Order Code RL33514 Social Security: What Would Happen If the Trust Funds Ran Out? Updated June 14, 2007 Kathleen Romig Analyst in Social Security Domestic Social Policy Division Social Security: What Would Happen If the Trust Funds Ran Out? Summary The Social Security trust funds are projected to become exhausted in 2041, according to the 2007 Social Security Trustees Report. If Congress does not act before then, the trust funds would be unable to pay full Social Security benefits on time. If full Social Security benefits could not be paid on time, the lives of millions of people who rely on Social Security could be disrupted. The consequences of waiting to act are also serious. By 2041, the benefit cuts and tax increases required to achieve long-range solvency are projected to be about twice as large as those needed today. The Social Security Act does not specify what would happen to benefits if the trust funds became insolvent. However, it is clear that full Social Security benefits could not be paid on time because the Antideficiency Act prohibits government spending in excess of available funds. After insolvency, Social Security would continue to receive tax income, from which some benefits could be paid. Either full benefit checks would be paid on a delayed schedule or reduced benefits would be paid on time. In either case, Social Security beneficiaries and qualifying applicants would remain legally entitled to full benefits and could take legal action to claim the balance of their benefits. The legal conflict between benefit entitlement and the Antideficiency Act would need to be resolved either by Congress or by the courts. Social Security solvency could be restored by cutting Social Security’s spending, increasing its income, or some combination of the two. Over the long range (i.e., over the next 75 years), the Social Security trustees estimate that the trust funds have a shortfall of $4.7 trillion in present value terms, or 1.95% of taxable payroll. The sooner Congress acts to fill this gap, the smaller the changes to Social Security need to be, because earlier changes could be spread to a larger number of workers and beneficiaries over a longer period of time. If Congress waits until the moment of insolvency to act, the trust funds’ annual deficits could be eliminated with benefit cuts of about 25% in 2041 that will gradually rise to about 30% by 2081. Congress could also eliminate annual deficits by raising the Social Security payroll tax rate from 12.40% to 16.41% in 2041, then gradually increasing it to 17.60% by 2081. To maintain annual balance after 2081, larger benefit reductions or tax increases would be required. Prompt action to restore Social Security solvency would be advantageous. The trustees project that the combined trust funds will begin to run annual cash-flow deficits in 2017, requiring the redemption of government bonds accumulated in earlier years. The Disability Insurance (DI) trust fund is already running cash-flow deficits. Cash-flow deficits do not affect Social Security directly, but the redemption of the trust fund bonds puts pressure on the overall federal budget, which is in deficit. Earlier changes would allow workers and beneficiaries time to adjust their retirement plans. Finally, if Congress were to act today, the benefit cuts or tax increases necessary to restore solvency until 2081 would be about half as large as those needed if Congress waited until the trust funds became insolvent to act. This report will be updated as events warrant. Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 The Social Security Trust Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 How the Trust Funds Work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Historical Trust Fund Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 The Trustees’ Projections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Legal Background on Trust Fund Insolvency . . . . . . . . . . . . . . . . . . . . . . . . 5 The Antideficiency Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Legal Entitlement to Social Security Benefits . . . . . . . . . . . . . . . . . . . . 6 What Happens to Benefits in the Case of Insolvency? . . . . . . . . . . . . . 6 What If Congress Waits to Act? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Benefit Cut Scenario . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Size of Benefit Cuts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Impact of Benefit Cuts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Tax Increase Scenario . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Size of Payroll Tax Rate Increases . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Impact of Payroll Tax Increases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 List of Figures Figure 1. Scheduled Benefits Payable at Current Law Payroll Tax Rates, 2007-2081 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Figure 2. Initial Replacement Rates Under Benefit Cut Scenario, 2007-2081 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Figure 3. Initial Annual Benefits Payable Under Benefit Cut Scenario, 2007-2081 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Figure 4. Combined Payroll Tax Rate Needed to Fund Scheduled Benefits, 2007-2081 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 List of Tables Table 1. Current Social Security Benefit Payment Schedule . . . . . . . . . . . . . . . . 7 Social Security: What Would Happen If the Trust Funds Ran Out? Introduction Each year when the Social Security trustees release their annual report, attention is focused on the trustees’ latest projections of when the Social Security trust funds will become insolvent.1 Less attention is paid to what trust fund insolvency would mean. What would happen to benefits? What options would Congress have to restore solvency? How would policy changes at this point affect beneficiaries? There are many misconceptions about what would happen if the Social Security trust funds ran out. For example, many Americans — particularly younger Americans — believe that if the trust funds were exhausted, Social Security will be completely broke and unable to pay any benefits.2 This is not the case. In fact, in 2041, the first year of projected insolvency, the program is projected to have enough tax income to pay about 75% of scheduled benefits, declining to about 70% in 2081, at the end of the trustees’ long-term projection period. Another myth is that the Social Security Act includes a specific “fail-safe” provision in case of trust fund exhaustion — for example, a formula for cutting benefits or raising taxes to eliminate annual deficits. This is also untrue. In fact, the act does not specify what would happen to benefits if the trust funds are exhausted. The most likely scenario seems to be that benefit checks would be delayed. This report explains what the Social Security trust funds are and how they work. It describes the historical operations of the trust funds and the Social Security trustees’ projections of future operations. It explains what could happen if Congress allowed the trust funds to run out. It also analyzes two scenarios that assume Congress waits until the moment of insolvency to act, showing the magnitude of benefit cuts or tax increases needed and how such changes would affect beneficiaries. 1 The 2007 Trustees Report projected trust fund exhaustion in 2041. (Social Security Administration, 2007 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, April 23, 2007, at [http://www.ssa.gov/OACT/TR/TR07/tr07.pdf]. Hereafter cited as 2007 Social Security Trustees Report.) 2 According to the 1997 Retirement Confidence Survey, 30% of Americans age 25 and older believed that trust fund exhaustion meant the “system will be broke and unable to pay any benefits.” Nearly half (48%) of Americans age 25 to 33 held this belief. (Employee Benefit Research Institute, Public and Employer Opinion on Social Security and Social Security Reform, SR-39, August 2001, at [http://www.ebri.org/pdf/publications/srpdfs/sr39.pdf].) CRS-2 Background The Social Security Trust Funds How the Trust Funds Work. Social Security provides retirement, disability, and survivor benefits to qualifying workers and their families. These benefits are funded from two trust funds: the Old-Age and Survivors Insurance (OASI) trust fund and the Disability Insurance (DI) trust fund. The two funds operate separately but are closely linked. This report generally assumes the merged operations of the OASI and DI trust funds, treating the two funds as if they were one collective OASDI fund. Income to the Trust Funds. The trust funds receive income from several sources. Their primary income source is the Social Security payroll tax levied on wages and self-employment income.3 Social Security covered employees and employers each pay 6.2% of wages up to the taxable maximum ($97,500 in 2007).4 By law, about 85% of Social Security payroll taxes are credited to the OASI trust fund and about 15% are credited to the DI trust fund.5 The trust funds also receive income from interest on the trust funds’ assets and from the taxation of Social Security benefits. In 2006, 84% of the trust funds’ income was from payroll taxes, 14% was from interest on trust fund assets, and 2% was from taxation of benefits.6 The proportion of income from each of these sources varies over time.7 Outgo from the Trust Funds. Almost all of the trust funds’ spending is for benefit payments and a small amount goes toward administrative expenses. The OASI trust fund is also party to a financial interchange with the Railroad Retirement Board.8 This annual exchange of funds places the Social Security trust funds in the same financial position in which they would have been if railroad service had been covered by Social Security. In 2006, more than 98% of the trust funds’ spending was 3 Payroll taxes are formally known as Federal Insurance Contributions Act (FICA) and SelfEmployment Contributions Act (SECA) taxes. FICA and SECA taxes also include a 1.45% payroll tax on each employee and employer for Medicare Hospital Insurance. 4 Self-employed individuals pay 12.4% of wages up to the taxable maximum. The taxable maximum is indexed to the Average Wage Index (AWI). Economists typically attribute both the employee and employer share of the payroll tax to workers since it is assumed that the employer portion of the tax is passed on to workers in the form of lower wages. 5 42 U.S.C. § 401. 6 For the OASI trust fund, 83% of income was from payroll taxes, 14% was from interest on trust fund assets, and 2% was from taxation of benefits in 2006. For the DI trust fund, 88% of income was from payroll taxes, 10% was from interest on trust fund assets, and 1% was from taxation of benefits in 2006. (Figures may not add to 100% due to rounding.) 7 The proportion of income from taxation of benefits is projected to increase over time as more people are subject to taxation of benefits. (See CRS Report RL32552, Social Security: Calculation and History of Taxing Benefits, by Christine Scott.) The proportion of income from interest is projected to increase in the short term, as Social Security continues to run surpluses, then decrease as the balance of the trust funds are drawn down to pay benefits. 8 See CRS Report RS22350, Railroad Retirement Board: Retirement, Survivor, Disability, Unemployment, and Sickness Benefits, by Kathleen Romig. CRS-3 for Social Security benefits, less than 1% was for administrative costs, and less than 1% was transferred to the Railroad Retirement Board (RRB).9 The trust funds spend essentially the same proportion of funds on each of these items each year. Annual Cash Flow. If, in a given year, the trust funds take in more tax income (i.e., payroll taxes and taxation of benefits) than they spend, the trust funds have a cash-flow surplus. By law, surplus revenues are invested in interest-bearing U.S. government securities — usually special issue Treasury bonds.10 In other words, Social Security’s cash surpluses (like proceeds from all government bonds) are borrowed by the U.S. Treasury and can be used for tax cuts, spending, or repaying debt. The Treasury, in turn, incurs an obligation to repay the bonds with interest, which is also credited to the trust funds. If, in a given year, the trust funds spend more than the tax income they receive, they have a cash-flow deficit. In deficit years, Social Security can redeem any bonds (including interest) accumulated in previous years. When the bonds are redeemed, assets are transferred from the Treasury’s general fund to the Social Security trust funds. In other words, unless the Treasury’s general fund is running a surplus, Congress would need to cut overall spending, raise taxes, or borrow during years in which Social Security has cash-flow deficits. Trust Fund Solvency. If the trust funds are not able to pay all of current expenses out of current tax income and accumulated trust fund assets, they are insolvent. Insolvency means that Social Security’s trust funds are unable to pay full benefits on time. It does not mean that Social Security will be completely broke and unable to pay any benefits. Historical Trust Fund Operations. The OASI trust fund was established in 1937; the DI trust fund was established in 1957. Neither of the Social Security trust funds has ever become insolvent. In 2006, the combined trust funds had a cashflow surplus of about $87 billion (about 11% of the trust funds’ income for that year), which was invested in Treasury bonds.11 The DI trust fund had a cash-flow deficit for the second year in a row. At the end of 2006, the combined trust funds held a total of about $2 trillion in Treasury bonds.12 Cash-Flow Surpluses and Deficits. The trust funds have run annual cashflow surpluses in most years. These annual surpluses were typically small relative 9 In 2006, about 99% of OASI trust fund spending was for benefits, less than 1% was for administrative costs, and less than 1% was transferred to the RRB. In 2006, about 97% of DI trust fund spending was for benefits and 2% was for administrative costs. (Figures may not add to 100% due to rounding.) 10 See CRS Report RS20607, Social Security: Trust Fund Investment Practices, by Dawn Nuschler. 11 In 2006, the OASI trust fund had a cash-flow surplus of $89.5 billion and the DI trust fund had a cash-flow deficit of $2.4 billion. 12 At the end of 2006, the OASI trust fund held $1.8 trillion and the DI trust fund held $204 million. CRS-4 to the size of the trust funds’ expenditures. After the 1983 amendments to the Social Security Act, which increased Social Security’s income and reduced its spending, the OASI trust fund began to run larger surpluses.13 The combined trust funds have run annual cash-flow deficits during 21 years, the last of which was in 1983.14 The trust funds made up the difference between income and outgo during these years by redeeming some of the bonds accumulated in earlier years. In other words, the Social Security trust funds received net transfers from the Treasury’s general fund. Near-Insolvency in the Early 1980s. The Social Security trust funds have never been exhausted. However, in the early 1980s, a solvency crisis loomed for the OASI trust fund. The 1982 Social Security Trustees Report projected that in the absence of legislative changes the OASI trust fund would become insolvent by July 1983.15 To relieve the pressure on the OASI trust fund temporarily, Congress permitted the fund to borrow from the DI and Medicare Hospital Insurance (HI) trust funds.16 Money was transferred to the OASI fund in 1982 and repaid by 1986.17 This temporary measure allowed policymakers time to develop a more sustainable solution to Social Security’s solvency problem — the 1983 amendments, which increased tax income and reduced benefits.18 Absent another act of Congress, the Social Security Act does not permit further interfund borrowing.19 The Trustees’ Projections. The Social Security trustees issue an annual report in which they describe their short- and long-range projections of trust fund financial operations.20 The Trustees Report describes a range of possible outcomes using different sets of demographic and economic assumptions, including intermediate assumptions, high cost (pessimistic) assumptions, and low cost (optimistic) assumptions. Each set of assumptions results in different projections of both when cash-flow deficits will begin and when the trust funds will become 13 There is little evidence to suggest that the 1983 amendments were intended to create surpluses or to “advance fund” future benefits. Records of Congressional proceedings at the time show that the primary goal of the legislation was to assure that Social Security would not be threatened by insolvency if economic conditions were worse than expected. 14 See CRS Report RL33028, Social Security: The Trust Fund, by Christine Scott. 15 Social Security Administration, 1982 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, April 1, 1982. (Hereafter cited as 1982 Social Security Trustees Report.) 16 P.L. 97-123. 17 The OASI trust fund borrowed $17.5 billion in November and December of 1982; about $5.1 billion was from the DI trust fund and $12.4 billion was from Medicare’s HI trust fund. 18 P.L. 98-21. 19 Even if interfund borrowing were legally permitted, it is unlikely that the Social Security trust funds would be able to borrow from Medicare’s HI trust fund. According to the 2007 Medicare Trustees Report, the HI trust fund is projected to become insolvent in 2019. 20 For more information, see CRS Report RS22139, Social Security: Summary of Program Solvency and Projections, by Gary Sidor. CRS-5 insolvent.21 This CRS report focuses on the trustees’ long-range projections under their intermediate assumptions, which reflect their “best estimates” of future trends. However, it is important to note that the trustees’ projections — like all long-term projections — are uncertain. Other estimates differ from the trustees’ projections. For example, the Congressional Budget Office (CBO) projects that the trust funds will begin cash-flow deficits and become insolvent later than the trustees project.22 Cash-Flow Projections. The Social Security trustees project that the combined trust funds will continue to have a cash-flow surplus (i.e., more tax income than spending on an annual basis) until early 2017, at which point annual cash-flow deficits will emerge. The DI trust fund has been running cash-flow deficits since 2005.23 When cash-flow deficits emerge, the trust funds need to redeem the Treasury bonds accumulated during earlier years. Redeeming the bonds requires transfers from the Treasury’s general fund to the Social Security trust funds. These transfers create pressure on the overall federal budget. Trust Fund Solvency Projections. According to the trustees’ intermediate projections, redemption of trust fund assets will allow the trust funds to pay full benefits on time until 2041, when the trust funds will become exhausted.24 At that time, the trust funds will continue to receive tax income (i.e., payroll taxes and taxation of benefits). The trustees project that tax income will be sufficient to cover about 75% of scheduled benefits during the first year of trust fund insolvency in 2041, gradually declining to about 70% of scheduled benefits in 2081. Legal Background on Trust Fund Insolvency The Antideficiency Act. The Social Security Act specifies that benefit payments shall be made only from the trust funds (i.e., accumulated trust fund assets and current tax income).25 Another law, the Antideficiency Act, prohibits government spending in excess of available funds.26 Consequently, if the Social Security trust funds become insolvent — that is, if current tax income and 21 Under the intermediate assumptions, the combined trust funds are projected to begin cashflow deficits in 2017 and to become insolvent in 2041. Under the low cost assumptions, the trust funds are projected to begin cash-flow deficits in 2022 and are not projected to become insolvent within the 75-year projection period. Under the high cost assumptions, the trust funds are projected to begin cash-flow deficits in 2014 and to become insolvent in 2030. (2007 Social Security Trustees Report, Tables IV.B1 and IV.B3.) 22 CBO projects that the combined trust funds will run cash-flow deficits starting in 2019 and will become insolvent in 2046. (Congressional Budget Office, Updated Long-Term Projections for Social Security, June 2006, at [http://www.cbo.gov/ftpdocs/72xx/doc7289/ 06-14-LongTermProjections.pdf].) 23 The OASI trust fund is projected to begin cash-flow deficits in 2018. 24 Under the trustees’ intermediate assumptions, the OASI trust fund is projected to become insolvent in 2042 and the DI trust fund is projected to become insolvent in 2026. 25 42 U.S.C. § 401(h). 26 31 U.S.C. § 1341. CRS-6 accumulated assets are not sufficient to pay the benefits to which people are entitled — the law effectively prohibits full Social Security benefits from being paid on time. Legal Entitlement to Social Security Benefits. The Social Security Act states that every individual who meets program eligibility requirements is entitled to benefits.27 In other words, Social Security is an entitlement program, which means that the government is legally obligated to pay Social Security benefits to all those who are eligible for them as set forth in the statute.28 If the government fails to pay the benefits stipulated by law, beneficiaries could take legal action. Insolvency would not relieve the government of its obligation to provide benefits. If benefits were reduced, beneficiaries would remain legally entitled to the balance. What Happens to Benefits in the Case of Insolvency? The Social Security Act does not stipulate what would happen to benefits if the trust funds ran out. Because the Antideficiency Act would effectively prohibit the government from paying full benefits on time and the Social Security Act entitles beneficiaries and qualifying applicants to scheduled benefits, the conflict between these two laws would need to be resolved by Congress or by the courts. In the meantime, either full benefit checks would be paid on a delayed schedule or reduced benefits would be paid on time, according to trust fund experts in multiple federal agencies.29 To see how a delay could affect beneficiaries, consider the current Social Security benefit payment schedule, shown in Table 1. (This schedule may be changed at the discretion of the Social Security Commissioner.) New beneficiaries’ payment dates are generally based on their day of birth — for example, if a retired worker was born on the first of the month (e.g., June 1), his or her benefit check is paid on the second Wednesday in the month.30 If trust fund insolvency caused delays in the benefit payment schedule, benefit checks could be paid in the usual order — first to those who receive benefits on the third of the month, then to those on the second Wednesday of the month, and so on, until the balance of the trust funds’ balance reached zero. At that point, no benefits could be paid until more tax receipts were credited to the trust funds. Then benefit payments could be picked up where 27 42 U.S.C. §§ 402 and 423. 28 However, Congress retains the right to modify provisions of the Social Security Act at any time, which could affect the benefits current and future beneficiaries may receive. (42 U.S.C. § 1304.) For more details, see CRS Report RL32822, Social Security Reform: Legal Analysis of Benefit Entitlement Issues, by Kathleen S. Swendiman and Thomas J. Nicola. 29 It seems most likely that benefits would be delayed (thus reducing the number of full benefit checks paid). It is unclear whether the Social Security Commissioner or the other trustees would have the authority to reduce the benefit amounts specified by law. The 1982 Trustees Report, which projected impending trust fund insolvency, stated that unless legislative changes were made, “inability to pay some benefits on time would result.” (1982 Trustees Report, p. 2, emphasis added.) 30 For beneficiaries who receive Social Security benefits based on another person’s work record (e.g., spouse benefits), their payment date depends on the birth date of the worker on whose record they receive benefits. The current benefit payment schedule was first implemented for new beneficiaries in May 1997. By 2041, the number of beneficiaries being paid each week of the month will be approximately equal. CRS-7 they left off when the trust funds ran out. This cycle could continue indefinitely. Under these circumstances, all beneficiaries would receive full benefit checks in about nine months of each year after the trust funds first became exhausted. The timing of these checks would be unpredictable. Table 1. Current Social Security Benefit Payment Schedule Birth Date of Worker on Whose Record Benefits are Paid Benefits Paid On Third of every month Any birth date for: (1) Beneficiaries who receive both Social Security and SSI benefits; (2) Most beneficiaries who began to receive benefits prior to May 1997. Second Wednesday 1st to 10th day of the month Third Wednesday 11th to 20th day of the month Fourth Wednesday 21st to 31st day of the month Source: Social Security Administration. Notes: For beneficiaries scheduled to receive payments on the third of the month, benefits may be paid earlier if the third is on a weekend or holiday. What If Congress Waits to Act? There are many options to restore Social Security solvency, which could be combined or targeted in a variety of ways. For example, Congress could decrease Social Security spending. This essentially means cutting benefits, since more than 98% of Social Security spending is on benefits. Benefit cuts could be applied proportionately to all beneficiaries or structured to protect certain beneficiaries (e.g., disabled or low-income beneficiaries). Congress could also increase Social Security’s income by raising tax revenue (e.g., raising payroll tax rates or the amount of wages taxed), boosting interest income (e.g., investing surpluses in stocks), or adding a new source of revenue (e.g., transferring funds from the Treasury’s general fund). Tax increases could be applied proportionately to all workers or targeted to certain workers (e.g., those who earn more than the taxable maximum). Over the long range (i.e., 75 years), the Social Security trustees project a shortfall of $4.7 trillion in present value terms, or 1.95% of taxable payroll. The next section presents two of the policy options Congress could choose to fill this gap: ! The benefit cut scenario assumes that Congress covers the annual cash-flow deficit by cutting benefits across the board. ! The tax increase scenario assumes that Congress covers the annual cash-flow deficit by raising the payroll tax rate. CRS-8 Both scenarios assume that Congress waits until the trust funds become insolvent to make changes. If made sooner, the changes could be smaller, since earlier changes could be spread to a larger number of workers and beneficiaries over a longer period of time.31 Either scenario would essentially convert Social Security to a pure pay-asyou-go system, in which income and outgo are equal on an annual basis and there are no trust fund assets. These scenarios are only two of a wide range of possibilities. Benefit Cut Scenario Size of Benefit Cuts. If the trust funds were allowed to run out, Congress could eliminate annual cash-flow deficits by cutting benefits so that spending equals tax income on an annual basis. According to the trustees, achieving annual balance would require benefit cuts of 25% in 2041, the first year of insolvency, rising to 30% by 2081. To maintain balance after 2081, the Social Security trustees project that larger benefit reductions would be needed, since the aging of the U.S. population is causing the cost of Social Security to grow over time. Figure 1 shows the percentage of scheduled benefits that are payable each year with scheduled revenues. Figure 1. Scheduled Benefits Payable at Current Law Payroll Tax Rates, 2007-2081 120% 100% 80% 60% 40% 20% 20 07 20 12 20 17 20 22 20 27 20 32 20 37 20 42 20 47 20 52 20 57 20 62 20 67 20 72 20 77 0% Percentage of Scheduled Benefits Source: Social Security Administration memorandum by Chris Chaplain and Jason Schultz, Actuaries, “Present-Law OASDI Payable Percentages: Present-Law OASDI Revenue as a Percent of the Cost Providing Scheduled Benefits for Years 2041 through 2081,” June 5, 2007. (Hereafter cited as SSA Payable Benefits Memo.) Notes: Although not shown in the figure, the trustees project that more than 100% of scheduled benefits could be payable with scheduled payroll taxes prior to 2041. 31 The trustees estimate that 75-year solvency could be restored through an immediate payroll tax increase of 1.95 percentage points (split between employers and employees) or benefit reduction of about 13% (for all current and future beneficiaries). These changes are about half as large as those required in 2041. (2007 Social Security Trustees Report.) CRS-9 Impact of Benefit Cuts. There are several ways to measure how beneficiaries would be affected under the benefit cut scenario. This report analyzes projected replacement rates and real benefit amounts for a series of hypothetical workers developed by the actuaries at the Social Security Administration (SSA). Replacement Rates. One way to illustrate the effect of across-the-board benefit cuts on beneficiaries is to use replacement rates. A replacement rate is a comparison between a person’s income before and after retirement; it is one way of measuring the adequacy of a person’s post-retirement income. Replacement rates can be calculated in different ways. This report uses the same methodology as SSA’s actuaries, which is to calculate a worker’s initial Social Security benefit as a percentage of his or her average indexed monthly earnings, thus showing the proportion of earnings replaced by benefits.32 Benefits tend to replace a higher proportion of lower earners’ wages than of higher earners’ wages since the Social Security benefit formula is progressive. In 2007, the estimated replacement rate for a medium earner retiring at age 65 is 40%. Under current law, beneficiaries’ replacement rates are gradually decreasing as the full retirement age gradually increases from 65 to 67. Replacement rates are an important measure of the adequacy of Social Security benefits. Social Security was established to replace income lost to a family as a result of the retirement, death, or disability of a worker. To ensure that benefit levels keep up with increases in wages over time — thus providing a steady replacement rate to beneficiaries — initial Social Security benefits are indexed to wage growth. Historically, wages have generally risen faster than prices, which has allowed the standard of living to rise from one generation to the next.33 Indexing initial Social Security benefits to wages has allowed beneficiaries to reap the benefits of rising living standards.34 Replacement rates show the extent to which initial Social Security benefits keep up with wage growth and with rising standards of living. Figure 2 shows projected initial replacement rates under the benefit cut scenario for a hypothetical low, medium, and high earner.35 The low earner is assumed to have earned 45% of the national average wage during each year of his or her career (about $18,000 in 2007) and to receive a monthly Social Security benefit of about 32 This formula uses the highest 35 years of earnings covered by Social Security, indexed to wages using the Average Wage Index (AWI). 33 The standard of living is usually measured in terms of income and reflects the quality of life that people enjoy, including factors such as the quality of housing, medical care, transportation, and communication. 34 For more information on how benefits are indexed, see CRS Report RL32900, Indexing Social Security Benefits: The Effects of Price and Wage Indexes, by Patrick Purcell, Laura Haltzel, and Neela Ranade. 35 For information on the development of the hypothetical workers, see Social Security Administration, Office of the Chief Actuary, Actuarial Note Number 144, “Internal Rates of Return Under the OASDI Program for Hypothetical Workers,” by Orlo R. Nichols, et al., June 2001, at [http://www.ssa.gov/OACT/NOTES/note2000s/note144.html]. CRS-10 $790 in 2007.36 The medium earner is assumed to have earned the average wage during each year of his or her career (about $40,000 in 2007) and to receive a monthly Social Security benefit of about $1,300 in 2007. The high earner is assumed to have earned 160% of the average wage during each year of his or her career (about $65,000 in 2007) and to receive a monthly Social Security benefit of about $1,720 in 2007. Each year in the graph shows the projected replacement rate for each beneficiary if he or she turned 65 and retired in January of that year. Figure 2. Initial Replacement Rates Under Benefit Cut Scenario, 2007-2081 60% 50% 40% 30% 20% 10% 20 07 20 12 20 17 20 22 20 27 20 32 20 37 20 42 20 47 20 52 20 57 20 62 20 67 20 72 20 77 0% Low Earner Medium Earner High Earner Source: Congressional Research Service calculations, using figures from the 2007 Social Security Trustees Report and the SSA Payable Benefits Memo. Notes: The workers in this figure are assumed to retire at age 65. The age at which beneficiaries may receive full Social Security benefits is currently rising from 65 to 67, so the early retirement reduction for workers in this example would increase over time. About two-thirds of new retirement beneficiaries began to receive benefits before age 65. Replacement rates for the beneficiaries in this example are projected to decline in the near term. Between 2007 and 2040, initial replacement rates are projected to decrease about 10%.37 This decline is mostly due to the increase in the full retirement age over the first two decades of that period. Under the benefit cut scenario, replacement rates are projected to drop significantly when the trust funds become insolvent, then level off. Between 2040 and 2042, the first full year of projected insolvency, initial replacement rates are 36 37 The average wage is defined by SSA’s Average Wage Index (AWI). Initial replacement rates are estimated to be 54% for the low earner, 40% for the medium earner, and 34% for the high earner in 2007, and 49% for the low earner, 36% for the medium earner, and 30% for the high earner by 2040. CRS-11 projected to decrease about 25%.38 Replacement rates are expected to continue to decline after 2042 as benefit cuts under this scenario grow larger. Between 2042 and 2081, the last year for which the trustees have projections, initial replacement rates are projected to fall about 7%.39 Real Benefit Levels. Another way to illustrate the effect of across-the-board benefit cuts is to look at projected initial annual benefit amounts in real terms (i.e., after inflation). Since benefits are based on workers’ lifetime earnings, higher earners tend to receive higher benefit amounts than lower earners. Figure 3. Initial Annual Benefits Payable Under Benefit Cut Scenario, 2007-2081 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 20 06 20 11 20 16 20 21 20 26 20 31 20 36 20 41 20 46 20 51 20 56 20 61 20 66 20 71 20 76 $0 Low Earner Medium Earner High Earner Source: Congressional Research Service calculations, using figures from the 2007 Social Security Trustees Report and the SSA Payable Benefits Memo. Note: Please see notes for Figure 2. The change in real benefit levels over time illustrates how well Social Security benefits are projected to keep up with inflation (i.e., price growth). The real benefit levels in Figure 3 show future initial benefit amounts in 2007 dollars — in other words, they illustrate the extent to which future beneficiaries could afford today’s living standards. Wages are expected to grow faster than prices over the long term, which would allow living standards to rise. Real benefit levels do not show the extent to which future beneficiaries could afford these rising living standards. 38 In 2042, replacement rates are estimated to be 37% for the low earner, 27% for the medium earner, and 23% for the high earner. 39 In 2081, replacement rates are estimated to be 34% for the low earner, 26% for the medium earner, and 21% for the high earner. CRS-12 Real benefit levels are expected to rise in the near term. The trustees project that Social Security benefits will rise as a result of growing wages, causing initial real benefit amounts to increase about 32% between 2007 and 2040.40 Under the benefit cut scenario, real benefit levels are projected to drop significantly after the trust funds become insolvent, then to rise gradually. Between 2040, the last full year of projected trust fund solvency, and 2042, the first full year of projected insolvency, initial real benefit levels are projected to decline about 23%.41 Initial real benefit levels under the benefit cut scenario are projected to be about 1% higher in 2042 than in 2007. Between 2042 and 2081, the last year for which the trustees have projections, initial real benefit levels under this scenario are expected to increase by about 41% as wages continue to rise.42 Tax Increase Scenario Size of Payroll Tax Rate Increases. Congress could also eliminate cashflow deficits by raising the payroll tax rate so that the trust funds’ tax income would equal spending each year. The trustees project that taking such an action at the point of insolvency would require combined employee and employer payroll taxes to increase from their current rate of 12.40% to 16.41% in 2041, the year in which the trust funds are projected to be exhausted, rising to 17.60% by 2081, the last year for which the trustees have projections. To maintain balance after 2081, the Social Security trustees project that the payroll tax rate would likely need to increase further. This is because the cost of Social Security is expected to grow, due to U.S. population aging and the design of the Social Security system. Figure 4 shows the payroll tax rates needed to pay scheduled benefits each year from 2007 to 2081. 40 Annual real benefits are estimated to be $9,443 for the low earner, $15,570 for the medium earner, and $20,604 for the high earner in 2007, rising to $12,426 for the low earner, $20,477 for the medium earner, and $27,151 for the high earner in 2040. 41 In 2042, annual real benefits are projected to be $9,580 for the low earner, $15,786 for the medium earner, and $20,926 for the high earner. 42 In 2081, annual real benefits are projected to be $13,485 for the low earner, $22,215 for the medium earner, and $29,451 for the high earner. CRS-13 Figure 4. Combined Payroll Tax Rate Needed to Fund Scheduled Benefits, 2007-2081 20 07 20 12 20 17 20 22 20 27 20 32 20 37 20 42 20 47 20 52 20 57 20 62 20 67 20 72 20 77 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Combined Social Security Payroll Tax Rate Source: CRS calculations, using figures from the 2007 Social Security Trustees Report. Note: Prior to 2041, scheduled payroll tax rates could fund more than scheduled benefits. Impact of Payroll Tax Increases. Raising the payroll tax rate would increase most workers’ taxes by the same proportion. However, since covered wages are taxable only up to a specified maximum ($97,500 in 2006), the effective increase in the payroll tax would be smaller for people who earn more than the taxable maximum than for other workers. About 6% of workers currently earn more than the taxable maximum.43 Unlike the federal income tax, the Social Security payroll tax is levied at a flat rate starting at the first dollar of wages. As a result of this flat structure and the cap on taxable wages, the Social Security payroll tax places a relatively greater burden on low- and middle-income workers.44 43 CRS Report RL32896, Social Security: Raising or Eliminating the Taxable Earnings Base, by Debra Whitman. 44 In 2003, about 74% of tax filers owed more in combined payroll taxes than in individual income taxes, including 85% of those with incomes of less than $40,000. (“Three-Quarters of Filers Pay More in Payroll Taxes Than in Income Taxes,” Tax Facts from the Tax Policy Center, Tax Notes, by William G. Gale and Jeffrey Rohaly, January 6, 2003, available at [http://www.taxpolicycenter.org/UploadedPDF/1000456_payroll_income.pdf].) CRS-14 Conclusion The consequences of allowing the trust funds to become insolvent can be avoided if Congress makes changes to Social Security. The sooner Congress acts, the smaller the changes need to be. If Congress acted today, the benefit cuts or tax increases necessary to restore solvency until 2081 would be about half as large as those needed if Congress waited until the trust funds became insolvent. Prompt action would also allow Congress to gradually phase in changes, rather than abruptly cutting benefits or raising taxes, thus allowing workers to plan in advance for their retirements. Another reason to act sooner rather than later is that the trustees project that the combined trust funds will begin to run annual cash-flow deficits in 2017, requiring the trust funds to redeem the bonds that they have accumulated in surplus years. Cash-flow deficits do not affect Social Security directly, but the redemption of the trust fund bonds puts pressure on the overall federal budget, which is in deficit.