January 18, 2022

What will the Fed’s phasing out plans in 2022 mean for Social Security?

Social Security trust funds currently have just over $2.8 trillion in assets in them, but still those funds are expected to run out by 2034, which would cut benefits by nearly a quarter. A major reason for the challenges of the trust funds is the way they are designed. They only have US Treasuries, which currently pay the program a weighted interest rate of less than 2.4%.

When that interest is compared to the a whopping 5.9% increase in benefits per recipient Social Security has to pay out this year due to inflation, it’s no wonder the trust funds are in trouble. They simply cannot earn enough to keep up with the raises the program has to pay out.

Still, there may well be some hope on the horizon. While the stock market has gotten a little nervous when it comes to the Federal Reserve’s plans to launch phasing out the bond purchase program, that news can very well mean good things for social security. Indeed, it could help increase Social Security’s return on its investments and reduce the amount the program has to pay out over time.

A senior couple with a social security card with a dollar bill on it.

Image source: Getty Images.

How phasing out can help Social Security’s return on investment

Because the Fed has the power to print legal currency, it can pay any price it chooses for the assets (usually bonds) it buys. That’s largely how it affects interest rates. If it wants interest rates to go down, it buys more bonds. If it wants interest rates to go up, it slows or halts its purchases — that’s what “winding down” means — and it could even sell some of the bonds it owns.

If the Fed buys less, it means: other people and institutions — those that can’t legally print money — must step up to buy the stockpile of bonds that the Fed no longer buys. given a consistent to deliver of bonds, but reduced ask for bonds, given the Fed’s winding-down decision, prices will of course fall to lower levels. A lower price for a bond means that the buyer will get a higher expected net return on that investment – essentially higher interest rates.

Since social security can only Buying U.S. Treasuries, higher interest means that when it buys new bonds for its trust funds, it gets a higher return on its investment than with lower rates. That could potentially help extend the life of the trust funds, but it won’t be by much. The reason is that with Social Security trust funds expected to begin to contract, Social Security will not be a net buyer of new bonds. So it won’t benefit as much as if it were still building its trust funds.

How tapering can help cut Social Security spending

The greater benefit to Social Security from tapering comes from the effect that tapering is expected to have on inflation. The Fed is winding down to curb inflation. This can work, because if interest rates rise, it becomes more expensive to borrow money. As a result, people and companies who do not have the ability to print legal currency need to be more careful with the money they spend. That tends to make them more price sensitive, which can help tame inflation.

If the Fed is able to slow inflation to a more manageable pace with its winding down, it could be a enormous assistance to social security. This is because social security must increase each year what it pays to recipients when there is positive inflation, to help those recipients cover that inflation. The lower the inflation rate, the less the Social Security outflow will be, making the trust funds last longer.

Fed winding down should help Social Security, but it won’t be enough

Because Social Security income could rise with higher interest rates and cost pressures eased with lower inflation, Social Security could be a big winner of the Fed winding down. Even with that boost, however, it doesn’t change the fundamental trajectory that Social Security follows.

Even under more optimistic assumptions than the base case, Social Security modeling predicts a 95% chance that if nothing changes in the way it works, the trust funds will be depleted by 2041. While that does indicate there’s a chance the trust funds will last longer than the current base projection for 2034, at best buy a few years before benefits risk being cut.

Regardless of when it happens, you have to recognize that there are really only a handful of tools Congress can use to protect Social Security for the longer term. It can raise taxes, it can reduce distributions in a more controlled way than simply leaving the trust funds empty, or it can change the way those trust funds are invested. All three of these options come with a different set of tradeoffs and risks, and they will all affect most Americans as taxpayers, as recipients, or both.

So take the chance you have now to prepare for the changes that will take place in social security in the not-too-distant future. Based on the trajectory it is on, it is not a matter of if the program will change, it’s a matter of how it will change. The better prepared you are in advance, the easier it will be for you to get through those changes, regardless of what they will ultimately look like.

With just over a decade before trust funds are expected to run out, you still have time to craft a plan for yourself, but the longer you wait, the harder any disruption will be. So get started now and be even better prepared for all that is at stake for Social Security.


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