Ask a person what they need to survive and they're liable to say air and water. Ask senior citizens what they'd need to be financially stable in retirement and they're probably going to respond with strong Social Security and Medicare programs.
Currently, Social Security is paying out benefits for more than 60 million people a month, two-thirds of whom are retired workers aged 62 and up. In 2016 alone, Congress set aside $944 billion, or a quarter of the approximately $3.8 trillion federal budget, just to cover Social Security benefits. When Gallup questioned current beneficiaries on the importance of Social Security income, nearly 6 in 10 responded that Social Security payments comprise a "major" part of their income.
There are also 56 million people enrolled in Medicare, with approximately 5 in 6 enrollees seniors aged 65 and up. Medicare helps protect seniors from potentially high medical costs during their golden years. On average, the program covers about 80% of eligible medical costs, with seniors picking up the tab for the remaining 20%. Medicare has been shown to be considerably cheaper than private insurance plans for seniors.
In plainer terms, Social Security and Medicare are vital to the financial well-being of today's retirees, and there's a good chance the same will hold true for baby boomers who are set to hang up their work gloves over the next two decades.
What's really wrong with Social Security and Medicare
Unfortunately, neither program is exactly on solid footing, at least based on the latest findings of the Social Security and Medicare Board of Trustees, which were released within the past couple of weeks. According to the Trustees, both Social Security and Medicare are on unsustainable paths that will soon see the two programs deplete their excess cash reserves. This excess cash is what both programs invest in special issue bonds and other guaranteed interest-bearing assets.
In the case of Social Security, the ongoing retirement of baby boomers is straining the program. As more boomers leave the workforce, there simply won't be enough payroll tax revenue generated to cover the cost of benefits being paid out. Between 2015 and 2035, the worker-to-beneficiary ratio is expected to fall from 2.8-to-1 to 2.1-to-1.
The other issue for Social Security is that people are living longer than ever. I don't want to misconstrue this as a bad thing -- a longer life expectancy is great news for everyone. But for a program that's been designed to pay out benefits for a certain period of time, longer life expectancies are proving to be a strain.
Many of the same problems are apparent for Medicare. A swelling elderly population that the U.S. Census Bureau predicts will grow to 83.7 million by 2050 -- nearly double what it was in 2012 -- will mean a likely increase in benefits paid out via Medicare. Likewise, people living longer than ever probably means higher expenditures for the program.
Medicare is also dealing with exceptionally high healthcare inflation rates. Healthcare inflation has outpaced the general rate of inflation, as measured by the Consumer Price Index, in nine of the past 10 years. Prescription drug inflation has been even higher, with prices for specialty drugs targeting cancer soaring into the stratosphere.
Here's when Social Security and Medicare will burn through their excess cash
Based on the annual Trustees' report, the Social Security's Old-Age, Survivors and Disability Insurance Trust, or OASDI, is on track to run out of its excess cash reserves by 2034, unchanged from the 2015 report. Once the OASDI is out of excess cash, the Trustees have opined that benefits could be cut by as much as 21%.
It's worth noting that if Congress figures out a way to collect more payroll tax revenue, or cuts benefits, the Trustees' projections could be adjusted. Additionally, running out of excess cash reserves doesn't mean Social Security is insolvent or going bankrupt. However, it does mean today's payouts aren't sustainable if the current payout and retirement trajectories hold through 2034.
Based on the 2016 report, Medicare's Hospital Insurance Trust Fund is in an even more precarious spot. The authors have estimated that the HI Trust will burn through its cash reserves by 2028, a full two years earlier than predicted in the 2015 annual report. If Medicare's extra cash were to run out, the program would become budget-neutral. In easy-to-understand terms, it would only reimburse physicians and hospitals equal to the amount of revenue being brought in. Essentially, it would cut reimbursements to 87% of current levels.
These cuts could be devastating to most seniors. Medicare reimbursement cuts could dramatically reduce the number of hospitals and physicians that accept Medicare, while Social Security benefit cuts could make it even more difficult for seniors to make ends meet in retirement.
What everyone should be doing
The annual Social Security and Medicare Board of Trustees report serves as a warning to pre-retirees, and even recent retirees, that alternative sources of income are a must in retirement.
Officially, the Social Security Administration advises that Social Security benefits are only designed to replace about 40% of your working wages. This implies that a majority of your income should come from other sources, such as a retirement account. Similarly, it would not be surprising if Medicare began pushing more costs onto consumers in the years and decades that lie ahead. You need to be prepared for what could be lower-than-expected benefits and higher medical expenses come retirement.
Two of the best moves you could make to prepare are opening and contributing to a Roth IRA and a Health Savings Account, or HSA, assuming you qualify for both.
The advantages of a Roth IRA have been well-advertised by yours truly. The major advantage is that investment gains within a Roth are completely free of taxation as long as you make no unqualified withdrawals. Additionally, there are no age limits when it comes to contributing to a Roth, nor are there any minimum required distributions. It really is the plan that gives seniors the most flexibility in retirement. Perhaps best of all, since Roth IRA distributions don't count as income, they could help you avoid paying taxes on Social Security benefits or surcharges on your Medicare premiums.
On the other hand, an HSA acts just like a tax-deferred retirement account, such as a 401(k), giving you the freedom to invest your money as you see fit. When you reach retirement, you're able to take distributions on investment gains, although you'll pay tax on those distributions. The real advantage of the HSA is that it allows you to withdraw money penalty- and tax-free at any age prior to 65 (the age you'd enroll in Medicare) to pay for qualified medical expenses.
In order to qualify for an HSA, you'll need to be enrolled in a high-deductible health plan, you can't be claimed as a dependent by anyone else, and you can't be enrolled in Medicare.
The point being that you need a plan B in place for retirement. Although Social Security and Medicare will be there for you when you retire, counting too heavily on either program could be a mistake.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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