BPEA | Fall 2014

Seesaws and Social Security Benefits Indexing

A woman sits on a bench.


A middle-of-the-road reform for Social Security which indexes benefits, front-loads them for the shorter-lived elderly poor while back-loading pay-outs or “benefit enhancements” for those at advanced ages who have outlived their savings is a potentially powerful policy tool in terms of fiscal implications and has a possible role as a vehicle for redistribution.

While Social Security is often eyed by policymakers as potentially easier to reform compared to other entitlements, there are trade-offs — a see-saw — that needs to be taken into account, given the different life expectancies of the poor versus the wealthy, with a difficult choice between front-loading benefits to those short-lived elderly poor compared to those longer-lived who may have exhausted their benefits by the time they really need them, finds Associate Professor at Harvard Business School Matthew Weinzierl in “Seesaws and Social Security Benefits Indexing.”

Weinzierl looks at various proposals that have been discussed to reform Social Security, focusing on recent budget proposals by President Obama to include “indexing” of benefits, which was designed to reduce total spending by maintaining initial benefit levels but slowing their growth rate and used “benefit enhancements” at advanced ages to protect some of the effective annuitization that frontloading would otherwise have sacrificed. He finds that the progressive design of those benefit enhancements provides income protection largely to lower-income households, thus simultaneously achieving the positive effects of frontloading for the poorest, shortest-lived retirees and the positive effects of backloading on the poorest, longest-lived retirees, bringing substantial net welfare gains to these groups. On the other hand, he points out that that reform would generate losses as well, reducing the well-being of the higher-income half of the retiree population.

Retirees who rely on Social Security benefits to fund their consumption, either because their own resources are limited or they outlive their expected lifespan, are deeply impacted by any adjustments in the funding formulas contemplated by policymakers, he notes. For example, a 0.75% faster growth in benefits, as contemplated in some of the reform proposals, could result in a 25 percent increase in benefits if recipients outlive their private savings, whereas budget-neutral reform could mean a benefit cut of 10 percent at the start of retirement, when seniors are most sure to be alive to receive them.

The paper also examines new polling data generated from Amazon’s M-Turk interface conducted in August 2014 on the priorities Americans say they have for Social Security benefits. Respondents were asked to rank how much in benefits to pay out to different hypothetical retirees, and then asked to give their opinions on how policymakers should make choices. Participants, told there was found money to fund the changes, preferred to give a benefits increase to the oldest and poorest of the beneficiary choices.

Although the research shows that the backloaded benefits-indexing approach has substantial appeal because it can concentrate resources at later ages, when retirees face longevity risk and have exhausted their own resources, it could be politically impossible, he writes, because it would require a reduction in initial benefits to retain budget neutrality, or an increase in total spending on benefits to retain initial benefit levels – both highly unpopular. For this reason, Weinzierl notes the appeal of a “Hybrid Progressive Reform” with benefits-indexing that combines a shift to the chained CPI-U with benefit enhancements at advanced ages, such as President Obama’s 2014 budget proposal.

“Such a proposal captures the best parts of both of the simpler reforms — protecting both the poorest, shortest-lived retirees who would prefer frontloading and the large majority of retirees, especially those who live to advanced ages, who prefer backloading,” he concludes. “It is important to note that the President’s specific proposal combined this hybrid of frontloading and backloading with an increase in progressivity…and the potential disincentive effects from which this paper abstracts may therefore reduce this proposal’s appeal. Nevertheless, if those disincentive effects are limited and the normative preferences of Americans resemble those of either the conventional utilitarian criterion or those implied by the survey results in this paper, the Hybrid Progressive Reform is likely to generate–in terms of the direct effects on retirees–a sizeable net welfare gain.”