The table is set for this to be a market-moving week for investors, with considerably larger implications for all Americans.
On Wednesday, Dec. 14, the Federal Open Market Committee (FOMC) will decide whether to raise the federal funds target rate. Should it choose to do so, we'd likely see the target rate rise to 0.75% from 0.50%.
Interest rates hikes are sort of a push-pull event for investors. On one hand, rising interest rates imply that the U.S. economy is on solid footing, which is good for businesses. The other side of the coin is that borrowing suddenly becomes more expensive, which can slow business expansion, acquisition activity, and ultimately growth.
But the Fed's decision on interest is going to affect far more than just the stock market. Federal funds target rate increases will impact mortgage lending rates and credit card interest rates, pushing them higher in a correlative manner. The vast majority of revolving credit accounts today have variable interest rates attached, meaning tens of millions of Americans could suddenly find themselves paying more in interest each month if they carry a balance.
The upcoming decision on interest rates is also the perfect opportunity for seniors who are receiving Social Security benefits to cheer on the Fed. It might seem counterintuitive to root in favor of a higher interest rate environment, but higher lending rates (up to a point) can benefit Social Security. Allow me to explain how.
How Social Security is funded
Social Security is funded in three separate ways. By and large the greatest contributor of annual revenue to the program is the 12.4% payroll tax that working Americans pay on every cent they earn between $1 and $118,500 in 2016 (this earnings cap will increase to $127,200 next year). In 2015, 86.4% of the $920.2 billion in generated revenue came from payroll taxes. Most commonly, you and your employer split this tax right down the middle (6.2% each), while in rarer cases self-employed individuals are responsible for the full 12.4%.
On the other end of the spectrum, the taxation of Social Security benefits comprised just 3.4% of the $920.2 billion collected by the Social Security Administration last year. Single Social Security recipients earning more than $25,000 annually, and married couples receiving Social Security benefits with more than $32,000 in combined income, are subject to having a percentage of their benefits taxed by the federal government. These taxed benefits find their way back to the Social Security program as revenue.
The third component is interest earned from the program's more than $2.8 trillion in spare cash. In 2015, interest income totaled 10.1% of the $920.2 billion, or about $93 billion.
Here's how the Fed can impact Social Security
The Social Security Administration invests the program's spare cash very conservatively. Nearly all of the more than $2.8 trillion in spare cash is invested in special bonds issued by the U.S. government solely for Trusts, with a smaller amount invested in certificates of indebtedness.
The special-issue bonds from the U.S. government behave the same way as any debt offering: higher interest rate environments lead to higher bond yields, while lower interest rate environments lend to lower yields. Since 2008, the FOMC has kept the federal funds target rate near historic lows. As a result, many of the special-issue bonds that Social Security's spare cash is invested in recently are earning just 1.375% to about 3.5%. Returns in the 1% and 2% range aren't going to generate much in the way of interest income for the program, and many of its higher-yielding bonds (think 4%-5.625%) are set to mature in the next couple of years.
Now, back to the upcoming FOMC meeting. Should the Fed choose to increase the federal funds target rate to 0.75%, it could mean that future special-issue bonds for the Social Security Trust will have a successively higher yield than previous issues. That's good news for Social Security and indirectly for seniors, because it means the program could generate more in interest income. Understandably, a quarter-point (25-basis-point) increase isn't going to generate a game-changing amount of extra interest income, but anything extra is better than nothing.
Why seniors should care
The reason seniors should be cheering on the Fed and the possibility of interest rate hikes has to do with the grim outlook for Social Security. The latest annual report from the Social Security Board of Trustees estimates that the Trust will begin paying out more than it's generating in revenue by 2020, with the more than $2.8 trillion in spare cash being completely exhausted by 2034. Demographic shifts that include longer life expectancies and the ongoing retirement of baby boomers are mostly the cause of this expected depletion of the Trust's spare cash.
If Congress is unable to find an amicable solution to diminish this cash exhaustion, the Trustees' report projects that an across-the-board cut in benefits of up to 21% may be needed to sustain Social Security through 2090. Cutting benefits isn't something current retirees or working Americans want to consider as a viable option.
While a 25-basis-point increase in the federal funds target rate isn't going to generate too much in the way of extra interest income for Social Security, a several successive interest rate hikes from the Fed could begin making a small difference. To be clear, we're still not talking about enough interest income to save Social Security from eventually exhausting its spare cash. But it's always possible, if rates move higher enough without hurting economic growth, that billions or tens of billions of extra dollars could be generated annually in interest, which in turn could perhaps push out the spare cash exhaustion date a tad longer.
Seniors are still best off heading into retirement with multiple channels of income and minimal reliance on Social Security. But those who will lean heavily on the program can start crossing their fingers that the Fed sticks with its monetary tightening, and that U.S. economic growth remains robust for years to come.