The Truth about Fat Cats and Social Security

October 6, 2011 (PLANSPONSOR.com) - Of late there has been considerable discussion regarding the failure of the “rich” to pay their fair share of income and payroll taxes (with rich being defined differently depending on who is doing the defining).

 

By PS

Regarding the payroll tax for Social Security (the Old Age Survivors and Disability Insurance piece or OASDI), it is collected only on pay up to what is called the Social Security Wage Base.  For 2011 that amount is $106,800 of annual compensation. The current tax rate is 6.2% for both employees and employers.  (This year, as part of the economic stimulus package the rate for employees is 4.2% but that is expected to be temporary.)  The other part of what is typically thought of as the Social Security tax is for Medicare.  The Medicare rate is 1.45% for both employees and employers.  The pay considered for Medicare is not capped at the Social Security wage base and, since 1986, employees and employers who are not covered by Social Security also pay the Medicare tax.  (For pay above $456,662, the payroll tax collected for Medicare is actually greater than the payroll tax collected for OASDI given that there is no cap on wages subject to the Medicare tax.)

The maximum OASDI tax, based on the 6.2% rate, is $6,621.60.  That would be the tax paid by an employee earning $106,800 as it would be the tax paid by an employee earning $1,000,000.  This effectively means the million dollar earner is paying 0.662% of pay for OASDI rather than the 6.2% rate paid by those earning the wage base amount or less.  This is the evidence produced to establish the “fat cats win” scenario.  However, to see the complete picture, it is necessary to look at the benefit side of the equation.

Social Security was initially, and continues to be, a financial safety net.  That is, it was never intended to be the total source of retirement income but rather was designed to allow the elderly masses to live at something above the poverty level.  The benefit formula, which is designed to favor those on the lower end of the pay spectrum, is necessarily complicated by that objective. For the sake of clarity and big picture analysis, I will need to take a few liberties in describing how benefits are computed but it works something like this.

 

Rather than the formula in a conventional defined benefit plan, which is usually a fixed percentage of final average salary times years of service, the Social Security Primary Insurance Amount (PIA) is computed by determining a participant’s Average Indexed Monthly Earnings (AIME) and replacing various percentages of the AIME.  First, what is the AIME?  As a practical matter, it is average earnings up to the Social Security wage base over the 35 years prior to reaching age 62 indexed for inflation. For example, if a new employee is earning $50,000 a year currently and receives future pay increases at exactly the rate of inflation, that person’s AIME would be based on an annual salary that, in today’s dollars, would be $50,000.  Once the AIME is determined, the following benefit formula is applied.  (The dollar amounts are adjusted prospectively for inflation and, for ease of understanding, the dollar amounts are stated as annual amounts.)

            90% of the first $8,988

            32% of the next $45,216

            15% of the amount over $54,204

Assuming that a person’s current pay is reasonably reflective of their career earnings adjusted for inflation, the PIA for various salary levels would look something like the table on this page:

According to the Social Security Administration’s website, a person who earned the maximum-taxable earnings in each year since age 22 would have an AIME equal to $95,136 (annually) and a resulting annual PIA of $28,698.  This is less than the maximum amount shown in the table because historically there were times when the Social Security wage base was frozen for a number of years.  The table is intended to reflect what will happen for employees who are covered by the provisions where the formula and the wage base are automatically adjusted for inflation as current law provides. 

Now back to the perceived fat cat inequity. Presumably, if they are going to be taxed on all of their earnings they would expect their benefits to be computed on the basis of those earnings and related contributions. Because of the lengthy period used in computing the AIME, it would take many years before the benefits were based on actual total historical earnings but, eventually, a chart of the wage replacement with and without a cap on covered compensation would look something like this chart:

 

The wage replacement at the million dollar pay level without the cap on covered compensation would be in the area of 16% rather than the 3% amount based on current law, with either being small relative to the 53% wage replacement at the low end of the pay scale.

The policy questions to be resolved in this matter are fairly straightforward.  (1) Should a person who is earning a million dollars a year be paying $62,000 a year in Social Security contributions?  (2) If the answer to (1) is “yes,” should benefits be based on the pay on which they contributed? 

It is almost a certainty that there will not be universal agreement on those issues.  The 94% of workers with income below the wage base would likely see it differently than the 6% earning more than the wage base. Regardless of the outcome, there should not be any pretense about what is happening on both the contribution and benefit side of the equation. It is my hope that this overview will help policy makers keep the big picture aspects in focus.

 

Epilogue:

The information presented in the article was based on the results of simply eliminating the cap on OASDI covered compensation as was done with Medicare.  A variation on that theme, called the ‘‘Keeping Our Social Security Promises Act,’’ has been introduced in Congress as S. 1558. This act would, in addition to the current payroll tax, apply the OASDI rate of 6.2% to wages in excess of $250,000.  As can be seen from the following pay information, the only person on this list who would be subject to increased contributions for Social Security as the result of that act would be the President.

 

2011 Annual Rates of Pay for Certain Federal Officials

President - $400,000

Vice-President - $230,700

Chief Justice, U.S. Supreme Court - $223,500

Associate Justice, U.S. Supreme Court - $213,900

Senate Leadership
Majority Party Leader - $193,400
Minority Party Leader - $193,400

House LeadershipSpeaker of the House - $223,500
Majority Party Leader - $193,400
Minority Party Leader - $193,400

The current salary for rank-and-file members of the House and Senate is $174,000.

- Gary Findlay, Executive Director, Missouri State Employees’ Retirement System (MOSERS).    

Mr. Findlay is executive director of the Missouri State Employees' Retirement System (MOSERS), a position he has held since 1994. Prior to that, he spent 16 years as an administration and benefit consultant with Gabriel, Roeder, Smith & Company, a national actuarial and benefits consulting firm that specializes in serving the needs of public employee benefit plans. He was CEO of that firm from 1986 until he joined MOSERS. 

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