The Social Security Trust Funds, Explained

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 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.

Is the Government “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 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.

Now that you’ve read this article, test your knowledge on the Social Security trust funds.

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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.