2005 OASDI Trustees Report

V. ASSUMPTIONS AND METHODS UNDERLYING ACTUARIAL ESTIMATES

B. ECONOMIC ASSUMPTIONS AND METHODS

The basic economic assumptions are embodied in three alternatives that are designed to provide a reasonable range of effects on Social Security's financial status. The intermediate assumptions reflect the Trustees' consensus expectation of moderate economic growth throughout the projection period. The low cost assumptions represent a more optimistic outlook, with relatively strong economic growth. The high cost assumptions represent a relatively pessimistic scenario, with weak economic growth and two recessions in the short-range period. Based on the latest estimates, the economy is assumed to be at its potential level of output and employment in the latter half of 2004.

Under all three sets of assumptions the economy is assumed to be at the sustainable, potential level of output by the end of the short-range period. Economic cycles are not included in the assumptions beyond the first 5 to 10 years of the projection period because they have little effect on the long-range estimates of financial status.

This report also includes a stochastic projection that provides a probability distribution of possible future outcomes that is centered around the Trustees' intermediate assumptions. Additional economic assumptions and modeling are required for these projections. These are discussed in appendix E.

The following sections 1 through 4 discuss the principal economic assumptions for the three alternatives that are summarized in table V.B1. The subsequent sections 5 through 7 discuss additional economic factors, summarized in table V.B2, that are critical to the projections of the future financial status of the combined OASI and DI Trust Funds.

1. Productivity Assumptions

Total U.S. economy productivity is defined as the ratio of real gross domestic product (GDP) to hours worked by all workers.1 The rate of change in total productivity is a major determinant in the growth of average earnings. For the 40 years from 1963 to 2003, annual increases in total productivity averaged 1.8 percent, the result of average annual increases of 2.5, 1.1, 1.5, and 2.0 percent for the 10-year periods 1963-73, 1973-83, 1983-93, and 1993-2003, respectively.

However, productivity growth can vary substantially within economic cycles. Therefore, it is more useful to consider historical average growth rates for complete economic cycles. The annual increase in total productivity averaged 1.6 percent over the last four complete economic cycles (measured from peak to peak), covering the 34-year period from 1966 to 2000. The annual increase in total productivity averaged 2.2, 1.2, 1.3, and 1.6 percent over the business cycles 1966-73, 1973-78, 1978-89, 1989-2000, respectively. The ultimate annual increases in productivity are assumed to be 1.9, 1.6, and 1.3 percent for the low cost, intermediate, and high cost assumptions, respectively. These are the same as the ultimate rates assumed for the 2004 report.

For the intermediate assumptions, the annual change in productivity is assumed to decrease from 3.3 percent for 2004 to 2.0 percent for 2005 and 2006, then to an average of 1.8 percent for the years 2007 to 2009. Though declining, these changes are relatively strong by historical standards. After 2009, the annual change in productivity gradually decreases to the ultimate assumed level of 1.6 percent by 2013. For the low cost assumptions, the annual change in productivity decreases gradually from 3.2 percent for 2004 to the ultimate assumed level of 1.9 percent by 2012. For the high cost assumptions, the annual change in productivity decreases from 3.1 percent for 2004 to 0.5 percent for 2005. Thereafter, the annual change in productivity varies with the business cycle until reaching its ultimate growth rate of 1.3 percent for 2014.

As with other assumptions, a range of opinions exists among experts. We will continue to closely monitor experience in this area, particularly in light of recent rapid productivity growth that is not fully explained.

2. Price Inflation Assumptions

Future changes in the Consumer Price Index for Urban Wage Earners and Clerical Workers (hereafter denoted as CPI) will directly affect the OASDI program through the automatic cost-of-living benefit increases. Future changes in the GDP chain-type price index (hereafter, the GDP deflator) affect the nominal levels of the GDP, wages, self-employment income, average earnings, and the taxable payroll.

Historically, the CPI has increased by an average of 4.5 percent for the 40 years from 1963 to 2003, the result of average annual increases of 3.8, 8.4, 3.6, and 2.4 percent for the 10-year periods 1963-73, 1973-83, 1983-93, and 1993-2003, respectively. The GDP deflator has increased by 4.0 percent for 1963 to 2003, and by 3.9, 7.4, 3.1, and 1.8 percent annually for the same respective 10-year periods. It should be noted that several methodological changes made by the Bureau of Labor Statistics in methods for computing the CPI since 1995 will tend to reduce the difference between the growth rates of these indices in the future.

The ultimate annual increases in the CPI are assumed to be 1.8, 2.8, and 3.8 percent for the low cost, intermediate, and high cost assumptions, respectively. These rates of increase are the same as those used in the 2004 report, and reflect a growing belief that future inflationary shocks will more likely be offsetting and that future monetary policy will be more like the recent past, with its strong emphasis on holding the growth rate in prices to relatively low levels.

For each alternative, the ultimate annual increase in the GDP deflator is assumed to be equal to the sum of the annual increases in the CPI and a -0.3 percentage point price differential. This differential is the same one used in the 2004 report and is based primarily on methodological differences in the construction of the two indices. Hence, for the intermediate assumptions, the ultimate annual increase in the GDP deflator is 2.5 percent, the sum of the 2.8 percent assumed ultimate annual increase in the CPI and the -0.3 percentage point price differential. Similarly, the ultimate annual increases in the GDP deflator are 1.5 and 3.5 percent for the low cost and high cost assumptions, respectively.

For the intermediate assumptions, the annual change in the CPI is assumed to decrease from 2.6 percent for 2004 to 2.2 percent for 2005. Thereafter, the annual change in the CPI increases gradually to the assumed ultimate rate of 2.8 percent as of 2008. For the low cost assumptions, the annual change in the CPI decreases from 2.0 percent for 2005 to 1.7 percent for 2006, then rises to the assumed ultimate rate of 1.8 percent for 2007. For the high cost assumptions, the annual change in the CPI mostly increases from 2.5 percent for 2004 to 5.7 percent for 2009, then decreases to its assumed ultimate rate of 3.8 percent as of 2013. The price differential, defined as the percent change in the GDP deflator less the CPI percent change, is -0.4 percentage point in 2004. For all three alternatives, the price differential is projected to be approximately -0.5 percentage point for 2005, -0.4 percentage point for 2006, and -0.3 percentage point for 2007 and later.

3. Average Earnings Assumptions

The level of average (nominal) earnings in OASDI covered employment for each year has a direct effect on the size of the taxable payroll and on the future level of average benefits. In addition, increases in the level of average wages in the U.S. economy directly affect the indexation, under the automatic-adjustment provisions in the law, of the OASDI benefit formulas, the contribution and benefit base, the exempt amounts under the retirement earnings test, the amount of earnings required for a quarter of coverage, and under certain circumstances, the automatic cost-of-living benefit increases.

This covered earnings concept is closely linked to average U.S. earnings, defined as the ratio of the sum of total U.S. wage and salary disbursements and proprietor income to the sum of total U.S. military and total civilian (household) employment. The growth rates in average U.S. earnings can be broken down into the growth rates for total U.S. economy productivity and the GDP price index (see previous two sections), and the growth rates for other components, including average hours worked, the ratio of earnings to compensation (which includes fringe benefits), and the ratio of compensation to GDP.

The average annual change in average hours worked was -0.2 percent over the last 40 years, and -0.3, -0.5, 0.1, and -0.1 percent for the 10-year periods 1963-73, 1973-83, 1983-93 and 1993-2003, respectively. Though the historical data by 10-year periods suggest that the future trend growth rate in average hours worked may be positive, other evidence indicates differently. Some of the recent increase in the average percent change in average hours worked is believed to be associated with changes in the distribution of employment by age/sex and by educational attainment. In the future, these distributions are expected to be much more stable than in recent decades.

For the 2005 report, the ultimate annual rates of change for average hours worked are assumed to be 0.1, 0.0, and -0.1 percent for the low cost, intermediate, and high cost assumptions, respectively. These ultimate annual rates of change for average hours worked are the same as those assumed for the 2004 report.

The average annual change in the ratio of earnings to compensation was -0.3 percent from 1963 to 2003. For wage workers, the assumed ultimate annual rates of change are -0.1, -0.2, and -0.3 percent for the ratio of earnings to compensation, for the low cost, intermediate, and high cost assumptions, respectively. Under the intermediate assumptions, the ratio of wages to employee compensation is projected to decline from 0.806 for 2004 to 0.696 for 2079. The ratio of compensation to GDP is assumed to be stable.

Thus, the ultimate projected annual growth rate in average U.S. earnings is about 3.9 percent for the intermediate assumptions. This reflects assumed ultimate annual growth rates of about 1.6, -0.2, 0.0, and 2.5 percent for productivity, the ratio of earnings to compensation, average hours worked, and the GDP deflator, respectively. Similarly, the ultimate projected annual growth rate in average nominal U.S. earnings is 3.4 percent for the low cost assumptions and 4.5 percent for the high cost assumptions.

Over long periods of time the average annual growth rates in average U.S. earnings and average earnings in OASDI covered employment are expected to be very close to the average annual growth rates in the average wage in OASDI covered employment (henceforth the average covered wage). Thus, the assumed ultimate annual growth rates in the average covered wage are 3.4, 3.9, and 4.4 percent for the low cost, intermediate, and high cost assumptions, respectively. For the intermediate assumptions, the annual rate of change in the average covered wage is assumed to rise from the estimated 3.8 percent increase for 2004 to an average of 4.3 percent over the 2005 to 2008 period, then to fall to an average of 4.1 percent from 2009 to 2013. Thereafter, the annual rate of change in the average covered wage moves to its assumed ultimate annual growth rate of 3.9 percent for 2014.

4. Assumed Real-Wage Differentials

For simplicity, real increases in the average OASDI covered wage have traditionally been expressed in the form of real-wage differentials—i.e., the percentage change in the average covered wage minus the percentage change in the CPI. This differential is closely related to assumed growth rates in average earnings and productivity, which are discussed in the previous section. Over the 40-year period, 1964-2003, the real-wage differential averaged 1.0 percentage point, the result of averages of 1.8, -0.5, 0.9, and 1.6 percentage points for the 10-year periods 1964-73, 1974-83, 1984-93, and 1994-2003, respectively. The assumed ultimate annual average covered real-wage differentials are 1.6, 1.1, and 0.6 percentage point(s) for the low cost, intermediate, and high cost assumptions, respectively.

Based on preliminary data, the real-wage differential was 1.2 percentage points for 2004. For the intermediate assumptions, the real-wage differential is projected to rise to about 2.1 and 2.2 percentage points in 2005 and 2006, respectively. The real-wage differential is then projected to fall to 1.8 percentage points for 2007, 1.5 percentage points for 2008, and to the ultimate assumed differential of 1.1 percentage points (3.9 percent nominal wage growth less 2.8 percent CPI inflation) by 2014.

For the low cost assumptions, the real-wage differential is assumed to be in the range of 1.2 percentage points to 2.4 percentage points between 2004 and 2012, moving to the ultimate assumed real-wage differential of 1.6 percentage points thereafter. For the high cost assumptions, the real-wage differential for the short-range period is projected to fluctuate between -0.7 and 2.6 percentage points, eventually stabilizing at about 0.6 percentage point for 2013 and later.

5. Labor Force and Unemployment Projections

The civilian labor force is projected by age, sex, marital status, and presence of children. Projections of the labor force participation rates for each subgroup take into account the percentages of the population that are disabled or in the military, the levels of Social Security retirement benefits, the state of the economy, and changes in life expectancy. The projections also include a "lagged-cohort effect" that applies changes in participation rates for a cohort at a specific age (relative to earlier cohorts at the same age) to participation rates for that cohort at older ages.

The annual rate of growth in the size of the labor force decreased from an average of about 2.1 percent during the 1970s and 1980s to about 1.2 percent from 1990 to 2003. Further slowing of labor force growth is projected due to a substantial slowing of growth in the working age population in the future—a natural consequence of the baby-boom generation approaching retirement and the succeeding lower-birth-rate cohorts reaching working age. Under the intermediate assumptions, the labor force is projected to increase by about 0.9 percent per year, on average, through 2014. Thereafter, the labor force is projected to increase much more slowly, averaging about 0.3 percent over the 30-year period from 2015 to 2045, and 0.2 percent over the remainder of the 75-year projection period.

The ultimate projected labor force participation rates are not basic assumptions. They are derived from a historically-based structural relationship using demographic and economic assumptions specific to each alternative. Little variation in the structural relationship is assumed, and participation rates are not highly sensitive to most of the demographic and economic assumptions. Thus, the ultimate projected labor force participation rates vary modestly into the future, and across alternatives.

Historically, labor force participation rates have been influenced substantially by trends in demographics and pensions. Between the mid-1960s and the mid-1980s, labor force participation rates at ages 50 and over declined for males and were fairly stable for females. These overall declines were likely due in large part to the large numbers of workers entering the labor force from the baby-boom generation, and from the female population in general, during this period. This large supply of labor allowed employers to offer early-retirement options that were attractive. Between the mid-1980s and about 1995, these rates roughly stabilized for males and increased for females. Since 1995, however, participation rates at ages 50 and over have generally risen significantly, reflecting a decrease in early-out options and relatively strong economic growth.

For the future, changes in available benefit levels from Social Security and increases in the normal retirement age, and the effects of modifying the earnings test are expected to encourage work at higher ages. Some of these factors are modeled directly. However, other factors, like the trend away from defined benefit pension plans that often provided incentives to retire and toward defined contribution plans, are expected to provide additional upward pressure on labor force participation rates. In addition to this shift in private pensions, the aging of the population is expected to both increase the demand for workers and, through improved health associated with greater life expectancy, improve the ability of the older population to work. Longer life expectancy will also increase the amount of assets that will be needed to live comfortably through retirement years, also influencing workers to stay employed longer. In order to account for these effects, which are directly or indirectly related to increases in life expectancy, projected participation rates for prime age and older males and females are adjusted upward in relation to assumed increases in life expectancy. For the intermediate projections, this adjustment for changes related to life expectancy results in a total labor force that is about 1.5 percent higher by 2080.

For men age 16 and over, the projected age-adjusted labor force participation rates for 2080 are 72.8, 73.5, and 74.1 percent for the low cost, intermediate, and high cost assumptions, respectively, compared to the 2003 level of 73.6 percent. (Age-adjusted labor force participation rates are adjusted to the 2003 age distribution of the civilian noninstitutional U.S. population.) These reflect the net effect of increases due to assumed improvements in life expectancy, and decreases due to higher assumed disability prevalence rates and an increasing proportion of males who are never married. For women age 16 and over, the projected age-adjusted labor force participation rates for 2080 are 61.3, 61.4, and 61.3 percent, for the low cost, intermediate, and high cost assumptions, respectively, compared to the 2003 level of 59.8 percent. These projections are the net effect of decreases due to higher assumed disability prevalence rates, increases due to assumed improvements in life expectancy, and increases due to assumed changes in the proportion of females who are never married, separated, widowed, or divorced.

The unemployment rate presented in table V.B2 is in the most commonly cited form, the civilian rate. For years through 2014, total rates are presented without adjustment for changes in the age-sex distribution of the population. For years after 2014, unemployment rates are presented as total age-sex adjusted rates (using the age-sex distribution of the 2003 civilian labor force). Age-sex adjusted rates allow for more meaningful comparisons across longer time periods.

The total unemployment rate reflects the projected levels of unemployment for various age-sex subgroups of the population. The unemployment rate for each subgroup is projected based on a specification (consistent with Okun's Law) relating changes in the unemployment rate to the changes in the business cycle, as measured by the ratio of the actual to potential GDP. For each alternative, the total unemployment rate is projected to move toward the ultimate assumed rate as the economy moves toward the long-range sustainable growth path.

The ultimate age-sex-adjusted unemployment rate for each alternative is assumed to be reached by 2014. After 2014, the age-sex-adjusted rate is stable because the ratio of actual to potential GDP is assumed to be constant. The ultimate assumed unemployment rates are 4.5, 5.5, and 6.5 percent for the low cost, intermediate, and high cost assumptions, respectively. These are the same values assumed for the 2004 report.

6. Gross Domestic Product Projections

The real growth rate in gross domestic product (GDP) equals the combined growth rates for total employment, productivity, and average hours worked. Total employment is the sum of the U.S. Armed Forces and total civilian employment, which is based on the projected total civilian labor force and unemployment rates. For the 40-year period from 1963 to 2003, the average growth rate in real GDP was 3.3 percent, combining the approximate growth rates of 1.7, 1.8, and -0.2 percent for its components—total employment, productivity, and average hours worked, respectively.

For the intermediate assumptions, the average annual growth in real GDP is projected to be 2.7 percent over the short-range projection period (2005-14), a slower rate than the 3.3 percent average observed over the historical 40-year period (1963-2003). This slowdown is primarily due to slower projected growth in total employment. For the low cost assumptions, annual growth in real GDP is projected to average 3.3 percent over the decade ending in 2014. The relatively faster growth is due mostly to a higher assumed rate of growth in worker productivity. For the high cost assumptions, real GDP is assumed to fall in the last quarter of 2004 and the first and second quarters of 2005, resulting in a total decline in real GDP of 1.2 percent. After 11 quarters of recovery, a second recession, with a total decline in real GDP of 1.7 percent, is assumed to begin in the second quarter of 2008 and last 3 quarters. After the second recession, a moderate economic recovery is assumed through 2011, with continued modest economic growth thereafter. For the high cost assumptions, annual growth in real GDP is projected to average 2.0 percent for the decade ending in 2014.

After 2014, no economic cycles are assumed for the three alternatives. Thus, projected rates of growth in real GDP are determined by the projected full-employment rate of growth for total employment, and the assumed full-employment rates of growth for total U.S. economy productivity and average hours worked. For the intermediate assumptions, the projected rate of growth for real GDP falls toward the assumed productivity growth rate because of the projected decline in labor force growth over the period. By 2080, the growth in real GDP slows to about 1.8 percent, due to the assumed ultimate percent changes of 0.2, 1.6, and 0.0 for total employment, productivity, and average hours worked, respectively. These projected growth rates are the same as those assumed for the 2004 report.

7. Interest Rate Projections

The interest rate presented in table V.B2 for each year is the average of the nominal interest rates for special U.S. Government obligations issuable to the trust funds in each of the 12 months of the year. Interest for these securities is generally compounded semiannually. The real interest rate (ex post) is defined to be the annual (compounded) yield rate for investments in these securities divided by the annual rate of growth in the CPI for the first year after issuance. For 2004, the average annual nominal interest rate for securities newly issued to the trust funds was 4.3 percent, an increase of 0.2 percentage point from the average nominal interest rate of 4.1 percent for 2003.

In developing a reasonable range of assumed ultimate future real interest rates for the three alternatives, historical experience was examined for the 40 years, 1964-2003, and for each of the 10-year subperiods, 1964-73, 1974-83, 1984-93, and 1994-2003. For the 40-year period, the real interest rate averaged 2.9 percent per year. For the four 10-year subperiods, the real interest rates averaged 1.6, 0.8, 5.6, and 3.7 percent, respectively. The assumed ultimate real interest rates are 3.7 percent, 3.0 percent, and 2.2 percent for the low cost, intermediate, and high cost assumptions, respectively. The ultimate real yields are assumed to be reached by the end of the short-range period. These annual real yields are the same as those assumed in the 2004 report. These ultimate real interest rates, when combined with the ultimate CPI assumptions of 1.8, 2.8, and 3.8 percent, yield ultimate nominal interest rates of about 5.5 percent for the low cost assumptions, about 5.8 percent for the intermediate assumptions, and about 6.0 percent for the high cost assumptions.

For the 10-year short-range projection period, nominal interest rates are projected based on changes in the business cycle and in the CPI. Under the intermediate assumptions, the nominal interest rate is projected to rise from 4.3 percent for 2004 to 5.6 for 2008 and 2009, and to 5.7 percent for 2010, reflecting a recovering economy along with a higher rate of inflation. Thereafter, the nominal interest rate rises to the ultimate assumed level of 5.8 percent for 2011. For the low cost assumptions, the average annual nominal interest rate is assumed to reach an ultimate level of about 5.5 percent for 2012. For the high cost assumptions, it is assumed to peak at 8.7 percent for 2010, and then decline to an ultimate rate of about 6.0 percent for 2013.

1 Historical levels of real GDP are from the Bureau of Economic Analysis' (BEA) National Income and Product Accounts (NIPA). Historical total hours worked is an unpublished series provided by the Bureau of Labor Statistics (BLS), and is for all civilian and military wage and salary workers and the self-employed.

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