Social Security was created during the 1930s with the goal of providing economic security to the nation’s elderly, and was expanded in the 1950s to include support for the disabled. The program is established largely on a “pay-as-you-go” basis, current employed workers contribute taxes that fund benefits to retired and disabled workers and their families.
Today, Social Security is the largest single program in the federal budget and makes up approximately one quarter of total federal spending. The program provides benefits to more than 59 million beneficiaries, or about 18 percent of the American population. Nearly 9 out of 10 individuals over the age of 65 receive benefits, and benefits represent, on average, 39% of total income to the elderly.
Workers become eligible for Social Security benefits for themselves and their family members by working and paying Social Security taxes. Generally, a worker must have ten years of employment to be eligible for retirement benefits. Disability benefits depend on the worker’s earnings before disability, and the worker’s age at disability.
A worker’s initial monthly benefit is based on her career-average earnings.1 Benefits are calculated using a progressive formula that provides a higher replacement rate for workers with lower earnings.2 In 2016, a worker who retired at age 66 with $20,000 in career-average earnings would receive Social Security benefits that replaced 62% of her pre-retirement earnings. By contrast, Social Security benefits to workers earning $50,000 would replace only 44% of their career-average earnings.
Full benefits are payable at the full retirement age, which is between 65 and 67, depending on one’s birth year. Early retirement is possible at the age of 62, but benefits are subject to a permanent reduction. Similarly, if retirement is delayed, benefits are higher upon retirement. However, nearly half of retired-worker beneficiaries claim their retirement benefits as early as possible, and almost all of them claim before the full retirement age.
Retired workers account for 67 percent of the program’s beneficiaries. Disabled workers make up another 15 percent of beneficiaries. The remaining 18 percent are the survivors of deceased workers, as well as spouses and children.
Social Security is a major source of post-retirement income for low-income seniors. For seniors at the bottom of the income distribution, benefits make up over 80 percent their total yearly income. However, the benefits received by the low-income retirees are modest. Workers who earn $20,000 in career-average earnings before retirement would be expected to receive only $12,400 per year in Social Security benefits (in 2016 dollars) if they retired this year at the full retirement age.
Social Security is mainly funded through a dedicated payroll tax created by the Federal Insurance Contributions Act (FICA). Employers and employees each pay 6.2% of wages, with a cap on the amount of wages subject to the tax ($118,500 for 2016, adjusted annually for growth in economy-wide wages).3 Those who are self-employed pay both the employee and the employer share of the tax. These revenues are credited to the Social Security Old Age and Survivors Insurance and Disability Insurance (OASDI) trust funds, which keep track the programs’ receipts and expenses.
The program receives income from two other sources: a tax on Social Security benefits paid by higher-income beneficiaries and income generated by the investment of the trust fund reserves in non-marketable U.S. Treasury securities. However, from the perspective of the government’s overall budget, the interest income paid to the trust funds by the Treasury has no impact. Although it is a receipt to the trust funds, it is an equal dollar expense to the Treasury. Its net effect on the unified budget is zero.
The Social Security trust funds are used to conduct the financial operations of the OASDI programs. Income is credited to the funds and disbursements for benefits and administration are counted against the funds’ balances. The Social Security Administration (SSA) has the legal authority to spend any accumulated balances plus any incoming revenues. However, once a trust fund balance reaches zero, spending cannot exceed incoming revenues.
Between 1984 and 2009, the program ran significant cash surpluses (excluding interest). These surpluses were primarily the result of program reforms enacted in 1983. Those reforms slowly raised the retirement age and increased payroll taxes, which produced substantial trust fund reserves (or balances) during the 1990s and early 2000s.
Social Security’s surpluses are accounted for as an obligation of the Treasury to the trust funds and the funds are used in the general budget. It is important to understand, however, that while the surpluses are “invested” in Treasury securities, those securities are nothing more than IOUs. The funds are not actually set aside in any way. Instead, they are used to finance other government activities, which effectively reduced the level of overall deficits and debt that the government took on during the 1990s and early 2000s.
In 2010, Social Security began running cash deficits (excluding interest). Without reforms, the trustees project that cash-flow deficits will grow rapidly. Between now and 2034, the annual cash deficits will total $2.8 trillion dollars. As Social Security runs those cash deficits, the trust funds will “redeem” their Treasury securities, leading the Treasury to borrow funds from the public to cover the shortfalls. Those actions will increase the government’s overall budget deficits and its debt held by the public.
By 2034, the trust funds will be fully depleted. Once the trust funds are exhausted, the Social Security Administration will lack the legal authority to spend resources it does not have. At that point, spending will have to match incoming revenues, which puts 88 million beneficiaries at risk of an across-the-board benefit cut of 21 percent. For a retiree with average pre-retirement earnings, that would be an immediate benefit cut of approximately $5,360 in today’s dollars.
The transition from annual Social Security surpluses to annual Social Security deficits is the result of the changing demographic composition of the United States. The program is financed largely on a pay-as-you-go basis, which means that today's workers pay Social Security taxes into the program and money immediately flows back out as monthly income to beneficiaries. A pay-as-you-go system works well as long as there are enough workers contributing to the system to cover its costs.
However, as baby boomers retire and life expectancy continues to increase, the number of Social Security beneficiaries is projected to climb sharply. Between 2010 and 2030, the ratio of workers paying taxes to support each Social Security beneficiary declines from 2.9:1 to 2.3:1. As the population of beneficiaries grows faster than the population of workers, expenses will grow faster than income, and the finances of the system will become increasingly strained.
Because the Social Security system provides a form of social insurance against the risk of extreme poverty in old age, it redistributes income from higher earners to lower earners.
The lifetime benefit/tax ratio is one way to assess the degree of redistribution among people with different levels of career-average incomes and from different birth cohorts.4 If the ratio is less than one, people are expected to receive lifetime benefits that are less than their lifetime taxes; if it is greater than one, lifetime benefits are expected to exceed lifetime taxes.
For people in the 1960 birth cohort with income in the middle quintile, the benefit/tax ratio is projected to be 1.0, based on calculations using data from the Congressional Budget Office.5 For them, the expected value of their lifetime benefits roughly matches their expected contributions. This measure accounts not only for their projected path of earnings, but also the expected length of their life.
By contrast, people who are in the lowest income quintile of the 1960 birth cohort are projected have a benefit/tax ratio of 2.0. That means that their lifetime benefits are expected to be twice the amount that they contributed into the system, even after accounting for their shorter-than-average life expectancies.
At the same time, those in the highest income quintile in the 1960s birth cohort are projected to have a benefit/tax ratio of only 0.7, which means that their lifetime benefits are expected to be only 70% of the taxes that they paid. These results illustrate how Social Security provides social insurance: it redistributes income from retirees who have higher earnings to those with lower earnings.
The Social Security system faces major financial challenges. If reforms are not enacted, beneficiaries could face an across-the-board benefit cut of 21% in 2034 when the trust funds are exhausted. Because of the critical importance of this program for ensuring financial security for many retired and disabled people — especially those with low incomes — reforms are needed to ensure that the program can continue to provide benefits. There are many possible solutions which can be found on our Solutions webpage.
Any viable reform package will need to balance two priorities: adequacy of benefits for recipients and financial sustainability for the federal government. Any sensible reform should be announced well in advance and phased in gradually to give people time to prepare and adjust their saving and retirement plans.
1 Career-average earnings are measured by average indexed monthly earnings (AIME). Earnings before age 60 are adjusted by the growth of economy-wide wages, then the highest 35-years of indexed earnings are averaged.
2 In 2016, the first-year monthly benefits to workers claiming benefits at the normal retirement age are 90% of the first $856 of the AIME, 32% of the AIME between $856 and $5,157, and 15% of the AIME above $5,157.
4 The benefit/tax ratio is the expected present value of lifetime benefits divided by the present value of payroll taxes. Present value converts a stream of future benefits or taxes into an equivalent lump-sum amount received or paid today.
5 The estimates in the section are based on numbers from CBO’s 2015 Long-Term Projections for Social Security: Additional Information (December 2015). The benefit-tax ratios are based on payable benefits.