Celebrating its 75th anniversary in 2010, the history and evolution of the Social Security program can provide insights on the future changes that will be needed to keep the program solvent, as well as some of the changes and related issues facing State retirement systems and individual retirees. Can you say demographic perfect storm?
Possible changes to Social Security include:
- Increasing the full retirement age beyond age 67 to parallel longevity increases;
- Increasing up to 100% (from the current 85%) the taxation of benefits for those at higher income levels;
- Increasing the payroll tax rate from the current rate of 6.2%; and
- As was done with the Medicare payroll tax in 1993, eliminating (or accelerating increases in) the maximum wage base subject to the tax.
Background. The Social Security Act of 1935 (and the current version, as amended) is arguably the most significant piece of New Deal legislation and has been responsible for keeping many seniors above the poverty line. For example, Social Security supplies retirees about 40% of all their income. When broken down by sex, the % rises to 48% for women and is about 34% for men.
Social Security now encompasses a number of welfare benefits, is the world’s biggest government program, and the largest federal expenditure at over 21% of the annual budget, slightly more than for defense spending and for Medicare/Medicaid. In fact, Social Security and Medicare constitute about 1/3 of the federal budget!
Nearly 55 million retirees, disabled people and children of deceased parents (collectively beneficiaries) receive Social Security benefits, which totaled $725B in 2011 and average $1,077 monthly. About 47.5 million retirees receive Medicare benefits ($523B for 2010 vs. $486B in taxes collected). The cost to run these programs is $6.4B, @ .9% of benefits paid.
This commentary focuses on retirement benefits, the most expensive of the Social Security programs.
Initial Benefits and Taxes. Social Security was primarily created to facilitate the retirement of older workers and, thus, free up jobs for younger people during the Great Depression. Like many of FDR’s New Deal programs, the constitutionality of Social Security was challenged but this program was upheld by the Supreme Court. In 1935, average life expectancy was about 62 years, less than the minimum age of 65 needed to qualify for Social Security benefits! Thus, the benefit only was available to those who beat the actuarial odds. (The minimum age eventually would be lowered to age 62 — for women in 1956, and for men in 1961.)
Wages and the Taxable Wage Base. Benefits were based on wages earned only for 1937 and subsequent years, with the first monthly benefits scheduled to commence in 1942 based on as little as 5 years of work history. However, some “retirement” benefits were first paid in 1937 as lump-sum death benefits in an amount representing 3.5% of the worker’s covered wages.
The collection of payroll taxes also began in 1937 at a rate of just 1% from both the employee and employer on wages up to just $3,000. The $3,000 payroll tax wage limit would remain as is for 13 years until 1950(!) and then would rise slowly to only $9,000 by 1972 — a large bargain for those who paid in taxes during that time period.
Monthly benefit payments were accelerated to commence in January 1940, rather than 1942 as originally planned. The first recipient, Ida Mae Fuller, was a single working woman who turned age 65 in 1939. She received an initial monthly check of $22.54 based on the $24.75 (1%) of tax withheld during 1937-1939 on her total wages of $2,484 during that period. She lived to be 100 and collected $22,889 in benefits, a very good return on her investment of $24.75!
Benefit Calculation. Benefits are now based on the average your 35 highest years of earnings. The maximum monthly benefit for someone now retiring at NRA who has 35 years of maximum earnings is $2,323, or $27,876/yr. The average monthly benefit being paid is about half this amount. You generally need 10 years of work history to qualify for benefits on your own record. This translates into at least $1,120 earned/qtr. or $4,480 earned/yr.
“Pay-As-You-Go”. Social Security originally was to be funded through a separate and untouchable reserve or “lock box” holding the payroll taxes collected to pay future benefits. However, with more payroll taxes coming in than going out as benefit payments during its early years, Social Security quickly became a “pay-as-you-go” program as the government “loaned” these excess (surplus) tax revenues to itself to help finance other important activities, like WW II.
Evolution. Social Security provisions have been revised periodically to accommodate changes in economic conditions, evolving gender roles and work patterns, increased longevity of recipients, and program funding status. For example, self-employed persons were not covered until 1951 and their tax rate did not become twice the employee rate until 1984! Another good deal for many years!
Benefits were added in 1956 for those who became disabled and were unable work. In 1972, the Supplemental Income program superseded state programs to provide additional aid to the elderly and disabled (this program is not paid via employment taxes however.) The burial benefit, however, has remained at a paltry $255, we understand due to the insurance lobby that prefers you buy its product.
Maximum benefits initially were static and actually fell as a % of increasing average earnings. However, revisions made in the American supremacy of the 1950’s significantly raised benefit levels, and these benefits soared further after they were indexed to runaway inflation in the 1970’s. Benefits reached their height as a % of pay (@ 50%) in 1983 before various cost-saving measures were implemented to preserve the program’s solvency. Those who retired in 1983 fared far better than those coming next.
Unified Budget (Cloaking Device). In 1968 (at the height of the costly Vietnam War), the federal government adopted a “unified” budget approach which meant the Social Security “surplus” could offset total government debt, making this total debt appear much smaller than otherwise. By this time the payroll tax had risen to 3.8% and a Medicare tax, first implemented in 1966, was .8%.
Drunk on COLAs. In response to growing inflation in the 1970’s, a COLA was implemented in 1972 to provide an annual adjustment to benefit payments if the CPI increased by 3% or more. This formula was flawed, however, and resulted in higher COLAs than desired until it was fixed several years later. 2010 was the first year since 1975 that no COLA was granted.
The Demographic Tables Turn. By the mid-1970s, the “happy days” of many workers paying FICA taxes but few collecting benefits was just about over, and the ratio of benefit recipients to workers was increasing. With stagflation, wage increases lagged changes in the CPI and the COLAs being granted. The surplus between FICA revenues collected and benefits being paid began to shrink and, for the first time, serious questions arose about the long term financial sustainability of Social Security.
Unpopular Changes / Third Rail Politics. Politically unpopular changes were now needed to increase Social Security funding by limiting benefits and/or increasing taxes. Thus, needed change came slowly and often in piecemeal fashion. In the late 1970’s the maximum wage base formula was revised and began to rise more rapidly at about $2,000-$3,000 per year. This was a clever approach because it raised the level of payroll taxes collected and was self-adjusting without requiring additional Congressional action! (Wages subject to the payroll tax are $106,800 for 2011; $110,100 for 2012.) Payroll tax rates also continued to increase slowly but the Social Security financial picture still did not improve.
1983 Bi-Partisan Reform. Changes enacted in 1983 and made effective in 1984 attempted to push back the sustainability “doomsday” clock. One change raised the tax rate up to 5.7%, with subsequent increases up to 6.2% by 1990 where it remains today. (The current Medicare tax rate of 1.45% also was set in 1990, although it will now increase for high income individuals under the Health Care Reform bill). With these higher rates, about 80% of workers now pay more in FICA than they do in income taxes! Simply amazing or shocking dare we say!
Higher NRA and Higher Benefit Taxation. Also beginning in 1984, (i) the full-benefit normal retirement age (NRA) was increased up to age 67 depending on your date of birth, and (ii) up to 50% of the value of benefits were made taxable if your income level exceeded certain thresholds. (This % of taxable payment would increase up to a maximum 85% rate beginning in 1994 even though you paid in half the contributions to the program!) Retirees with income over $25,000 (“single”), or combined incomes over $32,000 (if married filing jointly) are subject to this tax (income = AGI + tax exempt municipal bond income). About 2/3 of recipients pay tax on their benefit!
By raising the NRA, money could be saved via greater reductions for benefits that commenced early, thru smaller increases where benefits commenced late, and windfalls where a person died prior to commencement at the increased age. For each month benefits commence before NRA they are reduced 5/9 of 1% for each month up to 36 months, then 5/12 of 1% for each additional month. At age 62 commencement (the earliest start date), this formula provides 80% of the full benefit if NRA = 65, a 75% benefit if NRA = 66, and just a 70% benefit if NRA = 67. For those born after 1942, benefits are increased by 8% for each year of delay after NRA. There is no additional benefit increase after age 70, even if you continue to delay taking benefits, sorry. The 1984 changes also broke out the two employment tax deductions from your paycheck: OASDI and Medicare.
Working and Receiving Benefits. You are clearly discouraged from working full-time and receiving Social Security benefits before your NRA because $1 is deducted from benefits for each $2 earned above $14,160 (this amount is indexed). In the year you reach full retirement, $1 is deducted for each $3 you earn above $37,680 until the month you reach full retirement age. You can receive a full Social Security check for any whole month you are retired, regardless of your prior YTD earnings.
Picking and Choosing. Adding to the fiscal shortfall are some generous benefits to spouses and former spouses (both divorced and widowed.) For example, the Social Security program added a benefit for non-working spouses of the traditional 50’s sitcom that was 50% of their husband’s benefit — even though the spouse never contributed a dime to Social Security! If the spouse did work, she could still take 50% of spouse’s benefit if it was greater than her own benefit.
If spouse A was receiving $1,500/mo and spouse B $1,000/mo and A died, B can bump up to the $1,500/mo for the rest of her life. A widow(er) also can commence benefits at age 60 with applicable % reductions and after age 60 can remarry without losing right to this benefit. Children up to age 18 also can collect benefits but the total family benefit generally cannot exceed 150%-180% of the primary benefit.
In case of divorce, if married at least 10 consecutive years, divorced for at least two years, and not remarried, the divorced spouse is entitled to 50% of the ex-spouse’s benefit if greater than their own. This does not affect the ex-spouse’s benefit. You can draw this benefit, for example, beginning at age 62 while waiting to commence your benefit if it is greater at NRA. This type of loophole could be closed by future law changes.
Privatization. The privatization idea went prime-time during Bush II’s second term. Some thought it an intentional diversion from Iraq or a handout for Wall Street investments. In all events, the subsequent market downturn made privatization a dead (not just lame) duck. Perhaps the public does appreciate socialism that puts money in its pockets, not just the pockets of those who are too big to fail. The theory of privatization has some appeal but it’s just not practical. The appeal is this: investing the combined payroll taxes paid on my behalf (12.4% of “wages”) in an IRA would give me a very big chunk of change at age 65. Moreover, if I died at anytime, I still would have “my” money to give to my beneficiaries. A big problem with this approach is the transition cost.
Where would the funds come from to pay current recipients if all or most of future payroll taxes were diverted to private accounts? Second, “funding” this transition cost through a massive debt instrument became impossible as the budget surplus of the 1990’s turned into a huge budget deficit. (A national lottery to fund this cost was never considered.) Third, stock market fluctuation “spooked” many investors who rather leave this investment risk up to Uncle Sam who can always print more money.
Measuring the Shortfall. Two approaches are typically used to measure the status of Social Security funding. The first measure is when the program no longer can pay for itself, in other words the annual payroll taxes coming in no longer exceed annual benefit payments going out. In 2005, this crossover date was projected to be 2017. (Medicare already flunked this test in 2004.) This crossover date is critical because the excess needed for payments will have to come from elsewhere in the budget — because no lockbox exists.
However, (1) payments have risen more than expected during the current downturn (jobs disappeared and people applied for benefits sooner than planned), and (2) revenue has fallen sharply, because there are fewer paychecks to tax. Thus, in 2010 Social Security paid out more in benefits ($713B) than it received in payroll taxes ($664B).
The second funding measure is when the “surplus” payroll tax payments collected in prior years (e.g., up to 2017 or sooner as noted above) is exhausted. In 2005, this projected date was 2041 (2020 for Medicare*). This milepost is less meaningful than the first metric because there is no actual surplus or trust fund per se, just book entries showing government IOUs in the form of bonds. Nonetheless, by law, Social Security cannot pay benefits beyond this balance or current year contributions! It is projected that only enough $ then would be coming in to cover about 75-77% of benefits owed! The recession has depleted Social Security’s funds more quickly than previously predicted so this year of reckoning has now been moved up to 2037 (to 2033 in the 2012 report).
The trust fund balance (i.e., government IOU’s) is currently about $2.6T (up from $2.5T last year representing more accrued interest). Now this accumulated revenue will slowly start to shrink (albeit CBO predicts wishful small post-recession annual surplus contributions in 2014 and 2015). After that, demographic forces will overtake the fund, as more and more baby boomers leave the work force, stop paying into the program and start collecting their benefits. Outlays then will exceed revenue every year, no matter how well the economy performs.
As Alice Rivlin, a senior fellow at the Brookings Institution, states: “The interaction of an aging population with rising health care spending is the reason federal spending is projected to rise faster than the economy can grow over the foreseeable future. Spending for Social Security alone is projected to rise from about 4.8 percent of Gross Domestic Product (GDP) in 2010 to about 6.2% by 2035, when most of the boomers will have retired. That is not a trivial increase in spending, even though spending for Medicare is projected to rise considerably faster—from 3.6% of GDP in 2010 to 5.9% in 2035 even if we are very successful in cutting the growth of medical costs. Tax increases can be part of the solution, but we cannot raise taxes continuously to offset the growth in spending without eventually damaging the economy, and we can’t afford to keep borrowing increasing amounts, so we have to find ways to keep total federal spending from growing significantly faster than the GDP.”
Proposals. The 18-member National Commission on Fiscal Responsibility and Reform is supposed to generate solutions for fiscal problems. To be endorsed by the Commission, an idea must garner 14 votes. The Commission is a bit unusual because it includes 12 members of Congress, six Democrats and six Republicans appointed by congressional leaders for this suicide mission, plus four non-lawmakers chosen by the White House. The Commission’s discussion of Social Security reforms can be found at the WSJ’s 8/20/10 article at http://online.wsj.com/article/SB10001424052748704476104575439792287255372.html. In all events, these projected dates of reckoning will keep getting closer if new benefit restrictions or increased funding does not occur. Stay tuned while Congress fiddles!
Since inception in 1965, Medicare grew by 2011 to a $554 billion dollar federal program―3.68% of GDP with about 50 million enrollees. The average beneficiary in 2011 paid $119,000 in premiums in his or her working career via payroll taxes and will receive $367,000 in health services — 27% in the last year of their life. In its 2011 report, the trustees state that the Medicare fund is now projected to run out of money in 2024, five years earlier than last year’s wishful estimate!
The Social Security trust funds are projected to be drained in 2036, one year earlier than the last estimate of 2037. Once the trust funds are exhausted, both programs can only collect enough money in payroll taxes to pay partial benefits. If the Medicare fund is drained, it will collect only enough payroll taxes to pay about 90% of benefits.
The trustees said “fixing” Social Security would require a 2.15% hike in the payroll tax or an immediate and permanent 14% benefit cut, while “fixing” Medicare would require a 1% increase in the payroll tax or a 17% cut in benefits. The six trustees are Treasury Secretary Tim Geithner, Charles Blahous, Robert Reischauer, Labor Secretary Hilda Solis, Health and Human Services Secretary Kathleen Sebelius, and Social Security Commissioner Michael Astrue. The 2011 and 2012 reports are here:
Waste & Overpayments. The Social Security Disability Insurance (SSDI) program’s separate trust fund will be exhausted by 2018 under certain assumptions in the 2011 trustees report (2016 in the 2012 report). SSDI was created in 1956 but of late disability rolls have been increasing significantly showing 6.7 million beneficiaries receiving $55 billion in 2000 and 10.2 million receiving $124 billion by 2010. Benefits continue as long as the person remains disabled or, if still living, until he or she reaches retirement age. Very few leave SSDI. In 2009, of 630,074 benefit terminations, only 5.1% returned to work, 54% reached full retirement age, 35% died, and 3.2% showed medical improvement but did not return to work.
Sen. Tom Coburn (R-OK) argues that billions could be saved on SSDI if “continuing disability reviews” of beneficiaries were performed. He noted that 669,000 reviews were done in 2003, but only 322,000 in 2010. In 2010, the GAO found 1,500 recipients were also collecting federal paychecks!
Supplemental Security Income (SSI) was established in 1972 and is a means-tested benefit to the disabled poor, elderly and blind. Payments under SSI of $53 billion are expected to go to 6.8 million recipients. In 2000, payments totaling $24 billion went to 5.1 million recipients. SSI recipients are required to report changes in income, resources and living arrangements, and the administrating agency is supposed to regularly perform “redeterminations” of recipients’ non-medical situations. From 2003 to 2008, as the rolls increased, redeterminations dropped 60%. The Social Security inspector general said that if redeterminations had been carried out at the 2003 level, his agency “would have saved taxpayers $3.3 billion during 2008 and 2009.”
* This date now has been wishfully moved back to 2029 due to the mystery numbers and assumptions that are part of health care reform or other magic tricks. For example, a 1990s law would require a 30% cut in certain reimbursement payments to doctors but this law is routinely waived each year by Congress.