Social Security's Collapse Is Accelerating

According to its 2011 Trustees' Report, the Social Security Trust Fund will be exhausted by 2036, one year faster than projected last year. As recently as 2008, the Trustees thought we'd have at least until 2041.

The projected trust fund collapse date is drawing uncomfortably near. While partially due to the passage of time, the more worrisome aspect is that its expected day of reckoning keeps moving up, in a sign that Social Security's problems are getting worse.

Did Jim Cramer get this one right?
At its core, a big part of the problem is Social Security's basic structure, which Jim Cramer has called the biggest Ponzi scheme in history. In essence, the money Social Security takes in as taxes gets paid to current recipients. If there are any surplus tax revenues, they're "invested" in Treasury debt. Or in other words, if the money coming in doesn't get spent on Social Security, it gets spent on other government programs.

While that accounting treatment may have seemed palatable when Social Security was running surpluses, it ran a $49 billion deficit in 2010 and expects a $46 billion deficit in 2011. To cover that gap, Social Security redeemed Treasury debt, raising the government's net borrowing. As Social Security begins aggressively drawing down its trust fund, that pressure on the Treasury will increase.

Ponzi scheme or not, the money in the trust fund has already been spent on existing government programs. As a result, redeeming those funds is will mean higher taxes, more borrowing, inflationary currency printing, or lower levels of government services.

After the collapse
Once the trust fund runs out of money, Social Security expects to be able to pay out about three-quarters of its currently scheduled benefits. That expected reduction means that if you expect to be alive in another 25 years, you need your retirement plan to cover that gap.

As of April, the average retiree received $1,179.50 per month from Social Security. Three-quarters of that benefit amount is about $885 per month. Since Social Security benefits are indexed for inflation, you'll need to cover about $295 per month more worth of today's purchasing power after adjusting for inflation between now and then.

That might not sound like much, until you look at the details. Assuming 4% annual inflation over the next 25 years and looking to follow the 4% rule for withdrawals, you'll need around an additional $236,000 by 2036 to support it. The table below shows how much additional money you'll need to invest each month to cover that gap, depending on your rate of return:

Can dividends get you there?
Since you're looking to replace your potentially missing future Social Security income with this money, it's only natural to ask if you can earn your returns via investment income (or dividends). While there are ways to hit any of those ranges directly from dividend yields, the returns may be a bit bumpy or significantly at risk, especially in the higher ranges.

Most companies in the 10%+ yield range these days are there because their dividends are at risk of being slashed. About the only companies that routinely pay yields in that range these days are mortgage REITs, and they need to pay out 90% or more of their earnings to keep their special tax advantaged status.

Among them, Annaly Capital Management (NYSE: NLY) has a 14% yield, and MFA Financial (NYSE: MFA) yields 11.5%. Even then, their highly leveraged operations and dependency on interest rates cooperating with their management's plans means those payments are nowhere near stable. Both Annaly and MFA have seen their dividends whipsawed around over the past few years as they haven't exactly had stable incomes to support those payments.

In the 8% to 10% range, you can often find stocks of companies that are absolutely loathed, like cigarette maker Vector Group (NYSE: VGR), which currently yields 8.5%. But even that payment may be at risk, since it represents a payout ratio well over 100% of earnings.

Between 6% and 8% yields sit many of the energy pipelines, like Kinder Morgan Energy Partners (NYSE: KMP) at 6.3% and Energy Transfer Partners (NYSE: ETP) at 7.5%. While they have enticing yields, they are structured as partnerships, which can make tax filing even more painful for investors than normal. After all, if you're a "partner," you may have to file state taxes in every state where the partnership does business.

Down in the 4% to 6% arena, though, sit many of the more traditional "widow and orphans" utility-like stocks such as AT&T (NYSE: T) at 5.5% and Exelon (NYSE: EXC) at 5%. With fairly stable businesses and at least partially regulated operations, the phone (AT&T) and power (Exelon) companies are generally considered lower risk payers of decent dividends.

Better get investing
Regardless of what investing strategy you choose to follow to cover your potential income gap, you'd better get started preparing for it, soon. Without major reform, Social Security's trust fund will run out of money in about 25 years, taking about a quarter of your potential benefits with it. Your best chance to cover that gap is to start now and keep time on your side.

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