November 13, 2013

Mandatory SpendingOption 15

Function 650 - Social Security

Link Initial Social Security Benefits to Average Prices Instead of Average Earnings

Change in Outlays                        
  Implement pure price indexing 0 0 -0.1 -0.7 -2.2 -5.1 -9.7 -16.2 -24.6 -34.8 -3.0 -93.4
  Implement progressive price indexing 0 0 -0.1 -0.5 -1.4 -3.1 -6.0 -9.9 -15.1 -21.4 -2.0 -57.5

Note: This option would take effect in January 2015.

Social Security benefits for retired and disabled workers are based on their average earnings over a lifetime. The Social Security Administration uses a statutory formula to compute a worker’s initial benefits, and through a process known as wage indexing, the benefit formula changes each year to account for economywide growth of wages. Average initial benefits for Social Security recipients therefore tend to grow at the same rate as do average wages, and such benefits replace a roughly constant portion of wages. (After people become eligible for benefits, their monthly benefits are adjusted annually to account for increases in the cost of living but not for further increases in wages.)

One approach to constrain the growth of Social Security benefits would be to change the computation of initial benefits so that the real (inflation-adjusted) value of average initial benefits did not rise over time. That approach, often called “pure” price indexing, would allow increases in average real wages to result in higher real Social Security payroll taxes but not in higher real benefits. The first alternative in this option takes that approach. It would link the growth of initial benefits to the growth of prices (as measured by changes in the consumer price index for all urban consumers) rather than to the growth of average wages, beginning with participants who became eligible for benefits in 2015.

That alternative would reduce federal outlays by $93 billion through 2023, the Congressional Budget Office estimates. By 2038, scheduled Social Security outlays would be reduced by 18 percent relative to what would occur under current law; when measured as a percentage of total economic output, the reduction would be 1.1 percentage points, as outlays would decline from 6.2 percent to 5.1 percent of gross domestic product.

Under pure price indexing, the reduction in payments relative to those that are scheduled to be paid under current law would be larger for each successive cohort of beneficiaries; the extent of the reduction would be determined by the growth of average real wages. For example, if real wages grew by 1.4 percent annually (approximately the rate underlying CBO’s long-term Social Security projections), workers who were newly eligible for benefits in the first year the policy was in effect would receive about 1.4 percent less than they would have received under the current rules; those becoming eligible in the second year would receive 2.8 percent less; and so on. The actual incremental reduction would vary from year to year, depending on the growth of real earnings. Under pure price indexing, people newly eligible for benefits in 2038, CBO estimates, would experience a reduction in benefits of about one-third relative to the benefits scheduled under current law.

Another approach, called “progressive” price indexing, would retain the current benefit formula for workers who had lower earnings and would reduce the growth of initial benefits for workers who had higher earnings. Currently, the formula for calculating initial benefits is structured so that workers who have higher earnings receive higher benefits, but the benefits paid to workers with lower earnings replace a larger share of their earnings.

Under the alternative with progressive price indexing in this option, initial benefits for the 30 percent of workers with the lowest lifetime earnings would increase with average wages, as they are currently slated to do, whereas initial benefits for other workers would increase more slowly, at a rate that depended on their position in the distribution of earnings. For example, for workers whose earnings put them at the 31st percentile of the distribution, benefits would rise only slightly more slowly than average wages, whereas for the highest earners, benefits would rise with prices—as they would under pure price indexing. Thus, under progressive price indexing, the initial benefits for most workers would increase more quickly than prices but more slowly than average wages. As a result, the benefit formula would gradually become flatter, and after about 60 years, everyone in the top 70 percent of earners would receive the same monthly benefit. A partially flat benefit formula would represent a significant change from Social Security’s traditional structure, under which workers who pay higher taxes receive higher benefits.

Progressive price indexing would reduce scheduled Social Security outlays less than would pure price indexing, and beneficiaries with lower earnings would not be affected. Real annual average benefits would still increase for all but the highest-earning beneficiaries. Benefits would replace a smaller portion of affected workers’ earnings than they would under current law but a larger portion than they would under pure price indexing.

A switch to progressive price indexing would reduce federal outlays by $58 billion through 2023, CBO estimates. By 2038, outlays for Social Security would be reduced by 10 percent; when measured as a percentage of total economic output, the reduction would be 0.6 percentage points, as outlays would fall from 6.2 percent to 5.6 percent of gross domestic product.

Under both approaches, the reductions in benefits relative to those under current law would be greatest for beneficiaries in the distant future. Those beneficiaries, however, would have had higher real earnings during their working years and thus a greater ability to save for retirement.

An advantage of both approaches in this option is that, although they would reduce outlays for Social Security compared with those scheduled to be paid under current law, average inflation-adjusted benefits in the program would not decline over time. If the pure price-indexing approach was adopted, future beneficiaries would generally receive the same real monthly benefit paid to current beneficiaries, and they would, as average longevity increased, receive larger total lifetime benefits.

But because benefits would no longer be linked to average wages, a disadvantage of both approaches is that affected beneficiaries would no longer share in overall economic growth. As a result, benefits would replace a smaller portion of workers’ earnings than they do today. Moreover, relative to currently scheduled benefits, reductions would be largest during periods of high wage growth.