The Social Security program is the foundation of the nation’s retirement income system. Since 1940, Social Security has been providing benefits to the nation’s eligible retired workers and their dependents. In addition to retired worker benefits, Social Security also provides protection for covered workers with severe disabilities and their dependents. Also, spouses and children of deceased workers may receive Social Security survivor benefits. The program is financed largely on a pay-as-you-go basis, with payroll taxes from today’s workers paying the benefits of today’s beneficiaries. Demographic trends indicate that the Social Security program will begin to experience a long-term financing problem after about 2013, when benefit payments will start exceeding cash revenues. The aging baby boom generation will be followed by a relatively smaller work force that will have to support a relatively larger group of retirees. This trend, combined with the increasing longevity of the elderly, will significantly drive up the costs of maintaining the program. Without action to raise program revenues or cut program spending, the Social Security Trust Funds will be exhausted by 2032. Proposals being considered for resolving the future solvency problem range from making adjustments to the tax and benefit structure of the current program to introducing features such as individual accounts that could substantially alter the existing program structure. Despite these differences, policymakers and Social Security experts agree that taking action soon is desirable to alleviate impacts on workers and beneficiaries. About 44 million people receive Social Security benefits today, and about 147 million covered workers pay Social Security payroll taxes. More than 40 percent of the cash income of those aged 65 and older comes from Social Security benefits, and over 60 percent of this population receives at least half their income from Social Security benefits. For 15 percent of this population, Social Security benefits are the only source of cash income. The Social Security program is one reason that poverty rates among the nation’s elderly have fallen dramatically—an estimated 39 percentage points since 1935. Social Security revenues come from three main sources: (1) payroll taxes of 12.4 percent on covered earnings (up to $68,400 in 1998) split equally between employees and their employers and paid in full by the self-employed, (2) income taxes on up to one-half an individual’s or couple’s Social Security benefits when total income exceeds certain thresholds, and (3) interest earnings on U.S. Treasury securities held by the Trust Funds. Program revenues in 1997 totaled $457.7 billion, of which almost 90 percent came from payroll taxes, about 1.7 percent from the income taxation of Social Security benefits, and 10 percent from interest on the Trust Funds’ assets. The share coming from the income taxation of benefits is expected to grow because the income thresholds at which benefits become taxable are not indexed. The portion coming from interest on the Trust Funds will increase until about 2020 and then fall dramatically as the Trust Funds redeem securities to help pay benefits. Social Security’s benefit structure has evolved and expanded considerably over time. Under the original 1935 Social Security Act, only retired workers meeting specified conditions were eligible for monthly benefits. Benefits under the original act had a strong “individual equity” component—that is, individual benefits were positively related to lifetime earnings. Benefits also contained a “social adequacy” component—that is, they were proportionately larger, but absolutely smaller, for those with relatively low lifetime earnings. Currently, benefits are calculated using the 35 years of highest earnings, not total lifetime earnings, and benefits are provided to workers’ spouses, children, and survivors, who may not have worked for pay. These changes improved the social adequacy component of the benefit structure. The appropriate balance between individual equity and social adequacy is a fundamental issue surrounding Social Security’s benefit structure and reflects the extent to which the program redistributes income among workers and beneficiaries. Social Security was originally designed to provide benefits only to retired workers. Major expansions were made to the program in 1939, when the Congress provided “auxiliary” benefits for workers’ eligible wives, children, and survivors. In 1956, it provided benefits for disabled workers and their eligible dependents. Other amendments to the act have extended benefits to husbands, widowers, divorced spouses, and mothers and fathers (spouses under age 65 with benefit-eligible children in their care). Some beneficiaries are eligible to receive retired worker benefits on the basis of their own work record and are also eligible to receive a higher benefit on the basis of their current or former spouse’s work record. Essentially, these beneficiaries, who are called “dually entitled,” receive their own retired worker benefit and the difference between that and the higher auxiliary benefit. Table 1.1 shows the current benefit categories and the number of beneficiaries in each category. Calculating Social Security benefits is a three-step process. First, a worker’s covered earnings over his or her 35 years of highest earnings are identified. Social Security uses average indexed monthly earnings (AIME) as its measure of these “lifetime” covered earnings. Second, a progressive benefit formula is applied to these lifetime covered earnings to determine the benefit that will be payable to the worker at the normal retirement age (NRA), currently age 65. This NRA benefit, or primary insurance amount (PIA), is the basic amount used to determine the actual benefit for those receiving benefits on the basis of a worker’s earnings record. Finally, the benefit is adjusted for the age at which the beneficiary first receives the benefit. Auxiliary benefits are based on the worker’s PIA. The benefits for dually entitled people are based on their own PIAs. If the spouse or widow(er)’s benefit is higher, the dually entitled person’s benefit is supplemented to raise it to the amount of the spouse or widow(er)’s benefit. Currently, automatic benefit indexing provisions generally increase the worker’s PIA by an annual COLA. The COLA is equal to the rise in the consumer price index over a congressionally established period of a year. Indexing allows Social Security benefits to maintain the same purchasing power over the beneficiary’s retirement. Retirement income from most other sources is not fully indexed and thus tends to decline in real terms over time. Social Security is financed largely on a pay-as-you-go basis. Under this type of financing structure, the payroll tax revenues collected from today’s workers are used to pay the benefits of today’s beneficiaries. Under a strict pay-as-you-go financing system, any excess of revenues over expenditures is credited to the program’s trust funds, which function as a contingency reserve. Social Security’s Trust Funds reserve allows the government to manage the inevitable differences over time between revenues and expenditures. One reason the pay-as-you-go approach was initially used is that it required relatively small contributions at a time when the program was young and benefit payments were small. However, this structure required increasing contribution levels as the program matured and more beneficiaries with higher average benefits were added to the beneficiary rolls. In addition, the pay-as-you-go structure leaves the program and the federal government susceptible to financing problems when costs increase more than expected or revenues fail to meet expected levels, such as might occur with changing short-term economic conditions. Every year, Social Security’s Board of Trustees estimates the financial status of the program for the next 75 years using three sets of economic and demographic assumptions about the future. According to the intermediate set of these assumptions, the nation’s Social Security program will face solvency problems in the years ahead unless corrective actions are taken. The Social Security program is not in long-term actuarial balance. That is, Social Security revenues are not expected to be sufficient to pay all benefit obligations from 1998 to 2072. Without changing the current program, excess cash revenues from payroll and income taxes are expected to begin to decline substantially around 2008. By 2013—15 years from now—these cash revenues will be insufficient to pay all program costs. After 2013, Social Security will have to start redeeming some of its assets to obtain the cash needed to pay benefits. The Trust Funds are expected to be exhausted in 2032. The anticipated revenue shortfall over the next 75 years is estimated at $3 trillion, or an average annual shortfall of $40 billion (in 1997 dollars). This $3 trillion shortfall is based on the assumption that the Social Security program will continue under its current structure. That is, new workers will enter the system, pay payroll taxes (which will be matched by their employers), accrue benefit credits while working, and receive benefits when they retire. Even if revenue or expenditure adjustments necessary to reach 75-year balance were achieved, the financing problem still might not be permanently resolved. For the foreseeable future, each new 75-year projection period will have a higher long-term financing shortfall than the last. For example, suppose the payroll tax was raised sufficiently to reach balance, and the current actuarial assumptions were realized for the period 1998 through 2072. Under this scenario, the Trust Funds would have only about 1 year’s worth of benefits remaining in 2072. If the same actuarial assumptions continued to be used in each of the years between 1998 and 2072, the Trust Funds would continue to be expected to be exhausted shortly after 2072, but, beginning in 1999, the 75-year projections would show a long-term revenue shortfall for the program that would grow over time. The program has another, higher revenue shortfall estimate—about $9 trillion, as of October 1, 1997. This is the amount of the program’s unfunded benefit obligations—the accrued future benefit obligations that will not be able to be paid with assets currently in hand. A large unfunded liability in a government program financed primarily on a pay-as-you-go basis is generally not considered a problem because of the government’s authority to tax current workers to pay current benefits. Thus, current unfunded liabilities are passed onto future generations.