What Is Social Security?
Social Security is probably the most popular federal program, yet most people know almost nothing about it. In practice, Social Security's complex benefit formulas and rules make it difficult for people to understand how their retirement benefits will work.
This paper explains what Social Security is and how it works. The first section explains what Social Security is and which programs are and are not part of Social Security. This includes a discussion about Social Security's retirement, survivors, and disability programs. It also explains why Supplemental Security Income is not part of Social Security, even though it is administered by the Social Security Administration.
How Social Security Is Financed
The second section explains the payroll taxes that mainly finance Social Security and how they are paid. It explores the level of payroll taxes used to finance the system, how those taxes are collected, and what programs they fund. One fact that is often overlooked is that a worker's paycheck normally shows only half of the Social Security payroll taxes that are paid on his or her behalf.
The Trust Funds
The third section explains what Social Security's trust funds are and are not. It examines how much goes into the trust funds, the sources of this money, and how the money is spent. It also discusses the annual trustees report.
As this section explains, there is no pool of actual assets that is being reserved to pay the benefits of future retirees. The Social Security trust fund contains nothing more than IOUs in the form of special-issue U.S. Treasury bonds, which the federal government can repay only though higher taxes, massive borrowing, or massive cuts in other federal programs. While many workers thought that the system's annual surpluses were being used to build a reserve for future retirees, the federal government has been spending this money to fund other government programs and to reduce the government debt.
How Benefits Are Calculated
The fourth and longest section discusses how Social Security benefits are calculated and who is eligible to receive them. Social Security benefits are determined by a complex formula that is based on past earnings. How those past earnings are indexed so that money earned long ago has the same purchasing power as salaries earned more recently is key to understanding efforts to fix the system. This section explains indexing and how different methods could result in different results.
In addition, this section explains such complex topics as the Government Pension Offset, which affects workers who have worked in government jobs that are not part of Social Security; the Windfall Elimination Provision, which affects every worker who has worked both in a job that is covered by Social Security and in one that is not; and the question of "notch babies."
A companion paper will discuss the fiscal problems facing the current system and why changes are necessary. All of the information contained in this paper comes from Social Security Administration sources.
Social Security is a remarkably complex program, and few people actually understand how it operates. However, if the current program's impending financial problems are to be avoided, it becomes increasingly important for informed citizens to measure different reform options against the existing program's actual operating structure and practices.
David C. John is Research Fellow in Social Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.