Can you really rely on Social Security for your retirement years? That is a question that has been asked for the last several years, but that concern is heating up in light of a recent reevaluation of the viability of the Social Security Trust Fund. For some people, it is the sole source of income in retirement years. Even for those that have been fortunate to save a considerable amount for their retirement, Social Security income still plays a big part in funding their retirement lifestyle. But, should you count on it?
Social Security was first introduced in 1935 to partly help “against poverty-ridden old age”. The first monthly recipient was Ida Mae Fuller of Vermont where she received lifetime benefits of $22,889 after having paid in a mere $25.1 (Before you get too jealous of Ida Mae and her generation, realize that she did have to live through two World Wars and the Great Depression.) It was originally set up as a temporary relief program and then began to be used as a safety net as more individuals were living longer than generations past, leading to a unique stage in life in which you did not – or could not – work, and had to rely on some other source of income to help meet basic lifestyle needs. From there, additional family benefits were created as part of a revamped Social Security, including spousal benefits, child benefits, and other benefits.
The funding of the eventual Social Security benefits comes from a portion of the FICA taxes – or commonly called the payroll tax -- that many of you paid during your working years. The funding is based on actuarial analysis that takes into account demographics, longevity, rates of return, and inflation. While the science was originally sound, the implementation of the system has not been sound and the adjustments that needed to be made – and clearly and more alarmingly need to be made today – have not been made.
FICA taxes are those extra taxes above and beyond federal and state income taxes and are comprised of a Social Security tax and a Medicare tax. The Social Security tax is 12.4% -- one-half from the employee portion and one-half from the employer portion (or all of it if you are self-employed under the SECA tax) – of your wages up to a certain threshold. Historically, those taxes have been used to pay current Social Security recipients and to be held into a trust fund for the payment of future Social Security benefit payments. The amount workers are paying into the system versus how much in benefits are being paid out to recipients will drive the increase or decrease of this trust fund, the pot of money used to supplement the Social Security benefits.
To paraphrase astronaut Jack Swigert on Apollo 13, “D.C., we have a problem.” Based on recent analysis, the Social Security Trust fund is scheduled to be depleted around 2034. Yikes! This does not mean that payments will cease to exist at that point. A portion of the benefits could still be paid to the recipients, but the funding would be generated exclusively from current payroll taxes – the trust fund would no longer be available to supplement the shortfall from current collections. In fact, it is estimated that there would be enough from current payroll to pay about 78% of the current benefits. That indeed can put a hamper on one’s retirement plans, especially those that have not been able to save on their own.
Fortunately, or unfortunately, this is not the first time there has been a problem with funding Social Security. As new benefits were legislated in and as unanticipated changes in the demographics occurred, there were issues of underfunding. As a result, there were corrections that had to be made to the funding equation. The last major change was made in 1983 by what was called a “blue ribbon panel”. (In light of their inability to solve the issue long-term, I question whether they should still be called a “blue ribbon panel” – perhaps a red ribbon panel or whatever color of ribbon the honorable mention receives.) The changes in 1983 included taxing Social Security benefits (that was a big deal to current and future retirees) and an increase in the retirement age (effectively reducing the benefits for future retirees). In 1993, the level of Social Security earnings taxes was increased from its 1983 levels (from a max of 50% to a max of 85%). There have been other changes through the years, some adding to the benefits and some decreasing the overall benefits paid.
Ways to Improve the Social Security System
So, it is clear something has been done to shore up the funding, and something will be done. Using history as a guide, there are a few solutions.
Cut benefits for current retirees. Some argue that the benefits of current retirees be reduced. While this is not politically popular and will likely not pass in light of the large voting block of Baby Boomers, this is also the least palatable as it does not give those individuals enough time to adjust and plan. My feeling is that the best political – and often the most fair – are the ones where its populace can make adjustments to laws to avoid too big of a disruption in their lives.
However, the amount of Social Security that is subject to income tax may increase for high income taxpayers. This is a reduction of benefits in any other name. What will be the impact to those individuals? Let’s say a SS recipient is receiving $35,000 in benefits. Assume now that 100% of the benefits will be included in their taxable income rather than 85% under the previous law (based on their higher income situation). If they are in one of the higher tax brackets (22% or higher), then that increases their taxes by approximately 3% to 5% on their overall Social Security benefits. Congress could also decide to enlarge the number of taxpayers that have to include the maximum amount of Social Security in taxable income. As discussed, this approach has been done twice in the past and might be done again in the future.
Cut benefits for future retirees. The actual payouts might decrease or the Full Retirement Age may be moved back. By having the same level of payments but paid out at a later age (say age 68 instead of age 67), the benefit payments will be effectively reduced, regardless of when the recipient elects to take the benefit. With the increased longevity of future generations, this is a likely change that will take place.
Increase FICA taxes on current and future wage earners. This has also been done in the past, and is arguably likely to be part of the solution. Currently, the Social Security tax rate is capped at $142,800 (2021). While this amount increases with inflation each year, by raising this cap to either a much higher amount or even eliminating this cap could have a profound impact on the funding. As the employer and employee portion is at a 12.4% rate, the increase in taxes by higher income taxpayers will certainly be felt. President Biden has proposed that there be two caps, effectively creating what some call a donut-hole effect: the $142,800 cap would still apply but the 12.4% would apply to any wages over $400,000, for example.
Other proposals relating to increasing taxes include what income is subject to income taxes, ranging from including more fringe benefits (e.g., health insurance benefits) and designating all income earned by S corporation shareholders subject to FICA taxes (the “pass through loophole” as some suggest). Similarly, the tax rate could increase. Some have suggested a mere .3% increase in tax rate would have a significant impact on shoring up the solvency issue. I think we will see some of these proposals passed in some form.
Allow taxpayers to invest in a private security fund. This privatization proposal gained popularity during the Bush years. The thought is that since our payments into the system receive an effective rate of return less than 3%, we, as individual investors, can do better with that money paid into the system by investing a portion of it in the stock market. While in theory this idea is not bad as I tend to like personal accountability, the actual implementation could lead to devastating effects and result in the eventual need to create a safety net for the safety net (that failed). I have not heard of this being proposed recently.
Eliminate certain special rules relating to Social Security benefits. There are various nuances of the Social Security payouts that have contributed to the funding issues. Fortunately, Congress has taken some action to eliminate some of these rules (e.g., file and suspend ability was eliminated with 2015 legislation, eliminated the ability of some in prison to receive Social Security benefits). There are other areas that it can shore up inconsistencies of where the benefits are paid.
Combination. Congress can obviously choose to shore up the system with a combination of these measures. A little here and a little (or a lot) there can make a big difference in the aggregate.
Congress, like when dealing with many tough decisions that have to be made across our amber waves of grain, has failed to act. The fear of not being elected is too great to pass sensible legislation. So, yes, the best solution is to have term limits in Congress to not only get changes to the Social Security system but so many pieces of legislation that should pass to live in a better world. But, I digress…
Congress should also be careful not to include more in the legislation than what is needed to shore up the trust fund. Unfortunately, just like any other piece of legislation, there will be attempts – perhaps successful – to add to the problem of underfunding, requiring even more drastic measures to increase the funding by various means. But, I digress again…
Fortunately, Congress will act because they have to. Kicking the can down the road is about to result in the can falling off a cliff -- they won’t be able to get the can back if they don’t act. As you study the quote of the Astronaut Swaggert (at least according to Wikipedia2), you will realize that the quote was actually, “OK, Houston, we have had a problem here.” This is past tense. At some point, as Americans and as Social Security benefit recipients, we will be able to say, “OK, D.C., we have had a problem here, but we have been able to pass sensible legislation to shore up the ability for future generations to rely on Social Security benefits to help meet or supplement their basic lifestyle needs in retirement.”
I do think Congress will pass legislation in the next 2 to 5 years to give us confidence in the system. I think it should be and will be a combination of increasing the threshold on which the payroll taxes will be paid, perhaps a slight increase on the payroll tax rate, the inclusion of certain fringe benefits in the payroll tax equation, and an effective reduction in benefits by extending the age at which benefits are paid for the younger crowd (however that line is ultimately drawn).
Should I Include Social Security Income in My Retirement Planning?
Thus, I still recommend that people incorporate future Social Security income into their retirement analysis. Not including such a benefit in your retirement analysis will likely result in either saving too much or delaying retirement longer than you need. While this is not necessarily a bad thing, planning for retirement also consists of striking the proper balance between living for today versus planning for tomorrow. If the analysis is faulty, then perhaps the right level of fulfillment is not achieved during your working years.
While I do indeed suggest that you incorporate some level of Social Security benefits in your analysis, I do recommend that you factor in the likelihood of higher FICA taxes during your working years and a reduction in future benefits. If taxes are higher in the future and you cannot otherwise adjust your spending in such a higher tax era, then that suggests that you save a bit more now while you have a bit more of a surplus. (That’s my recommendation.) Otherwise, you can wait and see what the tax increase might be for your situation and reduce spending to allow you to stay on track for your savings target.
As benefits might be lower, I suggest a certain part of the population (e.g., those under 45 or 40) reduce their Social Security estimates by 10% or so.
The impact of a 10% decrease in Social Security has an interesting impact on how much you should save for Day One at retirement. Of course, that depends on a variety of factors, including duration of retirement (age of death less age at retirement) and growth on your portfolio. In general, however, a 10% decrease in Social Security annual benefits suggests accumulating approximately 3% - 5% more in your retirement portfolio. You could solve this apparent deficit by either increasing your annual savings, pushing retirement back a bit, or spending less in retirement.
As a side note, you will also want to make sure you are interpreting your Social Security statement accurately. While that is another blog for another day, be careful that the estimated benefits that the Social Security Administration includes on your basic calculation worksheet assumes you continue to work at the level of wages that you most recently earned up to and through the applicable date of the benefit shown on the statement. That number may be higher or lower than what you may actually receive, depending on your situation. Often times, your actual benefits will be less than the Full Retirement Age and Age 70 amounts since most do not work until those particular ages.
If you don’t know what your Social Security benefit might be, go to Get Your Social Security Benefit Here! to open your account and to find out more. As discussed, once you find your estimated benefits you will then want to make an adjustment based on your particular situation and your comfort level of incorporating any future changes to the Social Security payouts.
Social Security – One Small Piece of Your Retirement Planning
Of course, Social Security is just one small aspect of retirement planning. Be sure to perform proper analysis of your individualized situation and incorporate many other details of retirement planning, including the timing of this Social Security, your pension, your investments and asset allocation, your detailed expenses and expense glidepath, income taxes and tax planning, your longevity, and a number of other issues. While there are some online tools that could address a few of these issues on a high level, we obviously recommend to find an expert in this area to help you proper analyze these issues. At Oasis Wealth Planning Advisors, we are uniquely positioned to help you and others you know to provide that suggested due diligence. Schedule a call today if you would value our consultation.