Budget Basics: How Does Social Security Work?
Last Updated April 19, 2023
Social Security was created in 1935 to provide economic security to the nation’s elderly; it was expanded in the 1950s to include support for people with disabilities. The program is operated largely on a “pay-as-you-go” basis: current employers and employees contribute taxes that fund benefits to retired workers and survivors in the Old-Age and Survivors Insurance (OASI) program as well as disabled workers and their families under the Disability Insurance (DI) program.
Today, Social Security is the largest program in the federal budget and typically makes up almost one-fifth of total federal spending. The program provides benefits to nearly 67 million beneficiaries, or about 20 percent of the American population. Almost 9 out of 10 individuals over the age of 65 receive benefits, representing about 30 percent of total income of older Americans.
Who Receives Social Security Benefits?
Retired workers account for 75 percent of the program’s beneficiaries, and disabled workers make up another 11 percent. The remainder are the survivors of deceased workers, as well as spouses and children of retired and disabled workers.
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 of their total yearly income. However, the benefits received by low-income retirees are modest. Workers who earned an average of $26,400 per year before retirement would receive only $16,208 per year in Social Security benefits if they retired this year at the full retirement age.
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 10 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 under the OASI program is based on their average indexed monthly earnings during the 35 years in which their earnings were highest.1 Benefits are calculated using a progressive formula that provides a higher replacement rate for workers with lower earnings.2 In 2023, workers who retired at age 67 with $26,400 in career-average earnings would receive Social Security benefits that replaced 61 percent of their pre-retirement earnings. By contrast, Social Security benefits to workers earning $59,000 would replace only 45 percent of their career-average earnings.
Full benefits are payable at the normal retirement age, which is between 65 and 67, depending on one’s birth year. Early retirement is possible at age 62, but benefits would be subject to a permanent reduction. Similarly, if retirement is delayed, benefits would be higher when they go into effect. However, nearly half of retirees claim their benefits as early as possible, and about 90 percent of them claim benefits before their full retirement age.
Disability benefits, on the other hand, are paid to people who cannot work due to a medical condition that is expected to persist for at least one year or result in death. Social Security does not grant benefits to individuals with partial or short-term disabilities. The Social Security Administration also pays benefits to disabled adults and children with limited income and resources under the Supplemental Security Income program; that program is reported separately in the budget.
How Is Social Security Funded?
Social Security is mainly funded through a dedicated payroll tax created by the Federal Insurance Contributions Act. Employers and employees each pay 6.2 percent of wages, with a cap on the amount of wages subject to the tax ($168,600 for 2024, adjusted annually for growth in economy-wide wages).3 Self-employed pay both the employee and the employer share of the tax. Those revenues are credited to the OASI and DI trust funds, which keep track of the programs’ receipts and expenses.
The programs also receive income from a tax on Social Security benefits paid by higher-income beneficiaries, as well as 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 effect. Although it is a receipt to the trust funds, it is an equal dollar expense to the Treasury.
Mechanics of Social Security’s Trust Funds
Income is credited to the funds and disbursements for benefits and administration are counted against the funds’ balances. The Social Security Administration 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.
As with other trust funds, Social Security’s surpluses are credited with securities issued by the Treasury; that excess income is used to reduce the amount of new federal borrowing necessary to finance governmental activities. The reverse happens when revenues for the trust funds fall short of their expenses.
The balance of the trust funds is a measure of the historical relationship between receipts dedicated to the programs and their expenditures. Therefore, it is important to understand that securities held by the funds are essentially bookkeeping mechanisms to track cash flows in and out of the accounts. However, trust funds have an important legal meaning in that a balance is required to permit spending from a fund.
Between 1984 and 2009, Social Security ran significant cash surpluses (excluding interest). Such 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 during the 1990s and early 2000s.
In 2010, Social Security began running cash deficits (excluding interest). Without reforms, the trustees project that those cash-flow deficits will grow rapidly. Annual cash deficits are expected to total $2.9 trillion between 2024 and 2035. As Social Security runs those cash deficits, the trust funds will “redeem” their Treasury securities and the Treasury will have to borrow funds from the public to cover the shortfalls.
By 2035, the Social Security Trustees project that the combined Social Security trust funds will be fully depleted. Separately, the OASI fund is projected to have its reserves depleted in 2033; the DI trust fund is not expected to deplete within the 75-year long-range projection period. Once the OASI trust fund is exhausted, the Social Security Administration will be limited to spending only as much as incoming revenues. Retirees could face an immediate 21 percent cut in their scheduled benefits upon depletion of the OASI fund. At that point, 70 million beneficiaries would be affected; the average retiree would incur an immediate benefit cut of around $6,681 in today’s dollars. If the funds of the two programs were combined, the reduction in benefits upon depletion of both funds would be 17 percent in 2035.
Demographics and Social Security
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.
In 2004, the ratio of workers paying taxes to support each Social Security beneficiary was 3:1; by 2044, that ratio is expected to decline to 2:1. As the population of beneficiaries grows faster than the population of workers, expenses will grow faster than income, and the system's finances will become increasingly strained.
Social Insurance and the Distributional Effects of Social Security
The Social Security system provides a form of social insurance against the risk of extreme poverty in old age by redistributing income from higher earners to lower earners.
The lifetime benefit-to-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 1960s birth cohort with income in the middle quintile, the benefit-to-tax ratio is projected to be 1.5, based on calculations using data from the Congressional Budget Office.5 For them, the expected value of their lifetime benefits is about 50 percent more than 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 1960s birth cohort are projected to have a benefit-to-tax ratio of 2.7. That means that their lifetime benefits are expected to be almost three times 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-to-tax ratio of only 1.1, which means that their lifetime benefits are expected to be a little more than 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, though the redistribution is not sufficient for the program to be sustainably funded.
Conclusion
The Social Security system faces major financial challenges. If reforms are not enacted, beneficiaries could face an across-the-board benefit cut of 17 percent in 2035 (on average) when the combined trust fund reserves are depleted. 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.
Any viable reform package will need to balance two priorities: adequacy of benefits for recipients and financial sustainability for the federal government. It should also be announced well in advance and phased in gradually to give people time to prepare and adjust their savings and retirement plans. There are many possible solutions which can be found on our Solutions webpage.
Further Reading
The Cost of Doing Nothing About Social Security
Any change to Social Security will impact how Americans approach retirement decisions, but the costliest choice would be doing nothing.
How Much Government Spending Goes to Children?
Interest costs on the national debt are expected to rapidly outstrip spending on children in coming years.
Swing State Voters Want Harris and Trump to Give Detailed Plans for Shoring Up Social Security
The majority of voters in key battleground states say it’s important for presidential candidates to have a plan to prevent automatic cuts to Social Security.