Friday, October 29, 2010

Social Security "Trust Funds"

    Sometimes, politicians refer to a social security “trust fund” that is running out of money, going broke, invested in Treasury bonds or, depending on the politician, bankrupt or headed there.  Representative Michele Bachmann, for instance, recently wrote a column stating, “Social Security is Broke”.
    In reality, social security is a pay-as-you-go system.  There is no giant trust fund invested to pay social security benefits.  Payroll taxes (FICA) are withheld from every employee’s paycheck and this money is used to pay the benefits of current retirees.  Currently, an employee pays 6.2% of the first $106,800 he earns and his employer has to pay an equal amount, totaling 12.4%.
    In other words, people who are employed today are paying for people who are retired today, and those people now paying for their parents’ generation’s retirement will have their social security benefits paid from the payroll taxes paid by their children’s generation of Americans.
    The Social Security Administration does not, as some people believe, invest your generation’s payroll taxes in a fund that will one day pay your generation’s social security benefits.  By the time you retire, your contributions will have been paid out to people who retired before you.
    At least, that’s the plan.  The problem is that the ratio of retired people to payroll tax-paying people is getting worse because of the Baby Boom.  There may not be enough workers to support all those retirees and that’s the reason for all the talk about cutting benefits and raising the retirement age.
    There is a trust fund (two actually, one for retirement benefits and one for disability), but it is mostly an accounting mechanism.  Here are two analogies to the family budget that might help explain.
    Imagine that your rich aunt died and left a million dollars in a trust fund to pay your retirement expenses.  She authorized a trustee to invest the money in stocks and bonds in a way that would preserve the capital in the fund and pay you the interest every year.  You could safely assume that you would always have at least a million dollars in the fund and that you will receive an interest check to live on every year for the rest of your life. 
    This is not the way the social security trust funds work.
    The Social Security program never had a rich aunt.
    The social security trust funds have two purposes, according to the Social Security Administration.  They provide an accounting mechanism for tracking all income to and disbursements from the trust funds, and they hold accumulated assets.  In other words, the payroll taxes collected in any year have to sit somewhere and be accounted for until they are paid out in the same year, and there must be a place to keep accumulated funds in years when payroll taxes exceed benefit payments.
    Let’s compare this to a household budget, which is more like social security than is the rich aunt scenario.  You expect to earn a certain amount of income for the year from your employer (like payroll taxes in the social security program).  You budget a certain amount for living expenses (payable benefits in the social security program).  If you make more than you spend, you place the excess in an interest-paying savings account for the future.  (Social Security buys Treasury bonds, but more on that shortly.)
    You don’t have your rich aunt’s pot of money to pay the bills; you have a budget (accounting scheme) that allows you to plan to pay future expenses from future job earnings. You “pay as you go”.  That’s more like the way social security works.
    The “accumulated assets” purpose of the social security trust funds is interesting and not entirely like your savings account at the bank.  When you (or a corporation or foreign country) purchase a Treasury bond, you are loaning the U.S. Government money.  Uncle Sam pays you interest until the bond matures and then you receive your principal back.
   When the U.S. Government buys Treasury bonds with the excess in the social security trust fund, it is borrowing money from itself and paying interest to itself.  It’s essentially an accounting mechanism, like having a few bucks left over at the end of the month and stuffing it under your mattress for some month you'll come up short.  Granted, you probably wouldn't pretend to pay yourself interest.
    Buying T-bonds does serve another important purpose.  If the U.S. Government merely tracked the excess funds in a budget, Congress could vote to simply to change the budget and make those funds disappear.  However, Uncle Sam must, by law, repay the debts of the U.S. Treasury.  They can't simply makes the bonds disappear like they can a budget item.
    There are social security trust funds, but they are primarily an accounting system to track income and expenses.  They don’t invest in stocks and bonds or anything else, unless you consider loaning yourself money an investment.
    So, what does it mean to say that the social security trust fund is broke or that social security is headed toward bankruptcy?
    The trust fund would run a deficit if payroll taxes plus the savings in the trust funds weren’t adequate to pay benefits in some year.  This nearly happened in 1982 and may be a problem again soon. 
    In 1982, Congress simply borrowed money that was paid back in four years.  This is a cash flow problem that was solved as anyone solves a cash flow problem, with borrowing.  It says, “the money will be there one day, we just won’t have it until after the bill has to be paid.”  It's the same mechanism that allows us to buy a home that we can't pay for with cash.
    The demographics issues, having a huge number of retirees and not enough tax-paying workers, is not a cash flow problem.  It is a budgeting issue.  According to the Trustee’s Report, under two different scenarios of future economic conditions, social security will remain solvent for thirty more years and in the best case 75 more years. 
    If the economy does better than expected and there are lots of payroll taxes to collect and the demand from future retirees isn’t as high as is expected, the program will be fine as is.  If not, expenses may have to be cut, by raising the retirement age or reducing payments, for example.  Or, payroll taxes could be raised, but that doesn't seem politically palatable.  Managing social security, like managing the family budget, is an ongoing process that will have good times and bad.
    Making a statement like “Social Security is Broke” simply doesn’t mean much.  If you think that your future job income won’t be enough to pay future bills, you make changes.  You earn more income and/or cut expenses.  That doesn’t mean you’re broke. 
    And it doesn't mean that the social security program doesn't need changes to remain solvent longer than thirty more years.  It just means that you might be broke one day if you don’t manage your money well going forward.

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