How Generous Are Social Security and Medicare?

Studies | Federal Spending | Health | Social Security

No. 290
Friday, October 27, 2006
by Andrew J. Rettenmaier & Thomas R. Saving


Wage Indexing versus Price Indexing

Table I - Social Security Benefits at the Normal Retirement Age as a Percentage of Workers' Preretirement Earnings

"Social Security replaces a higher percentage of wages for low-income workers than high-income workers."

When comparing the degree to which today's Social Security benefits replace the purchasing power of past earnings, it is important to use an appropriate method. The replacement rates given in the Trustees Reports are determined by comparing benefits at retirement to an individual's average annual lifetime earnings. Because of changes in price levels over time (inflation), past earnings must be adjusted so they are comparable to wages earned today. Ordinarily, this would be done by using a price index like the Consumer Price Index (CPI).4

However, the replacement rates presented in the Trustees Reports are determined by adjusting past earnings by means of a wage index. Since wages tend to rise more rapidly than prices over time (contributing to the growth in real incomes), wage indexing also produces higher average lifetime earnings than using a price index would.  

Figure I - Wage- and Price-Indexed Earnings for Retirees in 2006

"Wage indexing and price indexing of past earnings yields different results."

Effects of Price Indexing versus Wage Indexing. Figure I illustrates the effects of wage indexing and price indexing for average workers retiring this year.5 The same wages are used in each case, before accounting for inflation, but past wages are adjusted into today's dollars at retirement in two different ways: 1) wage-indexed to the Social Security average wage at age 65 and 2) price-indexed to the price level at age 65. As Figure I shows, the two methods produce different results:

  • Using wage indexing, Social Security replaces about 45.4 percent of preretirement earnings for the average worker.6
  • Using price indexing, by contrast, Social Security replaces 54.7 percent of preretirement consumption.

"Social Security replaces almost three-fourths of the real preretirement income of low-wage workers."

As these examples suggest, the way in which past earnings are compared to the Social Security benefits awarded to seniors at retirement makes a big difference in determining how much of lifetime earnings those benefits replace.

Table II presents the two alternative methods of calculating Social Security replacement rates for new retirees (workers born in 1941), but with four different levels of lifetime earnings (low, medium, high and earnings at the taxable maximum in each year). As suggested above, price indexing produces systematically higher replacement rates than wage indexing, and replacement rates fall as earnings rise due to Social Security's progressive benefit formula.

Table II - Social Security Replacement Rates for 65-Year-Old Retirees

"Health care — before and after retirement — is part of consumption."

Most important, price indexing shows Social Security replaces 73.3 percent of the average lifetime earnings of low-earning workers while wage indexing indicates a 61.3 percent replacement rate. The price-indexed replacement rate for high earners is 44.9 percent.7 These estimates suggest that Social Security benefits are more generous than commonly thought.


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