Beware! Each of These Social Security Fixes Carries a Hidden Flaw

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Social Security is arguably the most important program for the nearly 41 million seniors who received a benefit check in Aug. 2016, according to the Social Security Administration. Unfortunately, it's a program that appears headed for trouble.

The latest annual report from the Social Security Board of Trustees suggests that the program is on track to switch from a cash inflow to a cash outflow by the year 2020, resulting in the eventual depletion of more than $2.8 trillion in spare cash by 2034. If Social Security were to exhaust this spare cash, which is invested primarily in special issue bonds, the trustees predict that an across-the-board benefits cut of up to 21% may be needed to sustain the program through 2090. Given that a majority of seniors who've filed for benefits count on Social Security to provide at least half of their monthly income, a 21% benefits cut could prove devastating.

Long story short, lawmakers on Capitol Hill need to come to an agreement on how best to address Social Security's long-term budgetary shortfall.

These Social Security fixes carry hidden flaws

Now here's the kicker: Lawmakers aren't at a loss for ideas. There are more than a dozen different proposals to fix Social Security, and some of them would eliminate most, if not all, of the projected budgetary shortfall over the next 75 years. But what seniors and working Americans may not realize is that many of these solutions (even the popular ones) have hidden flaws.

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1. Raise the payroll tax earnings cap

Unquestionably the most popular solution to fix Social Security is to raise or eliminate the payroll tax earnings cap for wealthier individuals.

Currently, payroll taxes allow the Social Security Administration to collect 12.4% of earned income up to $118,500. This figure is subject to change on an annual basis, and it tends to increase side by side with wage growth. Since most American workers earn less than $118,500 per year, it means they're being taxed on every dollar they earn, albeit responsibility for this 12.4% payroll tax is usually split down the middle between you (6.2%) and your employer (6.2%). Any earned income above and beyond $118,500 is free and clear of being taxed by the Social Security Administration.

Advocates of raising the payroll tax earnings cap include Democratic presidential nominee Hillary Clinton. While Clinton hasn't settled on a specific number, an inferred idea has been that she would raise the payroll tax earnings cap to $250,000. This would allow payroll tax to be collected on earned income between $1 and $118,500, provide a moratorium on payroll tax collection for Social Security between $118,500 and $250,000, and reinstitute the 12.4% payroll tax on earned income above and beyond $250,000. Since most Americans don't make this much, it has the strongest support of any Social Security fix proposed to date.

However, raising the payroll tax earnings cap also has a hidden flaw: It simply doesn't fix the problem of a budgetary shortfall. Having the rich pay more into the program could buy lawmakers more time to come up with additional solutions, but according to the Centers for Retirement Research at Boston College, raising the payroll tax earnings cap resolves only an estimated 30% of the budgetary shortfall. In other words, benefit cuts would still be in the cards at some point in the next generation or two in order to keep the social program solvent. Not to mention, having the well-to-do pay more without seeing a commensurate increase in their Social Security benefits come retirement may not go over well.

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2. Freeze the purchasing power of benefits for middle- and upper-income seniors

While nowhere near as popular as raising the payroll tax earnings cap, freezing the purchasing power of Social Security benefits at 2016 levels would certainly go much further in reducing or eliminating the projected budgetary shortfall.

Just as the plan implies, benefits for new enrollees would be frozen at 2016 levels, meaning that as the price of goods and services grew, new beneficiaries' benefit checks would be static. Freezing benefits across the board, regardless of income decile, would essentially eliminate the budgetary shortfall. Of course, freezing benefits on the poorest income deciles could prove devastating.

A compromise of the above involves freezing the purchasing power of benefits on higher-income deciles while protecting say the bottom 30%, 40%, or 50% of income earners. This way lower-income individuals would still see their benefits increase on par with the Consumer Price Index for Urban Wage Earnings and Clerical Workers (CPI-W), while more well-to-do individuals would have their benefits frozen, since they're presumably better off financially.

The problem? Freezing benefits on middle- and upper-class workers could inadvertently impact lower-income beneficiaries who rely on the auxiliary benefits of a higher-income spouse. A study on the distributional effects of price indexing on Social Security benefits in 2010 found that women would be particularly susceptible since they often have a lower average Social Security benefit than their male counterparts as a result of taking time off from work to raise their children or to care for sick family members. If higher-earning spouses' benefits are frozen, it could ultimately hurt household income for quite a few lower-income decile individuals as well.

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3. Change the cost-of-living adjustment

On the other end of the spectrum from freezing benefits is the idea of changing how benefit increases are calculated.

As noted above, the current formula involves using last years' average CPI-W reading from the third quarter as the baseline, and then examining the average CPI-W from the third quarter in the current year. If it's increased, the percentage difference is the "raise" that Social Security beneficiaries will receive in the upcoming year. Since 2009, the cost-of-living adjustment, or COLA, has been 0% three times, implying that the CPI-W has decreased in value (Social Security benefits are protected from declining on a year-to-year basis due to deflation).

However, the issue is that what seniors spend their money on may not be reflective of what the CPI-W takes into account. A separate price index known as the Consumer Price Index for the Elderly, or CPI-E, factors in the spending habits of persons aged 62 and up. The CPI-E gives more credence to housing and medical expenditures, whereas the CPI-W puts more weight into education, entertainment, transportation, and apparel spending. Presumably, switching from the CPI-W to CPI-E would result in more accurate COLAs and extend the life of the Social Security program.

This somewhat popular plan also comes with two hidden flaws. To begin with, as with raising the payroll tax earnings cap, it doesn't come close to bridging the budgetary shortfall. Switching to the CPI-E may allow for added time to come up with solutions to fix Social Security, but it's more a Band-Aid than a fix.

The other problem is that the CPI-E takes into account the spending habits of tens of millions of fewer Americans than the CPI-W. Although two-thirds of Social Security beneficiaries are indeed seniors, and it would make sense that price indexing were somehow tied to their needs, the CPI-W offers a more encompassing view of Americans' spending habits since it includes far more people.

As you can see, fixing Social Security is going to be no easy task, which makes it all the more imperative that you have alternative sources of income in place when you retire, and that you have a working budget ready to go that'll keep your saving and spending habits on track before and after you retire.

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Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.

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