Social Insurance, Trust Fund Runoff, and Federal Debt

28 Thursday Apr 2022

Posted by pnoetx in Deficits, Social Security

Tags

Anti-Deficiency Act, Charles Blahous, Deficits, DI, Disability Income, Discretionary Budget, entitlements, Federal Reserve, Fiscal Inflation, Fiscal Tiger, Hospitalization Insurance, Joe Biden, Mandatory Spending, Medicaid, Medicare Part A, Medicare Part B, Medicare Part D, Medicare Reform, Medicare Trust Fund, Monetization, OASI, Old Age and Survivorship Income, Pay-As-You-Go, payroll taxes, SMI, Social Security Reform, Social Security Trust Fund, Student Loan Forgiveness, Supplementary Medical Insurance

The Social Security and Medicare trust funds are starting to shrink, but as they shrink something else expands in tandem, roughly dollar-for-dollar: government debt. There is a widespread misconceptions about these entitlement programs and their trust funds. Many seem to think the trust funds are like “pots of gold” that will allow the government to meet its mandatory obligations to beneficiaries. But, in fact, the government will have to borrow the exact amounts of any “assets” that are “cashed out” of the trust funds, barring other reforms or legislative solutions. So how does that work? And why did I put the words “assets” and “cashed out” in quote marks?

The Trust Funds

First, I should note that there are two Social Security trust funds: one for old age and survivorship income (OASI) and one for disability income (DI). Occasionally, for summary purposes, the accounts for these funds are combined in presentations. There are also two Medicare trust funds: one for hospitalization insurance (HI – Part A) and one for Supplementary Medical Insurance (SMI – Parts B and D). The first three of these trust funds are represented in the chart at the top of this post, which is from the Summary of the 2021 Annual Reports by the Boards of Trustees. It plots a measure of financial adequacy: the ratio of trust fund assets at the start of each year to the annual cost. The funds are all projected to be depleted, HI and OASI much sooner than DI.

Fund Accumulation

The first step in understanding the trust funds requires a clearing up of another misconception: the payroll taxes that workers “contribute” to these systems are not invested specifically for each of those workers. These programs are strictly “pay-as-you-go”, meaning that the payroll taxes (and premiums in the case of Medicare) paid this year by you and/or your employer are generally distributed directly to current beneficiaries.

Back when demographics of the American population were more favorable for these programs, with a larger number of workers relative to retirees, payroll taxes (and premiums) exceeded benefits. The excess was essentially loaned by these programs to the U.S. Treasury to cover other forms of spending. So the trust funds accumulated U.S. Treasury IOUs for many years, and the Treasury pays interest to the trust funds on that debt. On the upside, that meant the Treasury had to borrow less from the public to cover its deficits during those years. So the government spent the excess payroll tax proceeds and wrote IOUs to the trust funds.

Draining the Funds

The demographic profile of the population is no longer favorable to these entitlement programs. The number of retirees has increased so that benefit levels have grown more quickly than program revenue. Benefits now exceed the payroll taxes and premiums collected, so the trust funds must be drawn down. Current estimates are that the Social Security Trust Fund will be depleted in 2034, while the Medicare Trust Fund will last only to 2026. These dates are reflected in the chart above. It is the mechanics of these draw-downs that get to the heart of the first “pot of gold” misconception cited above.

To pay for the excess of benefits over revenue collected, the trust funds must cash-in the IOUs issued to them by the Treasury. And where does the Treasury get the cash? It will almost certainly be borrowed from the public, but the government could hike other forms of taxes or reduce other forms of spending. So, while the earlier accumulation of trust fund assets meant less federal borrowing, the divestment of those assets generally means more federal borrowing and growth in federal debt held by the public.

Given these facts, can you spot the misconception in this quote from Fiscal Tiger? It’s easy to miss:

“In the cases of Social Security, Medicare, and Medicaid, payroll taxes provide some revenue. Social Security also has trust funds that cover some of the program costs. However, when the government is short on funds for these programs after getting the revenue from taxes and trust funds, it must borrow money, which contributes to the deficit.”

This kind of statement is all too common. The fact is the government has to borrow in order to pay off the IOUs as the trust funds are drawn down, roughly dollar-for-dollar.

A second mistake in the quote above is that federal borrowing to pay excess benefits after the trust funds are fully depleted is not really assured. At that time, the Anti-deficiency Act prohibits further payments of benefits in excess of payroll taxes (and premiums), and there is no authority allowing the trust funds to borrow from the general fund of the Treasury. Either benefits must be reduced, payroll taxes increased, premiums hiked (for Medicare), or more radical reforms will be necessary, any of which would require congressional action. In the case of Social Security (combining OASI and DI), the projected growth of “excess benefits” is such that the future, cumulative shortfall represents 25% of projected benefits!

Again, the mandatory entitlement spending programs are technically insolvent. Charles Blahous discusses the implications of closing the funding gap, both in terms of payroll tax increases or benefit cuts, either of which will be extremely unpopular:

“How likely is it that lawmakers would immediately cut benefits by 25% for everyone, rich and poor, retiring next year and beyond? More likely, lawmakers would phase in reforms gradually, necessitating much larger eventual benefit changes for those affected—perhaps 30% or 40%. And if we want to spare lower-income individuals from reductions, they’d need to be still greater for everyone else.”

It should be noted that Medicaid is also a budget drain, though the cost is shared with state governments.

Discretionary vs. Mandatory Budgets

When it comes to federal budget controversies, discretionary budget proposals receive most of the focus. The federal deficit reached unprecedented levels in 2020 and 2021 as pandemic support measures led to huge increases in spending. Even this year (2022), the projected deficit exceeds the 2019 level by over $160 billion. Joe Biden would like to spend much more, of course, though the loss of proceeds from his student loan forgiveness giveaway does not even appear in the Administration’s budget proposal. Biden proposes to pay for the spending with a corporate tax hike and a minimum tax on very high earners, including an unprecedented tax on unrealized capital gains. Those measures would be disappointing in terms of revenue collection, and they are probably worse for the economy and society than bigger deficits. None of that is likely to pass Congress, but we’ll still be running huge deficits indefinitely..

In a further complication, at this point no one really believes that the federal government will ever pay off the mounting public debt. More likely is that the Federal Reserve will make further waves of monetization, buying government bonds in exchange for monetary assets. (Of course, money is also government debt.) The conviction that ever increasing debt levels are permanent is what leads to fiscal inflation, which taxes the public by devaluing the public debt, including (or especially) monetary assets. The insolvency of the trust funds is contributing to this process and its impact is growing..

Again, the budget discussions we typically hear involve discretionary components of the federal budget. Mandatory outlays like Social Security, Medicare, and Medicaid are nearly three times larger. Here is a good primer on the mandatory spending components of the federal budget (which includes interest costs). Blahous notes elsewhere that the funding shortfall in these programs will ultimately dwarf discretionary sources of budgetary imbalance. The deficit will come to be dominated by the borrowing required to fund mandatory programs, along with the burgeoning cost of interest payments on the public debt, which could reach nearly 50% of federal revenues by 2050.

Conclusion

It would be less painful to address these funding shortfalls in mandatory programs immediately than to continue to ignore them. That would enable a more gradual approach to changes in benefits, payroll taxes, and premiums. Politicians would rather not discuss it, however. Any discussion of reforms will be controversial, but it’s only going to get worse over time.

Political incentives being what they are, current workers (future claimants) are likely to bear the brunt of any benefit cuts, rather than retirees already enrolled. Payroll tax hikes are perhaps a harder sell because they are more immediate than trimming benefits for future retirees. Other reforms like self-directed Social Security contributions would create better tradeoffs by allowing investment of contributions at competitive (but more risky) returns. Medicare has premiums as an extra lever, but there are other possible reforms.

Again, the time to act is now, but don’t expect it to happen until the crisis is upon us. By then, our opportunities will have become more hemmed in, and something bad is more likely to be promulgated in the rush to save the day.

If You’re Already Eligible, Your Benefits Are Safe

06 Tuesday Nov 2018

Posted by pnoetx in Medicare, Social Security

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Asset Sales, COLA, Defined Benefits, Defined Contributions, Entitlement Reform, Federal Borrowing, Medicare, Medicare Advantage, Pay-As-You-Go, Paygo, payroll taxes, Social Security, Social Security Trust Fund, Swedish Public Pensions

I’m always hearing fearful whines from several left-of-center retirees in my circle of my acquaintances: they say the GOP wants to cut their Social Security and Medicare benefits. That expression of angst was reprised as a talking point just before the midterm election, and some of these people actually believe it. Now, I’m as big a critic of these entitlement programs as anyone. They are in very poor financial shape and in dire need of reform. However, I know of no proposal for broad reductions in Social Security and Medicare benefits for now-eligible retirees. In fact, thus far President Trump has refused to consider substantive changes to these programs. And let’s not forget: it was President Obama who signed into law the budget agreement that ended spousal benefits for “file and suspend” Social Security claimants.

Both Social Security (SS) and Medicare are technically insolvent and reform of some kind should happen sooner rather than later. It does not matter that their respective trust funds still have positive balances — balances that the federal government owes to these programs. The trust fund balances are declining, and every dollar of decline is a dollar the government pays back to the programs with new borrowing! So the trust funds should give no comfort to anyone concerned with the health of either of these programs or federal finances.

Members of both houses of Congress have proposed steps to shore up SS and Medicare. A number of the bills are summarized and linked here. The range of policy changes put forward can be divided into several categories: tax hikes, deferred benefit cuts, and other, creative reforms. Future retirees will face lower benefits under many of these plans, but benefit cuts for current retirees are not on the table, except perhaps for expedient victims at high income levels.

There is some overlap in the kinds of proposals put forward by the two parties. One bipartisan proposal in 2016 called for reduced benefits for newly-eligible retired workers starting in 2022, among a number of other steps. Republicans have proposed other types of deferred benefit cuts. These include increasing the age of full eligibility for individuals reaching initial (and partial) eligibility in some future year. Generally, if these kinds of changes were to become law now, they would have their first effects on workers now in their mid-to-late fifties.

Another provision would switch the basis of the cost-of-living adjustment (COLA) to an index that more accurately reflects how consumers shift their purchases in response to price changes (see the last link). The COLA change would cause a small reduction in the annual adjustment for a typical retiree, but that is not a future benefit reduction: it is a reduction in the size of an annual benefit increase. However, one Republican proposal would eliminate the COLA entirely for high-income beneficiaries (see the last link) beginning in several years. A few other proposals, including the bipartisan one linked above, would switch to an index that would yield slightly more generous COLAs.

Democrats have favored increased payroll taxes on current high earners and higher taxes on the benefits of wealthy retirees. Republicans, on the other hand, seem more willing to entertain creative reforms. For example, one recent bill would have allowed eligible new parents to take benefits during a period of leave after childbirth, with a corresponding reduction in their retirement benefits (in present value terms) via increases in their retirement eligibility ages. That would have almost no impact on long-term solvency, however. Another proposal would have allowed retirees a choice to take a portion of any deferred retirement credits (for declining immediate benefits) as a lump sum. According to government actuaries, the structure of that plan had little impact on the system’s insolvency, but there are ways to present workers with attractive tradeoffs between immediate cash balances and future benefits that would reduce insolvency.

The important point is that enhanced choice can be in the best interests of both future retirees and long-term solvency. That might include private account balances with self-directed investment of contributions or a voluntary conversion to a defined contribution system, rather than the defined benefits we have now. The change to defined contributions appears to have worked well in Sweden, for example. And thus far, Republicans seem more amenable to these creative alternatives than Democrats.

As for Medicare, the only truth to the contention that the GOP, or anyone else, has designs on reducing the benefits of current retirees is confined the to the possibility of trimming benefits for the wealthy. The thrust of every proposal of which I am aware is for programmatic changes for future beneficiaries. This snippet from the Administration’s 2018 budget proposal is indicative:

“Traditional fee-for-service Medicare would always be an option available to current seniors, those near retirement, and future generations of beneficiaries. Fee-for-service Medicare, along with private plans providing the same level of health coverage, would compete for seniors’ business, just as Medicare Advantage does today. The new program, however, would also adopt the competitive structure of Medicare Part D, the prescription drug benefit program, to deliver savings for seniors in the form of lower monthly premium costs.”

There was a bogus claim last year that pay-as-you-go (Paygo) rules would force large reductions in Medicare spending, but Medicare is subject to cuts affecting only 4% of the budgeted amounts under the Paygo rules, and Congress waived the rules in any case. Privatization of Medicare has provoked shrieks from certain quarters, but that is merely the expansion of Medicare Advantage, which has been wildly popular among retirees.

Both Social Security and Medicare are in desperate need of reform, and while rethinking the fundamental structures of these programs is advisable, the immediate solutions offered tend toward reduced benefits for future retirees, later eligibility ages, and higher payroll taxes from current workers. The benefits of currently eligible retirees are generally “grandfathered” under these proposals, the exception being certain changes related to COLAs and Medicare benefits for high-income retirees. The tendency of politicians to rely on redistributive elements to enhance solvency is unfortunate, but with that qualification, my retiree friends need not worry so much about their benefits. I suspect at least some of them know that already.

Without Reform, Social Security Is a Game of Chance

25 Sunday Oct 2015

Posted by pnoetx in Social Security

≈ 1 Comment

Tags

Congressional Budget Office, Cost of Living Adjustments, Intergenerational Transfers, Internal Rates of Return, Michael Tanner, Pay-As-You-Go, Social Security, Social Security Privatization, Social Security Trust Fund, Tax Policy Center, The Urban Institute

Social Security does not provide future retirees with a safe “return” on taxes paid into the system on their behalf, given the program’s funding problems. It’s not even clear that it provides a decent return to many current retirees, and it will get worse as younger age cohorts become eligible. Demographic changes worked in the system’s favor in its early years, but no more: the number of eligible retirees is growing faster than the working-age population. This has led to cash flow deficits since 2010 that will widen in the years ahead. The unfunded liabilities of the system are currently estimated to be $26 trillion. The so-called “Trust Fund” for retirement holds about about $2.8 trillion of government securities, but those can’t be “cashed out” without a raid on general tax revenue or new borrowing by the Treasury.

Michael Tanner reveals the absurdity of some of the myths surrounding SS, such as claims that there is “no crisis” (and even more absurdly, that benefits should be expanded), that the Trust Fund will “save” the system, and that SS payroll taxes are “saved” for retirees. They are not saved; it is a “pay-as-you-go” system with current payroll tax collections paid out to today’s retirees. Here is Tanner on the woeful state of the system’s finances:

“According to projections by the Congressional Budget Office, for workers born in the 1980s, there are only enough funds to pay 76 percent of their schedule benefits; for today’s children born in the 2000s, this falls to 69 percent. And, taxes are already so high relative to benefits that young people will receive far less than they could receive if they invested their taxes privately.“

Measuring the return on Social Security (SS) payroll taxes (otherwise known as FICA) is not without controversy. The Social Security Administration (SSA) performs its own analyses of the returns on payroll taxes periodically. They analyze individuals at different income levels for each of four circumstances: single men, single women, one-earner couples and two-earner couples. They do so under different scenarios about future payroll taxes and benefits. The benefits include cost-of-living adjustments. These calculations show that today’s younger workers, singles and high-income workers can expect to receive the lowest returns. According to the most recent report, from December 2014, annual rates of return for those not yet drawing benefits under present law varies from less than 1% to 6.5%. Of course, the promised benefits are not sustainable under present law.

Reforms are not optional, as the program cannot run a deficit under its current authority once the Trust Fund is exhausted. SSA attempts to analyze steps that might close the gap and the impact of those changes on returns to retirees. One scenario involves higher payroll taxes and another lower benefits. These changes reduce the calculated returns in all cases, though even the lowest returns remain positive, if barely. These alternative scenarios involve no changes until 2033, however.

At the time of the SSA report, the most recent Congressional Budget Office (CBO) predicted that the SS Trust Fund would be exhausted in 2033. More recently, the CBO predicted that the fund will run dry in 2029. (The Disability Trust Fund is projected to run dry in 2017.) Therefore, the returns calculated by SSA under the alternative scenarios are over-estimates, since more drastic and earlier measures are required to restore balance. It’s likely that some of those returns would turn negative using SSA’s methodology. And it’s not unreasonable to suggest that reforms, whatever shape they might take, should be implemented sooner than 2029. After all, the need for reforms is well known, and we’re talking about it now! As for the SSA’s alternative scenarios, changes much sooner than 2033 would cause even lower returns.

While the SSA’s effort to provide the estimates is laudable, there are several aspects of the methodology that are questionable. SSA claims that the returns are real (inflation-adjusted) internal rates of return (IRRs), but they do not offer a detailed explanation of the inflation adjustment that must take place after calculating the nominal IRR. Using projected cost-of-living increases to inflate future benefits does not make the calculated IRRs “real”, if that’s what they have in mind. Second, the cost-of-living adjuster is the Consumer Price Index for Urban Wage Earners, which underestimates inflation experienced by the elderly. Third, they do not attempt to account for the probability of death before retirement, which would obviously reduce the return on contributions for single earners.

The “present-law” returns are essentially irrelevant, given the unfunded projected benefits. But the calculations under the alternative scenarios fail on other grounds: they are not “dynamic” in terms of adjusting for the economic impacts of the policy changes. In particular, higher payroll taxes are likely to reduce employment and slow the economy. A slowdown might even lead to additional claims on the system from earlier-than expected retirements. Thus, the higher payroll tax rates used by SSA will not be sufficient to close the gap. Likewise, reduced benefits would have a negative impact on the economy, reducing payroll tax collections. In both cases, dynamic economic effects would cause a wider funding gap; closing it will reduce returns more than suggested by SSA’s calculations.

An analysis by the Urban Institute in 2012 made somewhat arbitrary assumptions about rates of return. They used a 2% real rate of return to compound past contributions and discount future benefits (presumably with no cost-of-living adjustment). Under their assumptions, the value of payroll tax contributions at retirement often exceeds the discounted value of SS benefits for age cohorts turning 65 in 2010 and 2030. That implies that the real IRR must be lower than 2%.

As a hypothetical exercise, if individuals could invest their own payroll contributions over their working lives, significantly better returns could be earned than the IRRs discussed above, even if workers were forced into low-risk investments as they approach retirement. Therefore, the implied value of payroll contributions at retirement inherent in the IRR calculations is far too low. And while the discounting of retirement benefits at a relatively low rate reflects an appropriate conservatism, the level of SS benefits would not be competitive with the dollar returns on safe investments funded by a larger pot at retirement. The IRR calculations show only that the SS program is about as good as stuffing money into a mattress.

Unfortunately, the mattress might burn. The risks inherent in future SS benefits are substantial, and none of the reform alternatives are very popular. Some of the opposition is rooted in unreasonable criticism: No one has suggested programatic changes that would affect the benefits of anyone over the age of 55. Still, cuts in benefits for future retirees, delayed eligibility and higher payroll taxes are not easy sells. Another solution is to phase out the pay-as-you-go system, allowing younger workers the option of a a self-directed account (subject to certain restrictions), including a discounted “cash value” credit as a buyout for previous contributions. This was discussed in a recent post on Sacred Cow Chips.

Social Security is unsustainable and is an inter-generational rip-off in its current, pay-as-you-go form, as younger, less affluent workers subsidize current retirees, who are relatively wealthy as a class. Rather than shutting-down debate over reforms with exaggerated political claims, those interested in assuring a viable public retirement program should consider proposals that would give workers more choice and control, taking advantage of the higher returns available on private investments. Only this type of program can take advantage of the economy’s ability to convert savings into productive investment and real growth. Simple transfers from young to old do not leverage this process, and can never hope to compete with it.