Is Social Security Going Broke?

Of the many topics having to do with Social Security, without question, the hottest and probably least understood is the fiscal health of the program. I regularly hear people quip that Social Security is “going broke.” But is this really true?

The question of whether Social Security is going broke really isn’t the right one. It implies a misunderstanding of how the program was designed and continues to be financed to this day.   

As a refresher, the original Social Security Act was passed in 1935 during the depths of the Great Depression. Its primary purpose was to help address the issue of poverty among the elderly. The original law stipulated that workers would be eligible for retirement benefits at age 65. A payroll tax was instituted to finance the program.

Today, Social Security remains funded via payroll taxes. Workers pay 6.2% of their wages up to $132,900 (this is the OASDI deduction on your paycheck). Employers match this for a total of 12.4% up to the wage cap.

What most people don’t understand is Social Security was not designed like a traditional corporate pension for example. Corporate pensions are considered “pre-funded” plans. Workers make contributions over their working career which are often matched by the sponsoring employer. These contributions are invested and upon retirement, a pool of money is available for the worker to draw from for the rest of his or her life.

Again, this is not how the Social Security program was designed. Social Security is considered a “pay-as-you-go” system. That means workers paying payroll taxes into the system today are supporting those who are currently receiving benefits. To remain solvent, the dollars going in must match or exceed those being withdrawn on an ongoing basis. So, unlike a corporate pension which is prefunded, current beneficiaries of Social Security are reliant on workers continuing to fund the system.

Shifting Demographics

In the early years, the pay-as-you-go approach worked well because there were vastly more workers than benefit recipients. In fact, according to Social Security, in 1940 there were 35.3 million “covered workers” in the United States against 222,000 beneficiaries. That works out to a ratio of 159.4 workers for every 1 person receiving benefits.[1] 

Unfortunately, this ratio has changed radically for the worse over the decades as US population growth has slowed. In 1960 it had fallen to 5.1 workers for every one person drawing Social Security benefits. By 1980 it was 3.2 to 1. In 2010, the ratio dipped to 2.9 to 1. Over the coming decades, the board of trustees expect the ratio to continue drifting downward towards 2 to 1. It doesn’t take an actuary to recognize that as the ratio continues to decline, it will undoubtedly create financial stress as there will be fewer workers to support benefit recipients.

What is the current financial status of the program?

The 2019 annual report from the Social Security board of trustees was released in April. The report indicates that demographic trends continue down an unfavorable path. In 2018, a total of approximately 176 million workers paid into the system to support about 63 million current beneficiaries. That works out to a ratio of just under 2.8 to 1.[2]

To put some dollar figures around this, in 2018, workers contributed approximately $920 billion to Social Security through payroll taxes. The program also was credited $83 billion from interest on trust fund reserves. This totals $1.003 trillion in total program income. Total outlays (including all administrative costs) for the year was about $1 trillion, meaning there was a very narrow surplus.[3] 

For many years, the board of trustees has been warning that Social Security was on track to flip from surplus to deficit. The 2019 annual report indicates the board expects the flip to occur this year. What that means is the money going into the system, plus interest on reserves, will be less than what is being paid out. The difference will be covered by trust fund reserves which have accumulated over the years the program has generated a surplus. Those reserves are projected to be depleted by 2035.

Trust Fund Myths 

The biggest myths around Social Security have to do with the so-called trust fund reserves. There are technically two pots of reserves, basically one for retirement benefits and the other for disability. For purposes of discussion, we’ll reference them together as one.

Unfortunately, there is a lot of loose talk that politicians of one political party or another have “raided” the trust fund, or the trust fund is full of worthless IOUs, and so-forth. These positions are largely the result of people not understanding what we discussed earlier, the contrast of prefunded pensions vs. the pay-as-you-go system.

Again, Social Security was set-up so that contributions from current workers support those collecting benefits. The program was never designed to accumulate a massive pool of money for future beneficiaries. Basically, it has been managed so that incoming funds at least match benefit payments, although a surplus has existed mostly since the 1980s. One can debate the merits of this financing concept but that is an issue for another day.

Over the 84 years Social Security has been in existence, the program has collected roughly $21.9 trillion, including interest on reserves, and paid out about $19 trillion in benefits (through 2018).[4] That means the trust fund holds reserves of approximately $2.9 trillion. This isn’t a very big number considering the program is paying out over $1 trillion annually.

So why do people say politicians raided the trust fund and that it is full of worthless IOUs?

The answers to these questions are a bit more complicated because it gets into the more granular aspects of laws governing Social Security, the federal debt and accounting. But I’ll do my best to explain.

The reason some people claim that politicians have raided the trust fund goes back to the pay-as-you-go concept. Social Security wasn’t designed as a pre-funded program. This means that when there is a surplus of money coming into the system, it is available to fund other parts of the US government. But contrary to the notion that the reserves have been spent and don’t exist, in return for their use, Social Security is credited with United States Treasury bonds which earn interest just as any individual would holding the same security. 

(Technically the Treasury bonds held by the trust fund are specially designated for Social Security. But for practical purposes, the bonds serve the exact same function as the ones most people reading this own via their 401k, IRA or directly held savings bonds.)

Some say the government is “borrowing from itself” by exchanging the reserves for Treasury bonds. While this is technically true, one can also simply say the trust fund reserves are fully invested in US government bonds as opposed to being held in cash or invested in something else (like stocks). Far from worthless, these bonds are backed by the full faith and credit of the United States government which is no different from the FDIC insurance you get at your local bank.

Is Social Security going broke?

The 2019 annual report from Social Security projects that outflows will exceed inflows beginning this year, and the trust fund reserves will be depleted by 2035. That sounds scary but is much less dire than some headlines would suggest. 

Remember, with pay-as-you-go, there will still be money coming into Social Security in 2035 once the trust fund reserves are depleted. Workers will still be paying payroll taxes. The problem is the money coming in will not be enough to cover what is going out.

In fact, if you look at your own Social Security statement, on page 2, about a third of the way down in bold you’ll find a paragraph stating:

*Your estimated benefits are based on current law. Congress has made changes to the law in the past and can do so at any time. The law governing benefit amounts may change because, by 2034, the payroll taxes collected will be enough to pay only about 79 percent of scheduled benefits.[5]

In other words, the system isn’t careening toward a sudden death. But it is on an unsustainable path which will require some combination of lower benefits and increased revenues.

The 2019 annual report explicitly prescribes changes that would need to be implemented immediately to maintain Social Security for the next 75 years. From page 4 of the report:

1. Increase payroll taxes by 2.70% (from the current combined employee/employer rate of 12.4%), or
2. Reduce scheduled benefits by 17% for all current and future beneficiaries, or
3. Reduce scheduled benefits by 20% for those eligible for benefits in 2019 and later, or
4. Some combination of the above.

The report emphasizes that these changes would be required today. The longer the funding problems are deferred, the more drastic the required remedies will be.

Concluding Thoughts

So is Social Security going broke? In the sense that the program is headed for a fiscal cliff, the answer is a qualified no. There is no date at which time benefits will suddenly stop. But there clearly is a funding problem that will have to be addressed in the not-so-distant future. As your Social Security statement spells out in bold print, by 2034 (or 2035 according to the latest trustee report), the revenues going into the system will only be able to support about 79% of benefits.

For purposes of agreeing to a solution, it’s important to recognize the two trends underlying the problem…the US population is aging and people are living longer.

In fact, when the original Social Security Act was passed in 1935, life expectancy in the US was only around 62 years. Remember, retirement benefits weren’t even available until 65! Today, life expectancy is just shy of 79 which means that the “cost” of providing retirement benefits has gone up substantially over the decades at the same time population growth has slowed meaning there are less workers to support the system. It’s a double whammy which is no one’s fault, but a problem that will undoubtedly require some financial pain to remedy.

That said I’m confident that Social Security will be around for future generations but there will most definitely be some changes. It’s also important to remember that any amendments to the program wouldn’t be the first. In the late 1970s we faced a very similar situation when outflows began to exceed inflows. By 1982, projections showed the Social Security trust fund would run out of reserves by 1983![6]

To address the financial crunch facing the program at the time, a panel was formed, The National Commission on Social Security Reform, and led by the future chairman of the Federal Reserve, Alan Greenspan. The panel studied the issues and submitted recommendations to Congress to address the problems.

From this panel came legislation commonly known as the Social Security Amendments of 1983 which was signed into law by Ronald Reagan. There were quite a few changes but among the most notable included:

1. An acceleration in scheduled payroll tax increases. The Social Security portion (OASDI) of the payroll tax increased from 5.4% in 1983 to 6.2% by 1990, which is where it remains today.
2. Making up to half of Social Security benefits taxable for higher earners. Today, up to 85% of benefits are taxable.
3. Raising the “full retirement age” from 65 to 67 in two phases. 

When all was said and done, the result of these amendments was enough to keep the program on solid footing for over 35 years.

Today, the program again faces a financial shortfall almost exclusively due to changing demographics and increased life expectancy. The good news is Social Security is not on track to suddenly implode.

I anticipate that Congress will not act until the problem becomes much more pressing absent public pressure. It also seems plausible that the issues will be addressed in a similar fashion as 1983. Perhaps Alan Greenspan would be willing to come out of retirement to lead the charge. For future beneficiaries, the most important thing to understand is the sooner that action is taken, the less painful the required changes will be.

Disclosure

_{Advisory services offered through Trott Brook Financial Inc. a registered investment advisor.  Securities offered through LaSalle St. Securities, LLC, a FINRA/SIPC member broker/dealer.  Trott Brook Financial Inc. and LaSalle Street Securities, LLC are unaffiliated separate legal entities.}