Social Security Reform: Responding to the Critics

Studies | Social Security

No. 281
Wednesday, November 16, 2005
by Andrew J. Rettenmaier and Zijun Wang


Executive Summary

Critics of President Bush’s Social Security reform proposal have used findings by Robert Shiller, professor of economics at Yale University, to suggest that many workers will lose money if they open personal retirement accounts (PRAs), which are a key component of the president’s reform approach.

Under a reformed system, American workers would release the government from the obligation to pay some of their expected retirement benefits in exchange for the opportunity to invest some of their payroll taxes through personal accounts. The amount of the reduction is based on what the personal account is estimated to grow to if it were invested entirely in government bonds. The monthly life annuity that could be purchased with this hypothetical accumulation is called the “benefit offset.”

If the annuity generated from a personal account is greater than the benefit offset, the worker gains from owning a PRA. If the account balance is less than the benefit offset, a worker would have been better off without the account.

Shiller measures how workers would fare under the president’s approach using financial market returns from 1871 to 2004 to construct 91 overlapping 44-year time periods. But instead of using the actual return on government bonds over these periods to determine the benefit offset rate, he uses a higher fixed real rate of 3 percent, which is the projected future government borrowing rate. Under these assumptions, in one-third of these time periods workers would have been worse off than if they had not invested at all.

However, as Shiller notes, the 3 percent offset rate is too high, and he suggests using a market return. Using the actual, historical bond rate of return to calculate the benefit offset, we repeated the simulations. The result provides a picture of how workers would fare under the president’s approach, if it were to incorporate the realized government borrowing rate. Based on the historical data we found that:

  • Workers with balanced portfolios of stocks and bonds exceed the break-even point in all of the simulations.
  • Workers who invest in a lifecycle fund suggested by Shiller will experience a net gain (personal account balance minus the benefit offset) of $15,830 to $102,031, with a real internal rate of return ranging from 1.57 percent to 4.68 percent, depending on the simulation.
  • If a worker instead invests in a more aggressive lifecycle fund, the net gain is $50,533 in the worst scenario and $248,400 in the best scenario.
  • Based on the historical data, some workers' net gain would have exceeded the benefit offset amount by more than two-and-a-half times.

There are two additional features that can be employed to protect workers from the ups and downs of the market. First, to avoid the pitfall of having to purchase an annuity in a down market (for example, requiring people to annuitize their personal accounts on their 65th birthday), workers could annuitize their PRAs over several years. In addition, workers could be allowed to purchase an annuity as soon as their accounts are large enough to support a specified pension, regardless of their age.

Second, workers who invest in a balanced portfolio of stocks and bonds can be assured they will receive at least the reformed Social Security benefit by setting the actual offset to either the PRA balance or the benefit offset amount, whichever is less. That is, with this provision, a worker who invests in a diversified portfolio will never be worse off for having opted for a PRA.


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