Myths and Realities of Social Security Replacement Rates

November 28, 2012

The adequacy of Social Security benefits are often measured by the "replacement rate," a ratio of one's retirement benefit to preretirement income. While this is intended to provide equity in benefits over time, there are some misunderstood features that have some unintended consequences for the overall evaluation of the program, says Charles Blahous, a senior research fellow at the Mercatus Center and public trustee for Medicare and Social Security.

  • First, younger workers' preretirement standards of living decline relative to their postretirement living standards because the cost of benefits increases over time.
  • Second, the actual replacement rates are high because they are not reported as they would be calculated by financial planners.
  • Third, the benefit formula causes replacement rates to rise over time for a given level of real wages.

There are also three often misunderstood aspects of Social Security replacement rate.

  • First, the replacement rate is increasing relative to workers' standards of living. But since younger generations must pay higher tax burdens to receive the same replacement rates, there is a decline in net benefits.
  • Second, Social Security replacement rates are higher than people assume. However, this assumes replacement rates as a percentage of career "wage-indexed" earnings, which results in under-evaluation.
  • Finally, Social Security benefits are rising for a given level of real wages. However, the current benefit formula keeps replacement rates constant for average-wage workers, which delivers rising benefits to workers with the same real wages across time and contributes to rising system costs.

Furthermore, people are deterred from further labor market participation and saving because total retirement income replacement rates exceed 100 percent of late-career earnings. There are several reforms the federal government could pursue to make future program evaluation more accurate and help fix the finances of the program.

  • First, prevent the decline in the ratio of preretirement income to postretirement benefits.
  • Second, prevent Social Security from forcing low-income families and individuals from over-saving for retirement.
  • Third, maintain constant replacement rates for those with the same real wages.

Source: Charles Blahous, "Understanding Social Security Benefit Adequacy: Myths and Realities of Social Security Replacement Rates," Mercatus Center, November 15, 2012.

 

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