Good news on Social Security?

An inflation gap means you may get more than you think – even if benefits are cut. It's a 'good' glitch, but it needs fixing.

Americans recently received some good news regarding Social Security. While the retirement and disability program still faces significant funding shortfalls, the annual trustees report released last month showed improved long-term finances. But there is more "good" news, this time for workers who receive an annual benefit statement from the Social Security Administration.

To help with retirement planning, the "Social Security Statement" estimates the benefits workers will be entitled to at retirement. The statement significantly underestimates promised benefits for younger workers. In fact, even if we fixed Social Security's solvency entirely by reducing future benefits, most workers would still receive higher benefits than their Social Security Statement indicates. Though the glitch means higher benefits for future retirees, it hurts Social Security's credibility with the public. Correcting the error is essential.

Social Security mails workers a statement each year about three months prior to their birthday. Based on earnings to date, the statement projects future retirement benefits. Social Security was never meant to be the only source of retirement income, so the benefit estimate helps workers plan how much to save on their own. This is important, since the Social Security benefit formula is so complex that many people simply couldn't calculate benefits themselves.

The Social Security statement is actually quite good at determining future retirement benefits. Using the statement's methods, I was able to project the benefits of selected current retirees based on their earnings through age 45 with an average error of less than 2 percent. While more sophisticated methods could be used to close even that gap, this is not where the statement's drawbacks lie.

The difficulty comes in translating these future benefits into terms that are understandable. The statement claims that estimated benefits are "in today's dollars," which means subtracting inflation to express them in today's purchasing power. For instance, a typical new retiree 20 years from now may receive an annual benefit of $33,000. That sounds like a lot, but if inflation runs at 3 percent per year, the real purchasing power of that benefit is only around $18,000. Expressing future benefits in today's dollars helps workers know how much their future benefits will actually buy years down the road.

But here's the problem: Despite what the statement says, its benefit estimates are not "in today's dollars." Benefits are expressed in what are called "wage-indexed dollars." Wage-indexing accounts not just for the growth of prices but also for the growth of average wages. Wages grow around 1 percent faster per year than prices, so adjusting for them reduces the statement's estimated benefit by around 1 percent for each year between now and when the worker would retire. While not a big deal for those about to retire, for younger workers – who need this information to plan their other savings – the annual errors compound. For instance, the $33,000 benefit for a typical retiree in 20 years would be wage-indexed back to only $15,000, 17 percent less than the true inflation-adjusted value.

Some might argue that it's OK for the statement to underestimate future benefits, since reform will likely reduce benefits anyway and low-balling estimated benefits might scare Americans into saving more for retirement. Maybe so. Social Security reform is a daunting task and, whether politicians will admit it or not, younger workers probably won't receive everything they have been promised. Given the statement's errors, benefits under reform could at least exceed workers' expectations.

But the statement's underestimate of future benefits is so large that most workers would come out ahead even if we fixed Social Security entirely by reducing benefits. An individual who relied on this estimate would tend to over-save, making it harder to meet current expenses such as a mortgage or education.

Higher retirement benefits hidden in the numbers is a nice surprise, but the Social Security Administration should nevertheless correct the statement's benefit calculations.

Right or wrong, Social Security already has credibility problems. For Americans to accept the sacrifices involved with reform, they need confidence that official numbers coming from the agency are accurate.

Andrew G. Biggs, a former principal deputy commissioner at the Social Security Administration, is a resident scholar at the American Enterprise Institute in Washington.

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