No Easy Fix for Social Security
Thursday, 24 May 2012
Three much-discussed ways to curb Social Security payouts may be inadequate—and come at a high human cost.
Reducing benefit payouts is one way to solve Social Security’s current shortfall. Three measures to accomplish this are to raise the full retirement age, encourage people to postpone retirement, or curtail benefits. Unfortunately, none of these methods are good solutions. Raising the full retirement age is likely to have little impact; later retirement may not trim outlays either. And reducing benefits will cause pain to the people most in need of Social Security.
Full retirement age, also called “normal retirement age,” is the age at which the retirees receive unreduced benefits. An individual can retire as early as age 62. But anyone who retires between 62 and his or her full retirement age will receive a reduced benefit.
The full retirement age had been 65 for many years. Then the 1983 Social Security Amendments raised it to 66 in 2009 and to 67 in 2027, in an effort to solve the financing problems faced at the time.
The justification for further raising the full retirement age is that now people live longer and remain productive at older ages. A higher full retirement age could provide incentives for workers to retire later, which would reduce the number of Social Security beneficiaries and benefit payouts. Later retirement also means more years of contributing to the Social Security system, thus increasing the tax revenue.
But a higher full retirement age improves Social Security finances only if people respond to the incentive and retire later.
People’s decisions about whether to retire are partly influenced by their capability and productivity at older ages, which vary across occupations.
Chart 1 shows the fraction of people age 65 and above who are not in the labor force (roughly considered retired) in select occupations. Note that occupations are tracked for only five years after retirement, so people who have been retired for more than five years are not included in these numbers. The percentages shown here are indicators of the difference in retirement rates across the occupations, rather than the actual retirement rates.
The variation is obvious. For occupations such as financial managers and lawyers, most people still work at age 65. However, for some blue-collar occupations such as machine operators and farm workers, fewer people continue to work at age 65. It seems likely that people whose jobs require more physical activity and manual labor tend to retire earlier.
This suggests that raising the full retirement age may not result in later retirement. Instead, it may simply reduce benefits for older people who are no longer physically capable of doing their jobs and need to retire earlier, regardless of incentives.
A related question is whether inducing people to postpone retirement would help reduce beneficiaries’ lifetime benefits, thus reducing outlays.
As a general rule, early or late retirement gives people about the same total Social Security benefits over their lifetimes. Workers who retire early receive benefits for longer periods of time, but their monthly benefit is reduced based on the gap between the age when they first file for benefits and their full retirement age. Workers who retire later enjoy fewer years of benefits, but their monthly benefits are higher with a delayed credit for the period between their full retirement age and actual retirement age, up to the age of 70.
Chart 2 shows the lifetime total retirement benefits at different retirement ages for a hypothetical worker who was born in 1928 and earned the median earnings in each year of his working life. His full retirement age is 65. For simplification, I assume that once the individual retires, he will be completely out of the labor force so that the earnings test (which reduces benefits for people whose income is above a given threshold) does not apply here.
The chart shows that retiring at 62 brings the highest lifetime total benefits when the length of life is lower than 70. If the individual lives longer, retiring at the full retirement age of 65 provides the highest lifetime total benefits for people whose lifespan extends to 84. If the individual lives to 85 and beyond, he receives the highest lifetime benefits by retiring at 68.
Even accounting for the extra tax revenue collected from this hypothetical worker during the additional years of work, the payout net of tax is not necessarily reduced with later retirement. My calculation shows that if the individual lives beyond the age of 74, as many people now do, the total payout to this individual is higher if he retires at 65 than at 62.
This exercise shows that while it may be possible to encourage people to retire later, the net effect on the Social Security trust fund balance is hard to predict.
Another interesting observation is that this hypothetical worker actually receives a benefit below the poverty threshold if he retires at 62, as shown in Chart 3. If he retires at the normal retirement age of 65, his Social Security benefits are slightly over the poverty threshold.
The 2012 Trustees’ report projects that benefits will have to be immediately and permanently reduced by 16.2 percent in order to maintain solvency for the Social Security program for a 75-year period, if a benefit cut is the only measure taken.
If nothing is done before the trust fund is exhausted, benefits will be automatically cut by 25 percent at the point of trust fund exhaustion, currently projected to occur in 2033.
Such benefit cuts would have a significant impact on retirees who depend heavily on Social Security. Social Security was intended as a foundation for retirement, not as a sole source of retirement income. However, many retirees rely substantially on it. Currently, Social Security provides at least 50 percent of total income for 54 percent of aged beneficiary couples and 73 percent of aged unmarried beneficiaries, according to the 2012 Trustee’s Report. It constitutes 90 percent or more of income for 22 percent of aged beneficiary couples and 43 percent of aged unmarried beneficiaries.
For retirees whose primary source of income is the Social Security benefit, a benefit cut, whether as a solution or as a consequence of fund exhaustion, may move them below the poverty line. Some might have to seek welfare assistance, which shifts the problem rather than solves it.
It seems the solutions available for reducing Social Security outlays are neither effective nor painless. The government will have to take measures to keep the program solvent. Allocating money from the general fund is one option. Another possibility is to raise tax revenue by increasing either the maximum taxable earnings or the Social Security payroll tax rate.