Retirement Policy in the 21st Century

Jon FormanAlfred P. Murrah Professor of LawUniversity of Oklahoma College of Law

OU’s Senior Adult Services “Mornings with the Professor” program

December 9, 2008

available at http://www.law.ou.edu/profs/forman.shtml

2

Overview

Retirement Security as a three-Legged Stool Social Security Private Pensions Savings

Aging of America Social Security Private Pensions

3

Aging of America Americans are living longer but

retiring earlier Life expectancy for a male born in

1940 was just 61.4 years today it is 73.9 years

Also, a man reaching age 65 in 1940 could expect to live another 11.9 years but a man reaching 65 in the year 2000

could expect to live another 15.9 years

4

Aging of America

Increasing percentage of Americans will survive to old age. For example, although just 54 percent of

men born in 1875 survived from age 21 to age 65 in 1940

Almost 83 percent of men born in 1985 are expected to survive from age 21 to age 65 in 2050

A graying of America

5

Aging of America

Trend toward earlier and earlier retirement

Average age at which workers begin receiving their Social Security retirement benefits fell from 68.7 years old in 1940 to 63.6 years

old in 2002

Labor force participation rates for the elderly have also dropped

6Bureau of Labor Statistics, Labor Force Statistics from the Current Population Survey: Civilian Labor Force Participation Rate (2004),available at <http://data.bls.gov/labjava/outside.jsp?survey=ln>.

Labor Force Participation of Men Aged 55 and Older, 1950-2003

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002

Year

Pa

rti

cip

ati

on

Ra

te

Males Age 55-64 Males Age 65 and Older

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How many people rely on Social Security for most of their income?

90% of people 65 and older get Social Security

Nearly 2 in 3 (66%) get half or more of their income from Social Security

About 1 in 5 (22%) get all their income from Social Security

8

Most elderly don’t receive pensions

Percent with Employer-Sponsored Pensions

All age 65+ 41%Couples 51%Unmarried men 39%Unmarried women 32%

9

Social Security

How Social Security Works Financing Social Security How Benefits Are Determined

Financial Troubles How to Fix It

Raise Taxes Cut Benefits Increase Investment Returns

10

How Many People Get Social Security?

49 million people receive Social Security each month

1 in 6 Americans get Social Security benefits

Nearly 1 in 4 households get income from Social Security

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Who Gets Social Security?

30.0 million retired workers 4.8 million widows and widowers 6.2 million disabled workers 0.8 million adults disabled since

childhood 3.1 million children

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How Much Does Social Security Pay?

www.ssa.gov/OACT/COLA/colaeffect.html

Type of Beneficiary AverageMonthly Benefit

All Retired Workers $1,044

Aged widow(er), non-disabled $1,008

Disabled worker $979

Aged couple-both receiving $1,713

Widowed mother and two children $2,167

13

Social Security and Poverty

2007 Poverty Levels Single individuals – $10,210 ($851/month) Married couples – $13,690 ($1,141/month)

With Social Security only 9% were poor in 2000

Without it, 48% would have been poor

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Financing Social Security Workers and their employers pay with

Social Security taxes Workers pay

6.2% of their earning for Social Security, and 1.45% of their earnings for Hospital Insurance

under Medicare (Part A) Employers pay an equal amount The total is 12.4% for Social Security and

2.9% for HI Social Security tax base is $97,500 in 2007

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Worker Benefits

Workers over 62 are eligible If they have worked 10 years

Benefits are based on a workers earnings history Career-average earnings Average Indexed Monthly Earnings (AIME)

16

Average Indexed Monthly Earnings (AIME)

Determine how much the worker earned every year through age 60 Determine Benefit Computation Years And Earnings in those years

Index those Earnings for Wage Inflation Up to the year the worker turns 60

Subsequent Work Years Also Count Pick the Highest 35 Years

Drop the rest

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Average Indexed Monthly Earnings (AIME), continued

Add those highest 35 years of earnings up

Divide by 35; Divide by 12 Result is called Average Indexed

Monthly Earnings (AIME) AIME is then linked by formula to the

basic retirement benefit Result is called Primary Insurance Amount

(PIA) Paid at full retirement age

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Full Retirement Age

http://www.ssa.gov/retire2/retirechart.htm

Year of Birth Full Retirement Age

1937 or earlier 65

1938 - 1942 plus 2 months per year

1942 – 1954 66

1955 - 1959 plus 2 months per year

1960 and later 67

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Primary Insurance Amount (PIA)

For a worker turning 62 in 2007,PIA = 90% of first $680 of AIME

+ 32% of AIME from $680 to $4,110 (if any)+ 15% of AIME over $4,110 (if any)

$680 and $4,110 are called bend points PIA indexed by cost of living after 62 Provides higher benefits relative to earnings

for lower paid

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Primary Insurance Amount (PIA) formulafor persons turning age 62 in 2007

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

$2,000

$2,200

$0 $1,000 $2,000 $3,000 $4,000 $5,000 $6,000

Average Indexed Monthly Earnings

Pri

mar

y I

nsu

ran

ce A

mo

un

t

PIA

Second Bend Point$4,110

FirstBend Point$680

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How do benefits compare to earnings?

$19,600$22,500

$15,800

$35,300

$55,400

$90,000

$14,800

$9,000

57%

42%

35%25%

$0

$20,000

$40,000

$60,000

$80,000

"low" "medium" "high" "maximum"

Earnings Amount

Past Wages Benefits

Retired worker age 65, 2005

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Worker Benefits:Increases and Decreases Indexed for inflation Actuarial decrease for early retirement

Example: average-wage worker, 62 in 2006 Will get $1,332.80 per month at her full

retirement age of 66 or $999 per month at 62

Actuarial increase for later retirement 8 percent per year

Retirement Earnings Test In 2007, early retirees lose $1 of benefits for

each $2 of earnings over $12,960

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Family Benefits

Spouses, dependents, and survivors Husband or wife gets 50% of worker’s

PIA Together, couple gets 150%

Widow or widower gets 100% of worker’s PIA

A joint and two-thirds annuity Dual entitlement rule limits benefits

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Estimates for 2006 Finances

Trust Fund income = $745 billion (taxes)Trust Fund outgo = $555 billion (benefits)Surplus = $190 billion

By law, surpluses are invested in U.S. government securities and earn interest that goes to the trust funds.

25

How do actuaries estimate the future?

Review the past: birth rates, death rates, immigration, employment, wages, inflation, productivity, interest rates

Assumptions for the next 75 years Three scenarios: Low cost; High cost;

Intermediate (best estimate)

26Social Security Administration, 2007 Trustees’ Report

27American Academy of Actuaries (2005), available at <http://www.actuary.org/pdf/socialsecurity/medicare_socsec_briefing_april05.pdf>.

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The Long-Range Forecast(Best estimate)

In 2017, tax revenues into the trust funds forecasted to be less than benefits due that year. Interest on the reserves and the assets themselves will help pay for benefits until 2041.

In 2041, reserves are projected to be depleted. Income is forecast to cover 75% of benefits due then.

By 2081, assuming no change in taxes, benefits or forecasts, revenue would cover 70% of benefits due then.

29

Social Security’s Financing Problem

2007 Trustees Report shows Expenses will exceed payroll tax income in 2017 Trust funds will be out of money in 2041

75-year deficit equals 1.95% of taxable payroll Immediate payroll tax increase of 1.95% needed to

restore actuarial balance Alternatively, immediate ~12.8% across-the-board

benefit cut $4.7 trillion unfunded liability About 0.7% as a share of the entire economy (GDP)

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Only 3 Ways to Fix Social Security

Raise Taxes Cut Benefits Increase Investment Returns

Private investment Either government or individual

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Options: Raise Taxes

OPTION Increase tax rate by

2% total Tax all earnings Tax 90% of earnings Include new state &

local govt. workers Tax SS benefits like

pensions

% of Deficit Eliminated104%

93%40%10%

20%

National Academy of Social Insurance, Social Security Brief No. 18 (2005); American Academy of Actuaries (2004).

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Options: Cut Benefits

OPTION Raise retirement age

(to 67 faster & index) Reduce COLA by ½%

each year Cut benefits by 5% for

those starting to get benefits in 2005

Increase # years in wage avg. to 40

% of Deficit Eliminated28%

41%

32%

21%

National Academy of Social Insurance, Social Security Brief No. 18 (2005); American Academy of Actuaries (2004).

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Options: Increase Investment Returns

OPTION Investments in equities

% of Deficit Eliminated36% - 50%

National Academy of Social Insurance, Social Security Brief No. 18 (2005); American Academy of Actuaries (2004).

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Social Security Game

American Academy of Actuaries Social Security reform game, http://www.actuary.org/socialsecurity/game.html

Play the game to explore options for Social Security reform and their impact on the program's solvency.

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Two Basic Types of Pensions

Defined benefit plans Defined contribution plans

Also, hybrid plans

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What is a Defined Benefit Plan?

Employer promises employees a specific benefit at retirement

To provide that benefit, the employer makes payments into a trust fund and makes withdrawals from the trust fund

Employer contributions are based on actuarial valuations

37

Defined Benefit Plan

Employer bears all of the investment risks and responsibilities

Typical plan provides each worker with a specific annual retirement benefit that is tied to the worker’s final average pay and number of years of service

38

Defined Benefit Plan

For example, a plan might provide that a worker’s annual retirement benefit is equal to 2% times years of service, times final average pay

B = 2% × yos × fap Final-average-pay formula

39

Defined Benefit Plan Worker with 30 years of service would

receive 60 percent of her pre-retirement earnings

Worker earning $50,000 would get $30,000-a-year pension B = $30,000 = 60% × $50,000 = 60% × fap = 2 percent × 30 yos × $50,000 fap

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Defined Benefit PlanEffect of inflation on real value of retirement income

Years in retirement

No inflation

3% Annual Inflation

10% Annual inflation

0 100 100 100

5 100 86 62

10 100 74 39

15 100 64 24

20 100 55 15

25 100 48 9

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Only 3 ways to fix an underfunded Defined Benefit Plan

Raise Contributions Cut Benefits Increase Investment Returns

42

What is a Defined Contribution Plan?

Individual account plan Employer typically contributes a

specified percentage of the worker’s pay to an individual investment account for the worker

Owned by employee Benefits based on contributions and

investment earnings

43

Defined Contribution Plan

For example, employer might contribute 10% of annual pay

Under such a plan, a worker who earned $30,000 in a given year would have $3,000 contributed to her account $3,000 = 10% × $30,000

Benefit at retirement based on contributions, plus earnings

44

Defined Contribution Plan

Money purchase pension plans 401(k) and 403(b) plans

allow workers to choose between receiving cash currently or deferring taxation by placing the money in a retirement account

Profit-sharing plans & stock bonus plans

45

What is a Hybrid Plan?

“Hybrid” plans mix features of defined benefit and defined contribution plans For example, a cash balance plan is a

defined benefit plan that looks like a defined contribution plan

Another common approach is to offer a combination of defined benefit and defined contribution plans

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Goals for a Pension Plan First, ensure that every employee

earns a meaningful retirement benefit and that long-time employees are

guaranteed an adequate income throughout their retirement years

Second, have a minimum of work disincentives for employees coming in and out of service

Third, be affordable and well-financed

47

Long-term Reform

Retirement system should ensure that every elderly American has an adequate retirement income

Redesign the current system Two-tier system

First tier: poverty-level benefit Second tier: earnings-related benefit Earnings sharing

48

First Tier: Basic Benefit

Government guarantee of poverty-level income

2007 Poverty Levels Single individuals – $10,210 ($851/month) Married couples – $13,690 ($1,141/month)

Would replace SSI and redistribution within the current SS system

Pay for with general revenues

49

Second Tier: Earnings-related Benefit

Individual accounts Hypothetical (“cash balance”) accounts Invested by professionals

Pay for with reduced payroll taxes Pay out lifetime annuities

Inflation-adjusted annuities

50

Earnings Sharing

Credit each spouse with one-half of couple’s combined earnings during marriage

At retirement, each spouse’s benefit would be based on her half of the couple’s earnings, plus her prior earnings

Would replace spousal benefits

51

Conclusions

Social Security has a $4.7 Trillion Unfunded Liability

Oldest baby-boomers are 60 Only half of the elderly have pensions Reforms are needed

52

Select Sources American Academy of Actuaries, Social Security Reform:

Solutions Inside the Box: Proposals Not Including Individual Accounts (2004), available at http://www.actuary.org/pdf/socialsecurity/briefing_041604.pdf.

Jon Forman, Making America Work (Washington, DC: Urban Institute Press, 2006). See http://www.urban.org/books/makingamericawork/index.cfm.

National Academy of Social Insurance, Options to Balance Social Security Over the Next 25 Years (Social Security Brief No. 18, February 2005), available at http://www.nasi.org/usr_doc/SS_Brief_18.pdf.

Social Security and Medicare Boards of Trustees, 2007 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds (2007), available at http://ssa.gov/OACT/TR/TR07/tr07.pdf.

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About the Author Jonathan Barry Forman (“Jon”) is the Alfred P.

Murrah Professor of Law at the University of Oklahoma College of Law, where he teaches courses on tax, pension, and elder law.

Professor Forman is also Vice Chair of the Board of Trustees of the Oklahoma Public Employees Retirement System (OPERS) and the author of Making America Work (Washington, DC: Urban Institute Press, 2006).

Prior to entering academia, Professor Forman served in all three branches of the federal government. He has a law degree from the University of Michigan, and he also has master’s degrees in economics and psychology.

Jon can be reached at jforman@ou.edu or (405) 325-4779. His web page is www.law.ou.edu/faculty/forman.shtml.