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.

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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?"

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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.

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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.

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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.

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A once-a-century stock decline: How common are stock returns like this year’s?

Recently I've been running some numbers on how individuals with personal accounts would have fared under current market conditions (although I may have to re-run them given that stocks are down since when I last posted a few days ago…). One question this exercise prompted is how uncommon are stock returns like today's, where the S&P 500 is down 32 percent year-to-date.

To give a quick answer I looked at inflation adjusted annual stock returns from 1871 through today (ok, meaning, literally yesterday). The arithmetic mean inflation-adjusted annual return from 1871 through today is 7.8 percent above inflation, which is equal to a compounded (geometric mean) return of 6.3 percent. The standard deviation of annual returns is 17.9 percent. From those numbers, and the assumption that returns are normally distributed, we can conclude that we should see stock returns like this year's about 0.8 percent of the time, meaning about once out of every 125 years. Here's an Excel file with the data and calculated for anyone interested.

But the year isn't over yet, so who knows where we'll end up…

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Obama Ad Hits McCain on Social Security

Barack Obama has a new ad criticizing John McCain for his support for adding personal retirement accounts to Social Security – an effective attack given the backdrop of the past several weeks. Take a look:

The claim 'cutting benefits in half' is a big stretch. President Bush's proposal for 'progressive indexing' would have addressed about half the long-term deficit – that's a lot different than cutting benefits in half. But we're in an election year so these kinds of claims by either side shouldn't be all that surprising.

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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!