An Issue at the Heart of the Social Security Debate: Would Private Accounts Provide a Higher Rate of Return Than Social Security?

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June 7, 2005 AN ISSUE AT THE HEART OF THE SOCIAL SECURITY DEBATE: WOULD PRIVATE ACCOUNTS PROVIDE A HIGHER RATE OF RETURN THAN SOCIAL SECURITY?

TELECONFERENCE THURSDAY JUNE 2, 2005 AT 1PM EASTERN TIME

ROBERT GREENSTEIN: Good afternoon, everybody. We’re focusing today on an issue that is in the middle of the Social Security debate: Would private accounts provide a higher rate of return than Social Security?

Today the Center released a new paper with precisely that title, by Jason Furman, as well as a related paper on the Social Security substitute program in Galveston, Texas, a program that is sometimes cited in discussions about rates of return.

To lead today’s briefing, we have two of the best people in the country on this issue: Jason Furman, who is an economist at New York University and a non-resident senior fellow at the Center on Budget and Policy Priorities (he also is identified in a new Congressional Quarterly article as one of the five most important analysts in the current Social Security debate), and Henry Aaron, a senior fellow with the Brookings Institution and the former head of economic studies at Brookings. Henry’s had a long history with Social Security: he’s the co-author, with Bob Reischauer, of a major book on Social Security that came out a few years ago; he chaired the Social Security advisory council on 1979; and he is the board chair of the National Academy of Social Insurance.

JASON FURMAN: If there’s one theme of this paper, it’s that private accounts do not provide a free lunch for Social Security. The Administration has been inconsistent on this point, acknowledging that private accounts don’t help restore the program’s solvency but still trying to claim that the miracle of compound interest will somehow deliver a higher rate of return for people under the Administration proposal than under proposals that don’t involve private accounts.

The Administration’s claim has been almost universally rejected by the economics profession. To just give a few examples:

 Gary Becker, a conservative Nobel Prize winning economist who supports personal accounts, has written that the higher returns produced by the stock market reflect higher risks, so there is no free lunch with private accounts.  Robert Barro, a conservative economist at Harvard University, has written that while advocates of personal accounts argue that the traditional Social Security system provides a low rate of return, this argument is misleading.

 Goldman Sachs, in an analysis of the seven leading myths on social security reform, identified as one of the key myths the claim that private accounts would produce a higher return than Social Security. Goldman Sachs wrote that when you adjust for two factors (which I’ll be talking about in a moment), “the difference in returns between personal savings accounts and the current system disappears.”

In short, there is no free lunch available via privatization.

The paper we are releasing today explains the three reasons why most economists agree that the comparison between the rates of return in Social Security and those in the stock market is misleading. The three principal reasons are:

1. Social Security provides insurance. If you buy a fire insurance policy for your house and your house doesn’t burn down, you don’t conclude that you did badly on that investment and decide to invest your money in the stock market instead of buying any more insurance. That’s not the way that we evaluate insurance programs.

One-third of Social Security benefits are provided in the form of insurance benefits to people with disabilities or to survivors. Social Security is designed to give you money when you most need it — if your parent has died, if you become disabled and are unable to work, or if you live a very long life in retirement and run down your other savings. Other things being equal, a program that provides that sort of financial security is going to be more attractive than a program that has variable rates of return and doesn’t necessarily give you the most money when you most need it.

2. The higher average returns in the stock market come with higher risks. This point has gotten some attention in the press recently because of several new research papers. On average, past returns on investments in stocks have been a little over four percentage points higher than returns on investments in the bond market. But the stock market is extremely variable: in any given year we’ve seen it go down by as much as 40 percent or up by as much as 50 percent.

Investing in the market through private accounts over a period of 40 years or so is not going to insulate you from that variability. For example, if you retire in a year in which the market goes down 40 percent, you’re going to lose significant money that year on the contributions you made in every one of the previous 40 years.

Professor Robert Shiller of Yale University, probably the nation’s leading financial economist, conducted a study and found that if the stock market’s historical pattern holds, people who invest in what the President is calling a “life cycle account” (which protects you somewhat against risk by shifting funds more into bonds as your retirement nears) would end up losing money 32 percent of the time. In other words, 32 percent of the time they

2 would not get a rate of return that was sufficient to compensate for the additional reductions in Social Security benefits to which people who elected private accounts would be subject under the President’s plan.

Moreover, there’s a growing consensus that historical returns aren’t a good guide to future returns. The Wall Street Journal surveyed ten leading financial economists and investment bank chief economists, and nine of them projected lower rates of return in the stock market in future decades than the Social Security Administration is predicting. In general, the analysts whom the Journal surveyed projected that future stock-market returns will be about two percentage points lower, on average, than what the Social Security Administration has been assuming.

There are a number of reasons for this. One reason, analyzed in a recent paper by Dean Baker, Brad DeLong, and Paul Krugman, is that economic growth is expected to slow in the future because labor force growth is projected to slow considerably (due to the aging of the population). That, in turn, will slow the growth of corporate earnings and thereby reduce the rate of return on the stock market. Some additional reasons are that as people invest more in the stock market, the risk premium for investing in stocks may diminish over time, and also that the stock market may be at a highly valued level today that will be difficult to maintain.

Shiller also replicated his analysis using what he regarded as more realistic assumptions of future stock market returns, along the lines of what the economists surveyed by the Wall Street Journal expect. With these assumptions, he found that people opting for the President’s private accounts would end up losing money 71 percent of the time. Either way, under a realistic simulation of the President’s private accounts, Shiller estimated that people will end up losing money 32 percent to 71 percent of the time. That’s nothing resembling a free lunch.

Most economists say this type of analysis illustrates the importance of incorporating a factor to reflect the additional risk that is associated with investing in the stock market. It’s not an apples-to-apples comparison to compare $1,000 that someone would receive with certainty to a coin toss under which they would receive $2,000 if the coin came up heads and nothing if it came up tails. For most people, the sure $1,000 would be more desirable.

When the Congressional Budget Office analyzes Social Security plans that include private accounts, CBO estimates rates of return on what is known as a “risk-adjusted” basis. CBO begins with the stock market rate of return but subtracts from it the cost of the added risk of investing in the stock market. In fact, I would speculate that one reason we haven’t seen many CBO analyses of private accounts plans is that a lot of proponents of those plans don’t want to see CBO’s results, which make clear that there is no free lunch from private accounts.

The Administration also uses risk adjustment in the Railroad Retirement System, a program for railroad workers that’s parallel to Social Security. The Railroad Retirement system invests partly in stocks. OMB explains that “if that risk [of investing in stocks] was taken into account, the returns on private securities would be no greater than the returns on government securities.” All of the official accounting of the Railroad Retirement system

3 conducted by CBO and OMB adjusts for the additional risk of investing in the stock market.

3. The most profound and important reason why you can’t simply compare the rate of return in the traditional Social Security system with the rate of return in private accounts is the large transition costs involved. You often hear the argument that Social Security has a one percent or two percent rate of return — and if people just took all of their payroll taxes out of Social Security and invested them in the bond market, they could get a three percent rate of return with no additional risk and everyone could be better off. The President recently made this argument. The argument, however, is a fallacy, because it ignores the transition costs of moving to a new system. Once you factor those in, you can’t get a higher rate of return from pulling out of Social Security.

To give an example, suppose everyone in the country did what 5,000 workers in Galveston, Texas and two other Texas counties did: pulled all of their payroll taxes out of the traditional Social Security system and invested in a separate retirement system. People might appear to receive a higher rate of return than they’re getting right now, but we would then need to come up with the $500 billion a year to pay benefits to current Social Security recipients. We could raise taxes on everyone, but if we did that, the higher taxes would cancel out the higher returns from the stock market. Alternatively, we could reduce or eliminate benefits for current Social Security recipients and give higher benefits to people in the future through private accounts, but there, too, there would be a cost: one group would gain, but another group would lose. Once again, there is no such thing as a free lunch from private accounts.

This commonsense notion that you can’t pull money out of Social Security without taking into account the cost of supporting current beneficiaries was analyzed several years ago in a landmark paper by three economists, one of whom, Olivia Mitchell, was on the President’s Social Security Commission. They showed that if you take the transition costs into account, the rate of return in the stock market is exactly the same as the rate of return in the current Social Security system.

To summarize, there are a lot of legitimate issues to debate about private accounts, but whether they provide a higher rate of return is not one of them. Virtually every economist agrees that they do not provide a free lunch, for three reasons: Social Security is an insurance program; the higher returns you get in the stock market are a reflection of the higher risk of investing in that market; and what may appear to be higher rates of return disappear when you factor in the transition costs associated with switching to private accounts.

HENRY AARON: In his remarks, Jason did not cover one of the points he discusses in his new paper that explains why the returns from a privatized system could actually be lower than those from Social Security: Social Security is administered with extreme parsimony. For the retirement portion of the system, the estimated administrative costs are on the order of .01 percent of the funds on deposit each year. The administrative costs associated with private accounts are about 30 times as high, or 0.3 percent of funds on deposit at a minimum, and they almost certainly would be higher.

When you factor in administrative costs as well as the other factors Jason noted, the returns under private accounts would tend to be lower than under traditional Social Security.

4 It’s also important to step back for a moment and recall why we have Social Security in the first place: to provide a high degree of reliability for a certain amount of basic income that will be available to people when they retire or become disabled or after a family breadwinner dies. That goal cannot be achieved through individual accounts. So not only are the returns provided by individual accounts either the same or more likely lower once one takes account of the risks involved, but these accounts cannot sustain the fundamental purposes of social insurance.

QUESTION: Jason, it sounds like you’re pretty down on the stock market in this report. Do you have any of your personal savings invested in stocks?

JASON FURMAN: Yes, I do, and I am expecting to get a Social Security benefit when I retire, as well. The question is not whether someone can benefit from having a diversified portfolio. The answer to that is yes, they can. The question is whether you can push people even more into stocks than they already are and get a free lunch out of that process, and the answer to that is no. In fact, you’re likely to subject them to more risk than they want to take.

There are a lot of great ways to get people into the stock market; Peter Orszag of the Retirement Security Project has described several of them, such as automatic enrollment in 401(k)s and allowing people to direct their tax refunds into IRAs. But none of these is going to give you a free lunch. If you adopt automatic 401(k) enrollment, you’re choosing to spend less today so you can spend more in the future. It’s a good idea to help people do that, but it’s not a free lunch. The idea that you can get a free lunch is what this paper is objecting to.

QUESTION: Jason, you compared personal accounts to a coin toss, where you might get $2,000 or nothing. With private accounts, do you believe there’s a chance investors could receive nothing after decades of investment?

JASON FURMAN: The bigger risk is that people would be allowed to withdraw their money at age 50 to deal with a health emergency, losing their job, or something like that. Historically, in programs like the Thrift Savings Plan for federal workers, withdrawal rules have been relaxed over time. The main way someone could end up without an account in retirement is if they were allowed to take it out early.

HENRY AARON: Work Jason has done for the Center indicates that after the individual repays the loan that one has, in effect, taken out from Social Security in order to finance the individual account, and after you take into the account the benefit cuts that are likely to be necessary to achieve long-term Social Security solvency, people could very well end up with zero in Social Security benefits. In many situations, the return on the individual account would not be great enough to pay off the loan from Social Security that one has to repay when one claims Social Security benefits.

JASON FURMAN: So there really are two questions. One is whether your traditional Social Security benefit could fall to zero, and as Henry just said, that will happen for a lot of people.

The second question is whether you could make a set of investments such that your account disappears and you lose all of the money in your account. The two principal risks of that happening are early withdrawal and if the rules were changed to allow people to invest in stocks like Enron.

QUESTION: CBO’s analysis of Plan Two of the President’s Commission on Social Security

5 seemed to say in some places that, on average, people would come out equal or ahead under private accounts, but in other places, it seemed to say this wouldn’t happen. Can you help me sort that out?

JASON FURMAN: It depends in part on the year you retire. Most people who retire toward the middle or end of the next century would end up worse under Plan Two — not only worse than under the benefits that are now promised, but worse than if we did nothing to restore Social Security solvency and let the trust fund be exhausted.

QUESTION: Surely the Administration is aware of all that you have said, yet it is adamant about pushing the benefit of private accounts. Is there a benefit to private accounts that you’re overlooking, or is the Administration deliberately misleading the American public?

HENRY AARON: There are a lot of reasons why one might support individual accounts. There is a tradition in the United States, one that deserves respect and honor, of emphasizing individual self-reliance. There is another tradition that also merits respect and attention, that a lot of problems require working together. Social Security reflects that latter tradition.

People disagree legitimately on the relative importance of those different traditions, but my view is that both are important. It’s vital to have a core income that people can count on, precisely to enable them to participate actively in financial markets, to invest in risky assets.

So it’s a false dichotomy to set the virtue of individual saving and wealth creation against the virtue of maintaining a strong social insurance system. They go together.

Having said all that, I also believe that some of the Administration’s comments are highly misleading and are incorrect for the reasons that Jason has described. I’m not suggesting that people are consciously trying to deceive, but it is possible to articulate incorrect views sincerely.

JASON FURMAN: I think the Administration’s economists understand the problems with the argument that private accounts provide a higher rate of return, but the argument is so potent that the Administration can’t help but make it from time to time, even though it knows it’s untrue.

After Greg Mankiw, who was the Chief Economic Advisor to the President, left the Administration, he wrote a piece for Brookings in which he said that the reasons to move Social Security from its current defined-benefit structure to a defined-contribution structure are that this would give individuals more choice and control over their retirement income and give the government greater transparency in its finances. I personally have some quibbles with that, but that’s why he supports private accounts.

Mankiw goes on to say that his “arguments are not based on any particular estimate of the average return to capital or of the equity premium.” He basically is all but saying that a higher rate of return is not the reason to support private accounts.

ROBERT GREENSTEIN: My impression is that around December and January, during the earlier part of the Administration’s push on Social Security, the Administration rarely used the misleading arguments about rates of return. It may be that senior economists in the Administration, perhaps including Greg Mankiw, were able to prevail internally on the notion of not using misleading arguments in this area.

6 But as Jason has suggested, any Administration of any political persuasion that is advancing a very high-profile policy is likely to experience internal dissension between the policy analysts and the political people, where the political people come up with messages and claims that are misleading or invalid analytically. What appears to have happened is that as the Administration has done worse in the Social Security debate (starting around the time the President was sent on the road), they dropped some of their reluctance to use what the senior economists seem to have known is a misleading argument and started to rely on it more. That may mean that the message people and the political people in the White House have gained more influence over some of the economists and analytic people, at least in this aspect of the Social Security debate.