Each and every month, nearly 62 million people receive a benefit check from Social Security. More than two-thirds of these recipients are retired workers, many of which are reliant to some degree on this guaranteed stipend to help make ends meet.
Social Security is also a program that probably covers you in some way, whether you realize it or not. According to the Social Security Administration, roughly 171 million workers are on track to receive some retirement income during their golden years. Additionally, around 90% of workers are protected in the event of a long-term disability, and approximately 96% of workers aged 20 to 49 have survivors insurance protection. Social Security is simply that important.
Unfortunately, it's also a program that's in deep trouble. The 2017 report from the Social Security Board of Trustees paints a grim picture for America's most important retirement program. By 2022, the Trustees foresee a shift, whereby more money will be paid to beneficiaries than is collected by payroll taxes, the taxation of benefits, and interest income earned from its asset reserves. This shift is most often attributed to the ongoing retirement of baby boomers and lengthening life expectancies. By 2034, some $3 trillion in asset reserves are expected to be completely exhausted.
The Trustees warn that a complete depletion of the Trust's asset reserves could lead to an across-the-board cut to current and future retiree benefits of up to 23% in order to keep the program solvent through the year 2091. Considering that more than 3 out of 5 retired workers counts on Social Security for at least half of their monthly income, such an outcome isn't acceptable.
How Social Security is funded
What the program really needs, if payouts are to remain on par with their current levels, is more revenue. Congress hasn't been much help in this department. While solutions have been proposed by both Democrats and Republicans to resolve the expected $12.5 trillion budget shortfall between 2034 and 2091, neither party has been willing to work with the other to effect any changes. In fact, we haven't seen any major overhauls to Social Security in 34 years!
Social Security has three means of generating revenue for the program. The primary funding channel is a 12.4% payroll tax on earned income between $0.01 and $127,200. The reason not all earned income is taxed is because there's also a cap on how much Social Security will pay out each month at full retirement age ($2,687 in 2017). In 2016, payroll taxes provided 87.3% of the $957.5 billion collected by the program.
The taxation of benefits wound up providing $32.8 billion (3.4%) in revenue last year. Individuals earning more than $25,000 annually and couples filing jointly with more than $32,000 in earned income are subject to having at least half of their Social Security benefits exposed to federal income tax.
Lastly, $88.4 billion, or 9.2% of total revenue, came from the interest Social Security's Trust earned on its asset reserves, which are invested in special-issue bonds and certificates of indebtedness. This latter form of funding is of particular interest.
The Fed's monetary tightening is great news for Social Security
Recent actions by the Federal Reserve may very well help increase Social Security's revenue in the short and intermediate term, which is why all current and future beneficiaries should consider sending the nation's central bank a thank-you card.
As of the end of September 2017, Social Security's Trust had $2.89 trillion invested in special issue bonds of various maturities and yields, as well as certificates of indebtedness (albeit to a far smaller extent), as you can see in the table below.
The key figure above is the average interest rate of 2.903%. The higher this average interest rate, the more interest income the program earns each year, and perhaps the longer the program can go without exhausting its cash reserves. As you'll note, most of the highest-yielding bonds are set to mature over the next five or six years, which will weigh down the average interest rate after they've matured and lead to less interest income being generated.
However, the Federal Reserve officially shifted course with regard to monetary policy back in December 2015. After seven years of maintaining a record-low federal funds target rate, which negatively impacted interest rates and caused Social Security's Trust to invest in new bonds at considerably lower yields (which is why you see a number of bonds with interest rates between 1.375% and 2.5%), the Fed is once again lifting its federal funds target rate. This, in turn, is leading to higher interest rates and yields.
Since December 2015, the Fed has lifted its federal funds target rate by 100 basis points (1 percentage point), and it's on track to increase these rates perhaps another 100 to 200 basis points over the next two or three years, assuming the U.S. economy keeps chugging along. This should allow Social Security's Trust to invest in higher-yielding bonds in the upcoming years.
What's more, the Fed also announced recently that it's going to begin unwinding its $4.5 trillion balance sheet. In order to buoy financial markets following the Great Recession, the Fed bought U.S. Treasuries. The Fed has decided to begin selling some of these assets. Since bond yields and bond prices work inversely to one another, selling bonds and pushing their price down should push yields higher. So we have a secondary factor that should be a positive for Social Security's asset reserves.
Admittedly, modestly higher interest rates aren't anywhere near enough to bridge Social Security's $12.5 trillion cash shortfall, but it's at least a baby step in the right direction to potentially extending the life of the program.
The Motley Fool has a disclosure policy.