Lifetime Earnings Patterns, the Distribution of Future Social Security Benefits, and the Impact of Pension Reform

Abstract

This paper describes an analysis of career earnings patterns developed for predicting the impact of Social Security reform. We produce estimates of age-earnings profiles of American men and women born between 1931 and 1960, obtained from Social Security earnings records. We forecast future individual earnings and estimate the shape and prevalence of nine stylized earnings patterns of U.S. workers. This approach is better than the traditional approach of examining a small number of representative workers who are assumed to have steady earnings throughout their careers, because few workers have level career earnings.

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Introduction

To evaluate the relationship between individual earnings and Social Security benefits and predict the distributional impact of Social Security reform, analysts have traditionally relied on policy simulations covering a handful of representative workers. The Social Security benefit formula is extremely complicated. Before the introduction of inexpensive electronic computation, it was not feasible to examine the detailed effects of reform on large numbers of individual workers. Even after the price of computation fell dramatically, however, analysts and policymakers often found it easier to understand the impact of reform by examining the effects on three or four representative workers rather than thousands of workers whose earnings patterns span the actual experiences of the U.S. workforce.

The recent Social Security Advisory Council performed fairly typical policy analysis based on a handful of representative cases.² The Council assessed the potential impacts of three alternative reform plans using calculations for four representative workers. The workers were assumed to have lifetime earnings patterns corresponding to four levels of stable relative wages. The lowest wage worker was assumed to earn roughly the minimum wage throughout his or her career; the second worker consistently earned wages corresponding to the economy-wide average wage; the third earned two-thirds of the maximum taxable wage; and the fourth received the maximum taxable wage throughout his or her career. A person's Social Security entitlement depends on the number of family dependents as well as his or her earnings level. To account for this complication, the Advisory Council examined the effect on benefits of various combinations of earnings patterns among married spouses (a high-wage husband married to an average-wage wife, for example, or an average-wage husband married to a wife with no career earnings). The Council's calculations permit readers to draw straightforward conclusions about the distributional impact of reform on different kinds of families. One traditional goal of Social Security is to offer special protection to low-wage workers. The Advisory Council's analysis shows whether this goal is achieved under each of the three plans examined in its Report.

An important shortcoming of the traditional analysis is that it accurately characterizes just one dimension of a worker's career earnings pattern—namely, the career average level of earnings. While this simple characterization is sufficient to predict the effects of some uncomplicated changes in the Social Security benefit formula, it provides an inadequate representation to examine other kinds of reform. Workers who have low career earnings may have below-average earnings either because they earned low wages over a full career or because their careers were interrupted several times by lengthy periods in which they earned no wages at all. Workers with high career earnings may have earned moderately high wages in every year of a lengthy career or below-average wages in some years and well-above-average earnings in others. For some kinds of reform, these differences can have major effects on a worker's retirement benefits.

One recent proposal is to reduce the defined-benefit pension now provided by Social Security and introduce a new defined-contribution benefit that would be financed out of contributions into individual retirement accounts. Benefits from this kind of retirement account vary with the investment earnings on contributions and thus depend crucially on the pattern of contributions over the course of a worker's career. Workers with the same average level of career earnings can obtain very different monthly pensions depending on the timing of their contributions into the retirement accounts. Workers who make large contributions early in their careers receive much bigger benefits than workers whose largest contributions occur near retirement. If there is a correlation between the timing of workers' earnings and the average level of their career earnings, distributional analysis that is based on assuming workers earn fixed relative wages throughout their careers can yield misleading conclusions.

In this paper we examine two alternatives to the traditional method of Social Security distributional analysis. The first alternative is microsimulation. Under this approach we examine lifetime earnings patterns of tens of thousands of workers and predict their future earnings through the age when they become eligible to receive Old-Age Insurance pensions. Policy simulation can then be performed by calculating the effects of alternative benefit formulas on the pension entitlements of each worker in the sample.

The second alternative is similar to the traditional method, but it involves development of more realistic approximations of the lifetime earnings patterns of typical American workers. In particular, we develop estimates of nine typical career earnings patterns that span the experiences of workers who become eligible to draw Old-Age Insurance or Disability Insurance benefits. We use simple mathematical formulas to characterize each stylized earnings pattern, and we then produce estimates of the average path of annual earnings for workers whose career earnings path falls in each of the nine stylized patterns. Policy simulation is then performed by calculating pension entitlements under alternative benefit formulas for each of the stylized earnings patterns. If we could develop appropriate population weights for each of the earnings patterns we examine, we could produce reasonably accurate estimates of the overall effects of reform as well as the distributional effects across different types of workers.

The unique aspect of this study is that we have access to the Social Security earnings records of a representative sample of the total population, namely, workers included in the 1990-93 Surveys of Income and Program Participation (SIPP). These data have shortcomings, but they provide generally accurate information about the pattern of earnings over workers' entire careers.

The remainder of this paper is organized as follows. The next section describes the data we use and the estimation of future earnings patterns under the microsimulation analytical approach. The following section describes our stylized representation of earnings for the second policy simulation approach. We examine career earnings patterns for people born in the 1930s who substantially completed their careers by 1996, when our earnings information ends. We also examine predicted career earnings patterns among workers born after the 1930s, although these tabulations are based in part on predicted earnings for years after 1996. The predictions of post-1996 earnings are derived from the estimates produced for the microsimulation policy analysis approach. In the next section we perform policy simulations based on the nine stylized earnings patterns. The paper concludes with a brief summary of conclusions.

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