Lee (WSJ) column 11/25/04

Sunday, November 28, 2004

Prepared to spend the next many months reading about reforming Social Security? Of course not. And you don't have to. Just read the next 975 words of this column and you will know all you need to know. In fact, you will be able to fix Social Security yourself in the time it takes to recite this sentence: "Drop the wage indexing formula." As anybody who has been breathing during the last decade knows, Social Security is heading for disaster. Boomers are going to start retiring, and paying for their benefits will slurp up all the payroll taxes coming into the system. And then what? Do we have to raise taxes? Borrow hundreds of billions of dollars? Slash benefits? None of the above.

Consider how Social Security benefits are computed. The initial benefit -- a person's monthly amount when she or he begins getting checks -- is indexed to real wage growth; after the initial benefit is established, future benefits are adjusted every year by the consumer price index.

If you drill down, here is what it looks like: All benefits are based on something called the primary insurance amount. This amount, in turn, is based on a worker's earnings, indexed to the growth in average real wages, for the highest 35 years of earnings. The total of these 35 years of wages are then divided by 420 months to produce the worker's average indexed monthly earnings (AIME). The primary insurance amount is then derived by a formula that includes the AIME and calculated using something called bend points that are also indexed to average real wages.

The calculation of the AIME is key. Earnings before age 60 are indexed to real growth in wages -- an adjustment that brings nominal wages close to current wage levels. (Earnings after age 59 enter into computations at actual levels, adjusted by the consumer price index.) So every retiring worker gets to take advantage of overall economic productivity, pushing up the level of wages during the time in which the work was performed. This adjustment allows the purchasing power of benefits to grow over time.

Simply put, it's the real wage growth component that is at the heart of Social Security's problem. The wage index functions like a little pituitary gland because rising productivity causes wages to grow faster than prices. So benefits keep getting larger for each cohort of retiring workers.

Thus, two workers who earn identical amounts -- and pay identical taxes -- will get different benefits if they are so much as five years apart in age. The younger worker will get more than the older worker just because of wage indexing. As economist John Cogan at the Hoover Institution points out, the purchasing power of benefits paid to today's teenager are scheduled to be 60 percent higher than benefits paid to a typical worker who retired in 2001.

Obviously, wage indexing is not financially sustainable. If benefits were indexed to prices however, Social Security would, at this very minute, be in balance over the long-term -- the system would be permanently solvent. Not only would future revenues equal future costs, but there would be a surplus! Indexing for price changes alone would protect retirees, new and not-so-new, from inflation, thereby maintaining purchasing power. Moreover, other proposed fixes -- such as raising the retirement age, changing the COLA, or increasing taxes on benefits -- are not as powerful, so a combination of several of them would have to be implemented. This is politically tricky since each fix would make one of the various constituents angry; blue-collar workers and minorities, for example, would be intensely unhappy if the retirement age were increased.

But solving Social Security's long-term financial crisis is not the same as solving its spiritual problem. Why, at the dawn of the 21st century, are workers forced into a government retirement program that will, very soon, deliver unto them a rate of return that is barely visible? And that's why the creation of personal accounts as part of Social Security reform is just as important as averting its bankruptcy. Rather than being a transfer payment filched from some young person's paycheck, such accounts generate returns on investments. And not only will personal accounts allow participants to earn a market rate of return on their savings, those savings will be real assets and not just a promise from the government.

Social Security benefits are not guaranteed. Just like all entitlement programs, they can -- and have been -- changed by Congress. The Social Security administration itself says so and so did the Supreme Court when it ruled, in Flemming v. Nestor, that workers and retirees have no legal claim to benefits. Regardless of how much in taxes they have paid into the system.

But here, too, a solution is at hand. Look no further than Plan Two offered by the President's Commission to Strengthen Social Security, in 2001. This plan would allow workers to divert 4 percent of their payroll taxes, up to $1000, to personal accounts. Workers who decide to open personal accounts would forgo a portion of their traditional Social Security benefit -- depending on the amount of payroll taxes they diverted.

That offset however does not get the system to solvency. For that, Plan Two changes the way benefits are allowed to grow. How? You guessed it, by replacing the computation of benefits via wage indexing to a policy under which initial benefits would grow from one cohort to the next at the rate of price increases. Thus, workers with identical real wages would receive the same real benefit, regardless of age difference.

True, the proposed switch to price indexing would reduce benefits relative to what the current law promises (and would require a 50 percent increase in payroll taxes to finance). But keeping benefits constant in real terms is not the same as cutting benefits. A reduction in an increase is not a cut and real benefits would be just as generous tomorrow as they are today.

So there you are. No need to puzzle over reforming Social Security. Plan Two deftly solves the system's financial crisis and gives current workers a property right to the returns on the taxes they pay toward retirement. Plus, I should mention, Plan Two suggests that the extra money gained from dropping the wage index be used to increase benefits for low-wage workers and widows of low-wage workers -- a better safety net for the few who really need it. That comes pretty close to having one's cake and eating it, too.

Susan Lee is a member of The Wall Street Journal's editorial board.

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