By Bruce D. Schobel
Vice President and Actuary, New York Life Insurance Company
Retirement income in the United States usually comes from one or more of the following three sources:
- Government programs. These programs provide the "floor of protection" on which other programs may be built. The primary government retirement program, is Social Security. (Most people use this term to refer to the Old-Age, Survivors, and Disability Insurance, or OASDI, program. Other government programs, especially those providing for medical-care benefits, are generally not included in the term.)
- Employer-sponsored pensions. Most Americans are covered by such plans, which usually are "integrated" with Social Security, directly or indirectly.
- Income from personal savings and investments. Most workers are able to set aside some assets during their working years to provide supplementary retirement income. In addition, they may inherit some assets.
These three sources of retirement income, taken together, are often called the "three-legged stool" of retirement income. Like a real three-legged stool, the retirement-income stool works best when the legs are about equal in length. A person depending on only one leg of the stool will not be sitting on it for very long! The extent to which people have all three sources of income varies considerably, however. For many, the Social Security leg has been the longest and most reliable for many years, but it will likely be getting shorter in the future. The program will likely need to be changed, but the direction of those changes is not yet clear.
The Social Security program is structured on several basic principles that traditionally have had — and still seem to have — widespread public support. Those principles include:
- Benefit receipt is based on an "earned right" (based on having paid taxes while working), rather than on a "means test" (based on financial need at the time of benefit receipt). This principle generally distinguishes so-called "entitlement" programs from "welfare" programs, which do use various means tests to determine eligibility.
- Social Security maintains a balance between "individual equity" (that benefits be directly related to taxes paid) and "social adequacy" (that benefit levels be sufficient to keep most beneficiaries out of poverty). This balance is evident in the program's "weighted" benefit formula, which provides relatively greater benefits to low-paid workers than to high-paid workers (as a percentage of previous earnings). Thus, low-paid workers get a better rate of return on their taxes than do high-paid workers.
- The program is self-supporting (financed by dedicated taxes and not dependent on general government revenues).
- Taxes are paid equally by employers and employees (the self-employed pay both halves).
History and Financial Operation
The Social Security program was enacted into law on August 14, 1935, in the middle of the "Great Depression" in the U.S. Many older people fell into deep poverty during this period. While the Social Security program could not solve this problem immediately (benefits would not be payable for several years), the program was intended to prevent such a situation from recurring.
The program began collecting taxes in 1937. The tax was initially 1 percent of wages up to $3,000 per year, payable by the employer and the employee, each. The taxes were (and still are) deposited into "trust funds" established as separate accounts within the U.S. Treasury. The first monthly benefit payments were made in 1940. All benefits and administrative costs are paid from the same trust funds that receive the tax income.
When the trust funds have more income than outgo, the excess is retained by the Treasury and used to meet the government's non-Social Security expenses. In return for using Social Security's extra revenue, the Treasury issues to the trust funds special U.S. government bonds. When the rest of the government is running deficits, as has generally been the case for almost three decades now, Social Security helps to finance those deficits by purchasing bonds. When the trust funds have less income than outgo, the difference must come from bond redemptions. In practice, this means that the Treasury cancels some of the trust funds' bonds and provides cash, which must come from other sources: the sale of bonds to the public, increased taxes, or simply the printing of money. The cash is used to meet the program's revenue shortfall. At the same time, bond redemptions obviously place a burden on the Treasury.
The trust funds grew virtually without interruption from 1937 through 1974, as the program expanded. Initially, Social Security covered only about 60 percent of the country's workers. The first expansion of this coverage was enacted into law in 1950, and many more followed. Today, 97 percent of jobs are covered by the program.
Benefit levels also rose, as a result of frequent legislation, both to reflect changes in the cost of living and in real terms. Also, while the normal retirement age (NRA) remained age 65 (for men and women both), early-retirement benefits became available, with appropriate reductions, as early as age 62. As the number of beneficiaries and their benefit levels rose, taxes needed to be raised, too (because the program had no significant accumulated funds on hand to finance these increases). The tax rate rose many times, finally reaching its current level of 6.2 percent of pay on employers and employees, each. The maximum taxable amount rose, too, reaching $62,700 in 1996. This amount, currently about 2.4 times the national average wage, is adjusted annually to maintain that ratio.
The expansion of the Social Security program reached its peak in 1972, when benefits were increased by 20 percent (much more than was justified by inflation), and subsequent benefit increases were made automatic and annual. In addition, the initial benefit formula was to be automatically adjusted. The adjustment procedure for the benefit formula was technically faulty in the way that it took inflation into account. Because the annual adjustments would reflect changes in the cost of living and increases in the national average wage, the flaw is sometimes referred to as "double indexing." The result was ever-increasing benefit levels relative to previous earnings and out-of-control program costs. The trust funds began to decline in 1975 and continued downward.
After much study, Congress fixed the faulty benefit formula in the Social Security Amendments of 1977, which were first effective with people becoming eligible for benefits in 1979, but phased in over several years. The initial benefit level was allowed to retain some of the unintended increases that resulted from the operation of the faulty law during 1972-78, and was permanently higher than the pre-1972 level. The higher benefit costs, combined with very poor economic conditions in 1979-82, brought the Social Security program to its most serious crisis.
From 1975 through November 1982, the trust funds dropped from $46 billion — about one year's outgo at the beginning of the period — to zero. Special legislation enacted at the end of 1981 allowed Social Security to borrow funds temporarily from the Medicare Hospital Insurance program. Loans totaling $12.4 billion in 1982 permitted Social Security benefit payments to be made until permanent changes could be enacted into law, which happened in April 1983.
The Social Security Amendments of 1983 were crafted by the National Commission on Social Security Reform and strengthened Social Security's financial condition in five ways:
- Payroll taxes were increased in 1984, 1988, and 1989.
- Coverage was expanded to include most of the remaining non-covered groups, including Federal government employees hired in 1984 and after.
- Cost-of-living benefit increases were delayed by six months each year.
- The normal retirement age (NRA) was raised gradually from age 65 for workers born before 1938 to age 67 for workers born after 1959 (but the early-retirement age was allowed to remain age 62).
- Benefits became subject to Federal income tax for the first time, but only for those beneficiaries with substantial incomes from other sources. The income from that taxation of benefits was returned to Social Security.
Because of these changes, Social Security's revenue — primarily payroll taxes — has greatly exceeded outgo since 1983, and the trust funds have grown rapidly (and the loans from Medicare were repaid). At the end of 1995, the trust funds held $496 billion in U.S. Treasury securities. The funds are expected to continue growing for about two more decades, according to the government's official forecasts, which are updated annually. The most recent projection was released on June 5, 1996.
Although Social Security's income has exceeded its outgo for more than a decade, everyone agrees that the situation will inevitably reverse when the "baby-boom" generation born during 1946-64 reaches retirement age and begins receiving benefits. When that happens, the large pool of government bonds that will have been accumulated in the trust funds will be drawn down. According to the government's best estimates, this will begin in 2019 and continue for about 10 years. During this time, the trust fund assets will shrink from nearly $3 trillion (2 1/2 years' outgo at the peak) to zero.
The government has recognized in its annual reports that these bond redemptions will place enormous pressure on the Treasury and the nation's economy. Still, the official projections assume that the redemptions will occur. In 2029, the last of the accumulated bonds will be redeemed, and the program will become unable to pay its benefits on time without changes in the law.
Last updated date 11/01/2010
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|Retirement Income in the United States: The Role of Social Security|