The Solution To Social Security's Funding Problem

"Now there are more 18 year olds who believe they have a better chance of seeing a UFO than a Social Security check." - John Kasich speaking @ a Republican presidential primary debate in 2016.  The reference to UFOs & Social Security goes back @ least 40 years based on my own recollection of discussions regarding Social Security checks & UFOs.

Social Security currently makes up almost 25% of federal spending.  It cannot continue indefinitely as the number of workers decreases, the number of beneficiaries increases, & benefits increase based on a wage indexing formula that grows faster than the cost of living.  

click on graphic to enlarge

Now the 18 year olders of decades ago who were not afraid of UFOs will learn in the real world, from the graphic above, that they were 20% correct in that they will receive only about 80% of their expected Social Security benefits when the Old Age & Survivors Insurance Trust Fund (OASI - solid blue line on above graphic) runs out of money.  Long time readers of this blog know that the Trust Fund is an accounting gimmick that draws on money from the general treasury until the Trust Fund balance reaches zero thereby signaling that the Trust Fund is exhausted & the reductions in benefits commence.

Check the bold print of page 2 of the document entitled "Your Social Security Statement" (available to everyone online with reminder to review your "Social Security Statement" online three months before your birthday & mailed to people over 60 who do not have an online account) that clearly tells people that "by 2035, the payroll taxes collected will be enough to pay only about 80% of scheduled benefits."

Because of Covid-19's  impact on the American economy the Congregational Budget Office (CBO) has updated this calculation, prior to the Social Security trustees' update, & determined that the Trust Fund will be depleted five years earlier, in 2030, with the reduction in benefits starting in 2031.  The OASI curve in the above graphic started to slope downward about 2010 - the year that 10,000 baby boomers per day started to retire.

I have never met one person @ any of my FairTax seminars or radio programs I have been on, including the radio hosts, who were aware of the Trust Fund's pending exhaustion & the program's subsequent reduction in benefits. 

Please remember that the Trust Fund was created because the large number of baby boomer payroll tax payments created a surplus which was promptly borrowed & spent by Congress - i.e., it's gone.  Today there are only IOUs remaining in the Trust Fund & money is drawn from the general treasury to meet Social Security benefit payments.  There are no real assets in the Trust Fund - only an accounting for returning the borrowed funds from the general treasury. 

This post is written to answer what I had hoped would be the third question asked to Biden & Trump during the 2020 presidential debates - "Shouldn't we be taking steps now to head off this 20% reduction in Social Security benefits & if so what are these steps?  If not, why not?"

Over the years there have been proposals made to sure up the Social Security program such as increasing the age to receive full Social Security benefits (which would also decrease the benefit for those filing @ age 62), increasing the amount of income taxes paid on Social Security benefits, raising the cap on payroll taxes, & allowing participation in private accounts.  Although this post presents the far & away best solution to the Social Security funding problem I also endorse letting young workers put, say 15%, of their payroll taxes up to age 50, into private stock market accounts - but that has politically blown the roof off any discussions of this issue in the past.

The Social Security Act was signed into law by FDR on August 14, 1935 with the understanding that Social Security benefits were not intended to be a total pension but rather "some measure of protection to the average citizen & to his family." 

This understanding is carried through even to today when on page 1 of the aforementioned "Your Social Security Statement" it says "Social Security benefits are not intended to be your only source of income when you retire.  On average, Social Security will replace about 40 percent of your annual pre-retirement reported earnings.  You will need other savings, investments, pensions, or retirement accounts to live comfortably when you retire."

But over the years Social Security expanded both the number of people in the program & the amount of money they received thereby making more & more people dependent on this government program.

The initial Social Security benefit is based on a formula that counts the highest 35 years of earnings, indexed to the growth in average real wages, over the lifetime of a person's earnings.  The formula fills in zeroes for years not worked when considering the 35 year period.

The highest 35 years of someone's earnings are all indexed, up to age 60 for that person, to real average growth in wages, an adjustment that brings nominal wages close to current wage levels meaning that Social Security benefits track productivity increases closely.  It is the real wage growth component of the formula, not the benefit starting age, or the ratio of beneficiaries to workers, or the amount of payroll taxes, that is @ the heart of the Social Security problem.  It is the wage indexing adjustment that brings the calculated benefits much higher, actually greater in inflation adjusted terms, than what people earned in those 35 years of work.  In short, benefits keep getting larger for each cohort of retiring workers, which has put the program on the path to unsustainability for the country.

As a check of this point, compare your Social Security benefit with that of your parents & you'll find that yours is much greater - for similar inflation adjusted incomes while working.  Accordingly, yours is much smaller than siblings several years younger than you.  It is this increase that is unsustainable as the workforce decreases.

John Cogan, of the Hoover Institution, has calculated that thanks to the benefit formula based on the average real wage index, the benefits paid to a teenager @ the turn of the twenty-first century are scheduled to be 60% higher, in real terms, than the typical worker who retired in 2001.

Just changing the benefit formula to follow inflation based on the Consumer Price Index (CPI) instead of the average real wage index will bring the Social Security system into long term solvency in a new system.  

The phase into the new CPI system would not affect anyone age 55 or older.  Anyone aged 54 or younger would retain their wage index work years in the benefit formula but would switch to the CPI basis immediately – so everyone would retain the portion of the existing system methodology up until the change in benefit basis from wage to CPI.  In essence, those aged 54 & younger would follow a sliding scale with people in their 50s today receiving higher real Social Security benefits when they retire than those just entering the workforce when they reach retirement age..

The above proposed system is based on a sound financial footing for everyone, especially younger workers, unlike the current system where the benefit formula is based on average real wage indexing – where the choices for a solution to the funding shortfall in the near future are to raise payroll taxes around 50% on younger workers (& all others), borrow hundreds of billions of dollars, or abruptly slash benefits 20% on current benefit recipients as the Social Security website indicates is a certainty under current law & described hereinabove. 

Adjusting Social Security benefits for inflation alone & ending the average real wage index increases would address the challenge.   This step limits the growth on projected benefits to preclude painful future cuts as described above. The wage index to CPI adjustment would make Social Security a smaller part of Americans' retirement package a few decades from now & would also erase at least two-thirds of the currently projected shortfall thereby eliminating the obvious predictable suffering & distress that will be realized by unsuspecting Social Security recipients in the not too distant future.  

I first learned of the above solution to the Social Security funding problem from Susan Lee in November, 2004.  Amity Shlaes confirmed its validity in November, 2007.  I am honored to cite the references of these two women who I deeply admire.

Just imagine how much farther ahead we would be if we would have started implementing the above solution 17 years ago.

For that matter just think how much farther ahead we would be if the media would have pressed Trump & Biden about the above solution during the 2020 presidential debates instead of questioning them about the mindless dribble that was asked.

But then again, can you imagine either Trump or Biden really addressing this issue?

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Special note for people born in 1960 regarding a big hit to Social Security benefits because of Covid:  Andrew Biggs of the American Enterprise Institute has calculated that Social Security benefits will be about 15% lower for people born in 1960 because of quirks in the current Social Security benefit formula, the formula described above, that indexes individuals' earnings to the growth of the national average real wages up to the year people turn 60, after which the formula follows the CPI.  Mr. Biggs calculated that because of Covid the national average wage in 2020 was 15% lower than projected for 2020 in the 2019 Social Security Trustees Report meaning that a worker, born in 1960, who earned $50,000 per year while working would permanently receive about $3,900 per year less than previously expected in Social Security benefits.

Since an individual's Social Security benefit is dependent on the value of the average real national wage in the year the individual reaches 60 years of age it follows that a 15% reduction in the average national wage in the year a person reaches 60 will carry back to all of the other years' earnings as they are indexed to this lower wage figure thereby resulting in a permanent reduction in benefits for the rest of such a person's life.

The 2020 Social Security benefit formula replaces 90% of the first $960 in average monthly earnings, 32% of monthly earnings between $960 & $5,785, & 15% of monthly earnings above $5,785.  The 2012 Social Security benefit formula called for commensurate inflection points @ $767 (instead of $960), $4,624 (instead of $5,785), plus 15% of amounts over $4,624 (instead of $5,785) meaning that the average real wage index increased 25% over this relatively short eight year time span while the CPI increased 13%.

Look @ a longer time frame to see the full impact of compounding that magnifies the difference of the two indices - the average real wage index increased 336% between 1979 & 2019 while the CPI increased 276% during this same 40 year period thereby showing the difference in growth of the two measures & verifying the improved sustainability of the Social Security program by adopting the CPI instead of the average real wage index in determining initial benefits.

In both the above numerical examples the average real wage earnings growth is greater than the CPI inflation growth so in essence the government is guaranteeing, by using the average real wage index to determine Social Security benefits, a real positive return on everyone's financial participation in the Social Security program - a guarantee no other investor has in the marketplace.

If Social Security benefits were based on CPI adjusted earnings instead of earnings indexed to the average real wage over the years this Covid related reduction would not have occurred to the people born in 1960.