The Coming Changes to The Social Security System

Social Security is run like a Ponzi scheme or chain letter that steals from the young to give to the old, and then placates the young by promising to give them a share of the future loot. Trouble is, demographics tell us that the number of old people per worker will increase over the rest of this century, and something will have to be done to cover the debt created by the government's promises. This implicit debt is approximately $11 trillion for Social Security alone. There's another $55 trillion of implicit debt that represents the government's promises to pay future Medicare and Medicaid health benefits to the elderly and the poor, the new Medicare drug benefit, food stamps, welfare payments, all the other transfer payments, and the accrual of interest on the outstanding fiscal gap. The total implicit debt is rising each year by roughly $1 trillion, or $250,000 per newborn.

Though short term fiscal discipline helps, the last five presidents have failed to meaningfully reform these programs, leaving us with projections of transfer payments as a share of GDP that rise insanely over the next seven decades. The less that the current generations pay, the greater the burden that will be left for those coming in the future. It's that simple. Because of the transfer payments to be received by the 77 million baby boomers approaching retirement, the present value of the net taxes of the current adult generation is negative and will drain the so called Trust Fund. Unless we adults make large sacrifices very quickly, our kids will face lifetime net tax rates much higher than those we now face; for example paying off the $66 trillion would require an immediate and permanent 100% hike in federal income taxes.

There's a limit to the fiscal burden we can impose on future generations. Confiscating a higher share of a generation's income will actually lower revenues because at some point that generation will either stop working or stop paying taxes. Basic economics tells us that we need to stabilize the tax rates levied on successive generations.

So if future generations can't pay the bills, what can we expect in the way of changes to Social Security in the immediate future?

For sure we can expect more tinkering around the edges. It's much easier to cut the growth of a benefit that to reduce or eliminate it once people have come to expect it. In recent years we have seen incremental changes that have included:

• Increasing the payroll tax (from 2% in 1937 to 12.4% today).
• Increasing the full retirement age (from 65 to 67).
• Increasing the amount of wages subject to the payroll tax, (this year it increases from $97,500 to $102,000).
• Increasing the taxation on Social Security benefits once they are received.

These incremental changes are not enough to eliminate the approximately $11 trillion deficit problem faced by Social Security. That requires a major overhaul. The most recent attempt at a major change, Bush's proposal to privatize the system, failed to gather support and died. There are some good ideas out there that would reform the system (Economist Larry Kotlikoff has proposals in his great book 'The Coming Generational Storm'), but even the best of these ideas must result in some pain to the current generation, those either already in retirement or now approaching it.

Will the politicians of the next Congress make the necessary changes, or will they pass the buck and do nothing? The fact that the elderly vote with great regularity means it's probably easier for politicians to default on other debt than on their Social Security and Medicare promises. Barring a drastic cut in these entitlement programs, or a rapid and radical rehaul of their financing structure through increasing taxes, the federal government will be forced, at some point, to print money to "meet" its bills. The result would be inflation that waters down the real value of the repayment. Inflation leaves creditors stuck with relatively worthless currency, causes your savings to evaporate, and reduces the living standards of retirees living on a fixed income, for example from annuities.

High inflation and high interest rates have wrecked economic and political havoc in scores of countries over the years and would do the same here. Do you remember the most recent use of inflation to default on US federal debt? In the 1970's, inflation reached double digits, and our government informally wiped out much of the real value of about half a trillion dollars of official obligations for the Vietnam War, when it made interest and principle payments with watered down dollars. Those were not happy times.

It seems a choice of pain now or pain later. How high will future tax, inflation and interest rates be? Any answer is a guess, but at Bay Area Planners we can help you with reasonable assumptions for Social Security and tax rates to be used in your retirement planning.

What do you think will happen to Social Security? Let us know by calling (408) 725-7135 or click here.

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