This post is a follow-up to my July 3, 2023 Advisor Perspectives article, Applying the Actuarial Process to Retirement Planning, where I encouraged financial advisors to employ the same actuarial process for retirement planning that Social Security actuaries employ for Social Security financing. In that article, I outlined the following six-step planning process and included an illustration showing how this process is applied to Social Security:
- Make reasonable assumptions about the future (generally deterministic, not stochastic).
- Calculate present values of assets (including future sources of income) and liabilities based on relevant demographic information, system provisions and assumptions made.
- Periodically (generally annually) compare estimated present values of assets to liabilities to determine the system’s funded status (snapshot comparison).
- Maintain a history of the system’s funded status over time and note trends.
- When warranted or required, make changes to assets or liabilities (or both) to restore desired funded status (and/or to address possible cash flow issues).
- Periodically evaluate/stress test assumptions to see if they need to be changed or to assess risk.
This month, the American Academy of Actuaries released an Issue Brief entitled, The Importance of Assumption-Setting for Social Security Valuations that involves Steps 1-3 and 6 of the actuarial process above, with emphasis on Step 1. While the Issue Brief discusses the steps the Social Security Trustees and Social Security Administration actuaries take to test that assumptions used for Social Security projections are “reasonable”, it does not specifically mention the importance of performing an annual gain and loss analysis by assumption source for this purpose, which is a common actuarial technique for measuring the reasonableness of individual assumptions (or groups of assumptions), particularly for larger systems. The exclusion of such discussion from the Academy Issue Brief is baffling, since the SSA performs just such an analysis, and it is quite informative in its role as Step 4 of the actuarial process described above. The gain/loss analysis by assumption source is summarized each year as part of the annual valuation process in Social Security Administration Actuarial Note Year.8.
The key take-aways from SSA Actuarial Note 2023.8 include:
- The system’s funded status (long-range actuarial balance) has declined fairly continuously over the past 40 years from 0.02% of taxable payroll in 1983 to -3.61% in 2023.
- Of this decline, 64% is attributable to annual changes in the valuation period (which I refer to as “the Valuation Date Creep”), 30% of the decline is attributable to economic data and assumptions and about 13% of the decline is attributable to disability data and assumptions.
- Demographic data and assumptions, which is frequently cited as a major factor in the system’s funded status decline since 1983, has actually had a small positive effect (-3%).
- Even if all assumptions are realized in the future, the system’s funded status is expected to keep deteriorating under current law because of the “Valuation Date Creep” discussed in more detail below.
Valuation Date Creep
Because the system’s funded status is measured over a 75-year period, the shortfalls expected after the end of the 75-year period under current law are ignored until subsequent years’ valuations. This approach implicitly assumes that annual system income will be equal to annual system outgo for years after 75. This implicit assumption has produced consistent actuarial losses for each year since 1983, which, as noted above, have accounted for 64% of the system’s total funded status decline since 1983. The effect of this questionable implicit assumption is to overstate the systems’ actual funded status under current law, and the consistent actuarial losses attributable to this source since 1983 all but scream out “unreasonable assumption to be fixed in future valuations.”
American Academy of Actuaries Issue Brief on Social Security Assumptions
The Academy’s Issue Brief effectively supports the conclusion that the valuation date creep is an unreasonable implied assumption resulting from treatment of expected shortfalls after the end of the 75-year valuation period. It says,
“Each year, the Social Security program gains another year of actual experience that can affect the projections in two ways. First, if experience is more favorable than projected in the aggregate, the system’s projected financial status improves; if experience is less favorable, the projected financial status worsens. Second, emerging experience constitutes additional evidence that can be used for setting assumptions. For example, if mortality improves more rapidly than expected, then the assumed future rate of mortality improvement might be adjusted to reflect that trend. The normal process provides for monitoring experience to detect any differences between actual experience and past projections and for fine-tuning assumptions based on the results of this analysis.”
As discussed above and as shown in SSA Actuarial Note 2023.8, the system has incurred significant actuarial losses since 1983 (deteriorating Funded Status) and the bulk of these actuarial losses are attributable to the Valuation Date Creep. If the “normal process” (to use the Academy’s words) calls for “monitoring experience to detect any differences between actual experience and past projections and for fine-tuning assumptions based on the results of this analysis”, then the Valuation Date Creep should be “fine-tuned” to keep it from generating consistent actuarial losses each year.
Even though the Valuation Date Creep is the largest source of actuarial losses over the past forty years, the Academy’s Issue Brief on the importance of assumptions and fine-tuning ones that don’t appear to be reasonable isn’t even discussed as an issue.
Conclusion
The Valuation Date Creep is a problem that Social Security actuaries and the Social Security Trustees have known about since 1983 (if not before). Like an unreasonable (non-implied) assumption, it has generated consistent actuarial losses for the past forty years and is the primary cause of the System’s deteriorated funded status (in addition to too long delayed Congressional action to bring the system back into actuarial balance). Note that neither demographic experience or economic experience over the past forty years are the primary causes of the system’s funded status deterioration, as has been argued by several “experts”.
The Valuation Date Creep should be fixed (fine-tuned) so that actuarial losses from this source are not expected each year. We needn’t wait for future Social Security reform to implement this change in the measurement of Social Security’s Funded Status. It’s simply the right thing to do now.