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


Adjustments for Health Care and Taxes

Table III - Social Security and Medicare Replacement Rates for Average 65-Year-Old Retirees

"Payroll taxes are not available for consumption."

Given that Social Security benefits are based on past earnings, it is natural to calculate replacement rates relative to those earnings. However, these comparisons ignore untaxed fringe benefits. Yet, fringe benefit dollars either allow direct consumption (in the case of health care, for example) or they put aside funds for later consumption (as is the case of 401(k) contributions, for example).

To get a more accurate picture of earnings available for consumption, therefore, the value of fringe benefits should be added into the calculation. On the other hand, it makes sense to subtract out payroll taxes and other labor taxes — especially Social Security and Medicare taxes — since these dollars are not available for current consumption.8

"Compensation includes health care and other fringe benefits."

Other adjustments also make sense if preretirement and postretirement consumption opportunities are to be compared. For example, 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 year of retirement.9 Also, if Social Security and Medicare payroll taxes and other federal labor taxes are taken out during the working years, Social Security benefit taxes paid during retirement should be removed from the calculation for the same reason.

After making all of these adjustments, what remains is after-tax consumable dollars both before and after retirement.

"Medicare will replace a growing share of workers' preretirement wages."

Table III presents replacement rates based on three measures of lifetime earnings or compensation for average workers born in 1941 who reach normal retirement age this year.10 These figures are adjusted by a price index, the conventional way of comparing consumption through time:

  • Social Security and Medicare benefits — net of Social Security benefit taxes and Medicare premium payments — replace 89.2 percent of price-indexed earnings and 66.5 percent of price-indexed compensation.
  • Surprisingly, when total price-indexed compensation is reduced by the tax payments workers make during their years in the labor force, Social Security and Medicare benefits replace 85.3 percent of average annual preretirement compensation.

"Combined benefits will be higher than preretirement wages for future retirees."

Thus, Medicare and Social Security benefits paid to new retirees will replace more than four-fifths of their average annual preretirement purchasing power.


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