Assessing Knowledge of Retirement Behavior (1996) / Chapter Skim
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7 A FRAMEWORK FOR ANALYZING FUTURE RETIREMENT INCOME SECURITY
7 A FRAMEWORK FOR ANALYZING FUTURE RETIREMENT INCOME SECURITY
Pages 244-272
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retirement income system. A popular image to describe that system is the three-legged stool, consisting of Social Security benefits, employer pensions, and private retirement saving.
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Will private pensions and nonpension savings be adequate to finance comfortable retirement consumption in the next century? The federal government regularly publishes a document that helps answer these questions the Annual Report of the Social Security trustees (see Social Security Administration, 1994~.
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The OASDI trustees' Annual Report now treats future national income as fixed and traces out the implications for Social Security of the assumed path of future gross domestic product. In the proposed framework, the net savings accumulated through Social Security, the employer pension system, and nonpension household saving would affect potential national income (and hence retirement consumption)
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The analytical framework could be extended to cover these consumption subsidies, but the extension will be left to future analysts. In the next section I describe the current methods used by the Social Security actuary to evaluate OASDI solvency and show how they can be extended to analyze private pensions and nonpension household saving.
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A reasonable baseline assumption is that these entitlements will be accumulated for the foreseeable future under current laws and private pension fund practice. This is the assumption used by the Social Security actuary in evaluating the current financial status of the OASDI Trust Funds, for example.
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Although the Trustees' Annual Report does not include estimates of the average replacement rate received by successive cohorts of Social Security claimants, such estimates could be produced using information generated by the actuarial model. The report also includes no estimates of the future increases in payroll taxes or reductions in Social Security benefits that would be needed to restore the program to long-term solvency.
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One example of a dynamic microsimulation model is the Dynamic Simulation of Income Model (DYNASIM) maintained by the Urban Institute (see Orcutt et al., 1976; Johnson, Wertheimer, and Zedlewski, 1983; Johnson and Zedlewski, 1983~.
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An advantage of the microsimulation strategy is that it allows straightforward calculation of the average Social Security replacement rate and rate of internal return on contributions for successive cohorts of retirees. More important, microsimulation allows analysts to examine the distribution of replacement rates within cohorts.
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This overview suggests it is much more difficult to accurately predict employer pension accruals than Social Security accruals in a dynamic microsimulation model. In addition to the information needed to forecast Social Security benefits, the analyst requires information on each worker's industrial attachment, tenure with a particular employer, pension plan coverage on each job, decision to be covered by the plan if it is voluntary, choice of contribution level (if applicable)
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To duplicate Schieber and Shoven's estimates in a microsimulation model, the analyst must calculate and then sum the worker and employer contributions to individual plans, calculate fund earnings on previous asset holdings, and subtract lump-sum withdrawals to active workers and pension payments to current retirees. If simple assumptions are used about the returns on fund assets, these calculations are straightforward for defined contribution plans.
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The worker's replacement rate is calculated as the real after-tax value of annuity income in some year of retirement divided by average real after-tax wages during some period of his or her active career. For each year in the forecast period, the proposed simulation yields estimates of aggregate contributions of workers and employers to private pension plans and Social Security, earnings on the assets held by the funds and the Social Security Trust Fund, and disbursements to pensioners and workers who withdraw assets from retirement plans before retirement.
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The more complex the saving rule followed by consumers, the greater the advantage of using dynamic microsimulation to predict future saving levels. Under a simple model of saving, persons save a fixed proportion of their current net income in a savings account that earns the average rate of return on financial assets typically held by households (i.e., on household savings outside of pension plans)
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Whatever saving model is adopted, the analyst must determine whether individuals take pension saving and accrual of Social Security benefit rights into account when they decide how much to save outside of pension funds. If pension accruals are taken into account, individuals in generous pension plans will save less than similar individuals who are not covered by a pension.
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While it is essential to know the economy-wide rate of return enjoyed by U.S. investors, in forecasting future retirement income flows it is also important to understand how these returns will be distributed across different pension plans and households.
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Under these circumstances, it is more accurate to predict diversity in the investment return of pension funds than to assume identical returns, even if the exact distribution of returns across funds is unknown. Moreover, by clearly defining the kind of information that is needed to describe the distribution of returns across pension funds and households, construction of the dynamic microsimulation model has helped define a research area where more empirical data are needed.
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Aggregate and cell-based prediction methods do not seem to require this kind of detailed modeling. Yet these methods implicitly rest on assumptions about detailed behavioral relationships that are explicitly treated in dynamic microsimulation modeling.
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MACROECONOMIC MODELING The results from the microsimulation models of Social Security, private pensions, and nonpension household saving can be combined in a natural way in a macroeconomic model. In fact, the macroeconomic model represents a crucial advance over current Social Security actuarial forecasts for the purposes of policy evaluation.
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is an efficiency parameter that rises from year to year as a result of technical progress. Labor supply in period t is assumed to be fixed and can be taken either from the Social Security actuary's forecast or directly from the dynamic microsimulation model.
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that would exactly reproduce the Social Security actuary' s 75-year forecast of future gross domestic product and average worker compensation. Deviations from this baseline assumption about the determinants of national saving will produce deviations in the future path of investment, national output, wages, pension accruals, and Social Security surpluses and deficits (see Aaron, Bosworth, and Burtless, 1989, pp.
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However, future reductions in the generosity of Social Security pensions would certainly be expected to increase the amount of private saving, either in employer pension plans or in other household accounts. If the life-cycle/permanent income model is correct, households will be induced to change their saving behavior by changes in their earnings prospects and movements in the real after-tax interest rate.
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The best way to investigate these issues is with a dynamic microsimulation model that realistically reflects the age distribution of the population over a very long time horizon. The fact remains, however, that economists have proven more adept at designing simulation models than achieving consensus on the crucial parameters of the individual life-cycle consumption function.
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If real interest rates are low when the Trust Funds have a large balance but then rise as the funds are depleted, the Social Security program will obviously be in a worse position than if the same average rate of return were sustained over the 75-year planning period. Moreover, if productivity improvement is rapid in the years immediately before the baby boom generation retires and then slows down after 2015, the Trust Fund may be in worse financial shape than if productivity improves smoothly over 75 years.~3 Cycles in critical economic variables can have an even larger impact on employer pensions and private saving.
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The proposed strategy can be implemented in discrete steps. An initial step requires the creation of a straightforward dynamic microsimulation model predicting labor force status, job tenure and turnover, private pension and Social Security accrual, and household saving behavior for a representative sample of U.S.
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If Social Security taxes were immediately increased to reduce the long-term imbalance in the Trust Funds, would the resulting increase in public saving adversely affect private pension returns? If so, would private pensions fall?
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The focus on predictable demographic variables is somewhat ironic. The outlook for Social Security solvency and future living standards has worsened for a variety of reasons, but the predictable aging of the population is far from the most important.
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If technical efficiency in production were to improve as fast between 1994 and 2034 as it did between 1948 and 1968, future workers would enjoy far higher living standards than today's workers, even if the payroll tax doubles between 1994 and 2034.~4 One goal of the alternative forecasts in the Social Security trustees' report is to alert readers to the influence of differences in underlying assumptions. This paper argues that the effects of differing assumptions should be evaluated for employer pensions and private savings as they are for Social Security solvency.
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Interest payments earned by the fund are an expense for the remainder of the government, so the interest payments have no net effect on government saving. In order to be consistent with the microsimulation model, net saving in government employee pension plans should be treated as part of household saving rather than government saving.
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Hanushek, eds. 1991 Improving Information for Social Policy Decisions: The Uses of Microsimulation Modeling.
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Hanushek, eds., Improving Information for Social Policy Decisions: The Uses of Microsimulation Modeling.
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