Demands by congressional Republicans to scale back the future cost of the Medicare and
Social Security programs nearly derailed the year-end fiscal cliff negotiations. In the end, congressional leaders and the White House postponed tough decisions on immediate budget cuts for two months and deferred discussions on larger issues, such as tax and entitlement reform, until an unnamed future date. But make no mistake, changes are coming.
One of the buzzwords kicked around during the lame-duck session negotiations—and during much of 2012 for that matter — was “chained CPI.” And no, it's not a reference to Quentin Tarantino's new movie. But the future debates could prove to be as gruesome as the film.
Measuring inflation
Currently, the federal government relies on the consumer price index (CPI) to index provisions of the budget and tax code to account for cost-of-living changes and maintain purchasing power for beneficiaries. There are several variations of the CPI.
The CPI-W, which is based on the typical purchases of a sample of wage and clerical workers — not retirees — is used to adjust Social Security benefits and other federal retirement programs. Why? It was the only inflation gauge in existence at the time Social Security was first indexed in 1972, notes former Congressional Budget Office (CB0) director Rudolph Penner in his 2010 Urban Institute paper “Adjusting Social Security Benefits for Changes in the Cost of Living”.
But economists of varying political stripes agree that the CPI-W overstates inflation because it doesn't account for the fact that when the price of one commodity increases substantially, consumers tend to substitute a less expensive alternative, such as swapping chicken for steak when beef prices rise.
An alternative benchmark
The Bureau of Labor Statistics has developed an alternative measure — the chained CPI — to account for the effects of economic substitution on changes in cost of living. Since 2000, the chained CPI has, on average, been 0.25% to 0.3% lower per year than the standard CPI measure. Though the difference is small, it compounds over time.
Instituting the chained CPI for Social Security cost-of-living adjustments would save $112 billion from 2012-2022, according to the CBO. Both the National Commission on Fiscal Responsibility, known as the Simpson-Bowles Commission, and the Bipartisan Policy Center's Debt Reduction Task Force, chaired by former GOP Senator Pete Domenici and founding CBO director Alice Rivlin, recommended switching to the chained CPI as a more accurate measure of inflation for indexed provisions in the federal budget.
Switching to the chained CPI for Social Security COLAs alone would close about 25% of Social Security's 75-year shortfall and would be a significant down payment on bringing that program into long-term balance, according the nonprofit New American Foundation's paper “Measuring Up: The Case for the Chained CPI”.
Differing opinions
While proponents of the switch to the chained CPI call it a “technical improvement”, the National Academy of Social Insurance (NASI), a longtime protector of national safety net programs, considers it a benefit cut.
NASI notes that existing CPI already undercompensates Social Security beneficiaries because it does not fully reflect their out-of-pocket health care expenses, which tend to be higher than those of younger Americans. “To shift to the chained CPI would appear to undercompensate them even further,” according to the NASI's fact sheet “Should Social Security's Cost-of-Living Adjustment Be Changed?”
That should give you a flavor of some of the competing viewpoints and stakeholders in the future debate on Social Security reform. It will be an enormously important discussion as more than 76 million baby boomers reach retirement age over the next 20 years. The fireworks could rival any action flick that Hollywood could devise.
For many retirees, Social Security benefits represent their only source of guaranteed income. Even if the rate of future COLAs are curtailed, the value of lifetime benefits can't be overstated and the decision of when and how to claim them is one of the most important decisions you and your clients will ever make.
