Social Security system isn't bankrupt-- yet, but it needs fixing

In mid-May, the trustees of the U.S. Social Security system issued their annual report.

The conclusion of the report is stated clearly and succinctly: "Projected long-run program costs for both Medicare and Social Security are not sustainable under currently scheduled financing and will require legislative corrections if disruptive consequences for beneficiaries and taxpayers are to be avoided."

One bit of information from the report that got some attention was that the total payouts in benefits have finally surpassed the collection of revenue from payroll taxes. This was not unexpected; we have known for a long time that the retirement of the baby boomers would eventually cause this to happen.

What was surprising is that it happened this year and that it is projected to remain this way for the foreseeable future. Last year's report projected this flipping point would occur in 2015.

The Social Security system is a pay-as-you-go system. Revenue collected from workers is used primarily to pay for the benefits of retirees. Only a small fraction of revenue (about 8.5 percent this year) goes into the trust fund. This is in contrast to most other retirement plans, where most or all of the revenue collected goes into holdings of financial assets earmarked specifically for future benefits.

Social Security is still generating net surpluses today because it earns interest on the $2.7 trillion held in the trust fund. The system is expected to start generating net deficits starting in 2022. From that point on, the balance in the trust fund will begin to fall until it drops to zero in the year 2035.

Once this milestone is reached, the system faces a conundrum. Since the Social Security trustees do not have the legal authority on their own to raise taxes or lower promised benefits and cannot issue debt obligations, they will have no choice but to pay only some portion of promised benefits. That will initially be about 80 percent.

The scenario laid out above is true as far as it goes, but it also misrepresents how our fiscal system actually works.

The Social Security trust fund holds all its assets in the form of U.S. Treasury securities. Since these are normally very safe assets, this might actually be prudent, but it also means that the trust fund is effectively a fiction. The trust fund is a set of government assets that is backed by the same government's debt. This means the public debt is not as big as reported, and it also means there is no nest egg tucked away in a secure vault somewhere.