Dr. Mike Walden
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 - generally known as 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 you make an adjustment, and this adjustment is called indexing.
Indexing actually is very simple. Some index is chosen that reflects how the value of dollars changes over time and is applied to past dollars to make them comparable to today's dollars. So, for example, if the index value for some past year happened to be 2, then this means a dollar in that past year really had the same purchasing power as two dollars today.
With Indexing 101 under your belt, let's go back to Social Security. 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 a month 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, how person's very first Social Security payment is calculated.
Here's the arithmetic on that 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 - increased - 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 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? A lot, 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 on that initial payment, all future payments would also be smaller.
The benefit of this change is that it could go a long way toward increasing Social Security's solvency. Some analysts estimate this one change would eliminate more than two-thirds of the program's projected financial shortfall. Also, there are proposals to introduce 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 the Social Security recipient's income rose.
But the impact of the change in indexing is clear: Many future retirees would receive noticeably less from Social Security with price indexing than with wage indexing. So it could be interpreted as a benefit cut. On the other hand, supporters of the change say it's not a cut if the alternative is a bankrupt Social Security system!
You'll have to decide who's correct, but one thing is clear: any change
in how indexing is applied to Social Security is a big deal!
Dr. Mike Walden is a William Neal Reynolds Professor and extension