Progressive Price Indexing and Social Security Benefits

In January 2008, the first members of the baby boom generation became eligible to collect Social Security retirement benefits. This milestone marks the beginning of a process that will stretch out over the next two decades, as millions of post-WWII workers move through retirement. The commencement of this process has generated intense debate concerning the long-term future of the Social Security program.

According to the Social Security Trustees, the Social Security Trust Fund will be able to pay full benefits until 2041, and incoming payroll taxes will be sufficient to pay all but about 25 percent of benefits thereafter. This gap in long-term funding is both modest and manageable. However, it has become the focal point for concerns about long-term funding and has been used to justify large cuts in benefits for future retirees.

President Bush has suggested that Social Security’s funding gap ought to be addressed by adjusting Social Security benefits through a mechanism called “progressive price indexing,” which would change the method used for setting a retiree’s initial benefit level. The concept was initially proposed by economist Robert Pozen. A more extreme version of price indexing has been advocated by one-time presidential candidate Fred Thompson. ¹Proponents of progressive price indexing argue that changing indexation methods would merely “slow the growth” in Social Security benefits, implying only minor reductions in benefits and a fundamentally unchanged Social Security program. This is clearly not the case.

The central feature of progressive price indexing is a shift from the current system of indexing Social Security benefits to reflect changes in wages to one which would set benefits to reflect changes in prices. This shift would reduce Social Security benefits for future retirees and eventually result in a uniform, welfare-level benefit for all retirees. The very nature of Social Security as a contributory social insurance program would be destroyed.

The three key findings of this analysis are:

• Progressive price indexing would cut Social Security benefits dramatically. Despite arguments that progressive price indexing only “slows the growth” in Social Security benefits, the policy would result in real reductions in benefits. Those reductions would increase substantially over time.

• Social Security replacement rates would be drastically reduced. The cuts in benefits would reduce the percentage of pre-retirement income replaced by Social Security benefits. Thus, Social Security replacement rates would shrink. The reductions in replacement rates would increase substantially over time.

• The link between Social Security benefits and earnings would be eliminated. Progressive price indexing would ultimately result in retirees, at all income levels, receiving approximately the same minimal Social Security benefit, regardless of their earnings.

Background

Social Security’s Current-law Wage-Indexing

Social Security is currently designed to ensure that each new group of retirees will receive a benefit that replaces the same proportion of past wages as the previous group of retirees. The portion of past wages that benefits replace is known as Social Security’s “replacement rate.” ²Wage-indexing allows replacement rates to stay steady from one generation to the next. Without wage-indexing, the value of Social Security benefits in replacing lost wages as a result of retirement would be reduced over time.

The issue of replacement rates is not merely academic. Wage-indexing is the fundamental component of the Social Security benefit formula that allows each successive generation of retirees to earn an initial benefit level reflecting their contributions to the economy throughout their working years. Changing this formula has a direct, real-world impact on retirees as they struggle to maintain a standard of living that reflects the economic growth they created and allows them to keep up with the world of the workers around them.

Due to Social Security’s progressive benefit formula, replacement rates vary by income. Low-wage earners receive benefits which replace a higher proportion of their earnings than do median- or high-wage earners.

Both steady replacement rates and progressivity are achieved through the benefit formula. Social Security benefits are calculated in the following way:

• The worker’s highest 35 years of earnings are indexed to wage growth, up to the year the worker reaches age 60, and then averaged.

• This amount is divided by 12 to determine the Average Indexed Monthly Earnings (AIME).

• The Social Security Benefit formula is applied to the worker’s AIME to determine the Primary Insurance Amount (PIA). A worker retiring at normal retirement age in 2008 will receive:

90 percent of the first $711 of AIME, plus

32 percent of AIME over $711 through $4,288, plus

15 percent of AIME above $4,288

The dollar amounts at which the percentages change, known as the bend points, are adjusted each year to reflect the annual increase in the average wage.

The formula both ensures steady replacement rates and produces progressivity of benefits. The overall formula creates replacement rates that remain constant for each successive generation of retirees with the same average lifetime earnings. The percentage factors in the formula produce the progressivity under which low-income workers receive benefits that replace a higher percentage of their pre-retirement income than do medium- and high-wage earners.

Proposed Price-Indexing

Progressive price indexing would shift away from pure “wage indexing” to “price indexing” of initial benefits. Fundamentally, the introduction of price indexing would break the link between life-time earnings and benefits. That bond defines Social Security as a social insurance program that is fair across generations and is what has made the program so popular and successful. Technically, price indexing would keep benefits for each new group of retirees up-to-date with price inflation, but only for the market-basket of goods and services available to previous generations. ³Retirees would receive an initial Social Security benefit adjusted to reflect price inflation over time, but not material improvements in the standard of living that their labor helped create during their working lives.

Several methods can be used to introduce price indexing into the Social Security initial benefit calculation. As proposed, progressive price indexing would only alter the percent factors in the Primary Insurance Amount formula. The PIA formula would be altered for all but low-wage workers, ⁴ but fewer retirees would fit the current definition of low-wage worker. Low-wage workers would have their benefits determined by the current wage-indexing formula. Medium- and high-wage workers would have their benefits calculated using a mixture of wage and price indexing.

Steps one and two of the current benefit formula would remain the same. However, under progressive price indexing, the PIA formula in step three would be calculated so that a worker retiring at normal retirement age in 2008 would receive:

90 percent of the first $711 of AIME, plus

32 percent of AIME over $711 through $1,037, plus ⁵

30.7 percent of AIME over $1,037 through $4,288, plus

14.4 percent of AIME above $4,288 ⁶

If progressive price indexing had been enacted in 2007, medium- and high-wage workers retiring in 2008 would experience about a 4 percent reduction in benefits compared with current law.

Although the change in the benefit appears small in the early years, its consequences are significant. Each year the 32 and 15 percent PIA factors would shrink, and over time, benefits would be substantially decreased. Assuming growth in prices and wages, the reductions in benefits would grow significantly as shown in Chart 1. Consequently, Social Security’s replacement rates would be significantly reduced for all but the lowest wage earners. As a result, many future retirees would have a smaller base upon which to build for their retirement and would be unable to keep up with the standard of living they worked to establish.

Report Findings

Progressive price indexing would cut Social Security benefits dramatically.

Proponents of progressive price indexing contend that their policy simply “slows the growth” in Social Security benefits. However, the effect of price indexing would be to cut Social Security benefits dramatically. Moreover, these cuts would grow over time. As Chart 1 shows, constant dollar benefits for medium-wage earners would be reduced by over 20 percent for those people retiring at age 65 in 2055 (today’s 17-year-old), and would be reduced by 28 percent for the people retiring at age 65 in 2075. Benefit cuts for high-wage earners would be even larger, reaching 31 percent for people retiring at age 65 in 2055 and 42 percent for people retiring at age 65 in 2075.

Chart 2 further illustrates the cuts in benefits that would be imposed by progressive price indexing. The medium-wage earner retiring at age 65 in 2055 would receive an average annual benefit of $21,124 under the current formula, but only $19,152 under progressive price indexing; nearly a $5,000 cut in annual benefits. The white space between the two benefit levels shows the increasing size of benefit cuts over time.

In addition, Chart 2 demonstrates that under progressive price indexing, benefits would fail to lift retirees out of poverty. Currently, Social Security benefits lift thirteen million elderly people out of poverty. ⁷As shown in Chart 2, under progressive price indexing, annual benefits would fail to keep a medium-wage earner retiree out of poverty. ⁸By 2055, the federal poverty threshold is projected to be around $21,419, but with progressive price indexing, annual benefits for a medium-wage earner would only amount to $19,152. Over time, the gap between benefits received under progressive price indexing and the poverty threshold would become larger, leaving more and more retirees struggling to make ends meet.

Social Security replacement rates would be substantially reduced.

One mechanism for calculating the amount of income needed in retirement is through the use of replacement rates. According to financial experts, retirees must replace 70-80 percent of pre-retirement earnings in order to maintain their pre-retirement standard of living. ⁹

Under current law, initial Social Security benefits are designed to provide steady replacement rates across generations of retirees. This provides each generation with a steady foundation of retirement income and a benefit that reflects the standard of living that their labor helped create. Progressive price indexing would substantially cut Social Security benefit replacement rates. This would thrust each succeeding generation of retirees further behind its working peers, turning the clock backward and returning them to a retirement income level that affords them only the standard of living of earlier generations of retirees.

Under current law, Social Security benefits are estimated to replace about 40 percent of pre-retirement earnings for medium-wage earners and about 34 percent for high-wage earners. By 2035, replacement rates, under current law, are projected to stabilize at about 36 percent for medium-wage earners and 30 percent for high-wage earners. ¹⁰

As shown in Chart 3, under progressive price indexing, replacement rates for all but the lowest wage earners would drop significantly. Medium-wage earners would experience a drop in their replacement rates from 32 percent in 2035 to 26 percent in 2075. For high-wage earners, replacement rates would fall from 25 percent in 2035 to less than 18 percent in 2075. ¹¹

The combined effect of the scheduled increase in the retirement age and the enactment of progressive price indexing would be to reduce the replacement rate for the medium-wage earner by one-third, and for the high-wage earner by one-half, between 2007 and 2075.

The link between earnings and benefits would be nearly eliminated

Over time, the reductions in benefits resulting from price-indexing would alter the nature of Social Security. Under current law, benefits are calculated based on earnings reported by individuals and employers. The current-law benefit structure provides high-wage earners with higher benefits in actual dollars than lower-wage earners, but lower-wage earners receive higher benefits relative to their earnings. As Chart 4 shows, by the end of the century, under progressive price indexing, low- medium-, and high-wage earner retirees will receive nearly equal minimum annual benefits regardless of their earnings and their contributions based on those earnings.

Once all retirees at all earning levels are receiving similar benefits, the link between a worker’s earnings during a lifetime of work and the benefit that worker will receive in retirement will be severed. Social Security will have been converted from a social insurance system that provides a sound basic retirement benefit reflecting a worker’s lifetime earnings to a welfare program for the elderly.

Conclusions

Progressive price indexing, as endorsed by President Bush, devalues workers, their increasing career-long productivity, and their earnings and contributions to Social Security. Under progressive price indexing, benefits would be slashed, replacement rates would fall, and fewer retirees would be lifted out of poverty as their pre-retirement standard of living would become more difficult to maintain.

Progressive price indexing would make Social Security increasingly less equitable across generations of retirees. Future retirees would receive initial benefits that are not only below currently scheduled benefit levels, but also are equal to an increasingly smaller percentage of their pre-retirement earnings. Lastly, the cuts to medium- and high-wage earners’ benefits would become so deep that by the end of the century they would receive nearly the same benefit as low-wage earners. Breaking the link between career earnings and initial benefits would effectively transform Social Security from a contributory social insurance program to a welfare program for the elderly. The nature of Social Security would be dramatically transformed and support among medium- and higher-wage earners would erode.

Social Security is the largest source of retirement income for two-thirds of beneficiaries. It is the foundation upon which Americans can build their pensions and individual savings. With national personal savings less than one percent of personal income ¹² and with private pension plans providing benefits to only about 30 percent of people 65 and older, ¹³ it is essential to ensure that America’s future retirees do not pay the price of progressive price indexing.

Works Consulted

Endnotes