Did Reid say that Social Security reform is “off the table”?

A number of press outlets are reporting on comments by Senate Majority Leader Harry Reid that Social Security reform is "off the table." Given the President's flaccid discussion of Social Security in the SOTU I don't really doubt that conclusion, but it's worth bearing in mind what Reid actually ruled out: "privatizing or eliminating" the program, which to most readers would leave a fair amount of policy options on the table. (E.g., do the recommendations of the President's fiscal commission fit under "privatizing or eliminating"? If proposed by a GOP Member of Congress they probably would, but given they came from the President's own appointees I'm hoping they'd get a pass.) In any case, here's the video of Senator Reid so you can watch for yourself.

Read more!

Hubbard (Not Mankiw!) on Social Security Accounts and the Public Option

Update: An unfortunate attribution error led to me treat Bush CEA chairs as interchangable. My apologies to all involved.

Glenn Hubbard writes in the New York Times, hitting a point that's occurred to me at various times during the health debate: the "public option" is to liberals today what Social Security personal accounts were to conservatives back in 2005, when President Bush promoted Social Security reform. From one point of view, neither the public option nor personal account are really all that important: many of the health reforms people wish to accomplish, such as broadening coverage or cutting waste, can be done without the public option; likewise, personal accounts don't reduce the need to raise taxes or cut benefits as part of Social Security reform.

At the same time, the public and personal accounts are the most important elements for many of the most energetic proponents of reform. The liberal base strongly desires the public option just as the conservative base desired personal accounts. Liberals have a philosophical belief that health care is a right that shouldn't be subject to markets and profit motives. Likewise, conservatives believe that individuals should have more control over their retirement savings, and government less. This "ownership society" viewpoint was a strong motivator for President Bush and others, including myself.

Glenn argues that for the good of reform, President Bush should have put aside personal accounts if doing so would have allowed him to accomplish reform of the rest of the Social Security program. Likewise, he says, Democrats should set aside the public option in order to accomplish health care reform. Despite my strong support for accounts over the years, I think Glenn is right on both counts.

Read more!

Marc Goldwein: The end of the ownership society?

The New America Foundation's Marc Goldwein has an excellent article in George Mason University's History News Network on the influences, rise and potential decline of what President Bush called the "ownership society," embodied by the idea of personal accounts for Social Security. It's a very good piece and well worth reading.

For what it's worth, here's an old article of mine which argues for the non-financial benefits of ownership. I still think the basic rationale for ownership has merit and many of the arguments against it don't stand up to scrutiny. But Goldwein's article is more about the political dynamics, and there I agree that with the decline in the stock market, housing prices, etc., the idea of personal ownership has taken a knock.

Read more!

The Social Security trust fund is a safe, dependable return. Right?

With the stock market crash, many have pointed to the safety and security of Social Security relative to 401(k) plans and the idea of adding personal accounts to Social Security. There is certainly merit to these arguments, and having a diversified portfolio of safe and risky investments makes sense.

At the same time, it's worth checking into how Social Security's investments have done over time. Surplus taxes paid into Social Security are invested in the Old Age, Survivors and Disability Trust Funds (OASDI), which hold special-issue government bonds whose interest rates are based on average Treasury bond interest rates at the time. The idea here is investments which provide safe, if modest, returns for the long-term.

But not many people have considered how modest. Effective annual interest rates on the trust funds are available through the Social Security actuaries' web site (see here). To calculate real returns I subtracted the annual rate of growth of the consumer price index (CPI), available here. A couple charts tell an interesting story. First is a fairly conventional comparison: how did the trust funds' returns compare to a mixed portfolio of 50 percent stocks and 50 percent bonds? The first chart shows average annual returns by decade and shows a couple interesting things. First, the mixed portfolio returns exceeded the trust fund's returns in all decades except for the truncated 2000-2008 period, by an average of around 2.9 percent. Second, both the stock-bond portfolio and the trust funds lost money in two decades, although only the trust funds had a truly terrible decade, losing 3.5 percent annually during the 1940s.

The second chart shows a running average return on the trust funds, beginning in 1940. The return value for each year represents the average of returns from 1940 through that years. Here's something I found pretty interesting: from the program's inception through 1986, the average annual return on the trust funds was negative. To repeat, through the first four and one half decades, the trust fund's investments lost money on average each year. Following 1986 the running average of annual returns was positive, but barely so: even extending through 2008, the average annual return on trust fund investments, adjusted for inflation, was only 1.38 percent above inflation. These returns are safe, to be sure, but far lower than the 4.4 percent real annual return on the stock-bond portfolio.

So here's a question: if the trust fund's returns have been so low, how did Social Security manage to pay such high benefit returns to early retirees? (The benefit return is a function of taxes paid and benefits received, with the trust fund's investment return having an only indirect effect on benefits.) We've talked here several times about the high returns paid to early retirees; here's a chart showing average annual returns paid to beneficiaries. The answer is that while a sustainable Social Security program would have built up a significant trust fund balance over time to help pay future benefits, the trust fund balance was kept very low and the extra funds paid out as benefits. When Social Security was begun, the idea was for it to become a "funded program" carrying a large trust fund balance. Congress soon acted to delay scheduled tax increases and move up the payment of benefits, in addition to making benefits more generous. (Lesson: past Congresses were pretty much like present ones in terms of catering to current voters over future ones.) High benefits were paid, at the expense of the trust fund balance that could help the system fund itself in perpetuity. This was, in effect, like eating your seed corn: things look good in the short-term, but you don't have the means necessary to keep things going for the long run.

Read more!

Elliot Spitzer whiffs on Social Security reform

There is one statement in Elliot Spitzer's Slate.com article on Social Security personal accounts that I fully agree with: "'We told you so' is just about the most annoying sentence one can utter." Sure is. Beyond that, though, Spitzer's argument that stock market declines over the past year just prove the foolishness of individual investing is pretty flaccid stuff.

Spitzer begins by simply highlighting that "Since Jan. 1, 2005, the year President Bush proposed the idea, the Dow Jones industrial average has dropped from 10,783 to around 8,000, a drop of more than 25 percent." Ok, but in the Bush plan older workers accounts would automatically switch to bonds beginning at age 55, meaning that most people retiring today would have had much less exposure to that falling market than younger workers.

Then Spitzer says that he will quantify the losses to today's retirees, "abeit roughly." Spitzer should have said albeit very roughly, since Spitzer relies for his numbers on a Fortune article by Allan Sloan that Sloan himself later retracted due to technical misunderstandings of how personal account plans would have worked.

In this recent post, I gave the results of a much more detailed simulation of personal accounts using historical market returns. The short story is that there is no historical period in which a worker holding an account for a full career would have failed to significantly increase his total Social Security benefits, including workers retiring today. Moreover, even workers who held an account for only a few years before retiring under today's market conditions would have experienced only tiny declines in total Social Security benefits.

Finally, Spitzer says, "as Paul Krugman has pointed out, the would-be privatizers make incredible—even impossible—assumptions about the likely performance of the market to justify their claim that private accounts would outdo the current system." The basic argument here is that as a slow-growing workforce reduces long-term GDP growth, stock returns must be lower as well.

But here's the problem: first, it's not the "privatizers" who make assumptions regarding future stock returns, it's the non-partisan actuaries at Social Security and economists at the Congressional Budget Office. Second, as I showed in this blog post using historical data from sixteen countries over a 100-year period, the correlation between GDP growth and stock returns is statistically very weak.

There are plenty of good arguments to make against adding personal accounts to Social Security. Spitzer should have spent more time actually making them.

Read more!

Follow-up: how would current retirees have fared if Social Security accounts had passed?

The Washington Times editorial I posted earlier prompted me to run some additional numbers on how Social Security benefits for current retirees would have been affected had a personal accounts reform plan been enacted.

In the Retirement Policy Outlook I published through AEI in November I showed that an individual retiring in 2008 who held a personal account his entire career would have increased his total Social Security benefits by around 15 percent. I also simulated full-career account holders retiring in years ranging from 1915 through 2008, showing that they would have increased their total benefits by between 6 and 23 percent, with an average increase of around 15 percent.

But there's a reasonable objection to these numbers: not every worker would hold a personal account their entire career. In particular, had Social Security reform passed, many workers would have held an account for just a few years before retirement – and these weren't exactly the best years to be in the market. Those with only a few years with personal accounts prior to retirement could have taken large losses.

So I ran some new numbers to test this idea. As before, I assumed that workers invested 4 percent of their earnings in a personal account holding a "life cycle" fund, which automatically held 85 percent stocks through age 30, then gradually declined to 15 percent stocks by age 60 and constant thereafter. Traditional benefits for account holders would be reduced by the amount they contributed to their accounts, compounded at the rate of return earned by government bonds. This is designed to make the traditional Social Security whole for lost taxes during working years.

As before, I assumed an individual who retired at age 65 as of November 2008, when stocks were down more than 30 percent for the year. The difference here is that I simulated account participation beginning not simply at age 21, but at every age through age 64. So we get to see the effects of having a personal account through only part of a person's working career. This will tend to exacerbate the ups and downs of the market, since there is less time to recover and revert to the long-term average.

The chart below shows the results. The full career worker receives a total Social Security benefit increase of around 15 percent, as in the previous study. (There are some very minor technical differences between the two, but nothing significant.) Total benefit gains decline through participation beginning at age 47, at which point the account holder would receive almost exactly the same benefit as someone who didn't choose a personal account.

Individuals who began participating in a personal account at ages 48 through 64 would have lost money by doing so, but these losses would be very small: on average, total benefits would be reduced by only 0.3 percent. Moreover, even this figure may be misleading, since under most reform plan specifications individuals over age 55 would not be allowed to participate in accounts, for the very reason that they would not have enough time prior to retirement.

Now, this exercise is hardly dispositive, and the usual caveats I made in the full paper apply. Yet, while anecdotal, this seems to me to be much stronger anecdotal evidence than the arguments that begin and end with, "Think what would have happened had personal accounts passed – wouldn't you have been sorry?"

Read more!

New paper: “Will Your Social Insurance Pay Off? Making Social Security Progressivity Work for Low-Income Retirees”

I have a new paper up in AEI's Retirement Policy Outlook series called "Will Your Social Insurance Pay Off? Making Social Security Progressivity Work for Low-Income Retirees." Here's the summary followed by some comments:

Although the Social Security program is progressive--meaning that the replacement rate of preretirement earnings offered by Social Security tends to rise as lifetime earnings decline--this relationship is erratic. While individuals with lower lifetime earnings receive better treatment on average, lifetime earnings are only a weak predictor of how any one person will be treated by the Social Security program. Many high-earning households receive high replacement rates, and many low-earning households fail to receive them. Thus, Social Security is not entirely effective as a social insurance program protecting low lifetime wage earners against a meager retirement. In order to make Social Security more reliably progressive--thus protecting low-earning workers and allowing them to plan more effectively for their financial future--one possible approach would be to offer a flat dollar benefit for each retiree along with an individual account whose benefits are tied directly to contributions.

A few charts give a feel for the main points, which I think are pretty important in policy terms. This first chart shows median Social Security replacement rates by lifetime earnings percentile. The slope of the line is negative, which means that as your lifetime earnings rise your replacement rate tends to fall. In other words, Social Security is progressive, on average.

But only on average. The second chart shows actual data points for couple's replacement rates, taken from the GEMINI microsimulation model. Even if the system is progressive on average, there's a ton of variation in replacement rates even for couples with the same lifetime earnings. The reason is there are a ton of pieces of the benefit formula – wage indexing of earnings; the 35 years averaging period for earnings; the 10-years required for benefit eligibility and divorced spouse benefits; the 50 percent spousal benefit; the tax max, etc – that can make benefits very different even for individuals or couples with the same earnings level.

There are a lot of low earners who receive low replacement rates, and a lot of high earners who receive high replacement rates. What's more, the variation in replacement rates rises for lower income people, who are precisely the ones who need social insurance the most. In other word, for low earners Social Security is like a home insurance policy that may or may not pay off if your house burns down – and sometimes pays off even if your house doesn't burn down.

But now check out the third chart. This shows results from a stylized reform plan: every retiree receives a flat dollar benefit of $600 per month from Social Security. In addition, every worker has a personal account in which they save 3 percent of their earnings; these are invested only in government bonds. The key thing here is that average benefits are around the same as Social Security, and average progressivity is also around the same (meaning the slope of the line is the same, although extremely low earners do receive higher replacement rates here than Social Security). What's different is that there's much less variation in replacement rates: low earners consistently receive high replacement rates, and high earners consistently receive low replacement rates.

What this shows is that for the purposes of social insurance, sometimes too much complexity actually makes things worse. A very simple and understandable reform plan can accomplish the social insurance purposes of Social Security better than current law.

Read more!

Economic growth and stock returns

In the comments over at Angry Bear, Bruce Webb brings up a common argument regarding Social Security reform and personal accounts: that Social Security's projected insolvency is due to low economic growth, but if the economy grows slowly then stock returns will also be low, and so personal accounts investing in stocks can't really do anything to help Social Security or Social Security beneficiaries.

I've got some sympathy for the economic growth/stock returns argument in theory (short story: future economic growth will be lower because birth rates/labor force growth will also be lower; this can lead to capital deepening, such that the ratio of capital to labor rises; this in turn leads to lower returns on capital). Although, Kotlikoff, Smetters and Walliser make an interesting opposite argument, that rising entitlement spending due to population aging will soak up so much excess capital that stock returns are likely to rise.

Moreover, as I argue here, I think the rate of return argument pitting personal accounts against Social Security is generally wrong.

But anyway, here's some data I haven't seen around before that some might find interesting. If you do believe that economic growth and stock returns should be strongly correlated, at least over the long term, then you'd think that if you compared long-term economic growth/stock returns from a number of countries that we'd see a tight fit.

The chart below shows average annual GDP growth and average real stock returns for 16 countries in the period 1900-2000. (The equity returns are from Dimson, Marsh and Staunton; the GDP growth is from Maddison.) The regression shows there is a positive relationship on average, such that average equity returns equal 1.96 percent plus 0.92 times the country's rate of GDP growth. Short story: higher GDP growth should mean higher equity estimate.

The problem here is that the fit of the regression is pretty poor: the R-squared value is 0.1, meaning that about 10 percent of the difference in equity returns between countries is accounted for by differences in their rates of GDP growth. The rest of the differences are due to other things. So from this chart (and the discussion above) we can conclude that while the economic growth/stock returns argument has some merit, it's not the major driver of things.

Read more!

Problems with Guaranteed Retirement Accounts

The New York Times calls Teresa Ghilarducci's proposal for Guaranteed Retirement Accounts one of the "ideas of the year." Here's some background, and then in later posts I'll look at a number of problematic issues regarding the proposal. The following summary of the GRA plan is pulled from this paper Ghilarducci wrote for the Economic Policy Institute:

How Guaranteed Retirement Accounts work

Structure. Guaranteed Retirement Accounts are like universal 401(k) plans except that the government, as befits a large and enduring institution, will invest and manage the pooled savings.

Participation. Participation in the program is mandatory except for workers participating in equivalent or better employer defined-benefit plans where contributions are at least 5% of earnings and benefits take the form of life annuities.

Contributions. Contributions equal to 5% of earnings are deducted along with payroll taxes and credited to individual accounts administered by the Social Security Administration. The cost of contributions is split equally between employer and employee. Mandatory contributions are deducted only on earnings up to the Social Security earnings cap, and workers and employers have the option of making additional contributions with post-tax dollars. The contributions of husbands and wives are combined and divided equally between their individual accounts.

Refundable tax credit. Employee contributions are offset through a $600 refundable tax credit, which takes the place of tax breaks for 401(k)s and similar individual accounts and is indexed to wage inflation. Eligibility for the tax credit is extended to part-time workers, caregivers of children under age six, and those collecting unemployment benefits. If an individual's annual contributions amount to less than $600, some or all of the tax credit is deposited directly into the account in order to ensure a minimum annual deposit of $600 for all participants.

Fund management. The accounts are administered by the Social Security Administration and funds are managed by the Thrift Savings Plan or similar body. Though funds are pooled, workers are able to track the dollar value of their accumulations, as with 401(k)s and other individual accounts.

Investment earnings. The pooled funds are conservatively invested in financial markets. However, participants earn a fixed 3% rate of return adjusted for inflation, guaranteed by the federal government. If the trustees determine that actual investment returns have been consistently higher than 3% over a number of years, the surplus will be distributed to participants, though a balancing fund will be maintained to ride out periods of low returns.

Retirement age. Participants begin collecting retirement benefits at the same time as Social Security, and therefore no earlier than the Social Security Early Retirement Age. Funds cannot be accessed before retirement for any reason other than death or disability.

Retirement benefits. Account balances are converted to inflation-indexed annuities upon retirement to ensure that workers do not outlive their savings. However, individuals can opt to take a partial lump sum equal to 10% of their account balance or $10,000 (whichever is higher), or to opt for survivor benefits in exchange for a lower monthly check. A full-time worker who works 40 years and retires at age 65 can expect a benefit equal to roughly 25% of pre-retirement income, adjusted for inflation, assuming a 3% real rate of return. Since Social Security provides the average such worker with an inflation-adjusted benefit equal to roughly 45% of pre-retirement income, the total replacement rate for this prototypical worker will be approximately 70%.

Death benefits. Participants who die before retiring can bequeath half their account balances to heirs; those who die after retiring can bequeath half their final account balance minus benefits received.

In following posts, I'll look at several aspects of the GRA plan that I think are worth considering more carefully before moving ahead.

Read more!

AARP mutual fund costs

This Bloomberg story isn't directly Social Security-related, but it reminds me of a few interesting issues from the Social Security debate from a few years back. Bloomberg reports that health and auto insurance purchased through AARP often costs far more than seniors could buy simply by calling up an insurance company on their own. Understandably, some AARP members were upset, thinking they would receive discounts by purchasing through the organization. They story didn't have extensive responses from AARP and they may well have good explanations for how they price their insurance products, so I don't want to hit that issue too hard.

But it does remind me of some research I did back in 2005. At the time, the personal accounts debate was going strong and AARP posted an online cartoon (download the file and open in Internet Explorer) in which supporters of President Bush's proposal for voluntary personal accounts are portrayed as greedy financiers with telescoping arms seeking to separate unwary workers from their retirement checks. You would take the risk, the cartoon says, while they would collect the profits. (The fact that accounts would have been handled by a low-cost government agency similar to the Thrift Savings Plan, and that estimated administrative costs were only 30 basis points, was apparently lost on them.)

This got me thinking: how much did AARP charge for their mutual funds, which they offered through a co-branding with Kemper Securities? Given their rhetoric regarding fees that would be charged for Social Security accounts, as well as their general mission of providing low-cost products and services to seniors, one would assume the admin charges on AARP branded mutual funds would be at least as low as those charged to someone who walked into an investment company off the street.

As it turned out, that wasn't really the case. For instance, consider funds that track the S&P 500 index. AARP's annual charge for their index fund in 2005 was 0.45 percent of account balances, or "45 basis points" in investors' jargon. This was almost twice the industry average of 25 basis points for products that are, by design, identical. Of the 10 largest S&P 500 index funds, 8 had lower expenses than AARP's.

Since I invest through Vanguard, I compared fees on a range of AARP funds to comparable funds offered through Vanguard. The table below shows what I came up with (remember, these were fees as of around April 2005). Averaging nine typical funds, AARP's fees to its members were 2.6 times higher than Vanguard's. I believe the minimum investment requirements were lower for AARP than for Vanguard, which could make the AARP funds a better deal for very small investors. But for a typical person, AARP's fees were definitdely higher than Vanguard's. Over long periods, this can make a big difference in what you end up with.

Annual fees on sample of 9 similar mutual funds (as percentage of fund assets) as of April 2005.
AARP		Vanguard
Fund	Fee	Fund	Fee
Tax Free Money Fund	0.70	Tax-Exempt Money Market Fund	0.13
US Treasury Money Fund	0.65	Treasury Money Market Fund	0.30
S&P 500 Index Fund	0.45	500 Index Fund Investor Shares	0.18
Emerging Markets Growth Fund	1.77	International Explorer Fund	0.57
Global Discovery Fund	1.51	Global Equity Fund	0.90
Balanced Fund	0.81	STAR Fund	0.37
Global Fund	1.45	Global Equity Fund	0.90
Small Cap Growth	1.00	Explorer Fund Investor Shares	0.57
Development Fund	1.48	U.S. Growth Fund Investor Shares	0.53

I believe AARP has changed its co-branding from Kemper to another company and its current fees appear more reasonable. The net admin cost for each of the three stock funds is 50 basis points. Each fund is composed of index funds of domestic and international stocks and corporate bonds. AARP's aggressive mutual fund is similar to Vanguard's LifeStrategy Moderate Growth, which carries an annual administrative cost of 23 basis points. However, the $3,000 minimum investment for Vanguard is higher than for AARP's fund, where the minimum is only $100. That said, if you have more than $3,000 – and I'd guess that most AARP members would – then it's not clear that AARP's funds offer better value than you'd get from Vanguard or some alternate provider. The lesson: shop around.

One final note: you could argue that while you'd pay more for an AARP mutual fund than from some other companies, AARP takes that extra money and puts it to good use through its policy advocacy and services to seniors. However, you'd still come out ahead if you bought the cheapest mutual fund available then donated the savings to the AARP Foundation, for which you would receive a charitable tax deduction.

Read more!

New paper: “Stock Market Fluctuations and Retiree Income: An Update”

Gary Burtless from the Brookings Institution has released an update to his earlier work on how stock market volatility could affect individuals holding Social Security personal accounts. Here's the summary, followed by my comments:

The recent plunge in home values and even bigger dive in stock prices offer painful reminders of why Social Security seemed like such a good idea in the 1930s. Benefits are predictable, are guaranteed by the government, and are adjusted every year to keep their purchasing power stable. In contrast, workers who count on the stock market to fund their retirement have seen their savings shrink more than 40% over the past year. The question is: what kind of retirement plan offers the best guarantee workers will receive a predictable and comfortable income when they grow old?

Luckily for most older Americans, the cornerstone of their retirement income is still a Social Security check. Social Security plays a crucial role in maintaining the incomes of Americans past the age of 65. Last year it accounted for 39% of the total income received by the elderly. It is a particularly important source of income for low-income seniors. For aged Americans in the bottom one-fifth of the income distribution, it accounts for nearly $9 out of every $10 they receive. The benefits and returns are more secure than incomes from private saving accounts, and they are indexed to inflation, which is rarely the case for private pensions or annuities.

Financial planners often recommend that workers aim to replace 75% to 85% of the wages they earn before retirement. Suppose workers set aside 4% of their salaries to meet this goal. How much would their retirement incomes fluctuate, depending on the start and end dates of their careers and the investment strategies they choose? Between 1999 and 2002 both the stock market and the yield on bonds declined. Wage earners who worked for 40 years and invested all their retirement savings in stocks would have seen their wage replacement rates fall 53 percentage points. Workers who followed a more conservative investing philosophy and placed half their retirement savings in bonds would have seen their replacement rates fall 18 percentage points. The latest market turmoil has delivered another jolt to workers who count on their stock investments to pay for retirement. Between October 31, 2007, and October 24, 2008, the drop in stock prices has reduced the expected retirement income flow from a stock-invested savings account by 46%.

The Great Depression and the stagflation years from 1974-1983 were the most recent periods of great economic uncertainty. Few people in those years suffered under the illusion that a private savings account offers a secure foundation for a comfortable retirement. Big selloffs in the stock and bond markets persuaded most Americans that government-guaranteed pensions were valuable and well worth preserving. The recent market selloff may have the same salutary effect on voters' opinions. Social Security's problems still need fixing. But it is hard to argue that the most sensible fix will involve scaling back Social Security's basic promises in order to make room for a bigger private savings system.

Since I'll disagree with Gary regarding some of the details, let me state upfront that I agree with many of his qualitative points and many of his conclusions. The stock market is volatile, Social Security accounts don't pay higher returns when adjusted for risk, and the recent market fluctuations do show the value of a combined defined benefit/defined contribution provision of pension income. In some senses, the numbers I'll present -- while a better representation of what an actual reform plan would have paid -- look too good; future returns could be lower and more volatile than in the past, so beware that past performance doesn't guarantee future results.

I have written on this topic recently and have a longer paper coming out soon, but I'll try to explain here what drives the differences between Gary's results and my own. While I don't question his calculations, I believe his modeling of the accounts differs in significant ways from the structure of actual account based reform plans and these modeling differences account for much of his results.

Let me first explain the stylized personal account plan that I modeled:

• Individuals would invest 4 percentage points of the 12.4 percent social security tax in a personal account. At retirement, the account would be annuitized to produce a steady monthly income.
  
• The account would hold a "life cycle" fund that holds 85 percent stocks through age 29, declining to 15 percent stocks by age 60. Individuals are assumed to work from 21 through 64 and retire at age 65.
  
• In exchange for being able to divert part of their payroll taxes to a personal account, individuals would give up traditional benefits equal to their account contributions compounded at the government bond rate of return. This "shadow account" would be annuitized on the same terms as the real personal account, and the annuity payment would be deducted from the worker's traditional benefits. This shadow account is designed to keep the trust fund roughly neutral with regard to personal account participation.
  

To keep things simple, total Social Security benefits would increase to the degree that the return on the real personal account exceeded the return on the all-government bond accounts.

I simulated personal accounts using stock and bond returns from 1871 through September 2008. The chart below shows total Social Security benefits – traditional benefit, minus shadow account offset, plus personal account annuity – relative to pre-retirement earnings. (Note that my replacement rates are relative to the workers Average Indexed Monthly earnings while Gary's are to earnings during the worker's 50s, so the levels of replacement rates will differ. However, the volatility is what we're interested in here so it's not a huge deal.)

The baseline replacement rate for Social Security benefits alone is 39 percent; this is the replacement rate an individual would receive if he did not participate in an account. The average total Social Security replacement rate for an account holder is 45 percent. The interquartile range is from 44 percent through 46 percent, meaning that half the cohorts receive replacement rates in this range. The minimum replacement rate was 41 percent while the maximum replacement rate was 48 percent.

I'll leave it to others to judge whether this constitutes too much volatility in retirement income derived from Social Security. However, it's clear that this level of volatility is significantly lower than found in Gary's paper. Why? Three reasons:

• First, I am modeling replacement rates from the total Social Security benefit, while Gary models only replacement rates from the account alone. Because of the interactions between the account and the shadow account, detailed below, I believe this is the only way to realistically analyze volatility of retirement income from reform proposals that could actually be considered.
  
• Second, part of the volatility in replacement rates in Gary's simulation derives not from risky stock returns but from differences in interest rates at the time the account is converted to an annuity. The annuity payment rises or falls based on the interest rate at the time the annuity is purchased. In the stylized reform plan I simulate – which again, more closely resembles actual reform plans than does Gary's approach – both the annuity from the personal account and the offset from the shadow account are calculated using the same interest rate. So if interest rates happen to be high at the time you retire, your personal account annuity would be higher, but so would the reduction in your traditional Social Security benefit. Likewise, if interest rates were low, both the account annuity and the traditional benefit offset would be lower. By itself, this eliminates a lot of risk.
  
• Third, Gary's portfolio is 100 percent stocks, while mine – following the default portfolios in most reform plans – is around 53 percent stocks on average. As a result, replacement rates would vary more in Gary's simulation than mine. Had I used an all-stock portfolio, the average replacement rate would have risen to 65 percent, with an interquartile rate of 53 to 72 percent. The minimum and maximum replacement rates were 42 percent and 108 percent. Again, people can judge for themselves whether the higher mean replacement rates justify the increased range of outcomes.
  

The point here is not to dispute Gary's numbers, which I'm sure are correct, nor is it to argue that we should all go out and put all our Social Security money into the stock market. However, if we more realistically simulate a reform plan as it might actually be introduced in Congress, the historical results look significantly better what Gary's paper might suggest. I have my data and calculations in an Excel spreadsheet, which I'm happy to share if anyone is interested.

Update: U.S. New's Emily Brandon discusses the two papers here.

Read more!

Argentina attempts to nationalize personal accounts system; workers object

Joaquin Cottani at the RGE Monitor reports on some interesting pension developments in Argentina that shed some light on Social Security policy in the U.S. Argentina, like most Latin American countries, bases its pension program on personal retirement accounts. Individuals contribute to their accounts during their working years, then at retirement use the account balance to purchase an annuity paying them a monthly benefit for life.

But the government of Argentina, led by President Cristina Kirchner, is attempting to end their personal accounts system. Is this a response to public pressure from Argentines who want the supposedly greater security and lower risk of a government-provided benefit? Not at all. In fact, it's a scheme by the Argentine government to paper over its current budget deficit and has parallels to what has gone on in the U.S. Social Security system for the past 25 years.

In the Argentine personal accounts system, workers pay contributions to their account fund, not to the government-run pay-as-you-go program. Argentina's government, however, is running a budget deficit and is setting their eyes on workers' account contributions. If workers are forced back into the pay-as-you-go system, the government gets access to their contributions which can be used to cover up deficits elsewhere in the government. Of course, the government is also obligated to pay these workers retirement benefits in the future – but these "implicit debts" aren't counted on the government's balance sheet , as they aren't counted on the U.S. balance sheet, and so the Argentine government effectively ignores them.

The Argentine government first tried to bribe workers back into the pay-as-you-go system by promising increased benefits later. This shows how eager the government is to get its hands on the workers' cash today. But few workers took the deal, and so now President Kirchner is apparently pushing legislation that would force Argentinean workers back into the pay-as-you-go program.

How does this relate to Social Security in the U.S., in particular the budgetary debate between the current pay-as-you-go system and proposed reforms using personal accounts? Since the last reforms in the mid-1980s, Social Security has been running payroll tax surpluses – collecting more in taxes than is needed to pay benefits. This surplus in Social Security helps cover up deficits in the rest of the budget. In fact, many analysts think that the Social Security surpluses encourage deficits in the rest of the budget. Moreover, when the rest of the budget borrows from Social Security, this borrowing isn't counted as part of the publicly-held national debt, the debt measure that most people focus on. In short, if we didn't have the Social Security surplus, both the budget deficit and the government debt would look a lot bigger than they do, and folks in Congress would be feeling more heat to do something about it. This is the situation that Argentina's President Kirchner is trying to restore.

Now, what happens if we allow people to invest part of their Social Security taxes in a personal account? Well, that immediately erases the Social Security surplus, which means that the budget deficit and the debt would start to look bigger. Now, some on the left blame this increased deficit/debt on the accounts, when in fact all the accounts do is reveal a budget shortfall that already existed. Moreover, to the degree that larger accounts create short term deficits, they also create assets that help pay Social Security benefits in the future. In other words, this claimed increase in the debt is mostly a function of government accounting, not of reality.

Update: Here's an editorial from the Wall Street Journal on the same topic.

Read more!

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.

Read more!

Saving the Surplus, or What’s Left of It…

Jack Kemp has a new op-ed promoting a book by Denny Smith and Peter Ferrara entitled "Stop the Raid," which promotes personal retirement accounts as way to keep Congress from "raiding" the Social Security surplus to spend on other things. As Kemp explains,

[I]n 2007, 88 percent of total Social Security tax income was spent immediately for current benefits and expenses, leaving a surplus at $80.3 billion. What happened to that surplus money? The federal government borrowed it and spent it on general budget expenditures. In return, Social Security got Federal IOUs, which promise to pay the money back, with interest. Over the next five years, from 2008 to 2012, the federal government will continue to raid (borrow) another $410 billion from the Social Security trust funds.

Using personal accounts to "save the surplus" is a very attractive – perhaps the most attractive – argument for them, as they could stop a practice most Americans agree is dishonest and harmful to their future retirement security. Saving the surplus, far more than potentially higher rates of return or even a simple ownership argument, is probably the best way to sell personal accounts to typical Americans.

I've used that argument myself, and in the past I think there was a lot of substance to it. Had we saved the Social Security surpluses generated since the 1980s, we would be sitting on a $2.5 trillion pool of assets with which to pay Social Security benefits rather than merely a stock of government bonds that will be repaid by raising taxes on ourselves in the future.

That said, it's a basic rule of economics that we make decisions at the margin: what matters is what we can do going forward, not what we could have done in the past. And the sad truth is that we've put off Social Security reform for so long that there's really not much of a surplus left to save.

Between 2008 and 2016 – the last year in which Social Security is projected to be in positive cash flow – cash surpluses will total around $462 billion in present value (assuming a 2.7% real interest rate). That's a good chunk of change, no doubt.

But many people act as if saving the surplus would be sufficient to fix Social Security, or at least make a good sized "down payment on reform." Social Security's total long-term shortfall equals roughly $13.6 trillion in present value, meaning that even if we saved every penny of the surpluses going forward it would amount to only around 3 percent of the total shortfall. Not much of a down payment. Moreover, given the political economy of things, it's likely that even if that surplus were saved in personal accounts through 2017, the government would make up most of it through increased borrowing. So the net take would likely be less than 3 percent.

Now, 3 percent is better than nothing, and a lot further than Social Security reform has gone to date. But even accounts to save that modest amount would demand vast amounts of political capital, almost surely more than the reform movement has at this point. While accounts have a role to play – an important one, in my view – to be viable that role, and how the accounts would be financed, should be fleshed out in more detail than in a simple "save the surplus" approach.

Read more!

Rep. Paul Ryan to Introduce Entitlements Bill

Wisconsin Republican Rep. Paul Ryan, the ranking Member on the House Budget Committee, previews in the Wall Street Journal comprehensive legislation he will introduce regarding health care, Medicare, Social Security and tax reform. Here are the relevant portions on Social Security reform:

Social Security. Workers under 55 will have the option of investing over one-third of their current Social Security taxes into personal retirement accounts. These personal accounts are likely to grow faster than the traditional benefit. They are also the property of the individual, and are thus fully inheritable. The bill includes a guarantee that no one's total Social Security benefits from the personal accounts will be less than if he had chosen to say in the current system.

Combined with a more realistic plan for growth in Social Security benefits, and an eventual increase in the retirement age, the Social Security program can thus become sustainable for the long term.

While more details would obviously be needed, I can say at this point that I prefer this formulation to Ryan's previous Social Security reform bill, co-sponsored with Sen. John Sununu of New Hampshire. The current Ryan approach would make (yet unspecified) reductions in the growth of future benefits along with increases in the retirement age to help maintain solvency.

Note: An article on the Ryan plan in National Review Online appears to miss these aspects of the bill, saying "the legislation provides a federal guarantee that workers with personal accounts will get at least as much from the accounts and continuing Social Security benefits as promised by Social Security under current law." That's not the case: the plan would guarantee that individuals choosing person accounts would receive benefits at least as high as those who chose to remain wholly within the current program, in which benefits would be reduced for solvency purposes. Roughly speaking, this would guarantee that account holders would receive a return on their account investments at least equal to the return on the bonds in the Social Security trust fund.

In general I'm not a fan of guarantees against market risk, which can be extremely expensive (see here for analysis of the cost of guarantees under the old Ryan-Sununu bill). However, this guarantee is more modest than in the prior Ryan plan and so is moving in the right direction.

Update: Here's some more details on the Social Security elements of the plan, from an extensive document circulated by Ryan's staff:

TITLE IV: SOCIAL SECURITY REFORM

Creation of Personal Accounts. Beginning in 2011, provides workers under 55 the option of dedicating portions of their FICA payroll taxes toward personal accounts, or remaining in the current Social Security system. Automatically enrolls these workers in personal accounts, but provides the option to withdraw. Those who opt out have one opportunity to re-enter the system. Those who originally decide to enter the system will have one opportunity to withdraw.

Account Phase-In. Gradually phases in accounts equivalent to 5.1 percent of the current 12.4-percent payroll tax over a 30-year period. Allows lower-income workers to contribute a higher percentage of their payroll taxes than high-income workers. Phase-in proceeds in four periods, as follows:
- First-Stage Initial Phase-In. For the first 10 years of the program, workers are allowed to invest 2 percent of their first $10,000 of annual payroll into personal accounts, and 1 percent of annual payroll above that up to the Social Security taxable maximum amount of $115,500. The $10,000 level is indexed to inflation. Taxable payroll also is indexed for inflation, as under current law.
- Second-Stage Phase-In. Beginning in 2021, workers are allowed to invest up to 4 percent of payroll of the first $10,000 (indexed to inflation), and 2 percent of payroll above that up to the Social Security taxable maximum amount (indexed to inflation).
- Third-Stage Phase-In. Beginning in 2031, workers are allowed to invest up to 6 percent of payroll of the first $10,000 (indexed to inflation), and 3 percent of payroll up to the Social Security taxable maximum amount (indexed to inflation).
- Fourth-Stage Phase-In. Beginning in 2041, workers are allowed to invest up to 8 percent of payroll of the first $10,000 (indexed to inflation), and 4 percent of payroll up to the Social Security taxable maximum amount (indexed to inflation).

Personal Accounts Deposits. Deposits each personal account contribution into a Social Security Savings Fund, bearing the individual’s name. Converts individual accounts into annuities upon retirement.

Guaranteed Minimum Benefit. Guarantees that those who select personal accounts the minimum benefits they would receive if they stayed in the current system, subject to the changes made to the current system. Should an individual’s account be too small to provide an annual annuity equal to this minimum level, the Social Security Trust Fund would make up the difference.

Property Right. Provides that each account is the property of the individual, allowing holders to pass on accumulated wealth to descendants.

No Change for Those Over 55. Retains the current system for those currently over 55, with no changes.

No Change for Survivors and the Disabled. Retains current survivor and disability benefits as under the current system, without change.

Increased Minimum Benefits for Low-Income Individuals. Provides that all individuals choosing personal accounts receive annuity payments of at least 150 percent of the poverty level. Increases to at least 120 percent of the poverty level the benefits for low-income individuals who choose to remain in the current system and meet certain working requirements.

Social Security Personal Savings Account Board. Creates a Board to administer the Savings Fund into which contributions to the personal accounts are deposited. Makes the Board responsible for paying administrative expenses and regulating investment options offered by nongovernment firms. Provides that the Board consist of five members – required to have substantial experience, training, and expertise in the management of financial investments and pension benefit plans – appointed by the President, two of whom are appointed after consideration of the recommendations by the House and Senate. Establishes 4-year terms for Board members.

Three-Tier Structure. Structures individual accounts in three tiers, with investment options similar to the Thrift Savings Plan [TSP].
- Tier One. Originally, the Board would invest the contributions in regulated, low-risk instruments until the personal account reached a low threshold.
- Tier Two. Once this threshold is reached, individuals are automatically enrolled into a “life cycle” fund that adjusts for risk and automatically invests the portfolio in a blend of equities and bonds appropriate for the individual’s age. An individual could remain in the “life cycle” fund or choose from five different options that are the same as offered under the TSP: 1) a Government Securities Investment Account; 2) a Fixed Income Investment Account; 3) a Common Stock Investment Account; 4) a Small Capitalization Stock Index Investment Account; and 5) an International Stock Index Investment Account.
- Tier Three. Once an account accumulated over $25,000 in inflation adjusted dollars, an individual could choose an option provided by a nongovernment firm certified by the Board. The Board certifies only those firms meeting a set of standards. These nongovernment funds also are subject to regulation by the Board to ensure their safety and soundness.

Purchase of Annuity. Provides that, when an individual either reaches the normal retirement age or decides to retire early, the individual will purchase an annuity to provide monthly payments equivalent to at least 150 percent of poverty. An individual may purchase a larger annuity if they choose. As described above, if the individual’s personal account is inadequate to purchase an annuity that would provide a monthly payment as large as would be received under the traditional system, the government will make up the difference. If an individual has excess money in their account, they may receive it in a lump sum payment and use it as they choose.

Early Retirement for Personal Account Participants. Allows an individual to retire and begin receiving an annuity at any time that their personal account has accumulated enough funds to purchase an annuity equivalent to at least 150 percent of poverty.

Annuity Purchase and Regulation. Establishes within the Office of the Board, an Annuity Issuance Authority [AIA], which will provide annuity options to be purchased by retiring individuals.

Provision for Early Death. Provides that, if an individual dies before their full annuity has been paid, the amount of funds left over in their annuity or personal account will be made available to their designated beneficiaries or estate.

No Taxation of Personal Account Benefits. No tax will be paid on the receipt of Social Security benefits generated from personal account payments either as a part of an individual’s Federal income tax or estate tax.

Progressive Price Indexing. Excluding those now over 55, employs, starting in 2016, a mix of wage indexing and “progressive price indexing” for calculating initial Social Security benefits under the traditional system, with adjustments for income levels as follows:
- Low-Income. Individuals who make less than a certain threshold level (approximately $25,000 per year in 2016) will continue to receive initial benefits based on wage indexing. Threshold will be indexed for inflation.
- Middle-Income. Individuals who make between the minimum threshold and the maximum taxable amount (approximately $25,000 and $113,000 in 2016) will have initial benefits adjusted upward by a combination of wage and price indexing that becomes more oriented toward price indexing as they move up the income scale. For example, an individual whose income is half way between $25,000 and $113,000 (in 2016 dollars) will have his initial benefit adjusted upward approximately 50 percent by wage indexing and 50 percent by price indexing. These amounts will also be adjusted for inflation.
- Upper-Income. Individuals who make more than the taxable maximum amount (approximately $113,000 in 2016) will have initial benefits adjusted upward by price indexing, also adjusted for inflation.
- No Effect on COLAs. The proposal does not affect the cost-of-living adjustment [COLA] that Social Security beneficiaries receive each year once they have already begun receiving benefits. Further, it does not affect any individuals over 55, as it is not applied to Social Security beneficiaries until 2016.

Acceleration of Ongoing Retirement Age Increase. Advances by 1 year the current retirement age adjustment, which, under current law, gradually rises to 67 years of age for those who reach that age in 2027.

Modernizes the Retirement Age. After the normal retirement age of 67 is reached in 2026, indexes further adjustments in the retirement age in accordance with the Social Security Administration’s projected life expectancy, which is expected to gradually increase the normal retirement age by 1 month every 2 years. At this rate, the normal retirement age would remain below 70 years until 2098. Does not affect the ability of an individual to retire early if he or she elects to retire early and has accumulated enough wealth to retire early.

I've attached a copy of the full document circulated by Rep. Ryan's office.

Read more!

John McCain on Social Security

Courtesy of The Wonk Room, which takes a decidedly negative view of McCain's staement, is a short passage on Social Security reform from, of all places, the Regis and Kelly show:

MCCAIN: What should be partisan about the fact that Social Security is going to go broke? I mean, should we be divided up among Republican and Democrat…

REGIS: Do you have a plan?

MCCAIN: Yes, sir. It’s gonna require, though, cooperation and participation by the other side. And I’ll reach my hand out…

REGIS: Is it privatization of the Social Security program?

MCCAIN: No, no it isn’t. But I would say that I support…I’d put everything on the table to start with…but second of all…young workers ought to be able to put part of their salary, part of their taxes into Social Security, into an account with their name on it. But that would not in any way effect older workers. But you’ve got to have a negotiation.

The running question underlying this and previous statements from McCain and his campaign is whether he supports so-called "carve out" accounts funded from the payroll tax or "add-on" accounts funded with additional contributions.

Here is the McCain campaign's "official" position on Social Security reform:

Reform Social Security: John McCain will fight to save the future of Social Security and believes that we may meet our obligations to the retirees of today and the future without raising taxes. John McCain supports supplementing the current Social Security system with personal accounts -- but not as a substitute for addressing benefit promises that cannot be kept. John McCain will reach across the aisle, but if the Democrats do not act, he will. No problem is in more need of honesty than the looming financial challenges of entitlement programs. Americans have the right to know the truth and John McCain will not leave office without fixing the problems that threatens our future prosperity and power.

This statement talks about accounts "supplementing" traditional Social Security benefits, which some have take as implying an add-on account, while today's statement seems to point toward a carve-out.

I suspect the true answer is that the "add-on vs carve-out" question hasn't really been decided, and at this point there probably isn't too much need to. Social Security reform will ultimately be a negotiated settlement between the parties, so what matters most will be the reform package, not the individual provisions. Read more!

Treasury releases Issue Brief on pre-funding Social Security

The Department of the Treasury today released its fourth issue brief on Social Security reform, entitled "Mechanisms for Achieving True Pre-Funding." This excerpt summarizes their argument pretty well:

Any reform of Social Security that makes the system permanently solvent and that seeks to maintain contributions and benefits at some stable fraction of people’s wages while working must accumulate resources in the near term when there are relatively more workers (that is, when the old age dependency rate is relatively low) so as to help finance benefit payments in later years when there are relatively more retirees (that is, when the old-age dependency rate is relatively high). This accumulation of resources is known as “pre-funding,” and is accomplished by having current revenues exceed expenditures and by safeguarding the resulting surpluses so that they provide resources with which to fund future benefits. If instead no attempt is made to pre-fund future benefits, then it will be necessary in a solvent system to reduce benefits for the cohorts of retirees that are relatively large and/or to require higher contributions from the later, relatively small cohorts of workers who are paying for the retirement benefits of the earlier cohorts. Either outcome would be viewed as unfair by most people because it causes the net value of Social Security to vary across birth cohorts depending on their size.

The brief explores pre-funding issues in great detail. I recommend it.

Significantly, the Treasury brief examines pre-funding using the Liebman-MacGuineas-Samwick reform plan as a model. In theory, any plan with pre-funding -- either via personal retirement accounts or trust fund investment -- could be used. Unlike almost all other plans, however, the LMS plan is almost totally self-financed. That is, it does not utilized transfers of general tax revenue to finance the "transition" to personal retirement accounts.

Being self-financing allows for much greater confidence that a reform plan actually will accomplish pre-funding. If transition costs are financed with general revenues, which in effect means that much of the cost will likely be borrowed, it is very difficult to determine how the financing burdens are distributed over generations. Given that pre-funding is all about distributing financing burdens over generations, self-financing plans have a strong advantage in this regard.

Update: Also see posts from Andrew Samwick and Angry Bear.
Read more!

Taking the personal out of personal accounts

Given my comments on Magin's argument that personal accounts essentially offer a free lunch, why do I favor personal accounts as part of Social Security? While arguments for accounts focus on the "personal" -- can I get a better rate of return? Can I leave the money to my kids? etc. -- the main argument of personal accounts has very little to do with what they can do for individuals and a lot to do with helping out the government.

Put it this way: if we wanted individuals to get higher returns (with higher risk) within Social Security, we could do that by investing the trust fund in stocks. Alternately, if we wanted individuals to be able to leave money behind we could simply increase the traditional program's survivor benefits. Most of the good things attributed to personal accounts could be accomplished through the current program.

But one thing can't: effectively saving excess contributions today to help pay benefits in the future. Magin comments on the argument first made by Smetters, then confirmed by Shoven and Nataraj and by Burtless and Bosworth, that Social Security surpluses since the 1980s have not translated into unified budget surpluses. Put another way, in a macro sense, the Social Security surplus has been "spent" rather than "saved," such that the government's net asset position and the country's capital stock are no larger than they would have been in the absence of the trust fund accumulation. So the trust fund's holdings, while assets to the program, have not been matched by an increase in the ability to repay those assets.

Given that, the choices appear to be between prefunding via accounts held outside the government or not prefunding at all. Given that Social Security reform is pretty much all about redistributing the net burdens inherited from prior generations -- the so-called "legacy debt" -- giving up on prefunding effectively means giving up on a significant part of what reform should be. Prefunding through accounts can be through a "carve out" or an "add on" -- each can be judged only in conjunction with other elements of the reform.

Now, from a given current individual's perspective, he probably doesn't care much much whether there's prefunding or not. He cares whether he's going to get what he's promised. And for current individuals, prefunding can mean a worse "deal" from Social Security rather than a better one.

But for policymakers attempting to balance the interests of both current and future generations, prefunding is an important tool and one that appears most likely to be effected through and accounts structure.

This isn't to say that accounts have no benefits for individuals. Transparency is greater, political risk is reduced, and so forth. But the major action regarding personal accounts really has very little to do with the person holding the account. Read more!

New paper: Why liberals should enthusiastically support Social Security personal retirement accounts

Konstantin Magin of U.C. Berkeley says

"...[R]oughly half of Americans have little or no stock market investments either directly or indirectly through pensions. This is too bad, because in the long run, U.S. stocks have remarkably high returns (about 6.6 percent per year even after adjusting for inflation). And, although liberals fear that these returns come at too high a risk, I will show here that that just isn’t so. Private Social Security accounts invested in long-run diversified equity portfolios promise substantial increases in the lifetime wealth of middle- and working-class Americans, at low risk."

While it's hard to argue with his math (and I've made similar arguments, with similar conclusions, in the past) a couple points are worth touching on.

First, since I favor personal accounts I agree with Magin's general conclusion. At the least, the opportunity to diversify their retirement savings portfolio has potential benefits to low earners. I half-agree with the underlying argument, which is that the equity premium is still sufficiently large that there's free money on the table for stock holders. If so, it makes sense for low earners to get their share. At the same time, the equity premium is set by the risk preferences of market participants; just because we can't explain it in the context of other risk preferences doesn't mean it comes about for no good reason.

Second, Magin is working with an equity premium of around 5.6% (assuming 6.6% real mean stock returns and a 1% bond return). Others see a more modest equity premium: The SSA actuaries project stock returns of 6.4% and a trust fund bond return of 2.9% (a higher bond return will tend to lower guarantee costs using Black-Scholes, so the overall effect is ambiguous). Trimming 50 basis points or so for a shorter-term interest rate gives you a risk premium of 4% -- still healthy, but the probability of falling short of the riskless return certainly rises. It's anyone's guess what future stock returns will look like, but many have argued for lower rather than higher than the past. (E.g., see Diamond, Shoven and Campbell here; Baker, Krugman and DeLong here; but also see Magin and DeLong here.)

Third, while Magin shows that the price of a put option guaranteeing against loss of principal is low, it's not clear why this should be the only standard. A guarantee against the lost of real principal is more expensive, and a guarantee against falling below the riskless rate more expensive still. In the policy context, it's most common to guarantee against the account purchasing an annuity smaller than current law scheduled benefits. This can get very expensive, as shown in this paper written with Kent Smetters and Clark Burdick. Read more!