Link Initial Social Security Benefits to Average Prices Instead of Average Earnings

Social Security benefits for retired and disabled workers are based on those individuals' average earnings over a lifetime. The Social Security Administration uses a statutory formula to compute a worker's initial benefit, and through a process known as wage indexing, the benefit formula changes each year to account for economywide growth of wages. Average initial benefits for Social Security recipients therefore tend to grow at the same rate as do average wages, and such benefits replace a roughly constant portion of wages. (After people become eligible for benefits, their monthly benefits also are adjusted annually to account for increases in the cost of living.)

One way to constrain the growth of Social Security benefits would be to change the initial benefit computation so that the real (inflation-adjusted) value of average initial benefits did not rise over time. That approach, often called "price indexing," would allow increases in real wages to result in higher real Social Security payroll taxes but not in higher real benefits. Specifically, beginning with participants who became eligible for benefits in 2012, this option would link the growth of initial benefits to the growth of prices (as measured by changes in the consumer price index) rather than to the growth of average wages. (The calculation of average indexed monthly earnings, a key step in the statutory formula for determining Social Security benefits, would continue to involve wage indexing. However, the benefit would be multiplied by the ratio of a price index to an average wage index--where the indexes are set to be equal in 2011.)

Switching to indexing initial benefits on the basis of prices rather than wages--a "pure price-indexing" approach--would reduce federal outlays by about $13 billion over five years and by almost $137 billion over the next decade. By 2050, scheduled Social Security outlays would be reduced by 29 percent relative to what would occur under current law--from 5.9 percent to 4.2 percent of gross domestic product. Under pure price indexing, the reduction in payments relative to those that are scheduled to be paid under current law would be larger for each successive cohort of beneficiaries; the extent of the reduction would be determined by the growth of real wages. For example, if real wages grew by 1.3 percent annually (approximately the rate used in the Congressional Budget Office's long-term Social Security projections), workers who were first eligible for benefits in 2012 would receive about 1.3 percent less than they would have received under the current rules; those becoming eligible in 2013 would receive 2.6 percent less; and so on. In reality, however, the incremental reduction would vary from year to year, depending on actual growth in real earnings. If real earnings shrank during a period--that is, if average wages grew more slowly than prices--then benefits would grow faster than they would under current law. Those eligible for benefits in 2030, CBO estimates, would experience a reduction in benefits of about 25 percent relative to benefits scheduled under current law, and the reduction would grow to more than 40 percent by 2050. An alternative approach, called "progressive price indexing," would retain the current formula for workers who had lower earnings and would reduce the growth of initial benefits only for workers who had higher earnings. Currently, the formula for calculating initial Social Security benefits is structured so that workers who have higher earnings receive higher benefits, but the benefits paid to workers with lower earnings replace a larger share of their earnings. Under the specifications for progressive price indexing in this option, initial benefits for the 30 percent of workers with the lowest lifetime earnings would increase with average wages, as they are currently slated to do, whereas initial benefits for higher-income workers would increase more slowly, at a rate that depended on their position in the distribution of earnings. For example, for workers whose earnings put them at the 31st percentile of the distribution, benefits would rise only slightly more slowly than wages, whereas for the highest earners, benefits would rise with prices--as they would under pure price indexing. Thus, under progressive price indexing, the initial benefits for most workers would increase more quickly than prices but more slowly than average wages. As a result, the benefit formula would gradually become flatter, and after about 60 years, everyone in the top 70 percent of earners would receive the same monthly benefit. A partially flat benefit formula would represent a significant change from Social Security's traditional structure, under which workers who pay higher taxes receive higher benefits.

Progressive price indexing would reduce scheduled Social Security outlays less than would pure price indexing, and beneficiaries with lower earnings would not be affected. Real annual average benefits would still increase for all but the highest-earning beneficiaries. Benefits would replace a smaller portion of affected workers' earnings than they do today but a larger portion than they would under pure price indexing.

A switch to progressive price indexing would reduce federal outlays by more than $8 billion over 5 years and by about $85 billion over 10 years. By 2050, outlays for Social Security would be reduced by 18 percent, or from 5.9 percent to 4.8 percent of gross domestic product. Under both approaches, the reductions in benefits relative to current law would be greatest for beneficiaries in the distant future. Those beneficiaries, however, would have had higher real earnings during their working years and thus a greater ability to save for retirement.

An advantage of both approaches in this option is that, although they would reduce outlays for Social Security compared with those scheduled to be paid under current law, average inflation-adjusted benefits in the program would not decline over time. If the pure price-indexing approach was followed, future beneficiaries would generally receive the same real monthly benefit paid to current beneficiaries, and they would, as average longevity increased, receive a larger total lifetime benefit.

A disadvantage of both approaches is that because benefits would no longer be linked to wages, affected beneficiaries would no longer share in overall economic growth. As a result, benefits would replace a smaller portion of workers' earnings than they do today. Another disadvantage is that relative to currently scheduled benefits, reductions would be largest during periods of high wage growth. Finally, the options would continue to reduce the rate of growth of scheduled benefits beyond what is needed to bring Social Security outlays in line with revenues.