Have you heard about the ideas for changing the indexing of Social Security? Does this sound like something only economists and accountants could get excited about? Well, beware, because the proposals to change the way Social Security payments are indexed could be the most significant element in the debate over the 70-year-old retirement program; indeed, much more important than the clash over personal accounts.
First, what in the world is indexing? Indexing addresses a common problem in economics—how to compare dollars in different years. The problem arises because dollars usually decline in their purchasing power over time. Because of the trend of rising prices from year to year—that is, inflation—a dollar this year buys less than a dollar did 10 years ago, and it’s likely a dollar 10 years in the future will purchase less than a dollar today. So it is incorrect, financially speaking, to compare dollar amounts in different years unless an adjustment is made, and this adjustment is called indexing.
Indexing actually works in a simple way. Some “index” is chosen that reflects how the value of dollars changes over time. This index is applied to past dollars in order to make them comparable to today’s dollars. So, for example, if the index value for some past year happened to be two, then this means a dollar in that past year really had the same purchasing power as two dollars today.
There are two places in Social Security where indexing is used. One is once a person is already receiving Social Security. Here, future payments received by the person are indexed to account for price increases that have occurred. This means, for instance, that a person receiving $1,000 a month this year would receive $1,030 monthly next year if the inflation rate for this year turns out to be 3 percent. The index used to make this adjustment is the widely quoted Consumer Price Index.
There are no proposals to change this indexing. Instead, the suggestions for change come in the second way that indexing is used in Social Security. This comes in the way a person’s first Social Security payment is calculated.
Here’s the arithmetic on the first payment. The history of the person’s wage earnings is laid out. Since past dollars have a higher purchasing power than current dollars, past dollars are indexed, meaning they are increased, in order to make them comparable to the purchasing power of today’s dollars. Once a person’s past wage incomes are expressed in the purchasing power of today’s dollars, an annual average is calculated, and this average is used to determine the individual’s initial Social Security payment.
Stay with me! The index used to adjust those past dollars in the figuring of a person’s first Social Security payment is a wage index, not a price index. The proposal floating around Washington is to drop the wage index and use a price index for many retirees.
So what, you might be thinking, what difference does this make? It makes a lot of difference because wages typically increase faster than prices. In the last 10 years, wage rates increased 39 percent compared to a 27 percent increase for prices. So a shift from wage indexing to price indexing would reduce a person’s initial Social Security payment, and since future payments are based from that initial payment, all future payments would also be smaller. Some analysts estimate this one change would eliminate more than two-thirds of Social Security’s projected financial shortfall.
Also, there are proposals to introduce the indexing on a sliding scale with income. Lower-income households would still use wage indexing, but the change to price indexing would gradually occur as income of the Social Security recipient rose.
Nevertheless, many Social Security recipients would receive less under price indexing than with wage indexing. But supporters of the change say this is not a cut if the alternative is a bankrupt Social Security system.
Michael L. Walden is a William Neal Reynolds distinguished professor in the Department of Agricultural and Resource Economics at North Carolina State University.