Most people know that the Social Security program faces long-term financial challenges. Yet what many don't realize is just how flush with cash the system is right now, thanks to the Social Security Trust Fund. Some policymakers have argued for changes in the rules governing the Trust Fund's permissible investments to allow for greater growth potential, in the hopes that larger earnings could help make up the anticipated funding shortfall in future years.
Yet even under the Trust Fund's current investment policy, changing macroeconomic conditions can affect the income that its assets generate. Rising interest rates, in particular, could have a huge impact on income levels because of the specific nature of the unique income-producing assets that the Trust Fund holds.
That leads to a simple question: If Trust Fund income goes up, will it be enough to prevent Social Security's financial crisis in the 2030s?
Image source: Getty Images.
Why the Trust Fund exists and how it works
The Social Security Trust Fund has been in existence since the late 1930s, but its function has changed over time. Until the 1970s, payroll taxes were generally enough to cover Social Security benefits, largely because the number of workers paying into the system was dramatically higher than the number of retirees receiving benefits. When necessary, lawmakers voted to increase payroll tax rates in order to handle the rising number of workers covered under Social Security. It took a couple of generations for Social Security to become fully vulnerable to demographic shifts.
The need to set up longer-term financial reserves to fund benefits for future retirees prompted a fundamental change in the nature and use of the Trust Fund. In the early 1980s, further amendments to Social Security laws set up a situation in which the program generated considerable excess amounts of payroll tax receipts over benefit payments. That excess went into the Trust Fund.
Over the course of more than 30 years, the Trust Fund has built up a balance of nearly $2.85 trillion as of the end of 2016. However, the demographic conditions that allowed that buildup to occur have now changed, and Social Security now spends more to pay for benefits than it brings in from payroll taxes. Only the interest on the investments that the Trust Fund holds has kept the fund's balance moving higher, and that's projected to change, as well, within the next few years.
What the Trust Fund invests in
The Trust Fund's income comes from the investments it makes. Under current law, the only permissible investment for the Trust Fund is a special type of securities issued by the U.S. Treasury. These special-issue securities come in two types: one for short-term investment that come due each year on June 30, and the other for longer-term investment of one to 15 years. The Trust Fund can invest in short-term issues whenever money is available, but it can only lock up money for longer periods once per year on June 30.
The interest rates of those securities is determined by looking at the average market yield of all outstanding U.S. debt that's due, or callable, more than four years into the future. On the bonds that the Trust Fund purchased in 2016, it received an interest rate of 1.875%.
It's therefore reasonable to expect that, as average market yields go up, so too will the interest paid on new bonds that the Trust Funds buy. However, the positive impact won't be enough to turn the tide and prevent the future depletion of Trust Fund assets.
Why rising rates won't be enough
There are two reasons why higher rates won't produce enough of an impact to solve the Trust Fund's financial challenges. First, rates aren't actually rising quickly enough on the longer end of the yield curve, which largely determines the returns on Trust Fund investments. Even after multiple rate increases, 30-year Treasury bonds still yield less than 3%. Based on current yields, Trust Fund assets would get a boost of less than a percentage point from the 1.875% level 1 1/2 years ago. Even on a $2.85 trillion base, that amounts to just $29 billion in annual revenue.
Moreover, any shift in interest rates won't have an immediate impact on the lion's share of Trust Fund assets. Because the Trust Fund has generally invested equal amounts in maturities ranging from one to 15 years, it's insulated from rate changes. That's actually helped cushion the blow to Trust Fund income in recent years, with interest income hitting a peak of $118 billion in 2009, and gradually falling to $88 billion in 2016. Yet it means that, when the next significant upward swing in interest rates occurs, only a tiny portion of assets will get the benefit of those increases, especially since there likely won't be any future payroll-tax surpluses for new investment.
The Social Security Trust Fund can't count on rising interest rates to provide the money it needs to cover its unfunded future obligations. At some point in the future, lawmakers will have to make similarly aggressive moves as were made in the 1980s to ensure the financial viability of Social Security for future generations of retirees.
