Urban InstituteRetirement Policy Center

Price Indexing

(Latest Distributional Estimates)

Price indexing Social Security, so that initial retirement benefits remain constant in inflation-adjusted dollars, could restore fiscal balance, but it would move the system away from its traditional role of replacing earnings in retirement.

Background

Social Security provides monthly retirement benefits that replace a portion of lifetime earnings.

  • Monthly benefits are set equal to a percentage of indexed earnings averaged over one’s career. The percentage factor falls as career earnings increase. Monthly benefits also depend on the age that workers start collecting. (Learn more about the benefit formula.)
  • A worker who earns the national average wage for 35 years and begins collecting Social Security at the full retirement age would receive benefits that replace about 45 percent of indexed earnings.
  • Because benefits are based on lifetime earnings and wages have historically grown faster than prices, benefits have increased over time, after adjusting for inflation.

How Would Price Indexing Work?

Price indexing would hold the purchasing power of initial retirement benefits constant over time, instead of adjusting benefits to wage growth, as under the current system.

  • The benefit calculation would be based on a worker’s Average Indexed Monthly Earnings as in the current system, but the percentage factors used in the benefit formula would be the change in consumer prices relative to the change in wages each year. The adjustment would generally be less than one, since wages normally grow faster than prices.
  • Benefits would fall further behind currently scheduled payments each year, to the extent that wage growth exceeds price growth over time.

Progressive price indexing is a variant of price indexing that would maintain currently scheduled (wage-indexed) benefits for retirees with low lifetime earnings but reduce scheduled benefits for higher-wage workers.

  • This plan would use the price-indexing adjustment described above to reduce the percentage factors in the benefit formula for workers who earned the taxable maximum ($106,800 in 2009) throughout their careers.
  • The percentage factors in the benefit formula would not change from current levels for low-wage workers. The plan proposed by Pozen (2005), for example, would maintain current benefits for workers with earnings below the 30th percentile of the career earnings distribution––equal to about $25,000 in 2005.
  • Those with career earnings above the low-wage threshold and less than the taxable maximum would receive benefits somewhere between those paid under the current system and the price-indexed system.

What Are Some Advantages of Price Indexing?

  • Price indexing could sharply reduce Social Security’s long-term fiscal deficit without increasing taxes, while maintaining the current purchasing power of retirement benefits.
  • Progressive price indexing would allow inflation-adjusted retirement benefits for low- and moderate-wage workers to increase over time as productivity grows.

What Are Some Drawbacks to Price Indexing?

  • Price indexing would fundamentally change Social Security, moving it from an earnings replacement program to one that provides more minimal benefits that replace a declining share of wages over time.
  • Over time, economic growth would substantially erode the relative value of the retirement benefit, possibly leading Congress to make ad-hoc benefit adjustments.
  • Progressive price indexing would reduce high-wage workers’ returns on their Social Security contributions, possibly eroding the system’s political support.
  • The cost of restoring Social Security’s fiscal balance would fall solely on future retirees.

How Would Price Indexing Affect Social Security Benefits?

Benefit reductions would cumulate over time, assuming wage growth continually outpaces price growth (figure 1).

  • Price indexing would reduce 2050 benefits to about 70 percent of currently scheduled benefits. Effects would not vary much across the earnings distribution.
  • Progressive price indexing would fully protect low-wage workers’ benefits and partially protect the benefits of middle-wage workers.

Distribution of Social Security Benefits Under Price Indexing and Progressive Price Indexing

Note: Estimates assume that changes take effect for those first eligible in 2012. The progressive price indexing option would begin price indexing at the 30th percentile of the lifetime earnings distribution. Shared lifetime earnings include workers’ entire earnings in years they are single and half of the earnings of workers and their spouses in years that they are married.

How Would Price Indexing Affect Social Security’s Long Term Fiscal Deficit?

Effects depend on how quickly reductions take place, for how many years they would continue, and whether a progressive scheme is adopted. (All estimates are from Social Security Administration (2006), assume that changes take effect for those first eligible in 2012, and use the intermediate assumptions of the 2005 Trustees Report.)

  • Pure price indexing would eliminate the 75-year fiscal imbalance.
  • The effects of progressive price indexing depend on where Congress sets the threshold for price indexing.
    • Setting the threshold at the 30th percentile of the lifetime earnings distribution would eliminate about 75 percent of the 75-year fiscal imbalance.
    • Setting the threshold at the 40th percentile of the lifetime earnings distribution would eliminate about 63 percent of the fiscal imbalance.
    • Setting the threshold at the median (or mid-way point) of the earnings distribution would eliminate about half of the fiscal imbalance.

Who Has Proposed Price Indexing?

  • Price indexing was included in one plan proposed by President George W. Bush’s Commission to Strengthen Social Security (President’s Commission to Strengthen Social Security 2001).
  • Pozen (2005) first proposed progressive price indexing.
  • Former Senator Fred Thompson supported progressive price indexing in his 2008 presidential campaign.

Distributional Effects

The Retirement Policy Program at the Urban Institute uses the DYNASIM3 computational model to estimate the effects of different Social Security reform designs on different groups of Americans. See our latest estimates here.

See the Following Reports To Learn More:

Mermin, Gordon B. T. 2005a. “Distributional Effects of Reforming Social Security through Benefit Reductions.” Washington, DC: The Urban Institute.

–––––. 2005b. “Reforming Social Security through Price and Progressive Price Indexing.Older Americans’ Economic Security Brief Series No. 6. Washington, DC: The Urban Institute.


Other References:

Pozen, Robert C. 2005. “A ‘Progressive Solution to Social Security.’” Wall Street Journal, p. A20. March 15.

President’s Commission to Strengthen Social Security. 2001. Strengthening Social Security and Creating Personal Wealth for all Americans: Report of the President’s Commission. Washington, DC: Author. http://csss.gov/reports/Final_report.pdf.

Social Security Administration, Office of the Chief Actuary. 2006. “Provisions Affecting Level of Monthly Benefits.” http://www.ssa.gov/OACT/solvency/provisions/benefitlevel.html.

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