## Work and Retirement

No. 162
Friday, November 03, 2006
by Liqun Liu and Andrew J. Rettenmaier

## Indexing Normal and Early Retirement Ages to Account for Increasing Longevity

"The normal retirement age could be indexed to account for increasing longevity."

The normal retirement age is already rising for workers born after 1938 as a result of Social Security reforms enacted in 1983. It began rising from age 65 in 2003 by two months every year and will continue until 2027 when it settles at 67 for workers born in 1960 and later. However, while the retirement age remains at 67, life expectancies will continue rising. In 1940, life expectancy for the average person reaching age 65 was 13 years. It is 18 years today and is expected to continue rising. Additionally, the chance that a young worker will live to retirement age rose from 73 percent in 1940 to 85 percent today.

The normal and early retirement ages could be indexed to reflect these changes.

Indexing the Normal Retirement Age. Figure IV identifies two ways of indexing the normal retirement age to longevity:

• Choose a retirement age that equalizes the number of years future retirees are expected to receive benefits, or
• Hold constant the ratio of expected retirement years to potential work years for all future new workers.

How each of these changes would work is considered below.

Option One: Equalize the Number of Years Future Retirees Are Expected to Receive Benefits. As a starting point, the average life expectancy after age 66 for individuals born in 1940 is approximately 18 years (or age 84).18 Life expectancy is about 18 years at age 67 for individuals born in 1950, 18 years at age 68 for individuals born in 1960 and 18 years at age 70 for those born in 1990. To equalize the number of years they receive benefits, the normal retirement age could be increased gradually to age 70 for future retirees born in 1990.

Option Two: Hold Constant the Ratio of Expected Retirement Years to Potential Work Years. Individuals born in 1940 who began working at age 20 could have spent 46 years in the labor force before reaching their normal retirement age of 66. And upon reaching age 66 they can expect to live 18 years, on the average. This means they will spend 38.4 percent as long in retirement, on the average, as they did working. Maintaining this ratio of retirement-to-work years results in a slower rise in the normal retirement age than Option One. For individuals born in 1950, it would increase the normal retirement age by one year (to age 67). The retirement age would remain the same for individuals born in 1960 and then increase for those born in all future years, ultimately resulting in a retirement age of 69 for individuals born in 2000.

Effect on Social Security's Finances. The Social Security program faces a growing projected shortfall in revenues relative to benefits in coming years. The Office of the Chief Actuary of Social Security recently estimated the effects of two ways of indexing the normal retirement age, similar to those illustrated in Figure IV.19 The first smoothes the progression of the normal retirement age to 67 under current law and increases the normal retirement age for succeeding cohorts of workers by one month for every two birth years until it reaches 68.20 This change would reduce the 75-year financing gap by 27 percent and the deficit in 2079 (the end of the projection period) by 13 percent.

Another change evaluated by the actuaries eliminates the pause in the progression of the normal retirement age to 67. It then continues to increase the normal retirement age by 1 month for every succeeding two-year cohort of workers until the normal retirement age is 70. This change would reduce the 75-year financing gap by 36 percent and the deficit in 2079 by 28 percent.

"The 1983 Social Security reforms did not raise the early retirement age of 62 years."

Indexing the Early Retirement Age. The 1983 Social Security reforms raised the normal retirement age but left the early retirement age at 62 years. Economists Alan L. Gustman and Thomas L. Steinmeier estimated that raising the early retirement age to 64 would result in a 7 percentage point reduction in men 62 to 63 years of age who are retired from full-time work. (This assumes no change in the earnings test for those 64 to the normal retirement age.)21

The early retirement age could be indexed to the rising normal retirement age by allowing early receipt of benefits to begin four years prior. If it were indexed to hold constant the years of expected life in retirement to potential work years, the early retirement age would rise to 63 for individuals born in 1950 and ultimately to 65 for individuals born in 2000.

### Actuarial Fairness under Current Law

One way to think about actuarial fairness is to see it as a system in which the cost to Social Security of benefit payments is the same regardless of the year in which an average worker retires. Of course, a schedule of benefit adjustments that are actuarially fair for an average worker will be perceived as more or less than fair at different ages depending on a worker's individual preferences and mortality expectations. Individuals with below-average life expectancies can increase their expected lifetime benefits by choosing to claim benefits early. Those with above-average life expectancies can increase their expected lifetime benefits by choosing to delay benefit receipt.

Besides different mortality expectations, individuals have different discount rates. Suppose there is a discount rate that makes expected benefits the same at all retirement ages for the average retiree. Those who are more present-oriented than average (which means they have a higher-than-average discount rate) can increase their expected lifetime benefits by choosing to retire early. Those who are more future-oriented (have lower discount rates) can increase their expected lifetime benefits by choosing a later retirement date. For example, consider workers born in 1950 who are thinking about retiring early at age 62:

• If they retire at age 62, the monthly benefit Social Security will pay is 75 percent of what it would pay at the normal retirement age (age 66).
• This benefit adjustment would be appropriate for workers with a real discount rate between 3 percent and 4 percent.
• But if the workers are present-oriented, meaning they value money in their pocket today more highly than the offer of more money at some point in the future, they may have a much higher discount rate, say, 9 percent.
• As a result, the 75 percent of full retirement benefits Social Security will pay at age 62 is more than they are willing to accept (63 percent), and they have an incentive to claim benefits early.

Putting aside differences in life expectancies and differences in discount rates, a third issue is risk aversion. A choice is fair for a "risk-neutral" individual if the options are equivalent - for example, receiving \$1,000 for certain or having a 50/50 chance of getting \$0 or \$2,000. Yet because most people are risk averse they will not be indifferent between the two choices. Early retirement allows people to cash in on certain benefits today at the expense of uncertain benefits in future years. For example, life expectancy is about 19 years for an average 62-year-old male, but there is a chance he may die next year or may live another 30 years. Given a system that is actuarially fair for risk-neutral individuals, risk-adverse individuals are better off choosing early retirement.

Actuarial Fairness and Individual Discount Rates. Figure V depicts the adjustments scheduled under current law for beneficiaries born between 1943 and 1954, compared with supposed actuarially fair benefit schedules for individuals with different real discount rates of 2 percent and 9 percent. 1

As the figure shows, the scheduled adjustments are quite similar to those based on the interest rate at which the government can borrow money. Across all potential retirement ages the 2 percent discount rate yields benefit adjustments that are quite close to the scheduled adjustments. A 3 percent discount rate also yields similar results. However, individuals are likely to have higher discount rates than these rates, which are in the same range as the government borrowing rate.

In contrast, at younger ages the scheduled adjustments yield higher expected lifetime benefits than the actuarially fair benefit adjustments that assume a 9 percent discount rate. In other words, at early retirement ages the scheduled adjustments overcompensate individuals with high personal discount rates and induce early retirement. Similarly, beyond the normal retirement age, the scheduled benefit adjustments undercompensate them. For example, as Figure V shows:

• A 56-year-old worker who retires at age 62 will receive a monthly benefit equal to 75 percent of full benefits, an amount considered actuarially fair for a worker with average longevity expectations and whose discount rate is the government borrowing rate.
• However, if this worker is present-oriented - meaning he or she discounts the value of \$1 received in the future compared to \$1 received today at the higher 9 percent rate - he or she would accept a much lower benefit (63 percent of full benefits) at early retirement than the 75 percent Social Security will pay and has the incentive to claim benefits early.
• Workers with high discount rates have little incentive to delay retirement because they will demand a much higher bonus than Social Security will pay. For example they will require 163 percent of full retirement age benefits to induce them to delay retirement to 70, whereas Social Security will pay 132 percent.

Thus, individuals with higher discount rates will more likely begin claiming benefits early. By contrast, individuals with lower discount rates are more likely to delay claiming benefits because Social Security undercompensates them at ages below normal retirement age, but overcompensates them above it.

Differences between Men and Women. The benefit adjustments depicted in Figure V are based on the unisex life tables for individuals born in 1950. These life tables do not take into account the fact that, on the average, men have shorter life expectancies than women. Since the same adjustments apply to both men and women, men will be more likely to retire early if everything else is equal. To illustrate this point, Figure VI compares the scheduled adjustments to adjustments based on a 4 percent real discount rate, separated by sex:

• At the early retirement age of 62, men will consider a payment of 72.5 percent of full benefits as actuarially fair; by contrast - because of their longer life expectancies - women would require 74.6 percent at age 62.
• Men will require a higher payment from Social Security than women at age 70 to induce them to delay retirement - 143.5 percent of full benefits for men versus 138.3 percent for women - because their relatively shorter lives make men are more present-oriented than women.

Men will view the scheduled benefits for retirement prior to 66 as more than actuarially fair. By contrast women are more likely to consider the scheduled benefits at early retirement ages as approximately fair. At later retirement ages, both men and women would require greater compensation for delayed retirement than is scheduled under current law. As these two figures illustrate, when examining actuarial fairness, it is important to remember there are differences between the sexes in life expectancies as well as differences in the rates at which individuals discount a stream of future benefits compared with benefits today.

Conclusion. Given these considerations, what should be the goal of public policy? At a minimum, the Social Security system should be actuarially fair for the average worker. But for the reasons mentioned above, such a structure encourages many individuals to claim benefits early.

1. The 9 percent real discount rate was chosen to represent someone who is very present-oriented.