On occasion, clients will ask about the safety of their social security benefits—will it be there, how much will they receive, etc. These are all good questions; particularly when you consider that the $3.44 trillion collected in taxes last year was not enough to pay the $4.4 trillion in costs.
Note the 2019 Federal Budget with the CBO Baseline Forecast (USD in trillions.)
I would like to say that our government’s deficit spending over the last year was an anomaly; but unfortunately, if you look back over the last 40 years, this has been the trend approximately 90% of the time. It reminds me of a friend of mine who, whenever asked, “How’s your cashflow?” would quickly reply, “One way.”
Note the past 40 years and the forecast over the next ten. The US government is anecdotally living out my friend’s sarcasm.
But Social Security is different, right? It’s a program that is not included in the federal budget because it has its own separate funding mechanism through the payroll tax. In fact, over that same forty-year period, they have accumulated a surplus of approximately $3 trillion.
As a quick reminder, the Social Security system is a pay-as-you-go program, promising to pay retirement benefits to individuals age 65 and older. Today, the retirement age can be as early as age 62, and over the years they’ve added survivorship and disability, along with other benefits, to the program. Nonetheless, even with adding more benefits and widening the age range for the retirement benefit, Social Security has carried on without a period of deficit spending. However, the increase in benefits and lack of indebtedness were heavily offset by a significant increase in taxes. Initially, the Social Security tax rate was 1% on a very limited portion of a worker’s pay. Over time, that tax rate has incrementally grown—until its most recent level of 12.4% of an individual’s pay, up to $132,900 in annual income.
Interestingly, 40 years ago, the government foresaw the impact baby boomers would have on the retirement system and began taxing social security benefits for a limited number of high-income recipients. The income rate utilized to determine whether your social security benefit was taxable was not indexed for inflation, so more and more retirees are now being taxed on that benefit. In fact, about 70% of current beneficiary recipients now have some portion of their social security benefit taxed. Over the years, I’ve had several clients who’ve come to this realization and said, “Wait a minute! I’m being taxed on income that I previously gave to the government that they are now returning to me in a form of my benefit?” As I duck under the desk, I quickly say, “Yes” and remind them I am only the messenger, and clearly not a representative of the Social Security group.
So, in summary, the money for the social security benefit comes from three sources:
- 88% from Payroll Tax
- 8% from interest on money in the surplus funds
- 4% from taxes recipients pay on their benefits
The money maintained as the Social Security surplus is invested in non-marketable securities — a fund that is projected to run out by 2034-2035. However, due to the ongoing payroll tax, the program should continue to cover nearly 80% of its obligations through 2090. So, while the surplus will be exhausted within 15 years without any changes to the program, it will still be able to pay out 80% of the promised benefits for several years.
The government has talked about solutions for the impending shortfall for a very long time, but to date, there have been no significant changes to it. Some of the ideas batted around have been implemented in the past—mainly additional increases in order to raise the income:
Raise the retirement age for people to begin receiving payments. The average life span is now age 78. When social security began, the average life span was only age 62.
Increase or eliminate the payroll tax cap. Today it is capped at $132,900. In the 1930s, it was only $3,000.
Increase the payroll tax rate. The current rate is 12.4%, up from the original rate of 1%.
Reduce benefits for higher earners. This first began in the 1980s, with taxation of benefits for high earning retirees.
- Invest a portion of surplus funds in equity market (a common strategy for other developed countries.)
- Tax 401k plan distributions.
- Cover all newly hired government employees.
- Eliminate the cost-of-living adjustment.
- Increase the number of years to calculate initial benefit (the current minimum is 10 years.)
With no easy answer, coming to a solution will be difficult task. People are living much longer than they used to and the ratio of workers to retirees has shrunk dramatically. Today, there are about 3 workers for every 1 retiree; while in the 1930s, there were 40 workers for every one retiree. Unless the US eliminates the payroll tax, which we do not foresee happening, the benefit will continue—but likely in a reduced amount. For many of our millennial clients (and some younger boomers), we calculate their retirement plan with the assumption that they’ll receive a reduced benefit.
If you or anyone you know has questions about social security and its role in retirement, please give us a call. We would be happy to share with you our insights and help you understand the best way to consider your social security benefits in your future retirement.
Bob Lagonegro, CFP®