Policy Basics: Understanding the Social Security Trust Funds
Few budgetary concepts generate as much unintended confusion and deliberate misinformation as the Social Security trust funds. Despite being described by some as “funny money,” or “IOUs,” the Social Security trust funds are invested in Treasury securities that are just as sound as the U.S. government securities held by investors around the globe; investors regard those securities as being among the world’s safest investments. Although Social Security has a long-term financial shortfall that must be closed, the program’s combined trust funds will not be depleted until around 2034, which gives policymakers time to develop a carefully crafted solvency plan.
September 21, 2017
How Do the Trust Funds Work?
Social Security’s financial operations are handled through two federal trust funds — the Old-Age and Survivors Insurance (OASI) trust fund and the Disability Insurance (DI) trust fund. Although legally distinct, they are often referred to collectively as “the Social Security trust fund.” All of Social Security’s payroll taxes and other earmarked income are deposited in the trust funds, and all of Social Security’s benefits and administrative expenses are paid from the trust funds.
In years when Social Security collects more in payroll taxes and other income than it pays in benefits and other expenses — as it has each year since 1984 — the Treasury invests the surplus in interest-bearing Treasury bonds and other Treasury securities. Social Security can redeem these bonds whenever needed to pay benefits. The balances in the trust funds thus provide legal authority to pay Social Security benefits when the Social Security program’s current income is insufficient by itself.
What Is the Trust Funds’ Financial Status?
Social Security is adequately financed in the short term but faces a modest long-term financial shortfall amounting to 1.0 percent of gross domestic product (GDP) over the next 75 years, the period that the program’s actuaries use in evaluating the program’s long-term finances. Social Security has run a surplus in every year since 1984, as was anticipated when Congress enacted and President Reagan signed the legislation based on the recommendations of the Greenspan Commission in 1983.
Social Security is adequately financed in the short term but faces a modest long-term financial shortfall amounting to 1.0 percent of gross domestic product (GDP) over the next 75 years.
Under current projections, the combined Social Security trust funds will continue to run annual surpluses until 2022. The interest income that the trust funds earn on their bonds, as well as the proceeds the trust funds will receive when their bonds are redeemed, will enable Social Security to keep paying full benefits until 2034.
In 2034, the combined trust funds are projected to run out of Treasury bonds to cash in. At that point, if nothing else is done, Social Security could still pay three-quarters of its scheduled benefits using its annual tax income. Contrary to a common misunderstanding, benefits would not stop. Of course, paying three-quarters of promised benefits is not an acceptable way to run the program, and Congress will need to act to restore long-term solvency to this vital program.
Most analyses of Social Security focus on the combined OASI and DI trust funds, since both are integral parts of Social Security, but the two trust funds are, in fact, separate. The DI trust fund faces exhaustion in 2028, and the much larger OASI fund is projected to last until 2035. Congress must therefore act by 2028 to replenish the DI trust fund. Increasing the share of the payroll tax that is allocated to DI (and reducing the OASI share) would assure that both the OASI and DI programs remained solvent through 2034.
Is It Better to Act Sooner Rather Than Later?
Not necessarily. Some people mistakenly suggest that Social Security’s shortfall gets larger the longer policymakers wait to address it, but that’s only an artifact of the projections. The annual Social Security trustees’ report includes projections that span the next 75 years. For example, the 2016 report included projections for 2016-2090, while the 2017 report includes projections for 2017-2091. Including the relatively large deficit for 2091 in the projection increases the estimated 75-year gap, even if the shortfall in each individual year of the projection remained the same.
That said, acting sooner to address the shortfall, whether by reducing benefits, raising contributions to Social Security, or a combination of the two, would spread the burden over more generations of workers and beneficiaries and allow for smaller future adjustments. For example, if Social Security tax increases were phased in soon, current workers could contribute to restoring solvency. But if payroll tax increases were delayed until the 2030s, they would fall entirely on younger workers still in the labor force after that date, and the required increase would be larger. At the same time, however, future generations will be more prosperous and better able to afford adjustments. Policymakers will need to balance these competing concerns.
Acting sooner to restore Social Security solvency would give workers plenty of notice about changes so that they can plan their work, saving, and retirement. It would also strengthen public confidence in the system by easing worries about its financing. Social Security faces no imminent crisis, however, and policymakers have time to develop a carefully crafted solvency package that minimizes cuts to the program’s modest but critical benefits.
How Are the Trust Funds Invested?
The Social Security trust funds are invested entirely in U.S. Treasury securities. Like the Treasury bills, notes, and bonds purchased by private investors around the world, the Treasury securities that the trust funds hold are backed by the full faith and credit of the U.S. government. The U.S. government has never defaulted on its obligations, and investors consider U.S. government securities to be one of the world’s safest investments.
The Treasury securities held by the trust funds have some special features that make them even more attractive investments than other Treasury securities. First, the trust funds’ investments do not fluctuate in value and can always be redeemed at par. Even if the securities must be redeemed early, Social Security is guaranteed not to lose money on its investment. Second, all of the securities purchased by the trust funds — even short-term securities that will mature in one or two years — earn interest at the same rate as medium- and long-term Treasury securities (those not due or callable for at least four years).
By the end of 2016, the trust funds had accumulated over $2.8 trillion worth of Treasury securities, earning an average interest rate of 3.2 percent during that year. The Social Security Administration provides monthly reports on the investment holdings of the trust funds, their maturities, and interest rates. The trustees project that the trust funds will earn $86 billion in interest income in 2017.
Is the Federal Government “Raiding” the Trust Funds?
No. Some critics have suggested that the lending of Social Security trust fund reserves to the Treasury represents a misuse of those funds. This view reflects a misunderstanding of how the Treasury manages the federal government’s finances.
When the rest of the budget is in deficit, a Social Security cash surplus allows the government to borrow less from the public to finance the deficit. (The “public” encompasses all lenders other than federal trust funds, including U.S. individuals and institutions, the Federal Reserve System, and foreign investors.) The Treasury always uses whatever cash is on hand — whether from Social Security contributions or other earmarked or non-earmarked sources — to meet its current obligations before engaging in additional borrowing from the public. There is no sensible alternative to this practice. After all, why should the Treasury borrow funds when it has cash in the till?
Money that the federal government borrows from the public or from Social Security is used to finance the ongoing operations of the government in the same way that money deposited in a bank is used to finance spending by consumers and businesses.
Back in 1938, the first Advisory Council on Social Security — a group of independent experts appointed to review the program’s long-term finances — firmly endorsed the investment of Social Security surpluses in Treasury securities:
The United States Treasury uses the moneys realized from the issuance of these special securities by the old-age reserve account in the same manner as it does moneys realized from the sale of other Government securities. As long as the budget is not balanced, the net result is to reduce the amounts which the Government has to borrow from banks, insurance companies and other private parties. When the budget is balanced, these moneys will be available for the reduction of the national debt held by the public. The members of the Advisory Council are in agreement that the fulfillment of the promises made to the wage earners included in the old age insurance system depends upon, more than anything else, the financial integrity of the Government. The members of the Council, regardless of differing views on other aspects of the financing of old-age insurance, are of the opinion that the present provisions regarding the investment of the moneys in the old-age reserve account do not involve any misuse of these moneys or endanger the safety of these funds.
Other Advisory Councils have reached the same conclusion.
Money that the federal government borrows from the public or from Social Security is used to finance the ongoing operations of the government in the same way that money deposited in a bank is used to finance spending by consumers and businesses. In neither case does this represent a “raid” or misuse of the funds. The bank depositor will get his or her money back when needed, and so will the Social Security trust funds.
When Social Security needs to start cashing in its holdings of Treasury securities to meet its benefit obligations, the federal government will have to increase its borrowing from the public, or raise taxes or spend less. That will be a concern for the Treasury — but not for Social Security, as long as the solvency of the federal government itself is not called into question. Social Security will be able to sell its bonds just as any private investor might do.
Would Investing the Trust Funds in Other Financial Assets Change the Situation?
No. Although some people have argued that the Social Security trust funds would be more “real” if they were invested in private stocks or bonds, there is nothing to this contention. If there were no change in the total federal budget deficit, such a policy would merely rearrange the holding of assets in the economy and would not change the net financial situation of Social Security, the federal government as a whole, or the private sector. As the Congressional Budget Office has explained:
Clearly, investing trust funds in private investments could have no significant impact on the government’s overall balance sheet. If the Treasury were cut off from access to trust fund moneys, it would have to sell more securities (bills, notes, and bonds) in the credit markets. At the same time, federal trust funds would accumulate more financial assets. Net federal indebtedness — liabilities minus assets — would be little different than under the current arrangement. Conversely, private investors would have to buy more Treasury debt than under current arrangements but would face a shrunken supply of the assets purchased by the trust funds. The upshot would be a rearrangement of public and private portfolios, perhaps accompanied by a small change in the relative returns on various financial instruments.
For example, if the Social Security trust funds were to invest $100 billion in corporate stock, the Treasury would need to finance the non-Social Security deficit by borrowing $100 billion more in private credit markets. As a result, the private sector would hold $100 billion less in equities and $100 billion more in government debt. Neither the government nor the private sector would be better or worse off. Last but not least, investing the trust funds in private stocks and bonds would subject the trust funds to a greater degree of risk.
Is Trust Fund Debt Real?
Yes. Budget experts generally focus on debt held by the public — which reflects what the government must borrow in private credit markets and which excludes trust fund holdings — as the most useful measure of federal debt for economic analysis. Some have argued that it is inconsistent to adopt that focus while simultaneously viewing the debt held by Social Security as real. This argument is incorrect: both measures of debt are important, but they measure different things.
Protecting Social Security requires not only assuring that the program itself is adequately financed but also putting the overall federal budget on a sustainable long-term course.
Debt held by the public is a measure of the federal government’s overall fiscal health. It represents money that must be borrowed and periodically refinanced in private credit markets; interest payments on that debt represent a current drain on government resources. If the specter of excessive debt led investors to lose confidence in U.S. government securities, federal interest costs could increase substantially, with potentially troubling implications for U.S. and world economies.
Debt held by Social Security, by contrast, provides information about the adequacy of the program’s dedicated financing. Debt held by trust funds does not have the same broader economic significance as debt held by the public. Since it does not need to be financed in private credit markets, it cannot lead to a refinancing crisis. As legal authority to spend money in the future, it is essentially similar to legal authority to meet spending commitments for other entitlement programs that are not financed through trust funds and are not included in measures of federal debt. In addition, an increase in trust fund balances that provides authority for higher Social Security expenditures in some distant year is not equivalent to issuing more publicly held debt to finance additional spending today. If additional spending authority leads to more federal borrowing at some time in the future, that borrowing will add to debt held by the public when that spending occurs.
As the 1938 Advisory Council on Social Security wrote in the passage quoted above, “The fulfillment of the promises made to the wage earners included in the old age insurance system depends upon, more than anything else, the financial integrity of the Government.” Protecting Social Security therefore requires not only assuring that the program itself is adequately financed but also putting the overall federal budget on a sustainable long-term course.