Replacement Rates: Another Reason Not to Expand Social Security

A penny saved is a penny earned. Benjamin Franklin's quote is apropos for the importance of saving money, but if you are saving money for retirement, you hope that you can get a better rate of return than that. Considering the number of people on Social Security, this is all the more relevant. For the millions on Social Security, many rely on it as a source of retirement. If Social Security does not provide a proper rate of return, then the livelihood of those who have retired is greatly diminished. Enter the replacement rate.

The replacement rate is the percentage of a worker's pre-retirement income that is paid out by a pension program for retirement. The ratio is commonly used to measure how adequate pension benefits can be. Before delving into details, let's keep in mind that financial advisors generally agree that a 70 percent replacement rate is adequate in order to maintain one's pre-retirement standard of living.

The replacement rate has been somewhat of a debate in years past because the rate can end up differently depending on how it is measured (Pang and Schieber, 2014). Financial advisors typically compare retirement income to the earnings in the year prior to retirement. The problem with this method is that income in the last year can be quite variable, and does not necessarily reflect one's standard of living. The Social Security Administration (SSA) has a different method. The SSA divides retirement income by average career earnings. This sounds reasonable until you reach the part where the SSA uses wage indexing to credit an individual with pre-retirement earnings that never existed since it overstates pre-retirement earnings and understates their retirement benefits relative to those earnings. The problem with the SSA's indexing is that it does not reflect the reality of financial planning to the point where the replacement rate seems inadequate to some, especially to those who are seeking to expand Social Security because they think Social Security benefits are too modest.

There are better ways to find a replacement rate than what the SSA uses (Biggs et al., 2015). The Congressional Budget Office (CBO) recently released some long-term projections on Social Security. Among those projections are mean initial replacement rates for retired workers. The CBO actually took one of the suggestions from the bipartisan Technical Panel on Assumptions and Methods and actually used the last five years of substantial earnings (i.e., equal to at least half of the individual's career-long average) as a basis for pre-retirement income, and decided to focus on those with full-working careers (as opposed to short careers). The results of some of those demographics are in the Exhibit below.

Before proceeding, I do want to point out the difference between scheduled and payable benefits. Scheduled is the amount that the SSA appropriates in spite of any trust fund balances. Payable benefits are what one is going to receive after the trust fund is exhausted by 2033. For those who are looking to retire in 17 years or more, I would look at the payable rates since those will be more realistic for you.

One finding which is interesting is that in terms of replacement rates, Social Security does more for the poorest than it does the middle and upper classes, which makes sense given the progressive nature  of the Social Security benefits formula. However, it does mean that it's not necessarily a good deal for those who are not in the lowest quintile. Another demographic to look at is at age via the birth cohorts. These data once again that older generations get a better payout while younger generations have to shoulder a higher tax burden in order to receive a lower replacement rate.

Now that we have replacement rates that reflect financial reality more adequately than the SSA, what are the implications of these rates? First is that the notion of a "retirement crisis" in America is overblown. Considering that one only needs about 70 percent of pre-retirement income in order to maintain pre-retirement living standards, the figures are not nearly as bleak as one might think. Such figures deliver a coup to those who argue for expanding Social Security because the replacement rates do not justify such an expansion.

These findings do come with a flip side, which is that Social Security is not a complete disaster. We should still be worried that the trust fund is going to be exhausted in 2033. Even more to the point, these findings do not negate the fact that the government shouldn't take 12.4 percent of my earnings for Social Security because in spite of these replacement rates, there are still better retirement investment plans than Social Security. Investing in something as low-risk as Treasury Bonds would increase the replacement rate by about 41 percent, which says nothing about the rate of return on something such as investing in the stock market of AAA corporate bonds. Imagine if you could retire in a way that is more than merely adequate. I would be happy to see full privatization of retirement savings so that Americans can enjoy retirement to the fullest. In the interim, there are policy alternatives to reform the benefit formula (Blahous, 2015). Although it would nice to see Social Security reform that would be headed in the direction of privatization, if there is one takeaway here for me, it is that these latest data do not justify the call for more Social Security benefits or higher payroll tax rates.


2-17-2016 Addendum: It looks like the CBO had to make some revisions from its original analysis. Although these downward revisions (see below) bring the revised replacement rates below what financial advisors would recommend, Social Security still covers a good chunk of the required replacement rate. While these numbers strengthen the argument for a "retirement crisis," they also strengthen the argument for private retirement accounts.