Social Security pays almost $1 trillion in benefits to retirees, disabled workers, and their families each year, and the way it does so is pretty simple. The program collects revenue primarily from payroll taxes that are withheld from workers' paychecks, with some additional money coming from income taxes that some people have to pay on the Social Security benefits they receive. It then pays out benefits from that revenue.

For a long time, the amount of revenue Social Security brought in was larger than what it paid out, and that allowed the program to build up a sizable balance in its trust funds. Overall, the program has more than $2.9 trillion in asset reserves, which it will use in future years to cover the coming shortfall as demographic shifts lead to a huge increase in the number of retirees receiving benefits. Social Security invests in debt obligations of the U.S. Treasury, but the investments that it holds aren't like what ordinary investors can buy for their portfolios. In particular, the features that these special investments have give the Social Security program the flexibility it needs to manage its own obligations effectively. It's important to understand how these investments work so that you can know what's supporting the Social Security payments you might receive in the future.

Social Security card in a pile of money.

Image source: Getty Images.

How the trust funds work

Social Security's trust funds were set up to hold the anticipated excess between tax revenue and benefit payouts. Following Social Security reform in the 1980s, taxes were raised to a sufficient amount to allow a substantial accumulation of assets within the trust funds, easing the potential burden of a pay-as-you-go system on the broader federal budget. To generate income, the trust funds invest the assets they have in an attempt to stretch those dollars as far as they can go.

But Social Security has ongoing financial demands that make investing a challenge. Although there's good information on how many people will qualify to take Social Security retirement benefits, the exact timing of when they'll do so is impossible to predict perfectly. Accordingly, the trust funds need to be able to cash in their investments when necessary in order to cover unanticipated obligations.

Social Security's special-issue securities

To help the Social Security program, the Treasury Department offers what it calls special-issue securities to help with financing. There are two different types of these special investments. For short-term needs, the Treasury allows Social Security to invest in certificates of indebtedness. The program can take money it receives on any given day and buy these certificates, which mature on the following June 30.

Interest rates are determined by a formula that looks at the average yield in the market for Treasury securities that mature four years or more into the future. The two sets of current-year certificates of indebtedness earn 2.75% and 2.875%.

Every year, Social Security gets a chance to invest in longer-term special issue bonds. These can have maturities of anywhere from one to 15 years. Interest rates are determined according to the same method. Currently, Social Security has a wide range of special-issue bonds in its portfolio, paying out interest at rates that range from 1.375% to 5.125% depending on when Social Security's trust funds made their investments.

Currently, Social Security's trust funds earn an average of 2.9% on the roughly $2.907 trillion in investments they hold. That works out to roughly $84 billion in interest annually that the program can use to help cover benefits based on current rates.

The great feature most bonds don't offer

The most important feature of Social Security's special-issue securities is one that ordinary Treasury bonds can't match. Social Security is allowed to redeem these securities without any penalty whatsoever. That gives the program the flexibility it needs to deal with the variable nature of when it receives payroll tax withholding revenue from employers as well as money from self-employed workers who pay their taxes in quarterly estimates. For instance, so far in 2018, the trust funds have bought $342 billion in certificates of indebtedness and redeemed $326 billion -- all without any penalty.

By contrast, the Treasury bills, notes, and bonds available to regular investors come with substantial interest rate risk. If you buy a 30-year bond but need to cash it in five years from now, you can end up losing a substantial amount of your principal if rates rise, because a buyer will pay you less for a low-rate bond than the price of a new, higher-rate bond.

Social Security gets even more preferential treatment in some respects. When it needs to make withdrawals, it's required to pull securities that have the earliest maturity date. However, among securities with the same date, it gets to choose the one with the lowest interest rate, hanging onto higher-rate investments to maximize interest income.

Social Security and investing

With the ability to get back its $2.9 trillion at any time, Social Security has all the benefits of long-term interest rates with the liquidity that a short-term debt security offers. That's a combination that ordinary investors just can't get, but it works to the benefit of everyone who gets Social Security now or expects to get it in the future.

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