New Working Paper on Social Security Replacement Rates

Back in July, I co-authored a Wall Street Journal article with Syl Schieber, the former chair of the Social Security Advisory Board, in which we raised questions regarding how Social Security’s actuaries calculate “replacement rates,” which measure retirees’ income as a percentage of their pre-retirement earnings. We argued that SSA’s method significantly overstates individuals’ pre-retirement earnings by indexing them to nationwide wage growth, which is even faster than inflation. Overstating their earnings causes their replacement rates to look lower, which make Social Security seem less generous and encourages the view that Americans face a “retirement crisis.” We argued that comparing Social Security benefits to retirees’ inflation-adjusted pre-retirement earnings gives a better measure of how well Social Security lets retirees maintain their pre-retirement standard of living.

These differences matter. For instance, a recent CBO report measured replacement rates both ways. Relative to wage indexed earnings, the average person born in the 1980s will receives a social security replacement rate of 48%. But relative to inflation-adjusted career earnings, Social Security provided a replacement rate of 64%, one-third higher. If you assume that the typical person requires a replacement rate of around 70% -- a common financial advisors benchmark, as well as calculated in some academic studies – these two figures paint very different pictures regarding the adequacy of Social Security benefits and retirement incomes overall.

Our op-ed coincided with the Social Security Trustees’ decision to delete the actuaries’ replacement rate calculations from their annual report. After that, it was game on: Boston College professor Alicia Munnell, whose National Retirement Risk Index uses a method similar to SSA’s actuaries, pushed back hard on our article. As did SSA’s actuaries themselves, publishing a defense of their methods back in July. More recently, the CBO and OECD issued reports that can be taken to support our point of view. I recently spoke to the Social Security Advisory Board regarding this issue, and the Board’s own Technical Panel on Assumptions and Methods – which is chaired by Munnell – took up the replacement rates question at their opening meeting.

To move the debate along, I have a new AEI working paper on replacement rates co-authored with Syl Schieber and Gaobo Pang, an economist at the pension consulting firm Towers Watson. Among the points we make:

• Until recently the Social Security Trustees calculated replacement rates relative to career average earnings indexed to wage growth; SSA’s actuaries continue to do so. This measure effectively compares the benefits paid to new retirees to the earnings of today’s workers, not to retirees’ own pre-retirement earnings. These “wage-indexed replacement rates” understate the ratio of retirees’ benefits to their own real pre-retirement earnings.
• We argue, and recent reports from the CBO and the OECD concur, that calculating replacement rates relative to inflation-adjusted average pre-retirement earnings is a better shorthand representation of the life cycle approach to retirement planning, as well as being more understandable to policymakers and individuals saving for retirement.
• The SSA actuaries’ method of calculating replacement rates for hypothetical worker examples is calibrated to produce a pre-determined result. Prior to 2002, SSA calculated replacement rates using a different method and using different hypothetical workers. But these previous hypothetical workers had very unrealistic earnings patterns, so SSA updated to more realistic stylized earners. But SSA then calibrated its methods to produce the same replacement rates figures as before: it changed its method of calculating replacement rates and increased the earnings of its stylized workers in order to reduce measured replacement rates to its previous value of around 40%. There is no reason these calculations should be given any special importance.
• A recent SSA actuarial study using administrative data concluded that wage-indexed replacement rates closely replicate those calculated relative to final earnings, a common practice for financial advisors. But the SSA OACT study excluded all spousal and widow benefits, thereby reducing measured replacement rates. Over one-third of female retired worker beneficiaries receive auxiliary benefits and, on average, auxiliary benefits increase their monthly payments by 78%. An analysis that included all beneficiaries and all benefits received by them would show higher replacement rates.

There is a lot of new information in our paper about what replacement rates mean and how they have been measured and I believe we add a great deal to the current debate.