In the midst of the Great Depression, Social Security was enacted to help ensure that the elderly would have adequate retirement incomes and would not have to depend on welfare. The program was designed to provide benefits that workers had earned to some degree through their contributions and those of their employers. The benefit amounts would depend in part on how much the worker had earned and therefore contributed. Today, about 10 percent of the elderly have incomes below the poverty line, compared with 35 percent in 1959. However, for about half of today’s elderly, incomes excluding Social Security benefits are below the poverty line. Importantly, Social Security does not just provide benefits to retired workers. In 1939, coverage was extended to the dependents of retired and deceased workers, and in 1956 the Disability Insurance program was added. To restore the long-term solvency and sustainability of the program, reductions in promised benefits and/or increases in program revenues will be needed. Within the program’s current structure, possible benefit changes might include increases in the full retirement age, changes to the benefit formula, or reductions in cost-of-living increases, among other options. Revenue increases might include increases in payroll taxes or transfers from the Treasury’s general fund. Some proposals would change the structure of the program to incorporate a system of individual retirement savings accounts. Many such proposals would reduce benefits under the current system and make up for those reductions to some degree with income from the individual accounts. Individual account proposals also try to increase revenues, in effect, by providing the potential for higher rates of return on the individual accounts’ investments than the trust funds would earn under the current system. Three key distinctions help to identify the differences between Social Security’s current structure and one that would use individual accounts. Insurance versus savings. Social Security is a form of insurance, while individual accounts would be a form of savings. As social insurance, Social Security protects workers and their dependents against a variety of risks such as the inability to earn income due to old age, disability, or death. In contrast, a savings account provides income only from individuals’ contributions and any earnings on them; individuals effectively insure themselves under a savings approach. Defined-benefit versus defined-contribution. Social Security provides a “defined-benefit” pension, while individual accounts would provide a “defined-contribution” pension. Defined-benefit pensions typically determine benefit amounts using a formula that takes into account individuals’ earnings and years of earnings. The provider assumes the financial and insurance risk associated with funding those promised benefit levels. Defined-contribution pensions, such as 401(k) plans, determine benefit amounts based on the contributions made to the accounts and any earnings on those contributions. As a result, the individual bears the financial and insurance risks under a defined- contribution plan until retirement. Pay-as-you-go versus full funding. Social Security is financed largely on a “pay-as-you-go” basis, while individual accounts would be “fully funded.” In a pay-as-you-go system, contributions that workers make in a given year fund the payments to beneficiaries in that same year, and the system’s trust funds are kept to a relatively small contingency reserve. In contrast, in a fully funded system, contributions for a given year are put aside to pay for future benefits. The investment earnings on these funds contribute considerable revenues and reduce the size of contributions that would otherwise be required to pay for the benefits. Defined-contribution pensions and individual retirement savings are fully funded by definition. To evaluate reform proposals, we have suggested that policy makers should consider three basic criteria: 1. the extent to which the proposal achieves sustainable solvency and how the proposal would affect the economy and the federal budget; 2. the balance struck between the twin goals of individual equity (rates of return on individual contributions) and income adequacy (level and certainty of benefits); and 3. how readily such changes could be implemented, administered, and explained to the public. Providing higher replacement rates for lower earners than for higher earners is just one of several aspects of our criterion for balancing adequacy and equity. With regard to adequacy, this criterion also considers the extent to which the proposal changes benefits for current and future retirees; maintains or enhances benefits for low-income workers who are most reliant on Social Security; and maintains benefits for the disabled, dependents, and survivors. In addition, providing higher replacement rates for lower earners than for higher earners does not by itself ensure adequacy. A reform proposal could make replacement rates vary even more by earnings level than under the current system yet provide lower and less adequate benefits. With regard to equity, our criterion for balancing adequacy and equity also considers the extent to which the proposal ensures that those who contribute receive benefits, expands individual choice and control over program contributions, increases returns on investment, and improves intergenerational equity. Moreover, reform proposals should be evaluated as packages that strike a balance among individual reform elements and important interactive effects. The overall evaluation of any particular reform proposal depends on the weight individual policy makers place on each criterion. In 2001, the President created the Commission to Strengthen Social Security to develop reform plans that strengthen Social Security and increase its fiscal sustainability while meeting certain principles: no changes to benefits for retirees or near retirees, dedication of entire Social Security surplus to Social Security, no increase in Social Security payroll taxes, no government investment of Social Security funds in the stock market, preservation of disability and survivor components, and inclusion of individually controlled voluntary individual retirement accounts. The commission developed three reform models, each of which represented a different approach to including voluntary individual accounts as part of Social Security. Under all three models, individuals could have a portion of their Social Security contributions deposited into individual accounts, and their Social Security defined benefits would be reduced relative to those account contributions. A governing board would administer the accounts in a fashion similar to the Thrift Savings Plan for federal employees. To continue paying benefits while also making deposits to the accounts, funds would need to be transferred from the Treasury’s general fund. The models varied in the size of the account contributions. Models 2 and 3 had additional provisions for reducing certain benefits overall and enhancing benefits for surviving spouses and selected low earners. To assess the extent to which the Social Security program or reform options are progressive—distributes in a way that favors lower earners— researchers first select a number of measures and then compare how different groups of earners fare according to those measures. The choice of measures reflects a particular perspective on the goals of the program. For example, those who analyze Social Security from an adequacy perspective are primarily concerned with the program’s role in securing adequate income and consequently tend to use measures of how much income Social Security provides. In contrast, those who view Social Security from an equity perspective focus on whether beneficiaries receive a fair return on their contributions and tend to choose measures balancing lifetime taxes against lifetime benefits. For each perspective, assessing progressivity involves determining how lower earners fare relative to higher earners on appropriate measures. In the context of Social Security reform, those scenarios in which the well-being of lower earners increased proportionally more, or decreased proportionally less, would be considered more progressive. Because of the different kinds of benefits that Social Security provides, many researchers agree that to investigate the distributional effect of the program, aggregating workers and their dependents into households better captures well-being, but doing so poses certain methodological challenges. Since its inception, Social Security’s primary goal has been to provide adequate income, upon entitlement, so as to reduce dependency and poverty among its participants. Studies emphasizing this goal reflect the adequacy perspective; they view the program more as a safety net that helps ensure a minimum level of subsistence. Consequently, such studies use measures of how much income Social Security benefits provide. These measures include absolute benefit levels at a point in time and benefit-to- earnings ratios. Benefit levels are useful for estimating whether Social Security offers adequate protection for people covered by the system. Benefit-to-earnings ratios, which reflect how much of past earnings Social Security benefits replace, help gauge the extent to which the program allows people to maintain their past standard of living. One way to assess the distributional effect of the current Social Security program or of various reform options is to look at how these adequacy measures are distributed across earners. Regarding benefit levels, one possibility is to compute the ratio of benefits received by lower earners to benefits received by higher earners, at a particular point in time. Comparing these benefit ratios under different policies helps determine how the well-being of lower earners changes relative to that of higher earners across reform proposals. If, for example, benefits collected by individuals in the 20th percentile of the earnings distribution relative to benefits collected by those in the 80th percentile increased from one Social Security system to the next, the adequacy perspective would conclude that, other things being equal, the second is more progressive, that it is tilted toward lower earners. Alternatively, one could compute the proportion of total benefits various groups of earners receive relative to the proportion the median gets and determine the manner in which these relative proportions change across proposals. For all groups below the median, for instance, an increase in this ratio would indicate a more progressive system. The distribution of replacement rates also helps assess progressivity. The change in the replacement rate of lower earners relative to that of high earners across reform options shows the extent to which lower earners are able to maintain their pre-entitlement standard of living relative to higher earners. Under the current Social Security system, for instance, the monthly benefit lower earners receive upon entitlement replaces a larger portion of their monthly earnings; from an adequacy perspective, the system is therefore tilted in their favor. A reform proposal that increased the replacement rate of lower earners relative to higher earners would be deemed more progressive than one that did not. By linking benefits to earnings, which link in turn to contributions, Social Security also incorporates the principle of individual equity. Under the current program, people who pay higher taxes generally collect higher benefits upon entitlement but not directly proportionally higher. Studies that reflect the equity perspective focus on whether, over their lifetimes, beneficiaries can expect to receive a fair return on their contributions or get their money’s worth from the system. These studies use such measures as lifetime benefit-to-tax ratios, internal rates of return, and net lifetime benefit-to-earnings ratios. The benefit-to-tax ratio measure compares the present value of Social Security lifetime benefits with the present value of lifetime Social Security taxes. The internal rate of return can be thought of as the interest rates individuals effectively receive on their lifetime contributions, given their lifetime Social Security benefits. Net lifetime benefit-to-earnings ratios show lifetime benefits minus lifetime taxes relative to lifetime earnings. This measure, also called the average rate of net taxation, borrows from the public finance literature the idea that equity measures ought to contain earnings. From an equity perspective, examining the distribution of these measures helps gauge the distributional effects of Social Security or reform options. Many studies adopting the equity perspective find, for example, that the current program favors lower earners because this group enjoys higher rates of return and benefits whose value is larger relative to the value of their contributions. Other studies confirm this result by observing that the net benefit-to-earnings ratio is higher for low earners. If under a reform proposal, these measures increased more for lower earners, then that system would be considered more progressive. Reform options that involve general revenue transfers to ensure solvency make it difficult to evaluate progressivity from an equity perspective because they do not typically specify how such transfers are to be financed or who will eventually bear their burden. Yet general revenue transfers implicitly require future tax increases, spending cuts, or a combination of both, all of which have substantial distributional consequences. Such consequences are difficult to evaluate analytically. Without knowing who will bear the costs of financing these transfers, the equity perspective cannot accurately determine how well lower earners fare relative to higher earners in a given system or across proposed reforms. Even if we knew how the tax burden of general revenues is distributed today, the tax system could change in the future in ways that would alter the distribution. Some proposals with individual account features, for example, involve general revenue transfers. They divert part of existing payroll tax revenues from traditional Social Security benefits and toward individual accounts. Consequently, to remain financially solvent, such proposals typically require additional resources from Treasury’s general fund for several years after implementation. Both the adequacy and the equity perspectives consider families or households, in addition to individuals, in assessing distributional effects. This is particularly relevant in the Social Security context because the program provides not only worker benefits to retired and disabled individuals, but also auxiliary benefits to current and former spouses, children, and surviving spouses. Household analysis has implications for progressivity. Most studies using equity measures find Social Security somewhat less progressive once workers and their dependents are combined in a single unit. This is largely due to the fact that some individuals with little or no earnings, hence “poor” by themselves, end up in high-earning households. The benefit they collect no longer counts as transfers to low earners. However, the household approach presents analytical challenges. Multiple divorces and marriages, for example, make it difficult to define “household” on a lifetime basis. Moreover, age differences between spouses, which imply different retirement dates, complicate the calculation of “total household benefit” at a given point in time. Nonetheless, researchers believe that aggregating workers and their dependents into households provides insight by giving a more complete picture of their well-being. Social Security’s distributional effects reflect program features, such as its benefit formula, and demographic patterns among its recipients, such as marriage between lower and higher earners. The benefit formula for retired workers favors lower earners by design, replacing a larger proportion of earnings for lower earners than for higher earners. Disability benefits use the same progressive benefit formula, and disability recipients are disproportionately lower lifetime earners. However, the extent to which these features favor lower earners may be offset to some degree by demographic patterns and other program features. Household formation reduces the system’s tilt toward lower-income people because some of the lower-earning individuals helped by the program, in fact, live in high- income households. Differences in mortality rates may reduce rates of return for lower earners and increase rates of return for higher earners. In order to help ensure adequate incomes in retirement, Congress designed Social Security’s benefit formula for retired workers to favor lower earners. When workers retire, Social Security uses their lifetime earnings records to determine their Primary Insurance Amount (PIA), on which initial monthly benefits are based. The PIA is determined by applying the Social Security benefit formula to a worker’s Average Indexed Monthly Earnings (AIME). The AIME is the monthly average of a worker’s 35 best years of earnings, with earnings before age 60 indexed to average wage growth. For workers who become eligible for benefits in 2004, PIA equals 90 percent of the first $612 dollars of AIME plus 32 percent of the next $3,077 dollars of AIME plus 15 percent of AIME above $3,689. Consequently, the benefit formula replaces a higher proportion of pre-retirement earnings for lower lifetime earners than for higher lifetime earners. Figure 1 shows replacement rates for illustrative workers under the current benefit formula. The replacement rate for the low earner is 49 percent, while the rate for the high earner is only around 30 percent. The Disability Insurance (DI) program, which provides benefits to workers who are no longer able to work because of severe long-term disabilities, also favors lower lifetime earners. Disability Insurance not only provides earnings replacement during the pre-retirement years but generally results in beneficiaries receiving higher benefits in retirement than they would have received if they had earned the same amount of money but had not received disability benefits. Disability Insurance favors lower earners because it uses the same progressive benefit formula as retired worker benefits and because DI recipients are more likely to be lower earners. Disability Insurance recipients are disproportionately lower lifetime earners because an inability to continue working is necessary to qualify for benefits. Also, researchers have found that individuals with lower levels of educational attainment are more likely to experience disability. An analysis of lifetime benefits using a microsimulation model illustrates DI’s tilt toward lower earners. To examine the distributional impact of DI, we simulated Social Security benefits for individuals born in 1985 under a scenario that pays retirement but not disability benefits and a scenario that pays all categories of Social Security benefits. Because simulations are sensitive to economic and demographic assumptions, it is more appropriate to compare benefits across the scenarios than to focus on the actual estimates themselves. Median lifetime Social Security benefits are 33 percent higher under the scenario that pays all types of Social Security benefits than under the scenario that does not pay disability benefits, with 30 percent of individuals receiving greater lifetime Social Security benefits due to the DI program. According to these simulations, DI increases median lifetime Social Security benefits for workers in the lowest fifth of lifetime earnings by 43 percent while increasing lifetime benefits for the top fifth by 14 percent (see fig. 2). Social Security favors lower earners less when considered from the household perspective. Some of the lower-earning individuals who gain from the benefit formula or disability benefits do not live in low-income households, because they are married to higher earners. The same is often true for lower earners who receive spouse and survivors benefits. Married individuals are eligible for the greater of their own worker benefits or 50 percent of their spouses’ benefits. Similarly, widows and widowers are eligible for the larger of their own worker benefits or 100 percent of their deceased spouses’ benefits. Because of the nature of spouses’ and survivors’ benefits, recipients are on average lower lifetime earners— effectively they must earn less than their spouses to qualify. However, many of the lower-earning individuals that the system favors through spouses’ and survivors’ benefits actually live at some point in higher- income households because of marriage. Some have suggested that household formation may have less of an impact on the degree to which Social Security favors lower earners in the future. Increased female labor force participation and changing marital patterns suggest there will be less earnings differences between spouses in the future as well as fewer people who are married long enough to qualify for spouses’ and survivors’ benefits. Consequently, there may be fewer instances of the system providing high replacement rates to low-earning spouses from high-income households. An analysis of simulated benefits and taxes illustrates how the system favors lower earners less when considered from the household perspective. For individuals born in 1985, figure 3 depicts the ratio of benefits received to taxes paid for the top and bottom fifths of earnings from an individual perspective and a household perspective. For example, the first bar indicates that individuals in the bottom fifth of earnings receive lifetime benefits that are 1.3 times higher than the lifetime taxes they paid to the program. When analyzed from an individual perspective, individuals are classified by their own lifetime earnings and ratios are calculated for their own taxes and benefits. When analyzed from a household perspective, individuals are classified by household earnings and ratios are calculated for household taxes and benefits. In both cases, benefit-to-tax ratios are higher for the bottom fifth than for the top fifth, suggesting that the system favors lower earners. However, the difference in the benefit-to-tax ratios is smaller when considered from the household perspective. The extent to which the benefit formula and disability benefits favor lower earners may be offset to the extent that lower earners have higher mortality rates than do higher earners. A number of studies suggest that lower earners do not live as long as higher earners. As a result, lower earners are likely to receive retirement benefits for fewer years than higher earners. Researchers have generally found that, to some degree, the relationship between mortality rates and earnings reduces rates of return for lower earners and increase rates of return for higher earners. Social Security taxes are levied on earnings up to a maximum level set each year, and earnings beyond the threshold are not counted when calculating benefits. In 2004, the cap on taxable earnings is $87,900, and in recent years about 6 percent of workers had earnings above the cap. Policy makers often argue that the cap helps higher earners because it results in their paying a smaller percentage of their earnings than do individuals whose earnings do not exceed the cap. Also, while the cap limits both lifetime contributions and benefits, it increases equity measures such as benefit-to-tax ratios and rates of return for high earners. If the cap were repealed, the additional contributions paid by high earners would only be partially reflected in increased benefits, because the benefit formula is weighted toward lower earners. Simulations illustrate that the cap on taxable earnings modestly favors higher earners for individuals born in 1985. We simulate benefits and taxes under a scenario with the cap on taxable earnings and one without the cap. Figure 4 shows household benefit-to-tax ratios by top and bottom fifth of earnings and top percentile of earnings. When the cap is removed, the median benefit-to-tax ratio for the bottom fifth remains unchanged and the ratio for the top fifth of earnings decreases from 0.61 to 0.59. Although 83 percent of households in the top fifth are affected by repealing the cap, the increase in median lifetime taxes, 8.9 percent, is almost offset by the increase in median lifetime benefits, 6.5 percent. However, the impact on very high earners is larger. According to these simulations, the median benefit-to-tax ratio for households in the top 1 percent of earnings decreases from 0.52 to 0.45 when the cap is removed, indicating that very high earners gain from the cap; the increase in median lifetime taxes paid by this group, 50.4 percent, is not offset as much by the increase in their median lifetime benefits, 34.4 percent. We analyzed three proposals that illustrate the variation in the potential distributional effects of different approaches to reform. CSSS Model 2 would create a new system of voluntary individual accounts while reducing Social Security’s defined benefits overall but increasing them for surviving spouses and lower earners. The Ferrara proposal would create a system of voluntary individual accounts that would ultimately be large enough to completely replace Social Security’s old-age benefits for workers and their spouses. The Diamond-Orszag proposal would restore long-term solvency without creating a new system of individual accounts by reducing benefits and increasing revenues while also increasing benefits for surviving spouses and lower earners. Under Model 2 of the President’s Commission to Strengthen Social Security, For individuals choosing to participate, the Social Security system would redirect 4 percentage points of the payroll tax (up to a $1,000 annual limit) into personal investment accounts. Participating individuals could access their accounts in retirement, but Social Security defined benefits would be reduced to reflect the amount diverted to their individual accounts. On net, benefits would increase for individuals whose accounts earned more than a 2 percent return beyond inflation. Social Security defined benefits would be lower than benefits promised under the current benefit formula. Changes to the benefit formula would slow the growth in initial benefits from wage growth to price growth. According to Social Security Administration’s (SSA) Office of the Chief Actuary, these formula changes apply to initial benefits for all types of beneficiaries, including disabled workers. Social Security defined benefits would be enhanced for certain surviving spouses and for low earners. When fully implemented, initial benefits for certain low-wage workers with steady work histories could be raised by as much as 40 percent. Beneficiaries who lived longer than their spouses would receive the larger of their own benefit or 75 percent of the benefit that would be received by the couple if both spouses were alive. We used simulations to examine how Model 2 might affect the distribution of Social Security benefits. We did not examine the distribution of equity measures such as benefit-to-tax ratios or rates of return, because the proposal’s individual account feature requires general revenue transfers. General revenue transfers are problematic when calculating equity measures because it is difficult to determine who ultimately pays for the additional financing. Because simulations are sensitive to economic and demographic assumptions, it is more appropriate to compare benefits across the scenarios than to focus on the actual estimates themselves. Since account participation is voluntary, we used two simulations to examine the effects of the Model 2 provisions, one with universal account participation (Model 2-100 percent) and one with no account participation (Model 2-0 percent). We also assumed that all account participants would invest in the same portfolios; consequently we did not capture any distributional effect that might occur if lower earners were to make different account participation or investment decisions than higher earners. We compared benefits under Model 2 with hypothetical benchmark policy scenarios that would achieve 75-year solvency either by only increasing payroll taxes or by only reducing benefits. The tax- increase, or “promised benefits,” benchmark scenario pays benefits defined by the current benefit formula and raises payroll taxes to bring the Social Security system into financial balance. The proportional benefit- reduction, or “funded benefits,” benchmark scenario maintains current tax rates and achieves financial balance by gradually phasing in proportional benefit reductions. In order to compare Model 2 with the benchmarks, we assumed all account participants convert their account balances at retirement into periodic monthly payments. We did not simulate other sources of retirement income, such as employer pensions or other individual retirement savings, and such sources may interact with Social Security policy. (See app. I for more details on the GEMINI microsimulation model, our benchmark policy scenarios, and our assumptions for CSSS Model 2.) Given our assumptions, our analysis suggests that Model 2 would favor lower earners somewhat more than the benchmark scenarios. Figure 5 shows the share of household lifetime benefits received by the bottom and top fifths of earnings for individuals born in 1985 for both Model 2 and for the promised and funded benefits scenarios. For example, households in the bottom fifth of earnings received about 12.5 percent of all lifetime benefits under both benchmark scenarios. According to our simulations, households in the bottom fifth of earnings would receive greater shares of lifetime benefits under both Model 2 scenarios than under the benchmark scenarios, while households in the top fifth of earnings would receive smaller shares under Model 2 than under the benchmarks. It should be noted that while the simulations suggest that the distribution of benefits under Model 2 is more progressive than under the benchmarks, this does not mean benefit levels are always higher for the bottom fifth under Model 2. (See fig. 6.) According to our simulations, median household lifetime benefits for the bottom fifth under Model 2-0 percent would be 3 percent higher than under the funded benefits scenario but 21 percent lower than under the promised benefits scenario. Median household lifetime benefits for the bottom fifth under Model 2-100 percent would be 26 percent higher than under the funded benefits scenario but 4 percent lower than under the promised benefits scenario. While Model 2 may improve the relative position of lower earners, it may not improve the adequacy of their benefits. To further understand how Model 2 distributes benefits toward lower earners, we examined the distributional effects of each of its core features. First we simulated a version of Model 2-100 percent that included the individual accounts and the reductions in Social Security defined benefits, but not the $1,000 cap on account contributions or the enhanced benefits for low earners and survivors. Next we simulated a version that included the defined-benefit reductions and the individual accounts with the $1,000 cap on account contributions. Finally, we simulated the complete Model 2- 100 percent scenario, which included the enhanced benefits for lower earners and survivors. Our analysis suggests that the effect of the individual accounts and defined benefit reductions, which favor higher earners, would be more than offset by the limit on account contributions and the enhanced benefits for lower earners and survivors. Figure 7 shows the distributional impact of each reform feature. First, we simulated adding the individual accounts and reducing Social Security defined benefits. The share of benefits received by the bottom fifth of earnings falls relative to the benchmarks by as much as a percentage point, and the share received by the top fifth increases by about 1.5 percentage points. Under this scenario, benefits from individual account balances effectively replace some of the benefits calculated from the Social Security benefit formula and the disability program. This shift favors higher earners because, unlike the benefit formula, accounts by themselves do not provide higher replacement rates for lower earners and because DI recipients are more likely to be lower earners. Figure 7 also shows the impact of the cap on contributions and the enhanced benefits for low earners and survivors. Adding the cap on contributions would increase the share of benefits for the lowest fifth of earnings by more than a percentage point and would reduce the top fifth’s share by two percentage points. The cap would reduce total benefits more for higher earners than for lower earners because higher earners have a greater proportion of earnings above the limit. As expected, adding the enhanced benefits for low earners and survivors also favors lower earners. The lowest fifth’s share of benefits increases by about a percentage point, and the top fifth’s share of benefits decreases by almost a percentage point. It should be emphasized that these simulations are only for individuals born in 1985, and the distributional impact of Model 2 could be different for individuals born in later years. For example, under the proposal, initial Social Security defined benefits only grow with prices, while initial benefits from account balances grow with wages. Since wages generally grow faster than prices, Social Security defined benefits will decline as a proportion of total benefits, reducing the importance of the progressive benefit formula, disability benefits, and the enhanced benefits for low earners and survivors. It should also be noted that the account feature of Model 2-100 percent likely exposes recipients to greater financial risk. Greater exposure to risk may not affect the shares of benefits received by the bottom and top fifths of earnings. However, greater risk may be more problematic for lower earners who likely have fewer resources to fall back on if their accounts perform poorly. The “Progressive Proposal for Social Security Personal Accounts,” offered by Peter Ferrara, would establish voluntary, progressive individual accounts and reduce the Social Security retirement and aged survivor benefits for those who participate. A governing board would administer the accounts centrally in a fashion similar to the Thrift Savings Plan for federal employees. Specifically, under the proposal, Account contributions would be redirected from the Social Security payroll tax. They would equal 10 percent of the first $10,000 of annual earnings and 5 percent of earnings over $10,000 up to the maximum taxable earnings level, which is $87,900 in 2004. The $10,000 threshold would increase annually according to Social Security’s national Average Wage Index. Participating workers would be guaranteed that the combined benefits from Social Security’s defined benefit and their personal accounts would at least equal the Social Security benefits that current law promises them, as long as they choose the default investment option. The default investment option would have an allocation of 65 percent in broad indexed equity funds and 35 percent in broad indexed corporate bond funds. Those who never participate in the personal account option would be provided benefits promised by the current system. To continue paying benefits while also making deposits to the accounts, funds would be transferred from the Treasury’s general fund. The accounts would eventually completely replace Social Security’s old- age benefits for workers and their spouses, under the assumptions for investment returns used by Social Security actuaries. Accordingly, the proposal anticipates reductions in the Social Security payroll tax in the long term that would be identical for all workers. Social Security benefits for workers who become disabled or who die before retirement would not be affected. Under the Ferrara proposal, no changes would be made to the Social Security defined benefits scheduled under current law for those who choose not to participate in the accounts or for whom the benefit guarantee would apply. In addition, benefits for disabled workers and those who die before retirement would remain in place, and the distributional effects of these parts of Social Security would remain largely unchanged. Thus, any changes to the distribution of benefits would occur through the individual accounts for those choosing the accounts. All workers would initially continue to pay payroll taxes at the same rate as under current law, which is the same for all earnings up to the maximum taxable earnings. At the same time, lower earners would have larger contributions made from the payroll tax to their voluntary individual accounts. As a result, holding all else equal, the annuities that lower earners could receive from their accounts would replace a higher share of their pre-retirement earnings than annuities for higher earners. However, without rigorous quantitative analysis, it remains unclear how the distributional effects of the accounts would compare with and interact with the effects of the current system. In particular, actual investment returns could vary depending on individuals’ investment choices or on market performance, and in some cases returns may not be high enough to completely replace Social Security benefits, in which case the guarantee would apply. The Ferrara proposal also would have significant distributional effects from an equity perspective due to its revenue provisions. The general revenue transfers needed to cover the transition to individual accounts could have substantial effects on rates of return and other equity measures. Also, once the transition is complete and it becomes possible under the proposal to reduce payroll taxes, such tax reductions would also affect equity measures and how they are distributed. A proposal offered by Peter Diamond and Peter Orszag would restore Social Security’s long-term solvency by increasing revenues and decreasing benefits while also increasing benefits for selected old-age survivors and low earners. Also provisions in the proposal ensure that benefits in the aggregate are not reduced for workers who become disabled and for the young survivors of workers who die before retirement. Specifically, under the proposal, Benefit reductions: Social Security benefits would decrease by having initial benefits grow at a slower rate to reflect expected gains in life expectancy. Benefits would decrease for higher earners through a change to the benefit formula. Benefits would decrease by an additional proportional 0.30 percent beginning in 2023. Revenue increases: Payroll taxes would gradually increase by raising the maximum earnings level subject to the payroll tax, which is $87,900 in 2004. Also, Social Security would cover all new state and local government employees. (This would increase revenues from the payroll tax immediately but would not result in additional benefit payments until the newly covered workers became eligible for benefits.) In addition, payroll taxes would increase 3 percentage points (divided equally between employees and employers) for all earnings above the maximum taxable earnings level. Benefit calculations would not reflect the additional earnings taxed under this provision. The tax on earnings above the maximum taxable earnings level would increase by an additional 0.51 percent annually beginning in 2023. Payroll taxes on earnings at or below the maximum taxable earnings level would increase by an additional 0.255 percent annually beginning in 2023. Benefit enhancements: Benefits would increase for lower earners through a new benefit formula for qualifying workers. This provision is conceptually similar to the enhanced benefit for lower earners under CSSS Model 2 but uses a different formula. Benefits would increase for old-age surviving spouses to 75 percent of the benefit the married couple would have received if both were still alive. This provision is conceptually similar to the enhanced survivor benefit under CSSS Model 2 but is specified somewhat differently. Benefits for those workers who become disabled and their dependents and for the young survivors of workers who die before retirement would increase under a “Super-COLA” through changes to the formula for calculating initial benefits, which would be recalculated each year benefits are received. This provision is designed so that the other reform provisions do not affect these beneficiaries. The Diamond-Orszag proposal would make a variety of benefit changes that would affect the distribution of benefits. Reducing benefits to reflect expected gains in life expectancy would be a proportional reduction, decreasing benefits by the same percentage across all earnings levels. The additional reductions beginning in 2023 would also be proportional. Proportional reductions do not, by definition, change the share of benefits received by each segment of the earnings distribution. Still, they represent a downsizing of a redistributive benefit program. As a result the size of the redistributions would be smaller under these proportional reductions than under the current system, holding all else equal. However, in addition, the proposal contains another benefit reduction that affects only higher earners, which would result in their getting a smaller share of total benefits and in increasing shares for all other workers not affected by the reduction. Moreover, the proposal would increase benefits for lower earners and surviving aged spouses. The proposal also preserves benefits for workers who become disabled and for young the survivors of workers who die before retirement. These workers tend to be lower earners, so all of the proposal's benefit increases would generally increase the share of total benefits received by lower earners. Finally, the proposal includes a variety of revenue increases, most of which increase the tax burden on higher earners relative to lower earners. As a result, the distribution of rates of return and other equity measures would favor lower earners more and higher earners less than under the current system. By design, Social Security distributes benefits and contributions across workers and their families in a variety of ways. These distributional effects illustrate how the program balances the goal of helping ensure adequate incomes with the goal of giving all workers a fair deal on their contributions. Any changes to Social Security would potentially alter those distributional effects and the balance between those goals. Therefore, policy makers need to understand how to evaluate distributional effects of alternative policies. The various evaluation approaches reflect varying emphases on Social Security’s adequacy and equity goals, so the methodological choices are connected inherently to policy choices. Regardless of policy perspectives, methodological issues such as the effects of general revenue transfers muddy distributional analysis. Moreover, greater progressivity is not the same thing as greater adequacy. Under some reform scenarios, Social Security could distribute benefits more progressively than current law yet provide lower, less adequate benefits. At the same time, our analysis shows that reform provisions that favor lower earners can offset other provisions that disfavor them. In addition, greater progressivity may result in less equity. As a result, any evaluations should consider a proposal’s provisions taken together as a whole. Moreover, distributional effects are only one of several kinds of effects proposals would have. A comprehensive evaluation is needed that considers a range of effects together. In our criteria for evaluating reform proposals, progressivity is just one of several aspects of balancing adequacy and equity. We provided SSA an opportunity to comment on the draft report. The agency provided us with written comments, which appear in Appendix II. In general, SSA concurred with the methodology, overall findings and conclusions of the report, noting that our modeling results are consistent with SSA’s internal efforts to model the features of Model 2 of the Commission to Strengthen Social Security. Many of SSA’s comments, for example those regarding progressivity measures and equity measure methodology, involve clarifying our presentation or conducting additional analyses to provide more consistency with other analyses or to extend the readers’ understanding. We revised our draft in response to these suggestions as appropriate, given our time and resource constraints. SSA agreed with GAO’s discussion of the complications involved in applying equity measures to reform proposals that include general revenue transfers and concurred that a satisfactory resolution of the issue is complex and methodologically troublesome. SSA suggested some additional analysis relying on some simplifying assumptions, for example assuming any general revenue transfer is financed through a payroll tax increase, that one could use to tackle the problem. We agree that despite its methodological complexity, the use of general revenue transfers raises many important distributional issues. However, the analytical difficulties raised by this issue would require thoughtful and deliberate research that was beyond the scope of the current study, given our time and resource constraints. SSA also had suggestions concerning our choice of benchmark policy scenarios against which to compare reform proposals. For example, while SSA is supportive of GAO’s development of standard benchmarks, they note that our benchmarks do not match the sustainable solvency achieved by Model 2 beyond 75 years and that this distinction should be noted in the report. SSA also suggests that a third benchmark be considered that would characterize a scenario where no reform action is taken and the program could only pay benefits equal to incoming payroll tax revenues. As we have noted in the past, we agree that sustainable solvency is an important objective and that the GAO benchmarks do not achieve solvency beyond the 75 year period. We share SSA’s emphasis on the importance of careful and complete annotation and we have clarified our report, where appropriate, to minimize the potential for misinterpretation or misunderstanding on this matter. However, in this case, we did not revise our benchmarks because we recognized (along with SSA actuaries we consulted early in the assignment) that the use of sustainable benchmarks would not have a noticeable effect on an analysis of the shape of the distribution of benefits and taxes. Regarding the use of a “no action” benchmark, we continue to believe that comparing a proposal that starts relatively soon to one that posits that no legislative action is ever taken does not provide the consistent bounds for reform captured by our current benchmarks. Appendix I of our report discusses the construction and rationale for the benchmarks used in this report. In our view, our set of benchmarks provides a fair and objective measuring stick with which to compare alternative proposals. SSA also provided technical and other clarifying comments that we incorporated as appropriate. We will send copies of this report to appropriate congressional committees and other interested parties. Copies will also be made available to others upon request. In addition, the report will be available at no charge on GAO’s Web site at http://www.gao.gov. Please contact me at (202) 512-7215, Charles Jeszeck at (202) 512-7036, or Ken Stockbridge at (202) 512-7264, if you have any questions about this report. Other major contributors include Gordon Mermin and Seyda Wentworth. Genuine Microsimulation of Social Security and Accounts (GEMINI) is a microsimulation model developed by the Policy Simulation Group (PSG). GEMINI simulates Social Security benefits and taxes for large representative samples of people born in the same year. GEMINI simulates all types of Social Security benefits including retired workers’, spouses’, survivors’, and disability benefits. It can be used to model a variety of Social Security reforms including the introduction of individual accounts. GEMINI uses inputs from two other PSG models, the Social Security and Accounts Simulator (SSASIM), which has been used in numerous GAO reports, and the Pension Simulator (PENSIM), which has been developed for the Department of Labor. GEMINI relies on SSASIM for economic and demographic projections and relies on PENSIM for simulated life histories of large representative samples of people born in the same year and their spouses. 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 only provide very rough estimates of future incomes. However, these estimates may be useful for comparing future incomes across alternative policy scenarios and over time. For this report we used GEMINI to simulate Social Security benefits and taxes for 100,000 individuals born in 1985. Benefits and taxes were simulated under our tax-increase (promised benefits) and proportional benefit-reduction (funded benefits) benchmarks (described below) and under Model 2 of the President’s Commission to Strengthen Social Security (CSSS). We also simulated variations of these scenarios to examine the impact of disability benefits, the cap on taxable earnings, each feature of Model 2, and different assumptions on the return to equities. To examine lifetime earnings, benefits, and taxes on a household basis, we chose a “shared” concept that researchers have used with the MINT3 and DYNASIM microsimulation models. In years that individuals are married, we assign them half of their own earnings, benefits, and contributions and half of their spouses’ earnings, benefits, and contributions. In years that individuals are single, we assign them their entire earnings, benefits, and contributions. This technique accounts for household dynamics including divorce, remarriage, and widowhood. To facilitate our modeling analysis, we made a variety of assumptions regarding economic and demographic trends and how CSSS Model 2’s individual accounts would work. In choosing our assumptions, we focused our analysis to illustrate relevant points about distributional effects and hold equal as much as possible any variables that were either not relevant to or would unduly complicate that focus. As a result of these assumptions as well as issues inherent in any modeling effort, our analysis has some key limitations, especially relating to risk, individual account decisions, and changes over time. The simulations are based on economic and demographic assumptions from the 2003 Social Security trustees’ report. We used trustees’ assumptions for inflation, real wage growth, mortality decline, immigration, labor force participation, and interest rates. The simulations assumed that mortality rates vary by educational attainment and disability status. In every year, mortality rates implied by trustees assumptions are increased for those with lower levels of education and reduced for those with higher levels of education. For example, mortality rates are multiplied by 1.5 for women who do not complete high school, while rates are multiplied by 0.7 for women with four-year college degrees. Adjustment factors for education were chosen to calibrate life expectancy by demographic group with the MINT3 simulation model. Mortality rates are multiplied by a factor of 2 for Disability Insurance (DI) recipients. The adjustment factor for disability was chosen so PENSIM life histories produced aggregate results consistent with 2003 Social Security Trustees Report. Assuming constant adjustment factors over time does not capture any convergence in mortality rates as a birth cohort ages. It may be the case that differences in mortality rates across education levels may narrow by the time a birth cohort retires. If that is the case, our simulations overstate differences in life expectancy at retirement. Rather than model account participation, we instead simulate benefits under two scenarios, one where all individuals participate and another scenario where no one participates. As a result, we do not capture any distributional effects that might result from account participation varying by earnings level. For instance, if lower earners are less likely to participate in the individual accounts, then our simulations may overstate their share of benefits, as account participation is likely to increase benefits. Like the analysis of Model 2 by OCACT we assume all individuals invest in the same portfolio: 50 percent in equities, 30 percent in corporate bonds, and 20 percent in Treasury bonds. We do not capture any distributional effects that might result if portfolio choice varies by earnings level. For instance, if lower earners were more risk averse and therefore choose more conservative portfolios, our simulations overstate the share of benefits for lower earners. We use the same assumptions for asset returns as OCACT: In all years real returns are 6.5 percent for equities, 3.5 percent for corporate bonds, and 3 percent for Treasury bonds, with an annual administrative expense of 30 basis points. For sensitivity analysis, we simulated a version of Model 2 that assumed a 4.9 percent real return to equities, a version that assumed an 8.7 percent real return to equities, and a version that assumed the return to equities varied stochastically across individuals and over time. Shares of benefits by earnings quintile were similar under all specifications. However, if portfolio choice or participation in accounts varied by earnings quintile, then shares of benefits might be more sensitive to rates of return. In order to compare account balances with Social Security defined benefits, we follow the assumption of OCACT that individuals fully annuitize their account balances at retirement. We assume individuals purchase inflation-indexed annuities, while married individuals purchasing inflation-indexed joint and two-thirds survivor annuities. The commission proposal, however, also allows participants to access their accounts through regular monthly withdrawals or through lump sum distributions if their monthly benefits (Social Security defined benefits and any annuity payments) are enough to keep them out of poverty. Given that few defined-contribution pension recipients currently choose to annuitize, it is possible that many retirees under Model 2 would not annuitize their accounts. To the extent that withdrawal decisions vary by earnings level, there may be distributional consequences that our simulations do not capture. For instance, some people may withdraw money too quickly, leaving themselves with inadequate income later in retirement, and such behaviors could vary by earnings level. Our quantitative analysis does not reflect differences in risk across policy scenarios. Because of financial market fluctuations, individual accounts likely expose recipients to greater financial risk. For sensitivity analysis, we simulated a version of Model 2 where the return to equities varied stochastically across individuals and over time. Stochastic rates of return had very little impact on shares of benefits received by earnings quintiles. However, greater risk may be more problematic for lower earners, who likely have fewer resources to fall back on if their accounts perform poorly. Consequently, lower earners may be more risk averse and therefore suffer greater utility loss from increased risk. We simulated benefits for individuals born in 1985 because Model 2’s reform features would be almost fully phased in for such workers. However, the distributional effects of Model 2 might change over time. For example, under the proposal initial Social Security defined benefits only grow with prices, while initial benefits from account balances grow with wages. Since wages generally grow faster than prices, Social Security defined benefits will decline as a proportion of total benefits, reducing the importance of the progressive benefit formula, disability benefits, and the enhanced benefits for low earners and survivors. To capture the distributional impact of pre-retirement mortality, we calculated benefit-to-tax ratios and lifetime benefits for all sample members who survived past age 24. However, our measure of well-being, lifetime earnings, may not be the best way to assess the well-being of those who die before retirement. Some high-wage workers are classified as low lifetime earners simply because they did not live very long, and consequently our analysis overstates the degree to which those who die young are classified as low earners. As a result, our measures underestimate the degree to which Social Security favors lower earners under all of the scenarios we analyze. For sensitivity analysis, we also calculated benefit-to-tax ratios and lifetime benefits only for sample members who lived to age 67 and beyond. While all of the measures of progressivity were lower, the findings were unchanged as the relationships across all of the scenarios remained the same. To assess the reliability of simulated data from GEMINI, we reviewed PSG’s published validation checks, examined the data for reasonableness and consistency, preformed sensitivity analysis, and compared our results with a study by the actuaries at the Social Security Administration. PSG has published a number of validation checks of its simulated life histories. For example, simulated life expectancy is compared with projections from the Social Security Trustees; simulated benefits at age 62 are compared with administrative data from SSA; and simulated educational attainment, labor force participation rates, and job tenure are compared with values from the Current Population Survey. We found that simulated statistics for the life histories were reasonably close to the validation targets. For sensitivity analysis, we simulated benefits and taxes for policy scenarios under a number of alternative specifications including higher and lower returns to equities, stochastic returns to equities, and limiting the sample to those who survive to retirement. Our findings were consistent across all specifications. Finally, we compared our results with those in a memo from the actuaries at the Social Security Administration. Our finding that the lowest earnings quintile receives a greater share of benefits under Model 2-100 percent than under promised benefits is consistent with the actuaries’ projections of benefits for illustrative high- and low- earning couples in 2052. Also, in a previous report we found that GEMINI simulations of promised Social Security benefits were similar to MINT simulations for the 1955 birth cohort. We conclude from our assessment that simulated data from GEMINI are sufficiently reliable for the purposes of this report, particularly since we focus on the differences in simulated measures across scenarios, as opposed to the actual estimates themselves. 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 2005 and 2035 to strike a balance between the size of the incremental reductions each year and the size of the ultimate reduction. At our request, SSA actuaries scored our benchmark policies and determined the parameters for each that would achieve 75-year solvency. Table 1 summarizes our benchmark policy scenarios. For our benefit- reduction scenarios, the actuaries determined these parameters assuming that disabled and survivor benefits would be reduced on the same basis as retired worker and dependent benefits. If disabled and survivor benefits were not reduced at all, reductions in other benefits would be deeper than shown in this analysis. 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, etc.); b. maintaining a proportional level of income transfers in dollars; 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. 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. 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. For our analysis, we apply benefit reductions in our benchmarks very generally to all types of benefits, including disability and survivors’ benefits as well as old-age benefits. Our objective is to find policies that achieve solvency while reflecting the distributional effects of the current program as closely as possible. Therefore, it would not be appropriate to reduce some benefits and not others. If disability and survivors’ benefits were not reduced at all, reductions in other benefits would be deeper than shown in this analysis. We selected a phase-in period that begins with those reaching age 62 in 2005 and continues for 30 years. We chose this phase-in period to achieve a balance between two competing objectives: (1) minimizing the size of the ultimate benefit reduction and (2) minimizing the size of each year’s incremental reduction to avoid “notches,” or unduly large incremental reductions. Notches create marked inequities between beneficiaries close in age to each other. Later birth cohorts are generally agreed to experience lower rates of return on their contributions already under the current system. Therefore, minimizing the size of the ultimate benefit reduction would also minimize further reductions in rates of return for later cohorts. The smaller each year’s reduction, the longer it will take for benefit reductions to achieve solvency, and in turn the deeper the eventual reductions will have to be. However, the smallest possible ultimate reduction would be achieved by reducing benefits immediately for all new retirees by over 10 percent; this would create a huge notch. Our analysis shows that a 30-year phase-in should produce incremental annual reductions that would be relatively small and avoid significant notches. In contrast, longer phase-in periods would require deeper ultimate reductions. In addition, we feel it is appropriate to delay the first year of the benefit reductions for a few years because those within a few years of retirement would not have adequate time to adjust their retirement planning if the reductions applied immediately. The Maintain Tax Rates (MTR) benchmark in the 1994-96 Advisory Council Report also provided for a similar delay. Finally, the timing of any policy changes in a benchmark scenario should be consistent with the proposals against which the benchmark is compared. The analysis of any proposal assumes that the proposal is enacted, usually within a few years. Consistency requires that any benchmark also assume enactment of the benchmark policy in the same time frame. Some analysts have suggested using a benchmark scenario in which Congress does not act at all and the trust funds become exhausted. However, such a benchmark assumes that no action is taken while the proposals against which it is compared assume that action is taken, which is inconsistent. It also seems unlikely that a policy enacted over the next few years would wait to reduce benefits until the trust funds are exhausted; such a policy would result in sudden, large benefit reductions and create substantial inequities across generations. When workers retire, become disabled, or die, Social Security uses their lifetime earnings records to determine each worker’s PIA, on which the initial benefit and auxiliary benefits are based. The PIA is the result of two elements—the Average Indexed Monthly Earnings (AIME) and the benefit formula. The AIME is determined by taking the lifetime earnings earnings record, indexing it, and taking the average of the highest 35 years of indexed wages. To determine the PIA, the AIME is then applied to a step- like formula, shown here for 2004. PIA = 90% (AIME $612) + 32% (AIME > $612 and $3689) + 15% (AIME > $3689) 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 3 PIA formula factors in year t and x = constant proportional formula factor reduction. The value of x is calculated to achieve 75-year solvency, given the chosen phase-in period and scope of reductions. The formula for this reduction specifies that the proportional reduction is always taken as a proportion of the current law factors rather than the factors for each preceding year. This maintains a constant rate of benefit reduction from year to year. In contrast, taking the reduction as a proportion of each preceding year’s factors implies a decelerating of the benefit reduction over time because each preceding year’s factors get smaller with each reduction. To achieve the same level of 75-year solvency, this would require a greater proportional reduction in earlier years because of the smaller reductions in later years. The proportional reduction hits lower earners hard because the constant x percent of the higher formula factors results in a larger percentage point reduction over the lower earnings segments of the formula. For example, in a year when the cumulative size of the proportional reduction has reached 10 percent, the 90 percent factor would then have been reduced by 9 percentage points, the 32 percent factor by 3.2 percentage points, and the 15 percent factor by 1.5 percentage points. As a result, earnings in the first segment of the benefit formula would be replaced at 9 percentage points less than the current formula, while earnings in the third segment of the formula would be replaced at only 1.5 percentage points less than the current formula. Hypothetical-account reduction: Each formula factor is reduced by annually subtracting a constant amount that is the same for all factors in all years. That is, where y = constant formula factor reduction. The value of y is calculated to achieve 75-year solvency, given the chosen phase-in period and scope of reductions. This reduction results in equal percentage point reductions in the formula factors, by definition, and subjects earnings across all segments of the PIA formula to the same reduction. Therefore, it avoids hitting lower earners as hard as the proportional reduction. We call this a hypothetical-account reduction because it has the same effect as a benefit reduction based on using a hypothetical account. In fact, we developed this benchmark first using a hypothetical-account approach and then discovered it can be reduced to a simple change in the PIA formula. Hypothetical-account calculations have become a common way to offset benefits under individual account proposals, such as those by the President’s Commission to Strengthen Social Security. Such proposals reduce Social Security’s defined benefit to reflect the fact that contributions have been diverted from the trust funds into the individual accounts. The account contributions are accumulated in a hypothetical account at a specified rate of return and then converted to an annuity value. We used a hypothetical-account offset in our 1990 analysis of a partial privatization proposal. In that analysis, we were charged with finding a benefit reduction that would leave the redistributive effects of the program unchanged while allowing a diversion of 2 percentage points of contributions into individual accounts. We demonstrated the distributional neutrality of this benefit reduction by showing that if all individuals earned exactly the cohort rate of return on their individual accounts, then their income under the proposal from Social Security and the new accounts would be exactly the same as under the current system. For the purposes of developing a benefit-reduction benchmark, we applied the hypothetical-account approach even though there are no actual individual accounts. From our previous analysis, we realized a hypothetical-account approach may produce distributional effects that might in some sense be more neutral than other reduction approaches and therefore worth studying as an alternative. In effect, using it to calculate a benefit-reduction benchmark implies calculating an annuity value of the percent of payroll that represents the system’s revenue shortage. As it turns out mathematically, the hypothetical-account approach to reducing benefits translates into PIA formula factor changes. Such a benefit reduction is proportional to the AIME, not to the PIA, because the contributions to a hypothetical account are proportional to earnings. Therefore, a benefit reduction based on such an account would also be proportional to earnings; that is, Benefit reduction = y AIME Therefore, the new PIA would be PIAnew =(90% - y) AIME + (32% - y) AIME + (15% - y) AIME Thus, the reduction from a hypothetical account can be translated into a change in the PIA formula factors. Because this reduction can be described as subtracting a constant amount from each PIA formula factor, it is reasonably transparent. In our analysis of CSSS Model 2, we found that Model 2 had a benefit distribution that was very close to our hypothetical-account benefit- reduction benchmark. For example, households in the bottom fifth of earnings received about 13.8 percent of all lifetime benefits under Model 2, compared with 13.5 percent under the hypothetical-account benefit- reduction benchmark. In this report, we present the results using the proportional benefit-reduction benchmark because this benefit-reduction approach is more easily understood. Table 2 summarizes the features of our three benchmarks. Social Security Reform: Analysis of a Trust Fund Exhaustion Scenario. GAO-03-907. Washington, D.C.: July 29, 2003. Social Security and Minorities: Earnings, Disability Incidence, and Mortality Are Key Factors That Influence Taxes Paid and Benefits Received. GAO-03-387. Washington, D.C.: Apr. 23, 2003. Social Security Reform: Analysis of Reform Models Developed by the President's Commission to Strengthen Social Security. GAO-03-310. Washington, D.C.: Jan. 15, 2003. Social Security: Program’s Role in Helping Ensure Income Adequacy. GAO-02-62. Washington, D.C.: Nov. 30, 2001. Social Security Reform: Potential Effects on SSA’s Disability Programs and Beneficiaries. GAO-01-35. Washington, D.C.: Jan. 24, 2001. Social Security Reform: Information on the Archer-Shaw Proposal. GAO/AIMD/HEHS-00-56. Washington, D.C.: Jan. 18, 2000. Social Security: Evaluating Reform Proposals. GAO/AIMD/HEHS-00-29. Washington, D.C.: Nov. 4, 1999. Social Security: Issues in Comparing Rates of Return with Market Investments. GAO/HEHS-99-110. Washington, D.C.: Aug. 5, 1999. Social Security: Criteria for Evaluating Social Security Reform Proposals. GAO/T-HEHS-99-94. Washington, D.C.: Mar. 25, 1999. Social Security: Different Approaches for Addressing Program Solvency. GAO/HEHS-98-33. Washington, D.C.: July 22, 1998. Social Security Financing: Implications of Government Stock Investing for the Trust Fund, the Federal Budget, and the Economy. GAO/AIMD/HEHS-98-74. Washington, D.C.: Apr. 22, 1998. Social Security: Restoring Long-Term Solvency Will Require Difficult Choices. GAO/T-HEHS-98-95. Washington, D.C.: Feb. 10, 1998.

Summary: Under the current Social Security benefit formula, retired workers receive benefits that equal about 50 percent of pre-retirement earnings for a low-wage worker but only about 30 percent for a relatively high-wage worker. Factors other than earnings also influence the distribution of benefits, including the program's provisions for disabled workers, spouses, children, and survivors. Changes in the program over time also affect the distribution of benefits across generations. Social Security faces a long-term structural financing shortfall. Program changes to address that shortfall could alter the way Social Security's benefits and revenues are distributed across the population and affect the income security of millions of Americans. To gain a better understanding of the distributional effects of potential program changes, the Chairman and Ranking Minority Member of the Senate Special Committee on Aging asked us to address (1) how to define and describe "progressivity," that is, the distribution of benefits and taxes with respect to earnings level, when assessing the current Social Security system or proposed changes to it; (2) what factors influence the distributional effects of the current Social Security program; and (3) what would be the distributional effects of various reform proposals, compared with alternative solvent baselines for the current system. Two distinct perspectives on Social Security's goals suggest different approaches to measuring "progressivity," or the distribution of benefits and taxes with respect to earnings level. Both perspectives provide valuable insights. An adequacy perspective focuses on benefit levels and how well they maintain pre-entitlement living standards. An equity perspective focuses on rates of return and other measures relating lifetime benefits to contributions. Both perspectives examine how their measures are distributed across earnings levels. However, equity measures take all benefits and taxes into account, which is difficult for reform proposals that rely on general revenue transfers because it is unclear who pays for those general revenues. The Social Security program's distributional effects reflect both program features and demographic patterns among its recipients. In addition to the benefit formula, disability benefits favor lower earners because disabled workers are more likely to be lower lifetime earners. In contrast, household patterns reduce the system's tilt toward lower earners, for example, when lower earners have high-earner spouses. The advantage for lower earners is also diminished by the fact that they may not live as long as higher earners and therefore would get benefits for fewer years on average. Proposals to alter the Social Security program would have different distributional effects, depending on their design. Model 2 of the President's Commission to Strengthen Social Security proposes new individual accounts, certain benefit reductions for all beneficiaries, and certain benefit enhancements for selected low earners and survivors. According to our simulations, the combined effect could result in lower earners receiving a greater share of all benefits than promised or funded under the current system if all workers invest in the same portfolio.