House Ways and Means Subcommittee on Social Security Hearing
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Mr. Chairman and members of the
I am not representing any specific individuals or organizations regarding the matters I address in the following discussion. I have worked more than 40 years on both practical and policy issues related to retirement security. I began my career working for the
Summary
There are many technical elements to determining whether workers are adequately preparing to meet their retirement income needs. How various analysts deal with these can play a significant role in their conclusions about the retirement income security prospects of workers and the current welfare of retirees.
. Retirement income replacement models are used widely in retirement plan design and communications for broad participant populations because generalized rule-of-thumb directions are the best vehicles available to plan sponsors and administrators.
. More microscopic lifecycle and similar models are beyond most workers' reach but can help policymakers and analysts understand whether the cruder measures are effectively helping workers achieve reasonable retirement savings goals.
.
. Conventional measures of
. Some analysts even apply wage indexing of all preretirement income in defining retirement income targets suggesting that workers should increase saving beyond what is needed to maintain preretirement living standards in retirement with the implication that normal working-period living standards would be reduced in order to finance much higher living standards after retirement. This problem may be accentuated over time (see Table 2 with accompanying discussion).
. The
. Comparison of the reported income provided by pension/annuity plans and IRAs to
. It is impossible to clearly understand who is doing well and who is doing poorly under the current arrangements if official government reports on the income status of retirees ignore hundreds of billions of dollars of their income.
Retirement Income Adequacy
Over the years, retirement researchers, policy analysts and retirement plan designers have come to think of an adequate retirement income as the level of income needed to allow retirees to maintain their preretirement standard of living. For a small segment of the elderly population, even this level of income is considered to be inadequate. Some workers live on an income for extended periods considered to be less than necessary to sustain even a basic living. For these people, there are assistance programs that help with needed food purchases, housing, health care and the like. For such individuals, it is likely that assistance outside of the benefits provided by contributory pensions and retirement savings is necessary to support them in retirement. For the remainder, an adequate retirement income is generally considered to be one that allows them to maintain their career living standards.
Economists often focus on whether workers are going to accumulate adequate resources to meet their retirement needs in the context of a life cycle model. The adaptations of these models are highly variable but can allow for borrowing early in life for education, as households are established, children are born, and so forth. As the career progresses, debts are paid off and savings for retirement accumulated. Then in retirement, the combination of
Retirement planners and consultants who design retirement plans for individuals and employers generally rely on an alternative model where preretirement spendable income is determined by subtracting work-period taxes and work-related expenses from gross earnings. To maintain the preretirement standard of living, a retiree's spendable income level post career must equal the level achieved before retirement. This spendable income is divided by gross earnings to calculate a target earnings "replacement rate" that will fulfill the goal of leveling consumption levels over the pre- and post-retirement periods.
The Retirement Security Projection Model developed by
Each of the approaches to considering whether workers are preparing adequately for retirement or retirees have adequate income has strengths and weaknesses. The Retirement Security Projection Model and the lifecycle model recognize that every household faces a unique set of circumstances as it progresses through its employment and retirement periods. The amount that each household should save, what its consumption should be in the preretirement period and during retirement are unique to that household. The replacement rate models are typically applied on a generalized basis and are often estimated on an individual worker basis instead of at the household level. For example, it is common for the consulting firms that help employers sponsoring plans with plan designs and assessments to estimate target earnings replacement rates for workers at various specified earnings levels. In developing these models, the analysts project earnings and retirement benefit accumulations to retirement age, estimate taxes unique to the working period and other work-related expenses to estimate spendable income which is then used to estimate the replacement of gross earnings required to maintain living standards in retirement. The adequacy of workers' retirement preparation is assessed by determining whether the combination of
There are a number of methodological problems with each type of model that are relatively technical and which are beyond the scope of the current discussion. n1 Beyond these, the problems with the models that focus on individual household units are that the assessments of their retirement income preparations result in a one-size-fits-one answer to whether workers are adequately preparing for retirement whereas the replacement rate assessments result in a one- size-fits-many answer. The Retirement Security Projection Model and lifecycle models are superior to the replacement rate model in assessing how individual households are doing but are of little practical use to a large sponsor of a retirement plan with many participants where the sponsor has limited information beyond the participants' own earnings levels, age, expected retirement age and other salient information. The structuring of generalized retirement plans fitting large populations or the generalized educational support that goes along with them has to utilize generalized rules-of-thumb to help workers assess whether they are accumulating the needed resources to meet their retirement needs. This is true for
Career Income and Replacement Rate Measurement Issues
Because
The "more common" measures of earnings replacement rates that the
Pang and Schieber have compared the method for computing the replacement rates presented by the trustees with some of the more common measures of replacement rates used by retirement plan designers, counselors and many researchers using a sample of
In order to compare alternative measures of earnings replacement provided by
Pang and Schieber calculated replacement rates two ways for comparative purposes in the analysis. In the first, they used actual benefits at retirement compared to a range of alternative measures of preretirement earnings. In the second, they recalculated benefits that would have been paid at normal retirement age assuming the long-career workers had not taken benefits until then. These latter calculations might have resulted in slightly lower benefits in some cases than retirees would have received had they deferred retirement until then but it is likely the differences are minimal since all the retirees considered had at least 35 years of covered earnings when they actually retired. Because the trustees' hypothetical workers' replacement rates are shown at age 65 and normal retirement age, for comparison purposes, only the replacement rate calculations for retirements at normal retirement age are considered in the following discussion.
Table 1 shows four sets of replacement rates each based on a different definition of pre-retirement earnings. The rates are shown for each of the AIME decile groupings described earlier. The first column of replacement rates was developed using the method used in deriving the rates shown by the trustees in their reports, namely, the rates are calculated using the average of the high-35 years of wage-indexed earnings based on the average national wage index in which the worker turned age 64. The second column of replacement rates is based on the benefit paid at retirement divided by the average of the nominal wages paid the workers in their last five years of positive earnings. The third column of rates is based on benefits divided by the average of fifth through ninth year's positive earnings prior to retirement indexed for price inflation. While this measure does not literally correspond with the measures of final earnings that retirement plan sponsors and their advisors typically consider in estimating replacement rates, I believe this is a better implicit proxy for their final-salary measures of replacement rates when applied to a general population like that of
Table 1: Median Re-estimated Social Security Replacement Rates for Beneficiaries at the End of 2004 Who Had Long Careers Assuming They Had Been Paid Normal-Retirement-Age Benefits
Measures of preretirement income used to estimate replacement rates
AIME deciles SS Trustees Age-64 based AIME Final 5-year average Average of years 5-9 pre-retirement CPI-W indexed Hi-35 CPI-W indexed average
1 85.8 115.5 105.3 103.7
2 71.0 101.4 93.2 86.0
3 57.6 82.9 71.2 69.8
4 50.6 70.1 59.7 60.6
5 46.0 64.4 54.2 54.9
6 42.9 60.9 50.7 50.9
7 40.6 58.6 47.9 48.1
8 38.3 52.9 42.4 45.2
9 34.8 43.3 34.8 41.1
10 31.7 31.3 29.4 36.6
Source: Gaobo Pang and
Considering the measures derived using the Social Security Trustees' method shown in Table 1, the median of the distribution of replacement rates would be the average of the rates shown for the fifth and sixth deciles or 44.5--(46.0 + 42.9) = 2 = 44.45.--almost precisely equal to the rate shown for the medium worker in the 2013 Trustees Report. The median for the distribution of replacement rates using the average of the final-five years of positive earnings is 62.7 percent, nearly 20 percentage points higher than the trustees' measure. The medians for the average of real earnings in years five-to-nine of positive earnings prior to retirement is 52.5 and that for the average of real career earnings is 52.9 percent. The latter two medians are about 15 to 20 percent greater than the average posited using the trustees' estimates.
According to the
Some research and policy analysts take the Social Security Trustees' approach to estimating preretirement earnings replacement rates and even apply it to the supplemental savings targets that workers should be aiming to fill. For example,
Consider a worker at the beginning of her career who anticipated earnings that will average
The practical situation that workers face during their working lives is that when they go to the grocery store, buy clothes, purchase a house or get their car repaired they have to spend real dollars not wage-indexed dollars. The real dollars they earn while working define the standard of living they can achieve prior to retiring unless they are getting welfare transfers which most career workers do not. Why their historically wage-indexed earnings levels should define their consumption targets in retirement is a question not explained by either the Social Security Trustees or the authors of models like the National Retirement Risk Index.
The situation of the hypothetical worker in the example would likely be exacerbated across time if workers are expected to maintain reasonable steady replacement rates relative to wage-indexed average earnings. Using the data files that Pang and I used in our analysis cited earlier, we compared the rates of growth of wage-indexed and real wages over the high-35 year career average earnings for
Clearly, the wage-indexed career average earnings were growing much more rapidly than workers' real earnings capacity across much of the earnings spectrum. In the top two deciles the opposite was true, but it was here, especially the top decile, where real wage growth was dragging up the national average wage index benefitting workers further down the distribution who were benefitting from wage growth (for which they were not accountable) used to determine their
Table 2: Percent Increase in the Average of High-35 Years of Earnings Wage Indexed with the National Average Wage Index at Age 60 and CPI-W Indexed to Age 64 for the 1931 to the 1938 Birth Cohorts
AIME Wage-indexed Price-indexed
deciles AIME AIME
1 14.4% 3.9%
2 27.4 16.1
3 26.8 15.9
4 34.3 23.0
5 33.1 22.0
6 32.3 21.4
7 30.4 20.0
8 31.4 21.1
9 4.0 20.5
10 5.2 31.5
Source: Derived by the author as described in the text.
Retirement Savings and Retirement Income
Today there is a somewhat pervasive perception that we face a "retirement crisis" in
According to SSA, among families with a person 65 years of age or older in 2010, 39.7 percent of households received regular income or annuities from a retirement plan other than
In order to assess the reporting of pension and other retirement income on the CPS, Miller and Schieber compared the survey results with data from a representative sample of federal income-tax filers for whom the
According to the tax files, in 2008 an estimated 23.4 million filing units reported
The
The CPS captures very little of the IRA income being reported on tax filings: 3.5 percent in 2000 and roughly 6 percent in 2008. The CPS has done a better job of capturing reported pension and annuity income but still comes up short by around half, and the underreporting appears to have worsened considerably in recent years. In aggregate, the CPS for 2008 captured only 40 percent of the pension/annuity or IRA income received by family units that were receiving
Recognizing that retirees at the bottom of the income distribution were not included, n15 Miller and Schieber used the 2008 tax files to evaluate the distribution of income derived from pensions and retirement savings. They split the tax-filing units into deciles (ten equal groups) based on total income. Both the prevalence and level of benefits were quite low in the bottom decile. By the second decile, 60 percent of the filing units reported receiving pension income or income from an IRA or similar individual retirement savings plan. For those receiving the benefits, at the median their pension/IRA income equaled 50 percent of the median
Miller and Schieber also found that among tax filers reporting
Table 3: Reported Pension/Annuity Income and Distributions from IRAs on Federal Income Tax Forms and the CPS for Social Security Beneficiaries for Selected Years
IRA distributions Pensions/annuities Total benefits (Dollar amounts in millions) 1988
1988 CPS
CPS/
2000
2000 CPS
CPS/
2008
2008 CPS
CPS/
Source:
A major reason the CPS does such a poor job reporting IRA and other individual retirement account distributions is because the
There are legitimate reasons to believe that some workers are not adequately preparing for retirement and that some retirees have inadequate resources to meet their economic needs, and the shift from defined benefit to defined contribution plans is widely considered to have made retirement more financially precarious for workers and retirees. It is impossible, however, to clearly sort out who is doing well and who is doing poorly under the current arrangements if official government reports on the income status of retirees ignore hundreds of billions of dollars of their income.
n1 Many of the methodological problems with the models are explored in Gaobo Pang and
n2 The 2013 Annual Report of the
n3 Ibid., p. 143.
n4 For example, see
n5 Gaobo Pang and
n6
n7 Pang and Schieber, "Understanding Social Security's Income Replacement Measurements."
n8
n9 Pang and Schieber also analyzed beneficiaries with shorter covered careers in their analysis not included in the current discussion because they do not align with the trustees' hypothetical workers' career profiles.</p>
n10
n11
n12
n13 Trenkamp, Brad, Income of the Population 55 or Older, 2010,
n14
n15 The number of income-tax filers reporting
Read this original document at: http://waysandmeans.house.gov/UploadedFiles/7_29_14_SS_Testimony_Sylvester_Schieber.pdf
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