The new Social Security notch

I have an article in Forbes outlining what could be a new "notch" for Social Security recipients. The original notch affected people born in the years 1917-21 and was due to a number of changes in the Social Security benefit formula during the 1970s. (See here for a Congressional report on the notch.)

The second notch affects mostly people who are 62 today and could result in an around 5 percent reduction in their Social Security benefits, which over time can end up as a lot of money. Put simply, the notch comes about because Social Security won't be paying Cost of Living Adjustments over the next two years. Here's the article, followed by a few comments:

Old-timers in Washington remember the Social Security "notch" as a quirk in the program's benefit formula that reduced payments for retirees born from 1917 to 1921. Eventually, a bipartisan Congressional commission concluded that the notch's effects were modest and did not require compensation. But not before members of Congress entered over 100 pieces of legislation to address the notch and senior advocacy groups, often under very dubious pretenses, reaped millions in contributions by claiming they could secure compensation for affected retirees.

A new Social Security notch coming soon should generate interest in Congress as it presents a much stronger case for help. Quirks in Social Security's formula for granting Cost of Living Adjustments (COLAs), interacting with a spike in inflation during 2008, could cause a typical 62-year-old couple to lose almost $25,000 in benefits over their lifetimes.

Social Security COLAs are calculated every October by comparing the third-quarter data of the Consumer Price Index for Urban Workers (CPI-W) with the previous year's numbers. An increase in the CPI results in a COLA the following January for retirees and other Social Security beneficiaries. Rising energy prices caused a 5.8% COLA to be ordered in the fall of 2008. However, plummeting prices between the fall of 2008 and the beginning of COLA payments in January 2009 caused the CPI as a whole to drop by around 5%. In effect, the 2009 Social Security COLA compensated retirees for inflation that no longer existed.

To make up for this overpayment, Social Security will pay no COLAs until prices rise back to their previous fall 2008 levels, which, according to the Congressional Budget Office, won't be until 2012. While seniors are upset by the lack of a COLA in the coming year, they actually benefited from the original overpayment. The overly large January 2009 COLA increased Social Security benefits purchasing power by around 5% above 2008 levels. For a typical retiree this is equivalent to an annual benefit increase of almost $700. Given that COLAs are designed merely to keep purchasing power constant, this is a large gain. Moreover, for all but the richest retirees, Medicare Part B premiums are not allowed to increase in a year without a COLA. This will save the typical senior almost $100 next year.

There is, however, one class of Americans who will lose big: people who turned 62 this year. 62 is the first age at which Social Security retirement benefits can be claimed, which means that individuals born in 1947 did not receive the 5.8% "windfall COLA" paid in January of this year. Like current retirees, however, today's 62-year-olds will not receive COLAs for the next two years. Inflation over the next two years will reduce the purchasing power of benefits for today's 62-year-olds by around 5% before COLAs resume in 2012. If today's 62-year-olds had received the "windfall COLA" of 2009, the lack of COLAs over the next two years would simply return their benefits to the proper level. But since today's 62-year-olds did not receive the 2009 COLA, the lack of COLA payments in 2010 and 2011 will have a significant negative impact on their lifetime benefits.

In addition, due to details of the Social Security benefit formula, this financial loss can't be avoided by delaying retirement until after COLAs resume in 2012. For a typical newly retired couple with a monthly benefit of $2,235, this penalty will cost them around $1,340 per year, for every year of their retirement. If they survive to a typical age of 83, these couples will lose almost $25,000 in lifetime benefits. While high-income households may shrug off a 5% cut in their Social Security benefits, for low earners every penny counts.

Americans turning 61 this year will also receive reduced benefits, though their cut will be around half that of 62-year-olds. Effects on younger individuals should generally be small, making this a true notch that affects only a small portion of retirees. While a Congressional ad hoc COLA for current beneficiaries is unjustified, given that the real purchasing power of today's benefits has increased, redress for new retirees over the next several years makes sense. Their reduced benefits stem from an unintended quirk in the benefit formula and restoring lost benefits will not make Social Security's precarious financing any worse. While Social Security benefits will need to be reduced as part of any reform, unintended cuts focused on a small group of near-retirees, rich and poor alike, make no sense.

It is time for Congress to adjust the Social Security benefit formula to make sure that neither unintended windfalls nor penalties take place.

I'm writing something now outlining the sources of the notch in more technical terms, but it mostly derives from the fact that Social Security benefits are based upon your average "indexed" wages. Indexing converts past earnings to make them comparable to earnings levels as of age 60. (For instance, if you earned half the economy-wide average wage when you were age 20, the indexed value would equal half the economy-wide wage as of age 60.) However, earnings after age 60 aren't indexed. This means that an increase in inflation that is later "revoked," as the 2008 increase was, would produce only a small increase in initial benefits but the lack of COLAs later would significantly reduce them. Current retirees aren't affected, as they first received an overly large COLA and later receive no COLAs, leaving their end benefits pretty much where they should be.

Here's one way to think about this: imagine that a bank inadvertently credited each of its customers accounts with an extra $1,000. It then discovered the error and said that it would deduct $500 from each customer's account over each of the next two years. In the meantime, though, bank customers could keep the interest on their accidentally higher balances. Now, current customers clearly aren't badly treated -- they got a bit extra today and will have it deducted over time. But now imagine if the bank made similar $500 per year deductions to the accounts of new customers, who hadn't received the initial $1,000 accidental credit. These new customers would obviously come out behind. In the Social Security world, current beneficiaries are the existing customers; they may gripe, but it's hard to say they've been badly treated. But today's 62 year olds are like the new customers, who have to pay back a credit they never received.