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Rethinking Retirement Benefit Calculation Could Aid Social Security

March 23, 2005 at 12:00 AM EDT
Business correspondent Paul Solman of WGBH-Boston examines the debate surrounding changing Social Security, including the pros and cons of reducing retirement benefits by tying them to cost-of-living increases rather than wage increases, in this second part of a two-part series.

TRANSCRIPT

PAUL SOLMAN: You’ve heard the problem, possibly to the point of numbness: Social Security face is a shortfall in the years ahead.

So, how to fix it? This story is about a controversial, some would say radical, change in the benefit formula, and its effect on workers past, present and future.

President Bush mentioned it in his recent state of the union address.

PRESIDENT GEORGE W. BUSH: Fixing Social Security permanently will require an open, candid review of the options.

Former Congressman Tim Penny has raised the possibility of indexing benefits to prices rather than wages.

PAUL SOLMAN: He ticked off some other options before announcing:

PRESIDENT GEORGE W. BUSH: All these ideas are on the table.

PAUL SOLMAN: Now we’re going to explain indexing benefits with reference to our three Americans from three different eras.

First, Ida May Fuller, the very first American to receive a monthly Social Security upon her retirement in 1940.

Second, this fellow who started working as a cab driver in 1970, and will be eligible to receive full Social Security benefits in 2009, when he hopes to still be working for you, and doing stories like this one, as the business correspondent for the NewsHour.

And third, 34-year-old Allen Arbeau, a student at Bunker Hill Community College in Boston, where we went to hear retirement expert Alicia Munnell discuss possible changes in the Social Security benefit formula.

Arbeau, a Navy vet who saw action in Bosnia, is now working on two different computer degrees while maintaining a nearly perfect grade-point average. His career future looks bright; his retirement uncertain.

ALLEN ARBEAU: If we keep things the way that they are, everything is going to go down the toilet.

PAUL SOLMAN: The way things are includes a benefit formula that has pushed Social Security costs way beyond anything Ida May Fuller could have imagined. Her first monthly check was $22.54, and it didn’t grow at all for a decade. But with inflation, that check bought less and less. So in 1950, Congress hiked retiree benefits to match the rise in the cost of living, and fuller started getting $41.30 a month.

Over the course of her life, Congress voted in 11 more special cost-of-living allowances, or COLAS, and then finally made them automatic, linked to the increase in consumer prices, in 1975.

That was the year Fuller died at age 100. It was also the year a second change kicked in, not for retirees, but for the workers of that era, no matter how scruffy.

PAUL SOLMAN: First, the government raised the amount of our income subject to Social Security taxes.

Then it raised the annual estimates of our future retirement benefits, linking both taxes and future benefits to the growth in U.S. wages. It’s the link between future benefits and wage growth that could now be rescinded.

To quote from the report of President Bush’s 2001 Social Security Commission, “Benefits in the traditional Social Security system would be indexed to price inflation rather than national wage growth beginning in 2009.”

Economist Alicia Munnell:

ALICIA MUNNELL: That sounds like a small change. But in point of fact, it has enormous, enormous impact on what will happen to benefits in the future.

PAUL SOLMAN: Let’s look at it from the point of view of folks like me and Ida May Fuller. Here’s the average annual Social Security benefit at age 65.

Starting at $1,140 in 1951, it rose sharply with wage indexing in the 1970s, reaching $14,700 in 2004. Had Social Security been indexed to prices rather than wages, however, today’s average benefit would be much less — $7,950.

One argument in favor of such a switch: $7,950 would buy you the same basket of good in 2004 that $1,140 would have bought in 1951. We’d have kept pace with inflation.

ALICIA MUNNELL: So, as the price of the black and white television went up, you would still be able to buy a black and white television.

PAUL SOLMAN: Because my benefit would go up to the same amount that the black and white television was going up in cost?

ALICIA MUNNELL: Right. And so now in 2005, when you retired you would be able to buy a black and white television. And you might say, “But I’m used to a color television.” And I’d say, “That’s too bad, we’re doing price indexing.”

PAUL SOLMAN: So price indexing uses purchasing power as a metric, letting people buy the same stuff year after year. Wage indexing, by contrast, is based on the standard of living, a standard that rises as the economy grows and Americans on average get richer.

STUDENT: What was the purpose for utilizing wage indexing initially, and not price indexing?

ALICIA MUNNELL: The notion was that you would like people in retirement to be able to live at kind of the same standard of living that they had before retirement. But Social Security was never intended to do the whole job. It was only intended to provide a base.

And so the compromise was that it would give the average person roughly 40 percent of how much they earned before retirement. And to keep that 40 percent constant, for Paul, for me and then for you guys, you have to do this wage indexing.

PAUL SOLMAN: Because otherwise as the work force gets richer, makes more money, you are falling further and further behind the average worker because prices are going up slower than wages are going up.

ALICIA MUNNELL: That’s right. That’s right.

ALLEN ARBEAU: If we don’t switch, what’s going to happen?

PAUL SOLMAN: Well, benefits will keep rising, surpassing the amount of payroll taxes coming into the system by, according to current official estimates, 2018; exhausting the so-called Social Security trust fund by 2042.

At that point revenues could fund something like 70 percent of promised benefits. So absent new taxes, or more borrowing or any other changes, our third worker, Allen Arbeau here, would see his benefits plunge from about $20,000 a year to $14,000. But switching from wages to prices would pretty much close the funding gap.

ALICIA MUNNELL: If we shift how benefits are calculated, then we’re not going to see this pattern of the average worker in each generation getting a benefit equal to 40 percent of earnings before retirement.

It’s going to go down continuously. Benefits in the future, as a percent of earnings before retirement, are going to become minuscule.

PAUL SOLMAN: Well, minuscule in some distant future. But in fact, under price indexing the average full retirement benefit would remain fixed at the equivalent of about $15,000 a year in today’s money, once you adjust for inflation because that’s what price indexing is.

But $15,000 would be an ever-smaller percentage of average U.S. wages, because they rise faster than inflation. So you’ll be making a lot less from Social Security relative to your past income and relative to what other workers who are still working at that point are making. That’s the difference. Do you like it?

STUDENT: No, actually, I want more.

PAUL SOLMAN: Sure you want more. We all want more.

STUDENT: Well, I deserve more, I should say.

PAUL SOLMAN: So you don’t want to have your current benefits cut?

STUDENT: No cuts.

PAUL SOLMAN: But are you willing to pay taxes so that there will be enough money in the system to pay you when you retire?

STUDENT: I think the taxes are pushing it.

ALICIA MUNNELL: I think that probably would be very useful to clarify that it’s not coming from heaven; that it’s coming out of your paycheck.

PAUL SOLMAN: But a tax increase was not on the table here. A vote on changing the benefit formula was.

How many people, after having heard what you’ve heard so far, would be in favor of switching the formula from wage indexing to price indexing? One. How many people opposed to the change? The class was overwhelmingly opposed, except Allen Arbeau.

ALLEN ARBEAU: But what you’re offering me is an option out. And that’s simply why I would vote to change. I’d like something long term, so that in the future, one, the problem gets solved, two, we don’t have the same problem again.

PAUL SOLMAN: And that’s the whole point of this exercise, solving the Social Security problem now because the most famous cliché in economics is actually true: There is no free lunch– which begs the question, who is going to pay for it?