What Military Members Need to Know About the Future of Social Security
If you’ve read the headlines, you’ve probably heard that Social Security is in financial trouble. In fact, Social Security posts a disclaimer on your statement, saying that “by 2035, the payroll taxes collected … will be enough to pay only about 80% of currently scheduled benefits.” In other words, if Congress does nothing by 2035, 20-25% of all Americans will experience a permanent reduction in their payments.
If you, for example, expected to earn $3,000 a month in benefits, you may only receive $2,400 a month instead. But don’t panic yet. Let’s look at how Social Security works and what might be done to fix the problem.
Understanding Social Security
Social Security works by taxing the paychecks of those who are currently working. These taxes are your contributions that pay benefits to those who are eligible (retirees, widows, disabled, etc.). You can think of Social Security as a wealth transfer between generations, generally from younger workers to older retirees, but also to beneficiaries (mostly widows and children) .
In contrast, your own contributions to your TSP and the ultimate benefits of your military pension (assuming you vested by minimum service requirements) are legally owned by you the contributor. You own that money, even if your employer goes bankrupt or out of business. That’s not how Social Security works.
The Social Security Administration (SSA) takes 12.4% a year out of your wages. You pay 6.2%, and your employer pays 6.2%. You, as an employee, pay half (6.2%), and your employer (the DoD) pays the other half. One common exception is for the self-employed. In that case, you are your own employer, and you pay the entire 12.4%.
Payroll taxes account for over 90% of the money that goes into SS, called “program receipts.”
Program receipts go to a type of savings account called the Old Age, Survivor, and Disability Insurance (OASDI). OASDI is a trust fund managed by the US Treasury that immediately pays benefits to those who are eligible. When program receipts (what goes in) exceed immediate benefit payments (what goes out), excess funds are invested in US Treasury bonds and held in reserve for future periods. When program receipts are insufficient to cover immediate benefit payments, bonds in the trust fund (if available) are redeemed to cover the shortfall.
Nearly all program expenditures go to paying benefits, with less than 1% spent on administration. Eligible beneficiaries include retirees and their families, surviving spouses and dependents, and those who are disabled and their families.
How Social Security Calculates Your Benefits
The program calculates how much benefit you will get using a formula based on your average monthly work earnings over 35 years. The formula averages your highest-paying working years and adjusts the amount for inflation. The result is called your Average Indexed Monthly Earnings (AIME). Your AIME is then used to calculate your potential SS benefit. This is called your Primary Insurance Amount (PIA).
How to Calculate AIME
The formula for your AIME is as follows: 1) take how much you earned in every year, up to the maximum contribution or benefit base for that specific year; 2) for years prior to the year in which you turned 60, inflate those amounts using the national average wage index; 3) rank your pre-60 indexed earnings along with your 60+ unindexed earnings from highest to lowest; 4) add up the highest 35 yearly figures; 5) divide the total by 420 months to get your AIME. Note that to qualify for retirement benefits, you must have 10+ years of earnings on which you paid Social Security payroll taxes. And, if you paid into Social Security for <35 years, all non-contributing years are considered zeroes in the AIME formula.
The formula for your PIA is the sum of three separate percentages of portions of your AIME. The percentages of the PIA formula are fixed by law at 90%, 32% and 15%, respectively. Since the percentages are declining for each portion of your AIME, the PIA formula is progressive. The dollar amounts in the formula (called “bend points”), which govern the portions of the AIME, change annually with changes in the national average wage index. For 2023, if your AIME is greater than $6,721, your PIA = 90% x ($1,115) + 32% x ($6,721 – $1,115) + 15% x (AIME – $6,721). For example, if your AIME is $8,000 your PIA in 2023 would be $2,989.
The PIA formula is progressive, meaning Social Security provides proportionally higher monthly benefits to lower-income workers. For example, retirement benefits may replace about 45% of a middle-income worker’s AIME vs. about 27% for a high-income worker. This is good news for most lower income people. Social Security can replace a greater share of their income needed in retirement.
How much retirement benefit you receive depends on your age when you apply or “file.”
Will Social Security Have Enough to Pay Your Benefit?
For almost four decades, Social Security has been cash-flow positive (more was paid in than paid out). In 2021, however, program benefits paid out were more than taxes paid in for the first time since 1982 (more was paid out than was being paid in). By 2020, the trust fund held about $2.91 trillion, enough to fully cover 2.6 years of program expenditures (everyone collecting benefits).
Given the magnitude of the benefits to be paid out (over $1 trillion a year) and the nation’s aging population, the program must rapidly use up its reserves to meet its obligations.
For every 65-year-old potential retiree in 1985, there were 5 workers aged 20 to 64 potentially paying into the SS system. In 2020, there were only 3.5 workers. Those in charge of the trust fund predict that, by 2035, there only will be 2.7 workers for every retiree and just 2.3 by 2080. In other words, fewer and fewer taxpayers will be supporting each eligible beneficiary, or alternatively, each taxpayer will be supporting more and more beneficiaries
The Board of Trustees of the OASDI trust fund (“Trustees”) predict the trust fund will be depleted by 2035, at which point program receipts (payroll taxes) will be enough to pay about 80% of promised benefits. In short, the trust fund will run out, but all the Social Security benefits will not.
What Can Fix Social Security?
Experts propose a few solutions to the problem. One is to increase how much Social Security takes out of a worker’s paycheck by a few percentage points (pay higher taxes). Another solution is to reduce the size of benefits. The longer Congress delays, however, the bigger the problem becomes and the more drastic the solutions.
To understand what it will take to fix Social Security, the Trustees analyze the program’s cash flows over the next 75 years and beyond. To start, the Trustees sum up the present value of future program receipts, add them to the current balance of the trust fund and subtract the present value of future expenditures. What’s left is an estimate of the program’s financial shortfall over that period. For example, the Trustees estimate the program needs $20.4 trillion of additional assets today to pay all promised benefits over the next 75 years (that’s 1.1% of GDP over that time).
The Trustees estimate that to close the $20.4 trillion shortfall, and pay all promised benefits over the next 75 years, requires an immediate and permanent increase in payroll taxes of 3.24 percentage points, a reduction in benefits of 20.3%, or some combination of the two. Unfortunately, if Congress delays until the trust fund is depleted in 2035, the required changes will be larger—e.g., a 4.07 percentage point increase in payroll taxes, a 24.9% reduction in benefits, or some combination.
Planning in Light of Uncertainty
Does this mean you should be planning on a future without Social Security? I don’t think so. Although the program clearly requires reform, as it did in the 1980s, it is far from bankrupt. It just needs modifications.
Sadly, Congressional action around Social Security tends to arrive at the last minute. Legislators will likely need to shore up the program’s 75-year shortfall using a combination of tax increases and benefit cuts.
For planning purposes, you may need to update your financial plan. For example, in 2023, we could see a 2.035 percentage point increase in payroll taxes (half paid by the employer and half by the employee) and a 12.45% decrease in benefits for all beneficiaries beginning in 2035.
All things equal, this means your financial plan may require more saving and support less spending, especially if you’re younger. That said, no matter the changes, Social Security will likely remain the best longevity insurance most Americans could ever hope for, so take the “doom and gloom” news you hear with a grain of salt. For military retirees with a pension on top of Social Security, they should be even less concerned than the general population.
Social Security and retirement planning are just a few of the thing the MFAA advisors are great a helping their clients figure out. If you’ve got financial questions, consider scheduling a call with one of our advisors.