By Alicia Munnell
Policy experts have focused on alternative ways of eliminating Social Securityâ€(tm)s 75-year financing gap, but lost in the debate is the fact that even under current law Social Security will provide less retirement income relative to previous earnings than it does today. Combine the already legislated reductions with potential cuts to close the financing gap, and Social Security may no longer be the mainstay of the retirement system for many people.
In 2002, the frequently quoted replacement rate for the â€oemedium earner†who earned about $42,000 in todayâ€(tm)s dollars and retired at age 65 was 41%; that is, Social Security benefits were equal to 41% of the individualâ€(tm)s previous earnings. Under current law, three factors will reduce this replacement rate: 1) the extension of the full retirement age; 2) the increase in Medicare premiums; and 3) the taxation of Social Security benefits.
1. The extension of the full retirement age
Under current law, the full retirement age is scheduled to increase from 65 for those reaching 62 in 2000 to 67 for people reaching age 62 in 2022. This increase is equivalent to an across-the-board benefit cut. For those who continue to retire at age 65, this cut takes the form of lower monthly benefits; for those who extend their work lives, it takes the form of fewer years of benefits. Thus, as reported in the Social Security Trustees Report, the replacement rate for the medium earner will drop from 41% to 36% for people who retire at age 65 in 2030.
2. The increase in Medicare premiums
The rising cost of Medicare will also affect future replacement rates. For the medium earner, Medicare premiums, which are automatically deducted from Social Security benefits, are scheduled to increase from 5% of benefits for someone retiring in 2002 to 12% for someone retiring in 2030.
3. The taxation of Social Security benefits
The taxation of Social Security benefits The third factor that will reduce Social Security benefits is the extent to which they are taxed under the personal income tax. Under current law, individuals with less than $25,000 and married couples with less than $32,000 of â€oecombined income†do not have to pay taxes on their Social Security benefits. (Combined income is adjusted gross income as reported on tax forms in addition to nontaxable interest income and half of your Social Security benefits.) Above those thresholds, recipients must pay taxes on either 50% or 85% of their benefits. In 2002, only 20% of people receiving Social Security had to pay taxes on their benefits, so median earners typically did not pay any taxes. But the thresholds are not indexed for growth in average wages or even for inflation so, by 2030, as real benefits and other income increases, many medium earners will pay tax on half of their benefits.
The bottom line is that the net Social Security replacement rate for the medium earner will decline from 39% in 2002 to 29% in 2030 under current law (see Figure). Policymakers need to be aware of this fact when they consider how much of the 75â€"year financing gap should be closed by benefit cuts and how much by tax increases.