Medicare and Social Security are two of the largest federal programs in the U.S. by expenditures. While most Americans will receive benefits from both programs at some point in their lives, these programs are not very well understood. This is a problem because “reforming Social Security and Medicare” is a frequent component of the national political dialogue, particularly with respect to federal budgets and deficits. The most common misconceptions about Medicare and Social Security seem to be about the roles and relative financial health of their respective trust funds.
The Role of the Social Security Trust Fund
Some people seem to believe that Social Security works like a 401k with the money that you invested, plus any returns that it has earned, sitting in an account with your name on it. Others seem to think that it works like a private pension, with a large account into which an amount of funds is deposited sufficient to pay off benefit obligations as they are accrued. Neither portrayal is accurate.
Unlike an employer pension fund, Social Security is not fully funded – not even close. Employers are required to fully pre-fund their pension funds. That means that they must put enough money into an account to cover the anticipated actuarial value of the pension obligation as it is accrued. Public pensions operate under similar principles but are not required to fully fund their pension funds. Social Security, in contrast, is what is known as a pay-as-you-go program – current benefits are paid for by current (and/or recent) payroll taxes.
As an example, the Texas Teachers Retirement System pension fund (a public pension fund) had a fund balance in 2018 of about $155 billion and paid out benefits of about $10 billion, for a ratio between the fund balance and the annual benefit payment of about 15:1. TRS estimated that 76.9% of the anticipated actuarial cost of future benefits was funded (i.e., it is not fully funded). On the other hand, in 2018, the Social Security trust fund had a fund balance of about $2.9 trillion and made benefit payments of about $946 billion, for a ratio between the fund balance and the annual benefit payment of about 3:1.
The Financial Health of the Social Security Trust Fund
Social Security has a dedicated revenue source – one portion of the payroll tax. In years when that tax (plus any interest earned by the trust fund) brings in more than is paid out in benefits, then the trust fund grows. In years when the opposite is the case, the trust fund shrinks. Each year, the Social Security trustees put out a report that includes projections of the future financial activity for the Social Security program. According to the most recent report, the trust fund will be depleted by 2034, at which point Congress would need to appropriate more funds to replenish it, or benefits would automatically be cut. With this outlook, politicians tend to talk about the need to dramatically reform Social Security, often by privatizing parts of it or cutting benefits.
While dramatic reform is certainly an option, it is hardly necessary. Minor changes to the benefit and tax structures would be adequate to ensure that the Social Security trust fund is never depleted. The American Academy of Actuaries has developed a simulator for some of the more commonly discussed policy options for shoring-up the Social Security trust fund called the Social Security Game. For each policy option, there are generally two to four choices that vary in impact. There are lots of permutations of the available policy options that will “win” the game. As an illustrative example, you can “win” the game by choosing the middle options for: 1) gradually increasing the full retirement age (slowly, by one year over two and a half decades); 2) subjecting higher wages to Social Security payroll tax (currently, the Social Security payroll tax only applies to income up to $128,400); and 3) lowering benefits for future high-income retirees.
Another useful way to think about the trust fund is by considering how big it is compared to the gap between inflows and outflows (i.e., the current annual “deficit”). In 2018, the Social Security program was estimated to have inflows of $997 billion and outflows of $952 billion, for a single-year deficit of $45 billion, or less than 2% of the amount of the trust fund. (While this ratio might seem like it would suggest that the trust fund could avoid getting depleted for more than 50 years, the benefit costs to Social Security will grow at an increasing rate as more baby boomers reach retirement age and begin drawing benefits.)
The Role of the Medicare Trust Fund
The Medicare trust fund plays less of a role in the funding of the Medicare program than the Social Security trust fund does for the Social Security program. A different portion of the payroll tax funds part of the Medicare program and, as in the case of Social Security, in years in which that portion of the payroll tax yields receipts in excess of costs, the balance goes into the Medicare trust fund. Unlike Social Security, several different revenue sources contribute significant portions of the cost of the Medicare benefit, as shown in the figure below by the Kaiser Family Foundation:
The Medicare component of the payroll tax pays for almost all of Medicare Part A (hospital services) and none of Part B (primary physician and other outpatient services) or Part D (prescription drugs), which are primarily funded by general revenue and premiums paid by recipients.
The Financial Health of the Medicare Trust Fund
As is the case for Social Security, the Medicare trustees issue a report each year describing the financial state of the program. The 2018 Medicare trustees report predicted that the Medicare trust fund would be depleted in 2026, at which point general revenue would need to be allocated to Part A to avoid reducing benefits. As noted in the Kaiser Family Foundation report, the projections of the year of depletion for the trust fund have varied significantly from year to year, sometimes taking swings of up to 12 years from one year to the next.
Unlike for the Social Security trust fund, the balance in the Medicare trust fund is less than the annual benefit costs. In 2018, the trust fund balance was about $295 billion with total anticipated expenditures of just over $710 billion and total anticipated income of about $705 billion for an annual “deficit” of about $5 billion (as with the Social Security trust fund, less than 2% of the trust fund balance). In addition, the benefit cost associated with Medicare is much less predictable than the benefit cost associated with Social Security. While Americans are living longer than initially predicted when Social Security was established, the year-to-year changes in future cost estimates do not change dramatically. For Medicare, however, significant changes in health care costs, driven by innovations such as expensive new drugs or changes in medical practice patterns, can produce sudden changes in year-to-year estimates of total future benefit costs.
The Social Security and Medicare trust funds act as buffers for the components of the payroll tax that are dedicated to those programs, which, combined with the dedicated nature of the taxes themselves, provides a certain amount of political protection for the programs. The trust funds create a mechanism whereby excess revenues from the dedicated taxes are not readily available for Congress to use for other programs and the dedicated nature of the taxes themselves would make it difficult for any potential reformer to redirect the funds without significant public debate. While both programs will need to be adjusted in order to be stable into perpetuity, the necessary changes need not be dramatic and claims that either program will “go broke” are misleading at best.