On January 31, 1940, the first Social Security retirement check was mailed to Ida May Fuller, a legal secretary from Vermont who went to grammar school with Calvin Coolidge.
75 years after that first check, Social Security is an integral part of American culture. Roughly 2/3 of elderly beneficiaries rely on Social Security for more than half of their income and 24% count on it for all of their income.
When we talk with clients about Social Security strategies or planning, the conversation often leads to the health of the program. We wrote last year about a better way to think about Social Security and suggested that deferring benefits was generally the most economically rational approach for healthy retirees. Readers inevitably emailed to remind us that means testing or exhaustion of program benefits needed to be considered in the analysis.
The national media has done an excellent job of convincing Americans that the Social Security program is in peril. More than 70% of respondents to a CNN poll believe Social Security is in crisis. Young and mid-career professionals often do not want to count on this income stream as part of their retirement plan and recent retirees are often ready to claim benefits as soon as possible so they can get their share before the program is insolvent.
It is no secret that advancements in medical science have done no favors for the health of the Social Security program. Today, men who reach age 65 have a remaining life expectancy of 17.6 years and women can expect another 20.3 years. These life expectancies compare to 12.3 (men) and 14.7 (women) in 1940 when Ida May Fuller received that first check.
A valuable part of any financial planner’s job is to help clients avoid making poor financial decisions resulting from existing behavioral biases or misinformation. When it comes to Social Security, many Americans reaching eligibility age tend to treat the system as a game of musical chairs where they need to find a chair before the music stops. Despite often being one of the two most important financial decisions that a retiree makes (the other being when to retire), most give this decision little or no thought. Data indicates that more than 50% of beneficiaries claim their benefits as early as possible and nearly 95% claim benefits at or before age 66.
Oddly enough, the program actually benefits from this sentiment of imminent insolvency where retirees simply claim benefits as early as possible. The present value of lifetime benefits is reduced for those who file early, especially in a period of low interest rates such as the one today. Moreover, the pervasive failure of Americans to exploit several loophole claiming strategies such as “file and suspend” or “restricted application” by filing early is estimated to save the system approximately $10 billion each year.
The rest of this article is intended to cover three important topics: 1) facts about the program’s health; 2) the most likely changes to the program; and 3) what this all means to retirement planning.
The Health of Social Security
Each year in June, the Social Security Trustees Report is released. It provides a wealth of insightful information and generally shows the trust fund getting closer to insolvency with each passing year. However, there are several really important facts from the report to consider, which the media often does a poor job of explaining or simply ignores:
- The Social Security trust fund is only used to pay for benefits that are not covered by Social Security taxes and interest income each year. In the most recent year, there was a surplus of $32 billion with $855 billion of revenue and expenditures of $823 billion.
- There has been a surplus in the program every year since 1982, the last time Social Security reform was passed. Revenues are expected to continue exceeding costs until 2020.
- According to the report, the trust fund is projected to be depleted in 2033. However, this simply means that there will be a shortfall between what is collected and what is to be paid that cannot be covered by the Social Security Trust Fund. It is critically important to understand that even if nothing is ever done to change or fix the program, the Social Security system will still be able to pay out 75% of benefits from incoming cash flow through 2088.
The often ignored reality is that Social Security is not in crisis and the fixes needed to fully protect benefits for another 75 years are not dramatically difficult. Alan Greenspan once said, “If you get the right people in the room, you can solve Social Security in 15 minutes, and the first seven minutes are pleasantries.”
Potential Changes to Social Security
Speaker of the House Tip O’Neill famously referred to the Social Security system as the third rail of American politics. There is clearly a strong societal motivation to maintain the program in its current state, making serious talk of reform the potential downfall of any political career. Despite political motivation to avoid addressing the issues, we will likely get to a point where this must be addressed to secure the future of the program. Consider the possible solutions, none of which are mutually exclusive:
- Increase payroll taxes. Workers currently pay 6.2% of employment income to Social Security taxes. Raising the tax from 6.2% to 7.6% would secure the program in its current state for another 75 years.
- Eliminate the cap on Social Security earnings. In 2015, the 6.2% tax only applies to the first $118,500 of employment income. This limit could be increased or removed to provide more revenue for the program.
- Increase retirement age. Gradually raising the retirement age to 70 would eliminate 1/3 of the long-range shortfall.
- Reduce the cost of living adjustments or use a chained-CPI measure that grows more slowly.
- Means test beneficiaries so that benefits are reduced for individuals with other income sources.
The National Academy of Social Insurance annually conducts an extensive survey to gauge public sentiment about various potential changes to Social Security. Each year, the results demonstrate that Americans dramatically favor addressing the funding side of the program (increasing payroll taxes or eliminating the earnings cap) over changing the benefits equation (cutting Social Security benefits). Nearly 80% of survey respondents were willing to pay more in taxes to secure the health of the program.
Impact on Retirement Planning
We’re not writing this as the arbiter of public opinion or how best to fix the Social Security program. Rather, our job as financial planners is to consider the most likely outcomes. Since we are not Marty McFly and don’t know what the future holds, all of our planning is founded on making rationally grounded assumptions. In the case of Social Security, we consider the true health of the program and the most likely changes to address the program’s health to then evaluate how any changes are likely to impact our planning recommendations.
Given public sentiment, political sensitivity to any reduction of benefits, and the health of the program detailed above, we think the most likely change to the program is a modest additional tax in the future. There obviously could be a combination of changes but it seems likely to be centered on increased revenue.
Resultantly, we do not generally advise that healthy clients take benefits immediately at the first possible date merely to obtain some benefit before the program becomes insolvent or benefits cut. We include Social Security benefits in retirement plans, even those of younger clients, since the concept that benefits will go away or be dramatically cut seems overly pessimistic and unreasonable. We may assume higher Social Security taxes during the working years but our advice on claiming strategies is grounded on the logic that program benefits will continue to be paid, even if minor changes to the inflation factor are implemented.
Assumptions will occasionally be incorrect, regardless of how well-constructed they are. This is why they’re assumptions and not facts. The objective of retirement planning or developing a Social Security strategy is to consider all the important facts without sway from media agenda, politics, or behavioral biases. Once reasonable assumptions are made, logic is applied to all the factors and a plan developed. Plans may change but the best retirement planning is an adaptive process and not a one-time event.
Agree or disagree with the thoughts above? Have additional thoughts or suggestions? Please do not hesitate to provide feedback below.
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