The Coronavirus (or COVID-19) is shuttering multitudes of
Nevertheless, the sudden decline in 2020 in average
Wage-Indexing in the Social Security Benefit Formula
In simplest terms, the
To compute an individual's
After past earnings are indexed for wage growth to age 60, the
While the AIME indexes pre-retirement earnings through age 60, the bend point formula is wage-indexed and frozen in place as of age 62. The benefit calculated using the PIA formula is then increased to the age of retirement according to the annual Social Security Cost of Living Adjustments (COLAs), which are based upon changes in the CPI-W. Benefits are reduced for early retirement, and increased for claiming after the Normal Retirement Age (up to age 70).
How Much Will the Average Wage Index Fall?
Both the AIME and PIA formulas are indexed to the
For 2018, the most recent year for which data are available, the AWI was
How big a decline there will be in the Average Wage Index is uncertain, but it could be substantial due to the manner in which changes in the AWI are calculated. The number of W-2s issued in 2020 is not likely to decline very much, because employment was high from January through March of 2020, but earnings are dropping sharply as layoffs and furloughs take effect. This implies that that the aggregate payroll total for 2020 will be substantially below what the 2019
Trustees Report projected. Accordingly, the Average Wage Index for 2020 is likely to fall far short of the level projected in the 2019 Trustees Report.
At the time of this writing, governmental agencies such as the
Modeling the Effect of Average Wage Declines on Social Security Benefits
To examine the possible impact of this phenomenon, I assume for illustrative purposes that GDP shrinks from the first quarter of 2020 to the second by the 24 percent projected by Goldman Sachs. I also assume that GDP remains level through the third quarter of 2020, and then it recovers by 15 percent in the fourth quarter. This produces average GDP in 2020 about 15 percent below levels in the first quarter of the year. I further posit that average labor earnings follow that same pattern. I further assume that economic recovery continues in 2021, such that GDP and wages are 10 percent below the 2019 Trustees Report forecasts, five percent below forecasts in 2022, and return to 2019 Trustees Report projected levels by 2023. Clearly these assumptions embody extreme uncertainty, but they do serve to illustrate how a decline in average economy-wide wages can affect the
To illustrate the potential impact of such a sudden contraction in payrolls, I utilize the stylized earnings patterns generated by the
I illustrate using the stylized workers born in 1960 who entered the workforce in 1982, and are expected to work continuously through age 66 and claim
A decline in the Average Wage Index versus previously forecasted levels affects the benefit formula for Americans born in 1960 in two ways. First, a lower AWI for 2020 reduces the value of the 1960 cohort's Average Indexed Monthly earnings. In percentage terms, a shortfall in the AWI versus previously forecast levels does not reduce AIME's on a one-for-one basis, because earnings after age 60 are included in the AIME calculation in nominal terms. However, the impact remains significant. Other things equal, a lower AIME will result in lower
Second, lower growth of the Average Wage Index is also carried through to the
For each scaled earner type, I next report the dollar value of annual benefits under the 2019 Trustees Report assumptions, as well as under my own assumptions regarding declines in the Average Wage Index. I also report percentage changes in annual benefits and changes in lifetime benefits. I then discount lifetime benefits assuming a zero percent real interest rate, which is approximately the yields currently available on
Compared to the baseline simulations using 2019 Trustees Report assumptions, the assumed lower economy-wide average wages from 2020 through 2020 reduce the Average Indexed Monthly Earnings of scaled earners from very low to high earnings by 13.1 percent, and for maximum wage workers by 12.5% (Table 1)./4 However, the entire percentage reduction of the AIME is not carried through to benefits. Nevertheless, annual retirement benefits will be lower by between 13.6 percent and 14.3 percent, depending upon the earnings level of the scaled earner. For a medium wage worker, annual retirement benefits will fall by
Next I calculate changes in lifetime benefits assuming differential mortality by lifetime earnings levels, such that a very low earner is assumed to survive for 13 years past retirement at age 67, a medium wage worker 18 years, and a maximum wage worker 23 years (Biggs, 2019). For a medium wage earner, lifetime benefits will fall by
Policy Options and Discussion
Such a sharp discontinuity in benefits between two succeeding cohorts of
One option would be to do nothing. Gelber et al. (2016) used
Should policymakers wish to address the forecasted benefit cuts for
A second option would be to temporarily alter the
Yet using a 2020 AWI calculated only on first quarter earnings data would still leave open benefit reductions for members of the 1961 birth cohort who turn age 60 in 2021. It is likely that the AWI for 2021 will still be substantially below the levels predicted for it in the 2019 Social Security Trustees Report. Nevertheless, a temporary fix for the 1960 cohort would give policymakers an additional year during which they could consider the necessity and form of other changes. Over time, wages will presumably return to baseline levels and
A third option would be to move away from wage indexing of the benefit formula, as part of a larger reform to address
In addition, as we have shown, wage-indexing of career-average earnings makes that career-average susceptible to a large change in earnings in the single year to which past earnings are wage-indexed. As we have shown, when the Average Wage Index in year falls below projected levels by a given amount, earnings in all past years are also reduced by a similar percentage. By contrast, if earnings in the
For instance, the
Nevertheless, even if wage-indexing of pre-retirement earnings were to be replaced with price-indexing of those earnings, the
Policymakers can enact ad hoc changes to the
Biggs, Andrew G. (2019) "How Much Should the Poor Save for Retirement? Data and Simulations on Retirement Income Adequacy among Low-Earning Households." Wharton Pension Research Council Working Paper WP2019-15.
Clingman, M. and Burkhalter, K. (2015) 'Scaled Factors For Hypothetical Earnings Examples Under The 2015 Trustees Report Assumptions.' Social Security Administration Actuarial Note 2015.3.
Clingman, M., and
Gustman, A. L., Steinmeier, T. L., & Tabatabai, N. (2012) "How Did the Recession of 2007-2009 Affect the Wealth and Retirement of the Near Retirement Age Population in the Health and Retirement Study?" Social Security Bulletin. 72. 47-66. 10.2139/ssrn.1945329.
Kennedy, Simon. 2020. "30% GDP drop: Morgan Stanley joins Goldman Sachs in Upping Estimates of Coronavirus Economic Pain." Fortune.
2/ There is a roughly two-year lag in applying the Average Wage Index to the
3/ Figures are taken from the
4/ The maximum wage worker's earnings follow a different pattern from the very low through high-wage earner, which accounts for the difference in how AIMEs are affected.
5/ Based upon the