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Key Takeaways

• Almost one in every five Americans receives income support from Social Security.
• Social Security is financed on a pay-as-you-go basis, which means that today’s workers’ payroll taxes are used to pay benefits to today’s beneficiaries.
• Changes in population demographics, including longevity improvements, have resulted in a sharp decline in the number of workers per beneficiary, and this trend is projected to continue.
• As a result, Social Security is facing significant financial challenges and policymakers must take action to ensure its long-term sustainability.

Social Security provides income security to more than 65 million Americans who are either retired or disabled or have experienced the death of a working spouse or parent. The program has reduced poverty among the elderly and given a measure of financial security to those who have paid into the program during the course of their careers. However, Social Security is facing significant financial challenges and policymakers must take action to ensure its long-term sustainability.

This policy brief will address how Social Security works and its importance for retirement.  It will describe how Congress changed the program in 1983 — the last time significant reforms were made — and outline the program’s current financial status as well as the differences between the risks facing Social Security now relative to 40 years ago. The policy brief will conclude with prescriptions and challenges for reforming the program.

Social Security:  The basics

Social Security was created in 1935, began collecting taxes in 1937, and paid its first benefits in 1940. Retirement benefits are calculated based on a worker's highest 35 years of earnings, where past earnings are first indexed upward for the growth of the national average wage. The earnings that determine Social Security contributions and benefits are subject to a taxable maximum, set at $160,200 in 2023. The maximum taxable salary is increased each year along with economy-wide wage growth. Retirement benefits are lowered for those who claim benefits before the full retirement age (67 for those born in 1960 and later), while those who delay claiming benefits receive an increase in their monthly payment.  Since benefits are paid until death, people who choose to claim early receive a lower monthly benefit amount for a longer expected time. 

Social Security was designed to provide a guaranteed income in retirement to protect seniors against the risk of outliving their savings. The program's benefit formula is designed to be progressive and replaces a higher percentage of pre-retirement earnings for lower lifetime earners than for higher lifetime earners.  While Social Security is not an explicit anti-poverty program — in that benefits are not based upon need — the progressive tilt of the Social Security benefit formula has reduced elderly poverty over time. Each year during retirement, the benefits are automatically increased by the rate of inflation.

Social Security is financed primarily on a pay-as-you-go basis, which means that payroll taxes collected from today’s workers are used to fund today's benefits. But Social Security also has two trust funds, the Old Age and Survivors Insurance (OASI) Trust Fund and the Disability Insurance (DI) Trust Fund. The trust funds hold the surplus funds generated by payroll taxes when the program is in surplus and draw down assets to pay benefits when the program runs deficits, as it has since 2010.

Payroll taxes are paid by employees and employers. The OASDI payroll tax rate is 6.2 percent for employees and 6.2 percent for employers for earnings below the taxable maximum ($160,200 in 2023). Self-employed individuals pay both the employee and employer portions of the payroll tax. Social Security also receives income from the taxation of Social Security benefits and interest earned on the trust funds’ assets.

The importance of Social Security in retirement

In 2015, Social Security represented 30 percent of income on average for individuals age 65 and over. Forty percent of all seniors in 2015 received 50 percent or more of their income from Social Security. Meanwhile, 14 percent of all seniors received 90 percent or more of their incomes from the program.[1] Social Security is a critical source of income for those who are widowed and low-income retirees, and Social Security represents a larger share of retirement income for women than for men.

Inequality in life expectancy has significant implications for the distributional consequences of Social Security. Lower-income individuals tend to have lower life expectancies than higher-income individuals, meaning that they may receive fewer years of Social Security benefits. This means that the increasing gap in life expectancy by income works against the progressivity in the benefit formula.[2]  

Figure 1 below shows life expectancy at birth for people at the 10th, 50th, and 90th percentile of the income distribution.  As shown in the figure, life expectancies are higher for those with higher income and, while life expectancies have increased for each group, the gains for those with more income have been larger than for those with less income.

Figure 1:  Life expectancy by income percentile, 2001-2014

Source: Equality of Opportunity Project

The 1983 amendments and the financial status of Social Security

The 1983 congressional amendments were significant reforms to Social Security, designed to address the program's short- and long-term financial sustainability.

Due to severe inflation and lower-than-expected wages in the early 1980s, the Social Security trust funds were at immediate risk of not being able to pay scheduled benefits in 1983. Insolvency would have prompted short-term reductions to Social Security benefits, though the program was projected to return to solvency by 1990 as the large baby-boom generation reached its peak earning and taxpaying years.

The 1983 reforms addressed short-term solvency by accelerating an increase in the combined employee and employer payroll tax rate from 10.8 to 12.4 percent, previously scheduled to take place by 1990, and by delaying the 1984 Cost of Living Adjustment by six months, a step that amounted to a one-time reduction in current benefits of about 1.75 percent.

Long-term solvency was improved by scheduling a two-year increase in the full retirement age, from 65 to 67, to take place between 2000 and 2022, and making 50 percent of Social Security benefits subject to income taxes for beneficiaries with incomes above $25,000 in nominal terms, a provision that generates increasing revenue over time as nominal income increases raise the share of retirees whose benefits are subject to income taxes.

The 1983 amendments increased revenues for the program, which helped to address the program's long-term funding shortfall, which was a significant concern at the time.  However, by 1984 the Social Security trustees once again projected an actuarial deficit over a 75-year window, with a trust fund depletion date in the mid-2030s projected by the trustees as early as 1993.

The projected that the OASDI Trust Fund will be depleted in 2034 and that the program faces a long-run actuarial deficit equal to 3.61 percent of wages subject to payroll taxes. This means that the deficit over the 75-year window could be closed either with an immediate and permanent payroll tax rate increase of 3.61 percent; an immediate across-the-board benefit reduction of 21.3 percent; or some combination of current and future tax increases and benefit cuts. The Congressional Budget Office’s show an even larger deficit of 4.9 percent of taxable payroll. The policy changes would need to be even more drastic in order to balance the program over a longer time horizon, as the shortfall is projected to grow larger over time.

After the trust funds are depleted, Social Security will still be able to pay a portion of promised benefits, with the level of payable benefits decreasing over time as revenues decline. The payable portion of benefits is projected to be 80 percent in 2034, declining to 74 percent by 2097, as shown in Figure 2 below.

Figure 2:  Old-Age, Survivors, and Disability Insurance (OASDI) Income, Cost, and Expenditures as Percentages of Taxable Payroll

Source:  2023 Social Security Trustees Report, Figure II.D2.

In the 40 years since this last major reform to the Social Security program, people are living longer and fertility rates are declining, resulting in more retirees per worker.  These demographic shifts combined with the pay-as-you-go nature of Social Security — where today’s workers’ payroll taxes are used to fund today's beneficiaries’ benefits — result in a trend toward increasing annual deficits.

Figure 3:  Fertility, Mortality, and the Number of Workers per Beneficiary

Source:  2023 Social Security Trustees Report, Figures V.A1, V.A5, II.D3.  Total Fertility Rate refers to the average number of children that would be born to a woman if she were to experience, at each age of her life, the birth rate observed in, or assumed for, the selected year, and if she were to survive the entire childbearing period.  Life Expectancy at Age 65 represents average remaining number of years expected prior to death for a person age 65, born on January 1, using the mortality rates for that year over the course of his or her remaining life.  Values beginning in 2022 are projected assuming Social Security’s intermediate cost scenario.

The effect of demographics on Social Security costs can be approximated in the following way. The average Social Security benefit in 2023 is projected to be equal to about 39 percent of the average worker’s wage in that year. If there are 2.7 workers for each beneficiary, as the Social Security actuaries estimate for 2023, the cost per worker is 14.4 percent of their wages (where 14.4 percent represents 39 percent divided by 2.7). If there were five workers per beneficiary, as there were in 1960, that same benefit could be funded at a cost of just 7.8 percent of worker’s wages. Likewise, if the worker to beneficiary ratio falls to 2.3, as is projected by the year 2035, the cost per worker rises to 16.9 percent of wages.

It is important to note that while the retirement of the baby-boom generation accelerated these trends, the underlying changes in mortality and fertility are projected to continue. Thus, Social Security is not expected to return to financial balance even after the baby-boom generation has passed on.

Principles for reforming Social Security

There are several principles that policymakers should consider when evaluating potential Social Security reforms. These include ensuring the program's long-term financial sustainability, maintaining the program's progressivity, protecting vulnerable populations, and avoiding sudden changes that could have significant impacts on beneficiaries.

However, these principles may come into conflict with each other. For instance, phasing in reforms slowly could reduce the impact of such changes on Social Security participants, but would make it more difficult to restore the program to long-run financial health. Likewise, a uniform benefit change that maintained the program’s current level of progressivity could reduce Social Security’s effectiveness at protecting the lowest-income beneficiaries.

Moreover, policymakers may consider more radical changes that alter the broader structure of Social Security. For instance, some countries, such as Australia and New Zealand, fund their retirement programs from general tax revenues rather than from a dedicated payroll tax. Likewise, those countries, as well as the United Kingdom and Canada, focus their retirement expenditures more closely on lower-income retirees while limiting benefits to higher-income seniors.

Barriers to reform and the cost of waiting

There are several barriers to reforming Social Security, including political polarization, the difficulty of making changes to a popular program, and the complexity of the program's finances and benefits.

Delaying Social Security reform could have significant costs. As the population ages, the number of beneficiaries will continue to grow, putting additional strain on the program's finances. Waiting too long to address Social Security's long-term funding shortfall could result in sudden benefit cuts or tax increases, which could have significant impacts on beneficiaries.

In this context, it is worth contrasting the financial situation that will face policymakers when the trust funds are projected to run dry in 2034 versus the conditions that prevailed in 1983, the last time Social Security faced insolvency.

While the 1983 funding crisis was driven by short-term economic changes that drew down the modest trust fund balance then held by the plan, Social Security’s projected insolvency in 2034 is largely the result of demographic changes that have been long in the making. At the same time, the 1983 funding shortfall was substantially more modest than what faces policymakers in 2034.

Had Social Security’s trust fund run out in 1983, Social Security beneficiaries would have faced benefit reductions of about 4 percent on average over a period of six years. By 1990, payroll taxes revenues from the large baby-boom generation would have returned Social Security to annual surplus and the trust funds were projected to remain solvent until between 2025 and 2034.

By contrast, if the trust funds are allowed to become exhausted in the 2030s, beneficiaries would face reductions of around 20 percent in their benefits, roughly five times larger in percentage terms than policymakers faced in 1983. Moreover, those cuts would increase over time, with practically zero possibility that the program would return to solvency on its own without structural changes. Thus, while the 1983 reforms were a model of bipartisan compromise, elected officials face an even larger task in addressing Social Security’s solvency today.

Conclusion

Social Security is an essential program that provides critical support to millions of retirees, survivors, and disabled individuals. However, the program's long-term financial sustainability is at risk due to demographic and economic changes. Policymakers must consider a range of potential reforms to ensure that the program can continue to provide vital support to current and future generations of beneficiaries.

While reforming Social Security is challenging, policymakers must act to address the program's long-term funding shortfall and ensure that the program can continue to meet its important mission.