Skip Navigation

Long-Term Budgetary Pressures and Policy Options May 1998

In 2008, the oldest members of the baby-boom generation will turn 62 and become eligible for early retirement benefits under Social Security. For about two decades thereafter, spending on Social Security benefits will rise steeply as workers born between 1946 and 1964 begin to collect benefits. Meanwhile, the growth of the labor force will slow significantly as the baby boomers retire. As a result of that demographic shift, the number of Social Security beneficiaries will be increasing much more rapidly than the number of workers paying Social Security taxes.

Last year, the federal government spent almost $400 billion to provide Social Security benefits to 44 million retired or disabled workers, their dependents, and survivors. The Social Security program's trustees project that in 2030, under the current benefit structure, total spending (in 1997 dollars) will more than double to over $800 billion for 82 million beneficiaries. But the trustees also anticipate that the Social Security trust funds will be depleted in 2029, in the absence of legislative change. By 2030, revenues earmarked for the Social Security program will be sufficient to pay only three-quarters of the program's projected costs.⁽¹⁾

Both the Congress and the Administration are interested in addressing that shortfall well before the baby boomers begin drawing benefits. Last year, both budget committees, the Senate Finance Committee, and the House Ways and Means Committee held hearings on the problems facing the Social Security system, and several Members introduced bills to scale back and restructure the program. In this year's State of the Union address, the President called for a national debate on Social Security throughout 1998, to be followed by negotiations with the Congressional leadership over Social Security reform in early 1999.

Policymakers are also considering pairing a reduction in the Social Security program with the establishment of mandatory individual investment accounts owned and directed by the workers themselves. Such proposals, often referred to as "privatization," would give those workers control over how their money is invested. Although establishing mandatory accounts would not resolve the projected shortfall between revenues earmarked for Social Security and program costs, they would provide an alternate source of income for former workers and their families if Social Security benefits were scaled back, and they could promote national saving. Specific issues raised by those privatization proposals, and discussed below, include their design as well as their potential effect on the economy and on the income of workers and their families after workers retire, become disabled, or die.

Slowing the growth in spending for Social Security would be one way of resolving its projected shortfall, as well as a way to increase national saving. Three broad approaches for doing so have received considerable attention. First, policymakers could alter the formula used to calculate benefits for newly eligible Social Security beneficiaries to reduce their initial benefits. Second, they could increase the normal retirement age--the age at which workers become eligible for full benefits. Third, they could reduce the cost-of-living adjustments beneficiaries receive. Further, they might combine any of those approaches with privatization plans that would require workers to contribute to mandatory individual investment accounts. Specific options to illustrate both the strengths and weaknesses of the major approaches are presented below, along with estimates of the savings that would result from implementing those options.

If policymakers decide to cut Social Security benefits, equity and efficiency argue for announcing those changes long before they would take effect. People view entitlement programs for the elderly and the disabled as long-term commitments between the government and the citizenry, and they have based their behavior on current provisions. Deciding soon on any future changes in such programs and making gradual changes in spending and tax policy would give people more time to plan and adjust.

The Congress set a precedent when it amended the Social Security system in 1983. When policymakers raised the age at which full retired-worker benefits begin, the first workers affected by that change were then only 45 years old. By announcing the change so far in advance, the government gave them the opportunity to take that new policy into account when planning for retirement.
 

Background

Social Security is, by far, the federal government's largest income redistribution program, playing a critical role in supporting the standard of living of its beneficiaries. In 1996, the elderly (those 65 and over) received about 40 percent of their cash income from Social Security. Reliance on Social Security was especially high among those elderly whose cash income was relatively low. Families with at least one member collecting Social Security benefits and who were in the lowest income quintile of elderly families received almost 90 percent of their income from Social Security, compared with only 25 percent for those in the highest income quintile.

Most of the discussion in this chapter focuses on Old-Age and Survivors Insurance (OASI), the part of the Social Security system that provides benefits to retired workers, members of their families, and their survivors. The other part, Disability Insurance (DI), funds disabled workers younger than the normal retirement age and their dependents. OASI is by far the larger program: last year it accounted for almost 90 percent of spending for the two combined (referred to as OASDI). Benefits for both parts are financed primarily from payroll taxes paid by workers and employers on earnings covered by the OASDI program. The combined tax rate for 1998 is 12.4 percent of covered earnings--up to $68,400 annually.

Social Security Trust Funds

Revenues received from Social Security payroll taxes and part of the revenues collected by the Treasury from taxing certain Social Security benefits are deposited in trust funds for the OASI and DI programs. (The remaining revenues from taxing benefits go into Medicare's Hospital Insurance Trust Fund.) Social Security benefits, administrative expenses, and other authorized expenditures are paid from the OASI and DI funds.

Those trust funds function primarily as accounting mechanisms to track receipts and spending and to monitor whether enough revenue from the designated sources is being raised to pay for benefits projected under current law. At the end of fiscal year 1997, the funds held more than $600 billion in assets, most of which was invested in special interest-bearing federal securities. The two trust funds are currently running a combined surplus of about $100 billion a year. By 2008, the annual Social Security surplus will approach $200 billion. Those surpluses will start to shrink rapidly, however, when the baby boomers begin to retire. According to the intermediate projections used by the funds' trustees in their 1997 report, the funds will be exhausted in 2029. In their 1998 report, the trustees changed that date to 2032, largely because of better actual and expected economic performance.

The trustees also conclude that the funds will not be in close actuarial balance over the next 75 years. They express the size of the long-term imbalance by estimating the size of the increase in the payroll tax rate that would be needed to bring the funds into balance. That measure--2.2 percent of taxable payroll--is conceptually similar to the measure of the fiscal gap in the federal budget used in the previous chapter, except that it is expressed as a percentage of taxable payroll rather than of GDP. If the payroll tax was raised 2.2 percent, the additional revenue would build up a larger surplus in the trust funds that would be sufficient to pay projected benefits at least through the end of the 75-year projection period. Likewise, if the larger surpluses were not offset by larger deficits in the rest of the federal budget, they would contribute to an increase in national savings.

Program History

The history of Social Security from its enactment in 1935 until the mid-1970s was largely one of program expansion. Payroll tax rates and the base on which those taxes were levied increased as needed to keep up with the legislated increases in eligibility and benefit levels. The 1939 amendments broadened eligibility to include spouses and survivors. Disabled workers were added in 1956. Substantial increases in benefit levels were enacted in 1950 and 1972 and smaller increases in several other years. The 1972 legislation also introduced automatic cost-of-living adjustments (COLAs). The program was initially financed with a tax rate of 2 percent of the first $3,000 of annual earnings (split equally between the employer and the employee). By 1974, the tax rate had increased to nearly 10 percent of the first $13,200 of earnings.

In contrast, since the mid-1970s, policymakers have had to deal with various short-term and long-term financial problems faced by the program. The Social Security Amendments of 1983 contained some of the most significant changes.⁽²⁾ Those changes were in response to projections that the trust funds would not have enough money to continue paying current Social Security beneficiaries the amounts due that year and that the program faced a large, long-range deficit as well. Social Security outlays were reduced in the short run primarily by delaying a scheduled COLA for six months. The biggest reduction in long-run costs came from gradually raising the age at which retired workers could receive full benefits from 65 to 67. Lawmakers raised Social Security revenues largely by moving up the effective dates for the already scheduled increases in the payroll tax, introducing the income taxation of Social Security benefits, and covering new federal employees and all employees of nonprofit organizations.⁽³⁾
 

Major Issues

U.S. workers have come to expect that when they retire or become disabled, Social Security will provide them with income that will replace a significant portion of their previous earnings. They also expect that Social Security benefits will be available for their survivors. The Congress will need to decide what the Social Security system should attempt to accomplish and what legislative changes will be needed to ensure that the system achieves those goals for the retirement of the baby boomers.

The current design of the Social Security system represents a trade-off between ensuring an adequate level of benefits to even the poorest beneficiaries and equitably distributing benefits so that workers who have paid more taxes for Social Security receive more in benefits. The progressive benefit structure reflects those dual goals. Retired workers with a history of low wages receive benefits that replace a higher percentage of their preretirement earnings than do other retired workers. Nonetheless, workers who earned higher wages receive higher benefits.

Policymakers will need to consider the potential effect on people's incentive to work and save when redesigning the Social Security system. For example, lower benefits for retired workers could encourage them to remain in the labor force longer, particularly if the age of earliest eligibility was raised. Reductions in benefits could also encourage workers to save more.⁽⁴⁾ If a change in the design of the system resulted in more work effort or more saving (whether by the government or by the private sector), the nation's total income would rise. Such a change would improve the nation's ability to cope with the aging of the U.S. population.

The 1994-1996 Advisory Council on Social Security, appointed by the Secretary of Health and Human Services, struggled with the issue of how to improve the long-range financial status of the Social Security program and failed to reach a consensus. Part of the reason for disagreement was that members held divergent views about the role Social Security should play in the future.⁽⁵⁾

Much of the debate within the council reflected members' differing views about the extent to which the government should be responsible for the well-being of workers and their families once they have retired or become disabled. At least two competing views emerged. One envisioned keeping the Social Security benefit structure essentially as it is, continuing to provide the largest component of many retirees' income. The other proposed a smaller public system for future workers in combination with alternate sources of retirement income, such as private pensions, individual retirement accounts, and other savings.⁽⁶⁾

Many backers of a smaller public system would pair a reduction in the Social Security program with the establishment of mandatory individual investment accounts owned and directed by the workers themselves. Two of the three competing plans offered by members of the council include that feature (see Box 3-1).
 

"Privatizing" Social Security

Most privatization plans contain at least four elements:

• Reducing Social Security benefits below the amounts specified under current law;
  
  
• Requiring (or at least giving a strong financial incentive to) workers to put a certain percentage of their earnings into individual investment accounts;
  
  
• Allowing workers to decide for themselves how their accounts are invested; and
  
  
• Prohibiting withdrawal of money from those accounts until the worker reaches a certain age.

Although the Congress could require workers to establish individual investment accounts without reducing Social Security benefits, the policy proposals are invariably linked. Privatization plans would reduce the long-term imbalance between revenues earmarked for the Social Security program and the program's projected costs to the extent that the plans either cut benefits or raised revenues. The individual investment accounts themselves would not directly affect Social Security. They could, however, help offset the loss in income to retired workers and their families that would result from reductions in Social Security benefits. The magnitude of those reductions and how they would be achieved differ from plan to plan.

Privatization proposals raise a number of issues concerning their potential consequences for the economy and for the income of workers and their families after the workers retire, become disabled, or die. Proponents of plans to replace all or part of future Social Security benefits with income from mandatory defined contributions contend that doing so would increase national income and enable workers to receive much higher returns on their investments than they could get by putting their money into the Social Security system. Opponents argue that those claims are exaggerated and that even partial privatization could subject workers, particularly low-wage workers, to unnecessary risks. The validity of each side's argument depends on the details of the specific proposal under consideration.

Designing a Privatization Plan

There are two basic approaches to privatization. One approach, illustrated by the individual accounts (IA) plan discussed in Box 3-1, adds a new mandatory payroll contribution to the existing Social Security payroll tax to fund workers' investment accounts. At the same time, that approach eliminates the projected long-term imbalance between Social Security costs and revenues through the types of benefit reductions described below.

The other approach, illustrated by the personal security accounts (PSA) plan, diverts some of the existing payroll tax into individual investment accounts, requiring larger reductions in Social Security benefits to eliminate the projected long-term imbalance. As with the first approach, those mandatory investment accounts would supplement the remaining Social Security program.

Under either approach, the designers of a privatization plan need to specify, among other things, the options workers would have for investing their money. Would workers be given a menu of investment options from which to choose, or would they be free to find their own opportunities? For example, the IA plan would offer workers a limited range of investment options akin to those offered federal employees who participate in the government's Thrift Savings Plan. The PSA plan would permit a much wider range of options, akin to those available to workers who hold individual retirement accounts.

Similarly, the designers need to specify the conditions under which the funds in the investment accounts could be withdrawn. For example, would there be any circumstances under which withdrawals would be permitted before age 62? Could workers withdraw their accounts as lump sums, or would they be required to annuitize them? What provision would be made for workers' spouses? The answers to those and other design questions are important for the assessment of a proposal's potential impact on the economy and on workers and their families.

But a major "transition problem" looms for any proposal that would divert some of the existing payroll tax into individual accounts. The Social Security system operates mostly on a pay-as-you-go basis in which current payroll taxes pay for current benefits. The transition problem occurs when any diversion of taxes into individual accounts reduces the funds available to pay people already receiving Social Security benefits or the future benefits of workers who are currently contributing to the system. Either the commitments made to current beneficiaries and to workers who have already paid into the system would need to be scaled back, or some workers would need to pay both for their own retirement and for current beneficiaries.

Potential Effects

Supporters claim that privatization would lead to higher national income because of an associated rise in the rate of national saving. Increased saving would result in more investment, which in turn would enable the economy to grow at a faster pace.

Whether national saving would increase as a result of privatization depends on the specific elements of the plan and on how people respond to it. Changes in national saving could stem from changes in saving by the government sector, by the private sector, or both. If a proposed change reduced the growth in Social Security benefits, government saving would increase unless it was offset by greater tax reductions or by added spending for other programs.

The potential effects of a privatization proposal on saving by the private sector depend on the reaction of workers to the changes in Social Security and to the mandate imposed. With or without the introduction of mandatory investment accounts, prudent workers will save more if their future Social Security benefits are cut. A key question for privatization is whether the requirement to set aside a certain percentage of their earnings would induce more workers to save additional amounts. Preliminary analysis of the IA and PSA plans indicates that both proposals would result in additional national saving, but the magnitude of that saving is difficult to predict.

How workers will fare in retirement under a privatization plan also depends on the details of the plan and is even more difficult to predict. The current Social Security system provides inflation-indexed defined benefits for retired workers and their families, guaranteed by the federal government. In effect, the financial risks associated with making good on those commitments are borne collectively by future workers.

A likely outcome of privatization would be increased uncertainty and variation in retirement income. That uncertainty results from not being able to predict how workers would allocate their investment portfolio or what return they would get on each portion of their portfolio. On average, the rate of return to individual accounts would most likely exceed the rate of return from Social Security. But through bad luck or poor judgment, some workers would do much worse than average; others would do much better.

Also, the current Social Security system includes a complicated benefit structure that favors workers with low earnings over workers with high earnings, whereas a system in which benefits were based purely on the proceeds from investments would not. Proposals such as the IA and PSA plans preserve the redistributive aspect of the current system by reducing the growth in Social Security benefits for workers with high earnings by much more than for those with low earnings. But other features of the current system--such as the protection afforded workers who become disabled before they have the opportunity to build up substantial individual investment accounts--would be more difficult to preserve.
 

Approaches and Illustrative Options for Slowing the Growth in Social Security

To reduce the projected growth in spending for Social Security, legislation needs to curtail commitments made under current law. All of the approaches examined below have been proposed in recent years. The specific options were selected to illustrate both the strengths and weaknesses of those approaches as well as trade-offs the Congress would face in designing a specific policy. The saving estimates, provided by the Social Security Administration's Office of the Actuary, are intended to indicate relative magnitudes of change. They are based on the intermediate economic and demographic assumptions used in the 1997 annual report of the trustees.

Reduce Initial Benefits

The most straightforward method of reducing the growth in Social Security spending is to lower the rates at which benefits replace preretirement earnings. The immediate effect of that approach would be to reduce benefits going to newly eligible beneficiaries. The full savings of a specified reduction would not be achieved until all of the beneficiaries whose initial benefit had been determined under the previous formula were no longer receiving benefits.

Current law bases the benefits of retired (and disabled) workers on their past earnings, expressed as an average level of earnings over their working lifetime--their average indexed monthly earnings (AIME). From that average, a formula calculates a worker's primary insurance amount (PIA). The Social Security Administration then adjusts the PIA for a number of factors, such as reductions for early retirement, credits for later retirement, and increases for inflation.

The Social Security Administration bases a worker's AIME on wages in covered employment (up to the taxable maximum), with some adjustments. Earnings on which retired workers and their employers paid Social Security taxes are indexed to compensate for past inflation and real wage growth. To convert the AIME to the PIA, the Social Security Administration applies a progressive formula in which the PIA replaces a larger proportion of preretirement earnings for people with low average earnings than for those with higher earnings.

The following formula is used for workers who reached 62 in 1997: PIA equals 90 percent of the first $455 of the AIME, plus 32 percent of the AIME between $455 and $2,741, plus 15 percent of the AIME over $2,741 (see Figure 3-1). Those thresholds at which the percentage of the AIME is replaced by the PIA, known as "bend points," are indexed to average annual earnings for the labor force as a whole. Consequently, as wages rise over time, average replacement rates remain constant.
 

Figure 3-1. Primary Insurance Amounts in Relation to Average Indexed Monthly Earnings Under Current Law for Workers Who Turned 62 in 1997

SOURCE: Congressional Budget Office.

NOTE: For workers in this cohort who retired at 65 (in 2000), the primary insurance amount would be based on the formula illustrated in this figure, with the amounts increased by the cost-of-living adjustments effective in 1997, 1998, and 1999.

In general, workers receive 100 percent of their own PIA in benefits if they first receive benefits at the normal retirement age, currently 65, and less if they retire earlier. For example, a worker who retires at 62 receives a permanent 20 percent reduction. The size of that reduction is intended to be actuarially fair: the present value of the reduced monthly benefits that average workers could expect at 62 is similar to the present value of the full monthly benefits they could expect by delaying initial benefits until the normal retirement age. Similarly, workers who delay collecting benefits beyond their normal retirement age receive a delayed retirement credit to compensate them for the reduction in the length of time that they will receive benefits, although that credit will not reach its actuarially fair level of 8 percent a year for another decade.⁽⁷⁾

Workers who had average earnings throughout their career and retired at 65 in 1997 were eligible for an annual retired-worker benefit of about $11,200, which replaced 44 percent of their previous annual earnings. Because the benefit structure is progressive, the replacement rate is inversely related to past earnings. For example, workers who earned 45 percent of average earnings each year would receive about $6,800, replacing about 59 percent of their past earnings. Workers who always earned the maximum taxable amount ($65,400 in 1997) would receive about $16,000, replacing about 25 percent of their past covered earnings.

Under current law, workers with average earnings who retire at 65 after the turn of the century will be eligible for higher (inflation-adjusted) benefits than those paid to today's average earner, but those benefits will replace a smaller percentage of their past earnings. For example, the Social Security Administration projects that workers with average earnings who retire in 2030 will receive about $12,300 a year (in 1997 dollars) which will replace 37 percent of their earnings during the preceding year.⁽⁸⁾ Although that replacement rate is well below the average in recent years, it is similar to the percentage of earnings that was replaced for workers who retired at 65 in the late 1960s.⁽⁹⁾

The scheduled increase in the normal retirement age, which becomes 67 for workers born in 1960 or later, will produce most of the projected decline in the replacement rate. Thus, workers who retire in 2030 at 65 will receive a permanent reduction in their benefits of about 13 percent because of the actuarial reduction for early retirement. If they wait until 67 to retire, their replacement rate will be 42 percent, not far below the current rate for workers retiring at 65.

The major advantage of using an across-the-board reduction in replacement rates to achieve savings is that it would otherwise preserve the existing benefit structure. If policymakers announced the change in the formula far in advance of the date it would take effect, workers could try to adjust their retirement and saving plans accordingly. The major disadvantage of that approach is that some people, such as workers who become disabled and eligible for DI, would not be able to change their behavior and would therefore receive lower benefits than they would have under current law.

By way of illustration, consider a specific option, starting in 1998 and ending in 2032, that would reduce by 0.5 percent a year the benefits of each successive cohort of workers who became eligible for Social Security's disability or retired-worker benefits. Under that option, workers becoming eligible in 2010 would receive about 94 percent of their benefits under current law, and those becoming eligible in 2032 and thereafter would receive about 84 percent. Workers who had average earnings, became eligible for benefits in 2030, and retired at 65 would receive annual benefits of roughly $10,700 (in 1997 dollars)--about $500 below the amount that similar workers retiring at 65 received in 1997.

Any savings realized in a specific year would depend on the composition of beneficiaries by year of eligibility. The Social Security actuaries estimate that this option would achieve a 10 percent reduction in 2030 and, ultimately, a 16 percent reduction in Social Security expenditures, once all beneficiaries were subject to the full reduction in replacement rates. The Social Security system could realize larger savings, of course, if the replacement rates of newly eligible beneficiaries were reduced further after 2032.

A variation of that option (included in one of three sets of options presented by the advisory council) would cut the replacement rates in only the second and third brackets of the benefit formula. That is, beneficiaries would continue to receive 90 percent of their average earnings up to the first bend point. That variation, designed to shield workers with histories of relatively low earnings, would save less money unless larger reductions were made in the second and third brackets.

Raise the Retirement Age

Under current law, the age at which a worker becomes eligible for full retirement benefits (the normal retirement age, or NRA) is 65 and will gradually increase to 67. For workers born before 1938, the NRA is 65. The NRA increases in two-month increments for workers thereafter, reaching 66 for workers born in 1943. It remains at 66 for workers born from 1944 through 1954. It then begins to rise again, in two-month increments, reaching 67 for workers born in 1960 or later.

Members of Congress and others have recommended that the change to an NRA of 67 be accelerated and that the NRA be further increased thereafter. Proponents point out that people age 65 today live longer than was the case in the early days of the Social Security system, that life expectancy is projected to continue to increase, and that that otherwise favorable development will raise the cost of the program.⁽¹⁰⁾

Two specific options to raise the retirement age illustrate that approach (see Table 3-1). The first would speed up the transition to 67 and then further increase it to keep up with future increases in life expectancy. The NRA of workers born in 1949 would be 67. Thereafter, the NRA would increase by one month every two years, reflecting projected growth in the ratio of life expectancy at the NRA to potential work-years. For example, the NRA would be 68 for workers born in 1973 and 69 for workers born in 1997. Workers would still be able to begin receiving benefits at 62, but the amounts would be reduced accordingly.
 

The second option would also accelerate the transition to 67 but would continue increasing the NRA by two months a year until it reached 70 for workers born in 1967. Thereafter, it would raise the NRA from 70 by one month every other year. As with the first option, workers would still be able to begin receiving reduced benefits at 62.

Each option would produce substantial savings in relation to projected spending levels under current law. The first option would reduce outlays by about 3 percent in 2030 and 8 percent in 2070. The second option would reduce outlays by about 8 percent in 2030 and 18 percent in 2070.

For most purposes, such an approach to cutting the growth in benefits is equivalent to cutting replacement rates. To arrive at that equivalence, compare the reductions from PIAs that workers who begin receiving retired-worker benefits at age 65 would get under current law and under the two options. A worker retiring at 65 in 2038 would receive about 13 percent less in benefits under current law, 20 percent less under the first option, and more than 30 percent less under the second option than if he or she had waited until the normal retirement age.

However, benefits of workers who qualify for Disability Insurance would not be reduced under either of those options. Workers would have a somewhat stronger incentive to apply for DI benefits in order to receive higher monthly benefits. Under current law, for instance, workers retiring at 62 in 2011 would receive 75 percent of their PIA; yet if they qualified for DI benefits, they would receive 100 percent. Under both of the options for increasing the normal retirement age discussed above, workers retiring at 62 in 2011 would receive only 70 percent of their PIA but would still receive 100 percent if they qualified for DI benefits.

Finally, some proposals for increasing the normal retirement age would raise the earliest age of eligibility for retired-worker benefits as well. Currently, more than two-thirds of retired-worker beneficiaries choose to begin receiving benefits before 65. Increasing the earliest age of eligibility most likely would increase the size of the workforce as some workers delayed retirement, thereby adding to the nation's economic output. Moreover, those workers, once they retired, would have higher benefits because they would incur a smaller actuarial reduction or none at all. Opponents of raising the earliest age of eligibility argue that some of the workers who begin receiving benefits at 62 have little if any choice--for example, because the jobs they hold are especially physically demanding. Opponents also contend that many of those early retirees have no pensions or other sources of income.

Reduce the Cost-of-Living Adjustments

Each year, the Social Security Administration adjusts monthly benefits by the increase in the consumer price index (CPI). To give an example, the 2.1 percent cost-of-living adjustment effective for December 1997 was based on the increase in the CPI for urban wage earners and clerical workers between the third quarter of 1996 and the third quarter of 1997. The basic benefit amount is indexed by the increase in the CPI, beginning when a worker becomes eligible for Social Security benefits. For retired-worker benefits, indexing starts at 62.

Another way of reducing the growth in Social Security benefits is to reduce the automatic COLA. Some policymakers suggest that the law be changed to provide a COLA equal to the increase in the CPI minus a specified number of percentage points. To illustrate that approach, Social Security actuaries estimated the effect of determining the COLA based on the increase in the CPI less 1 percentage point for December 1998 and thereafter.⁽¹¹⁾ Doing so would reduce outlays by about 10 percent in 2030 and slightly more in future years.

Reducing the automatic COLA for Social Security benefits has been widely discussed as a way of achieving considerable savings. Many analysts feel that the CPI overstates increases in the cost of living, but they debate the magnitude of the overstatement and what should be done about it. In 1996, the Advisory Commission to Study the Consumer Price Index (known as the Boskin Commission) estimated the size of the upward bias to be about 1 percentage point a year.⁽¹²⁾ If that is the case, then Social Security beneficiaries have been receiving increases in benefits beyond what is necessary to keep up with inflation. But that estimate is not universally accepted. Furthermore, since the commission prepared its report, the Bureau of Labor Statistics has made changes in the way the CPI is calculated that address several of those concerns.

If the CPI overstates increases in the cost of living for beneficiaries, then policymakers could reduce the COLA by a commensurate amount without lowering real benefits to beneficiaries below what they received when they became eligible for the program. Compared with an equivalent across-the-board reduction in replacement rates (or an equivalent increase in the normal retirement age), the people whose benefits would be most affected by reducing COLAs would be the oldest beneficiaries and those who initially became eligible for Social Security on the basis of disability. Alternatively, lawmakers might choose to reduce the COLAs of only those beneficiaries whose benefits or incomes were above specified levels, but that would reduce the savings. (Some beneficiaries with low incomes and few assets would receive Supplemental Security Income (SSI) benefits, which would offset some or all of the reduction in their Social Security benefits; the increased spending for SSI would help those beneficiaries, but it would also directly reduce the budgetary savings from this option by a small amount.)

The impact of even a relatively small reduction in COLAs would be quite large for future older beneficiaries whose benefits would reflect the cumulative effects of a series of smaller COLAs. For example, if benefits were adjusted by 1 percentage point less than the increase in the CPI every year, retired workers (or their survivors) at 74 would incur an 11 percent reduction in benefits compared with what they would have received under current law; at 84 they would get a 19 percent reduction; and at 94 they would get a 27 percent reduction.

Whether or not the real value of the Social Security benefits received by older beneficiaries would then be below what it was when they first became eligible, their benefits would fall relative to those of new beneficiaries. That decline would occur because initial benefits would continue to be based on a formula in which past earnings are indexed to compensate for growth in nominal wages, which is the sum of inflation and real wage growth. Under current law, each new group of beneficiaries that begins receiving benefits at the normal retirement age receives a slightly higher average benefit than the group that became eligible the previous year, reflecting the increase in real wages. If policymakers reduced COLAs by 1 percentage point, the gap between consecutive age groups would widen accordingly.

Other Approaches

Carrying out any of the options presented above would eventually reduce the amount of Social Security benefits (in relation to current law) for the majority of beneficiaries. Other approaches that have received attention in recent years would achieve savings by reducing or eliminating benefits for specific groups of beneficiaries. To achieve comparable savings, policymakers would have to impose much deeper reductions on those beneficiaries. Combining several options affecting specific groups could produce more significant savings.

In some cases, the number of beneficiaries affected would be too small to have much impact on total spending, even if their benefits were eliminated. For example, lowering the benefit to spouses from one-half to one-third of the retired worker's PIA would reduce Social Security outlays by less than 2 percent because most spouses are eligible for retired-worker benefits themselves.

Another approach to reducing expenditures for Social Security (as well as for other programs) is to reduce or eliminate benefits going to people in middle- and upper-income families, although that could create a disincentive for families to save or to earn other income. In principle, Social Security benefits could be cut by any desired percentage by reducing benefits as beneficiaries' income rose, denying benefits to people with income above specified thresholds, or increasing the taxes on benefits. CBO examined specific options for doing so in a separate report.⁽¹³⁾ One option described in that report would pare Social Security and other entitlement benefits as the total family income of the beneficiaries rose above $40,000. That option, proposed by the Concord Coalition, would reduce projected spending for Social Security benefits by about 7 percent in 2002. Making Social Security benefits fully subject to the individual income tax would increase revenue by a similar amount.
 

Conclusions

Reducing the growth in spending for Social Security would require cutbacks in the commitments that have been made under current law. Phasing in a reduction in initial benefits, increasing the normal retirement age, or reducing future cost-of-living adjustments could each produce substantial savings while still preserving the basic benefit structure of the Social Security system. But each approach would leave beneficiaries, as a group, worse off than they would be if their benefits had not been cut. The last approach would leave initial benefits untouched but would have the largest effects on the benefits of very elderly beneficiaries and those who began receiving benefits at an early age because of disability.

Each of the options used to illustrate those approaches would slow the growth in Social Security spending. But not one, by itself, would be enough to prevent outlays for that program from becoming a significantly larger share of national income once the baby-boom generation retires. Specific options for phasing in a 16 percent across-the-board reduction in initial benefits, increasing the normal retirement age to 70 for workers born in 1967 (and later for subsequent cohorts), and reducing future COLAs by 1 percentage point would each cut projected spending in 2030 to about 6.0 percent of GDP, rather than the 6.6 percent projected under current law (see Figure 3-2).
 

Figure 3-2. Illustrative Options for Reducing Growth in Social Security Outlays

SOURCE: Congressional Budget Office based on estimates provided by the Social Security Administration, Office of the Actuary, March 3, 1998.

NOTES: These estimates are based on the intermediate assumptions used in the 1997 report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds. Data are plotted at five-year intervals.

CPI = consumer price index.

Moreover, each option would improve the long-term financial status of the Social Security system, although not one, by itself, would keep the Social Security trust funds solvent. The Social Security actuaries project that the 75-year imbalance in the combined OASDI trust funds would be reduced from about 2.2 percent of taxable payroll under current law to between 0.8 percent and 1.1 percent under each option, based on the intermediate assumptions used in the 1997 report of the program's trustees. Likewise, those options roll back by eight years the year in which the trust funds would run out of money under the option for phasing in an across-the-board reduction in initial benefits and by five years under the option for increasing the normal retirement age. The COLA option would extend the projected exhaustion date the longest--by 17 years--because it would achieve more savings in the early years. Two or more options could be used together, of course, to achieve larger savings and to restore the long-term solvency of the trust funds, but that would further reduce the income of beneficiaries.

Proposals to partially privatize Social Security raise a number of difficult issues that the Congress would need to address. The introduction of mandatory investment accounts would not reduce the growth in spending for Social Security, although it might help offset the income losses that retired workers and their families would otherwise incur from those options. It might also increase national saving by requiring some workers to save more than they otherwise would. Replacing part of Social Security with individual accounts would shift some financial risk, now borne collectively, onto the workers themselves, but at the same time it would offer workers the potential to substantially increase their income in retirement.

1. Board of Trustees, Federal Old-Age and Survivors and Disability Insurance Trust Funds, 1997 Annual Report (April 24, 1997), based on their intermediate assumptions regarding future economic and demographic trends. Their just-released 1998 Annual Report moves back the depletion date by three years but is otherwise similar to the 1997 report.

2. For more detailed information about the 1983 legislation, see John A. Svahn and Mary Ross, "Social Security Amendments of 1983: Legislative History and Summary of Provisions," Social Security Bulletin, vol. 46, no. 7 (July 1983), pp. 3-48.

3. Two previous laws that also significantly scaled back the growth of benefits are described in House Committee on Ways and Means, 1996 Green Book (November 4, 1996), pp. 80-83. The 1977 amendments changed the method by which initial benefits were calculated; payroll tax rates and the earnings base were increased as well. The Omnibus Budget Reconciliation Act of 1981 made further reductions in Social Security benefits, the largest of which was the elimination of family benefits for postsecondary students.

4. Much has been written about the effect of Social Security on labor supply and private saving, and on the extent to which changes in Social Security provisions might alter people's decisions about when to retire and how much to save. That literature is reviewed in Michael D. Hurd, "Research on the Elderly: Economic Status, Retirement, and Consumption Saving," Journal of Economic Literature, vol. 28 (June 1990), pp. 565-637. See also 1994-1996 Advisory Council on Social Security, "Report of the Technical Panel on Trends and Issues in Retirement Savings," Report of the 1994-1996 Advisory Council on Social Security, vol. 2 (January 1997).

5. Until recently, the Social Security Act required that an advisory council be established every four years to review the status of the Social Security and Medicare trust funds and their relationship to their long-term commitments. That requirement ended when the Social Security Administration became an independent agency.

6. For a fuller discussion of the council's separate views, as well as a comprehensive survey of options for reducing the actuarial imbalance in the Social Security system and the presentation of a framework for assessment, see Report of the 1994-1996 Advisory Council on Social Security, vols. 1 and 2 (January 1997).

7. Starting with beneficiaries born in 1943, each year delayed beyond the normal retirement age (which will be 66 for that cohort) will add 8 percent to their retired-worker benefits. The delayed retirement credit for workers reaching the normal retirement age in 1997 (65) is only 5 percent.

8. Board of Trustees, 1997 Annual Report, p. 186.

9. Robert J. Myers, Social Security, 4th ed. (Philadelphia: Pension Research Council and University of Pennsylvania Press, 1993), p. 363.

10. Board of Trustees, 1997 Annual Report. The intermediate assumptions in the report are that in 2030, men who reach 65 will live an additional 17.0 years and women an additional 20.4 years. In 1997, the life expectancy of men age 65 was 15.6 years and that of women was 19.2 years. In 1940, the life expectancies of men and women age 65 were only 11.9 years and 13.4 years, respectively.

11. As under current law, no COLA would be made in years in which there was no increase in the CPI. Any reductions in the modified index would be accumulated until a net increase was achieved in a future year.

12. Advisory Commission to Study the Consumer Price Index, Toward a More Accurate Measure of the Cost of Living, Final Report to the Senate Finance Committee (December 4, 1996).

13. Congressional Budget Office, Reducing the Deficit: Spending and Revenue Options (March 1997), pp. 288-291.

---