Social Security Trustees recently released their annual report for 2022. Remarkably, their estimates showed the program’s combined trust funds would last through 2035, a one-year reprieve from the 2034 exhaustion date. that they projected last year.
Of course, each modeled projection is based on assumptions for the future. Unfortunately, there is a significant risk that the assumptions that social security administrators build into their modeling will turn out to be overly optimistic. If that turns out to be the case, then these overly generous assumptions could very well condemn Social Security’s trust funds to run out sooner than the 2035 date predicted by its trustees.
Inflation is a huge risk
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The biggest glaring risk in these assumptions is the rate of inflation the administrators used in their models. The trustees assumed an inflation rate of 4.54% in 2022, 2.33% in 2023 and 2.40% thereafter. Given that the Bureau of Labor Statistics has published real annualized inflation rates at or above 7.5% for every month in 2022 so far, the administrators’ assumptions are laughably understated.
This creates a gigantic risk for Social Security, since its payments are adjusted for inflation each year. The higher the rate of inflation, the more money the program will have to shell out and the faster its trust funds will run out.
For example, in 2023, Social Security administrators estimate the program will pay $1.1698 trillion in benefits. These assumptions are based on the Trustees’ assumed inflation rate of 4.54%. Pushing inflation to 8.3% – latest figure released real level – and program costs could skyrocket to closer to $1.2119 trillion. That’s a one-year cost increase of about $42 billion, and that’s just the beginning.
The biggest problem with inflation is that it builds up year after year. This potential $42 billion in additional costs is on top of the new baseline on which Next the year’s inflation adjustment is added. And with 2023 inflation projected in the Directors’ model at just 2.33%, the size of this expense risk relative to the Directors’ estimates can quickly skyrocket.
To get a sense of the magnitude of the risk due to inflation, the High Cost of Social Security estimate models that the program trust funds will empty in the fourth quarter of 2031. This model assumes a rate of inflation long-term of only 1.8%. If inflation is causing Social Security costs to rise faster than even this high cost estimate, then even 2031 could be a bountiful date by which Social Security trust funds will empty.
Is the Social Security inflation model disconnected?
Perhaps somewhat ironically, the Social Security model assumes that higher inflation is actually good for program trust funds. To quote the 2022 Directors’ Report: “…a higher rate of price inflation immediately leads to a higher nominal rate of growth in earnings and incomes, while the resulting additional growth in benefit levels nominal occurs with a lag, resulting in an overall increase (improvement) in the actuarial balance.
This assumption strength logic in a world where inflation is driven by wage growth. The sad reality, however, is that wages have not kept up with the over 8% inflation rate that people are currently facing. In addition, Social Security’s other key source of revenue — interest on the Treasury bills it holds — has also failed to keep up with inflation. Indeed, high-yield Treasuries only pay around 3.3%, well below recent inflation rates.
Neither wages (the main source of Social Security tax revenue) nor interest rates (the main source of non-tax Social Security revenue) follow inflation. This combination makes it very difficult to see how this particular manifestation of inflation turns out to be a good thing for program trust funds over time, no matter what the models say. (NYSEMKT: VOO)
Prepare now for the changes to come
Regardless of whether Social Security Trust Funds last until 2035 or not, the reality is that the program is on track to see its asset base deplete in the not-too-distant future. If nothing is done, when these trust funds are exhausted, social security benefits will have to be reduced by about 25% to come close to a sustainable level.
If history is any guide, Congress will likely act to shore up Social Security before trust funds are completely depleted. The problem with this, however, is that consolidating it will likely involve a combination of tax increases and/or benefit cuts to keep the program as a whole solvent longer. Or in other words, we should expect to pay for these fixes somehow.
Therefore, one of the best things you can do is start saving and investing now to better prepare for the future of Social Security. If taxes go up, it’s easier to reduce your savings than to cut essentials from your lifestyle. If benefits are reduced, you’ll be happy to have that extra money to help cover the gap that Social Security won’t cover. Either way, you’ll be better off when these changes come because you’ll have started saving as soon as possible.
So get started now and put yourself in a better position to meet the challenges that Social Security will soon have in store for us all.
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Chuck Saletta has no position in the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.