Social Security Income Replacement Ratios

Wednesday, November 10, 2010

Most workers in the US are subject to Social Security taxes on earned income up to $106,800 for both 2009 and 2010 at a rate of 6.2% for both the employee and employer. Self-employed persons pay a 12.4% tax rate on their earnings up to $106,800, also for 2009 and 2010. Thus for a worker earning $55,000 in 2009 and 2010, employed or self-employed, a total of $6,820 will be paid into the Social Security Trust Fund (Old-Age and Survivors Insurance (OASI) and Disability Insurance (DI) Trust Funds) on their behalf. In addition to Social Security taxes, workers and their employers pay a Medicare tax of 1.45% (2.9% total) each on all earnings. Self-employed individuals pay a total Medicare tax of 2.9%, which may be offset by certain income tax provisions on their earnings.

For a large majority of US workers, Social Security will constitute a significant portion of their retirement income ranging from 69% to 36% for retires whose pre-retirement income ranged from $20,000 to $90,000 respectively, based on Aon’s 2008 Replacement Ratio Study A Measurement Tool For Retirement Planning. Aon Consulting and Georgia State University (GSU) have collaborated since 1980 to produce periodically an analysis of Social Security and private retirement income replacement ratios. Initially issued as part of the President’s Commission on Pension Policy, the 1980 edition has been followed by seven follow-up studies; the latest is the 2008 Replacement Ratio Study.

The 2008 report by Aon and GSU suggests that to maintain a similar lifestyle in their post-retirement years, a worker will need a 94% to 78% income replacement ratio as their pre-retirement income ranges downward from $20,000 to $90,000. The findings here indicate that lower income levels require a protionally higher level of income replacement, proportionally, than do their upper income counter-parts. The current Aon/GSU study further points out that as the proportion of retirement income replaced by Social Security decreases (from 69% to 36%), the proportion replaced by other sources, i.e., private retirement plans (DB/DC) and personal savings has to increase to compensate for the loss.

Historically, the US retirement system has been based on three components: Social Security/Railroad Retirement, private employer defined benefit pensions, and personal savings. However, beginning in the 1980’s this “Three Legged Stool” increasingly has had the private employer defined benefit (DB) pension leg replaced by private employer defined contribution (DC) plans. However, since defined contribution plans generally require active participant contributions by employees, this change has effectively combined the private employer DC plans and personal savings into a single leg. Moreover, since most workers have a limited ability to save, the loss of private employer DB pension plans, which generally did not require contributions by employees, represents a decline in the employee’s overall income replacement ratios.

Clearly, to achieve income replacement ratios as suggested by Aon and GSU latest report will require significant disciplined behaviors by most workers throughout their working lifetime. Since the retirement of 76 million baby boomers could place substantial strains on both the Social Security and Medicare systems, it is essential that workers save more and sooner. These behaviors could include reduced consumption during the employee’s working lifetime in an effort to increase saving’s rates, something most workers may find hard to achieve. One obvious behavior would entail workers remaining in the labor force longer and even past their normal retirement age. Nevertheless, the coming decades will, no doubt, see a fundamental change in what is meant by retirement.