In the next few months, we will be encouraging you to perform an actuarial valuation of your assets and future spending liabilities to determine your spending budget for 2021. When you do your January 1, 2021 actuarial valuation, we ask, in this post, that you consider the possibility that future Social Security reform may decrease the future benefits you receive from the system and/or increase your future taxes in some manner. Thus, we are asking our U.S. readers to consider how future uncertain Social Security reform might affect your current spending budget. To help you do this, this post will discuss the estimated size of Social Security’s financial problem and several ways you can use our recently updated Actuarial Budget Calculator workbooks to reflect the potential impact of future system reform in your current financial plan.
Future System Reform--Lots of Uncertainty
No one knows what future Social Security reform will look like (we certainly do not). System reform uncertainties include:
- When the trust fund will be exhausted (TFE)
- Whether Congress will take reform action prior to TFE
- If Congress takes reform action prior to TFE, what those actions might entail, including:
- Specific benefit increases/decreases
- Specific tax increases
- Possible different treatment of different individuals/couples (e.g., wealthier vs. less wealthy, younger vs. older, etc.)
In our post of November 4, 2020, we quoted Steven Goss, the Chief Actuary of the Social Security Administration:
"The choice before Congress and the American people is really rather simple. We're going to have to increase the revenue by about one-third or reduce the scheduled benefits by about one-fourth, or some combination of the two."
In that post, we also noted:
“a one-quarter reduction in scheduled benefits [for both retired and non-retired individuals] is estimated to be necessary if Congress takes no action and the Trust Fund assets become exhausted. If, however, Congress does take action, benefit reductions do not have to be applied across the board. In addition to increasing taxes somewhat on those who have yet to retire, Congress could also decide to decrease benefits only for a sub-group of the beneficiary population. Therefore, in theory, Congress could decide to reduce benefits for more wealthy beneficiaries, for example, by more than 25%.”
It is important to note that the “default solution” to improving system financial balance, assuming Congress takes no action prior to TFE, involves approximately a 25% across the board reduction in benefits paid to all current and future beneficiaries at TFE.
Estimated Timing of Social Security TFE
Estimated TFE depends on assumptions made about the future. In the 2020 Trustees Report, the estimated TFE, based on assumptions used in that report, was 2035. The Social Security actuaries have recently revised their baseline TFE, reflecting recent Covid-19 experience and other revised assumptions to be 2034. Using different assumptions, the Congressional Budget Office estimated TFE to be 2031, before reflecting the impact of Covid-19. Other groups have developed different TFEs based on different assumptions. For planning purposes, we assume that TFE will occur about ten years from now plus or minus 3 years.
Possible System Changes Prior to TFE
Many Baby Boomers are confident (hopeful) that, because of their advanced age, their Social Security benefits will be “grandfathered” if Congress acts to change the program prior to TFE. Others argue than much of the financial problem can be addressed by increasing the taxes on more affluent workers but not increasing their benefits commensurately.
Younger and more affluent workers may not fully buy into these reform alternatives. Given the “default solution” if Congress takes no action prior to TFE, these workers may find the necessary tax increases/benefit reductions imposed on them to provide grandfathered benefits to older individuals to be unfair. They may lobby Congress to find ways for older and younger generations to more equitably “share the pain” associated with repairing the system’s financial condition. More affluent workers may also balk at solutions that require them to contribute significantly more for no increase in benefits. These more affluent workers may note, for example, that they are not required to spend a specific percentage of their income on products such as cars, so why should they have to spend X% of their income on a specific level of lifetime retirement income that can be effectively purchased for much less by a less wealthy individual.
More “share the pain” reform proposals could involve, for example, benefit reductions (or freezes) for some or all current beneficiaries and/or increased taxation (including federal, non-FICA taxation), with such income also used to partially finance the system.
In the section below, we take a look at a hypothetical retired individual and attempt to quantify what the impact would be of a 25% reduction in her Social Security benefit in 2034.
2021 Budgeting Example
Betsy is a 67-year-old single female. She has accumulated savings of $600,000, an immediate fixed income pension of $12,000 per year and an immediate Social Security benefit of $22,000 per annum. To make things simple, we will assume in the base-case scenario that her only non-recurring spending goal is a bequest motive of $20,000 in today’s dollars, and she desires that her recurring spending budget remain constant from year to year in real dollars. She uses the default assumptions to produce a maximum spending budget for 2021 of $54,389. Assuming no future changes in her Social Security benefit (other than annual cost of living increases), the present value of her future Social Security benefit payments under the default assumptions is $558,403.
Betsy wants to see the effect on her 2021 spending budget if thirteen years from now (2034), her Social Security benefit is reduced by 25%. She does this by entering $16,500 (75% of $22,000) for her annual Social Security benefit payable for life and she enters $5,500 as “other income” which she labels “Social Security to 2033” in row 16 of the Input & Results tab of the ABC for Single Retirees as shown in the screenshot below. She indicates that this benefit will be payable immediately for 13 years and will increase with assumed inflation of 2% each year. These are the only changes she makes to the workbook.
As shown in the screenshot below, the effect of these changes is to reduce Betsy’s maximum spending budget for 2021 from $54,389 to $51,548 (a reduction of $2,841, or about 5%). The total present value of her future estimated Social Security benefits under this scenario is $486,282, which is $72,121 less (about a 13% decrease) than under her base-case scenario. If Betsy divides this present value difference between the two scenarios of $72,121 by the lifetime cost of $1 per annum increasing with inflation of $25.382, she would obtain the 2021 spending budget difference between the two scenarios of $2,821.
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In theory, Betsy could reduce her spending each year by $2,821 from her base scenario and accumulate the annual difference in her rainy-day fund. If all her assumptions were realized, the accumulated difference in her rainy-day fund would be sufficient in 2034 to fund her continued spending after that time at the $51,548 level even if her Social Security benefit were reduced by 25% at that time.
Betsy could also use the workbook to reflect higher taxes that might become payable after 2033 by entering expected higher amounts in one of the non-recurring expense rows (22-24). We leave that exercise up to you.
Summary
Significant changes will be necessary in the relative near future to bring Social Security’s revenue more into balance with its expected outgo. As discussed in our post of November 4, 2020, the Congressional Budget Office (CBO) also projects significant increases in U.S. debt if no policy changes are made. We can’t tell you how what the Social Security changes will be or how rising federal debt will affect things like your future taxes. As discussed in the summary section of our November 4 post,
“Mitigation of the risks highlighted in the CBO report will generally involve saving more and spending less today. This may be accomplished by using more conservative assumptions when developing your spending budget and/or accumulating a larger rainy-day fund. In order to facilitate risk mitigation decisions, it may make sense to model the estimated impact on your spending budget of higher rates of inflation, possible Social Security benefit reductions and significant stock market drops in the future.”
The changes we recently made to our workbooks can help you model some of these possible negative scenarios. We encourage you to do some stress testing of your financial plan when you crunch your numbers for your 2021 Spending Budget so that you can be better prepared for future anticipated changes.
