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A MESSAGE TO THE PUBLIC:

Each year the Trustees of the Social Security and Medicare trust funds report on the current status and projected condition of the funds over the next 75 years. This message summarizes the 2004 Annual Reports.

The fundamentals of the financial status of Social Security and Medicare remain problematic under the intermediate economic and demographic assumptions. Social Security's current annual cash surpluses will soon begin to decline and then turn into rapidly growing cash deficits toward the end of the next decade as the baby-boom generation retires. The financial outlook for the Medicare Hospital Insurance (HI) Trust Fund that pays hospital benefits has deteriorated significantly from last year, with annual cash flow deficits beginning this year and expected to grow rapidly after 2010 as baby boomers begin to retire. The growing annual cash deficits in both programs will lead to exhaustion in trust fund reserves for HI in 2019 and for Social Security in 2042. In addition, the Medicare Supplementary Medical Insurance (SMI) Trust Fund that pays for physician services and the new prescription drug benefit will require substantial increases over time in both general revenue transfers and premium charges. As the reserves in Social Security and HI are drawn down and SMI general revenue financing requirements continue to grow, the pressure on the Federal budget will intensify. We do not believe the currently projected long run growth rates of Social Security and Medicare are sustainable under current financing arrangements.

Social Security

The annual cost of Social Security benefits represents 4.3 percent of Gross Domestic Product (GDP) today and is projected to rise to 6.6 percent of GDP in 2078. The projected 75-year actuarial deficit in the combined Old-Age and Survivors Insurance (OASI) and Disability Insurance (DI) Trust Funds is 1.89 percent of taxable payroll, down slightly from 1.92 percent in last year's report. The program continues to fail our long-range test of close actuarial balance by a wide margin. Projected OASDI tax income will begin to fall short of outlays in 2018 and will be sufficient to finance only 73 percent of scheduled annual benefits by 2042, when the combined OASDI trust fund is projected to be exhausted.

Social Security could be brought into actuarial balance over the next 75 years in various ways, including an immediate increase in payroll taxes of 15 percent or an immediate reduction in benefits of 13 percent (or some combination of the two). To the extent that changes are delayed or phased in gradually, greater adjustments in scheduled benefits and revenues would be required. Ensuring the sustainability of the system beyond 2078 would require even larger changes.

Medicare

As we reported last year, Medicare's financial difficulties come sooner--and are much more severe--than those confronting Social Security. While both programs face essentially the same demographic challenge, health care costs per enrollee are projected to rise faster than the wages per worker on which the payroll tax is paid and on which Social Security benefits are based. As a result, while Medicare's annual costs are currently 2.7 percent of GDP, or about 60 percent of Social Security's, they are now projected to surpass Social Security expenditures in 2024 and reach almost 14 percent of GDP in 2078, more than twice the percent for Social Security in that year.

The projected 75-year actuarial deficit in the Hospital Insurance (HI) Trust Fund is now 3.12 percent of taxable payroll, up significantly from 2.40 percent in last year's report mainly due to higher actual and projected hospital expenditures, as well as lower actual and projected taxable payroll, and new Medicare legislation. The fund now fails our test of short-range financial adequacy, as assets drop below the level of the next year's projected expenditures within 10 years--in 2012. The fund also continues to fail our long-range test of close actuarial balance by a wide margin. The projected date of HI Trust Fund exhaustion has moved forward significantly to 2019, from 2026 in last year's report, and projected HI tax income falls short of outlays beginning this year, as compared to 2013 in last year's report. HI could be brought into actuarial balance over the next 75 years by an immediate 108 percent increase in program income or an immediate 48 percent reduction in program outlays (or some combination of the two). However, as with Social Security, adjustments of far greater magnitude would be necessary to the extent changes are delayed or phased in gradually, and continuation of the program after 2078 would require substantial changes.

Part B of the Supplementary Medical Insurance (SMI) Trust Fund, which pays doctors' bills and other outpatient expenses, and the new Part D, which pays for access to prescription drug coverage, are both projected to remain adequately financed into the indefinite future because current law automatically sets financing each year to meet next year's expected costs. However, this automatic provision will result in a rapidly growing amount of general revenue financing--projected to rise from 0.9 percent of GDP today to 6.2 percent in 2078--as well as substantial increases over time in beneficiary premium charges.

Conclusion

Though highly challenging, the financial difficulties facing Social Security and Medicare are not insurmountable. But we must take action to address them in a timely manner. The sooner they are addressed the more varied and less disruptive can be their solutions. The problem of finding ways to allow older Americans access to high quality medical care is daunting and likely to demand frequent legislative adjustments in the future, as it has since Medicare was first enacted. With informed public discussion and creative thinking that relates the principles underlying these programs to the economic and demographic realities, as well as to the changing needs and preferences of working and retired households, Social Security and Medicare can continue to play a critical role in the lives of all Americans.

A SUMMARY OF THE 2004 ANNUAL SOCIAL SECURITY
AND MEDICARE TRUST FUND REPORTS

Who Are the Trustees? There are six Trustees: the Secretary of the Treasury, the Secretary of Labor, the Secretary of Health and Human Services, the Commissioner of Social Security and two members appointed by the President and confirmed by the Senate to represent the public. The Public Trustees are John L. Palmer, University Professor at Syracuse University's Maxwell School of Citizenship and Public Affairs, and Thomas R. Saving, Director of the Private Enterprise Research Center and Professor of Economics at Texas A & M University.

What Are the Trust Funds?The trust funds were created in the U.S. Treasury to account for all program income and disbursements. Social Security and Medicare taxes, premiums and other income are credited to the funds. Benefit payments and program administrative costs are the only purposes for which disbursements from the funds can be made. Program revenues not needed in the current year to pay benefits and administrative costs are invested in special non-negotiable securities of the U.S. Government on which a market rate of interest is credited. Thus, the trust funds represent the accumulated value, including interest, of all prior program annual surpluses, and provide automatic authority to pay benefits.

There are four separate trust funds. For Social Security, the Old-Age and Survivors Insurance (OASI) Trust Fund pays retirement and survivors benefits, and the Disability Insurance (DI) Trust Fund pays disability benefits. (The combined trust funds are described as OASDI.) For Medicare, the Hospital Insurance (HI) Trust Fund pays for inpatient hospital and related care. The Supplementary Medical Insurance (SMI) Trust Fund is composed of Part B, which pays for physician and outpatient services, and effective this year, Part D, which provides a new prescription drug benefit that begins in 2006. Medicare benefits are provided to most people age 65 and over and to most workers who are receiving Social Security disability benefits.

What Were the Trust Fund Results in 2003? In December 2003, 39.4 million people were receiving OASI benefits, 7.6 million were receiving DI benefits, and 41 million were covered under Medicare. Trust fund operations, in billions of dollars, are shown below (totals may not add due to rounding).

What Are the Major Changes in the Outlook for the Trust Funds Since Last Year? The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 introduced the most sweeping changes to Medicare since the program began in 1965. The new prescription drug benefit will bring Medicare more in line with modern insurance coverage and medical practice. Together with other provisions of the Act, it will add greatly to the overall cost of SMI, however, and will increase the proportion of total Medicare costs financed from Federal general fund revenues. Also, lower than anticipated tax income and higher than anticipated expenditures, combined with provisions of the new law affecting HI, caused significant deterioration in HI's financial outlook this year. The outlook for Social Security did not change appreciably.

How Are Social Security and Medicare Financed? For OASDI and HI, the major source of financing is payroll taxes on earnings that are paid by employees and their employers and by the self employed (154 million for OASDI and 158 million for HI in 2003). The self employed are charged the equivalent of the combined employer and employee tax rates. The payroll tax rates are set by law and for OASDI apply to earnings up to an annual maximum that rises as average wages increase (it is $87,900 in 2004). HI taxes are paid on total earnings. The tax rates (in percent) for 2004 and later are:

Within SMI both Part B and Part D are financed largely (about 75 percent) by payments from Federal general fund revenues supplemented by monthly premiums charged beneficiaries ($66.60 in 2004 for Part B; Part D premiums begin in 2006). Part D also will receive payments from States beginning in 2006 for Federal assumption of Medicaid responsibilities for premium and cost-sharing subsidies for individuals eligible for both Medicare and Medicaid. Part B and Part D premium amounts are based on methods defined in law and increase as the estimated costs of those programs rise. Income to each trust fund by source in 2003 is shown in the table below (totals may not add due to rounding).

* Less than $50 million.

What Were the Administrative Expenses in 2003? Administrative expenses, as a percentage of total expenditures, were:

Chart A--OASI, DI, and HI Trust Fund Ratios
[Assets as a percentage of annual expenditures]

[D]

For SMI, a less stringent annual "contingency reserve" asset test applies to both Part B and Part D, because the financing of each of those accounts is provided by beneficiary premiums and Federal general fund revenue payments that are automatically adjusted each year to meet expected costs. Thus, under current law both SMI accounts are fully financed throughout the 75-year projection period no matter what the costs may be.

The table below shows the projected income and outgo, and the change in the balance of each trust fund except SMI, over the next 10 years. Note the separation of SMI income and expenditures into columns for Part B and for the new Part D account. The change in SMI is not shown because of its automatic annual adjustments in income to meet the next year's projected expenditures.

What is the Long-Range (2004-2078) Outlook for Social Security and Medicare Costs? Costs for both programs increase steeply between 2010 and 2030 because the number of people receiving benefits will increase rapidly as the large "baby-boom" generation retires. Thereafter, Social Security costs grow slowly due primarily to projected increasing life expectancy. Medicare costs continue to grow rapidly due to expected increases in the use and cost of health care. In particular, continuing development and use of new technology is expected to cause per capita health care expenditures to continue to grow faster in the long term, as they have in the past, than the economy as a whole.

Thus, a good way to view the projected cost of Social Security and Medicare is in relation to gross domestic product (GDP), the most frequently used measure of the total U.S. economy (Chart B below). Social Security outgo amounted to 4.3 percent of GDP in 2003 and is projected to increase by just over one-half to 6.6 percent of GDP in 2078. Medicare's cost was smaller in 2003, 2.6 percent of GDP, but is projected to grow more than fivefold to 13.8 percent of GDP in 2078, when it will be more than twice Social Security's.

Chart B--Social Security and Medicare Cost as a Percentage of GDP

[D]

What is the Outlook for OASDI and HI Costs Relative to Tax Income? Although Medicare's and Social Security's costs are projected to grow substantially faster than the economy over the next several decades, tax income to the HI and OASDI Trust Funds is not. Because their primary source of income is the payroll tax, it is customary to compare their income and cost rates as a percentage of taxable payroll, as in Chart C. Note that the income rate lines do not rise significantly over the long run. This is because payroll tax rates are not scheduled to change and income from the other tax source to these programs, taxation of OASDI benefits, will rise only gradually, primarily because a greater proportion of beneficiaries will become subject to taxation in future yea