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The real threat to your Social Security
Private accounts and higher taxes grab the headlines, but it's a one-word change in the Social Security benefits formula that could affect your future most.
By Rick VanderKnyff
Ready to retire on less?
Since his re-election, President Bush has been pushing hard to allow workers to divert some of their payroll taxes into "personal retirement accounts." That idea has grabbed most of the headlines and taken most of the heat.
But his real mechanism for taming Social Security is a change in the way initial benefits to future retirees are calculated. It could seriously dent their buying power, slicing as much as a third from checks that will be delivered in, say, 2052. Even investments in personal retirement accounts are unlikely to make up the difference.
The change in formula was part of all three models outlined by the president's handpicked commission on Social Security reform, and the administration has signaled that it will also be part of the president's proposal. In his State of the Union address, Bush listed the change as one proposal he would consider -- but stopped short of giving it an outright endorsement.
How they determine your benefits check
The Social Security Administration uses a formula that calculates benefits by, among other things, averaging a worker's 35 highest-earning years. It adjusts those past earnings by indexing them against overall wage growth in the economy, then calculates the monthly check. The change proposed by Bush would index those past earnings against the increase in prices rather than wages.
It makes a big difference. Over time, paychecks tend to rise faster than prices; that's why the American standard of living has risen steadily, allowing families to own bigger homes, two cars, microwave ovens, computers, and multiple television sets and cell phones.
Retirees have profited from the gap. If Social Security checks had been adjusted for inflation instead of wages since the program started in 1935, according to a Business Week report, retirees today would take home only $425 a month. A retiree today would then be able to buy the same "basket" of goods as a retiree in 1935 -- but because living standards have risen (thanks in part to all those new or improved consumer goods now taken for granted), that $425 would not appear to go far.
The change in indexing essentially freezes buying power the day a retiree draws his first check. Had Social Security been created this way, "people today would be retiring with a benefit tied to the living standard of the 1930s," says a report by American Progress Action Fund, a think tank.
Others disagree, of course, but the bottom line is this: Even with personal accounts, a change in the way future initial benefits are calculated will mean less money in your pocket.
Why wage indexing?
It's a reasonable question: Why should future benefit levels be tied to wage growth in the first place, especially when it means that future retirees will have more buying power than today's beneficiaries (and when it puts a strain on the solvency of the system).
Proponents of price indexing say that future retirees are getting an unfair advantage, and that the most important function of Social Security is to preserve the purchasing power of future retirees (and other beneficiaries).
Others say wage indexing more accurately reflects the change in living standards over time. Defenders of the current system also say that a switch to price indexing would lead to a steady erosion of the system's "replacement rate" -- the percentage of a worker's pre-retirement income replaced by Social Security benefits.
According to the Social Security Administration, benefits for a 65-year-old medium-wage worker retiring in 2004 cover about 41.9% of his earnings. Under a switch to price indexing, according to the Center on Budget and Policy Priorities, replacement rates would fall to 27% for a worker retiring in 2042 and 20% for a worker retiring in 2075.
Democrats in Congress have come out almost uniformly against the president's plan, not surprisingly. But so have such powerful organizations as the AARP, which is drafting its own strategy to cope with the projected shortfall. It will include more modest tinkering with the initial benefits formula, a higher cap on taxable wages and a gradual increase in the retirement age to 70.
Private accounts aside, any attempt to address the projected shortfall in Social Security obligations will need to include either tax hikes or benefits cuts, or both. For now, the White House proposal -- focusing on benefits cuts -- is what is on the table.
Freezing initial benefits at current levels
A medium-wage earner retiring at 65 in 2004 received an initial annual benefit of $14,209, according to the Social Security Administration. If price indexing were put into effect, initial benefits of future medium-wage earners would remain locked at about that level in constant (i.e., price-adjusted) 2004 dollars.
In contrast, here are estimated initial benefits for future medium-wage earners under current law, by year of retirement.
| Initial benefits, by retirement year | | Year of retirement | Initial annual benefit* | | 2012 | $14,755 | | 2022 | $15,882 | | 2032 | $16,987 | | 2042 | $18,914 | | 2052 | $21,080 | | 2080 | $28,421 |
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* for medium-wage earners, in constant 2004 dollars
Source: Social Security Administration
Compare those numbers to $14,209, and you see that -- all other things being equal -- a seemingly arcane change in the indexing formula would mean a tangible cut in your future benefit levels, a cut that grows over time -- about 16% if you're 38 now and plan to retire in 2032, about 32% if you're 18 now, just entering the workforce and hoping to retire in 2052.
Private accounts would help . . . some
Of course, all other things are not equal. For one, the president wants to institute those personal accounts, and for retirees that could make up some -- but not all -- of the cut in promised benefits. Then there's the pesky state of the system's trust fund, now stuffed with trillions in Treasury bonds but projected by the Social Security Administration to run dry in its "pessimistic" scenario in 2042. After that, assuming no fix is enacted, Social Security would not be able to pay out all of its promised benefits.
That date is disputed by some, but we'll use it here to give a more detailed look at what a couple of hypothetical workers might be looking at: one retiring in 2032 (10 years before the dreaded date) and one retiring in 2052 (10 years after).
President Bush has not yet released his detailed plan for reforming Social Security, so we'll use the most commonly cited model proposed by his commission. The so-called "Model 2" would allow workers to divert 4% of their pay (carved out of their current 12.4% Social Security payroll tax) into a small selection of diversified bond and equity funds.
(To learn how these accounts might work, click here.)
What it means: The 38-year-old
Let's run the numbers for a 38-year-old worker who retires in 2032 at age 65. We're using 2001 figures here so we can compare with the Social Security commission report.
| Retiring in 2032 | | 2001 benefit level | $12,624 | | Promised under current law | $16,116 | | Expected benefit w/account* | $14,772 |
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All amounts in constant 2001 dollars for medium-earning retiree
* Under Model 2, president's commission, assuming individual invests in 50/50 stock/bond portfolio earning 4.6% annually
Source: President's Commission to Strengthen Social Security
Under current law, our 38-year-old would get an initial benefit estimated at $16,116 in 2001 dollars -- a sizable premium over what the 2001 retiree received upon leaving the workforce. Under price indexing, that premium would disappear, meaning an effective cut of about 22%.
If that worker opts to divert 4% of income into a personal account, that annual benefit could rise to $14,772 if the stock and bond markets behave as expected, making up some of the cut that a change in indexing formula would bring.
This leads to the wiggle room needed to allow both sides to make wildly different but essentially truthful conclusions about what retirees would get with a partially privatized system. Proponents claim that future retirees would get more than current retirees (true, if projections hold); opponents say that what the president is planning is a cut in benefits (also true -- future retirees would get less than what is promised under current law, even with personal accounts).
What it means: The 18-year-old
Now let's see what might be in store for an 18-year-old who retires in 2052 at age 65.
| Retiring in 2052 | | 2001 benefit level | $12,624 | | Promised under current law | $19,536 | | Current law (w/underfunding)* | $14,148 | | Expected benefit w/account** | $18,300 |
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All amounts in constant 2001 dollars for medium-earning retiree
* The system is projected to be 27.6% underfunded in 2052
** Under Model 2, president's commission, assuming individual invests in 50/50 stock/bond portfolio earning 4.6% annually
Source: President's Commission to Strengthen Social Security
Under current law, initial benefits rise to $19,536 -- and all of that rise would be eliminated by a change in indexing, an effective cut in promised benefits of about 32%. But private accounts, because they will have been accumulating and gathering interest longer, would (again, if projections hold) make up a greater percentage of that cut, bringing expected annual benefits up to $18,300 for our hypothetical medium-wage earner.
There's a wrinkle here, however, as underscored by the extra row in the table above. If the Social Security trust fund does run dry in 2042, the system would be underfunded by a projected 27.6% in 2052. In other words, if no changes are made in current law, no personal accounts are enacted and no other fixes are put in place, Social Security would be able to meet only 72.4% of its obligations.
Let's say that meant an across-the-board cut to all beneficiaries in 2052 -- new retirees as well as existing recipients (an unlikely scenario, but useful for discussion). Our 2052 retiree would receive an initial benefit of $14,148 annually -- still higher than current retirees in 2001 dollars, but far short of the benefit promised under current law.
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