This Is How We'll Fix Social Security

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The buzz around Washington is that the deficit commission established by the president will recommend moderate Social Security reforms to extend the 75-year old program's life well into the 21st century. Reforming Social Security sounds easy. You can raise revenue or cut spending. How hard is that to understand?

Some solutions for fixing our federal pension program are, in fact, pretty straightforward. One is to raise the Social Security tax on employers and employees above 6.2 percent. Another is to raise the "ceiling" of taxable income so that Social Security taxes apply to dollars earned over $107,000. Another is to push back the normal retirement age, or the age at which seniors can receive full benefits.

Those solutions are easy enough to grasp. But one of the most popular ideas for reforming Social Security is a little more complicated. It would involve making benefits more progressive by writing smaller checks to wealthier retirees.

This post is about to dive into wonky waters, so let's start with the basics. Workers with lower wages already get a higher portion (say, 45%) of their average earnings back, and workers with higher wages get a bigger check, but it replaces a smaller chunk (say, 25%) of their wages. That's fair. Social Security was designed to be a mandatory federal piggy bank, and people who put more coins into the piggy should have more to take out.

The problem is that Social Security isn't like a full piggy bank. It's a liability, a promise to future seniors the federal government has to fund with money, taxed and borrowed. And according to the program's accountants, the federal government will have to break that promise in the next few decades.

We must cut costs. But for whom? As the graph shows, the richest 20 percent doesn't rely on Social Security benefits for their income nearly as much as the bottom 50 percent. The wealthier are healthier, they earn more and they save more for retirement. That's one reason why conservatives and liberals agree it's reasonable to cut their benefits to preserve the program.

The simple solution is: Write smaller checks to rich people. If that's all you want to know, stop here. If you want to understand how the gears work, keep reading.

Most benefits provided by Social Security mimic your lifetime earnings taxed by Social Security. You take the highest 35 years, find the monthly average, put it in today's dollars, and run it through a formula. How does the formula work? You can begin to understand it by thinking about the progressive income tax.

With the progressive income tax, you're taxed 10 percent of your first dollars, 15 percent of your next dollars, 25 percent of the dollars after that, and so on. People who earn more pay a higher tax on their last dollar. Social Security mirrors that idea. People who have earned less receive a higher percentage of their last dollar. After Social Security calculates your average monthly earnings in today's dollars, it pays back 90 percent of the first dollars, 32 percent of the next chunk and 15 of everything up to the max. Remember, just as there's a ceiling for taxed wages, there's also a ceiling for monthly benefits.

The upshot is that poorer workers get a higher percent of their wages, and richer workers get a lower percent. The payout should be progressive, because middle-class workers pay Social Security on most of their income, and upper-class workers don't. But with Social Security straining under its obligation to pay full benefits after 2030, people are thinking about shaving those benefits for richer retirees.

To understand how, let's go back to the income tax analogy. To make the income tax more progressive, we talk about higher rates at the top and lower rates at the bottom. Once again, Social Security benefits work like a mirror, because they replace earnings rather than tax them. To reduce benefits for richer folks, you'd lower the 15 percent rate to replace less income. Or we could add a fourth rate (or a third "bendpoint") to pay back even a smaller percentage of income near the ceiling.

From my conversations with people near the deficit commission, it sounds like a change in the benefits formula will almost certainly be part of a package to reform Social Security. Yes, it's a little more complicated than raising the payroll tax. But only a little.