Social Security Administration headquarters in Baltimore. Social Security Administration headquarters in Baltimore. (Photo: Dennis Brack/Bloomberg)

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.

Social Security 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.

Social Security 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. Social Security’s chief actuary estimated that failing to reinstate payroll taxes would deplete the trust fund by 2023, although the tax will likely be reinstated and the deferred taxes collected in 2021. However, it is now very possible that the Social Security trust funds will be depleted within the next decade, thus forcing congressional action.

Are the Bonds Held in the Trust Funds Real Assets?

By law, Social Security has to invest any annual surpluses in special issue Treasury bonds only available to Social Security. It cannot buy or hold other financial assets such as stocks, mutual funds or corporate bonds. Like other government-issued bonds, these bonds pay interest and are backed by the full faith and credit of the U.S. government. These bonds are real assets.

As Social Security draws down the assets in the OASI and DI trust funds in order to continue paying full benefits, the redemption of those bonds held in the trust funds will require that the Treasury Department issue additional public debt.

However, the way the federal government accounts for the trust funds masks the true size of costs passed on to future generations. While bonds are real assets to the private market, future generations of taxpayers or borrowers will have to cover the future redemptions of bonds issued today because the federal government has used the money it has received from Social Security to pay for education, wars and other items.

In other words, the government has already spent the money it received in exchange for the Treasury bonds issued to the Social Security trust funds. This was accurately explained in President Obama’s 2011 federal budget: “The existence of large trust fund balances, therefore, does not, by itself, increase the government’s ability to pay benefits.”

Finally, in spite of the similarities, the government trust funds are meaningfully different from private sector ones. In a private trust, the beneficiaries legally own the income from it. That is not the case with a government trust fund.

Does This Mean That the Government Is “Raiding” Social Security?

Not technically. It is true that the federal government has spent the tax revenues allegedly collected to pay for future benefits. But the Treasury bonds are guaranteed by law. This means that beginning in 2021 when Social Security starts redeeming Treasury bond holdings in the trust funds to pay scheduled benefits, the government will have to borrow from the public, raise taxes or cut spending to finance those redemptions.

Public Debt vs. Gross Debt

Government accounting hides the true costs of Social Security by reporting on the public debt, rather than the gross debt. Debt held by the public represents the obligations the United States has to private investors and other governments. Total, or gross debt, is the debt held by the public plus the intragovernmental debt, i.e. the Social Security bonds.

Gross debt represents the entire fiscal borrowing position of the U.S. government and its total debt obligations. At the end of September 2020, the U.S. gross debt was approximately $27 trillion consisting of just over $21 trillion in public debt and approximately $6 trillion in intergovernmental debt.

If the government pays for redeemed Treasury bonds through additional borrowing or taxes, this will add to the overall financial burden of the government. This demonstrates why total debt is a better measure of fiscal position than just debt held by the public. No one knows whether the government will respond by raising taxes, cutting benefits or increasing the publicly held debt, or what the implications of its actions on financial markets and economic growth will be.

Policy Implications of the Social Security Funding Shortfall

This issue is important beyond the problem of solvency of the Social Security program. Investors assess the risk a country represents based on its perceived ability to pay back its obligations. That perception is based upon the level of debt a country has and its anticipated future needs for more financing. Investors also rate countries on a curve relative to one another. As such, it makes a difference whether investors look at the level of debt the United States currently owes, or whether investors look at the debt the country will owe, and based on this measure, how it stacks up against other countries.

Payroll tax revenue alone is no longer sufficient to cover Social Security’s cost. The government will have to borrow money from the private sector to continue paying interest on the bonds held in the trust funds.

Starting in 2021, it is likely Social Security will begin to redeem the trust fund bonds, at which time the government will have to borrow even more from the private markets. Though the borrowing need will increase gradually, the need to borrow an additional $2.9 trillion, the value of Social Security trust funds at the end of 2019, from the private market will be harder and harder over time.

Additionally, Social Security is not the only entitlement program facing financial difficulty. Of the $27 trillion in gross federal debt, Social Security holds $2.9 trillion of the total $6 trillion in government-held debt. The additional $3 trillion in debt from other government obligations will also have an effect on the nation’s ability to borrow from the private markets.

The Medicare program also faces a funding shortfall, with the most recent estimates suggesting that the HI trust fund could be depleted in 2026. Though Social Security will redeem the trust fund bonds gradually, the increased borrowing needs of the federal government to finance the nation’s entitlement programs will expand dramatically. The financing needs of the Medicare program will compete with the funding needs of the Social Security system, further straining the country’s ability to borrow money from the private sector.

Policy Considerations

Trust funds hold real assets, but Social Security faces the real financial problems nonetheless. Saying that these assets are real does not imply that future beneficiaries have a right to these assets or that future beneficiaries should not worry about the program until the trust funds are depleted.

Social Security will soon run a permanent cash flow deficit and the federal government will soon start redeeming the bonds held in the trust funds. At such time, the federal government will have to borrow money from the private markets or raise taxes, which will have implications not only for financial markets, but also for future generations asked to bear the burden of future benefit reductions and/or tax increases.

Social Security Reform

There are, however, many reform options that will help achieve sustainable solvency and do not raise taxes. For example, Congress can increase the retirement age, link benefits increases to longevity, and better account for automatic adjustments to the benefit formula for changes in price inflation. It is likely, however, that the government will be forced to institute some combination of tax increases on higher-income workers and reduced benefits (or, more likely, a decrease in benefit growth).

Dismissing the real and current fiscal challenges facing the Social Security system and kicking the reform can further down the road will only increase the severity of the burden associated with reforms when they inevitably must take place.

The Role of Financial Advisors

Financial advisors will need to help clients navigate the uncertainty and risk associated with the impact that the impending depletion of the Social Security trust funds will have on retirement security.

Social Security also faces political risk. Policy solutions to the crisis will depend on which party controls the Presidency or the Congress and the economic and political environment at the time the trust funds are depleted.

While most Social Security experts doubt that Congress will let benefits be reduced by 25% once the trust funds are depleted, it is very likely that both current and future beneficiaries will face meaningful reductions in lifetime benefits that could affect financial security in retirement. For those people who are very risk averse, or for younger people whose retirement is still decades away, financial advisors may want to consider planning advice to account for a potential 25% reduction in future benefits as a baseline worst case scenario.

It is likely that more of the burden for paying for the trust fund depletion will fall on higher earners. Those currently making more than the wage limit may be subject to additional income taxes during their working years. Retirees may face higher taxes on earnings, and may also be asked to pay for a greater share of health expenses. Younger high-income workers face the possibility of a triple whammy of higher payroll taxes before retirement, lower retirement benefits, and higher costs. Strategies that shelter savings from income taxation, for example through the use of tax-exempt Roth accounts and health savings accounts, could become even more valuable when the tax bill for funding promised benefits comes due.

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Pen (Image: iStock)Jason Fichtner is the associate director of the Master of International Economics and Finance Program at the Johns Hopkins School of Advanced International Studies. Michael Finke, Ph.D., CFP, is a professor of wealth management and Frank M. Engle  Distinguished Chair in Economic Security at The American College of Financial Services.