Retirement Policy in the 21st Century Jon Forman Alfred P. Murrah Professor of Law University of Oklahoma College of Law December 14, 2005 available at http://www.law.ou.edu/profs/forman.shtml

Overview Retirement Security as a three-Legged Stool Aging of America Social Security Private Pensions Savings Aging of America

Aging of America Americans are living longer but retiring earlier Life expectancy for a male born in 1940 was just 61.4 years today it is 73.9 years Also, a man reaching age 65 in 1940 could expect to live another 11.9 years but a man reaching 65 in the year 2000 could expect to live another 15.9 years

Aging of America Increasing percentage of Americans will survive to old age. For example, although just 54 percent of men born in 1875 survived from age 21 to age 65 in 1940 Almost 83 percent of men born in 1985 are expected to survive from age 21 to age 65 in 2050 A graying of America

Aging of America Trend toward earlier and earlier retirement Average age at which workers begin receiving their Social Security retirement benefits fell from 68.7 years old in 1940 to 63.6 years old in 2002 Labor force participation rates for the elderly have also dropped

Bureau of Labor Statistics, Labor Force Statistics from the Current Population Survey: Civilian Labor Force Participation Rate (2004), available at <http://data.bls.gov/labjava/outside.jsp?survey=ln>.

How many people rely on Social Security for most of their income? 90% of people 65 and older get Social Security Nearly 2 in 3 (66%) get half or more of their income from Social Security About 1 in 5 (22%) get all their income from Social Security Social Security benefits are relatively modest both in dollar amounts and in relation to retirees’ prior earnings. Yet, the benefits are critically important to the families that receive them. About 90 percent of married couples and unmarried persons age 65 and older receive Social Security. It is the major source of income for most of those beneficiaries. Nearly two in three of these beneficiaries (66 percent) rely on Social Security for half or more of their total income from all sources. About one in five elderly Americans (22 percent) get all of their income from Social Security. National Academy of Social Insurance, Social Security Finances: A Primer (2005)

Most elderly don’t receive pensions Percent with Employer-Sponsored Pensions All age 65+ 41% Couples 51% Unmarried men 39% Unmarried women 32% One reason that Social Security is such a large portion of income is that most Americans age 65 and older do not receive income from pensions, from either private employment or from jobs in federal, state or local government. Of couples age 65 and older just half (51 percent) do have a pension from the husband’s or wife’s work, or both. The unmarried are less likely to have pensions. About 32 percent of unmarried women and 39 percent of unmarried men receive pensions. Combining couples and the unmarried together, the pension receipt rate is 41 percent. National Academy of Social Insurance, Social Security Finances: A Primer (2005)

Social Security How Social Security Works Financial Troubles Financing Social Security How Benefits Are Determined Financial Troubles How to Fix It Raise Taxes Cut Benefits Increase Investment Returns

How Many People Get Social Security? 47.7 million people receive Social Security each month 1 in 6 Americans get Social Security benefits Nearly 1 in 4 households get income from Social Security National Academy of Social Insurance, Social Security Finances: A Primer (2005)

Who Gets Social Security? 30.0 million retired workers 4.8 million widows and widowers 6.2 million disabled workers 0.8 million adults disabled since childhood 3.1 million children National Academy of Social Insurance, Social Security Finances: A Primer (2005)

How Much Does Social Security Pay? Type of Beneficiary Average Monthly Benefit All Retired Workers $955 Aged widow(er), non-disabled $920 Disabled worker $895 Aged couple-both receiving $1,574 Widowed mother and two children $1,979 How much does Social Security pay? Social Security is designed to serve as a foundation of retirement income that could be supplemented by pensions, savings, and earnings. Benefits alone do not provide a comfortable level of living. The average retired worker benefit in January 2005 was $955 a month, or about $11,500 a year. The average is somewhat lower for widowed spouses age 60 and older, $920 a month or about $11,000 a year. The average benefit for disabled workers is $894, or about $10,700 a year. When both a retired husband and wife receive benefits, the average is $1,574 or about $18,900 a year. Each year the benefits are adjusted to keep up with the cost of living. The cost of living adjustment comes in the January checks. www.ssa.gov/OACT/COLA/colaeffect.html

Social Security and Poverty 2005 Poverty Levels Single individuals – $9,570 ($798/month) Married couples – $12,830 ($1,070/month) With Social Security only 9% were poor in 2000 Without it, 48% would have been poor

Financing Social Security Workers and their employers pay with Social Security taxes Workers pay 6.2% of their earning for Social Security, and 1.45% of their earnings for Hospital Insurance under Medicare (Part A) Employers pay an equal amount The total is 12.4% for Social Security and 2.9% for HI Social Security tax base is $94,200 in 2006

Worker Benefits Workers over 62 are eligible If they have worked 10 years Benefits are based on a workers earnings history Career-average earnings Average Indexed Monthly Earnings (AIME)

Average Indexed Monthly Earnings (AIME) Determine how much the worker earned every year through age 60 Determine Benefit Computation Years And Earnings in those years Index those Earnings for Wage Inflation Up to the year the worker turns 60 Subsequent Work Years Also Count Pick the Highest 35 Years Drop the rest

Average Indexed Monthly Earnings (AIME), continued Add those highest 35 years of earnings up Divide by 35; Divide by 12 Result is called Average Indexed Monthly Earnings (AIME) AIME is then linked by formula to the basic retirement benefit Result is called Primary Insurance Amount (PIA) Paid at full retirement age

Full Retirement Age Year of Birth Full Retirement Age 1937 or earlier 65 1938 - 1942 plus 2 months per year 1942 – 1954 66 1955 - 1959 1960 and later 67 How much does Social Security pay? Social Security is designed to serve as a foundation of retirement income that could be supplemented by pensions, savings, and earnings. Benefits alone do not provide a comfortable level of living. The average retired worker benefit in January 2005 was $955 a month, or about $11,500 a year. The average is somewhat lower for widowed spouses age 60 and older, $920 a month or about $11,000 a year. The average benefit for disabled workers is $894, or about $10,700 a year. When both a retired husband and wife receive benefits, the average is $1,574 or about $18,900 a year. Each year the benefits are adjusted to keep up with the cost of living. The cost of living adjustment comes in the January checks. http://www.ssa.gov/retire2/retirechart.htm

Primary Insurance Amount (PIA) For a worker turning 62 in 2006, PIA = 90% of first $656 of AIME + 32% of AIME from $656 to $3,955 (if any) + 15% of AIME over $3,955 (if any) $656 and $3,955 are called bend points PIA indexed by cost of living after 62 Provides higher benefits relative to earnings for lower paid

How do benefits compare to earnings? Retired worker age 65, 2005 This chart shows how Social Security benefits compare to a retiree’s past earnings for a “low;” “medium;” “high;” and “maximum” earner. The short bars are the benefits that a retiree would get at age 65. The tall bars represent the retiree’s typical (or average indexed) lifetime earnings while working. Social Security benefits replace a larger share of past earnings for lower earners. While higher earners receive larger benefit checks, those checks represent a smaller fractions of what they had been making. For example, a 65-year-old who retired in 2005 with a lifetime of “medium” earnings (about $35,300 in 2004) would receive about $14,800 a year, which would replace about 42 percent of past earnings. A “low” earner, who made about $15,800 in 2004 would receive about $9,000, which would replace about 57 percent of prior earnings. A worker who always earned the maximum amount that is taxed and counted toward Social Security ($90,000 in 2004) would get benefits that replace about 25 percent of prior earnings. These benefits are for workers who claim Social Security at age 65. Workers who take benefits at 62 (the earliest eligibility age) would receive 20 percent less because they claimed benefits early. National Academy of Social Insurance, Social Security Finances: A Primer (2005)

Worker Benefits: Increases and Decreases Indexed for inflation Actuarial decrease for early retirement Example: average-wage worker, 62 in 2006 Will get $1,332.80 per month at her full retirement age of 66 or $999 per month at 62 Actuarial increase for later retirement 8 percent per year Retirement Earnings Test In 2006, early retirees lose $1 of benefits for each $2 of earnings over $12,480

Family Benefits Spouses, dependents, and survivors Husband or wife gets 50% of worker’s PIA Together, couple gets 150% Widow or widower gets 100% of worker’s PIA A joint and two-thirds annuity Dual entitlement rule limits benefits

Estimates for 2005 Finances Trust Fund income = $690 billion (taxes) Trust Fund outgo = $527 billion (benefits) Surplus = $163 billion By law, surpluses are invested in U.S. government securities and earn interest that goes to the trust funds. First, in the near term Social Security is taking more in than it is paying out in benefits. In 2004, projected income to the trust funds (mainly Social Security taxes) was $690 billion, while projected outgo (mainly benefit payments) was $527 billion, leaving an annual surplus of $163 billion. These surpluses, by law, are invested in U.S. treasury securities and earn interest that goes to the trust funds. The “outgo” from the Social Security trust funds covers administrative expenses of the Social Security program, as well as benefit payments. Administrative costs are about 1 percent of total outgo. National Academy of Social Insurance, Social Security Finances: A Primer (2005)

Social Security’s Financing Problem 2005 Trustees Report shows Expenses will exceed payroll tax income in 2017 Trust funds will be out of money in 2041 75-year deficit equals 1.92% of taxable payroll Immediate payroll tax increase of 1.92% needed to restore actuarial balance Alternatively, immediate 12.8% across-the-board benefit cut $4 trillion unfunded liability 0.6% as a share of the entire economy (GDP)

Social Security Administration, 2005 Trustees’ Report

How do actuaries estimate the future? Review the past: birth rates, death rates, immigration, employment, wages, inflation, productivity, interest rates Assumptions for the next 75 years Three scenarios: Low cost; High cost; Intermediate (best estimate) How do actuaries project the future? The Social Security actuaries forecast the future of the Social Security system 75 years into the future. They update their forecast every year. The purpose is to help policy makers anticipate whether Social Security is likely to face financing problems in the future. The actuaries make three forecasts: Low cost; High cost; and Intermediate (or best estimate). For each, they use assumptions that have been reviewed and agreed to by the Trustees. The assumptions are about future trends in aspects of the population and the economy that would affect the income and outgo of the trust funds. National Academy of Social Insurance, Social Security Finances: A Primer (2005)

The Long-Range Forecast (Best estimate) In 2017, tax revenues into the trust funds forecasted to be less than benefits due that year. Interest on the reserves and the assets themselves will help pay for benefits until 2041. In 2041, reserves are projected to be depleted. Income is forecast to cover 74% of benefits due then. By 2079, assuming no change in taxes, benefits or forecasts, revenue would cover about 68% of benefits due then. What does the 2005 long range forecast show? Under the intermediate (or best estimate) set of assumptions, the 2005 report finds: The system will continue to run annual surpluses until 2017. In that year, for the first time, tax revenue is projected to be less than benefits due. But interest income on the reserves will help cover the costs. Interest on the trust fund reserves and the assets themselves will help pay for benefits until 2041. In 2041, reserves are projected to be depleted (assuming no change in benefits or taxes). Income is projected to cover 74 percent of benefits due then. The system will not be “broke” in that Social Security taxes will keep coming in. But, if this projection holds, policymakers will need to make some changes before 2041, to ensure that all legislated benefits can be paid. National Academy of Social Insurance, Social Security Finances: A Primer (2005)

American Academy of Actuaries (2005), available at <http://www

Only 3 Ways to Fix Social Security Raise Taxes Cut Benefits Increase Investment Returns Private investment Either government or individual

Options: Raise Taxes OPTION Increase tax rate by 2% total Tax all earnings Tax 90% of earnings Include new state & local govt. workers Tax SS benefits like pensions % of Deficit Eliminated 104% 93% 40% 10% 20% National Academy of Social Insurance, Social Security Brief No. 18 (2005); American Academy of Actuaries (2004).

Options: Cut Benefits OPTION Raise retirement age (to 67 faster & index) Reduce COLA by ½% each year Cut benefits by 5% for those starting to get benefits in 2005 Increase # years in wage avg. to 40 % of Deficit Eliminated 28% 41% 32% 21% National Academy of Social Insurance, Social Security Brief No. 18 (2005); American Academy of Actuaries (2004).

Options: Increase Investment Returns Investments in equities % of Deficit Eliminated 36% - 50% National Academy of Social Insurance, Social Security Brief No. 18 (2005); American Academy of Actuaries (2004).

Two Basic Types of Pension Plans Defined benefit plans Defined contribution plans Also, hybrid plans

What is a Defined Benefit Plan? Employer promises employees a specific benefit at retirement To provide that benefit, the employer makes payments into a trust fund and makes withdrawals from the trust fund Employer contributions are based on actuarial valuations

Defined Benefit Plan Employer bears all of the investment risks and responsibilities Typical plan provides each worker with a specific annual retirement benefit that is tied to the worker’s final average pay and number of years of service

Defined Benefit Plan For example, a plan might provide that a worker’s annual retirement benefit is equal to 2% times years of service, times final average pay B = 2% × yos × fap Final-average-pay formula

Defined Benefit Plan Worker with 30 years of service would receive 60 percent of her pre-retirement earnings Worker earning $50,000 would get $30,000-a-year pension B = $30,000 = 60% × $50,000 = 60% × fap = 2 percent × 30 yos × $50,000 fap

Defined Benefit Plan Effect of inflation on real value of retirement income Years in retirement No inflation 3% Annual Inflation 10% Annual inflation 100 5 86 62 10 74 39 15 64 24 20 55 25 48 9

Only 3 ways to fix an underfunded Defined Benefit Plan Raise Contributions Cut Benefits Increase Investment Returns

What is a Defined Contribution Plan? Individual account plan Employer typically contributes a specified percentage of the worker’s pay to an individual investment account for the worker Owned by employee Benefits based on contributions and investment earnings

Defined Contribution Plan For example, employer might contribute 10% of annual pay Under such a plan, a worker who earned $30,000 in a given year would have $3,000 contributed to her account $3,000 = 10% × $30,000 Benefit at retirement based on contributions, plus earnings

Defined Contribution Plan Money purchase pension plans 401(k) and 403(b) plans allow workers to choose between receiving cash currently or deferring taxation by placing the money in a retirement account Profit-sharing plans & stock bonus plans

Goals for a Pension Plan First, ensure that every employee earns a meaningful retirement benefit and that long-time employees are guaranteed an adequate income throughout their retirement years Second, have a minimum of work disincentives for employees coming in and out of service Third, be affordable and well-financed

Conclusions Social Security has a $4 Trillion Unfunded Liability Oldest baby-boomers are 59½ Only half of the elderly have pensions Reforms are needed

Sources American Academy of Actuaries, Social Security Reform: Solutions Inside the Box: Proposals Not Including Individual Accounts (2004), available at http://www.actuary.org/pdf/socialsecurity/briefing_041604.pdf. Jon Forman, Reforming Social Security, 76 (9) Oklahoma Bar Journal 657-661 (March 12, 2005), available at http://jay.law.ou.edu/faculty/jforman/SS-OBJ-2005.pdf. Jonathan Barry Forman, Public Pensions: Choosing Between Defined Benefit and Defined Contribution Plans, 1999 (1) Law Review of Michigan State University Detroit College of Law 187-213 (2000).

Sources, cont. Jonathan Barry Forman, Making Pensions Work, in New York University Review of Employee Benefits and Compensation, Chapter 5, pp. 5-1 to 5-60 (Alvin D. Lurie ed., 2004). National Academy of Social Insurance, Social Security Finances: A Primer (April 2005), available at http://www.nasi.org/usr_doc/Financing_Social_Security.ppt. National Academy of Social Insurance, Options to Balance Social Security Over the Next 25 Years (Social Security Brief No. 18, February 2005), available at http://www.nasi.org/usr_doc/SS_Brief_18.pdf. Social Security and Medicare Boards of Trustees, 2005 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds (2005), available at http://ssa.gov/OACT/TR/TR05/tr05.pdf.