Executive Summary
The latest release of the 2012 Social Security Trustees Report shows once again that the Social Security trust fund is not only heading for insolvency, but doing so at an increasingly rapid rate, with current projections showing total depletion by 2033. Yet the reality is that the Social Security trust fund is only used to pay Social Security benefits that can't be funded from Social Security taxes alone - which even by 2033 are projected to cover 75% of payments due! Consequently, for most financial planning clients, who may only rely on Social Security retirement benefits for 25%-50% of total retirement income (or even less in some cases), the impact may not really be very severe at all; a 25% reduction in Social Security payments that are only 25% of retirement income constitutes a 6.25% pay cut, that doesn't even occur for over 20 years! Are we overstating the impact of Social Security's fiscal woes for the average financial planning client?
The inspiration for today's blog post was the release this week of the latest 2012 Trustees Report on Social Security, which showed that under current projections, the Social Security trust fund will be depleted by 2033 (down from 2036 in last year's report), leading to a projected 75-year shortfall that would require a present value of $8.6 trillion to fully fund - a whopping sum that itself is nearly 60% of our country's GDP!
Yet despite this dismal outlook, it's important to bear in mind the true realities of how Social Security benefits are funded. The overwhelming majority of benefits are actually paid by transferring taxes collected from current workers as payments to current retirees (and other Social Security recipients). In fact, in recent decades the Social Security system has actually collected more in taxes than it paid out in benefits, leading to the surplus that has been accumulated in the trust fund and invested into government bonds. In 2011, for example, Social Security collected $691 billion in taxes, and generated $114 billion in interest on the bond investments in the trust fund; the combined $805 billion of income was used to pay $736 billion in benefits, with the $69 billion remainder reinvested back into more government bonds. By 2021, though, the projected cost of Social Security benefits will exceed the combination of Social Security taxes and interest paid on the bonds in the Social Security trust fund, which will force some of the trust fund bonds to be liquidated to fund payments in that year. And as noted earlier, by 2033 the bonds will be completely depleted, as ongoing benefits obligations in excess of Social Security taxes and trust fund interest continue to force ongoing liquidations.
Nonetheless, the fact remains that the assets in the Social Security trust fund are merely used to fund the difference between the Social Security taxes collected from workers and the amounts need to pay benefits. Even by 2033, this shortfall is projected to be only approximately 25% of the payments due. In other words, once the Social Security trust fund is "bankrupt" with a balance of $0, the Social Security system still has the financial means to pay 75% of benefits from then-current cash flows! And those are the consequences if nothing is done to shore up the system over the next 20 years. If Social Security taxes are raised by 2.67% (from a total of 15.3% to a total of 17.97%), the system is fully funded and there is no benefit cut at all! Alternatively, if the shortfall is bridged by some combination of benefit adjustments and tax increases, the future retiree may experience some benefit cut, but it would be less than the 25% automatic cut that occurs if nothing is done.
For a client who relies solely on Social Security to fully fund retirement, a spending cut up to 25% that occurs in two decades may be painful - although recent research has suggested that typical clients may in fact reduce their spending nearly this much in their later years (as today's 65-year-olds would be less mobile 86-year-olds at the projected shortfall date). However, for a "mass affluent" client who may only be relying on Social Security benefits to provide 50%, 25%, or less of the total retirement income needs, the outlook on Social Security is even less impactful. If Social Security is only 25% of the client's portfolio, then a future 25% cut represents only a 6.25% decline in income that still doesn't hit for two decades. And of course, if part of the Social Security solution includes a tax increase (not just spending cuts), the size of the benefit cut would be even less. Alternatively, it's notable that most current policy proposals have indicated that any benefits cuts would be borne by future retirees, not current retirees, suggesting that the risk of lower future benefits is primarily an impact to those who have many years to go until retirement.
Yet for those future retirees who are most likely to face some benefit cuts, the reality is that with 10+ years remaining until retirement, the primary driver of retirement success is actually the market's return, which is needed to double the value of the portfolio in the final decade before retirement in a traditional retirement plan. As a result, while a distant future reduction in Social Security benefits of up to 25% may lie in wait for those who are currently in their early 50s, 40s, or younger, any such individuals who plan to rely on a portfolio for a material portion of retirement income will still be more sensitive to market returns than potential Social Security benefits adjustments!
This isn't to say that the potential for a cut in Social Security benefits is irrelevant; in my experience, many planners trim projected Social Security benefits for future retirees, most commonly by giving a "haircut" to the total benefits (e.g., reducing them to only 75%-85% of the originally projected amount), or by reducing the cost-of-living adjustment to be lower than the overall inflation rate (e.g., projecting Social Security COLAs at 2% while overall inflation is projected at 3%).
But the point remains that such changes are not nearly as drastic, even for mass affluent clients, as the headline "Social Security is going bankrupt" would suggest. Even for those who may rely more heavily on Social Security, the entire shortfall from the system would be projected to be "only" a 25% decline in benefits at the worst, starting in 20 years. While such a reduction certainly isn't trivial, it's still nowhere near a total reduction to $0! And for those who aren't retired yet, changes in the economy and markets will still have far more of an impact on retirement success than proposed benefits changes!
So what do you think? Do you make any adjustments to your client Social Security or overall retirement projections to account for potential benefit reductions? How concerned are your clients about their Social Security benefits? Has the demise of Social Security been exaggerated? Would your clients react differently if the Social Security deficits were simply framed as the risk of a 25% shortfall, not an implied "bankruptcy" of the entire system?
