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Report to Congressional Requesters:

United States General Accounting Office:

GAO:

June 2004:

SOCIAL SECURITY:

Distribution of Benefits and Taxes Relative to Earnings Level:

GAO-04-747:

GAO Highlights:

Highlights of GAO-04-747, a report to congressional requesters 

Why GAO Did This Study:

Under the current Social Security benefit formula, retired workers 
receive benefits that equal about 50 percent of pre-retirement earnings 
for a low-wage worker but only about 30 percent for a relatively high-
wage worker. Factors other than earnings also influence the 
distribution of benefits, including the programs provisions for 
disabled workers, spouses, children, and survivors. Changes in the 
program over time also affect the distribution of benefits across 
generations. 

Social Security faces a long-term structural financing shortfall. 
Program changes to address that shortfall could alter the way Social 
Securitys benefits and revenues are distributed across the population 
and affect the income security of millions of Americans.

To gain a better understanding of the distributional effects of 
potential program changes, the Chairman and Ranking Minority Member of 
the Senate Special Committee on Aging asked us to address (1) how to 
define and describe "progressivity," that is, the distribution of 
benefits and taxes with respect to earnings level, when assessing the 
current Social Security system or proposed changes to it; (2) what 
factors influence the distributional effects of the current Social 
Security program; and (3) what would be the distributional effects of 
various reform proposals, compared with alternative solvent baselines 
for the current system.

What GAO Found:

Two distinct perspectives on Social Securitys goals suggest different 
approaches to measuring progressivity, or the distribution of 
benefits and taxes with respect to earnings level. Both perspectives 
provide valuable insights. An adequacy perspective focuses on benefit 
levels and how well they maintain pre-entitlement living standards. An 
equity perspective focuses on rates of return and other measures 
relating lifetime benefits to contributions. Both perspectives examine 
how their measures are distributed across earnings levels. However, 
equity measures take all benefits and taxes into account, which is 
difficult for reform proposals that rely on general revenue transfers 
because it is unclear who pays for those general revenues.

The Social Security programs distributional effects reflect both 
program features and demographic patterns among its recipients. In 
addition to the benefit formula, disability benefits favor lower 
earners because disabled workers are more likely to be lower lifetime 
earners. In contrast, household patterns reduce the systems tilt 
toward lower earners, for example, when lower earners have high-earner 
spouses. The advantage for lower earners is also diminished by the fact 
that they may not live as long as higher earners and therefore would 
get benefits for fewer years on average.

Proposals to alter the Social Security program would have different 
distributional effects, depending on their design. Model 2 of the 
Presidents Commission to Strengthen Social Security proposes new 
individual accounts, certain benefit reductions for all beneficiaries, 
and certain benefit enhancements for selected low earners and 
survivors. According to our simulations, the combined effect could 
result in lower earners receving a greater share of all benefits than 
promised or funded under the current system if all workers invest in 
the same portfolio.

Social Security Benefit Formula Provides Higher Replacement Rates for 
Lower Earners: 

[See PDF for image]

Note: Replacement rates are the annual retired worker benefits at age 
65 for workers born in 1985 divided by the earnings in the previous 
year. For such workers, the full retirement age will be 67. Steady 
earners have earnings equal to various percentages of Social Securitys 
Average Wage Index in every year of their careers. 

[End of figure]

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[End of section]

Contents:

Letter:

Results in Brief:

Background:

Different Distributional Measures Reflect Different Perspectives:

Program's Distributional Effects Reflect Various Program Features and 
Demographic Patterns:

Distributional Effects Vary across Reform Proposals:

Concluding Observations:

Agency Comments and Our Evaluation:

Appendix I: Microsimulation Modeling Methodology:

Microsimulation Model:

Benchmark Policy Scenarios:

Appendix II: Comments from the Social Security Administration:

Related GAO Products:

Tables:

Table 1: Summary of Benchmark Policy Scenarios:

Table 2: Summary of Benchmark Policy Scenario Parameters:

Figures:

Figure 1: Benefit Formula Provides Higher Replacement Rates for Lower 
Earners:

Figure 2: Disability Insurance Increases Median Lifetime Social 
Security Benefits by a Larger Percentage for Lower Earners:

Figure 3: Social Security Favors Lower Earners Less when Considered 
from the Household Perspective:

Figure 4: Cap on Taxable Earnings Favors High Earners:

Figure 5: Model 2 Might Favor Lower Earners More than Benchmarks for 
Individuals Born in 1985:

Figure 6: Median Household Lifetime Benefits under Model 2 and the 
Benchmarks for Individuals Born in 1985:

Figure 7: Contribution Cap and Enhanced Benefits for Lower Earners and 
Survivors Offset the Distributional Effect of the Accounts and 
Reductions in Social Security Defined Benefits:

Abbreviations:

AIME: Average Indexed Monthly Earnings:

CSSS: Commission to Strengthen Social Security:

DI: Disability Insurance:

GEMINI: Genuine Microsimulation of Social Security and Accounts:

MINT3: Modeling Income in the Near Term:

OCACT: Social Security Administration's Office of the Chief Actuary:

PENSIM: Pension Simulator:

PIA: Primary Insurance Amount:

PSG: Policy Simulation Group:

SSA: Social Security Administration:

SSASIM: Social Security and Accounts Simulator:

United States General Accounting Office:

Washington, DC 20548:

June 15, 2004:

The Honorable Larry E. Craig: 
Chairman: 
The Honorable John Breaux: 
Ranking Minority Member: 
Special Committee on Aging: 
United States Senate:

Under Social Security, retired workers receive benefits that equal 
about 50 percent of pre-retirement earnings for a worker with 
relatively lower earnings but only about 30 percent of earnings for one 
with relatively higher earnings. To help ensure that beneficiaries have 
adequate incomes, Social Security's benefit formula is designed to be 
"progressive," that is, to provide disproportionately larger benefits, 
as a percentage of earnings, to lower earners than to higher earners. 
However, the benefit formula is just one of several program features 
that influence the way benefits are distributed. Other such program 
features include provisions for disabled workers, spouses, children, 
and survivors. Changes in the program over time also affect the 
distribution of benefits across generations. So the distribution of 
Social Security benefits can vary by eligibility, household type, and 
birth year as well as by earnings level.

Social Security faces a long-term structural financing shortfall, 
largely because people are living longer and having fewer children. 
According to the 2004 intermediate--or best-estimate--assumptions of 
the Social Security trustees, Social Security's annual benefit payments 
will exceed annual revenues beginning in 2018, and it will be necessary 
to draw on trust fund reserves to pay full benefits. In 2042, the trust 
funds will be exhausted, and annual revenues will only be sufficient to 
pay about 73 percent of benefits. As a result, some combination of 
benefit and/or revenue changes will be needed to restore the long-term 
solvency and sustainability of the program. Any such changes could 
alter the way Social Security's benefits and revenues are distributed 
across the population and affect the income security of millions of 
working Americans and their families.

To gain a better understanding of the distributional effects of 
potential program changes, you asked us to address (1) how to define 
and describe "progressivity," that is, the distribution of benefits and 
taxes with respect to earnings level, when assessing the current Social 
Security system or proposed changes to it; (2) what factors influence 
the distributional effects of the current Social Security program; and 
(3) what would be the distributional effects of various reform 
proposals, compared with alternative solvent baselines for the current 
"defined-benefit" system.

To address how to define and measure progressivity, we conducted a 
literature review and interviewed researchers familiar with 
distributional analysis of Social Security benefits. To describe the 
factors affecting the current Social Security program's distributional 
effects, we calculated benefits and contributions for a sample of 
workers born in 1985 using a microsimulation model.[Footnote 1] We 
tailored the analysis to examine the effects of specific program 
features, such as spouse, survivor, and disability benefits. In 
consultation with your staff, we selected three reform proposals for 
our analysis to illustrate a range of possible approaches to restoring 
solvency. To describe the distributional effects of the "Model 2" 
proposal put forth by the President's Commission to Strengthen Social 
Security (CSSS), we used our model to simulate benefits for workers 
born in 1985.[Footnote 2] In our modeling, we focused on workers born 
in 1985 because all prospective program changes under all alternative 
policy scenarios would be almost fully phased in for such workers. We 
focused on examining the distribution of benefits and did not assess 
their adequacy. We did not examine other sources of retirement income, 
such as employer pensions or other individual retirement savings, and 
such sources may interact with Social Security benefits. Also, in our 
modeling, to illustrate a full range of possible outcomes, we used 
hypothetical benchmark policy scenarios that would achieve 75-year 
solvency either by only increasing payroll taxes (which simulated 
"promised benefits") or only reducing benefits (which simulated "funded 
benefits"). If benefits were reduced proportionally under the funded-
benefits benchmark, then even though the benefits would be lower, the 
shape of the distribution of benefits would be very similar to that of 
the promised benefits benchmark. We also conducted a qualitative 
analysis of the distributional effects of two other proposals, one 
offered by Peter Ferrara and the other by Peter Diamond and Peter 
Orszag.[Footnote 3] Our work was done between September 2003 and June 
2004 in accordance with generally accepted government auditing 
standards.

Results in Brief:

The research literature reveals several approaches to measuring 
progressivity--or the distribution of benefits and taxes with respect 
to earnings level. In the context of Social Security reform, these 
approaches reflect different perspectives on the program's objectives. 
One perspective focuses on the program's role in securing adequate 
incomes. Studies designed to reflect this perspective address the 
question of the extent to which Social Security benefits help ensure a 
minimal subsistence or maintain past standards of living. Consequently, 
these studies use measures such as absolute benefit levels at a point 
in time and benefit-to-earnings ratio, and then look at how these 
measures are distributed across various groups of earners. The measures 
themselves describe adequacy, but their distribution with respect to 
earnings level describes progressivity. Another perspective focuses on 
the program's role in assuring equity. Studies that adopt this 
perspective compare lifetime benefits with lifetime taxes to gauge 
whether participants get their money's worth from the system. The 
measures they use include internal rates of return, ratios of benefits 
received to taxes paid, and ratios of net benefits--benefits minus 
taxes--to earnings. However, these equity measures cannot accurately 
assess the distributional effects of reform proposals that rely on 
general revenue transfers. Such proposals do not generally specify what 
kind of future taxes or spending cuts will finance the transfers or who 
will bear their burden, but evaluating progressivity from an equity 
perspective requires that all taxes and benefits be clearly allocated. 
There is no one measure that best assesses progressivity or 
distributional effects; both the adequacy and the equity perspectives 
provide insights.

Social Security's distributional effects reflect program features, such 
as its benefit formula, and demographic patterns among its recipients, 
such as marriage between lower and higher earners. The retired worker 
benefit formula favors lower earners by design, replacing about 50 
percent of pre-retirement earnings for an illustrative low earner but 
only about 30 percent of pre-retirement earnings for an illustrative 
high earner. The disability benefit formula also favors lower earners, 
and disability recipients are disproportionately lower earners. Our 
simulations suggest that for individuals born in 1985, compared with a 
hypothetical program without disability insurance, Social Security's 
disability provisions increase lifetime Social Security benefits for 
the bottom fifth of earners by 43 percent, compared with 14 percent for 
the top fifth of earners. The extent to which Social Security benefits 
favor lower earners may be offset to some degree by demographic 
patterns. Household formation reduces the system's tilt toward lower 
earners because some of the lower-earning individuals helped by the 
program live in high-income households. For example, many of the lower-
earning individuals that the system favors through spouse and survivor 
benefits actually live at some point in higher-income households 
because of marriage. In our simulations, the ratio of benefits received 
to payroll taxes contributed is higher for lower earners than for 
higher earners, but this difference is reduced when we account for 
household formation. Also, differences in mortality rates may reduce 
rates of return for lower earners, as studies show they may not live as 
long as higher earners and therefore would receive benefits for fewer 
years.

Alternative Social Security reform proposals would have different 
distributional effects. Model 2 of the President's Commission to 
Strengthen Social Security proposes a new system of voluntary 
individual accounts, along with a combination of certain benefit 
reductions for all beneficiaries and certain benefit enhancements for 
selected low earners and survivors. According to our simulations, the 
distribution of benefits under Model 2 could favor lower earners more 
than the distribution of benefits under either currently promised or 
currently funded benefits. For example, assuming universal account 
participation, households in the lowest fifth of earnings may receive 
about 14 percent of all lifetime benefits under Model 2, compared with 
about 12.5 percent under either currently promised or currently funded 
benefits. While the proposal's individual accounts and benefit 
reductions together may favor higher earners, this is more than offset 
by a limit on account contributions and the enhanced benefits for low 
earners and survivors. However, if individuals' investment decisions 
varied by earnings level, then the distribution of income from the 
accounts would differ from our simulations. In addition, the Ferrara 
proposal illustrates seeking progressivity solely through an individual 
account approach, while the Diamond-Orszag proposal illustrates 
enhancing progressivity solely through modifications of the current 
defined-benefit program structure.

Background:

In the midst of the Great Depression, Social Security was enacted to 
help ensure that the elderly would have adequate retirement incomes and 
would not have to depend on welfare. The program was designed to 
provide benefits that workers had earned to some degree through their 
contributions and those of their employers. The benefit amounts would 
depend in part on how much the worker had earned and therefore 
contributed. Today, about 10 percent of the elderly have incomes below 
the poverty line, compared with 35 percent in 1959. However, for about 
half of today's elderly, incomes excluding Social Security benefits are 
below the poverty line. Importantly, Social Security does not just 
provide benefits to retired workers. In 1939, coverage was extended to 
the dependents of retired and deceased workers, and in 1956 the 
Disability Insurance program was added.

To restore the long-term solvency and sustainability of the program, 
reductions in promised benefits and/or increases in program revenues 
will be needed. Within the program's current structure, possible 
benefit changes might include increases in the full retirement age, 
changes to the benefit formula, or reductions in cost-of-living 
increases, among other options. Revenue increases might include 
increases in payroll taxes or transfers from the Treasury's general 
fund.

Some proposals would change the structure of the program to incorporate 
a system of individual retirement savings accounts. Many such proposals 
would reduce benefits under the current system and make up for those 
reductions to some degree with income from the individual accounts. 
Individual account proposals also try to increase revenues, in effect, 
by providing the potential for higher rates of return on the individual 
accounts' investments than the trust funds would earn under the current 
system.

Three key distinctions help to identify the differences between Social 
Security's current structure and one that would use individual 
accounts.

* Insurance versus savings. Social Security is a form of insurance, 
while individual accounts would be a form of savings. As social 
insurance, Social Security protects workers and their dependents 
against a variety of risks such as the inability to earn income due to 
old age, disability, or death. In contrast, a savings account provides 
income only from individuals' contributions and any earnings on them; 
individuals effectively insure themselves under a savings approach.

* Defined-benefit versus defined-contribution. Social Security 
provides a "defined-benefit" pension, while individual accounts would 
provide a "defined-contribution" pension. Defined-benefit pensions 
typically determine benefit amounts using a formula that takes into 
account individuals' earnings and years of earnings. The provider 
assumes the financial and insurance risk associated with funding those 
promised benefit levels. Defined-contribution pensions, such as 401(k) 
plans, determine benefit amounts based on the contributions made to the 
accounts and any earnings on those contributions. As a result, the 
individual bears the financial and insurance risks under a defined-
contribution plan until retirement.[Footnote 4]

* Pay-as-you-go versus full funding. Social Security is financed 
largely on a "pay-as-you-go" basis, while individual accounts would be 
"fully funded." In a pay-as-you-go system, contributions that workers 
make in a given year fund the payments to beneficiaries in that same 
year, and the system's trust funds are kept to a relatively small 
contingency reserve.[Footnote 5] In contrast, in a fully funded system, 
contributions for a given year are put aside to pay for future 
benefits. The investment earnings on these funds contribute 
considerable revenues and reduce the size of contributions that would 
otherwise be required to pay for the benefits. Defined-contribution 
pensions and individual retirement savings are fully funded by 
definition.

To evaluate reform proposals, we have suggested that policy makers 
should consider three basic criteria:[Footnote 6]

1. the extent to which the proposal achieves sustainable solvency and 
how the proposal would affect the economy and the federal budget;

2. the balance struck between the twin goals of individual 
equity[Footnote 7] (rates of return on individual contributions) and 
income adequacy (level and certainty of benefits); and:

3. how readily such changes could be implemented, administered, and 
explained to the public.

Providing higher replacement rates for lower earners than for higher 
earners is just one of several aspects of our criterion for balancing 
adequacy and equity. With regard to adequacy, this criterion also 
considers the extent to which the proposal:

* changes benefits for current and future retirees;

* maintains or enhances benefits for low-income workers who are most 
reliant on Social Security; and:

* maintains benefits for the disabled, dependents, and survivors.

In addition, providing higher replacement rates for lower earners than 
for higher earners does not by itself ensure adequacy. A reform 
proposal could make replacement rates vary even more by earnings level 
than under the current system yet provide lower and less adequate 
benefits.[Footnote 8]

With regard to equity, our criterion for balancing adequacy and equity 
also considers the extent to which the proposal:

* ensures that those who contribute receive benefits,

* expands individual choice and control over program contributions,

* increases returns on investment, and:

* improves intergenerational equity.

Moreover, reform proposals should be evaluated as packages that strike 
a balance among individual reform elements and important interactive 
effects. The overall evaluation of any particular reform proposal 
depends on the weight individual policy makers place on each criterion.

In 2001, the President created the Commission to Strengthen Social 
Security to develop reform plans that strengthen Social Security and 
increase its fiscal sustainability while meeting certain principles:

* no changes to benefits for retirees or near retirees,

* dedication of entire Social Security surplus to Social Security,

* no increase in Social Security payroll taxes,

* no government investment of Social Security funds in the stock 
market,

* preservation of disability and survivor components,[Footnote 9] and:

* inclusion of individually controlled voluntary individual retirement 
accounts.

The commission developed three reform models, each of which represented 
a different approach to including voluntary individual accounts as part 
of Social Security. Under all three models, individuals could have a 
portion of their Social Security contributions deposited into 
individual accounts, and their Social Security defined benefits would 
be reduced relative to those account contributions. A governing board 
would administer the accounts in a fashion similar to the Thrift 
Savings Plan for federal employees. To continue paying benefits while 
also making deposits to the accounts, funds would need to be 
transferred from the Treasury's general fund. The models varied in the 
size of the account contributions. Models 2 and 3 had additional 
provisions for reducing certain benefits overall and enhancing benefits 
for surviving spouses and selected low earners.

Different Distributional Measures Reflect Different Perspectives:

To assess the extent to which the Social Security program or reform 
options are progressive--distributes in a way that favors lower 
earners--researchers first select a number of measures and then compare 
how different groups of earners fare according to those measures. The 
choice of measures reflects a particular perspective on the goals of 
the program. For example, those who analyze Social Security from an 
adequacy perspective are primarily concerned with the program's role in 
securing adequate income and consequently tend to use measures of how 
much income Social Security provides. In contrast, those who view 
Social Security from an equity perspective focus on whether 
beneficiaries receive a fair return on their contributions and tend to 
choose measures balancing lifetime taxes against lifetime benefits. For 
each perspective, assessing progressivity involves determining how 
lower earners fare relative to higher earners on appropriate measures. 
In the context of Social Security reform, those scenarios in which the 
well-being of lower earners increased proportionally more, or decreased 
proportionally less, would be considered more progressive. Because of 
the different kinds of benefits that Social Security provides, many 
researchers agree that to investigate the distributional effect of the 
program, aggregating workers and their dependents into households 
better captures well-being, but doing so poses certain methodological 
challenges.

The Adequacy Perspective Focuses on Reducing Poverty and Dependency:

Since its inception, Social Security's primary goal has been to provide 
adequate income, upon entitlement, so as to reduce dependency and 
poverty among its participants. Studies emphasizing this goal reflect 
the adequacy perspective; they view the program more as a safety net 
that helps ensure a minimum level of subsistence. Consequently, such 
studies use measures of how much income Social Security benefits 
provide. These measures include absolute benefit levels at a point in 
time and benefit-to-earnings ratios. Benefit levels are useful for 
estimating whether Social Security offers adequate protection for 
people covered by the system. Benefit-to-earnings ratios, which reflect 
how much of past earnings Social Security benefits replace, help gauge 
the extent to which the program allows people to maintain their past 
standard of living.

One way to assess the distributional effect of the current Social 
Security program or of various reform options is to look at how these 
adequacy measures are distributed across earners. Regarding benefit 
levels, one possibility is to compute the ratio of benefits received by 
lower earners to benefits received by higher earners, at a particular 
point in time. Comparing these benefit ratios under different policies 
helps determine how the well-being of lower earners changes relative to 
that of higher earners across reform proposals.[Footnote 10] If, for 
example, benefits collected by individuals in the 20th percentile of 
the earnings distribution relative to benefits collected by those in 
the 80th percentile increased from one Social Security system to the 
next, the adequacy perspective would conclude that, other things being 
equal, the second is more progressive, that it is tilted toward lower 
earners.[Footnote 11] Alternatively, one could compute the proportion 
of total benefits various groups of earners receive relative to the 
proportion the median gets and determine the manner in which these 
relative proportions change across proposals. For all groups below the 
median, for instance, an increase in this ratio would indicate a more 
progressive system.[Footnote 12]

The distribution of replacement rates also helps assess progressivity. 
The change in the replacement rate of lower earners relative to that of 
high earners across reform options shows the extent to which lower 
earners are able to maintain their pre-entitlement standard of living 
relative to higher earners. Under the current Social Security system, 
for instance, the monthly benefit lower earners receive upon 
entitlement replaces a larger portion of their monthly earnings; from 
an adequacy perspective, the system is therefore tilted in their favor. 
A reform proposal that increased the replacement rate of lower earners 
relative to higher earners would be deemed more progressive than one 
that did not.

The Equity Perspective Focuses on the Relationship between 
Contributions and Benefits over a Lifetime:

By linking benefits to earnings, which link in turn to contributions, 
Social Security also incorporates the principle of individual equity. 
Under the current program, people who pay higher taxes generally 
collect higher benefits upon entitlement but not directly 
proportionally higher.[Footnote 13] Studies that reflect the equity 
perspective focus on whether, over their lifetimes, beneficiaries can 
expect to receive a fair return on their contributions or get their 
money's worth from the system. These studies use such measures as 
lifetime benefit-to-tax ratios, internal rates of return, and net 
lifetime benefit-to-earnings ratios.[Footnote 14] The benefit-to-tax 
ratio measure compares the present value of Social Security lifetime 
benefits with the present value of lifetime Social Security 
taxes.[Footnote 15] The internal rate of return can be thought of as 
the interest rates individuals effectively receive on their lifetime 
contributions, given their lifetime Social Security benefits. Net 
lifetime benefit-to-earnings ratios show lifetime benefits minus 
lifetime taxes relative to lifetime earnings. This measure, also called 
the average rate of net taxation, borrows from the public finance 
literature the idea that equity measures ought to contain 
earnings.[Footnote 16]

From an equity perspective, examining the distribution of these 
measures helps gauge the distributional effects of Social Security or 
reform options. Many studies adopting the equity perspective find, for 
example, that the current program favors lower earners because this 
group enjoys higher rates of return and benefits whose value is larger 
relative to the value of their contributions.[Footnote 17] Other 
studies confirm this result by observing that the net benefit-to-
earnings ratio is higher for low earners.[Footnote 18] If under a 
reform proposal, these measures increased more for lower earners, then 
that system would be considered more progressive.

Reform options that involve general revenue transfers to ensure 
solvency make it difficult to evaluate progressivity from an equity 
perspective because they do not typically specify how such transfers 
are to be financed or who will eventually bear their burden. Yet 
general revenue transfers implicitly require future tax increases, 
spending cuts, or a combination of both, all of which have substantial 
distributional consequences. Such consequences are difficult to 
evaluate analytically. Without knowing who will bear the costs of 
financing these transfers, the equity perspective cannot accurately 
determine how well lower earners fare relative to higher earners in a 
given system or across proposed reforms. Even if we knew how the tax 
burden of general revenues is distributed today, the tax system could 
change in the future in ways that would alter the distribution. Some 
proposals with individual account features, for example, involve 
general revenue transfers. They divert part of existing payroll tax 
revenues from traditional Social Security benefits and toward 
individual accounts. Consequently, to remain financially solvent, such 
proposals typically require additional resources from Treasury's 
general fund for several years after implementation.[Footnote 19]

Analyzing Households to Assess Social Security's Distributional Effects 
Offers Insight but Presents Analytical Challenges:

Both the adequacy and the equity perspectives consider families or 
households, in addition to individuals, in assessing distributional 
effects. This is particularly relevant in the Social Security context 
because the program provides not only worker benefits to retired and 
disabled individuals, but also auxiliary benefits to current and former 
spouses, children, and surviving spouses. Household analysis has 
implications for progressivity. Most studies using equity measures find 
Social Security somewhat less progressive once workers and their 
dependents are combined in a single unit.[Footnote 20] This is largely 
due to the fact that some individuals with little or no earnings, hence 
"poor" by themselves, end up in high-earning households. The benefit 
they collect no longer counts as transfers to low earners.[Footnote 21]

However, the household approach presents analytical challenges. 
Multiple divorces and marriages, for example, make it difficult to 
define "household" on a lifetime basis.[Footnote 22] Moreover, age 
differences between spouses, which imply different retirement dates, 
complicate the calculation of "total household benefit" at a given 
point in time. Nonetheless, researchers believe that aggregating 
workers and their dependents into households provides insight by giving 
a more complete picture of their well-being.

Program's Distributional Effects Reflect Various Program Features and 
Demographic Patterns:

Social Security's distributional effects reflect program features, such 
as its benefit formula, and demographic patterns among its recipients, 
such as marriage between lower and higher earners. The benefit formula 
for retired workers favors lower earners by design, replacing a larger 
proportion of earnings for lower earners than for higher earners. 
Disability benefits use the same progressive benefit formula, and 
disability recipients are disproportionately lower lifetime earners. 
However, the extent to which these features favor lower earners may be 
offset to some degree by demographic patterns and other program 
features. Household formation reduces the system's tilt toward lower-
income people because some of the lower-earning individuals helped by 
the program, in fact, live in high-income households. Differences in 
mortality rates may reduce rates of return for lower earners and 
increase rates of return for higher earners.

Benefit Formula Favors Lower Earners by Design:

In order to help ensure adequate incomes in retirement, Congress 
designed Social Security's benefit formula for retired workers to favor 
lower earners.[Footnote 23] When workers retire, Social Security uses 
their lifetime earnings records to determine their Primary Insurance 
Amount (PIA), on which initial monthly benefits are based. The PIA is 
determined by applying the Social Security benefit formula to a 
worker's Average Indexed Monthly Earnings (AIME). The AIME is the 
monthly average of a worker's 35 best years of earnings, with earnings 
before age 60 indexed to average wage growth.[Footnote 24] For workers 
who become eligible for benefits in 2004, PIA equals 90 percent of the 
first $612 dollars of AIME plus 32 percent of the next $3,077 dollars 
of AIME plus 15 percent of AIME above $3,689. Consequently, the benefit 
formula replaces a higher proportion of pre-retirement earnings for 
lower lifetime earners than for higher lifetime earners. Figure 1 shows 
replacement rates for illustrative workers under the current benefit 
formula.[Footnote 25] The replacement rate for the low earner is 
49 percent, while the rate for the high earner is only around 30 
percent.

Figure 1: Benefit Formula Provides Higher Replacement Rates for Lower 
Earners:

[See PDF for image]

Note: Replacement rates are the annual retired worker benefits at age 
65 for workers born in 1985 divided by the earnings in the previous 
year. For such workers, the full retirement age will be 67. Steady 
earners have earnings equal to a constant percentage of Social 
Security's Average Wage Index in every year of their careers. Those 
percentages are 45, 100, and 160, respectively, for low, average, and 
high earners. Taxable maximum earners have earnings equal to the 
maximum taxable earnings in each year. Replacement rates are simulated 
under the tax-increase benchmark (promised benefits); they would be 
lower under the proportional benefit-reduction benchmark by a constant 
proportion and would therefore show a similar pattern. See appendix I 
for more on the benchmark policy scenarios.

[End of figure]

Disability Benefits Favor Lower Earners:

The Disability Insurance (DI) program, which provides benefits to 
workers who are no longer able to work because of severe long-term 
disabilities, also favors lower lifetime earners. Disability Insurance 
not only provides earnings replacement during the pre-retirement years 
but generally results in beneficiaries receiving higher benefits in 
retirement than they would have received if they had earned the same 
amount of money but had not received disability benefits.[Footnote 26] 
Disability Insurance favors lower earners because it uses the same 
progressive benefit formula as retired worker benefits and because DI 
recipients are more likely to be lower earners. Disability Insurance 
recipients are disproportionately lower lifetime earners because an 
inability to continue working is necessary to qualify for benefits. 
Also, researchers have found that individuals with lower levels of 
educational attainment are more likely to experience 
disability.[Footnote 27]

An analysis of lifetime benefits using a microsimulation model 
illustrates DI's tilt toward lower earners. To examine the 
distributional impact of DI, we simulated Social Security benefits for 
individuals born in 1985 under a scenario that pays retirement but not 
disability benefits and a scenario that pays all categories of Social 
Security benefits. Because simulations are sensitive to economic and 
demographic assumptions, it is more appropriate to compare benefits 
across the scenarios than to focus on the actual estimates themselves. 
Median lifetime Social Security benefits are 33 percent higher under 
the scenario that pays all types of Social Security benefits than under 
the scenario that does not pay disability benefits, with 30 percent of 
individuals receiving greater lifetime Social Security benefits due to 
the DI program. According to these simulations, DI increases median 
lifetime Social Security benefits for workers[Footnote 28] in the 
lowest fifth of lifetime earnings by 43 percent while increasing 
lifetime benefits for the top fifth by 14 percent (see fig. 
2).[Footnote 29]

Figure 2: Disability Insurance Increases Median Lifetime Social 
Security Benefits by a Larger Percentage for Lower Earners:

[See PDF for image]

Note: Percentage changes are the increase in individual lifetime Social 
Security benefits from a version of our tax-increase benchmark 
(promised benefits) where disability benefits are not paid to a version 
where all benefits are paid. Percentage changes would be different 
under the proportional benefit-reduction benchmark but would show a 
similar pattern. See appendix I for more on the benchmark policy 
scenarios. This includes all sample members who survive past age 24.

[End of figure]

Household Formation Reduces the System's Tilt toward Lower Earners:

Social Security favors lower earners less when considered from the 
household perspective.[Footnote 30] Some of the lower-earning 
individuals who gain from the benefit formula or disability benefits do 
not live in low-income households, because they are married to higher 
earners. The same is often true for lower earners who receive spouse 
and survivors benefits. Married individuals are eligible for the 
greater of their own worker benefits or 50 percent of their spouses' 
benefits. Similarly, widows and widowers are eligible for the larger of 
their own worker benefits or 100 percent of their deceased spouses' 
benefits. Because of the nature of spouses' and survivors' benefits, 
recipients are on average lower lifetime earners--effectively they must 
earn less than their spouses to qualify. However, many of the lower-
earning individuals that the system favors through spouses' and 
survivors' benefits actually live at some point in higher-income 
households because of marriage.

Some have suggested that household formation may have less of an impact 
on the degree to which Social Security favors lower earners in the 
future.[Footnote 31] Increased female labor force participation and 
changing marital patterns suggest there will be less earnings 
differences between spouses in the future as well as fewer people who 
are married long enough to qualify for spouses' and survivors' 
benefits.[Footnote 32] Consequently, there may be fewer instances of 
the system providing high replacement rates to low-earning spouses from 
high-income households.

An analysis of simulated benefits and taxes illustrates how the system 
favors lower earners less when considered from the household 
perspective. For individuals born in 1985, figure 3 depicts the ratio 
of benefits received to taxes paid for the top and bottom fifths of 
earnings from an individual perspective and a household perspective. 
For example, the first bar indicates that individuals in the bottom 
fifth of earnings receive lifetime benefits that are 1.3 times higher 
than the lifetime taxes they paid to the program. When analyzed from an 
individual perspective, individuals are classified by their own 
lifetime earnings and ratios are calculated for their own taxes and 
benefits.[Footnote 33] When analyzed from a household perspective, 
individuals are classified by household earnings and ratios are 
calculated for household taxes and benefits. In both cases, benefit-to-
tax ratios are higher for the bottom fifth than for the top fifth, 
suggesting that the system favors lower earners. However, the 
difference in the benefit-to-tax ratios is smaller when considered from 
the household perspective.

Figure 3: Social Security Favors Lower Earners Less when Considered 
from the Household Perspective:

[See PDF for image]

Note: Bars indicate the ratio of lifetime benefits received to lifetime 
taxes paid to the system. For example, the first bar indicates that 
lifetime benefits received are 1.3 times larger than taxes paid. 
Earnings fifths are based on the present value of total lifetime 
earnings. Individual analysis is based on own benefits, taxes, and 
earnings. Household analysis is based on per capita benefits, taxes, 
and earnings. Analysis includes all sample members who survive past age 
24. Benefits and taxes are simulated under the tax-increase benchmark 
(promised benefits). Ratios would be different under the proportional 
benefit-reduction benchmark but would show a similar pattern. See 
appendix I for more on the benchmark policy scenarios.

[End of figure]

Mortality Rates May Reduce the Degree to Which Social Security Favors 
Lower Earners:

The extent to which the benefit formula and disability benefits favor 
lower earners may be offset to the extent that lower earners have 
higher mortality rates than do higher earners. A number of studies 
suggest that lower earners do not live as long as higher 
earners.[Footnote 34] As a result, lower earners are likely to receive 
retirement benefits for fewer years than higher earners. Researchers 
have generally found that, to some degree, the relationship between 
mortality rates and earnings reduces rates of return for lower earners 
and increase rates of return for higher earners.[Footnote 35]

Cap on Taxable Earnings Reduces Social Security's Tilt toward Lower 
Earners:

Social Security taxes are levied on earnings up to a maximum level set 
each year, and earnings beyond the threshold are not counted when 
calculating benefits. In 2004, the cap on taxable earnings is $87,900, 
and in recent years about 6 percent of workers had earnings above the 
cap. Policy makers often argue that the cap helps higher earners 
because it results in their paying a smaller percentage of their 
earnings than do individuals whose earnings do not exceed the 
cap.[Footnote 36] Also, while the cap limits both lifetime 
contributions and benefits, it increases equity measures such as 
benefit-to-tax ratios and rates of return for high earners. If the cap 
were repealed, the additional contributions paid by high earners would 
only be partially reflected in increased benefits, because the benefit 
formula is weighted toward lower earners.

Simulations illustrate that the cap on taxable earnings modestly favors 
higher earners for individuals born in 1985. We simulate benefits and 
taxes under a scenario with the cap on taxable earnings and one without 
the cap. Figure 4 shows household benefit-to-tax ratios by top and 
bottom fifth of earnings and top percentile of earnings. When the cap 
is removed, the median benefit-to-tax ratio for the bottom fifth 
remains unchanged and the ratio for the top fifth of earnings decreases 
from 0.61 to 0.59. Although 83 percent of households in the top fifth 
are affected by repealing the cap,[Footnote 37] the increase in median 
lifetime taxes, 8.9 percent, is almost offset by the increase in median 
lifetime benefits, 6.5 percent. However, the impact on very high 
earners is larger. According to these simulations, the median benefit-
to-tax ratio for households in the top 1 percent of earnings decreases 
from 0.52 to 0.45 when the cap is removed, indicating that very high 
earners gain from the cap; the increase in median lifetime taxes paid 
by this group, 50.4 percent, is not offset as much by the increase in 
their median lifetime benefits, 34.4 percent.

Figure 4: Cap on Taxable Earnings Favors High Earners:

[See PDF for image]

Note: Earnings fifths and the top 1 percent of total earnings are based 
on the present value of total household lifetime earnings. Household 
analysis is based on per capita benefits, taxes, and earnings. Includes 
all sample members who survive past age 24. Benefits and taxes are 
simulated for a version of the tax-increase benchmark (promised 
benefits) with no cap on taxable earnings and a version with a cap. 
Ratios would be different under the proportional benefit-reduction 
benchmark but would show a similar pattern. See appendix I for more on 
the benchmark policy scenarios.

[End of figure]

Distributional Effects Vary across Reform Proposals:

We analyzed three proposals that illustrate the variation in the 
potential distributional effects of different approaches to reform. 
CSSS Model 2 would create a new system of voluntary individual accounts 
while reducing Social Security's defined benefits[Footnote 38] overall 
but increasing them for surviving spouses and lower earners. The 
Ferrara proposal would create a system of voluntary individual accounts 
that would ultimately be large enough to completely replace Social 
Security's old-age benefits for workers and their spouses. The Diamond-
Orszag proposal would restore long-term solvency without creating a new 
system of individual accounts by reducing benefits and increasing 
revenues while also increasing benefits for surviving spouses and lower 
earners.

CSSS Model 2:

Under Model 2 of the President's Commission to Strengthen Social 
Security,

* For individuals choosing to participate, the Social Security system 
would redirect 4 percentage points of the payroll tax (up to a $1,000 
annual limit[Footnote 39]) into personal investment accounts. 
Participating individuals could access their accounts in retirement, 
but Social Security defined benefits would be reduced to reflect the 
amount diverted to their individual accounts. On net, benefits would 
increase for individuals whose accounts earned more than a 2 percent 
return beyond inflation.[Footnote 40]

* Social Security defined benefits would be lower than benefits 
promised under the current benefit formula. Changes to the benefit 
formula would slow the growth in initial benefits from wage growth to 
price growth.[Footnote 41] According to Social Security 
Administration's (SSA) Office of the Chief Actuary, these formula 
changes apply to initial benefits for all types of beneficiaries, 
including disabled workers.[Footnote 42]

* Social Security defined benefits would be enhanced for certain 
surviving spouses and for low earners. When fully implemented, initial 
benefits for certain low-wage workers with steady work histories could 
be raised by as much as 40 percent.[Footnote 43] Beneficiaries who 
lived longer than their spouses would receive the larger of their own 
benefit or 75 percent of the benefit that would be received by the 
couple if both spouses were alive.[Footnote 44]

Simulations:

We used simulations to examine how Model 2 might affect the 
distribution of Social Security benefits. We did not examine the 
distribution of equity measures such as benefit-to-tax ratios or rates 
of return, because the proposal's individual account feature requires 
general revenue transfers.[Footnote 45] General revenue transfers are 
problematic when calculating equity measures because it is difficult to 
determine who ultimately pays for the additional financing. Because 
simulations are sensitive to economic and demographic assumptions, it 
is more appropriate to compare benefits across the scenarios than to 
focus on the actual estimates themselves. Since account participation 
is voluntary, we used two simulations to examine the effects of the 
Model 2 provisions, one with universal account participation (Model 2-
100 percent) and one with no account participation (Model 2-0 percent). 
We also assumed that all account participants would invest in the same 
portfolios; consequently we did not capture any distributional effect 
that might occur if lower earners were to make different account 
participation or investment decisions than higher earners.[Footnote 46] 
We compared benefits under Model 2 with hypothetical benchmark policy 
scenarios that would achieve 75-year solvency either by only increasing 
payroll taxes or by only reducing benefits. The tax-increase, or 
"promised benefits," benchmark scenario pays benefits defined by the 
current benefit formula and raises payroll taxes to bring the Social 
Security system into financial balance. The proportional benefit-
reduction, or "funded benefits," benchmark scenario maintains current 
tax rates and achieves financial balance by gradually phasing in 
proportional benefit reductions. In order to compare Model 2 with the 
benchmarks, we assumed all account participants convert their account 
balances at retirement into periodic monthly payments.[Footnote 47] We 
did not simulate other sources of retirement income, such as employer 
pensions or other individual retirement savings, and such sources may 
interact with Social Security policy. (See app. I for more details on 
the GEMINI microsimulation model, our benchmark policy scenarios, and 
our assumptions for CSSS Model 2.):

Model 2 Might Favor Lower Earners More than Benchmarks:

Given our assumptions, our analysis suggests that Model 2 would favor 
lower earners somewhat more than the benchmark scenarios. Figure 5 
shows the share of household lifetime benefits received by the bottom 
and top fifths of earnings for individuals born in 1985 for both Model 
2 and for the promised and funded benefits scenarios. For example, 
households in the bottom fifth of earnings received about 12.5 percent 
of all lifetime benefits under both benchmark scenarios.[Footnote 48] 
According to our simulations, households in the bottom fifth of 
earnings would receive greater shares of lifetime benefits under both 
Model 2 scenarios than under the benchmark scenarios, while households 
in the top fifth of earnings would receive smaller shares under Model 2 
than under the benchmarks.

Figure 5: Model 2 Might Favor Lower Earners More than Benchmarks for 
Individuals Born in 1985:

[See PDF for image]

Notes: Earnings fifths are based on the present value of total 
household lifetime earnings. Household analysis is based on per capita 
benefits, taxes, and earnings. This includes all sample members who 
survive past age 24. It assumes all account participants choose the 
same portfolio--50 percent equities, 30 percent corporate bonds, and 20 
percent Treasury bonds. Accounts earn a constant real return of 4.6 
percent. For sensitivity analysis, we also simulated scenarios with 
rates of return varying stochastically across individuals and over time 
and scenarios with higher and lower returns to equities. Shares of 
benefits by earning fifths were similar under all specifications.

[End of figure]

It should be noted that while the simulations suggest that the 
distribution of benefits under Model 2 is more progressive than under 
the benchmarks, this does not mean benefit levels are always higher for 
the bottom fifth under Model 2. (See fig. 6.) According to our 
simulations, median household lifetime benefits for the bottom fifth 
under Model 2-0 percent would be 3 percent higher than under the funded 
benefits scenario but 21 percent lower than under the promised benefits 
scenario. Median household lifetime benefits for the bottom fifth under 
Model 2-100 percent would be 26 percent higher than under the funded 
benefits scenario but 4 percent lower than under the promised benefits 
scenario.[Footnote 49] While Model 2 may improve the relative position 
of lower earners, it may not improve the adequacy of their benefits.

Figure 6: Median Household Lifetime Benefits under Model 2 and the 
Benchmarks for Individuals Born in 1985:

[See PDF for image]

Note: Earnings fifths are based on the present value of total household 
lifetime earnings. Household analysis is based on per capita benefits, 
taxes, and earnings. This includes all sample members who survive past 
age 24. It assumes all account participants choose the same portfolio-
-50 percent equities, 30 percent corporate bonds, and 20 percent 
Treasury bonds. Accounts earn a constant real return of 4.6 percent.

[End of figure]

Features That Favor Higher Earners Are More than Offset by Features 
That Favor Lower Earners:

To further understand how Model 2 distributes benefits toward lower 
earners, we examined the distributional effects of each of its core 
features. First we simulated a version of Model 2-100 percent that 
included the individual accounts and the reductions in Social Security 
defined benefits, but not the $1,000 cap on account contributions or 
the enhanced benefits for low earners and survivors. Next we simulated 
a version that included the defined-benefit reductions and the 
individual accounts with the $1,000 cap on account contributions. 
Finally, we simulated the complete Model 2-100 percent scenario, which 
included the enhanced benefits for lower earners and survivors.

Our analysis suggests that the effect of the individual accounts and 
defined benefit reductions, which favor higher earners, would be more 
than offset by the limit on account contributions and the enhanced 
benefits for lower earners and survivors. Figure 7 shows the 
distributional impact of each reform feature. First, we simulated 
adding the individual accounts and reducing Social Security defined 
benefits. The share of benefits received by the bottom fifth of 
earnings falls relative to the benchmarks by as much as a percentage 
point, and the share received by the top fifth increases by about 1.5 
percentage points. Under this scenario, benefits from individual 
account balances effectively replace some of the benefits calculated 
from the Social Security benefit formula and the disability program. 
This shift favors higher earners because, unlike the benefit formula, 
accounts by themselves do not provide higher replacement rates for 
lower earners[Footnote 50] and because DI recipients are more likely to 
be lower earners.

Figure 7: Contribution Cap and Enhanced Benefits for Lower Earners and 
Survivors Offset the Distributional Effect of the Accounts and 
Reductions in Social Security Defined Benefits:

[See PDF for image]

Note: Earnings fifths are based on the present value of total household 
lifetime earnings. Household analysis is based on per capita benefits, 
taxes, and earnings. This includes all sample members who survive past 
age 24 and assumes 100 percent account participation with all account 
participants choosing the same portfolios--50 percent equities, 
30 percent corporate bonds, and 20 percent Treasury bonds. Accounts 
earn a constant real return of 4.6 percent.

[End of figure]

Figure 7 also shows the impact of the cap on contributions and the 
enhanced benefits for low earners and survivors. Adding the cap on 
contributions would increase the share of benefits for the lowest fifth 
of earnings by more than a percentage point and would reduce the top 
fifth's share by two percentage points. The cap would reduce total 
benefits more for higher earners than for lower earners because higher 
earners have a greater proportion of earnings above the limit.[Footnote 
51] As expected, adding the enhanced benefits for low earners and 
survivors[Footnote 52] also favors lower earners. The lowest fifth's 
share of benefits increases by about a percentage point, and the top 
fifth's share of benefits decreases by almost a percentage point.

It should be emphasized that these simulations are only for individuals 
born in 1985, and the distributional impact of Model 2 could be 
different for individuals born in later years. For example, under the 
proposal, initial Social Security defined benefits only grow with 
prices, while initial benefits from account balances grow with wages. 
Since wages generally grow faster than prices, Social Security defined 
benefits will decline as a proportion of total benefits, reducing the 
importance of the progressive benefit formula, disability benefits, and 
the enhanced benefits for low earners and survivors.

It should also be noted that the account feature of Model 2-100 percent 
likely exposes recipients to greater financial risk. Greater exposure 
to risk may not affect the shares of benefits received by the bottom 
and top fifths of earnings.[Footnote 53] However, greater risk may be 
more problematic for lower earners who likely have fewer resources to 
fall back on if their accounts perform poorly.[Footnote 54]

Ferrara Proposal:

The "Progressive Proposal for Social Security Personal Accounts," 
offered by Peter Ferrara, would establish voluntary, progressive 
individual accounts and reduce the Social Security retirement and aged 
survivor benefits for those who participate.[Footnote 55] A governing 
board would administer the accounts centrally in a fashion similar to 
the Thrift Savings Plan for federal employees. Specifically, under the 
proposal,

* Account contributions would be redirected from the Social Security 
payroll tax. They would equal 10 percent of the first $10,000 of annual 
earnings and 5 percent of earnings over $10,000 up to the maximum 
taxable earnings level, which is $87,900 in 2004. The $10,000 threshold 
would increase annually according to Social Security's national Average 
Wage Index.

* Participating workers would be guaranteed that the combined benefits 
from Social Security's defined benefit and their personal accounts 
would at least equal the Social Security benefits that current law 
promises them, as long as they choose the default investment option. 
The default investment option would have an allocation of 65 percent in 
broad indexed equity funds and 35 percent in broad indexed corporate 
bond funds. Those who never participate in the personal account option 
would be provided benefits promised by the current system.

* To continue paying benefits while also making deposits to the 
accounts, funds would be transferred from the Treasury's general fund.

* The accounts would eventually completely replace Social Security's 
old-age benefits for workers and their spouses, under the assumptions 
for investment returns used by Social Security actuaries. Accordingly, 
the proposal anticipates reductions in the Social Security payroll tax 
in the long term that would be identical for all workers.

* Social Security benefits for workers who become disabled or who die 
before retirement would not be affected.

Under the Ferrara proposal, no changes would be made to the Social 
Security defined benefits scheduled under current law for those who 
choose not to participate in the accounts or for whom the benefit 
guarantee would apply. In addition, benefits for disabled workers and 
those who die before retirement would remain in place, and the 
distributional effects of these parts of Social Security would remain 
largely unchanged. Thus, any changes to the distribution of benefits 
would occur through the individual accounts for those choosing the 
accounts. All workers would initially continue to pay payroll taxes at 
the same rate as under current law, which is the same for all earnings 
up to the maximum taxable earnings. At the same time, lower earners 
would have larger contributions made from the payroll tax to their 
voluntary individual accounts. As a result, holding all else equal, the 
annuities that lower earners could receive from their accounts would 
replace a higher share of their pre-retirement earnings than annuities 
for higher earners. However, without rigorous quantitative analysis, it 
remains unclear how the distributional effects of the accounts would 
compare with and interact with the effects of the current system. In 
particular, actual investment returns could vary depending on 
individuals' investment choices or on market performance, and in some 
cases returns may not be high enough to completely replace Social 
Security benefits, in which case the guarantee would apply.

The Ferrara proposal also would have significant distributional effects 
from an equity perspective due to its revenue provisions. The general 
revenue transfers needed to cover the transition to individual accounts 
could have substantial effects on rates of return and other equity 
measures. Also, once the transition is complete and it becomes possible 
under the proposal to reduce payroll taxes, such tax reductions would 
also affect equity measures and how they are distributed.

Diamond-Orszag Proposal:

A proposal offered by Peter Diamond and Peter Orszag would restore 
Social Security's long-term solvency by increasing revenues and 
decreasing benefits while also increasing benefits for selected old-age 
survivors and low earners. Also provisions in the proposal ensure that 
benefits in the aggregate are not reduced for workers who become 
disabled and for the young survivors of workers who die before 
retirement.[Footnote 56] Specifically, under the proposal,

* Benefit reductions: Social Security benefits would decrease by having 
initial benefits grow at a slower rate to reflect expected gains in 
life expectancy. Benefits would decrease for higher earners through a 
change to the benefit formula.[Footnote 57] Benefits would decrease by 
an additional proportional 0.30 percent beginning in 2023.

* Revenue increases: Payroll taxes would gradually increase by raising 
the maximum earnings level subject to the payroll tax, which is $87,900 
in 2004. Also, Social Security would cover all new state and local 
government employees. (This would increase revenues from the payroll 
tax immediately but would not result in additional benefit payments 
until the newly covered workers became eligible for benefits.) In 
addition, payroll taxes would increase 3 percentage points (divided 
equally between employees and employers) for all earnings above the 
maximum taxable earnings level. Benefit calculations would not reflect 
the additional earnings taxed under this provision. The tax on earnings 
above the maximum taxable earnings level would increase by an 
additional 0.51 percent annually beginning in 2023. Payroll taxes on 
earnings at or below the maximum taxable earnings level would increase 
by an additional 0.255 percent annually beginning in 2023.

* Benefit enhancements: Benefits would increase for lower earners 
through a new benefit formula for qualifying workers. This provision is 
conceptually similar to the enhanced benefit for lower earners under 
CSSS Model 2 but uses a different formula. Benefits would increase for 
old-age surviving spouses to 75 percent of the benefit the married 
couple would have received if both were still alive. This provision is 
conceptually similar to the enhanced survivor benefit under CSSS Model 
2 but is specified somewhat differently. Benefits for those workers who 
become disabled and their dependents and for the young survivors of 
workers who die before retirement would increase under a "Super-COLA" 
through changes to the formula for calculating initial benefits, which 
would be recalculated each year benefits are received. This provision 
is designed so that the other reform provisions do not affect these 
beneficiaries.

The Diamond-Orszag proposal would make a variety of benefit changes 
that would affect the distribution of benefits. Reducing benefits to 
reflect expected gains in life expectancy would be a proportional 
reduction, decreasing benefits by the same percentage across all 
earnings levels. The additional reductions beginning in 2023 would also 
be proportional. Proportional reductions do not, by definition, change 
the share of benefits received by each segment of the earnings 
distribution. Still, they represent a downsizing of a redistributive 
benefit program. As a result the size of the redistributions would be 
smaller under these proportional reductions than under the current 
system, holding all else equal.

However, in addition, the proposal contains another benefit reduction 
that affects only higher earners, which would result in their getting a 
smaller share of total benefits and in increasing shares for all other 
workers not affected by the reduction. Moreover, the proposal would 
increase benefits for lower earners and surviving aged spouses. The 
proposal also preserves benefits for workers who become disabled and 
for young the survivors of workers who die before retirement. These 
workers tend to be lower earners, so all of the proposal's benefit 
increases would generally increase the share of total benefits received 
by lower earners.

Finally, the proposal includes a variety of revenue increases, most of 
which increase the tax burden on higher earners relative to lower 
earners. As a result, the distribution of rates of return and other 
equity measures would favor lower earners more and higher earners less 
than under the current system.

Concluding Observations:

By design, Social Security distributes benefits and contributions 
across workers and their families in a variety of ways. These 
distributional effects illustrate how the program balances the goal of 
helping ensure adequate incomes with the goal of giving all workers a 
fair deal on their contributions. Any changes to Social Security would 
potentially alter those distributional effects and the balance between 
those goals. Therefore, policy makers need to understand how to 
evaluate distributional effects of alternative policies. The various 
evaluation approaches reflect varying emphases on Social Security's 
adequacy and equity goals, so the methodological choices are connected 
inherently to policy choices. Regardless of policy perspectives, 
methodological issues such as the effects of general revenue transfers 
muddy distributional analysis. Moreover, greater progressivity is not 
the same thing as greater adequacy. Under some reform scenarios, Social 
Security could distribute benefits more progressively than current law 
yet provide lower, less adequate benefits. At the same time, our 
analysis shows that reform provisions that favor lower earners can 
offset other provisions that disfavor them. In addition, greater 
progressivity may result in less equity. As a result, any evaluations 
should consider a proposal's provisions taken together as a whole. 
Moreover, distributional effects are only one of several kinds of 
effects proposals would have. A comprehensive evaluation is needed that 
considers a range of effects together. In our criteria for evaluating 
reform proposals, progressivity is just one of several aspects of 
balancing adequacy and equity.

Agency Comments and Our Evaluation:

We provided SSA an opportunity to comment on the draft report. The 
agency provided us with written comments, which appear in Appendix II. 
In general, SSA concurred with the methodology, overall findings and 
conclusions of the report, noting that our modeling results are 
consistent with SSA's internal efforts to model the features of Model 2 
of the Commission to Strengthen Social Security. Many of SSA's 
comments, for example those regarding progressivity measures and equity 
measure methodology, involve clarifying our presentation or conducting 
additional analyses to provide more consistency with other analyses or 
to extend the readers' understanding. We revised our draft in response 
to these suggestions as appropriate, given our time and resource 
constraints.

SSA agreed with GAO's discussion of the complications involved in 
applying equity measures to reform proposals that include general 
revenue transfers and concurred that a satisfactory resolution of the 
issue is complex and methodologically troublesome. SSA suggested some 
additional analysis relying on some simplifying assumptions, for 
example assuming any general revenue transfer is financed through a 
payroll tax increase, that one could use to tackle the problem. We 
agree that despite its methodological complexity, the use of general 
revenue transfers raises many important distributional issues. However, 
the analytical difficulties raised by this issue would require 
thoughtful and deliberate research that was beyond the scope of the 
current study, given our time and resource constraints.

SSA also had suggestions concerning our choice of benchmark policy 
scenarios against which to compare reform proposals. For example, while 
SSA is supportive of GAO's development of standard benchmarks, they 
note that our benchmarks do not match the sustainable solvency achieved 
by Model 2 beyond 75 years and that this distinction should be noted in 
the report. SSA also suggests that a third benchmark be considered that 
would characterize a scenario where no reform action is taken and the 
program could only pay benefits equal to incoming payroll tax revenues.

As we have noted in the past, we agree that sustainable solvency is an 
important objective and that the GAO benchmarks do not achieve solvency 
beyond the 75 year period.[Footnote 58] We share SSA's emphasis on the 
importance of careful and complete annotation and we have clarified our 
report, where appropriate, to minimize the potential for 
misinterpretation or misunderstanding on this matter. However, in this 
case, we did not revise our benchmarks because we recognized (along 
with SSA actuaries we consulted early in the assignment) that the use 
of sustainable benchmarks would not have a noticeable effect on an 
analysis of the shape of the distribution of benefits and taxes. 
Regarding the use of a "no action" benchmark, we continue to believe 
that comparing a proposal that starts relatively soon to one that 
posits that no legislative action is ever taken does not provide the 
consistent bounds for reform captured by our current 
benchmarks.[Footnote 59] Appendix I of our report discusses the 
construction and rationale for the benchmarks used in this report. In 
our view, our set of benchmarks provides a fair and objective measuring 
stick with which to compare alternative proposals.

SSA also provided technical and other clarifying comments that we 
incorporated as appropriate.

We will send copies of this report to appropriate congressional 
committees and other interested parties. Copies will also be made 
available to others upon request. In addition, the report will be 
available at no charge on GAO's Web site at http://www.gao.gov. Please 
contact me at (202) 512-7215, Charles Jeszeck at (202) 512-7036, or Ken 
Stockbridge at (202) 512-7264, if you have any questions about this 
report. Other major contributors include Gordon Mermin and Seyda 
Wentworth.

Signed by: 

Barbara D. Bovbjerg: 
Director, Education, Workforce, and Income Security Issues:

[End of section]

Appendix I: Microsimulation Modeling Methodology:

Microsimulation Model:

Description:

Genuine Microsimulation of Social Security and Accounts (GEMINI) is a 
microsimulation model developed by the Policy Simulation Group (PSG). 
GEMINI simulates Social Security benefits and taxes for large 
representative samples of people born in the same year. GEMINI 
simulates all types of Social Security benefits including retired 
workers', spouses', survivors', and disability benefits. It can be used 
to model a variety of Social Security reforms including the 
introduction of individual accounts.

GEMINI uses inputs from two other PSG models, the Social Security and 
Accounts Simulator (SSASIM), which has been used in numerous GAO 
reports, and the Pension Simulator (PENSIM), which has been developed 
for the Department of Labor. GEMINI relies on SSASIM for economic and 
demographic projections and relies on PENSIM for simulated life 
histories of large representative samples of people born in the same 
year and their spouses.[Footnote 60] Life histories include educational 
attainment, labor force participation, earnings, job mobility, 
marriage, disability, childbirth, retirement, and death. Life histories 
are validated against data from the Survey of Income and Program 
Participation, the Current Population Survey, Modeling Income in the 
Near Term (MINT3),[Footnote 61] and the Panel Study of Income Dynamics. 
Additionally, any projected statistics (such as life expectancy, 
employment patterns, and marital status at age 60) are, where possible, 
consistent with intermediate-cost projections from Social Security 
Administration's Office of the Chief Actuary (OCACT). At their best, 
such models can only provide very rough estimates of future incomes. 
However, these estimates may be useful for comparing future incomes 
across alternative policy scenarios and over time.

For this report we used GEMINI to simulate Social Security benefits and 
taxes for 100,000 individuals born in 1985. Benefits and taxes were 
simulated under our tax-increase (promised benefits) and proportional 
benefit-reduction (funded benefits) benchmarks (described below) and 
under Model 2 of the President's Commission to Strengthen Social 
Security (CSSS). We also simulated variations of these scenarios to 
examine the impact of disability benefits, the cap on taxable earnings, 
each feature of Model 2, and different assumptions on the return to 
equities.

To examine lifetime earnings, benefits, and taxes on a household basis, 
we chose a "shared" concept that researchers have used with the MINT3 
and DYNASIM[Footnote 62] microsimulation models.[Footnote 63] In years 
that individuals are married, we assign them half of their own 
earnings, benefits, and contributions and half of their spouses' 
earnings, benefits, and contributions. In years that individuals are 
single, we assign them their entire earnings, benefits, and 
contributions. This technique accounts for household dynamics including 
divorce, remarriage, and widowhood.

Assumptions and Limitations:

To facilitate our modeling analysis, we made a variety of assumptions 
regarding economic and demographic trends and how CSSS Model 2's 
individual accounts would work. In choosing our assumptions, we focused 
our analysis to illustrate relevant points about distributional effects 
and hold equal as much as possible any variables that were either not 
relevant to or would unduly complicate that focus. As a result of these 
assumptions as well as issues inherent in any modeling effort, our 
analysis has some key limitations, especially relating to risk, 
individual account decisions, and changes over time.

2003 Social Security Trustees' Assumptions:

The simulations are based on economic and demographic assumptions from 
the 2003 Social Security trustees' report.[Footnote 64] We used 
trustees' assumptions for inflation, real wage growth, mortality 
decline, immigration, labor force participation, and interest rates.

Adjusting Mortality for Educational Attainment and Disability:

The simulations assumed that mortality rates vary by educational 
attainment and disability status. In every year, mortality rates 
implied by trustees assumptions are increased for those with lower 
levels of education and reduced for those with higher levels of 
education. For example, mortality rates are multiplied by 1.5 for women 
who do not complete high school, while rates are multiplied by 0.7 for 
women with four-year college degrees. Adjustment factors for education 
were chosen to calibrate life expectancy by demographic group with the 
MINT3 simulation model. Mortality rates are multiplied by a factor of 2 
for Disability Insurance (DI) recipients. The adjustment factor for 
disability was chosen so PENSIM life histories produced aggregate 
results consistent with 2003 Social Security Trustees Report. Assuming 
constant adjustment factors over time does not capture any convergence 
in mortality rates as a birth cohort ages. It may be the case that 
differences in mortality rates across education levels may narrow by 
the time a birth cohort retires. If that is the case, our simulations 
overstate differences in life expectancy at retirement.

Model 2's Individual Accounts:

Account participation:

Rather than model account participation, we instead simulate benefits 
under two scenarios, one where all individuals participate and another 
scenario where no one participates. As a result, we do not capture any 
distributional effects that might result from account participation 
varying by earnings level. For instance, if lower earners are less 
likely to participate in the individual accounts, then our simulations 
may overstate their share of benefits, as account participation is 
likely to increase benefits.

Portfolio choice:

Like the analysis of Model 2 by OCACT[Footnote 65] we assume all 
individuals invest in the same portfolio: 50 percent in equities, 30 
percent in corporate bonds, and 20 percent in Treasury bonds. We do not 
capture any distributional effects that might result if portfolio 
choice varies by earnings level. For instance, if lower earners were 
more risk averse and therefore choose more conservative portfolios, our 
simulations overstate the share of benefits for lower earners.

Rates of return:

We use the same assumptions for asset returns as OCACT: In all years 
real returns are 6.5 percent for equities, 3.5 percent for corporate 
bonds, and 3 percent for Treasury bonds, with an annual administrative 
expense of 30 basis points. For sensitivity analysis, we simulated a 
version of Model 2 that assumed a 4.9 percent real return to equities, 
a version that assumed an 8.7 percent real return to equities, and a 
version that assumed the return to equities varied stochastically 
across individuals and over time. Shares of benefits by earnings 
quintile were similar under all specifications. However, if portfolio 
choice or participation in accounts varied by earnings quintile, then 
shares of benefits might be more sensitive to rates of return.

Annuitization:

In order to compare account balances with Social Security defined 
benefits, we follow the assumption of OCACT that individuals fully 
annuitize their account balances at retirement. We assume individuals 
purchase inflation-indexed annuities, while married individuals 
purchasing inflation-indexed joint and two-thirds survivor annuities. 
The commission proposal, however, also allows participants to access 
their accounts through regular monthly withdrawals or through lump sum 
distributions if their monthly benefits (Social Security defined 
benefits and any annuity payments) are enough to keep them out of 
poverty. Given that few defined-contribution pension recipients 
currently choose to annuitize, it is possible that many retirees under 
Model 2 would not annuitize their accounts. To the extent that 
withdrawal decisions vary by earnings level, there may be 
distributional consequences that our simulations do not capture. For 
instance, some people may withdraw money too quickly, leaving 
themselves with inadequate income later in retirement, and such 
behaviors could vary by earnings level.

Risk:

Our quantitative analysis does not reflect differences in risk across 
policy scenarios. Because of financial market fluctuations, individual 
accounts likely expose recipients to greater financial risk.[Footnote 
66] For sensitivity analysis, we simulated a version of Model 2 where 
the return to equities varied stochastically across individuals and 
over time. Stochastic rates of return had very little impact on shares 
of benefits received by earnings quintiles. However, greater risk may 
be more problematic for lower earners, who likely have fewer resources 
to fall back on if their accounts perform poorly. Consequently, lower 
earners may be more risk averse and therefore suffer greater utility 
loss from increased risk.

Distributional Effects over Time:

We simulated benefits for individuals born in 1985 because Model 2's 
reform features would be almost fully phased in for such workers. 
However, the distributional effects of Model 2 might change over time. 
For example, under the proposal initial Social Security defined 
benefits only grow with prices, while initial benefits from account 
balances grow with wages. Since wages generally grow faster than 
prices, Social Security defined benefits will decline as a proportion 
of total benefits, reducing the importance of the progressive benefit 
formula, disability benefits, and the enhanced benefits for low earners 
and survivors.

Pre-retirement Mortality:

To capture the distributional impact of pre-retirement mortality, we 
calculated benefit-to-tax ratios and lifetime benefits for all sample 
members who survived past age 24. However, our measure of well-being, 
lifetime earnings, may not be the best way to assess the well-being of 
those who die before retirement. Some high-wage workers are classified 
as low lifetime earners simply because they did not live very long, and 
consequently our analysis overstates the degree to which those who die 
young are classified as low earners. As a result, our measures 
underestimate the degree to which Social Security favors lower earners 
under all of the scenarios we analyze. For sensitivity analysis, we 
also calculated benefit-to-tax ratios and lifetime benefits only for 
sample members who lived to age 67 and beyond. While all of the 
measures of progressivity were lower, the findings were unchanged as 
the relationships across all of the scenarios remained the same.

Data Reliability:

To assess the reliability of simulated data from GEMINI, we reviewed 
PSG's published validation checks, examined the data for reasonableness 
and consistency, preformed sensitivity analysis, and compared our 
results with a study by the actuaries at the Social Security 
Administration.

PSG has published a number of validation checks of its simulated life 
histories. For example, simulated life expectancy is compared with 
projections from the Social Security Trustees; simulated benefits at 
age 62 are compared with administrative data from SSA; and simulated 
educational attainment, labor force participation rates, and job tenure 
are compared with values from the Current Population Survey. We found 
that simulated statistics for the life histories were reasonably close 
to the validation targets.

For sensitivity analysis, we simulated benefits and taxes for policy 
scenarios under a number of alternative specifications including higher 
and lower returns to equities, stochastic returns to equities, and 
limiting the sample to those who survive to retirement. Our findings 
were consistent across all specifications.

Finally, we compared our results with those in a memo from the 
actuaries at the Social Security Administration.[Footnote 67] Our 
finding that the lowest earnings quintile receives a greater share of 
benefits under Model 2-100 percent than under promised benefits is 
consistent with the actuaries' projections of benefits for illustrative 
high-and low-earning couples in 2052. Also, in a previous report we 
found that GEMINI simulations of promised Social Security benefits were 
similar to MINT simulations for the 1955 birth cohort.[Footnote 68] We 
conclude from our assessment that simulated data from GEMINI are 
sufficiently reliable for the purposes of this report, particularly 
since we focus on the differences in simulated measures across 
scenarios, as opposed to the actual estimates themselves.

Benchmark Policy Scenarios:

According to current projections of the Social Security trustees for 
the next 75 years, revenues will not be adequate to pay full benefits 
as defined by the current benefit formula. Therefore, estimating future 
Social Security benefits should reflect that actuarial deficit and 
account for the fact that some combination of benefit reductions and 
revenue increases will be necessary to restore long-term solvency.

To illustrate a full range of possible outcomes, we developed 
hypothetical benchmark policy scenarios that would achieve 75-year 
solvency either by only increasing payroll taxes or by only reducing 
benefits.[Footnote 69] In developing these benchmarks, we identified 
criteria to use to guide their design and selection. Our tax-increase-
only benchmark simulates "promised benefits," or those benefits 
promised by the current benefit formula, while our benefit-reduction-
only benchmarks simulate "funded benefits," or those benefits for which 
currently scheduled revenues are projected to be sufficient. Under the 
latter policy scenarios, the benefit reductions would be phased in 
between 2005 and 2035 to strike a balance between the size of the 
incremental reductions each year and the size of the ultimate 
reduction.

At our request, SSA actuaries scored our benchmark policies and 
determined the parameters for each that would achieve 75-year 
solvency.[Footnote 70] Table 1 summarizes our benchmark policy 
scenarios. For our benefit-reduction scenarios, the actuaries 
determined these parameters assuming that disabled and survivor 
benefits would be reduced on the same basis as retired worker and 
dependent benefits. If disabled and survivor benefits were not reduced 
at all, reductions in other benefits would be deeper than shown in this 
analysis.

Table 1: Summary of Benchmark Policy Scenarios:

Benchmark policy scenario: Tax increase only (promised benefits); 
Description: Increases payroll taxes in 2002 by amount necessary to 
achieve 75-year solvency (0.95 percent of payroll each for employees 
and employers); 
Phase-in period: Immediate; 
Ultimate new benefit reductions[A] (percent): Minimum: 0%; 
Ultimate new benefit reductions[A] (percent): Maximum: 0%.

Benchmark policy scenario: Proportional benefit reduction (funded 
benefits); 
Description: Reduces benefit formula factors proportionally across all 
earnings levels; 
Phase-in period: 2005-2035; 
Ultimate new benefit reductions[A] (percent): Minimum: 24%; 
Ultimate new benefit reductions[A] (percent): Maximum: 24%.

Benchmark policy scenario: Hypothetical-account benefit reduction; 
Description: Reduces benefit formula factors by smaller proportion for 
lower earners; 
Phase-in period: 2005-2035; 
Ultimate new benefit reductions[A] (percent): Minimum: 11%; 
Ultimate new benefit reductions[A] (percent): Maximum: 33%. 

Source: GAO.

[A] These benefit reduction amounts do not reflect the implicit 
reductions resulting from the gradual increase in the full retirement 
age that has already been enacted.

[End of table]

Criteria:

According to our analysis, appropriate benchmark policies should 
ideally be evaluated against the following criteria:

4. "Distributional neutrality": the benchmark should reflect the 
current system as closely as possible while still restoring solvency. 
In particular, it should try to reflect the goals and effects of the 
current system with respect to redistribution of income. However, there 
are many possible ways to interpret what this means, such as:

a. producing a distribution of benefit levels with a shape similar to 
the distribution under the current benefit formula (as measured by 
coefficients of variation, skewness, kurtosis, etc.);

b. maintaining a proportional level of income transfers in dollars;

c. maintaining proportional replacement rates; and:

d. maintaining proportional rates of return.

5. Demarcating upper and lower bounds: These would be the bounds within 
which the effects of alternative proposals would fall. For example, one 
benchmark would reflect restoring solvency solely by increasing payroll 
taxes and therefore maximizing benefit levels, while another would 
solely reduce benefits and therefore minimize payroll tax rates.

6. Ability to model: The benchmark should lend itself to being modeled 
within the GEMINI model.

7. Plausibility: The benchmark should serve as a reasonable alternative 
within the current debate; otherwise, the benchmark could be perceived 
as an invalid basis for comparison.

8. Transparency: The benchmark should be readily explainable to the 
reader.

Tax-Increase-Only, or "Promised Benefits," Benchmark Policies:

Our tax-increase-only benchmark would raise payroll taxes once and 
immediately by the amount of Social Security's actuarial deficit as a 
percentage of payroll. It results in the smallest ultimate tax rate of 
those we considered and spreads the tax burden most evenly across 
generations; this is the primary basis for our selection. The later 
that taxes are increased, the higher the ultimate tax rate needed to 
achieve solvency, and in turn the higher the tax burden on later 
taxpayers and lower on earlier taxpayers. Still, any policy scenario 
that achieves 75-year solvency only by increasing revenues would have 
the same effect on the adequacy of future benefits in that promised 
benefits would not be reduced. Nevertheless, alternative approaches to 
increasing revenues could have very different effects on individual 
equity.

Benefit-Reduction-Only, or "Funded Benefits," Benchmark Policies:

We developed alternative benefit-reduction benchmarks for our analysis. 
For ease of modeling, all benefit-reduction benchmarks take the form of 
reductions in the benefit formula factors; they differ in the relative 
size of those reductions across the three factors, which are 90, 32, 
and 15 percent under the current formula. Each benchmark has three 
dimensions of specification: scope, phase-in period, and the factor 
changes themselves.

Scope:

For our analysis, we apply benefit reductions in our benchmarks very 
generally to all types of benefits, including disability and survivors' 
benefits as well as old-age benefits. Our objective is to find policies 
that achieve solvency while reflecting the distributional effects of 
the current program as closely as possible. Therefore, it would not be 
appropriate to reduce some benefits and not others. If disability and 
survivors' benefits were not reduced at all, reductions in other 
benefits would be deeper than shown in this analysis.

Phase-in Period:

We selected a phase-in period that begins with those reaching age 62 in 
2005 and continues for 30 years. We chose this phase-in period to 
achieve a balance between two competing objectives: (1) minimizing the 
size of the ultimate benefit reduction and (2) minimizing the size of 
each year's incremental reduction to avoid "notches," or unduly large 
incremental reductions. Notches create marked inequities between 
beneficiaries close in age to each other. Later birth cohorts are 
generally agreed to experience lower rates of return on their 
contributions already under the current system. Therefore, minimizing 
the size of the ultimate benefit reduction would also minimize further 
reductions in rates of return for later cohorts. The smaller each 
year's reduction, the longer it will take for benefit reductions to 
achieve solvency, and in turn the deeper the eventual reductions will 
have to be. However, the smallest possible ultimate reduction would be 
achieved by reducing benefits immediately for all new retirees by over 
10 percent; this would create a huge notch.

Our analysis shows that a 30-year phase-in should produce incremental 
annual reductions that would be relatively small and avoid significant 
notches. In contrast, longer phase-in periods would require deeper 
ultimate reductions.

In addition, we feel it is appropriate to delay the first year of the 
benefit reductions for a few years because those within a few years of 
retirement would not have adequate time to adjust their retirement 
planning if the reductions applied immediately. The Maintain Tax Rates 
(MTR) benchmark in the 1994-96 Advisory Council Report also provided 
for a similar delay.[Footnote 71]

Finally, the timing of any policy changes in a benchmark scenario 
should be consistent with the proposals against which the benchmark is 
compared. The analysis of any proposal assumes that the proposal is 
enacted, usually within a few years. Consistency requires that any 
benchmark also assume enactment of the benchmark policy in the same 
time frame. Some analysts have suggested using a benchmark scenario in 
which Congress does not act at all and the trust funds become 
exhausted.[Footnote 72] However, such a benchmark assumes that no 
action is taken while the proposals against which it is compared assume 
that action is taken, which is inconsistent. It also seems unlikely 
that a policy enacted over the next few years would wait to reduce 
benefits until the trust funds are exhausted; such a policy would 
result in sudden, large benefit reductions and create substantial 
inequities across generations.

Defining the PIA Formula Factor Reductions:

When workers retire, become disabled, or die, Social Security uses 
their lifetime earnings records to determine each worker's PIA, on 
which the initial benefit and auxiliary benefits are based. The PIA is 
the result of two elements--the Average Indexed Monthly Earnings (AIME) 
and the benefit formula. The AIME is determined by taking the lifetime 
earnings earnings record, indexing it, and taking the average of the 
highest 35 years of indexed wages. To determine the PIA, the AIME is 
then applied to a step-like formula, shown here for 2004.

PIA = 90% X (AIME[sub1] $612) + 32% X (AIME[sub2] > $612 and $3689) + 
15% X (AIME[sub3] > $3689):

where AIME[sub i] is the applicable portion of AIME.

All of our benefit-reduction benchmarks are variations of changes in 
PIA formula factors.

Proportional reduction: Each formula factor is reduced annually by 
subtracting a constant proportion of that factor's value under current 
law, resulting in a constant percentage reduction of currently promised 
benefits for everyone. That is,

F^i[sub t+1] = F^i[sub t] - (F^i[sub 2004] X x):

where F^i[sub t] represents the 3 PIA formula factors in year t and:

x = constant proportional formula factor reduction.

The value of x is calculated to achieve 75-year solvency, given the 
chosen phase-in period and scope of reductions.

The formula for this reduction specifies that the proportional 
reduction is always taken as a proportion of the current law factors 
rather than the factors for each preceding year. This maintains a 
constant rate of benefit reduction from year to year. In contrast, 
taking the reduction as a proportion of each preceding year's factors 
implies a decelerating of the benefit reduction over time because each 
preceding year's factors get smaller with each reduction. To achieve 
the same level of 75-year solvency, this would require a greater 
proportional reduction in earlier years because of the smaller 
reductions in later years.

The proportional reduction hits lower earners hard because the constant 
x percent of the higher formula factors results in a larger percentage 
point reduction over the lower earnings segments of the formula. For 
example, in a year when the cumulative size of the proportional 
reduction has reached 10 percent, the 90 percent factor would then have 
been reduced by 9 percentage points, the 32 percent factor by 
3.2 percentage points, and the 15 percent factor by 1.5 percentage 
points. As a result, earnings in the first segment of the benefit 
formula would be replaced at 9 percentage points less than the current 
formula, while earnings in the third segment of the formula would be 
replaced at only 1.5 percentage points less than the current 
formula.[Footnote 73]

Hypothetical-account reduction:[Footnote 74] Each formula factor is 
reduced by annually subtracting a constant amount that is the same for 
all factors in all years. That is,

F^i[sub t]+1 = F^i[sub t] - y:

where y = constant formula factor reduction.

The value of y is calculated to achieve 75-year solvency, given the 
chosen phase-in period and scope of reductions.

This reduction results in equal percentage point reductions in the 
formula factors, by definition, and subjects earnings across all 
segments of the PIA formula to the same reduction. Therefore, it avoids 
hitting lower earners as hard as the proportional reduction.

We call this a hypothetical-account reduction because it has the same 
effect as a benefit reduction based on using a hypothetical account. In 
fact, we developed this benchmark first using a hypothetical-account 
approach and then discovered it can be reduced to a simple change in 
the PIA formula. Hypothetical-account calculations have become a common 
way to offset benefits under individual account proposals, such as 
those by the President's Commission to Strengthen Social Security. Such 
proposals reduce Social Security's defined benefit to reflect the fact 
that contributions have been diverted from the trust funds into the 
individual accounts. The account contributions are accumulated in a 
hypothetical account at a specified rate of return and then converted 
to an annuity value.

We used a hypothetical-account offset in our 1990 analysis of a partial 
privatization proposal.[Footnote 75] In that analysis, we were charged 
with finding a benefit reduction that would leave the redistributive 
effects of the program unchanged while allowing a diversion of 
2 percentage points of contributions into individual accounts. We 
demonstrated the distributional neutrality of this benefit reduction by 
showing that if all individuals earned exactly the cohort rate of 
return on their individual accounts, then their income under the 
proposal from Social Security and the new accounts would be exactly the 
same as under the current system.

For the purposes of developing a benefit-reduction benchmark, we 
applied the hypothetical-account approach even though there are no 
actual individual accounts. From our previous analysis, we realized a 
hypothetical-account approach may produce distributional effects that 
might in some sense be more neutral than other reduction approaches and 
therefore worth studying as an alternative. In effect, using it to 
calculate a benefit-reduction benchmark implies calculating an annuity 
value of the percent of payroll that represents the system's revenue 
shortage.

As it turns out mathematically, the hypothetical-account approach to 
reducing benefits translates into PIA formula factor changes. Such a 
benefit reduction is proportional to the AIME, not to the PIA, because 
the contributions to a hypothetical account are proportional to 
earnings. Therefore, a benefit reduction based on such an account would 
also be proportional to earnings; that is,

Benefit reduction = y X AIME:

Therefore, the new PIA would be:

PIAnew =90% X AIME[sub 1] + 32% X AIME[sub2] + 15% X AIME[sub3] - y X 
AIME[sub T]:

Where AIME[sub i] is the applicable portion of AIME and AIME[sub T] is 
the total AIME. In turn,

PIAnew =(90% - y) X AIME[sub 1] + (32% - y) X AIME[sub2] + (15% - y) X 
AIME[sub3]:

Thus, the reduction from a hypothetical account can be translated into 
a change in the PIA formula factors. Because this reduction can be 
described as subtracting a constant amount from each PIA formula 
factor, it is reasonably transparent.

In our analysis of CSSS Model 2, we found that Model 2 had a benefit 
distribution that was very close to our hypothetical-account benefit-
reduction benchmark. For example, households in the bottom fifth of 
earnings received about 13.8 percent of all lifetime benefits under 
Model 2, compared with 13.5 percent under the hypothetical-account 
benefit-reduction benchmark. In this report, we present the results 
using the proportional benefit-reduction benchmark because this 
benefit-reduction approach is more easily understood.

Table 2 summarizes the features of our three benchmarks.

Table 2: Summary of Benchmark Policy Scenario Parameters:

Benchmark policy scenario: Tax increase only (promised benefits); 
Phase-in period: 2002; 
Annual PIA factor reduction (percentage point): 90 percent factor: 
0.00; 
Annual PIA factor reduction (percentage point): 32 percent factor: 
0.00; 
Annual PIA factor reduction (percentage point): 15 percent factor: 
0.00; 
Ultimate PIA factor (2035) (percent): 90 percent factor: 90.00; 
Ultimate PIA factor (2035) (percent): 32 percent factor: 32.00; 
Ultimate PIA factor (2035) (percent): 15 percent factor: 15.00.

Benchmark policy scenario: Proportional benefit reduction (funded 
benefits); 
Phase-in period: 2005-2035; 
Annual PIA factor reduction (percentage point): 90 percent factor: 
0.71; 
Annual PIA factor reduction (percentage point): 32 percent factor: 
0.25; 
Annual PIA factor reduction (percentage point): 15 percent factor: 
0.12; 
Ultimate PIA factor (2035) (percent): 90 percent factor: 68.10; 
Ultimate PIA factor (2035) (percent): 32 percent factor: 24.21; 
Ultimate PIA factor (2035) (percent): 15 percent factor: 11.35.

Benchmark policy scenario: Hypothetical-account benefit reduction; 
Phase-in period: 2005-2035; 
Annual PIA factor reduction (percentage point): 90 percent factor: 
0.32; 
Annual PIA factor reduction (percentage point): 32 percent factor: 
0.32; 
Annual PIA factor reduction (percentage point): 15 percent factor: 
0.32; 
Ultimate PIA factor (2035) (percent): 90 percent factor: 80.11; 
Ultimate PIA factor (2035) (percent): 32 percent factor: 22.11; 
Ultimate PIA factor (2035) (percent): 15 percent factor: 5.11. 

Source: GAO's analysis as scored by SSA actuaries.

[End of table]

[End of section]

Appendix II: Comments from the Social Security Administration:

SOCIAL SECURITY: 
Office of the Commissioner:

June 9, 2004:

Ms. Barbara Bovberg: 
Director:
Education, Workforce, and Income Security Issues: 
U.S. General Accounting Office 
441 G Street, N.W. Room 5928 
Washington, DC 20548:

Dear. Ms. Bovberg,

Thank you for the opportunity to review and comment on the preliminary 
draft report "Social Security: Distribution Of Benefits And Taxes 
Relative To Earnings Level" (GAO-04-747).

GAO has done an excellent job discussing progressivity issues and 
analyzing key factors that influence the benefit-to-tax-ratio. This 
analysis will provide policy makers and analysts with important 
information as they consider Social Security solvency reforms.

Enclosed are detailed comments and suggestions we have on the draft 
report. If your staff have questions about our comments, they may 
contact Andrew Biggs, Associate Commissioner for Retirement Policy. Mr. 
Biggs can be reached by phone at (202) 358-6064 or by E-mail at 
andrew.biggs@ssa.gov.

Sincerely,

Signed by: 

Jo Anne B. Barnhart:

Enclosure:

SOCIAL SECURITY ADMINISTRATION	BALTIMORE MD 21235-0001:

COMMENTS ON THE GENERAL ACCOUNTING OFFICE (GAO) REPORT "SOCIAL 
SECURITY: DISTRIBUTION OF BENEFITS AND TAXES RELATIVE TO EARNINGS 
LEVEL" (GAO-04-747):

We appreciate the opportunity to review and comment on the draft 
report. The General Accounting Office has provided a thorough 
discussion of progressivity, the factors that affect progressivity in 
the current program and how progressivity may change under Model 2 of 
the President's Commission to Strengthen Social Security and other 
reform proposals. Major comments are provided first, followed by a 
listing of technical comments.

Progressivity:

The discussion of progressivity measures and their adequacy and equity 
perspectives will be of great use to policy makers and analysts who are 
unfamiliar with the context of these measures' uses. Similarly, the 
discussion of the effect that the benefit formula, the cap on taxable 
earnings, disability benefits and mortality all have on progressivity 
will help policy makers who are considering reform proposals.

The discussion of how the current program favors lower earners from an 
individual perspective but less so from a household perspective could 
use more explanation. The discussion of how household formation reduces 
the system's tilt toward low earners should at least acknowledge the 
operation of the dual entitlement provision as it applies to 
individuals who are entitled to both a benefit as a worker and as a 
spouse/widow(er).

Furthermore, Figure 3 refers to the rate of return from the individual 
perspective and from the household perspective. For some readers it may 
not be clear how the ratio of benefits to taxes could fall for the 
lowest quintile of households compared to the lowest quintile of 
individuals. It appears that this might be caused by higher household 
income, i.e., a higher income wage earner, in the lowest quintile of 
households compared to the lowest quintile of individuals. It might be 
helpful to give income levels for each to make this clear - if this is 
the case.

Similarly, it would be helpful to include the earning levels of the 
highest quintiles of individuals and households to shed light on how 
the benefit-to-tax ratios could be the same for the highest quintiles 
of individuals and households. Since measuring by household earnings 
combines individuals with higher and low rates of return, the result 
should be to compress the distribution of returns on both the high and 
low end. Intuitively, the highest household quintile could be expected 
to have a higher rate of return than the highest individual quintile 
since at least some of these households would include wage earners from 
lower individual quintiles, which should result in a higher household 
benefit-to-tax ratio. Further, because some of the households 
presumably include one-earner couples (who receive the "free" spouse's 
benefit) this would tend to increase the rate of return on taxes paid 
for the household versus the individual. Any difference in the earnings 
levels that define the individual and household quintiles may explain 
this to readers who find the constant ratios counterintuitive.

CSSS Model 2 Findings:

Our own internal modeling has produced similar results to those in the 
draft report: Model 2 would favor lower earners over higher earners. 
This should be mutually reassuring from a modeling standpoint as well 
as to others who have done analyses of Model 2 and found the same 
results.

Benchmarks:

SSA has previously commented on the three GAO benchmarks (see SSA 
comments on page 101 of "Social Security Reform: Analysis of Reform 
Models Developed by the President's Commission to Strengthen Social 
Security, GAO-03-310) and will briefly summarize the relevant comments 
here.

* GAO is to be commended for developing standard benchmarks for 
comparison with proposed reforms.

* In the comparisons between Model 2 and the benchmarks, the report 
should note the difference in how solvent the proposal and the 
benchmarks are. The benchmarks are sustainable only for 75 years while 
Model 2 is sustainably solvent beyond that period. These different 
solvency horizons affect the level of benefits paid under each, and 
therefore affect comparisons of progressivity. Alternately, a 
sustainably solvent tax increase or benefit reduction benchmark could 
be introduced.

* Perhaps the primary benchmark that was not considered in this report 
is what would happen if nothing were done and Social Security could 
only pay benefits equal to incoming payroll tax revenues. While the 
report states that comparing a proposal that starts in a few years 
against a scenario where no action is taken for decades is 
inconsistent, comparing a policy change against a no-change scenario is 
a standard practice in policy analysis and is generally considered 
illustrative, not inconsistent. In many cases such a comparison is the 
only one that is done.

The report also states that a no-action scenario would create large 
notches, which GAO says creates marked inequities between beneficiaries 
close in age to each other. However any notch implicit in a no-action 
scenario would not create these inequities because beneficiaries close 
in age would experience similar lifetime reductions in benefits (while 
there would be a "notch" across generations, that is true of many 
reform proposals as well). The only inequity that would occur between 
beneficiaries close in age would be between those who would live long 
enough to receive the reductions and those who would die before 
insolvency occurs and thus avoid those reductions.

Equity measure methodology:

The shared earnings methodology used in the report is a good approach 
for several reasons. It partially accounts for benefits and taxes of 
the household that don't belong to the individual. This method also 
neatly avoids the two problems of 1) attributing spousal and survivor 
benefits 
to the person who earned them or the person who received them and 2) 
resolving situations where an individual paid no taxes but received 
benefits from a spouse.

Hypothetical steady workers are used in the report's replacement rate 
analysis even though the SSA actuaries (OCACT) have switched to using 
more representative hypothetical scaled workers. This was first done in 
the 2002 Trustees Reports and included using career average earnings 
levels in the denominator of the replacement rate calculation instead 
of steady earnings from the year the prior to retirement.	To be 
consistent, GAO may want to consider using scaled worker replacement 
rates for hypothetical earners (easily attainable for 1985 cohort from 
the OCACT website).

Accounting for general revenue transfers:

The report provides a good discussion of the complications involved in 
applying equity measures to reform proposals that include general 
revenue transfers. The incidence of any tax increases or spending 
reductions required to fund the transfers was noted as particularly 
troublesome, which is an important point to make. However, there are 
ways to deal with these complications other than to forgo an analysis 
of the individual equity aspects of reform proposals. It is even more 
important to make the effort to account for the general revenue 
transfers in the equity measures when analyzing a reform proposal that 
is designed in part to raise the rates of return on Social Security 
contributions, such as CSSS Model 2 and the Ferrara proposal.

There is probably not one correct way to account for the general 
revenue transfers when the source of those funds is not clearly 
designated. However, the simplest possibility would be to not account 
for the general revenue transfers in any way. GAO could have taken the 
same type of approach that they used for their benchmarks and used 
multiple methods that would show the range of outcomes that may occur 
dependent upon the source of the general revenue transfers. The tax 
increase only benchmark assumed the payroll tax would be increased to 
pay promised benefits - why not assume a payroll tax increase as the 
source of the general revenue transfers as a regressive possibility? On 
the non-tax side, given that so many reformers want to fund their GR 
transfer with spending cuts, the question would be how progressive is 
the government spending that would be reduced? With a rough assumption 
as an answer, one could assess people with a tax whose progressivity is 
geared to match that of government spending that would be cut.

This is not to say that a precise estimate of the distributional impact 
of a proposal incorporating general revenue transfers is possible. 
However, various simplifying assumptions might allow the analysis to go 
somewhat further than presented in the draft.

Full retirement age:

The use of "age 65" at various points in the draft may be inaccurate. 
Because of the gradual increase of full retirement age from age 65 to 
age 67 over a period of years, age 65 is usually replaced with "full 
retirement age." For workers born in 1985 who are central to this 
report, full retirement age is at age 67. The Ferrara proposal is 
described as not affecting benefits for workers who die before age 65. 
If appropriate, in describing the Ferrara proposal, replace "age 
65" in the final bullet to "full retirement age." If age 65 is intended 
rather than the full retirement age for the 1985 birth cohort, adding a 
note to clarify that "age 65" is not intended to refer to the full 
retirement age would help.

Technical comments:

Page 4:

The 4THsentence of the first full paragraph states that simulations 
suggest for the 1985 cohort an increase in lifetime Social Security 
benefits for the bottom fifth of earners by 43% compared with 14% for 
the top fifth of earners. This appears to be comparing current-law 
Social Security without disability benefits at all (i.e., no DI 
program) to the current-law OASDI program, as discussed later in the 
report. If so, this passage should be clarified.

Page 6:

Second bullet: Some plans with individual accounts provide a guarantee 
of current-law Social Security benefits (see for example the Ferrara 
proposal if the default investment option is chosen) no matter how 
investments in the accounts fare. Consider mentioning this fact in the 
discussion.

Page 9:

First line contains a typo - an errant number 9.

Page 13:

The last sentence in footnote 17 says that Social Security taxes are 
proportional. However, this should be expanded to say they are 
proportional if one is just looking at most typical earners but 
regressive when all earners are included because of the contribution 
and wage base (taxable maximum).

Page 15:

The last sentence on the page says the replacement rate for the low 
earner is over 50 percent, but the graph shows it to be 49 percent; it 
might be more accurate to say the replacement rate was almost 50 
percent.

Page 16:

The statement that DI insurance generally results in higher retirement 
benefits than would have been received with the same earnings but no 
disability is not entirely correct. DI benefits are based on the PIA 
and are equal to benefits paid to a worker retiring at the full 
retirement age. Further clarification may explain under what 
circumstances DI results in higher retirement benefits than if no 
disability occurred.

Page 22:

Footnote 34, end of the 2nd line, has a typo - "they their families".

Pages 22-23:

To some readers, it may seem inconsistent that 6 percent of workers 
earn more than the current taxable earnings cap in recent years, as 
stated on page 22, but 83 percent of the households in the top 20 
percent of household lifetime earnings would be affected by repealing 
the cap, as stated 
on page 23. Footnote 36 should be clarified to better explain that this 
is not inconsistent by directly mentioning that the 6 percent number on 
page 22 is based on a single year while the 83 percent number is based 
on a lifetime perspective.

Page 36:

First full sentence: Per OCACT's memo on the Diamond-Orszag proposal, 
the "Super-COLA" provision applies to child survivors or a surviving 
spouse with a child in care. This is a subset of beneficiaries relating 
to workers who die before retirement, which includes aged and disabled 
widow(er)s who are not affected by the super-COLA.

[End of section]

Related GAO Products:

Social Security Reform: Analysis of a Trust Fund Exhaustion Scenario. 
GAO-03-907. Washington, D.C.: July 29, 2003.

Social Security and Minorities: Earnings, Disability Incidence, and 
Mortality Are Key Factors That Influence Taxes Paid and Benefits 
Received. GAO-03-387. Washington, D.C.: Apr. 23, 2003.

Social Security Reform: Analysis of Reform Models Developed by the 
President's Commission to Strengthen Social Security. GAO-03-310. 
Washington, D.C.: Jan. 15, 2003.

Social Security: Program's Role in Helping Ensure Income Adequacy. 
GAO-02-62. Washington, D.C.: Nov. 30, 2001.

Social Security Reform: Potential Effects on SSA's Disability Programs 
and Beneficiaries. GAO-01-35. Washington, D.C.: Jan. 24, 2001.

Social Security Reform: Information on the Archer-Shaw Proposal. GAO/
AIMD/HEHS-00-56. Washington, D.C.: Jan. 18, 2000.

Social Security: Evaluating Reform Proposals. GAO/AIMD/HEHS-00-29. 
Washington, D.C.: Nov. 4, 1999.

Social Security: Issues in Comparing Rates of Return with Market 
Investments. GAO/HEHS-99-110. Washington, D.C.: Aug. 5, 1999.

Social Security: Criteria for Evaluating Social Security Reform 
Proposals. GAO/T-HEHS-99-94. Washington, D.C.: Mar. 25, 1999.

Social Security: Different Approaches for Addressing Program Solvency. 
GAO/HEHS-98-33. Washington, D.C.: July 22, 1998.

Social Security Financing: Implications of Government Stock Investing 
for the Trust Fund, the Federal Budget, and the Economy. GAO/AIMD/
HEHS-98-74. Washington, D.C.: Apr. 22, 1998.

Social Security: Restoring Long-Term Solvency Will Require Difficult 
Choices. GAO/T-HEHS-98-95. Washington, D.C.: Feb. 10, 1998.

FOOTNOTES

[1] We used the GEMINI model under a license from the Policy Simulation 
Group, a private contractor. GEMINI estimates individual effects of 
policy scenarios for a representative sample of future beneficiaries. 
GEMINI can simulate different reform features, including individual 
accounts with an offset, for their effects on the level and 
distribution of benefits. See appendix I for more detail on the 
modeling analysis, including a discussion of our assessment of the data 
reliability of the model.

[2] In its final report, the commission proposed three models, each of 
which would create a new system of individual accounts. The models 
varied in the combination and specifications for various provisions, 
including the size of the accounts, benefit reductions, general revenue 
transfers, and benefit enhancements for survivors and low earners. We 
analyzed reform Models 2 and 3 in a previous report. See U.S. General 
Accounting Office, Social Security Reform: Analysis of Reform Models 
Developed by the President's Commission to Strengthen Social Security, 
GAO-03-310 (Washington, D.C.: January 15, 2003).

[3] The Ferrara proposal would create a new system of individual 
accounts that would ultimately be large enough to completely replace 
Social Security's old-age benefits for workers and their spouses; it 
would use general revenue transfers and other revenue increases to 
cover the costs of making the transition to the new system. The 
Diamond-Orszag proposal would restore long-term solvency without 
creating a new system of individual accounts using a variety of benefit 
reductions and revenue increases; it would also enhance benefits for 
survivors and low earners. We were limited to a qualitative analysis on 
these proposals because of modeling and time constraints.

[4] At retirement, individuals do have the option of purchasing an 
annuity with their defined-contribution accounts, which then transfers 
the financial and insurance risk to the annuity provider. Before 
retirement, individuals may also have the option of purchasing deferred 
annuities.

[5] Social Security is now temporarily deviating from pure pay-as-you-
go financing by building up substantial trust fund reserves. Social 
Security is currently collecting more in revenues than it pays in 
benefits each year, partly because the baby boom generation makes the 
size of the workforce larger relative to the beneficiary population. 
However, these surpluses are currently being spent on other government 
expenses, and the trust funds are being credited with special issue 
U.S. Treasury securities. These securities are backed by the full faith 
and credit of the U.S. government as to both principal and interest. 
They have legal, political, and moral significance. They do not, 
however, have any independent economic value. In 2018, shortly after 
the baby boom starts to retire, the benefit payments are expected to 
exceed revenues, and the government will begin drawing on the trust 
funds to help pay the baby boom's retirement benefits. Importantly, 
drawing on the trust funds requires the Treasury to provide cash in 
exchange for redeemed bonds, which will in turn require increased 
revenue, increased borrowing, or reduced spending in the rest of the 
government. For more detail about this temporary trust fund buildup and 
how it interacts with the federal budget, see U.S. General Accounting 
Office, Social Security Financing: Implications of Government Stock 
Investing for the Trust Fund, the Federal Budget, and the Economy, GAO/
AIMD/HEHS-98-74 (Washington, D.C.: Apr. 22, 1998), U.S. General 
Accounting Office, Social Security Reform: Demographic Trends Underlie 
Long-Term Financing Shortage, GAO/T-HEHS-98-43 (Washington, D.C.: Nov. 
20, 1997).

[6] See U.S. General Accounting Office, Social Security: Criteria for 
Evaluating Reform Proposals, GAO/T-HEHS-99-94 (Washington, D.C.: Mar. 
25, 1999), and U.S. General Accounting Office, Social Security: 
Evaluating Reform Proposals, GAO/AIMD/HEHS-00-29 (Washington, D.C.: 
Nov. 4, 1999).

[7] For a discussion of individual equity issues, see U.S. General 
Accounting Office, Social Security: Issues in Comparing Rates of Return 
with Market Investments, GAO/HEHS-99-110 (Washington, D.C.: Aug. 5, 
1999).

[8] U.S. General Accounting Office, Social Security: Program's Role in 
Helping Ensure Income Adequacy, GAO-02-62 (Washington, D.C.: Nov. 30, 
2001).

[9] The commission's final report states: "The Commission's short life 
span has not allowed time for the careful deliberation necessary to 
develop sound reform plans for the disability program. Because of the 
complexity and sensitivity of the issues involved, we recommend that 
the President address the DI [Disability Insurance] program through a 
separate policy development process.  In the absence of fully 
developed proposals, the calculations carried out for the Commission 
and included in this report assume that defined benefits will be 
changed in similar ways for the two programs. This should not be taken 
as a Commission recommendation for policy implementation." President's 
Commission to Strengthen Social Security, Strengthening Social Security 
and Creating Personal Wealth for All Americans. Washington, D.C., 
Dec. 21, 2001, http://www.csss.gov/reports/, p. 149.

[10] Martin Feldstein and Jeffrey B. Liebman ("The Distributional 
Effects of an Investment-Based Social Security System," NBER Working 
Paper 7492, National Bureau of Economic of Economic Research, January 
2000, p.46) suggest several reform options that raise everyone's 
benefit above its current law level but identify the most progressive 
plan as the one under which low earners' benefits increase by much more 
than high earners' benefit. In the same vein, Barry Bosworth and Gary 
Burtless (Economic and Distributional Effects of the Proposals of 
President Bush's Social Security Commission, the Brookings Institution, 
July 2002, p.25) predict no adverse distributional impact within a 
cohort in going from a pay-as-you-go system such as the current one to 
plans with individual accounts, since low earners lose proportionally 
less, or gain proportionally more, than high earners. Andrew Biggs 
("Testimony before the Senate Finance Committee Hearing on the Final 
Report Produced by the President's Commission to Strengthen Social 
Security," October 2002, p.22) argues that the Commission to Strengthen 
Social Security's Model 2 maintains the progressivity of the current 
system, since the percent increase in benefit a low-wage worker 
receives under this model is higher than what a high-wage worker gets.

[11] The literature on inequality typically identifies low earners as 
individuals in the 20th percentile of the income distribution and high 
earners as those in the 80th percentile. See Karen Smith, How Will 
Recent Patterns of Earnings Inequality Affect Future Retirement 
Incomes? The Urban Institute, May 2003, p.16.

[12] The opposite holds for groups of earners above the median. An 
increase in the share of total benefits going to these high earners 
relative to the median would indicate a tilt in their favor, hence a 
less progressive system. 

[13] A person contributing twice the amount of another, for instance, 
does not receive twice the benefit. This is because Social Security 
combines social adequacy and individual equity, transferring income 
from higher earners to lower earners within cohorts.

[14] These measures are the most commonly cited in the literature but 
do not constitute an exhaustive list. Alan L. Gustman and Thomas L. 
Steinmeier, "How Effective Is Redistribution under the Social Security 
Benefit Formula?" Retirement Research Center Working Paper 2000-005, 
University of Michigan, August 2000, for example, use the portion of 
total benefits received minus the portion of total taxes paid by 
different earnings groups. Some researchers also look at lifetime net 
transfers, that is, benefits minus taxes.

[15] A value less than one, for example, indicates that benefits 
collected fall short of taxes paid. 

[16] See Julia L. Coronado, Don Fullerton, and Thomas Glass, "The 
Progressivity of Social Security," NBER Working Paper 7520, National 
Bureau of Economic Research, February 2000, and Jeffrey B. Liebman, 
"Redistribution in the Current U.S. Social Security System," NBER 
Working Paper 8625, National Bureau of Economic Research, December 
2001. 

[17] See Dean R. Leimer, "Lifetime Redistribution under the Social 
Security Program: A Literature Synopsis," Social Security Bulletin, 
Vol. 62, No. 2, 1999, for a review of the literature. It is important 
to note that in computing lifetime benefits and taxes, past values are 
accumulated and future values discounted using a particular interest 
rate. The choice of the interest rate has implications for 
progressivity. A higher interest rate makes the distant future less 
valuable, reducing the importance of benefits received in retirement 
relative to taxes paid earlier in life. Since benefits are more 
progressive and payroll taxes are regressive, given the contribution 
cap, higher interest rates generally decrease the progressivity of the 
program.

[18] See Coronado, Fullerton, and Glass, 2000, and Liebman, 2001. 

[19] CSSS Model 2, for example, does not specify any financing methods; 
Ferrara's Progressive Personal Account Plan relies on a reduction in 
federal spending growth coupled with a future increase in corporate tax 
revenues, but many analysts question the feasibility of the plan, given 
its assumptions and the budget deficit of the last few years.

[20] See, for example, Gustman and Steinmeier, 2000, p.18; Coronado, 
Fullerton, and Glass, 2000, p.2.

[21] Social Security data reveal that this is often the case with 
spouses of high earners. These spouses do not work, or do so at low 
wage rates or limited hours, appearing as low earners on an individual 
basis but not on a household basis.

[22] This is especially relevant in analyzing reform options because 
trends indicate that people in the future will experience relatively 
more marriages and divorces.

[23] See U.S. General Accounting Office, Social Security Reform: 
Program's Role in Helping Ensure Income Adequacy, GAO-02-62 
(Washington, D.C.: November 30, 2001), pp. 7-8.

[24] Indexing the earnings to changes in wage levels ensures that the 
same relative value is accorded to wages, no matter when they were 
earned.

[25] The annual trustees' report uses illustrative "scaled earnings" 
patterns. The values of the replacement rates for these scaled earnings 
patterns at age 65 are virtually identical to the ones presented in 
figure 1. See The Board of Trustees, Federal Old-Age and Survivors 
Insurance and Disability Insurance Trust Funds, The 2004 Annual Report 
of the Board of Trustees of the Federal Old-Age and Survivors Insurance 
and Disability Insurance Trust Funds (Washington, D.C.: Mar. 23, 2004). 
pp. 186-187. 

[26] DI recipients are converted to retired worker recipients at the 
normal retirement age. Their retirement benefit is based on their 
disability benefit as opposed to the retirement benefit they would 
qualify for given their earnings record. This results in higher 
benefits because there are generally less computation years used when 
calculating AIME for disability benefits than for retirement benefits.

[27] See Constantijn Panis and Lee Lillard, Final Report: Near Term 
Model Development Part II, RAND (Santa Moncia, CA: Aug. 1999).

[28] These calculations are for all workers born in 1985--not just for 
those with disabilities.

[29] Studies also find that DI favors lower earners from equity 
perspectives such as benefit-to-tax ratios and real internal rates of 
return. See U.S. General Accounting Office, Social Security and 
Minorities: Earnings, Disability Incidence, and Mortality Are Key 
Factors That Influence Taxes Paid and Benefits Received, GAO-03-387 
(Washington, D.C.: April 23, 2003) and Lee Cohen, Eugene Steuerle, and 
Adam Carasso, "The Effects of Disability Insurance on Redistribution 
within Social Security by Gender, Education, Race, and Income," 
presented at the Fourth Annual Joint Conference for the Retirement 
Research Consortium: Directions for Social Security Reform, May 30-31, 
2002, Washington, DC, revision date June 11, 2002. 

[30] A number of studies find that the Social Security system is less 
progressive when considered from the household perspective. See Karen 
Smith, Eric Toder, and Howard Iams, "Lifetime Distributional Effects of 
Social Security Retirement Benefits," prepared for the Third Annual 
Joint Conference for the Retirement Research Consortium "Making Hard 
Choices about Retirement," Washington, D.C., May 17-18, 2001; Jeffrey 
Liebman, "Redistribution in the Current U.S. Social Security System," 
NBER Working Paper 8625, National Bureau of Economic Research, December 
2001; Coronado, Fullerton, and Glass, 2000; and Gustman and Steinmeier, 
March 2000. 

[31] See Liebman 2001 and Smith, Toder, and Iams 2001.

[32] Divorced individuals must have been married for at least 10 years 
to qualify for spouses' and survivors' benefits.

[33] Spouses' and survivors' benefits are attributed to the individuals 
who receive them as opposed to the relevant retired workers.

[34] See Angus Deaton and Cristina Paxson, "Mortality, Education, 
Income, and Inequality among American Cohorts," NBER Working Paper 
7140, National Bureau of Economic Research, May 1999; Adriana Lleras-
Muney, "The Relationship between Education and Adult Mortality in The 
United States", NBER Working Paper 8986, National Bureau of Economic 
Research, June 2002; Constantijn Panis and Lee Lillard, Final Report: 
Near Term Model Development Part II, RAND, August 1999; and Eugene 
Rogot, Paul Sorlie, and Norman Johnson, "Life Expectancy by Employment 
Status, Income, and Education in the National Longitudinal Mortality 
Study," Public Health Reports, 107:4, 457-461. 

[35] The "implicit" rate of return equals the average interest rate 
workers would hypothetically have to earn on their contributions in 
order to pay for all the benefits they and their families will receive 
from Social Security. See U.S. General Accounting Office, Social 
Security: Issues in Comparing Rates of Return with Market Investments, 
GAO/HEHS-99-110 (Washington, D.C.: Aug., 1999), pp. 16 and 27-28; Lee 
Cohen, C. Eugene Steuerle, and Adam Carasso, "Social Security 
Redistribution by Education, Race, and Income: How Much and Why?" 
prepared for the Third Annual Conference of the Retirement Research 
Consortium: "Making Hard Choices about Retirement," Washington, D.C., 
May 17-18, 2001; and Julia Lynn Coronado, Don Fullerton, and Thomas 
Glass, "Distributional Impacts of Proposed Changes to the Social 
Security System," NBER Working Paper 6989, National Bureau of Economic 
Research, March 1999.

[36] See Laura Haltzel, Social Security: Raising or Eliminating the 
Taxable Earnings Base, Congressional Research Service (97-166 EPW), 
2004.

[37] The number of simulated households affected might appear 
inconsistent with the earlier reference to 6 percent of workers having 
earnings above the cap in recent years. However, the household number 
refers to the number of households that are ever affected on a lifetime 
basis while the 6 percent refers to the number of individual workers 
exceeding the cap in a given year. The number of workers that ever have 
earnings above the cap in at least one year over their careers is 
likely larger than the number exceeding the cap in a given year.

[38] In this report, we use "Social Security defined benefits" to refer 
to benefits not derived from the accounts, that is, retired workers' 
and aged spouses' and survivors' benefits.

[39] The limit on account contributions would be $1,000 in 2002 and 
would grow over time with wages.

[40] Social Security defined benefits for account participants would be 
offset by the annuitized value of a hypothetical account balance. 
Hypothetical account balances would be determined by individuals' 
actual account contributions and a 2 percent real return.

[41] On average, wages grow faster than prices. 

[42] The commission's final report discusses the pros and cons of 
applying the benefit reduction to DI benefits. While all of the 
calculations in the report assume the benefit reductions apply to DI, 
the report states that the commission makes no recommendation as to 
whether DI benefits should be reduced. See Strengthening Social 
Security and Creating Personal Wealth for All Americans, Dec. 21, 2001, 
http://www.csss.gov/reports/, pp. 149-150.

[43] To receive the maximum enhancement, a retired worker would have to 
have wages less than a certain threshold and work for at least 30 
years. The wage threshold would be $5.15 in 2000 and indexed thereafter 
by growth in the Social Security average wage index.

[44] The enhanced survivors' benefit is capped at the average Primary 
Insurance Amount for all retired workers. 

[45] See GAO-03-310, p. 24. 

[46] Each participant has portfolio allocation of 50 percent in 
equities, 30 percent in corporate bonds, and 20 percent in U.S. 
Treasury long-term bonds. All portfolios earn a constant 4.6 percent 
real rate of return. For sensitivity analysis, we also simulated 
scenarios with rates of return varying stochastically across 
individuals and with higher and lower returns to equities. Shares of 
benefits by quintiles of lifetime earnings were very similar under all 
specifications. 

[47] We assume participants purchase unisex annuities indexed to the 
Consumer Price Index with married individuals purchasing joint and two-
thirds survivor annuities. 

[48] Shares of benefits under the promised and funded benchmark 
scenarios are similar because the funded scenario reduces benefits by 
the same proportion for all recipients becoming eligibile in the same 
year. The small difference in shares is due to the timing of benefit 
reductions under the funded benefits scenario. The benefit reductions 
are phased in from 2005-2035, resulting in smaller reductions for 
individuals born in 1985 who become eligible for benefits before age 
50. Those who become eligible before age 50 tend to be lower lifetime 
earners, which results in somewhat higher shares of benefits for the 
bottom quintile under the funded benefits scenario.

[49] Note that a previous GAO report found that real monthly individual 
benefits were slightly higher for the lowest benefit quintile under 
Model 2-100 percent than under the promised benefits (tax-increase) 
benchmark. Possible explanations for the apparent discrepancy include 
different measures of benefits and quintiles, and different assumptions 
for real wage growth. The previous report calculated real monthly 
individual benefits by benefit quintile, while this report calculates 
real household lifetime benefits by lifetime earnings quintile. This 
report assumes higher real wage growth than the previous report due to 
the Social Security trustees increasing their projection of real wage 
growth. Model 2 reduces PIA factors by real wage growth; so assuming 
higher real wage growth results in lower simulated benefits under the 
proposal. See GAO-03-310.

[50] This is because, assuming no differences in investment choices, 
individual accounts provide the same average rate of return across 
earnings levels.

[51] The cap on account contributions favors lower earners only if 
account participation increases benefits. In our simulations, account 
participation increases benefits because we assume actual real returns 
are 4.6 percent, which exceeds the 2 percent real return used by the 
hypothetical-account offsets. If actual real returns were lower than 2 
percent, account participation would reduce benefits, and the cap on 
account contributions would favor higher earners by limiting their 
losses. If the actual returns equaled 2 percent, then account 
participation, and consequently the cap on the contributions, would 
have no distributional effect. 

[52] We expect the enhanced survivors' benefit to favor lower earners 
because it is capped by the average Primary Insurance Amount for all 
retired workers.

[53] We simulated an alternative version of Model 2-100 percent where 
the return to equities varied stochastically across individuals and 
over time. Shares of benefits by earnings quintile were almost 
identical to the scenario that assumed constant returns to equities.

[54] Lower earners may be more risk averse and therefore suffer greater 
utility loss from increased risk. 

[55] According to SSA actuaries, the benefit reduction would be equal 
to the Social Security benefits scheduled under current law "multiplied 
by the ratio of (a) the present value of all contributions redirected 
to the worker's account, to (b) the present value of all potential 
contributions that might have been made if the plan had been in 
existence throughout the working lifetime of the worker. Workers who 
first enter the workforce in 2005 or later, and who choose to 
participate fully in the personal account through their working 
lifetime would have their affected OASI benefits reduced to zero." For 
more details on the proposal, see Peter Ferrara, "A Progressive 
Proposal for Social Security Personal Accounts," Institute for Policy 
Innovation, Policy Report #176, Lewisville, TX, June 2003 at http://
www.ipi.org and the analysis by SSA actuaries, "Estimated Financial 
Effects of "The Progressive Personal Account Plan" -INFORMATION," memo 
by Steve Goss, SSA, Dec.1, 2003, at http://www.ssa.gov/OACT/solvency/.

[56] For more details on the proposal, see Peter A. Diamond and Peter 
R. Orszag, Saving Social Security: A Balanced Approach. Brookings 
Institution Press, Washington, D.C., 2003, or Peter A. Diamond and 
Peter R. Orszag, Reforming Social Security: A Balanced Plan. Brookings 
Institution, Policy Brief #126, Washington, DC, December 2003 at http:/
/www.brookings.org/comm/policybriefs/pb126.pdf, and the analysis by 
SSA actuaries, "Subject: Estimates of Financial Effects for a Proposal 
to Restore Solvency to the Social Security Program--INFORMATION," memo 
by Stephen Goss, SSA, Oct. 8, 2003, at http://www.ssa.gov/OACT/
solvency/DiamondOrszag_20031008.pdf.

[57] In the formula for the Primary Insurance Amount, the 15 percent 
formula factor would be reduced gradually to 10 percent. This formula 
factor is the rate at which Average Indexed Monthly Earnings are 
replaced above the second bend point, which is $3,689 in 2004.

[58] U.S. General Accounting Office, Social Security Reform: Analysis 
of Reform Models Developed by the President's Commission to Strengthen 
Social Security, GAO 03-310 (Washington, D.C.: Jan. 15, 2003), p. 9.

[59] It should be noted that a benchmark predicated on trust fund 
exhaustion would exhibit benefit levels that are significantly lower 
than other alternative benchmarks as well as most reform proposals.

[60] While these models use sample data, our report, like others using 
these models, does not address the issue of sampling errors. The 
results of the analysis reflect outcomes for individuals in the 
simulated populations and do not attempt to estimate outcomes for an 
actual population.

[61] MINT3 is a detailed microsimulation model developed jointly by the 
Social Security Administration, the Brookings Institution, RAND, and 
the Urban Institute to project the distribution of income in retirement 
for the 1931 to 1960 birth cohorts.

[62] The Urban Institute's Dynamic Simulation of Income Model.

[63] See Cori Uccello, Melissa Favreault, Karen Smith, and Lawrence 
Thompson, "Simulating the Distributional Consequences of Personal 
Accounts: Sensitivity to Annuitizaton Options," Working Paper 2003-17, 
Center for Retirement Research at Boston College, October 2003; U.S. 
General Accounting Office, Social Security and Minorities: Earnings, 
Disability Incidence, and Mortality are Key Factors That Influence 
Taxes Paid and Benefits Received, GAO-03-387 (Washington, D.C.: Apr. 
23, 2003); See Smith, Eric Toder, and Howard Iams, "Lifetime 
Distirubtional Effects of Social Security Retirement Benefits," 
prepared for the Third Annual Join Conference for the Retirement 
Research Consortium "Making Hard Choices About Retirement," Washington, 
D.C., May 17-18, 2001; and Lee Cohen, Eugene Steuerle, and Adam 
Carasso, "The Effects of Disability Insurance on Redistribution Within 
Social Security By Gender, Education, Race, and Income," presented at 
the Fourth Annual Joint Conference for the Retirement Research 
Consortium: Directions for Social Security Reform, May 30-31, 2002.

[64] The Board of Trustees, Federal Old-Age and Survivors Insurance and 
Disability Insurance Trust Funds, The 2003 Annual Report of the Board 
of Trustees of the Federal Old-Age and Survivors Insurance and 
Disability Insurance Trust Funds (Washington, D.C.: Mar. 17, 2003).

[65] "Estimates of Financial Effects for Three Models Developed by the 
President's Commission to Strengthen Social Security" Memo from Steve 
Goss and Alice Wade, SSA, January 31, 2002, http://www.ssa.gov/OACT/
solvency/PresComm_20020131.pdf.

[66] U.S. General Accounting Office, Social Security Reform: Analysis 
of Reform Models Developed by the President's Commission to Strengthen 
Social Security, GAO-03-310 (Washington, D.C.: January 15, 2003), p. 
44-50.

[67] See Goss and Wade, 2002.

[68] See U.S. General Accounting Office, Social Security Reform: 
Program's Role in Helping Ensure Income Adequacy, GAO-02-62 
(Washington, D.C.: Nov. 30, 2001), p. 84.

[69] These benchmarks were first developed for our report entitled 
Social Security: Program's Role in Helping Ensure Income Adequacy 
(GAO-02-62, Nov. 30, 2001). We have since used them in other studies, 
including GAO-03-310, Social Security Reform: Analysis of a Trust Fund 
Exhaustion Scenario (GAO-03-907, July 29, 2003), and GAO-03-387.

[70] The Social Security actuaries provided these scorings for a 
previous report and used assumptions from the 2001 trustees' report. 
The actuaries did not believe it was necessary to provide new scorings 
using updated assumptions for the purposes of our study since the 
assumptions and the estimates of actuarial balance on which they are 
based have changed little from the 2001 report. In particular, they did 
not believe that the differences in assumptions would materially affect 
the shape of the distribution of benefits, which is the focus of our 
analysis.

[71] Advisory Council on Social Security. Report of the 1994-1996 
Advisory Council on Social Security, Vols. 1 and 2. Washington, D.C.: 
Jan. 1997.

[72] See U.S. General Accounting Office, Social Security Reform: 
Analysis of a Trust Fund Exhaustion Scenario, GAO-03-907 (Washington, 
D.C.: July 29, 2003), in which we analyzed such a policy scenario under 
a congressional request.

[73] Other analyses have addressed the concern about the effect of the 
proportional reduction on low earners by modifying that offset to apply 
only to the 32 and 15 percent formula factors. The MTR policy in the 
1994 to 1996 Advisory Council Report used this approach, which in turn 
was based on the Individual Account (IA) proposal in that report. 
However, the MTR policy also reflected other changes in addition to PIA 
formula changes.

[74] For this benchmark, we used the label "progressive benefit-
reduction benchmark" in our report entitled Social Security: Program's 
Role in Helping Ensure Income Adequacy (GAO-02-62, Nov. 30, 2001).

[75] U.S. General Accounting Office, Social Security: Analysis of a 
Proposal to Privatize Trust Fund Reserves, GAO/HRD-91-22 (Washington, 
D.C.: Dec. 12, 1990).

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