How Generous Are Social Security and Medicare?

Studies | Federal Spending | Health | Social Security

No. 290
Friday, October 27, 2006
by Andrew J. Rettenmaier & Thomas R. Saving


Executive Summary

It is commonly understood that Social Security replaces about 40 percent of preretirement earnings for average workers. But what are we trying to replace? And why? If the real goal is to maintain consumption during retirement at levels comparable to preretirement consumption, preretirement earnings are not a very good guide. Fringe benefits comprise a growing share of preretirement compensation, particularly health insurance.

Even if we are confident we are measuring the right set of numbers, there is a further problem: How do you compare consumption opportunities over many years? Reported Social Security replacement rates are based on converting workers' past earnings into today's dollars using the rise in average wages over time — a process known as wage indexing. But since wages usually rise faster than prices, wage indexing compensates retirees more than is necessary to maintain their purchasing power. Price indexing, by contrast, would give a more accurate measure of preretirement resources available for consumption. The two indices produce very different replacement rates:

  • Using wage indexing, Social Security replaces about 45 percent of preretirement earnings for the average worker retiring this year.
  • Using price indexing, Social Security replaces about 55 percent of preretirement earnings.

The wages that Social Security payments are based on are essentially cash wages. They do not include noncash employee benefits. However, these fringe benefit dollars either allow direct consumption (in the case of health care, for example) or later consumption (as is the case with 401(k) contributions, for example). Thus, including fringe benefits would give a more accurate picture of earnings available for consumption. If preretirement health care dollars are added in and payroll taxes that fund Medicare are subtracted out, Medicare dollars net of premium payments should be added to Social Security to get comparable consumption figures for the years of retirement. Also, since payroll taxes that fund Social Security and Medicare are not available for consumption, these taxes should be subtracted from preretirement income along with other labor taxes to give a more accurate gauge of preretirement consumption opportunities. With these adjustments, the government replaces 85.3 percent of price-indexed preretirement "consumable income" for the average worker.

Looking to the future, the replacement rate will rise over time:

  • For workers who are 46 years old today, elderly entitlements will replace 105.3 percent of price-indexed average preretirement compensation, net of federal labor taxes.
  • As a result, today's middle-age workers will, on the average, consume more during an average year in retirement with government benefits alone (not including pensions and personal savings) than before retirement.

Since Social Security's replacement rate for preretirement earnings will remain relatively constant over time, almost all of the increase in replacement rates is due to Medicare. In fact, Medicare's replacement rate will rise dramatically:

  • Medicare's replacement rate will grow over the next 20 years, from 37 percent of preretirement earnings for new retirees today to about 48 percent by the time today's 46-year-old workers retire, based on current projections.
  • Although Medicare's replacement rate equals 70 percent of Social Security's rate for new retirees, it will equal 90 percent for workers retiring in 2027.
  • For workers younger than age 37, Medicare benefits are projected to be larger than Social Security benefits, on the average.

Social Security and Medicare benefits are more generous than commonly thought, and benefits paid to seniors are projected to grow rapidly over time. Unfortunately, this growth in benefits will likely prove to be unsustainable. Policymakers must consider ways to control the growth in federal entitlement spending before it swamps the entire federal budget.


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