Progressive Approaches to Benefit Changes In Social Security Reform

Ed Lorenzen
Revised April 29, 2005
Originally Published January 26, 2005

According to press reports President Bush will endorse a Social Security reform proposals which would make benefit changes to close the financing gap facing Social Security in a progressive manner. These changes would have a greater impact on higher wage workers who are not as dependent on Social Security benefits for retirement income.

This is an encouraging development for centrists, who are concerned about protecting the most vulnerable in society and believe that the burden of the tough choices necessary to restore solvency of the Social Security system should be borne by those best able to make sacrifices. Such a change would satisfy a key centrist criterion: Hold down costs, but strengthen the safety net.

This approach described in the article is known as “progressive price indexing.”  Under the current Social Security benefit formula, initial benefits for new retirees are computed by increasing their average career earnings per year by the rate of wage growth during their careers -- which is roughly 1.1% per year above price inflation.   Under the current Social Security benefit formula average benefits for new retirees tend to rise over time at the rate of wage growth, which is roughly 1.1 percent above inflation. This “wage indexing” maintains scheduled benefits as a roughly constant proportion of worker’s pre-retirement earnings -- the replacement ratio. .  By contrast, "price indexing" of initial benefits so that the average career earnings per year of workers would rise only by the rate of price inflation over their careers.  This would maintain the real purchasing power of benefits, but would not increase them in real terms to maintain a constant replacement rate of pre-retirement wages.  “Progressive price indexing” would maintain wage indexed benefits for low wage earners but subject higher earners to price indexing.  The effect of this proposal is to maintain the current replacement rates (i.e. benefits promised under current law) for lower income workers and gradually reduce the replacement rates for earnings up the income scale.

The proposal endorsed by the President was initially put forward by Robert Pozen, a member of the President’s Commission on Social Security reform.  The Pozen proposal would continue wage indexing for all workers retiring in 2012 and later years whose career earnings average $25,000 per year or less (indexed to wages over time).  The initial benefits of workers above $25,000 per year and lower than $113,000 per year in average career earnings would be increased by a proportional mix of wage and price indexing.  The initial benefits of all workers with career earnings above $113,000 per year in 2012 (the maximum wage base subject to FICA taxes in that year) would be increased by price indexing -- the rise in prices during their working careers. 

Gene Steuerle of the Urban Institute has suggested that any reform plan which includes changes in benefits to restore solvency include a new minimum benefit which would rise in real terms as earnings in the population rise. Several reform plans, including the plans put forward by the President’s Commission on Social Security reform, contain some version of a minimum benefit.  This would increase the benefits for many workers whose wages were low during their pre-retirement years.  A minimum benefit ensures that the largest transfers are given to individuals with the lowest earnings and not to the spouses of the wealthiest earners.  It would also create a floor under which benefits could not fall and effectively hold low income workers harmless from the changes in benefits made to restore solvency.  

A key criterion for Social Security reform is to strengthen the safety net features of the system and maintain or enhance the programs' progressivity and anti-poverty provisions.  Analysis of Social Security reform proposals should contain information regarding the impact of the plan on system progressivity and poverty protections.  A full assessment of the progressivity of Social Security reforms must be made based on the total package, including all changes in the defined benefit as well as any individual account component, and should not be assessed on a provision by provision basis.  Individual provisions may work against progressivity, but may be balanced by other provisions enhancing progressivity.

The rationale for preserving or enhancing the benefit for workers at the lower end of the income scale approach is that most low-wage workers do not have significant non-Social Security sources of retirement income such as 401(k) plans or IRAs.

 Thus, a uniform price indexing plan would create larger reductions in total retirement income for low wage workers than for high.  A progressive price indexing proposal or minimum benefit provision would tend to equalize government support of total retirement income, including both Social Security and private retirement plans like 401ks and IRAs. These plans used mainly by high and middle earners receive large tax subsidies from the federal government, as shown in the federal tax expenditure budget.

The social insurance nature of the Social Security system is intended to reduce poverty and hardship in retirement.  Any reforms of the Social Security system must preserve this vital social insurance function and allocate a larger share of the available revenues to beneficiaries with the lowest lifetime incomes and the greatest need.  Policymakers should be careful to protect low income workers who will depend primarily on Social Security for retirement income from the impact of changes in benefits necessary to restore solvency.  Most of these low-wage workers do not have sources of retirement income other than Social Security such as 401(k) plans or IRAs.  Maintaining replacement rates at or close to current levels is essential to ensuring a basic standard of living for low and moderate income workers.  Society should be comfortable granting this basic standard to all workers.

At the same time, social insurance does not prescribe that all people who retire receive higher and higher benefits in real terms. The costs of meeting the benefit promises under current law will grow much faster than revenues as the dependency ratio increases, making some restraint in benefit growth inevitable. A responsible reform plan should target the tough choices necessary to restrain the growth of benefit costs at workers best able to adjust to a change in promised Social Security benefits.  These workers are relatively well off and were afforded greater opportunity to save for retirement through other avenues such as 401(k) plans and IRAs in addition to Social Security benefits.  It is therefore reasonable for Social Security to provide these workers with a lower replacement rate in retirement.  Indeed, reducing the replacement rate from Social Security benefits for higher income workers would provide an incentive for increased private savings by these workers to ensure that they may retain their standard of living in retirement.

A more basic reason to make reforms of Social Security system in a progressive manner is that the system’s redistributive elements are not particularly well targeted to deal with the threat of poverty among tomorrow’s elderly. As Gene Steuerle of the Urban Institute has noted, an ever smaller share of Social Security expenditures are going to the poorest recipients.   In particular, the increasing numbers of women in the workforce – including divorcees, those who never married, and two-earner couples – are among those who are not well-served by the system’s anti-poverty protections.  For example, a low-income, two-earner couple receives a lower rate of return than a high-income, one-earner couple, despite the progressivity of the benefit formula. Much of this difference is due to the relative generosity of the non-working-spouse benefit, in comparison with the relatively low rate of return on an individual’s primary Social Security tax contributions.  The progressivity of the basic benefit formula is often undermined in its effects by redistribution to one-earner couples from households with working women. Social Security reform presents an opportunity to improve the redistributive functions of the Social Security system.

Making benefit changes in a progressive manner is particularly important for plans which provide advance funding through individual accounts. Any attempt to pre-fund a portion of future retirement income through private accounts adds economic risk to the system.  We can expect the rich to absorb a greater amount of that risk, and the middle class to incur some of it, but the poor cannot reasonably be expected to take on additional risk.  Plans to reform Social Security including individual accounts should target changes in the defined benefit system at middle and upper income workers who are able to tolerate a higher level of risk in individual accounts and therefore have a greater opportunity to benefit from the prospects for higher returns from individual accounts.

Progressives should be encouraged that the administration is supporting a Social Security plan which protect low income workers and target reductions in promised benefits at higher income workers.  But ironically many Democrats react negatively to proposals making changes in benefits based on income, fearing that it is a type of “means testing” that would move toward changing the universal nature of the program and undermine the political support for Social Security. They fear that if well-off workers don't get sufficient benefits, their support for the social insurance programs will fade, and the current universal entitlements will evolve into targeted welfare programs with limited public support.

While the concern about diminished support for the system should not be dismissed lightly, that risk is relatively minor compared to the impact that making benefit changes across-the-board would have on low and moderate income workers. As long as people of all incomes and generations believe the programs are fair and will efficiently reduce poverty among the elderly their political support should continue.

Many of those who argue that progressive price indexing would undermine political support for the program support proposals which rely on substantial increases in taxes paid into the Social Security system by upper income workers.  Both approaches would reduce the rate of return earned by these workers.  Some of the proposals which rely on tax surcharges to restore solvency do not give workers additional benefits for the increased contributions.  If reducing the benefits that upper income workers will receive in the future will create political risks for the Social Security system, then increasing the taxes that these workers pay today will create even greater risks, particularly if workers do not receive any increase in benefits for their increased contributions.

If the growth of benefits is restrained, as will be necessary unless workers are asked to shoulder an ever growing payroll tax burden, it is preferable to structure those changes to protect those who are most dependent on Social Security benefits to meet basic needs by asking higher income workers to accept a greater proportion of the reduction in promised benefits. Americans would have greater confidence in the long-term viability of the social insurance programs if they knew policymakers were facing these tradeoffs in a straightforward manner.