Indexing Social Security Benefits: The Effects of Price and Wage Indexes

Publication Date: May 2005

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Economics

Type:

Abstract:

Under current law, Social Security benefits increase from one generation to the next at the rate that the national average wage rises. In other words, initial Social Security benefits are wage-indexed. Once enrolled in the program, beneficiaries' Social Security checks increase each year at the same rate as the Consumer Price Index (CPI); that is, they are price-indexed. Due to increases in worker productivity, wages tend to rise faster than prices when measured over long periods of time. Consequently, if initial benefits were based on the rate at which prices rise rather than the rate at which wages rise, initial benefits for each succeeding generation of workers would grow more slowly than under current law.

The growth of Social Security benefits over time can be measured against either the rate of growth of prices or wages. If benefits grow faster than the rate at which prices rise, the benefits increase in purchasing power, and future retirees will enjoy higher standards of living than today's retirees. If benefits grow at the same rate as prices, purchasing power is unchanged, and future retirees will be able to maintain a standard of living similar to that of today's retirees. Benefit levels that grow more slowly than the rate at which prices rise will decline in purchasing power, resulting in falling standards of living for future retirees. Because Social Security benefits are wage-indexed, the purchasing power of benefits rises from one generation of workers to the next, and the replacement rate -- initial benefits as a percentage of workers' career-average earnings -- remains constant for each successive generation of workers. If benefits were price-indexed, the purchasing power of benefits would remain constant for each generation of workers, and replacement rates would fall.

Price-indexing would make small annual reductions in initial benefits, but the cumulative reduction would be substantial when compounded over many years. This could have serious implications for the retirement income of low-wage workers. Price-indexing benefits also would make deeper cuts in benefits if wages grow faster than projected, even as Social Security's financial situation would be improving. Likewise, if wages grow more slowly than projected, price-indexing would make smaller cuts in benefits, leading to a larger financing deficit.

One way to preserve benefits for low-wage workers would be to progressively price-index initial benefits. Initial benefits of low-wage workers would continue to be fully wage-indexed, the benefits of average-wage workers would be based on a mix of wage-indexing and price-indexing, and the benefits of high-wage workers would be fully price-indexed. President Bush has suggested that Congress consider progressive price-indexing of Social Security benefits. The Social Security Administration (SSA) has analyzed a method of progressive price-indexing that would continue to wage-index Social Security benefits for workers with careeraverage earnings in the lowest 30% of the earnings distribution. SSA has estimated that this proposal would eliminate about three-fourths of the program's 75-year unfunded liability. One consequence of this method of progressive price-indexing would be that, eventually, all workers with earnings in the top 70% of the earnings distribution would receive the same benefit. This report will not be updated.