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

Letter

Background

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.

Social Security Currently Indexes Both Benefits and Revenues

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.

Program Did Not Use Indexing until 1970s

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.”

1977 Amendments Created Indexing Approach of Current Social Security System

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.

Indexing Lifetime Earnings to Wages

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.

Indexing Initial Benefit Formula to Wages

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.

Indexing Maximum Taxable Earnings to Wages

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.

Various Reform Proposals Include Indexing Provisions

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.

A Variety of Indexing Approaches Highlight International Reform Efforts

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.

Retirement Indexing Approaches in Other Countries Generally Focus on Benefit Reductions instead of Increased Contributions

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.

Indexing Approaches Aim at Containing Costs

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.

Indexing Approaches Affect Both Current and Future Beneficiaries

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.

Indexing Can Be Used to Achieve Desired Distributional Effect

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.

Proposals to Index Initial Benefits Have a Proportional Effect on the Distribution of Benefits

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.

Indexing Approaches Could Also Be Modified to Achieve Nonproportional Effects

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.

Indexing Applied to Taxes Would Have Adequacy and Equity Considerations

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.

Revising COLA for Existing Beneficiaries Would Have Important Distributional Implications for Multiple Subpopulations

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.

Key Considerations in Choosing an Index

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.

Choice of a Particular Index Implies Assumptions about the Appropriate Level of Benefits and Taxes, Adequacy and Equity

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.

Stability of Economic or Demographic Relationships Underlying the Index Is a Consideration

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.

The Treatment of Disabled and Survivor Beneficiaries Poses Challenges When Modifying the Indexing

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.

Concluding Observations

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.

Agency Comments

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.

Appendix I: Methodology

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.

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. 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.

Criteria

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.

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 disabled and survivor 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 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.

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 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.

Appendix II: Background on Development of Social Security’s Indexing Approach

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.

Program Did Not Use Indexing until 1970s

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.

Ad Hoc Benefit and Tax Changes Had Sporadic Effects

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.

Indexing in 1972 Amendments Built on Previous Ad Hoc Benefit Increases

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.

Approach Used for Ad Hoc Benefit Increases

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.

1972 Amendments Introduced Indexing

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.

Indexing Approach Introduced Potential Instability in Benefit Costs

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.)

Related GAO Products

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.