Social Insecurity: Inside the 'Trust Fund' Illusion

The recent tax deal approved by Congress and the president cut the payroll taxes that employees will contribute to Social Security for 2011 by about a third, and that $112 billion reduction in receipts has advocates of the program worried that the political meddling in Social Security's finances may threaten its viability.

Unfortunately, the Social Security Administration's (SSA) finances have been meddled with for decades, and a one-year tax holiday is the least of the program's problems. As I reported on DailyFinance this week, Social Security is already deep in the red, with outlays exceeding payroll tax revenues by $76 billion in 2010 -- a deficit that wasn't expected to occur until 2018.

Though the program's trustees continue to reassure the public that Social Security's funding is secure through 2037, rising outlays and slumping revenues -- not even counting the "tax holiday" cut -- call that rosy outlook into question. And the trustees' short-term projections have been so far off the mark that the validity of their longer-term estimates must also be in doubt. Their estimate of total revenues was too high by $50 billion in 2010, and their estimate for 2011 income is $855 billion -- fully $114 billion more than the system's 2010 income.

It would require a stupendous increase in employment to hit that mark, and precious little evidence suggests such a powerful hiring boom is in the works. Instead, there's plenty of evidence that the current recovery is a jobless one: 9 million jobs -- 8% of all private-sector jobs -- have vanished since 2008, and another 8% more have slipped from full-time to part-time or temporary. America's millions of self-employed, freelance and contract workers have seen their incomes decline by 5%.

But if payroll taxes don't rebound strongly in 2011 and beyond, the long-term viability of Social Security will be in doubt, because with the baby boomers beginning to retire en masse, the number of people receiving benefits is climbing rapidly.

About One-Fifth of the Federal Budget

To understand the basics of Social Security's cloudy future, we need a quick refresher on the system.

Social Security has over 53 million beneficiaries -- 17% of the U.S. population of 312 million, or about 1 in 6 Americans. As a comparison, that's substantially more than the entire population of Spain (46.5 million). Its outlays in fiscal year 2010 totaled $707 billion, about one-fifth of the $3.45 trillion federal budget. And its payouts will inexorably rise in coming decades, thanks to the 76 million-strong baby boom generation. The first boomers qualified for Social Security in 2008, and over 3 million more enter the system every year.

Social Security is a "pay as you go" retirement system, intended to run with a surplus designed to fund future shortfalls. Payroll taxes paid by current workers and employers fund today's retiree benefits, and the difference between tax receipts and outlays -- a surplus, until recently -- is transferred to the U.S. Treasury.

In exchange for this excess cash, the Treasury issued the Social Security Trust Fund special nonmarketable securities. The Trust Fund now holds about $2.6 trillion in these securities. (Technically, there are two trust funds, one for the main Social Security program and one for Disability Insurance, but the SSA usually combines the two.)

If You Can't Sell a Bond, Is It Worthless?

Though the SSA doesn't state it directly, what this means is that the Treasury took $2.6 trillion in Social Security cash surpluses and transferred it to the federal government to spend on other government programs. (For context, the total net wealth of U.S. households is $54.9 trillion, according to Federal Reserve data.)

The fact that the Treasury bonds the Trust Fund received in return for that $2.6 trillion are nonmarketable -- that is, they aren't bonds that can be sold on the global bond market -- has led some observers to characterize them as worthless.

The Social Security Administration defends the worthiness of its special bonds in its FAQ page:

"The [surplus] money flowing into the trust funds is invested in U.S. Government securities. Because the government spends this borrowed cash, some people see the current increase in the trust fund assets as an accumulation of securities that the government will be unable to make good on in the future. Without legislation to restore long-range solvency of the trust funds, redemption of long-term securities prior to maturity would be necessary.

Far from being 'worthless IOUs,' the investments held by the trust funds are backed by the full faith and credit of the U.S. Government. The government has always repaid Social Security, with interest. The special-issue securities are, therefore, just as safe as U.S. Savings Bonds or other financial instruments of the Federal government."

This debt to Social Security is called "intragovernmental holdings," and it is included in the total national debt, along with other special Treasury securities held by other agencies.

The "Trust Fund" Is Not a "Lockbox"

What the Social Security website fails to explain is where the Treasury gets the money to redeem those bonds. The answer: It borrows the money on the global bond market by selling freshly issued real Treasury bonds.

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In other words, Social Security's nonmarketable bonds are merely markers for actual Treasury bonds, which must be sold, and for which interest must be paid. Thus, Social Security is entirely dependent on the Treasury's sale of new bonds for its future solvency. If interest rates spike or global buyers become wary of buying trillions of dollars in U.S. T-bills, costs for that borrowing will skyrocket, crowding out all other federal spending.

As a result, U.S. taxpayers are now paying twice for their Social Security benefits: Once through payroll taxes, and again when the Treasury uses their taxes to pay interest on the bonds it sold to fund Social Security.

This is not some far-in-the-future issue: The Treasury reported in October that it had to sell new bonds to fund Social Security shortfalls in 15 of the previous 25 months.

A Budgetary Illusion

Another way of understanding the hollowness of Social Security's nonmarketable securities is to ask: What difference would it make if we erased the Trust Fund from the ledger?

The answer: none whatsoever. In the "Trust Fund" we now have, when Social Security's outlays exceed its payroll-tax income, then the Treasury sells freshly minted bonds and transfers the cash to Social Security. If we eliminated the so-called Trust Fund, the exact same thing would occur: When Social Security's outlays exceed its payroll-tax income, the Treasury would sell bonds and transfer the cash to Social Security.

This thought experiment reveals that the Trust Fund is illusory, but the reality is that the U.S. Treasury will have to borrow $2.6 trillion on the global bond market to redeem Social Security's nonmarketable securities. That means the Social Security system is totally dependent on the Treasury's ability to sell trillions of dollars of bonds at interest rates that won't cripple the federal government.

The Treasury borrowed $1.3 trillion in 2010 just to fund the federal deficit. As baby boomers retire and payroll taxes remain stagnant, the Treasury will have to borrow substantially more to fund shortfalls in Social Security. If the global bond market hesitates to buy more Treasury debt at low interest rates, then all federal programs will feel the impact -- including Social Security.