Reforming Social Security through Price and Progressive Price Indexing

Brief #6 from the series Older Americans' Economic Security

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Social Security's long-run financial imbalance is prompting some policymakers to consider changing the method of indexing retirement benefits. In 2001, the President's Commission to Strengthen Social Security (CSSS) proposed indexing initial benefits to prices instead of to wages. Now the White House has signaled support for progressive price indexing: indexing benefits to prices for high-wage workers, but retaining wage indexing for low-wage workers. Since prices generally grow more slowly than wages, price indexing would reduce benefits for most new retirees by about 30 percent by 2050, compared to current law. Progressive price indexing would reduce average benefits by about 18 percent, but hold harmless the lowest earners. Both proposals reduce benefits further below current law every year and, if continued indefinitely, would significantly reduce Social Security's role in providing retirement security for middle-income workers.

Price Indexing Reduces Replacement Rates

Social Security benefits are currently wage-indexed, meaning that starting benefits at the normal retirement age increase by the growth in average wages. Initial benefits replace about the same proportion of preretirement earnings over time. Because wages generally grow faster than prices, starting benefits increase in inflationadjusted dollars. The Urban Institute's Dynamic Simulation of Income Model (DYNASIM)¹ projects that average benefits as a percent of economy-wide earnings will hold steady at about 30 percent, and average inflation-adjusted benefits will increase from $12,100 to $17,600 between 2012 and 2050 (table 1).

Under price indexing, benefits are reduced annually relative to current law by the growth in wages beyond inflation.² Starting benefits remain constant in inflation-adjusted dollars, but replace ever-smaller proportions of preretirement earnings. If price indexing were implemented in 2012, average inflation-adjusted benefits at retirement would only be slightly higher in 2050 and average benefits would be only 20 percent of economy-wide earnings. According to the Congressional Budget Office (CBO), price indexing would replace Social Security's cumulative deficit over the next 75 years with a modest surplus.³

Progressive price indexing is an alternative that preserves benefits for low-income retirees.⁴ Retirees with career average earnings above the maximum covered by Social Security, currently $90,000, would receive price-indexed benefits. Those with career average earnings below the 30th percentile, currently about $25,000, would receive wage-indexed benefits. All other retirees would receive something in between.⁵ Assuming implementation in 2012, average inflation-adjusted benefits at retirement would increase to $14,400 in 2050 and average benefits as a percentage of economy-wide earnings would fall to 24 percent. According to CBO, progressive price indexing would eliminate most of Social Security's cumulative deficit over the next 75 years.

Notes from this section of the report

1. See Favreault and Smith (2004) for a description of DYNASIM.

2. See CSSS (2001) and H.R. 530, introduced by Rep. Johnson (R-TX) on February 2, 2005.

3. See CBO (2005), http://www.cbo.gov/ftpdocs/63xx/doc6377/Social_Security_Menu-SSA_baseline.pdf.

4. Proposed by former CSSS member Paul Pozen. Sen. Bennett (R-UT) has said he plans to introduce a bill including progressive price indexing. See Pozen (2005) and http://bennett.senate.gov/press/documents/062205bennett_sossummary.pdf.

5. The indexing formula for those with lifetime earnings between the 30th percentile and maximum covered earnings would gradually shift from full wage indexing to price indexing as earnings rise.

Note: This report is available in its entirety in the Portable Document Format (PDF).

This brief was adapted from Distributional Effects of Reforming Social Security through Benefit Reductions.

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Disclaimer: The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.