From Project Syndicate by Martin Feldstein:
Public pension programs around the world are in financial trouble. Because of continuing increases in life expectancy, the number of eligible retirees is rising more rapidly than the tax revenue available to finance benefits.
In the United States, the Congressional Budget Office projects the relative cost of the Social Security program’s old-age pension benefits to rise by more than a quarter over the next 25 years, from 4.9% of GDP today to 6.2% in 2038. Because the taxes that are earmarked to support Social Security do not automatically rise faster than GDP, either the growth rate of benefits must be reduced or tax rates must be increased.
One reason for the rapid rise in benefits stems from how they are adjusted for inflation. Under current US law, retirees’ benefits are automatically adjusted to account for increases in the traditional consumer price index (CPI). But experts have long understood that the CPI overstates the true increase in the cost of living, and that the resulting over-indexing of benefits should be fixed.
Part of the problem is that the CPI does not reflect how consumers change the composition of their purchases over time as relative prices change. President Barack Obama’s administration initially followed expert advice and suggested that the traditional CPI be replaced by a more accurate measure known as the chain-weighted CPI. Although this would reduce the annual rate of increase in benefits by only about 0.25%, outlays for Social Security and other inflation-indexed programs over the next ten years would be more than $200 billion lower. Applying the chain-weighted CPI to tax-bracket adjustments would raise more than $100 billion over the same period.
But there is another, more fundamental reason why the traditional CPI overstates the true rise in the cost of living: It does not accurately reflect the introduction of new goods and services or improvements in the quality of existing goods and services. So it is unfortunate that Obama recently withdrew his proposal to change the traditional index, preferring the political gesture of “protecting Social Security benefits” to the more responsible policy of correcting the way that benefits and taxes reflect rising prices.
But the more important reform for stabilizing the financing of Social Security pension benefits is to adjust the benefits for the rise in life expectancy. When the US created its Social Security program in the 1930’s, the legislation specified that benefits would be paid to retirees at age 65. Life expectancy at age 65 rose after that by about one year per decade. Today, life expectancy at age 65 is about six years higher than it was in 1940. The increase in the number of retirement years put Social Security in financial trouble.