For years, experts have warned that Social Security is in serious financial trouble. In fact, the most recent projections from the Social Security trustees indicated the program's trust fund will run short in 2035, requiring a major cut to benefits. And the coronavirus isn't helping the situation.
In fact, due to the COVID-19 economic fallout, the University of Pennsylvania Wharton School estimates the trust fund will be depleted as much as two years sooner than expected if there's a V-shaped economic recovery, or four years sooner in a U-shaped recovery. A V-shaped recovery would mean a sharp rise in economic activity with measures of economic health returning quickly to a prior peak; a U-shaped recovery works similarly, but economic indicators linger longer at the bottom before returning to prior peaks.
While no one can predict exactly how quickly the economy will recover, it's easy to see why COVID-19 will hurt Social Security's future. In fact, Penn Wharton has identified three ways this will happen.
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1. Reduced payroll tax collection
Payroll taxes are Social Security's primary funding source. But when unemployment rises, payroll tax collection falls because employers and employees aren't paying into the system and no payroll taxes are collected on unemployment benefits.
Job losses are also largely concentrated among low-wage workers, according to Wharton's data. That means the impact on collected revenue will be greater since low-wage workers pay these taxes on their entire income while higher earners don't because there's a wage base limit capping the amount of money subject to tax.
Payroll tax collection may also be reduced because coronavirus relief bills enabled employers to defer the payment of some of these taxes for several years. While they'll have to pay eventually, the money won't be going into the program now. And since funds paid in are invested and earn income for the trust fund, the loss of that interest revenue will only exacerbate existing funding shortfalls.
2. Lower interest rates reduce income the trust fund collects
Speaking of reduced interest revenue for the trust fund, there's another problem: The fund isn't likely to earn as generous a return on investments due to COVID-19. The trust fund is invested in U.S. Treasury securities, and interest income from them helps to support the program along with payroll tax revenue and taxes on high earners. But Penn Wharton indicates current low interest rates on Treasury securities are likely to persist and reduce income from this source as well.
With the program earning a lower rate of return and having less tax revenue it can invest, this could profoundly affect its financial future.
3. Low inflation reduces earnings and reduces tax revenue
Finally, Penn Wharton indicates COVID-19 could lead to a prolonged period of low inflation. This downward pressure on prices will suppress wage growth and reduce the collection of payroll taxes over the long term.
Retirees should prepare for benefit cuts
With the trust fund already in danger of running dry, these further reductions to Social Security's funding sources could have dire consequences. And while lawmakers could prevent a disastrous benefit cut by taking action, such as raising the payroll taxes, there's little political will to compromise when it comes to changes to this popular entitlement program.
Because the threat of insolvency becomes more real with each passing year, current and future retirees should begin preparing now for a day when Social Security provides less income than they were expecting.
