benefit formula is progressive, such that low earners get higher replacement rate than higher earners. This will reduce poverty rates versus an un-weighted scheme, though I wouldn't over estimate the effects of progressivity. Redistribution in practice is often quite haphazard; while Social Security likely reduces poverty versus an otherwise identical program with no redistribution, it would be quite easy to design a system with better poverty protections than the current program.

Average rates of return from Social Security: Social Security pays a below-market average rate of return today because it paid an above-market rate of return to early participants. In the absence of Social Security, past retirees would have been poorer and current retirees, on average, richer. This would reduce poverty in retirement.

Total saving rates: Fuchs, Krueger, and Poterba surveyed public finance economists, asking what the personal saving rate would have been if Social Security had never been enacted. The median response was that the saving rate would have been 60 percent higher. If so, output per worker today would be around 20 percent higher. Presumably this would drag more than a few low earners out of poverty.

Labor force participation: Social Security contributions are viewed by many workers as a pure tax, meaning that (accurately or not) they don't expect to receive anything in return for them. This will tend to reduce labor force participation. Moreover, Social Security benefit rules tend to encourage earlier retirement, which would also reduce lifetime earnings.

Portfolio allocation: Social Security is in many ways equivalent to mandatory saving in an all-bond portfolio: low risk, but low return. For higher earning individuals this doesn't make much difference since we can alter our non-Social Security savings portfolio to get the mix of risk and return we like (this is one reason why personal accounts wouldn't be a "better deal" for higher earners; if we want more stocks we can already do it). For lower earners, though, Social Security constrains their portfolio to one that is probably lower risk than they'd prefer.

Additionally, Arnold Kling makes the point that the reduction in elderly poverty over time is as much attributable to the growth of the economy than to Social Security. Per capita national income today is far higher than it was in the 1930s, so even assuming no Social Security program we should expect to see poverty declining over time.

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New paper: A guide to starting Social Security benefits

Richard L. Kaplan of the University of Illinois College of Law has a new paper in the Journal of Retirement Planning, July-August, 2008 entitled "A Guide to Starting Social Security Benefits," which focuses on the decisions facing an individual who is considering claiming retirement benefits. It's a good paper overall, but (like many articles on Social Security written by law professors) it has a great deal of detail but could benefit from greater context.

For instance, Kaplan correctly points out that the Social Security formula is neutral with regard to claiming age, meaning that the average person will collect just about the same amount (in present value) regardless of when he claims. But the decision is framed in terms of a "gamble" over whether an individual who delays claiming will live long enough to break even:

Early benefits are smaller in amount, but will be received for more years, all things being equal, while delayed benefits are larger in amount, but will be received for fewer years, once again all things being equal. The question then becomes what the person estimates will be his or her life expectancy. To put this issue in the starkest terms, getting less now in exchange for more later makes sense only if there is, in fact, a "later." Thus, the question inevitably turns at the outset on such factors as one's personal medical history, including that of one's natural parents, if known.

An alternate, and equally correct, framing devise is to view the Social Security benefit as insurance against outliving your assets. Even people who believe they will live less shorter than the average nevertheless have significant uncertainty regarding their actual age of death. By delaying claiming, you are effectively "buying" more insurance against longevity risk. Put in these terms, more individuals may choose to delay claiming past 62 or 63, the most common ages for Americans to retire.

Likewise, while Kaplan does not describe the retirement earnings test incorrectly, it is framed as an onerous "tax" that most people would seek to avoid:

Any Social Security recipient who has not yet attained the applicable full retirement age faces onerous retirement earnings test that substantially reduces the economic rewards from working. This provision has the same economic impact as a 50 percent marginal tax rate on the affected earnings. Those earnings, moreover, are subject to a federal income tax on income generally of at least 15 percent in addition to Social Security's effective 15.3 percent payroll tax on wages and self-employment income, a combined effective marginal tax rate of over 80 percent and possibly even more, depending upon a retiree's other sources of income. In fact, additional income of $19,940 in 2008 would push this taxpayer into the 25 percent federal income tax bracket, raising that person's effective marginal tax rate to 90.3 percent.27 State income taxes would raise this effective marginal tax rate still higher.

The problem is that the earnings test doesn't have "the same economic impact as a 50 percent marginal tax rate on the affected earnings." If benefits are increased at the normal retirement age to account for the earnings test (as I discuss in this paper), then the earnings test is no more a tax than is, say, the automatic deduction of contributions to a 401(k) plan. Yet if this isn't made clear, the typical person will misunderstand the provision and potentially mis-react to it.

All that said, an interesting paper and a good resource for someone looking to understand the questions a potential claimant should consider.

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New Social Security retirement benefit estimator: a good step, but improvement needed

SSA has released a new online version of the Social Security Statement, which allows users to electronically access an estimate of their future Social Security benefits, as well as to alter assumptions regarding future wages and the age at which they will retire. This is a good step forward in helping Americans plan for retirement.

However, the new online calculator needs to be clearer about the benefit estimates it provides. The calculator does not specify whether dollar figures are in "current" or nominal dollars, meaning the actual dollar amount you would see on your check when you retire, or in today's dollars, meaning dollars adjusted for inflation to give a better feeling for the purchasing power of your future benefit.

In fact, as discussed in this op-ed, the Social Security Statement and the new online calculator don't do either. The benefit estimate is expressed "wage indexed" dollars. Technically, this means that the future dollar amount is discounted by the rate of compound wage growth between the time the estimate is made and the time of retirement. (If you want to do the math, the wage indexed benefit , where Bc equals the current or nominal benefit amount, g equals the average rate of nominal wage growth, and n equals the number of years until retirement.

Here's an example: let's say that the nominal benefit amount you would receive – that is, the actual dollar figure on your monthly Social Security check – would be $2500 and you have 20 years until you plan to retire. Typically, you would either think about the benefit in nominal terms or, better, convert it today's dollars to better represent what the benefit can actually buy. Assuming 2.8 percent annual inflation, as the Trustees do, the benefit in today's dollars would equal $2500/(1+0.028)²⁰, or $1,439.

However, expressed in wage-indexed dollars the figure will be significantly lower. Assuming that wages rise 1.1 percent faster than inflation (as the Trustees projection), the wage-indexed figure would equal $2500/(1+0.039)²⁰, or $1,163, a difference of $276 per month.

The new calculator is at least superior to the Statement, which says that benefits are "in today's dollars" – meaning inflation-adjusted dollars, when they're not. But first, it's not clear how helpful the new calculator will be when it does not even state what terms the benefit figures are in, and second, even if that were made explicit, it's not clear how helpful a wage-indexed dollar amount is.

Why? The purpose of a benefit estimator is so that people can determine whether they're saving enough on their own to provide for a comfortable retirement. Remember, Social Security wasn't intended to cover all retirement needs. Most people who have a defined benefit pension receive an estimate of future benefits in nominal terms. For people estimating the benefit payable from a DC pension, such as a 401(k) or IRA, they'll either project it in nominal or in real terms. (For instance, this retirement income calculator from AARP deals mostly in today's dollars, as does this 401(k) calculator from Quicken.) To be useful in making comparisons, a wage-indexed Social Security benefit figure must be converted to either nominal or inflation-adjusted dollars, which is well beyond the skills of the typical person even if they knew the conversion needed to be made.

Again, at the very least, users should be notified of what kind of dollars their benefits are estimated in. Preferably, they would be given a choice between nominal and inflation-adjusted dollars, and provided with information on what each figure means.

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New SSA publication: “When To Start Receiving Retirement Benefits”

Social Security has a new two-page pamphlet designed to help individuals decide when to claim retirement benefits. It's a big improvement from previous publications and provides a lot of useful information in a very short space. Read for yourself, give to a friend. (Full disclosure: while at SSA I was involved with designing the pamphlet, though it has changed somewhat since I left the agency. I do think it's great, though.)

The key points, as I see them:

• Choosing your retirement age isn't about maximizing your lifetime benefits – for the typical person, these are the same regardless of when you claim – but ensuring you'll have enough income later in life.
  
• Social Security benefits last as long as you live, and so are valuable insurance against outliving your assets. While the average 65 year old lives to age 83, about 25 percent will survive to at least age 90 and 10 percent will live past age 95.
  
• Delaying claiming doesn't just increase your benefit, it also raises benefits for your survivors. A simple "break-even age" approach doesn't factor in survivors benefits.
  
• The earnings test isn't a tax; while you may lose some benefits before the full retirement age, you'll receive an increase afterwards to make up for them.
  

Kudos to the SSA staff who put this together. You can download the pamphlet here.

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New book: “Working Longer: The Solution to the Retirement Income Challenge”

Alicia Munnell and Steven Sass of the Center for Retirement Research at Boston College have a new book, Working Longer: The Solution to the Retirement Income Challenge. Here's a short summary of the topics covered:

Why Do We Need to Work Longer?

• Americans need to work longer due to a contracting retirement income system, longer lifespans, and rising health care costs.

• Working longer does not mean working forever — the goal should be to move the average retirement age from 63 to 66.

• Working longer improves retirement security by: 1) boosting monthly Social Security benefits; 2) allowing workers to build up larger 401(k) balances; and 3) reducing the period over which households must rely on their retirement assets.

Will We Be Able to Work Longer?

• Most people will be healthy enough to work until at least 66.

Will We Want to Work Longer?

• Reasons for Hope: For men, the century-long decline in their labor force participation has halted and even begun to reverse. For women, labor force patterns have been converging toward those of men.

• Reasons for Caution: The ability to claim Social Security benefits at age 62 is a powerful inducement to retire. Also greater job turnover makes employment more difficult for workers in their fifties.

Will Employers Want to Employ Us?

• Reasons for Hope: Employers value older workers' productivity and reliability. And some industries could experience labor shortages as the population ages.

• Reasons for Caution: Employers are concerned about older workers' wage and health care costs and question their ability and desire to keep their skills current. Also, many employers can tap a global labor market to replace older workers.

How Can We Encourage Longer Work Lives?

• Workers: Make a plan to keep working and stick to it.

• Employers: Redesign production and personnel systems to fit older workers.

• Federal government: Raise Social Security's Earliest Eligibility Age.

• State government: Develop job skills and job matching programs.

Also, click here for a list of myths regarding retirement that Munnell and Sass discuss, and click here to order a copy.

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New paper: “The Social Security Earnings Test: The Tax That Wasn’t”

In the interests of self-promotion, I have a new paper in the AEI Tax Policy Outlook series that focuses on the Social Security earnings test. Here's the short story:

Most seniors view the Social Security earnings test as a "tax" that reduces their Social Security benefits by fifty cents for each dollar they earn above a modest limit. In fact, the earnings test is not a tax at all: at a person's full retirement age, Social Security increases benefits to account for any lost to the earnings test in earlier years. Over the typical retiree's lifetime, total benefits are almost exactly the same. Most retirees are unaware of this because the Social Security Administration (SSA) and financial advisers fail to inform them of how the earnings test works. Retirees need better information--and policymakers should consider whether the earnings test makes sense at all.

The basic story is that the earnings test has all the bad parts of a tax – distortion choices, limiting earnings, pushing people out of the workforce – without the good part, raising any revenue. People think of the earnings test as a tax because they're not told that at the full retirement age SSA adjusts their benefits to account for any months of benefits lost to the earnings test. At the least, we need to better inform the public; we should also think about whether the earnings test really makes sense going forward, given how hard it is to educate people about it.

The full text is available here.

UPDATE: For those interested in how the repeal of the earnings test for individuals over the full retirement age has played out, I should have also cited this paper by Joyce Manchester (CBO) and Jae Song (SSA).

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A bad story (that I happen to agree with)

Today's Washington Post has a story entitled "Many Retirees Face Prospect of Outliving Savings, Study Says." Here's a quote:

The study, set to be released tomorrow, finds that Americans will have to drastically reduce their standard of living before retirement to live comfortably, or even avoid destitution, later in life. Middle-income Americans entering retirement now will have to reduce their standard of living by an average of 24 percent to minimize their chances of outliving their financial assets, the study found. Workers seven years from retirement will have to cut their spending by even more -- 37 percent.

And here's a quote from University of Maryland economist Peter Morici:

"Most people, if they look at their life expectancy and they think they will live to 90, they are nuts to retire at 60. They're going to be living in poverty at 80," said Peter Morici, an economist at the University of Maryland. "I think it's a wake-up call to baby boomers to get serious about getting their houses in order."

Now, with rising life expectancies and fewer defined benefit pensions, it is more important to think about making your money last. A 65 year old may have an average life expectancy of around 83, but there's a non-trivial chance of living to 90, 95 or beyond. You need to play for those years if you don't want to end up running short.

So what's the problem with the article? The study, undertaken by Ernest & Young, was commissioned by Americans for a Secure Retirement, a group that essentially lobbies on behalf of the insurance industry to get government subsidies for annuities. Now, I think more people should annuitize and subsidies might be a good idea, but there's very little hint in the article that the study might be self-serving. There are plenty of good academic studies, including some that conclude that most American retirees are doing just fine. (For example, this paper which concludes that "Fewer than 20 percent of households have less wealth than their optimal targets, and the wealth deficit of those who are undersaving is generally small.") I'm not sure we need to rely on studies funded by groups with a clear financial incentive.

Second, while it's nice to have a quote from an outside expert, Peter Morici is a trade economist – and I'm sure a fine one – not an expert in retirement issues. There are a lot of readily available experts on broad retirement security – say, Alicia Munnell at Boston College or Olivia Mitchell at the Pension Research Council – and a story would benefit from talking to them.

So again, the story's conclusions are good, but I'm not so keen on how they got there.

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New paper: Encouraging 401(k) holders to purchase annuities

Here's an interesting new paper from the Retirement Security Project by Bill Gale and Mark Iwry of the Brookings Institution, David John, of The Heritage Foundation and Lina Walker, of the RSP. Here's the summary:

This paper proposes a policy that would increase the role of lifetime income products in future retirees' overall retirement planning. Over the next few decades, a substantial number of workers will retire with larger balances in their retirement accounts and have fewer sources of longevity protection than retirees today. They, therefore, must manage these resources to ensure they last throughout their retirement. Lifetime income products would be beneficial for many because payments are made for life and they mitigate the risk of running out of resources late in life. Despite the benefits of lifetime income, current retirees do not use lifetime income products very much and future retirees are unlikely to do so under current arrangements. The reasons may be that retirees already feel they have sufficient guarantees—for example, from social security benefits—against the risk of outliving their resources. However, evidence suggests also that the market for lifetime income products functions poorly and that people do not understand and are biased against the products.

Our strategy addresses market function by making it easier for a substantial number of retirees to purchase lifetime income plans; the increased volume of sales would reduce prices and make them a better value for the average consumer. Our strategy addresses the role of ignorance and bias by giving retirees an opportunity to "test drive" a lifetime income product, which would help overcome existing biases, reframe their view of lifetime income products and improve their ability to evaluate their retirement distribution option.

Specifically, we propose that a substantial portion of assets in 401(k) and other similar plans be automatically directed (defaulted) into a two-year trial income product when retirees take distributions from their plan, unless they affirmatively choose not to participate. Retirees would receive twenty-four consecutive monthly payments from the automatic trial income plan. At the end of the trial period, retirees may elect an alternative distribution option or, if they do nothing, be defaulted into a permanent income distribution plan. Employers and plan sponsors would be encouraged to offer the trial income plan and would have discretion over some of its structure and implementation. By making the proposal voluntary, we allow opting out by anyone who is not interested in purchasing guaranteed lifetime income. Several important questions would have to be resolved before this strategy could be implemented. The aim of this paper is to map out the first of several steps toward increasing the use of income products in 401(k)-type plans, with the ultimate goal of enabling improved retirement outcomes for workers.

Some quick comments: First, I agree with the overall goal of the paper, since annuities provide valuable protection against outliving your assets but most Americans typically don't purchase them. At the same time, I wonder how pressing a problem under-annuitization is for the typical retiree. Low-income retirees subsist largely on Social Security, and so are almost entirely annuitized, while higher income retirees are, well, higher income and presumably can self-insure a bit better. This isn't to say that they wouldn't benefit from greater access to annuities, particularly as we shift from a DB to a DC pension world, but I'll be interested in finding out more about this.

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Met Life Social Security Claiming Age Calculator

Met Life has released an online calculator to help people determine the best age at which to claim Social Security benefits. This is obviously a step in the right direction, given how many people choose to claim at 62, the earliest age at which retirement benefits available. As best I can tell, the underlying approach is taken from SSA's own retirement calculators, though Met Life tweaks it with gender specific life expectancies and a generally snazzier interface (including Snoopy).

In short, the user inputs their age, earnings and gender, and the calculator estimates their benefits and life expectancies at different ages. Users compare claiming benefits at age 62 with claiming at some higher wage (say, the normal retirement age or age 70). The calculator then calculates the break-even age -- the age at which total benefits received are equal between the two claiming ages -- and the probability of the user surviving to the break-even age.

That said, and as much as I'm reluctant to criticize something which attempts to move in the right direction, there are a couple problems with the Met Life calculator.

First, if you're going to do a break-even analysis, total benefits should be calculated as a present value, meaning that the interest value of benefits is included, rather than simply summing benefits received in multiple years. Granted, SSA also simply adds up benefits, but this is wrong; no economist or actuary would do it this way.

Second, the break-even age approach isn't really the best way to choose a retirement age. Choosing your retirement age isn't a game in which you try to maximize lifetime benefits. Rather, you should retire at an age that provides you with an adequate income. Imagine, for instance, that you could maximize your lifetime Social Security benefits by claiming at age 62, but that your benefit at 62 would be below the poverty line. Would it make sense to claim then, or delay a few years to receive a higher benefit? Common sense says to delay, if you are able, but the considerations of benefit adequacy aren't accounted for in break-even exercises.

Third, the calculator doesn't take into account the annuity value of Social Security benefits. Retirement benefits are paid as an annuity, meaning that they last as long as you live. Annuities are very valuable compared to lump sums since they insure against the chance of outliving your assets. (So much so that even groups with below-average life expectancies, like black males, benefit from the Social Security annuity. See here.) By delaying claiming benefits, you're essentially "buying" more of the Social Security annuity. The insurance value of an annuity is hard to represent in an online tool, but it's worth bearing in mind research showing that a retiree would need a lump sum of around $150,000 to provide the same lifetime income security as an actuarially fair annuity with a premium of $100,000.

Fourth, the calculator doesn't tell the full story on the Social Security earnings test. It does note that early retirees with earnings above $13,560 will have their benefits reduced on a $1-for-$2 basis. What it doesn't tell is that at the full retirement age, Social Security not only stops reducing your benefits, but actually increases them to make up for benefits lost to the earnings test in earlier years. Over the course of a full retirement, total benefits are around the same. So the earnings test shouldn't discourage people from working while collecting benefits.

Overall, the Met Life calculator is a welcome addition to financial planning tools, particularly since it's designed to be easy to use. However, with improvements it could be significantly better.

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How accurate is the Social Security Statement?

I have an article in today's Christian Science Monitor about the benefit projections in workers' annual Social Security statement. The short story is that the statement tends to underestimate future benefits by about 1.1% (the rate of real wage growth ) for each year between the time you receive the statement and the time you'll retire. So if the statement projects you'll receive around $1,000 per month and you're currently 45 years old, the best guess of your true scheduled benefits would be around $1,245.

One way to think about it is that the statement's projections would be accurate if we switched today from wage indexing to price indexing of initial benefits.

First, here's the article. Later I'll post with more technical details and upload the data I used in simulating the statement's projections.

Good news on Social Security?

An inflation gap means you may get more than you think – even if benefits are cut. It's a 'good' glitch, but it needs fixing.

By Andrew G. Biggs

from the April 15, 2008 edition

Washington - Americans recently received some good news regarding Social Security. While the retirement and disability program still faces significant funding shortfalls, the annual trustees report released last month showed improved long-term finances. But there is more "good" news, this time for workers who receive an annual benefit statement from the Social Security Administration.

To help with retirement planning, the "Social Security Statement" estimates the benefits workers will be entitled to at retirement. The statement significantly underestimates promised benefits for younger workers. In fact, even if we fixed Social Security's solvency entirely by reducing future benefits, most workers would still receive higher benefits than their Social Security Statement indicates. Though the glitch means higher benefits for future retirees, it hurts Social Security's credibility with the public. Correcting the error is essential.

Social Security mails workers a statement each year about three months prior to their birthday. Based on earnings to date, the statement projects future retirement benefits. Social Security was never meant to be the only source of retirement income, so the benefit estimate helps workers plan how much to save on their own. This is important, since the Social Security benefit formula is so complex that many people simply couldn't calculate benefits themselves.

The Social Security statement is actually quite good at determining future retirement benefits. Using the statement's methods, I was able to project the benefits of selected current retirees based on their earnings through age 45 with an average error of less than 2 percent. While more sophisticated methods could be used to close even that gap, this is not where the statement's drawbacks lie.

The difficulty comes in translating these future benefits into terms that are understandable. The statement claims that estimated benefits are "in today's dollars," which means subtracting inflation to express them in today's purchasing power. For instance, a typical new retiree 20 years from now may receive an annual benefit of $33,000. That sounds like a lot, but if inflation runs at 3 percent per year, the real purchasing power of that benefit is only around $18,000. Expressing future benefits in today's dollars helps workers know how much their future benefits will actually buy years down the road.

But here's the problem: Despite what the statement says, its benefit estimates are not "in today's dollars." Benefits are expressed in what are called "wage-indexed dollars." Wage-indexing accounts not just for the growth of prices but also for the growth of average wages. Wages grow around 1 percent faster per year than prices, so adjusting for them reduces the statement's estimated benefit by around 1 percent for each year between now and when the worker would retire. While not a big deal for those about to retire, for younger workers – who need this information to plan their other savings – the annual errors compound. For instance, the $33,000 benefit for a typical retiree in 20 years would be wage-indexed back to only $15,000, 17 percent less than the true inflation-adjusted value.

Some might argue that it's OK for the statement to underestimate future benefits, since reform will likely reduce benefits anyway and low-balling estimated benefits might scare Americans into saving more for retirement. Maybe so. Social Security reform is a daunting task and, whether politicians will admit it or not, younger workers probably won't receive everything they have been promised. Given the statement's errors, benefits under reform could at least exceed workers' expectations.

But the statement's underestimate of future benefits is so large that most workers would come out ahead even if we fixed Social Security entirely by reducing benefits. An individual who relied on this estimate would tend to over-save, making it harder to meet current expenses such as a mortgage or education.

Higher retirement benefits hidden in the numbers is a nice surprise, but the Social Security Administration should nevertheless correct the statement's benefit calculations.

Right or wrong, Social Security already has credibility problems. For Americans to accept the sacrifices involved with reform, they need confidence that official numbers coming from the agency are accurate.

• Andrew G. Biggs, a former principal deputy commissioner at the Social Security Administration, is a resident scholar at the American Enterprise Institute in Washington.

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How dependent are retirees on Social Security?

Warning: This post is long.

In discussions of the role Social Security plays in providing retirement income, one will often hear some variant of the following: Social Security

“is the major source of income (providing 50% or more of total income) for 66% of the beneficiaries. It contributes 90% or more of income for one-third of the beneficiaries and is the only source of income for 22% of them.”

These are official SSA statistics. Perceptions of Americans' dependence on the Social Security program help influence views regarding the shape of possible reforms. For that reason, as well as others, it is important to have a clear idea what these statistics mean.

The interpretation of these statistics, and their sensitivity to alternate formulations, are the subjects of an important series of papers in the Social Security Bulletin by Lynn Fisher, an economist at the Social Security Administration.

Fisher shows that commonly used figures regarding seniors' dependency on Social Security rely on a series of measurement decisions, any of which could reasonably be decided in other ways. Using plausible alternate methodologies, the percentage of seniors entirely dependent on Social Security – around one-in-five, by the standard measure – could be as low as 3.5 percent.

Fisher examines four potential sources of bias in how we measure dependence on Social Security benefits:

• Unit of measurement: do we count "elderly units" or individuals?
• Benefit reporting: do we use self-reported benefit levels or rely on government data?
• Asset income: do we include only regular income payments, irregular payments such as IRA or 401(k) withdrawals, or even assets that can be liquidated to produce income?
• Non-cash benefits: Should we include non-cash benefits such as energy, food or housing assistance?

Any number of reasonable answers can be made to these questions. What is important is that people understand these choices when they ask "How dependent are retirees on Social Security?"

Unit of measurement: The SSA measures of dependence are expressed in terms of “aged units.” Aged units treat each marital unit (married couple or nonmarried individual) as one unit. A non-married individual has only his or her own income and demographic attributes.

How can this affect measured levels of dependence on Social Security? In two ways. First, single individuals tend to have lower incomes, and therefore be more dependent on Social Security, than do married couples. However, since both a single individual and a married couple count as one unit, this can overstate the percentage of individuals who are dependent on Social Security. For instance, if a single person was entirely dependent on Social Security while a married couple was not, on a ‘aged unit’ basis 50% would be wholly dependent on Social Security while on an individual basis only 33% would be.

Second, a non-married individual may share a household with other individuals, but the aged unit does not include the resources of these non-married cohabitants. (Thus, the ‘aged unit’ measure is not as broad as a ‘household’ measure.) If non-married cohabitants share incomes and costs, this can cause overstatement of unmarried individuals’ dependence on Social Security.

Using the individual as the unit of reporting and assuming that family income is shared, the percentage of seniors wholly dependent on Social Security drops from around one-fifth to around 13%.

Asset income: As the pension world shifts from traditional defined benefit plans to defined contribution plans, in which individuals would draw down their account balances to fund retirement expenses, one would expect that the share of seniors reporting asset income would increase. The measured percentage has actually decreased from 1991-2000, but this may be due to the limitations of the CPS survey data SSA uses in its calculations of Social Security dependency. Fisher turns to another survey – the Federal Reserve’s Survey of Consumer Finances, which emphasizes measures of asset holdings, to supplement existing data.

Fisher found that SCF data supported the view that receipt of asset income had remained roughly constant from 1991-2000. From this improved measure of asset holdings, she was able to infer receipt of asset income. This previously unreported asset income was relatively small, but concentrated among lower earners. While it does not greatly affect the average level of dependence on Social Security, it would lower the percentage wholly reliant on the program, from around 20% to around 10%.

Survey data: Fisher examines two issues dealing with data. First, how the Census Bureau’s Current Population Survey (CPS), which SSA uses to calculate its dependency statistics, compares to the Survey of Income and Program Participation (SIPP), another Census survey that can be used to calculate the income of the aged. Second, Fisher examines how results differ when survey data regarding receipt of Social Security benefits is replaced with administrative data.

Survey choice: The SSA dependency data are derived from the Census Bureau’s Current Population Survey (CPS). One advantage of the CPS is that a new survey is conducted annually, allowing for more up-to-date data. Another Census survey, the Survey of Income and Program Participation (SIPP), is conducted less frequently but asks more detailed questions. Survey subjects are asked about 70 sources of income, versus 35 in the CPS, and the survey takers check back with subjects four times per year, versus only once in the CPS. The SIPP also asks detailed questions about financial assets, while the CPS does not.

Administrative data: SSA’s figures regarding dependency on Social Security use self-reported levels of Social Security benefits contained in the CPS survey. However, researchers have matched CPS survey results to SSA administrative files to see how accurately individuals can recount their Social Security benefits. For a number of reasons, individuals misreport their Social Security benefits – confusing them with SSI or other benefits; reporting them net of Medicare Part B premiums, etc.

Taken together, using both the SIPP survey data and matching survey findings to administrative data and reduce reported dependence on Social Security benefits. Using 1996 survey data, Fisher found that the percentage 100% dependent on Social Security using the CPS with self-reported benefits was 17.9%; add administrative data to the CPS and dependence fell to 17.3%; use the SIPP survey with self-reported benefits and 100% dependence fell to 8.5%, and using SIPP matched to administrative records dependence fell to 8.4%.

Effects in combination: Fisher examines a number of different methodological questions separately, the sees how they affect measured dependence on Social Security when used in combination. Table 1 provides details: Combining all the issues discussed above and applied to 1996 data, the percentage of individuals over 65 depending on Social Security for 100% of their income declined from 17.9% to 4.8%. The percentage depending on Social Security for 90% of their income declined from 30.4% to 13.7%.

In an appendix, Fisher explores the effects of including non-cash benefits, such as food stamps or housing or energy assistance. These are not cash, but are nevertheless valuable resources. If non-cash benefits are included, the percentage wholly reliant on Social Security declines to 3.5%.

As we consider potential reforms to the Social Security program, it is important to have good information regarding the retirement incomes of current seniors, and for policymakers to understand what existing information really means. Put another way, if someone asks the qualitative question, "What percentage of seniors are totally dependent on Social Security?", the answer can range from as high as 20% to under 4%. The two different answers may well lead to two different policy conclusions.

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