Monday, June 22, 2015

What's Wrong with Social Security and Why it's Important to Gen X and the Millenniums- Part Two

We're all familiar with the payroll taxes that support Social Security, simply by looking at our pay stubs. FICA taxes, or required employee and employer payments under the Federal Insurance Contributions Act, provide the foundation of financial support for Social Security. 

The total FICA tax is evenly split between the employer and the employee, with each paying a tax equal to 6.3% of earned wages for a total of 12.6% (as of 2014). The payments are directed to the Internal Revenue Service and then paid into the Social Security Trust Fund (also known as the Federal Old Age and Survivors Insurance Trust) where they are administered by the Department of Treasury.

For many years, approximately 70, the system worked just fine with annual inflows to the Social Security Trust Fund from taxes and interest, exceeding outflows, in the form of benefits payments to retirees and the expenses of running the system. But in 2013 these lines would begin to cross as the number of program beneficiaries would rise to 62 million, and outflows would exceed inflows. The deficit of the Trust Fund in that year would total $75 billion, a level at which deficits are projected to continue through 2018 (whereafter they are projected to spike sharply upwards).

The problem with all of this is largely the basis of accounting by which the Trust Fund is managed and operated. Unlike defined benefit plans run by corporations and governed under ERISA, no such regulation guides the planning, management and investment of Social Security. Social Security today runs as it always has, as a PAYGO system. Revenue flows in from taxes paid by current workers (and employers) and flows out to retirees and services, each on an annual basis. In effect, we are borrowing from Peter (today's workers) to pay Paul (retirees). Some refer to this as a Ponzi Scheme, although that's perhaps a bit too harsh. Nonetheless, this is essentially how the system functions.

Under ERISA, companies are required to retain actuaries to quantify the present value of future, accrued benefits. They are then required to invest to meet those future liabilities. But this is not at all the way Social Security works. And it's this failure to to do so, that has allowed the Trust Fund to rise and fall with demographics. It's almost as if we knew this day of reckoning would come, when demographics would threaten the solvency of Social Security, but no one ever chose to address it.

Today Social Security reform is the third rail of politics. Everyone knows some level of reform is necessary, but to propose any modification prompts outright ridicule. Yet, with the median retirement savings of 55-64 year olds only $14,000 this generation, like those currently in retirement, will need to receive Social Security benefits just to make ends meet.

If you are interested in reading further about this topic, a full plan for Social Security reform is presented in my new book, "Up in Smoke: How the Retirement Crisis Shattered the American Dream". You can access it here.