Social Security: Bankrupt System Will Impact Markets Sooner than Expected

Includes: DIA, QQQ, SPY
by: Bruce Krasting

Steven Gross, the Chief Actuary of the Social Security Trust fund wrote a letter* on 9/15/2008. In that letter he included this graph ():

On 2/12/2009 Mr. Gross wrote a letter* to Senator Robert Bennet. That letter contained this graph ().

The two graphs describe a financial gearing ratio. Note that the data used in the 2008 graph shows a 'surplus' in this ratio through 2025. The updated 2009 graph shows that surplus is gone as of today. This represents a significant change in assumptions over the five month period. Mr. Gross is telling us 'something' is coming. That 'something' is likely to be on the front pages of newspapers as well as impact the markets sooner than was thought.

Here is a link to a report produced by the Trustees of the Social Security Trust Funds (“SSTF”).

This is a status report on the health of America’s Social Security and Medicare system. The conclusions contained in this report should come as no surprise. The system is bankrupt. It is just a matter of time. The magnitude of the problem is enormous. The Trustees estimate that the present value of the unfunded portion is $13.6 trillion. It is virtually certain that unless the imbalances are addressed in the near future, the U.S. Legacy Costs will destroy our economy.

The US is currently spending trillions of dollars in borrowed money to shore up a weakened economy. All of that money will be wasted. At best it will result in a resumption of economic growth for a few more years. By the end of President Obama’s first term the Social Security problem will already be a drag on the economy. By 2016 the damage will be impossible to reverse.

The 2009 SSTF report will likely show a continued deterioration in the footings of the Fund. The dynamics that impact the SSTF include: economic growth, prevailing short and long term interest rates and the rate of payouts. All of these factors are working against the Fund currently. These impacts will foreshorten the day of reckoning.

This observer believes that it is folly to be spending trillions today when it is a given that the system will collapse in less than a decade. Every prior effort to address the looming crisis has been dismissed by DC. That is understandable. It is perceived that this is a problem that will be realized in 2032. That is not correct. The problem is already affecting us. The negative impacts to the broad economy began a few years ago.

The recession that started in 2008 will negatively affect the results of the SSTF. Should economic growth hover near zero for the next twenty-four months the drag from entitlements will become meaningful as early as 2011.

This is from the 2008 SS Trustees report:

Social Security’s current annual surpluses of tax income over expenditures will begin to decline in 2011 and then turn into rapidly growing deficits as the baby boom generation retires. Medicare’s financial status is even worse.

The term used “current annual surpluses” requires a closer look. These surpluses have been a critical component in the success of our economy for the past 60 years. The SSTF has been a net saver since its inception. It currently holds $2.4 trillion of US Treasury IOU’s. That amount is approximately 1/4 of the entire US Public Sector Debt that has been accumulated since 1938. This pool of ‘savings’ helped finance the country’s ever growing deficit. The SSTF projected in 2008 that the annual surpluses would be eliminated by 2011. It is quite possible that this significant nexus has already occurred. Consider the following:

The following graph () shows a blue average trend line for SSTF cash flow. Above that a green line that describes the significant month-to-month variations from the mean. Notice that in all of the trough cash flow months there were none that resulted in an actual shortfall.

Not recorded in this chart is the fact that in August and October of 2008 and again in February of 2009, the SSTF ran monthly deficits. The total deficits amounted to $2 billion. These are the only negative monthly cash flows over the past decade. An ominous sign.

The next chart () shows the expense side of the Fund. The jump in outlays is due primarily to baby boomers who are just starting to enter the system. The March 2008-2009 rate of growth was 9.5%. The historical average is closer to 5%. This growth will compound at double-digit rates from now on.

The final graph () shows the average yield on the SSTF. The return has been in a long-term decline. This is largely due to the fact that for several decades we have been in a low interest rate environment. The levels of interest rates being set by the Federal Reserve today for short and long term Treasury paper are hurting the Trust Funds results. The Fund is earning a rate far less than the rate of growth of its expenditures. The interest rates used are set by a formula. As a result, the impacts of lower rates are felt with a significant lag. This lag effect will be realized on June 30th of this year.

The Trustees of the SSTF do not mince words on the seriousness of the problem:

The financial condition of the Social Security and Medicare programs remains problematic. Projected long run program costs are not sustainable under current financing arrangements.”

It will be interesting to review the next Trustees up-date. My guess is that it will confirm that the economy is already being negatively influenced by the dynamics of the Social Security System. It could not be happening at a worse time. This could sucker punch an already weak system.

The reality is that the entitlement problem is a 2009 issue and not a 2032 issue. The Trustees of the fund recommend:

The system could be brought into actuarial balance with an immediate increase in payroll tax revenues of 26 percent (from 12.4 percent to 15.6 percent) or an immediate reduction in benefits of 20 percent, or some combination of the two.

A 26% increase in the payroll tax is out of the question today. Social Security payroll deductions totaled $637 billion in the past twelve months. On a tax adjusted basis this amount is equal to the entire two-year stimulus program recently enacted.

If SS payroll deductions were eliminated for one year, the economy would bounce back to life. A one-year suspension would also kill the SSTF. But, the system is dead already, we just think it is asleep.

There is a bright side to this. The issue of the Social Security System is about to come onto the table. Exactly where it belongs. It will be a gut-wrenching process. The outcome of this debate will shape the economy for the next generation. It is possible that the result will be the foundation for an extended period of prosperity.

There is a solution. We must acknowledge that a significant amount of the Entitlement promises that have been made simply can’t be met. In addition we must dramatically change our health care system.

There are three possible outcomes:

(1) We do nothing today to address the imbalances. The result will be that we fall into a long period of economic decline. That decline may have begun already. It will certainly begin in less than five years. Lights out.

(2) We take action to address the visible issues with social security by raising taxes. Raising payroll taxes is no solution. It would just slow economic growth. That runs counter to the long-term interests of the SSTF. In addition, it is simply unfair to ask workers to pay more for a broken system. Lights out.

(3) We accept reality. We recognize that we are not as ‘rich’ as we thought we were. It is not necessary that all existing beneficiaries have their benefits curtailed.

The following however is necessary:

a) All persons under age 60 will have their programmed benefits cut significantly.
b) There has to be a “means” test.
c) People under age 45 will lose most of what they have contributed.
d) The only lasting promise made is the availability of health care.

In return for these concessions American workers get back a significant portion of the $650 billion they are currently paying each year into a black hole. It is the only alternative that keeps the lights on. The good news is that the vast amount of American workers do not believe that they will ever receive SS benefits. Confirming that will come as no surprise.

*Link to Steven Gross's letters and the charts