Sunday, March 1, 2015

How Secure is Your Social Security?

This website is all about developing a reasonable spending budget in retirement.  For the last five years, I’ve recommended a spend-down strategy for self-managed assets in order to develop an overall spending budget that is coordinated with all sources of retirement income, including Social Security.  The Actuarial Approach advocated in this website is based on the premise that current law benefits will not be reduced for those retirees who are currently receiving or who are close to receiving Social Security.  In light of Social Security’s financial problem, there are reasons to question this premise. 

For many retirees in the United States, Social Security is the most important retirement income source they have.  It would be nice to know that we can count on the system to continue to provide the same real dollar level of benefits as long as we live.  But we read articles almost every day pointing to Social Security’s financial problems.  As retirees, should we worry about these problems?  Many “experts” tell us that historically, system financial problems have generally been resolved without reducing benefits for those who have already retired or who are close to retirement.  While this provides us with some level of comfort, we also know that there is nothing in the Social Security law that prevents Congress from reducing benefits of those who are already in pay status.  The issue of whether our Social Security benefits will be reduced (and if so, by how much) is an important one for retirees because we will need to make appropriate adjustments in our retirement plans and spending budgets.  Unfortunately, reductions in future Social Security benefits may be yet another risk we need to address when managing our retirement.

This post will briefly discuss Social Security’s financing problem, how likely it is that this financing problem will lead to benefit reductions for retirees in pay status, when reductions may occur, and how large the reductions might be.

The Problem

Under “intermediate assumptions” in the 2014 OASDI Trustees Report and assuming no future changes in the system, Social Security’s actuaries project that in the year 2033, the combined OASDI trust funds (if they were combined) will be exhausted.  The combined trust funds are currently about $2.8 billion.  Under the same assumptions, the actuaries project that the system’s 2034 cost rate will be about 17.03% of taxable payroll and the system’s income rate will only be 13.18% of taxable payroll, a shortfall of 3.85% of taxable payroll.  Absent Congressional action prior to 2034, benefits to those receiving payments at that time would have to be reduced by almost 23% across the board.  Technically, full benefits would still be paid, but they would be delayed so the effect would be the same as a cut in benefits.  Note that this is the “default option” if Congress does not act prior to trust fund exhaustion. 

It is also important to note that these projections are based on lots of assumptions.  If actual experience differs from the assumptions, the size of the shortfall could be larger or smaller and/or the exhaustion date earlier or later than 2033. 

Will Benefits be Reduced for Those in Pay Status?

Well, this is the $64,000 question isn’t it?  Will Congress and the President find some other solution to the problem in the next 18 years that doesn’t involve benefit reductions for those in pay status or for those who are close to being in pay status.   The solution could involve payroll tax increases, general revenue financing, benefit reductions for those not in pay status or combinations of these or other actions.   

For example, if Congress waits until the last minute to address this issue and does not want the default option to go into effect in 2034, it could increase the combined employer/employee tax rate of 12.4% of taxable wages (6.2% for workers and 6.2% for employers) by 3.85% or by approximately 31%.  It is important to note that if no changes are made to the system in the next 19 years and Congress decides in 2034 to limit benefit reductions only to future beneficiaries, the only option would be the 31% tax rate increase (or raise some other form of additional system revenue).   Similarly, if no changes are made to the system in the next 19 years and Congress decides at that time that it can only increase taxes by 1% each on workers and employers, then benefits in pay status will have to be reduced by at least 11% across the board. 

Given recent Congressional actions, there is certainly a non-zero probability that it will not address this problem prior to trust fund exhaustion.  Rather than raise payroll or income taxes or cut benefits, Congress may be willing to follow Thelma and Louise’s example and simply drive the Social Security car over the cliff into the Grand Canyon.

Even if Congress does act prior to trust fund exhaustion, there is a non-zero probability that such action will involve some type of benefit reduction for beneficiaries in pay status.  Congress may feel that a fair solution to the problem should involve a certain amount of shared pain from all the system’s stakeholders.  And while earlier action can reduce the size of the problem somewhat, the magnitude of tax increases/benefit reductions required to solve the problem will still be substantial if they are totally borne by those who are not in pay status.  Don’t be misled by the actuarial deficit of 2.88% in the 2014 OASDI Trustees Report.  Just one look at the graph on page 12 of the report will convince you that the long-range size of the problem is a lot closer to 4% of taxable payroll. 

How Large Might the Reductions Be?

As noted above, if Congress does nothing prior to 2034, the default option is to effectively reduce benefits in pay status by 23% across the board.  If Congress does take action prior to 2034, across the board reductions are likely to be somewhat less.  However, even though the average reduction in benefits might be less than 23%, it is quite possible that certain types of beneficiaries could be hit harder than others.  For example, Congress may reduce some spousal benefits or may reduce benefits for more wealthy retirees.  There is no way of knowing at this time what Congress will do. 

In conclusion, retirees (especially the more wealthy ones) may find it prudent to consider the possibility of future Social Security benefit reductions when developing their retirement spending budgets.