V I E W P O I N T

Social Security: "Price Indexing" and Middle-Class Benefit Cuts

President Bush in his FY 2008 budget recommendations again endorsed a proposal, known as "price indexing,"¹ which would drastically reduce Social Security benefits. In his budget, the President also proposed once again a plan to divert payroll taxes into private investment accounts. While described as reducing benefits for the most affluent Americans, Bush's price indexing proposal would dramatically cut benefits for middle-income workers.

Under the proposal, seventy percent of workers under age 55 would lose between 20 and 50 percent of their guaranteed Social Security benefit over time, whether or not they opt for a private account. Those who take the risk of investing in private accounts would lose an additional dollar of their Social Security benefit for every dollar they invest in the accounts, plus interest and inflation. They would see this reduction in benefits regardless of how their accounts performed. Thus, for many workers who invest in private accounts, the guaranteed benefit Social Security provides would disappear completely over time.

Under current law, initial Social Security benefits for each group of new retirees rise at the rate of average wages in the economy.  This ensures that each generation receives Social Security benefits that reflect the growing standard of living that they helped create during their working years.  This goal is achieved by indexing prior year's earnings to reflect wage inflation. Historically, wages have risen more quickly than prices, so indexing a retirees' initial benefit amount to reflect wage inflation provides a retirement benefit that more accurately represents the value of those wages in the year they were earned. A proposal to change the system of indexation from wages to prices for all workers was included in Plan 2 proposed by the Bush Social Security Commission and has been repeatedly endorsed by the President. This change would result in dramatic benefit cuts - which grow progressively larger over time - for all retirees, excluding those with the lowest incomes.

The premise of the Bush price indexing proposal is to allow benefits for low-wage earners to continue rising in line with wages, thus protecting them from future benefit cuts, while converting benefits for maximum earners to a pure price based index, eroding their benefits dramatically. Everyone in between would see some combination of the two, as their initial benefits would be calculated by applying a hybrid formula that blends wage and price indexing. This hybrid formula results in dramatic benefit cuts for the heart of the middle class, and eventually breaks the current connection between worker's contributions to Social Security and their benefit amounts. Over time, all workers would receive essentially the same poverty-level flat benefit, thus converting the current earnings-based program into a welfare payment, and seriously undermining public support for Social Security in the future.

Under progressive price indexing, the bottom 30 percent of workers - those that made less than about $20,000 in 2005 - would have their benefits calculated under the current formula. Those workers who earn the taxable maximum -$90,000 in 2005 - over their lifetimes would have their benefits calculated using price indexing. Those earning between $20,000 and $90,000 would get a benefit somewhere between the benefit provided under current law and that provided under price indexing. For example, a worker making about $35,000 annually would be subject to about half of the price-indexing benefit reduction, while a worker making about $55,000 annually would be subject to more than 80 percent of the price-indexing benefit reduction.

National Committee Position

The National Committee to Preserve Social Security and Medicare opposes a shift from the current wage indexing formula to the new price indexing formula, especially if it is combined with a carve-out private accounts proposal. The plan endorsed by President Bush would dismantle the current social insurance program, substantially reducing benefits and transforming Social Security into a welfare program.

The Bush price indexing proposal would impose substantial benefit cuts on middle class Americans.   Under the Bush price indexing proposal, benefits would be cut for all workers whose lifetime average earnings are more than $20,000 a year. Moreover, the proposal's benefit reductions - relative to the benefits scheduled under current law - would grow sharply over time. For example, once fully phased in:

•  A worker who had earned $37,000 per year would have a 28 percent benefit cut

•  A worker who had earned $58,000 per year would have a 42 percent benefit cut

•  A worker who had earned $90,000 per year would have a 49 percent benefit cut ²

Combining the Bush price indexing proposal with private accounts carved out of Social Security would cut benefits twice for all but the lowest income earners.  On top of the substantial benefit cuts for all but the poorest workers, individuals who would take the risk of investing in private accounts would have every dollar of traditional Social Security benefits offset by the amount of personal account contributions compounded at a real interest rate of three percent. They would see this reduction in benefits regardless of how their accounts performed.  Consider an average worker retiring in 2055, the first worker who would be eligible to participate fully in the President's proposed accounts.  The sliding-scale benefit reduction would reduce this worker's scheduled benefit by 21 percent.  The benefit offset would reduce the scheduled traditional Social Security benefit by 45 percent.  Together, these two benefit reductions would reduce the traditional defined benefit by 66 percent. ³  This worker would have a guaranteed benefit of only $7,500 annually. ⁴ For many workers, the guaranteed benefit would disappear completely over time. By diverting money into private accounts and implementing massive, new sliding-scale benefit cuts, the proposal will erode Social Security's safety net leaving the average worker with a fraction of the benefit he or she is entitled to today. ⁵

The Bush price indexing proposal would transform Social Security from a universal insurance program into a welfare program.   The Bush price indexing proposal would result in a profound transformation of the current Social Security system. The current Social Security benefit structure uses a complex formula to translate a worker's earnings into the worker's Social Security benefit. The fact that there is a link between what a worker contributes in payroll taxes and the level of the benefit the worker receives has contributed to the widespread public support that Social Security enjoys. Under price indexing, benefits for low-wage workers would continue to grow (in relation to inflation), while benefits for the top wage workers would be frozen in inflation-adjusted terms. Ultimately, most beneficiaries would get the same monthly benefit, despite having paid in very different amounts in payroll taxes. In other words, those who paid substantially more in taxes would get the same benefit as those who paid in much less. This would transform the current universal social insurance program into a means-tested welfare program, eventually undermining the broad public support that Social Security has enjoyed for nearly 70 years.

HOW "PROGRESSIVE" PRICE INDEXING WORKS

Under current law, initial benefits received by each group of new retirees rise at the rate of wage growth. The procedure involves three steps. First, a worker's previous earnings are restated in terms of today's wages by indexing past earnings to wage growth. Second, earnings for the highest 35 years are then averaged and divided by 12 to calculate "Average Indexed Monthly Earnings" (AIME). Finally, the Social Security benefit formula is applied to Average Indexed Monthly Earnings to yield the benefit payable at the normal retirement age, known as the Primary insurance Amount (PIA). The benefit formula is progressive in that the factor applied to the first dollars of earnings is higher than those applied to additional amounts. Thus, the formula replaces a larger share of the income of low-wage workers compared to high-wage workers.

The so-called "bend points"- $627 and $3,779 in 2005 - are adjusted each year in line with the growth in average wages over the previous year. Once this initial benefit is awarded, it is adjusted each year in line with the Consumer Price Index so that beneficiaries can maintain their purchasing power in retirement.

Under the progressive indexing proposal, AIME would continue to be calculated as under current law. But the procedure would introduce a new "bend point" of $1,528 to isolate low-income workers from benefit changes. The $1,528 "bend point" was selected so that 30 percent of workers have AIMEs below that amount. Progressive indexing works by reducing the factors in the benefit formula above the newly introduced "bend point"- that is, the 32 percent between $1,528 and $3,779 and the 15 percent above $3,779. Note that under progressive indexing, as under current law, the bend points - $627, $1,528, and $3,779 - would be adjusted each year in line with the growth in average wages.

The mechanics of price indexing are as follows: Average Indexed Monthly Earnings would continue to be calculated as under current law. But the benefit formula would be changed. Each year, the 90%, 32% and 15% factors would be reduced by a small amount, approximately 1% per year, so that by 2035, the 32 percent (of the new bend point) and 15 percent factors would be 20 percent and 9 percent, respectively. ⁶ By 2075, those factors would be reduced to 5 percent and 2 percent. ⁷This is done by multiplying each factor by the ratio of the change in the consumer price index over the previous year to the change in nominal wages. Since wages typically increase faster than prices, this number will generally be less than one. For example, if in the year after price indexing was enacted the Consumer Price Index increased by 3 percent and wages increased by 4 percent, the ratio would be 1.03 divided by 1.04, or 0.99 percent. The factors would then be multiplied by .99. And the effect on benefits would be cumulative over time.

¹Robert Pozen, chairman of MFS Investment Management and a member of President Bush's Social Security Commission, developed this proposal reformulating the Social Security benefit structure-- known as "progressive" price indexing-- in 2005.

² Jason Furman, Center on Budget and Policy Priorities, An Analysis of Using "Progressive Price Indexing" To Set Social Security Benefits (May 2, 2005). Authors calculations based on Social Security Administration, Office of the Chief Actuary, "Estimated Financial Effects of a Comprehensive Social Security Reform Proposal Including Progressive Price Indexing -- INFORMATION," February 10, 2005 and Social Security Trustees, 2004 Annual Report .  Note that all percentage reductions in benefits for 2025-2075 are taken directly from the actuaries' memo.

³Jason Furman, Robert Greenstein and Gene Sperling, Center on Budget and Policy Priorities, Why the President's Social Security Proposals Could Ultimately Lead To The Unraveling Of Social Security (May 2, 2005).

⁴Id.

⁵ Pozen's original proposal included a private investment account carved out of Social Security that is smaller than the President's. Since that time, he has reportedly expressed his support for abandoning the accounts entirely, allowing progressive indexation to go forward alone. This would only mitigate the double benefit cut inherent in a system that combines progressive indexation with private accounts - the deep cuts in benefits for middle-class workers that result from the change in indexation itself would remain.

⁶According to the intermediate scenario assumptions used in the 2004 Social Security Trustees Report. See also, Alicia H. Munnell and Mauricio Soto, Center for Retirement Research at Boston College , Just The Facts On Retirement Issues: What Is Progressive Price Indexing? ( April 2005, Number 17).

⁷Id.