2001 OASDI Trustees Report

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 stronger economic growth. The high cost assumptions represent a relatively pessimistic forecast, with weaker economic growth and two recessions in the short-range period. Economic cycles are not included in 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.

The following sections 1 through 4 discuss the basic economic assumptions 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 OASDI Trust Funds.

1. Productivity Assumptions

Total U.S. economy productivity is defined as the ratio of real gross domestic produce (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 195999, annual increases in total productivity averaged 1.8 percent, the result of average annual increases of 2.6, 1.8, 1.3, and 1.5 percent for the 10-year periods 1959-69, 1969-79, 1979-89 and 1989-99, respectively. The ultimate annual increases in productivity are assumed to be 1.8, 1.5, and 1.2 percent for alternatives I, II, and III, respectively. These are the same ultimate rates assumed for the 2000 report.

For alternative II, the annual change in productivity is assumed to decrease from 3.2 percent in 2000 to 2.1 percent in 2001 and 2002, then gradually decrease further to the 1.4 to 1.5 percent range between 2006 and 2010. Some of this slowdown in productivity growth reflects the assumption that the latest historical level of real GDP is greater than the sustainable full-employment (or potential) level. Thus, the future growth in real GDP (and therefore productivity) includes a component that gradually pulls the level of the real GDP down to the full-employment path. For alternative I, the annual change in productivity decreases from 3.2 percent in 2000 to 2.3 percent in 2002, then decreases gradually to the 1.7 to 1.8 percent range between 2007 and 2010. For alternative III, the annual change in productivity decreases from 3.2 percent in 2000 to 0.5 percent in 2001, then varies with projected changes in the business cycle, until reaching its ultimate growth rate of 1.2 percent in 2010.

2. 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) may affect the nominal levels of the GDP, wages, self-employment income, average earnings, and the taxable payroll.

Historically, the CPI has increased, on average, by 4.4 percent for the 40 years from 1959 to 1999, the result of average annual increases of 2.3, 7.1, 5.3, and 2.9 percent for the 10-year periods 1959-69, 1969-79, 1979-89 and 1989-99, respectively. The GDP deflator has increased by 4.0 percent for 1959 to 1999, and 2.3, 6.6, 4.8, and 2.3 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 2.3, 3.3, and 4.3 percent for alternatives I, II, and III, 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 -0.2 percentage price differential. This differential is based primarily on methodological differences in the construction of the two indices. Hence, for alternative II, the ultimate annual increase in the GDP deflator is 3.1 percent, the sum of the 3.3 percent assumed ultimate annual increase in the CPI and the -0.2 percent price differential. Similarly, the ultimate annual increases in the GDP deflator are 2.1 and 4.1 percent for alternatives I and III, respectively. The assumed ultimate annual rates of increase in the CPI and the GDP deflator for each alternative are the same as those used in the 2000 report.

For alternative II, the annual change in the CPI is assumed to decrease from 3.5 percent in 2000 to 3.0 percent in 2001, then increase gradually to the assumed ultimate rate of 3.3 percent by 2006. For alternative I, the annual change in the CPI decreases from 3.5 percent in 2000 to 3.0 percent in 2001, then decreases gradually to the assumed ultimate rate of 2.3 percent by 2004. For alternative III, the annual change in the CPI decreases from 3.5 percent in 2000 to 3.1 percent in 2001, and reaches its assumed ultimate rate of 4.3 percent in 2008. For all three alternatives, the price differential, defined as the percent change in the GDP deflator less the CPI percent change, is -1.3 percentage points in 2000, and is projected to move smoothly toward -0.2 percentage point by 2006.

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 to 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.

Over the last 40 years, the average percent change in average hours worked was -0.2, the result of annual average changes of -0.2, -0.7, -0.1, and 0.3 percent for the 10-year periods 1959-1969, 1969-1979, 1979-1989, and 1989-1999, respectively. 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 distributional effects are expected to fade. The average percent change in the ratio of earnings to compensation was -0.2 percent from 1959 to 1999. The assumed ultimate annual rates of change are 0.0, -0.1, and -0.2 percent for average hours worked, and -0.1, -0.2, and -0.3 percent for the ratio of earnings to compensation, for alternatives I, II, and III, respectively. No ultimate change is assumed for the ratio of compensation to GDP.

The assumed ultimate annual growth rate in average U.S. earnings is 4.3 percent for the intermediate alternative II. This reflects assumed ultimate annual growth rates of 1.5, -0.2, -0.1, and 3.1 percent for productivity, the ratio of earnings to compensation, average hours worked, and the GDP deflator respectively. Similarly, the assumed ultimate annual growth rate in average nominal U.S. earnings is 3.8 percent for alternative I and 4.8 percent for alternative III. (See table V.B1 for historical and assumed future values.)

The assumed ultimate annual growth rates in average U.S. earnings are very similar to the assumed ultimate annual growth rates for average earnings in OASDI covered employment, and for the average wage in OASDI covered employment (henceforth the average covered wage). Thus, the assumed ultimate annual growth rates in average covered wages are 3.8, 4.3, and 4.8 percent for alternatives I, II, and III, respectively. For alternative II, the annual rate of change in the average covered wage is assumed to drop from the estimated 5.5 percent increase in 2000 to 4.9 percent in 2001, 4.8 percent in 2002, the 4.2 to 4.4 percent range from 2003 to 2008, and then to the ultimate assumed average rate of 4.3 percent in 2009 and thereafter.

4. Assumed Real-Wage Differentials

For simplicity, real increases in the average covered wage have traditionally been expressed in the form of real-wage differentials-i.e., the percentage increase in the average covered wage minus the percentage increase in the CPI. Over the last 40 years, 1960-99, the real-wage differential averaged 1.1 percentage points, the result of averages of 2.0, 0.4, 0.5, and 1.5 percentage points for the 10-year periods 1960-69, 1970-79, 1980-89 and 1990-99, respectively. The assumed ultimate annual average covered real-wage differentials are 1.5, 1.0, and 0.5 percentage point(s) for alternatives I, II, and III, respectively.

Based on preliminary data, the real-wage differential was 2.0 percentage points in 2000. For alternative II, the real-wage differential is projected to fall to about 1.9 percentage points in 2001 and 2002, 1.3 percentage points in 2003, 1.2 percentage points in 2004 to 2006, then to about the ultimate assumed differential of 1.0 percentage point (4.3 percent nominal wage growth less 3.3 percent CPI inflation) for 2007 and thereafter.

For the low cost alternative I, the real-wage differential is assumed to be in the range of 1.4 percentage points to 2.2 percentage points between 2001 and 2009, remaining at the ultimate assumed real-wage differential of 1.5 percentage points thereafter. For the high cost alternative III, the real-wage differential for the short-range period is projected to fluctuate between -1.8 and 2.1 percentage points, eventually stabilizing at about 0.5 percentage point in 2008 and later.

5. Labor Force and Unemployment Estimates

The civilian labor force is projected as the sum of components that subdivide the population by age, sex, marital status and presence of children. The projected labor force for each of these components is the product of expected population levels and labor force participation rates specific to the category. Projections of the labor force participation rates take into account a lagged cohort effect, the percentages of the population that are disabled or in the military, the levels of Social Security retirement benefits, and the state of the economy.

The annual rate of growth in the size of the labor force decreased from an average of about 2.0 percent per year during the 1970s and 1980s to about 1.2 percent from 1991 to 1999. Further slowing of labor force growth is projected due to a substantial slowing of growth in the working age population in the future as the 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 the cessation of relatively rapid growth in labor force participation rates, particularly for women, by about 2005. Under alternative II, after 1999 the labor force is projected to increase by about 0.9 percent per year, on average, through 2010, and to increase much more slowly thereafter, ultimately reaching a 0.2 percent annual growth rate toward the end of the 75-year projection period.

For men, the projected age-adjusted labor force participation rates for 2075 for alternatives I, II, and III are 1.3, 1.3, and 1.1 percentage points lower, respectively, than the 1999 level of 74.7 percent. (Age-adjusted labor force participation rates are adjusted to the 1999 age distribution of the non-institutionalized U.S. population.) These declines are due to the business cycle, increases in the disability prevalence rates, and increases in the proportion of workers who are never married. For women, the projected age-adjusted labor force participation rates for 2075 for alternatives I, II, and III are 0.6, 0.6, and 0.4 percentage point higher, respectively, than the 1999 level of 60.0 percent. These increases are due, in part, to cohort-effect increases in the labor force participation rates for older workers, and to increases in the proportion of workers who are never married.

The ultimate projected labor force participation rates are not basic assumptions. They are derived from a historically based structural relationship using economic and demographic assumptions specific to each alternative. However, because no variation in the structural relationship is assumed, and participation rates are not highly sensitive to most of the economic and demographic assumptions, the ultimate projected labor force participation rates vary only slightly across alternatives.

Unemployment rates are presented in the most commonly cited form, the civilian rate. For years after 2010, unemployment rates are presented as total age-sex adjusted rates (using the age-sex distribution of the 1999 civilian labor force). These age-sex adjusted rates allow for more meaningful comparisons across time periods. The ultimate age-sex adjusted unemployment rate for each alternative is assumed to be reached by 2010. The ultimate assumed unemployment rates are 4.5, 5.5, and 6.5 percent for alternatives I, II and III, respectively. These are the same values assumed in the 2000 report.

Prior to 2011, the total unemployment rate is constructed from projected levels of unemployment for various age-sex components. Each component 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 rise toward the ultimate assumed rate as the economy moves toward the long-range sustainable growth path.

6. GDP Estimates

The real growth rate in GDP increases with the growth rates in 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 30 year period from 1969 to 1999, the average growth rate in real GDP was 3.1 percent, and approximately 1.7, 1.5, and -0.2 percent for its components-total employment, productivity, and average hours worked, respectively.

For alternative II, the average annual growth in real GDP is projected to be 2.4 percent over the short-range projection period (2000-10), a slower rate than the 3.1 percent average observed over the historical 30-year period (1969-99). This slowdown is primarily due to slower projected growth in total employment. For alternative I, annual real growth in GDP is projected to average 2.9 percent over the next 10 years. The relatively faster growth is due mostly to a higher assumed rate of growth in worker productivity. For alternative III, relatively weak economic growth is assumed for the first quarter of 2001, followed by a recession lasting 3 quarters, and resulting in a total decline in real GDP of 0.7 percent. After 8 quarters of recovery, a second recession, with a total decline in real GDP of 2.5 percent, is assumed to begin in the first quarter of 2004, lasting 4 quarters. After the second recession, a moderate economic recovery is assumed through 2007, with continued modest economic growth thereafter. For alternative III, annual growth in real GDP is projected to average 1.6 percent for the next 10 years, from 2000 to 2010.

After 2010, no economic cycles are assumed, and thus projected rates of growth in real GDP are determined by the full-employment rates of growth projected for total employment, and assumed for labor productivity and average hours worked. For alternative II, 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 2075, the growth in real GDP slows to about 1.6 percent, due to the assumed ultimate percent changes of 0.2, 1.5, and -0.1 for total employment, productivity, and average hours worked, respectively.

7. Interest Rate Estimates

The interest rate presented in this report is the nominal interest rate, which is (generally) compounded semiannually, for special U.S. Government obligations issuable to the trust funds in each of the 12 months of the year. 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.

In developing a reasonable range of assumed ultimate future real interest rates for the three alternatives, historical experience was examined for the 40 years, 1960-99, and for each of the 10-year subperiods, 1960-69, 1970-79, 1980-89, and 1990-99. For the 40-year period, the real interest rate averaged 3.2 percent per year. For the four 10-year subperiods, the real interest rates averaged 2.1, 0.7, 5.6 and 4.5 percent, respectively. The assumed ultimate real interest rates are 3.7 percent, 3.0 percent, and 2.2 percent for alternatives I, II, and III, 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 2000 report.

For the 10-year short-range projection period, nominal interest rates are projected based on changes in the business cycle and changes in the CPI. Under the intermediate assumptions, the nominal interest rate is projected to drop from 6.2 percent in 2000 to 5.6 percent in 2001, reflecting a slowing economy and a lower rate of inflation. Thereafter, the nominal interest rate rises gradually, reaching the ultimate assumed level of about 6.3 percent in 2009. For the low cost alternative I assumptions, the average annual nominal interest rate is assumed to reach an ultimate level of about 6.0 percent in 2009. In the high cost alternative III, it is assumed to peak at 8.3 percent in 2003, and then decline to an ultimate rate of about 6.5 percent in 2008.

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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