Distributional Effects of Reforming Social Security through Benefit Reductions

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Introduction

While Social Security's long-term financial imbalance has been known for many years, it has recently received increased attention due to the current administration making Social Security reform a legislative priority. Much of 2005's debate has focused on incorporating private accounts into the system, although the accounts themselves would do little to address Social Security's financial shortfall.¹ Most analysts agree that either additional revenue needs to be raised or benefits need to be reduced below the levels scheduled in current law. To date, reform proposals introduced in Congress have focused on reducing benefits as the way to achieve solvency, although some experts have developed options that include tax increases.²

The purpose of this study is to examine which demographic and economic groups will be affected more than others in 2050 under various options for reducing benefits. The study compares the projected distribution of benefits under current law with benefits projected under four options: (1) indexing benefits by price growth instead of wage growth; (2) indexing benefits by price growth for high-income workers and by wages for low-income workers (progressive price indexing); (3) reducing the annual cost of living adjustment after retirement; and (4) raising the normal retirement age.

Policy Scenarios

The analysis includes simulations of the following policy scenarios:

• Scheduled Benefits. This scenario pays current-law benefits assuming the Social Security trust funds receive additional revenues to avoid becoming insolvent in the early 2040s.³ Initial benefits are wage indexed, meaning benefits at the normal retirement age increase across generations by the growth in wages. Wage indexing results in starting benefits replacing about the same proportion of preretirement earnings for each generation.
• Benefits Supportable by Trust Funds. Scheduled benefits are paid until the Social Security trust funds are exhausted, at which point benefits are reduced by the same percentage for all beneficiaries⁴ to equate program outlays and revenues. This scenario provides context for the size of reductions under the various alternatives but is not included in the dis tributional analyses because it reduces benefits for all recipients by the same proportion.
• Price Indexing of Initial Benefits. Beginning in 2012, initial benefit growth is indexed to prices instead of wages. Under price indexing, each generation of retirees receives starting benefits that are about constant in inflation-adjusted dollars. Because wages grow faster than prices, benefits under this proposal would replace smaller proportions of preretirement earnings over time.
• Progressive Price Indexing of Initial Benefits. Beginning in 2012, benefits for retirees with career average earnings above the maximum covered by Social Security, currently $90,000, receive price-indexed benefits; those with career average earnings below the 30th percentile, currently about $25,000, receive wage-indexed benefits; and all other retirees receive something in between.⁵
• Reducing the Annual Cost of Living Adjustments (COLA). Beginning in 2012, the annual COLA is reduced by 0.4 percentage points for all beneficiaries.⁶ Reducing the COLA has little impact on initial benefits, but unlike the other policy options, it continues to reduce benefits relative to scheduled amounts after initial entitlement.⁷
• Raising the Normal Retirement Age (NRA). Accelerates the currently scheduled increase to age 67 and continues increasing the NRA until it reaches age 70 for those turning 62 after 2028. Currently, benefits are reduced for workers who retire early by a factor that increases with each month before the NRA that benefit receipt begins. If workers continue to retire at the same ages, raising the NRA will reduce initial benefits because it increases the number of months early for those retiring before the NRA.

Notes from this section of the report

1 See GAO (2005).

2 For proposals that reduce benefits see Commission to Strengthen Social Security (2001), Pozen (2005), Senator Bennett's proposal — http://bennett.senate.gov/press/documents/?062205bennett_sossummary.pdf, H.R. 440 (Kolbe and Boyd—109th Congress), H.R. 530 (Johnson—109th Congress), and S. 540 (Hagel—109th Congress). For proposals that increase revenues see Diamond and Orszag (2004), H.R. 440 (Kolbe and Boyd—109th Congress), and H.R. 2472 (Wexler—109th Congress).

3 The Social Security Board of Trustees (2005) and the Congressional Budget Office (2005) project the trust funds will be depleted by 2041 and 2044, respectively.

4 Benefits would be reduced for all types of recipients, including spouse, survivor, and disability beneficiaries.

5 The rate of indexing for those with lifetime earnings between the 30th percentile and maximum covered earnings would gradually decline with lifetime earnings.

6 The analysis assumes annual COLAs of 2.8 percent under current law and 2.4 percent under the reduced scenario.

7 COLAs can affect initial benefits because they begin at the year of first eligibility (attainment of age 62, disability, or death) as opposed to the year of first benefit receipt.

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

Results for highlights of price indexing and progressive price indexing.

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.

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