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A few weeks ago, the 2013 Trustees Report on Social Security was released, confirming once again that the Social Security system continues to pay out more than it takes in, remaining on a path that is ultimately unsustainable. Yet the details underlying the report reveal a more profound reality: that while Social Security as it is currently constituted is not viable in the long run, the downside of depleting Social Security is far less severe than we often make it out to be.

The reality of the Trustees Report is actually that, even if we do nothing to resolve Social Security in the coming decades, that the system will still be able to pay out 77% of its projected benefits in 2033 when the trust fund is depleted, and continue to pay out more than 70% of its projected benefits for the remainder of the century. In other words, even if we do nothing to fix the system at all, today's Generation X and Y young adults would still be anticipated to receive about 3/4ths of their anticipated benefits for their entire retirement. 

And that's if nothing is done. If instead the woes of Social Security ultimately are addressed, through some combination of current and/or future benefit adjustments, and increases in the Social Security payroll tax rate, wage base, or the taxation of benefits, the shortfalls decline further and the ability to pay future benefits rises. Which means that ultimately, the most likely future outcome is a haircut of less than 23% of benefits for today's young adults, and that most future benefits will in fact still be funded. As a result, it's important to recognize the real state of the Social Security system, to ensure that clients receive appropriate advice in light of what isn't, and is, likely to be there when the time comes.

The Current State Of Social Security 

The latest Trustees Report on Social Security shows that last year in 2012, Social Security paid out benefits to approximately 57 million people, including 40 million retirees and their dependents, 6 million widows and widowers, and 11 million disabled individuals and their dependents. The total payments to these individuals amounted to $775 billion (and total outflows were $786 billion, including a small amount of Railroad Retirement benefits and the administrative expenses of the Social Security system).

To fund these costs, approximately 161 million workers in the US paid at least some payroll taxes last year, adding up to a total of nearly $704 billion (including about $114B that was actually paid from the General Fund of the Treasury to cover the 2% payroll tax "holiday" in place for 2012). In addition, another $27B of revenue was collected from the taxation of Social Security benefits, bringing the total up to nearly $731B, and leaving a shortfall of almost $55B of expenditures paid in excess of the revenue collected.

However, the balance of the Social Security trust fund entering 2012 was $2,677.9 billion - the accumulation of several decades' worth of years where the Social Security tax revenue was in excess of the costs - and its investment in US government bonds yielded a total return of about $109B in interest. This more than made up the remaining shortfall, and in fact left more than $54B of excess remaining, which was re-invested into government bonds, bringing the Social Security Trust Fund up to $2,732.3 billion at the end of the year.

Or stated more simply - this year, the total revenue from ongoing Social Security taxes on workers, plus interest on prior reserves, was enough to fully cover all payments for Social Security, with a small excess left over that was invested for future needs.

Getting A Real Handle On Social Security's Future

Of course, as we've all long since heard, the balance of the current Social Security system's flow of payments are not going to remain where they are; going forward, the number of people eligible to claim benefits will continue to rise as more and more of the baby boomers reach their 60s, and their ongoing retirements will simultaneously reduce the number of workers paying into the system. As a result, while the ratio of workers to retirees had remained remarkably stable at about 3.2 to 3.4 from 1974 to 2008, it has begun to decline, falling to 2.9 by 2012, and is projected to decline as low as 2.1 workers per retiree by 2035. Anticipated increases in longevity impact the numbers slightly further, as the ratio is further anticipated to fall to about 1.9 workers per retiree by the end of the 21st century.

As the numbers shift, Social Security will soon reach the point where current tax revenues, plus interest payments on the Social Security Trust Fund's government bond investments, will be insufficient to fund the ongoing benefits payments (currently projected to be the year 2021). This will force the trust fund to begin to liquidate some of its principal - redeeming an increasing chunk of its government bond holdings - until eventually, 20 years from now, all of the prior savings will have been depleted. At that point, there will be nothing remaining to cover the shortfall.

However, the key is that when that date arrives - currently projected to be the year 2033 - it's only the shortfall that will no longer be covered by liquidating Social Security trust fund assets. The bulk of Social Security funding - which comes in the form of our ongoing Social Security payroll taxes levied on current workers - will continue to come in, as there will still be more than 2 workers paying the tax for every baby boomer retired and claiming benefits from it. Given that balance of workers to retirees, the Social Security system will still be able to pay 77% of its promised benefits, just from then-current tax revenue alone. As the worker/retiree ratio declines slightly further through the end of the century, the ability to pay annual benefits will slip slightly further, from 77% of benefits down to 72% by the 2080s.

Keeping Social Security Planning In Proper Context

Ultimately, the point of this discussion is to recognize that when doing Social Security projections - and especially, when making adjustments to anticipated future benefits for now-retiring clients or especially young clients who won't retire for decades to come - that suggesting Social Security will be "broke" or "insolvent" or "gone" in the future is to grossly overstate the actual situation, which can potentially result in a drastically inaccurate series of financial planning recommendations to clients. 

Instead, the reality, as noted above, is that clients 20 years from now will begin to take a 23% haircut on their benefit payments. That's it. Today's young people in Generations X and Y, who won't reach retirement until well past the point that the Social Security trust fund is depleted, aren't on a path to lose all their Social Security benefits, or even most of them. They might find that about a quarter of their original benefits can't be paid when the time comes to retire. 

And of course, that assumes we do nothing at all to fix the problem, at any point for the remainder of the century, even for a problem that has been communicated well in advance. On the other hand, if we simply enacted benefit cuts today to address the problem, rather than waiting until the situation gets worse, the reduction wouldn't even be 23% of benefits; instead, cuts of only be 16.5% of benefits would be necessary to get the system back on track. Alternatively, we might split the difference, such as cutting for future benefits for those starting in 2013 or beyond, a less severe outcome than cutting for everyone including current retirees, or just waiting and cutting future retirees more severely in 2033. These scenarios that shift the distribution of cuts somewhere between the extremes would result in benefit reductions somewhere between 16.5% and 23%.

In addition, all of these shortfalls assume that we do nothing to address the revenues side of the equation - the Social Security payroll tax - in the next century either. As the Trustees Report reveals, though, it would take a payroll tax increase of "only" 2.66% (increasing it from today's 12.4% for Social Security, up to 15.06%) to render the system fully funded for the next 75 years. While that's not a trivial amount, and would have some noticeable impact on the economy, it's also not exactly a catastrophe, either; ultimately, funding the entirety of Social Security's projected deficits actuarially amounts to less than 1%/year of GDP for the rest of the century. 

Realistically, the most likely outcome will include some combination of benefits adjustments and a Social Security payroll tax increase (either by increasing the rate, adjusting the Social Security wage base, or both), which further mitigates the magnitude of benefit reductions. For instance, the adoption of chained CPI would reduce the Social Security shortfall by 21% over the next 75 years, and the projected impact is that Social Security benefits would grow by about 0.25% - 0.3% per year slower than they would under the current system; while this impact is not trivial, it's still far less of a benefit reduction than a 23% haircut starting in 2033. If you'd like to check out the impact of other proposed reforms and the extent to which they resolve the Social Security system's projected shortfalls, here's a good summary of proposed changes from the Social Security Administration, or you can check out this tool from the Committee For A Responsible Federal Budget.

The bottom line, though, is simply this: even if you believe that we will come to no resolution to adjust benefits or Social Security taxes at any point in the future, the "downside" to Social Security in this relatively "worst case do nothing and run off the cliff" scenario for clients is still only a 23% reduction in benefits, starting 20 years from now. To the extent that we intervene in the coming decades, through some combination of changes to benefits and tax rates, the impact on a client's future retirement benefits would be even less. While these potential consequences are not insignificant, they are all scenarios where clients are still projected to have 77% of their benefits - or more - ready and waiting for them when the time comes to retire. So be cautious that, when planning for a client's Social Security future, you're not overstating the true consequences of Social Security's so-called "insolvency" in the decades to come.

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Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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