I’ve spoken on Social Security and retirement security issues at various events in recent years. At times, I’m asked what low interest rates mean for the financial security of today’s retirees, to which I reply with a joke: “Why does the Federal Reserve hate old people?”
Though the joke always gets a laugh from the audience, perpetual low interest rates are no laughing matter to the millions of American retirees relying on Social Security benefits and fixed-income securities for their retirement income.
The Federal Reserve has kept its benchmark short-term interest rate at or near zero for several years in an effort to stimulate the economy. Although low interest rates can financially benefit those borrowing money to buy a house or a car or even to fund a new business, such rates can directly weaken the financial well-being of retirees who are living off their life savings.
Low interest rates translate into lower yields on fixed-income assets, meaning the monthly interest and dividend payments that seniors rely on in retirement will generally be lower than anticipated. This lack of income could lead to reduced consumption and an inability to pay bills. Low interest rates also negatively impact Social Security’s broader finances because Social Security Trust Funds earn interest on their US Treasury bond holdings.
By law, Social Security has to invest its surpluses in special-issue Treasury bonds that are available only to Social Security. It cannot buy or hold other financial assets such as stocks, mutual funds, or corporate bonds. Like other government-issued bonds, those bonds pay interest and are real assets; however, the way the federal government accounts for the Trust Funds masks the true scope of the costs passed on to future generations.
Even though bonds are real assets to the private market, coming generations of taxpayers or borrowers will have to cover the cost of future redemptions of bonds issued today because the federal government used the money it received from Social Security to pay for education, wars, and other items. That is to say, the government already spent the money it received for the IOUs placed in the Social Security Trust Funds.
Interest rates have been below 2 percent for most of 2016, and revenue generated from interest payments made to the Trust Funds has been declining since 2009. Although the Federal Reserve’s policy of low interest rates is designed to stimulate economic growth, there hasn’t been much growth leading to more jobs, higher wages, and higher incomes—all items on which Social Security payroll taxes would be levied.
All else equal, this lack of payroll tax revenue hastens the depletion of the combined Social Security Trust Funds, which is currently projected for 2034. In sum, continued low interest rates, combined with slow economic growth and an aging population of baby boomers who are receiving Social Security payments and who are living longer, contribute to a quicker depletion of the Social Security Trust Funds. This lack of additional funds further threatens the financial security of retirees because it means they are at risk of greater Social Security benefit cuts much sooner as a result of Trust Fund depletion.
For seniors who can afford to delay claiming Social Security, there are, however, potentially considerable financial benefits to a low-interest-rate environment. Social Security is basically an inflation-protected annuity. Companies that sell annuities in the private sector generally adjust their payouts and make them less generous when life spans increase or when interest rates decrease.
However, Social Security doesn’t adjust monthly benefits this way—its age adjustments are fixed by law. Consider someone whose full retirement age today is 66. For each year that person delays claiming Social Security retirement benefits, the monthly benefit amount will be approximately 8 percent higher. Delaying a claim until age 70 results in a 32 percent higher monthly benefit whether or not a low-interest-rate environment perseveres.
But what would happen if interest rates rose 500 basis points? Would that increase help or hurt Social Security? It is hard to say. To a first approximation, high interest rates have positive effects on Social Security finances. If, however, the high interest rates were in response to an overheated economy, thereby leading to a recession and job losses, payroll tax revenue would decline. This change would place negative pressure on Social Security finances.
Retirees may be facing a no-win situation: low interest rates and high interest rates are both potentially bad for Social Security. But there is a middle ground—low and stable interest rates coupled with moderate economic growth in wages. Nominal interest rates of 3 to 4 percent (100–200 basis points higher than where they are today) with similar economic growth rates would provide a stable interest-rate environment for the Social Security program and retirees.
Under current law, even if we do achieve a “Goldilocks” range of interest rates and economic growth, Social Security finances will still remain on an unsustainable trajectory. The 2016 Social Security Trustees Report shows a continuing trend toward insolvency of both trust funds irrespective of interest rates. Trustees estimate that Social Security’s combined retirement and disability trust funds will become depleted in 2034—but a crisis date almost 20 years away has lulled some into falsely believing the program’s finances are now stable. Don’t be fooled; payroll tax revenues will fund a declining share of benefits between now and 2034, and this decline will put pressure on the rest of the federal budget. Assuming there are no tax increases, the difference will have to be made up through borrowing or reductions in other federal spending.
Social Security faces severe, urgent financial challenges that policymakers must address immediately to ensure the program remains viable for future generations. Ignoring or delaying a response to fiscal challenges will only increase the magnitude of changes required, regardless of whether we maintain low, medium, or high interest rates.