October 20, 1998

Social Security
by Al Levit (alanl@ix.netcom.com)

Part 2: How We Fund Our Social Security System

From day one until the present, our Social Security System has never been a "funded system." For most of Social Security's history, the system has been financed through a "pay-as-you-go" mechanism, where the money collected this year is used to pay benefits currently due. In other words, there really isn't a significant savings component to the system -- it's cash in and cash out.

So in most of the years of Social Security's history, contributions were set to pay current benefits with a small margin, but there was not any attempt to specifically fund for future benefits. In a very real sense, Social Security has always been a transfer payment system, where income from one set of citizens (active employees) was directly transferred to another set of citizens (retirees). Many people have had the mistaken belief that their contributions built up a benefit in their own names. Psychologically, okay. But directly? No. That's never been how the system worked.

Now this sort of transfer system worked well at the start of Social Security because:

a.The average life expectancy was less than today's average retirement age of 65;
b.There were more than 16 active workers for every beneficiary.

But that was then, this is now. Today the average life expectancy in America is about 76. And today there are less than 3.5 workers for every beneficiary. My, oh my, things have changed.

In the late 1970s, it became clear that our system was unstable. So in 1977 Social Security taxes were increased and the way that benefits were calculated was changed. In general, the new method for calculating benefits produced lower benefits, so the sculptors of the new vision provided for some "grandfathering." People who were close to the age affected by the amendments would get some of the benefits of the old Social Security provisions.

As has been typical of Social Security throughout history, this reduction of benefits proved very unpopular. Very, very unpopular. And representatives of people who were close to the "grandfathered" age argued that they should then also be given some relief. You can see the dominos falling, eh? This relief was never granted, though the issue was studied for years. The final report on this so-called "notch issue" was written in 1994, striking down the notion that tweeners should be granted extra benefits.

A few years later, someone noticed that even after the 1977 amendments the system would still result in a crushing tax burden when the baby boom retired. Therefore, in 1983 more changes were made to build up the Social Security Trust Fund. According to the recently published 1998 Social Security Trustee's report, these Trust Fund funds are expected to be used for the first time in the year 2021.

The additional assets that are being collected for us baby boomers (dating myself for your reference!) are projected to give us another 11 years, so the real trouble won't start until the year 2032. At that point, the total benefits to be paid out to retirees will be greater than all the assets available to pay them. Bad news. The transfer will break down. There'll be no choice but to again increase Social Security taxes and/or cut back significantly on the benefits.

If we wait until the mid-21st century to take action, the size of both those tax increases and the benefit cutbacks will be horrendous.

Unfortunately, the news gets a little worse than that because there are other real concerns that greatly pre-date the year 2032. The surplus assets currently collected for the baby boomers benefits are 100% invested in U.S.Treasury securities -- with returns that barely eke out inflation. But worse, as the Social Security system redeems these securities to pay benefits, either the federal government will have to increase other taxes, which would defeat the purpose of the advance funding, or it'll have to increase the deficit. Neither option is likely to be terribly good for our economy.

Here I get on my soapbox for a paragraph or two...

Given all of the above, how ironic it is that most of our politicians today congratulate themselves about having brought our federal budget out of deficit. But what's rarely mentioned is that they're including the additional Social Security taxes, collected for baby boomer benefits, as revenues in this calculation. Wow. Future benefits are counted as present revenues. That's awfully aggressive.

To do things honestly and conservatively, they'd also include an offset for the liability, representing the future Social Security benefits that these taxes are being collected for. But then the budget would still be in deficit. That doesn't sound good. So our politicians skip that, great marketers that they are. (Beware, Fool, when marketing finds its way to the office of the Chief Financial Officer!)

Next -- some of the ideas for fixing the social security problem