Thursday, March 31, 2011

Social Security and Life Expectancy

By: Dirk van Dijk, CFA
March 29, 2011

One of the key reasons cited for possibly raising the retirement age for Social Security is that life expectancy has gotten much longer than when the Program started back in 1936. While that is true, a longer life expectancy at birth does not mean the same thing as more years of retirement.

As the graph below shows (from this source), life expectancy at birth (bottom line), increased significantly over the course of the 20th century. For men it rose from just over 50 years to more than 80. For women the increase was only slightly less dramatic, from about 57 years to 85 years.

Most of that improvement came from lower infant mortality. In 1900, it was common for children to die from diseases that have now been more or less eliminated, at least in the developed world. Penicillin was not generally available until after WWII.

As far as Social Security is concerned, changes in infant mortality are totally irrelevant. Yes, if someone dies when they are 2 years old, they will never collect Social Security benefits. They will never pay into the system, either. As far as the Social Security system is concerned, it is as if the person never existed.

The improvement in life expectancy from age 20 has been less dramatic (very feint middle line), and about half of the improvement occurred before the Social Security program was started.

The reduction in youth mortality (between ages five and 20) has been very dramatic, to the point where life expectancy at age 20 is almost the same as life expectancy at birth. In addition to medical advances, things like safer cars and seat belts have played a big role in reducing the chance that one will die before age 20. That is the age when most people start to contribute to Social Security.

From the actuary’s point of view, the best thing a person can due to make the Social Security system solvent is to die shortly after your 65th birthday. Then you will have paid in for a lifetime, and collect nothing (other than a very nominal death benefit).

What really counts for the Social Security system is the change in life expectancy at age 65 (top line). That has increased much more modestly. The retirement age for Social Security is already rising gradually, from age 65 to age 67. This takes care of most of the increase in life expectancy at age 65 that has occurred since Social Security started 75 years ago.

Raising the retirement age is the equivalent of an across-the-board cut in benefits. Since the poor and working class tend to die earlier than the upper middle class and the wealthy, it is a cut that will hit the poor the hardest. They also tend to have jobs that are more physically demanding. It is one thing for a lawyer (or an equity strategist) to continue working until age 67 or even 75; it is quite another for a coal miner to continue working at that age.

Keep in mind that the Social Security system has its own dedicated revenue source: the payroll tax. That tax is applied to the very first dollar of income, but stops after you have earned about $105,000 for the year. Those who make claims about what percentage of taxes that the wealthy pay almost only talk about the income tax, and forget about the payroll tax.

These people tend to make statements like almost half of all Americans pay no taxes. That is simply not true. It is the equivalent of saying that practicing Mormons pay no taxes, which is true if the only taxes you are considering are excise taxes on booze and smokes.

Anticipating the demographic bulge from the retirement of the Baby Boomers, payroll taxes were increased significantly during the Reagan Administration. The idea was to “over pay” on taxes and build up a surplus. That surplus was then invested in the most conservative investment around, Treasury Notes. That surplus now stands at about $2.5 Trillion.

In building up that surplus and investing in T-notes, the Social Security system has been massively subsidizing the rest of the government, which is largely funded by income taxes. It is true that the relatively wealthy pay most of the income taxes.

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