By Andrew Gray CFP®
Valentine Ventures, LLC
With the recent pandemic, something that I hear in the media and with a few clients lately is “Given that the Social Security system was already in a precarious position pre-COVID and with today’s very tough economic situation where unemployment is in the 15-20% range, is this going to push the Social Security system over the edge?”
The Social Security program has started to draw down its assets in the Trust Fund to pay for all of the benefits promised and per recent projections, if no adjustments are made, the Social Security trust fund is expected to be depleted in about 15 years around 2035. And the current economic environment will undoubtedly add strain.
However, this doesn’t mean that benefits will stop being paid or that the system is “broken” or not working as it should. And COVID-19 is not going to “bankrupt” the system. It means that the surplus of funds built up from the large Baby Boom generation will be used up. Benefits will then need to be supported by current working generations. This is the way a pay-as-you-go system like ours works. You might be wondering how we got into this situation in the first place. So, let’s start with a little history…
History of Social Security
The story behind it is fairly straightforward and its funding challenges were predicted well in advance. The Social Security system as envisioned by FDR as part of the New Deal resembled a private insurance plan—a fully funded way for workers to gradually build retirement savings that would grow at the rate of return of government bonds. He expected each generation to receive benefits roughly equal to their lifetime contributions plus interest. However, this is not how the program was actually implemented by lawmakers.
Many older people were destitute in the 1930s during the Great Depression, and there was extreme pressure to provide financial assistance. As a result, political pressure was rising to tap into Social Security funds to immediately give money to those that were destitute. Roosevelt initially resisted this because he did not want future generations to go into debt to finance the system. He felt it would be unfair to have large unfunded obligations that would have to compete with other programs for government resources in the future. He also felt it was unfair for anyone to get less out of the system than they put in, which would be necessary if funds were given to the elderly in the 1930s who hadn’t contributed.
However, lots of money was just sitting in the Social Security system with people in need and Roosevelt lost his political and policy fight. In 1939, lawmakers decided to use the funds to start paying full benefits to those who had paid little or nothing into the system. This turned Social Security into a pay-as-you-go system with predictable consequences down the road for future generations. By paying lifetime benefits to these early recipients, the nation effectively gave away the Trust Fund that would have accumulated, as well as the interest that would have been earned on that money. Researchers call this the “Missing Trust Fund,” which raises the cost of the program because taxes must be higher in the future to cover the lost interest payments on this money. In fact, the Center for Retirement Research estimates that payroll taxes are 3.7% higher than if Social Security was operated as a fully funded plan.
Another effect of paying large benefits to early cohorts is that later generations will necessarily earn a comparatively low rate of return on their contributions. Early beneficiaries make out very well because they didn’t contribute much, yet they received full benefits. This is not indicative of a flaw in the Social Security system. It’s simply the mathematical reality of a pay-as-you-go system that has matured.
Where we are Today
Now that we understand the history, let’s look at the system today.
Take a look at the following chart:
As you can see above, there are significantly less workers supporting the retiree receiving benefits in 2020. In addition, the life expectancy in 1935 when the Social Security Act was passed was 61 for men, 64 for women. Today, it’s 76 for a male, 81 for a woman. With a rising number of retirees and a drop in the birthrate, the latest projection has the combined Social Security trust funds that pay retirement and disability benefits running out of cash reserves by 2034.
With less than three workers to support each benefit and COVID-19, is the SS system on the verge of going broke or bankrupt? No. Suggesting Social Security will be “broke” or “insolvent” or “gone” in the future is to grossly overstate the actual situation. In fact, we’ve been here before in the past, but instead of the trust fund running out within 15 years, when Ronald Reagan was sworn in, that runway of trust fund depletion was less than two years. In 1983, Congress shored up the program by gradually increasing the full retirement age from 65 to 67 and started to tax benefits based on income levels.
Social security benefits are paid through payroll taxes collected from current workers and their employers, and the program currently operates with a surplus of about $2.8 trillion. Today, 76% of benefits paid are funded by payroll taxes and 24% funded from the trust fund. If you’re an employee that receives a W2, that’s 6.2% tax plus your employer pays in 6.2 for the total 12.4% (as shown above). Now, this tax is coming out of wages up to $137,700. Therefore, if you make more, say significantly more like $300,000 or millions per year, you’re paying 6.2% on the first $137,700 only. Taxing more income by increasing the wage base has been one proposal that is discussed below. However, if nothing is done at this time which is highly unlikely, all beneficiaries would get 80% of scheduled benefits, according to the Social Security Administration’s trustees report released recently.
Now that we understand the current state of the system, where do we go from here? In working with our clients at Valetine Ventures, optimal Social Security claiming strategies are always discussed as part of retirement planning and we also conduct various stress-tests in financial plans. One of those many stress-tests include how much a 20% to 30% reduction in benefits would impact their plan, if any, and try to create a plan to compensate for that gap, if needed.
Clearly, at some point in the next 12-15 years, change will need to be implemented. Either benefits will need to be cut, taxes will need to increase, or some combination of the two will need to occur. There’s also discussion of means testing, privatization of the system, and allowing a small portion of the large Trust Fund to be invested, among others. Regarding the latter, the trust fund can only invest in US Government Bonds and we all know the low rate of return those bonds have been earning the past 10+ years in the lowest interest rate environment our country has seen.
Changes will probably happen later rather than sooner given our political climate, but the demographics are certain—there are going to be too many people drawing benefits relative to those contributing to the system. This is nothing new and lawmakers are keenly aware of the problem but have been reluctant to deal with it until it’s forced upon them. If taxes are left unchanged, benefit cuts are projected to be around 20% and could take the form of smaller monthly checks, reduced inflation adjustments, a delay in the start date of benefits, or some form of means testing for the wealthy. The Center for Retirement Research at Boston College projects that to keep benefits the same, payroll tax deductions would need to permanently increase by 3-4% or income taxes would need to permanently go up a little over 2% to fully fund the system.
No doubt, Social Security faces funding challenges; but not immediately, and not bankruptcy. As stated above, even if Congress does nothing to shore up the system by 2034, Social Security will be able to pay out nearly 80% percent of promised benefits until 2090. Realistically, the most likely outcome will include some combination of benefits adjustments and a Social Security payroll tax increase (either by increasing the rate, adjusting the Social Security wage base, or both), which further mitigates the magnitude of benefit reductions. It is impossible to know how the future will unfold but we will continue to keep on top of changes to the Social Security system and planning opportunities as we continue to help with you with your long-term retirement planning.