Social Security reform: What 'chained CPI' proposal by Obama means

President Obama's latest bargaining position in fiscal talks with Republicans contains this controversial element: revising the way Social Security benefits get adjusted each year to help recipients cope with inflation.

Mr. Obama's move is an overture to Republicans who support the idea, as the two sides try to broker a deal that reduces future federal deficits with a mix of tax hikes and spending cuts. 

So what is the "chained CPI," the revised consumer price index that Obama says could replace the current system?

Details will come in a moment, but first this point: A lot of people don't like the president's idea.

As news of the proposal emerged, the idea was swiftly met by opposition from interest groups opposed to benefit cuts in Social Security, the widely popular program on which millions of Americans rely for retirement income.

"Almost every elected official just spent an entire election season saying they wouldn't cut the benefits of those 55 and older," Alex Lawson, director of Social Security Works, said in a statement released Tuesday morning. "The truth is the chained CPI hits everyone's benefits on day one. It hits the oldest of the old and disabled veterans the hardest."

Obama and everyone in Congress know that alterations to Social Security aren't politically easy. Some lawmakers want the program left out of the negotiations entirely as Congress weighs what to do about the "fiscal cliff," the set of tax hikes and federal spending cuts set to occur in the new year if no new legislation is passed.

But entitlement programs including Social Security represent a central part of America's fiscal challenge, say many economists, so it's important to have entitlement programs on the bargaining table. 

Chained CPI is just one of several ideas for reforming Social Security, so that the program is able to finance itself in years and decades ahead. To understand the idea, it's important to define a some terminology:

Consumer price index (CPI). This is the US Labor Department's main index of inflation, or changes in the overall level of consumer prices. If inflation goes up 2 percent (about the pace of CPI change over the past 12 months), then that's how much more it costs a consumer to buy a typical basket of goods and services from food to utilities. In effect, the purchasing power of a consumer's dollar has gone down by 2 percent. 

Cost of living adjustment (COLA). Many federal programs, including Social Security and the pensions paid to military veterans, are typically adjusted upward each year on the basis of inflation. 

Chained CPI. Since 2002, the US Bureau of Labor Statistics has released an alternative inflation calculation called the chained CPI. It tends to find smaller changes in consumer prices than the bureau's traditional inflation index, because it accounts for the way consumers gradually adjust their habits of consumption as prices change. If beef gets a lot more expensive and chicken stays the same, consumers will tend to buy more chicken and less beef. 

Differences between the two inflation measures are small, often about 0.3 percent in a given year. But over time, the impact can add up. Basing the COLA adjustments on the chained CPI instead of on the traditional CPI would cut the typical 65-year-old's benefit by $130 per year, but after 30 years of retirement that person's annual income would be $1,400 less, says the National Committee To Preserve, Social Security & Medicare.

Supporters of the change say using a more accurate measure of inflation is a rational way to reduce a looming shortfall, as baby boomers retire.

Occupying a middle ground in the debate are some who argue that the change should be cushioned by supplementing benefits for older retirees.

"I think there is a good case for basing any COLA on what we may believe to be the most appropriate index of price changes," Eugene Steuerle of the Urban Institute said in congressional testimony last year. But he said it would result in a greater "front-loading" of the total benefits that people receive during retirement.

"If such an adjustment is made, it is more important than ever to offset such front-loading with a more back-loaded package of benefits," Mr. Steuerle said.

Obama's bipartisan Simpson-Bowles commission on fiscal reform called for using chained CPI in Social Security.
The Committee for a Responsible Federal Budget, a nonpartisan group pushing for deficit reduction, has outlined how chained CPI, coupled with other changes including a one-year boost in the eligibility age for full benefits and slower benefit growth for high-income Americans, could close Social Security's projected shortfall in coming decades.
 
If a shift to chained CPI were to occur across all government programs, it could affect the cost-of-living adjustments for veterans and federal retirees, and the number of Americans who migrate into higher tax brackets each year.