2003 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 vary Social Security's financial status, and illustrate the likely range of outcomes that might be encountered. 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. 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. Based on the latest estimates, the economy is assumed to be below its potential level of output and employment in the latter half of 2002.

This report also includes, for the first time, 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 1961 to 2001, annual increases in total productivity averaged 1.7 percent, the result of average annual increases of 2.7, 1.4, 1.3, and 1.5 percent for the 10-year periods 1961-71, 1971-81, 1981-91 and 1991-2001, 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 2002 report.

For the intermediate assumptions, the annual change in productivity is assumed to decrease from 3.6 percent in 2002 to 1.9 percent for 2003, and to increase to 2.3 percent for 2004. This pattern reflects relatively slow economic growth assumed for the last quarter of 2002, followed by gradually accelerating economic growth through 2003. Thereafter, the annual change in productivity gradually decreases to the ultimate assumed level of 1.6 percent by 2011. For the low cost assumptions, the annual change in productivity decreases gradually from 3.6 percent in 2002 to the ultimate assumed level of 1.9 percent by 2010. For the high cost assumptions, the annual change in productivity decreases from 3.4 percent in 2002 to 1.1 percent for 2003. Thereafter, the annual change in productivity varies with the business cycle until reaching its ultimate growth rate of 1.3 percent for 2012.

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 1961 to 2001, the result of average annual increases of 3.1, 8.4, 3.9, and 2.6 percent for the 10-year periods 1961-71, 1971-81, 1981-91 and 1991-2001, respectively. The GDP deflator has increased by 4.0 percent for 1961 to 2001, and by 3.1, 7.4, 3.7, and 2.0 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 2.0, 3.0, and 4.0 percent for the low cost, intermediate, and high cost assumptions, respectively. 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 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 2.7 percent, the sum of the 3.0 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 1.7 and 3.7 percent for the low cost and high cost assumptions, respectively. The assumed ultimate annual rates of increase in the CPI are the same as those used in the 2002 report. The assumed ultimate annual rates of increase in the GDP deflator for each alternative are 0.1 percentage point lower than those used in the 2002 report. Hence, for all three alternatives, the price differential was changed from -0.2 percentage point in the 2002 report to -0.3 percentage point in the 2003 report. This change is based on new research by the BLS indicating that the effect of one of the methodological differences (i.e. an upper-level substitution bias embedded in the CPI measure only) is now expected to be 0.1 percentage point greater than previously estimated.

For the intermediate assumptions, the annual change in the CPI is assumed to increase from 1.4 percent for 2002 to 2.4 percent for 2003 and 2004. Thereafter, the annual change in the CPI increases gradually to the assumed ultimate rate of 3.0 percent as of 2007. For the low cost assumptions, the annual change in the CPI increases from 1.4 percent for 2002 to 2.2 percent for 2003, then decreases to the assumed ultimate rate of 2.0 percent for 2004. For the high cost assumptions, the annual change in the CPI increases from 1.4 percent for 2002 to 5.8 percent for 2006, and decreases to its assumed ultimate rate of 4.0 percent as of 2010. The price differential, defined as the percent change in the GDP deflator less the CPI percent change, is -0.3 percentage point in 2002. For all three alternatives, the price differential is projected to be -0.8 percentage point for 2003, -0.6 percentage point for 2004, and to move smoothly toward -0.3 percentage point as of 2009 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.

These concepts are 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 -0.1 percent over the last 40 years, and -0.4, -0.5, 0.0, and 0.4 percent for the 10-year periods 1961-71, 1971-81, 1981-91 and 1991-2001, respectively. Though the historical data by 10-year periods suggest that the trend growth rate in average hours worked may have shifted from negative to 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 largely stabilize. Furthermore, the percent average annual change in average hours worked over the post-1990 period is expected to be revised downward when the BLS releases revised civilian employment data reflecting higher population levels associated with the 2000 Census. Finally, it is believed that workers will take part of their future gains in real earnings (due to the assumed growth in productivity) in increased leisure time, therefore reducing average hours worked.

However, the most recent data and analyses suggest a slightly stronger underlying move toward a less negative growth rate in average hours worked over the historical period. The BLS revisions to the Household Survey data are now known and indicate that the post-1990 percent average annual change in average hours worked, after adjusting for changes in the age-sex and educational distribution of the workforce, was positive. Furthermore, productivity was relatively high in the post-1990 period, suggesting a potentially less robust link between increases in real earnings and leisure. Consequently, for the 2003 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. Compared to the 2002 report, these ultimate annual rates of change for average hours worked are 0.1 percentage point higher in all three alternatives.

The average annual change in the ratio of earnings to compensation was -0.2 percent from 1961 to 2001. 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. 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 4.1 percent for the intermediate assumptions. This reflects assumed ultimate annual growth rates of about 1.6, -0.2, 0.0, and 2.7 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 3.6 percent for the low cost assumptions and 4.6 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 3.6, 4.1, and 4.6 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 increase from the estimated 1.9 percent increase in 2002 to 3.9 percent for 2003, and to 4.4 percent for 2004, as the economy recovers. For 2005 and later, the annual rate of change in the average covered wage moves gradually to its assumed ultimate annual growth rate of 4.1 percent. (See table V.B1 for historical and assumed future values.)

While the assumed ultimate projected annual growth rates in the average wage in OASDI covered employment and in the average nominal U.S. earnings in the 2003 Trustees Report are the same as the assumed ultimate projected annual growth rates in last year's report, the levels in last year's report are significantly higher. This occurred because the Bureau of Economic Analysis (BEA) overestimated wages for 2001 and 2002 in its initial release of National Income and Product Accounts (NIPA) data. Subsequently, as part of its annual July 2002 revisions to the NIPA, the BEA lowered its previous estimate of the level of NIPA wage and salary disbursements by about 2.9 percent for 2001 and by 3.8 percent for the first quarter of 2002. Thus, for the 2002 Trustees Report, the projected annual level of wages was overestimated by 2.9 percent for 2001 and by about 4.0 percent for 2002, which was then carried forward as overestimates in the average wage in OASDI covered employment and in the average nominal U.S. earnings in 2003 and later.

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, 1962-2001, the real-wage differential averaged 1.2 percentage points, the result of averages of 1.8, -0.2, 1.0, and 1.8 percentage points for the 10-year periods 1962-71, 1972-81, 1982-91, and 1992-2001, 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 0.5 percentage point for 2002. For the intermediate assumptions, the real-wage differential is projected to rise to about 2.0 percentage points by 2004, as the economy recovers. The real-wage differential is projected to fall to 1.6 percentage points for 2005, 1.4 percentage points for 2006, and to the ultimate assumed differential of 1.1 percentage points (4.1 percent nominal wage growth less 3.0 percent CPI inflation) by 2012.

For the low cost assumptions, the real-wage differential is assumed to be in the range of 0.5 percentage point to 2.3 percentage points between 2002 and 2010, remaining at about 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 -1.1 and 2.5 percentage points, eventually stabilizing at about 0.6 percentage point for 2011 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 (starting with this report) 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 1.1 percent from 1990 to 2000. 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. The projected slowdown in labor force growth also reflects a slowdown in the relatively rapid growth in older female labor force participation rates by about 2006. Under the intermediate assumptions, after 2001 the labor force is projected to increase by about 1.0 percent per year, on average, through 2012, and to increase much more slowly thereafter, ultimately reaching a 0.2 percent annual growth rate over the final third 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. In past Trustees reports, because little variation in the structural relationship is assumed, and participation rates are not highly sensitive to most of the demographic and economic assumptions, the ultimate projected labor force participation rates vary only slightly into the future, and across alternatives. However, the projected participation rates for prime-age and older males and females are adjusted upward due to assumed increases in their life expectancies. By itself, this results in a total labor force that is about 1.8 percent higher by 2080.

For men, the projected age-adjusted labor force participation rates for 2080 are 74.4, 74.2, and 74.3 percent for the low cost, intermediate, and high cost assumptions, respectively, compared to the 2001 level of 74.3 percent. (Age-adjusted labor force participation rates are adjusted to the 2001 age distribution of the civilian noninstitutional U.S. population.) These are 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, the projected age-adjusted labor force participation rates for 2080 are 61.1, 61.1, and 61.0 percent, for the low cost, intermediate, and high cost assumptions, respectively, compared to the 2001 level of 60.1 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 2012, total rates are presented without adjustment for changes in the age-sex distribution of the population. For years after 2012, unemployment rates are presented as total age-sex adjusted rates (using the age-sex distribution of the 2001 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 2012. After 2012, 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 in the 2002 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 1961 to 2001, the average growth rate in real GDP was 3.4 percent, combining the growth rates of 1.7, 1.7, and -0.1 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 2.9 percent over the short-range projection period (2003-12), a slower rate than the 3.4 percent average observed over the historical 40-year period (1961-2001). 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 3.4 percent over the decade ending in 2012. 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 fourth quarter of 2002 and in the first quarter of 2003, resulting in a total decline in real GDP of 0.9 percent. After 12 quarters of recovery, a second recession, with a total decline in real GDP of 1.5 percent, is assumed to begin in the second quarter of 2006 and last 3 quarters. After the second recession, a moderate economic recovery is assumed through 2009, with continued modest economic growth thereafter. For the high cost assumptions, annual growth in real GDP is projected to average 2.1 percent for the decade ending in 2012.

After 2012, 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. In last year's report, real GDP growth was 1.6 percent by 2080, due to the assumed ultimate percent changes of 0.2, 1.6, and -0.1 for total employment, productivity, and average hours worked, respectively.

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 2002, the average annual nominal interest rate for securities newly issued to the trust funds was 4.9 percent, a decrease of 0.3 percentage point from the average nominal interest rate of 5.2 percent for 2001.

In developing a reasonable range of assumed ultimate future real interest rates for the three alternatives, historical experience was examined for the 40 years, 1962-2001, and for each of the 10-year subperiods, 1962-71, 1972-81, 1982-91, and 1992-2001. For the 40-year period, the real interest rate averaged 3.3 percent per year. For the four 10-year subperiods, the real interest rates averaged 2.3, 0.2, 6.5 and 4.3 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 2002 report. These ultimate real interest rates, when combined with the ultimate CPI assumptions of 2.0, 3.0, and 4.0 percent, yield ultimate nominal interest rates of about 5.7 percent for the low cost assumptions, 6.0 percent for the intermediate assumptions, and about 6.2 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 4.9 percent in 2002 to 6.4 percent in 2006, reflecting a recovering economy along with a higher rate of inflation. Thereafter, the nominal interest rate declines steadily to the ultimate assumed level of 6.0 percent in 2010. For the low cost assumptions, the average annual nominal interest rate is assumed to reach an ultimate level of about 5.7 percent in 2007. For the high cost assumptions, it is assumed to peak at 8.3 percent in 2007, and then decline to an ultimate rate of about 6.2 percent in 2011.

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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