Last week President Barack Obama finally produced his 2014 budget proposal (which actually covers the period from October 2013 until September 2014). One of his key concessions to deficit-conscious Republicans is a switch to the "chained CPI" method of calculating inflation. This proposal has been on the table for more than a month, and liberal Democrats have slammed it as a cut to workers' hard-earned Social Security benefits. However, a switch to chained CPI will not in fact cut Social Security benefits; it will just make future cost-of-living adjustments smaller. In other words, Social Security benefits will not be quite as generous in the future as they are today.
While Social Security is not currently a driver of the federal deficit, under current law the program will run out of money in a few decades. At that point, the government would be forced to increase revenue or cut benefits. Obama's proposal therefore seems like a sensible way to improve the solvency of the Social Security program. Nevertheless, it will have a significant impact on current and future retirees. In the future, it will be more important than ever for Americans to have well-funded retirement accounts. Improving your financial literacy now can help you invest appropriately (considering your retirement goals) so that changes to Social Security will be a mere inconvenience, rather than a major problem.
The current political climate in the U.S. is strongly anti-deficit. Increasingly, people are blaming the country's deficit problem on entitlement spending, although, as I wrote last month, defense spending has played a big part as well. While the extent of the problem is sometimes overstated, Social Security and Medicare reforms are still necessary. Based on recent projections, neither system will remain solvent for more than 20 years or so. The longer we wait to make changes, the more drastic they will need to be.
If Social Security reform needs to occur, there are two main possibilities: revenue increases or benefit reductions. Many Democrats are lobbying for removing the cap on Social Security taxes; in 2013, Social Security taxes only apply to the first $113,700 of income. Some people are even advocating for higher payroll tax rates. However, an increase in Social Security taxes is highly unrealistic in the current political climate.
Moreover, removing the cap on Social Security would not be in keeping with the program's goal of providing social insurance. Generally speaking, everybody pays into Social Security, and everybody is entitled to benefits in return -- though there are some exceptions in practice. People who pay more into the system are entitled to higher benefits, but only up to a limit. Forcing the wealthy to pay more into Social Security without getting more out of the system is a political non-starter -- but it's also simply unfair. Wealthy people arguably get more benefits from government and can reasonably be asked to pay higher income taxes; the same does not apply to Social Security, because there is a cap on benefits.
There's no easy way out for America. The Social Security system is in much better financial shape than Medicare, but analysts estimate that it would need to cut benefits by 24% in two decades to cover its deficits. Raising payroll taxes could theoretically close this gap, but that would force taxpayers to cut back on other expenses (including individual retirement savings). The reality is that today's senior citizens are receiving an unsustainably high level of benefits relative to the taxes they paid into the system. Reducing cost-of-living increases will certainly hurt people who are dependent on Social Security today, but failing to reform the system will hurt future generations even more.
What it means for you
Fears that Social Security will disappear are overblown. While the system is not quite solvent today, relatively minor changes such as moving to the chained CPI and/or raising the retirement age by a year or two could make it sustainable. On the other hand, Social Security reform will almost certainly mean that future retirees will receive less valuable benefits than they would under the current system.
Today, the maximum starting benefit for somebody who begins taking benefits at full retirement age (66) is about $2,500 per month. That's already a fairly tight budget, especially if you have significant medical expenses that are not covered by Medicare. Furthermore, most people receive significantly less than the maximum benefit. Lastly, under Obama's proposal, cost-of-living increases will be smaller in the future. As a result, it's critical to save money on your own for retirement and to invest that money wisely.
One way to grow your retirement savings is by investing in low-fee index funds, such as State Street's (NYSE:STT) ETF that tracks the S&P 500 index: SPDR S&P 500 (NYSEMKT:SPY). State Street invented the ETF concept two decades ago and remains a leader in the ETF market, with index funds tracking individual S&P 500 sectors as well as the full index. (State Street has actively managed funds, as well.)
Index funds like the SPDR S&P 500 fund will limit your transaction costs while enabling you to participate in the growth of the stock market as a whole, thus growing your savings at a healthy rate. From 1926 to 2010, stocks grew at a compound rate of 9.9%, while government bonds only returned 5.5% on average. If you have retirement money that you don't need for at least 10 years, you should be invested in the stock market, because stocks reliably outperform bonds in the long run.
It's also possible to buy actively managed funds. Unfortunately, high management fees all too frequently cause these funds to underperform the broader market. Managing your investments yourself can be a better solution if you're looking for market-beating returns. It takes a fair amount of work, but it's worth it if you can find great stocks that will beat the market over time. Does that sound like a tough task? Don't worry -- The Motley Fool can help!
Fool contributor Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.