“The rule for effective governance is simple…when there is a problem, you fix it.” – Chris Christie
Last week, in Show Me The (Social Security) Money!, we discussed the history of our nation’s social security program as well as taking a look at how the social security trust fund works. In this post we’ll analyze the long-term viability of the plan, and how that impacts us as savers and investors.
As we pointed out last time, 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 assertion is based on the reality that the money in the social security trust fund has already been spent, and the fund is now chock full of government IOU’s (bonds). As the baby boomers continue to transition into retirement, the fund will run a perpetual deficit (benefit payouts exceeding tax revenues) creating a gap that will necessitate the federal government making good on those IOU’s through increased taxes, increased borrowing or decreased spending.*
It’s important to note that the shrinking size of 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.
We 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.
So, Is It Solvent Or Not?
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. From the most recent annual report from Social Security’s Chief Actuary,
“Neither Medicare nor Social Security can sustain projected long-run programs in full under currently scheduled financing, and legislative changes are necessary to avoid disruptive consequences for beneficiaries and taxpayers.”
Costs to the system will continue to outstrip revenues, leading to a depletion of the trust fund around 2033 according to the same report. At that point the only source of income left to sustain benefit payouts would be current year tax revenue. This would require program benefits to be cut by roughly 23% overnight, and would no additional buffer in the form of a positive asset base in the trust fund. What we’re saying is not that 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 20% of the 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.
Social Security underwent careful scrutiny and broad revisions in the early 80’s, and eventually it will happen again. The only question is how long it will be before we have leadership in Washington willing to fire the first bullet, and what the reforms will end up looking like. Regardless of what shape they take, any proposed reform will ultimately equate to an increase in revenue or a cut in benefits.
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.
In the meantime, our planning advice to our clients will vary based on age, objectives and their personal propensity to trust or mistrust the government’s ability to resolve this issue. At the very least, applying an aggressive haircut to estimated social security benefits in planning projections is wise in our view, especially for individuals under 55 years of age. In more extreme cases building a plan that completely disregards future social security benefits only leaves room for a pleasant surprise if and when benefits are actually realized. Ultimately we are each all responsible for our own financial security, so the less reliance our clients have to put on the federal government fixing its broken systems the better.
* A point of clarification for those who are interested. Technically speaking the trust fund deficit is calculated prior to accounting for the interest earned on the fund’s assets. This means that the interest is another source of funds that can be used to plug the gap. This is, in fact, the case right now, as the fund’s interest earnings are projected to exceed the deficit through the end of 2021.
Author 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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