An inflation gap means you may get more than you think – even if benefits are cut. It's a 'good' glitch, but it needs fixing.
Americans recently received some good news regarding Social Security. While the retirement and disability program still faces significant funding shortfalls, the annual trustees report released last month showed improved long-term finances. But there is more "good" news, this time for workers who receive an annual benefit statement from the Social Security Administration.
To help with retirement planning, the "Social Security Statement" estimates the benefits workers will be entitled to at retirement. The statement significantly underestimates promised benefits for younger workers. In fact, even if we fixed Social Security's solvency entirely by reducing future benefits, most workers would still receive higher benefits than their Social Security Statement indicates. Though the glitch means higher benefits for future retirees, it hurts Social Security's credibility with the public. Correcting the error is essential.
Social Security mails workers a statement each year about three months prior to their birthday. Based on earnings to date, the statement projects future retirement benefits. Social Security was never meant to be the only source of retirement income, so the benefit estimate helps workers plan how much to save on their own. This is important, since the Social Security benefit formula is so complex that many people simply couldn't calculate benefits themselves.
The Social Security statement is actually quite good at determining future retirement benefits. Using the statement's methods, I was able to project the benefits of selected current retirees based on their earnings through age 45 with an average error of less than 2 percent. While more sophisticated methods could be used to close even that gap, this is not where the statement's drawbacks lie.
The difficulty comes in translating these future benefits into terms that are understandable. The statement claims that estimated benefits are "in today's dollars," which means subtracting inflation to express them in today's purchasing power. For instance, a typical new retiree 20 years from now may receive an annual benefit of $33,000. That sounds like a lot, but if inflation runs at 3 percent per year, the real purchasing power of that benefit is only around $18,000. Expressing future benefits in today's dollars helps workers know how much their future benefits will actually buy years down the road.