A Primer on the Social Security and Medicare Trustees’ Reports: Part II -- Quantitative Findings

This is the second of two pieces on the annual Social Security and Medicare Trustees’ Reports. The first, published by e21 on May 23, focused on process, concepts and thematic findings. This one will summarize the reports’ quantitative projections.

This is the second of two pieces on the annual Social Security and Medicare Trustees’ Reports. The first, published by e21 on May 23, focused on process, concepts and thematic findings. This one will summarize the reports’ quantitative projections.

Social Security

Current Operations: Social Security is currently running a deficit of tax income relative to annual expenditures. One of the headline findings of this year’s report is that this deficit will be a permanent feature of program finances, growing enormously in the future under current law. (Technically the program can no longer run a deficit after its trust fund is ultimately exhausted, but the deficit is permanent in the sense that benefit obligations will forever exceed tax income). This operating deficit emerged last year. Total program costs were $713 billion while $664 billion in tax revenues were collected, for a total deficit of $49 billion.

This year, dedicated tax revenues will lag a full $151 billion behind payment obligations, meaning that Social Security’s operations will add $151 billion to the federal deficit. This is much bigger than last year’s shortfall primarily because the Social Security payroll tax has been temporarily reduced from 12.4% to 10.4%. That legislation that cut the payroll tax is also transferring $105 billion in (debt-financed) general revenues to the Trust Funds, making up part of the shortfall. The rest of the deficit will be made up with interest payments from the general fund to the Trust Fund.

The Trust Fund and its interest earnings were explained in my last piece. Of note here is that even though there is a deficit of tax income relative to payment obligations, the Trust Fund balance continues to rise because of ongoing interest payments. As explained before, these interest payments are made from one government account to another, and do not lessen the amount by which Social Security adds to the larger federal deficit.

Projected Cost Growth: Going forward, Social Security costs will rise markedly as the Baby Boom generation enters the retirement rolls. The Trustees have traditionally expressed these annual costs as a percentage of taxable worker wages, in effect measuring the cost burden per worker. In 2007, before the recession hit and before the first Baby Boomers filed for Social Security benefits, total system costs amounted to roughly 11 ½ percent of worker wages. Under current projections, the annual cost rate will rise to about 17% in 2035, as seen on the accompanying graph from the report.

Projected Social Security Costs and Income as a % of Taxable Worker Wages

In other words, by 2035 the cost of financing Social Security would amount to slightly more than one of each six taxable dollars that American workers earn. Over the very long run, costs will rise somewhat further as Americans continue to live longer, but the vast majority of the cost growth straining Social Security will be manifested by 2035. This is vital to an understanding of Social Security finances. If Social Security’s cost growth is to be meaningfully addressed, it must be addressed well before most of these Baby Boomers are on the verge of collecting benefits.

The cash deficits the program will experience in the years ahead under current law far exceed anything that Social Security has weathered in the past. Even by 2020, annual shortfalls would be greater than in the so-called “crisis” years of 1977 and 1982, and would yet be followed by still larger deficits.

Trust Fund Exhaustion: The latest report projects that the combined Social Security Trust Funds will be exhausted by 2036, one year earlier than last year’s report. By 2036, incoming tax revenues would only be sufficient to fund 77% of scheduled benefits. This is a date that draws attention because it represents the point at which the program’s authority to send benefit payments will be interrupted. But it is extremely important to understand that this date tells us nearly nothing about how soon legislative corrections should be implemented. 2036 simply represents the worst-case scenario in which the program’s aggregate shortfall would be resolved in the harshest possible way, through sudden, sharp benefit reductions hitting even the most vulnerable of those previously retired.

There is no precedent in Social Security history for enacting sudden financial corrections of the size that would be required if action is delayed until 2036 or even close to it. If the program is to remain self-financing while maintaining reasonable equity in tax and benefit schedules, legislative action will be required much sooner, probably within the next few years.

Though the nominal balance of the combined Trust Funds is still rising due to interest payments, their authority to finance benefits is actually already in decline. The OASDI Trust Fund Ratio, which measures the number of years of benefits that could be financed from Trust Fund assets, peaked at 358 in 2008. It is now 353 and dropping. This is because the cost of paying benefits is growing relatively faster than Trust Fund assets.

The 2036 date referenced here pertains to the combined (Old-Age, Survivors and Disability) Social Security Trust Funds. The Disability Insurance Fund faces much more severe problems, and would be insolvent by 2018 under current projections.

Reasons for Deterioration: Last year’s report projected an OASDI actuarial deficit equal to 1.92% of taxable wages over the next 75 years. This year’s report shows an increase to 2.22%. That’s a 0.30 point worsening, which along with a comparable deterioration in the 2009 report is the largest single-year worsening in any Trustees’ report since 1994.

The main reason for this is longevity growth. Death rates for the last few years are lower than measured in the 2010 report, especially among those 65 and older. That’s obviously good news, but it nevertheless increases Social Security costs. A slower-than-anticipated economic recovery also took a toll, both directly upon real wage growth and on the number of payroll-taxpaying illegal immigrants. But longevity was the biggest factor.

Degree of Certainty. Each year the Trustees publish an analysis that shows how much deviation there is in the overall projections as individual variables change. The answer is that the Social Security shortfall is extremely certain; the only real question is how large it will be. From the 2.5th percentile of scenarios to the 97.5th, the trust funds would be exhausted at some point between 2030 and 2049. It is actually more likely that the actuarial shortfall will be twice as large as now projected as that it will fade away without legislative correction.

Medicare

Current Operations: Medicare has many more moving parts than Social Security. In 2010, it had $523 billion in total expenditures. Against this, Medicare brought in $469 billion in non-interest income, while also receiving $17 billion in HI Trust Fund interest payments. Medicare’s various income sources include payroll taxes, benefit tax income, premiums, state transfers and general revenues.

Medicare includes Part A (Hospital Insurance), which has a Trust Fund much like Social Security’s and is similarly financed predominantly by payroll tax revenues. Medicare also contains Parts B and D (Supplementary Medical Insurance), which receive premium income but are financed mostly with general revenues. The SMI Fund is deemed solvent virtually by statutory construction; it simply is given whatever amount of general revenues is required.

There is a statutory “funding warning” that the Trustees are required to issue whenever general revenues encompass more than 45% of Medicare’s total funding requirement within the next seven years. That funding warning was again triggered this year, as general revenues will fund more than 45% of Medicare costs in fiscal year 2011.

Projected Cost Growth: Because of Medicare’s various funding sources, its cost growth can’t be readily understood as a percentage of a particular tax base. Its costs are thus often described in relation to total GDP. Currently, total program costs absorb 3.65% of GDP. This level is projected – under current Trustees’ assumptions (a huge qualifier, as I will note below) -- to grow to over 6% within the 75-year valuation window, with most of the cost growth occurring by 2035 and driven by demographic change.

Projected Medicare Costs as a % of GDP

Medicare’s total cost growth is compared to Social Security’s on the following graph. Pre-2035, when demographics are the bigger factor, Social Security is more expensive overall and shows comparable aggregate growth. Only after 2035, when demographics stabilize somewhat and excess health care inflation becomes a larger factor, does Medicare start to grow at a significantly faster rate, overtaking Social Security around 2050.

Projected Social Security and Medicare Costs as a % of GDP

Trust Fund Exhaustion: Trust Fund exhaustion is only a meaningful concept in Part A (HI) of Medicare, for reasons noted above. Under current projections, Medicare HI would be exhausted by 2024, five years earlier than last year’s report.

Reasons for Deterioration: Medicare’s worsening is a much more complex story than with Social Security. The first thing to note is that HI Trust Fund Ratios are projected to be quite low for several years prior to exhaustion. Thus, it does not require a qualitative change in annual operations for the exhaustion date to move several years. Even in this year’s report, for example, the Trust Fund Ratio dips below 50 (i.e., holding assets that would fund less than six months of benefits) before the end of 2015, and hovers at low levels for many years before ultimately running out. It would not take great movement in the annual numbers for the exhaustion date to move several years again in the next report.

Beyond that, the easiest superficial explanation is that with the economic recovery being weaker than expected, nominal Medicare revenues are now lower than previous projections while nominal costs are about the same, producing a net worsening. The real picture is more complex than that; there is an increase in real projected costs relative to the 2010 report as economy-wide compensation growth rates have been adjusted downward, but a full explanation of these factors would exceed the scope of this summary.

Degree of Certainty: Simply put: Social Security’s future finances are qualitatively quite certain. Medicare’s are not – for several reasons.

The first reason, noted repeatedly in the Trustees’ Report, is political uncertainty. Like the Congressional Budget Office the Trustees must score current law as it is given to us, whether it appears to be politically sustainable or not. Current law, for example, envisions a 29% reduction in physician payments in early 2012. Recent political history tells us this payment reduction will likely be overridden, but current law must be scored as it is.

Skepticism is also expressed in the Trustees’ report about the sustainability of various cost-reduction measures in the 2010 Affordable Care Act. The main such provision is a requirement that various Medicare provider payments be reduced annually by the growth in economy-wide multifactor productivity. To maintain profitability, therefore, Medicare providers would have to improve their productivity by the rate of growth in the economy as a whole. This has not been achieved historically, producing a debate as to whether these cost savings will actually be realized or whether they too will ultimately be overridden.

The Trustees’ report handles this analytical conundrum first by showing the results under current law under the assumption that these various cost savings are realized. At the same time, the Trustees authorized the Medicare Actuary to release an Illustrative Alternative Scenario in which the physician payment reductions are overridden and the productivity adjustments phased out from 2020-2035. These show much higher long-term Medicare costs than in the main Medicare report (10.7% of GDP in 2085 instead of 6.2%).

The other reason the Medicare projections are uncertain is simply that they are uncertain even if current law doesn’t change. The long-term rate of health cost inflation is the single most determinative assumption in the whole report, and yet it is also probably the hardest to predict. The Trustees employee a baseline assumption that health care cost inflation in the economy as a whole (that is, irrespective of ACA) will equal per-capita GDP growth plus 1%, on average, over 75 years. The growth rate is higher in the near term and lower in the long term, on the logic that higher growth rates are unsustainable once health care costs threaten to swallow up the lion’s share of the economy.

The overall tone of the Medicare Trustees’ report is to say: “Here are our projections for long-term Medicare cost growth, but here are also several reasons to take them with a grain of salt.” A Technical Panel is currently exploring these issues with an eye towards producing a long-term health care cost growth assumption that doesn’t require the grain of salt.

Overall, this year’s Medicare report is characterized by worsened finances relative to last year’s projections, along with various indications that actual costs will be still higher than shown. The Trustees’ methodology is likely to be further refined in the 2012 report, but it is far too soon to say how.

The best summary of both reports is probably given in the Public Trustees’ Message, which states that the “Social Security and Medicare programs face real and substantial challenges,” and that “elected officials will best serve the interests of the public if financial corrections are enacted at the earliest practicable time.”

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