Social Security, a federal program created in the depths of the Great Depression, provides significant financial support for retirees and is a pillar of financial planning. The program, however, faces the long-term threat of receiving less money each year than it pays out in benefits. This reality has occurred since 2010, and even the excess reserves of the Social Security Trust Fund are expected to reach depletion in 2034. After a short review of Social Security’s history, we’ll examine some of the options available to keep the program on sound footing. More importantly, though, is what those options mean for individuals and families.
Social Security, once one of the three pillars of retirement planning alongside corporate pensions and personal savings, is under the threat of being unable to pay full benefits to retirees by 2034. While many of the baby boomer generation have the remnants of corporate pensions, most of us who don’t plan to serve entire military or government careers will likely have to depend on a combination of Social Security and personal savings and investments to fund retirement. While 2034 seems to be in the distant future, we can mitigate a decrease in benefits through diligent planning now, maximizing our most valuable asset: time.
The History of Social Security
The Social Security we know today was born in the Great Depression of the 1930s that lasted until the United States’ entry into World War II. Its creation was the culmination of growing support for welfare programs after the industrial revolution, which began in the late 1700s into the early 1800s, had shifted the U.S. economy from one based on agriculture and the export of raw materials to one of industry.
As many people left farms and moved into the cities, they went from owning productive assets (farm land) to owning nothing. The bull market in U.S. stocks in the 1920s, built on significant speculation and some outright fraud, drew many Americans into stocks. As the value of these stocks plunged, it took the savings of many Americans with it. Many of these city dwellers, finding themselves unemployed with their savings wiped out, had nothing to fall back on, no crops to harvest, no animals to sell, no productive land. The oldest were impacted the most.
Recognizing that recessions and depressions exacerbated the economic pain of people who were dependent on wages and didn’t own productive assets, various business leaders, politicians, and other public figures made many attempts at different programs, from charities to state welfare programs, but none were too successful. The Great Depression created a political environment that enabled creation of a social insurance program for the elderly and Social Security was born.
While the program went through many changes in benefits and eligibility in the following decades, it was run mostly as a pay-as-you-go system, with payroll taxes being adjusted to roughly match benefit payouts. With some foresight, Congress in the 1970s and 1980s changed the payroll tax system and other Social Security rules to allow the buildup of a Social Security Trust Fund that would later (as in today) be used to pay benefits to the boomer generation as they retired.
Congress, however, made the error of analyzing Social Security funding in 75-year time horizons. The program adjustments made in 1983 were set based on the being able to pay benefits for the next 75 years with Congress knowing that the program had unsustainable deficits at the end of the 75-year window. While the specific data is to massive for me to analyze to understand the reasons, the reality is that Social Security began running deficits in 2010, less than 30 years after the 1983 adjustments. The Social Security trust fund, which stood at $2.8 trillion at the end of 2016, is projected to reach depletion in 2034. Social Security receipts following trust fund depletion are expected to support only 75% of entitlements under the current rules.
For some background on the challenges facing Social Security, we can look at how life expectancy and the ratio of workers to beneficiaries have changed. In 1940, soon after Congress created Social Security, a man who started receiving benefits at age 65 was expected to reach 78. A woman was expected to reach 80. Today, those expectancies are 84 and 86, respectively, with one quarter expected to reach age 90. Additionally, there were 16.5 workers for each beneficiary in 1950. That dropped to 5.1 in 1960 and has trended down to less than 3 today. In the end, Social Security is paying more people than ever before who are also living longer, making inflation a serious factor. This completes your history lesson…
Now that we have covered the history of Social Security and how the program arrived at its current state, we can look at some of the options available to solve (or not solve) this challenge and determine how they affect our financial planning.
Option 1: Do Nothing
I imagine that Congress will stick with this option for as long as it is the easier route politically. Ultimately, through voter apathy or congressional gridlock, it’s possible that no changed will occur before the trust fund runs out. For now, the prediction remains that payroll taxes will be sufficient to pay about 75% of entitled benefits for some period of time after 2034. In this scenario, financial plans will have to be adjusted in some form. People in or near retirement may have to adjust their spending expectations. Younger investors have the benefit of more time and can adjust their savings plans to make up for lost future benefits.
Option 2: Cut Benefits for All
This option is similar to option one, except the end goal here would be to adjust benefits to make the Social Security program self-sufficient for the foreseeable future. More detailed analysis may result in benefit cuts to lower levels than the do-nothing option (in the short-term).
Option 3: Fund the Deficit via the General Fund
Perhaps the easiest option of them all to implement, this choice would simply cause Social Security obligations to spill into the U.S. Treasury’s general fund. Given our current deficit spending, this plan would simply require the treasury to sell more bonds and, on its face, not affect anyone.
Option 4: Raise Payroll Taxes
Taxes have been one of the hottest and most divisive topics throughout U.S. history, even before income taxes became the norm. A simple increase in the tax rate would be tough given that the rate is a flat 6.2% of income on top of the normal income tax. I imagine voters from both parties would resent such an increase. Perhaps a more politically feasible option would be to raise the income cap on payroll taxes, which stands at $128,400 for 2018. Keep in mind that benefits are currently capped as well, so high earners don’t receive huge benefits.
Option 5: Reduce Benefits for Future Generations
The last option is to maintain benefits for current retirees and those approaching retirement while cutting benefits for our younger and future generations. Benefit cuts could come through a combination of reduced payouts based on an individual’s income history, an increase in the age which qualifies for benefits, and/or a form of means testing. The payout reduction is simple to fathom. An increase in qualification age would mean that future generations would have to work longer before receiving benefits, which is a natural by-product of an increased life expectancy that should continue to increase in the future. Means testing implies that individuals with a certain amount of assets would receive reduced benefits or no benefits.
Pick a Card, Any Card
The ultimate outcome of Social Security after depletion of the trust fund is still relatively unpredictable. 2034 is still far off and many things, both good and bad, could happen between now and then. While a future decision may be a combination of more than one of the listed options along with ideas I haven’t listed, I think some form of Option 5 will be the ultimate result because of the political forces involved.
First, more immediate and tangible benefits tend to weigh most on the minds of voters. Therefore, older voters will likely support maintaining benefits for themselves while cutting benefits for younger people. Younger voters, with retirement far in the distance (many also simply accept that they will receive nothing from Social Security), will not be as engaged in the debate. Second, the usual class warfare will occur, with voters demanding cuts to benefits for people deemed too wealthy (means testing).
So why does all of this matter? Two reasons. Number 1: most financial plans include Social Security benefits as a source of income to help determine savings rates and investment selection. Individuals and families should understand how different changes in Social Security benefits could affect their plan. Number 2: People who are disciplined with their spending, saving, and investing often end up with significant wealth despite modest means (read The Millionaire Next Door). Younger people today who implement a financial plan and achieve long-term wealth face the significant possibility of falling into the “too wealthy” category based on future political winds. They should consider the possibility of receiving little to no benefits from Social Security. This reality may also apply to military retirees depending on those future political winds, even without significant wealth.
Command & Signal
My goal in writing this post is to inform, not to spread fear. There is plenty of time between now and 2034 for the government to make changes to Social Security and, more importantly, for individuals and families to adjust their plans accordingly. While understanding how and why Social Security arrived at its current state may inform future voting, it’s more important that people control what they are able to control: their financial plan. Additionally, I’ve attempted to simplify the narrative into something easier to digest, but I’ve posted many links below for anyone who wants to conduct more research on their own.
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