Andrew G. Biggs is a resident scholar at the American Enterprise Institute (AEI), where he studies Social Security reform, state and local government pensions, and public sector pay and benefits.
The Coronavirus pandemic is shuttering U.S. businesses and has pummeled the retirement savings of nearly all Americans. But in a new working paper, I find that the virus poses a potentially worse financial threat to a small group of near-retirees whose Social Security benefits could be cut due to quirk in how national wage growth interacts with the Social Security benefit formula.
As social distancing and quarantines are imposed, jobs are lost and wages are reduced. Based on independent projections and details of the Social Security benefit formula, I estimate that, in 2020, the Average Wage Index – the Social Security Administration’s measure of national average wages – could fall 15% below the level projected for this year in the 2019 Social Security Trustees Report.
While most Americans understand that Social Security is designed to replace a percentage of a participant’s career-average pre-retirement earnings, the actual benefit formula is significantly more complex. In two important ways the benefit formula integrates the growth rate of economywide average earnings.
First, before a worker’s career-average earnings are calculated, those annual earnings are indexed to changes in the Average Wage Index up through age 60. Any earnings after age 60 are entered in nominal form, into the average. A percentage change in the Average Wage Index in the year a participant turns 60 has a nearly one-for-one impact on the Social Security benefit formula’s calculation of the career-average earnings. For an American born in 1960 and aged 60 in 2020, a 15% decline in the Average Wage Index would reduce the value of his career-average earnings by about 13.1%. By itself, this development will reduce participants’ retirement benefits.
Second, the Social Security benefit formula’s “bend points” also indexed to changes in the Average Wage Index. For an American age 62 in 2020, Social Security will replace 90% of his first $960 in average monthly earnings, 32% of monthly earnings between $960 and $5,785, and 15% of any earnings between $5,785 and the maximum salary subject to Social Security payroll taxes (currently $137,200). When today’s 60-year olds become eligible for benefits at age 62, the bend point dollar amounts will reflect any drop in the Average Wage Index experienced this year. Lower bend point values would mean that a smaller share of participants’ earnings would be replaced at the 90% replacement rate, and a larger share at the 32% or 15% replacement rates.
I estimate that, for in a medium wage worker aged 60 in 2020, a 15% decline this year in the Average Wage Index could lead to a permanent reduction Social Security retirement benefits of around 13.8%. This $3,900 annual benefit reduction would reduce his lifetime benefits by over $70,000. Similar percentage benefit cuts would apply to retirees at all earnings levels. While we expect the economy will eventually recover, Americans age 60 in 2021 may also receive lower-than-expected benefits.
Should policymakers wish to avert this benefit cut, one ad hoc solution is go to back to how Social Security calculated average wages in the 1970s, using wage data only for the first quarter of the year. Using Q1 2020 data would avoid most of the decline in the Average Wage Index for 2020, though the 2021 Average Wage Index would remain a problem.
A better option might be for the Social Security benefit formula to stop wage-indexing past earnings in the first place. Retirees seek to replace the real earnings power they had prior to retirement, which points toward calculating Social Security benefits as a percentage of the worker’s inflation-adjusted career-average earnings. Wage-indexing of past earnings equates them to the earnings level of today’s workers, which is generally much higher than today’s retirees had back when they were working. The 90, 32, and 15% replacement factors could be increased to keep the dollar value of retirees’ benefits the same.
If the Social Security benefit formula worked with inflation-adjusted pre-retirement earnings, even a large decline in national average wages in a single year would have only a tiny effect on retirees’ Social Security benefits.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.
