Monday, July 12, 2010

Social Security Reform: The Power of Compounding

In today's Wall Street Journal, Fred Barnes writes about a proposal by Robert Pozen, former vice chairman of Fidelity Investments. For several years now, Robert Pozen, a Democrat, has offered a bipartisan approach for restoring Social Security to long term solvency. His proposal calls for using the historical inflation rate, rather than wage growth data, to index earnings as part of the calculation of Social Security benefits. He would exempt lower income individuals from this shift, and instead, continue to use wage indexing for them. That's why Pozen calls it "progressive indexing."

How does indexing work? Indexing occurs as Social Security takes your earnings from each year of your life, and then converts them into "current dollars" for the year of your retirement. Then, they use this average earnings in current dollars number as the basis of their benefit calculation.

Historically, wages risen over 1 percent faster per year than prices. Thus, shifting to wage indexing would shave benefits. Your average earnings in current dollars is significantly lower if we gross up your wages by 1% less per year. Barnes explains that this subtle change would "erase more than two-thirds of Social Security's long-term shortfall of $4 trillion."

At first, I was shocked by that claim. Yet, I then spent some time thinking about how that 1% slower growth per year in the indexing calculation might affect benefits. Of course, the power of compounding turns out to be enormous. We all know this, of course, but until you actually run the numbers, you often do not realize how great an impact compounding can have. Over a 35 year career, if we index each year's earnings at a 1% less growth rate per year, we end up with quite a different number for average earnings in current dollars. It's substantially lower, and thus, benefits are significantly lower as well.

Overall, Pozen's proposal seems like a sensible reform that could help put Social Security on much more stable footing, all without raising taxes at a time when the economy cannot tolerate an added distortion in the labor market. Let's see if the deficit commission moves forward with a recommendation to embrace this idea.