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A Political Hot Potato

Posted on April 23, 2019

“Social Security: the hot potato no one wants to touch.” – Don Brunell, Quad City Herald

2019-04-23_potato.jpgLast week we introduced a short series on the retirement crisis in America. As we mentioned, the crisis is rooted in unrealistic expectations embedded in three categories: social security, public and private pensions and individual savings rates. This week we’ll focus on the future outlook for America’s social security system.* But before we look forward, let’s take a quick look backward at the history of this institution in our country.


History

The idea of social insurance is nothing new. It has been implemented in a variety of ways and with mixed success throughout human history, but the modern day version of America’s social insurance program dates back to 1935 with the signing of the Social Security Act by President Roosevelt. The program was originally designed to provide economic security to a select group of American workers during the Great Depression. Coverage was extended only to retired workers in certain commerce-related and industrial sectors, there was no built-in cost of living adjustment and children and spouses of covered workers were not eligible to receive payments. There were also no benefits for disability, and the inception of Medicare as an extension of social insurance was still three decades away. The program was paid for with a new 2% payroll tax that would eventually become known as the Federal Insurance Contribution Act (“FICA”) tax.

Over the ensuing five decades Social Security underwent many changes, slowing morphing into the version of the program that exists today. So one important thing to remember is that the “rules of the game” are not set in stone. They have changed continually over the past 80+ years, and they will certainly continue changing in the future as we’ll explain below.

Show Me The Money

The Social Security Trust Fund, managed by the US Treasury Department, is the account into which revenues are added and benefits are paid. Every year the fund receives in taxes and interest while paying out retirement and disability benefits. When inflows exceed outflows the fund has a surplus, and the value of the trust fund grows. These excess funds are “invested” into special-issue government bonds that are not available for purchase or sale by the general public. These bonds are internal to the US government and are essentially IOU’s between the Treasury and the trust fund. In other words, the federal government has already spent all FICA taxes that we’ve paid into the Social Security system, promising to someday pay that money back so that it can be paid out in the form of benefits to us, the tax payers.

President Clinton’s Office of Management and Budget once described it this way:

“These balances are available to finance future benefit payments … only in a bookkeeping sense. They do not consist of real economic assets that can be drawn down in the future to fund benefits. Instead, they are claims on the Treasury that, when redeemed, will have to be financed by raising taxes, borrowing from the public, or reducing benefits, or other expenditures.

As long as the trust fund runs a surplus, the federal government has some additional money to spend and the fund’s coffers get stuffed with a few more IOU’s. But what happens when those surpluses turn into deficits? This question ceased to be hypothetical in 2010 when the fund experienced its first deficit of $49 billion. Indeed, we are now in an era where annual deficits, not surpluses, will be the norm. Not only will deficits persist, but they will grow substantially into the foreseeable future. This trend is largely due to the transition of the baby boomer generation into retirement years. The ratio of workers paying into the system vs beneficiaries drawing out of the system has been trending downward for decades and is projected to continue dropping sharply as more baby boomers retire and begin drawing benefits.

Under this scenario the federal government must make good on (read: borrow, tax or cut spending) enough of its IOU’s to plug the gap between the trust fund’s inflows and outflows. Thus, questions surrounding the long-term viability of social security really boil down to whether or not the federal government will be willing and able to meet its future obligations. This is no small matter, as spending on Social Security and Medicare already accounts for well over a third of the federal budget, and the true unfunded liabilities of the federal government are estimated to be in excess of $100 trillion.

Social (In)Security

It’s important to note that the deficit being run in the social security trust fund, while not preferable, is not necessarily a problem. Consider the chart below which depicts the calendar year surplus/deficit (excluding interest payments) with the green bars, and the historical balance of the trust fund in gray. You can see that prior to the 1980’s social security was essentially a “pay as you go” system, meaning tax revenues more or less covered expenditures. Under this regime the social security trust fund provided a small buffer year to year, but was not accumulating significant assets. In the early 1980’s, however, Congress realized that the baby boomer generation would create enormous imbalances in the future. They raised taxes on the boomers in order to “save up” a cumulative surplus in the trust fund in anticipation of those imbalances.

2019-04-23_ss_chart.pngWe should fully expect the trust fund to shrink substantially in the coming decades as the baby boomers withdraw out of the system the taxes that they paid in.** Remember, the ongoing viability of social security is not solely dependent on the trust fund – it is still, at its core, a pay as you go system that will continue to be sustained at some level by ongoing tax revenues in the future.

Is It Solvent?

Assuming no change to current law, the answer to this all important question is that no, Social Security in its current form is not solvent long-term. Costs to the system will continue to outstrip revenues, leading to a depletion of the trust fund around 2035 according to the most recent government report on Social Security. At that point the only source of income left to sustain benefit payouts would be current year tax revenue.

We’re not suggesting the program is destined to go completely belly up, but simply that it will eventually have to undergo a significant restructuring in order to balance inflows and outflows. One should never assume “no change” when it comes to future US policy. The long-term outlook for Social Security is fixable, and it’s almost certain that the needed reforms will eventually be implemented. The problem is well documented and understood by politicians on both sides of the aisle, and the program is simply too important to too many Americans not to fix. Consider the fact that Social Security replaces 40% of pre-retirement income for the average American retiree. Additionally, nearly a quarter of the country’s population is currently drawing from the system, including 9 out of every 10 Americans age 65 and older. Despite all the dysfunction in Washington, we think it’s safe to assume that this issue will eventually be immediate enough to receive some serious attention.

Here are a few of the most widely discussed reform proposals:

Reforms that INCREASE REVENUE:

Increase the payroll tax cap
The Social Security payroll tax currently applies to annual earnings up to $117,000 for 2014. This cap could be raised or even eliminated to increase the tax base on which FICA is collected.

Increase the payroll tax rate
The 2014 Social Security FICA tax is levied at 6.2% on the employee and 6.2% on the employer for a total of 12.4%. This tax rate could be increased in order to generate more income for the system.

Reforms that CUT BENEFITS:

Raise the retirement age
We’re living and staying healthier longer than we were back with Social Security was first enacted. The full retirement age could be increased over time to reflect this, thereby increasing the number of years an American pays in and reducing the number of years of withdrawals.

Use a different COLA index
Cost of living adjustments are currently calculated using the Consumer Price Index. There are other inflation indexes available that over time would likely lag the CPI, resulting in lower cost of living adjustments for beneficiaries.

Begin means-testing benefits
Means-testing would take into account the level of earnings and assets a potential recipient has, reducing or even eliminating benefits for those that are determined to need the benefits the least.

Given the current trajectory, our Social Security program is in need of broad, sweeping reforms in order to re-establish long-term sustainability, and the system will need to look substantially different in the future than it does today. Any one, or combination of, the proposals mentioned above may be enacted in coming years in order to accomplish this. It’s our personal opinion that most current and soon to be retirees will not see any change to their benefits, but future generations and perhaps those near the top of the wealth scale will pay the highest price. It’s easy to see why Social Security has become such a political hot potato, but eventually expectations will need to be reset in order to avoid making the situation worse.

*While our focus is on social security specifically, much of the analysis is relevant to Medicare as well.
**You may have noticed the balance of the trust fund has not yet started declining as of 12/31/17 as reflected in the chart. This is due to the fact that the interest being earned within the account is still outpacing the size of the annual deficit being run.


david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.


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