Andrew G. Biggs is a resident scholar at the American
Enterprise Institute (AEI), where he studies Social Security reform,
state and local government pensions, and public sector pay and benefits.
The Coronavirus pandemic is shuttering U.S. businesses and has
pummeled the retirement savings of
nearly all Americans. But in a new working paper,
I find that the virus poses a potentially worse financial threat to a
small group of near-retirees whose Social Security benefits could be cut
due to quirk in how national wage growth interacts with the Social
Security benefit formula.
As social distancing and quarantines are imposed, jobs are lost and
wages are reduced. Based on independent projections and details of the
Social Security benefit formula, I estimate that, in 2020, the Average
Wage Index – the Social Security Administration’s measure of national
average wages – could fall 15% below the level projected for this year
in the 2019 Social Security Trustees Report.
While most Americans understand that Social Security is designed to
replace a percentage of a participant’s career-average pre-retirement
earnings, the actual benefit formula is significantly more complex. In
two important ways the benefit formula integrates the growth rate of
economywide average earnings.
First, before a worker’s career-average earnings are calculated,
those annual earnings are indexed to changes in the Average Wage Index
up through age 60. Any earnings after age 60 are entered in nominal
form, into the average. A percentage change in the Average Wage Index in
the year a participant turns 60 has a nearly one-for-one impact on the
Social Security benefit formula’s calculation of the career-average
earnings. For an American born in 1960 and aged 60 in 2020, a 15%
decline in the Average Wage Index would reduce the value of his
career-average earnings by about 13.1%. By itself, this development will
reduce participants’ retirement benefits.
Second, the Social Security benefit formula’s “bend points” also
indexed to changes in the Average Wage Index. For an American age 62 in
2020, Social Security will replace 90% of his first $960 in average
monthly earnings, 32% of monthly earnings between $960 and $5,785, and
15% of any earnings between $5,785 and the maximum salary subject to
Social Security payroll taxes (currently $137,200). When today’s 60-year
olds become eligible for benefits at age 62, the bend point dollar
amounts will reflect any drop in the Average Wage Index experienced this
year. Lower bend point values would mean that a smaller share of
participants’ earnings would be replaced at the 90% replacement rate,
and a larger share at the 32% or 15% replacement rates.
I estimate that, for in a medium wage worker aged 60 in 2020, a 15%
decline this year in the Average Wage Index could lead to a permanent
reduction Social Security retirement benefits of around 13.8%. This
$3,900 annual benefit reduction would reduce his lifetime benefits by
over $70,000. Similar percentage benefit cuts would apply to retirees at
all earnings levels. While we expect the economy will eventually
recover, Americans age 60 in 2021 may also receive lower-than-expected
benefits.
Should policymakers wish to avert this benefit cut, one ad hoc
solution is go to back to how Social Security calculated average wages
in the 1970s, using wage data only for the first quarter of the year.
Using Q1 2020 data would avoid most of the decline in the Average Wage
Index for 2020, though the 2021 Average Wage Index would remain a
problem.
A better option might be for the Social Security benefit formula to
stop wage-indexing past earnings in the first place. Retirees seek to
replace the real earnings power they had prior to retirement, which
points toward calculating Social Security benefits as a percentage of
the worker’s inflation-adjusted career-average earnings.
Wage-indexing of past earnings equates them to the earnings level of
today’s workers, which is generally much higher than today’s retirees
had back when they were working. The 90, 32, and 15% replacement factors
could be increased to keep the dollar value of retirees’ benefits the
same.
If the Social Security benefit formula worked with inflation-adjusted
pre-retirement earnings, even a large decline in national average wages
in a single year would have only a tiny effect on retirees’ Social
Security benefits.
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