Solving for Social Security

Social Security is constantly in the spotlight with the ever-looming question on everyone's mind: "Will Social Security disappear for good?"

On today's financials edition of Industry Focus, our analysts will walk us through the Social Security system and help us understand the importance of early investing to help us live long, happy, retired lives on our own returns, rather than putting our fate in the hands of the government.

A full transcript follows the video.

Gaby Lapera: Solving for insolvency in Social Security... Is Social Security really dying? That's what we'll talk about this week on Industry Focus, financials edition.

Welcome, everyone. I have John Maxfield on the phone. This is Gaby Lapera here as your host. We're going to talk about Social Security this week. I have been reading a lot about this on The Motley Fool's website. We published quite a few articles on this, so I think this will be an interesting show.

The thing about Social Security that I think is on everyone's mind is whether or not Social Security is going to die anytime soon. I know that I initially misunderstood what was going on. Social Security is made up of two different funds, right, John?

John Maxfield: That's exactly right. You have one trust fund -- when we think of Social Security, it's basically two big trust funds, and then taxes that pay into those funds. Then those funds pay out the benefits. One fund is for retirement benefits and the other is for disability benefits.

Lapera: The Social Security system started during the Great Depression, but the system has gotten a lot bigger than it was initially, and the type of people in it are pretty different. Initially, the system was imagined for people who weren't living that much beyond retirement age and that's not the case anymore.

People are living 20+ years past retirement age now regularly and some people live far beyond that. On top of that, there are a lot more people in the system than there were initially. That's kind of what's driving the depletion of the Social Security funds, right?

Maxfield: That's exactly right. If you think about it, it's a "pay as you go" system. You have a whole bunch of taxpayers that are paying a percentage of their income into the system every year, and right now I think it's 15.3% when you combine all the employment taxes. You have people paying into these systems, then you have a certain number that are drawing out of it.

The solvency or insolvency of the trust funds themselves is all just a function of that ratio between the number of people paying into it and the number of people drawing out of it.

Lapera: The ratio is falling. Right now, it's around 2.8:1, but it's expected to be around 2.1:1 by 2040. The thing that I think a lot of people misunderstand about this is when people say that Social Security is dying, I think people imagine that Social Security is going to disappear in a cloud in 20 or 30 years. That's not really the case. It just means in 2033 they're going to have to reduce the benefit level to 79% of its current level.

Do you think that will actually happen?

Maxfield: That figure you cited there is based on the fact that every year Social Security has a committee that oversees it and the secretary of the Treasury is on that committee along with all these other high-ranking government officials. They sit down and make all these different projections about what's going to happen in the future based on this ratio between the number of people paying into it and the number of people drawing out of it.

Based on their intermediate assumption, they're projecting that the trust funds themselves -- which hold around $2.8 trillion in assets right now, so there's a lot of money in them right now -- but because of the baby boomer generation and how that's going to tweak that ratio of the number of people that are paying in and the number of people that are drawing out of the system at any one point in time.

They're projecting that the trust funds themselves will be insolvent by around 2034 because of that. The thing to keep in mind about these projections is that they're all based on so many different assumptions. We could get to 2033 or 2034, and it could be totally different. This is just the best guess right now.

Let me give you one good example of what could change this. If the United States' economy starts roaring again and people are making a ton of money, then the payroll taxes that are paying into the system are going to be dramatically higher than they are right now. That's just one thing that could make those assumptions wrong, but with that being said, it's important to recognize, that holding all else equal right now, if no changes are made; these trust funds will be insolvent.

Even if they're insolvent -- and this is a long way to answer your question -- there will still be people paying into the system and those funds themselves will be available to distribute. I think the estimate is if the trust funds are insolvent, just based on the revenue that is coming in, that will support roughly 75% of the benefits at that time. There will be a 25% reduction in the size of each individual's benefits.

Lapera: That's fine if you're in your mid-20s and you have time to plan for that and get ready for retirement, but it's really problematic for people who are already on Social Security. The Social Security Administration says that Social Security should not be your sole source of income. Unfortunately for about 22% of married couples and 47% of unmarried people, they receive 90% or more of their income from Social Security.

It can be problematic, but I think the other thing to keep in mind about fixing Social Security is that this isn't the first time that the United States has faced this. Back in '83, Congress faced the same question. They messed with Social Security parameters and we actually ended up with a huge surplus.

Maxfield: That's right. In 1983, it was almost the exact same scenario, but right now we're looking at 20 years out. In 1983, it was the next year or something like that, where the Social Security trust funds were supposed to be insolvent. Congress set up a committee that was chaired by Alan Greenspan before he was the Federal Reserve chairman and they made a number of adjustments to the system.

They changed the full retirement age, they tweaked how much was coming in and how much was going out, and they tweaked the cost of living adjustments. What that resulted in was a huge surplus in these trust funds. That went from $0 at the time that the changes were made to $2.8 trillion today. The point being, in this instance, politicians generally kick the can down the road to the very last instance, last time we came up to this problem.

The second thing is, once they addressed it, they addressed it in a way that it was solvent for many more decades.

Lapera: Right. It's not in Congress' best interest not to fix Social Security. If you look at the voting demographics, those are the people that are putting them in Congress. They're going to do their best to fix everything before it completely implodes.

The question now becomes: What are our options to reform Social Security so it will continue to pay out benefits at the current level? There are two fundamental philosophies. You can either raise more revenue or cut benefits.

Maxfield: Right. When you dig into that "raising the revenue" -- and this is how math works -- if you have too much going out relative to what's going in, you either need a decrease on what's going out and an increase on what's coming in. When you talk about revenue, there's really two ways that you can do it.

The first is that you can simply raise the payroll tax. Again, I think the combined payroll taxes right now are 15.3%. You could increase that to 18%, but that's also not a very popular solution. If you look back at the history of Social Security, I think the very first year it started out, the payroll tax was something like 1%.

They've consistently increased it over the decades since then. I think the last time they increased it was in 1990. That was on the tail end of all those changes that Greenspan's committee put up for debate.

Lapera: Things have changed quite a bit in 25 years. I'm shocked that this hasn't as well.

Maxfield: That was before Ace of Base. Ace of Base was a long time ago. You may not know Ace of Base, Gaby.

Lapera: I'm not that young. I do remember. The other option is to raise the maximum taxable earning. Right now, anything above $118,500 is not subject to payroll tax. You don't have to pay payroll tax on that. That's actually one of the more popular options, according to the Washington Post online poll. Take that for what it's worth.

The thing to think about when you think about raising the maximum taxable earning is that the median income in the United States right now, at least in 2013, was $51,399. It's not like 75% of the country is going to be taxed a lot more. It's a lot fewer people than that.

Maxfield: Right. That's a good thing from the perspective how that would decrease the burden, but it's a bad thing because the question was whether or not doing that alone, because it would impact so few people on a proportional basis; whether that would be enough. I don't know the answer to that question.

Lapera: It would not be enough, according to projections. I don't have the numbers right in front of me, but I believe it reduces the shortfall around 75%.

Maxfield: That seems to be a relatively fair solution, but the question is: are they going to have to couple that with some other things? To your point, it sounds like they would have to.

Lapera: Absolutely. I don't think you can look at fixing Social Security like they're just going to raise a bunch of revenue. Cuts are probably going to happen, which leads us into the next way of fixing Social Security, which is a way that no one really wants to think about. That way is cutting expenditures.

Maxfield: Right. There are two principle ways you can do this. Now that we're in political season I think the candidates are talking a lot about these things, but one way is doing a means test. Let's say you're in your 70s and you're still pulling in$200 thousand in income, or $250 thousand in income. In that case, do you really need Social Security? How much would it hurt them if you took their benefits away and gave it to people who actually need them? That's one way; going through means testing.

The other way is raising the full retirement age. Right now the full retirement age is 66 and some month. You could raise that up to 68, and that actually makes sense when you consider that our life expectancy is increasing. If you increase your full retirement age that decreases the expenditures because people will have to wait longer before they start drawing from the system.

Lapera: Right. I want to take a moment to explain what full retirement age is to our listeners. Most people can claim Social Security at 62, but you're not going to receive the full amount of the benefit until your full retirement age. That varies depending on the year in which you were born.

This is something that's already started, but they could be much more aggressive about where the full retirement age is.

Maxfield: Right. If you think about it, you have an eight year window to take Social Security benefits. Between 62 and 70. 66 is the point which you receive your full, primary insurance amount. That's the amount you're entitled to, based upon your work history. But if you take it early, then you get reductions each year in the size of your monthly benefits depending on how long you take them.

If you wait longer, you get 8% more in monthly benefits for every year that you wait, up until the age of 70.

Lapera: Right. Deciding when you want to retire might play into people's decisions about their retirement planning. You could take Social Security as early as possible -- at 62 -- or you could put it off until 70 and receive more. When would you break even on that? If you wait until you're 70 and you die at 72...

Maxfield: You would not maximize what you're getting from your Social Security system. I probably shouldn't be laughing because that's not funny, but the point you're making is very valid. Let's compare if you take it at the earliest possible moment, which is right when you turn 62 -- 62 is the most prevalent age that people take Social Security benefits. That's an important one to look at.

Let's compare that to if you take it at your full retirement age, which is currently 66. If you're looking at how much in aggregate you're going to be taking form Social Security by adding up all those different checks over the lifespan of the time you'll be taking Social Security benefits, your breakeven point for that will be at the age of 78.

That's between taking them at 62 and 66. The question is: If you're in a position where you don't need the benefits immediately to live, and if you believe that you're going to live significantly beyond the age of 78; in that instance, it's unquestionably in your favor to wait as long as possible before taking that.

A lot of people don't have that luxury of being able to wait. A lot of people are stuck in a situation where they are basically forced to take Social Security benefits as early as possible.

Lapera: Which is why I want to emphasize to our younger listeners that if you have the opportunity while you're young -- which you do -- to invest and not have to rely on Social Security, you should.

Maxfield: Yeah. The other thing about it for our younger viewers is that Social Security is going to be there when you retire. I think that's probably a safe assumption. If politicians get rid of Social Security, those politicians are probably not going to have a job come the next election. The amount that Social Security supplements -- which is what Social Security is designed for... to supplement your income, not provide all your retirement income -- you will not be living a very good life in your retirement years.

The earlier you can stock money away and let the law of investing, the law of compounding returns take effect and work on that, you'll really be doing yourself an enormous favor.

Lapera: Absolutely. Part of the reason Social Security is designed the way it is, is because it was designed with the pension system in mind, which is pretty much gone now. So you have to make your own pension there, kids.

The takeaway here is: if you're young, try to invest now. If you're older, really think about when you want to start taking your Social Security benefits, maybe look at some actuarial tables because I know once you live past a certain age you're much more likely to reach another certain age. If your finances allow it, maybe you should wait and don't worry about Social Security dying. Relax. It's probably not going to happen anytime soon.