Retirement Policy in the 21st Century Jon Forman Alfred P. Murrah Professor of Law University of Oklahoma College of Law OU’s Senior Adult Services “Mornings with the Professor” program December 9, 2008 available at

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

3 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

4 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

5 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

6 Bureau of Labor Statistics, Labor Force Statistics from the Current Population Survey: Civilian Labor Force Participation Rate (2004), available at.

7 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

8 Most elderly don’t receive pensions Percent with Employer-Sponsored Pensions All age 65+41% Couples51% Unmarried men39% Unmarried women32%

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

10 How Many People Get Social Security?  49 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

11 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

12 How Much Does Social Security Pay? Type of BeneficiaryAverage Monthly Benefit All Retired Workers$1,044 Aged widow(er), non-disabled$1,008 Disabled worker$979 Aged couple-both receiving$1,713 Widowed mother and two children$2,167

13 Social Security and Poverty  2007 Poverty Levels Single individuals – $10,210 ($851/month) Married couples – $13,690 ($1,141/month)  With Social Security only 9% were poor in 2000  Without it, 48% would have been poor

14 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 $97,500 in 2007

15 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)

16 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

17 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

18 Full Retirement Age Year of BirthFull Retirement Age 1937 or earlier plus 2 months per year 1942 – plus 2 months per year 1960 and later67

19 Primary Insurance Amount (PIA)  For a worker turning 62 in 2007, PIA = 90% of first $680 of AIME + 32% of AIME from $680 to $4,110 (if any) + 15% of AIME over $4,110 (if any)  $680 and $4,110 are called bend points  PIA indexed by cost of living after 62  Provides higher benefits relative to earnings for lower paid

20

21 How do benefits compare to earnings? Retired worker age 65, 2005

22 Worker Benefits: Increases and Decreases  Indexed for inflation  Actuarial decrease for early retirement Example: average-wage worker, 62 in 2006 Will get $1, 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 2007, early retirees lose $1 of benefits for each $2 of earnings over $12,960

23 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

24 Estimates for 2006 Finances Trust Fund income = $745 billion (taxes) Trust Fund outgo = $555 billion (benefits) Surplus = $190 billion By law, surpluses are invested in U.S. government securities and earn interest that goes to the trust funds.

25 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)

26 Social Security Administration, 2007 Trustees’ Report

27 American Academy of Actuaries (2005), available at.

28 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  In 2041, reserves are projected to be depleted. Income is forecast to cover 75% of benefits due then.  By 2081, assuming no change in taxes, benefits or forecasts, revenue would cover 70% of benefits due then.

29 Social Security’s Financing Problem  2007 Trustees Report shows Expenses will exceed payroll tax income in 2017 Trust funds will be out of money in 2041  75-year deficit equals 1.95% of taxable payroll Immediate payroll tax increase of 1.95% needed to restore actuarial balance Alternatively, immediate ~12.8% across-the-board benefit cut $4.7 trillion unfunded liability About 0.7% as a share of the entire economy (GDP)

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

31 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).

32 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).

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

34 Social Security Game  American Academy of Actuaries Social Security reform game, /game.html /game.html  Play the game to explore options for Social Security reform and their impact on the program's solvency. Play the game

35 Two Basic Types of Pensions  Defined benefit plans  Defined contribution plans  Also, hybrid plans

36 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

37 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

38 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

39 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

40 Defined Benefit Plan Effect of inflation on real value of retirement income Years in retirement No inflation 3% Annual Inflation 10% Annual inflation

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

42 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

43 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

44 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

45 What is a Hybrid Plan?  “Hybrid” plans mix features of defined benefit and defined contribution plans For example, a cash balance plan is a defined benefit plan that looks like a defined contribution plan Another common approach is to offer a combination of defined benefit and defined contribution plans

46 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

47 Long-term Reform  Retirement system should ensure that every elderly American has an adequate retirement income  Redesign the current system  Two-tier system First tier: poverty-level benefit Second tier: earnings-related benefit Earnings sharing

48 First Tier: Basic Benefit  Government guarantee of poverty-level income  2007 Poverty Levels Single individuals – $10,210 ($851/month) Married couples – $13,690 ($1,141/month)  Would replace SSI and redistribution within the current SS system  Pay for with general revenues

49 Second Tier: Earnings-related Benefit  Individual accounts Hypothetical (“cash balance”) accounts Invested by professionals  Pay for with reduced payroll taxes  Pay out lifetime annuities Inflation-adjusted annuities

50 Earnings Sharing  Credit each spouse with one-half of couple’s combined earnings during marriage  At retirement, each spouse’s benefit would be based on her half of the couple’s earnings, plus her prior earnings  Would replace spousal benefits

51 Conclusions  Social Security has a $4.7 Trillion Unfunded Liability  Oldest baby-boomers are 60  Only half of the elderly have pensions  Reforms are needed

52 Select Sources  American Academy of Actuaries, Social Security Reform: Solutions Inside the Box: Proposals Not Including Individual Accounts (2004), available at df. df  Jon Forman, Making America Work (Washington, DC: Urban Institute Press, 2006). See America Work  National Academy of Social Insurance, Options to Balance Social Security Over the Next 25 Years (Social Security Brief No. 18, February 2005), available at  Social Security and Medicare Boards of Trustees, 2007 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds (2007), available at

53 About the Author  Jonathan Barry Forman (“Jon”) is the Alfred P. Murrah Professor of Law at the University of Oklahoma College of Law, where he teaches courses on tax, pension, and elder law.  Professor Forman is also Vice Chair of the Board of Trustees of the Oklahoma Public Employees Retirement System (OPERS) and the author of Making America Work (Washington, DC: Urban Institute Press, 2006).  Prior to entering academia, Professor Forman served in all three branches of the federal government. He has a law degree from the University of Michigan, and he also has master’s degrees in economics and psychology.  Jon can be reached at or (405) His web page is