Social Security: Trust Funds, Actuarial Balance, Sustainable Solvency

Social Security arithmetic isn’t hard. Tedious perhaps and with counter-intuitive results but once certain terminological obstacles are swept away not requiring advanced math skills. But oy that terminology! This post proposes to start demolishing those conceptual barriers.

Social Security is considered ‘solvent’ when its ‘Trust Fund’ is in ‘actuarial balance’. The Social Security Trust Fund was created pursuant to the Social Security Amendments of 1939 to hold any excess of dedicated Social Security revenue over cost and serves primarily as a reserve fund. Those excess revenues are held in the form of interest earning Special Treasuries with that interest being included as revenue. When the accumulated principal including retained interest equals 100% of projected NEXT YEAR cost the Trust Fund is considered to be in ‘actuarial balance’. Now since Social Security income and cost project to change each year ‘actuarial balance’ cannot effectively be measured in nominal dollar terms because a year end 2012 balance equal to 100% of 2013 projected cost will generally be something less than 100% of 2014 cost. And this quite aside from any fluctuations in the economy, that is all things being equal a steady-state Social Security system requires a steadily increasing Trust Fund principal balance to be judged in ‘actuarial balance’.

Meaning ‘fixing’ Social Security, making it ‘solvent’, means something more than restoring actuarial balance for the current year, instead it requires having the system project to maintain ‘actuarial balance’ over time. Historically the Trustees of Social Security established two different measures of solvency: ‘short term actuarial balance’ and ‘long term actuarial balance’. ‘Short term’ here means the same 10 year budget window used by the rest of government, if year end principal balance in the SS Trust Funds projects to be 100% or greater (in SS jargon a ‘trust fund ratio of 100 or more’) in EACH of the next 10 years Social Security ‘meets the test for short term actuarial balance’. Similarly if the TF ratio projects to be 100 or more in EACH of the next 75 years Social Security meets the test for ‘long term actuarial balance’. In the last couple decades ‘short term’ and ‘long term’ actuarial balance have been supplemented by two new ways of considering solvency. In 2002 we saw the introduction of  ‘Infinite Future Horizon’, that is in principle extending solvency to Heat Death of the Sun. More reasonably for long-term planning purposes is something called ‘sustainable solvency’ which takes into account the predictable increase in structural cost year over year and argues that ‘long term actuarial balance’ should include not just years 1-75, but also the trend for year 76 and after. That is we shouldn’t just fix Social Security for 2012, we should take steps to make sure it won’t fail the test for ‘long term actuarial balance’ come 2013.

Okay having (I hope) adequately defined ‘solvency’, ‘actuarial balance’, ‘trust fund ratio’, ‘Infinite Future Horizon’ and ‘sustainable solvency’ we can develop some implications below the fold.

What would ‘sustainable solvency’ look like? Now given that year 76 total cost will be predictably more than year 75 year total cost even if the current year 75 year model is perfect, it follows that maintaining a trust fund ratio of EXACTLY 100 requires a small increase in Trust Fund balance EACH year. Which is where things start getting odd.

Okay assume we have a Trust Fund with a principal balance equal to 100% of next year’s cost where that principal is held in interest earning Special Treasuries whose interest is in turn counted as income. Further assume that all non-interest SS income for the upcoming year projects to be equal to projected cost. What is the result for the Trust Fund? Well one thing to recognize is that maturing Special Treasuries are not in themselves counted as ‘income’. If the dollars represented by those Treasuries are not needed for current year cost they are simply retained and rolled over into new issues. The second is that interest on the current portfolio IS counted as ‘income’ but if not needed to pay current year cost is itself rolled over into new Special Treasuries. That is under the assumptions of our current scenario, where NON-interest income equals current cost, the result will be retention of 100% of principal augmented by interest converted to new principal in the form of new issues along side those rolled over.

Simple enough but with some odd results. Under our scenario maturing principal is not redeemed for cash, it is simply exchanged for new Special Treasuries with new (typically) 10 year maturities. And a few seconds of thought shows that in a steady state system of  ‘sustainable solvency’ they might NEVER need to be redeemed for cash. In fact, and this is a key point, they would all need to be retained and augmented with new principal sufficient to maintain that Trust Fund ratio of 100. Meaning that those Treasuries, though real interest earning obligations of the U.S. government, never actually get paid off.

This tends to throw supporters of Social Security for a loop. Because they often believe that the Trust Funds were established in 1983 as a method of pre-funding Boomer retirement and were ALWAYS expected to be paid down to zero and so be temporary: “Reagan borrowed the money to pay for tax cuts, they NEED to pay it back”. Well actually under ideal circumstances they don’t need to pay it back. They only need to honor the obligation by continuing to pay and/or credit interest on the accumulated principal with the latter being retained to maintain the crucial function of ‘sustainable solvency’ as measured by ‘trust fund ratio’.

And this is where things get hairy, because note I said in reference to interest that it needs to be paid and/or credited. And by ‘credited’ I mean retained in the form of new Special Treasuries sufficient to maintain a trust fund ratio of 100. Which means that portion of interest retained to maintain an overall condition of ‘sustainable solvency’ is never paid off by cash transfers either. In terms understandable to Paulite TeaTards those Special Treasuries used to roll over existing principal and to ‘finance’ retained interest are just ‘fiat money’. Or in terms understandable by the rest of us ‘Interest Earning Obligations backed by Full Faith and Credit of the U.S.’

If this sounds crazy it is probably because Social Security is not now in ‘sustainable solvency’. Although on a combined basis the OASDI Trust Funds do meet the test for ‘short term actuarial balance’ they DO NOT meet the ‘long term’ test and still less either the test for ‘sustainable solvency’ (i.e. year 76 and some years after) or ‘infinite future’ (i.e. year 76 and EVERY year for centuries to come). Under current projections Trust Fund principal will need to be redeemed for cash starting in the 2020s and project to be totally redeemed by the mid 2030s. But given a sensible worker friendly fix that starts by taking the numbers and methodology of the Social Security Reports seriously they don’t need to be.

(After all it is eminently sensible to maintain a prudent reserve and reasonable enough to consider a TF ratio of 100 to be a simple minimum. On the other hand there is a limit beyond which too much reserve actually becomes dangerous (topic for another post). And when I started blogging on this in 2004 it appeared we were on that dangerous ‘over-funded’ path. But the 2007 recession took care of THAT problem with the result that TF ratios are already dropping from their peak even as they still remain right around 350 (three and a half years of reserve). Of course there is no real world problem with those ratios dropping, that is after all what the extra reserve is for, to be tapped as needed. On the other hand simple prudence mandates putting into place a plan to keep them from dropping to levels which would cause the failure of  ‘short term actuarial balance’ and even to put them onto a glide path towards ‘long term actuarial balance’ and heck even ‘sustainable solvency’. Which (cough, cough) the Northwest Plan for a Real Social Security Fix does even as it maintains 100% of the current law scheduled benefit. Even as it largely avoids substantial paydown of Trust Fund principal in nominal terms, instead putting Social Security on the path to permanent TF ratios in the 130 range.)

What then would ‘sustainable solvency’ look like from the perspective of the General Fund? Well for one thing the Social Security Trust Fund balance, while still being a very real claim on the future, with a minimum amount of due diligence never actually become itself ‘due’. Not in cash anyway. And interestingly neither will that portion of accrued interest needed to maintain the targeted TF ratio whether that be 100 or 130 or whatever. On the flip side not all interest can simply be credited to the Trust Fund as new Special Treasuries without potentially boosting the TF ratio to a point where worker’s rebel as a prudent ‘reserve’ transmutes into an interest free loan to the General Fund. I mean who is the ‘moocher’ or ‘looter’ in that scenario?

I leave as an exercise for the reader to poke at the numbers and see what part of Trust Fund interest simply gets retained as Special Treasuries (and so not financed from the real economy) to maintain minimum TF ratios as opposed to that portion of that interest that needs to be paid out in benefits to keep that TF ratio below acceptable sustainable maximums, which for the sake of argument we could put at 166. Whatever is the result of the offset due to retained interest is in effect the discount on the cash interest rate and under standard Intermediate Cost assumptions is something like 40% off the nominal rate. But it doesn’t discount to zero, the Trust Fund never becomes (or shouldn’t anyway) a purely free lunch. Pretty cheap for the social utililty and equity Social Security delivers but not cost free. As Chief Actuary of SS Steve Goss explained in a crucially important article in the 70th anniversary edition of the Social Security Bulletin: The Future Financial Status of the Social Security Program  (bolding mine)

However, the occurrence of a negative cash flow, when tax revenue alone is insufficient to pay full scheduled benefits, does not necessarily mean that the trust funds are moving toward exhaustion. In fact, in a perfectly pay-as-you-go (PAYGO) financing approach, with the assets in the trust fund maintained consistently at the level of a “contingency reserve” targeted at one year’s cost for the program, the program might well be in a position of having negative cash flow on a permanent basis. This would occur when the interest rate on the trust fund assets is greater than the rate of growth in program cost. In this case, interest on the trust fund assets would be more than enough to grow the assets as fast as program cost, leaving some of the interest available to augment current tax revenue to meet current cost. Under the trustees’ current intermediate assumptions, the long-term average real interest rate is assumed at 2.9 percent, and real growth of OASDI program cost (growth in excess of price inflation) is projected to average about 1.6 percent from 2030 to 2080. Thus, if program modifications are made to maintain a consistent level of trust fund assets in the future, interest on those assets would generally augment current tax income in the payment of scheduled benefits.

That is within stated limits neither the fact nor the timing of Social Security going cash flow negative means a damn thing in the bigger picture. Something some commenters have a hard time grasping.