Social Security: Peering Through the Fog

Social Security, our largest federal program, is unsustainable in its current form. In fact, according to the most recent projections, the program is only expected to be able to fully pay out scheduled benefits until 2033, with all recipients facing a potential 21% cut to benefits after this date (figure 1). It is therefore no shock that workers and retirees are concerned, as some may be operating under the assumption that their payroll taxes were meant to guarantee their financial security in their golden years. Unfortunately, most are misinformed about how this system works and what they are due. Perhaps more concerning, some policy makers show a similar lack of understanding about the structure and solvency of the program, which has slowed the adoption of corrective policy.  

However, while there is real danger in ignoring the looming crisis that is Social Security, there is also danger in assuming that the failure of Social Security is already a foregone conclusion. We will leave the former for the politicians, as even though we will discuss potential policy changes and their effect on taxpayers, we are not here to offer solutions. Instead, we will dissect the economics of the program with an eye towards trying to do what we always do – frame it not as something to panic and fret over, but something to be planned around.

History and Structure

To think clearly about Social Security going forward, it’s vital to understand its original purpose and structure. Unfortunately, an examination of the program’s history reveals that the issues that we are now facing were implicit at the very creation of the program and then worsened through decades of amendment and expansion.  

Like many major government programs we still have today, Social Security was essentially a creation of President Franklin D. Roosevelt’s New Deal policies to counter the prolific economics woes of the Great Depression. And like many of these programs, it was created with noble intentions – to offer aid to the elderly, the unemployed, widowed, orphaned, and disabled. In FDR’s own words, the program would “take care of human needs and at the same time provide for the United States an economic structure of vastly greater soundness.”ⁱ With regards to the former, if only the former, the program could be considered a success, as the social safety net it created for those who need it the most kept, and keeps, them out of poverty.ⁱⁱ

But as with many social welfare programs that are popular among voters, and by extension, elected officials, the scope and scale of Social Security soon expanded considerably, and the taxpayer burden grew. The decades following the program’s creation saw the introduction of an option to begin receiving benefits prior to age 65, additional supplementary payments, and large cost-of-living adjustments. But it wasn’t until the 1980s that policy makers recognized that the fiscal footing of the program was increasingly shaky. This led to a collection of sweeping changes by the Reagan and Clinton administrations to claw back some of the excess by increasing taxation of benefits and pushing full-retirement age from 65 to 67.ⁱⁱⁱ But despite these adjustments, more solvency issues began to develop because the program never addressed a key problem - shifting demographics.

You see, then, as now, the benefits for what is referred to as Old-Age and Survivors Insurance (OASI) were paid out of taxes collected from current workers – a workaround for both a timely need for aid and concerns at the time about the constitutionality of levying taxes to pay individual benefits. This means that Social Security is essentially a “pay as you go” program. In other words, as long as there are enough workers to support those already in retirement, or more accurately, the number of wage earners is growing faster than the number of retirees, the program is likely to be in good shape.

But when that benefit growth ran headlong into shifting demographics - due to falling birth rates, longer life spans, and a precipitous fall in the worker-to-beneficiary ratio due to retiring Boomers - cracks started to show and have continued to widen (figure 2). This brings us to our current predicament.

The Current State

Social Security is a massive program, spending over $1.2 trillion in 2023 alone.^iv By 2033, total outlays will be more than $2 trillion, which is expected to be over 5% of our gross domestic product (GDP). More importantly, the program has operated at a deficit since 2010, which simply means that revenue from payroll taxes is no longer adequate to cover benefit payments (figure 3). This shortfall is expected to come in at around $184 billion this year, and if the current trajectory holds, this deficit could double in a decade.

Now, benefits are still being paid out despite this deficit. But in order to accomplish this, the Social Security Administration must fall back on perhaps the most muddled concept in all of governmental finance – an intra-governmental accounting ledger known as the Social Security Trust Fund. And perhaps nothing has done more harm to the future solvency of Social Security than the misconceptions surrounding what this fund truly represents.

When Social Security runs a surplus, which it did for a couple of decades after the reforms of the 1980s, these additional funds are credited to the Trust Fund account to provide a cushion to cover future benefit payments. This account currently has credits equal to approximately $2.7 trillion.^v But you will notice the use of the word "credited" as opposed to "invested in."  This is because the assets held in this fund are not what you would typically associate with an investment account – they aren’t real, liquid assets that could be sold on the open market to raise funds. Instead, the Trust Fund is made up of specially issued Treasury bonds that, while accruing interest, represent little more than an IOU that can be redeemed for cash to cover benefit payments. By extension, there is no cash or investments sitting on the sidelines waiting to be used, as the program surpluses have frequently been repurposed to pay for other government spending. Instead, when the program runs a deficit and redeems these securities, the Treasury still has to find a way to come up with the cash, with this Trust Fund representing little more than a ledger that tells the Treasury how much it will have to borrow in the future.  

But even this capacity is expected to run out in 2033. Over the next decade, the expected growth of benefits, given current demographic trends, payroll taxation, and benefit formulas, is expected to fully deplete the accumulated IOUs, and by extension, the capability to legally use government debt to pay for Social Security. Short of Congress changing the law to allow general taxation to cover benefits, the entire burden then falls back on inadequate payroll taxes. This results in the mandatory benefit reduction that we discussed at the start of this commentary. That’s the bad news.

Potential Reforms

But let’s make something very clear: despite a barrage of headlines to the contrary representing the same level of misunderstanding (or worse, misleading narratives) discussed above, Social Security doesn’t go bankrupt when this occurs. Yes, by law, benefits will have to be reduced if nothing changes. But luckily, this is too important an issue for policy makers to ignore now that the event horizon is clearly in view. And even better, there are already a wide variety of relatively simple adjustments available that could solve many of these issues with little impact on taxpayers or benefit recipients. That’s the good news.   

Remember, these are modeled projections for a future shortfall. And as with all models, small changes in the inputs can have outsized impacts, particularly over longer time periods. Our job, as we mentioned before, is to provide you with a reasonable expectation of what the future of Social Security could look like – not by minimizing the risks of inaction, but by laying out potential options, discussing their likelihood, and quantifying their impact on you as an investor, worker, or retiree.

Let’s start with the obvious - the gap between expected future benefits and expected future payroll revenue must shrink, and that only happens in three ways: 1) Taxes must increase; 2) benefits must be reduced; or 3) we implement a combination of the two. This means there is no realistic outcome where we don’t pay higher taxes and also keep all of our currently scheduled benefits - despite what anyone in D.C. may promise.  Clearly, none of this makes for an enjoyable conversation, but the silver lining is that there are potential changes that may be considerably less drastic that you think.

Increase Tax Rates

Perhaps the most impactful, and thus most politically unattractive, change would simply be to raise more money through taxation. Currently, the Social Security payroll tax is 12.4%, which is split between workers and employers. According to the Congressional Budget Office’s (CBO) 2024 projections, covering the 75-year funding shortfall (their standard projection length) would require a payroll tax increase of 3.33%, to 15.73%. If the current split remains, workers would pay an additional 1.66%, or $800 a year for the median earner.^vi

Tax More Income

There is currently a limit on how much of your income can be taxed by Social Security ($168,600 in 2024). While this limit tends to increase gradually over the years in line with wages, the CBO has put forward two policy options to drastically expand taxable income.^vii One option is to simply increase this limit immediately. According to the CBO, increasing taxable income to $300,000 could shrink the shortfall by $670 billion over the next decade. The second option is referred to as a “donut” policy and would involve taxing income below the current limit and income above some higher amount (say, $250,000). And since there is no cap on this latter amount, the potential program deficit reduction is considerably higher (projected at over a trillion dollars over the next ten years). Of the two, the simple limit increase is considerably less extreme, and since the tax rate itself wouldn’t be changing, it could be more politically palatable.

Push Back Retirement Age

People are simply living longer than the founders of Social Security could have foreseen.^viii The average life expectancy at birth has increased nearly 20 years since Social Security was created, yet the only change in full-retirement benefit age has been from 65 to 67 (and even that was very recent). Slight shifts (2-3 years) in both early-retirement and full-retirement ages could reduce the looming shortfall by 20-30%.^ix Luckily, these changes have historically been phased in over many years, meaning if they are implemented, they likely won’t impact those near retirement. 

Change the Benefit Formula

Since 1977, initial benefits have been indexed to wage growth over the beneficiary’s career. This means that when someone applies for Social Security, their past wages must be adjusted to current day. Because this is accomplished using an average wage tracker, it essentially gives a worker credit for improvements in the overall labor market, which can be skewed by high earners, even if they didn’t earn commensurate wages during their careers. According to a recent report from the Social Security Trustees, simply indexing to inflation instead could close nearly 80% of the funding gap over the next 75 years.^x This also has the benefit of being relatively subtle, which could make it attractive both those who craft policy and those who would have to vote to pass it.  

Change Cost-of-Living Adjustments (COLAs)

Existing benefits are adjusted each year to keep up with inflation using the traditional Consumer Price Index (CPI). This is unique in government accounting, as most other programs (and even tax brackets) are instead indexed to what is called the “chained” CPI, which is built to overcome many of the statistical quirks and measurement error of the traditional CPI and more accurately reflects changes in consumer behavior due to price changes. Simply bringing Social Security in line with other programs could reduce the program’s shortfall by over $250 billion over the next decade.^xi This change, however, has been debated for quite a while, and the impact would be more acutely felt by current beneficiaries, meaning it may be less likely to occur due to a lack of political resolve.  

Means Testing

In the spirit of the original intent of Social Security to avoid poverty in old age, the idea of linking benefits to other income or wealth has always been on the table. However, we again run into the idea that the program is often, rightly or wrongly, considered an entitlement by workers, not a social welfare program. While there may be some means-related adjustments – perhaps reducing income taxation on benefits for lower income or less wealthy recipients – drastic changes to the program based on income levels are simply not likely to occur due to their radical departure from history.  

Regardless of the relative impacts on the long-term shortfall for Social Security, any changes to the program will likely come down to political reality. This means it’s reasonable to expect some combination of slight adjustments across many of these parameters, as policy makers will likely not risk the material blowback from the impacted constituency that could come from massive change.

Conclusion

Social Security is a flawed program, and it has led generations of people to believe that they were paying into a system which has the primary purpose of supporting their retirement. However, this was never the intent and is legally not the case. In fact, our highest courts have already decided that we have no contractual claim (Fleming v. Nestor) to Social Security benefits. But that doesn’t change the fact that Americans are frustrated that they may, even partially, lose out on something that they have counted on for a long time, namely comfort and security in retirement in exchange for years of work and taxes. This is why the idea of change affects us at such a deep level.

But Social Security policy has been shifting for decades. It will keep shifting. In fact, it must keep shifting if it’s going to survive. That being the case, hopefully the framework we have provided here will help you recognize two key points: 1) the changes don’t have to be major to have a drastic impact on the long-term health of the program, and 2) the outlook is not as dire as characterized by those that either misunderstand or mischaracterize the program’s future.

At the end of the day, we are all at the whim of public policy. Luckily, the makers of said policy are elected officials who are unlikely to risk allowing the program to reach its current projected shortfall, or make such drastic cuts to save it that they risk their positions in D.C. Thankfully, if action is taken early enough, that won’t be necessary. And most importantly for our purposes, the gradual adjustments that we are most likely to see will provide workers and retirees enough time to plan around whatever form Social Security takes going forward.  

 

ⁱhttps://www.ssa.gov/history/fdrstate.html
ⁱⁱhttps://www.nasi.org/discussion/social-securitys-past-present-and-future/#:~:text=Before%20Social%20Security%2C%20in%201934,it%20has%20hovered%20ever%20since.
ⁱⁱⁱhttps://www.aarp.org/retirement/social-security/info-2020/social-security-history-timeline.html
^ivhttps://www.usaspending.gov/agency/social-security-administration?fy=2024
^vhttps://www.ssa.gov/oact/trsum/#:~:text=The%20Old%2DAge%20and%20Survivors,79%20percent%20of%20scheduled%20benefits.
^vihttps://www.bls.gov/oes/current/oes_nat.htm
^viihttps://www.cbo.gov/budget-options/58630
^viiihttps://ourworldindata.org/life-expectancy#:~:text=Across%20the%20world%2C%20people%20are,has%20this%20dramatic%20change%20occurred%3F
^ixhttps://www.heritage.org/social-security/commentary/should-the-social-security-retirement-age-be-raised-yes
^xhttps://www.ssa.gov/oact/solvency/provisions_tr2022/summary.pdf
^xihttps://www.cbo.gov/budget-options/58656


The information in this report was prepared by John Weitzer, Chief Investment Officer, Matt Wiley, Vice President of Investment Management and Matt Conner, Senior Investment Consultant of First Command. Opinions represent First Command’s opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual advisor. All statistics quoted are as of the date of this publication, unless otherwise noted. First Command does not undertake to advise you of any change in its opinions or the information contained in this report. This report is not intended to be a client specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Should you require investment advice, please consult with your financial advisor. Risk is inherent in the market. Past performance does not guarantee future results. Your investment may be worth more or less than its original cost. Your investment returns will be affected by investment expenses, fees, taxes and other costs.

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