Social Security: Will it go bust?

According to Forbes magazine, Social Security replaces about 40% of the average person’s retirement income and is the largest source of retirement income for most people. Contrary to common assumption, your contributions are not really going into an account with your name on it. They are going out to those who are currently getting Social Security checks. You may ask, where will they get the money to pay your Social Security check when you retire? Will there be enough payroll taxes coming in to cover your benefit check?

To answer those questions, we must first address the common confusion about how the Social Security system works. A recent podcast at the American Institute of Certified Public Accountants (AICPA) – accessible only to AICPA members – explains how the Social Security system works. Via the payroll tax system, we tax current workers via FICA withholding at 6.2% to the employee and 6.2% is paid by the employer with 12.4% to the self-employed. These dollars go into the Social Security program and are turned around to pay out to current retirees in Social Security benefit checks. This has been how it has worked for the past thirty years. We have had more money coming in from payroll taxes than going out in benefit checks. Thus, we have a surplus called the Social Security Trust Fund, which funds have been invested in special government bonds that did not have any interest rate risk.

This year, however, we are nearing a crossover point. The money being paid out to retirees is a little bit more than the money coming in from payroll taxes. We are beginning to have to sell bonds to get cash.

If we literally do nothing to fix the system for the next 100 years, the benefits paid out will not go to zero. Not even close. The worst situation will be that in 100 years the Social Security benefit checks will be 75% of what they are now. That is the situation if we do nothing and run this puppy off the cliff.

Many people are saying the Social Security system is bankrupt and they either need to start taking money now while they can get or they assume they will get nothing. This is not a 100% problem. This is a 25% problem. In the AICPA podcast, Michael Kitces, nationally known financial planner, says, “about 20 years from now you might have to take a 25% haircut if we literally do nothing.”

Kitces explains further that no one took a benefit cut after the 1984 law instituted taxation of Social Security and increased the age for taking normal benefits. “By the time the 30-somethings reach retirement, they could be waiting until age 70 to start getting Social Security and will have been paying another 1% in payroll taxes. Sustainability of Social Security is not a mystery of what to do. It is actually just one giant actuarial math problem. We know how to do the calculation.” With technology, our ability to calculate projections is far greater now than it was thirty years ago.

Also on the AICPA podcast is my friend and colleague, Ted Sarenski, CPA/PFS, CFP. He is an expert on Social Security and wrote the “CPA’s Guide to Social Security Planning” for financial planners. He points out the general concern is that the lower paid people will be hurt the most. In the podcast, he explains a simple scenario. If the FICA withholding is increased by one-percent (half a percent for the employee and half a percent for the employer), that would generate $100 per year to Social Security on a $20,000 per year employee. Over 40 years, that is $4,000 extra for Social Security. When this employee retires, they will get $1,000 per month in Social Security benefits. They will have recovered their money in four and a half months. In contrast, the higher earners never recover get their money back under the current system. Sarenski tells us that even if we increased the withholding amount, we would still be skewing the benefits to the lower earners.

Each year the Social Security trustees say there are only two solutions: raise the payroll tax rate and/or reduce the benefit check amounts. These two gentlemen say that increasing the payroll tax rate by just 2-3% will get our Social Security paid up for the century. “Moving the normal retirement age a few years out almost completely resolves the shortfall issue.”

There is a lot of paranoia out there about a bankrupt Social Security system. Understanding how the system really works helps clear up this fear. CPAs say to use this understanding in your financial and retirement planning.