New article: “What does the turbulent stock market tell us about Social Security personal accounts?”

I've written about this before, but I have an article today on National Review Online that looks at how Social Security personal accounts would have fared under today's market conditions. The motivation behind the piece was a question from Sen. Obama, asking how you would have felt had you invested part of your Social Security taxes in an account. Presumably it was a rhetorical question, but I took it seriously and was surprised at what I found: assuming a full career with a personal account, even a person retiring today would have increased their total Social Security benefits.

A note on titles: last week I had a piece with Kent Smetters in the Wall Street Journal, which was given the title "The Rich Pay Their Fair Share"; what we actually argued was that you couldn't even judge whether the rich pay their fair share given the type of information on tax policy generally reported in the press. The title here – "Still a Good Idea" – is a bit similar: my analysis doesn't prove that accounts are a good idea, but it disproves one argument for why they'd be a bad idea. So I guess you could have called it "Personal accounts: No worse an idea than before" or something along those lines. (My career prospects as a headline writer are probably very limited – although I always thought that "Headless body in Topless Bar" was a classic.)

In any case, here's the piece followed by an added chart.

Still a Good Idea
What does the turbulent stock market tell us about Social Security personal accounts?

By Andrew G. Biggs

The recent financial crisis and ensuing stock-market gyrations have drawn renewed attention to Social Security reform, in particular proposals to establish personal retirement accounts investing in stocks and bonds. Sensing a political opening, Sen. Barack Obama tells campaign audiences, "If my opponent had his way millions of Americans would have had their Social Security tied to stock market this week. Millions would have watched as the market tumbled and their nest egg disappeared before their eyes… Imagine if you had some of your Social Security money in the stock market right now. How would you be feeling about the prospects for your retirement?"

Well, let's imagine that: if Social Security included personal accounts, how would an American retiring today have fared? Despite recent market downturns — the S&P 500 index is down 24 percent for the year as this article is written — the answer is not at all what you would think.

Consider a simple personal account plan similar to those introduced in Congress. Workers could voluntarily invest 4 percentage points of the 12.4 percent Social Security payroll tax in a "life cycle portfolio," which would shift from holding 85 percent stocks through age 29 to only 15 percent stocks by age 55. At retirement, the account balance would be converted to pay a monthly annuity benefit.

However, workers who chose to divert a portion of their payroll taxes to a personal account would also receive a reduced traditional benefit. Traditional Social Security benefits for account holders would be reduced by the amount they contributed to the account, plus interest at the rate earned by government bonds held in the Social Security trust fund. This would keep the current system's finances roughly neutral.

Account holders' total Social Security benefits would increase if their account returned more than the interest rate on government bonds. This makes analyzing how account holders would have fared a relatively simple task.

Using historical stock and bond returns since 1965, I simulated an individual who held a personal account his entire career and retired in September 2008. A typical retiree in 2008 would be entitled to a traditional Social Security benefit of around $15,700 per year. For workers who chose personal accounts, this traditional benefit would be reduced by around $7,800. However, the worker's personal account balance of $161,500 would pay an annual annuity benefit of around $10,100. This $2,300 net benefit increase would raise total Social Security benefits by around 15 percent.

While today's retiree would have faced the subprime crisis and the tech bubble earlier in the decade, he also would have benefited from the bull markets of the 1980s and 1990s. The average return on his account — 4.9 percent above inflation — would more than compensate for a reduced traditional benefit.

While this is an isolated case, it is telling that the very example Sen. Obama uses to illustrate the dangers of personal accounts in fact refutes the point he is attempting to make. Even workers retiring today would have increased their Social Security benefits by choosing a personal account.

But we can go further. Using stock and bond data from 1871 through 2008 I simulated 95 separate cohorts of account holders retiring from 1915 through 2008. Despite the ups and downs of the stock market, every single group of retirees would have increased their benefits by investing in personal accounts. Total benefits would have increased by between 6 and 23 percent, with an average increase of 15 percent.

The point here isn't that stock investments are a free lunch. In an efficient market the higher returns paid to stocks are nothing more than compensation for their higher risk, and we don't know that future market returns will be as good as those in the past. But accounts do provide a valuable tool to prefund future retirement benefits and reduce cost burdens on tomorrow's workers. And these numbers put the lie to Sen. Obama's exaggerations of the risks of investing in the market.

— Andrew G. Biggs is a resident scholar at the American Enterprise Institute in Washington, D.C.

Here's a chart comparing the real internal rates of return on personal accounts holding a life cycle fund versus an all-bond account, for individuals retiring from 1915 through today.

I have a longer paper (hopefully) coming out soon from AEI that will look into this issue in more detail and show why my results differ from those of Robert Shiller. When that comes out I'll post the data and calculations showing where the numbers came from.