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. 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. 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.” 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. 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. 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.