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A Social Security primer

By Ray Martin, CBS.MarketWatch.com
Mar 2, 2004

BOSTON (CBS.MW) -- Comments by Federal Reserve Chairman Alan Greenspan about the growing federal budget deficit and the need to reduce the real rate of growth of Social Security benefits created quite a stir among policymakers, politicians and groups that represent the interests of older Americans.
For many people, this raised the insecurity level about the future of Social Security and what they can expect from it when they retire.

Social Security, also know as the Federal Old-Age and Survivors and Disability Insurance Trust Fund, pays benefits to more than 45 million people and covers over 150 million workers by providing eligibility for benefits. For almost 70 years, this has been the foundation of American retirement and survivor financial security.
The way Social Security operates is that workers and their employers pay a tax into the system based on wages or pay (also know as the Federal Insurance Contribution Act Tax, or FICA tax). These taxes are used to make payments to individuals collecting monthly benefits.

As long as the taxes collected are equal to or more than the benefits paid out, everything is fine. This is the present situation as Social Security is currently taking in more money than it pays out. In fact, there has been a surplus for quite some time, and this adds up to over $1.4 trillion, which is allocated to the so-called "Social Security Trust Fund." This surplus is actually on loan to the U.S. Treasury, in the form of Treasury bonds paying about $80 billion annually in interest.

A Social Security crisis looms
The crisis, and it is a crisis, is that according to the 2003 Annual Board of Trustees Report on Social Security, the annual benefit payments are very likely to exceed the taxes collected in 14 years, or in the year 2018.
At that time, the so-called surplus would be used to make up the gap in taxes collected versus the benefits paid out. By 2042, the surplus will be exhausted and, if nothing has been done to address that situation, some abrupt changes will be required.

This crisis is due mainly to three factors all converging during in the next several years: a rapidly growing number of baby boomer retirees, increases in life expectancy during retirement and lower birth rates. When Social Security was first established in 1935, it was expected that a retiree aged 65 would live to age 77. Today, 65 year olds are expected to live to around age 85, or more.
In 1950, there were 16 workers paying FICA taxes into Social Security for every one person collecting benefits. Today, that ratio has shrunk to 3.3 to one and in 2033, it is projected to be as little as 2.1 to one.

Potential solutions
There are a number of possible solutions that are being or should be discussed:Increase the FICA tax: The current combined tax for employers and employees is 12.4 percent. It is projected that this would have to be increased to 17 percent by 2043 and 18.9 percent by 2077 for collections to keep pace with projected increases in benefit payments. The problem is that these taxes have been raised 20 times and that almost 80 percent of workers already pay more in FICA tax than they do in income taxes.

Cut benefits for future retirees: There are no plans to cut benefits for current retirees and many proposed plans also preserve scheduled benefits for near-retirees, those 50 to 55 or older. But workers younger than 50 could see an increase in the age at which they become eligible for full benefits, currently at age 66 to 67. Younger workers could also have their projected income benefit reduced by up to 27 percent. Finally, annual cost-of-living increases for retirement benefits could also be reduced or eliminated.

Create personal accounts: There have been several proposals for allowing younger workers to invest a part of the FICA taxes they pay in a private account, which would in turn be invested in a line-up of diversified stock and bond funds. The thought is that personal accounts could provide a higher return, thereby potentially making up for a cut back in retirement benefits under the current program. Critics say this would mean higher risks for younger workers and they say personal accounts would be costly to administer. Federal employees and members of Congress have a version of this, under the federal governments Thrift Savings Plan.

Add payers: People who work for U.S. companies offshore do not pay into Social Security -- another disturbing effect of the growing trend of employers filling American jobs with foreign workers. U.S. companies replacing "higher cost" U.S. workers with lower cost workers abroad could be required to pay the equivalent of the FICA taxes into Social Security.

While there are many opinions and even more debate, it is likely that any changes will include some of these options. Whatever the case, the time to act is now because the changes can be phased in gradually, there will be more options to consider and younger workers will be better able to take the necessary actions to react to these changes.

What younger workers should do:
Review Social Security statements: If you are 25 or older, three months before your birthday Social Security sends you a statement that includes a personal record of the earnings on which you've paid Social Security taxes, the taxes paid by you and your employer and the estimated benefits you could receive in retirement, if you are disabled or that would be available to your survivors. Incorporate this information into your financial planning, review it for accuracy and understand the portion of your retirement income that will come from this benefit.

Calculate your retirement income and saving needs: According to the 2003 Retirement Confidence Survey, only about 37 percent of individuals have actually calculated how much money they would need to save by the time they retire. You should have a well-rounded estimate of what your retirement needs are and what your sources of retirement income could be.

Increase savings: It's obvious that if Social Security benefits could be cut back, you will need to save more for your own retirement. Maybe that's part of the reason why the tax laws were changed to allow for more generous contributions to tax advantaged retirement plans. Workers can contribute $13,000 to retirement plans and those 50 and older can contribute an additional $3,000, for a total of $16,000. These limits will continue to rise through 2006, where younger workers can contribute up to $15,000 and those 50 and over can put away $20,000.

Downsize your debt: If you have high-rate credit card debt, redouble your efforts to pay it down. When your debt payments are reduced, you will be able to save more. Also, if you have a mortgage, make an extra payment each year. This will shorten a mortgage from 30 years to 17 years, increase your equity and reduce your housing costs -- and will help you to compensate for a possible reduction in benefits from Social Security.