Social Security and Market Risk
Tuesday, July 31, 2001
by Liqun Liu, Andrew J. Rettenmaier, and Zijun Wang
Table of Contents
There have been a number of proposals to invest the Social Security surplus in the financial markets. Some proposals call for the government to do the investing. Others would have workers deposit part of their payroll tax payments in individual accounts that would be invested in assets, such as stocks and bonds. Are such investments inherently risky?
The returns on both stocks and bonds fluctuate widely - and at times wildly - from day to day and even from year to year. However, over longer investment periods this volatility is dramatically reduced - often to a few percentage points. Over the past 128 years:
- The annual returns on stocks range from a worst-year drop of 35 percent to a best-year increase of 47 percent.
- However, over investment periods of 35 years, the return on stocks ranges from a worst-period low of 2.7 percent to a high of 9.5 percent.
- The return on bonds ranges from a one-year low of -10.8 percent to a one-year high of 18.4 percent.
- However, over investment periods of 35 years the return on bonds ranges only from a worst-period low of 0.6 percent to a high of 5.1 percent.
In calculating benefits, the Social Security Administration considers the 35 years of highest earnings. To determine how financial investments might fare over a similar period of time, this paper examines historic returns from portfolios holding the Standard & Poor's 500 stocks and top-rated corporate bonds for the ninety-five 35-year periods ending between 1906 and 2000. The analysis finds that:
- Although there is a common perception that stocks are more risky than bonds, stocks outperformed bonds in every one of the 95 periods.
- In addition, all-stock portfolios almost always outperformed mixed portfolios containing both stocks and bonds.
Furthermore, the performance of the capital markets is much better than what young people today can expect on their Social Security payroll tax dollars.
- The average annual real rate of return for an all-stock portfolio was 6.4 percent over the 95 periods, with the lowest being 2.7 percent for the period ending in 1921.
- A portfolio of 60 percent stocks and 40 percent bonds produced an average annual real return of 5.1 percent, with the lowest being 2.0 percent for the period ending in 1920.
- By contrast, virtually all young people entering the labor market can expect a rate of return on their Social Security taxes of less than 2 percent.
To provide insurance against outliving one's savings, a retirement system based on individual retirement accounts must convert the funds into annuities upon retirement. The amount paid by an annuity is determined by the expected rate of return, the amount paid in and the expected life span of the retiree.
A number of reform proposals call for workers to contribute 2 percent of earnings to personal retirement accounts over their work lives. Based on historical stock market data, we estimate that if workers are in 100 percent stock portfolios prior to retirement:
- During retirement, a private annuity would be expected to equal 43 percent of currently promised Social Security benefits.
- In the best-case scenario, the annuity would equal 85 percent of the Social Security benefit.
- In the worst-case scenario, the annuity would equal 17 percent.
How do these potential variations in the size of the annuity affect the pension benefit the retiree actually receives? This depends on the specific reform adopted. Every serious proposal limits the downside risk to the retiree. But there are differences among them. Under one proposal, the annuity would offset Social Security benefits dollar for dollar. Under this plan, the retiree would not face any risk.
Under another proposal, retirees would be guaranteed a minimum benefit equal to the current system's promises. In addition, retirees would get an extra benefit equal to 25 percent of their private annuity. Even so, the year-to-year difference in total pension benefits for retirees with the same lifetime income would be less than 4 percent.