the inflation-adjusted (or "real") implicit rate of return averaged more than 25 percent annually for the earliest retirees covered by Social Security. For the baby boomers (those people born between 1946 and 1964), the real implicit rate of return is projected to be around 2 percent, according to a Social Security Administration (SSA) study. Implicit returns that workers receive also vary on average by their earnings level, by the number of their dependents and survivors, by their life expectancies, and whether they become disabled. These characteristics vary by race and gender and therefore the associated implicit rates of return do also. 9. What is social insurance? Under a social insurance program, society as a whole insures its members against various risks they all face, and members pay for that insurance through contributions to the system. Social Security is a social insurance program through which the government assumes some of the responsibility for a variety of risks that workers face regarding their retirement income security. Such risks include individually based risks, such as how long they will be able to work, how long they will live, whether they will be survived by a spouse or other dependents, how much they will earn and save over their lifetimes, and how much they will earn on retirement savings. Workers also face some collective risks, such as the performance of the economy and the extent of inflation. Different types of retirement income embody different ways of assigning responsibility for these risks. For example, employers sponsoring defined benefit pension plans bear the risk of investing a plan's assets and ensuring that contributions are adequate to fund promised benefits. In contrast, individuals saving for retirement bear that investment risk. SOCIAL SECURITY'S REVENUES 10. Where do Social Security's revenues come from? Social Security's revenues generally come from three sources: contributions in the form of payroll taxes, interest on the trust funds, and While these early beneficiaries may have received a substantial income transfer within the Social Security system, as a group they contributed substantial amounts outside the system to the retirement incomes of their parents' generation, which did not qualify for Social Security benefits: Such contributions included not only income support that some provided to their own parents but also taxes and charitable contributions that paid for other forms of support. Dean R. Leimer, Cohort-Specific Measures of Lifetime Net Social Security Transfers, working paper 59 (Washington, D.C.: SSA, Office of Research and Statistics, Feb. 1994) income taxes attributable to Social Security benefits. In 2004, the shares of total revenue were • 84.1 percent from payroll taxes, ⚫ 13.5 percent from interest on the trust funds, and • 2.4 percent from income taxes on Social Security benefits. 11. How much is the Social Security payroll tax? In 2005, workers pay a payroll tax of 6.2 percent of their covered wage çarnings up to $90,000 into Social Security, that is, into the OASDI trust funds. Their employers pay an equal amount for a combined total tax rate of 12.4 percent. Most analysts agree that employees ultimately pay the employers' share because employers pay lower wages than they would if the employers' contribution did not exist. Self-employed workers pay 12.4 percent, but they are allowed an income tax deduction for half of the payroll tax. This deduction parallels the favorable tax treatment that employers receive on their share of the payroll tax. Of the 12.4 percent tax, 1.8 percent is allocated specifically to Disability Insurance. The other 10.6 percent is allocated to Old-Age and Survivors Insurance. In addition, workers and their employers each pay a payroll tax of 1.45 percent of all wage earnings (without any cap) into Medicare. When Social Security started collecting payroll taxes in 1937, the total payroll tax rate was 2 percent. Higher rates were not necessary because only a small share of the elderly had contributed enough to the program to qualify for benefits. As the system matured-that is, as each year passed and another group of people reaching retirement age qualified for benefits— benefit costs increased and tax rates eventually were increased accordingly. When the program began, payroll taxes were anticipated to increase over time with the growth in benefit payments as the system matured and more retirees received benefits. 12. Why is there a cap on taxable earnings? The cap on taxable earnings in 2005 is $90,000. This cap is technically known as the contribution and benefit base because the same cap also effectively limits the earnings that can be used in the benefit formula. This in turn limits the size of benefits, reflecting the program's role of only providing for a floor of protection. Limiting the size of benefits also limits the program's costs and the payroll taxes needed to pay for them. The cap on taxable earnings has also changed over time. The maximum annual earnings subject to the payroll tax were only $3,000 in 1937. However, in 1937, 97 percent of all covered workers had total earnings below $3,000. In recent years, about 94 percent have had total earnings below the taxable maximum. 13. What interest rate do the Social Security trust funds earn? In 2004, the Social Security trust funds earned interest at an effective nominal annual rate of 5.7 percent (or 3.1 percent after inflation). By law, the Social Security trust fund invests in securities backed by the federalgovernment and receives a relatively low return that reflects the low level of relative risk. The interest rate on special Treasury securities is equal, at the time of issue, to the average market yield on outstanding marketable government securities not due or redeemable for at least 4 years. This statutory rate was intended to confer neither an advantage nor a disadvantage on the trust fund but was intended to approximate how much it would cost the government to borrow from the public for the long term. 14. Why are Social Security benefits taxed? Since 1984, some Social Security beneficiaries have had to pay federal income tax on up to one-half of their Social Security benefits. 10 These income tax revenues are returned to the Social Security trust funds. In 2004, they provided 2 percent of the trust funds' total income." Currently, about two-thirds of Social Security beneficiaries are not affected by the taxation of benefits. This tax treatment of Social Security benefits roughly parallels the tax treatment of similar defined-benefit pension benefits. 12 In addition, because of changes in 1993, some of these beneficiaries also have to pay federal income taxes on an additional 35 percent of their benefits. However, the additional revenues collected from this source are 10 Individual income tax filers pay this tax if their adjusted gross income plus tax-exempt interest income plus one-half their Social Security benefits exceeds $25,000. A married couple filing jointly will pay the tax if this income exceeds $32,000. These levels are not adjusted for inflation, so the percentage of beneficiaries paying tax on Social security benefits is expected to rise in the future. 11. The Social Security trust funds also receive interest income that is not subject to tax. In 2004, 14 percent of the trust funds' income came from interest on the Social Security trust funds. 12In most defined-contribution pensions, such as 401(k) plans, contributions are made from taxdeferred income and participants are subject to income taxation on all benefits they receive. dedicated to the Hospital Insurance (HI, or Medicare Part A) trust fund and do not increase OASDI revenues. 15. What does "pay-as-you-go financing" mean? Social Security is financed largely on a pay-as-you-go basis. In a payas-you-go system, contributions that workers make in a given year are used primarily to pay beneficiaries in that same year. Social Security is now temporarily deviating from pure pay-as-you-go financing by building up reserves that are by law invested in Treasury bonds. This situation has arisen partly because the baby boom generation makes the size of the workforce larger relative to the beneficiary population. In contrast, in a fully funded, or advance funded, system, contributions for a given year are put aside to pay for future benefits. The investment earnings on these funds contribute considerable revenues and reduce the size of contributions that would otherwise be required to pay for the benefits. Defined-contribution pensions and individual retirement accounts (IRAs) are fully funded by definition, as the benefits received equal the funds accumulated in the account. Also, defined-benefit employer pensions are designed with the goal of being advance funded: however, at any given point in time total assets may be more or less than accrued liabilities and obligations. The pension funds accumulate substantial assets that constitute a large share of national saving. Virtually from the beginning, Social Security was financed on a payas-you-go basis. Congress had rejected the idea of advance funding for the program. Many expressed concern that if the federal government amassed huge reserve funds, it would find a way to spend them. Social Security has run a surplus (e.g. $151 billion in fiscal 2004). Also, if the trust funds were invested in private securities, some people would be concerned about the influence that government could have on the private sector (e.g. social investing). SOCIAL SECURITY AND THE FEDERAL BUDGET 16. How do the Social Security trust funds relate to the federal budget? The Social Security trust funds are sub-accounts within the federal accounting and budget systems. Trust funds are budget accounts that are used to record receipts and expenditures earmarked for specific purposes and designated as trust funds by law. 13 The Department of the Treasury has permanent authority to make Social Security benefit payments when there is a fund balance sufficient to make those payments. As a result, benefit payments do not require annual appropriations from Congress. The trust funds also provide a contingency reserve to help ensure that short-term economic downturns do not result in funding shortfalls. The Social Security trust funds are not included in the measure of the federal budget that is known as the "on-budget” deficit. However, the trust fund's "off-budget" status does not change the way its year-to-year finances contribute to the government's impact on the economy. Therefore, Social Security is included, along with all other federal programs, in the commonly used unified budget measure. The unified budget measures the government's current incremental borrowing from the public and related draw on financial markets. Social Security's current cash surplus, plus interest earned on treasury securities held by the trust funds, partially offsets the deficit in the rest of the government's accounts. (See table 2 and fig. 5.) *This includes the $151 billion Social Security surplus and a $4 billion surplus for the Postal Service. 13 GAO, Federal Trust and Other Earmarked Funds: Answers to Frequently Asked Questions, GAO-01-199SP (Washington, D.C.: Jan. 2001). |