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Smetters, Kent

Article Prospects for social security reform in the United States

NBER Reporter Online

Provided in Cooperation with: National Bureau of Economic Research (NBER), Cambridge, Mass.

Suggested Citation: Smetters, Kent (2005) : Prospects for social security reform in the United States, NBER Reporter Online, National Bureau of Economic Research (NBER), Cambridge, MA, Iss. Summer 2005, pp. 11-14

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Prospects for Social Security Reform in the United States

Kent Smetters*

One of the most far-reaching typically already fairly portable across of idiosyncratic risks, traditional shifts in fiscal policy around the world employers. With a few exceptions, the defined-benefit systems more easily during the past two decades has been public pension benefit formula in most allow for sharing wage and longevity the fundamental restructuring of pub- countries is dependent on the wages of uncertainty.2 Relatively larger transac- lic pension systems. Over two dozen the worker regardless of the actual tion costs in defined contribution countries across five continents have employer. plans, as well as problems associated converted at least part of their pay-as- In fact, the public plan conver- with financial literacy, moral hazard, you-go, defined-benefit, public pen- sions seem fairly puzzling at first. To and adverse selection, only seem to sion systems into systems based on be sure, many common arguments buttress the case for the traditional funded, defined-contribution accounts. have been put forth in favor of “per- design. So why are more and more Several additional countries are cur- sonal accounts” including the potential countries abandoning the traditional rently in the process of conversion, to earn higher rates of return in equi- design for the funded, defined contri- and even more countries, including the ties, increased national savings, as well bution model that, in theory, is no bet- United States, are debating it. as greater bequeath-ability. However, ter than the traditional design and The shift toward defined-contri- even if we believed that a portion of potentially even worse? bution plans in the private sector has the equity premium were a “freebie” Adding to the puzzle is that these increased the mobility of workers, and not just a compensation for risk, reforms have taken on numerous because traditional defined-benefit higher returns could be earned by a shapes and sizes across the world. plans have a “lock-in effect” that dis- public pension system by investing in While, politically, the adoption of per- courages employees from switching equities, which has the added benefit sonal accounts are often linked to employers. Therefore, the conversion of potentially improving risk sharing demographic concerns (for example, of public pension plans to the defined- across generations.1 National saving retirement of baby boomers in the contribution model sometimes has also could be increased by pre-funding United States), the actual evidence been lumped together as part of this the traditional pension system. The does not seem to support this motive same “modernization” movement. traditional pension scheme also could for personal accounts. Indeed, the However, that explanation is problem- be complemented with a life largest reforms occurred in less devel- atic, because public pension plans are payment upon death that replicated oped countries where future demo- the bequeath-ability aspect of personal graphic problems are projected to be * Smetters is a Research Associate in the accounts. the least severe, including Chile (1981), NBER’s Program on Public Economics and Indeed, in a deterministic setting, Columbia (1993), Peru (1993), Mexico an associate professor at The Wharton School the traditional public defined benefit (1997), Bolivia (1997), El Salvador at the University of Pennsylvania. His pro- pension systems in theory could (1998), and Kazakhstan (1998). In each file appears later in this issue. achieve the same economic objectives of these countries, the vast majority of as personal accounts. In the presence the final expected retirement benefit is

NBER Reporter Summer 2005 11 derived from income produced by of reform but simply a necessary by about 1.5 percent of wages. assets held in the new defined-contri- byproduct of securing a safer retire- These calculations, however, bution accounts. In contrast, more ment income independent of the sub- unrealistically and optimistically modest reforms occurred in countries stantial level of trust required by a pay- assume that people continue to work with higher per-capita incomes where as-you-go financed scheme. Personal and earn just as much as before the demographic problems are more retirement accounts in these countries change in fiscal policy. New empirical severe, including Switzerland (1985), probably would have been created evidence by Prescott (2004), though, the United Kingdom (1986), Denmark even without demographic concerns. suggests otherwise: he attributes the (1990), Australia (1992), Argentina In contrast, in developed coun- sizable difference in the average num- (1994), China (1995), Uruguay (1996), tries, where reforms have been smaller, ber of working hours per worker in the Hungary (1998), Sweden (1998), and previous downward benefit adjust- United States versus many European Poland (1999). These countries have ments and inequities, while existing, countries to the differences in tax adopted systems that blend defined have been less important. Instead, the rates, largely used to finance state- contribution accounts with a defined primary objective in these countries is based retirement benefits.5 Even using benefit. Some countries with the most to pre-fund future benefits since many a much smaller labor supply elasticity serious demographic problems, includ- of these countries face more severe than implied by his study, raising pay- ing Germany and Japan, have passed demographic problems. Partial pre- roll taxes could substantially reduce only minor reforms. So, why are the funding of future benefits avoids more household savings and output relative largest reforms appearing in countries drastic changes, whether benefit cuts to controlling the growth rate of Social with the least amount of demographic or tax increases, down the road. Security benefits.6 problems? However, the governments in these Personal accounts themselves, One central theme appears to countries are not trusted enough to however, don’t improve or worsen emerge that might help to explain properly save or invest the required Social Security’s financial outlook. these puzzles: the public pension con- additional resources. So, in developed Contrary to some proponents, person- versions appear to represent a funda- countries, the creation of personal al accounts don’t offer a “free lunch” mental distrust in the ability of the accounts is a byproduct of attempts to by reducing Social Security’s shortfall. government to provide secure retire- increase funding. But the reforms are At the same time, contrary to many ment resources.3 The exact nature of smaller because they are mainly moti- opponents, personal accounts, when the distrust, though, differs between vated by demographics. If these coun- designed similarly to President Bush’s developing and developed countries, tries faced no demographic pressures, recent proposal, don’t add an addition- consistent with the differences in the the incentive to partially privatize al burden to the Social Security system. magnitudes of pension reforms. would be greatly reduced. The appearance of “transition costs” Traditional pay-as-you-go pen- from creating personal accounts sim- sion systems require a significant The United States ply reflects the fact that the federal amount of trust between workers of cash-flow budget system fails to different generations — the so-called According to the 2005 Social account for the long-term liabilities in “social contract.” The median voter Security Trustees’ Report, the U. S. the nation’s entitlement programs.7 who supports a pay-as-you-go pension Social Security system currently faces a While the diversion of payroll taxes to system is typically a middle-aged work- shortfall equal to about $11.1 trillion, personal accounts increases the er: she has no incentive to support a which is equal to the present value of amount of debt held by the public, the system that might not be viable when all future projected benefits minus the unfunded obligations in the Social she is retired. present value of all future projected Security program are reduced by an In developing countries, where payroll taxes after subtracting the value equal amount in present value. The reforms have been the largest, the dis- of the trust fund.4 This shortfall is federal budget tracks the increase in trust in the government provision of equal to about 3.5 percent of future the debt but not the concomitant public pensions appears to be condi- payroll. The shortfall in the Medicare reduction in obligations. tioned on past downward movements program, including the commitments in the real value of benefits (often on general revenue, is about seven The Social Security Trust caused by inflation), misuse of retire- times larger. Absent benefit cuts, plac- ment resources, and other risks and ing Social Security and Medicare on a Fund inequities in the pre-reform public permanently sustainable course could Currently, the Social Security sys- pension systems. Workers in develop- hypothetically be achieved by increas- tem collects more in revenue than it ing countries don’t trust the govern- ing payroll taxes from their current rate pays in benefits. The excess is placed ment to run even a strict pay-as-you-go of 15.3 percent of wages to about 36.1 into the Social Security Trust Fund. system. Funded defined-contribution percent of wages — immediately and The Trustees currently project that accounts, therefore, give workers an forever. For each 5 years in which outlays will begin to exceed revenue independence from the government. action were delayed, the required around 2017, at which time the Trust The concomitant increase in the level immediate and permanent payroll tax Fund will be tapped in order to pay of funding is not the primary objective hike increases by about 10 percent, or

12 NBER Reporter Summer 2005 benefits. The Trust Fund is projected time toward the size of government though, because, ironically, they pro- to become depleted around 2041, would tend to create an upward bias vide “transition relief ” in an effort to after which only about 74 percent of (positive correlation). When controls protect the value of previous contribu- benefits can be paid. for these factors are added to the tions. Partial transition relief, however, Central to the debate on how to regression model, the correlation turns can lead to Pareto gains. reform Social Security is whether the negative and statistically significant Upon extending the life-cycle Social Security trust fund really repre- even at the 2 percent level over the model to three or more periods, a sents a “store of value.” To be sure, entire sample period.8 In fact, the household’s accrued benefit — which the assets in the Trust Fund are “real” results suggest that the entire Trust is observable by the government — in the sense that the U.S. Treasury will Fund buildup since 1983 has been becomes a source for an efficient honor the claims made by the Social used to hide additional spending or tax implicit lump sum tax that can be used Security Administration. But the rele- reductions elsewhere in the budget. It to replace some future revenue that vant question is whether Congress appears that Trust Fund surpluses would have been collected from that really uses Trust Fund surpluses to failed to reduce the debt held by the household using a distorting labor reduce the amount of debt held public, public! income tax. Equivalently, this implicit thereby increasing the government’s Probably the most suggestive wealth levy can afford participants a ability to pay future benefits. Or, does indication that Congress has routinely higher return on their future contribu- Congress simply use Trust Fund sur- used Trust Fund surpluses to mask tions, thereby reducing the effective pluses to hide additional spending or tax larger non-Social Security deficits is tax rate on their labor supply. A back- reductions elsewhere in the federal the evidence of a structural break of-the-envelope calculation suggests budget? Congress is potentially able to when unified budget accounting was that the efficiency gains for the United mask larger non-Social Security adopted in 1970. Before 1970, Trust States could exceed $1 trillion, deficits because the federal unified Fund surpluses certainly existed, although this calculation should be budget combines the Trust Fund sur- although they dwindled over time as interpreted with some caution because pluses with non-Social Security deficits Congress increased the generosity of it ignores the transaction and other even though, as a pure technicality, benefits during the 1970s. But there is costs associated with personal Social Security is officially “off budget.” no evidence that Congress used Trust accounts. If Trust Fund surpluses are part- Fund surpluses to hide larger deficits ly hiding fiscal looseness elsewhere in elsewhere in the budget before 1970. 1 If Social Security purchased equities the budget then diverting future Social The evidence only appears after the with its excess contributions, risk shar- Security surpluses to personal accounts adoption of the unified budget ing could be potentially improved might require more fiscal restraint on accounting scheme. across generations. See H. Bohn, policymakers in the future, that is, per- “Should the Social Security Trust Fund sonal accounts may be a superior “lock Social Security hold Equities? An Intergenerational box.” Keeping the money away from Welfare Analysis,” Review of Economic politicians, though, trades one risk for Privatization with Second Dynamics, 2 (3) (July 1999), pp. 666-97. another, namely, keeping the money Best Taxes It is possible to replicate this same away from pensioners before they retire. effect using a capital income tax with- Nonetheless, personal accounts would It is generally believed that allow- out direct government ownership. See likely improve the informational con- ing workers to divert a portion of their K. Smetters, “The Equivalence of the tent of government spending. pay-as-you-go payroll taxes to private Social Security’s Trust Fund Portfolio It is not hard to find Republican accounts would require levying a new Allocation and Capital Income Tax and Democrats who believe that tax in order to continue to pay the Policy,” NBER Working Paper No. Congress routinely “spends the Trust Social Security benefits of those 8259, April 2001. Fund” whenever Congress runs a uni- retired at the time of privatization. In 2 S. Nishiyama and K. Smetters, “Does fied deficit. But if Congress would other words, privatization simply sub- Social Security Privatization Produce have run the same “on budget” deficits stitutes one distorting tax for another, Efficiency Gains?” NBER Working (excluding Social Security) without producing no efficiency gains. This Paper, forthcoming. Trust Fund surpluses then the Trust conventional wisdom, though, is based 3 K. Smetters and C. Park, A Matter of Fund surpluses were actually saved. on the standard life-cycle model with Trust: Understanding A Matter of Trust: Empirically, over the passed six just two periods. Understanding Worldwide Public Pension decades, “on budget” (non-Social Recent research, using a multi- Conversion, in progress. Security) and “off budget” (Social period life-cycle model, has shown 4 The 2005 OASDI Trustees Report, Security) surpluses have been uncorre- how to privatize in a way that reduces Table IV, B6. lated, which appears to suggest that labor supply distortions to current and 5 E. Prescott, “Why Do Americans Trust Fund surpluses have not been future generations without hurting ini- Work More than Europeans?” Federal used to hide non-Social Security tial retirees — a Pareto improvement.9 Reserve Bank of Minneapolis Quarterly deficits. However, macroeconomic The two most common methods of Review, 28 (1) (July 2004), pp. 2-13. shocks and changes in attitudes over privatization fail to reduce distortions, 6 L.J. Kotlikoff, K. Smetters, and J.

NBER Reporter Summer 2005 13 Walliser, “Finding a Way Out of 2005. Trust Funds?” NBER Working Paper America’s Demographic Dilemma,” 8 K. Smetters, “Is the Social Security No. 10953, December 2004. NBER Working Paper No. 8258, April Trust Fund Worth Anything?” 9 K. Smetters, “Social Security 2001. American Economic Review (Papers and Privatization with Elastic Labor Supply 7 See the discussion in J. Gokhale and Proceedings), 94 (2) (May 2004) pp. and Second-Best Taxes,” NBER K. Smetters, “Measuring Social 176–81. Also see, S. Nataraj and J.B. Working Paper No. 11101, February Security’s Financial Problems,” NBER Shoven, “Has the Unified Budget 2005. Working Paper No. 11060, January Undermined the Federal Government

Behavioral Finance

Jeremy C. Stein*

Much of my research over the who examines a firm’s annual report price, she will tend to favor the growth last several years has been in the broad may focus on earnings per share, while strategy when the stock market is fol- area of behavioral finance. Some of ignoring much of the other material in, lowing a valuation model that pays this work investigates the beliefs of say, the footnotes. more attention to performance on the less-than-fully rational investors — the Of course, even people who use growth dimension. Conversely, it can valuation models they use, and the par- very simple models are likely to give up be rational for the stock market to ticular sources of information that on these models when they fare poor- weight observed growth measures they pay attention to. Another part ly — as the honest-accounting model more heavily when it is known that the focuses on the constraints that profes- is likely to have done in recent years — firm is following a growth strategy. sional arbitrageurs face because of the and to move on to alternatives. This two-way feedback between firms’ agency problems inherent in delegated Motivated by this idea, Harrison Hong business strategies and the market’s money management. Finally, a third and I study the implications of learn- valuation model can lead to purely strand explores the connection ing in an environment where the true intrinsic fluctuations in sales and out- between investor irrationality and cor- model of the world is multivariate, but put, creating excess volatility in these porate-finance outcomes. in which agents update only over the real variables even in the absence of class of simple univariate models.1 If a any external source of shocks. Simple Models particular simple model does a poor job of forecasting over a period of Local and Social Influences In attempting to make even the time, it is eventually discarded in favor most basic kinds of forecasts, we can of an alternative — yet equally simple on Investment Decisions find ourselves inundated with a stag- — model that would have done better A number of recent papers show gering amount of potentially relevant over the same period. This theory that investors tend to have a strong raw data. A large literature in psychol- makes several distinctive predictions. local bias in their portfolio choices. ogy suggests that people simplify such For example, it suggests that a high- This bias shows up not only as a pref- forecasting problems by focusing their priced glamour stock has particularly erence for domestic as opposed to for- attention on a small subset of the low conditional expected returns, and eign stocks, but perhaps more striking- available data. One powerful way to particularly high conditional volatility, ly as a preference for those domestic simplify is with the aid of a theoretical in the wake of recent bad news about stocks that are headquartered close by.3 model. A parsimonious model will fundamentals, because this high- While the existence of within-country focus the user’s attention on those price/bad-news configuration suggests local bias now seems to be incontro- pieces of information deemed to be that the potential for a “paradigm vertible, there is little evidence to date particularly relevant for the forecast at shift” among investors is elevated. regarding its equilibrium asset-pricing hand; the user will disregard the rest. In a related vein, Philippe Aghion implications. For example, an investor with an “hon- and I examine a setting in which a firm Hong, Jeffrey Kubik, and I est-accounting” model of the world can devote its efforts either to increas- explore these asset-pricing effects.4 We ing sales growth or to improving per- begin by constructing a variable we call unit profit margins, for example by * Stein is a Research Associate in NBER's 2 RATIO which, for any given region at Program on Corporate Finance and a profes- cutting costs. If the firm’s manager is any point in time, is equal to the aggre- sor of economics at . concerned with the current stock gate book value of all firms headquar-

14 NBER Reporter Summer 2005