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What Will the Fed's 2022 Taper Plans Mean for Social Security?

By Chuck Saletta – Jan 9, 2022 at 8:30AM

Key Points

  • Social Security's trust funds will benefit from lower outflows if inflation drops.
  • Those same trust funds will benefit from higher income if interest rates rise.
  • Both those outcomes will likely happen if the Fed can successfully taper its bond buying program.

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Social Security may be the biggest beneficiary.

Social Security's Trust Funds currently have just over $2.8 trillion in assets in them,  yet those funds are expected to run dry by 2034, which would cut benefits by nearly a quarter. A key reason for the trust funds' challenges comes from the way they're designed. They only hold U.S. Treasury debt, which right now pays the program a weighted interest rate below 2.4%. 

When that interest rate is compared with the whopping 5.9% increase in per recipient benefits Social Security has to pay out this year due to inflation, it's no wonder the trust funds are in trouble. They simply can't earn enough to keep up with the increases that the program has to pay out.

Still, some hope may very well be on the horizon. While the stock market has gotten a bit nervous when it comes to the Federal Reserve's plans to start tapering its bond purchase program, that news may very well mean good things for Social Security. Indeed, it could help both increase Social Security's return on its investments and reduce the amount the program needs to pay out over time.

A senior couple with a Social Security card that has a dollar bill superimposed in it.

Image source: Getty Images.

How tapering can help Social Security's return on investment

Because the Fed has the authority to print legal currency, it has the ability to pay any price it chooses for the assets (typically bonds) that it buys. That is largely how it influences interest rates. If it wants rates to go down, it buys more bonds. If it wants rates to go up, it slows or stops its purchases -- that's what "tapering" means -- and it could even sell some of the bonds it owns.

When the Fed buys less, it means that other people and institutions -- ones who can't print legal money -- need to step up to buy the supply of bonds that the Fed is no longer purchasing. Given a consistent supply of bonds, but lowered demand for bonds given the Fed's tapering decision, prices will naturally drop to a lower level. A lower price for a bond means the buyer gets a higher net expected return on that investment -- in effect, higher interest rates.

Since Social Security can only buy U.S. Treasury bonds, higher interest rates mean that when it purchases new bonds for its trust funds, it gets a higher return on its investment than it would with lower rates. That could potentially help extend the life of the trust funds, but it won't be by all that much. The reason is that now that Social Security's trust funds are expected to start shrinking, Social Security won't be a net buyer of new bonds. Thus, it won't benefit as much as if it were still building its trust funds.

How tapering can help lower Social Security's expenses

The bigger benefit to Social Security from tapering comes from the impact that tapering is expected to have on inflation. The Fed is tapering in order to tamp down on inflation. This can work because when interest rates go up, it gets more expensive to borrow money. As a result, people and companies that don't have the ability to print legal currency have to be more careful with the money they do spend. That tends to make them more price-sensitive, which can help tame inflation.

If the Fed is able to successfully slow inflation to a more manageable pace with its tapering, that can be a huge help to Social Security. This is because Social Security has to increase what it pays out to its recipients every year that there's positive inflation, to help those recipients cover that inflation. The lower inflation is, the less Social Security's outflows will be, thus helping its trust funds last longer.

The Fed's taper should help Social Security, but it won't be enough

Because Social Security's income could increase from higher interest rates and its expense pressures could reduce from lower inflation, Social Security could be a big winner from the Fed's taper. Even with that boost, however, it doesn't change the fundamental trajectory that Social Security is on.

Even under more optimistic assumptions than its base case, Social Security's modeling projects a 95% probability that if nothing changes in how it operates, its trust funds will empty by 2041. While that does indicate there's a chance that its trust funds could last beyond the current 2034 baseline projection, it at best buys a few years before benefits are at risk of being slashed.

Regardless of when it happens, you need to recognize that there are really only a handful of tools that Congress can use to protect Social Security for the longer term. It can raise taxes, it can cut benefits in a more controlled way than simply letting the trust funds empty, or it can change the way those trust funds are invested. All three of those options involve a different set of trade-offs and risks, and they all will impact most Americans as taxpayers, as recipients, or both.

So take the opportunity that you have now to prepare for the changes that will take place to Social Security in the not too distant future. Based on the trajectory it is on, it's not a matter of if the program will change, it's a matter of how it will change. The better prepared you are in advance, the easier it will be for you to manage through those changes, regardless of what that ultimately look like.

With a little more than a decade until the trust funds are expected to empty, you still have time to put a plan in place for yourself, but the longer you wait, the tougher any disruption will likely be. So get started now, and be all that much more ready for whatever comes down the pike for Social Security.

Chuck Saletta has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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