Social Security benefits are paid through a self-financing system. Workers and employers pay taxes that are then used to pay Social Security benefits to current recipients.
In anticipation of the future retirement of the Baby Boom generation, in 1984, the Social Security Administration purposely began collecting more revenue than was needed to pay benefits each year. As required by law, the excess revenue has been invested in special-issue U.S. Treasury bonds rather than in private stocks, bonds, and other publicly traded assets. These Treasury bonds, which are fully guaranteed by the U.S. government, provide interest income to the Social Security Trust Funds (Old-Age and Survivors Insurance Trust Fund and the Disability Insurance Trust Fund). When Social Security revenue is insufficient to pay full benefits, Social Security can redeem trust fund bonds, to the extent available, to make up this difference.
Social Security will require some adjustments to ensure that promised benefits continue to be paid in full in the future. Because of demographic and economic changes—such as members of the Baby Boom generation beginning to receive benefits and declining fertility rates—the system’s finances have eroded. Social Security currently pays out more in benefits than it collects each year. Restoring fiscal balance to Social Security will require an increase in revenue, a reduction in benefits, or some combination of the two.
Proposals to increase revenue include investing a portion of trust fund revenue in private equities, increasing the amount of earnings subject to the Social Security payroll tax, and taking other steps to increase the progressivity of the financing system.
Investing a portion of the trust fund revenue in instruments other than U.S. government securities would increase rates of return for the trust funds over the long term. Pooling investments reduces the risk of large fluctuations in returns and keeps transaction and reporting costs to a minimum, thus producing higher net returns than similarly invested individual accounts. Some policy experts have expressed concerns that political considerations could drive government investment decisions, that the government might interfere in corporate governance, or that an influx of so much government money into the stock market might interfere with or skew the market.
Increasing the amount of earnings taxed to pay for Social Security benefits would improve the system’s finances. Workers and employers each pay 6.2 percent in taxes on wages up to the maximum amount of taxable earnings for Social Security which is $132,900 in 2019. (This maximum taxable wage increases annually based on wage growth, provided a cost-of-living adjustment is made.) In 1977, Congress set the maximum taxable wage with the intent of covering about 90 percent of covered earnings. Today, because wage growth has not been evenly distributed, only about 83 percent of covered wages are subject to the payroll tax. In other words, this decline has occurred because wages above the maximum taxable wage have increased more rapidly than wages in general. Only workers earning more than that threshold would be affected by increasing the maximum taxable wage to cover a larger portion of wages. (If Social Security were taxing 90 percent of American wages as intended, the maximum taxable wage would already have been about $261,900 in 2018 and $273,900 in 2019, according to the Urban Institute.)
From time to time, a shortfall may develop in one of the trust funds even though total revenue to both trust funds is sufficient to continue paying benefits. Reallocating assets from one trust fund to the other can protect against potential cuts in benefits.
SOCIAL SECURITY FINANCING: Policy
Trust funds reserves
The Old-Age, Survivors, and Disability Insurance Trust Funds should maintain a minimum reserve of one and a half to two years as a cushion against an economic downturn.
Conditions for investing trust funds assets
If changes are made to Social Security that extend the life of the trust funds, Congress could authorize the investment of a portion of the Social Security reserves in investments other than Treasury securities. These investments should be made by designated fiduciaries on behalf of the trust funds and for the sole benefit of the trust funds.
The fiduciaries should be responsible for monitoring investment managers and assessing the adequacy of the investment returns with due regard for the risk to the plan’s assets.Proposals for diversifying investments must:
- be insulated from political influence and structured to protect the integrity of the fund and issuer;
- minimize risk while maximizing yield; and
- prevent interference with or negative effects on markets, corporate governance, economic growth, and productivity.
Increasing the wage base
Policymakers should increase the percentage of wages subject to the payroll tax at least to historically intended levels and otherwise increase the progressivity of the Social Security financing system.
As necessary, Congress should rebalance assets in the Social Security trust funds as well as dedicated payroll tax revenue to ensure benefit payments continue without disruption or reduction.