Will Overly Generous Assumptions Doom Social Security Sooner?

The Social Security trustees recently released their annual report for 2022. Remarkably, their estimates showed the program’s combined trust funds lasting until 2035, a one-year reprieve vs. the 2034 depletion date they projected last year.

Of course, every modeled projection is based on assumptions for the future. Unfortunately, there is a significant risk that the assumptions that Social Security’s trustees put into their modeling will turn out to be overly optimistic. If that turns out to be the case, then those overly generous assumptions could very well doom Social Security’s trust funds to deplete sooner than the 2035 date that its trustees project.

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Inflation is a huge risk

The biggest glaring risk in those assumptions is the rate of inflation that the trustees used in their models. The Trustees assumed an inflation rate of 4.54 percent in 2022, 2.33 percent in 2023, and 2.40 percent thereafter. Given that the Bureau of Labor Statistics has published actual annualized inflation rates at or above 7.5% for every month in 2022 so far, the Trustees’ assumptions are laughably lower than reality.

This creates a gigantic risk for Social Security, since its payouts get adjusted for inflation every year. The higher the inflation rate, the more the program will have to pay out, and the faster its trust funds will deplete.

For instance, in 2023, Social Security’s trustees estimate that the program will pay $1.1698 trillion in benefits. Those assumptions are based on the trustees’ 4.54% assumed inflation rate. Bump up inflation to 8.3% — the most recently published actual level — and the program’s costs could spiral to closer to $1.2119 trillion. That’s a one-year cost increase around $42 billion, and that’s just the start.

The bigger problem with inflation is that it stacks, year on year. That potential $42 billion in additional costs gets added to the new base upon which the next year’s inflation adjustment is added. And with 2023 inflation projected in the trustees’ model to be a mere 2.33 percent, the size of that spending risk vs. the trustees’ estimates can quickly skyrocket.

For a sense of just how much is at risk due to inflation, Social Security’s High Cost estimate models that the program’s trust funds will empty in the fourth quarter of 2031. That model assumes a long-run inflation rate of only 1.8 percent. If inflation causes Social Security’s costs to rise faster than even that High Cost estimate projects, then even 2031 might be a generous date for when Social Security’s trust funds will empty.

Is Social Security’s inflation model out of touch?

Perhaps somewhat ironically, Social Security’s model presumes that higher inflation is actually good for the program’s trust funds. To quote the 2022 trustees report: “…a higher price inflation rate immediately results in a higher nominal rate of growth in both earnings and revenues, while the resulting added growth in nominal benefit levels occurs with a delay, causing an overall increase (improvement) in the actuarial balance.”

That assumption might make sense in a world where inflation is driven by wage growth. The ugly reality, however, is that wages have not kept up with the 8+% inflation rate that people are currently facing. In addition, Social Security’s other key source of income — interest on the Treasury Bonds it holds — has also failed to keep up with inflation. Indeed, the highest yield Treasury bonds only pay around 3.3%, well below recent inflation rates.

Neither wages (the major source of Social Security tax revenues) nor interest rates (the major source of Social Security’s non-tax revenue) are keeping up with inflation. That combination makes it very hard to see how this particular manifestation of inflation really works out to be a good thing for the program’s trust funds over time, no matter what the models say. (NYSEMKT: VOO)

Get ready now for changes ahead

Regardless of whether the Social Security trust funds last until 2035 or not, the reality is that the program is on track to see its asset base run out in the not too distant future. If nothing is done, when those trust funds empty, Social Security’s benefits will need to be cut by around 25% in order to approach a sustainable level.

If history is any guide, Congress will likely act to shore up Social Security before the trust funds completely empty. The problem with that, though, is that shoring it up will likely involve some combination of tax hikes and/or benefit cuts to keep the program as a whole solvent for longer. Or in other words, we should expect to pay for those fixes in one way or another.

As a result, one of the best things you can do is start saving and investing now to better prepare for Social Security’s future. If taxes go up, it’s easier to cut back on savings than it is to cut out core parts of your lifestyle. If benefits get cut, you’ll be glad to have that additional pot of money to help cover the gap that Social Security won’t. Either way, you’ll be better off when those changes come thanks to having started saving as early as possible.

So get started now, and get yourself in a better spot to handle the challenges that Social Security will soon have in store for all of us.

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Chuck Saletta has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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