How Social Security Works

The Social Security system began in 1935 as a pension program, with receipts to be held in trust for future beneficiaries in much the same way as a corporate pension plan. That did not last very long, however, and the system was quickly transformed into a pay-as-you-go format, with current workers' contributions paying for current retirees' benefits. As time has elapsed, little real relationship continues to exist between the dollar amount contributed by a worker and the benefits that he or she receives. Benefits have been gradually extended to many who have not contributed into the fund, and since 1972 benefits have been increased each year according to adjustments in the Consumer Price Index. Although often looked upon as providing only retirement benefits, the system also affords benefits to survivors of deceased participants as well as to participants who become disabled.

The increases made in Social Security benefits along with the annual adjustment in payments for inflation had the effect of almost bankrupting the system. However, legislative changes were enacted in the early 1980's to increase mandatory fund contributions (Social Security and a part of Medicare are funded by payroll deductions of 12.4% and 2.9%, respectively, with employer and employee splitting the costs evenly) and to gradually extend the retirement age to 67. Additionally, a portion of some recipients' benefits became taxable. These changes brought the system back into solvency, and were also successful in building up fund reserves to ensure payment of benefits to present as well as future participants – at least, relatively near-future participants.

The problem of the Social Security system running out of money is quite complex. Indeed, the system has grown so large over the years that it has its own set of rules. As workers' Social Security payments are made into the U.S. Treasury, they're invested exclusively into non-marketable Treasury-issued debt. The funds are then spent by the Treasury for general government purposes. In other words, the money received is spent and replaced in the trust fund by a Treasury IOU to be paid at some future point in time.

Clearly then, the Social Security trust fund is not simply a large pot of money available for purpose of paying beneficiaries. Current public contributions are spent by the government for whatever purposes the government deems necessary. More accurately, the trust fund can be viewed as a totally separate account on the government's books, reflecting the government's promise to pay future benefits by means of taxing or borrowing as needed. Proposals to use the trust fund for other purposes would have the effect of merely transferring the obligation to pay the IOUs to another program; future tax revenues or borrowing would doubtless still be required to pay for the alternative uses. And plans to reduce the Social Security payroll tax would simply reduce Treasury receipts that are currently spent, thereby decreasing only the growth of the pool of IOUs in the fund. The government's obligation to pay Social Security beneficiaries is prescribed by law and therefore must be met – in other words, the spending is mandatory.