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11c_Privatizing_SS

11c_Privatizing_SS - WOULD A PRIVATIZED SOCIAL SECURITY...

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Unformatted text preview: WOULD A PRIVATIZED SOCIAL SECURITY SYSTEM REALLY PAY A HIGHER RATE OF RETURN? BY JOHN GEANAKOPLOS, OLIVIA S. MITCHELL AND STEPHEN P. ZELDES COWLES FOUNDATION PAPER NO. 1002 COWLES FOUNDATION FOR RESEARCH IN ECONOMICS AT YALE UNIVERSITY Box 208281 New Haven. Connecticut 06620-8281 2000 Would a Privatized Social Security System Really Pay a Higher Rate of Return? John Geanakoplos, Olivia .S'. Mitchell, and Stephen P. Zeldes As THE U.S. Social Security system has matured, the rate of return received by participants has fallen. In the coming years, around the time the baby boom generation retires, the system will experience a budget shortfall. First, tax revenues will fall short of promised benefits, requiring spending the interest earnings, and then the principal, of the trust fund. Eventually, the trust fund will be depleted. This projected insolvency will necessitate benefit cuts or tax increases, leading to further declines in the rates of return individuals can expect. Many advocates of reform suggest that an answer to this problem is to pri- vatize Social Security. They argue that the creation of individual accounts invested in private capital markets, and especially in the stock market, will produce better rates of return for individuals than will Social Security. For example, Stephen Moore of the Cato Institute recently claimed that “privati- zation offers a much higher financial rate of return to young workers than the current system. . . if Congress were to allow a 25-year-old working woman today to invest her payroll tax contributions in private capital markets, her retirement benefit would be two to five times higher than what Social Security is offering?" Presidential candidate Steve Forbes criticized Social Security because “the average worker retiring today receives a lifetime return of only about 2.2 percent on the taxes he has paid into the system. Contrast this with This paper draws on a longer paper by the authors (Geanakoplos, Mitchell, and Zeldes, forth- coming). Useful comments were provided by Jeff Brown, Martin Feldstein, and Kent Smetters. 14. Moore (1997) 138 SOCIAL SECURITY: IN WHAT FORM? the historic 9—10 percent annual returns from stock market investments. . . . The advantages of an IRA-type approach are overpowering.”15 Our goal in this paper is to challenge the following popular argument: pro- jected returns to Social Security are low relative to expected returns on stocks and bonds, and therefore everyone would receive higher returns and be better off if the United States moved to a privatized system where individuals could directly invest their contributions in stocks and bonds. We argue that for house- holds with access to diversified capital markets, privatization without prefund- ing would not increase Social Security returns, when properly measured. Privatization together with prefunding would eventually raise the rate of return to future generations of participants, but at the cost of a lower rate of return to early generations. The real economic benefit to privatization is the diversification that would be made available to constrained households that cannot participate on their owu in diversified capital market investment portfolios. The improved rate—of-return argument in favor of privatization thus has no force unless there are constrained households without access to diversified capital markets. However, this group of people is not generally recognized to be key to the popular argument just quoted. Indeed, in the presence of such constrained households, young market- savvy workers, who according to the pepular argument should find privatiza- tion most appealing, will probably get lower returns as a result of privatization. We begin by defining what privatization means and by distinguishing that concept from diversification and from prefunding. Next, we ask whether pro- jected returns on Social Security are in fact below those anticipated from US capital markets.” Finally, we ask whether low Social Security returns are a valid reason to support a privatization that does not involve prefunding. We conclude that several valid rationales can be offered to support privatization, but taken by itself, the low rate of return on Social Security is not among them. What Do We Mean by Social Security Privatization? To begin, it is useful to draw a clear distinction between three terms that are often confused: privatization versus diversification versus prefimdr'ng of Social Security. By privatization we mean replacing the current mostly unfunded defined-benefit Social Security old—age program with a defined—contribution sys— tem of individual accounts held in individual workers’ names. By diversification 15. Steve Forbes. “How to Replace Social Security." Wall Street Journal, December 18, 1996 16. Although we focus on the rate-of-return concept of money's worth in this paper, additional measures are evaluated in more detail in our longer study (Geanakoplos, Mitchell, and Zeldes, forthcoming). SOCIAL SECURITY: lN WHAT FORM? 139 we mean investing funds (either from the personal accounts or from the Social Security trust fund) into abroad range of assets. These assets might include US. private sector stocks and bonds, and foreign securities, in addition to the gov- ernment bonds now used exclusively by the Social Security trust fund. At the present time, the focus is on diversifying into stocks. By prefunding we mean reducing the sum of the system’s implicit and explicit debt (table 4-4).” In the public debate these terms are often linked, but they are conceptually different. It is easy to see why all three categories nevertheless appear together in the public mind. Suppose the Social Security system had begun as a forced saving plan in which all workers were obliged to set aside money for their retirement, which would be put into private accounts invested in a balanced portfolio of stocks and bonds. Then from the beginning the system would have been privatized, diversified, and completely prefunded. The situation is quite different now from what it was in 1935 when the U.S. Social Security system began. Social security systems in the United States and in most developed economies have amassed substantial unfunded liabilities; assets on hand are insufficient to pay for the present value of benefits that have been accrued and promised to workers and retirees based on contributions already made.” In the United States, for instance, the unfunded present value of Social Security promises totals about $9 trillion.” Although this Social Security debt is implicit rather than explicit, it is economically significant. The United States will surely not decide to eliminate this implicit debt by ignoring all of the promised benefits. Our tripartite decomposition is intended to emphasize that Social Security reform could change any one of these three categories without changing the other two. For example, the trust fund could invest in stocks as well as bonds, thus diversifying without privatizing. Alternatively, workers could be given pri— vate accounts in which the money was always invested in government bonds, thus privatizing without diversifying. This is the casein Mexico’s new individ- ual account system, where the government has required that all pension assets be invested only in inflation-indexed bonds.1m It is also possible to raise system 17. There is debate over whether prefunding should refer to a change that reduces the total gov— ernment debt rather than just the Social Security debt. Here we assume that any changes in Social Security do not change the non-Social Security debt or deficit 18. The concept of unfunded liability is difi'erent from that of actuarial imbalance. Actuarial imbalance is defined as the present value of expected benefits over some period (often seventy-five years) minus the present value of expected tax receipts over the same period, minus the current value of the trust fimd. The United States currently has a seventy~five-year actuarial imbalance of about 2.2 percent of payroll a year, or about 2.9 trillion dollars in present value. See Goss (forthcoming). 19. Goss (forthcoming). 20. Mitchell and Barreto (I997). 140 SOCIAL SECURITY: IN WHAT FORM? Table 4-4. Dtfierentiating Privatization, Prefimding, and Diversification of Social Security 0 Privatization: Replace existing Social Security system with a system of individuai accounts held and managed by individuals. - Prefimding: Raise contributions or cut benefits so as to lower the sum of explicit and implicit debt associated with the system. 0 Diversification: Invest Social Security funds into a broad range of assets, including equities. No ' Current system No Diversification No: Current system Yes: Borrow, invest proceeds in equities through trust fund - Raise taxes/cut benefits to decrease unfunded liability Prefanding Yes Diversification No: Invest trust fund in bonds Yes: Invest trust fund in equities Privatization Yes - Create individual accounts - Issue recognition bonds - Perpetually roll over principal and enough interest to keep path of debt same as that of unfunded liability under current system Diversification No: Require individual accounts to hold bonds Yes: Permit individual accounts to hold equities and bonds - Create individual accounts - Issue recognition bonds - Raise taxes/cut benefits to make path of debt lower than path of unfunded liability under current system Diversification No: Require individual accounts to hold bonds Yes: Permit individual accounts to hold equities and bonds Privatization, prefunding. and diversification are distinct concepts. It is possible to have any one. without either of the other two. SOCIAL SECURITY: IN WHAT FORM? 141 funding without involving individual accounts; taxes could be raised or bene— fits cut and the proceeds could be put into a central trust fund. Singapore’s national Provident Fund, for example, is a nonprivatized, prefunded system where the central government collects taxes sufficient to generate substantial assets, which it then invests on the system’s behalf. Conversely, people could be given individual accounts without prefunding of benefit promises. A privatized but unfunded pension system has recently been established in Latvia, where payroll taxes are collected by the government, which then credits workers’ so- called notional accounts with paper returns on contributions. Chile is the best- known example of a country whose program is both prefunded and privatized: here workers hold assets in individually managed accounts, and debt under the old system is being reduced over time. Likewise in the United States, privatization without prefunding is quite pos- sible; a Social Security reform that created a national 401(k)-type system of pri- vate accounts could be implemented with no change in Social Security debt. For example, the Social Security system could issue new explicit debt (recognition bonds), guaranteed by the federal government, with payouts set exactly equal to the benefit pronuses that have accrued to date under the current system. These bonds would be given to current participants in lieu of their accrued future ben- efit payments. All new contributions to Social Security would then go directly into private individual accounts.21 If the recognition bonds were paid off in full with new government tax receipts, the debt would eventually disappear when the last of today’s workers finally died. However, the Social Security system could instead borrow again in the future by issuing new bonds to meet the recognition bond coupon payments, and then again and again to meet the payments on these new bonds. Subject to some limits, the government could choose how much interest and principal to roll over and how much to pay off. If the government were to choose to keep the path of explicit debt equal to the path of unfunded lia- bilities under the current system (the implicit debt), the result would be a Social Security system that was privatized without being prefunded. In what follows we shall examine the claim that a privatized, diversified Social Security system could deliver higher returns without any additional pre— funding. We do so in three steps. First, we analyze returns in a privatized sys- tem that confines investments to government bonds. Next, we examine returns in a privatized and diversified system in which investments in stocks are per— mitted. Finally, we analyze returns in a privatized and diversified system and allow for the possibility that there are some constrained households who do not currently have access on their own to diversified capital markets. 21. More gradual transitions to a system of individual accounts that leave (implicit plus explicit) debt unchanged are also possible. 142 SOCIAL SECURITY: IN WHAT FORM? Table 4-5. Annual Inflation-Adjusted Returns on Stocks and Government Bonds, 1926M96 Percent W Arithmetic average Standard Asset real return deviation S&P 500 9.4 20.4 Long-term government bond 2.4 10.5 Intermediate-term government bond 2.3 7.1 Short—term T—bill 0.7 4.2 —-——~———-——-—-————.—.__,_._____________ Source: Authors’ calculations based on data from lbbotson & Associates (1998). Are Projected Rates of Return on Social Security Lower Than Those on U.S. Capital Markets? A starting point for projecting future returns on U.S. capital markets is to examine historical returns. Table 4-5 reports the historical average of inflation— adjusted (that is. real) returns on stocks, bonds, and Treasury bills, as well as their variability. The average annual real return on stocks (as proxied by the S&P 500) was 9.4 percent; the corresponding return on intermediate-term gav- ernment bonds was 2.3 percent.22 Whether these provide reasonable forecasts for future years depends in part on one’s judgment about whether the past will predict the future. Cohort-specific rates of return under Social Security, from a study by Dean Leimer, are presented in figure 4-1.23 Historical data on current and past work- ers and retirees, as well as projections of future contributions and benefits, are used to compute rates of return, which we sometimes call by their more precise name, internal rates of return (IRRS). We note first that prOSpective (internal) rates of return depend on a host of predictions, including mortality, papulation growth, and real wage growth.24 Second, the prospective IRR data are not those 22. These are arithmetic averages of annual returns from 1926 through 1996 taken from Ibbotson and Associates (1998). The 1994—96 Social Security Advisory Council projected that in the future stocks would earn a 7 percent real retum, compared with 2 percent real return on bonds. ' 23. Leirner (1994}. 24. The internal rate of return ([RR) is defined as the interest rate that equates the present value of taxes paid to the system and the present value of benefits received, by cohort. “five other “money’s worth" measures sometimes reported are the present value ratio (PVBIPV'I'), or the pres- ent value of benefits divided by the present value of taxes, and the net present value (NPV), or the present value of benefits received minus the present value of taxes paid. The IR and its compan- ion money‘s worth measures are appealing because they seek to summarize in a single measure how a household might evaluate the complex multiyear stream of Social Security payments and SOCIAL SECURITY: m WHAT FORM? 143 Figure 4-1. Estimated Real Internal Rates ofRetum on Social Security Contributions Percant Percent 40 30 All birth years (use lefi scale) 20 Birth years 192446 ( use right scale) 10 0 1876 1886 1896 1906 19t6 1926 1936 1946 1956 1966 i976 BiithYear Source: Leimer (1994) tax increase balanced budget scenario. that would follow from forecasting taxes and benefits under current Social Security rules, since that system faces insolvency or actuarial imbalance. Instead the IRR figures for the future assume that taxes will be increased suffi- ciently so that the system does not run out of money.25 Figure 4-1 shows that early cohorts under the program received very high IRS in real terms. Workers born in 1876 received a real return of over 35 per- cent a year. Workers born in 1900 received a 12 percent real return. The figure reveals that lRRs fell over time for subsequent cohorts. Leimer estimated the receipts. However the measure‘s simplicity belies the extensive assumptions and calculations needed to arrive at a single summary number. For example, in order to conclude that workers bum in 1930 anticipate a Social Security [RR of 4 percent. it is necessary to compute what that cohort paid in payroll taxes over all years of work (Leimer 1994). Not all those born in 1930 have retired as yet, so future earnings profiles, taxes, and retirement patterns must be forecast. Each group's tax payments must then be compared against the stream of Social Security benefits actually paid out to people of that birth year. Of course, many 1930-cohort members are still living, so future bene- fit payments and mortality pattems must again be estimated. For details see Geanakoplos, Mitchell, and Ethics (forthcoming). 25. Leimer also provides estimates under the assumption that benefits are reduced to maintain solvency. 144 SOCIAL SECURITY.“ IN WHAT FORM? return to be 5.7 percent for those born in 1920, and about 2 percent for those born 195040. For workers born in 1975, he forecasted that IRRs would be around 1.8 percent, dropping down to 1.5 percent for those born in 1998. Young or middle-aged workers listening to the Social Security reform debate today could reasonably ask how their anticipated [RR from Social Security would compare with what could be earned by investing in US. capi- tal markets. Leimer’s data indicate IRRs of about 1.5 percent for future cohorts; theoretical models of a pure pay-as—you-go Social Security system in steady state suggest that the [RR would be expected to equal the growth of the wage basc, which is currently forecast to be about 1.2 percent.25 Either way, it is clear that projected lRRs are well below expected returns from investment in equi- ties based on historical averages, and fall short of average government bond returns in table 4-5 as well. Thus. the pepular rate of return argument in favor of privatization seems to apply whether or not the investments are diversified. Why Are Projected Social Security Returns Low? Projected Social Security returns are low, not because of waste or ineffi- ciency, but because the system developed as a primarily unfunded, pay—as—you- go system. In a pure pay-as-you—go system, all contributions received by the system are paid out in the same year as benefits to someone else, and no trust fund is accumulated. This means that there are some early beneficiaries who receive benefits even though they have not made any contributions. The US. Social Security system was not started as a pure pay—as-you—go system, because only those individuals who contributed some money to the system were eligi- ble for benefits. Nevertheless, the accumulated trust fund was minimal, so that it was still the case that the present value of benefits received by those retiring soon after 1940 far exceeded the present value of contributions they had made. The key to understanding why IRRs must fall in our nearly pay-as-you—go Social Security system is to exploit the connection between net present values (NPV) and internal rates of retum (IRR). Whenever the NPV for a cohort is positive, the IRR for the cohort will be greater than the market rate, and vice versa. Therefore, stating that early generations received a positive net transfer from Social Security is equivalent to saying that they received above-market rates of return on their contributions.27 26. For a discussion of the assumptions used to estimate future wage base growth rates as well as future Social Security benefit and tax paths, see Advisory Council on Social Security (1997). 27. Comparing the present value of a c...
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