The Social Security Formula
For Social Security to work, cash coming in has to equal cash going out. That’s a pretty simple formula. The difficulty comes from the massive size and infinite timeline of the program. The Social Security Administration (SSA) is responsible for setting the formula and ensuring the trust fund’s solvency.
Money Coming In
The SSA collects money through payroll taxes (see Part 1). The amount of payroll taxes collected depends on the tax rate, the number of people employed, and the wages they earn. Setting the tax rate at an appropriate level requires accurately predicting the number people working and their earnings, which fluctuate constantly.
It’s impossible to collect exactly the right amount of payroll tax because the wage base changes constantly but tax rate remains the same. If lawmakers were more easily able to change the rate, the inflows for Social Security could be more evenly collected.
Money Going Out
The SSA needs to predict the benefits that will be paid to eligible retirees. Total outflow is impacted by the number of people claiming benefits, how much they qualify for, and how long they live. The larger the benefit a person qualifies for, and the longer they live, the more that gets paid out.
It’s important that the Social Security Trust Fund maintain appropriate tax revenue to offset the benefits being paid out. Doing so requires accurately predicting many different variables. Unfortunately, many of the assumptions made by the SSA have proven incorrect.
The Biggest Assumption: Population Growth
A major factor in setting up the Social Security formula correctly was predicting population growth. A steadily growing population means more people working (paying in) than retired (drawing benefits).
When it was founded, the ratio of workers to retirees was 3.3:1. That means for every 10 people working there were 3 retirees. At it’s very simplest, if each of those 3 retirees is eligible for $10,000 a year in benefits ($30k total), then each of the 10 working people needs to pay $3,000 a year in taxes ($30k total).
The Social Security formula was set up with the assumption the worker to retiree ratio would stay around 3.3:1.
That Didn’t Happen
Instead, about the worst thing (in terms of math) happened. Following WWII there was a huge boom in birth rates (baby-boomers), followed by a steady decrease in population growth. As baby-boomers retire there’s a smaller pool of workers replacing them. This puts a strain on Social Security because more benefits need to be paid out, but there are less workers paying payroll taxes. By 2030 the ratio of workers to retirees is expected to be 2:1.
If we look back to our example, raising the $30k necessary to support our 3 retirees now comes from only 6 workers. Each worker would have to pay in $5k, instead of $3k, to maintain the retirees’ benefits.
What it Means for You.
It means things have to change if we’re going to make the Social Security formula self-sustaining again. There are two ways it can happen, (1) increase inflows, or (2) decrease outflows. Social Security has already done both.
Inflows increased by hiking the tax rate from 3% in 1949 to 6.2% now. The amount of wages subject to tax also climbed from $3,000 in 1949 to $118,500 now. Adjusting for inflation, the $3,000 in 1949 is about $29,000 today. The tax rate has doubled and the wage base has quadrupled since Social Security began.
The other way to ensure solvency is decreasing outflows. This happened in several ways, but the most notable was raising the age people become entitled to full benefits . When the program began the full retirement age was 65. For people born after 1959 it’s 67.
Social Security is Broke
Despite these measures Social Security is still underfunded. So what should be done? You might argue the shortfall is caused by the current beneficiaries failing to adequately fund the program during their working years. Using that logic they should bear the consequences.
I can promise you right now your grandma’s Social Security check is not about to get cut in half. A huge portion of current retirees rely exclusively on social security for support; drastically cutting benefits would make the majority of our elderly destitute, which was the problem Social Security sought to remedy in the first place! Also, retirees show out at the polls, and I don’t see them voting “yes” to reducing their income.
The fix has to come from younger generations. It’s obvious, so why is change happening so slowly? Imagine a politician who runs a campaign based on raising taxes and reducing benefits…probably not going to win. For actual change to occur people will have to feel like it’s an emergency.
How Bad is It?
The Social Security Administration (SSA) predicts Social Security will be insolvent by 2035. Insolvent doesn’t mean no payments will be made; it means the trust fund that benefits are paid out of will have no assets. It sounds almost the same, but the distinction is important. Benefits will continue to be paid, but the only money available to pay with is whatever the working class is currently paying in. If this sounds vaguely familiar, try googling “Ponzi Scheme”.
The SSA estimates that in 2035, and onward, tax payments made to Social Security will cover about 75% of the benefit level. The Social Security Act has a special provision that doesn’t allow borrowing to pay benefits. As it’s currently structured, the Social Security Trust Fund cannot go negative. If nothing changes, benefit checks will be reduced by 25% in 2035. That’s just math.
What’s My Prediction?
The primary goal of Social Security is preventing a destitute elderly population. I think this means anyone not at risk of being homeless or hungry will have their benefits cut. If you save a large sum in your retirement accounts (like 401ks), or have high lifetime earnings, I think your Social Security benefits will be reduced. In this way prolific savers will be penalized for having saved. I also think the tax rate, wage base, and benefit eligibility age will continue going up.
Please don’t mistake this for a doomsday tirade. The Social Security shortfall is not as end-of-the-world scary as some pundits would have you believe. For one, worst case scenario is benefits are cut to 75%, not zero. Secondly, the SSA projects that the future shortfall could be remedied with a 2% increase in the payroll tax rate. And finally, this has happened before. Social Security faced a similar projected future shortfall in 1983 and the program was reformed. Pretty much everyone agrees another reform is necessary, and it will require either raising taxes or reducing benefits (or both), but no need to start hoarding canned goods, reforming a major public program every 35 years seems pretty reasonable to me.