Social Security Reform
Implications of Different Indexing Choices Gao ID: GAO-06-804 September 14, 2006The financing shortfall currently facing the Social Security program is significant. Without remedial action, program trust funds will be exhausted in 2040. Many recent reform proposals have included modifications of the indexing currently used in the Social Security program. Indexing is a way to link the growth of benefits and/or revenues to changes in an economic or demographic variable. Given the recent attention focused on indexing, this report examines (1) the current use of indexing in the Social Security program and how reform proposals might modify that use, (2) the experiences of other developed nations that have modified indexing, (3) the effects of modifying the indexing on the distribution of benefits, and (4) the key considerations associated with modifying the indexing. To illustrate the effects of different forms of indexing on the distribution of benefits, we calculated benefit levels for a sample of workers born in 1985, using a microsimulation model. We have prepared this report under the Comptroller General's statutory authority to conduct evaluations on his own initiative as part of a continued effort to assist Congress in addressing the challenges facing Social Security. We provided a draft of this report to SSA and the Department of the Treasury. SSA provided technical comments, which we have incorporated as appropriate.
Indexing currently plays a key role in determining Social Security's benefits and revenues, and is a central element of many proposals to reform the program. The current indexing provisions that affect most workers and beneficiaries relate to (1) benefit calculations for new beneficiaries, (2) the annual cost-of-living adjustment (COLA) for existing beneficiaries, and (3) the cap on taxable earnings. Some reform proposals would slow benefit growth by indexing the initial benefit formula to changes in prices or life expectancy rather than wages. Some would revise the COLA under the premise that it currently overstates inflation, and some would increase the cap on taxable earnings. National pension reforms in other countries have used indexing in various ways. In countries with high contribution rates that need to address solvency issues, recent changes have generally focused on reducing benefits. Although most Organisation for Economic Co-operation and Development (OECD) countries compute retirement benefits using wage indexing, some have moved to price indexing, or a mix of both. Some countries reflect improvements in life expectancy in computing initial benefits. Reforms in other countries that include indexing changes sometimes affect both current and future retirees. Indexing can have various distributional effects on benefits and revenues. Changing the indexing of initial benefits through the benefit formula typically results in the same percentage change in benefits across income levels regardless of the index used. However, indexing can also be designed to maintain benefits for lower earners while reducing or slowing the growth of benefits for higher earners. Indexing payroll tax rates would maintain scheduled benefit levels but reduce the ratio of benefits to contributions for younger cohorts. Finally, the effect of modifying the COLA would be greater the longer people collect benefits. Indexing raises considerations about the program's role, the treatment of disabled workers, and other issues. For example, indexing initial benefits to prices instead of wages implies that benefit levels should maintain purchasing power rather than maintain relative standards of living across age groups (i.e., replacement rates). Also, as with other ways to change benefits, changing the indexing of the benefit formula to improve solvency could also result in benefit reductions for disabled workers as well as retirees.
GAO-06-804, Social Security Reform: Implications of Different Indexing Choices
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Report to Congressional Addressees:
United States Government Accountability Office:
GAO:
September 2006:
Social Security Reform:
Implications of Different Indexing Choices:
Social Security Indexing:
GAO-06-804:
GAO Highlights:
Highlights of GAO-06-804, a report to congressional addressees
Why GAO Did This Study:
The financing shortfall currently facing the Social Security program is
significant. Without remedial action, program trust funds will be
exhausted in 2040. Many recent reform proposals have included
modifications of the indexing currently used in the Social Security
program. Indexing is a way to link the growth of benefits and/or
revenues to changes in an economic or demographic variable.
Given the recent attention focused on indexing, this report examines
(1) the current use of indexing in the Social Security program and how
reform proposals might modify that use, (2) the experiences of other
developed nations that have modified indexing, (3) the effects of
modifying the indexing on the distribution of benefits, and (4) the key
considerations associated with modifying the indexing. To illustrate
the effects of different forms of indexing on the distribution of
benefits, we calculated benefit levels for a sample of workers born in
1985, using a microsimulation model. We have prepared this report under
the Comptroller General‘s statutory authority to conduct evaluations on
his own initiative as part of a continued effort to assist Congress in
addressing the challenges facing Social Security. We provided a draft
of this report to SSA and the Department of the Treasury. SSA provided
technical comments, which we have incorporated as appropriate.
What GAO Found:
Indexing currently plays a key role in determining Social Security‘s
benefits and revenues, and is a central element of many proposals to
reform the program. The current indexing provisions that affect most
workers and beneficiaries relate to (1) benefit calculations for new
beneficiaries, (2) the annual cost-of-living adjustment (COLA) for
existing beneficiaries, and (3) the cap on taxable earnings. Some
reform proposals would slow benefit growth by indexing the initial
benefit formula to changes in prices or life expectancy rather than
wages. Some would revise the COLA under the premise that it currently
overstates inflation, and some would increase the cap on taxable
earnings.
National pension reforms in other countries have used indexing in
various ways. In countries with high contribution rates that need to
address solvency issues, recent changes have generally focused on
reducing benefits. Although most Organisation for Economic Co-operation
and Development (OECD) countries compute retirement benefits using wage
indexing, some have moved to price indexing, or a mix of both. Some
countries reflect improvements in life expectancy in computing initial
benefits. Reforms in other countries that include indexing changes
sometimes affect both current and future retirees.
Indexing can have various distributional effects on benefits and
revenues. Changing the indexing of initial benefits through the benefit
formula typically results in the same percentage change in benefits
across income levels regardless of the index used. However, indexing
can also be designed to maintain benefits for lower earners while
reducing or slowing the growth of benefits for higher earners. Indexing
payroll tax rates would maintain scheduled benefit levels but reduce
the ratio of benefits to contributions for younger cohorts. Finally,
the effect of modifying the COLA would be greater the longer people
collect benefits.
Indexing raises considerations about the program‘s role, the treatment
of disabled workers, and other issues. For example, indexing initial
benefits to prices instead of wages implies that benefit levels should
maintain purchasing power rather than maintain relative standards of
living across age groups (i.e., replacement rates). Also, as with other
ways to change benefits, changing the indexing of the benefit formula
to improve solvency could also result in benefit reductions for
disabled workers as well as retirees.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-804].
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[End of Section]
Contents:
Letter:
Results in Brief:
Background:
Social Security Currently Indexes Both Benefits and Revenues:
A Variety of Indexing Approaches Highlight International Reform
Efforts:
Indexing Can Be Used to Achieve Desired Distributional Effect:
Key Considerations in Choosing an Index:
Concluding Observations:
Agency Comments:
Appendix I: Methodology:
Microsimulation Model:
Benchmark Policy Scenarios:
Appendix II: Background on Development of Social Security's Indexing
Approach:
Program Did Not Use Indexing until 1970s:
Indexing in 1972 Amendments Built on Previous Ad Hoc Benefit Increases:
Indexing Approach Introduced Potential Instability in Benefit Costs:
Related GAO Products:
Tables:
Table 1: Key Indexing Approaches under Current U.S. Social Security
System:
Table 2: Summary of Indexes and Automatic Adjustments Proposed in
United States:
Table 3: Characteristics of Earnings-Related Public Pension Programs-
Selected Countries:
Table 4: Application of So-called Scaling of PIA Factors for Aged
Dependency Ratio Benefit Reduction Index: An Example Using 2050 PIA
Formula Factors:
Table 5: Summary of Benchmark Policy Scenarios:
Table 6: Summary of Benchmark Policy Scenario Parameters:
Table 7: Percentage Increases in OASI Benefits, Prices, and Wages, by
Effective Date of OASI Change, 1950-1971:
Figures:
Figure 1: Social Security Benefit Formula Replaces Earnings at
Different Rates:
Figure 2: Social Security's Earnings Replacement Rates for Illustrative
Workers:
Figure 3: Indexing Changes with a Larger Proportional Reduction Have a
Greater Impact on the Distribution of Benefits, but Scaling to Achieve
75-Year Solvency Illustrates That the Proportional Effects Have Similar
Results:
Figure 4: Proportional Indexing Changes Would Maintain the
Progressivity of the Current Benefit Formula, but Could Reduce Adequacy
(Initial Benefits in 2050):
Figure 5: Lower-Income Individuals Would Fare Comparatively Better
under the Progressive Application of the CPI Index than under the CPI
Index Alone (Initial Benefits in 2050):
Figure 6: Scaling the Progressive Application of the CPI Index to
Achieve Equivalent Solvency Demonstrates That Most Individuals above a
Certain Point Would Receive About the Same Level of Benefits (Initial
Benefits in 2050):
Figure 7: A Onetime Payroll Tax Increase Would Spread the Tax Burden
More Evenly across Cohorts than Gradual Increases through an Index:
Figure 8: The Growth of $1,000 Benefit under the CPI and Two
Alternatives Illustrate That Those Beneficiaries Who Receive Benefits
Longer Will Be Affected the Most:
Figure 9: Inflation-Adjusted Values of the Maximum Taxable Earnings
Level before Automatic Adjustments, 1937-1975:
Figure 10: Percentage of Total Covered Earnings below Social Security's
Maximum Taxable Earnings Level, 1937-2005:
Figure 11: Changes in Average Wage Index and Consumer Price Index, 1951-
1985:
Figure 12: Social Security Workers per Beneficiary:
Abbreviations:
ABM: automatic balancing mechanism:
AIME: average indexed monthly earnings:
AWI: average wage index:
COLA: cost-of-living adjustment:
CPI: consumer price index:
CPI-E: consumer price index for older Americans:
CPI-U: consumer price index for all urban consumers:
CPI-W: consumer price index for urban wage earners and clerical
workers:
DI: Disability Insurance:
GDP: gross domestic product:
GEMINI: Genuine Microsimulation of social Security and Accounts:
OASDI: Old-Age, Survivors, and Disability Insurance:
OASI: Old-Age and Survivors Insurance:
OCACT: Office of the Chief Actuary:
OECD: Organisation for Economic Co-operation and Development:
PENSIM: Pension Simulator:
PIA: primary insurance amount:
PSG: Policy Simulation Group:
SSA: Social Security Administration:
SSASIM: Social Security and Accounts Simulator:
United States Government Accountability Office:
Washington, DC 20548:
September 14, 2006:
The Honorable Charles E. Grassley:
Chairman:
The Honorable Max Baucus:
Ranking Minority Member:
Committee on Finance:
United States Senate:
The Honorable Jim McCrery:
Chairman:
The Honorable Sander M. Levin:
Ranking Minority Member:
Subcommittee on Social Security:
Committee on Ways and Means:
House of Representatives:
The Honorable John Warner:
United States Senate:
The total long-term financing shortfall currently facing the Social
Security program is significant and growing over time, thereby making
system reform an important priority. Once the Social Security trust
fund balances are exhausted in 2040, annual revenue will be sufficient
only to pay about 74 percent of promised benefits, according to the
Social Security trustees' 2006 intermediate assumptions. Benefit costs
are projected to exceed income in 2017, and thus trust fund securities
will need to be redeemed. This will require increased government
revenue, increased borrowing from the public, reduced spending in the
rest of the government, or some combination of these. Redeeming these
securities will have an adverse impact on the federal budget much
sooner than the 2040 trust fund exhaustion date.
Many recent reform proposals have proposed modifications to the
indexing currently used in the Social Security program. Indexing is a
way to link the growth of benefits and/or revenues to changes in
economic or demographic variables. For example, initial benefits can be
set to grow with changes in average wages or changes in prices.
Modifications to indexing seek to slow the growth of benefits or
increase the growth of revenues, either of which would improve
solvency. However, indexing does not guarantee that the program will
achieve and remain in long-term financial balance. Proposals that would
modify Social Security's indexing implicitly pose the question of
whether and how such adjustments could provide a mechanism to keep the
program sustainably solvent and minimize the need for periodic
rebalancing of the program's finances. At the same time, how it is done
can affect the distribution of benefits between low and high earners
and across generations of workers.
Given the recent attention focused on indexing as a critical component
of reform, this report examines (1) the current use of indexing in the
Social Security program and how reform proposals might modify that use,
(2) the experiences of other developed nations that have modified
indexing when reforming their public pension systems, (3) the effects
of indexing modifications on the distribution of Social Security
benefits, and (4) the key considerations associated with modifying
Social Security's indexing.
To examine the use of indexing in the Social Security program and how
reform proposals might modify the indexing, we conducted a literature
review and reviewed recent Social Security reform proposals. To examine
the experience of other developed nations that changed indexing when
reforming their own national pension systems, we reviewed the academic
literature and documentation on other countries' public pension
systems. To analyze the effects of different forms of indexing on the
distribution of benefits, we calculated benefit levels for a sample of
workers using a microsimulation model (see app. I for a more detailed
discussion of our scope and methodology).[Footnote 1] For this
analysis, we selected four well-known indexing approaches to illustrate
the effects on the distribution of benefits.[Footnote 2] To describe
the distributional effects of the different indexing approaches, we
used our model to simulate benefits for workers born in 1985.[Footnote
3] Consistent with our past work on Social Security reform, and to
illustrate a full range of possible outcomes, we used hypothetical
benchmark policy scenarios that would achieve 75-year solvency either
by only increasing payroll taxes (which simulated "promised benefits")
or only reducing benefits (which simulated "funded benefits").[Footnote
4] To determine the key considerations associated with various forms of
indexing, we reviewed the literature and talked with relevant experts.
We have prepared this report under the Comptroller General's statutory
authority to conduct evaluations on his own initiative as part of a
continued effort to assist Congress in addressing the challenges facing
Social Security. We conducted our work between July 2005 and August
2006 in accordance with generally accepted government auditing
standards.
Results in Brief:
While the initial Social Security program did not use automatic
indexing, it is now a key feature of the program's design, as well as a
central element of many proposals to reform the program. Under the
current system, the indexing provisions that affect most workers and
beneficiaries relate to (1) the formula used to calculate initial
benefits for new beneficiaries, (2) the cost-of-living adjustment
(COLA) for existing beneficiaries, and (3) the cap on taxable earnings.
The benefit indexing provisions help maintain relative standards of
living across age groups and protect the purchasing power of benefits
over time. Various reform proposals have suggested changes to all of
these provisions. For example, for future beneficiaries, some proposals
would index initial benefit levels to keep pace with price inflation
rather than wages. This would result in gradually declining earnings
replacement rates but maintain the purchasing power of current benefit
levels across age groups, assuming wages grow faster than prices on
average over time.[Footnote 5] Other proposals accept slowing the
growth of initial benefits, in general, but seek to protect benefit
levels for the lowest earners, consistent with the program's goal of
helping ensure income adequacy. Proposals to change the annual COLA for
existing beneficiaries generally focus on making it reflect inflation
levels more accurately, with the presumption that this would result in
lower benefits. On the revenue side, proposals to increase the cap on
taxable earnings generally seek to raise revenue from higher earners
and avoid increasing tax rates for all workers.
Other countries' efforts to reform their national pension systems
reveal a diversity of indexing approaches. Countries with relatively
high contribution rates tend to focus on methods that reduce benefits
to address the financial solvency of their pension systems. Although
most Organisation for Economic Co-operation and Development (OECD)
countries index past earnings to reflect wage growth in computing
initial retirement benefits, some now use a price growth index (France,
Belgium, and South Korea), or an index that blends price and wage
growth (Portugal, Poland, and Finland). Some benefit formulas contain a
measure of life expectancy that reduces payments to new retirees in
accordance with increases in longevity (Sweden, Italy, and Poland).
Changes to indexing approaches abroad sometimes affect both current and
future retirees. Germany includes a "sustainability" factor that lowers
pension amounts for both new and old retirees when the number of
workers paying into the system declines relative to those drawing
benefits. Similarly, other national systems rely on automatic balancing
mechanisms that modify both the future benefits of workers and the
benefits of current pensioners (Sweden, Japan).
Indexing can have different effects on the distribution of benefits and
on the relationship between contributions and benefits, depending on
how it is applied. Regardless of the index, adjusting the initial
benefit level through the benefit formula typically would have a
proportional effect, with constant percentage changes at all earnings
levels, on the distribution of benefits. However, indexing can also be
used to achieve specific distributional goals. For example, so-called
progressive indexing applies different indexes at different earnings
levels to adjust benefits of higher-income earners more than the
benefits of lower-income earners. Indexing payroll tax rates would have
distributional effects across generations, maintaining the existing
distribution of benefits but instead affecting equity measures like the
ratio of benefits to contributions across age cohorts. In this case,
younger cohorts would have lower ratios, because they would receive
lower benefits relative to their contributions. Finally, proposals that
modify the indexing of annual COLAs for existing beneficiaries would
have adverse distributional effects for groups with longer life
expectancies, such as women, but these individuals would still receive
higher lifetime benefits since they live longer. In addition, disabled
worker beneficiaries, especially those who receive benefits for many
years, would also experience lower benefits because such proposals
would typically reduce future benefits, and this effect compounds over
time.
Indexing raises other important considerations about the program's
role, the stability of economic or demographic relationships underlying
the index, and the treatment of disabled worker beneficiaries. The
choice of the index implies certain assumptions about the appropriate
level of benefits and taxes for the program. Thus, if the current
indexing of initial benefits to wage growth was changed to track price
growth, there is an implication that the appropriate level of benefits
is one that maintains purchasing power over time rather than the
current approach that maintains replacement rates. The solvency effects
of an index are predicated upon the relative stability and historical
trends of the underlying economic or demographic relationships implied
by the index. For example, the 1970s were a period of economic
instability in which actual inflation rates and earnings growth
diverged markedly from past experience, with the result that benefits
unexpectedly grew much faster than revenues. Finally, since the benefit
formula for Social Security retirement and disability benefits are
linked, an important consideration of any indexing proposal, as with
any other change to benefits, is its effect on the benefits provided to
disabled workers. Disabled worker beneficiaries typically become
entitled to benefits much sooner than retired workers and under
different eligibility criteria. An index that is designed to improve
solvency, for example, by adjusting retirement benefits, could also
result in large reductions to disabled workers, who often have fewer
options to obtain additional income from other sources.
Background:
Title II of the Social Security Act, as amended, establishes the Old-
Age, Survivors, and Disability Insurance (OASDI) program, which is
generally known as Social Security. The program provides cash benefits
to retired and disabled workers and their eligible dependents and
survivors. Congress designed Social Security benefits with an implicit
focus on replacing lost wages. However, Social Security is not meant to
be the sole source of retirement income; rather it forms a foundation
for individuals to build upon. The program is financed on a modified
pay-as-you-go basis in which payroll tax contributions of those
currently working are largely transferred to current beneficiaries.
Current beneficiaries include insured workers who are entitled to
retirement or disability benefits, and their eligible dependents, as
well as eligible survivors of deceased insured workers. The program's
benefit structure is progressive, that is, it provides greater
insurance protection relative to contributions for earners with lower
wages than for high-wage earners. Workers qualify for benefits by
earning Social Security credits when they work and pay Social Security
taxes[Footnote 6]; 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.[Footnote 7] Social Security's long-
term financing shortfall stems primarily from the fact that people are
living longer and labor force growth has slowed.[Footnote 8] 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:[Footnote 9]
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[Footnote
10] (rates of return on individual contributions) and income
adequacy[Footnote 11] (level and certainty of monthly benefits); and:
3. how readily such changes could be implemented, administered, and
explained to the public.
Moreover, reform proposals should be evaluated as packages that strike
a balance among the individual elements of the proposal and the
interactions among these elements. The overall evaluation of any
particular reform proposal depends on the weight individual policy
makers place on each of the above criteria.
Changing the indexing used by the OASDI program could be used to
increase income or reduce costs. Indexing provides a form of regular
adjustment of revenues or benefits that is pegged to a particular
economic, demographic, or actuarial variable. An advantage of such
indexing approaches is that they take some of the "politics" out of the
system, allowing the system to move toward some agreed-upon objective;
they may also be administratively simple. However, this "automatic
pilot" aspect of indexing poses a challenge, as it may make policy
makers hesitant to enact changes, even when problems arise.
Social Security Currently Indexes Both Benefits and Revenues:
While Social Security did not use automatic indexing initially, it is
now a key feature of the program's design, as well as a central element
of many reform proposals. Under the current program, benefits for new
beneficiaries are computed using wage indexing, benefits for existing
beneficiaries are adjusted using price indexing, and on the revenue
side, the cap on the amount of earnings subject to the payroll tax is
also adjusted using wage indexing. Reform proposals have included
provisions for modifying each of these indexing features.
Program Did Not Use Indexing until 1970s:
Before the 1970s, the Social Security program did not use indexing to
adjust benefits or taxes automatically. For both new and existing
beneficiaries, benefit rates increased only when Congress voted to
raise them. Benefit levels, when adjusted for inflation, fell and then
jumped up with ad hoc increases, and these fluctuations were dramatic
at times. Similarly, Congress made only ad hoc changes to the tax rate
and the cap on the amount of workers' earnings that were subject to the
payroll tax, which is also known as the maximum taxable earnings level.
Adjusted for inflation, the maximum taxable earnings level also
fluctuated dramatically, and as a result, the proportion of all wages
subject to the payroll tax also fluctuated. (See app. II for more
detail.)
For the first time, the 1972 amendments provided for automatic
indexing. They provided for automatically increasing the maximum
taxable earnings level based on increases in average earnings, and this
approach is still in use today. However, the 1972 amendments provided
an indexing approach for benefits that became widely viewed as flawed.
In particular, the indexing approach in the 1972 amendments resulted in
(1) a "double-indexing" of benefits to inflation for new beneficiaries
though not for existing ones[Footnote 12]; (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."[Footnote 13]
1977 Amendments Created Indexing Approach of Current Social Security
System:
The 1977 amendments instituted a new approach to indexing benefits that
remains in use today. The experience with the 1972 amendments and
double indexing made clear the need to index benefits differently for
new and existing beneficiaries, which was referred to as "decoupling"
benefits. Indexing now applies to several distinct steps of the benefit
computation process, including (1) indexing lifetime earnings for each
worker to wage growth, (2) indexing the benefit formula for new
beneficiaries to wage growth, and (3) indexing benefits for existing
beneficiaries to price inflation.[Footnote 14] Under this approach,
benefit calculations for new beneficiaries are indexed differently than
for existing beneficiaries, and earnings replacement rates have been
fairly stable. The cap on taxable earnings is still indexed to wage
growth as specified by the 1972 amendments.
Indexing Lifetime Earnings to Wages:
Social Security benefits are designed to partially replace earnings
that workers lose when they retire, become disabled, or die. As a
result, the first step of the benefit formula calculates a worker's
average indexed monthly earnings (AIME), which is based on the worker's
lifetime history of earnings covered by Social Security taxes. The
formula adjusts these lifetime earnings by indexing them to changes in
average wages.[Footnote 15] Indexing the earnings to changes in wage
levels ensures that the same relative value is accorded to each year's
earnings, no matter when they were earned.
For example, consider a worker who earned $5,000 in 1965 and $40,000 in
2000. The worker's earnings increased by eight times, but much of that
increase reflected changes in the average wage level in the economy,
which increased by about seven times (690 percent) over the same
period. The growth in average wages in turn partially reflects price
inflation; however, wages may grow faster or slower than prices in any
given year. Indexed to reflect wage growth, the $5,000 would become
roughly $35,000, giving it greater weight in computing average earnings
over time and making it more comparable to 2000 wage levels.
Indexing Initial Benefit Formula to Wages:
Once the AIME is determined, it is applied to the formula used to
calculate the worker's primary insurance amount (PIA). This formula
applies different earnings replacement factors to different portions of
the worker's average earnings. The different replacement factors make
the formula progressive, meaning that the formula replaces a larger
portion of earnings for lower earners than for higher earners. For
workers who become eligible for benefits in 2006, the PIA equals:
* 90 percent of the first $656 dollars of AIME plus:
* 32 percent of the next $3,299 dollars of AIME plus:
* 15 percent of AIME above $3,955.
For workers who do not collect benefits until after the year they first
become eligible, the PIA is adjusted to reflect any COLAs since they
became eligible. The PIA is used in turn to determine benefits for new
beneficiaries and all types of benefits payable on the basis of an
individual's earnings record. To determine the actual monthly benefit,
adjustments are made reflecting various other provisions, such as those
relating to early or delayed retirement, type of beneficiary, and
maximum family benefit amounts. Figure 1 illustrates how the PIA
formula works.
Figure 1: Social Security Benefit Formula Replaces Earnings at
Different Rates:
[See PDF for image]
Source: Social Security Administration.
[End of figure]
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.[Footnote 16] Replacement rates declined
before the first benefit increases were enacted in 1950 and then rose
sharply as a result of those increases. From 1950 until the early
1970s, replacement rates fluctuated noticeably more from year to year
than over other periods; this pattern reflects the ad hoc nature of
benefit increases over that period. Between 1974 and 1979, replacement
rates grew rapidly for new beneficiaries, reflecting the double
indexing of the 1972 amendments. The 1977 amendments corrected for the
unintended growth in benefits from double indexing, and replacement
rates declined rapidly as a result. This pattern of increasing and then
declining benefit levels is known as the notch.[Footnote 17] Finally,
replacement rates have been considerably more stable since the 1977
amendments took effect, a fact that has helped to stabilize program
costs. (See app. II.)
Figure 2: Social Security's Earnings Replacement Rates for Illustrative
Workers:
[See PDF for image]
Source: SSA.
Note: Replacement rates are the annual retired worker benefits at age
65 divided by career-average earnings. Illustrative workers have career-
average earnings equal to about 45, 100, and 160 percent of Social
Security's Average Wage Index, respectively, for low, medium, and high
earners. These three cases have earnings patterns that reflect
differences by age in the probability of work and in average earnings
levels. Taxable maximum earners have earnings equal to the maximum
earnings taxable under OASDI in each year. Variations in these
illustrative replacement rates result not only from program changes but
also from short-term fluctuations in the growth rate of wages, which
helps determine the earnings histories of the illustrative earners.
[End of figure]
Indexing Benefits to Prices for Existing Beneficiaries:
After initial benefits have been set for the first year of entitlement,
benefits in subsequent years increase with a COLA designed to keep pace
with inflation and thereby help to maintain the purchasing power of
those benefits. The COLA is based on the consumer price index (CPI), in
contrast to the indexing of lifetime earnings and initial benefits,
which are based on the national average wage index.[Footnote 18]
Indexing Maximum Taxable Earnings to Wages:
The cap on taxable earnings increases each year to keep pace with
changes in average wages. As a result, in combination with a constant
tax rate, total program revenues tend to keep pace with wage growth and
therefore also with benefits to some degree. In 2006, the cap is set at
$94,200. As the distribution of earnings in the economy changes, the
percentage of total earnings that fall below the cap can also change.
(See app. II.)
Table 1 summarizes the various indexing and automatic adjustment
approaches that affect most workers and beneficiaries under the current
program.
Table 1: Key Indexing Approaches under Current U.S. Social Security
System:
Approach: Benefit provisions: Wage-indexing initial benefit
calculation;
How it works: Before averaging workers' earnings over their careers,
AIME adjusts actual earnings using average wage index; Bendpoints of
PIA formula rise over time according to wage growth; Earnings
replacement factors in PIA formula remain constant;
Comments: Maintains relative standards of living across age groups
(that is, replacement rates), at time of retirement; Actuarial balance
of the program is relatively insensitive to economic fluctuations
because benefit levels and tax revenues are both linked to wages;
Initial benefits keep pace with standard of living, as reflected by
wage levels.
Approach: Benefit provisions: Price-indexing post-entitlement benefits;
How it works: Benefits rise yearly according to rise in the CPI;
Comments: Purchasing power of benefits remains constant over time, once
benefits start.
Approach: Tax provisions: Wage-indexing maximum taxable earnings;
How it works: Earnings are only taxed on the first $94,200 per year in
2006. Limit rises every year according to average wage growth;
Comments: Share of earnings not taxed can change as income distribution
changes.
Approach: Tax provisions: Constant tax rate;
How it works: Earnings are taxed yearly at 12.4 percent (6.2 percent
from workers and 6.2 percent from employers);
Comments: Program revenue rises annually with the rise in wages;
Constant tax rate maintains the same proportion of taxes for all
workers earning less than maximum taxable earnings.
Source: GAO.
[End of table]
Various Reform Proposals Include Indexing Provisions:
Various reform proposals have suggested changes to most of the indexing
features of the current Social Security system. Some proposals would
use alternative indexes for initial benefits in order to slow their
growth. Other proposals would take the same approach but would limit
benefit reductions on workers with lower earnings. Some propose
modifying the COLA in the belief that the CPI overstates the rate of
inflation. Still others propose indexing revenue provisions in new
ways.
Changes to the indexing of Social Security's initial benefits could be
implemented by changing the indexing of lifetime earnings or the PIA
formula's bendpoints.[Footnote 19] However, they could also be
implemented by adjusting the PIA formula's replacement factors, even
though these factors are not now indexed. Under this approach, which is
used in this report, the replacement factors are typically multiplied
by a number that reflects the index being used. The replacement factors
would be adjusted for each year in which benefits start, beginning with
some future year. So such changes would not affect current
beneficiaries. Indexing the replacement factors would reduce benefits
at the same proportional rate across income levels, while changing the
indexing of lifetime earnings or the bendpoints could alter the
distribution of benefits across income levels. Recent reform proposals,
as described by the Social Security Administration's (SSA) Office of
the Chief Actuary in its evaluations, generally implement indexing
changes as adjustments to the PIA formula's replacement factors.
Two indexing approaches--to reflect changes in the CPI or increasing
longevity--have been proposed as alternatives to the average wage index
for calculating initial benefits. Proponents of using CPI indexing for
initial benefit calculations generally offer the rationale that wage
indexing has never been fiscally sustainable and CPI indexing would
slow the growth of benefits to an affordable level while maintaining
the purchasing power of benefits. They say that maintaining the
purchasing power of benefits should be the program's goal, as opposed
to maintaining relative standards of living across age groups (that is,
earnings replacement rates), which the current benefit formula
accomplishes. Proponents of longevity indexing offer the rationale that
increasing longevity is a key reason for the system's long-term
insolvency. Since people are living longer on average, and are expected
to continue to do so in the future, they will therefore collect
benefits for more years on average. Using an index that reflects
changes in life expectancy would maintain relatively comparable levels
of lifetime benefits across birth years and thereby promote
intergenerational equity. Also, longevity indexing could encourage
people to work longer.
Some indexing proposals accept the need to slow the growth of initial
benefits in general but seek to protect benefit levels for the lowest
earnings levels, consistent with the program's goal of helping ensure
income adequacy. Such proposals would modify how a new index would be
applied to the formula for initial benefits so that the formula is
still wage-indexed below a certain earnings level. As a result, they
would maintain benefits promised under the current program for those
with earnings below that level such as, for example, those in the
bottom 30 percent of the earnings distribution. Such an approach has
been called progressive price indexing.
A few proposals would alter the COLA used to adjust benefits for
current retirees. Some proposals respond to methodological concerns
that have been raised about how the CPI is calculated and would adjust
the COLA in the interest of accuracy.[Footnote 20] In general, such
changes would slightly slow the growth of the program's benefit costs.
However, other proposals call for creating a new CPI for older
Americans (CPI-E) specifically tailored to reflect how inflation
affects the elderly population and using the CPI-E for computing Social
Security's COLA.[Footnote 21] Depending on its construction, such a
change could increase the program's benefit costs.
Some proposals would index revenues in new ways. Some would apply a
longevity index to payroll tax rates, again focused on the fact that
increasing life expectancy is a primary source of the program's
insolvency. Proponents of indexing tax rates feel that benefits are
already fairly modest, so the adjustment for longevity should not come
entirely from benefit reductions. Other proposals would institute other
types of automatic revenue adjustments. Some would raise the maximum
taxable earnings level gradually until some percentage of total
earnings are covered and then maintain that percentage into the future.
Implicitly, such proposals reflect a desire to hold constant the
percentage of earnings subject to the payroll tax. Still another
proposal would provide for automatically increasing the tax rate when
the ratio of trust fund assets to annual program costs is projected to
fall.
Table 2 summarizes the various indexing and automatic adjustment
approaches that reform proposals have contained.
Table 2: Summary of Indexes and Automatic Adjustments Proposed in
United States:
Provision: Provisions affecting initial benefit calculations for future
beneficiaries: Longevity indexing;
How it works: Proportionally reduces replacement factors in PIA formula
to reflect adjustments for increasing life expectancy.[A];
Rationales offered by proponents: Increasing longevity is a key reason
for the system's long-term solvency problem; People are living longer
on average and therefore collecting benefits for more years on average;
Would maintain comparable levels of lifetime benefits across birth
years and thereby promote intergenerational equity.
Provision: Provisions affecting initial benefit calculations for future
beneficiaries: Price indexing[B];
How it works: Proportionally reduces replacement factors in PIA formula
to reflect changes in index.[A];
Rationales offered by proponents: "Wage-indexing — has never been
fiscally sustainable."[C]; Would slow the growth of benefits to an
affordable level; Would still maintain the purchasing power of
benefits.
Provision: Provisions affecting initial benefit calculations for future
beneficiaries: Progressive price indexing;
How it works: Proportionally reduces replacement factors in PIA formula
to reflect changes in index.[A]; But no change to factors for earnings
below a certain level; Effectively adds new bendpoint between two
current ones;
Rationales offered by proponents: Protects benefits for lower earnings
to help ensure income adequacy.
Provision: Provisions affecting benefit COLAs for current and future
beneficiaries: Revise COLA to reflect more accurate calculation of CPI;
How it works: Use more accurate CPI in determining COLA;
Rationales offered by proponents: Greater accuracy.
Provision: Provisions affecting taxes for current and future workers:
Longevity indexing of payroll tax rates;
How it works: Proportionally increase payroll tax rate to reflect
changes in index;
Rationales offered by proponents: Increasing longevity is a key reason
for the system's long-term solvency problem.
Provision: Provisions affecting taxes for current and future workers:
Increase payroll tax rates to ensure maintaining ratio of trust fund
assets to program costs;
How it works: Use trustees' intermediate projections of trust fund
ratios;
Rationales offered by proponents: Ensure ongoing solvency.
Provision: Provisions affecting taxes for current and future workers:
Increase maximum taxable earnings to ensure a constant percentage of
aggregate earnings are taxed;
How it works: Use recent data on earnings distribution with trustees'
intermediate projections of wage growth;
Rationales offered by proponents: Promote intergenerational equity by
ensuring consistent application of payroll tax.
Source: GAO.
[A] Average indexed monthly earnings would be computed as under present
law.
[B] An implication of price indexing is that it would slow benefit
growth to a greater degree if wages grow faster than projected, even as
Social Security's financial situation would be improving.
[C] Commission to Strengthen Social Security. "Strengthening Social
Security and Creating Personal Wealth for All Americans: Report of the
President's Commission" p. 120, Washington, D.C.: Dec. 21, 2001.
[End of table]
A Variety of Indexing Approaches Highlight International Reform
Efforts:
Faced with adverse demographic trends, many countries have enacted
reforms in recent years to improve the long-term fiscal sustainability
of their national pension systems. New indexing methods now appear in a
variety of forms around the world in earnings-related national pension
systems.[Footnote 22] In general, they seek to contain pension costs
associated with population aging. Some indexing methods affect both
current and future retirees.
Retirement Indexing Approaches in Other Countries Generally Focus on
Benefit Reductions instead of Increased Contributions:
A number of reforms have focused on methods that primarily adjust
benefits rather than taxes to address the fiscal solvency of national
pension systems. There are two main reasons for this. First,
contribution rates abroad are generally high already, making it
politically difficult to raise them much further. For example, while in
the United States total employer-employee Social Security contribution
rates are 12.4 percent of taxable earnings, they are above 16 percent
in Belgium and France, more than 18 percent in Sweden and Germany,
above 25 percent in the Netherlands and the Czech Republic, and over 30
percent in Italy.[Footnote 23] In fact, some countries have stipulated
a ceiling on employee contribution rates in order to reassure the
young--or current contributors--that the burden would be shared among
generations. For example, Japan settled, with the 2004 Reform Law, its
pension premium rates for the next 100 years with an increase of 0.35
percent per year until 2017, at which time premium levels are to be
fixed at 18.3 percent of covered wages. Similarly, Canada chose to
raise its combined employer-employee contribution rate more quickly
than previously scheduled, from 5.6 percent to 9.9 percent between 1997
and 2003, and maintain it there until the end of the 75-year projection
period.[Footnote 24] This increase is meant to help Canada's pension
system build a large reserve fund and spread the costs of financial
sustainability across generations.[Footnote 25] Germany's recent
reforms set the workers' contribution rate at 20 percent until 2020 and
at 22 percent from 2020 to 2030. Second, increasing employee
contribution rates without significantly reducing benefit levels will
tend to make continued employment less attractive compared to
retirement. In the context of population aging and fiscally stressed
national pension systems facing many countries, reform measures seek to
do the opposite: encourage people to remain in the labor force longer
to enhance the fiscal solvency of pension programs. Contribution rates
that become too high are not likely to provide sufficient incentives to
continue work.
Indexing Approaches Aim at Containing Costs:
One commonly used means of reducing, or containing the growth of,
promised benefits involves changing the method used to compute initial
benefits. For example, France, Belgium, and South Korea now adjust past
earnings in line with price growth rather than wage growth to determine
the initial pension benefits of new retirees. In general, this shift to
price indexation tends to significantly lower benefits relative to
earnings, as over long periods prices tend to grow more slowly than
wages.[Footnote 26] Because of compounding, the effect of such a change
is larger when benefits are based on earnings over a long period than
when they reflect only the last few years of work, as in pension plans
with benefits based on final salaries. In fact, the OECD estimates
that, in the case of a full-career worker with 45 years of earnings,
price indexation can lead to benefits 40 percent lower than with wage
indexation.[Footnote 27] In contrast to full price indexing, some
nations use an index that is a mix of price growth and wage growth,
which tends to produce higher benefits than those calculated using
price indexation only, then adjust the relative weights of the two to
cover program costs. Finland, for example, changed its indexation of
initial benefits from 50 percent prices and 50 percent wages to 80
percent and 20 percent, respectively. Similarly, Portugal's index
combines 75 percent price growth and 25 percent wage growth.[Footnote
28]
A few countries have moved away from wage indexing but without
necessarily adopting price indexation. Sweden, for instance, uses an
index that reflects per capita wage growth to compute initial benefits,
provided the system is in fiscal balance. However, when the system's
obligations exceed its assets, a "brake" is applied automatically that
allows the indexation to be temporarily abandoned.[Footnote 29] This
automatic balancing mechanism (ABM) ensures that the pension system
remains financially stable.[Footnote 30] In Germany and Japan, recent
reforms changed benefit indexation from a gross-wage base to a net-wage
base--i.e., gross wages minus contributions. In Italy, workers' benefit
accounts rise in line with gross domestic product (GDP) growth so both
the changes in the size of the labor force and in productivity dictate
benefit levels.
Another approach countries have used is adding a longevity index to the
formula determining pension payments. In Sweden, Poland, and Italy, for
example, remaining life expectancy at the time of retirement inversely
affects benefit levels. Thus, as life spans gradually increase,
successive cohorts of retirees get smaller benefit payments unless they
choose to begin receiving them later in life than those who retired
before them. Also, people who retire earlier than their peers in a
given cohort get significantly lower benefits throughout their
remaining life than those who retire later. Longevity indexing helps
ensure that improvements in life expectancy do not strain the system
financially.[Footnote 31]
Germany, on the other hand, now uses a sustainability factor that links
initial benefits to the system's dependency ratio--i.e., the number of
people drawing benefits relative to the number paying into the system.
This dependency ratio captures variations in fertility, longevity, and
immigration, and consequently makes the pension system self-
stabilizing. For example, higher fertility and immigration, which raise
labor force growth, will, other things equal, improve the dependency
ratio, leading to higher pension benefits, while higher longevity or
life expectancy will increase the dependency ratio, and hence cause
benefits to decline.[Footnote 32]
Indexing Approaches Affect Both Current and Future Beneficiaries:
In some of the countries we studied, changes in indexing methods affect
both current and future retirees. In Japan, for example, post-
retirement benefits were indexed to wages net of taxes before 2000.
However, reforms enacted that year altered the formula by linking post-
retirement benefits to prices. As a result, retirees saw their
subsequent benefits rise at a much slower pace. The 2004 reforms
reduced retirees' purchasing power further by introducing a negative
"automatic adjustment indexation" to the formula. With this provision,
post-retirement benefits increase in line with prices minus the
adjustment rate, currently fixed at 0.9 percent until about 2023. This
rate is the sum of two demographic factors: the decline in the number
of people contributing to the pension program (projected at 0.6
percent) plus the increase in the number of years people collect
pensions (projected at 0.3 percent). This negative adjustment also
enters the formula determining the benefit of new recipients as past
earnings are indexed to net wages minus the same 0.9 percent adjustment
rate.
Sweden's ABM modifies both the retirement accounts of workers--or
future retirees--and the benefits paid to current pensioners. As
explained earlier, this mechanism is triggered whenever system assets
fall short of system liabilities. Moreover, post-retirement benefits in
Sweden are indexed each year to an economic factor equal to prices plus
the average rate of real wage increase minus 1.6 percent, which is the
projected real long-term growth in wages. As a result, if average real
wages grow annually at 1.6 percent, post-retirement benefits are
adjusted for price increases. On the other hand, if real wage growth
falls below 1.6 percent, benefits do not keep up with prices, leading
to a decline in retiree purchasing power.[Footnote 33]
Germany's sustainability factor affects those already retired, as it is
included in the formula that adjusts their benefits each year. If, as
projected, the number of contributors falls relative to that of
pensioners, increasing the dependency ratio, all benefits are adjusted
downward, so all cohorts share the burden of adverse demographic
trends. This intergenerational burden sharing is also apparent in the
indexation of all benefits to net wages--wages minus contributions,
which affect workers and pensioners alike. Thus an increase in
contributions, everything else equal, lowers both initial benefits and
benefits already being paid.
Table 3 summarizes relevant characteristics of earnings-related public
pension programs in selected countries.
Table 3: Characteristics of Earnings-Related Public Pension Programs-
Selected Countries:
Belgium;
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 15.8; 19.7;
(2002);
Normal retirement age (early retirement age)[B]: 65 (60);
Average contribution rate (percentage of earnings): 16.36;
Years of individual earnings considered in initial benefit calculation:
Lifetime average;
Indexing of earnings for calculating initial benefits: Prices;
Indexing of benefits in retirement: 100% prices.
Canada;
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 17.4; 20.8;
Normal retirement age (early retirement age)[B]: 65 (60);
Average contribution rate (percentage of earnings): 9.9;
Years of individual earnings considered in initial benefit calculation:
Lifetime average excluding worst 15% of years;
Indexing of earnings for calculating initial benefits: Average
earnings;
Indexing of benefits in retirement: 100% prices.
Czech Republic;
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 13.9; 17.3;
Normal retirement age (early retirement age)[B]: Men: 63; Women: 59-63;
(men: 60, women: 56-60)c;
Average contribution rate (percentage of earnings): 28;
Years of individual earnings considered in initial benefit calculation:
Since 1985 moving to 30;
Indexing of earnings for calculating initial benefits: Average
earnings;
Indexing of benefits in retirement: 67% prices 33% real wage growth.
France;
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 17.1; 21.4;
(2002);
Normal retirement age (early retirement age)[B]: 60;
Average contribution rate (percentage of earnings): 16.45;
Years of individual earnings considered in initial benefit calculation:
Lifetime average; (public employees: best 20 moving to 25);
Indexing of earnings for calculating initial benefits: Prices;
Indexing of benefits in retirement: 100% prices.
Germany;
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 16.1; 19.6;
Normal retirement age (early retirement age)[B]: 65 (63);
Average contribution rate (percentage of earnings): 19.5;
Years of individual earnings considered in initial benefit calculation:
Lifetime average;
Indexing of earnings for calculating initial benefits: Average net
earnings (subject to demographic adjustment);
Indexing of benefits in retirement: 100% wages net of contributions
(subject to demographic adjustment).
Italy;
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 16.7; 20.7;
(2001);
Normal retirement age (early retirement age)[B]: 65 (60);
Average contribution rate (percentage of earnings): 32.7;
Years of individual earnings considered in initial benefit calculation:
Lifetime average;
Indexing of earnings for calculating initial benefits: 5-year moving
average of GDP growth (subject to demographic adjustment);
Indexing of benefits in retirement: Between 75-100% prices depending on
benefit level.
Japan;
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 18.2; 23.3;
(2004);
Normal retirement age (early retirement age)[B]: 65 (60);
Average contribution rate (percentage of earnings): 13.58;
Years of individual earnings considered in initial benefit calculation:
Lifetime average;
Indexing of earnings for calculating initial benefits: Average earnings
(subject to demographic adjustment);
Indexing of benefits in retirement: 100% prices (subject to demographic
adjustment).
Sweden;
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 17.4; 20.6;
(2004);
Normal retirement age (early retirement age)[B]: 65 (61);
Average contribution rate (percentage of earnings): 18.5;
Years of individual earnings considered in initial benefit calculation:
Lifetime average;
Indexing of earnings for calculating initial benefits: Average earnings
(subject to demographic and fiscal adjustments);
Indexing of benefits in retirement: 100% prices plus real wages less
1.6% (subject to demographic and fiscal adjustments).
United States;
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 16.8; 19.8;
Normal retirement age (early retirement age)[B]: 67 (62);
Average contribution rate (percentage of earnings): 12.4;
Years of individual earnings considered in initial benefit calculation:
Best 35;
Indexing of earnings for calculating initial benefits: Average earnings
up to age 60;
Indexing of benefits in retirement: 100% prices.
Source: GAO:
[A] In 2003 unless otherwise indicated.
[B] 2002 data, including legislated changes.
[C] Women's retirement ages (full and early) depend on the number of
children.
[End of table]
Indexing Can Be Used to Achieve Desired Distributional Effect:
In the U.S. Social Security program, indexing can have different
effects on the distribution of benefits and on the relationship between
contributions and benefits, depending on how it is applied to benefits
or taxes. There are a variety of proposals that would change the
current indexing of initial benefits, including a move to the CPI, to
longevity or mortality measures, or to the dependency ratio.[Footnote
34] When the index is implemented through the benefit formula, each
will have a proportional effect, with constant percentage changes at
all earnings levels, on the distribution of benefits (i.e., the
progressivity of the current system is unchanged). However, indexing
provisions can be modified to achieve other distributional effects. For
example, so-called progressive indexing applies different indexes at
different earnings levels in a manner that seeks to protect the
benefits of low-income workers. Indexing payroll tax rates would also
have distributional effects. Such changes maintain existing benefit
levels but affect equity measures like the ratio of benefits to
contributions across age cohorts, with younger cohorts having lower
ratios because they receive lower benefits relative to their
contributions. Finally, proposals that modify the indexing of COLAs for
existing beneficiaries have important and adverse distributional
effects for groups that have longer life expectancies, such as women
and highly educated workers, because such proposals would typically
reduce future benefits, and this effect compounds over time. In
addition, disabled worker beneficiaries, especially those who receive
benefits for many years, would also experience lower benefits.
Proposals to Index Initial Benefits Have a Proportional Effect on the
Distribution of Benefits:
There are a variety of proposals that would change the current indexing
of initial benefits from the growth in average wages. These include a
move to a measure of the change in prices like the CPI, to longevity
measures that seek to capture the growth in population life
expectancies, or to the dependency ratio that measures changes in the
number of retirees compared to the workforce. We analyzed three
indexing scenarios; the dependency ratio index, which links the growth
of initial benefits to changes in the dependency ratio, the ratio of
the number of retirees to workers; the CPI index, which links the
growth of initial benefits to changes in the CPI; and the mortality
index, which links the growth of initial benefits to changes in life
expectancy to maintain a constant life expectancy at the normal
retirement age.[Footnote 35] Figure 3 illustrates the projected
distribution of benefits for workers born in 1985 under three different
indexing scenarios[Footnote 36] (on the left side of the figure) and
under a so-called benefit reduction benchmark that reduces benefits
just enough to achieve program solvency over a 75-year projection
period (on the far right).[Footnote 37] Median benefits under the
dependency ratio index and the CPI index are lower than the median
benefit for the benchmark; they reduce benefits more than is needed to
achieve 75-year solvency.[Footnote 38] In contrast, the mortality index
has a higher median benefit level than the benchmark, so without
further modifications, it would not achieve 75-year solvency.
Figure 3: Indexing Changes with a Larger Proportional Reduction Have a
Greater Impact on the Distribution of Benefits, but Scaling to Achieve
75-Year Solvency Illustrates That the Proportional Effects Have Similar
Results:
[See PDF for image]
Source: GAO analysis of GEMINI data.
Note: Benefits are for all individuals in the GEMINI 1985 cohort sample
in 2052 (the year the cohort reaches age 67). Scenarios are modeled
using the intermediate assumptions of the 2005 trustees' report. The
dependency ratio index links the growth of initial benefits to changes
in the dependency ratio, the ratio of the number of retirees to
workers. The dependency ratio index has a 197 percent improvement in 75-
year solvency, generating far more programmatic savings than is needed
to achieve solvency. The CPI index links the growth of initial benefits
to changes in the CPI. The CPI index has a 127 percent improvement in
75-year solvency, generating more programmatic savings than is needed
to achieve solvency. The mortality index links the growth of initial
benefits to changes in life expectancy to maintain a constant life
expectancy at the normal retirement age. The mortality index has a 72
percent improvement in 75-year solvency, which does not generate enough
programmatic savings to be solvent. The benefit reduction benchmark is
a hypothetical benchmark policy scenario that would achieve 75-year
solvency by only reducing benefits. Thus, the benchmark has a 100
percent improvement in 75-year solvency, being exactly solvent at the
end of the 75-year period. The scaled scenarios are adjusted to achieve
a 75-year actuarial balance of zero. While scaling allows comparisons
across distributions over 75 years, the different indexing scenarios
are not identical in terms of sustainability. For a more complete
description of the indexing scenarios, the benchmark, or the scaling,
see appendix I.
[End of figure]
Regardless of the index used to modify initial benefits, most proposals
apply the new index in a way that has proportional effects on the
distribution of benefits.[Footnote 39] Thus, benefits at all levels
will be affected by the same percentage reduction, for example, 5
percent, regardless of earnings. The left half of figure 3 illustrates
this proportionality in terms of monthly benefits. While the level of
benefits differs, the distribution of benefits for each scenario has a
similar structure. However, the range of each distribution varies by
the difference in the size of the proportional reduction. A larger
proportional reduction--the dependency ratio index--will result in a
distribution with a similar structure, compared to promised benefits.
However, each individual's benefits are reduced by a constant
percentage; therefore, the range of the distribution, the difference
between benefits in the 25th and 75th percentile, would be smaller,
compared to promised benefits. This proportional reduction in benefits
is also illustrated in figure 4, which compares the currently scheduled
or promised benefit formula with our three alternative indexing
scenarios. Under each scenario, the line depicting scheduled benefits
is lowered, by equal percentages at each AIME amount, by the difference
between the growth in covered wages and the new index. Each indexing
scenario maintains the shape of the current benefit formula; thus the
progressivity of the system is maintained, but the line for each
scenario is lower than scheduled benefits, which would affect the
adequacy of benefits.
Figure 4: Proportional Indexing Changes Would Maintain the
Progressivity of the Current Benefit Formula, but Could Reduce Adequacy
(Initial Benefits in 2050):
[See PDF for image]
Source: GAO calculations.
Note: The illustrated PIAs are for individuals who become eligible in
2050. The dependency ratio index links the growth of initial benefits
to changes in the dependency ratio, the ratio of the number of retirees
to workers. The CPI index links the growth of initial benefits to
changes in the CPI. The mortality index links the growth of initial
benefits to changes in life expectancy to maintain a constant life
expectancy at the normal retirement age. For more information on each
index see appendix I.
[End of figure]
The proportional effects of indexing are best illustrated by adjusting,
or scaling, each index to achieve comparable levels of solvency over 75
years.[Footnote 40] Thus, for those indexes that do not by themselves
achieve solvency, the benefit reductions are increased until solvency
is achieved; for those that are more than solvent, the benefit
reductions are decreased until solvency is achieved but not exceeded.
The right half of figure 3 shows the distribution of monthly benefits
for each of the scaled indexing scenarios and the benchmark scenario.
Once the different indexing scenarios are scaled to achieve solvency,
the distribution of benefits for each scenario is almost identical in
terms of the level of benefits. Differences in the distributions deal
with the timing associated with implementing the changes. Scaling the
indexing scenarios also reveals that the shape of the distributions is
the same. The distributions of monthly benefits for the indexing
scenarios are also very similar to the distribution of benefits
generated under the benefit reduction benchmark. Therefore, changes to
the benefit formula, applied through the replacement factors, will have
similar results regardless of whether the change is an indexing change
or a straight benefit reduction, because of the proportional effect of
the change.
Indexing Approaches Could Also Be Modified to Achieve Nonproportional
Effects:
Indexing could also be modified to achieve other distributional goals.
For example, so-called progressive indexing, or the use of different
indexes--such as prices and wages--at various earnings levels, has been
proposed as a way of changing the indexing while protecting the
benefits of low-income workers. Thus, under progressive price indexing,
those individuals with indexed lifetime earnings below a certain point
would still have their initial benefits adjusted by wage indexing;
those individuals with earnings above that level would be subject to a
combination of wage and price indexing on a sliding scale, with those
individuals with the highest lifetime earnings having their benefits
adjusted completely by price indexing.[Footnote 41]
The effect that progressive price indexing would have on the benefit
formula can be seen in figure 5, where the CPI indexing scenario is
compared to a progressive CPI indexing scenario and to benefits
promised under the current program formula.[Footnote 42] Many lower-
income individuals would do better under the progressive application of
the CPI index than under the CPI indexing alone. However, a progressive
application of CPI indexing does not by itself achieve 75-year
solvency, and further changes would be necessary to do so. Figure 6
shows what happens to the benefit formula when each of these indexing
scenarios is scaled to achieve comparable levels of solvency over 75
years. Under progressive price indexing, to protect the benefits of low-
income workers, the indexing to prices at higher earnings levels begins
to flatten out benefits, causing the line in figure 6 to plateau. Thus,
under this scenario, most individuals with earnings above a certain
level would receive about the same level of benefits regardless of
income--in the case of figure 6, a retiree with average indexed monthly
earnings of $2,000 would receive a similar benefit level as someone
with average indexed monthly earnings of $7,000. Since progressive
price indexing would change the shape of the benefit formula, making it
more progressive, it would reduce individual equity for higher earners,
as they would receive much lower benefits relative to their
contributions.
Figure 5: Lower-Income Individuals Would Fare Comparatively Better
under the Progressive Application of the CPI Index than under the CPI
Index Alone (Initial Benefits in 2050):
[See PDF for image]
Source: GAO calculations.
Note: The illustrated PIAs are for individuals who become eligible in
2050. The CPI index links the growth of initial benefits to changes in
the CPI. Progressive CPI indexing uses different indexes at various
earnings levels. Individuals with earnings below a certain point would
have their initial benefits adjusted by wage indexing; those
individuals with earnings above that level would be subject to a
combination of wage and price indexing on a sliding scale, with those
individuals with the highest earnings having their benefits adjusted
completely by price indexing. However, progressive CPI indexing does
not achieve 75-year solvency, it has only a 74 percent improvement in
solvency. For more information on the indexes see appendix I.
[End of figure]
Figure 6: Scaling the Progressive Application of the CPI Index to
Achieve Equivalent Solvency Demonstrates That Most Individuals above a
Certain Point Would Receive About the Same Level of Benefits (Initial
Benefits in 2050):
[See PDF for image]
Source: GAO calculations.
Note: The illustrated PIAs are for individuals who become eligible in
2050. The CPI index links the growth of initial benefits to changes in
the CPI. Progressive CPI indexing uses different indexes at various
earnings levels. Individuals with earnings below a certain point would
have their initial benefits adjusted by wage indexing; those
individuals with earnings above that level would be subject to a
combination of wage and price indexing on a sliding scale, with those
individuals with the highest earnings having their benefits adjusted
completely by price indexing. While scaling allows comparisons across
distributions over 75 years, the different indexing scenarios are not
identical in terms of sustainability. For more information on the
indexes and the scaling, see appendix I.
[End of figure]
While proposals that have suggested progressive indexing have focused
on using prices, any index can be adjusted to achieve the desired level
of progressivity, and the results will likely be similar. However, to
the extent that wages grow faster than the new index over a long period
of time, the benefit formula will eventually flatten out and all
individuals above a certain income level would receive the same level
of benefits.
Indexing Applied to Taxes Would Have Adequacy and Equity
Considerations:
Indexing changes could also be applied to program financing. Under the
current structure of the system, one way this could be accomplished is
by indexing the Social Security payroll tax rate.[Footnote 43] As with
indexing benefits, the payroll tax rate could be indexed to any
economic or demographic variable. Under the tax scenarios presented,
only the indexing of taxes would change, so promised benefits would be
maintained. However, workers would be paying more in payroll taxes,
which, like any tax change, could affect work, saving, and investment
decisions.
While benefit levels would be higher under tax increase scenarios, as
compared to benefit reduction scenarios, the timing of the tax changes
matters, just as it did with benefit changes. Since benefits would be
unchanged in the tax-increase-only scenarios, we use benefit-to-tax
ratios to compare the effects of different tax increase scenarios.
Benefit-to-tax ratios compare the present value of Social Security
lifetime benefits with the present value of lifetime Social Security
taxes.[Footnote 44] The benefit-to-tax ratio is an equity measure that
focuses on whether, over their lifetimes, beneficiaries can expect to
receive a fair return on their contributions or get their "money's
worth" from the system. With benefits unchanged in the tax increase
scenarios, the benefit-to-tax ratios would vary across scenarios
because of differences in the timing of tax increases.[Footnote 45]
To illustrate the effects of the timing of a change in tax rates,
figure 7 shows the benefit-to-tax ratios, for four different birth
cohorts, for two tax increase scenarios: (1) the dependency ratio tax
indexing scenario scaled to achieve 75-year solvency and (2) our tax
increase benchmark scenario that increases taxes just enough to achieve
program solvency over a 75-year projection period.[Footnote 46] By
raising payroll taxes once and immediately, the tax increase benchmark
would spread the tax burden more evenly across generations. This is
seen in figure 7, where the benefit-to-tax ratios are fairly stable
across cohorts for this scenario.[Footnote 47] The dependency ratio tax
indexing scenario would increase the tax rate annually, in this case
with changes in the dependency ratio. Under this scenario, later
cohorts would face a higher tax rate and thus bear more of the tax
burden, compared to earlier cohorts. This would result in declining
benefit-to-tax ratios across cohorts, with later generations receiving
relatively less compared to their contributions.
Figure 7: A Onetime Payroll Tax Increase Would Spread the Tax Burden
More Evenly across Cohorts than Gradual Increases through an Index:
[See PDF for image]
Source: GAO analysis of GEMINI data.
Note: Benefit-to-tax ratios are the sum of the present value of family
benefits divided by the present value of family taxes summed for all
individuals in the cohort that survive until age 24. Scenarios are
modeled using the 2005 trustees' report intermediate assumptions. The
dependency ratio tax index links the growth in the payroll tax rate to
changes in the dependency ratio, the ratio of the number of retirees to
workers. The dependency ratio tax index has been adjusted--or "scaled"-
-to achieve a 75-year actuarial balance of zero. While scaling allows
comparisons across distributions over 75 years, the different indexing
scenarios are not identical in terms of sustainability. The tax
increase benchmark is a hypothetical benchmark policy scenario that
would achieve 75-year solvency by only increasing payroll taxes. For a
more complete description of the indexing scenario, the scaling, or the
benchmark, see appendix I.
[End of figure]
Revising COLA for Existing Beneficiaries Would Have Important
Distributional Implications for Multiple Subpopulations:
Indexing changes can also be applied to the COLA used to adjust
existing benefits. Under the current structure of the program, benefits
for existing beneficiaries are adjusted annually in line with changes
in the CPI. The COLA helps to maintain the purchasing power of benefits
for current retirees. Some proposals, under the premise that the
current CPI overstates the rate of price inflation because of
methodological issues associated with how the CPI is calculated, would
alter the COLA. Figure 8 shows the difference in benefit growth over
time under the current COLA and two alternatives: growing at rate of
CPI minus 0.22 and growing at rate of CPI minus 1.[Footnote 48] Changes
to the COLA would also have adequacy implications. After 20 years,
benefits growing at the rate of the CPI minus 0.22 would slow the
growth of benefits by about 4 percent below the level given by the
current COLA and growing at the rate of the CPI minus 1 by about 17
percent. This slower benefit growth would improve the finances of the
system, but would also alter the distribution of benefits, particularly
for some subpopulations. Since changes to the COLA compound over time,
those most affected are those with longer life expectancies, for
example, women, as they would have the biggest decrease in lifetime
benefits as they tend to receive benefits over more years. In addition,
as education is correlated with greater life expectancy, highly
educated workers would also experience a significant benefit decrease.
There could also be a potentially large adverse effect on the benefits
paid to disabled beneficiaries, especially among those who become
disabled at younger ages and receive benefits for many years. These
beneficiaries could have a large decrease in lifetime
benefits.[Footnote 49]
Figure 8: The Growth of $1,000 Benefit under the CPI and Two
Alternatives Illustrate That Those Beneficiaries Who Receive Benefits
Longer Will Be Affected the Most:
[See PDF for image]
Source: GAO analysis.
[End of figure]
Reducing the COLA would also have equity implications. Since the COLA
is applied to all beneficiaries, reductions in the COLA would lower the
return on contributions for all beneficiaries. However, the magnitude
of the effect will vary across subpopulations, similar to its effect on
adequacy. Those individuals who have the biggest decrease in lifetime
benefits will have the biggest decrease in individual equity. While
these individuals have a large decrease in equity, they would still
receive higher lifetime benefits since they live longer and collect
benefits over more years. Individuals with shorter life expectancies
will experience a decrease in equity, but they will fare comparably
better than other groups that live longer, since their lifetime
benefits will decrease much less. Therefore, men, African- Americans,
low earners, and less educated individuals would experience a much
smaller decrease in equity compared to their counterparts.
Key Considerations in Choosing an Index:
Indexing raises other important considerations about the program's
role, the stability of the variables underlying the index, and the
treatment of Disability Insurance (DI) beneficiaries. The choice of the
index implies certain assumptions about the appropriate level of
benefits and taxes for the program. Thus, if the current indexing of
initial benefits was changed to price growth, there is an implication
that the appropriate level of benefits is one that maintains purchasing
power over time rather than the current approach that maintains a
relative standard of living across age groups (i.e., replacement
rates). The solvency effects of an index are predicated upon the
relative stability and historical trends of the underlying economic or
demographic relationships implied by the index. For example, the 1970s
were a period of much instability, in which actual inflation rates and
earnings growth diverged markedly from past experience, with the result
that benefits unexpectedly grew much faster than expected. Finally,
since the benefit formulas for the Old-Age and Survivors Insurance
(OASI) and DI programs are linked, an important consideration of any
indexing proposal is its effect on the benefits provided to disabled
workers. Disabled worker beneficiaries typically become entitled to
benefits much sooner than retired workers and under different
eligibility criteria. As with other ways to change benefits, an index
that is designed to improve solvency by adjusting retirement benefits
may result in large reductions to disabled workers, who often have
fewer options to obtain additional income from other sources.
Choice of a Particular Index Implies Assumptions about the Appropriate
Level of Benefits and Taxes, Adequacy and Equity:
The choice of an index suggests certain assumptions about the
appropriate level of benefits and the overall goal of the
program.[Footnote 50] The current indexing of initial benefits to wage
growth implies that the appropriate level of benefits is one that
maintains replacement rates across birth years. In turn, maintaining
replacement rates implies a relative standard of adequacy and an
assumption that initial benefits should reflect the prevailing standard
of living at the time of retirement. In contrast, changing the current
indexing of initial benefits to price growth implies that the
appropriate level of benefits is one that maintains purchasing
power.[Footnote 51] In turn, maintaining purchasing power implies an
absolute standard of adequacy and an assumption that initial benefits
should reflect a fixed notion of adequacy regardless of improvements in
the standard of living. Also, any index that does not maintain
purchasing power results in workers born in one year receiving higher
benefits than workers with similar earnings born 1 year later.[Footnote
52] This would occur with any benefit change that would reduce
currently promised benefits more than price indexing initial benefits
would, since price indexing maintains the purchasing power of initial
benefits. In the case of longevity indexing, if the growth of initial
benefits were indexed to life expectancy, then this implies that the
increased costs of benefits that stem from increasing life expectancy
should be borne by all future beneficiaries, even if society has become
richer. Therefore, the desired outcome, in terms of initial benefit
levels at the time of retirement, should drive the choice of an index.
The current indexing of existing benefits with the COLA implies that
maintaining the purchasing power of benefits for current retirees is
the appropriate level of benefits. Revising the COLA to reflect a more
accurate calculation of the CPI retains this assumption. However,
adjusting the COLA in a way that does not keep pace with the CPI would
change that assumption and imply a view that the costs of reform should
be shared by current as well as future retirees.
Similarly, on the revenue side, the program currently uses a constant
tax rate, which maintains the same proportion of taxes for all workers
earning less than the maximum taxable earnings level. Applying a life
expectancy index to payroll tax rates suggests that the appropriate
level of taxes is one that prefunds the additional retirement years
increased life expectancy will bestow on current workers, but also that
the appropriate level of benefits is one that maintains replacement
rates, as benefits are unchanged.
Stability of Economic or Demographic Relationships Underlying the Index
Is a Consideration:
Indexing raises other considerations about the stability of the
underlying relationships between the economic and demographic variables
captured by the index. The choice of an index includes issues of risk
and methodology. Some indexes could be based on economic variables that
are volatile, introducing instability because the index generates wide
swings in benefits or taxes. In other cases, long-standing economic or
demographic relationships premised by the index could change, resulting
in unanticipated and unstable benefit or tax levels. While most indexes
will also pose methodological issues, these can become problematic to
address after the index has already been widely used, and the
correction will have implications for benefits or taxes. An example is
the current measurement limitations of the CPI. In other instances, the
index may be based on estimates about future trends in variables like
mortality that could later prove incorrect and erode public confidence
in the system.
Some indexes are premised on the past behavior of economic or
demographic relationships. If these long-standing relationships diverge
for a significant period of time, they may result in unanticipated and
unstable benefit or tax levels. For example, the 1972 amendments that
introduced indexing into the Social Security program were premised on
the belief that over time, wage growth will generally substantially
exceed price inflation. However, for much of the 1970s, actual
inflation rates and earnings growth diverged markedly from past
experience; price inflation grew much faster than wages, with the
result that benefits grew much faster than anticipated. This
development introduced major instability into the program, which was
unsustainable. Congress addressed this problem when it passed the 1977
amendments.[Footnote 53] Moreover, even though the 1977 amendments
succeeded in substantially stabilizing the replacement rates for
initial benefits, a solvency crisis required reforms just 6 years later
with the 1983 amendments. High inflation rates resulted in high COLAs
for existing benefits just as recession was depressing receipts from
the payroll taxes. The indexing of initial benefits under the 1977
amendments did not address the potential for such economic conditions
to affect COLAs or payroll tax receipts.
Many indexes have methodological issues associated with their
calculation, which can become problems over time. For example, the CPI
has long been in use by the Social Security program and other social
welfare programs. However, the CPI is not without its methodological
problems. Some studies have contended that the CPI overstates inflation
for a number of reasons, including that it does not account for how
consumers can substitute one good for another because the calculation
assumes that consumers do not change their buying patterns in response
to price changes.[Footnote 54] Correcting for this "substitution
effect" would likely lower the CPI. Changing the calculation in
response to this concern might improve accuracy but is controversial
because it would also likely result in lower future benefits and put
more judgment into the calculation.
Indexes that are constructed around assumptions about future experience
raise other methodological issues. An example is a mortality index,
which seeks to measure future changes in population deaths. Such a
measure would presumably capture an aspect of increased longevity or
well-being in retirement and could be viewed as a relevant determinant
of program benefits or taxes. Accuracy in this index would require
forecasts of future mortality based on assumptions of the main
determinants influencing future population deaths (i.e., medical
advances, diet, income changes). Such forecasts would require a clear
consensus about these factors and how to measure and forecast them.
However, currently there is considerable disagreement among researchers
in terms of their beliefs about the magnitude of mortality change in
the future.[Footnote 55] In choosing an index, such methodological
issues would need to be carefully considered to maintain public support
and confidence.
The Treatment of Disabled and Survivor Beneficiaries Poses Challenges
When Modifying the Indexing:
Under the current structure of the U.S. Social Security system, the
OASI and DI programs share the same benefit formula. Thus, any changes
that affect retired workers will also affect survivors and disabled
workers. However, the circumstances facing these beneficiaries differ
from those facing retired workers. For example, the disabled worker's
options for alternative sources of income, especially earnings-related
income, to augment any reduction in benefits are likely to be more
limited than are those for the retired worker. Further, DI
beneficiaries enter the program at younger ages and may receive
benefits for many years. As a result, disabled beneficiaries could be
subject to benefit changes for many years more than those beneficiaries
requiring benefits only in retirement.[Footnote 56]
These differing circumstances among beneficiaries raise the issue of
whether any proposed indexing changes, or any other benefit changes,
should be applied to disabled worker and survivor beneficiaries, as
well as to retired worker beneficiaries.[Footnote 57] If disabled
worker beneficiaries are not subject to indexing changes applied to
retirees, benefit levels for disabled workers could ultimately be
higher than those of retired workers. This difference in benefit levels
would occur because disabled workers typically become entitled to
benefits sooner than retired workers, and thus any reductions in their
replacement factors would be smaller. Such a differential could
increase the incentive for older workers to apply for disability
benefits as they near retirement age.
Excluding the disability program from indexing changes has implications
for solvency and raises implementation issues. If the indexing changes
are not applied to the disability program, even larger benefit
reductions or revenue increases would be needed to achieve fiscal
solvency. Since the OASI and DI programs share the same benefit
formula, excluding disabled worker beneficiaries from indexing changes
might also necessitate the use of two different benefit formulas or
require a method to recalculate benefits in order to maintain different
indexing in each program. Such changes could lead to confusion among
the public about how the programs operate, which may require
significant additional public education.
Concluding Observations:
Indexing has played an important role in the determination of Social
Security's benefits and revenues for over 30 years. As in other
countries seeking national pension system reform, recent proposals to
modify the role of indexing in Social Security have primarily focused
on addressing the program's long-term solvency problems. In theory, one
index may be better than another in keeping the program in financial
balance on a sustainable basis. However, such a conclusion would be
based on assumptions about the future behavior of various demographic
and economic variables, and those assumptions will always have
considerable uncertainty. Future demographic patterns and economic
trends could emerge that affect solvency in ways that have not been
anticipated. So, while indexing changes may reduce how often Congress
needs to rebalance the program's finances, there is no guarantee that
the need will not arise again.
Yet program reform, and the role of indexing in that reform, is about
more than solvency. Reforms also reflect implicit visions about the
size, scope, and purpose of the Social Security system. Indexing
initial benefits, existing benefits, tax rates, the maximum taxable
earnings level, or some other parameter or combination will have
different consequences for the level and distribution of benefits and
taxes, within and across generations and earnings levels. These
questions relate to the trade-off between income adequacy and benefit
equity.
In the final analysis, indexing, like other individual reforms, comes
down to a few critical questions: What is to be accomplished or
achieved, who is to be affected, is it affordable and sustainable, and
how will the change be phased in over time? Although these issues are
complex and controversial, they are not unsolvable; they have been
reconciled in the past and can be reconciled now. Indexing can be part
of a larger, more comprehensive reform package that would include other
elements whose cumulative effect could achieve the desired balance
between adequacy and equity while also achieving solvency. The
challenge is not whether indexing should be part of any necessary
reforms, but that necessary action is taken soon to put Social Security
back on a sound financial footing.
Agency Comments:
We provided a draft of this report to SSA and the Department of the
Treasury. SSA provided technical comments, which we have incorporated
as appropriate.
We are sending copies of this report to the Social Security
Administration and the Treasury Department, as well as other interested
parties. Copies will also be made available to others upon request. In
addition, the report will be available at no charge on the GAO Web site
at [Hyperlink, http://www.gao.gov]. Please contact me at (202) 512-
7215, if you have any questions about this report. Other major
contributors include Charles Jeszeck, Michael Collins, Anna Bonelli,
Charles Ford, Ken Stockbridge, Seyda Wentworth, Joseph Applebaum, and
Roger Thomas.
Signed by:
Barbara D. Bovbjerg:
Director, Education, Workforce, and Income Security Issues:
[End of section]
Appendix I: Methodology:
Microsimulation Model:
Description:
Genuine Microsimulation of Social Security and Accounts (GEMINI) is a
microsimulation model developed by the Policy Simulation Group (PSG).
GEMINI simulates Social Security benefits and taxes for large
representative samples of people born in the same year. GEMINI
simulates all types of Social Security benefits, including retired
worker, spouse, survivor, and disability benefits. It can be used to
model a variety of Social Security reforms including the introduction
of individual accounts.
GEMINI uses inputs from two other PSG models, the Social Security and
Accounts Simulator (SSASIM), which has been used in numerous GAO
reports, and the Pension Simulator (PENSIM), which has been developed
for the Department of Labor. GEMINI relies on SSASIM for economic and
demographic projections and relies on PENSIM for simulated life
histories of large representative samples of people born in the same
year and their spouses.[Footnote 58] 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),[Footnote 59] and the Panel Study of Income Dynamics.
Additionally, any projected statistics (such as life expectancy,
employment patterns, and marital status at age 60) are, where possible,
consistent with intermediate cost projections from Social Security
Administration's Office of the Chief Actuary (OCACT). At their best,
such models can provide only very rough estimates of future incomes.
However, these estimates may be useful for comparing future incomes
across alternative policy scenarios and over time.
GEMINI can be operated as a free-standing model or it can operate as a
SSASIM add-on. When operating as an add-on, GEMINI is started
automatically by SSASIM for one of two purposes. GEMINI can enable the
SSASIM macro model to operate in the Overlapping Cohorts (OLC) mode or
it can enable the SSASIM micro model to operate in the Representative
Cohort Sample (RCS) mode. The SSASIM OLC mode requests GEMINI to
produce samples for each cohort born after 1934 in order to build up
aggregate payroll tax revenues and OASDI benefit expenditures for each
calendar year, which are used by SSASIM to calculate standard trust
fund financial statistics. In either mode, GEMINI operates with the
same logic, but typically with smaller cohort sample sizes in OLC mode
than in the RCS or stand-alone-model mode.
For this report we used GEMINI to simulate Social Security benefits and
taxes primarily for 100,000 individuals born in 1985. Benefits and
taxes were simulated under our tax increase (promised benefits) and
proportional benefit reduction (funded benefits) benchmarks (described
below) and various indexation approaches.
Assumptions and Limitations:
To facilitate our modeling analysis, we made a variety of assumptions
regarding economic and demographic trends. 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 and changes over time.
2005 Social Security Trustees' Assumptions:
The simulations are based on economic and demographic assumptions from
the 2005 Social Security trustees' report.[Footnote 60] While the 2006
trustees' report has been released, the assumptions have changed very
little from the 2005 assumptions. We used trustees' intermediate
assumptions for inflation, real wage growth, mortality decline,
immigration, labor force participation, and interest rates.
Distributional Effects Over Time:
We simulated benefits for individuals born in 1955, 1970, 1985, and
2000. However, the majority of our figures focus on individuals born in
1985 because all prospective indexing changes would be almost fully
phased in for these individuals. However, the distributional effects
might change over time. This is because each index phases in over time
and reduces the primary insurance amount (PIA) formula factors (or
increases the Old-Age and Survivors Insurance (OASI) and Disability
Insurance (DI) taxes) at different rates. For example, individuals in
the 1955 cohort that survive to age 65 do so in the year 2020, so the
benefit reductions (or tax increases), which we specify to begin
sometime between 2006 and 2012, depending on the scenario, have only
been implemented for about 8 to 14 years. Additionally, members of the
cohort that become disabled might become disabled prior to the
implementation of annual PIA reductions or tax increases. Such issues
become less pronounced with the younger cohorts.
Pre-retirement Mortality:
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.[Footnote 61]
Description of Alternative Policy Scenarios:
CPI Indexing:
To simulate consumer price indexing (CPI) indexing, which essentially
links the growth of initial benefits to changes in the CPI, we
successively modified the PIA formula replacement factors (90, 32, and
15) beginning in 2012, reducing them successively by real wage growth
in the second prior year. This specification mimics provision B6 of the
August 10, 2005 memorandum to SSA's Chief Actuary regarding the
provision requested by the Social Security Advisory Board (SSAB), which
is an update of provision 1 of Model 2 of the President's Commission to
Strengthen Social Security (CSSS).[Footnote 62] As noted in the CSSS
solvency memorandum from SSA's Chief Actuary, "[t]his provision would
result in increasing benefit levels for individuals with equivalent
lifetime earnings across generations (relative to the average wage
level) at the rate of price growth (increase in the CPI), rather than
at the rate of growth in the average wage level as in current law."
This provision as specified and scored by OCACT in the SSAB memo would
increase the size of the long-range OASDI actuarial balance (reduce the
actuarial deficit) by an estimated 2.38 percent of taxable payroll.
Using the overlapping cohort mode of SSASIM, we estimated this
provision as increasing the size of the long-range OASDI actuarial
balance by 2.43 percent of taxable payroll, or 5 basis points more than
the OCACT scoring.
Mortality Indexing:
To simulate mortality indexing, which links the growth of initial
benefits to changes in life expectancy to maintain a constant life
expectancy at the normal retirement age, we successively modified the
PIA formula replacement factors (90, 32, 15) beginning in 2009,
reducing them annually by multiplying them by 0.995. This specification
mimics provision 1 of Model 3 of CSSS.[Footnote 63] The CSSS solvency
memorandum notes that the 0.995 successive reduction "reduces monthly
benefit levels by an amount equivalent to increasing the normal
retirement age (NRA) for retired workers by enough to maintain a
constant life expectancy at NRA, for any fixed age of benefit
entitlement."[Footnote 64]
This provision as specified and scored--using the intermediate
assumptions of the 2001 trustees' report--in the CSSS memo by SSA's
Office of the Chief Actuary would reduce the size of the long-range
OASDI actuarial balance (reduce the actuarial deficit) by an estimated
1.17 percent of taxable payroll. Using the overlapping cohort mode of
SSASIM and specifications, which mimic the intermediate assumptions of
the 2005 trustees' report, we estimated this provision as increasing
the size of the long-range OASDI actuarial balance by 1.39 percent of
taxable payroll, or 22 basis points more than the earlier OCACT
scoring.
Dependency Indexing:
Benefits:
To simulate so-called dependency indexing of benefits, which links the
growth of initial benefits to changes in the dependency ratio, we
successively modified the PIA formula replacement factors (90, 32, and
15) beginning in 2010, by reducing them annually by an index that
follows the inverse of the increase in the aged dependency ratio from 2
years prior. For example, the reduction for 2010 is given by dividing
the 2009 PIA formula factors (90, 32, and 15) by 1.0098, which is rate
of increase from 2007 to 2008.[Footnote 65]
This provision as specified has not been scored by OCACT. Using the
overlapping cohort mode of SSASIM and specifications that mimic the
intermediate assumptions of the 2005 trustees' report, we estimated
this provision as increasing the size of the long-range OASDI actuarial
balance by 3.78 percent of taxable payroll.
Taxes:
To simulate so-called dependency indexing of payroll taxes, which links
the growth of payroll taxes to changes in the dependency ratio, we
increased the initial OASI and DI tax rates (both employer and employee
combined) in 2009 by a cumulative index that increases annually by the
rate of increase in the aged dependency ratio from 2 years prior. For
example, the increase for 2010 is given by multiplying the 12.4 percent
tax rate (employer and employee combined--10.60 percent for OASI and
1.80 percent for DI) by 1.0098--the rate of increase from 2007 to 2008-
-to arrive at a rate of 10.70 percent for OASI and 1.82 percent for DI.
By 2050 the cumulative index is 1.863, and the tax rates (employer and
employee combined) are 19.75 percent for OASI and 3.35 percent for DI.
This provision as specified has not been scored by OCACT. Using the
overlapping cohort mode of SSASIM and specifications that mimic the
intermediate assumptions of the 2005 trustees' report, we estimated
this provision as increasing the size of the long-range OASDI actuarial
balance by 6.98 percent of taxable payroll.
Scaling to Achieve Comparable Levels of Solvency over 75 Years:
We modified the aforementioned CPI, mortality, and dependency indexes
to "scale" them to achieve comparable levels of solvency over a 75-year
period--the same actuarial period used by OCACT in trustees' reports
and solvency memorandums.[Footnote 66] To scale the proposals, we
modified the PIAs (or OASI and DI tax rates in the case of the aged
dependency ratio tax increase index) by a scaled factor equal to the
inverse of the percentage of solvency attained by the original,
unscaled version of the proposal. For each year in the 75-year period,
the scaling factor is multiplied by the percentage point difference
between the unscaled PIA factors and the factors prior to
implementation of the proposal (i.e., 90, 32, and 15).[Footnote 67] The
application of the so-called scaling factor to the PIA factors (or
OASDI tax rates) conveniently modifies the index in such a way that 75-
year actuarial balance is 0.[Footnote 68]
Table 4: Application of So-called Scaling of PIA Factors for Aged
Dependency Ratio Benefit Reduction Index: An Example Using 2050 PIA
Formula Factors:
Step: 1;
Description: PIA formula factors in 2009;
PIA formula factor or calculation: 90.0;
PIA formula factor or calculation: 32.0;
PIA formula factor or calculation: 15.0.
Step: 2;
Description: PIA formula factors in 2050;
PIA formula factor or calculation: 48.3;
PIA formula factor or calculation: 17.2;
PIA formula factor or calculation: 8.1.
Step: 3;
Description: Difference between factors in 2050 and initial factors
(i.e., the factors in 2009 or prior);
PIA formula factor or calculation: 41.7;
PIA formula factor or calculation: 14.8;
PIA formula factor or calculation: 6.9.
Step: 4;
Description: Scaling factor[A];
PIA formula factor or calculation: .508;
PIA formula factor or calculation: .508;
PIA formula factor or calculation: .508.
Step: 5;
Description: Difference multiplied by scaling factor (i.e., step 3 *
step 4);
PIA formula factor or calculation: 21.2;
PIA formula factor or calculation: 7.5;
PIA formula factor or calculation: 3.5.
Step: 6;
Description: New, so-called "scaled" PIA formula factors (i.e., step 1-
step 5);
PIA formula factor or calculation: 68.8;
PIA formula factor or calculation: 24.5;
PIA formula factor or calculation: 11.5.
Source: GAO.
[A] The aged dependency benefit reduction index increases the 75-year
OASDI actuarial balance by 3.78 percent of taxable payroll. This is
196.9 percent of 1.92 percent of taxable payroll, which is the amount
required to produce a 75-year actuarial balance of 0 under the
intermediate assumptions of the 2005 trustees' report. The inverse
(i.e., 1/x) of 196.9 percent is 50.8 percent.
[End of table]
Data Reliability:
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
solvency estimates, where applicable, with published results from 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
limiting the sample to those who survive to retirement. Our findings
were consistent across all specifications.
Benchmark Policy Scenarios:
According to current projections of the Social Security trustees for
the next 75 years, revenues will not be adequate to pay full benefits
as defined by the current benefit formula. Therefore, estimating future
Social Security benefits should reflect that actuarial deficit and
account for the fact that some combination of benefit reductions and
revenue increases will be necessary to restore long-term solvency.
To illustrate a full range of possible outcomes, we developed
hypothetical benchmark policy scenarios that would achieve 75-year
solvency either by only increasing payroll taxes or by only reducing
benefits.[Footnote 69] In developing these benchmarks, we identified
criteria to use to guide their design and selection. Our tax-increase-
only benchmark simulates "promised benefits," or those benefits
promised by the current benefit formula, while our benefit-reduction-
only benchmarks simulate "funded benefits," or those benefits for which
currently scheduled revenues are projected to be sufficient. Under the
latter policy scenarios, the benefit reductions would be phased in
between 2010 and 2040 to strike a balance between the size of the
incremental reductions each year and the size of the ultimate
reduction.
SSA actuaries scored our original 2001 benchmark policies and
determined the parameters for each that would achieve 75-year
solvency.[Footnote 70] Table 5 summarizes our benchmark policy
scenarios. For our benefit reduction scenarios, the actuaries
determined these parameters assuming that disabled and survivor
benefits would be reduced on the same basis as retired worker and
dependent benefits. If disabled and survivor benefits were not reduced
at all, reductions in other benefits would be greater than shown in
this analysis.
Table 5: Summary of Benchmark Policy Scenarios:
Benchmark policy scenario: Tax increase only (promised benefits);
Description: Increases payroll taxes in 2006 by amount necessary to
achieve 75-year solvency (0.98 percent of payroll each for employees
and employers);
Phase-in period: Immediate;
Ultimate new benefit reductions[A] (percent): 0.
Benchmark policy scenario: Proportional benefit reduction (funded
benefits);
Description: Reduces benefit formula factors proportionally across all
earnings levels;
Phase-in period: 2010-2040;
Ultimate new benefit reductions[A] (percent): 25.
Source: GAO.
[A] These benefit reduction amounts do not reflect the implicit
reductions resulting from the gradual increase in the full retirement
age that has already been enacted.
[End of table]
Criteria:
According to our analysis, appropriate benchmark policies should
ideally be evaluated against the following criteria:
1. Distributional neutrality: The benchmark should reflect the current
system as closely as possible while still restoring solvency. In
particular, it should try to reflect the goals and effects of the
current system with respect to redistribution of income. However, there
are many possible ways to interpret what this means, such as:
a. producing a distribution of benefit levels with a shape similar to
the distribution under the current benefit formula (as measured by
coefficients of variation, skewness, kurtosis, and so forth),
b. maintaining a proportional level of income transfers in 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.
Tax-Increase-Only, or "Promised Benefits," Benchmark Policies:
Our tax-increase-only benchmark would raise payroll taxes once and
immediately by the amount of Social Security's actuarial deficit as a
percentage of payroll. It results in the smallest ultimate tax rate of
those we considered and spreads the tax burden most evenly across
generations; this is the primary basis for our selection. The later
that taxes are increased, the higher the ultimate tax rate needed to
achieve solvency, and in turn the higher the tax burden on later
taxpayers and lower on earlier taxpayers. Still, any policy scenario
that achieves 75-year solvency only by increasing revenues would have
the same effect on the adequacy of future benefits in that promised
benefits would not be reduced. Nevertheless, alternative approaches to
increasing revenues could have very different effects on individual
equity.
Benefit-Reduction-Only, or "Funded Benefits," Benchmark Policies:
We developed alternative benefit reduction benchmarks for our analysis.
For ease of modeling, all benefit reduction benchmarks take the form of
reductions in the benefit formula factors; they differ in the relative
size of those reductions across the three factors, which are 90, 32,
and 15 percent under the current formula. Each benchmark has three
dimensions of specification: scope, phase-in period, and the factor
changes themselves.
Scope:
For our analysis, we apply benefit reductions in our benchmarks very
generally to all types of benefits, including disability and survivors'
benefits as well as old-age benefits. Our objective is to find policies
that achieve solvency while reflecting the distributional effects of
the current program as closely as possible. Therefore, it would not be
appropriate to reduce some benefits and not others. If disabled and
survivor benefits were not reduced at all, reductions in other benefits
would be deeper than shown in this analysis.
Phase-in Period:
We selected a phase-in period that begins with those becoming initially
entitled in 2010 and continues for 30 years. We chose this phase-in
period to achieve a balance between two competing objectives: (1)
minimizing the size of the ultimate benefit reduction and (2)
minimizing the size of each year's incremental reduction to avoid
"notches," or unduly large incremental reductions. Notches create
marked inequities between beneficiaries close in age to each other.
Later birth cohorts are generally agreed to experience lower rates of
return on their contributions already under the current system.
Therefore, minimizing the size of the ultimate benefit reduction would
also minimize further reductions in rates of return for later cohorts.
The smaller each year's reduction, the longer it will take for benefit
reductions to achieve solvency, and in turn the greater the eventual
reductions will have to be. However, the smallest possible ultimate
reduction would be achieved by reducing benefits immediately for all
new retirees by 13 percent; this would create a notch.
In addition, we feel it is appropriate to delay the first year of the
benefit reductions for a few years because those within a few years of
retirement would not have adequate time to adjust their retirement
planning if the reductions applied immediately. The Maintain Tax Rates
(MTR) benchmark in the 1994-1996 Advisory Council report also provided
for a similar delay.[Footnote 71]
Finally, the timing of any policy changes in a benchmark scenario
should be consistent with the proposals against which the benchmark is
compared. The analysis of any proposal assumes that the proposal is
enacted, usually within a few years. Consistency requires that any
benchmark also assumes enactment of the benchmark policy in the same
time frame. Some analysts have suggested using a benchmark scenario in
which Congress does not act at all and the trust funds become
exhausted.[Footnote 72] However, such a benchmark assumes that no
action is taken while the proposals against which it is compared assume
that action is taken, which is inconsistent. It also seems unlikely
that a policy enacted over the next few years would wait to reduce
benefits until the trust funds are exhausted; such a policy would
result in a sudden, large benefit reduction and create substantial
inequities across generations.
Defining the PIA Formula Factor Reductions:
When workers retire, become disabled, or die, Social Security uses
their lifetime earnings records to determine each worker's PIA, on
which the initial benefit and auxiliary benefits are based. The PIA is
the result of two elements--the Average Indexed Monthly Earnings (AIME)
and the benefit formula. The AIME is determined by taking the lifetime
earnings record, indexing it, and taking the average of the highest 35
years of indexed wages.[Footnote 73] To determine the PIA, the AIME is
then applied to a step-like formula, shown here for 2006.
PIA = 90% times (AIME(1) < $656):
+ 32% times (AIME(2) > $656 and $3955):
+ 15% times (AIME(3) > $3955):
where AIME(1) 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,
FI(t+1) = FI(t) - (Fi(2006) times x):
where:
FI(t) represents the three PIA formula factors in year t and:
x = constant proportional formula factor reduction.
The value of x is calculated to achieve 75-year solvency, given the
chosen phase-in period and scope of reductions.
The formula for this reduction specifies that the proportional
reduction is always taken as a proportion of the current law factors
rather than the factors for each preceding year. This maintains a
constant rate of benefit reduction from year to year. In contrast,
taking the reduction as a proportion of each preceding year's factors
implies a decelerating of the benefit reduction over time because each
preceding year's factors gets smaller with each reduction. To achieve
the same level of 75-year solvency, this would require a greater
proportional reduction in earlier years because of the smaller
reductions in later years.
The proportional reduction hits lower earners harder than higher
earners because the constant x percent of the higher formula factors
results in a larger percentage reduction over the lower earnings
segments of the formula. For example, in a year when the cumulative
size of the proportional reduction has reached 10 percent, the 90
percent factor would then have been reduced by 9 percentage points, the
32 percent factor by 3.2 percentage points, and the 15 percent factor
by 1.5 percentage points. As a result, earnings in the first segment of
the benefit formula would be replaced at 9 percentage points less than
the current formula, while earnings in the third segment of the formula
would be replaced at only 1.5 percentage points less than the current
formula.[Footnote 74]
Table 6 summarizes the features of our benchmarks.
Table 6: Summary of Benchmark Policy Scenario Parameters:
Benchmark policy scenario: Tax increase only (promised benefits);
Phase-in period: 2006;
Annual PIA factor reduction (percentage point): 90 percent factor: 0;
Annual PIA factor reduction (percentage point): 32 percent factor: 00;
Annual PIA factor reduction (percentage point): 15 percent factor: 0;
Ultimate PIA factor (2040) (percent): 90 percent factor: 90.00;
Ultimate PIA factor (2040) (percent): 32 percent factor: 32.00;
Ultimate PIA factor (2040) (percent): 15 percent factor: 15.00.
Benchmark policy scenario: Proportional benefit reduction (funded
benefits);
Phase-in period: 2010-2040;
Annual PIA factor reduction (percentage point): 90 percent factor:
0.74;
Annual PIA factor reduction (percentage point): 32 percent factor:
0.26;
Annual PIA factor reduction (percentage point): 15 percent factor:
0.12; [
Ultimate PIA factor (2040) (percent): 90 percent factor: 67.07;
Ultimate PIA factor (2040) (percent): 32 percent factor: 23.85;
Ultimate PIA factor (2040) (percent): 15 percent factor: 11.18.
Source: GAO's analysis as scored by SSA actuaries.
Note: Annual PIA factor reductions rounded to the nearest hundredth of
a percent.
[End of table]
[End of section]
Appendix II: Background on Development of Social Security's Indexing
Approach:
Social Security did not originally use indexing to automatically adjust
benefit and tax provisions; only ad hoc changes were made. The 1972
amendments provided for automatic indexing of benefits and taxes for
the first time, but the indexing approach for benefits was flawed,
introducing potential instability in benefit costs. The 1977 amendments
addressed those issues, resulting in the basic framework for indexing
benefits still in use today.
Program Did Not Use Indexing until 1970s:
Before the 1970s, the Social Security program did not use indexing to
adjust benefits or taxes automatically. For both new and existing
beneficiaries, benefit rates increased only when Congress voted to
raise them. The same was true for the tax rate and the cap on the
amount of workers' earnings that were subject to the payroll tax. Under
the 1972 amendments to the Social Security Act, benefits and taxes were
indexed for the first time, and revisions in the 1977 amendments
created the basic framework still in use today.
Ad Hoc Benefit and Tax Changes Had Sporadic Effects:
Until 1950, Congress legislated no changes to the benefit formula of
any kind. As a result, average inflation-adjusted benefits for retired
workers fell by 32 percent between 1940 and 1949. Under the 1950
amendments to the Social Security Act, these benefits increased 67
percent in 1 year. Afterward, until 1972, periodic amendments made
various ad hoc adjustments to benefit levels. Economic prosperity and
regular trust fund surpluses facilitated gradual growth of benefit
levels through these ad hoc adjustments.[Footnote 75] In light of the
steady growth of benefit levels, the 1972 amendments instituted
automatic adjustments to constrain the growth of benefits as well as to
ensure that they kept pace with inflation. Table 7 summarizes the
history of benefit increases before 1972. It illustrates that between
1940 and 1971, average benefits for all current beneficiaries tripled
while prices nearly doubled and wages more than quintupled.[Footnote
76] Some benefit increases were faster and some were slower than wages
increases.
Table 7: Percentage Increases in OASI Benefits, Prices, and Wages, by
Effective Date of OASI Change, 1950-1971:
Date of change[A]: September 1950;
Increase in OASI benefit: Since prior amendment[B]: 81.3[C];
Increase in OASI benefit: Since January 1940: 81.3;
Increase in consumer price index: Since prior amendment: 75.5[C];
Increase in consumer price index: Since January 1940: 75.5;
Increase in average wages: Since prior amendment: 148.8[C];
Increase in average wages: Since January 1940: 148.8.
Date of change[A]: September 1952;
Increase in OASI benefit: Since prior amendment[B]: 14.1;
Increase in OASI benefit: Since January 1940: 106.9;
Increase in consumer price index: Since prior amendment: 9.3;
Increase in consumer price index: Since January 1940: 91.8;
Increase in average wages: Since prior amendment: 12.5;
Increase in average wages: Since January 1940: 179.9.
Date of change[A]: September 1954;
Increase in OASI benefit: Since prior amendment[B]: 13.3;
Increase in OASI benefit: Since January 1940: 134.3;
Increase in consumer price index: Since prior amendment: 0.5;
Increase in consumer price index: Since January 1940: 92.8;
Increase in average wages: Since prior amendment: 7.7;
Increase in average wages: Since January 1940: 201.5.
Date of change[A]: January 1959 (1958);
Increase in OASI benefit: Since prior amendment[B]: 7.7;
Increase in OASI benefit: Since January 1940: 152.4;
Increase in consumer price index: Since prior amendment: 7.9;
Increase in consumer price index: Since January 1940: 108.0;
Increase in average wages: Since prior amendment: 19.4;
Increase in average wages: Since January 1940: 259.9.
Date of change[A]: January 1965;
Increase in OASI benefit: Since prior amendment[B]: 7.7;
Increase in OASI benefit: Since January 1940: 171.9;
Increase in consumer price index: Since prior amendment: 7.9;
Increase in consumer price index: Since January 1940: 124.5;
Increase in average wages: Since prior amendment: 22.3;
Increase in average wages: Since January 1940: 340.2.
Date of change[A]: February 1968 (1967);
Increase in OASI benefit: Since prior amendment[B]: 14.2;
Increase in OASI benefit: Since January 1940: 210.5;
Increase in consumer price index: Since prior amendment: 9.3;
Increase in consumer price index: Since January 1940: 145.4;
Increase in average wages: Since prior amendment: 18.0;
Increase in average wages: Since January 1940: 419.4.
Date of change[A]: January 1970 (1969);
Increase in OASI benefit: Since prior amendment[B]: 15.6;
Increase in OASI benefit: Since January 1940: 258.9;
Increase in consumer price index: Since prior amendment: 10.8;
Increase in consumer price index: Since January 1940: 171.8;
Increase in average wages: Since prior amendment: 12.2;
Increase in average wages: Since January 1940: 482.8.
Date of change[A]: January 1971;
Increase in OASI benefit: Since prior amendment[B]: 10.4;
Increase in OASI benefit: Since January 1940: 296.2;
Increase in consumer price index: Since prior amendment: 5.2;
Increase in consumer price index: Since January 1940: 185.9;
Increase in average wages: Since prior amendment: 5.3;
Increase in average wages: Since January 1940: 513.7.
Source: Martha Derthick, Policymaking for Social Security, The
Brookings Institution, Washington, D.C., 1979, p. 276. Reprinted with
permission of the Brookings Institution Press, and GAO analysis.
[A] Year of enactment, if different from year in which change took
effect, is in parentheses.
[B] Average increases for current beneficiaries, that is, people who
were on the rolls. At the same time, increases approximately equal to
these were promised by statutory formula, to active workers.
[C] Percentage increase since January 1940, when OASI benefits were
first paid.
[End of table]
On the revenue side, payroll tax rates have never been indexed.
However, Social Security's revenue also depends on the maximum amount
of workers' earnings that are subject to the payroll tax. This cap is
technically known as the contribution and benefit base because it
limits the earnings level used to compute benefits as well as
taxes.[Footnote 77] Just as with benefits, the maximum taxable earnings
level did not change until the 1950 amendments even as price and
earning levels were increasing. From 1940 to 1950, the inflation-
adjusted value of the cap fell by over 40 percent. Also, until the 1972
amendments, adjustments to the maximum taxable earnings level were made
on an ad hoc basis. With the enactment of the 1972 amendments, the
maximum taxable earnings level increased automatically based on
increases in average earnings. Figure 9 shows the inflation-adjusted
values for the maximum taxable earnings level before automatic
adjustments took effect in 1975.[Footnote 78] Figure 10 shows that as a
result of the fluctuations in the maximum taxable earnings level, the
proportion of earnings subject to the payroll tax varied widely before
indexing, ranging from 71 to 93 percent.
Figure 9: Inflation-Adjusted Values of the Maximum Taxable Earnings
Level before Automatic Adjustments, 1937-1975:
[See PDF for image]
Source: SSA, and GAO analysis.
Note: The maximum taxable earnings level is the level at which earnings
are subject to the payroll tax.
[End of figure]
Figure 10: Percentage of Total Covered Earnings below Social Security's
Maximum Taxable Earnings Level, 1937-2005:
[See PDF for image]
Source: SSA.
[End of figure]
Indexing in 1972 Amendments Built on Previous Ad Hoc Benefit Increases:
The 1972 amendments, in effect, provided for indexing initial benefits
twice for new beneficiaries. The indexing changed the benefit formula
in the same way that previous ad hoc increases had done.
Approach Used for Ad Hoc Benefit Increases:
Before the 1972 amendments, benefits were computed essentially by
applying different replacement factors to different portions of a
worker's earnings. For example, under the 1958 amendments, a workers'
PIA[Footnote 79] would equal:
58.85 percent of first $110 of average monthly wages plus 21.40 percent
of next $290,
where the 58.85 and 21.40 percents are the replacement factors that
determine how much of a worker's earnings will be replaced by the
Social Security benefit.[Footnote 80] Subsequent amendments increased
benefits by effectively increasing the replacement factors. For
example, the 1965 amendments increased benefits by 7 percent for a
given average monthly wage by increasing the replacement factors by 7
percent to 62.97 from 58.85 and to 22.9 percent from 21.4.[Footnote 81]
The automatic adjustments under the 1972 amendments increased these
same replacement factors according to changes in the CPI. These changes
in the benefit computation applied equally to both new and existing
beneficiaries.[Footnote 82]
To illustrate how the benefit formula worked, take, for example, a
worker with an average monthly wage of $200 who became entitled in 1959
(when the 1958 amendments first took effect). The PIA for this worker
would be:
58.85 percent of $110 plus:
21.4 percent of the average monthly wage over $110, that is, $200-110 =
$90, which equals:
$64.74 + $19.26 = 84.00.
When the 1965 amendments took effect, this same beneficiary would have
the PIA recalculated using the new formula. Assuming no new wages, the
average monthly wage would still be $200, and the new PIA would be:
62.97 percent of $110 plus:
22.9 percent of the average monthly wage over $110, that is, $200-110 =
$90, which equals:
$69.27 + $20.61 = 89.88, which is 7 percent greater than the previous
$84.00.
Now consider the example of a new beneficiary, who became entitled in
1965 (when the 1965 amendments first became effective). For the
purposes of this illustration, to reflect wage growth, assume this
worker had an average monthly wage of $240.00, or 20 percent more than
our previous worker who became entitled in 1959. For this new
beneficiary, the PIA in 1965 would be $99.04, which, as a result of the
wage growth, is much more than 7 percent higher than the initial
benefit for the worker in 1959.
1972 Amendments Introduced Indexing:
The 1972 amendments provided for automatic indexing of benefits and
taxes for the first time. The indexing approach for benefits was flawed
and raised issues that the 1977 amendments addressed; these issues help
explain the basic framework for indexing benefits still in use today.
In particular, the indexing approach in the 1972 amendments resulted in
(1) double-indexing benefits to inflation for new beneficiaries though
not for existing ones and (2) a form of bracket creep that slowed
benefit growth as earnings increased over time. Within a few years, the
problems raised by the double indexing under the 1972 amendments became
apparent, with benefits growing far faster than anticipated.
Under the 1972 amendments, indexing the replacement factors in the
benefit formula to inflation had the effect of indexing twice for new
beneficiaries. First, the increase in the replacement factors
themselves reflected changes in the price level. Second, the benefit
calculations were based on earnings levels, which were higher for each
new group of beneficiaries, partially as a result of
inflation.[Footnote 83] Thus, benefit levels grew for each new year's
group of beneficiaries because both the benefit formula reflected
inflation and their higher average wages reflected inflation. For
existing beneficiaries who had stopped working, the average earnings
used to compute their benefits did not change, so growth in earnings
levels did not affect their benefits and double indexing did not occur.
Once the double indexing for new beneficiaries was understood, the need
became clear to index benefits differently for new and existing
beneficiaries, which was referred to as "decoupling" benefits.
The effect of double indexing on replacement rates could be offset by a
type of "bracket creep" in the benefit formula, depending on the
relative values of wage and price growth over time. Bracket creep
resulted from the progressive benefit formula, which provided lower
replacement rates for higher earners than for lower earners. As each
year passed and average earnings of new beneficiaries grew, more and
more earnings would be replaced at the lower rate used for the upper
bracket, making replacement rates fall on average, all else being
equal.
Indexing Approach Introduced Potential Instability in Benefit Costs:
The combination of double indexing and bracket creep implied in the
1972 amendments introduced a potential instability in Social Security
benefit costs. Price growth determined the effects of double indexing,
and wage growth determined the effects of bracket creep. The extent to
which bracket creep offset the effects of double indexing depended on
the relative values of price growth and wage growth, which could vary
considerably. Had wage and price growth followed the historical pattern
at the time, benefits would not have grown faster than expected and
replacement rates would not have risen; the inflation effect and the
bracket creep effect would have balanced out. However, during the
1970s, actual rates of inflation and earnings growth diverged markedly
from past experience (see fig. 11), with the result that benefit costs
grew far faster than revenues.
Figure 11: Changes in Average Wage Index and Consumer Price Index, 1951-
1985:
[See PDF for image]
Source: SSA and US Bureau of Labor Statistics.
[End of figure]
In contrast, an indexing approach that stabilized replacement rates
would help to stabilize program costs. To illustrate this, annual
benefit costs can be expressed as a fraction of the total taxable
payroll in a given year, that is, total covered earnings.[Footnote 84]
In turn, this can be shown to relate closely to replacement rates.
Total Benefits/Total covered earnings =
Number of beneficiaries times Average benefit/Number of workers times
Average taxable earnings =
Number of beneficiaries/Number of workers times Average benefit/Average
taxable earnings
While not precisely a replacement rate, the second term on the last
line above--the ratio of the average benefit to average taxable
earnings--is closely related to the replacement rates provided under
the program. While replacement rates are now relatively stable after
the 1977 amendments, it is the first term on the last line above-
-the ratio of beneficiaries to workers--that has been increasing and
placing strains on the system's finances. The inverse of this is the
ratio of covered workers to beneficiaries. While 3.3 workers support
each Social Security beneficiary today, only 2 workers are expected to
be supporting each beneficiary by 2040. (See fig. 12.)
[See PDF for image]
[End of figure]
Figure 12: Social Security Workers per Beneficiary:
[See PDF for image]
Source: SSA.
Note: This is based on the intermediate assumptions of the 2006 Social
Security trustees' report.
[End of figure]
[End of section]
Related GAO Products:
Social Security Reform: Answers to Key Questions. GAO-05-193SP.
Washington, D.C.: May 2005.
Options for Social Security Reform. GAO-05-649R. Washington, D.C.: May
6, 2005.
Social Security Reform: Early Action Would Be Prudent. GAO-05-397T.
Washington, D.C.: Mar. 9, 2005.
Social Security: Distribution of Benefits and Taxes Relative to
Earnings Level. GAO-04-747. Washington, D.C.: June 15, 2004.
Social Security Reform: Analysis of a Trust Fund Exhaustion Scenario.
GAO-03-907. Washington, D.C.: July 29, 2003.
Social Security Reform: Analysis of Reform Models Developed by the
President's Commission to Strengthen Social Security. GAO-03-310.
Washington, D.C.: Jan. 15, 2003.
Social Security: Program's Role in Helping Ensure Income Adequacy. GAO-
02-62. Washington, D.C.: Nov. 30, 2001.
Social Security Reform: Potential Effects on SSA's Disability Programs
and Beneficiaries. GAO-01-35. Washington, D.C.: Jan. 24, 2001.
Social Security: Evaluating Reform Proposals. GAO/AIMD/HEHS-00-29.
Washington, D.C.: Nov. 4, 1999.
Social Security: Issues in Comparing Rates of Return with Market
Investments. GAO/HEHS-99-110. Washington, D.C.: Aug. 5, 1999.
Social Security: Criteria for Evaluating Social Security Reform
Proposals. GAO/T-HEHS-99-94. Washington, D.C.: Mar. 25, 1999.
Social Security: Different Approaches for Addressing Program Solvency.
GAO/HEHS-98-33. Washington, D.C.: July 22, 1998.
Social Security: Restoring Long-Term Solvency Will Require Difficult
Choices. GAO/T-HEHS-98-95. Washington, D.C.: Feb. 10, 1998.
FOOTNOTES
[1] We used the GEMINI model under a license from the Policy Simulation
Group, a private contractor. GEMINI estimates individual effects of
policy scenarios for a representative sample of future beneficiaries.
GEMINI can simulate different reform features, including individual
accounts with an offset, for their effects on the level and
distribution of benefits. See appendix I for more detail on the
modeling analysis, including a discussion of our assessment of the data
reliability of the model.
[2] These are consumer price index (CPI) indexing, dependency ratio
indexing, mortality indexing, and a so-called progressive indexing
approach that uses different indexes at various earnings levels. See
appendix I for a discussion of these indexes and our scope and
methodology, as well as GAO, Social Security: Program's Role in Helping
Ensure Income Adequacy, GAO-02-62 (Washington, D.C.: Nov. 30, 2001),
GAO, 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), and GAO, Social Security:
Distribution of Benefits and Taxes Relative to Earnings Level, GAO-04-
747 (Washington, D.C.: June 15, 2004).
[3] We focused on workers born in 1985 because all prospective program
changes under all alternative policy scenarios would be almost fully
phased in for these workers.
[4] See appendix I for a complete description of our benchmark policy
scenarios.
[5] Earnings replacement rates measure the extent to which retirement
income replaces pre-retirement income for particular individuals and
thereby helps them maintain a pre-retirement standard of living.
[6] In 2006, workers receive 1 credit for each $970 of earnings, up to
the maximum of 4 credits per year. To be eligible for retirement
benefits a worker needs 40 credits.
[7] These estimates are based on the Social Security trustees' 2006
intermediate, or best-estimate, assumptions.
[8] Life expectancy has increased fairly steadily since the 1930s, and
further increases are expected. Increases in life expectancy vary by
gender, education, and earnings. Women, highly educated individuals,
and higher-income individuals generally experience greater life
expectancy.
[9] See GAO, Social Security: Criteria for Evaluating Reform Proposals,
GAO/T-HEHS-99-94 (Washington, D.C.: Mar. 25, 1999), and GAO, Social
Security: Evaluating Reform Proposals, GAO/AIMD/HEHS-00-29 (Washington,
D.C.: Nov. 4, 1999).
[10] For a discussion of individual equity issues, see GAO, Social
Security: Issues in Comparing Rates of Return with Market
Investments,GAO/HEHS-99-110 (Washington, D.C.: Aug. 5, 1999).
[11] GAO-02-62.
[12] One type of indexing took the form of automatic inflation
adjustments to the earnings replacement factors in the benefit formula.
At the same time, the earnings used in the formula were higher on
average for each new group of beneficiaries, partially because of
inflation. See appendix II.
[13] Lawrence H. Thompson. "Toward the Rational Adjustment of Social
Security Benefit Levels," Policy Analysis, Vol. 3, No. 4, Fall 1977.
[14] Wage indexing also applies to other provisions of the program that
are not part of the primary benefit computations. Such provisions
include earnings test thresholds, maximum family benefits, coverage
thresholds, and thresholds relating to disability insurance.
[15] A worker's earnings for a given year are indexed by multiplying
them by the ratio of the national average wage for the indexing year to
the national average wage in the year the income was earned. The
indexing year is the second calendar year before the year in which the
worker is first eligible--the year the worker reaches age 62, becomes
disabled, or dies. Earnings after the indexing year are counted at
their actual value.
[16] In this figure, replacement rates are the annual retired worker
benefits at age 65 divided by career-average earnings. Illustrative
workers have career-average earnings equal to about 45, 100, and 160
percent of Social Security's Average Wage Index, respectively, for low,
medium, and high earners. These three cases have earnings patterns that
reflect differences by age in the probability of work and in average
earnings levels. Taxable maximum earners have earnings equal to the
maximum earnings taxable under OASDI in each year. Using illustrative
workers holds other factors equal that might also affect replacement
rates. For example, using illustrative workers filters out the effects
of changes in the covered population or changes in work and retirement
patterns.
[17] See GAO, Social Security: GAO's Analysis of the Notch Issue, GAO/
T-HEHS-94-236 (Washington, D.C.: Sept. 16, 1994).
[18] Specifically, Social Security's COLAs are based on the consumer
price index for urban wage earners and clerical workers (CPI-W), as
opposed to the CPI series for all urban consumers (CPI-U).
[19] Andrew G. Biggs, Jeffrey R. Brown, Glenn Springstead, "Alternative
Methods of Price Indexing Social Security: Implications for Benefits
and System Financing," National Bureau of Economic Research, Working
Paper 11406 (2005).
[20] For more information on the CPI and how it overstates the true
rate of inflation, see Advisory Commission to Study the Consumer Price
Index, "Toward a More Accurate Measure of the Cost of Living," Final
Report to the Senate Committee on Finance, Dec. 1996, which is known as
the Boskin Commission report. A variety of changes have been made to
the CPI since that report, including changes that in turn affect Social
Security's COLA. In addition, a new "chained" CPI reflects how
consumers substitute one product for another when their relative prices
change. This new CPI is not yet used by government agencies, but some
reform proposals call for using a variation of it in computing COLAs.
[21] For example, the elderly allot a larger proportion of their
expenses to medical care than the general population, which partially
depends on Medicare's coverage and premiums.
[22] In earnings-related public pension systems reviewed here,
indexation appears in different forms but in all cases affects the way
in which pension rights are accrued. For example, in notional defined
contribution systems such as in Sweden and Italy, workers earn a
notional rate of return on their contributions (based on their
earnings), and indexation is implicit in that notional return. In point
systems such as in Germany, workers earn pension points (also based on
their earnings) that are multiplied by a pension-point value at the
time of retirement. There, indexation is implicit in the value of the
pension point.
[23] It is important to note that the structure of public pension
programs differ across countries, and hence are not strictly
comparable. For example, contributions in some cases help finance
maternity/paternity and unemployment benefits in addition to old age
benefits.
[24] The total employer and employee contributions of 9.9 percent may
appear low, but the retirement pension benefits these generate are
relatively modest, replacing only 25 percent of average pensionable
earnings.
[25] Canada's reserve fund is managed by an Investment Board that
operates independently from the government since the late 1990s and
invests in both foreign and domestic assets subject to some
restrictions.
[26] As in the United States in the 1970s and 1980s, prices at times
grow faster than wages; nonetheless, these periods remain exceptional.
[27] A full-career worker is defined as one having earnings between the
ages of 20 and 65. The computation reflects the average effect, in OECD
countries, for a manufacturing worker with average earnings.
[28] In most OECD countries, the formula used varies by either
individual earnings, age or length of service.
[29] Using per capita wage growth, i.e., wage growth divided by the
labor force, as an index implies that when the labor force shrinks, per
capita wage growth goes up. As a result, benefits increase right when
the number of contributors gets smaller, creating an imbalance.
[30] More precisely, the average-wage-growth indexation is reduced
whenever the Balance Ratio is less than 1, where Balance Ratio =
(Contribution Asset + Buffer Funds)/Pension Liability. The index then
automatically becomes average wage growth multiplied by the Balance
Ratio, and remains so as long as the Balance Ratio is less than 1. The
Buffer Funds are a collection of reserve funds to which part of pension
contributions are transferred. These are then invested in domestic and
foreign assets with the objective of achieving the highest possible
returns. The Buffer Funds play an important role in ensuring the
financial stability of the pension program insofar as high rates of
return on these funds may partially or fully compensate for any adverse
demographic or economic developments.
[31] The longevity factor enters the formula determining initial
benefits for a given cohort and does not change for that cohort after
the normal retirement age. It ensures that the present value of
benefits does not increase with life expectancy across cohorts.
[32] Changes in fertility or longevity are likely to affect the
dependency ratio in the long run, but little in the short run.
[33] Benefits at the time of retirement are determined by remaining
life expectancy and a growth "norm" of 1.6 percent. Benefits are then
adjusted each year for inflation plus or minus deviations from this
norm.
[34] Longevity and mortality are differing measures of life expectancy.
[35] See appendix I for more information on these indexes.
[36] We focused on workers born in 1985 because all prospective program
changes under all alternative policy scenarios would be almost fully
phased in for such workers.
[37] The benefit reduction benchmark is a hypothetical benchmark policy
scenario that would achieve 75-year solvency by only reducing benefits.
For ease of modeling, the benefit reduction benchmark takes the form of
reductions in the benefit formula factors. Each formula factor is
reduced annually by subtracting a constant proportion of the factor's
value under current law, resulting in a constant percentage reduction
of currently promised benefits for everyone. See appendix I for more
information about the benefit reduction benchmark. Consistent with the
Social Security trustees' report, we use a 75-year projection period in
assessing the solvency of different indexing scenarios and our
benchmarks. The 75-year projection period has been standard practice
for many years, although it does not capture sustainability over longer
time horizons. We believe it is important to consider sustainability,
and there are different ways to do so, but this issue is outside the
scope of this report.
[38] While the level of solvency differs among these scenarios, the
level of benefits under each scenario is lower than promised benefits,
and replacement rates have declined in each scenario.
[39] The general application of these indexes is to multiply the PIA
formula's replacement factors by a factor that reflects the new index.
This is the approach taken by the Social Security actuaries and most
proposals. See appendix I.
[40] While scaling allows comparisons across distributions over 75
years, the different indexing scenarios are not identical in terms of
sustainability.
[41] For more details on the progressive price indexing proposal, see
provision B7 of the August 10, 2005 Office of the Chief Actuary (OCACT)
memo at http://www.ssab.gov/documents/advisoryboardmemo--2005tr--
08102005.pdf, which was the basis for our analysis.
[42] Progressive price indexing and progressive CPI indexing are two
ways of referring to the same proposal.
[43] Under the current system, the maximum taxable earnings level, the
level at which earnings are subject to the Social Security payroll tax,
is indexed to the growth in wages, but the payroll tax rate itself is
not indexed. Some proposals have suggested changing the indexing of the
maximum taxable earnings level so that it maintains coverage of 90
percent of all wages. Other proposals have not focused on the 90
percent goal, but rather have suggested raising or completely
eliminating the cap. With any of these changes, several issues arise,
most importantly whether the benefit formula takes into account these
higher earnings. These issues go beyond the scope of our work, and thus
we did not analyze changes to the maximum taxable earnings level.
[44] A value less than one, for example, indicates that benefits
collected fall short of taxes paid. The present value of benefits or
taxes is the equivalent value, at a point in time, of the entire stream
of benefits the individual receives or taxes the individual pays in his
or her lifetime.
[45] Changing benefits would also affect the benefit-to-tax ratios,
which would have adequacy and equity considerations.
[46] The tax increase benchmark is a hypothetical benchmark policy
scenario that would achieve 75-year solvency by only increasing payroll
taxes. It raises payroll taxes once and immediately by the amount of
Social Security's actuarial deficit as a percentage of payroll (1.96
percentage points divided evenly between employers and employees). It
results in the smallest ultimate tax rate that would achieve 75-year
solvency and spreads the tax burden evenly across generations. See
appendix I for more information about the tax increase benchmark.
[47] Since the 1955 cohort reaches age 62 in 2017, the earliest age of
eligibility for retired worker benefits, members of this cohort will
spend fewer years contributing to the system at the higher tax rate
than the other cohorts. Thus, their benefit-to-tax ratios will be
higher than those for the other cohorts. Also, since lifetime benefits
grow over time as people live longer, the benefit-to-tax ratios for the
tax increase benchmark will begin to increase, as can be seen for the
2000 cohort.
[48] The 0.22 percentage point reduction in the growth of the CPI has
been proposed as a modification to the COLA to correct methodological
issues associated with how the CPI is calculated. Thus the COLA would
be based on a new CPI-W series that would reflect a "superlative"
formula, of the type currently used for the new chained CCPI-U. The 1
percentage point reduction in the CPI is another possibility for
slowing the growth of benefits that has been analyzed by the Office of
the Actuary at SSA.
[49] Since the current benefit formula links the calculation of
benefits for all beneficiaries, any proposed changes would affect the
benefits of disabled workers as well as retirees. Proposals to reform
Social Security often modify the benefit formula without taking into
account that the circumstances facing disabled workers differ from
those facing retired workers. See the next section of this report for a
discussion of this issue, as well as GAO-03-310, and GAO, Social
Security Reform: Potential Effects on SSA's Disability Programs and
Beneficiaries, GAO-01-35 (Washington, D.C.: Jan. 24, 2001).
[50] Most proposals that change the indexing of initial benefits would
implement the new index through the benefit formula by multiplying the
replacement factors by the difference between the growth in wages and
the growth in the new index. In such instances, changing the indexing
would not likely pose any serious implementation issues from an agency
operational perspective.
[51] Purchasing power reflects the amount of goods and services
individuals can afford with a given level of benefits.
[52] This is the so-called notch effect. Such a situation occurred
immediately after the 1977 amendments. Notches generate controversy and
confusion among beneficiaries because of inequities that result from
them. See GAO/T-HEHS-94-236.
[53] For more detail on the 1977 amendments, see appendix II.
[54] For more information on the CPI and how it overstates the true
rate of inflation, see Advisory Commission to Study the Consumer Price
Index, "Toward a More Accurate Measure of the Cost of Living," Final
Report to the Senate Committee on Finance, Dec. 1996; Congressional
Budget Office, "Is the Growth of the CPI a Biased Measure of Changes in
the Cost of Living?" (Washington, D.C., 1994). In recent years a
variety of changes have been made to the CPI, including changes that in
turn affect Social Security's COLA. In addition, a new "chained" CPI
reflects how consumers substitute one product for another when their
relative prices change. This new CPI is not yet used by government
agencies, but some reform proposals call for using a variation of it in
computing COLAs.
[55] See Ronald D. Lee and Lawrence R. Carter, "Modeling and
Forecasting U.S. Mortality," Journal of the American Statistical
Association, Vol. 87, No. 419, 1992; and Michael Sze, Stephen C. Goss,
and Jose Gomez de Leon, "Effect of Aging Population with Declining
Mortality on Social Security and NAFTA Countries," North American
Actuarial Journal, Vol. 2, No. 4, 1998.
[56] For more information on the effects of reform on the DI program
and beneficiaries, see GAO-01-35.
[57] Some proposals have suggested reducing the disabled worker benefit
only at the time of conversion from DI to retired worker status, but
only in proportion to the percentage of their potential working years
that occurred in a nondisabled state.
[58] While these models use sample data, our report, like others using
these models, does not address the issue of sampling errors. The
results of the analysis reflect outcomes for individuals in the
simulated populations and do not attempt to estimate outcomes for an
actual population.
[59] MINT3 is a detailed microsimulation model developed jointly by the
Social Security Administration, the Brookings Institution, RAND, and
the Urban Institute to project the distribution of income in retirement
for the 1931 to 1960 birth cohorts.
[60] The Board of Trustees, Federal Old-Age and Survivors Insurance and
Disability Insurance Trust Funds, The 2005 Annual Report of the Board
of Trustees of the Federal Old-Age and Survivors Insurance and
Disability Insurance Trust Funds (Washington, D.C.: Mar. 23, 2005).
[61] For benefit-to-tax ratios we followed the methodology followed in
GAO-04-747; see appendix I of this report for more detail.
[62] See page 3 of http://www.ssab.gov/documents/advisoryboardmemo--
2005tr--08102005.pdf for description of the provision. For the original
provision from the President's Commission to Strengthen Social
Security, see page 4 of
http://www.ssa.gov/OACT/solvency/PresComm_20020131.pdf .
[63] For more information on provision 1 or Model 3, see page 8 of the
CSSS proposal at
http://www.ssa.gov/OACT/solvency/PresComm_20020131.pdf.
[64] We chose the CSSS specification because it was already scored and
readily available. Other constructions or interpretations of a
mortality index are certainly possible. For example, life expectancy at
birth or some other age could be used. Further, life expectancy could
be defined as period or cohort. A period life table represents the
mortality conditions at a specific point in time, whereas a cohort
table depicts the mortality conditions of a specific group of
individuals born in the same year or series of years.
[65] The aged dependency ratio is 0.204 and 0.206 under the
intermediate assumptions of the 2005 Trustees' report for 2007 and
2008, respectively.
[66] Though we do not present SSASIM or GEMINI results for the
progressive CPI index, we also scaled this proposal. For an OCACT
scoring of this proposal, which was the basis of our SSASIM OLC
estimates for the scaled and unscaled versions presented in the report,
see provision B7 of the August 10, 2005 OCACT memo at
http://www.ssab.gov/documents/advisoryboardmemo--2005tr--08102005.pdf.
To scale this scenario, we consulted with OCACT and only scaled the
third and fourth PIA formula factors, as these were the only factors
reduced in the original provision. This effectively sped up the rate of
indexing so that the benefit reductions were faster than pure price
indexing across generations of steady maximum earners. Additionally, we
had to slightly raise the scaling value for this scenario because the
third and fourth formula factors would need to have been of a negative
value beginning in 2065. However, we censored negative values at zero
and raised the scaling factor by one percentage point to achieve a 75-
year actuarial balance of 0 for the scaled version of progressive CPI
index.
[67] In the case of the aged dependency ratio tax increase index, the
increase from the initial OASI and DI tax rates is multiplied by the
scaling factor--again, represented by the inverse of the percentage of
solvency attained by the index.
[68] Despite a similar 75-year actuarial balance across the indexes
studied, each index may have a unique balance in the 75th year because
of the unique timing of the benefit reductions (or tax increases) of
each index.
[69] These benchmarks were first developed for our report GAO-02-62. We
have since used them in other studies, including GAO-03-310; GAO,
Social Security Reform: Analysis of a Trust Fund Exhaustion Scenario,
GAO-03-907 (Washington, D.C.: July 29, 2003); GAO, 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); and GAO-04-747.
[70] The Social Security actuaries provided these scorings for a
previous report and used assumptions from the 2001 trustees' report.
The actuaries did not believe it was necessary to provide new scorings
using updated assumptions for the purposes of our study, since the
assumptions and the estimates of actuarial balance on which they are
based have changed little from the 2001 report. In particular, they did
not believe that the differences in assumptions would materially affect
the shape of the distribution of benefits, which is the focus of our
analysis. All estimates related to the indexing scenarios and benchmark
policy scenarios were simulated using the SSASIM OLC mode.
[71] Advisory Council on Social Security. Report of the 1994-1996
Advisory Council on Social Security, Vols. 1 and 2. Washington, D.C.:
Jan. 1997.
[72] See GAO-03-907, in which we analyzed such a policy scenario under
a congressional request.
[73] The highest 35 years of salary are used in the calculation of a
retired worker benefit. The disabled worker benefit is calculated using
the number of years between the age of entitlement and age 21, divided
by 5.
[74] Other analyses have addressed the concern about the effect of the
proportional reduction on low earners by modifying that offset to apply
only to the 32 and 15 percent formula factors. The MTR policy in the
1994 to 1996 Advisory Council report used this approach, which in turn
was based on the individual account (IA) proposal in that report.
However, the MTR policy also reflected other changes in addition to PIA
formula changes.
[75] Until the 1970s, trust fund projections were routinely exceeded at
least in part as a result of actuarial methods that assumed no growth
in average earnings.
[76] These estimates of average benefit increases include both existing
and initial benefits.
[77] The contribution and benefit base reflects the program's role of
only providing for a floor of protection.
[78] In 2006, the maximum taxable earnings cap is set at $94,200.
[79] The PIA is the monthly amount payable to a retired worker who
begins to receive benefits at normal retirement age or (generally) to a
disabled worker. This is also the amount used as a base for computing
all types of benefits payable on the basis of one individual's earnings
record.
[80] The declining replacement factors for higher levels of earnings
made the formula progressive.
[81] When the maximum taxable earnings level increased, a new
replacement factor would be applied to the newly covered portion of
earnings. For example, the 1965 amendments increased the maximum
taxable earnings from $4,800 to $6,600. Accordingly, the benefit
formula added a new component, with a replacement factor of 21.4
percent for the next $150 of average monthly wages.
[82] The fact that benefits were changed for both new and current
beneficiaries using the same computations came to be known as
"coupling" of benefit increases.
[83] Part of the growth in wages reflects inflation. Wage growth makes
the average monthly earnings for a new year's group of beneficiaries
higher on average than for the previous year's group.
[84] In a pay-as-you-go system, the payroll tax would equal annual
benefit costs as a percentage of payroll.
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