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Report to Congressional Addressees: 

United States Government Accountability Office: 

GAO: 

September 2006: 

Social Security Reform: 

Implications of Different Indexing Choices: 

Social Security Indexing: 

GAO-06-804: 

GAO Highlights: 

Highlights of GAO-06-804, a report to congressional addressees 

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 Generalís 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 Securityís 
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 programís 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. 

[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-804]. 

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Barbara Bovbjerg at (202) 
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[End of Section] 

Contents: 

Letter: 

Results in Brief: 

Background: 

Social Security Currently Indexes Both Benefits and Revenues: 

A Variety of Indexing Approaches Highlight International Reform 
Efforts: 

Indexing Can Be Used to Achieve Desired Distributional Effect: 

Key Considerations in Choosing an Index: 

Concluding Observations: 

Agency Comments: 

Appendix I: Methodology: 

Microsimulation Model: 

Benchmark Policy Scenarios: 

Appendix II: Background on Development of Social Security's Indexing 
Approach: 

Program Did Not Use Indexing until 1970s: 

Indexing in 1972 Amendments Built on Previous Ad Hoc Benefit Increases: 

Indexing Approach Introduced Potential Instability in Benefit Costs: 

Related GAO Products: 

Tables: 

Table 1: Key Indexing Approaches under Current U.S. Social Security 
System: 

Table 2: Summary of Indexes and Automatic Adjustments Proposed in 
United States: 

Table 3: Characteristics of Earnings-Related Public Pension Programs- 
Selected Countries: 

Table 4: Application of So-called Scaling of PIA Factors for Aged 
Dependency Ratio Benefit Reduction Index: An Example Using 2050 PIA 
Formula Factors: 

Table 5: Summary of Benchmark Policy Scenarios: 

Table 6: Summary of Benchmark Policy Scenario Parameters: 

Table 7: Percentage Increases in OASI Benefits, Prices, and Wages, by 
Effective Date of OASI Change, 1950-1971: 

Figures: 

Figure 1: Social Security Benefit Formula Replaces Earnings at 
Different Rates: 

Figure 2: Social Security's Earnings Replacement Rates for Illustrative 
Workers: 

Figure 3: Indexing Changes with a Larger Proportional Reduction Have a 
Greater Impact on the Distribution of Benefits, but Scaling to Achieve 
75-Year Solvency Illustrates That the Proportional Effects Have Similar 
Results: 

Figure 4: Proportional Indexing Changes Would Maintain the 
Progressivity of the Current Benefit Formula, but Could Reduce Adequacy 
(Initial Benefits in 2050): 

Figure 5: Lower-Income Individuals Would Fare Comparatively Better 
under the Progressive Application of the CPI Index than under the CPI 
Index Alone (Initial Benefits in 2050): 

Figure 6: Scaling the Progressive Application of the CPI Index to 
Achieve Equivalent Solvency Demonstrates That Most Individuals above a 
Certain Point Would Receive About the Same Level of Benefits (Initial 
Benefits in 2050): 

Figure 7: A Onetime Payroll Tax Increase Would Spread the Tax Burden 
More Evenly across Cohorts than Gradual Increases through an Index: 

Figure 8: The Growth of $1,000 Benefit under the CPI and Two 
Alternatives Illustrate That Those Beneficiaries Who Receive Benefits 
Longer Will Be Affected the Most: 

Figure 9: Inflation-Adjusted Values of the Maximum Taxable Earnings 
Level before Automatic Adjustments, 1937-1975: 

Figure 10: Percentage of Total Covered Earnings below Social Security's 
Maximum Taxable Earnings Level, 1937-2005: 

Figure 11: Changes in Average Wage Index and Consumer Price Index, 1951-
1985: 

Figure 12: Social Security Workers per Beneficiary: 

Abbreviations: 

ABM: automatic balancing mechanism: 

AIME: average indexed monthly earnings: 

AWI: average wage index: 

COLA: cost-of-living adjustment: 

CPI: consumer price index: 

CPI-E: consumer price index for older Americans: 

CPI-U: consumer price index for all urban consumers: 

CPI-W: consumer price index for urban wage earners and clerical 
workers: 

DI: Disability Insurance: 

GDP: gross domestic product: 

GEMINI: Genuine Microsimulation of social Security and Accounts: 

OASDI: Old-Age, Survivors, and Disability Insurance: 

OASI: Old-Age and Survivors Insurance: 

OCACT: Office of the Chief Actuary: 

OECD: Organisation for Economic Co-operation and Development: 

PENSIM: Pension Simulator: 

PIA: primary insurance amount: 

PSG: Policy Simulation Group: 

SSA: Social Security Administration: 

SSASIM: Social Security and Accounts Simulator: 

United States Government Accountability Office: 
Washington, DC 20548: 

September 14, 2006: 

The Honorable Charles E. Grassley: 
Chairman: 
The Honorable Max Baucus: 
Ranking Minority Member: 
Committee on Finance: 
United States Senate: 

The Honorable Jim McCrery: 
Chairman: 
The Honorable Sander M. Levin: 
Ranking Minority Member: 
Subcommittee on Social Security: 
Committee on Ways and Means: 
House of Representatives: 

The Honorable John Warner: 
United States Senate: 

The total long-term financing shortfall currently facing the Social 
Security program is significant and growing over time, thereby making 
system reform an important priority. Once the Social Security trust 
fund balances are exhausted in 2040, annual revenue will be sufficient 
only to pay about 74 percent of promised benefits, according to the 
Social Security trustees' 2006 intermediate assumptions. Benefit costs 
are projected to exceed income in 2017, and thus trust fund securities 
will need to be redeemed. This will require increased government 
revenue, increased borrowing from the public, reduced spending in the 
rest of the government, or some combination of these. Redeeming these 
securities will have an adverse impact on the federal budget much 
sooner than the 2040 trust fund exhaustion date. 

Many recent reform proposals have proposed modifications to 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 
economic or demographic variables. For example, initial benefits can be 
set to grow with changes in average wages or changes in prices. 
Modifications to indexing seek to slow the growth of benefits or 
increase the growth of revenues, either of which would improve 
solvency. However, indexing does not guarantee that the program will 
achieve and remain in long-term financial balance. Proposals that would 
modify Social Security's indexing implicitly pose the question of 
whether and how such adjustments could provide a mechanism to keep the 
program sustainably solvent and minimize the need for periodic 
rebalancing of the program's finances. At the same time, how it is done 
can affect the distribution of benefits between low and high earners 
and across generations of workers. 

Given the recent attention focused on indexing as a critical component 
of reform, 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 when reforming their public pension systems, (3) the effects 
of indexing modifications on the distribution of Social Security 
benefits, and (4) the key considerations associated with modifying 
Social Security's indexing. 

To examine the use of indexing in the Social Security program and how 
reform proposals might modify the indexing, we conducted a literature 
review and reviewed recent Social Security reform proposals. To examine 
the experience of other developed nations that changed indexing when 
reforming their own national pension systems, we reviewed the academic 
literature and documentation on other countries' public pension 
systems. To analyze the effects of different forms of indexing on the 
distribution of benefits, we calculated benefit levels for a sample of 
workers using a microsimulation model (see app. I for a more detailed 
discussion of our scope and methodology).[Footnote 1] For this 
analysis, we selected four well-known indexing approaches to illustrate 
the effects on the distribution of benefits.[Footnote 2] To describe 
the distributional effects of the different indexing approaches, we 
used our model to simulate benefits for workers born in 1985.[Footnote 
3] Consistent with our past work on Social Security reform, and to 
illustrate a full range of possible outcomes, we used hypothetical 
benchmark policy scenarios that would achieve 75-year solvency either 
by only increasing payroll taxes (which simulated "promised benefits") 
or only reducing benefits (which simulated "funded benefits").[Footnote 
4] To determine the key considerations associated with various forms of 
indexing, we reviewed the literature and talked with relevant experts. 
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 conducted our work between July 2005 and August 
2006 in accordance with generally accepted government auditing 
standards. 

Results in Brief: 

While the initial Social Security program did not use automatic 
indexing, it is now a key feature of the program's design, as well as a 
central element of many proposals to reform the program. Under the 
current system, the indexing provisions that affect most workers and 
beneficiaries relate to (1) the formula used to calculate initial 
benefits for new beneficiaries, (2) the cost-of-living adjustment 
(COLA) for existing beneficiaries, and (3) the cap on taxable earnings. 
The benefit indexing provisions help maintain relative standards of 
living across age groups and protect the purchasing power of benefits 
over time. Various reform proposals have suggested changes to all of 
these provisions. For example, for future beneficiaries, some proposals 
would index initial benefit levels to keep pace with price inflation 
rather than wages. This would result in gradually declining earnings 
replacement rates but maintain the purchasing power of current benefit 
levels across age groups, assuming wages grow faster than prices on 
average over time.[Footnote 5] Other proposals accept slowing the 
growth of initial benefits, in general, but seek to protect benefit 
levels for the lowest earners, consistent with the program's goal of 
helping ensure income adequacy. Proposals to change the annual COLA for 
existing beneficiaries generally focus on making it reflect inflation 
levels more accurately, with the presumption that this would result in 
lower benefits. On the revenue side, proposals to increase the cap on 
taxable earnings generally seek to raise revenue from higher earners 
and avoid increasing tax rates for all workers. 

Other countries' efforts to reform their national pension systems 
reveal a diversity of indexing approaches. Countries with relatively 
high contribution rates tend to focus on methods that reduce benefits 
to address the financial solvency of their pension systems. Although 
most Organisation for Economic Co-operation and Development (OECD) 
countries index past earnings to reflect wage growth in computing 
initial retirement benefits, some now use a price growth index (France, 
Belgium, and South Korea), or an index that blends price and wage 
growth (Portugal, Poland, and Finland). Some benefit formulas contain a 
measure of life expectancy that reduces payments to new retirees in 
accordance with increases in longevity (Sweden, Italy, and Poland). 
Changes to indexing approaches abroad sometimes affect both current and 
future retirees. Germany includes a "sustainability" factor that lowers 
pension amounts for both new and old retirees when the number of 
workers paying into the system declines relative to those drawing 
benefits. Similarly, other national systems rely on automatic balancing 
mechanisms that modify both the future benefits of workers and the 
benefits of current pensioners (Sweden, Japan). 

Indexing can have different effects on the distribution of benefits and 
on the relationship between contributions and benefits, depending on 
how it is applied. Regardless of the index, adjusting the initial 
benefit level through the benefit formula typically would have a 
proportional effect, with constant percentage changes at all earnings 
levels, on the distribution of benefits. However, indexing can also be 
used to achieve specific distributional goals. For example, so-called 
progressive indexing applies different indexes at different earnings 
levels to adjust benefits of higher-income earners more than the 
benefits of lower-income earners. Indexing payroll tax rates would have 
distributional effects across generations, maintaining the existing 
distribution of benefits but instead affecting equity measures like the 
ratio of benefits to contributions across age cohorts. In this case, 
younger cohorts would have lower ratios, because they would receive 
lower benefits relative to their contributions. Finally, proposals that 
modify the indexing of annual COLAs for existing beneficiaries would 
have adverse distributional effects for groups with longer life 
expectancies, such as women, but these individuals would still receive 
higher lifetime benefits since they live longer. In addition, disabled 
worker beneficiaries, especially those who receive benefits for many 
years, would also experience lower benefits because such proposals 
would typically reduce future benefits, and this effect compounds over 
time. 

Indexing raises other important considerations about the program's 
role, the stability of economic or demographic relationships underlying 
the index, and the treatment of disabled worker beneficiaries. The 
choice of the index implies certain assumptions about the appropriate 
level of benefits and taxes for the program. Thus, if the current 
indexing of initial benefits to wage growth was changed to track 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 replacement rates. The solvency effects 
of an index are predicated upon the relative stability and historical 
trends of the underlying economic or demographic relationships implied 
by the index. For example, the 1970s were a period of economic 
instability in which actual inflation rates and earnings growth 
diverged markedly from past experience, with the result that benefits 
unexpectedly grew much faster than revenues. Finally, since the benefit 
formula for Social Security retirement and disability benefits are 
linked, an important consideration of any indexing proposal, as with 
any other change to benefits, is its effect on the benefits provided to 
disabled workers. Disabled worker beneficiaries typically become 
entitled to benefits much sooner than retired workers and under 
different eligibility criteria. An index that is designed to improve 
solvency, for example, by adjusting retirement benefits, could also 
result in large reductions to disabled workers, who often have fewer 
options to obtain additional income from other sources. 

Background: 

Title II of the Social Security Act, as amended, establishes the Old- 
Age, Survivors, and Disability Insurance (OASDI) program, which is 
generally known as Social Security. The program provides cash benefits 
to retired and disabled workers and their eligible dependents and 
survivors. Congress designed Social Security benefits with an implicit 
focus on replacing lost wages. However, Social Security is not meant to 
be the sole source of retirement income; rather it forms a foundation 
for individuals to build upon. The program is financed on a modified 
pay-as-you-go basis in which payroll tax contributions of those 
currently working are largely transferred to current beneficiaries. 
Current beneficiaries include insured workers who are entitled to 
retirement or disability benefits, and their eligible dependents, as 
well as eligible survivors of deceased insured workers. The program's 
benefit structure is progressive, that is, it provides greater 
insurance protection relative to contributions for earners with lower 
wages than for high-wage earners. Workers qualify for benefits by 
earning Social Security credits when they work and pay Social Security 
taxes[Footnote 6]; they and their employers pay payroll taxes on those 
earnings. In 2005, approximately 159 million people had earnings 
covered by Social Security, and 48 million people received 
approximately $521 billion in OASDI benefits. 

Currently, the Social Security program collects more in taxes than it 
pays out in benefits. However, because of changing demographics, this 
situation will reverse itself, with the annual cash surplus beginning 
to decline in 2009 and turning negative in 2017. In addition, all of 
the accumulated Treasury obligations held by the trust funds are 
expected to be exhausted by 2040.[Footnote 7] Social Security's long- 
term financing shortfall stems primarily from the fact that people are 
living longer and labor force growth has slowed.[Footnote 8] As a 
result, the number of workers paying into the system for each 
beneficiary has been falling and is projected to decline from 3.3 today 
to about 2 by 2040. The projected long-term insolvency of the OASDI 
program necessitates system reform to restore its long-term solvency 
and assure its sustainability. Restoring solvency and assuring 
sustainability for the long term requires that either Social Security 
gets additional income (revenue increases), reduces costs (benefit 
reductions), or undertakes some combination of the two. 

To evaluate reform proposals, we have suggested that policy makers 
should consider three basic criteria:[Footnote 9] 

1. the extent to which the proposal achieves sustainable solvency and 
how the proposal would affect the economy and the federal budget; 

2. the balance struck between the goals of individual equity[Footnote 
10] (rates of return on individual contributions) and income 
adequacy[Footnote 11] (level and certainty of monthly benefits); and: 

3. how readily such changes could be implemented, administered, and 
explained to the public. 

Moreover, reform proposals should be evaluated as packages that strike 
a balance among the individual elements of the proposal and the 
interactions among these elements. The overall evaluation of any 
particular reform proposal depends on the weight individual policy 
makers place on each of the above criteria. 

Changing the indexing used by the OASDI program could be used to 
increase income or reduce costs. Indexing provides a form of regular 
adjustment of revenues or benefits that is pegged to a particular 
economic, demographic, or actuarial variable. An advantage of such 
indexing approaches is that they take some of the "politics" out of the 
system, allowing the system to move toward some agreed-upon objective; 
they may also be administratively simple. However, this "automatic 
pilot" aspect of indexing poses a challenge, as it may make policy 
makers hesitant to enact changes, even when problems arise. 

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. Reform proposals have included 
provisions for modifying each of these indexing features. 

Program Did Not Use Indexing until 1970s: 

Before the 1970s, the Social Security program did not use indexing to 
adjust benefits or taxes automatically. For both new and existing 
beneficiaries, benefit rates increased only when Congress voted to 
raise them. Benefit levels, when adjusted for inflation, fell and then 
jumped up with ad hoc increases, and these fluctuations were dramatic 
at times. Similarly, Congress made only ad hoc changes to the tax rate 
and the cap on the amount of workers' earnings that were subject to the 
payroll tax, which is also known as the maximum taxable earnings level. 
Adjusted for inflation, the maximum taxable earnings level also 
fluctuated dramatically, and as a result, the proportion of all wages 
subject to the payroll tax also fluctuated. (See app. II for more 
detail.) 

For the first time, the 1972 amendments provided for automatic 
indexing. They provided for automatically increasing the maximum 
taxable earnings level based on increases in average earnings, and this 
approach is still in use today. However, the 1972 amendments provided 
an indexing approach for benefits that became widely viewed as flawed. 
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[Footnote 12]; (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. (See app. II for more detail.) Within a few years, 
problems with the 1972 amendments became apparent. Benefits were 
growing far faster than anticipated, especially since wage and price 
growth varied dramatically from previous historical experience. 
Addressing the instability of this indexing approach became a focus of 
policy makers' efforts to come up with a new approach. As a 1977 paper 
on the problem noted, "Clearly, it is a system that needs to be brought 
under greater control, so that the behavior of retirement benefits over 
time will stop reflecting the chance interaction of certain economic 
variables."[Footnote 13] 

1977 Amendments Created Indexing Approach of Current Social Security 
System: 

The 1977 amendments instituted a new approach to indexing benefits that 
remains in use today. The experience with the 1972 amendments and 
double indexing made clear the need to index benefits differently for 
new and existing beneficiaries, which was referred to as "decoupling" 
benefits. Indexing now applies to several distinct steps of the benefit 
computation process, including (1) indexing lifetime earnings for each 
worker to wage growth, (2) indexing the benefit formula for new 
beneficiaries to wage growth, and (3) indexing benefits for existing 
beneficiaries to price inflation.[Footnote 14] Under this approach, 
benefit calculations for new beneficiaries are indexed differently than 
for existing beneficiaries, and earnings replacement rates have been 
fairly stable. The cap on taxable earnings is still indexed to wage 
growth as specified by the 1972 amendments. 

Indexing Lifetime Earnings to Wages: 

Social Security benefits are designed to partially replace earnings 
that workers lose when they retire, become disabled, or die. As a 
result, the first step of the benefit formula calculates a worker's 
average indexed monthly earnings (AIME), which is based on the worker's 
lifetime history of earnings covered by Social Security taxes. The 
formula adjusts these lifetime earnings by indexing them to changes in 
average wages.[Footnote 15] Indexing the earnings to changes in wage 
levels ensures that the same relative value is accorded to each year's 
earnings, no matter when they were earned. 

For example, consider a worker who earned $5,000 in 1965 and $40,000 in 
2000. The worker's earnings increased by eight times, but much of that 
increase reflected changes in the average wage level in the economy, 
which increased by about seven times (690 percent) over the same 
period. The growth in average wages in turn partially reflects price 
inflation; however, wages may grow faster or slower than prices in any 
given year. Indexed to reflect wage growth, the $5,000 would become 
roughly $35,000, giving it greater weight in computing average earnings 
over time and making it more comparable to 2000 wage levels. 

Indexing Initial Benefit Formula to Wages: 

Once the AIME is determined, it is applied to the formula used to 
calculate the worker's primary insurance amount (PIA). This formula 
applies different earnings replacement factors to different portions of 
the worker's average earnings. The different replacement factors make 
the formula progressive, meaning that the formula replaces a larger 
portion of earnings for lower earners than for higher earners. For 
workers who become eligible for benefits in 2006, the PIA equals: 

* 90 percent of the first $656 dollars of AIME plus: 

* 32 percent of the next $3,299 dollars of AIME plus: 

* 15 percent of AIME above $3,955. 

For workers who do not collect benefits until after the year they first 
become eligible, the PIA is adjusted to reflect any COLAs since they 
became eligible. The PIA is used in turn to determine benefits for new 
beneficiaries and all types of benefits payable on the basis of an 
individual's earnings record. To determine the actual monthly benefit, 
adjustments are made reflecting various other provisions, such as those 
relating to early or delayed retirement, type of beneficiary, and 
maximum family benefit amounts. Figure 1 illustrates how the PIA 
formula works. 

Figure 1: Social Security Benefit Formula Replaces Earnings at 
Different Rates: 

[See PDF for image] 

Source: Social Security Administration. 

[End of figure] 

The dollar values in the formula that indicate where the different 
replacement factors apply are called bendpoints. These bendpoints ($656 
and $3,955) are indexed to the change in average wages, while the 
replacement factors of 90, 32, and 15 percent are held constant. In 
contrast, under the 1972 amendments, the bendpoints were held constant 
and the replacement factors were indexed. (See app. II.) Indexing the 
bendpoints and holding replacement factors constant prevents bracket 
creep and keeps the resulting earnings replacement rates relatively 
level across birth years. Indexing the benefit formula in this way 
helps benefits for new retirees keep pace with wage growth, which 
reflects increases in the standard of living. 

Figure 2, which shows earnings replacement rates for successive groups 
of illustrative workers, illustrates the program's history with 
indexing initial benefits.[Footnote 16] Replacement rates declined 
before the first benefit increases were enacted in 1950 and then rose 
sharply as a result of those increases. From 1950 until the early 
1970s, replacement rates fluctuated noticeably more from year to year 
than over other periods; this pattern reflects the ad hoc nature of 
benefit increases over that period. Between 1974 and 1979, replacement 
rates grew rapidly for new beneficiaries, reflecting the double 
indexing of the 1972 amendments. The 1977 amendments corrected for the 
unintended growth in benefits from double indexing, and replacement 
rates declined rapidly as a result. This pattern of increasing and then 
declining benefit levels is known as the notch.[Footnote 17] Finally, 
replacement rates have been considerably more stable since the 1977 
amendments took effect, a fact that has helped to stabilize program 
costs. (See app. II.) 

Figure 2: Social Security's Earnings Replacement Rates for Illustrative 
Workers: 

[See PDF for image] 

Source: SSA. 

Note: Replacement rates are the annual retired worker benefits at age 
65 divided by career-average earnings. Illustrative workers have career-
average earnings equal to about 45, 100, and 160 percent of Social 
Security's Average Wage Index, respectively, for low, medium, and high 
earners. These three cases have earnings patterns that reflect 
differences by age in the probability of work and in average earnings 
levels. Taxable maximum earners have earnings equal to the maximum 
earnings taxable under OASDI in each year. Variations in these 
illustrative replacement rates result not only from program changes but 
also from short-term fluctuations in the growth rate of wages, which 
helps determine the earnings histories of the illustrative earners. 

[End of figure] 

Indexing Benefits to Prices for Existing Beneficiaries: 

After initial benefits have been set for the first year of entitlement, 
benefits in subsequent years increase with a COLA designed to keep pace 
with inflation and thereby help to maintain the purchasing power of 
those benefits. The COLA is based on the consumer price index (CPI), in 
contrast to the indexing of lifetime earnings and initial benefits, 
which are based on the national average wage index.[Footnote 18] 

Indexing Maximum Taxable Earnings to Wages: 

The cap on taxable earnings increases each year to keep pace with 
changes in average wages. As a result, in combination with a constant 
tax rate, total program revenues tend to keep pace with wage growth and 
therefore also with benefits to some degree. In 2006, the cap is set at 
$94,200. As the distribution of earnings in the economy changes, the 
percentage of total earnings that fall below the cap can also change. 
(See app. II.) 

Table 1 summarizes the various indexing and automatic adjustment 
approaches that affect most workers and beneficiaries under the current 
program. 

Table 1: Key Indexing Approaches under Current U.S. Social Security 
System: 

Approach: Benefit provisions: Wage-indexing initial benefit 
calculation; 
How it works: Before averaging workers' earnings over their careers, 
AIME adjusts actual earnings using average wage index; Bendpoints of 
PIA formula rise over time according to wage growth; Earnings 
replacement factors in PIA formula remain constant; 
Comments: Maintains relative standards of living across age groups 
(that is, replacement rates), at time of retirement; Actuarial balance 
of the program is relatively insensitive to economic fluctuations 
because benefit levels and tax revenues are both linked to wages; 
Initial benefits keep pace with standard of living, as reflected by 
wage levels. 

Approach: Benefit provisions: Price-indexing post-entitlement benefits; 
How it works: Benefits rise yearly according to rise in the CPI; 
Comments: Purchasing power of benefits remains constant over time, once 
benefits start. 

Approach: Tax provisions: Wage-indexing maximum taxable earnings; 
How it works: Earnings are only taxed on the first $94,200 per year in 
2006. Limit rises every year according to average wage growth; 
Comments: Share of earnings not taxed can change as income distribution 
changes. 

Approach: Tax provisions: Constant tax rate; 
How it works: Earnings are taxed yearly at 12.4 percent (6.2 percent 
from workers and 6.2 percent from employers); 
Comments: Program revenue rises annually with the rise in wages; 
Constant tax rate maintains the same proportion of taxes for all 
workers earning less than maximum taxable earnings. 

Source: GAO. 

[End of table] 

Various Reform Proposals Include Indexing Provisions: 

Various reform proposals have suggested changes to most of the indexing 
features of the current Social Security system. Some proposals would 
use alternative indexes for initial benefits in order to slow their 
growth. Other proposals would take the same approach but would limit 
benefit reductions on workers with lower earnings. Some propose 
modifying the COLA in the belief that the CPI overstates the rate of 
inflation. Still others propose indexing revenue provisions in new 
ways. 

Changes to the indexing of Social Security's initial benefits could be 
implemented by changing the indexing of lifetime earnings or the PIA 
formula's bendpoints.[Footnote 19] However, they could also be 
implemented by adjusting the PIA formula's replacement factors, even 
though these factors are not now indexed. Under this approach, which is 
used in this report, the replacement factors are typically multiplied 
by a number that reflects the index being used. The replacement factors 
would be adjusted for each year in which benefits start, beginning with 
some future year. So such changes would not affect current 
beneficiaries. 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. Recent reform proposals, 
as described by the Social Security Administration's (SSA) Office of 
the Chief Actuary in its evaluations, generally implement indexing 
changes as adjustments to the PIA formula's replacement factors. 

Two indexing approaches--to reflect changes in the CPI or increasing 
longevity--have been proposed as alternatives to the average wage index 
for calculating initial benefits. Proponents of using CPI indexing for 
initial benefit calculations generally offer the rationale that wage 
indexing has never been fiscally sustainable and CPI indexing would 
slow the growth of benefits to an affordable level while maintaining 
the purchasing power of benefits. They say that maintaining the 
purchasing power of benefits should be the program's goal, as opposed 
to maintaining relative standards of living across age groups (that is, 
earnings replacement rates), which the current benefit formula 
accomplishes. Proponents of longevity indexing offer the rationale that 
increasing longevity is a key reason for the system's long-term 
insolvency. Since people are living longer on average, and are expected 
to continue to do so in the future, they will therefore collect 
benefits for more years on average. Using an index that reflects 
changes in life expectancy would maintain relatively comparable levels 
of lifetime benefits across birth years and thereby promote 
intergenerational equity. Also, longevity indexing could encourage 
people to work longer. 

Some indexing proposals accept the need to slow the growth of initial 
benefits in general but seek to protect benefit levels for the lowest 
earnings levels, consistent with the program's goal of helping ensure 
income adequacy. Such proposals would modify how a new index would be 
applied to the formula for initial benefits so that the formula is 
still wage-indexed below a certain earnings level. As a result, they 
would maintain benefits promised under the current program for those 
with earnings below that level such as, for example, those in the 
bottom 30 percent of the earnings distribution. Such an approach has 
been called progressive price indexing. 

A few proposals would alter the COLA used to adjust benefits for 
current retirees. Some proposals respond to methodological concerns 
that have been raised about how the CPI is calculated and would adjust 
the COLA in the interest of accuracy.[Footnote 20] In general, such 
changes would slightly slow the growth of the program's benefit costs. 
However, other proposals call for creating a new CPI for older 
Americans (CPI-E) specifically tailored to reflect how inflation 
affects the elderly population and using the CPI-E for computing Social 
Security's COLA.[Footnote 21] Depending on its construction, such a 
change could increase the program's benefit costs. 

Some proposals would index revenues in new ways. Some would apply a 
longevity index to payroll tax rates, again focused on the fact that 
increasing life expectancy is a primary source of the program's 
insolvency. Proponents of indexing tax rates feel that benefits are 
already fairly modest, so the adjustment for longevity should not come 
entirely from benefit reductions. Other proposals would institute other 
types of automatic revenue adjustments. Some would raise the maximum 
taxable earnings level gradually until some percentage of total 
earnings are covered and then maintain that percentage into the future. 
Implicitly, such proposals reflect a desire to hold constant the 
percentage of earnings subject to the payroll tax. Still another 
proposal would provide for automatically increasing the tax rate when 
the ratio of trust fund assets to annual program costs is projected to 
fall. 

Table 2 summarizes the various indexing and automatic adjustment 
approaches that reform proposals have contained. 

Table 2: Summary of Indexes and Automatic Adjustments Proposed in 
United States: 

Provision: Provisions affecting initial benefit calculations for future 
beneficiaries: Longevity indexing; 
How it works: Proportionally reduces replacement factors in PIA formula 
to reflect adjustments for increasing life expectancy.[A]; 
Rationales offered by proponents: Increasing longevity is a key reason 
for the system's long-term solvency problem; People are living longer 
on average and therefore collecting benefits for more years on average; 
Would maintain comparable levels of lifetime benefits across birth 
years and thereby promote intergenerational equity. 

Provision: Provisions affecting initial benefit calculations for future 
beneficiaries: Price indexing[B]; 
How it works: Proportionally reduces replacement factors in PIA formula 
to reflect changes in index.[A]; 
Rationales offered by proponents: "Wage-indexing Ö has never been 
fiscally sustainable."[C]; Would slow the growth of benefits to an 
affordable level; Would still maintain the purchasing power of 
benefits. 

Provision: Provisions affecting initial benefit calculations for future 
beneficiaries: Progressive price indexing; 
How it works: Proportionally reduces replacement factors in PIA formula 
to reflect changes in index.[A]; But no change to factors for earnings 
below a certain level; Effectively adds new bendpoint between two 
current ones; 
Rationales offered by proponents: Protects benefits for lower earnings 
to help ensure income adequacy. 

Provision: Provisions affecting benefit COLAs for current and future 
beneficiaries: Revise COLA to reflect more accurate calculation of CPI; 
How it works: Use more accurate CPI in determining COLA; 
Rationales offered by proponents: Greater accuracy. 

Provision: Provisions affecting taxes for current and future workers: 
Longevity indexing of payroll tax rates; 
How it works: Proportionally increase payroll tax rate to reflect 
changes in index; 
Rationales offered by proponents: Increasing longevity is a key reason 
for the system's long-term solvency problem. 

Provision: Provisions affecting taxes for current and future workers: 
Increase payroll tax rates to ensure maintaining ratio of trust fund 
assets to program costs; 
How it works: Use trustees' intermediate projections of trust fund 
ratios; 
Rationales offered by proponents: Ensure ongoing solvency. 

Provision: Provisions affecting taxes for current and future workers: 
Increase maximum taxable earnings to ensure a constant percentage of 
aggregate earnings are taxed; 
How it works: Use recent data on earnings distribution with trustees' 
intermediate projections of wage growth; 
Rationales offered by proponents: Promote intergenerational equity by 
ensuring consistent application of payroll tax. 

Source: GAO. 

[A] Average indexed monthly earnings would be computed as under present 
law. 

[B] An implication of price indexing is that it would slow benefit 
growth to a greater degree if wages grow faster than projected, even as 
Social Security's financial situation would be improving. 

[C] Commission to Strengthen Social Security. "Strengthening Social 
Security and Creating Personal Wealth for All Americans: Report of the 
President's Commission" p. 120, Washington, D.C.: Dec. 21, 2001. 

[End of table] 

A Variety of Indexing Approaches Highlight International Reform 
Efforts: 

Faced with adverse demographic trends, many countries have enacted 
reforms in recent years to improve the long-term fiscal sustainability 
of their national pension systems. New indexing methods now appear in a 
variety of forms around the world in earnings-related national pension 
systems.[Footnote 22] In general, they seek to contain pension costs 
associated with population aging. Some indexing methods affect both 
current and future retirees. 

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. There are two main reasons for this. First, 
contribution rates abroad are generally high already, making it 
politically difficult to raise them much further. For example, while in 
the United States total employer-employee Social Security contribution 
rates are 12.4 percent of taxable earnings, they are above 16 percent 
in Belgium and France, more than 18 percent in Sweden and Germany, 
above 25 percent in the Netherlands and the Czech Republic, and over 30 
percent in Italy.[Footnote 23] In fact, some countries have stipulated 
a ceiling on employee contribution rates in order to reassure the 
young--or current contributors--that the burden would be shared among 
generations. For example, Japan settled, with the 2004 Reform Law, its 
pension premium rates for the next 100 years with an increase of 0.35 
percent per year until 2017, at which time premium levels are to be 
fixed at 18.3 percent of covered wages. Similarly, Canada chose to 
raise its combined employer-employee contribution rate more quickly 
than previously scheduled, from 5.6 percent to 9.9 percent between 1997 
and 2003, and maintain it there until the end of the 75-year projection 
period.[Footnote 24] This increase is meant to help Canada's pension 
system build a large reserve fund and spread the costs of financial 
sustainability across generations.[Footnote 25] Germany's recent 
reforms set the workers' contribution rate at 20 percent until 2020 and 
at 22 percent from 2020 to 2030. Second, increasing employee 
contribution rates without significantly reducing benefit levels will 
tend to make continued employment less attractive compared to 
retirement. In the context of population aging and fiscally stressed 
national pension systems facing many countries, reform measures seek to 
do the opposite: encourage people to remain in the labor force longer 
to enhance the fiscal solvency of pension programs. Contribution rates 
that become too high are not likely to provide sufficient incentives to 
continue work. 

Indexing Approaches Aim at Containing Costs: 

One commonly used means of reducing, or containing the growth of, 
promised benefits involves changing the method used to compute initial 
benefits. For example, France, Belgium, and South Korea now adjust past 
earnings in line with price growth rather than wage growth to determine 
the initial pension benefits of new retirees. In general, this shift to 
price indexation tends to significantly lower benefits relative to 
earnings, as over long periods prices tend to grow more slowly than 
wages.[Footnote 26] Because of compounding, the effect of such a change 
is larger when benefits are based on earnings over a long period than 
when they reflect only the last few years of work, as in pension plans 
with benefits based on final salaries. In fact, the OECD estimates 
that, in the case of a full-career worker with 45 years of earnings, 
price indexation can lead to benefits 40 percent lower than with wage 
indexation.[Footnote 27] In contrast to full price indexing, some 
nations use an index that is a mix of price growth and wage growth, 
which tends to produce higher benefits than those calculated using 
price indexation only, then adjust the relative weights of the two to 
cover program costs. Finland, for example, changed its indexation of 
initial benefits from 50 percent prices and 50 percent wages to 80 
percent and 20 percent, respectively. Similarly, Portugal's index 
combines 75 percent price growth and 25 percent wage growth.[Footnote 
28] 

A few countries have moved away from wage indexing but without 
necessarily adopting price indexation. Sweden, for instance, uses an 
index that reflects per capita wage growth to compute initial benefits, 
provided the system is in fiscal balance. However, when the system's 
obligations exceed its assets, a "brake" is applied automatically that 
allows the indexation to be temporarily abandoned.[Footnote 29] This 
automatic balancing mechanism (ABM) ensures that the pension system 
remains financially stable.[Footnote 30] In Germany and Japan, recent 
reforms changed benefit indexation from a gross-wage base to a net-wage 
base--i.e., gross wages minus contributions. In Italy, workers' benefit 
accounts rise in line with gross domestic product (GDP) growth so both 
the changes in the size of the labor force and in productivity dictate 
benefit levels. 

Another approach countries have used is adding a longevity index to the 
formula determining pension payments. In Sweden, Poland, and Italy, for 
example, remaining life expectancy at the time of retirement inversely 
affects benefit levels. Thus, as life spans gradually increase, 
successive cohorts of retirees get smaller benefit payments unless they 
choose to begin receiving them later in life than those who retired 
before them. Also, people who retire earlier than their peers in a 
given cohort get significantly lower benefits throughout their 
remaining life than those who retire later. Longevity indexing helps 
ensure that improvements in life expectancy do not strain the system 
financially.[Footnote 31] 

Germany, on the other hand, now uses a sustainability factor that links 
initial benefits to the system's dependency ratio--i.e., the number of 
people drawing benefits relative to the number paying into the system. 
This dependency ratio captures variations in fertility, longevity, and 
immigration, and consequently makes the pension system self- 
stabilizing. For example, higher fertility and immigration, which raise 
labor force growth, will, other things equal, improve the dependency 
ratio, leading to higher pension benefits, while higher longevity or 
life expectancy will increase the dependency ratio, and hence cause 
benefits to decline.[Footnote 32] 

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. In Japan, for example, post- 
retirement benefits were indexed to wages net of taxes before 2000. 
However, reforms enacted that year altered the formula by linking post- 
retirement benefits to prices. As a result, retirees saw their 
subsequent benefits rise at a much slower pace. The 2004 reforms 
reduced retirees' purchasing power further by introducing a negative 
"automatic adjustment indexation" to the formula. With this provision, 
post-retirement benefits increase in line with prices minus the 
adjustment rate, currently fixed at 0.9 percent until about 2023. This 
rate is the sum of two demographic factors: the decline in the number 
of people contributing to the pension program (projected at 0.6 
percent) plus the increase in the number of years people collect 
pensions (projected at 0.3 percent). This negative adjustment also 
enters the formula determining the benefit of new recipients as past 
earnings are indexed to net wages minus the same 0.9 percent adjustment 
rate. 

Sweden's ABM modifies both the retirement accounts of workers--or 
future retirees--and the benefits paid to current pensioners. As 
explained earlier, this mechanism is triggered whenever system assets 
fall short of system liabilities. Moreover, post-retirement benefits in 
Sweden are indexed each year to an economic factor equal to prices plus 
the average rate of real wage increase minus 1.6 percent, which is the 
projected real long-term growth in wages. As a result, if average real 
wages grow annually at 1.6 percent, post-retirement benefits are 
adjusted for price increases. On the other hand, if real wage growth 
falls below 1.6 percent, benefits do not keep up with prices, leading 
to a decline in retiree purchasing power.[Footnote 33] 

Germany's sustainability factor affects those already retired, as it is 
included in the formula that adjusts their benefits each year. If, as 
projected, the number of contributors falls relative to that of 
pensioners, increasing the dependency ratio, all benefits are adjusted 
downward, so all cohorts share the burden of adverse demographic 
trends. This intergenerational burden sharing is also apparent in the 
indexation of all benefits to net wages--wages minus contributions, 
which affect workers and pensioners alike. Thus an increase in 
contributions, everything else equal, lowers both initial benefits and 
benefits already being paid. 

Table 3 summarizes relevant characteristics of earnings-related public 
pension programs in selected countries. 

Table 3: Characteristics of Earnings-Related Public Pension Programs- 
Selected Countries: 

Belgium; 
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 15.8; 19.7; 
(2002); 
Normal retirement age (early retirement age)[B]: 65 (60); 
Average contribution rate (percentage of earnings): 16.36; 
Years of individual earnings considered in initial benefit calculation: 
Lifetime average; 
Indexing of earnings for calculating initial benefits: Prices; 
Indexing of benefits in retirement: 100% prices. 

Canada; 
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 17.4; 20.8; 
Normal retirement age (early retirement age)[B]: 65 (60); 
Average contribution rate (percentage of earnings): 9.9; 
Years of individual earnings considered in initial benefit calculation: 
Lifetime average excluding worst 15% of years; 
Indexing of earnings for calculating initial benefits: Average 
earnings; 
Indexing of benefits in retirement: 100% prices. 

Czech Republic; 
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 13.9; 17.3; 
Normal retirement age (early retirement age)[B]: Men: 63; Women: 59-63; 
(men: 60, women: 56-60)c; 
Average contribution rate (percentage of earnings): 28; 
Years of individual earnings considered in initial benefit calculation: 
Since 1985 moving to 30; 
Indexing of earnings for calculating initial benefits: Average 
earnings; 
Indexing of benefits in retirement: 67% prices 33% real wage growth. 

France; 
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 17.1; 21.4; 
(2002); 
Normal retirement age (early retirement age)[B]: 60; 
Average contribution rate (percentage of earnings): 16.45; 
Years of individual earnings considered in initial benefit calculation: 
Lifetime average; (public employees: best 20 moving to 25); 
Indexing of earnings for calculating initial benefits: Prices; 
Indexing of benefits in retirement: 100% prices. 

Germany; 
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 16.1; 19.6; 
Normal retirement age (early retirement age)[B]: 65 (63); 
Average contribution rate (percentage of earnings): 19.5; 
Years of individual earnings considered in initial benefit calculation: 
Lifetime average; 
Indexing of earnings for calculating initial benefits: Average net 
earnings (subject to demographic adjustment); 
Indexing of benefits in retirement: 100% wages net of contributions 
(subject to demographic adjustment). 

Italy; 
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 16.7; 20.7; 
(2001); 
Normal retirement age (early retirement age)[B]: 65 (60); 
Average contribution rate (percentage of earnings): 32.7; 
Years of individual earnings considered in initial benefit calculation: 
Lifetime average; 
Indexing of earnings for calculating initial benefits: 5-year moving 
average of GDP growth (subject to demographic adjustment); 
Indexing of benefits in retirement: Between 75-100% prices depending on 
benefit level. 

Japan; 
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 18.2; 23.3; 
(2004); 
Normal retirement age (early retirement age)[B]: 65 (60); 
Average contribution rate (percentage of earnings): 13.58; 
Years of individual earnings considered in initial benefit calculation: 
Lifetime average; 
Indexing of earnings for calculating initial benefits: Average earnings 
(subject to demographic adjustment); 
Indexing of benefits in retirement: 100% prices (subject to demographic 
adjustment). 

Sweden; 
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 17.4; 20.6; 
(2004); 
Normal retirement age (early retirement age)[B]: 65 (61); 
Average contribution rate (percentage of earnings): 18.5; 
Years of individual earnings considered in initial benefit calculation: 
Lifetime average; 
Indexing of earnings for calculating initial benefits: Average earnings 
(subject to demographic and fiscal adjustments); 
Indexing of benefits in retirement: 100% prices plus real wages less 
1.6% (subject to demographic and fiscal adjustments). 

United States; 
Remaining life expectancy at age 65[A[MEN-WOMEN] men: 16.8; 19.8; 
Normal retirement age (early retirement age)[B]: 67 (62); 
Average contribution rate (percentage of earnings): 12.4; 
Years of individual earnings considered in initial benefit calculation: 
Best 35; 
Indexing of earnings for calculating initial benefits: Average earnings 
up to age 60; 
Indexing of benefits in retirement: 100% prices. 

Source: GAO: 

[A] In 2003 unless otherwise indicated. 

[B] 2002 data, including legislated changes. 

[C] Women's retirement ages (full and early) depend on the number of 
children. 

[End of table] 

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. There are a variety of proposals that would change the 
current indexing of initial benefits, including a move to the CPI, to 
longevity or mortality measures, or to the dependency ratio.[Footnote 
34] When the index is implemented through the benefit formula, each 
will have a proportional effect, with constant percentage changes at 
all earnings levels, on the distribution of benefits (i.e., the 
progressivity of the current system is unchanged). However, indexing 
provisions can be modified to achieve other distributional effects. For 
example, so-called progressive indexing applies different indexes at 
different earnings levels in a manner that seeks to protect the 
benefits of low-income workers. Indexing payroll tax rates would also 
have distributional effects. Such changes maintain existing benefit 
levels but affect equity measures like the ratio of benefits to 
contributions across age cohorts, with younger cohorts having lower 
ratios because they receive lower benefits relative to their 
contributions. Finally, proposals that modify the indexing of COLAs for 
existing beneficiaries have important and adverse distributional 
effects for groups that have longer life expectancies, such as women 
and highly educated workers, because such proposals would typically 
reduce future benefits, and this effect compounds over time. In 
addition, disabled worker beneficiaries, especially those who receive 
benefits for many years, would also experience lower benefits. 

Proposals to Index Initial Benefits Have a Proportional Effect on the 
Distribution of Benefits: 

There are a variety of proposals that would change the current indexing 
of initial benefits from the growth in average wages. These include a 
move to a measure of the change in prices like the CPI, to longevity 
measures that seek to capture the growth in population life 
expectancies, or to the dependency ratio that measures changes in the 
number of retirees compared to the workforce. 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.[Footnote 35] Figure 3 illustrates the projected 
distribution of benefits for workers born in 1985 under three different 
indexing scenarios[Footnote 36] (on the left side of the figure) and 
under a so-called benefit reduction benchmark that reduces benefits 
just enough to achieve program solvency over a 75-year projection 
period (on the far right).[Footnote 37] Median benefits under the 
dependency ratio index and the CPI index are lower than the median 
benefit for the benchmark; they reduce benefits more than is needed to 
achieve 75-year solvency.[Footnote 38] In contrast, the mortality index 
has a higher median benefit level than the benchmark, so without 
further modifications, it would not achieve 75-year solvency. 

Figure 3: Indexing Changes with a Larger Proportional Reduction Have a 
Greater Impact on the Distribution of Benefits, but Scaling to Achieve 
75-Year Solvency Illustrates That the Proportional Effects Have Similar 
Results: 

[See PDF for image] 

Source: GAO analysis of GEMINI data. 

Note: Benefits are for all individuals in the GEMINI 1985 cohort sample 
in 2052 (the year the cohort reaches age 67). Scenarios are modeled 
using the intermediate assumptions of the 2005 trustees' report. The 
dependency ratio index links the growth of initial benefits to changes 
in the dependency ratio, the ratio of the number of retirees to 
workers. The dependency ratio index has a 197 percent improvement in 75-
year solvency, generating far more programmatic savings than is needed 
to achieve solvency. The CPI index links the growth of initial benefits 
to changes in the CPI. The CPI index has a 127 percent improvement in 
75-year solvency, generating more programmatic savings than is needed 
to achieve solvency. The mortality index links the growth of initial 
benefits to changes in life expectancy to maintain a constant life 
expectancy at the normal retirement age. The mortality index has a 72 
percent improvement in 75-year solvency, which does not generate enough 
programmatic savings to be solvent. The benefit reduction benchmark is 
a hypothetical benchmark policy scenario that would achieve 75-year 
solvency by only reducing benefits. Thus, the benchmark has a 100 
percent improvement in 75-year solvency, being exactly solvent at the 
end of the 75-year period. The scaled scenarios are adjusted to achieve 
a 75-year actuarial balance of zero. While scaling allows comparisons 
across distributions over 75 years, the different indexing scenarios 
are not identical in terms of sustainability. For a more complete 
description of the indexing scenarios, the benchmark, or the scaling, 
see appendix I. 

[End of figure] 

Regardless of the index used to modify initial benefits, most proposals 
apply the new index in a way that has proportional effects on the 
distribution of benefits.[Footnote 39] Thus, benefits at all levels 
will be affected by the same percentage reduction, for example, 5 
percent, regardless of earnings. The left half of figure 3 illustrates 
this proportionality in terms of monthly benefits. While the level of 
benefits differs, the distribution of benefits for each scenario has a 
similar structure. However, the range of each distribution varies by 
the difference in the size of the proportional reduction. A larger 
proportional reduction--the dependency ratio index--will result in a 
distribution with a similar structure, compared to promised benefits. 
However, each individual's benefits are reduced by a constant 
percentage; therefore, the range of the distribution, the difference 
between benefits in the 25th and 75th percentile, would be smaller, 
compared to promised benefits. This proportional reduction in benefits 
is also illustrated in figure 4, which compares the currently scheduled 
or promised benefit formula with our three alternative indexing 
scenarios. Under each scenario, the line depicting scheduled benefits 
is lowered, by equal percentages at each AIME amount, by the difference 
between the growth in covered wages and the new index. Each indexing 
scenario maintains the shape of the current benefit formula; thus the 
progressivity of the system is maintained, but the line for each 
scenario is lower than scheduled benefits, which would affect the 
adequacy of benefits. 

Figure 4: Proportional Indexing Changes Would Maintain the 
Progressivity of the Current Benefit Formula, but Could Reduce Adequacy 
(Initial Benefits in 2050): 

[See PDF for image] 

Source: GAO calculations. 

Note: The illustrated PIAs are for individuals who become eligible in 
2050. The dependency ratio index links the growth of initial benefits 
to changes in the dependency ratio, the ratio of the number of retirees 
to workers. The CPI index links the growth of initial benefits to 
changes in the CPI. The mortality index links the growth of initial 
benefits to changes in life expectancy to maintain a constant life 
expectancy at the normal retirement age. For more information on each 
index see appendix I. 

[End of figure] 

The proportional effects of indexing are best illustrated by adjusting, 
or scaling, each index to achieve comparable levels of solvency over 75 
years.[Footnote 40] Thus, for those indexes that do not by themselves 
achieve solvency, the benefit reductions are increased until solvency 
is achieved; for those that are more than solvent, the benefit 
reductions are decreased until solvency is achieved but not exceeded. 

The right half of figure 3 shows the distribution of monthly benefits 
for each of the scaled indexing scenarios and the benchmark scenario. 
Once the different indexing scenarios are scaled to achieve solvency, 
the distribution of benefits for each scenario is almost identical in 
terms of the level of benefits. Differences in the distributions deal 
with the timing associated with implementing the changes. Scaling the 
indexing scenarios also reveals that the shape of the distributions is 
the same. The distributions of monthly benefits for the indexing 
scenarios are also very similar to the distribution of benefits 
generated under the benefit reduction benchmark. Therefore, changes to 
the benefit formula, applied through the replacement factors, will have 
similar results regardless of whether the change is an indexing change 
or a straight benefit reduction, because of the proportional effect of 
the change. 

Indexing Approaches Could Also Be Modified to Achieve Nonproportional 
Effects: 

Indexing could also be modified to achieve other distributional goals. 
For example, so-called progressive indexing, or the use of different 
indexes--such as prices and wages--at various earnings levels, has been 
proposed as a way of changing the indexing while protecting the 
benefits of low-income workers. Thus, under progressive price indexing, 
those individuals with indexed lifetime earnings below a certain point 
would still have their initial benefits adjusted by wage indexing; 
those individuals with earnings above that level would be subject to a 
combination of wage and price indexing on a sliding scale, with those 
individuals with the highest lifetime earnings having their benefits 
adjusted completely by price indexing.[Footnote 41] 

The effect that progressive price indexing would have on the benefit 
formula can be seen in figure 5, where the CPI indexing scenario is 
compared to a progressive CPI indexing scenario and to benefits 
promised under the current program formula.[Footnote 42] Many lower- 
income individuals would do better under the progressive application of 
the CPI index than under the CPI indexing alone. However, a progressive 
application of CPI indexing does not by itself achieve 75-year 
solvency, and further changes would be necessary to do so. Figure 6 
shows what happens to the benefit formula when each of these indexing 
scenarios is scaled to achieve comparable levels of solvency over 75 
years. Under progressive price indexing, to protect the benefits of low-
income workers, the indexing to prices at higher earnings levels begins 
to flatten out benefits, causing the line in figure 6 to plateau. Thus, 
under this scenario, most individuals with earnings above a certain 
level would receive about the same level of benefits regardless of 
income--in the case of figure 6, a retiree with average indexed monthly 
earnings of $2,000 would receive a similar benefit level as someone 
with average indexed monthly earnings of $7,000. Since progressive 
price indexing would change the shape of the benefit formula, making it 
more progressive, it would reduce individual equity for higher earners, 
as they would receive much lower benefits relative to their 
contributions. 

Figure 5: Lower-Income Individuals Would Fare Comparatively Better 
under the Progressive Application of the CPI Index than under the CPI 
Index Alone (Initial Benefits in 2050): 

[See PDF for image] 

Source: GAO calculations. 

Note: The illustrated PIAs are for individuals who become eligible in 
2050. The CPI index links the growth of initial benefits to changes in 
the CPI. Progressive CPI indexing uses different indexes at various 
earnings levels. Individuals with earnings below a certain point would 
have their initial benefits adjusted by wage indexing; those 
individuals with earnings above that level would be subject to a 
combination of wage and price indexing on a sliding scale, with those 
individuals with the highest earnings having their benefits adjusted 
completely by price indexing. However, progressive CPI indexing does 
not achieve 75-year solvency, it has only a 74 percent improvement in 
solvency. For more information on the indexes see appendix I. 

[End of figure] 

Figure 6: Scaling the Progressive Application of the CPI Index to 
Achieve Equivalent Solvency Demonstrates That Most Individuals above a 
Certain Point Would Receive About the Same Level of Benefits (Initial 
Benefits in 2050): 

[See PDF for image] 

Source: GAO calculations. 

Note: The illustrated PIAs are for individuals who become eligible in 
2050. The CPI index links the growth of initial benefits to changes in 
the CPI. Progressive CPI indexing uses different indexes at various 
earnings levels. Individuals with earnings below a certain point would 
have their initial benefits adjusted by wage indexing; those 
individuals with earnings above that level would be subject to a 
combination of wage and price indexing on a sliding scale, with those 
individuals with the highest earnings having their benefits adjusted 
completely by price indexing. While scaling allows comparisons across 
distributions over 75 years, the different indexing scenarios are not 
identical in terms of sustainability. For more information on the 
indexes and the scaling, see appendix I. 

[End of figure] 

While proposals that have suggested progressive indexing have focused 
on using prices, any index can be adjusted to achieve the desired level 
of progressivity, and the results will likely be similar. However, to 
the extent that wages grow faster than the new index over a long period 
of time, the benefit formula will eventually flatten out and all 
individuals above a certain income level would receive the same level 
of benefits. 

Indexing Applied to Taxes Would Have Adequacy and Equity 
Considerations: 

Indexing changes could also be applied to program financing. Under the 
current structure of the system, one way this could be accomplished is 
by indexing the Social Security payroll tax rate.[Footnote 43] As with 
indexing benefits, the payroll tax rate could be indexed to any 
economic or demographic variable. Under the tax scenarios presented, 
only the indexing of taxes would change, so promised benefits would be 
maintained. However, workers would be paying more in payroll taxes, 
which, like any tax change, could affect work, saving, and investment 
decisions. 

While benefit levels would be higher under tax increase scenarios, as 
compared to benefit reduction scenarios, the timing of the tax changes 
matters, just as it did with benefit changes. Since benefits would be 
unchanged in the tax-increase-only scenarios, we use benefit-to-tax 
ratios to compare the effects of different tax increase scenarios. 
Benefit-to-tax ratios compare the present value of Social Security 
lifetime benefits with the present value of lifetime Social Security 
taxes.[Footnote 44] The benefit-to-tax ratio is an equity measure that 
focuses on whether, over their lifetimes, beneficiaries can expect to 
receive a fair return on their contributions or get their "money's 
worth" from the system. With benefits unchanged in the tax increase 
scenarios, the benefit-to-tax ratios would vary across scenarios 
because of differences in the timing of tax increases.[Footnote 45] 

To illustrate the effects of the timing of a change in tax rates, 
figure 7 shows the benefit-to-tax ratios, for four different birth 
cohorts, for two tax increase scenarios: (1) the dependency ratio tax 
indexing scenario scaled to achieve 75-year solvency and (2) our tax 
increase benchmark scenario that increases taxes just enough to achieve 
program solvency over a 75-year projection period.[Footnote 46] By 
raising payroll taxes once and immediately, the tax increase benchmark 
would spread the tax burden more evenly across generations. This is 
seen in figure 7, where the benefit-to-tax ratios are fairly stable 
across cohorts for this scenario.[Footnote 47] The dependency ratio tax 
indexing scenario would increase the tax rate annually, in this case 
with changes in the dependency ratio. Under this scenario, later 
cohorts would face a higher tax rate and thus bear more of the tax 
burden, compared to earlier cohorts. This would result in declining 
benefit-to-tax ratios across cohorts, with later generations receiving 
relatively less compared to their contributions. 

Figure 7: A Onetime Payroll Tax Increase Would Spread the Tax Burden 
More Evenly across Cohorts than Gradual Increases through an Index: 

[See PDF for image] 

Source: GAO analysis of GEMINI data.  

Note: Benefit-to-tax ratios are the sum of the present value of family 
benefits divided by the present value of family taxes summed for all 
individuals in the cohort that survive until age 24. Scenarios are 
modeled using the 2005 trustees' report intermediate assumptions. The 
dependency ratio tax index links the growth in the payroll tax rate to 
changes in the dependency ratio, the ratio of the number of retirees to 
workers. The dependency ratio tax index has been adjusted--or "scaled"-
-to achieve a 75-year actuarial balance of zero. While scaling allows 
comparisons across distributions over 75 years, the different indexing 
scenarios are not identical in terms of sustainability. The tax 
increase benchmark is a hypothetical benchmark policy scenario that 
would achieve 75-year solvency by only increasing payroll taxes. For a 
more complete description of the indexing scenario, the scaling, or the 
benchmark, see appendix I. 

[End of figure]

Revising COLA for Existing Beneficiaries Would Have Important 
Distributional Implications for Multiple Subpopulations: 

Indexing changes can also be applied to the COLA used to adjust 
existing benefits. Under the current structure of the program, benefits 
for existing beneficiaries are adjusted annually in line with changes 
in the CPI. The COLA helps to maintain the purchasing power of benefits 
for current retirees. Some proposals, under the premise that the 
current CPI overstates the rate of price inflation because of 
methodological issues associated with how the CPI is calculated, would 
alter the COLA. Figure 8 shows the difference in benefit growth over 
time under the current COLA and two alternatives: growing at rate of 
CPI minus 0.22 and growing at rate of CPI minus 1.[Footnote 48] Changes 
to the COLA would also have adequacy implications. After 20 years, 
benefits growing at the rate of the CPI minus 0.22 would slow the 
growth of benefits by about 4 percent below the level given by the 
current COLA and growing at the rate of the CPI minus 1 by about 17 
percent. This slower benefit growth would improve the finances of the 
system, but would also alter the distribution of benefits, particularly 
for some subpopulations. Since changes to the COLA compound over time, 
those most affected are those with longer life expectancies, for 
example, women, as they would have the biggest decrease in lifetime 
benefits as they tend to receive benefits over more years. In addition, 
as education is correlated with greater life expectancy, highly 
educated workers would also experience a significant benefit decrease. 
There could also be a potentially large adverse effect on the benefits 
paid to disabled beneficiaries, especially among those who become 
disabled at younger ages and receive benefits for many years. These 
beneficiaries could have a large decrease in lifetime 
benefits.[Footnote 49] 

Figure 8: The Growth of $1,000 Benefit under the CPI and Two 
Alternatives Illustrate That Those Beneficiaries Who Receive Benefits 
Longer Will Be Affected the Most: 

[See PDF for image] 

Source: GAO analysis. 

[End of figure] 

Reducing the COLA would also have equity implications. Since the COLA 
is applied to all beneficiaries, reductions in the COLA would lower the 
return on contributions for all beneficiaries. However, the magnitude 
of the effect will vary across subpopulations, similar to its effect on 
adequacy. Those individuals who have the biggest decrease in lifetime 
benefits will have the biggest decrease in individual equity. While 
these individuals have a large decrease in equity, they would still 
receive higher lifetime benefits since they live longer and collect 
benefits over more years. Individuals with shorter life expectancies 
will experience a decrease in equity, but they will fare comparably 
better than other groups that live longer, since their lifetime 
benefits will decrease much less. Therefore, men, African- Americans, 
low earners, and less educated individuals would experience a much 
smaller decrease in equity compared to their counterparts. 

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. The choice of the 
index implies certain assumptions about the appropriate level of 
benefits and taxes for the program. 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). The solvency effects of an index are predicated upon the 
relative stability and historical trends of the underlying economic or 
demographic relationships implied by the index. For example, the 1970s 
were a period of much instability, in which actual inflation rates and 
earnings growth diverged markedly from past experience, with the result 
that benefits unexpectedly grew much faster than expected. Finally, 
since the benefit formulas for the Old-Age and Survivors Insurance 
(OASI) and DI programs are linked, an important consideration of any 
indexing proposal is its effect on the benefits provided to disabled 
workers. Disabled worker beneficiaries typically become entitled to 
benefits much sooner than retired workers and under different 
eligibility criteria. 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. 

Choice of a Particular Index Implies Assumptions about the Appropriate 
Level of Benefits and Taxes, Adequacy and Equity: 

The choice of an index suggests certain assumptions about the 
appropriate level of benefits and the overall goal of the 
program.[Footnote 50] The current indexing of initial benefits to wage 
growth implies that the appropriate level of benefits is one that 
maintains replacement rates across birth years. In turn, maintaining 
replacement rates implies a relative standard of adequacy and an 
assumption that initial benefits should reflect the prevailing standard 
of living at the time of retirement. In contrast, changing the current 
indexing of initial benefits to price growth implies that the 
appropriate level of benefits is one that maintains purchasing 
power.[Footnote 51] In turn, maintaining purchasing power implies an 
absolute standard of adequacy and an assumption that initial benefits 
should reflect a fixed notion of adequacy regardless of improvements in 
the standard of living. Also, any index that does not maintain 
purchasing power results in workers born in one year receiving higher 
benefits than workers with similar earnings born 1 year later.[Footnote 
52] This would occur with any benefit change that would reduce 
currently promised benefits more than price indexing initial benefits 
would, since price indexing maintains the purchasing power of initial 
benefits. In the case of longevity indexing, if the growth of initial 
benefits were indexed to life expectancy, then this implies that the 
increased costs of benefits that stem from increasing life expectancy 
should be borne by all future beneficiaries, even if society has become 
richer. Therefore, the desired outcome, in terms of initial benefit 
levels at the time of retirement, should drive the choice of an index. 

The current indexing of existing benefits with the COLA implies that 
maintaining the purchasing power of benefits for current retirees is 
the appropriate level of benefits. Revising the COLA to reflect a more 
accurate calculation of the CPI retains this assumption. However, 
adjusting the COLA in a way that does not keep pace with the CPI would 
change that assumption and imply a view that the costs of reform should 
be shared by current as well as future retirees. 

Similarly, on the revenue side, the program currently uses a constant 
tax rate, which maintains the same proportion of taxes for all workers 
earning less than the maximum taxable earnings level. Applying a life 
expectancy index to payroll tax rates suggests that the appropriate 
level of taxes is one that prefunds the additional retirement years 
increased life expectancy will bestow on current workers, but also that 
the appropriate level of benefits is one that maintains replacement 
rates, as benefits are unchanged. 

Stability of Economic or Demographic Relationships Underlying the Index 
Is a Consideration: 

Indexing raises other considerations about the stability of the 
underlying relationships between the economic and demographic variables 
captured by the index. The choice of an index includes issues of risk 
and methodology. Some indexes could be based on economic variables that 
are volatile, introducing instability because the index generates wide 
swings in benefits or taxes. In other cases, long-standing economic or 
demographic relationships premised by the index could change, resulting 
in unanticipated and unstable benefit or tax levels. While most indexes 
will also pose methodological issues, these can become problematic to 
address after the index has already been widely used, and the 
correction will have implications for benefits or taxes. An example is 
the current measurement limitations of the CPI. In other instances, the 
index may be based on estimates about future trends in variables like 
mortality that could later prove incorrect and erode public confidence 
in the system. 

Some indexes are premised on the past behavior of economic or 
demographic relationships. If these long-standing relationships diverge 
for a significant period of time, they may result in unanticipated and 
unstable benefit or tax levels. For example, the 1972 amendments that 
introduced indexing into the Social Security program were premised on 
the belief that over time, wage growth will generally substantially 
exceed price inflation. However, for much of the 1970s, actual 
inflation rates and earnings growth diverged markedly from past 
experience; price inflation grew much faster than wages, with the 
result that benefits grew much faster than anticipated. This 
development introduced major instability into the program, which was 
unsustainable. Congress addressed this problem when it passed the 1977 
amendments.[Footnote 53] Moreover, even though the 1977 amendments 
succeeded in substantially stabilizing the replacement rates for 
initial benefits, a solvency crisis required reforms just 6 years later 
with the 1983 amendments. High inflation rates resulted in high COLAs 
for existing benefits just as recession was depressing receipts from 
the payroll taxes. The indexing of initial benefits under the 1977 
amendments did not address the potential for such economic conditions 
to affect COLAs or payroll tax receipts. 

Many indexes have methodological issues associated with their 
calculation, which can become problems over time. For example, the CPI 
has long been in use by the Social Security program and other social 
welfare programs. However, the CPI is not without its methodological 
problems. Some studies have contended that the CPI overstates inflation 
for a number of reasons, including that it does not account for how 
consumers can substitute one good for another because the calculation 
assumes that consumers do not change their buying patterns in response 
to price changes.[Footnote 54] Correcting for this "substitution 
effect" would likely lower the CPI. Changing the calculation in 
response to this concern might improve accuracy but is controversial 
because it would also likely result in lower future benefits and put 
more judgment into the calculation. 

Indexes that are constructed around assumptions about future experience 
raise other methodological issues. An example is a mortality index, 
which seeks to measure future changes in population deaths. Such a 
measure would presumably capture an aspect of increased longevity or 
well-being in retirement and could be viewed as a relevant determinant 
of program benefits or taxes. Accuracy in this index would require 
forecasts of future mortality based on assumptions of the main 
determinants influencing future population deaths (i.e., medical 
advances, diet, income changes). Such forecasts would require a clear 
consensus about these factors and how to measure and forecast them. 
However, currently there is considerable disagreement among researchers 
in terms of their beliefs about the magnitude of mortality change in 
the future.[Footnote 55] In choosing an index, such methodological 
issues would need to be carefully considered to maintain public support 
and confidence. 

The Treatment of Disabled and Survivor Beneficiaries Poses Challenges 
When Modifying the Indexing: 

Under the current structure of the U.S. Social Security system, the 
OASI and DI programs share the same benefit formula. Thus, any changes 
that affect retired workers will also affect survivors and disabled 
workers. However, the circumstances facing these beneficiaries differ 
from those facing retired workers. For example, the disabled worker's 
options for alternative sources of income, especially earnings-related 
income, to augment any reduction in benefits are likely to be more 
limited than are those for the retired worker. Further, DI 
beneficiaries enter the program at younger ages and may receive 
benefits for many years. As a result, disabled beneficiaries could be 
subject to benefit changes for many years more than those beneficiaries 
requiring benefits only in retirement.[Footnote 56] 

These differing circumstances among beneficiaries raise the issue of 
whether any proposed indexing changes, or any other benefit changes, 
should be applied to disabled worker and survivor beneficiaries, as 
well as to retired worker beneficiaries.[Footnote 57] If disabled 
worker beneficiaries are not subject to indexing changes applied to 
retirees, benefit levels for disabled workers could ultimately be 
higher than those of retired workers. This difference in benefit levels 
would occur because disabled workers typically become entitled to 
benefits sooner than retired workers, and thus any reductions in their 
replacement factors would be smaller. Such a differential could 
increase the incentive for older workers to apply for disability 
benefits as they near retirement age. 

Excluding the disability program from indexing changes has implications 
for solvency and raises implementation issues. If the indexing changes 
are not applied to the disability program, even larger benefit 
reductions or revenue increases would be needed to achieve fiscal 
solvency. Since the OASI and DI programs share the same benefit 
formula, excluding disabled worker beneficiaries from indexing changes 
might also necessitate the use of two different benefit formulas or 
require a method to recalculate benefits in order to maintain different 
indexing in each program. Such changes could lead to confusion among 
the public about how the programs operate, which may require 
significant additional public education. 

Concluding Observations: 

Indexing has played an important role in the determination of Social 
Security's benefits and revenues for over 30 years. As in other 
countries seeking national pension system reform, recent proposals to 
modify the role of indexing in Social Security have primarily focused 
on addressing the program's long-term solvency problems. In theory, one 
index may be better than another in keeping the program in financial 
balance on a sustainable basis. However, such a conclusion would be 
based on assumptions about the future behavior of various demographic 
and economic variables, and those assumptions will always have 
considerable uncertainty. Future demographic patterns and economic 
trends could emerge that affect solvency in ways that have not been 
anticipated. So, while indexing changes may reduce how often Congress 
needs to rebalance the program's finances, there is no guarantee that 
the need will not arise again. 

Yet program reform, and the role of indexing in that reform, is about 
more than solvency. Reforms also reflect implicit visions about the 
size, scope, and purpose of the Social Security system. Indexing 
initial benefits, existing benefits, tax rates, the maximum taxable 
earnings level, or some other parameter or combination will have 
different consequences for the level and distribution of benefits and 
taxes, within and across generations and earnings levels. These 
questions relate to the trade-off between income adequacy and benefit 
equity. 

In the final analysis, indexing, like other individual reforms, comes 
down to a few critical questions: What is to be accomplished or 
achieved, who is to be affected, is it affordable and sustainable, and 
how will the change be phased in over time? Although these issues are 
complex and controversial, they are not unsolvable; they have been 
reconciled in the past and can be reconciled now. Indexing can be part 
of a larger, more comprehensive reform package that would include other 
elements whose cumulative effect could achieve the desired balance 
between adequacy and equity while also achieving solvency. The 
challenge is not whether indexing should be part of any necessary 
reforms, but that necessary action is taken soon to put Social Security 
back on a sound financial footing. 

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. 

We are sending copies of this report to the Social Security 
Administration and the Treasury Department, as well as other interested 
parties. Copies will also be made available to others upon request. In 
addition, the report will be available at no charge on the GAO Web site 
at [Hyperlink, http://www.gao.gov]. Please contact me at (202) 512-
7215, if you have any questions about this report. Other major 
contributors include Charles Jeszeck, Michael Collins, Anna Bonelli, 
Charles Ford, Ken Stockbridge, Seyda Wentworth, Joseph Applebaum, and 
Roger Thomas. 

Signed by: 

Barbara D. Bovbjerg: 
Director, Education, Workforce, and Income Security Issues: 

[End of section] 

Appendix I: Methodology: 

Microsimulation Model: 

Description: 

Genuine Microsimulation of Social Security and Accounts (GEMINI) is a 
microsimulation model developed by the Policy Simulation Group (PSG). 
GEMINI simulates Social Security benefits and taxes for large 
representative samples of people born in the same year. GEMINI 
simulates all types of Social Security benefits, including retired 
worker, spouse, survivor, and disability benefits. It can be used to 
model a variety of Social Security reforms including the introduction 
of individual accounts. 

GEMINI uses inputs from two other PSG models, the Social Security and 
Accounts Simulator (SSASIM), which has been used in numerous GAO 
reports, and the Pension Simulator (PENSIM), which has been developed 
for the Department of Labor. GEMINI relies on SSASIM for economic and 
demographic projections and relies on PENSIM for simulated life 
histories of large representative samples of people born in the same 
year and their spouses.[Footnote 58] Life histories include educational 
attainment, labor force participation, earnings, job mobility, 
marriage, disability, childbirth, retirement, and death. Life histories 
are validated against data from the Survey of Income and Program 
Participation, the Current Population Survey, Modeling Income in the 
Near Term (MINT3),[Footnote 59] and the Panel Study of Income Dynamics. 
Additionally, any projected statistics (such as life expectancy, 
employment patterns, and marital status at age 60) are, where possible, 
consistent with intermediate cost projections from Social Security 
Administration's Office of the Chief Actuary (OCACT). At their best, 
such models can provide only very rough estimates of future incomes. 
However, these estimates may be useful for comparing future incomes 
across alternative policy scenarios and over time. 

GEMINI can be operated as a free-standing model or it can operate as a 
SSASIM add-on. When operating as an add-on, GEMINI is started 
automatically by SSASIM for one of two purposes. GEMINI can enable the 
SSASIM macro model to operate in the Overlapping Cohorts (OLC) mode or 
it can enable the SSASIM micro model to operate in the Representative 
Cohort Sample (RCS) mode. The SSASIM OLC mode requests GEMINI to 
produce samples for each cohort born after 1934 in order to build up 
aggregate payroll tax revenues and OASDI benefit expenditures for each 
calendar year, which are used by SSASIM to calculate standard trust 
fund financial statistics. In either mode, GEMINI operates with the 
same logic, but typically with smaller cohort sample sizes in OLC mode 
than in the RCS or stand-alone-model mode. 

For this report we used GEMINI to simulate Social Security benefits and 
taxes primarily for 100,000 individuals born in 1985. Benefits and 
taxes were simulated under our tax increase (promised benefits) and 
proportional benefit reduction (funded benefits) benchmarks (described 
below) and various indexation approaches. 

Assumptions and Limitations: 

To facilitate our modeling analysis, we made a variety of assumptions 
regarding economic and demographic trends. In choosing our assumptions, 
we focused our analysis to illustrate relevant points about 
distributional effects and hold equal as much as possible any variables 
that were either not relevant to or would unduly complicate that focus. 
As a result of these assumptions, as well as issues inherent in any 
modeling effort, our analysis has some key limitations, especially 
relating to risk and changes over time. 

2005 Social Security Trustees' Assumptions: 

The simulations are based on economic and demographic assumptions from 
the 2005 Social Security trustees' report.[Footnote 60] While the 2006 
trustees' report has been released, the assumptions have changed very 
little from the 2005 assumptions. We used trustees' intermediate 
assumptions for inflation, real wage growth, mortality decline, 
immigration, labor force participation, and interest rates. 

Distributional Effects Over Time: 

We simulated benefits for individuals born in 1955, 1970, 1985, and 
2000. However, the majority of our figures focus on individuals born in 
1985 because all prospective indexing changes would be almost fully 
phased in for these individuals. However, the distributional effects 
might change over time. This is because each index phases in over time 
and reduces the primary insurance amount (PIA) formula factors (or 
increases the Old-Age and Survivors Insurance (OASI) and Disability 
Insurance (DI) taxes) at different rates. For example, individuals in 
the 1955 cohort that survive to age 65 do so in the year 2020, so the 
benefit reductions (or tax increases), which we specify to begin 
sometime between 2006 and 2012, depending on the scenario, have only 
been implemented for about 8 to 14 years. Additionally, members of the 
cohort that become disabled might become disabled prior to the 
implementation of annual PIA reductions or tax increases. Such issues 
become less pronounced with the younger cohorts. 

Pre-retirement Mortality: 

To capture the distributional impact of pre-retirement mortality, we 
calculated benefit-to-tax ratios and lifetime benefits for all sample 
members who survived past age 24. However, our measure of well-being, 
lifetime earnings, may not be the best way to assess the well-being of 
those who die before retirement. Some high-wage workers are classified 
as low lifetime earners simply because they did not live very long, and 
consequently our analysis overstates the degree to which those who die 
young are classified as low earners. As a result, our measures 
underestimate the degree to which Social Security favors lower earners 
under all of the scenarios we analyze.[Footnote 61] 

Description of Alternative Policy Scenarios: 

CPI Indexing: 

To simulate consumer price indexing (CPI) indexing, which essentially 
links the growth of initial benefits to changes in the CPI, we 
successively modified the PIA formula replacement factors (90, 32, and 
15) beginning in 2012, reducing them successively by real wage growth 
in the second prior year. This specification mimics provision B6 of the 
August 10, 2005 memorandum to SSA's Chief Actuary regarding the 
provision requested by the Social Security Advisory Board (SSAB), which 
is an update of provision 1 of Model 2 of the President's Commission to 
Strengthen Social Security (CSSS).[Footnote 62] As noted in the CSSS 
solvency memorandum from SSA's Chief Actuary, "[t]his provision would 
result in increasing benefit levels for individuals with equivalent 
lifetime earnings across generations (relative to the average wage 
level) at the rate of price growth (increase in the CPI), rather than 
at the rate of growth in the average wage level as in current law." 

This provision as specified and scored by OCACT in the SSAB memo would 
increase the size of the long-range OASDI actuarial balance (reduce the 
actuarial deficit) by an estimated 2.38 percent of taxable payroll. 
Using the overlapping cohort mode of SSASIM, we estimated this 
provision as increasing the size of the long-range OASDI actuarial 
balance by 2.43 percent of taxable payroll, or 5 basis points more than 
the OCACT scoring. 

Mortality Indexing: 

To simulate mortality indexing, which links the growth of initial 
benefits to changes in life expectancy to maintain a constant life 
expectancy at the normal retirement age, we successively modified the 
PIA formula replacement factors (90, 32, 15) beginning in 2009, 
reducing them annually by multiplying them by 0.995. This specification 
mimics provision 1 of Model 3 of CSSS.[Footnote 63] The CSSS solvency 
memorandum notes that the 0.995 successive reduction "reduces monthly 
benefit levels by an amount equivalent to increasing the normal 
retirement age (NRA) for retired workers by enough to maintain a 
constant life expectancy at NRA, for any fixed age of benefit 
entitlement."[Footnote 64] 

This provision as specified and scored--using the intermediate 
assumptions of the 2001 trustees' report--in the CSSS memo by SSA's 
Office of the Chief Actuary would reduce the size of the long-range 
OASDI actuarial balance (reduce the actuarial deficit) by an estimated 
1.17 percent of taxable payroll. Using the overlapping cohort mode of 
SSASIM and specifications, which mimic the intermediate assumptions of 
the 2005 trustees' report, we estimated this provision as increasing 
the size of the long-range OASDI actuarial balance by 1.39 percent of 
taxable payroll, or 22 basis points more than the earlier OCACT 
scoring. 

Dependency Indexing: 

Benefits: 

To simulate so-called dependency indexing of benefits, which links the 
growth of initial benefits to changes in the dependency ratio, we 
successively modified the PIA formula replacement factors (90, 32, and 
15) beginning in 2010, by reducing them annually by an index that 
follows the inverse of the increase in the aged dependency ratio from 2 
years prior. For example, the reduction for 2010 is given by dividing 
the 2009 PIA formula factors (90, 32, and 15) by 1.0098, which is rate 
of increase from 2007 to 2008.[Footnote 65] 

This provision as specified has not been scored by OCACT. Using the 
overlapping cohort mode of SSASIM and specifications that mimic the 
intermediate assumptions of the 2005 trustees' report, we estimated 
this provision as increasing the size of the long-range OASDI actuarial 
balance by 3.78 percent of taxable payroll. 

Taxes: 

To simulate so-called dependency indexing of payroll taxes, which links 
the growth of payroll taxes to changes in the dependency ratio, we 
increased the initial OASI and DI tax rates (both employer and employee 
combined) in 2009 by a cumulative index that increases annually by the 
rate of increase in the aged dependency ratio from 2 years prior. For 
example, the increase for 2010 is given by multiplying the 12.4 percent 
tax rate (employer and employee combined--10.60 percent for OASI and 
1.80 percent for DI) by 1.0098--the rate of increase from 2007 to 2008-
-to arrive at a rate of 10.70 percent for OASI and 1.82 percent for DI. 
By 2050 the cumulative index is 1.863, and the tax rates (employer and 
employee combined) are 19.75 percent for OASI and 3.35 percent for DI. 

This provision as specified has not been scored by OCACT. Using the 
overlapping cohort mode of SSASIM and specifications that mimic the 
intermediate assumptions of the 2005 trustees' report, we estimated 
this provision as increasing the size of the long-range OASDI actuarial 
balance by 6.98 percent of taxable payroll. 

Scaling to Achieve Comparable Levels of Solvency over 75 Years: 

We modified the aforementioned CPI, mortality, and dependency indexes 
to "scale" them to achieve comparable levels of solvency over a 75-year 
period--the same actuarial period used by OCACT in trustees' reports 
and solvency memorandums.[Footnote 66] To scale the proposals, we 
modified the PIAs (or OASI and DI tax rates in the case of the aged 
dependency ratio tax increase index) by a scaled factor equal to the 
inverse of the percentage of solvency attained by the original, 
unscaled version of the proposal. For each year in the 75-year period, 
the scaling factor is multiplied by the percentage point difference 
between the unscaled PIA factors and the factors prior to 
implementation of the proposal (i.e., 90, 32, and 15).[Footnote 67] The 
application of the so-called scaling factor to the PIA factors (or 
OASDI tax rates) conveniently modifies the index in such a way that 75- 
year actuarial balance is 0.[Footnote 68] 

Table 4: Application of So-called Scaling of PIA Factors for Aged 
Dependency Ratio Benefit Reduction Index: An Example Using 2050 PIA 
Formula Factors: 

Step: 1; 
Description: PIA formula factors in 2009; 
PIA formula factor or calculation: 90.0; 
PIA formula factor or calculation: 32.0; 
PIA formula factor or calculation: 15.0. 

Step: 2; 
Description: PIA formula factors in 2050; 
PIA formula factor or calculation: 48.3; 
PIA formula factor or calculation: 17.2; 
PIA formula factor or calculation: 8.1. 

Step: 3; 
Description: Difference between factors in 2050 and initial factors 
(i.e., the factors in 2009 or prior); 
PIA formula factor or calculation: 41.7; 
PIA formula factor or calculation: 14.8; 
PIA formula factor or calculation: 6.9. 

Step: 4; 
Description: Scaling factor[A]; 
PIA formula factor or calculation: .508; 
PIA formula factor or calculation: .508; 
PIA formula factor or calculation: .508. 

Step: 5; 
Description: Difference multiplied by scaling factor (i.e., step 3 * 
step 4); 
PIA formula factor or calculation: 21.2; 
PIA formula factor or calculation: 7.5; 
PIA formula factor or calculation: 3.5. 

Step: 6; 
Description: New, so-called "scaled" PIA formula factors (i.e., step 1-
step 5); 
PIA formula factor or calculation: 68.8; 
PIA formula factor or calculation: 24.5; 
PIA formula factor or calculation: 11.5. 

Source: GAO. 

[A] The aged dependency benefit reduction index increases the 75-year 
OASDI actuarial balance by 3.78 percent of taxable payroll. This is 
196.9 percent of 1.92 percent of taxable payroll, which is the amount 
required to produce a 75-year actuarial balance of 0 under the 
intermediate assumptions of the 2005 trustees' report. The inverse 
(i.e., 1/x) of 196.9 percent is 50.8 percent. 

[End of table] 

Data Reliability: 

To assess the reliability of simulated data from GEMINI, we reviewed 
PSG's published validation checks, examined the data for reasonableness 
and consistency, preformed sensitivity analysis, and compared our 
solvency estimates, where applicable, with published results from the 
actuaries at the Social Security Administration. 

PSG has published a number of validation checks of its simulated life 
histories. For example, simulated life expectancy is compared with 
projections from the Social Security trustees; simulated benefits at 
age 62 are compared with administrative data from SSA; and simulated 
educational attainment, labor force participation rates, and job tenure 
are compared with values from the Current Population Survey. We found 
that simulated statistics for the life histories were reasonably close 
to the validation targets. 

For sensitivity analysis, we simulated benefits and taxes for policy 
scenarios under a number of alternative specifications, including 
limiting the sample to those who survive to retirement. Our findings 
were consistent across all specifications. 

Benchmark Policy Scenarios: 

According to current projections of the Social Security trustees for 
the next 75 years, revenues will not be adequate to pay full benefits 
as defined by the current benefit formula. Therefore, estimating future 
Social Security benefits should reflect that actuarial deficit and 
account for the fact that some combination of benefit reductions and 
revenue increases will be necessary to restore long-term solvency. 

To illustrate a full range of possible outcomes, we developed 
hypothetical benchmark policy scenarios that would achieve 75-year 
solvency either by only increasing payroll taxes or by only reducing 
benefits.[Footnote 69] In developing these benchmarks, we identified 
criteria to use to guide their design and selection. Our tax-increase- 
only benchmark simulates "promised benefits," or those benefits 
promised by the current benefit formula, while our benefit-reduction- 
only benchmarks simulate "funded benefits," or those benefits for which 
currently scheduled revenues are projected to be sufficient. Under the 
latter policy scenarios, the benefit reductions would be phased in 
between 2010 and 2040 to strike a balance between the size of the 
incremental reductions each year and the size of the ultimate 
reduction. 

SSA actuaries scored our original 2001 benchmark policies and 
determined the parameters for each that would achieve 75-year 
solvency.[Footnote 70] Table 5 summarizes our benchmark policy 
scenarios. For our benefit reduction scenarios, the actuaries 
determined these parameters assuming that disabled and survivor 
benefits would be reduced on the same basis as retired worker and 
dependent benefits. If disabled and survivor benefits were not reduced 
at all, reductions in other benefits would be greater than shown in 
this analysis. 

Table 5: Summary of Benchmark Policy Scenarios: 

Benchmark policy scenario: Tax increase only (promised benefits); 
Description: Increases payroll taxes in 2006 by amount necessary to 
achieve 75-year solvency (0.98 percent of payroll each for employees 
and employers); 
Phase-in period: Immediate; 
Ultimate new benefit reductions[A] (percent): 0. 

Benchmark policy scenario: Proportional benefit reduction (funded 
benefits); 
Description: Reduces benefit formula factors proportionally across all 
earnings levels; 
Phase-in period: 2010-2040; 
Ultimate new benefit reductions[A] (percent): 25. 

Source: GAO. 

[A] These benefit reduction amounts do not reflect the implicit 
reductions resulting from the gradual increase in the full retirement 
age that has already been enacted. 

[End of table] 

Criteria: 

According to our analysis, appropriate benchmark policies should 
ideally be evaluated against the following criteria: 

1. Distributional neutrality: The benchmark should reflect the current 
system as closely as possible while still restoring solvency. In 
particular, it should try to reflect the goals and effects of the 
current system with respect to redistribution of income. However, there 
are many possible ways to interpret what this means, such as: 

a. producing a distribution of benefit levels with a shape similar to 
the distribution under the current benefit formula (as measured by 
coefficients of variation, skewness, kurtosis, and so forth), 

b. maintaining a proportional level of income transfers in dollars, 

c. maintaining proportional replacement rates, and: 

d. maintaining proportional rates of return. 

2. Demarcating upper and lower bounds: These would be the bounds within 
which the effects of alternative proposals would fall. For example, one 
benchmark would reflect restoring solvency solely by increasing payroll 
taxes and therefore maximizing benefit levels, while another would 
solely reduce benefits and therefore minimize payroll tax rates. 

3. Ability to model: The benchmark should lend itself to being modeled 
within the GEMINI model. 

4. Plausibility: The benchmark should serve as a reasonable alternative 
within the current debate; otherwise, the benchmark could be perceived 
as an invalid basis for comparison. 

5. Transparency: The benchmark should be readily explainable to the 
reader. 

Tax-Increase-Only, or "Promised Benefits," Benchmark Policies: 

Our tax-increase-only benchmark would raise payroll taxes once and 
immediately by the amount of Social Security's actuarial deficit as a 
percentage of payroll. It results in the smallest ultimate tax rate of 
those we considered and spreads the tax burden most evenly across 
generations; this is the primary basis for our selection. The later 
that taxes are increased, the higher the ultimate tax rate needed to 
achieve solvency, and in turn the higher the tax burden on later 
taxpayers and lower on earlier taxpayers. Still, any policy scenario 
that achieves 75-year solvency only by increasing revenues would have 
the same effect on the adequacy of future benefits in that promised 
benefits would not be reduced. Nevertheless, alternative approaches to 
increasing revenues could have very different effects on individual 
equity. 

Benefit-Reduction-Only, or "Funded Benefits," Benchmark Policies: 

We developed alternative benefit reduction benchmarks for our analysis. 
For ease of modeling, all benefit reduction benchmarks take the form of 
reductions in the benefit formula factors; they differ in the relative 
size of those reductions across the three factors, which are 90, 32, 
and 15 percent under the current formula. Each benchmark has three 
dimensions of specification: scope, phase-in period, and the factor 
changes themselves. 

Scope: 

For our analysis, we apply benefit reductions in our benchmarks very 
generally to all types of benefits, including disability and survivors' 
benefits as well as old-age benefits. Our objective is to find policies 
that achieve solvency while reflecting the distributional effects of 
the current program as closely as possible. Therefore, it would not be 
appropriate to reduce some benefits and not others. If disabled and 
survivor benefits were not reduced at all, reductions in other benefits 
would be deeper than shown in this analysis. 

Phase-in Period: 

We selected a phase-in period that begins with those becoming initially 
entitled in 2010 and continues for 30 years. We chose this phase-in 
period to achieve a balance between two competing objectives: (1) 
minimizing the size of the ultimate benefit reduction and (2) 
minimizing the size of each year's incremental reduction to avoid 
"notches," or unduly large incremental reductions. Notches create 
marked inequities between beneficiaries close in age to each other. 
Later birth cohorts are generally agreed to experience lower rates of 
return on their contributions already under the current system. 
Therefore, minimizing the size of the ultimate benefit reduction would 
also minimize further reductions in rates of return for later cohorts. 
The smaller each year's reduction, the longer it will take for benefit 
reductions to achieve solvency, and in turn the greater the eventual 
reductions will have to be. However, the smallest possible ultimate 
reduction would be achieved by reducing benefits immediately for all 
new retirees by 13 percent; this would create a notch. 

In addition, we feel it is appropriate to delay the first year of the 
benefit reductions for a few years because those within a few years of 
retirement would not have adequate time to adjust their retirement 
planning if the reductions applied immediately. The Maintain Tax Rates 
(MTR) benchmark in the 1994-1996 Advisory Council report also provided 
for a similar delay.[Footnote 71] 

Finally, the timing of any policy changes in a benchmark scenario 
should be consistent with the proposals against which the benchmark is 
compared. The analysis of any proposal assumes that the proposal is 
enacted, usually within a few years. Consistency requires that any 
benchmark also assumes enactment of the benchmark policy in the same 
time frame. Some analysts have suggested using a benchmark scenario in 
which Congress does not act at all and the trust funds become 
exhausted.[Footnote 72] However, such a benchmark assumes that no 
action is taken while the proposals against which it is compared assume 
that action is taken, which is inconsistent. It also seems unlikely 
that a policy enacted over the next few years would wait to reduce 
benefits until the trust funds are exhausted; such a policy would 
result in a sudden, large benefit reduction and create substantial 
inequities across generations. 

Defining the PIA Formula Factor Reductions: 

When workers retire, become disabled, or die, Social Security uses 
their lifetime earnings records to determine each worker's PIA, on 
which the initial benefit and auxiliary benefits are based. The PIA is 
the result of two elements--the Average Indexed Monthly Earnings (AIME) 
and the benefit formula. The AIME is determined by taking the lifetime 
earnings record, indexing it, and taking the average of the highest 35 
years of indexed wages.[Footnote 73] To determine the PIA, the AIME is 
then applied to a step-like formula, shown here for 2006. 

PIA = 90% times (AIME(1) < $656): 

+ 32% times (AIME(2) > $656 and $3955): 

+ 15% times (AIME(3) > $3955): 

where AIME(1) is the applicable portion of AIME. 

All of our benefit-reduction benchmarks are variations of changes in 
PIA formula factors. 

Proportional reduction: Each formula factor is reduced annually by 
subtracting a constant proportion of that factor's value under current 
law, resulting in a constant percentage reduction of currently promised 
benefits for everyone. That is, 

FI(t+1) = FI(t) - (Fi(2006) times x): 

where: 

FI(t) represents the three PIA formula factors in year t and: 

x = constant proportional formula factor reduction. 

The value of x is calculated to achieve 75-year solvency, given the 
chosen phase-in period and scope of reductions. 

The formula for this reduction specifies that the proportional 
reduction is always taken as a proportion of the current law factors 
rather than the factors for each preceding year. This maintains a 
constant rate of benefit reduction from year to year. In contrast, 
taking the reduction as a proportion of each preceding year's factors 
implies a decelerating of the benefit reduction over time because each 
preceding year's factors gets smaller with each reduction. To achieve 
the same level of 75-year solvency, this would require a greater 
proportional reduction in earlier years because of the smaller 
reductions in later years. 

The proportional reduction hits lower earners harder than higher 
earners because the constant x percent of the higher formula factors 
results in a larger percentage reduction over the lower earnings 
segments of the formula. For example, in a year when the cumulative 
size of the proportional reduction has reached 10 percent, the 90 
percent factor would then have been reduced by 9 percentage points, the 
32 percent factor by 3.2 percentage points, and the 15 percent factor 
by 1.5 percentage points. As a result, earnings in the first segment of 
the benefit formula would be replaced at 9 percentage points less than 
the current formula, while earnings in the third segment of the formula 
would be replaced at only 1.5 percentage points less than the current 
formula.[Footnote 74] 

Table 6 summarizes the features of our benchmarks. 

Table 6: Summary of Benchmark Policy Scenario Parameters: 

Benchmark policy scenario: Tax increase only (promised benefits); 
Phase-in period: 2006; 
Annual PIA factor reduction (percentage point): 90 percent factor: 0; 
Annual PIA factor reduction (percentage point): 32 percent factor: 00; 
Annual PIA factor reduction (percentage point): 15 percent factor: 0; 
Ultimate PIA factor (2040) (percent): 90 percent factor: 90.00; 
Ultimate PIA factor (2040) (percent): 32 percent factor: 32.00; 
Ultimate PIA factor (2040) (percent): 15 percent factor: 15.00. 

Benchmark policy scenario: Proportional benefit reduction (funded 
benefits); 
Phase-in period: 2010-2040; 
Annual PIA factor reduction (percentage point): 90 percent factor: 
0.74; 
Annual PIA factor reduction (percentage point): 32 percent factor: 
0.26; 
Annual PIA factor reduction (percentage point): 15 percent factor: 
0.12; [
Ultimate PIA factor (2040) (percent): 90 percent factor: 67.07; 
Ultimate PIA factor (2040) (percent): 32 percent factor: 23.85; 
Ultimate PIA factor (2040) (percent): 15 percent factor: 11.18. 

Source: GAO's analysis as scored by SSA actuaries. 

Note: Annual PIA factor reductions rounded to the nearest hundredth of 
a percent. 

[End of table] 

[End of section] 

Appendix II: Background on Development of Social Security's Indexing 
Approach: 

Social Security did not originally use indexing to automatically adjust 
benefit and tax provisions; only ad hoc changes were made. The 1972 
amendments provided for automatic indexing of benefits and taxes for 
the first time, but the indexing approach for benefits was flawed, 
introducing potential instability in benefit costs. The 1977 amendments 
addressed those issues, resulting in the basic framework for indexing 
benefits still in use today. 

Program Did Not Use Indexing until 1970s: 

Before the 1970s, the Social Security program did not use indexing to 
adjust benefits or taxes automatically. For both new and existing 
beneficiaries, benefit rates increased only when Congress voted to 
raise them. The same was true for the tax rate and the cap on the 
amount of workers' earnings that were subject to the payroll tax. Under 
the 1972 amendments to the Social Security Act, benefits and taxes were 
indexed for the first time, and revisions in the 1977 amendments 
created the basic framework still in use today. 

Ad Hoc Benefit and Tax Changes Had Sporadic Effects: 

Until 1950, Congress legislated no changes to the benefit formula of 
any kind. As a result, average inflation-adjusted benefits for retired 
workers fell by 32 percent between 1940 and 1949. Under the 1950 
amendments to the Social Security Act, these benefits increased 67 
percent in 1 year. Afterward, until 1972, periodic amendments made 
various ad hoc adjustments to benefit levels. Economic prosperity and 
regular trust fund surpluses facilitated gradual growth of benefit 
levels through these ad hoc adjustments.[Footnote 75] In light of the 
steady growth of benefit levels, the 1972 amendments instituted 
automatic adjustments to constrain the growth of benefits as well as to 
ensure that they kept pace with inflation. Table 7 summarizes the 
history of benefit increases before 1972. It illustrates that between 
1940 and 1971, average benefits for all current beneficiaries tripled 
while prices nearly doubled and wages more than quintupled.[Footnote 
76] Some benefit increases were faster and some were slower than wages 
increases. 

Table 7: Percentage Increases in OASI Benefits, Prices, and Wages, by 
Effective Date of OASI Change, 1950-1971: 

Date of change[A]: September 1950; 
Increase in OASI benefit: Since prior amendment[B]: 81.3[C]; 
Increase in OASI benefit: Since January 1940: 81.3; 
Increase in consumer price index: Since prior amendment: 75.5[C]; 
Increase in consumer price index: Since January 1940: 75.5; 
Increase in average wages: Since prior amendment: 148.8[C]; 
Increase in average wages: Since January 1940: 148.8. 

Date of change[A]: September 1952; 
Increase in OASI benefit: Since prior amendment[B]: 14.1; 
Increase in OASI benefit: Since January 1940: 106.9; 
Increase in consumer price index: Since prior amendment: 9.3; 
Increase in consumer price index: Since January 1940: 91.8; 
Increase in average wages: Since prior amendment: 12.5; 
Increase in average wages: Since January 1940: 179.9. 

Date of change[A]: September 1954; 
Increase in OASI benefit: Since prior amendment[B]: 13.3; 
Increase in OASI benefit: Since January 1940: 134.3; 
Increase in consumer price index: Since prior amendment: 0.5; 
Increase in consumer price index: Since January 1940: 92.8; 
Increase in average wages: Since prior amendment: 7.7; 
Increase in average wages: Since January 1940: 201.5. 

Date of change[A]: January 1959 (1958); 
Increase in OASI benefit: Since prior amendment[B]: 7.7; 
Increase in OASI benefit: Since January 1940: 152.4; 
Increase in consumer price index: Since prior amendment: 7.9; 
Increase in consumer price index: Since January 1940: 108.0; 
Increase in average wages: Since prior amendment: 19.4; 
Increase in average wages: Since January 1940: 259.9. 

Date of change[A]: January 1965; 
Increase in OASI benefit: Since prior amendment[B]: 7.7; 
Increase in OASI benefit: Since January 1940: 171.9; 
Increase in consumer price index: Since prior amendment: 7.9; 
Increase in consumer price index: Since January 1940: 124.5; 
Increase in average wages: Since prior amendment: 22.3; 
Increase in average wages: Since January 1940: 340.2. 

Date of change[A]: February 1968 (1967); 
Increase in OASI benefit: Since prior amendment[B]: 14.2; 
Increase in OASI benefit: Since January 1940: 210.5; 
Increase in consumer price index: Since prior amendment: 9.3; 
Increase in consumer price index: Since January 1940: 145.4; 
Increase in average wages: Since prior amendment: 18.0; 
Increase in average wages: Since January 1940: 419.4. 

Date of change[A]: January 1970 (1969); 
Increase in OASI benefit: Since prior amendment[B]: 15.6; 
Increase in OASI benefit: Since January 1940: 258.9; 
Increase in consumer price index: Since prior amendment: 10.8; 
Increase in consumer price index: Since January 1940: 171.8; 
Increase in average wages: Since prior amendment: 12.2; 
Increase in average wages: Since January 1940: 482.8. 

Date of change[A]: January 1971; 
Increase in OASI benefit: Since prior amendment[B]: 10.4; 
Increase in OASI benefit: Since January 1940: 296.2; 
Increase in consumer price index: Since prior amendment: 5.2; 
Increase in consumer price index: Since January 1940: 185.9; 
Increase in average wages: Since prior amendment: 5.3; 
Increase in average wages: Since January 1940: 513.7. 

Source: Martha Derthick, Policymaking for Social Security, The 
Brookings Institution, Washington, D.C., 1979, p. 276. Reprinted with 
permission of the Brookings Institution Press, and GAO analysis. 

[A] Year of enactment, if different from year in which change took 
effect, is in parentheses. 

[B] Average increases for current beneficiaries, that is, people who 
were on the rolls. At the same time, increases approximately equal to 
these were promised by statutory formula, to active workers. 

[C] Percentage increase since January 1940, when OASI benefits were 
first paid. 

[End of table] 

On the revenue side, payroll tax rates have never been indexed. 
However, Social Security's revenue also depends on the maximum amount 
of workers' earnings that are subject to the payroll tax. This cap is 
technically known as the contribution and benefit base because it 
limits the earnings level used to compute benefits as well as 
taxes.[Footnote 77] Just as with benefits, the maximum taxable earnings 
level did not change until the 1950 amendments even as price and 
earning levels were increasing. From 1940 to 1950, the inflation- 
adjusted value of the cap fell by over 40 percent. Also, until the 1972 
amendments, adjustments to the maximum taxable earnings level were made 
on an ad hoc basis. With the enactment of the 1972 amendments, the 
maximum taxable earnings level increased automatically based on 
increases in average earnings. Figure 9 shows the inflation-adjusted 
values for the maximum taxable earnings level before automatic 
adjustments took effect in 1975.[Footnote 78] Figure 10 shows that as a 
result of the fluctuations in the maximum taxable earnings level, the 
proportion of earnings subject to the payroll tax varied widely before 
indexing, ranging from 71 to 93 percent. 

Figure 9: Inflation-Adjusted Values of the Maximum Taxable Earnings 
Level before Automatic Adjustments, 1937-1975: 

[See PDF for image] 

Source: SSA, and GAO analysis. 

Note: The maximum taxable earnings level is the level at which earnings 
are subject to the payroll tax. 

[End of figure] 

Figure 10: Percentage of Total Covered Earnings below Social Security's 
Maximum Taxable Earnings Level, 1937-2005: 

[See PDF for image] 

Source: SSA. 

[End of figure] 

Indexing in 1972 Amendments Built on Previous Ad Hoc Benefit Increases: 

The 1972 amendments, in effect, provided for indexing initial benefits 
twice for new beneficiaries. The indexing changed the benefit formula 
in the same way that previous ad hoc increases had done. 

Approach Used for Ad Hoc Benefit Increases: 

Before the 1972 amendments, benefits were computed essentially by 
applying different replacement factors to different portions of a 
worker's earnings. For example, under the 1958 amendments, a workers' 
PIA[Footnote 79] would equal: 

58.85 percent of first $110 of average monthly wages plus 21.40 percent 
of next $290, 

where the 58.85 and 21.40 percents are the replacement factors that 
determine how much of a worker's earnings will be replaced by the 
Social Security benefit.[Footnote 80] Subsequent amendments increased 
benefits by effectively increasing the replacement factors. For 
example, the 1965 amendments increased benefits by 7 percent for a 
given average monthly wage by increasing the replacement factors by 7 
percent to 62.97 from 58.85 and to 22.9 percent from 21.4.[Footnote 81] 
The automatic adjustments under the 1972 amendments increased these 
same replacement factors according to changes in the CPI. These changes 
in the benefit computation applied equally to both new and existing 
beneficiaries.[Footnote 82] 

To illustrate how the benefit formula worked, take, for example, a 
worker with an average monthly wage of $200 who became entitled in 1959 
(when the 1958 amendments first took effect). The PIA for this worker 
would be: 

58.85 percent of $110 plus: 
21.4 percent of the average monthly wage over $110, that is, $200-110 = 
$90, which equals: 
$64.74 + $19.26 = 84.00. 

When the 1965 amendments took effect, this same beneficiary would have 
the PIA recalculated using the new formula. Assuming no new wages, the 
average monthly wage would still be $200, and the new PIA would be: 

62.97 percent of $110 plus: 
22.9 percent of the average monthly wage over $110, that is, $200-110 = 
$90, which equals: 
$69.27 + $20.61 = 89.88, which is 7 percent greater than the previous 
$84.00. 

Now consider the example of a new beneficiary, who became entitled in 
1965 (when the 1965 amendments first became effective). For the 
purposes of this illustration, to reflect wage growth, assume this 
worker had an average monthly wage of $240.00, or 20 percent more than 
our previous worker who became entitled in 1959. For this new 
beneficiary, the PIA in 1965 would be $99.04, which, as a result of the 
wage growth, is much more than 7 percent higher than the initial 
benefit for the worker in 1959. 

1972 Amendments Introduced Indexing: 

The 1972 amendments provided for automatic indexing of benefits and 
taxes for the first time. The indexing approach for benefits was flawed 
and raised issues that the 1977 amendments addressed; these issues help 
explain the basic framework for indexing benefits still in use today. 
In particular, the indexing approach in the 1972 amendments resulted in 
(1) double-indexing benefits to inflation for new beneficiaries though 
not for existing ones and (2) a form of bracket creep that slowed 
benefit growth as earnings increased over time. Within a few years, the 
problems raised by the double indexing under the 1972 amendments became 
apparent, with benefits growing far faster than anticipated. 

Under the 1972 amendments, indexing the replacement factors in the 
benefit formula to inflation had the effect of indexing twice for new 
beneficiaries. First, the increase in the replacement factors 
themselves reflected changes in the price level. Second, the benefit 
calculations were based on earnings levels, which were higher for each 
new group of beneficiaries, partially as a result of 
inflation.[Footnote 83] Thus, benefit levels grew for each new year's 
group of beneficiaries because both the benefit formula reflected 
inflation and their higher average wages reflected inflation. For 
existing beneficiaries who had stopped working, the average earnings 
used to compute their benefits did not change, so growth in earnings 
levels did not affect their benefits and double indexing did not occur. 
Once the double indexing for new beneficiaries was understood, the need 
became clear to index benefits differently for new and existing 
beneficiaries, which was referred to as "decoupling" benefits. 

The effect of double indexing on replacement rates could be offset by a 
type of "bracket creep" in the benefit formula, depending on the 
relative values of wage and price growth over time. Bracket creep 
resulted from the progressive benefit formula, which provided lower 
replacement rates for higher earners than for lower earners. As each 
year passed and average earnings of new beneficiaries grew, more and 
more earnings would be replaced at the lower rate used for the upper 
bracket, making replacement rates fall on average, all else being 
equal. 

Indexing Approach Introduced Potential Instability in Benefit Costs: 

The combination of double indexing and bracket creep implied in the 
1972 amendments introduced a potential instability in Social Security 
benefit costs. Price growth determined the effects of double indexing, 
and wage growth determined the effects of bracket creep. The extent to 
which bracket creep offset the effects of double indexing depended on 
the relative values of price growth and wage growth, which could vary 
considerably. Had wage and price growth followed the historical pattern 
at the time, benefits would not have grown faster than expected and 
replacement rates would not have risen; the inflation effect and the 
bracket creep effect would have balanced out. However, during the 
1970s, actual rates of inflation and earnings growth diverged markedly 
from past experience (see fig. 11), with the result that benefit costs 
grew far faster than revenues. 

Figure 11: Changes in Average Wage Index and Consumer Price Index, 1951-
1985: 

[See PDF for image] 

Source: SSA and US Bureau of Labor Statistics. 

[End of figure] 

In contrast, an indexing approach that stabilized replacement rates 
would help to stabilize program costs. To illustrate this, annual 
benefit costs can be expressed as a fraction of the total taxable 
payroll in a given year, that is, total covered earnings.[Footnote 84] 
In turn, this can be shown to relate closely to replacement rates. 

Total Benefits/Total covered earnings =

Number of beneficiaries times Average benefit/Number of workers times 
Average taxable earnings = 

Number of beneficiaries/Number of workers times Average benefit/Average 
taxable earnings

While not precisely a replacement rate, the second term on the last 
line above--the ratio of the average benefit to average taxable 
earnings--is closely related to the replacement rates provided under 
the program. While replacement rates are now relatively stable after 
the 1977 amendments, it is the first term on the last line above-
-the ratio of beneficiaries to workers--that has been increasing and 
placing strains on the system's finances. The inverse of this is the 
ratio of covered workers to beneficiaries. While 3.3 workers support 
each Social Security beneficiary today, only 2 workers are expected to 
be supporting each beneficiary by 2040. (See fig. 12.) 

[See PDF for image] 

[End of figure] 

Figure 12: Social Security Workers per Beneficiary: 

[See PDF for image] 

Source: SSA. 

Note: This is based on the intermediate assumptions of the 2006 Social 
Security trustees' report. 

[End of figure] 

[End of section] 

Related GAO Products: 

Social Security Reform: Answers to Key Questions. GAO-05-193SP. 
Washington, D.C.: May 2005. 

Options for Social Security Reform. GAO-05-649R. Washington, D.C.: May 
6, 2005. 

Social Security Reform: Early Action Would Be Prudent. GAO-05-397T. 
Washington, D.C.: Mar. 9, 2005. 

Social Security: Distribution of Benefits and Taxes Relative to 
Earnings Level. GAO-04-747. Washington, D.C.: June 15, 2004. 

Social Security Reform: Analysis of a Trust Fund Exhaustion Scenario. 
GAO-03-907. Washington, D.C.: July 29, 2003. 
 
Social Security Reform: Analysis of Reform Models Developed by the 
President's Commission to Strengthen Social Security. GAO-03-310. 
Washington, D.C.: Jan. 15, 2003. 

Social Security: Program's Role in Helping Ensure Income Adequacy. GAO-
02-62. Washington, D.C.: Nov. 30, 2001. 

Social Security Reform: Potential Effects on SSA's Disability Programs 
and Beneficiaries. GAO-01-35. Washington, D.C.: Jan. 24, 2001.  

Social Security: Evaluating Reform Proposals. GAO/AIMD/HEHS-00-29. 
Washington, D.C.: Nov. 4, 1999. 

Social Security: Issues in Comparing Rates of Return with Market 
Investments. GAO/HEHS-99-110. Washington, D.C.: Aug. 5, 1999. 

Social Security: Criteria for Evaluating Social Security Reform 
Proposals. GAO/T-HEHS-99-94. Washington, D.C.: Mar. 25, 1999. 

Social Security: Different Approaches for Addressing Program Solvency. 
GAO/HEHS-98-33. Washington, D.C.: July 22, 1998. 

Social Security: Restoring Long-Term Solvency Will Require Difficult 
Choices. GAO/T-HEHS-98-95. Washington, D.C.: Feb. 10, 1998. 

FOOTNOTES 

[1] We used the GEMINI model under a license from the Policy Simulation 
Group, a private contractor. GEMINI estimates individual effects of 
policy scenarios for a representative sample of future beneficiaries. 
GEMINI can simulate different reform features, including individual 
accounts with an offset, for their effects on the level and 
distribution of benefits. See appendix I for more detail on the 
modeling analysis, including a discussion of our assessment of the data 
reliability of the model. 

[2] These are consumer price index (CPI) indexing, dependency ratio 
indexing, mortality indexing, and a so-called progressive indexing 
approach that uses different indexes at various earnings levels. See 
appendix I for a discussion of these indexes and our scope and 
methodology, as well as GAO, Social Security: Program's Role in Helping 
Ensure Income Adequacy, GAO-02-62 (Washington, D.C.: Nov. 30, 2001), 
GAO, Social Security Reform: Analysis of Reform Models Developed by the 
President's Commission to Strengthen Social Security, GAO-03-310 
(Washington, D.C.: Jan. 15, 2003), and GAO, Social Security: 
Distribution of Benefits and Taxes Relative to Earnings Level, GAO-04-
747 (Washington, D.C.: June 15, 2004). 

[3] We focused on workers born in 1985 because all prospective program 
changes under all alternative policy scenarios would be almost fully 
phased in for these workers. 

[4] See appendix I for a complete description of our benchmark policy 
scenarios. 

[5] Earnings replacement rates measure the extent to which retirement 
income replaces pre-retirement income for particular individuals and 
thereby helps them maintain a pre-retirement standard of living. 

[6] In 2006, workers receive 1 credit for each $970 of earnings, up to 
the maximum of 4 credits per year. To be eligible for retirement 
benefits a worker needs 40 credits. 

[7] These estimates are based on the Social Security trustees' 2006 
intermediate, or best-estimate, assumptions. 

[8] Life expectancy has increased fairly steadily since the 1930s, and 
further increases are expected. Increases in life expectancy vary by 
gender, education, and earnings. Women, highly educated individuals, 
and higher-income individuals generally experience greater life 
expectancy. 

[9] See GAO, Social Security: Criteria for Evaluating Reform Proposals, 
GAO/T-HEHS-99-94 (Washington, D.C.: Mar. 25, 1999), and GAO, Social 
Security: Evaluating Reform Proposals, GAO/AIMD/HEHS-00-29 (Washington, 
D.C.: Nov. 4, 1999). 

[10] For a discussion of individual equity issues, see GAO, Social 
Security: Issues in Comparing Rates of Return with Market 
Investments,GAO/HEHS-99-110 (Washington, D.C.: Aug. 5, 1999). 

[11] GAO-02-62. 

[12] One type of indexing took the form of automatic inflation 
adjustments to the earnings replacement factors in the benefit formula. 
At the same time, the earnings used in the formula were higher on 
average for each new group of beneficiaries, partially because of 
inflation. See appendix II. 

[13] Lawrence H. Thompson. "Toward the Rational Adjustment of Social 
Security Benefit Levels," Policy Analysis, Vol. 3, No. 4, Fall 1977. 

[14] Wage indexing also applies to other provisions of the program that 
are not part of the primary benefit computations. Such provisions 
include earnings test thresholds, maximum family benefits, coverage 
thresholds, and thresholds relating to disability insurance. 

[15] A worker's earnings for a given year are indexed by multiplying 
them by the ratio of the national average wage for the indexing year to 
the national average wage in the year the income was earned. The 
indexing year is the second calendar year before the year in which the 
worker is first eligible--the year the worker reaches age 62, becomes 
disabled, or dies. Earnings after the indexing year are counted at 
their actual value. 

[16] In this figure, replacement rates are the annual retired worker 
benefits at age 65 divided by career-average earnings. Illustrative 
workers have career-average earnings equal to about 45, 100, and 160 
percent of Social Security's Average Wage Index, respectively, for low, 
medium, and high earners. These three cases have earnings patterns that 
reflect differences by age in the probability of work and in average 
earnings levels. Taxable maximum earners have earnings equal to the 
maximum earnings taxable under OASDI in each year. Using illustrative 
workers holds other factors equal that might also affect replacement 
rates. For example, using illustrative workers filters out the effects 
of changes in the covered population or changes in work and retirement 
patterns. 

[17] See GAO, Social Security: GAO's Analysis of the Notch Issue, GAO/ 
T-HEHS-94-236 (Washington, D.C.: Sept. 16, 1994). 

[18] Specifically, Social Security's COLAs are based on the consumer 
price index for urban wage earners and clerical workers (CPI-W), as 
opposed to the CPI series for all urban consumers (CPI-U). 

[19] Andrew G. Biggs, Jeffrey R. Brown, Glenn Springstead, "Alternative 
Methods of Price Indexing Social Security: Implications for Benefits 
and System Financing," National Bureau of Economic Research, Working 
Paper 11406 (2005). 

[20] For more information on the CPI and how it overstates the true 
rate of inflation, see Advisory Commission to Study the Consumer Price 
Index, "Toward a More Accurate Measure of the Cost of Living," Final 
Report to the Senate Committee on Finance, Dec. 1996, which is known as 
the Boskin Commission report. A variety of changes have been made to 
the CPI since that report, including changes that in turn affect Social 
Security's COLA. In addition, a new "chained" CPI reflects how 
consumers substitute one product for another when their relative prices 
change. This new CPI is not yet used by government agencies, but some 
reform proposals call for using a variation of it in computing COLAs. 

[21] For example, the elderly allot a larger proportion of their 
expenses to medical care than the general population, which partially 
depends on Medicare's coverage and premiums. 

[22] In earnings-related public pension systems reviewed here, 
indexation appears in different forms but in all cases affects the way 
in which pension rights are accrued. For example, in notional defined 
contribution systems such as in Sweden and Italy, workers earn a 
notional rate of return on their contributions (based on their 
earnings), and indexation is implicit in that notional return. In point 
systems such as in Germany, workers earn pension points (also based on 
their earnings) that are multiplied by a pension-point value at the 
time of retirement. There, indexation is implicit in the value of the 
pension point. 

[23] It is important to note that the structure of public pension 
programs differ across countries, and hence are not strictly 
comparable. For example, contributions in some cases help finance 
maternity/paternity and unemployment benefits in addition to old age 
benefits. 

[24] The total employer and employee contributions of 9.9 percent may 
appear low, but the retirement pension benefits these generate are 
relatively modest, replacing only 25 percent of average pensionable 
earnings. 

[25] Canada's reserve fund is managed by an Investment Board that 
operates independently from the government since the late 1990s and 
invests in both foreign and domestic assets subject to some 
restrictions. 

[26] As in the United States in the 1970s and 1980s, prices at times 
grow faster than wages; nonetheless, these periods remain exceptional. 

[27] A full-career worker is defined as one having earnings between the 
ages of 20 and 65. The computation reflects the average effect, in OECD 
countries, for a manufacturing worker with average earnings. 

[28] In most OECD countries, the formula used varies by either 
individual earnings, age or length of service. 

[29] Using per capita wage growth, i.e., wage growth divided by the 
labor force, as an index implies that when the labor force shrinks, per 
capita wage growth goes up. As a result, benefits increase right when 
the number of contributors gets smaller, creating an imbalance. 

[30] More precisely, the average-wage-growth indexation is reduced 
whenever the Balance Ratio is less than 1, where Balance Ratio = 
(Contribution Asset + Buffer Funds)/Pension Liability. The index then 
automatically becomes average wage growth multiplied by the Balance 
Ratio, and remains so as long as the Balance Ratio is less than 1. The 
Buffer Funds are a collection of reserve funds to which part of pension 
contributions are transferred. These are then invested in domestic and 
foreign assets with the objective of achieving the highest possible 
returns. The Buffer Funds play an important role in ensuring the 
financial stability of the pension program insofar as high rates of 
return on these funds may partially or fully compensate for any adverse 
demographic or economic developments. 

[31] The longevity factor enters the formula determining initial 
benefits for a given cohort and does not change for that cohort after 
the normal retirement age. It ensures that the present value of 
benefits does not increase with life expectancy across cohorts. 

[32] Changes in fertility or longevity are likely to affect the 
dependency ratio in the long run, but little in the short run. 

[33] Benefits at the time of retirement are determined by remaining 
life expectancy and a growth "norm" of 1.6 percent. Benefits are then 
adjusted each year for inflation plus or minus deviations from this 
norm. 

[34] Longevity and mortality are differing measures of life expectancy. 

[35] See appendix I for more information on these indexes. 

[36] We focused on workers born in 1985 because all prospective program 
changes under all alternative policy scenarios would be almost fully 
phased in for such workers. 

[37] The benefit reduction benchmark is a hypothetical benchmark policy 
scenario that would achieve 75-year solvency by only reducing benefits. 
For ease of modeling, the benefit reduction benchmark takes the form of 
reductions in the benefit formula factors. Each formula factor is 
reduced annually by subtracting a constant proportion of the factor's 
value under current law, resulting in a constant percentage reduction 
of currently promised benefits for everyone. See appendix I for more 
information about the benefit reduction benchmark. Consistent with the 
Social Security trustees' report, we use a 75-year projection period in 
assessing the solvency of different indexing scenarios and our 
benchmarks. The 75-year projection period has been standard practice 
for many years, although it does not capture sustainability over longer 
time horizons. We believe it is important to consider sustainability, 
and there are different ways to do so, but this issue is outside the 
scope of this report. 

[38] While the level of solvency differs among these scenarios, the 
level of benefits under each scenario is lower than promised benefits, 
and replacement rates have declined in each scenario. 

[39] The general application of these indexes is to multiply the PIA 
formula's replacement factors by a factor that reflects the new index. 
This is the approach taken by the Social Security actuaries and most 
proposals. See appendix I. 

[40] While scaling allows comparisons across distributions over 75 
years, the different indexing scenarios are not identical in terms of 
sustainability. 

[41] For more details on the progressive price indexing proposal, see 
provision B7 of the August 10, 2005 Office of the Chief Actuary (OCACT) 
memo at http://www.ssab.gov/documents/advisoryboardmemo--2005tr--
08102005.pdf, which was the basis for our analysis. 

[42] Progressive price indexing and progressive CPI indexing are two 
ways of referring to the same proposal. 

[43] Under the current system, the maximum taxable earnings level, the 
level at which earnings are subject to the Social Security payroll tax, 
is indexed to the growth in wages, but the payroll tax rate itself is 
not indexed. Some proposals have suggested changing the indexing of the 
maximum taxable earnings level so that it maintains coverage of 90 
percent of all wages. Other proposals have not focused on the 90 
percent goal, but rather have suggested raising or completely 
eliminating the cap. With any of these changes, several issues arise, 
most importantly whether the benefit formula takes into account these 
higher earnings. These issues go beyond the scope of our work, and thus 
we did not analyze changes to the maximum taxable earnings level. 

[44] A value less than one, for example, indicates that benefits 
collected fall short of taxes paid. The present value of benefits or 
taxes is the equivalent value, at a point in time, of the entire stream 
of benefits the individual receives or taxes the individual pays in his 
or her lifetime. 

[45] Changing benefits would also affect the benefit-to-tax ratios, 
which would have adequacy and equity considerations. 

[46] The tax increase benchmark is a hypothetical benchmark policy 
scenario that would achieve 75-year solvency by only increasing payroll 
taxes. It raises payroll taxes once and immediately by the amount of 
Social Security's actuarial deficit as a percentage of payroll (1.96 
percentage points divided evenly between employers and employees). It 
results in the smallest ultimate tax rate that would achieve 75-year 
solvency and spreads the tax burden evenly across generations. See 
appendix I for more information about the tax increase benchmark. 

[47] Since the 1955 cohort reaches age 62 in 2017, the earliest age of 
eligibility for retired worker benefits, members of this cohort will 
spend fewer years contributing to the system at the higher tax rate 
than the other cohorts. Thus, their benefit-to-tax ratios will be 
higher than those for the other cohorts. Also, since lifetime benefits 
grow over time as people live longer, the benefit-to-tax ratios for the 
tax increase benchmark will begin to increase, as can be seen for the 
2000 cohort. 

[48] The 0.22 percentage point reduction in the growth of the CPI has 
been proposed as a modification to the COLA to correct methodological 
issues associated with how the CPI is calculated. Thus the COLA would 
be based on a new CPI-W series that would reflect a "superlative" 
formula, of the type currently used for the new chained CCPI-U. The 1 
percentage point reduction in the CPI is another possibility for 
slowing the growth of benefits that has been analyzed by the Office of 
the Actuary at SSA. 

[49] Since the current benefit formula links the calculation of 
benefits for all beneficiaries, any proposed changes would affect the 
benefits of disabled workers as well as retirees. Proposals to reform 
Social Security often modify the benefit formula without taking into 
account that the circumstances facing disabled workers differ from 
those facing retired workers. See the next section of this report for a 
discussion of this issue, as well as GAO-03-310, and GAO, Social 
Security Reform: Potential Effects on SSA's Disability Programs and 
Beneficiaries, GAO-01-35 (Washington, D.C.: Jan. 24, 2001). 

[50] Most proposals that change the indexing of initial benefits would 
implement the new index through the benefit formula by multiplying the 
replacement factors by the difference between the growth in wages and 
the growth in the new index. In such instances, changing the indexing 
would not likely pose any serious implementation issues from an agency 
operational perspective. 

[51] Purchasing power reflects the amount of goods and services 
individuals can afford with a given level of benefits. 

[52] This is the so-called notch effect. Such a situation occurred 
immediately after the 1977 amendments. Notches generate controversy and 
confusion among beneficiaries because of inequities that result from 
them. See GAO/T-HEHS-94-236. 

[53] For more detail on the 1977 amendments, see appendix II. 

[54] For more information on the CPI and how it overstates the true 
rate of inflation, see Advisory Commission to Study the Consumer Price 
Index, "Toward a More Accurate Measure of the Cost of Living," Final 
Report to the Senate Committee on Finance, Dec. 1996; Congressional 
Budget Office, "Is the Growth of the CPI a Biased Measure of Changes in 
the Cost of Living?" (Washington, D.C., 1994). In recent years a 
variety of changes have been made to the CPI, including changes that in 
turn affect Social Security's COLA. In addition, a new "chained" CPI 
reflects how consumers substitute one product for another when their 
relative prices change. This new CPI is not yet used by government 
agencies, but some reform proposals call for using a variation of it in 
computing COLAs. 

[55] See Ronald D. Lee and Lawrence R. Carter, "Modeling and 
Forecasting U.S. Mortality," Journal of the American Statistical 
Association, Vol. 87, No. 419, 1992; and Michael Sze, Stephen C. Goss, 
and Jose Gomez de Leon, "Effect of Aging Population with Declining 
Mortality on Social Security and NAFTA Countries," North American 
Actuarial Journal, Vol. 2, No. 4, 1998. 

[56] For more information on the effects of reform on the DI program 
and beneficiaries, see GAO-01-35. 

[57] Some proposals have suggested reducing the disabled worker benefit 
only at the time of conversion from DI to retired worker status, but 
only in proportion to the percentage of their potential working years 
that occurred in a nondisabled state. 

[58] While these models use sample data, our report, like others using 
these models, does not address the issue of sampling errors. The 
results of the analysis reflect outcomes for individuals in the 
simulated populations and do not attempt to estimate outcomes for an 
actual population. 

[59] MINT3 is a detailed microsimulation model developed jointly by the 
Social Security Administration, the Brookings Institution, RAND, and 
the Urban Institute to project the distribution of income in retirement 
for the 1931 to 1960 birth cohorts. 

[60] The Board of Trustees, Federal Old-Age and Survivors Insurance and 
Disability Insurance Trust Funds, The 2005 Annual Report of the Board 
of Trustees of the Federal Old-Age and Survivors Insurance and 
Disability Insurance Trust Funds (Washington, D.C.: Mar. 23, 2005). 

[61] For benefit-to-tax ratios we followed the methodology followed in 
GAO-04-747; see appendix I of this report for more detail. 

[62] See page 3 of http://www.ssab.gov/documents/advisoryboardmemo--
2005tr--08102005.pdf for description of the provision. For the original 
provision from the President's Commission to Strengthen Social 
Security, see page 4 of 
http://www.ssa.gov/OACT/solvency/PresComm_20020131.pdf . 

[63] For more information on provision 1 or Model 3, see page 8 of the 
CSSS proposal at 
http://www.ssa.gov/OACT/solvency/PresComm_20020131.pdf. 

[64] We chose the CSSS specification because it was already scored and 
readily available. Other constructions or interpretations of a 
mortality index are certainly possible. For example, life expectancy at 
birth or some other age could be used. Further, life expectancy could 
be defined as period or cohort. A period life table represents the 
mortality conditions at a specific point in time, whereas a cohort 
table depicts the mortality conditions of a specific group of 
individuals born in the same year or series of years. 

[65] The aged dependency ratio is 0.204 and 0.206 under the 
intermediate assumptions of the 2005 Trustees' report for 2007 and 
2008, respectively. 

[66] Though we do not present SSASIM or GEMINI results for the 
progressive CPI index, we also scaled this proposal. For an OCACT 
scoring of this proposal, which was the basis of our SSASIM OLC 
estimates for the scaled and unscaled versions presented in the report, 
see provision B7 of the August 10, 2005 OCACT memo at 
http://www.ssab.gov/documents/advisoryboardmemo--2005tr--08102005.pdf. 
To scale this scenario, we consulted with OCACT and only scaled the 
third and fourth PIA formula factors, as these were the only factors 
reduced in the original provision. This effectively sped up the rate of 
indexing so that the benefit reductions were faster than pure price 
indexing across generations of steady maximum earners. Additionally, we 
had to slightly raise the scaling value for this scenario because the 
third and fourth formula factors would need to have been of a negative 
value beginning in 2065. However, we censored negative values at zero 
and raised the scaling factor by one percentage point to achieve a 75- 
year actuarial balance of 0 for the scaled version of progressive CPI 
index. 

[67] In the case of the aged dependency ratio tax increase index, the 
increase from the initial OASI and DI tax rates is multiplied by the 
scaling factor--again, represented by the inverse of the percentage of 
solvency attained by the index. 

[68] Despite a similar 75-year actuarial balance across the indexes 
studied, each index may have a unique balance in the 75th year because 
of the unique timing of the benefit reductions (or tax increases) of 
each index. 

[69] These benchmarks were first developed for our report GAO-02-62. We 
have since used them in other studies, including GAO-03-310; GAO, 
Social Security Reform: Analysis of a Trust Fund Exhaustion Scenario, 
GAO-03-907 (Washington, D.C.: July 29, 2003); GAO, Social Security and 
Minorities: Earnings, Disability Incidence, and Mortality Are Key 
Factors That Influence Taxes Paid and Benefits Received GAO-03-387 
(Washington, D.C.: Apr. 23, 2003); and GAO-04-747. 

[70] The Social Security actuaries provided these scorings for a 
previous report and used assumptions from the 2001 trustees' report. 
The actuaries did not believe it was necessary to provide new scorings 
using updated assumptions for the purposes of our study, since the 
assumptions and the estimates of actuarial balance on which they are 
based have changed little from the 2001 report. In particular, they did 
not believe that the differences in assumptions would materially affect 
the shape of the distribution of benefits, which is the focus of our 
analysis. All estimates related to the indexing scenarios and benchmark 
policy scenarios were simulated using the SSASIM OLC mode. 

[71] Advisory Council on Social Security. Report of the 1994-1996 
Advisory Council on Social Security, Vols. 1 and 2. Washington, D.C.: 
Jan. 1997. 

[72] See GAO-03-907, in which we analyzed such a policy scenario under 
a congressional request. 

[73] The highest 35 years of salary are used in the calculation of a 
retired worker benefit. The disabled worker benefit is calculated using 
the number of years between the age of entitlement and age 21, divided 
by 5. 

[74] Other analyses have addressed the concern about the effect of the 
proportional reduction on low earners by modifying that offset to apply 
only to the 32 and 15 percent formula factors. The MTR policy in the 
1994 to 1996 Advisory Council report used this approach, which in turn 
was based on the individual account (IA) proposal in that report. 
However, the MTR policy also reflected other changes in addition to PIA 
formula changes. 

[75] Until the 1970s, trust fund projections were routinely exceeded at 
least in part as a result of actuarial methods that assumed no growth 
in average earnings. 

[76] These estimates of average benefit increases include both existing 
and initial benefits. 

[77] The contribution and benefit base reflects the program's role of 
only providing for a floor of protection. 

[78] In 2006, the maximum taxable earnings cap is set at $94,200. 

[79] The PIA is the monthly amount payable to a retired worker who 
begins to receive benefits at normal retirement age or (generally) to a 
disabled worker. This is also the amount used as a base for computing 
all types of benefits payable on the basis of one individual's earnings 
record. 

[80] The declining replacement factors for higher levels of earnings 
made the formula progressive. 

[81] When the maximum taxable earnings level increased, a new 
replacement factor would be applied to the newly covered portion of 
earnings. For example, the 1965 amendments increased the maximum 
taxable earnings from $4,800 to $6,600. Accordingly, the benefit 
formula added a new component, with a replacement factor of 21.4 
percent for the next $150 of average monthly wages. 

[82] The fact that benefits were changed for both new and current 
beneficiaries using the same computations came to be known as 
"coupling" of benefit increases. 

[83] Part of the growth in wages reflects inflation. Wage growth makes 
the average monthly earnings for a new year's group of beneficiaries 
higher on average than for the previous year's group. 

[84] In a pay-as-you-go system, the payroll tax would equal annual 
benefit costs as a percentage of payroll. 

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