The Truth About Social Security

It's an election year which means speeches, commercials and news banter about political issues and the candidates' respective stances.  In the interest of public relations, candidates' views on Social Security are diced into sentence fragments and sound bites which does little to address the real issue.  Compounding the problem is that few people understand how the system works and where the funds go leading to all sorts of myths, misperceptions and exaggerations.  Let's examine how the system works so you can make your own decisions about the best approach to fixing it.



Let's start with how Social Security (SS) is actually funded.  Congress, in its infinite wisdom, created a "pay-as-you-go" system when SS was created in 1935.  That means, current revenue pays current benefits.  There is no account with your SS number.  There is no opportunity for one generation's contributions to grow and fund that same generation's retirement.  Instead, taxes collected this year pay for benefits this year.  Currently, workers pay 6.2% on wages up to a maximum of $102,000 (called the "wage base").  Employers match this, so the entire tax is 12.4%.  You pay the whole 12.4% if self-employed.  This system works fine, until taxes collected are not adequate to pay benefits.  This isn't the case today, as SS is now experiencing a "surplus": more money is coming in the door than going out, so the trust fund balance is growing.  Here comes the "but": But, sometime around 2020 payments will exceed revenue.

Examining the demographic drivers of this phenomenon is helpful in understanding the problem.  According to the U.S. Census Bureau, in 2000 there were over 166 million Americans of working age (20-65) compared to 35 million over 65- a ratio of 4.7 to 1.  That ratio is projected to fall to 3.5 by 2020 and to 2.8 as the baby boomers are retiring in droves in 2030.  That means there are less than 3 people to pay the full benefits for each retiree.  Since not all 3 people of working age actually work, the ratio is realistically between 1 and 2.  For example, if one of my parents collect say $20,000 in annual benefits (2008 dollars), that leaves just my sister and I to generate enough taxes to pay for it.  What about the other parent?  Not a pretty picture.

The trust fund currently has ~$1.5 trillion and is growing, so won't drawing down principal make up for the revenue shortfall?  Yes and no.  (You were expecting a simple answer?)  Drawing on principal does buffer the inevitable insolvency, but only for so long.  This is similar to a reservoir during a drought- as long as the water gets used as the same rate as the water coming into the reservoir- there is no problem.  But when the inflow decreases or the downstream demand from the suburbs grows, the reservoir eventually runs dry forcing users to ration what water is available.  Projections show SS starting to dip into principal in 2028 and exhausting it entirely by 2041 at which time revenue will be roughly 30% shy of payments.  This doesn't mean there will be no SS!  It means that benefits would have to be cut 30% to remain solvent without changes.

Now comes the truly complicated part.  The trust fund is empty (sort of).  There is no vault at the Treasury with SS funds.  What happens to the cash then?  According to law, excess payments are invested in special bonds issued by the Federal government by the U.S. Treasury, redeemable upon demand by the SSA.  The government includes the cash received from the bonds as part of its operating budget and uses it in the current year just as it would cash from any other Treasury borrowings.

Here is where armchair economists and anti-government folk get confused:  Because the trust fund consists of government obligations (U.S. Treasury bonds) to another government agency (the SSA), they say "the government is just lending to itself".  Well, not exactly.  If you picture the government as including the SSA and all of it as "the government", then yes it is taking money from one pocket to pay the other.  Rather you should think of the SSA as being separate from the rest of the Federal government, like a trust fund at a bank.  Only instead of FirstOneNationalTrustBankOfNewCaliTexas (or some such ridiculous bank name- they are so similar, aren't they?) investing retiree money in mutual funds, the SSA only buys U.S. Treasury bonds.  Suppose however, you do consider the SSA and the Treasury as just "the government"?  It doesn't matter, because the total amount of debt in the system is the same and supported by the same cash flow.  Imagine a married couple with a $200,000 mortgage and $70,000 of income between them.  Would it matter if they each had a $100,000 note or one $200,000 note? The real problem is that demographics will cause outflows to greatly exceed inflows.

It should be obvious by now that "fixing" the system is going to require tough decisions involving how to balance those larger future outflows with inadequate inflows.  The solution is to increase inflows (taxes) or decrease outflows (benefits) or both.  Whether a tax is "new" or simply an increase is a matter of semantics.  If benefits become adjusted for only a portion of inflation, it still amounts to a benefit cut.  Delaying full retirement age is both a tax and a benefit cut.  Needless to say, any politician's phrasing is misleading.  For most people, I expect their opinion on SS to depend on how close to retirement they are and their political views.  Those in their accumulation (working) years or wealthy, would probably rather see benefit cuts.  Those in or closer to retirement or expecting SS to be a major component of retirement income would prefer higher taxes to pay their benefits.  My advice when pondering this issue is to ignore any political commentary and focus on the impact of the proposal.  Is the proposal going to materially affect the program's solvency with tradeoffs you can live with?