Today, the discussion of Social Security's long-term financial challenges is pretty much limited to when the consequences arrive rather than how we will manage them when they arrive.
These consequences are generally expressed in terms of the unfunded liability, or "financing shortfall". While these outcomes are dire and getting worse every year, the public debate about Social Security reform suggests that these measures are not completely understood.
The "unfunded liability" represents the amount of money that the government would need to invest today in order to reasonably expect Social Security to operate over a specific timeframe. The calculation of the figure converts the difference between projected revenue and expected expense into a present value. For example, if the experts believe that Social Security will spend $1 more than it will collect in 2086, the math would add roughly $0.15 to the total because that amount invested today will grow into $1 in 2086.
Generally, the shortfall is expressed over 75 years, roughly the time to get all voting-aged Americans through the system. According to the Social Security Trustees Report for 2016, the present value of the financing gaps over that period equals $11.4 trillion. So if we add that amount of money today, the system should function for 75 years. In year 76, the system would be just as troubled as it is today.
While many pundits use unfunded liabilities in definitive terms, the calculation is not an exact science. The figure is a ballpark warning of what should happen in a normal economy if we do nothing.
If $11.4 trillion sounds unpleasant, you need to understand that the 75-year projection is fundamentally flawed because the concept does not truly reflect the actual mechanics of Social Security. The math tends to understate the actual problem.
Social Security is a financed program. Every dollar that comes into the program creates promises of future benefits for the worker who made the contribution. Conceptually, this is no different from going to a bank to borrow money in the form of a loan. Unfortunately, the 75-year projection shows the unfunded obligation of Social Security as though the "loan" payments due in the 76th year and afterward do not exist.
There is no free lunch in Social Security. This reality is demonstrated by the projections for expanding the coverage of Social Security to nearly 5 million state and local workers. Yes, the current taxes paid by the new workers would improve the near-term finances. The system would however be worse off by the 75th year due to the benefits that would be paid to these new workers in retirement.
The second weakness of the 75-year calculation is affected by the passage of time. The trustees reported in the 2016 report that solely changing the valuation date would have added $500 billion to the unfunded liabilities of the program. That is a lot for a program that only collects $800 billion in total.
Part of the increased cost comes from the discounting process in which we have one less year to discount. Over the past year, the $1 gap for 2086 has grown from $0.15 (2015 $s) to $0.16 (2016 $s). In other words, the unfunded liabilities grow just like debt that accrues a normal rate of interest.
The rest of the cost comes from changing the timeframe. Over the past year, the definition of solvency changed to the period from 2016 to 2090. So the valuation has replaced 2015 – a year with a modest surplus – with 2090 – a year with a large shortfall.
In conjunction, we can add $11.4 trillion to Social Security, and the system will meet the definition of solvency for a year. The next year it likely will not. Time is the Achilles Heel of Social Security, much more so than demographics. The difference is demographic forces may from time to time make the system better off, but time never will.
Today the discussion of Social Security is limited to the length of the fuse. Virtually no one is talking about the increasing size of the bomb.
This article was provided by our partners at moneytips.com.
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