Examining ways to fix Social Security

Bill Cass, CFP®, CPWA®

Bill Cass, CFP®, CPWA®, 04/12/23


With discussions in Washington heating up around raising the debt ceiling limit and the pace of government spending, the future of Social Security has also been part of the conversation. Consider the recent federal budget outlook and our post on the breakdown of government spending. While the administration and lawmakers from both sides of the aisle have taken a position that changes to Social Security are off-limits, the program faces serious funding issues.

The recently released 2023 Social Security Trustees Report projects that the trust fund will be able to pay scheduled benefits on a timely basis until 2034, when the trust fund is depleted. This is one year earlier than the projection from the 2022 report. Beginning in 2035, payments will be funded solely from current payroll tax revenues, and benefit amounts will decline by roughly 20%.

In 1983 Social Security faced a similar crisis, which prompted Congress to pass bipartisan legislation to reform the program. Some of the changes included partial taxation of benefits and an increase in the retirement age. Following passage of the law, program trustees projected solvency of the trust fund until 2057. While their forecasts around population growth and longevity were fairly accurate, longer-term estimates on economic activity (interest rates, economic growth, inflation, and productivity growth) did not reflect the historical record. For example, the 1983 Trustees Report projected that wages would increase by 1.5% annually, while, in reality, they have grown by roughly half that amount. This highlights the challenge of making long-term forecasts on the future financial health of Social Security.

Options to address solvency

While proposals to address the long-term future of Social Security take many forms, they can be divided into two approaches: raising taxes or reducing benefits. According to the 2023 Trustees Report, a payroll tax increase of 3.44% would make the program solvent for the next 75 years. Currently, the Social Security payroll tax is 12.4% (6.2% for workers, 6.2% for employers). Under this option, the individual portion of the payroll tax would increase to 7.92%. Conversely, if benefits were reduced across the board by 21%, the same result could be presumably reached. Realistically, a plan to address solvency will likely include both tax increases and benefit reductions. If lawmakers wait longer to act, more severe steps will be needed.

Here are some potential policy options:

Increase taxes Reduce benefits
Increase the payroll tax (currently 6.2% for individuals) Raise the retirement age (currently the full retirement age is 67 for those born in 1960 or later)
Increase the taxable wage base (currently the first $160,200 in wages is subject to payroll tax) Change the measurement for calculating annual cost of living adjustments (from CPI-W to CPI-U, also known as chained CPI)
Treat a greater percentage of benefits as taxable income (currently, up to 85% of benefits may be subject to income tax) Limit the maximum benefit amount by modifying the relationship with contributions made to the program (currently, the more you contribute, the greater benefit you receive)
Apply a surtax on higher-income households (similar to the current 3.8% surtax on net investment income for individual taxpayers with more than $200,000 of income, $250,000 for married couples) Modify the calculation of benefits by applying a lower percentage factor on higher income levels (involves modifying “bend points” used to calculate average indexed monthly earnings (AIME))
Apply a surtax on pass-through income of certain businesses (e.g., S-Corp, partnerships) Increase the number of years worked considered when calculating benefits (currently, your top 35 earning years are factored)
Subject the benefit of employer-provided health insurance to Social Security payroll tax Change the benefit calculation formula so indexed growth of benefits is based on inflation instead of the U.S. average wage index (worker earnings have historically grown faster than inflation)

Additional points to address the challenge

  • Some plans to increase the taxable wage base propose applying payroll taxes at higher income thresholds. For example, make earnings above $250,000 subject to payroll tax. That would mean, based on current limits, a worker’s first $160,200 would be subject to the 6.2% payroll tax and then the payroll tax would apply again on all earnings above $250,000. This would result in a “donut hole” where earnings between roughly $160,000 and $250,000 would not be subject to Social Security payroll tax.
  • Originally, the taxable wage base was designed to cover 90% of workers’ earning in the U.S. Currently, 83% of earnings are subject to Social Security payroll tax since wages for higher-income taxpayers have grown faster than those of lower-income taxpayers. If policymakers wanted to reach the 90% target now, the taxable wage base would have to increase to roughly $300,000.
  • Certain lawmakers have advocated for expanding benefits for some beneficiaries. Recently, Senators Bernie Sanders (I-VT) and Elizabeth Warren (D-MA) introduced a bill to increase benefits and raise annual cost-of-living adjustments (COLAs), funded by additional taxes on higher-income taxpayers.
  • Some proposals call for including all state and local employees to be part of the Social Security system. In some states and municipalities, employees are covered by a separate retirement program instead of Social Security (roughly 4% of workers nationwide are not covered by Social Security).

Considerations for retirement planning

The long-term future of Social Security is in the balance. However, even if Congress doesn’t act, beneficiaries are projected to receive roughly 80% of scheduled benefits. There is confusion that the depletion of the trust fund will mean that benefits are completely gone. This is not the case. However, prudent planning must incorporate the risks of a reduced benefit amount in the future, higher taxes, or both.

  • Consider strategies to improve tax diversification. Roth IRA conversions or health savings accounts (HSAs) may provide a hedge against higher taxes in the future.
  • For younger investors, factor in potential benefit reductions in Social Security as part of a comprehensive retirement savings and income plan. Look for opportunities to increase savings as early as possible.
  • Take a thoughtful approach to claiming Social Security, especially if those benefits are the only source of guaranteed, lifetime income. Avoid making a rash decision to claim Social Security early just because you’ve heard that the trust fund is being exhausted. An eventual plan to address the issue will likely not impact current and near retirees as much as younger workers.

Sources: 2023 Social Security Trustees Report, American Academy of Actuaries.

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