Discussions of Social Security benefit adequacy are often framed in terms of the “replacement rate,” or the ratio of one’s retirement benefits to pre-retirement income. But the current-law method of indexing Social Security benefits—intended to provide benefit equity over time—features a number of poorly understood quirks and unintended results. First, because it causes cost rates to rise over time, it causes younger workers’ pre-retirement standards of living to decline relative to their own post-retirement standards of living. Second, Social Security’s actual replacement rates are much higher than most people realize because they are not reported as they would be calculated by most financial planners. Third, the current benefit formula causes replacement rates to rise over time for a given level of real wages.
As policymakers debate the future of Social Security, many policy advocates will argue that its current benefit formula should remain essentially intact. But a thorough analysis shows significant downsides of leaving the current benefit formula in place: harmful outcomes for many workers, especially including low-income and younger workers. To prevent American workers from being forced into sub-optimal income and consumption patterns over the course of their lives, corrections to Social Security’s benefit formula will almost certainly be necessary.
In a new Mercatus Center study, Charles Blahous, senior research fellow and public trustee for Social Security, reviews the most misunderstood aspects of the current Social Security replacement rate formula, looks at the effects it creates, and discusses potential reforms. While acknowledging that the replacement rate concept may be too flawed to serve as a sound basis for policy development, Blahous concludes that it is possible to address Social Security’s projected financing shortfalls in a way that honors some advocates’ focus on replacement rates, while allowing for other advocates’ focus on reducing costs and improving system finances relative to current law. But to accomplish this in a sound debate, a clear understanding of the current replacement rates formula—with all of its peculiarities and flaws—is critical.
Below are key points. To read “Understanding Social Security Benefit Adequacy: Myths and Realities of Social Security Replacement Rates,” in its entirety and learn more about the author, please click here.
Often-Misunderstood Aspects of Social Security Replacement Rates
1. Social Security Replacement Rates are Rising Relative to Worker Standards of Living
A widespread misconception concerning Social Security benefits is that maintaining constant replacement rates ensures comparable treatment of successive generations of Social Security beneficiaries.
- This argument fails to acknowledge that under existing financing methods, younger generations must shoulder considerably higher tax burdens to receive the same replacement rates. Thus, net benefits (benefits net of contributions) decline under the current formula. In fact, the current formula causes retirement benefit replacement rates to rise relative to workers’ previous after-tax income.
- In sum, the current benefit formula continually depresses pre-retirement standards of living relative to post-retirement benefits.
2. Current Social Security Replacement Rates are Higher than Commonly Understood
Social Security publicly reports its benefit replacement rates as a percentage of career “wage-indexed” earnings. This method essentially consists of translating one’s prior earnings years into current near-equivalents by adjusting them for intervening growth in national average wages, then averaging the individual’s highest-earnings years.
- This wage-indexed method of assessing one’s pre-retirement income standard is atypical, and routinely results in an under-evaluation of Social Security replacement rates relative to the way most people think of them.
- For some beneficiaries, total retirement-income replacement rates (including income from other sources such as pensions and individual savings) exceed 100 percent of late-career earnings. This is a deterrent both to continued labor participation and to further discretionary saving by workers.
- Social Security forces many low-income, liquidity-constrained workers to “oversave” by carrying high tax burdens to finance higher total income in retirement than they received while working.
3. Social Security Benefits are Rising for a Given Level of Real Wages
Current benefit increases are a result of indexing initial benefit levels to keep pace with rising worker wages. But this formula also results in steadily higher benefits being paid for a constant real wage.
- Because the current benefit formula aims to keep replacement rates constant for average-wage workers (whose wages rise over time relative to inflation), it actually delivers rising benefits—and replacement rates—to workers with the same real wages across time.
- This steady increase in benefits for a given real wage level is a significant contributor to rising system costs.
- The current benefit formula reflects a highly subjective value judgment in which, as society grows wealthier, the federal safety net should expand so that benefits for a worker with a given real level of wages automatically become more generous relative to his cost of living. One could just as fairly make the opposite value judgment that as society grows richer, dependence on government should proportionally diminish.
While one could argue the Social Security replacement rate metric is too flawed to serve as a reasonable basis for future program evaluation, it is an entrenched feature of Social Security policy discussion. Thus, an informed debate requires that all participants first understand the differences between how replacement rates are often understood and what they actually measure.
By understanding—and removing—the quirks that arise under the current benefit formula, policymakers could both reduce projected cost growth and strengthen system finances, while still honoring the replacement rate concept. Blahous demonstrates that regardless of the policy the lawmakers choose, any policy based on replacement rates should reflect those received at the statutory normal retirement age (not at an arbitrary fixed age), to produce a self-consistent appraisal of the effects of federal law.
Possible reforms to the benefit formula, aiming at different replacement policies (discussed further in the study) include:
- Preventing the ratio of pre-retirement income to post-retirement benefits from further declining.
- Preventing Social Security from forcing low-income Americans to “over-save” for retirement.
- Maintaining constant replacement rates for those with the same real wages.
Each of these methodological corrections would involve a different philosophical approach, but each would require downward adjustments in the growth of future benefits and would thus also improve Social Security finances relative to current schedules. Doing so would honor some advocates’ philosophical emphasis on replacement rates while also achieving other advocates’ goals of restraining the growth of system costs and improving program finances.