Will Deflation Provide an Opportunity for Social Security Reform?

May 12, 2009 4:15 PM

In most advanced industrial countries, the value of public pension benefits is protected by annual cost-of-living adjustments, also known as COLAs. Every year, the value of pension benefits is adjusted upward, in line with inflation, wages, or a combination of the two.1 The adjustments are meant to protect the purchasing power of retirees against inflation.

But what happens to pension benefits when countries experience deflation rather than inflation? The experience of other countries provides an instructive lesson that could help the United States toward the elusive goal of reforming Social Security.

In the United States, since 1975 automatic COLAs have increased Social Security benefits in line with increases in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The law calls for Social Security benefits to be adjusted in December of each year to reflect increases in the CPI-W from the third quarter of that year over the third quarter of the previous year.2

The political rationale for why governments want to protect the purchasing power of retirees is obvious. But if prices and wages decline, should retirees “share the pain” with the working population of a lower nominal income? Put another way: Have governments ever implemented nominal income cuts on retirees?

Recent history in Japan suggests both yes and no.3 COLAs for public pensions in Japan are fully linked to changes in prices, as in the United States. When Japan first went into deflation in 1999–2001 and prices declined by 0.3 and 0.7 and 0.7 percent, respectively, nominal cuts in benefits to Japanese retirees were not implemented. Instead they were frozen and the real value of pensions during this period of deflation thus rose by 1.7 percent. On the other hand, the Japanese government, in an attempt to claw back this real increase in pension benefit levels, will reduce future increases, once inflation returns to Japan, thus easing the adverse long-term fiscal impact on the pension system.4 However, as deflation in Japan continued after 2001, corresponding nominal cuts in annual benefits were implemented mirroring price declines of 0.9, 0.3, and 0.3 percent from 2002–05. Prolonged periods of deflation thus eventually led to nominal pension benefit cuts.

A change in German pension laws announced in early May follows the Japanese example in many ways.5 German public pensions cannot decline in nominal terms in any year for any reason, not even in years of wage deflation.6 Any adjustment shortfall is to be made up by halving future benefit increases after 2011.7 German retirees therefore at least initially, and importantly for the 2009 election year, will not have to share the pain with German workers of expected wage deflation in 2010. What the German government calls a “COLA adjustment smoothing mechanism” effectively postpones much of the pain of relative income declines for German retirees to the years after 2011, when they will theoretically see their nominal benefit increases rise by less than the working population’s wages. Time will tell whether this is politically feasible in Germany after 2011.

This issue will soon matter profoundly for the United States. Historically, the lowest annual COLAs for Social Security were 1.3 percent in 1986 and 1998.8 But the Congressional Budget Office (CBO) recently projected no COLA adjustment to Social Security benefits in the United States for 2010–12.9 Similarly, in their 2009 report, the OASDI Trustees project instances of zero COLAs in their three scenarios between 2009 and 2012.10

The three-year freeze predicted by the CBO arises from US COLA legislation that is not very different from Japan’s or Germany’s. As in Japan and Germany, US Social Security benefits cannot decline in nominal terms, so the COLA must always be greater than zero.11 Unlike Germany, however, where pain is postponed until after 2011, the United States faces immediate claw backs in benefits. As mentioned earlier, Social Security benefits cannot increase until the CPI-W for the third quarter of a year rises above the value of the year in which the latest COLAs were implemented, which was the 5.8 percent increase from Q3 2007 to Q3 2008.12

According to CBO projections for CPI-W, the COLA will decline by about 4 percent until Q3 2009 and then only gradually rise by 1.1 percent each year until Q3 2011. Hence the CPI-W will only rise above the Q3 2008 level by Q3 2012, meaning that the next nominal increase in Social Security checks in the United States may not happen until December 2012, or two full American election cycles from now.

Whether the current scenario of frozen Social Security benefits until December 2012 is politically realistic in the United States is questionable. The US Congress is especially attuned to the interests of an increasingly aging US population. Despite the huge fiscal deficit facing the US government, the Congress will likely come under the same pressures that affected the parliaments in Japan and Germany. An added factor is that frozen Social Security benefits will be accompanied by continued, rampant healthcare inflation for those covered by Medicare. Congress will undoubtedly be tempted to come up with some sort of temporary, off-budget fudge permitting a positive annual COLA, or a functional equivalent thereof, from now until late 2012.13 If that happens, it will weaken the long-term solvency of the Social Security and DI trust funds, whose combined cash flow is now expected to turn negative at the end of a two-term Obama presidency in 2016 and to be fully exhausted by 2037.14

In the face of these pressures is a countervailing factor. Opinion surveys show that Americans are increasingly concerned about the long-term costs of their government retirement systems. It is possible that US leaders will use the likely COLA crisis as an opportunity not to be wasted. With luck Congress will transform the COLA dilemma into a launching platform for the needed, and relatively simple from a technical point of view, broader fiscal reform of the Social Security program.15 The short-term political imperative of avoiding a freeze in nominal Social Security benefits should be harnessed to push through required long-term reforms.

Notes

1. See table 2.3 in Pensions at a Glance (OECD, 2004). Indexing to average wage growth will usually be more generous than indexing to inflation, and serves to maintain a stable replacement ratio for pension benefits.

2. See SSA at http://www.ssa.gov/OACT/COLA/colaseries.html.

3. See Edward Whitehouse, 2009, Pensions, Purchasing-Power Risk, Inflation and Indexation, OECD Social, Employment and Migration WP #77.

4. Only for a brief period in 2008 saw inflation in Japan. As a result, the fiscal effects of the earlier nominal pension freeze have not yet been fully clawed back.

5. See Keine Rentenkürzung 2010 and Schutz vor Rentenkürzungen. See also Financial Times, “Threat to German Welfare System,” May 8 2009.

6. German pensions are linked to wages, net of pension contributions.

7. German annual pension level adjustments are numerous and correspondingly complex. Since 2004 the system has incorporated a special “sustainability factor” according to which German pension COLAs are adjusted (downward) according to developments in the system’s contributor/beneficiary ratio. However, the effect of the sustainability factor in isolation was never intended to lead to nominal cuts in benefit levels. Instead, zero was the lower bound and cumulative effects of “cuts thus not applied” would instead be offset by halving any pension increases after 2011 until the postponed adjustment had been fully made up. Essentially, the German governments’ announcement of May 6 expands the smoothing mechanism from just the sustainability factor to any effect, such as annual wage deflation, that may cause a nominal decline in German wages.

8. See SSA at http://www.ssa.gov/OACT/COLA/colaseries.html.

9. See the CBO Director’s blog.

10. In the programmatic assumptions for the Trustees' "low-cost scenario", COLAs are zero for three years from 2009-2011 and with 1.5 percent inflation in 2012. The standard "intermediate scenario" foresees zero COLAs in 2009 and 2010, with a 1.4 percent increase in 2011, while the "high-cost scenario" indicates zero inflation for only 2009, with 0.2 percent inflation returning in 2010. See SSA Website at http://www.ssa.gov/OACT/TR/2009/V_programatic.html#227509.

11. See SSA at http://www.ssa.gov/OACT/COLA/positivecola.html.

12. The CPI-W rose from 203.4 to 215.2 in this period, equaling 5.8 percent.

13. There are obviously many ways in which governments could assist retiree incomes. The UK government in the late 1990s, in response to very low COLAs, introduced a fixed “winter fuel payment” to retirees and exempted those over 75 from TV license fees. See Edward Whitehouse, 2009, Pensions, Purchasing-Power Risk, Inflation and Indexation.

14. See 2009 OASDI Trustee Report.

15. See Baily and Kirkegaard, US Pension Reform: Lessons from Other Countries (2009) for one set of proposals.