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A Guide to the 2012 Social Security Trustees Report

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A Guide to the 2012 Social Security Trustees Report

April 26, 2012

This will be the first of two articles on the 2012 Social Security and Medicare Trustees’ reports. I am one of the six trustees of these two programs, and one of two public trustees along with Dr. Robert Reischauer. Our annual reports on these two programs’ finances were released with an accompanying summary on Monday, April 23.

Highlights from the Current Report

Social Security is now putting substantial pressure on the federal budget and will add much more in the years to come. In 2011, program costs exceeded tax collections by $148 billion. In 2012 they’re projected to exceed tax collections by $165 billion. Some of this gap arises from the recently-adopted policy of cutting the payroll tax. The graph here (copied from the report summary) shows the future budget pressure that would arise from making scheduled benefit payments of Social Security and Medicare. The bottom blue portion of the graph (“OASDI”) represents Social Security. As seen here, the fiscal strains arising from Social Security will diminish but not disappear once the payroll tax cut expires, but will then rise substantially before and until insolvency occurs in 2033.

Excess of Scheduled Benefits over Tax/Premium Income for Soc. Sec./Medicare (As % of GDP)

Key dates for the Social Security trust funds are 2008, 2010 and 2033. Though the trust funds are but one prism for viewing program financing, it’s their status that the trustees’ reports are largely about. Social Security’s combined “trust fund ratio” peaked in 2008. This number measures the duration of benefit payments that could be financed from the level of assets in its trust funds. Some occasionally overemphasize the fact that these trust funds are still growing in nominal terms. This however neglects that benefit payments are rising even faster, so the purchasing power of trust fund assets has effectively been in decline since 2008. In 2010, Social Security began to strain the federal budget when its expenditures surpassed its tax collections. Program costs are rising rapidly and by 2030 will exceed 17 cents of every taxable wage dollar workers earn, after which the combined trust funds are projected to be exhausted in 2033. This would trigger automatic benefit reductions if the law is not changed before then. This is seen in the accompanying figure copied from the main report.

Social Security Costs and Income Expressed as a Percentage of Taxable Worker Wages

Social Security’s financing shortfall is the worst seen since the 1983 reforms. The program’s actuarial deficit is traditionally measured in terms of its tax base (worker wages) and has now reached 2.67% of taxable payroll. This is the largest seen since before the last major Social Security reforms in 1983. The deterioration this year (0.44 points) is the second-worst single-year deterioration in over three decades of annual trustees’ reports.

The disability insurance (DI) trust fund is projected to be insolvent in 2016. The figures above pertain to the program’s combined trust funds. Social Security has different trust funds for old-age and disability benefits. Each must separately remain solvent to permit full benefit payments. The DI trust fund is in more immediate trouble than any of the other trust funds on which the trustees report.

In practical effect, Social Security’s financing challenge is not distant but very near. We are rapidly running out of time to enact an acceptable solution to Social Security’s shortfall. Inaction until 2033 would mean that benefits are cut 25% across the board – affecting everyone already on the rolls (many of whom are receiving benefits today in 2012). The alternative is a sudden payroll tax hike on workers from 12.4% to 16.7%. In 2033 we would not be able to protect benefit payments for those already receiving them even if 100% of new retirees’ benefits were cut off. There is no precedent for enacting sudden corrections of the magnitude required near the time Social Security is projected to be insolvent. The window of opportunity for protecting current and low-income beneficiaries, and sparing workers from unprecedented tax hikes, is closing rapidly.

Why Has the Situation Grown So Much Worse This Year?

Among the contributing factors:

  • The cost-of-living adjustment (COLA) this year (3.6%) was much higher than projected.
  • Worker taxable earnings in 2011 were 1.6% lower than projected. This has spillover effects onto estimates for 2012 and beyond.
  • We’ve refined our projections for future changes in worker hours per week to better reflect historical data and the aging of the population.
  • The passage of another year without legislative action worsens the outlook somewhat.
  • Each year there’s a usual assortment of technical corrections. This year most of these turned up on the negative side.
  • Birth rate data for 2009 and 2010 are a little lower than projected.

Most of these factors are relatively small individually, but together they add up to a significant worsening. The most significant factors are the updated economic data.

What’s New in the Report: For Wonks Only

Most of the information in the trustees’ report and summary has been present in some form in previous years. One change this year may interest hard-core wonks. It has to do with how the trustees present projection uncertainty.

For years the trustees have struggled with how to present the degree of uncertainty associated with their projections. They have traditionally used two methods.

The first method is to construct “high-cost” and “low-cost” alternative scenarios, in which the major variables all break either to the good or to the bad (from a financial perspective). The advantage of this is that readers can see how much each specific variable must change to produce good or bad financial outcomes. One disadvantage of this approach is that these artificially-constructed scenarios are highly improbable. Some readers have in the past missed this, pointing for example to the “low-cost” scenario to suggest the Social Security shortfall might disappear despite the substantial improbability of this happening.

The other method is a “stochastic” analysis in which the relevant variables randomly fluctuate, with the results compiled to assign probabilities to general financial outcomes. This has the advantage of illuminating how likely it is that reality will resemble the trustees’ best guesses. But it has the disadvantage of not always being fully clear how changes in individual factors affect the results.

In the past it also hasn’t been clear how the two methods related to one another. For example, the “low-cost” alternative scenario looks a lot like the stochastic analysis’s 2.5th percentile scenario if you just inspect annual program cash income and outgo. Yet the “low-cost” scenario looks a lot better in terms of the trust fund balance. Past trustees’ reports never really explained why that was.

The answer has to do with interest rates. In the low-cost scenario, there is both faster economic growth and substantially higher interest rates. So, not only do the program’s annual cash operations look better, but its trust fund earns interest at a faster rate and so lasts a lot longer. The stochastic analysis by contrast doesn’t assume that correlation, allowing instead for random fluctuations in each variable.

The models’ different treatment of interest rates is either visible, or not, depending on what one is looking at. It’s not visible in graphs showing annual tax collections and benefit payments, neither of which depend on interest rates. The difference is however visible on graphs showing trust fund balances, where interest earnings matter.

This is why the constructed “low-cost” scenario has always shown much better trust fund outcomes than even the most optimistic range of the stochastic analysis. This year the trustees included a new appendix in the report explaining what is going on.

Important Messages

Each year the trustees highlight certain points in their message to the public. Here are excerpts from this year’s message of the public trustees:

  1. The situation is growing more urgent. “(B)y almost any objective measure, the financial health of the Social Security system has entered a concerning decline. “
  2. Further delay in resolution is inadvisable. “(L)awmakers should be aware that it will become increasingly difficult to avoid adverse effects on current beneficiaries, those close to retirement, and low-income beneficiaries in all birth cohorts if legislative changes are delayed much further. . . such action must be prompt and sufficiently decisive if these programs are to serve future generations as well as they have served earlier ones.”
  3. Continued financing of Social Security from the general fund to cover for the payroll tax cut may have unintended adverse consequences. “Under this policy, over $200 billion will be transferred from the General Fund of the Treasury to replace foregone Social Security tax collections. In 2011, due in large part to this change in program financing, payroll tax revenue represented only 70 percent of total Social Security income. Lawmakers should carefully consider whether continued significant General Fund financing for Social Security could threaten to undermine long-standing public perceptions of the program as an earned benefit financed by workers according to contributory social insurance principles.”

Charles Blahous is a research fellow with the Hoover Institution, a senior research fellow with the Mercatus Center, and the author of Social Security: The Unfinished Work.

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