Thursday, December 15, 2016

Johnson’s Social Security Reform Proposal Will Require Millennials to Save 4% More of Their Annual Pay, on Average, to Replace Benefit Reductions

On December 8, House Ways and Means Social Security Subcommittee Chairman Sam Johnson introduced legislation (referred to here as the Johnson proposal) that he claims “will permanently save Social Security.”  His press release notes that, “this year, the Trustees Report warned workers will face a 21 percent benefit cut starting in 2034 if Congress does not reform the program.  Chairman Johnson’s legislation, the Social Security Reform Act of 2016 (H.R. 6489), puts Social Security back on a sustainable path…”  The Johnson proposal would achieve this “sustainable path” primarily by reducing future benefits for today’s younger workers by an even larger percentage, on average, than 21%.

Readers of our previous blogposts are reminded that the success of any proposed change in Social Security in achieving a permanent fix depends on realization of assumptions made by the Social Security Trustees at the time of reform, and there is no guarantee that these assumptions will be accurate for the next 75 years (and no mechanism in the current law to maintain actuarial balance in the future if the assumptions prove to be inaccurate).  In fact, common sense tells us that it is highly likely that actual experience will deviate from the assumptions made for 75 years or longer.  Therefore, any statements that claim to permanently save the System need to be viewed with a high degree of skepticism.

The graph below, from the December 8, 2016 letter from the Social Security Office of the Actuary to Congressman Johnson scoring his proposal, shows projected costs under current law and under the Johnson proposal for the next 75 years, as a percentage of taxable payroll under the 2016 Trustee’s Report Intermediate Assumptions about the future.  Under these assumptions, it appears that, on average for years after 2050, the Johnson proposal would reduce System costs (benefits) (the red and blue dashed line) compared with current law benefits by about 25% or more, and even below benefit levels anticipated if no reform action is taken (the dark black line).

(click to enlarge)

So, it looks like while most participants in Social Security would experience some degree of benefit reduction relative to current law under the Johnson proposal, benefits for Millennials and generations that follow would be most affected.  Note that the reductions depicted in the graph are averages and the actual benefit reductions relative to current law for some Millennials might be larger than 25% and reductions for others might be less.  Also, note that while the anticipated reductions for Millennials relative to current law are significant, they are not much larger than reductions required if no reform action is taken.  And there are probably some Millennials (and their employers) who might prefer the Johnson proposal to having to pay increased FICA taxes in the future (which the above graph shows to be somewhere in the 3.5%-4% neighborhood in total from employees and employers under current Trustees assumptions).

The Johnson proposal is just a proposal, and it may not be enacted.  However, Millennials may want to factor proposals like this one in their current spending/savings decisions.  We encourage Millennials, other pre-retirees and their financial advisors to use our Actuarial Budget Calculator (ABC) for Pre-Retirees annually to develop reasonable spending/savings budgets.  The following is an example showing how a hypothetical Millennial could use the ABC to determine how much more she should be saving today to replace future benefit reductions anticipated under the Johnson proposal.  The example also shows how our hypothetical Millennial can use the ABC to calculate the savings rate needed to satisfy her retirement goals if assumptions about her continued employment are not realized in the future.


Let’s look at a 30-year old unmarried female (who we will call Ann) who is currently saving 10% of her gross pay of $50,000 each year, has accumulated $25,000 in savings (some pre-tax and some after tax) and has no other assets.  Her employer matches her 401(k) contributions $.50 on the dollar up to 6% of her pay, but her employer does not sponsor a defined benefit pension plan.  For planning purposes, Ann makes the following assumptions:

  • Her investments will earn 4% per annum each year in the future 
  • Inflation will be 2% per annum 
  • Her compensation will increase by 3% per annum 
  • She plans to cease employment and fully retire at age 69 (39 years from now) and commence her Social Security benefit at that age 
  • She will contribute at least 6% of her pay annually to her employer’s 401(k) plan to obtain the maximum matching employer contributions 
  • The present value of her unexpected expenses are $25,000 
  • The present value of her expected long-term care costs are $75,000 
  • She desires to leave $100,000 at her death (in nominal dollars and $27,605 in inflation-adjusted dollars) to cover her anticipated end-of-life expenses 
  • She has no other anticipated non-recurring pre-retirement or post-retirement expenses 
  • She expects to live until age 95
Her retirement goals include:
  • retiring on or prior to age 69 and 
  • having a first year of retirement real dollar spending budget that is at least 75% of her real dollar spending budget in her last year of employment, and 
  • having her spending budget increase in retirement by 1.5% per year (inflation minus 0.5%) for the rest of her life to cover her estimated recurring annual expenses.
Ann uses the Social Security Online Quick Calculator to estimate her Social Security benefit commencing at age 69 under current law expressed in today’s dollars of $25,692 per annum. She then increases this amount for 39 future years of 3% per year pay increases (assuming a constant replacement ratio) to develop an estimated Social Security benefit under current law of $81,367.  She enters this amount in the Input and Results tab for Social Security (commencing in 39 years) and the assumptions and data discussed above.  She determines that if these assumptions are exactly realized, she must save at least 8% of her pay each year to achieve her retirement goals assuming no change in Social Security.

She estimates the approximate reduction in the value of her Social Security benefit under the Johnson proposal to be 75% of her projected benefit under current law of $81,367 (or $61,025).  She inputs that new Social Security benefit in the ABC and, keeping all the other assumptions the same, reruns the ABC.  Under the Johnson proposal, to achieve her same 75% replacement goal, she must increase her savings rate from 8% of her pay to 12% of her pay each year.

In addition to being concerned about Social Security benefits, Ann also worries that she may not be able to work at her current employer (or at another comparably paying job) for 39 years.  She decides to rerun her Johnson proposal numbers assuming she ceases full time employment at age 62 and works in part-time employment at 40% of her previous gross pay for 7 years, with such pay increasing with inflation (2%) each year but assumes her Social Security benefit will still commence at age 69.  Under this scenario, she determines that she must save 15% of her pay each year until age 62 to meet her retirement goals.

Finally, she decides to look at what her required savings rate would be under the Johnson proposal if she is laid off at age 62 and doesn’t want to, or otherwise can’t, work at all after that age.  Under this scenario, she calculates that she must save 20% of her pay each year to meet her retirement goals.

Ann uses these “data points” to determine that she probably should be trying to save closer to 20% of her pay each year rather than the 10% she had been targeting previously.

Note that while our hypothetical worker has determined that she may need to save an additional 4% of her pay to replace the anticipated reduction in the value of her Social Security benefits if the Johnson proposal is enacted, the amount of increased savings necessary could vary significantly from individual to individual and will depend on many factors.  For example, while higher paid Millennials may experience larger than average Social Security benefit reductions, not all their pay may be subject to FICA tax, so they may not need to save as much as 4% of their gross pay to replace the reductions anticipated for them under the Johnson proposal.