That Bump You Are Getting On Social Security Benefits Helps Making The System Insolvent

According to a recent report from the Social Security trustees, the trust fund that pays for retirees’ benefits (OASDI, or Old Age and Survivors Insurance fund) will become depleted by 2033. This means that the fund will be exhausted and nothing will be left in its portfolio to help pay benefits. It does not mean, however, that all payments will cease: there will still be an ongoing payroll tax collection and income tax collection on benefits, but the trustees’ report estimates that this may cover around 76% of scheduled benefits. If it comes to that, recipients may then get their payments on a delayed schedule, or on time but not in full.

This raises a legal problem, as noted by a recent Congressional Research Service (CRS) report: The Social Security Act establishes that beneficiaries are legally entitled to their full scheduled benefits, but the Antideficiency Act prohibits government spending in excess of available funds. If the funds are allowed to deplete and 100% of all benefits cannot be paid out, the conflict between the two federal laws suggests that the Supreme Court may end up getting involved. This will be a nasty case guaranteed to leave a lot of people very angry.

What to do? The trustees of the Social Security funds think that benefits would have to be cut between 22% and 26%, or the Social Security payroll tax rate would have to climb to perhaps 15.8% from the current 12.4%, or some combination of the two will have to be worked out when the funds arrive to the edge of insolvency. Given how people vote, higher taxes on the young would be likelier than smaller benefits on the old. Neither solution will be popular.

The CRS concludes its report with the obvious truth that the sooner adjustments to Social Security policy are undertaken the better, because it would give both workers and beneficiaries more time to plan and adjust their work and savings behavior and prevent abrupt changes to the system.

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One wonders if the CRS researchers who put together this report have ever set foot in the main chambers of Congress (they probably have, since the CRS is an office of the Library of Congress) and witnessed first-hand the acrimony with which legislators operate these days. Chances that something of this magnitude could be tackled in the current environment are nil, at least for the foreseeable future.

Meanwhile, inflation numbers are climbing to levels that seemed inconceivable just a few quarters ago.  Social Security payments are adjusted according to CPI-W, an inflation measure, at the end of every third quarter. The most recent adjustment was of 5.9%, its highest level since the 7.4% adjustment of 1982. 

At first glance this seems good news for beneficiaries, who will receive the highest increase in years. But the Social Security trust funds are invested in special-issue U.S. Treasury securities with an average maturity around 7 years, and this is a problem. In 1982 the 7-year U.S. Treasury had a yield of 11.7%, which was well in excess of the 7.4% payout increase of that year. In contrast, at the end of 3Q 2021 the 7-year U.S. Treasury note had a yield of 1.3%, far short of this year’s 5.9% increase.

The fact that U.S. Treasury rates are stubbornly low is a real hindrance to the viability of the Social Security funds, because it will bring their insolvency date sooner than 2033 if current trends continue. It is worth pointing out that the Social Security trustees report came out a month before the last CPI-W adjustment, which made matters considerably worse for the funds. From the standpoint of beneficiaries the picture is equally complex and discouraging.

Employees closer to retirement are the least likely to see a higher payroll tax, given the reluctance of legislators to get in front of this problem anytime soon. The hyper-politicized environment of the day makes anyone willing to tackle something like this an instant political target. This means that those further away from retirement are at the highest risk of being hit with a much higher payroll tax rate.

If benefits were to be reduced, the question then turns to who will bear the brunt of the cut. If smaller payments or older retirement age eligibility befall on those newest to the system, it would create an unacceptable two-tier system of beneficiaries: those grandfathered into the current system with higher payments and an earlier start of benefits and the unlucky ones falling under a new, far less generous regime. Again, it seems likelier that in such a contest younger generations will get the short end of the stick.

Planning for a change in Social Security is problematic, since it’s far too early to take preemptive action without knowing which way the chips could fall.

Would self-employed individuals be better off than W-2 employees? Self-employment compensation structured by a mix of salary (which is subject to SS tax) and dividends (which are not) as opposed to salary-only would reduce the tax liability, but potentially reduce benefits down the road because they are calculated on salary history. And this would surely be subject to close scrutiny from taxing authorities, however defanged they might continue to be.

Would it pay to claim early and bet on being part of a privileged set of beneficiaries? This would reduce the potential amount of benefits that could be obtained than claiming at full retirement age, and it may turn out to be a really bad bet if benefits end up slashed across the board.

On these and other matters the best advice for future beneficiaries is disappointing: do nothing for now but stay alert to developments. Those who can may want to redouble their focus on building their savings and rely less on future Social Security benefits in their planning.

The relationship between inflation and Treasury rates will be one of the key variables to watch as this drama unfolds. If nominal rates do not start to line up closer to inflation in the next few quarters (creating problems on other fronts) or inflation is not “transitory” as the Federal Reserve insists, the day of reckoning for Social Security could come considerably sooner than even the most dire predictions have it. This is the unfortunate warning to those who plan to rely on Social Security benefits to fund their retirement years.

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