How to Fix Social Security's Financing Problem

Last Updated Aug 15, 2011 10:51 AM EDT

The recent debt compromise calls for Congress to set up a bi-partisan committee to review entitlements, including Social Security, and to make recommendations by Thanksgiving. As a result, we'll probably hear more impassioned debates about so-called "raids" by politicians on the Social Security trust fund. Here I'll suggest two possible fixes that would prevent such raids, and we'll look at the implications.

To understand these potential solutions, we'll need to first review Social Security financing. The Social Security trust fund stood at about $2.6 trillion as of January 1, 2011, according to the 2011 Social Security trust fund report. The fund has been growing since the early 1980s because Social Security collected tax money from workers during the 1980s, 1990s, and 2000s that was substantially greater than the total benefit payments being made during this same period. This surplus resulted from changes to Social Security that were enacted in 1983 under the Reagan administration, and were intended to boost the funding of the trust fund to pay for Social Security benefits owed to the baby boom generation.

For the first time in decades, benefits paid last year exceeded the Social Security taxes collected, primarily attributable to reduced tax collections and increases in early retirement applications due to the poor economy. From now until about 2023, benefits will be paid from the Social Security taxes collected each year plus the interest on the trust fund. Thereafter, we'll start dipping into the principal of the trust fund; by 2036, the trust fund assets are projected to be exhausted. At that time, only about 77 percent of the Social Security benefits owed will be able to be paid from taxes collected.

The Social Security trust fund is invested in special U.S. treasury bonds. The pictures above show Social Security's "Fort Knox" -- a file cabinet with notebooks containing the $2.6 trillion in these special bonds. These bonds are part of the total U.S. federal debt, which is estimated to be $14.3 trillion as of August 3, 2011. These special bonds are used to finance all the various operations of the U.S. government, including the military, foreign aid, and entitlement programs.

But in reality, there's been no raiding of these bonds going on. The word "raid" implies that greedy politicians in a smoke-filled room have been stealing our money for their pet pork projects. In reality, these special bonds are being used in accordance with the laws passed in 1983 by a Republican Senate and a Democratic House, and signed by a Republican President -- in plain sight of everybody. The proceeds of these bonds became part of the total financial machinery that funds the U.S. government -- they weren't spent on any specific government projects.

This is not to say there aren't any problems with the way Social Security is being financed. In the future, when we dip into the Social Security trust fund to pay benefits, the special U.S. treasury bonds must be converted into cash, and there will be only two sources of this cash: (1) future taxes in addition to Social Security taxes or (2) new federal borrowing.

The recent brouhaha over the debt ceiling arose because of concerns that our federal debt is getting too large, and that eventually we'll be unable to make payments on this debt. If that happens, then part of the debt that won't get paid are the assets in the Social Security trust fund, thereby jeopardizing the security of future benefit payments.

And while I don't agree with use of the word "raid," I do share the concern about the growth in the federal debt. If the total federal debt is manageable, then there's no doubt that the special U.S. treasury bonds in the Social Security trust fund will be repaid. But the concern is that the federal debt is growing to unmanageable levels.

One obvious solution to the problem is to bring the total federal debt down to manageable levels, so that once again, there's no doubt that the special treasury bonds in the Social Security trust fund will be safe. The obvious difficulty with this solution is that it requires running a surplus each year, through some combination of tax increases and reduced federal spending -- and you know that's easier said than done.

The other possibility is to set up Social Security financing such that future benefits aren't dependent on future borrowing or future taxes other than Social Security taxes. And that brings us to our two possible fixes.

Next: Pay-as-you-go financing

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.