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How Does the Trust Fund Work and is it Filled with IOUs?

Social Security has always been a pay-as-you-go system: The payroll taxes of today’s workers pay the benefits of today’s recipients. Workers provide for their parents, just as their children will provide for them.

Social Security has always been a pay-as-you-go system: The payroll taxes of today’s workers pay the benefits of today’s recipients. Workers provide for their parents, just as their children will provide for them.

Payroll tax dollars come into a “trust fund” and immediately go out as benefit payments. For most of Social Security’s history, the amount left over has rarely been more than the equivalent of a year’s payout, which serves as a cushion in case of economic downturn.

In 1983, however, a bi-partisan commission recognized that the baby boom generation would place a heavy burden on Social Security and recommended a build-up in the Trust Fund reserve. As a result, there is a $177 billion annual surplus (2006) in reserve — an amount that will continue to grow to a total of nearly $5 trillion until the baby boomers retire. Then, the reserve will be used to pay benefits until it is exhausted. The larger the build-up in the Trust Fund reserve, the longer it can pay benefits.

As noted previously, current projections show that the reserve will be empty in 2040, when Social Security will return to its traditional pay-as-you-go system. The payroll tax will then be sufficient to cover 75 percent of scheduled benefits.

By law, Trust Fund reserves have always been invested in federal government bonds, which earn interest for Social Security at market rates. These bonds are backed by “the full faith and credit” of the federal government and are essentially risk-free. Are they IOUs? Well, that depends on whether you consider U.S. Savings Bonds and Treasury Bills to be IOUs. Most Americans think they’re sound investments and expect to be repaid with interest when the notes come due. 

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