by Chris Bixby, CFP®, EA
Senior Vice President
Portfolio and Wealth Management
There has been a lot of commotion and misconceptions, in media and political settings, about the health of Social Security. As such, we want to help make sense of the claims about Social Security by shedding some light on our current system, its solvency and its potential future.
Social Security was signed into law in 1935 providing a social insurance plan for retirement aged folks. This plan, to be financed by payroll taxes, was meant to provide workers with retirement benefits related to their earnings. The first check, with a value of $22.54, was received in 1940 by Miss Ida May Fuller, a legal secretary from Ludlow, Vermont.
Since then, Social Security has gone through many expansions of benefits, such as adding coverage for spouses, children and those with a disability. As inflation began to erode purchasing power, inflation adjustments were also added to the plan. These expansions and adjustments helped create the system we have today - a system that is the sole source of retirement income for an estimated 40% of retirees.
Life Expectancy Challenges
When Social Security was founded, benefits were mostly claimed by 65 years old male workers, but the average life expectancy for males was 60.8 years old. At the time, this was seen as proof that Social Security was founded as way to fund the government’s general budget, because “benefits were never meant to be paid out.” The problem with this reasoning is that 60.8 was the life expectancy at birth. In the 1930’s and 1940’s, child mortality was significantly higher than today - boys worked dangerous, physically demanding jobs and died at war. The reality is that over 50% of men and 60% of women lived until age 65, and the average remaining life expectancy was another 13 years. Congress estimated that 8.3 million people would be over age 65 in 1940.
Additionally, as women entered the workforce and benefits were expanded to cover spouses, the length of time benefits were paid out over gradually increased by 3 to 5 years. However, that increased benefit period has recently been partially offset by Congress raising the full retirement age to 67. As such, the net effect is an increase in benefit period of 1-3 years.
Social Security Trust Fund
Social Security was initially conceived as a “pay-as-you-go" program, using incoming payroll taxes to fund the benefits that would need to be paid out. A growing population would serve to continuously grow the income, always staying ahead of the required benefit payouts. As the first payment to Miss Fuller was about to be made, Congress had already seen the problems with this system and established the “Federal Old-Age and Survivors Insurance Trust Fund.” Surplus collections from payroll taxes and congressional budget allocations fund the Trust Fund which has peaked at $2.8 trillion.
This gives rise to another misconception which is based on some level of truth: the Social Security Trust Fund (SSTF) is just a piggy bank for Congress. Any trust fund, pension fund, or endowment must invest their assets for some growth. Most pension funds, especially those that have not built up significantly large surplus reserves, will invest the funds in a conservative manner. Utilizing this strategy, Congress instructed the SSTF to invest in assets that were as close to risk-free as possible (U.S. Treasuries). In other words, the SSTF exists as a ledger asset of the U.S. government, that is invested in U.S. Treasuries, which Congress then uses to fund their spending. In effect, Congress does issue an IOU to future Social Security recipients, but it is not as concerning as some might believe.
One unintended consequence of this limitation on investment is that competing Congressional priorities can hurt the SSTF. We have recently been through an economic period where we have seen historically low interest rates - this was done to promote spending to grow the economy. The stock market benefited from this. Savers, however, bore the brunt of this policy, and the SSTF was no exception. Inflation was growing faster than the interest earned and for the first time in history there were fewer tax receipts than benefit outflows. An aging population, high inflation increases and low investment yields conspired to see the SSTF shrink for the first time in history.
Current estimates show that the SSTF will now be depleted in the next decade. At that point, benefits will be paid out based on revenue (a pay-as you go system) which is estimated to gradually reduce benefits to 74% of the current level. However, two factors yet to fully play out may improve these numbers: life expectancy in this country has seen a decrease for the first time and we are now seeing interest rates rise, which will help the earnings for the SSTF.
Solving the Trust Fund Shortage
These trends are not new, they are not unexpected and they have been predicted for several decades. If the problems were so visible, why hasn’t Congress done anything about them? The problems are too easy to solve as both parties gain more by arguing about the problem than by solving it. We are reaching an inflexion point where delayed action could be irreversible. However, there are still several simple steps that Congress could, and likely will, take to solve the Social Security shortfall.
The Office of the Chief Actuary has produced a series of potential solutions along with the amount of the shortfall that it will solve. Here, we will discuss several of the options that have the most benefit and are the most likely to be implemented.
Option 1: Reduce the Cost-of-Living Adjustment (COLA) by 1% every year to solve 56% of the shortfall. However, that would be punitive and be the most detrimental for lower income workers who rely solely on their Social Security benefits. A more logical approach might be to calculate COLA using the chained Consumer Price Index; a method that is more in line with actual spending habits. This would solve 14% of the current shortfall.
Option 2: Recalculate how benefits are computed. The current calculation is complex but replaces more income for lower income workers. Changing the calculation method to further reduce the high-end benefits (for those making over $100/k year) would solve between 31% and 80% of the problem.
Option 3: Increasing the retirement age. Previously we discussed the increased longevity in this country, albeit with a decrease in the last couple of years. Changes to the retirement age have already been implemented in the past (from 65 to 67) and are likely to be implemented in the future. Further increasing the retirement age to age 69 will solve 38% of the current shortfall.
Option 4: Increase payroll taxes. This could increase the percentage taken for all workers, or it could focus on high wage earners. Under current law, high wage earners are not taxed for Social Security on wages exceeding $137,700. Removing this limitation would solve 75% of the shortfall. Increasing tax scenarios have the greatest impact on the success of the plan. The likelihood of this happening, at some level, would seem almost certain.
Moving Forward
So, where do we go from here? Winston Churchill is credited with saying that Americans will always wait until the last minute to do the right thing. However, it is untenable to imagine that Congress would allow the Social Security system to fail.
The Congress of the past, and even the present, has not had to think about the demise of Social Security during their term. After this presidential election, all future presidents and Congress will have to look at Social Security as a problem for them to solve. In four more years, they will no longer be able to delay action.
Given that the solutions to solving the SSTF shortage are relatively simple, and generally politically tenable, it is reasonable to assume the structure of Social Security benefits will remain similar for generations to come. Changes will likely affect higher earners, but that is true of most political decisions that affect the entire population. At this time, our recommendation would be to continue planning as if your Social Security will be a benefit that you will enjoy. For the most cautious, a look at the impact of reduced benefits may be considered.
Please reach out to your portfolio manager if you would like to take a deeper look into maximizing your future benefits.
Ferguson Wellman, Octavia Group and West Bearing do not provide tax, legal, insurance or medical advice. This material has been prepared for general educational and informational purposes only and not as a substitute for qualified counsel. You should consult qualified professionals to understand how this information may, or may not, apply specifically to you.