A New Way to Treat Social Security Beneficiaries with Work Outside the System

Congress is considering a new way to compute Social Security benefits for beneficiaries with earnings outside the Social Security system.  The House Ways and Means Committee will hold a hearing tomorrow on this alternative approach, and it merits serious consideration.

All but about 4 percent of U.S. workers pay into Social Security.  About a quarter of state and local employees, plus some federal workers hired before 1984, don’t pay Social Security taxes, and their non-taxed earnings don’t count towards Social Security benefits.  Instead, they pay into “non-covered” pension systems meant to replace Social Security.  Nonetheless, most of these workers eventually receive Social Security, either through other work covered by Social Security or through their spouses.

Addressing Social Security beneficiaries who have worked outside the system is tricky, because Social Security’s benefit formula is progressive — that is, benefits replace a greater share of earnings for low earners than for high earners.  Workers with earnings outside the system can look like low earners, even when they’re not.  Without adjustment, non-covered workers would receive benefits that replace a larger share of their earnings than similar workers whose earnings were totally covered — plus pensions that were intended to replace Social Security benefits.

To level the playing field, policymakers enacted the Windfall Elimination Provision (WEP) and Government Pension Offset (GPO), which reduce the Social Security benefits of some beneficiaries who also receive non-covered pensions.  Data limitations of years ago forced policymakers to use imprecise rules of thumb.  Starting next year, however, the Social Security Administration will have the data it needs to calculate a benefit based on all of a worker’s earnings using the standard formula, and can then determine what proportion of that benefit can be attributed to the worker’s covered earnings.

There’s bipartisan support for using this “proportional” approach to treating beneficiaries who worked outside the system.  President Obama, House Ways and Means Committee Chairman Kevin Brady, and the bipartisan Social Security Advisory Board have proposed similar methods.  

The proportional approach would:

• Treat similar workers similarly:  Beneficiaries with the same lifetime earnings will receive a benefit that replaces the same portion of their Social Security-covered earnings, as policymakers intended when they created the WEP and GPO.
• Reduce overpayments:  Under the WEP and GPO, beneficiaries must report their non-covered pensions.  Some beneficiaries’ failure to do so is a leading cause of overpayments.  The proportional approach doesn’t require self-reporting and would improve payment accuracy.
• Increase predictability:  The WEP and GPO rules are difficult to explain.  Benefit estimates on Social Security statements can’t show WEP and GPO adjustments, leading some affected beneficiaries to believe they’ll get higher benefits than they actually do.  The proportional approach would allow for more accurate estimates.
• Save money:  The approach would improve Social Security’s solvency.  For example, the proportional formula provision in Chairman Brady’s bill would save Social Security about $13.6 billion over 10 years.

The proportional approach also raises some concerns.  It would:

• Create winners and losers:  On average, future beneficiaries who would have been affected by WEP would be better off under the proportional approach.  However, some individuals would have lower benefits.
• Affect more people:  Some beneficiaries who would not have been subject to the current-law rules would have small benefit reductions under the new approach.  The new rules would affect nearly all beneficiaries with work outside Social Security — unlike the WEP and GPO, which affect only workers who receive non-covered pensions or don’t qualify for other exemptions.
• Possibly increase income inequality:  The newly affected beneficiaries receive neither a Social Security benefit nor a pension based on their earnings outside the system.  Thus, they may have lower incomes than those who would receive higher benefits under the proposal.