What Is "Progressive Price Indexing"?
Guest post: hilzoy
I have been messing around with a long post on Social Security, and in the course of writing it I realized that I did not fully understand what 'price indexing' was, in the context of Social Security. The general concept of price indexing was easy enough: something that is currently indexed to wages would, under price indexing, be indexed to prices instead. Since prices tend to rise more slowly than wages, this would lead benefits to grow more slowly (or: be cut, depending on which you prefer) over time. But what, exactly, were people proposing to price-index? I had somehow picked up the (correct) idea that the mysterious indexed entity was not benefits themselves: these are adjusted each year according to the Consumer Price Index, which is to say: they are price-indexed. Price-indexing, I knew, had something to do with the initial calculation of benefits, and thus with the mysterious arcana of Social Security benefit calculations that I have thus far tried very hard to avoid having to figure out. But I realized, as I wrote my Social Security post, that I couldn't avoid this any longer. If I was to be a Truly Responsible Blogger™, I had to figure it out. Having done so, I thought I might as well try to explain it as clearly as possible, since it's not what you might think.
Warning: it's wonky.
Here is how your Social Security benefits are calculated, assuming you retire at 65 and are not disabled:
- First, the Social Security Administration selects the 35 years in which you earned the most. The amount you earned in any of those years before you turned 60 is adjusted by the amount that wages rose between that year and the year you turned 60. (Earnings in years after you turned 60 are not adjusted.) These adjusted annual earnings are then averaged, and divided by 12 to yield your "average indexed monthly earnings" (AIME).
- Next, a formula is applied to your AIME. Each month, Social Security will provide you with 90% of the first $627 of your average indexed monthly earnings; 32% of your earnings between $627 and $3779, and 15% of any covered earnings above that point.
- The dollar amounts just mentioned ($627, $3779) are called "bend points": the points at which additional monthly income stops being replaced at one rate and begins to be replaced at a lower rate. (Imagine a graph plotting Social Security benefits for each dollar of monthly income. These are the points at which the line on this graph would bend.) The 'bend points' are adjusted each year by the increase in average wages. So if wages were to rise 3% this year, then next year's bend points would be 3% higher.
- Once your benefits have been calculated, they are adjusted each year to take account of inflation (that is: they are price-indexed.)
I spelled this out so that you can see that there are a number of adjustments taking place:
- Your earnings are adjusted for to take account of increases in wages in calculating your average indexed monthly earnings.
- The 'bend points' that determine how much of your monthly earnings are replaced at 90%, how much at 32%, and how much at 15% are adjusted to take account of wage growth.
- And your benefits, once they have been calculated, are adjusted to take account of increases in prices.
Clear? I hope so. That's as clear as I can make it.
Now: presumably, the switch from wage-indexing to price-indexing cannot involve a change to the way your benefits, once calculated, are adjusted to keep up with the cost of living, since this adjustment is already price-indexed. It must involve either (a) the calculation of your average indexed monthly earnings, or (b) the calculation of the bend points. And there is a big difference between these two, which turns on the question: when does this indexing begin?
When your average indexed monthly earnings are calculated, you begin with your actual earnings in your 35 best years. Suppose the first of these years occurs after price-indexing takes effect: your actual wages will reflect any growth in wages that has occurred between the onset of price indexing and that year. So any divergence between using wage- and price-indexing in calculating your average indexed monthly earnings would concern the difference between the rates of growth of wages and prices during your working life. Moreover, the difference between wage and price indexing will be greatest in that first year; thereafter, it will shrink. And assuming that the relationship between wages and prices holds steady, each generation will lose about as much as those who came before.
This is not true if price-indexing is used to calculate 'bend points'. These are indexed to a particular year (currently, 1979), and absent any changes in Social Security's rules, they will go on being indexed to that year indefinitely. Thus, the calculation of the first bend point today is as follows: $180 (the first bend point in 1979) times $34,064.95 (the average wage in 2003) divided by $9,779.44 (the average wage in 1979) equals $627.00. If we do not change Social Security, we will continue to calculate the bend points relative to 1979 as long as our country survives.
And this means that changing the sort of indexing used to calculate the bend points is a much, much bigger deal, in the long run, than changing the means of indexing used to calculate your average indexed monthly earnings. If price-indexing is used to calculate your average indexed monthly earnings, then you will be affected only by the divergence between the rates of growth in wages and prices over your working life. But if price-indexing is used to calculate the bend points, then the bend points will continue to decline, as a share of wages, as long as Social Security exists. Moreover, this decline will compound itself, like interest rates. Whereas, if price-indexing were introduced into the calculation of people's average indexed monthly earnings, each generation would lose about as much as the last as long as the relation between wage growth and price growth held steady, using price indexing to calculate the bend points means that every generation will have a smaller share of its income replaced than those that preceded it, until the end of time (or Social Security, whichever comes first.)
The version of price indexing that President Bush seems to be considering is a version of the second: adjusting the 'bend points' in accordance with the growth in prices, not wages. Specifically, he seems to be considering "progressive price indexing", a sort of hybrid between wage and price indexing. According to the Pozen plan (warning: long wonky pdf) on which the President's vague gestures in the general direction of a plan are supposedly based, people who make around $20,000 a year would have their benefits calculated as they do now. The cap on maximum earnings replaced by Social Security, by contrast, would be price-indexed. And the bend points in between would be calculated using a combination of the two approaches.
This means that while people making below $20,000 a year would receive the same benefits under the President's approach that they would receive if Social Security remained unchanged, people making more would receive significant cuts. The more time goes by, the deeper those cuts become. Eventually, the difference between the benefits given to those making below $20,000 and those making more would approach zero. (The Center for Budget and Policy Priorities estimates that benefits would be essentially flat for anyone making $20,000/year or more by 2100.)
All of this, of course, doesn't take into account the effects of personal accounts; but that's a topic for another day. All I really wanted to do with this post was to make it clear what 'price indexing' is, on the assumption that if I, a reasonably well-informed person, didn't get it, I might not be alone.
[Cross-posted at Obsidian Wings]