Social Security Currently Indexes Both Benefits and Revenues

While Social Security did not use automatic indexing initially, it is now a  key feature of the program’s design, as well as a central element of many  reform proposals. Under the current program, benefits for new  beneficiaries are computed using wage indexing, benefits for existing  beneficiaries are adjusted using price indexing, and on the revenue side,  the cap on the amount of earnings subject to the payroll tax is also  adjusted using wage indexing. In particular, the  indexing approach in the 1972 amendments resulted in (1) a “double- indexing” of benefits to inflation for new beneficiaries though not for  existing ones; (2) a form of “bracket creep” based on the structure of the  benefit formula that slowed benefit growth as earnings increased over  time, which offset the double indexing to some degree; and (3) instability  of program costs that was driven by the interaction of price and wage  growth in benefit calculations. Various Reform Proposals Include Indexing Provisions

Various reform proposals have suggested changes to most of the indexing  features of the current Social Security system. Indexing the replacement  factors would reduce benefits at the same proportional rate across income  levels, while changing the indexing of lifetime earnings or the bendpoints  could alter the distribution of benefits across income levels. Some proposals would index revenues in new ways. Retirement Indexing Approaches in Other Countries Generally Focus on Benefit Reductions instead of Increased Contributions

A number of reforms have focused on methods that primarily adjust  benefits rather than taxes to address the fiscal solvency of national  pension systems. Indexing Approaches Affect Both Current and Future Beneficiaries

In some of the countries we studied, changes in indexing methods affect  both current and future retirees. Indexing Can Be Used to Achieve Desired Distributional Effect

In the U.S. Social Security program, indexing can have different effects on  the distribution of benefits and on the relationship between contributions  and benefits, depending on how it is applied to benefits or taxes. Indexing payroll tax rates would also  have distributional effects. We analyzed three indexing scenarios; the  dependency ratio index, which links the growth of initial benefits to  changes in the dependency ratio, the ratio of the number of retirees to  workers; the CPI index, which links the growth of initial benefits to  changes in the CPI; and the mortality index, which links the growth of  initial benefits to changes in life expectancy to maintain a constant life  expectancy at the normal retirement age. Thus, benefits at all levels will be affected by the  same percentage reduction, for example, 5 percent, regardless of earnings. Reducing the COLA would also have equity implications. Key Considerations in Choosing an Index

Indexing raises other important considerations about the program’s role,  the stability of the variables underlying the index, and the treatment of  Disability Insurance (DI) beneficiaries. Thus, if the current indexing of initial benefits was changed  to price growth, there is an implication that the appropriate level of  benefits is one that maintains purchasing power over time rather than the  current approach that maintains a relative standard of living across age  groups (i.e., replacement rates). As with other ways to change benefits, an  index that is designed to improve solvency by adjusting retirement  benefits may result in large reductions to disabled workers, who often  have fewer options to obtain additional income from other sources. Some indexes are premised on the past behavior of economic or  demographic relationships. Agency Comments

We provided a draft of this report to SSA and the Department of the  Treasury. SSA provided technical comments, which we have incorporated  as appropriate. For this report we used GEMINI to simulate Social Security benefits and  taxes primarily for 100,000 individuals born in 1985. If disabled and survivor benefits  were not reduced at all, reductions in other benefits would be greater than  shown in this analysis. 2. 3. 4. Bracket creep resulted from  the progressive benefit formula, which provided lower replacement rates  for higher earners than for lower earners. Social Security Reform: Analysis of a Trust Fund Exhaustion Scenario.
Why GAO Did This Study

The financing shortfall currently facing the Social Security program is significant. Without remedial action, program trust funds will be exhausted in 2040. Many recent reform proposals have included modifications of the indexing currently used in the Social Security program. Indexing is a way to link the growth of benefits and/or revenues to changes in an economic or demographic variable. Given the recent attention focused on indexing, this report examines (1) the current use of indexing in the Social Security program and how reform proposals might modify that use, (2) the experiences of other developed nations that have modified indexing, (3) the effects of modifying the indexing on the distribution of benefits, and (4) the key considerations associated with modifying the indexing. To illustrate the effects of different forms of indexing on the distribution of benefits, we calculated benefit levels for a sample of workers born in 1985, using a microsimulation model. We have prepared this report under the Comptroller General's statutory authority to conduct evaluations on his own initiative as part of a continued effort to assist Congress in addressing the challenges facing Social Security. We provided a draft of this report to SSA and the Department of the Treasury. SSA provided technical comments, which we have incorporated as appropriate.

What GAO Found

Indexing currently plays a key role in determining Social Security's benefits and revenues, and is a central element of many proposals to reform the program. The current indexing provisions that affect most workers and beneficiaries relate to (1) benefit calculations for new beneficiaries, (2) the annual cost-of-living adjustment (COLA) for existing beneficiaries, and (3) the cap on taxable earnings. Some reform proposals would slow benefit growth by indexing the initial benefit formula to changes in prices or life expectancy rather than wages. Some would revise the COLA under the premise that it currently overstates inflation, and some would increase the cap on taxable earnings. National pension reforms in other countries have used indexing in various ways. In countries with high contribution rates that need to address solvency issues, recent changes have generally focused on reducing benefits. Although most Organisation for Economic Co-operation and Development (OECD) countries compute retirement benefits using wage indexing, some have moved to price indexing, or a mix of both. Some countries reflect improvements in life expectancy in computing initial benefits. Reforms in other countries that include indexing changes sometimes affect both current and future retirees. Indexing can have various distributional effects on benefits and revenues. Changing the indexing of initial benefits through the benefit formula typically results in the same percentage change in benefits across income levels regardless of the index used. However, indexing can also be designed to maintain benefits for lower earners while reducing or slowing the growth of benefits for higher earners. Indexing payroll tax rates would maintain scheduled benefit levels but reduce the ratio of benefits to contributions for younger cohorts. Finally, the effect of modifying the COLA would be greater the longer people collect benefits. Indexing raises considerations about the program's role, the treatment of disabled workers, and other issues. For example, indexing initial benefits to prices instead of wages implies that benefit levels should maintain purchasing power rather than maintain relative standards of living across age groups (i.e., replacement rates). Also, as with other ways to change benefits, changing the indexing of the benefit formula to improve solvency could also result in benefit reductions for disabled workers as well as retirees.