Social Security Reform: Implications of Different Indexing Choices
Published: 2006-09-14T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The financing shortfall currently facing the Social Security program is significant. Without remedial action, program trust funds will be exhausted in 2040. Many recent reform proposals have included modifications of the indexing currently used in the Social Security program. Indexing is a way to link the growth of benefits and/or revenues to changes in an economic or demographic variable. Given the recent attention focused on indexing, this report examines (1) the current use of indexing in the Social Security program and how reform proposals might modify that use, (2) the experiences of other developed nations that have modified indexing, (3) the effects of modifying the indexing on the distribution of benefits, and (4) the key considerations associated with modifying the indexing. To illustrate the effects of different forms of indexing on the distribution of benefits, we calculated benefit levels for a sample of workers born in 1985, using a microsimulation model. We have prepared this report under the Comptroller General's statutory authority to conduct evaluations on his own initiative as part of a continued effort to assist Congress in addressing the challenges facing Social Security. We provided a draft of this report to SSA and the Department of the Treasury. SSA provided technical comments, which we have incorporated as appropriate.
section_title: What GAO Found
paragraphs: Indexing currently plays a key role in determining Social Security's benefits and revenues, and is a central element of many proposals to reform the program. The current indexing provisions that affect most workers and beneficiaries relate to (1) benefit calculations for new beneficiaries, (2) the annual cost-of-living adjustment (COLA) for existing beneficiaries, and (3) the cap on taxable earnings. Some reform proposals would slow benefit growth by indexing the initial benefit formula to changes in prices or life expectancy rather than wages. Some would revise the COLA under the premise that it currently overstates inflation, and some would increase the cap on taxable earnings. National pension reforms in other countries have used indexing in various ways. In countries with high contribution rates that need to address solvency issues, recent changes have generally focused on reducing benefits. Although most Organisation for Economic Co-operation and Development (OECD) countries compute retirement benefits using wage indexing, some have moved to price indexing, or a mix of both. Some countries reflect improvements in life expectancy in computing initial benefits. Reforms in other countries that include indexing changes sometimes affect both current and future retirees. Indexing can have various distributional effects on benefits and revenues. Changing the indexing of initial benefits through the benefit formula typically results in the same percentage change in benefits across income levels regardless of the index used. However, indexing can also be designed to maintain benefits for lower earners while reducing or slowing the growth of benefits for higher earners. Indexing payroll tax rates would maintain scheduled benefit levels but reduce the ratio of benefits to contributions for younger cohorts. Finally, the effect of modifying the COLA would be greater the longer people collect benefits. Indexing raises considerations about the program's role, the treatment of disabled workers, and other issues. For example, indexing initial benefits to prices instead of wages implies that benefit levels should maintain purchasing power rather than maintain relative standards of living across age groups (i.e., replacement rates). Also, as with other ways to change benefits, changing the indexing of the benefit formula to improve solvency could also result in benefit reductions for disabled workers as well as retirees.

section_title: Letter
paragraphs: The total long-term financing shortfall currently facing the Social Security  The total long-term financing shortfall currently facing the Social Security  program is significant and growing over time, thereby making system  program is significant and growing over time, thereby making system  reform an important priority. Once the Social Security trust fund balances  reform an important priority. Once the Social Security trust fund balances  are exhausted in 2040, annual revenue will be sufficient only to pay about  are exhausted in 2040, annual revenue will be sufficient only to pay about  74 percent of promised benefits, according to the Social Security trustees’  74 percent of promised benefits, according to the Social Security trustees’  2006 intermediate assumptions. Benefit costs are projected to exceed  2006 intermediate assumptions. Benefit costs are projected to exceed  income in 2017, and thus trust fund securities will need to be redeemed.  income in 2017, and thus trust fund securities will need to be redeemed.  This will require increased government revenue, increased borrowing from  This will require increased government revenue, increased borrowing from  the public, reduced spending in the rest of the government, or some  the public, reduced spending in the rest of the government, or some  combination of these. Redeeming these securities will have an adverse  combination of these. Redeeming these securities will have an adverse  impact on the federal budget much sooner than the 2040 trust fund  impact on the federal budget much sooner than the 2040 trust fund  exhaustion date.  exhaustion date.
Many recent reform proposals have proposed modifications to the  Many recent reform proposals have proposed modifications to the  indexing currently used in the Social Security program. Indexing is a way  indexing currently used in the Social Security program. Indexing is a way  to link the growth of benefits and/or revenues to changes in economic or  to link the growth of benefits and/or revenues to changes in economic or  demographic variables. For example, initial benefits can be set to grow  demographic variables. For example, initial benefits can be set to grow  with changes in average wages or changes in prices. Modifications to  with changes in average wages or changes in prices. Modifications to  indexing seek to slow the growth of benefits or increase the growth of  indexing seek to slow the growth of benefits or increase the growth of  revenues, either of which would improve solvency. However, indexing  revenues, either of which would improve solvency. However, indexing  does not guarantee that the program will achieve and remain in long-term  does not guarantee that the program will achieve and remain in long-term  financial balance. Proposals that would modify Social Security’s indexing  financial balance. Proposals that would modify Social Security’s indexing  implicitly pose the question of whether and how such adjustments could  provide a mechanism to keep the program sustainably solvent and  minimize the need for periodic rebalancing of the program’s finances. At  the same time, how it is done can affect the distribution of benefits  between low and high earners and across generations of workers.
Given the recent attention focused on indexing as a critical component of  reform, this report examines (1) the current use of indexing in the Social  Security program and how reform proposals might modify that use, (2) the  experiences of other developed nations that have modified indexing when  reforming their public pension systems, (3) the effects of indexing  modifications on the distribution of Social Security benefits, and (4) the  key considerations associated with modifying Social Security’s indexing.
To examine the use of indexing in the Social Security program and how  reform proposals might modify the indexing, we conducted a literature  review and reviewed recent Social Security reform proposals. To examine  the experience of other developed nations that changed indexing when  reforming their own national pension systems, we reviewed the academic  literature and documentation on other countries’ public pension systems.  To analyze the effects of different forms of indexing on the distribution of  benefits, we calculated benefit levels for a sample of workers using a  microsimulation model (see app. I for a more detailed discussion of our  scope and methodology). For this analysis, we selected four well-known  indexing approaches to illustrate the effects on the distribution of  benefits. To describe the distributional effects of the different indexing  approaches, we used our model to simulate benefits for workers born in  1985. Consistent with our past work on Social Security reform, and 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”). To determine  the key considerations associated with various forms of indexing, we  reviewed the literature and talked with relevant experts. We have prepared  this report under the Comptroller General’s statutory authority to conduct  evaluations on his own initiative as part of a continued effort to assist  Congress in addressing the challenges facing Social Security. We  conducted our work between July 2005 and August 2006 in accordance  with generally accepted government auditing standards.
subsections: section_title: Background
paragraphs: Title II of the Social Security Act, as amended, establishes the Old-Age,  Survivors, and Disability Insurance (OASDI) program, which is generally  known as Social Security. The program provides cash benefits to retired  and disabled workers and their eligible dependents and survivors.  Congress designed Social Security benefits with an implicit focus on  replacing lost wages. However, Social Security is not meant to be the sole  source of retirement income; rather it forms a foundation for individuals  to build upon. The program is financed on a modified pay-as-you-go basis  in which payroll tax contributions of those currently working are largely  transferred to current beneficiaries. Current beneficiaries include insured  workers who are entitled to retirement or disability benefits, and their  eligible dependents, as well as eligible survivors of deceased insured  workers. The program’s benefit structure is progressive, that is, it provides  greater insurance protection relative to contributions for earners with  lower wages than for high-wage earners. Workers qualify for benefits by  earning Social Security credits when they work and pay Social Security  taxes; they and their employers pay payroll taxes on those earnings. In  2005, approximately 159 million people had earnings covered by Social  Security, and 48 million people received approximately $521 billion in  OASDI benefits.
Currently, the Social Security program collects more in taxes than it pays  out in benefits. However, because of changing demographics, this  situation will reverse itself, with the annual cash surplus beginning to  decline in 2009 and turning negative in 2017. In addition, all of the  accumulated Treasury obligations held by the trust funds are expected to  be exhausted by 2040. Social Security’s long-term financing shortfall  stems primarily from the fact that people are living longer and labor force  growth has slowed. As a result, the number of workers paying into the  system for each beneficiary has been falling and is projected to decline  from 3.3 today to about 2 by 2040. The projected long-term insolvency of  the OASDI program necessitates system reform to restore its long-term  solvency and assure its sustainability. Restoring solvency and assuring  sustainability for the long term requires that either Social Security gets  additional income (revenue increases), reduces costs (benefit reductions),  or undertakes some combination of the two.
To evaluate reform proposals, we have suggested that policy makers  should consider three basic criteria: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 goals of individual equity (rates of  return on individual contributions) and income adequacy (level and  certainty of monthly benefits); and  3. how readily such changes could be implemented, administered, and  explained to the public.
Moreover, reform proposals should be evaluated as packages that strike a  balance among the individual elements of the proposal and the  interactions among these elements. The overall evaluation of any  particular reform proposal depends on the weight individual policy makers  place on each of the above criteria.
Changing the indexing used by the OASDI program could be used to  increase income or reduce costs. Indexing provides a form of regular  adjustment of revenues or benefits that is pegged to a particular economic,  demographic, or actuarial variable. An advantage of such indexing  approaches is that they take some of the “politics” out of the system,  allowing the system to move toward some agreed-upon objective; they  may also be administratively simple. However, this “automatic pilot”  aspect of indexing poses a challenge, as it may make policy makers  hesitant to enact changes, even when problems arise.
section_title: Social Security Currently Indexes Both Benefits and Revenues
paragraphs: While Social Security did not use automatic indexing initially, it is now a  key feature of the program’s design, as well as a central element of many  reform proposals. Under the current program, benefits for new  beneficiaries are computed using wage indexing, benefits for existing  beneficiaries are adjusted using price indexing, and on the revenue side,  the cap on the amount of earnings subject to the payroll tax is also  adjusted using wage indexing. Reform proposals have included provisions  for modifying each of these indexing features.
subsections: section_title: Program Did Not Use Indexing until 1970s
paragraphs: Before the 1970s, the Social Security program did not use indexing to  adjust benefits or taxes automatically. For both new and existing  beneficiaries, benefit rates increased only when Congress voted to raise  them. Benefit levels, when adjusted for inflation, fell and then jumped up  with ad hoc increases, and these fluctuations were dramatic at times.  Similarly, Congress made only ad hoc changes to the tax rate and the cap  on the amount of workers’ earnings that were subject to the payroll tax,  which is also known as the maximum taxable earnings level. Adjusted for  inflation, the maximum taxable earnings level also fluctuated dramatically,  and as a result, the proportion of all wages subject to the payroll tax also  fluctuated. (See app. II for more detail.)
For the first time, the 1972 amendments provided for automatic indexing.  They provided for automatically increasing the maximum taxable earnings  level based on increases in average earnings, and this approach is still in  use today. However, the 1972 amendments provided an indexing approach  for benefits that became widely viewed as flawed. In particular, the  indexing approach in the 1972 amendments resulted in (1) a “double- indexing” of benefits to inflation for new beneficiaries though not for  existing ones; (2) a form of “bracket creep” based on the structure of the  benefit formula that slowed benefit growth as earnings increased over  time, which offset the double indexing to some degree; and (3) instability  of program costs that was driven by the interaction of price and wage  growth in benefit calculations. (See app. II for more detail.) Within a few  years, problems with the 1972 amendments became apparent. Benefits  were growing far faster than anticipated, especially since wage and price  growth varied dramatically from previous historical experience.  Addressing the instability of this indexing approach became a focus of  policy makers’ efforts to come up with a new approach. As a 1977 paper  on the problem noted, “Clearly, it is a system that needs to be brought  under greater control, so that the behavior of retirement benefits over time  will stop reflecting the chance interaction of certain economic variables.”
section_title: 1977 Amendments Created Indexing Approach of Current Social Security System
paragraphs: The 1977 amendments instituted a new approach to indexing benefits that  remains in use today. The experience with the 1972 amendments and  double indexing made clear the need to index benefits differently for new  and existing beneficiaries, which was referred to as “decoupling” benefits.  Indexing now applies to several distinct steps of the benefit computation  process, including (1) indexing lifetime earnings for each worker to wage  growth, (2) indexing the benefit formula for new beneficiaries to wage  growth, and (3) indexing benefits for existing beneficiaries to price  inflation. Under this approach, benefit calculations for new beneficiaries  are indexed differently than for existing beneficiaries, and earnings  replacement rates have been fairly stable. The cap on taxable earnings is  still indexed to wage growth as specified by the 1972 amendments.
subsections: section_title: Indexing Lifetime Earnings to Wages
paragraphs: Social Security benefits are designed to partially replace earnings that  workers lose when they retire, become disabled, or die. As a result, the  first step of the benefit formula calculates a worker’s average indexed  monthly earnings (AIME), which is based on the worker’s lifetime history  of earnings covered by Social Security taxes. The formula adjusts these  lifetime earnings by indexing them to changes in average wages. Indexing  the earnings to changes in wage levels ensures that the same relative value  is accorded to each year’s earnings, no matter when they were earned.
For example, consider a worker who earned $5,000 in 1965 and $40,000 in  2000. The worker’s earnings increased by eight times, but much of that  increase reflected changes in the average wage level in the economy,  which increased by about seven times (690 percent) over the same period.  The growth in average wages in turn partially reflects price inflation;  however, wages may grow faster or slower than prices in any given year.  Indexed to reflect wage growth, the $5,000 would become roughly $35,000,  giving it greater weight in computing average earnings over time and  making it more comparable to 2000 wage levels.
section_title: Indexing Initial Benefit Formula to Wages
paragraphs: Once the AIME is determined, it is applied to the formula used to calculate  the worker’s primary insurance amount (PIA). This formula applies  different earnings replacement factors to different portions of the worker’s  average earnings. The different replacement factors make the formula  progressive, meaning that the formula replaces a larger portion of earnings  for lower earners than for higher earners. For workers who become  eligible for benefits in 2006, the PIA equals    90 percent of the first $656 dollars of AIME plus    32 percent of the next $3,299 dollars of AIME plus    15 percent of AIME above $3,955.
For workers who do not collect benefits until after the year they first  become eligible, the PIA is adjusted to reflect any COLAs since they  became eligible. The PIA is used in turn to determine benefits for new  beneficiaries and all types of benefits payable on the basis of an  individual’s earnings record. To determine the actual monthly benefit,  adjustments are made reflecting various other provisions, such as those  relating to early or delayed retirement, type of beneficiary, and maximum  family benefit amounts. Figure 1 illustrates how the PIA formula works.
The dollar values in the formula that indicate where the different  replacement factors apply are called bendpoints. These bendpoints ($656  and $3,955) are indexed to the change in average wages, while the  replacement factors of 90, 32, and 15 percent are held constant. In  contrast, under the 1972 amendments, the bendpoints were held constant  and the replacement factors were indexed. (See app. II.) Indexing the  bendpoints and holding replacement factors constant prevents bracket  creep and keeps the resulting earnings replacement rates relatively level  across birth years. Indexing the benefit formula in this way helps benefits  for new retirees keep pace with wage growth, which reflects increases in  the standard of living.
Figure 2, which shows earnings replacement rates for successive groups of  illustrative workers, illustrates the program’s history with indexing initial  benefits. Replacement rates declined before the first benefit increases  were enacted in 1950 and then rose sharply as a result of those increases.  From 1950 until the early 1970s, replacement rates fluctuated noticeably  more from year to year than over other periods; this pattern reflects the ad  hoc nature of benefit increases over that period. Between 1974 and 1979,  replacement rates grew rapidly for new beneficiaries, reflecting the double  indexing of the 1972 amendments. The 1977 amendments corrected for the  unintended growth in benefits from double indexing, and replacement  rates declined rapidly as a result. This pattern of increasing and then  declining benefit levels is known as the notch. Finally, replacement rates  have been considerably more stable since the 1977 amendments took  effect, a fact that has helped to stabilize program costs. (See app. II.)
After initial benefits have been set for the first year of entitlement, benefits  in subsequent years increase with a COLA designed to keep pace with  inflation and thereby help to maintain the purchasing power of those  benefits. The COLA is based on the consumer price index (CPI), in  contrast to the indexing of lifetime earnings and initial benefits, which are  based on the national average wage index.
section_title: Indexing Maximum Taxable Earnings to Wages
paragraphs: The cap on taxable earnings increases each year to keep pace with  changes in average wages. As a result, in combination with a constant tax  rate, total program revenues tend to keep pace with wage growth and  therefore also with benefits to some degree. In 2006, the cap is set at  $94,200. As the distribution of earnings in the economy changes, the  percentage of total earnings that fall below the cap can also change. (See  app. II.)
Table 1 summarizes the various indexing and automatic adjustment  approaches that affect most workers and beneficiaries under the current  program.
section_title: Various Reform Proposals Include Indexing Provisions
paragraphs: Various reform proposals have suggested changes to most of the indexing  features of the current Social Security system. Some proposals would use  alternative indexes for initial benefits in order to slow their growth. Other  proposals would take the same approach but would limit benefit  reductions on workers with lower earnings. Some propose modifying the  COLA in the belief that the CPI overstates the rate of inflation. Still others  propose indexing revenue provisions in new ways.
Changes to the indexing of Social Security’s initial benefits could be  implemented by changing the indexing of lifetime earnings or the PIA  formula’s bendpoints. However, they could also be implemented by  adjusting the PIA formula’s replacement factors, even though these factors  are not now indexed. Under this approach, which is used in this report, the  replacement factors are typically multiplied by a number that reflects the  index being used. The replacement factors would be adjusted for each  year in which benefits start, beginning with some future year. So such  changes would not affect current beneficiaries. Indexing the replacement  factors would reduce benefits at the same proportional rate across income  levels, while changing the indexing of lifetime earnings or the bendpoints  could alter the distribution of benefits across income levels. Recent reform  proposals, as described by the Social Security Administration’s (SSA)  Office of the Chief Actuary in its evaluations, generally implement  indexing changes as adjustments to the PIA formula’s replacement factors.
Two indexing approaches—to reflect changes in the CPI or increasing  longevity—have been proposed as alternatives to the average wage index  for calculating initial benefits. Proponents of using CPI indexing for initial  benefit calculations generally offer the rationale that wage indexing has  never been fiscally sustainable and CPI indexing would slow the growth of  benefits to an affordable level while maintaining the purchasing power of  benefits. They say that maintaining the purchasing power of benefits  should be the program’s goal, as opposed to maintaining relative standards  of living across age groups (that is, earnings replacement rates), which the  current benefit formula accomplishes. Proponents of longevity indexing  offer the rationale that increasing longevity is a key reason for the system’s  long-term insolvency. Since people are living longer on average, and are  expected to continue to do so in the future, they will therefore collect  benefits for more years on average. Using an index that reflects changes in  life expectancy would maintain relatively comparable levels of lifetime  benefits across birth years and thereby promote intergenerational equity.  Also, longevity indexing could encourage people to work longer.
Some indexing proposals accept the need to slow the growth of initial  benefits in general but seek to protect benefit levels for the lowest  earnings levels, consistent with the program’s goal of helping ensure  income adequacy. Such proposals would modify how a new index would  be applied to the formula for initial benefits so that the formula is still  wage-indexed below a certain earnings level. As a result, they would  maintain benefits promised under the current program for those with  earnings below that level such as, for example, those in the bottom  30 percent of the earnings distribution. Such an approach has been called  progressive price indexing.
A few proposals would alter the COLA used to adjust benefits for current  retirees. Some proposals respond to methodological concerns that have  been raised about how the CPI is calculated and would adjust the COLA in  the interest of accuracy. In general, such changes would slightly slow the  growth of the program’s benefit costs. However, other proposals call for  creating a new CPI for older Americans (CPI-E) specifically tailored to  reflect how inflation affects the elderly population and using the CPI-E for  computing Social Security’s COLA. Depending on its construction, such a  change could increase the program’s benefit costs.
Some proposals would index revenues in new ways. Some would apply a  longevity index to payroll tax rates, again focused on the fact that  increasing life expectancy is a primary source of the program’s insolvency.  Proponents of indexing tax rates feel that benefits are already fairly  modest, so the adjustment for longevity should not come entirely from  benefit reductions. Other proposals would institute other types of  automatic revenue adjustments. Some would raise the maximum taxable  earnings level gradually until some percentage of total earnings are  covered and then maintain that percentage into the future. Implicitly, such  proposals reflect a desire to hold constant the percentage of earnings  subject to the payroll tax. Still another proposal would provide for  automatically increasing the tax rate when the ratio of trust fund assets to  annual program costs is projected to fall.
Table 2 summarizes the various indexing and automatic adjustment  approaches that reform proposals have contained.
section_title: A Variety of Indexing Approaches Highlight International Reform Efforts
paragraphs: Faced with adverse demographic trends, many countries have enacted  reforms in recent years to improve the long-term fiscal sustainability of  their national pension systems. New indexing methods now appear in a  variety of forms around the world in earnings-related national pension  systems. In general, they seek to contain pension costs associated with  population aging. Some indexing methods affect both current and future  retirees.
subsections: section_title: Retirement Indexing Approaches in Other Countries Generally Focus on Benefit Reductions instead of Increased Contributions
paragraphs: A number of reforms have focused on methods that primarily adjust  benefits rather than taxes to address the fiscal solvency of national  pension systems. There are two main reasons for this. First, contribution  rates abroad are generally high already, making it politically difficult to  raise them much further. For example, while in the United States total  employer-employee Social Security contribution rates are 12.4 percent of  taxable earnings, they are above 16 percent in Belgium and France, more  than 18 percent in Sweden and Germany, above 25 percent in the  Netherlands and the Czech Republic, and over 30 percent in Italy. In fact,  some countries have stipulated a ceiling on employee contribution rates in  order to reassure the young—or current contributors—that the burden  would be shared among generations. For example, Japan settled, with the  2004 Reform Law, its pension premium rates for the next 100 years with an  increase of 0.35 percent per year until 2017, at which time premium levels  are to be fixed at 18.3 percent of covered wages. Similarly, Canada chose  to raise its combined employer-employee contribution rate more quickly  than previously scheduled, from 5.6 percent to 9.9 percent between 1997  and 2003, and maintain it there until the end of the 75-year projection  period. This increase is meant to help Canada’s pension system build a  large reserve fund and spread the costs of financial sustainability across  generations. Germany’s recent reforms set the workers’ contribution rate  at 20 percent until 2020 and at 22 percent from 2020 to 2030. Second,  increasing employee contribution rates without significantly reducing  benefit levels will tend to make continued employment less attractive  compared to retirement. In the context of population aging and fiscally  stressed national pension systems facing many countries, reform measures  seek to do the opposite: encourage people to remain in the labor force  longer to enhance the fiscal solvency of pension programs. Contribution  rates that become too high are not likely to provide sufficient incentives to  continue work.
section_title: Indexing Approaches Aim at Containing Costs
paragraphs: One commonly used means of reducing, or containing the growth of,  promised benefits involves changing the method used to compute initial  benefits. For example, France, Belgium, and South Korea now adjust past  earnings in line with price growth rather than wage growth to determine  the initial pension benefits of new retirees. In general, this shift to price  indexation tends to significantly lower benefits relative to earnings, as  over long periods prices tend to grow more slowly than wages. Because  of compounding, the effect of such a change is larger when benefits are  based on earnings over a long period than when they reflect only the last  few years of work, as in pension plans with benefits based on final  salaries. In fact, the OECD estimates that, in the case of a full-career  worker with 45 years of earnings, price indexation can lead to benefits 40  percent lower than with wage indexation. In contrast to full price  indexing, some nations use an index that is a mix of price growth and  wage growth, which tends to produce higher benefits than those  calculated using price indexation only, then adjust the relative weights of  the two to cover program costs. Finland, for example, changed its  indexation of initial benefits from 50 percent prices and 50 percent wages  to 80 percent and 20 percent, respectively. Similarly, Portugal’s index  combines 75 percent price growth and 25 percent wage growth.
A few countries have moved away from wage indexing but without  necessarily adopting price indexation. Sweden, for instance, uses an index  that reflects per capita wage growth to compute initial benefits, provided  the system is in fiscal balance. However, when the system’s obligations  exceed its assets, a “brake” is applied automatically that allows the  indexation to be temporarily abandoned. This automatic balancing  mechanism (ABM) ensures that the pension system remains financially  stable. In Germany and Japan, recent reforms changed benefit indexation  from a gross-wage base to a net-wage base—i.e., gross wages minus  contributions. In Italy, workers’ benefit accounts rise in line with gross  domestic product (GDP) growth so both the changes in the size of the  labor force and in productivity dictate benefit levels.
Another approach countries have used is adding a longevity index to the  formula determining pension payments. In Sweden, Poland, and Italy, for  example, remaining life expectancy at the time of retirement inversely  affects benefit levels. Thus, as life spans gradually increase, successive  cohorts of retirees get smaller benefit payments unless they choose to  begin receiving them later in life than those who retired before them. Also,  people who retire earlier than their peers in a given cohort get significantly  lower benefits throughout their remaining life than those who retire later.
Longevity indexing helps ensure that improvements in life expectancy do  not strain the system financially.
Germany, on the other hand, now uses a sustainability factor that links  initial benefits to the system’s dependency ratio—i.e., the number of  people drawing benefits relative to the number paying into the system.  This dependency ratio captures variations in fertility, longevity, and  immigration, and consequently makes the pension system self-stabilizing.  For example, higher fertility and immigration, which raise labor force  growth, will, other things equal, improve the dependency ratio, leading to  higher pension benefits, while higher longevity or life expectancy will  increase the dependency ratio, and hence cause benefits to decline.
section_title: Indexing Approaches Affect Both Current and Future Beneficiaries
paragraphs: In some of the countries we studied, changes in indexing methods affect  both current and future retirees. In Japan, for example, post-retirement  benefits were indexed to wages net of taxes before 2000. However,  reforms enacted that year altered the formula by linking post-retirement  benefits to prices. As a result, retirees saw their subsequent benefits rise at  a much slower pace. The 2004 reforms reduced retirees’ purchasing power  further by introducing a negative “automatic adjustment indexation” to the  formula. With this provision, post-retirement benefits increase in line with  prices minus the adjustment rate, currently fixed at 0.9 percent until about  2023. This rate is the sum of two demographic factors: the decline in the  number of people contributing to the pension program (projected at 0.6  percent) plus the increase in the number of years people collect pensions  (projected at 0.3 percent). This negative adjustment also enters the  formula determining the benefit of new recipients as past earnings are  indexed to net wages minus the same 0.9 percent adjustment rate.
Sweden’s ABM modifies both the retirement accounts of workers—or  future retirees—and the benefits paid to current pensioners. As explained  earlier, this mechanism is triggered whenever system assets fall short of  system liabilities. Moreover, post-retirement benefits in Sweden are  indexed each year to an economic factor equal to prices plus the average  rate of real wage increase minus 1.6 percent, which is the projected real  long-term growth in wages. As a result, if average real wages grow  annually at 1.6 percent, post-retirement benefits are adjusted for price  increases. On the other hand, if real wage growth falls below 1.6 percent,  benefits do not keep up with prices, leading to a decline in retiree  purchasing power.
Germany’s sustainability factor affects those already retired, as it is  included in the formula that adjusts their benefits each year. If, as  projected, the number of contributors falls relative to that of pensioners,  increasing the dependency ratio, all benefits are adjusted downward, so all  cohorts share the burden of adverse demographic trends. This  intergenerational burden sharing is also apparent in the indexation of all  benefits to net wages—wages minus contributions, which affect workers  and pensioners alike. Thus an increase in contributions, everything else  equal, lowers both initial benefits and benefits already being paid.
Table 3 summarizes relevant characteristics of earnings-related public  pension programs in selected countries.
section_title: Indexing Can Be Used to Achieve Desired Distributional Effect
paragraphs: In the U.S. Social Security program, indexing can have different effects on  the distribution of benefits and on the relationship between contributions  and benefits, depending on how it is applied to benefits or taxes. There are  a variety of proposals that would change the current indexing of initial  benefits, including a move to the CPI, to longevity or mortality measures,  or to the dependency ratio. When the index is implemented through the  benefit formula, each will have a proportional effect, with constant  percentage changes at all earnings levels, on the distribution of benefits  (i.e., the progressivity of the current system is unchanged). However,  indexing provisions can be modified to achieve other distributional  effects. For example, so-called progressive indexing applies different  indexes at different earnings levels in a manner that seeks to protect the  benefits of low-income workers. Indexing payroll tax rates would also  have distributional effects. Such changes maintain existing benefit levels  but affect equity measures like the ratio of benefits to contributions across  age cohorts, with younger cohorts having lower ratios because they  receive lower benefits relative to their contributions. Finally, proposals  that modify the indexing of COLAs for existing beneficiaries have  important and adverse distributional effects for groups that have longer  life expectancies, such as women and highly educated workers, because  such proposals would typically reduce future benefits, and this effect  compounds over time. In addition, disabled worker beneficiaries,  especially those who receive benefits for many years, would also  experience lower benefits.
subsections: section_title: Proposals to Index Initial Benefits Have a Proportional Effect on the Distribution of Benefits
paragraphs: There are a variety of proposals that would change the current indexing of  initial benefits from the growth in average wages. These include a move to  a measure of the change in prices like the CPI, to longevity measures that  seek to capture the growth in population life expectancies, or to the  dependency ratio that measures changes in the number of retirees  compared to the workforce. We analyzed three indexing scenarios; the  dependency ratio index, which links the growth of initial benefits to  changes in the dependency ratio, the ratio of the number of retirees to  workers; the CPI index, which links the growth of initial benefits to  changes in the CPI; and the mortality index, which links the growth of  initial benefits to changes in life expectancy to maintain a constant life  expectancy at the normal retirement age. Figure 3 illustrates the  projected distribution of benefits for workers born in 1985 under three  different indexing scenarios (on the left side of the figure) and under a  so-called benefit reduction benchmark that reduces benefits just enough  to achieve program solvency over a 75-year projection period (on the far  right). Median benefits under the dependency ratio index and the CPI  index are lower than the median benefit for the benchmark; they reduce  benefits more than is needed to achieve 75-year solvency. In contrast, the  mortality index has a higher median benefit level than the benchmark, so  without further modifications, it would not achieve 75-year solvency.
Regardless of the index used to modify initial benefits, most proposals  apply the new index in a way that has proportional effects on the  distribution of benefits. Thus, benefits at all levels will be affected by the  same percentage reduction, for example, 5 percent, regardless of earnings.  The left half of figure 3 illustrates this proportionality in terms of monthly  benefits. While the level of benefits differs, the distribution of benefits for  each scenario has a similar structure. However, the range of each  distribution varies by the difference in the size of the proportional  reduction. A larger proportional reduction—the dependency ratio index— will result in a distribution with a similar structure, compared to promised  benefits. However, each individual’s benefits are reduced by a constant  percentage; therefore, the range of the distribution, the difference between  benefits in the 25th and 75th percentile, would be smaller, compared to  promised benefits. This proportional reduction in benefits is also  illustrated in figure 4, which compares the currently scheduled or  promised benefit formula with our three alternative indexing scenarios.  Under each scenario, the line depicting scheduled benefits is lowered, by  equal percentages at each AIME amount, by the difference between the  growth in covered wages and the new index. Each indexing scenario  maintains the shape of the current benefit formula; thus the progressivity  of the system is maintained, but the line for each scenario is lower than  scheduled benefits, which would affect the adequacy of benefits.
The proportional effects of indexing are best illustrated by adjusting, or  scaling, each index to achieve comparable levels of solvency over 75  years. Thus, for those indexes that do not by themselves achieve  solvency, the benefit reductions are increased until solvency is achieved;  for those that are more than solvent, the benefit reductions are decreased  until solvency is achieved but not exceeded.
The right half of figure 3 shows the distribution of monthly benefits for  each of the scaled indexing scenarios and the benchmark scenario. Once  the different indexing scenarios are scaled to achieve solvency, the  distribution of benefits for each scenario is almost identical in terms of the  level of benefits. Differences in the distributions deal with the timing  associated with implementing the changes. Scaling the indexing scenarios  also reveals that the shape of the distributions is the same. The  distributions of monthly benefits for the indexing scenarios are also very  similar to the distribution of benefits generated under the benefit  reduction benchmark. Therefore, changes to the benefit formula, applied  through the replacement factors, will have similar results regardless of  whether the change is an indexing change or a straight benefit reduction,  because of the proportional effect of the change.
section_title: Indexing Approaches Could Also Be Modified to Achieve Nonproportional Effects
paragraphs: Indexing could also be modified to achieve other distributional goals. For  example, so-called progressive indexing, or the use of different indexes— such as prices and wages—at various earnings levels, has been proposed  as a way of changing the indexing while protecting the benefits of low- income workers. Thus, under progressive price indexing, those individuals  with indexed lifetime earnings below a certain point would still have their  initial benefits adjusted by wage indexing; those individuals with earnings  above that level would be subject to a combination of wage and price  indexing on a sliding scale, with those individuals with the highest lifetime  earnings having their benefits adjusted completely by price indexing.
The effect that progressive price indexing would have on the benefit  formula can be seen in figure 5, where the CPI indexing scenario is  compared to a progressive CPI indexing scenario and to benefits promised  under the current program formula. Many lower-income individuals  would do better under the progressive application of the CPI index than  under the CPI indexing alone. However, a progressive application of CPI  indexing does not by itself achieve 75-year solvency, and further changes  would be necessary to do so. Figure 6 shows what happens to the benefit  formula when each of these indexing scenarios is scaled to achieve  comparable levels of solvency over 75 years. Under progressive price  indexing, to protect the benefits of low-income workers, the indexing to  prices at higher earnings levels begins to flatten out benefits, causing the  line in figure 6 to plateau. Thus, under this scenario, most individuals with  earnings above a certain level would receive about the same level of  benefits regardless of income—in the case of figure 6, a retiree with  average indexed monthly earnings of $2,000 would receive a similar  benefit level as someone with average indexed monthly earnings of $7,000.  Since progressive price indexing would change the shape of the benefit  formula, making it more progressive, it would reduce individual equity for  higher earners, as they would receive much lower benefits relative to their  contributions.
While proposals that have suggested progressive indexing have focused on  using prices, any index can be adjusted to achieve the desired level of  progressivity, and the results will likely be similar. However, to the extent  that wages grow faster than the new index over a long period of time, the  benefit formula will eventually flatten out and all individuals above a  certain income level would receive the same level of benefits.
section_title: Indexing Applied to Taxes Would Have Adequacy and Equity Considerations
paragraphs: Indexing changes could also be applied to program financing. Under the  current structure of the system, one way this could be accomplished is by  indexing the Social Security payroll tax rate. As with indexing benefits,  the payroll tax rate could be indexed to any economic or demographic  variable. Under the tax scenarios presented, only the indexing of taxes  would change, so promised benefits would be maintained. However,  workers would be paying more in payroll taxes, which, like any tax  change, could affect work, saving, and investment decisions.
While benefit levels would be higher under tax increase scenarios, as  compared to benefit reduction scenarios, the timing of the tax changes  matters, just as it did with benefit changes. Since benefits would be  unchanged in the tax-increase-only scenarios, we use benefit-to-tax ratios  to compare the effects of different tax increase scenarios. Benefit-to-tax  ratios compare the present value of Social Security lifetime benefits with  the present value of lifetime Social Security taxes. The benefit-to-tax ratio  is an equity measure that focuses 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. With benefits unchanged in the  tax increase scenarios, the benefit-to-tax ratios would vary across  scenarios because of differences in the timing of tax increases.
To illustrate the effects of the timing of a change in tax rates, figure 7  shows the benefit-to-tax ratios, for four different birth cohorts, for two tax  increase scenarios: (1) the dependency ratio tax indexing scenario scaled  to achieve 75-year solvency and (2) our tax increase benchmark scenario  that increases taxes just enough to achieve program solvency over a 75- year projection period. By raising payroll taxes once and immediately,  the tax increase benchmark would spread the tax burden more evenly  across generations. This is seen in figure 7, where the benefit-to-tax ratios  are fairly stable across cohorts for this scenario. The dependency ratio  tax indexing scenario would increase the tax rate annually, in this case  with changes in the dependency ratio. Under this scenario, later cohorts  would face a higher tax rate and thus bear more of the tax burden,  compared to earlier cohorts. This would result in declining benefit-to-tax  ratios across cohorts, with later generations receiving relatively less  compared to their contributions.
section_title: Revising COLA for Existing Beneficiaries Would Have Important Distributional Implications for Multiple Subpopulations
paragraphs: Indexing changes can also be applied to the COLA used to adjust existing  benefits. Under the current structure of the program, benefits for existing  beneficiaries are adjusted annually in line with changes in the CPI. The  COLA helps to maintain the purchasing power of benefits for current  retirees. Some proposals, under the premise that the current CPI  overstates the rate of price inflation because of methodological issues  associated with how the CPI is calculated, would alter the COLA. Figure 8  shows the difference in benefit growth over time under the current COLA  and two alternatives: growing at rate of CPI minus 0.22 and growing at rate  of CPI minus 1. Changes to the COLA would also have adequacy  implications. After 20 years, benefits growing at the rate of the CPI minus  0.22 would slow the growth of benefits by about 4 percent below the level  given by the current COLA and growing at the rate of the CPI minus 1 by  about 17 percent. This slower benefit growth would improve the finances  of the system, but would also alter the distribution of benefits, particularly  for some subpopulations. Since changes to the COLA compound over  time, those most affected are those with longer life expectancies, for  example, women, as they would have the biggest decrease in lifetime  benefits as they tend to receive benefits over more years. In addition, as  education is correlated with greater life expectancy, highly educated  workers would also experience a significant benefit decrease. There could  also be a potentially large adverse effect on the benefits paid to disabled  beneficiaries, especially among those who become disabled at younger  ages and receive benefits for many years. These beneficiaries could have a  large decrease in lifetime benefits.
Reducing the COLA would also have equity implications. Since the COLA  is applied to all beneficiaries, reductions in the COLA would lower the  return on contributions for all beneficiaries. However, the magnitude of  the effect will vary across subpopulations, similar to its effect on  adequacy. Those individuals who have the biggest decrease in lifetime  benefits will have the biggest decrease in individual equity. While these  individuals have a large decrease in equity, they would still receive higher  lifetime benefits since they live longer and collect benefits over more  years. Individuals with shorter life expectancies will experience a  decrease in equity, but they will fare comparably better than other groups  that live longer, since their lifetime benefits will decrease much less.  Therefore, men, African-Americans, low earners, and less educated  individuals would experience a much smaller decrease in equity compared  to their counterparts.
section_title: Key Considerations in Choosing an Index
paragraphs: Indexing raises other important considerations about the program’s role,  the stability of the variables underlying the index, and the treatment of  Disability Insurance (DI) beneficiaries. The choice of the index implies  certain assumptions about the appropriate level of benefits and taxes for  the program. Thus, if the current indexing of initial benefits was changed  to price growth, there is an implication that the appropriate level of  benefits is one that maintains purchasing power over time rather than the  current approach that maintains a relative standard of living across age  groups (i.e., replacement rates). The solvency effects of an index are  predicated upon the relative stability and historical trends of the  underlying economic or demographic relationships implied by the index.  For example, the 1970s were a period of much instability, in which actual  inflation rates and earnings growth diverged markedly from past  experience, with the result that benefits unexpectedly grew much faster  than expected. Finally, since the benefit formulas for the Old-Age and  Survivors Insurance (OASI) and DI programs are linked, an important  consideration of any indexing proposal is its effect on the benefits  provided to disabled workers. Disabled worker beneficiaries typically  become entitled to benefits much sooner than retired workers and under  different eligibility criteria. As with other ways to change benefits, an  index that is designed to improve solvency by adjusting retirement  benefits may result in large reductions to disabled workers, who often  have fewer options to obtain additional income from other sources.
subsections: section_title: Choice of a Particular Index Implies Assumptions about the Appropriate Level of Benefits and Taxes, Adequacy and Equity
paragraphs: The choice of an index suggests certain assumptions about the  appropriate level of benefits and the overall goal of the program. The  current indexing of initial benefits to wage growth implies that the  appropriate level of benefits is one that maintains replacement rates  across birth years. In turn, maintaining replacement rates implies a relative  standard of adequacy and an assumption that initial benefits should reflect  the prevailing standard of living at the time of retirement. In contrast,  changing the current indexing of initial benefits to price growth implies  that the appropriate level of benefits is one that maintains purchasing  power. In turn, maintaining purchasing power implies an absolute  standard of adequacy and an assumption that initial benefits should reflect  a fixed notion of adequacy regardless of improvements in the standard of  living. Also, any index that does not maintain purchasing power results in  workers born in one year receiving higher benefits than workers with  similar earnings born 1 year later. This would occur with any benefit  change that would reduce currently promised benefits more than price  indexing initial benefits would, since price indexing maintains the  purchasing power of initial benefits. In the case of longevity indexing, if  the growth of initial benefits were indexed to life expectancy, then this  implies that the increased costs of benefits that stem from increasing life  expectancy should be borne by all future beneficiaries, even if society has  become richer. Therefore, the desired outcome, in terms of initial benefit  levels at the time of retirement, should drive the choice of an index.
The current indexing of existing benefits with the COLA implies that  maintaining the purchasing power of benefits for current retirees is the  appropriate level of benefits. Revising the COLA to reflect a more accurate  calculation of the CPI retains this assumption. However, adjusting the  COLA in a way that does not keep pace with the CPI would change that  assumption and imply a view that the costs of reform should be shared by  current as well as future retirees.
Similarly, on the revenue side, the program currently uses a constant tax  rate, which maintains the same proportion of taxes for all workers earning  less than the maximum taxable earnings level. Applying a life expectancy  index to payroll tax rates suggests that the appropriate level of taxes is  one that prefunds the additional retirement years increased life  expectancy will bestow on current workers, but also that the appropriate  level of benefits is one that maintains replacement rates, as benefits are  unchanged.
section_title: Stability of Economic or Demographic Relationships Underlying the Index Is a Consideration
paragraphs: Indexing raises other considerations about the stability of the underlying  relationships between the economic and demographic variables captured  by the index. The choice of an index includes issues of risk and  methodology. Some indexes could be based on economic variables that  are volatile, introducing instability because the index generates wide  swings in benefits or taxes. In other cases, long-standing economic or  demographic relationships premised by the index could change, resulting  in unanticipated and unstable benefit or tax levels. While most indexes  will also pose methodological issues, these can become problematic to  address after the index has already been widely used, and the correction  will have implications for benefits or taxes. An example is the current  measurement limitations of the CPI. In other instances, the index may be  based on estimates about future trends in variables like mortality that  could later prove incorrect and erode public confidence in the system.
Some indexes are premised on the past behavior of economic or  demographic relationships. If these long-standing relationships diverge for  a significant period of time, they may result in unanticipated and unstable  benefit or tax levels. For example, the 1972 amendments that introduced  indexing into the Social Security program were premised on the belief that  over time, wage growth will generally substantially exceed price inflation.  However, for much of the 1970s, actual inflation rates and earnings growth  diverged markedly from past experience; price inflation grew much faster  than wages, with the result that benefits grew much faster than  anticipated. This development introduced major instability into the  program, which was unsustainable. Congress addressed this problem  when it passed the 1977 amendments. Moreover, even though the 1977  amendments succeeded in substantially stabilizing the replacement rates  for initial benefits, a solvency crisis required reforms just 6 years later with  the 1983 amendments. High inflation rates resulted in high COLAs for  existing benefits just as recession was depressing receipts from the payroll  taxes. The indexing of initial benefits under the 1977 amendments did not  address the potential for such economic conditions to affect COLAs or  payroll tax receipts.
Many indexes have methodological issues associated with their  calculation, which can become problems over time. For example, the CPI  has long been in use by the Social Security program and other social  welfare programs. However, the CPI is not without its methodological  problems. Some studies have contended that the CPI overstates inflation  for a number of reasons, including that it does not account for how  consumers can substitute one good for another because the calculation  assumes that consumers do not change their buying patterns in response  to price changes. Correcting for this “substitution effect” would likely  lower the CPI. Changing the calculation in response to this concern might  improve accuracy but is controversial because it would also likely result in  lower future benefits and put more judgment into the calculation.
Indexes that are constructed around assumptions about future experience  raise other methodological issues. An example is a mortality index, which  seeks to measure future changes in population deaths. Such a measure  would presumably capture an aspect of increased longevity or well-being  in retirement and could be viewed as a relevant determinant of program  benefits or taxes. Accuracy in this index would require forecasts of future  mortality based on assumptions of the main determinants influencing  future population deaths (i.e., medical advances, diet, income changes).  Such forecasts would require a clear consensus about these factors and  how to measure and forecast them. However, currently there is  considerable disagreement among researchers in terms of their beliefs  about the magnitude of mortality change in the future. In choosing an  index, such methodological issues would need to be carefully considered  to maintain public support and confidence.
section_title: The Treatment of Disabled and Survivor Beneficiaries Poses Challenges When Modifying the Indexing
paragraphs: Under the current structure of the U.S. Social Security system, the OASI  and DI programs share the same benefit formula. Thus, any changes that  affect retired workers will also affect survivors and disabled workers.  However, the circumstances facing these beneficiaries differ from those  facing retired workers. For example, the disabled worker’s options for  alternative sources of income, especially earnings-related income, to  augment any reduction in benefits are likely to be more limited than are  those for the retired worker. Further, DI beneficiaries enter the program at  younger ages and may receive benefits for many years. As a result,  disabled beneficiaries could be subject to benefit changes for many years  more than those beneficiaries requiring benefits only in retirement.
These differing circumstances among beneficiaries raise the issue of  whether any proposed indexing changes, or any other benefit changes,  should be applied to disabled worker and survivor beneficiaries, as well as  to retired worker beneficiaries. If disabled worker beneficiaries are not  subject to indexing changes applied to retirees, benefit levels for disabled  workers could ultimately be higher than those of retired workers. This  difference in benefit levels would occur because disabled workers  typically become entitled to benefits sooner than retired workers, and thus  any reductions in their replacement factors would be smaller. Such a  differential could increase the incentive for older workers to apply for  disability benefits as they near retirement age.
Excluding the disability program from indexing changes has implications  for solvency and raises implementation issues. If the indexing changes are  not applied to the disability program, even larger benefit reductions or  revenue increases would be needed to achieve fiscal solvency. Since the  OASI and DI programs share the same benefit formula, excluding disabled  worker beneficiaries from indexing changes might also necessitate the use  of two different benefit formulas or require a method to recalculate  benefits in order to maintain different indexing in each program. Such  changes could lead to confusion among the public about how the  programs operate, which may require significant additional public  education.
section_title: Concluding Observations
paragraphs: Indexing has played an important role in the determination of Social  Security’s benefits and revenues for over 30 years. As in other countries  seeking national pension system reform, recent proposals to modify the  role of indexing in Social Security have primarily focused on addressing  the program’s long-term solvency problems. In theory, one index may be  better than another in keeping the program in financial balance on a  sustainable basis. However, such a conclusion would be based on  assumptions about the future behavior of various demographic and  economic variables, and those assumptions will always have considerable  uncertainty. Future demographic patterns and economic trends could  emerge that affect solvency in ways that have not been anticipated. So,  while indexing changes may reduce how often Congress needs to  rebalance the program’s finances, there is no guarantee that the need will  not arise again.
Yet program reform, and the role of indexing in that reform, is about more  than solvency. Reforms also reflect implicit visions about the size, scope,  and purpose of the Social Security system. Indexing initial benefits,  existing benefits, tax rates, the maximum taxable earnings level, or some  other parameter or combination will have different consequences for the  level and distribution of benefits and taxes, within and across generations  and earnings levels. These questions relate to the trade-off between  income adequacy and benefit equity.
In the final analysis, indexing, like other individual reforms, comes down  to a few critical questions: What is to be accomplished or achieved, who is  to be affected, is it affordable and sustainable, and how will the change be  phased in over time? Although these issues are complex and controversial,  they are not unsolvable; they have been reconciled in the past and can be  reconciled now. Indexing can be part of a larger, more comprehensive  reform package that would include other elements whose cumulative  effect could achieve the desired balance between adequacy and equity  while also achieving solvency. The challenge is not whether indexing  should be part of any necessary reforms, but that necessary action is taken  soon to put Social Security back on a sound financial footing.
section_title: Agency Comments
paragraphs: We provided a draft of this report to SSA and the Department of the  Treasury. SSA provided technical comments, which we have incorporated  as appropriate.
We are sending copies of this report to the Social Security Administration  and the Treasury Department, as well as other interested parties. Copies  will also be made available to others upon request. In addition, the report  will be available at no charge on the GAO Web site at http://www.gao.gov.  Please contact me at (202) 512-7215, if you have any questions about this  report. Other major contributors include Charles Jeszeck, Michael Collins,  Anna Bonelli, Charles Ford, Ken Stockbridge, Seyda Wentworth, Joseph  Applebaum, and Roger Thomas.
section_title: Appendix I: Methodology
paragraphs: 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 worker, spouse,  survivor, 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. 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), 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 provide only very rough estimates of future  incomes. However, these estimates may be useful for comparing future  incomes across alternative policy scenarios and over time.
GEMINI can be operated as a free-standing model or it can operate as a  SSASIM add-on. When operating as an add-on, GEMINI is started  automatically by SSASIM for one of two purposes. GEMINI can enable the  SSASIM macro model to operate in the Overlapping Cohorts (OLC) mode  or it can enable the SSASIM micro model to operate in the Representative  Cohort Sample (RCS) mode. The SSASIM OLC mode requests GEMINI to  produce samples for each cohort born after 1934 in order to build up  aggregate payroll tax revenues and OASDI benefit expenditures for each  calendar year, which are used by SSASIM to calculate standard trust fund  financial statistics. In either mode, GEMINI operates with the same logic,  but typically with smaller cohort sample sizes in OLC mode than in the  RCS or stand-alone-model mode.
For this report we used GEMINI to simulate Social Security benefits and  taxes primarily 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 various indexation approaches.
subsections: section_title: Benchmark Policy Scenarios
paragraphs: 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. 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 2010 and 2040 to strike a balance between the size  of the incremental reductions each year and the size of the ultimate  reduction.
SSA actuaries scored our original 2001 benchmark policies and  determined the parameters for each that would achieve 75-year solvency.  Table 5 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 greater than  shown in this analysis.
subsections: section_title: Criteria
paragraphs: According to our analysis, appropriate benchmark policies should ideally  be evaluated against the following criteria:  1.  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, and so forth),  b.  maintaining a proportional level of income transfers in  c.  maintaining proportional replacement rates, and  d.  maintaining proportional rates of return.  2.  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.  3.  Ability to model: The benchmark should lend itself to being modeled  within the GEMINI model.  4.  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.  5.  Transparency: The benchmark should be readily explainable to the  reader.
section_title: Tax-Increase-Only, or “Promised Benefits,” Benchmark Policies
paragraphs: 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.
section_title: Benefit-Reduction-Only, or “Funded Benefits,” Benchmark Policies
paragraphs: 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.
subsections: section_title: Scope
paragraphs: 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 disabled and survivor benefits  were not reduced at all, reductions in other benefits would be deeper than  shown in this analysis.
section_title: Phase-in Period
paragraphs: We selected a phase-in period that begins with those becoming initially  entitled in 2010 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 greater 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 13 percent; this would create a notch.
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 1994-1996 Advisory Council report also provided for a  similar delay.
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 assumes 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.  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 a sudden, large benefit reduction  and create substantial inequities across generations.
section_title: Defining the PIA Formula Factor Reductions
paragraphs: 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 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 2006.  90%  (AIME ≤ $656)  + 32%  (AIME > $656 and ≤ $3955)  + 15%  (AIME > $3955)  where AIME 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,    x)   represents the three 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 gets  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 harder than higher earners  because the constant x percent of the higher formula factors results in a  larger percentage 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.
Table 6 summarizes the features of our benchmarks.
section_title: Appendix II: Background on Development of Social Security’s Indexing Approach
paragraphs: Social Security did not originally use indexing to automatically adjust  benefit and tax provisions; only ad hoc changes were made. The 1972  amendments provided for automatic indexing of benefits and taxes for the  first time, but the indexing approach for benefits was flawed, introducing  potential instability in benefit costs. The 1977 amendments addressed  those issues, resulting in the basic framework for indexing benefits still in  use today.
subsections: section_title: Program Did Not Use Indexing until 1970s
paragraphs: Before the 1970s, the Social Security program did not use indexing to  adjust benefits or taxes automatically. For both new and existing  beneficiaries, benefit rates increased only when Congress voted to raise  them. The same was true for the tax rate and the cap on the amount of  workers’ earnings that were subject to the payroll tax. Under the 1972  amendments to the Social Security Act, benefits and taxes were indexed  for the first time, and revisions in the 1977 amendments created the basic  framework still in use today.
subsections: section_title: Ad Hoc Benefit and Tax Changes Had Sporadic Effects
paragraphs: Until 1950, Congress legislated no changes to the benefit formula of any  kind. As a result, average inflation-adjusted benefits for retired workers  fell by 32 percent between 1940 and 1949. Under the 1950 amendments to  the Social Security Act, these benefits increased 67 percent in 1 year.  Afterward, until 1972, periodic amendments made various ad hoc  adjustments to benefit levels. Economic prosperity and regular trust fund  surpluses facilitated gradual growth of benefit levels through these ad hoc  adjustments. In light of the steady growth of benefit levels, the 1972  amendments instituted automatic adjustments to constrain the growth of  benefits as well as to ensure that they kept pace with inflation. Table 7  summarizes the history of benefit increases before 1972. It illustrates that  between 1940 and 1971, average benefits for all current beneficiaries  tripled while prices nearly doubled and wages more than quintupled.  Some benefit increases were faster and some were slower than wages  increases.
On the revenue side, payroll tax rates have never been indexed. However,  Social Security’s revenue also depends on the maximum amount of  workers’ earnings that are subject to the payroll tax. This cap is  technically known as the contribution and benefit base because it limits  the earnings level used to compute benefits as well as taxes. Just as with  benefits, the maximum taxable earnings level did not change until the 1950  amendments even as price and earning levels were increasing. From 1940  to 1950, the inflation-adjusted value of the cap fell by over 40 percent.  Also, until the 1972 amendments, adjustments to the maximum taxable  earnings level were made on an ad hoc basis. With the enactment of the  1972 amendments, the maximum taxable earnings level increased  automatically based on increases in average earnings. Figure 9 shows the  inflation-adjusted values for the maximum taxable earnings level before  automatic adjustments took effect in 1975. Figure 10 shows that as a  result of the fluctuations in the maximum taxable earnings level, the  proportion of earnings subject to the payroll tax varied widely before  indexing, ranging from 71 to 93 percent.
section_title: Indexing in 1972 Amendments Built on Previous Ad Hoc Benefit Increases
paragraphs: The 1972 amendments, in effect, provided for indexing initial benefits  twice for new beneficiaries. The indexing changed the benefit formula in  the same way that previous ad hoc increases had done.
subsections: section_title: Approach Used for Ad Hoc Benefit Increases
paragraphs: Before the 1972 amendments, benefits were computed essentially by  applying different replacement factors to different portions of a worker’s  earnings. For example, under the 1958 amendments, a workers’ PIA  would equal  58.85 percent of first $110 of average monthly wages plus   21.40 percent of next $290,  where the 58.85 and 21.40 percents are the replacement factors that  determine how much of a worker’s earnings will be replaced by the Social  Security benefit. Subsequent amendments increased benefits by  effectively increasing the replacement factors. For example, the 1965  amendments increased benefits by 7 percent for a given average monthly  wage by increasing the replacement factors by 7 percent to 62.97 from  58.85 and to 22.9 percent from 21.4. The automatic adjustments under the  1972 amendments increased these same replacement factors according to  changes in the CPI. These changes in the benefit computation applied  equally to both new and existing beneficiaries.
To illustrate how the benefit formula worked, take, for example, a worker  with an average monthly wage of $200 who became entitled in 1959 (when  the 1958 amendments first took effect). The PIA for this worker would be  58.85 percent of $110 plus   21.4 percent of the average monthly wage over $110,           that is, $200-110 = $90, which equals  $64.74 + $19.26 = 84.00.
When the 1965 amendments took effect, this same beneficiary would have  the PIA recalculated using the new formula. Assuming no new wages, the  average monthly wage would still be $200, and the new PIA would be  62.97 percent of $110 plus   22.9 percent of the average monthly wage over $110,           that is, $200-110 = $90, which equals  $69.27 + $20.61 = 89.88,           which is 7 percent greater than the previous $84.00.
Now consider the example of a new beneficiary, who became entitled in  1965 (when the 1965 amendments first became effective). For the  purposes of this illustration, to reflect wage growth, assume this worker  had an average monthly wage of $240.00, or 20 percent more than our  previous worker who became entitled in 1959. For this new beneficiary,  the PIA in 1965 would be $99.04, which, as a result of the wage growth, is  much more than 7 percent higher than the initial benefit for the worker in  1959.
section_title: 1972 Amendments Introduced Indexing
paragraphs: The 1972 amendments provided for automatic indexing of benefits and  taxes for the first time. The indexing approach for benefits was flawed and  raised issues that the 1977 amendments addressed; these issues help  explain the basic framework for indexing benefits still in use today. In  particular, the indexing approach in the 1972 amendments resulted in  (1) double-indexing benefits to inflation for new beneficiaries though not  for existing ones and (2) a form of bracket creep that slowed benefit  growth as earnings increased over time. Within a few years, the problems  raised by the double indexing under the 1972 amendments became  apparent, with benefits growing far faster than anticipated.
Under the 1972 amendments, indexing the replacement factors in the  benefit formula to inflation had the effect of indexing twice for new  beneficiaries. First, the increase in the replacement factors themselves  reflected changes in the price level. Second, the benefit calculations were  based on earnings levels, which were higher for each new group of  beneficiaries, partially as a result of inflation. Thus, benefit levels grew  for each new year’s group of beneficiaries because both the benefit  formula reflected inflation and their higher average wages reflected  inflation. For existing beneficiaries who had stopped working, the average  earnings used to compute their benefits did not change, so growth in  earnings levels did not affect their benefits and double indexing did not  occur. Once the double indexing for new beneficiaries was understood,  the need became clear to index benefits differently for new and existing  beneficiaries, which was referred to as “decoupling” benefits.
The effect of double indexing on replacement rates could be offset by a  type of “bracket creep” in the benefit formula, depending on the relative  values of wage and price growth over time. Bracket creep resulted from  the progressive benefit formula, which provided lower replacement rates  for higher earners than for lower earners. As each year passed and average  earnings of new beneficiaries grew, more and more earnings would be  replaced at the lower rate used for the upper bracket, making replacement  rates fall on average, all else being equal.
section_title: Indexing Approach Introduced Potential Instability in Benefit Costs
paragraphs: The combination of double indexing and bracket creep implied in the 1972  amendments introduced a potential instability in Social Security benefit  costs. Price growth determined the effects of double indexing, and wage  growth determined the effects of bracket creep. The extent to which  bracket creep offset the effects of double indexing depended on the  relative values of price growth and wage growth, which could vary  considerably. Had wage and price growth followed the historical pattern at  the time, benefits would not have grown faster than expected and  replacement rates would not have risen; the inflation effect and the  bracket creep effect would have balanced out. However, during the 1970s,  actual rates of inflation and earnings growth diverged markedly from past  experience (see fig. 11), with the result that benefit costs grew far faster  than revenues.
In contrast, an indexing approach that stabilized replacement rates would  help to stabilize program costs. To illustrate this, annual benefit costs can  be expressed as a fraction of the total taxable payroll in a given year, that  is, total covered earnings. In turn, this can be shown to relate closely to  replacement rates.  taxable earningsWhile not precisely a replacement rate, the second term on the last line  above—the ratio of the average benefit to average taxable earnings—is  closely related to the replacement rates provided under the program.  While replacement rates are now relatively stable after the 1977  amendments, it is the first term on the last line above—the ratio of  beneficiaries to workers—that has been increasing and placing strains on  the system’s finances. The inverse of this is the ratio of covered workers to  beneficiaries. While 3.3 workers support each Social Security beneficiary  today, only 2 workers are expected to be supporting each beneficiary by  2040. (See fig. 12.)
section_title: Related GAO Products
paragraphs: Social Security Reform: Answers to Key Questions. GAO-05-193SP.  Washington, D.C.: May 2005.
Options for Social Security Reform. GAO-05-649R. Washington, D.C.:   May 6, 2005.
Social Security Reform: Early Action Would Be Prudent. GAO-05-397T.  Washington, D.C.: Mar. 9, 2005.
Social Security: Distribution of Benefits and Taxes Relative to Earnings  Level. GAO-04-747. Washington, D.C.: June 15, 2004.
Social Security Reform: Analysis of a Trust Fund Exhaustion Scenario.  GAO-03-907. Washington, D.C.: July 29, 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: 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: Restoring Long-Term Solvency Will Require Difficult  Choices. GAO/T-HEHS-98-95. Washington, D.C.: Feb. 10, 1998.