Many Americans don’t believe they will receive their full promised Social Security retirement income benefits, according to a 2015 Gallup poll. A recent payroll tax suspension led to a warning by the Social Security Administration that the trust fund could be depleted by 2023.
The complexity and confusion that surrounds financing of the trust fund makes it difficult for clients to understand how much income they’re likely to receive. Many wealthier families dismiss the value of these income benefits promised by a supposedly bankrupt government system.
In reality, the value of Social Security income is significant and retirees are likely to receive most of what they’ve been promised. Also, the value of these benefits increases in a low interest rate environment such as that faced by investors today.
A recent research paper published in the Journal of Financial Planning estimates the value of a $30,000 inflation-adjusted income annuity (as promised by Social Security) to be about $600,000 for a 65-year old man. This promise represents a significant portion of an affluent retiree’s portfolio, and advisors and clients should not dismiss its value because they’re worried about whether the system can survive.
Unfortunately, there is rampant confusion about how the Social Security trust funds operate. Some question whether the bonds held as assets in the trust funds are “real,” while others misleadingly claim that the existence of trust funds means that Social Security does not face a financial problem.
The truth is that while the trust funds hold real assets, Social Security also faces real financial problems.
Is the Social Security trust fund in trouble? Yes. The government has spent excess payroll taxes to cover current federal spending for decades.
Does this mean that retirees won’t receive a Social Security paycheck? No. Retirees will continue to get paid as long as there are workers making contributions.
Is there a possibility that promised income payments will receive a haircut in the future? Yes, but the cut is unlikely to be as big as many pessimists imagine.
Are increasing payments to Social Security going to impact the federal budget? Absolutely, and advisors should understand the consequences for expected taxes for workers and retirees, and for other benefits that may be reduced for high earners.
Trust Fund History
For almost 50 years following its inception in 1935, Social Security was a pay-as-you-go program. Each year, the government paid benefits to retirees with the money it collected from payroll taxes on current workers.
However, at the beginning of the 1980s the amount of taxes collected was not enough to cover the benefits of all retirees. Social Security was out of financial balance.
Congress appointed several commissions to fix the program. It charged the one headed by former Federal Reserve Chairman Alan Greenspan to focus on short-term fixes. The Greenspan Commission recommended increasing the taxes funding the programs, increasing the retirement age and other revenue-saving measures.
Accordingly, Congress changed the law in 1983 so that in any given year, current taxpayers would pay more in taxes than the program needed to pay all the benefits. Social Security would then invest the difference, or surplus, into trust funds which would pay the benefits when program outlays exceed payroll tax receipts.
Trust Funds and Their Financing
It is important to note that the Social Security program has two legally separate trust funds. The OASI and DI trust funds are legally separate because they are designed to serve different purposes and different populations.
The Old-Age and Survivors Insurance (OASI) trust fund provides benefit payments to retired workers, their spouses, some children, and the survivors of deceased workers. The Disability Insurance (DI) trust fund provides benefits to disabled workers and their spouses and children.
Social Security paid out $1 trillion in benefits during 2019, almost one-quarter of the entire $4.4 trillion federal budget. Of these benefits, 86% came from the OASI trust fund and 14% from the DI trust fund.
The only purpose of these two trust funds is to pay the benefits and associated administrative costs of the OASI or DI program.
By law, any excess revenue not spent on benefits or administrative costs must be invested in special-issue Treasury bonds that are only available to Social Security. A market rate of interest is paid on these special-issue bonds held by the Social Security trust funds and is part of the income that the program receives.
The size of the Social Security trust funds is the value of these trust fund bonds. At the point when income is no longer sufficient to cover full benefits, the bonds in the trust funds are redeemed in order to continue paying full benefits.
When all of the bonds are redeemed, and the trust funds are depleted, Social Security can only pay out in benefits what it receives in income from Social Security payroll taxes.
The trust funds are primarily financed by a tax, currently 12.4% (6.2% each by employers and employees), on covered wages up to $137,700 for 2020 and $142,800 for 2021. Of the 12.4%, 10.6% goes to the OASI trust fund and 1.8% to the DI trust fund.
The trust funds receive additional revenue from income taxes on benefits (a backdoor type of means testing) and interest paid on the bonds held in the trust fund (a form of intragovernmental transfer).
Total revenues into the trust funds in 2019 were just over $1 trillion, with $944.5 billion from payroll taxes, $80.8 billion from interest earned on trust fund assets, and $36.5 billion on the taxation of benefits.
It’s important to keep in mind that while the Social Security payroll tax rate is 12.4%, the total payroll tax rate is 15.3% when the 2.9% Medicare Hospital Insurance tax is included.
When Will the Social Security Trust Funds Run Out?
According to the Social Security Trustees, the combined OASI and DI trust funds face a financial shortfall of $16.8 trillion in present value through 2094 and $53.0 trillion over an infinite horizon.
Further, the Social Security trust funds will be depleted and unable to finance full benefits in 2035. Separately, the OASI trust fund will be depleted in 2034, but the DI trust fund will run out in 2065.
Although the date of depletion for the combined trust funds varies somewhat from year to year based on economic conditions, for the last 20 years the Trustee reports have consistently estimated that the combined trust funds will be exhausted between 2037 and 2042.
The financial problems of the Social Security program are real and will require real changes to benefit levels, taxation or a combination of the two.
Trust fund depletion does not mean bankruptcy. Social Security does not have legal borrowing authority, so when the trust funds are depleted the program can only pay out in benefits what it receives in tax revenue. That’s different from bankruptcy, which would imply that the program cannot pay benefits at all.
However, unless Congress takes action to reform Social Security, the program will only be able to pay approximately 75% of estimated benefits when the OASI trust fund runs out of assets in 2035. For DI, trust fund exhaustion in 2065 will reduce the payout to about 90% of scheduled benefits.
There’s a very large caveat, though, with respect to the 2020 Social Security Trustees’ report; it was finalized before the economic effects of the current COVID-19 pandemic could be taken into account. The 2021 report is not due out until April 2021.
However, some organizations have attempted to estimate how the pandemic will impact the Social Security trust funds.
Using the 2008 financial crisis as a proxy, the Bipartisan Policy Center estimates that if the financial impact of the pandemic is similar to that experienced as a result of the 2008 Great Recession, the Social Security OASI trust fund depletion date would hasten to 2030, while the DI trust fund depletion date would be dramatically sooner — moving up from 2065 to 2024.
On top of the drop in payroll taxes from increased unemployment, President Trump signed an executive order to “defer” payroll taxes until the end of 2020.