How the Social Security System Contributes to Inequity
The well off can maximize benefits while the less fortunate cannot
Don’t get me wrong, the Social Security system is a terrific safety net. It’s crucial to the financial well being and health of tens of millions of older and disabled Americans.
But it doesn’t spread the wealth. In fact, it contributes to inequality.
This is for two reasons. First, the payroll tax funding mechanism is regressive. Second, the payments skew towards the well off.
The Regressive Social Security Tax
The first part is well known. Since the Social Security tax is a flat 6.2% tax (7.65% including the Medicare tax) and is capped on incomes at $160,200 (in 2023), it taxes a much higher percentage of the income of lower-income than of higher-income workers. By way of example, while a worker earning $100,000 a year pays a 6.2% tax on their income, one earning $500,000 pays just 2% of their income to the Social Security trust fund. (In addition, those undocumented workers who use fake or borrowed Social Security numbers contribute to the system but never see a dime of benefits. And while those who work under the table don’t pay in to the system, neither do their employers.)
The Benefits Penalizes Early Retirees
The second part of the inequity equation is less well known. It has to do with finances, health and longevity. While the Social Security benefit structure is somewhat progressive, paying lower-wage workers a higher percentage of their lifetime contributions than it pays higher-income workers, the fact that higher-income workers are in better health, work longer, and live longer means that on average they get a much greater payout from the system than do lower earners.
The Social Security payment rules are designed to encourage people to work until age 70 by augmenting the benefits of those who retire after their full retirement age and and reducing the benefits of those who retire before their full retirement age. (The full retirement age is being gradually raised from 66 for those born before 1955 to 67 for those born in 1960 or later.) On the carrot side, it increases the monthly payout by 8% for every year the worker delays receiving benefits up until age 70. So, someone born before 1955 who keeps working until age 70, or who doesn’t work but can simply afford to delay receiving benefits until that age, will get a 32% bump in benefits for the rest of their life. (The raise is a bit less for those born after 1954, down to 24% for those born in 1960 or later.)
They’ve given up four years of benefits, but the crossover is at about age 82 and a half (not factoring in potential earnings on benefits paid earlier or the larger annual inflation increases on those paid later). In other words, it takes 12 and a half years for the increased benefit to make up for the loss of four years of Social Security benefits. So delaying benefits is a bit of a gamble, but it means that the long-lived retiree gets significantly more for the rest of their lives. And this increase is extended by the annual COLA inflation adjustment to the Social Security payout, since it will be factored on a base that is almost a third higher for older baby boomers.
The Social Security system also penalizes those who take their benefits before their full retirement age by reducing them and imposing a penalty if they continue working or go back to work. (Think of the worker who took early retirement during the Covid-19 pandemic and then went back to work after the pandemic ended.) Workers can take their benefits as early as age 62, but will receive lower benefits for the rest of their lives. The reduction calculation is a bit complicated. It’s 6.7% a year for up to three years of early retirement and 5% a year beyond three years. So a worker born in 1960 or later would see a 30% reduction in benefits if they retired at age 62, and a full 43.5% less than a worker of the same age who delayed retirement until age 70. And, again, remember that the benefits of waiting and the penalty for not waiting are compounded by the annual COLA adjustments.
Of course, the early retiree receives their reduced benefits for eight years while the late retiree receives nothing, and in fact continues to contribute to the system (contributions which may increase their ultimate benefit amount). But the late retiree recoups this lost amount even more quickly than they do the lost amount by delaying retirement beyond the full retirement, doing so in 10.3 years, so by age 80. This does not mean that it’s always a bad decision to take early Social Security benefits. The early retiree may really need the money, be unable to work, or be pretty sure due to their health that they won’t live to age 80.
The Work Penalty
The system further discourages workers from taking early retirement benefits by imposing a penalty on those who receive benefits and continue to work, reducing the benefit by $1 for every $2 of earned income above $21,240 (in 2023). (The rules are a bit different in the year the worker reaches full retirement age.) So, someone who takes early retirement due to financial constraints but then can go back to work, may be further penalized for that decision. (If you take early retirement and go back to work within the following year, you do have the option of reversing your decision, but must repay the benefits you’ve received in the meantime. And once you do reach your full retirement age, you can suspend your benefits and get the 8% annual increase until age 70.)
The result of these rules is that those workers who can delay taking their Social Security benefit longer receive a larger payout for the rest of their lives, compounded by COLA adjustments and potentially by increasing their benefit due to the quarters of work they add to the benefit calculation. But they don’t get the full benefit of these increases until they live into their 80s.
The Impact of Health and Mortality
The reality is that it’s just those people who are able to delay receiving benefits until age 70 who are most likely to live into their 80s and 90s and enjoy their greater benefit level for many years. But just 10% of retirees plan to wait until age 70 and 40% take their benefits between ages 62 and 65.
The fundamental reason that the system described above contributes to inequality has to do with the health and longevity of those who take lower benefits early as compared to that of those who delay receiving benefits. Those who contribute to the system but do not live until age 62 receive no benefit (unless they took disability benefits or benefits go to a surviving spouse or minor children). Those who die before age 80 and take early retirement may well receive more in Social Security benefits than they would have if they had waited until their full retirement age or until age 70, but they will not receive as much as those who live into their 80s and beyond.
And it’s those most likely to live into their 80s and 90s who are both most likely to maximize their Social Security benefits by delaying retirement and least likely to need those benefits for a secure old age. As we discussed in an earlier post, there’s a 14-year longevity gap between the richest and poorest men in the United States and a 10-year gap for women. The economists Anne Case and Angus Deaton have discovered a seven-year longevity gap between college and non-college educated Americans, a gap that grew since the Covid-19 pandemic.
Averages vs. Individuals
Of course, choosing when to begin receiving Social Security retirement benefits is far from random. It’s often driven by financial need. But it can also be driven by one’s assessment of how long they are likely to live with those not foreseeing a long life choosing to begin receiving benefits earlier than those who expect to live to a ripe old age.
On average, the decision to take early benefits is not in retirees’ best interest. The economists David Altig, Victor Yifan Ye and Laurence J. Kotlikoff have calculated that with life expectancy for women at age 65 being 21 years and for men 18 years, 90% of Americans should wait until age 70 to begin taking benefits. Including taxes and other factors that can affect the total dollar impact of Social Security benefits, they conclude that the median worker will raise their lifetime benefit by more than $180,000 if they waited until age 70 as compared to taking early retirement at age 62. But the benefit of waiting is not equal among all retirees. Not surprisingly, those at the 75th percentile of distribution table stand to receive more than four times as much by waiting as those at the 25th percentile, almost $290,000 as compared to $70,000.
But the smaller gain by waiting for lower earners may have more impact on their financial status. Altig, Ye and Kotlikoff conclude: “High-income retirees have the most in absolute terms to gain from maximizing their lifetime benefits. But low-income retirees can raise their living standards by a far higher percentage. Whether rich, middle-class, or poor, what’s required is simply patience – waiting to apply for the right benefits at the right time.”
The good news is that a study by the Center for Retirement Research at Boston College found that the percentage of women receiving Social Security retirement benefits who had begun claiming at age 62 dropped from 60% in 2005 to 48% in 2013 and the number of men from 55% to 42%. With longer lifespans (until the last few years), baby boomers are working longer than prior generations and taking their Social Security benefits later.
Yet, early claiming of benefits may reflect retirees’ own assessement of their likely longevity. A 2001 study comparing Social Security and mortality data found “that men taking benefits at exactly age 62 have higher mortality risk than men taking benefits” at later ages. Looking at data going back to 1973, the study finds that earlier retirement is also correlated with less schooling, with more workers claiming benefits at age 65 (the full retirement age at that time) being college educated than those taking benefits at age 62. “Less-educated male workers who retire early may face higher mortality risk than other groups of workers because of both the correlation between educational attainment and mortality and the correlation between early retirement and mortality.”
Solutions?
A few relatively easy solutions would both shore up the Social Security system and make it more redistributive (from the rich to the poor rather than the other way around). These include:
Raise or eliminate the cap on earnings subject to the Social Security tax.
Include unearned income (interest, dividends and capital gain) as well as earned income in what is taxed since higher earners and those who can afford not to work have much more unearned income than do lower-income workers.
Allow retirees to pause their Social Security benefits at any age without having to pay back what they have already received.
Raise the threshold at which the 50 cents on the dollar work penalty is assessed on early retirees.
With the Social Security trust fund projected to run dry in 10 years, now is the time to make these (and other) changes.