Appendix B

ACTUARIAL COST ESTIMATES FOR THE COUNCIL'S RECOMMENDATIONS

(Prepared by Robert J. Myers, Chief Actuary, Social Security Administration)

This appendix first discusses various matters relating to the actuarial cost estimates (such as the underlying assumptions and methodology) and then presents the results of these estimates.


A. CONCEPT OF ACTUARIAL BALANCE OF SYSTEM

The concept of actuarial balance as it applies to the old-age, survivors, and disability insurance system differs considerably from this concept as it applies to private insurance and private pension plans, although there are certain points of similarity with the latter. In connection with individual insurance, the insurance company or other administering institution, in order to be in actuarial balance,
must have sufficient funds on hand so that if operations are terminated, it will be in a position to pay off all the accrued liabilities. This requirement, however, is not necessary for a national compulsory social insurance system. It might be pointed out that well-administered private pension plans have sometimes not funded all their liability for prior service benefits.

It can reasonably be presumed that, under Government auspices, such a social insurance system will continue indefinitely into the future. The test of financial soundness, then, is not a question of whether there are sufficient funds on hand to pay off all accrued liabilities. Rather, the test is whether the expected future income from tax contributions and from interest on invested assets will be sufficient to meet anticipated expenditures for benefits and administrative costs. Thus, since the concept of "unfunded accrued liability" does not by any means have the same significance for a social insurance system as it does for a plan established under private insurance principles, it is quite proper to count both on receiving contributions from new entrants to the system in the future and on paying benefits to this group. These additional assets and liabilities must be considered in order to determine whether the system is in actuarial balance.

The question of whether the old-age, survivors, and disability insurance program is in actuarial balance depends upon whether the estimated future income from contributions and from interest earnings on the accumulated trust fund investments will, over the long run, support the disbursements for benefits and administrative expenses. Obviously, future experience may be expected to vary from the actuarial cost estimates made now. Nonetheless, the intent that the system be self-supporting can be expressed in law by utilizing a contribution schedule that, according to the intermediate-cost estimate, results in the system being in balance or substantially close thereto.

The congressional committees concerned with the program have expressed the belief that it is a matter for concern if any portion of the old-age, survivors, and disability insurance system shows any significant actuarial insufficiency. Traditionally, the view has been held that for the old-age and survivors insurance portion of the program, if such actuarial insufficiency when measured over perpetuity has been no greater than 0.25 percent of payroll, it is at the point where it is within the limits of permissible variation. The corresponding point for the disability insurance portion of the system is about 0.05 percent of payroll (lower because of the relatively smaller financial magnitude of this program). Furthermore, traditionally when there has been an actuarial insufficiency exceeding the limits indicated, any subsequent liberalizations in benefit provisions were fully financed by appropriate changes in the tax schedule or through raising the earnings base, and at the same time the actuarial status of the program was improved.

The Council has recommended that long-range costs should be measured over a 75-year period, rather than over perpetuity, and that then the estimated actuarial status of both trust funds should be reasonably close to an exact balance, and much closer than has been the standard in the past. The cost estimates have been made on this basis, with the assumption that, if the estimates show an exact balance, at the end of the 75-year period the balances in the trust funds should approximate 1 year's benefit payments.

B. ACTUARIAL STATUS AFTER ENACTMENT OF 1961 ACT

The changes made by the 1961 amendments involved an increased cost that was fully met by the changes in the financing provisions (namely, an increase in the combined employer-employee contribution rate of one-fourth of 1 percent, a corresponding change in the rate for the self-employed, and an advance in the year when the ultimate rates would be effective--from 1969 to 1968. As a result, the actuarial balance of the program remained unchanged from what it was before this legislation.

Subsequent to 1961, the cost estimates were further reexamined in the light of developing experience. The earnings assumption was changed to reflect the 1963 level, and the interest-rate assumption used was modified upward to reflect recent experience. At the same time, the retirement-rate assumptions were increased somewhat to reflect the experience in respect to this factor.

The further developing disability experience indicated that costs for this portion of the program were significantly higher than previously estimated (because benefits are not being terminated by death or recovery as rapidly as had been originally assumed). Accordingly, the actuarial balance of the disability insurance program was shown to be in an unsatisfactory position, and this has been recognized by the Board of Trustees, who recommended that the allocation to this trust fund should be increased (while, at the same time, correspondingly decreasing the allocation to the old-age and survivors insurance trust fund, which under present law is estimated to be in satisfactory actuarial balance even after such a reallocation). As indicated in the main part of this report, the Council concurs with this view. The portion of the combined employer-employee contribution rate that is assigned to the disability insurance trust fund under the recommendations of the Advisory Council is 0.75 percent (see footnote 1), while for the self-employed contribution rate the corresponding figure is 0.475 percent (based on 0.1 percent above half of the combined employer-employee allocation, which is consistent with the Council's principles on the self-employed rate basis, as is also followed in connection with the hospital insurance proposal).

C. BASIC ASSUMPTIONS FOR COST ESTIMATES

(1) General Basis for Long-Range Cost Estimates

Benefit disbursements under old-age and survivors insurance may be expected to increase continuously for at least the next 50 to 70 years because of such factors as the aging of the population of the country and the slow but steady growth of the benefit roll. Similar factors are inherent in any retirement program, public or private, that has been in operation for a relatively short period. Estimates of the future cost of the old-age, survivors, and disability insurance program are affected by many elements that are difficult to determine. Accordingly, the assumptions used in the actuarial cost estimates may differ widely and yet be reasonable.

The long-range cost estimates (shown for 1975 and thereafter) are presented on a range basis so as to indicate the plausible variation in future costs depending upon the actual trends developing for the various cost factors. Both the low- and high-cost estimates are based on high economic assumptions, intended to represent close to full employment, with average annual earnings at about the level prevailing in 1963. In addition to the presentation of the cost estimates on a range basis, intermediate estimates developed directly from the low- and high-cost estimates (by averaging their components) are shown so as to indicate the basis for the financing provisions.

The cost estimates for old-age and survivors insurance are extended beyond the year 2000, since the aged population itself cannot mature by then. The reason for this is that the number of births in the 1930's was very low as compared with subsequent experience. As a result, there will be a dip in the relative proportion of the aged from 1995 to about 2010, which would tend to result in low benefit costs for the old-age and survivors insurance system during that period. Accordingly, the year 2000 is by no means a typical ultimate year insofar as these costs are concerned.

The cost estimates have been prepared on the basis of the same assumptions and methodology as those contained in the 24th Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance Trust Fund and the Federal Disability Insurance Trust Fund (H. Doc. No. 236, 88th Cong.). These estimates and their underlying assumptions are given in more detail in Actuarial Study No. 58 of the Social Security Administration.

The underlying assumptions have not been revised, and new detailed cost estimates prepared, because preliminary study indicates that the changes that would be made would be largely counterbalancing from a cost standpoint. For example, lower costs would result from using the higher earnings level of 1964, but higher costs would arise from considering the higher retirement rates of the last few years arid other factors. Besides, there is the advantage of consistency and comparability in using the same cost bases for a period of a few years, when no significant net changes in the results would occur.

(2) Measurement of Costs in Relation to Taxable Payroll

In general, the costs are shown as percentages of covered payroll. This is the best measure of the financial cost of the program. Dollar figures taken alone are misleading. For example, a higher earnings level will increase not only the outgo of the system but also, and to a greater extent, its income. The result is that when earnings rise, benefit costs in terms of dollars will also rise, but the cost relative to payroll will decrease.


(3) General Basis for Short-Range Cost Estimates

The short-range cost estimates (shown for the individual years 1965-72) are not presented on a range basis since--assuming a continuation of present economic conditions--it is believed that the demographic factors involved can be reasonably closely forecast, so that only a single estimate is necessary. A gradual rise in the earnings level in the future, paralleling that which has occurred in the past few years, is assumed. As a result of this assumption, even though then all provisions of the system including the earnings base are assumed to remain unchanged in the future at what the Council has recommended, contribution income is somewhat higher than if level earnings were assumed, while benefit outgo under the cash benefits program is only slightly affected.

Since the long-range cost assumptions do not involve an increasing-earnings assumption, the short-range and long-range cost estimates do not "link up" as between the 1972 data for the former and the 1975 data for the latter. Thus, for the cash-benefits program the balances in the trust funds at the end of 1972 according to the short-range estimates are higher than what the long-range estimates would show for that year. On the other hand, for the hospital benefits program the balance in the trust fund at the end of 1972 according to the short-range estimates is lower than what the long range estimates show for that year (since the hospital benefit costs are assumed to rise as earnings increase--see subsequent discussion).


(4) Level-Cost Concept

An important measure of long-range cost is the level-equivalent contribution rate required to support the system over a long-range future period, based on discounting at interest. If such a level rate were adopted relatively large accumulations in the trust funds would result, and in consequence there would be sizable eventual income from interest. Even though such a method of financing is not followed, this concept may be used as a convenient measure of long-range costs, which permits comparison of various possible alternative plans, with weight being given to both early-year and deferred benefit costs.


(5) Future Earnings Assumptions

The long-range estimates are based on level-earnings assumptions at the level prevailing in calendar year 1963. This, however, does not mean that covered payrolls are assumed to be the same each year; rather, they are assumed to rise steadily as the population at the working ages is estimated to increase. If in the future the earnings level should be considerably above that which now prevails, and if the cash benefits are adjusted upward so that the annual costs relative to payroll will remain the same as now estimated for the present system, then the increased dollar outgo resulting will offset the increased dollar income. This is an important reason for considering costs relative to payroll rather than in dollars.

The long-range cost estimates have not taken into account the possibility of a rise in earnings levels, although such a rise has characterized the past history of this country. If such an assumption were used in the cost estimates, along with the unlikely assumption that the benefits, nevertheless, would not be changed, the cost relative to payroll would, of course, be lower for the cash benefits, but the reverse would be so for the hospitalization and related benefits (as will be discussed in more detail later).

It is important to note that the possibility that a rise in earnings levels will produce lower costs of the cash-benefits program in relation to payroll is a very important safety factor in the financial operations of this system. Its financing is based essentially on the intermediate-cost estimate, along with the assumption of level earnings; if experience follows the high-cost assumptions, and earnings do not rise, additional financing will be necessary. However, if covered earnings increase in the future as in the past, the resulting reduction in the cost of the program (expressed as a percentage of taxable payroll) will more than offset the higher cost arising under experience following the high-cost estimate. If the latter condition prevails, the reduction in the relative cost of the program coming from rising earnings levels can be used to maintain the actuarial balance of the system, and any remaining savings can be used to adjust the cash benefits upward (to a lesser degree than the increase in the earnings level). The possibility of future increases in earnings levels should be considered only as a safety factor and not as a justification for adjusting benefits upward in anticipation of such increases.

If benefits are adjusted currently to keep pace with rising earnings trends as they occur, the year-by-year costs as a percentage of payroll would be unaffected. If benefits are increased in this manner, the level-cost of the program would be higher than now estimated, since, under such circumstances, the relative importance of the interest receipts of the trust funds would gradually diminish with the passage of time. If earnings and benefit levels do consistently rise, thorough consideration will need to be given to the financing basis of the system because then the interest receipts of the trust funds will not meet as large a proportion of the benefit costs as would be anticipated if the earnings level had not risen (under the present law, for example, for the old-age and survivors insurance system, under level-earnings assumptions this proportion would average about 15 percent over the long range).


(6) Assumptions for Hospitalization Benefits

In considering the hospitalization-benefit costs in conjunction with a level-earnings assumption for the future, it is sufficient for the purposes of long-range cost estimates merely to analyze possible future trends in hospitalization costs relative to covered earnings. Accordingly, any study of past experience of hospitalization costs should be made on this relative basis. The actual experience in recent years has indicated, in general, that hospitalization costs have risen more rapidly than the general earnings level, with the differential being in the neighborhood of 3 percent per year--2.7 percent in the last 10 years.

One of the uncertainties in making cost estimates for hospitalization benefits, then, is how long and to what extent this tendency of hospital costs to rise more rapidly than the general earnings level will continue in the future, and whether or not it may in the long run be counterbalanced by a trend in the opposite direction. Some factors to consider are the relatively low wages of hospital employees (which have been rapidly "catching up" with the general level of wages and obviously may be expected to "catch up" completely at some future date, rather than to increase indefinitely at a more rapid rate than wages generally) and the development of new medical techniques and procedures, with resultant increased expense.

In connection with the latter factor, there are possible counter balancing factors. The higher costs involved for more refined and extensive treatments may be offset by better general health conditions, the development of out-of-hospital facilities, shorter durations of hospitalization, and less expense for subsequent curative treatments as a result of preventive measures. Also, it is possible that at some time in the future, the productivity of hospital personnel will increase significantly as the result of changes in the organization of hospital services or for other reasons, so that, as in other fields of economic activity, their wages might in the long run increase more rapidly than hospitalization prices.

Perhaps the major difficulty in making and in presenting these actuarial cost estimates for hospitalization benefits is that-unlike the situation in regard to cost estimates for the monthly benefits, where the result is the opposite--an unfavorable cost result is shown when total earnings levels rise, unless the provisions of the system are kept up to date (insofar as the maximum taxable earnings base and the dollar amounts of any deductibles are concerned). The reason for this is that there is the fundamental actuarial assumption that the hospitalization costs will rise at a rate over the long run somewhat approximating the rate of increase of the level of total earnings, whereas the contribution income would rise less rapidly than the total earnings level unless the earnings base is kept up to date. Under these conditions, it is hypothesized that the base will be kept up to date with the changes in the general level of earnings; contributions depend on the covered earnings level, and the level is dampened if the earnings base is not raised as earnings go up. It is assumed in the actuarial cost estimates for hospitalization benefits either that earnings levels will be unchanged in the future or that, if wages continue to rise (as they have done in the past), the system will be kept up to date insofar as the earnings base and the deductibles are concerned.

One important reason for the fact that recently hospitalization costs have risen faster than the general earnings level is that the wages of hospital employees have risen at a faster rate than the general earnings level. Personnel costs are about 60 percent of all hospital costs. The fact that the wages of hospital employees have been rising at a faster rate than all earnings reflects a "catching up" from a situation where hospital workers were significantly underpaid in relation to other workers. It is obvious that such a trend cannot continue and that a point will be reached after which wages paid to hospital workers will rise, on the average, at the same rate as the general earnings level. Nor can other elements in hospitalization costs be presumed to rise indefinitely at a faster rate than the general earnings level.
It is not unlikely that the price of hospital services will for a considerable time rise faster than other prices, but if the price of any product continues to rise faster than earnings, it would eventually be priced out of the market. Actually, over the long run, hospitalization costs to the consumer are likely to show conflicting trends. On the one hand, improved technology is leading to more expensive hospital services and to the need for additional personnel. On the other hand, the duration of hospital stays is declining as a result of the improvement in care.

The cost assumptions for the hospitalization and related benefits have been made on what is believed to be a conservative basis. Those used for the cost estimates in this report are based on the assumptions underlying the estimates that the Social Security Administration made for the legislation considered in 1962-63 (see Actuarial Study No. 57 and "Actuarial Cost Estimates for the Old-Age, Survivors, and Disability Insurance System as Modified by H.R. 11865, as Passed by the House of Representatives and as According to the Action of the Senate" issued by the House Ways and Means Committee), but with additional safety margins for the early year costs. The differential of hospitalization costs over total earnings rates is assumed to be 2.7 percent per year for the first 5 years after 1965; then it is assumed to decrease to zero over the next 5 years, and then after a further 5 years wages are assumed to rise at an annual rate that is 0.5 percent greater than the increase in hospitalization costs.

The net effect of these modified assumptions, for purposes of the long-range cost estimates, is to produce level-costs that are about 10 percent higher than those resulting from the assumptions used in Actuarial Study No. 57 and that are about the same as those resulting from the assumptions used in the Ways and Means Committee report. For short-range purposes, however, the modified assumptions produce significantly higher estimates than either of the other sets of assumptions.


(7) Interrelationship With Railroad Retirement System

An important element affecting old-age, survivors, and disability insurance costs arose through amendments made to the Railroad Retirement Act in 1951. These provide for a combination of railroad retirement compensation and old-age, survivors, and disability insurance covered earnings in determining benefits for those with less than 10 years of railroad service (and also for all survivor cases).

Financial interchange provisions are established so that the trust funds are to be placed in the same financial position in which they would have been if railroad employment had always been covered under the program. It is estimated that over the long range the net effect of these provisions will be a relatively small loss to the old-age, survivors, and disability insurance system since the reimbursements from the railroad retirement system will be somewhat smaller than the net additional benefits paid on the basis of railroad earnings.


(8) Reimbursement for Costs of Military Service Wage Credits

Another important element affecting the financing of the program arose through legislation in 1956 that provided for reimbursement from general revenues for past and future expenditures in respect to the noncontributory credits that had been granted for persons in military service before 1957. The cost estimates contained here reflect the effect of these reimbursements (which are included as contributions), based on the assumption that the required appropriations will be made in the future, as the Council has strongly recommended should be done.

D. INTERMEDIATE-COST ESTIMATES

(1) Purposes of Intermediate-Cost Estimates

The long-range intermediate-cost estimates are developed from the low- and high-cost estimates by averaging them (using the dollar estimates and developing therefrom the corresponding estimates relative to payroll). The intermediate-cost estimate does not represent the most probable estimate, since it is impossible to develop any such figures. Rather, it has been set down as a convenient and readily available single set of figures to use for comparative purposes.

The Congress, in enacting the 1950 act and subsequent legislation, was of the belief that the old-age, survivors, and disability insurance program should be on a completely self-supporting basis. Therefore, a single estimate is necessary in the development of a tax schedule intended to make the system self-supporting. Any specific schedule will necessarily be somewhat different from what will actually be required to obtain exact balance between contributions and benefits. This procedure, however, does make the intention specific, even though in actual practice future changes in the tax schedule might be necessary. Likewise, exact self-support cannot be obtained from a specific set of integral or rounded fractional tax rates increasing in orderly intervals, but rather this principle of self-support should be aimed at as closely as possible.


(2) Interest Rate Used in Cost Estimates

The interest rate used for computing the level-costs is 3.5 percent for the intermediate-cost estimate. This is somewhat above the average yield of the investments of the trust funds at the end of 1963 (about 3 percent), but is below the rate currently being obtained for new investments (about 4 1/4 percent).


(3) Actuarial Balance of System as Modified by Proposal

Table A summarizes the actuarial balance of the existing old-age, survivors, and disability insurance program in terms of percentages of taxable payroll, according to the intermediate-cost estimate, and gives corresponding information for the program as it would be changed by the recommendations of the Council (and also for programs that are intermediate steps between the present program and these recommendations). For purposes of comparability, the data for the present program are shown on both the basis of measuring costs over perpetuity and the basis of measuring costs over only a 75-year period (as recommended by the Council). The data for the proposed program, as shown here and as shown elsewhere in this report, are on the 75-year cost basis.

Information on the actuarial balance of the proposed hospital insurance program is contained in a table in Part II, which shows that the level-cost of the benefits for all beneficiaries is estimated at .90 percent of taxable payroll, while the level-equivalent of the contribution schedule is also estimated at .90 percent of taxable payroll. Included in the foregoing cost figures is the level-cost of the benefits for the disability insurance beneficiaries, which is estimated at .05 percent of taxable payroll. It should be noted that the recommended 0.15 percent contribution from general revenues for a period of 50 years has an estimated level-cost of 0.10 percent of taxable payroll.


(4) Year-by-Year Projections of Income and Outgo

Table B shows the estimated operations of the old-age and survivors insurance trust fund in various future years according to the intermediate-cost estimate, as well as giving actual data for the past 14 years. Table C shows corresponding data for the disability insurance trust fund, while Table D relates to the hospital insurance trust fund. With respect to the latter table, it should be observed that the benefit-disbursement estimates do not include the total hospital insurance benefit payments made to railroad retirement beneficiaries, but rather only the net effect of the financial-interchange provisions for these benefits. It will also be remembered that the estimate of total benefit payments includes the payments with respect to persons who are not eligible for cash benefits, whereas the estimates relating to the hospital insurance trust fund that were made for the King-Anderson bill and the Senate-approved version of the legislation considered in 1964 did not include such payments (since they were to be financed currently out of the General Treasury, and not through direct trust-fund operations).

It is interesting to note that for each of the three trust funds separately, the short-range cost estimates indicate that the balance in the trust fund at the end of each year increases steadily during 1966-72 and in most instances quite closely approximates one year's benefit payments.

Tables E and F show long-range year-by-year cost projections for the old-age and survivors insurance trust fund and for the disability insurance trust fund, respectively, under the low-cost and high-cost estimates.
Table G presents the actuarial balance of the old-age, survivors, and disability insurance program as it would be changed by the recommendations of the Council, in terms of percentages of taxable payroll according to the low-cost and high-cost estimates. It will be noted that the level-cost of the benefits of the old-age, survivors, and disability insurance program according to the low-cost estimate is 8.9 percent of taxable payroll, which approximates the 9.4 percent combined employer-employee contribution rate that is recommended for 1971-75. This basis is in accordance with one of the financing principles enunciated by both this Council and the last one in regard to the next-to-last step in the contribution schedule (to be reached in the next few years).