Despite making uninterrupted retired-worker payouts for just shy of 80 years, America's most storied and important social program finds itself on the verge of some very big problems.
Social Security, the program that 62% of retirees currently rely on to account for at least half of their monthly income, is set to be hammered by a number of ongoing demographic changes in the years to come. After generating a net-cash surplus in each of the past 36 years, the 2019 Board of Trustees report has forecast that, in 2020, Social Security will expend more than it collects for the first time since 1982.
The real problem is that this net-cash outflow isn't a one-time event. These outflows will grow in size rapidly with each subsequent year until Social Security's $2.9 trillion in asset reserves are completely gone (which is predicted to happen in 2035). Should this excess capital be exhausted, an across-the-board cut to retired worker benefits of up to 23% may be needed to sustain payouts through the year 2093.
That's not exactly a rosy outlook for a social program that senior citizens heavily lean on. The question is: How do we fix it?
Democrats and Republicans are miles apart on a Social Security solution
Right now, solutions are plentiful on Capitol Hill. The problem is that Democrats and Republicans are unwavering on their core ideologies and have therefore been unwilling to work with each other to find common ground -- which is imperative if 60 votes are to be collected in a politically divided Senate.
For their part, Democrats want to approach Social Security's estimated $13.9 trillion cash shortfall between 2035 and 2093 by raising additional revenue. More specifically, Democrats have called for raising or removing the payroll tax earnings cap, which currently sits at $132,900, as of 2019.
The payroll tax is a 12.4% tax on earned income (wages and salary, but not investment income) ranging from $0.01 to $132,900. Since roughly 94% of workers won't reach $132,900 in earned income in 2019, they'll effectively be paying into Social Security on every dollar they earn. Meanwhile, the 6% of well-to-do workers who do earn more will have every dollar above $132,900 (in 2019) exempted from the payroll tax.
By raising or lifting this tax cap, Democrats would be requiring the well-to-do to pay more into the program. This added revenue should strengthen Social Security and counter the $13.9 trillion in estimated cash shortfall over the next 75 years.
On the other side of the aisle are Republican lawmakers who are calling for a gradual increase to the full retirement age (FRA) -- which is the age at which you become eligible to receive 100% of your monthly payout, as determined by your birth year. Currently, the full retirement age is 66 years and six months for those born in 1957 and it'll peak at age 67 for persons born in 1960 or later.
Members of the GOP would like to see this figure gradually increased to as high as age 70. While protecting existing and near-term retirees, such a move would require workers set to retire decades from now (i.e., millennials and Generation Z) to wait longer to receive their full payouts or to claim early and accept an even steeper reduction to their monthly benefits. Their objective is to reduce long-term outlays from Social Security.
Here's how I'd fix Social Security right now
So, which plan is better? I believe that's a trick question because aspects of both plans are critical to ensuring the well-being of Social Security over the long run.
For example, the Republican approach takes a long time to begin paying dividends. The cost savings realized by reducing lifetime outlays from the program wouldn't begin showing up for decades, which does nothing to counter the fact that Social Security's asset reserves could be gone in just over 15 years.
At the same time, the Democrats' solution fails to factor in increased longevity and persistently low birth rates (at least over the past decade). It's possible that no amount of added taxation on the rich will counter either of these negatives.
In short, a bipartisan approach is a must if Social Security is going to be strengthened over the long run. Although I don't have Social Security actuaries at my disposal to determine exactly how well this would work, I do have a plan as to how Social Security can be fixed right now.
1. Increase the payroll tax earnings cap to $175,000
First of all, I would suggest a modest increase in the payroll tax cap to $175,000, which would help counter the fact that an increasing percentage of earnings (about 17% of earned income) is now exempt from the payroll tax. You'll note, though, that I don't believe removing the cap in its entirety is a reasonable idea.
The payroll tax cap exists because there's also a cap on what Social Security will pay in monthly benefits at full retirement age. If the most a worker can receive each month in 2019 is $2,861 at full retirement age, then taxing, say, $10 million at the payroll tax rate doesn't make sense.
After raising the payroll tax cap to $175,000, I'd re-tether it to the National Average Wage Index (NAWI), which is what currently dictates its annual increase.
2. Gradually increase the payroll tax by 2% over the next 20 years
However, I don't believe the full burden of generating new revenue streams should be placed on just a small sliver of the population. Rather, I'd like to see the aggregate payroll tax rise by 10 basis points per year over two decades, equaling a 2 percentage-point increase to 14.4% from 12.4%. This would mean all workers would owe this gradually higher tax rate over time.
Mind you, most working Americans are employed by someone else or a company and therefore have half of their payroll tax liabilities paid for by their employers. This would mean that the typical worker would only see a 1 percentage point increase (6.2% to 7.2%) in their payroll tax liability over the next 20 years. People who are self-employed, though, would face the full brunt of the 2% hike.
3. Increase the full retirement age to 70 by 2040, then index to longevity
Next, I'd recommend raising the full retirement age to 70, with annual increases of two months to the FRA through 2040. These are currently set to end in 2022 at age 67 but would be continued until 2040, at which time the full retirement age would be 70. Remember, since Social Security was signed into law in 1935, the full retirement age has risen by less than two years, while average life expectancy has risen by more than 16 years. Allowing retired workers to receive a payout for 20 or more years with regularity from Social Security is a major strain on the program.
When a person reaches age 70, I'd suggest the full retirement age, as well as the claiming-age-based payout schedule, be indexed to match longevity. In other words, if life expectancy rises by, say, three years between 2040 and 2055, then the full retirement age should increase by three years to match. At the same time, eligible beneficiaries should continue to have the option of waiting until up to three or four years after their full retirement ages to begin taking their benefits in order to receive a 24% to 32% boost to their payouts.
In my view, modestly increasing the tax cap, gradually raising the payroll tax on all workers, gradually increasing the full retirement age, and ultimately indexing it and the payout schedule to longevity, will make Social Security a lot stronger than it is today.
The $16,728 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,728 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.