Are We Overstating The Consequences Of Social Security's "Insolvency"?

Posted by Michael Kitces on Thursday, April 26th, 11:34 am, 2012 in Retirement Planning

The latest release of the 2012 Social Security Trustees Report shows once again that the Social Security trust fund is not only heading for insolvency, but doing so at an increasingly rapid rate, with current projections showing total depletion by 2033. Yet the reality is that the Social Security trust fund is only used to pay Social Security benefits that can't be funded from Social Security taxes alone - which even by 2033 are projected to cover 75% of payments due! Consequently, for most financial planning clients, who may only rely on Social Security retirement benefits for 25%-50% of total retirement income (or even less in some cases), the impact may not really be very severe at all; a 25% reduction in Social Security payments that are only 25% of retirement income constitutes a 6.25% pay cut, that doesn't even occur for over 20 years! Are we overstating the impact of Social Security's fiscal woes for the average financial planning client? 

The inspiration for today's blog post was the release this week of the latest 2012 Trustees Report on Social Security, which showed that under current projections, the Social Security trust fund will be depleted by 2033 (down from 2036 in last year's report), leading to a projected 75-year shortfall that would require a present value of $8.6 trillion to fully fund - a whopping sum that itself is nearly 60% of our country's GDP!

Yet despite this dismal outlook, it's important to bear in mind the true realities of how Social Security benefits are funded. The overwhelming majority of benefits are actually paid by transferring taxes collected from current workers as payments to current retirees (and other Social Security recipients). In fact, in recent decades the Social Security system has actually collected more in taxes than it paid out in benefits, leading to the surplus that has been accumulated in the trust fund and invested into government bonds. In 2011, for example, Social Security collected $691 billion in taxes, and generated $114 billion in interest on the bond investments in the trust fund; the combined $805 billion of income was used to pay $736 billion in benefits, with the $69 billion remainder reinvested back into more government bonds. By 2021, though, the projected cost of Social Security benefits will exceed the combination of Social Security taxes and interest paid on the bonds in the Social Security trust fund, which will force some of the trust fund bonds to be liquidated to fund payments in that year. And as noted earlier, by 2033 the bonds will be completely depleted, as ongoing benefits obligations in excess of Social Security taxes and trust fund interest continue to force ongoing liquidations.

Nonetheless, the fact remains that the assets in the Social Security trust fund are merely used to fund the difference between the Social Security taxes collected from workers and the amounts need to pay benefits. Even by 2033, this shortfall is projected to be only approximately 25% of the payments due. In other words, once the Social Security trust fund is "bankrupt" with a balance of $0, the Social Security system still has the financial means to pay 75% of benefits from then-current cash flows! And those are the consequences if nothing is done to shore up the system over the next 20 years. If Social Security taxes are raised by 2.67% (from a total of 15.3% to a total of 17.97%), the system is fully funded and there is no benefit cut at all! Alternatively, if the shortfall is bridged by some combination of benefit adjustments and tax increases, the future retiree may experience some benefit cut, but it would be less than the 25% automatic cut that occurs if nothing is done.

For a client who relies solely on Social Security to fully fund retirement, a spending cut up to 25% that occurs in two decades may be painful - although recent research has suggested that typical clients may in fact reduce their spending nearly this much in their later years (as today's 65-year-olds would be less mobile 86-year-olds at the projected shortfall date). However, for a "mass affluent" client who may only be relying on Social Security benefits to provide 50%, 25%, or less of the total retirement income needs, the outlook on Social Security is even less impactful. If Social Security is only 25% of the client's portfolio, then a future 25% cut represents only a 6.25% decline in income that still doesn't hit for two decades. And of course, if part of the Social Security solution includes a tax increase (not just spending cuts), the size of the benefit cut would be even less. Alternatively, it's notable that most current policy proposals have indicated that any benefits cuts would be borne by future retirees, not current retirees, suggesting that the risk of lower future benefits is primarily an impact to those who have many years to go until retirement.

Yet for those future retirees who are most likely to face some benefit cuts, the reality is that with 10+ years remaining until retirement, the primary driver of retirement success is actually the market's return, which is needed to double the value of the portfolio in the final decade before retirement in a traditional retirement plan. As a result, while a distant future reduction in Social Security benefits of up to 25% may lie in wait for those who are currently in their early 50s, 40s, or younger, any such individuals who plan to rely on a portfolio for a material portion of retirement income will still be more sensitive to market returns than potential Social Security benefits adjustments!

This isn't to say that the potential for a cut in Social Security benefits is irrelevant; in my experience, many planners trim projected Social Security benefits for future retirees, most commonly by giving a "haircut" to the total benefits (e.g., reducing them to only 75%-85% of the originally projected amount), or by reducing the cost-of-living adjustment to be lower than the overall inflation rate (e.g., projecting Social Security COLAs at 2% while overall inflation is projected at 3%).

But the point remains that such changes are not nearly as drastic, even for mass affluent clients, as the headline "Social Security is going bankrupt" would suggest. Even for those who may rely more heavily on Social Security, the entire shortfall from the system would be projected to be "only" a 25% decline in benefits at the worst, starting in 20 years. While such a reduction certainly isn't trivial, it's still nowhere near a total reduction to $0! And for those who aren't retired yet, changes in the economy and markets will still have far more of an impact on retirement success than proposed benefits changes!

So what do you think? Do you make any adjustments to your client Social Security or overall retirement projections to account for potential benefit reductions? How concerned are your clients about their Social Security benefits? Has the demise of Social Security been exaggerated? Would your clients react differently if the Social Security deficits were simply framed as the risk of a 25% shortfall, not an implied "bankruptcy" of the entire system?

  • Joseph Perrotta

    Interesting post, Mike.

    When you put in those terms, it makes it seem much less important than the media portrays it to be.

    But when you look at the dollar amount of that change over a person’s retirement, it’s a bit different.

    For the wealthiest American’s, waiting until age 70 generates SS benefits of about $40k per year. 25% of that is $10,000.
    $10,000 per year for 20 years (not unrealistic for those who can afford proper healthcare), with a 7% return yields ~$400,000.

    That’s a pretty big number that people will now not have to pay for healthcare, travel, or even pass to their children or grandchildren.

    My personal view on the situation is that the government will make some last tax adjustments that will keep benefits at, or very close to, what they are projected to be.

    I just don’t see congress ever making the decision to upset a large majority of their constituents when they can just raise taxes.

    Thanks again!


    • Ishaq

      1)Do you think you’ll have enough money for a calmortobfe retirement?Does not apply. I love my career as an artist and hope to die with the tools of the trade in my hands.2) Do you plan on receiving the social security benefits that have been promised to you?Sure, I’m a boomer. I plan to tap in at 62. But my intent is to pass it along every month to someone in one of the following generations. There’s some delicious irony there.3) What % of your income do you save today for retirement?When I work my savings rate is usually around 40-50%. But let me say that life so far has been like a long summer vacation. I have taken as much as a year to enjoy myself and recharge my batteries several times in my adult life. I rarely reject an offer to go river rafting or fishing (which are very low cost and high enjoyment activities). On the financial side, I sold my suburban home four years ago and rent a small farm now. The cash is well invested (I hope) since it has more than doubled in that time. To buy in my locale would cost me at least triple what I now pay in rent. 4) Where would you like to retire?I’m an avid, no, really I’m a compulsive food gardener and tree grower. Soil, water, four real seasons and open spaces blow my skirt up. I’ll stay in the USA and take my chances with the coming times since my tribe is here. 5) How old are you, and what age do you plan on retiring?The answer to part one is that I’m just about to turn 61. For part B see the above.A little rambling: The real goal is to have a good life. Keep it simple and full of heart. Be joyful doing vigorous work. Eat healthy food not poisonous crap. My key to having enough money has been to tighten down the outflow spigot rather than exert myself in the mind numbing quest for big bucks. Oh yeah, exchange goods and services with others because the return is much greater (though a bit difficult to quantify). You have all seen pictures of some ancient and very wrinkled peasant in bib overalls holding a bunch of grapes with a twinkle in his eye and a wise smile on his face. This is not a bad goal. Finally, it is better to die deservedly well loved than rich.

  • Louis Stein

    You are just forgetting one thing. The surpluses that have been generated all these years have not been squirreled away, the have been used to fund the government. The government’s borrowing and money printing ability was been stretched to the limit and instead of funds inflowing from social security they will begin out flowing. These funds are significant to the discretionary portion of the budget. To look at just the piece of outflows compared to inflows might be reassuring to some, but the entire forest is a dangerous place.

    • Michael Kitces

      The trust fund is holding legally enforceable government bonds.

      If the Federal government is going to outright default on its government bonds, the Social Security trust fund is the least of our worries, compared to the cataclysmic insolvency it would render on every other bank and insurance company in the country (and most of the world). Not to mention every government bond our clients invest in.
      – Michael

  • Nick

    Nice post, thanks for sharing the information. I just have one quick correction to the following sentence: “If Social Security taxes are raised by 2.67% (from a total of 15.3% to a total of 17.97%), …” Look like you added Social Security (12.4%) and Medicare (2.9%) tax. I believe this should have been 12.4% and 15.07% in your sentence. Thanks again for sharing!

  • Michael Kitces

    I would look at this from the opposite side.

    $10,000/year for 20 years at a 7% discount rate is a present value of only $105,940.

    Furthermore, accumulating $105,940 that itself wouldn’t be required for 21 years (when the current trust fund runs out) requires only $25,585.93.

    So in the context you presented, for the wealthiest Americans waiting until age 70 to generate a Social Security benefit of $40k/year, a 25% cut that starts in 2033 and lasts for 20 years only has a present value of $25,585.93. Hardly a crisis for a wealthy American earning a near-maximum Social Security benefit!

    Just food for thought. :)

    – Michael

  • Joseph Perrotta

    And that’s why I follow this blog. Always appreciate the varying points of view presented by you and the other comments.

    Thanks for responding!


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