Social Security: A guide to critical questions

 


(J. Scott Applewhite/AP)

This is an updated version of The Fact Checker’s guide to Social Security and how it is financed. The details of Social Security are often misunderstood, making it a frequent subject of political hyperbole and misinformation. This primer is intended to answer basic questions about the program.

What is Social Security?

Social Security was created in response to the pervasive poverty during the Great Depression. It is designed to provide workers with a basic level of income in retirement, as well as disability pay and life insurance while they work.

About 70 percent of the 57 million beneficiaries are retired workers; the rest are disabled workers, dependents or survivors. The benefits are progressive, meaning lower-income workers get a relatively better deal than higher-income workers; however, workers making above a certain salary ($117,000 in 2014) don’t have to pay as much of their income into the system, though their benefits are capped too. (About six percent of workers earn above taxable maximum.)

The benefits are inflation-adjusted after initial receipt, a feature that is almost impossible to find in the U.S. annuity market. The initial benefit formula is adjusted annually for growth in the Average Wage Index (AWI), which tends to rise faster than price inflation. This is why per capita Social Security benefits rise in real terms.

How is Social Security financed?

About 96 percent of workers must pay a certain amount of their paycheck, generally 6.2 percent, into the system, an amount that is matched by their employers. (Some state and local workers don’t participate in Social Security.)

This results in a 12.4 percent tax on income, as most economists would agree that the full amount is taken from the worker’s wage compensation.

Social Security is a pay-as-you-go system, which means that payments collected today are immediately used to pay benefits. Until recently, more payments were collected than were needed for benefits. So, Social Security loaned the money to the U.S. government, which used it for other things. In exchange, Social Security receives interest-bearing Treasury securities. The value of those bonds is now nearly $2.8 trillion.

Why do some politicians label Social Security a ‘Ponzi scheme,’ meaning that it will eventually collapse?

Because Social Security was not pre-funded, it depends heavily on the contributions of current workers. The baby-boom generation has begun to retire, reducing the number of workers per retiree. Meanwhile, people are living longer and thus would collect benefits longer, while parents are not having as many children, which limits the pool of new workers. Wages for many Americans have also stagnated in recent decades.

Largely because of the Great Recession, payroll collections now are not covering all benefit payments, and in 2010, Social Security started to tap its trust funds. Most experts predict that the demographic, life expectancy and fertility trends will continue even after the baby-boom generation passes.

Indeed, after years of running a cash surplus, Social Security now has a negative cash flow (excluding interest income from bonds, which is paid in more bonds). And that means that in recent years the Treasury has had to go into the private market and issue bonds to investors on Wall Street and overseas in order to make good a relatively small percentage of benefit payments — about $75 billion in 2013. (Contrary to the view of some commentators, this is not a controversial statement. It comes directly from the Social Security Trustees report: “The Trustees project that this cash-flow deficit will average about $75 billion between 2013 and 2018 before rising steeply.” See also pages 223-224.)

But in any case, Social Security is not a “Ponzi scheme,” meaning a fraudulent investment vehicle with a nonexistent investment strategy, which usually collapses within a few years.

Why do some people say the trust funds have nothing but IOUs?

IOU is just a pejorative way of saying “bond.” These bonds are backed by the full faith and credit of the U.S. government. Until the 2011 debt-ceiling impasse, one could not imagine that any president or Congress would risk defaulting on them because it would damage the nation’s financial standing. Still, Treasury bonds are considered a good bet — deemed to be one of the safest places to keep money.

But, then, doesn’t the government have to pay for them somehow?

This is where it gets confusing. The bonds are a real asset to Social Security, but they also represent an obligation of the rest of the government. Like any entity that issues debt, such as a corporation, the government will have to make good on its obligations, generally by taking the money out of revenue, reducing expenses or issuing new debt. The action taken really depends on the resources available at the time. There is nothing particularly unusual about this, except that the U.S. government is better placed to make good on these obligations than virtually any other debt-issuer.

Some analysts, however, question whether the Social Security system holding those bonds lowers the cost of paying benefits relative to if the system did not hold them. Since the bonds have to be redeemed by general taxpayers, as a group taxpayers have to provide the same level of revenues to finance benefit payments as if Social Security were not holding any bonds.

So then the question becomes whether the fact that Social Security ran these surpluses in the past improved the government’s overall fiscal position and thereby made it easier for the government to finance the total level of upcoming benefit payments. Some analysts contend that the existence of the earlier Social Security surpluses spurred lawmakers to spend more, resulting in higher public debt.

Meanwhile, Democrats sometimes claim that Social Security “has not added one penny to the deficit.” The complexity of the financing makes this a confusing topic, but we have previously warned that readers should be wary of such assertions. You don’t get something for nothing.

Why wasn’t the surplus cash generated by Social Security placed in stocks or something else?

That has been an option discussed from time to time, though people were concerned about government control of corporate assets and having retirement funds subject to market swings. But it’s important to remember that if the $2.8 trillion now in the Social Security trust funds had been invested in some other security, not only would the value of the trust funds be subject to more volatility, but all things being equal, the publicly held debt of the United States would be $2.8 trillion higher today. That’s because for years the Social Security surpluses were used to help fund government operations, thus reducing the overall budget deficit at the time.

Is there anything wrong with issuing new debt as benefits exceed tax revenue?

Issuing new debt is a choice with certain consequences. It is one thing to issue debt to build schools; it is another thing to build up debt to finance the expenses of the elderly. When the government issues new debt and the economy is near full employment, it crowds out capital formation and ultimately passes on a smaller economy to future generations. (In an economy with high unemployment after a recession, many economists would say the impact of borrowing on capital formation is greatly reduced.)

Policymakers will have to decide whether it is more important to worry about people alive 20 years from now or people alive 50 years from now. Some believe future generations will be richer and more productive, and thus able to afford the bill. Currently, however, Social Security costs are rising relative to the earnings of workers, indicating that the United States’ economic capacity is not keeping up with the rate of growth of Social Security obligations.

In the end, the ability to pay benefits will be determined by how big the economy is at the time, not necessarily what kinds of assets are held by Social Security. At the moment, the government’s finances are such that it has no choice but to issue more debt to make payments.

Would creating individual accounts, as Republicans advocate from time to time, also require more debt?

Yes, if the accounts are funded out of existing payroll taxes, which was favored by then-President George W. Bush when he unsuccessfully attempted to overhaul the system. Creating such accounts would require Social Security to tap the trust fund even faster. That is because the system would need to keep paying current beneficiaries while also funding nascent accounts for people who are not likely to retire for decades. If no new source of revenue is added, some sort of loan, potentially worth trillions of dollars, may be needed to help bridge the financing gap in the early decades of a revised program.

Are there other ways to deal with a financing gap in Social Security?

In the past, payroll taxes have been increased and benefits have been adjusted. Some propose eliminating the cap on income subject to payroll taxes. The effective retirement age has been increased as people are living longer. More recently, President Obama has proposed achieving savings by adjusting the index used to calculate cost-of-living increases. This idea, which has Democratic roots, is intended to more accurately reflect how people react to price increases — but Obama’s plan was opposed by many Democrats on Capitol Hill because it was perceived as a benefit cut.

It’s important to remember that Social Security does not run out of money or go “broke” even when its key trust fund is exhausted in 2035, as projected in the 2013 Social Security trustees report. The report says that tax income would be sufficient to pay about 72 percent of scheduled benefits through 2087. Even with current trends, the program will be there, although with reduced benefits if absolutely no changes are made — which is not politically likely.

However, it is worth noting that the trust fund for disability payments (DI) is expected to be depleted in 2016. Although many people refer to the trust funds as a combined entity, the depletion of the DI fund might change the focus. Without new legislation, benefits for the disabled will be cut by 20 percent in 2016. 

It seems like I put a lot of money into Social Security and won’t get a lot back.

Social Security was never intended to generate wealth, but rather to supply an income floor.

You are paying not only for retirement benefits, but also for disability and life insurance. Moreover, wealthier people are helping subsidize poorer workers. We also are paying for the fact that as the system was set up and expanded, earlier generations of retirees got much more in benefits than they contributed in payroll taxes.

The Urban Institute has produced an interesting study which shows that a two-earner couple making an average wage retiring in 1960 received eight times in Social Security benefits what they paid in taxes — while a similar couple turning 65 in 2010 would have expected to get only about one-third more in benefits than what they paid in taxes.

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Glenn Kessler has reported on domestic and foreign policy for more than three decades. He would like your help in keeping an eye on public figures. Send him statements to fact check by emailing him, tweeting at him, or sending him a message on Facebook.
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