Social Security Reform
How Carve-Out Private Accounts Deal with Increases in Life Expectancy
Research Report
John Turner, AARP Public Policy Institute
July 2005
Increases in life expectancy are one cause of Social Security’s projected insolvency. As people live longer, they receive Social Security benefits for more years, which raises the cost of providing benefits. When no countervailing changes in the U.S. Social Security system are made, longer average life expectancy eventually leads to financing problems.
Increasing life expectancy, however, has no effect on the financial solvency of proposed private account plans. Rather, the financial burden of increased life expectancy is typically borne by workers individually instead of by the Social Security system. When workers as a group live longer in retirement, they, or their annuity provider, must reduce the annual benefits for a given account balance and retirement age.
This paper addresses how voluntary carve-out private accounts, as discussed by President George W. Bush, deal with increased life expectancy. A voluntary carve-out private account is an account to which workers may voluntarily divert part of their payroll tax contributions from Social Security.
Participants would receive reduced Social Security benefits at retirement in exchange for having diverted part of their Social Security contributions to a private account. The Social Security Administration (SSA) would calculate the reduction in Social Security benefits using the device of a hypothetical account. That account would be "credited" with an amount equal to the actual contributions made by the person to the private account and with a predetermined interest rate on its hypothetical balance.
At retirement, the hypothetical balance resulting from the crediting of contributions and interest would be converted into a hypothetical annuity using a life table reflecting current life expectancy at retirement. The annuitized monthly benefit calculated for the hypothetical account would be subtracted from the Social Security monthly benefit that the retiree would have received if not contributing to the private account. The retiree would receive the reduced Social Security benefit resulting from this subtraction, plus the proceeds from the private account.
As reflected in the life table used to calculate the hypothetical annuity, increasing life expectancy would reduce the annuitized benefit from the hypothetical account. Because that benefit amount would be subtracted from the traditional Social Security benefit to determine the actual Social Security benefit the retiree would receive, the reduction in the annuitized benefit from the hypothetical account would increase by an equal amount the Social Security benefit received by the retiree taking the private account. For example, if a jump in life expectancy before a worker reached retirement age resulted in a $10 reduction in the monthly benefit calculated from the hypothetical account, the worker’s Social Security benefit would increase by $10 a month.
The increased life expectancy would also reduce the annuitized benefit from the private account, but, according to the President’s proposal, the actual value of the private account would not affect the value of Social Security benefits.
The net result for the person taking the private account would be that the reduction in the benefit from the hypothetical account would be exactly offset by an increase in his or her traditional Social Security benefit. The net result for the Social Security trust fund, however, is that it would bear the increased benefit cost due to increased life expectancy for those persons taking private accounts, as it does under current law.
When life expectancy increases, lifetime Social Security benefit costs also increase for workers not opting for carve-out private accounts because Social Security benefits would be paid for more years. Thus, whether the worker takes the private account or remains fully in Social Security, the Social Security Trust Fund would bear the increased benefit costs associated with longer life expectancy.
Carve-out private accounts do not solve the financing problem created by increased life expectancy raising benefit costs for Social Security. Increased life expectancy would necessitate further changes in Social Security financing or further cuts in Social Security benefits, with or without carve-out private accounts.
Written by John Turner, AARP Public Policy Institute
July 2005
©2005 AARP
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Pub ID: FS121