Earlier this year, many people became alarmed that the Social Security system
was already going negative—that is, it was starting to pay out more in benefits
than it was receiving in payroll taxes. This was not supposed to happen until
2016, according to the 2009
OASDI Trustees report.
The worriers noted that high unemployment is taking its toll on Social
Security in ways that were not accounted for in the 2009 report. Fewer people
working means fewer payroll taxes are being collected. And Social Security
applications are up as out-of-work people age 62 and older decide go on Social
Security earlier than they had anticipated.
Indeed, these concerns were supported by monthly data. Each month, during the
last six months of 2009, the Social Security system paid out more in benefits
than it received in payroll taxes. This raised the question, Has the system
already started its inexorable slide into insolvency?
The three-month delay in the publication of the 2010 OASDI Trustees Report
didn’t help. As it turns out, the delay was not because of Social Security but
because of the extra time needed to analyze the impact on Medicare of the new
Affordable Care Act.
When the report finally came out on Aug. 5, it became clear that focusing on
any one month or year is not the right way to look at Social Security. The
trustees analyzed Social Security’s finances over the next 75 years, and the
period ranging from 2009 through 2083—even taking into account the latest
recession—is little changed from the period ranging from 2008 through 2082.
Trust fund grows to $2.54 trillion
Anyone who focuses on the near-term status of Social Security should know
that the system is as healthy as ever. More so, in fact.
During 2009, the Social Security trust fund increased by $122 billion to
$2.54 trillion. This was primarily due to the interest earned on the securities
in the trust fund, a total of $118 billion. So even though the system paid out
$686 billion in benefits and took in just $667 billion in payroll taxes, the
$118 billion in interest, plus the $22 billion in income taxes that
higher-income retirees pay on their Social Security benefits, kept the system in
the black. Total revenues were $807 billion, and total expenses were $685
billion.
Still, people worry. They worry that the $118 billion in interest isn’t a
legitimate source of income because it’s just the government paying money to
itself. For that matter, they worry that the $2.5 trillion trust fund itself
isn’t even a legitimate asset, because the government has borrowed it all in
exchange for special-issue Treasury securities. What’s going to happen, the
worriers say, when the Social Security system needs to redeem those securities
in 2025, the year that costs will start to exceed revenues from all sources?
According to Stephen C. Goss, chief actuary of the Social Security
Administration and a voice of reason amid the political rhetoric, the government
will simply replace those special-issue Treasury securities with publicly held
debt. In other words, the government will borrow from ABC mutual fund or XYZ
pension fund or any of your clients who invest directly in U.S. Treasury
securities and use the proceeds to pay back the Social Security system.
Redemption of the special-issue Treasury securities held by the Social
Security trust fund will not change the balance sheet of the U.S. government. It
will simply replace one form of debt with another. The amount will not change.
Just like all publicly held debt obligations issued by the Treasury, the
securities held by the Social Security trust fund are guaranteed as to principal
and interest by the full faith and credit of the U.S. government. There is no
risk of default.
So why do people worry? The problem arises when people confuse the actuarial
deficit of the Social Security system with the budget deficit of the U.S.
government. There is no question that the U.S. budget deficit is high and
worrisome. But the impending redemption of the Treasury securities held by the
Social Security trust fund will have no impact on it.
These are two distinct accounts. And no one is proposing that Social
Security’s actuarial deficit be made up by the general Treasury. Indeed, the
beauty of the Social Security system is that it is a standalone system,
self-financed, and prohibited by law from borrowing. Unlike the general
Treasury, it can’t run at a deficit. That’s why the trustees make their 75-year
projections, so the system can be fixed before the money runs out.
So if you have clients who don’t trust the trust fund, you can reassure them
that the $2.5 trillion in assets are legitimate debt instruments, the same as
the $7.5 trillion in Treasury securities held by other investors around the
world plus the $1.8 trillion held by other government entities.
If they refer to these debt obligations as “just a bunch of IOUs” remind them
that all debt securities could be described that way. Fortunately, the IOUs
issued by the U.S. government are not at risk. When the time comes for Social
Security to redeem its securities, the government will pay up—borrowing from
somewhere else if it has to—just as it will when your clients’ Treasury bills
and bonds mature.
This is not to say the government shouldn’t get a handle on its debt and stop
borrowing from Peter to pay Paul. But from the point of view of Social Security,
that’s a separate issue.
Long-term outlook improves slightly
OK. Now that we’ve separated the U.S. government budget deficit from the
Social Security actuarial deficit, let’s better understand that issue. As we
said earlier, near term, no problem. In years 2010 and 2011, benefits will
exceed payroll taxes, but the interest income will more than cover the costs.
Starting in 2015 (up from 2016 in last year’s report), costs will begin to
exceed payroll taxes on a permanent basis. The system’s two other revenue
sources—interest income and taxes on benefits—will make up the shortfall from
2015 through 2024.
Starting in 2025, the trust fund—which will now be worth about $4
trillion—will gradually be liquidated. In 2037 the trust fund will be exhausted
and the system will return to a straight pay-as-you-go system with payroll taxes
covering only 78% of promised benefits (up from 76% in last year’s report). Good
thing we’re finding out about this now.
Actually, we’ve known about it for some time. Every year, the Social Security
trustees project income and expenses over the next 75 years under three
scenarios: low-cost, intermediate-cost, and high-cost. They factor in the many
demographic and economic assumptions that impact the amount of money coming into
the system vs. the amount going out, including fertility rates, mortality rates,
immigration rates, total economic productivity, wage growth, the inflation rate,
the unemployment rate, and interest rates.
In their conclusion, they state very succinctly what needs to happen in order
for the system to be brought into actuarial balance over the next 75 years.
These are not practical reform proposals, but simple mathematical equations
designed to show Congress the amount by which taxes would need to be raised or
benefits cut in order to be able to pay promised benefits under the current
formula over the next 75 years.
These remedies change slightly from year to year as new information is
factored into their assumptions. This year they stated that under the
intermediate-cost scenario, the payroll tax would need to be raised by 1.84% or
benefits would have to be cut by 12% in order to bring the system into actuarial
balance. Last year’s numbers were 2.01% and 13.3%, respectively.
So the long-term outlook has actually improved slightly since last year.
Still, Social Security is on everyone’s radar screen right now, and people are
screaming for reform. This is a good thing. The sooner the system is brought
into actuarial balance, the less painful the remedies will be. Changes can be
phased in over many years so that people can plan ahead.
The surprising cause of the deficit
Interestingly, it was not the baby boom itself, or even the fact that we are
living longer today, that created the actuarial deficit, according to chief
actuary Goss. Rather, it’s the fact that baby boomers had so few kids. By 1970
the birth rate had dropped from three children per woman to just two children
per woman. And it has not gone back up.
Our kids are also having fewer kids. So now we are looking at a permanent
reduction in the number of younger workers funding benefits for older retirees.
Right now there are about three workers for every retiree drawing benefits.
Around 2030 there will be just two workers for every retiree drawing benefits.
This is not expected to change before the end of 2084. But it’s not the end of
the world. It just means something will have to change. And this is the other
source of worry for Social Security watchers. Someone is bound to be
shortchanged.
Working people are worried that their payroll taxes will be raised and they
won’t get their share of benefits in the future. Retired people are worried that
the benefits they’ve come to rely on will be cut, leaving them with insufficient
income at a time when they are unable to go back to work. It’s no wonder Social
Security has been termed the “third rail” by politicians who don’t dare touch it
for fear of getting zapped. Some voters, somewhere, are going to be unhappy.
President Obama has appointed a bipartisan deficit commission that is likely
to address Social Security reform sometime after the midterm elections. Many
proposals have been put on the table, but it remains to be seen what the
commission will come up with. At this point all we can do is wait and see. If
you are interested in studying some of the reform proposals so you and your
clients can get an idea of how the system might change, you might review these
reports:
- “Social
Security Policy Options,” Congressional Budget Office - “Social
Security Reform: Possible Changes in the Benefit Formulas and Taxation,”
American Academy of Actuaries - “Reform Options
for Social Security,” AARP Public Policy Institute
But the main thing for advisors is to be the voice of reason as the deficit
rhetoric heats up and the Social Security myths circulate. Keep the conversation
focused on your clients’ individual retirement plans and what they can do to
prepare for their own future, whether it means saving more in IRAs or qualified
retirement plans, working longer to improve their Social Security earnings
record, understanding some of the innovative claiming strategies designed to
maximize benefits, or reviewing their overall retirement income plan including
cash flows and investments.
The public attention on Social Security today is your perfect opportunity to
teach them about Social Security as well as review their entire portfolio and
overall financial plan with the goal of helping them establish a more secure
financial future.
References and further reading
“Social
Security and the Federal Deficit: Not Cause and Effect”
“Quick
Answers to Common Questions About Social Security”
“The Future
Financial Status of the Social Security Program”
