The Real Reason Social Security Is Going Bankrupt, and What It Means for Workers and Retirees

Retirees may be in for a rude awakening in the not-too-distant future unless Congress does something to fix Social Security. The government-funded retirement pension program is headed for insolvency in just a few years as its annual deficit grows larger.

The most recent estimates indicate that the Old-Age and Survivors Insurance trust fund will run out of cash before the end of 2032. It might be able to dip into the Disability Insurance trust to pay retirement benefits at that point, but those funds would run out by the middle of 2034.

There are a host of theories about why Social Security is running out of money, ranging from mostly accurate to wildly inaccurate, but Social Security Chief Actuary Karen P. Glenn set the record straight last month in Congressional testimony. The real reason Social Security is going bankrupt comes down to a few simple economic realities.

Image source: Getty Images.

Falling well short of expectations

This isn't the first time Social Security has faced insolvency. The program nearly had to cut benefits for recipients in the 1980s, but Congress acted at the 11th hour, implementing a series of changes to the Social Security program. At the time, the actuaries at Social Security estimated that the new laws would effectively extend Social Security's life at least 75 more years. In fact, it looks as if the changes were only good for a 50-year extension.

Here's what Glenn says the actuaries got wrong in 1983, when Congress passed the Social Security amendment.

First, the economy failed to perform as expected. Glenn points out that the 2007 to 2009 recession was extremely deep, the recovery was slow, and perhaps even incomplete. Labor productivity and output per hour worked remain below expectations. That's had a notable impact on the amount of revenue collected from Social Security taxes on wages during the past 20 years.

The bigger unforeseen problem, however, is that the taxable ratio declined considerably from 1983 through 2000. The taxable ratio is the percentage of total wages subject to Social Security tax. The tax is capped at a certain wage level, so if you earn more than that amount, you won't pay any additional Social Security taxes. For 2026, the wage cap is $184,500.

A declining taxable ratio is indicative of growing wage inequality. High earners increased their earnings significantly faster than lower earners. And since high earners have their taxes capped, the total tax collected relative to total wages declined. Despite increased awareness of wage inequality in recent years, the taxable ratio has remained relatively steady since 2000.

Those simple factors account for practically all of Social Security's shortfall relative to expectations 40 years ago. That's pushing Congress to act much sooner than anticipated to improve the health of the program tens of millions of Americans rely on for their current and future retirements.

Changes are coming for workers and retirees

As Social Security approached insolvency in the 1980s, Congress took a handful of measures to pull it back from the brink. Today, Glenn says Congress needs to increase the program's income by a third, decrease its scheduled benefits by a fourth, or some combination of the two. Indeed, finding a way to modestly increase revenue and slightly decrease benefits is perhaps the most palatable solution for everyone.

One of the easiest targets is addressing the decline in the taxable ratio. Several ideas have been floated about increasing the amount of earnings subject to Social Security tax. It could simply raise the wage cap or introduce another tax bracket for earnings above a certain level.

Another possibility is for Congress to expand the income subject to Social Security tax to include pass-through income and other income sources. That would increase revenue for the program but likely increase scheduled benefits by a small amount as well, since taxpayers should receive some level of benefits for the taxes they paid into the system.

Congress may also look to increase taxation on Social Security benefits themselves, perhaps focusing most on those with the highest benefit levels. It might be considered something of a retroactive tax on the wages they should've had taxed if the taxable ratio had been held stable throughout the 1980s and 1990s.

An increase in the full retirement age or adjustments to early claiming penalties and delayed retirement credits are also on the table. In other words, future retirees may have to wait longer to receive the same level of benefits or else face steeper cuts if they claim earlier. Continued improvements in life expectancy will likely offset the rising retirement age.

Those are likely the biggest changes Congress is considering, but it may also look to change the cost-of-living adjustment calculation, benefits for family members, and how it invests the trust fund. But the clock is ticking. The longer Congress waits, the more severe the changes will have to be to prevent a cash shortfall to pay scheduled benefits.

The Motley Fool has a disclosure policy.