Once again, the Social Security and Medicare Boards of Trustees have released their annual report on the fiscal health of the Social Security and Medicare programs, and once again the Trustees report shows that the fiscal health of the two programs has further deteriorated, a combination of primarily slower-than-projected growth, upwards adjustments to long-term costs (Medicare), and increases in estimated longevity (Social Security). With the latest projections, the Social Security trust fund is projected to be exhausted in 2036 (last year it was anticipated to last until 2037), and the Medicare trust fund will be depleted in 2024 (compared to last year’s estimate of 2029). But while it’s true that the systems are both headed for serious trouble as the trust funds potentially go "bankrupt" – the reality is that the actual depletion of the trust funds may still have a far less severe financial planning impact than many assume, for one simple reason: the overwhelming majority of Social Security and Medicare benefits will actually still be funded, via our ongoing Social Security and Medicare tax system!
The inspiration for today’s blog post comes from the recent release itself of the Social Security and Medicare 2011 Trustees Report, and a follow-up article about it from Marketwatch last week, along with a discussion that emerged last week on the same topic in my retirement income panel session at the FPA Maryland spring symposium.
The rising discussion and furor over the dire long-term situation on Social Security and Medicare is starting to permeate the consciousness of the average American, and especially the average financial planner, who is increasingly cognizant of the fact that the trust funds for one or both systems may run out of money in our clients’ lifetimes. Yet with all the discussion about the potential depletion of the assets we have set aside over the decades for Social Security and Medicare, we seem to continue to forget the most important part: that each year, MOST of the benefits we pay out for Social Security and Medicare are actually funded from current tax revenues collected from current workers. The only purpose of the trust fund is to pay the difference, when committed benefits exceed collected revenue.
Accordingly, the Trustees Report points out that in fact, Social Security just reached the crossing point this year – total revenues collected from employee FICA taxes exceeded the benefits being paid out to Social Security recipients. Notably, though, while benefits paid exceeded taxes collected, the trust fund actually still isn’t depleting yet – because the money is invested and generates a (modest) return. In point of fact, it won’t be until 2022 that the benefits paid are anticipated to exceed the tax revenues collected plus interest income generated by the trust fund assets themselves. Once that crossover point is reached, only then does the trust fund begin to deplete, ultimately running out in 2036. Medicare is in a similar situation, although it has already reached the crossover point where benefits paid exceed both tax revenues and interest income, so the trust fund balance is declining currently – and again, is projected to run out in 2024.
The truly important question, though, is what happens to the benefits paid by the programs if/when the trust funds are actually depleted? The answer is that in theory, they can continue paying as much of the benefits as they can manage, simply using the ongoing tax revenues that are still being collected. And how much is that? Most of it!
In fact, as the Trustees Report notes, the Social Security system could continue to pay 3/4ths of its benefits in 2037, even after the trust fund is exhausted, simply by directing then-current tax revenue against the benefits promised at the time. Medicare would actually have enough income from tax revenues to pay 90 percent of its benefit costs when the trust fund is initially exhausted, although that percentage too declines to revenue that pays about 3/4ths of benefits by 2045 due to shifting demographics.
Of course, shortfalls to pay benefits of this magnitude are still significant. But nonetheless, it’s important to observe that "Social Security and Medicare going ‘bankrupt’" does not mean all payments stop and benefits go to $0! It actually means that 75% to 90% of benefits are still fully funded. This is a big contrast to the assumption of many clients – that "bankrupt" actually means ALL benefits will cease and the drop-off would not be 10%-25% of the benefits, but 100% of the benefits.
Similarly, it’s notable that the Trustees report states that the actuarial shortfall to make the system solvent has risen to a "mere" 2.22% of taxable payroll for Social Security, and 0.79% of taxable payroll for Medicare. In other words – slightly oversimplified – we could solve virtually all the solvency problems of Social Security and Medicare with a 2.22% + 0.79% = ~3 percentage point increase in overall payroll taxes (applied annually on an ongoing basis). Granted, a 3 percentage point increase in all payroll taxes is not a trivial thing – there are significant potential economic ramifications, and relative to the 15.3% current tax rate for Social Security and Medicare, that’s a big jump – but we’re still only talking about needing to raise revenues by a few percentage points. Which implies that the solutions some clients worry about – like means-testing Social Security benefits to reduce or eliminate them completely for wealthier high income individuals – may actually be an unnecessary and far more extreme step for system solvency than realized.
So the bottom line is that while the long-term viability of Social Security and Medicare are definitely a concern – outflows can only exceed inflows for a limited period of time before the money runs out – the bankruptcy of the trust funds for Social Security and Medicare is not the same bankruptcy of the entire programs. Even when the trust fund is depleted, the systems can still pay 75% – 90% of benefits, simply funded from then-current tax revenues. Which means in all likelihood, even clients who are deeply concerned about their benefits from these systems should probably be talking about potential haircuts to their future benefits, and not assuming that their benefits will be eliminated to $0! In turn, this may affect decisions, as well – for instance, if the shortfall in Social Security still allows 100% of benefits to be paid out for the next 25 years, and 75% of benefits to be paid out thereafter, does it still make sense for clients to take benefits early because they’re afraid about solvency of the system?
So what do you think? Are you and/or your clients worried about the solvency of Social Security and Medicare? Do you ever talk about what might happen if the trust funds really do run out of money? Would the observation that tax revenues can still pay 75% to 90% of promised benefits be a relief to any of your clients? Would it change any planning decisions you might make or have already made?