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SOCIAL SECURITY: Wage-Indexing vs. Price Indexing Initial Benefits


SOCIAL SECURITY:  Wage-Indexing vs. Price Indexing Initial Benefits

The Social Security privatization proposal that appears to be favored by President Bush contains drastic reductions in Social Security benefits .  Under the proposal, benefits would be dramatically reduced by using "price indexing" rather than "wage indexing" when calculating initial Social Security benefits .   This little-known change in how initial Social Security benefits are calculated would "save" money for Social Security by drastically reducing benefits and the amount of pre-retirement earnings that are replaced by monthly Social Security benefits.  This change would not be voluntary and would impact future beneficiaries regardless of whether or not they opt for private accounts. It would result in a lower standard of living for future Social Security recipients and increased poverty among the elderly.

National Committee's Position

The National Committee to Preserve Social Security and Medicare opposes a shift from wage indexing to price indexing Social Security benefits. The plan President Bush favors as a model would cut Social Security benefits by nearly 50 percent for tomorrow's retirees. Such a change would condemn today's workers to a level of comfort in retirement that would be below that of their parents and would decline with each succeeding generation.  If retirees' purchasing power were limited to a price-based increase, they would never benefit from advances in the standard of living which they contributed to during their working years and that is enjoyed by the rest of society.  This proposal is yet another attempt by the privatizers to cut benefits, dismantle Social Security and force workers into a retirement that is loaded with risk.

Current Calculation Using Wage-Indexing

Using wage-indexing to calculate Social Security benefits guarantees that retirees' benefits are pegged to the standard of living at the time they retire, not the lower standard of living that existed in their early working years. The current benefit formula is intended to ensure that the replacement rate - the percentage of workers' pre-retirement earnings that are replaced by Social Security - remains constant whether someone retires today or in the future. 

A person's initial Social Security benefit is determined by a two-step process.  First, the worker's highest 35 years of earnings are indexed to wage growth, up to the year the worker reaches age 60, and then averaged.  This amount is divided by 12 to determine the average indexed monthly earnings (AIME) . Second, the Social Security benefit formula is applied to the worker's average indexed monthly earnings to determine the primary insurance amount (PIA) . A worker retiring at the normal retirement age in 2005 will receive:

  • 90 percent of the first $627 of AIME, plus
  • 32 percent of AIME over $627 through $3779, plus
  • 15 percent of AIME above $3779

This formula is designed so that low-income workers receive a higher percentage of their pre-retirement income than do average- and middle-income workers. In addition, by annually adjusting the bend points - the dollar amounts in the formula - to reflect wage inflation, the replacement rates for workers with comparable earnings histories stay the same.

Proposals to Change to Price-Indexing

Changes that incorporate price indexing in the calculation of initial Social Security benefits would result in benefit reductions because prices tend to increase more slowly than wages . Two days after he was reelected, President Bush reiterated his support for privatizing Social Security and cited Model 2 of his 2001 Presidential Commission to Strengthen Social Security as a good starting point. Under the Commission's proposal, the first step in calculating initial Social Security benefits would remain the same as under current law.  However, the second step would be changed by reducing the 90 percent, 32 percent, and 15 percent replacement factors in the benefit formula.  The reduction would be calculated by multiplying each factor by the ratio of the percentage change in the Consumer Price Index to the percentage change in average wages over the preceding 12 months.  It is estimated that initial benefits would be reduced by nearly one percent in the first year; this decrease would be compounded each year until it reached a 46 percent reduction for an average worker retiring in 2075.  

Adverse Impact on Social Security Benefits

All workers would receive reduced benefits. Even if private accounts are voluntary, the cuts in Social Security benefits are not. All workers would be subject to a reduction in traditional Social Security benefits, due to the effect of price indexing over time, whether or not they chose to divert a portion of their payroll taxes into private accounts. Moreover, the Congressional Budget Office estimates that, for workers who chose private accounts, the combined income from Social Security and individual accounts would be significantly lower than the Social Security benefits payable under current law. The amounts "saved" by cuts in benefits are significantly higher than the cost of ensuring solvency of Social Security over the long term. Thus, workers who opt-out of private accounts are effectively subsidizing those who opt-in.

Replacement rates would decline. The replacement rate is intended to provide a comparable percentage of pre-retirement earnings for workers with equivalent wages whether they retire today or in the future. It is currently 42 percent for an average wage earner retiring at age 65. Due to the already-scheduled increase in the retirement age to age 67, the replacement rate at age 65 will decline to 36 percent and remain at that level. Under the proposal favored by the President, the replacement rate would decline even further. For an average wage earner, the replacement rage would drop to 27 percent in 2042 and to 20 percent in 2075.

Future Retirees would experience a lower standard of living. If Social Security benefits were calculated to reflect price inflation, rather than wage inflation, they would reflect a past standard of living rather than the standard of living at the time a worker retires. Retirees would not benefit from the economic gains they produced during their working years; rather their standard of living would be lower than that of the rest of society. Today's retirees would be living at 1940's standards if the system had not been waged indexed. And if future retirees were locked into our current standard of living, they would be unable to share in future technological progress and gains brought about by a growing economy.

Disabled workers and survivors would be hard hit. Because Social Security uses the same benefit formula to calculate benefits for all new beneficiaries, the payments received by disabled workers and survivors would also be reduced. In addition, workers who become disabled or die at a young age would be more adversely affected by the proposed change in computing benefits because they would not have time to accumulate adequate money in private accounts intended to supplement their reduced Social Security benefits.  

Supporters of Social Security understand that diverting money from Social Security to private accounts does nothing to solve Social Security's long-term funding gap. In fact, it makes it worse. To finance their proposal to dismantle Social Security, the White House favors a change from wage-indexing to price-indexing when calculating initial Social Security benefits. This would result in reductions in benefits, much larger than needed to ensure solvency or that can realistically be replaced by private accounts, and therefore a lower standard of living for future retirees.

Government Relations and Policy, January 2005


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