How Much Do Americans Depend on Social Security?
Tuesday, August 07, 2007
by Laurence J. Kotlikoff, Ben Marx and Pietro Rizza
Table of Contents
Measuring the Effects of Social Security on Living Standards
This study measures the dependence on Social Security retirement benefits of representative single-parent and married, two-earner households (each with two children who live at home until they enter college), with different levels of expected lifetime earnings, savings and debts scaled to their preretirement incomes. Financial data for these households were entered into ESPlanner ™, a financial planning program, to model the effects on their current and future household living standards if immediate changes in Social Security benefits were announced when they are ages 35 and 65. [See the side bar, “Using ESPlanner ™ to Create Household Profiles.”]
Using ESPlanner™ to Create Household Profiles
ESPlanner™ is a financial planning software program that allows individuals and couples to project how much retirement savings and life insurance they will need to maintain a given standard of living throughout their lives. They input into the program details about their current wages, interest and dividends; payroll and income taxes; living expenses such as mortgage payments and child care; and expectations about the future, such as a college education for their children and the rate of return they hope to earn on their investments. ESPlanner™ estimates their future consumption — income left after subtracting savings, mortgage, taxes and life insurance premiums — and adjusts for inflation. This allows an individual or couple to calculate their highest sustainable living standard over the rest of their lives, taking into account their economic resources, including Social Security benefits.
For this study, ESPlanner™ was used to create financial profiles of seven married and seven single-parent households at age 30 with different income levels, using a number of assumptions about their saving and consumption habits. Each household starts off with specific assets and liabilities scaled to their income level. [For details, see the Appendix.] Each household has two children (who leave when the couple or single parent is older). Given expected increases in earnings and average interest rates, ESPlanner™ determined their assets and liabilities at ages 35 and 65. Each household's consumption was calculated at each age and in the absence and presence of Social Security benefits.
This study focuses on discretionary consumption spending — or discretionary income — as a measure of household living standards. This is income that can be spent (consumed) as the household chooses, after subtracting “off the top” obligatory expenditures for such things as taxes, contributions to tax-favored savings, mortgage payments, college tuition and life insurance premiums. All of a household's income is allocated to either discretionary consumption or obligatory spending, and when discretionary consumption changes, the model automatically adjusts obligatory spending. Discretionary consumption is important for a household's living standards since it includes spending for such things as food and out-of-pocket health care costs. Furthermore, the consumption expenditures required to maintain a household's living standards vary from year to year as children and adults age. The model assumes that “off the top” expenditures are lower in retirement than at younger ages.
"People try to even out their consumption over their lives to avoid drastic changes in living standards."
The cuts are treated as a surprise at the time they are announced. For the singles and couples who are 65 years old at the time of the announcement, their retirement living standards after the cuts are compared to what their retirement living standards would be if they received full, projected Social Security benefits. 3 For the younger households, their current discretionary consumption with and without benefits is compared, and their discretionary consumption at retirement with benefits is compared to their consumption without benefits. These comparisons show the extent to which younger households adjust to the benefit cuts, and thus avoid a severe reduction in their standard of living when they retire. The model assumes that, other things equal, people will try to maintain their standard of living by evening out their consumption over their remaining lifetimes. [See the side bar “Comparison of Consumption Smoothing by Two Couples.”]
For all of these households, the financial impact over their remaining lives was simulated for three policy options:
- Policy Option 1: Social Security benefits under current law are completely paid.
- Policy Option 2: Social Security benefits are immediately and completely eliminated.
- Policy Option 3: There is an immediate 30 percent benefit cut — affecting 65-year-olds who are about to retire as well as younger workers.
In all cases, it is assumed that workers continue to pay Social Security taxes under current law.
Comparison of Consumption Smoothing by Two Couples
Other things equal, people will attempt to smooth consumption over their lifetimes — that is, they will try to avoid abrupt changes in their standard of living. This is the theory underlying the life-cycle model of consumption and saving used in this study. It is also the way people behave. There are two ways people can smooth their lifetime consumption: 1) They can borrow in order to increase their current consumption, or 2) They can save in order to increase their future spendable income. Borrowing requires them to lower their future standard of living (as they pay back the debt), while saving requires them to lower their current standard of living (by cutting spending). However, this is difficult for lower income people. Due to their current obligations, they often cannot increase their retirement savings. Also, they are limited in their ability to borrow in order to increase their current consumption.
For example, take two young couples starting out. The first couple consists of two credit-worthy, middle-income earners who can finance some of their current consumption by borrowing. For credit-worthy, higher-income couples, the cost of borrowing will be lower than the rate of return on their retirement savings. During their retirement years, they live on the savings accrued during their working years in addition to Social Security benefits. Borrowing and saving allows them to smooth their consumption
over their remaining lives.
The second young couple earns less and cannot finance current consumption by borrowing against their future income. The reason is that the cost of additional borrowing would be greater than the rate of return they would receive on their savings. In other words, they are borrowing constrained due to their existing debt obligations. They save less, but due to the progressive Social Security benefit formula, they expect a retirement standard of living that is higher than their current standard of living.
If Social Security benefits were cut 30 percent, the first couple, which is not borrowing constrained, would reduce their current consumption in order to save more — lowering their current standard of living in order to avoid a large reduction in living standards at retirement. The second couple, which is borrowing constrained, would reduce their current consumption very little, if at all — even though a 30 percent cut in Social Security benefits represents a greater percentage of retirement income for them than it does for the first couple. The reasons: 1) The cut would not drastically reduce their retirement living standards below their current living standards, and 2) They cannot borrow against their Social Security benefits. If Social Security benefits were completely eliminated, however, the second couple would face a drastic decline in their living standard at retirement; in response, they would reduce their current consumption in order to save more.