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Social Security Benefits Going Up--But Not for Everyone

Baird's Tim Steffen explains why some beneficiaries won't see an increase and looks at the state of Social Security today.

Jeremy Glaser: Social Security benefits are set to rise 2.8% next year. Here to discuss that and the state of Social Security as a whole is Tim Steffen. He is the director of advanced planning at Baird.

Tim, thanks for joining me.

Tim Steffen: Thanks, Jeremy.

Glaser: I just mentioned that 2.8% increase in Social Security benefits. But not all beneficiaries will experience that. Who won't see that increase?

Steffen: First of all, the 2.8%, that's one of the bigger increases we've seen. I think it's been since 2011. Maybe the largest increase last year was 2.0% which seemed like a big one at that time. So 2.8% is a pretty significant increase relatively speaking for Social Security benefits. The downside is, not everybody is going to get the full benefit of that, and particularly, those who have been subject to something called the Medicare hold harmless provision. That's basically a rule that says, as Medicare premiums increase, they can't cause a reduction in your Social Security benefits. Most people have Medicare premiums paid right out of their Social Security.

In the past, Medicare premiums have been rising faster than Social Security, so they haven't been able to apply that entire increase to some retirees. Now that Social Security benefits are going up a little more, those retirees are going to see a bigger jump in their Medicare benefits which will eat into more of that Social Security increase they are getting. Those who haven't been subject to what they call the hold harmless, they are going to get the full 2.8%, and then Medicare premiums will go up a little bit as well. Those who have been protected by that in the past though, it's going to catch up and kind of flip around in them this year and they may not see the full 2.8% now.

Glaser: That's on the benefits side. But on paying into Social Security, that's also indexed to inflation, the amount of income that's subject to FICA tax. What's happening there? How will that impact higher earning income?

Steffen: Like with benefits themselves, the amount of income that's subject to the FICA tax is always adjusted for inflation as well. We saw a pretty decent size increase in that this year, too. For 2018, the first $128,700 of what they call earned income, that's your wages paid by your employer or self-employment income, that's subject to the 6.2% FICA tax. That is going to go up in 2019 to $132,900, so about a $4,200 increase in the amount of income subject to the tax. You apply a 6.2% rate to that, so that means anybody who is over that $132,900 number is going to pay about $260 or so of additional tax next year that will go into their Social Security benefit.

Glaser: Let's pull back and look at the health of the system as a whole. Where do you characterize how healthy the system is? Without any changes, how would it run from here?

Steffen: We're probably not quite to life support yet, but it's certainly in critical care anyway. There's certainly a need to pay attention to the future of Social Security. We've been hearing this for a long time, we're running out of money, running out money; 2018 was a pretty significant year and we really turned the corner when it comes to the future of Social Security. By that I mean this is the first year we've seen now where total retirement benefits paid out of the system will be more than the tax revenue coming in and the investment income inside the trust fund. The benefits paid out have exceeded tax revenue now for a few years. This is the first year they have actually exceeded tax revenue and investment earnings. From an accounting standpoint, the trust fund is in a true deficit position. There will be less money in the trust fund at the end of this year than it was at the end of last year. Again, that's the first time that's happened in a while.

The trust fund is in a precarious situation, and what they are projecting is that come 2034, that trust fund is going to be empty. They won't be able to continue to pay the same benefits that they've been paying in the past. That doesn't mean that they are going to stop paying benefits. Just because the trust fund is out of money, doesn't mean benefits stop. It just means they can't pay what they used to. They are going to have to rely on the tax revenue coming in from those who are still working. That effectively means about a 21% cut in benefits come 2034, barring any other changes to the system.

Glaser: Let's look at what some of those changes could be. One would be potentially to raise taxes, have a higher rate. Is that something that you think could make a different in that trust fund?

Steffen: One of the things the Social Security Administration or the trustees do is they take a look at what are the different options that are available for extending the life of the trust fund. One of those is raising taxes. What they have said in the last couple of years is that to increase taxes on those paying into the system, you are looking at about a 2.8% increase in the payroll tax, if you did something today. Now, that 2.8% could be split between employees and employer. But that's what you would take today to extend the life of the trust fund out for this 75-year window that they look at. If they waited until the trust fund runs out of money, then you are looking at about a 3.8% increase to extend it out. It's one of those things where the longer you wait, the bigger the cut is going to be or the bigger the increase it's going to have to be.

One of the other suggestions out there is, this wage base that we talked about earlier, that $132,900, what if we just got rid of that and said there is no cap on earnings. What if all earnings were subject to FICA tax. Well, that would be a pretty massive increase in taxes, but it would do a lot to shore up the fund as well. What the actuaries are saying is that if you remove that cap on wages and then didn't increase benefits paid at all--so you just said, you are going to pay more tax into the system, but you are not going to get a larger benefit as a result of that--that would actually add about 40 years to the life of the system. That's a pretty significant increase and enhancement to the program at the cost of a pretty major tax increase. You're talking about 12.4% tax increase on anybody with income over that threshold. That's a big number.

Glaser: On the other side though, you could see benefit cuts as well. You talked about what could happen if it runs out. Does that 20% cut seem like about what would have to happen to shore things up without raising taxes?

Steffen: What the board of trustees is saying is that if you were to cut benefits today on all beneficiaries right now, anybody who is getting a benefit right now, you'd have to cut it about 17%. If you just cut it on future retirees--so leave existing retirees alone, but cut in future ones right now--it's about 21%. If you wait until 2034, you are adding a few points on to that as well.

It's one of those that the longer they wait to do something, the bigger the hits going to have to be. It's pretty clear from those who look at it that neither one of those options, the 12.4% tax increase or some other tax increase or the cut in benefits just in and of itself is going to be acceptable to most people. It's going to take a combination of those two. Realistically, you are looking at a combination of tax increases, benefit cuts, maybe some changes to retirement age, a lot of those other things out there.

Glaser: Tim, I appreciate the update.

Steffen: Thanks, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.