SS Topic #2: What is the Wage Index anyway, and how does it affect Social Security Benefits?
The national average wage index is used to compute social security benefits. It is a table of average wages and year-to-year wage growth. (you may notice that the last 3 years have been not only the only 3 consecutive years to register sub-3% growth, they are also the only 3 consecutive to register sub-4% growth over the last 50 years)
When you turn 60, your highest 35 years of income will be indexed, that is adjusted to translate each of those years' income into the language of present-day money. This is done by multiplying it by the ratio created when you divide the average wage of the year you turned 60 by the average wage of the year in question. So for a person retiring at 62 in 2005, the 1970 earnings are adjusted by multiplying the number by 5.5066 (because the 2003 wage index, 34,064.95 divided by the 1970 wage index, 6,186.24, is 5.5066.). They add up these adjusted earnings into one sum, and divide it by 420, the number of months in 35 years. This gives the Average Indexed Monthly Earnings number (AIME). This number is ultimately filtered through a percentage system that already benefits the lowest earners more than higher earners, and then multiplied for cost-of-living increases during a person's retirement to calculate actual benefits.
So, changing the index used to calculate the average earnings that will be the heart of the benefit calculation is no small adjustment. The index is used not to increase benefits while you are retired (like I had wrongly assumed, like the cost-of-living increase), it is used to translate earnings from previous years into a present-day context, to assure that if you managed average wages in 1970, it affects you just the same as being an average wage earner in 1990, even though obviously real earnings would be higher in 1990. It really affects this fundamental question: how much did you earn while you were working? Using the wage index, as they do now, will translate past earnings one way; using the price index would translate past earnings, thus answer that question, in a different (smaller) way.
Bush's plan, so far as anyone can guess, would still use the wage index to adjust the earnings of low-income workers, but would use only a price-index to adjust the earnings of maximum earnings workers (90,000 and above). Earners in the middle would see a combination of wage index and price index to adjust their previous years' earnings. This change would be phased in for future retirees.