In Brief: How Will Recent Patterns of Earnings Inequality Affect Future Retirement Incomes?

Introduction

The increase in income and earnings inequality—the gap between those at the top, middle and bottom of the income scale—over the last 30 years is one of the most discussed trends in the labor market. Another significant trend is that Americans, on average, are living longer than ever before—by 2000 life expectancy had reached a record high of 76.9 years. As life expectancy continues to increase, the importance of stable, long-term retirement income increases as well. What is not yet understood is the relationship between income and earnings inequality in retirement income. What will be the impact of the equality gap? Will the trends toward greater earnings and income inequality change the income distribution of future retired populations? And, if so, how?

This paper by Karen Smith of the Urban Institute provides one picture. It makes use of the latest version of the Dynamic Simulation Income Model (DYNASIM3) to simulate economic and demographic events from 1992 to 2040 and illustrates how the complex interactions among earnings patterns of men and women, marriage and divorce, mortality and Social Security policy affect the future distribution of retirement benefits.

Principal Findings

Lifetime Earnings Inequality. The model projects that the inequality in men's lifetime earnings will remain fairly stable over time, while inequality in women's lifetime earnings will decline considerably. The decline in women's lifetime earnings inequality reduces family lifetime earnings inequality over time. Because men's earnings continue to dominate family earnings, the decline in family earnings inequality is not nearly as dramatic as the decline in women's earnings inequality.

Replacement Rates. Social Security replaces less of individual earnings over time, and the gap between men's and women's replacement rates narrows. The replacement rate decline will be more severe for women than for men, because women in later cohorts have more lifetime earnings than earlier cohorts and consequently move into higher lifetime earnings brackets (with lower Social Security replacement rates). Family earnings replacement rates (based on shared earnings while a couple is married) decline over time, but not as steeply as individual replacement rates.

Retirement Income. Average real per beneficiary Social Security income will rise over time, but at a decreasing rate. Changes in the Social Security benefit formula, lifetime earnings, and demographic composition all affect the rate of benefit growth over time. DYNASIM3 shows that between 1992 and 2000, Social Security income became more unequally distributed, and between 2000 and 2040, it will become more equally distributed. Non-Social Security income is much more unequally distributed than Social Security income, but it is projected to become slightly more evenly distributed over time.

Future Poverty. The model projects that poverty rates for individuals at or above the normal retirement age will fall from 12 percent in 1992 to 6 percent in 2020, and to 3 percent in 2040. Although the rates decline, never-married and divorced women, high school dropouts, and older retirees remain at risk of absolute poverty in the future. (If the model adjusts poverty thresholds by wage rather than price growth, relative poverty rates remain at about 12 percent over the coming decades.)

Conclusions

The DYNASIM3 projections show that recent increases in earnings inequality will translate into modest increases in retirement income inequality throughout most of the income distribution. Social Security and women's earnings both equalize the distribution of retirement income. Social Security benefits accomplish this because of the progressive benefit formula and women's earnings equalize the distribution because they pull up the bottom of the distribution. Increased rates of Social Security coverage also make retirement incomes more equal.

While increased wage growth, increased female labor force participation, and increased Social Security coverage rates all raise the incomes of future retirees, many historically disadvantaged groups remain vulnerable to poverty. These groups include the oldest retirees, those with less education, and individuals without access to spousal Social Security benefits.

This paper underlines the importance of looking at the whole retirement income picture rather than just the individual components. It also highlights inequalities among specific population groups, and thus emphasizes the importance of studying and understanding the implications to all segments of the population of all proposed changes to the retirement income system.

Source

Karen Smith, The Urban Institute, How Will Recent Patterns of Earnings Inequality Affect Future Retirement Incomes? (2003-06)

Written by Karen Smith, The Urban Institute
Laurel Beedon, Project Manager, AARP Public Policy Institute
May 2003
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