Social Security Reform: Responding to the Critics
Wednesday, November 16, 2005
by Andrew J. Rettenmaier and Zijun Wang
Table of Contents
- Executive Summary
- Social Security Reform
- Evaluating the President's Approach
- Examining the Options
- Results Using Historical Data
- Results Using Adjusted Historical Data
- Results Based on Simulated Data
- Protection against Downside Risk
- Flexible Annuitization Rules
- Summary and Conclusions
- Appendix: Basic Assumptions and Additional Findings
- About the Authors
- See Andrew J. Rettenmaier and Thomas R. Saving, “Social Security and Progressive Indexing,” National Center for Policy Analysis, Brief Analysis No. 520, July 11, 2005.
- See the solvency memorandum from Stephen C. Goss, Chief Actuary of Social Security, to Bob Pozen dated February 10, 2005 for further details and for an evaluation of the proposal. Note that Pozen’s plan coupled the particular adjustment to the benefit formula outlined with accounts equal to 2 percent of earnings. However, the benefit offsets are conceptually the same regardless of the account size.
- Another vantage point from which to view the transaction is that of the workers. In effect they have an arrangement with the government in which they agree to pay taxes in exchange for a retirement pension and an insurance policy. In this view, workers are the lenders rather than the government. For the opportunity to redirect their taxes to personal retirement accounts, workers must relinquish some of their benefits that they would otherwise expect from the government. With this understanding, the benefit offset rate is not the government borrowing rate but rather the implicit return to Social Security. This return could be higher or lower than the government borrowing rate and future rates are subject to legislative reforms.
- Robert J. Shiller, “">The Life-Cycle Personal Accounts Proposal for Social Security: An Evaluation,” March 2005. Web publication.
- In an attempt to address the perceived risks embodied in investing in the stock market, an oft-mentioned investment strategy uses lifecycle portfolios (also known as funds of funds, allocation funds and pre-mixed portfolios.) A “lifecycle account” invests in a pre-mixed portfolio of stocks and bonds, and automatically adjusts the level of risk as the worker ages, primarily by changing the allocations of equities and bonds. An example of a lifecycle account is the Vanguard Total Retirement 2045 Fund. The fund is targeted toward a person retiring in 2045; the fund invests almost completely in stocks, but gradually and automatically shifts to almost all bonds by 2045. The mix of stocks and bonds — and the rate of the replacement of one with the other — has a dramatic effect on the fund’s returns.
- See solvency memorandum from Stephen C. Goss to Charles P. Blahous, February 3, 2005.
- See the solvency memorandum from Chris Chaplain and Alice H. Wade to Stephen C. Goss, Chief Actuary of Social Security, November 18, 2003, which evaluates a proposal introduced by Sen. Lindsey Graham for a proposed benefit offset rate equal to the realized long term bond rate less 0.3 percentage points.
Note that the 2005 Social Security Trustees Report projects the government’s borrowing rate — the real rate of return on government bonds — will average 3 percent above inflation. This rate is appropriate for static projections of the benefit offset, but it is not the appropriate rate for performing stochastic simulations if the intent of the benefit offset is to repay additional government borrowing during a worker’s lifetime.
- Robert J. Shiller, “The Life-Cycle Personal Accounts Proposal for Social Security: An Evaluation,” March 2005.
- President’s Commission to Strengthen Social Security, Strengthening Social Security and Creating Personal Wealth for All Americans, 2001.
- Market returns on equity are represented by total returns on Standard & Poors 500 stocks including both capital appreciation and dividend income. The historical stock and money market and long term government bond return series are compiled by Robert J. Shiller, “The Life-Cycle Personal Accounts Proposal for Social Security: An Evaluation,” March 2005.
For the full discussion of assumptions and for additional findings see the Appendix.
- Note that the internal rates of return presented in Table II are essentially identical to the results Table 3 of Robert J. Shiller, “The Life-Cycle Personal Accounts Proposal for Social Security: An Evaluation,” March 2005.
- See Campbell and Feldstein, eds., Risk Aspects of Investment-Based Social Security Reform (Chicago: University of Chicago Press, 2001), for a collection of papers that discuss in detail how to address risk in Social Security reforms involving personal investment accounts.
- Laurence Kotlikoff, “Fixing Social Security for Good” presented at the University of Maryland on September 13, 2003.
- See Estelle James, “Private Pension Annuities in Chile,” National Center for Policy Analysis, Policy Report No. 271, December 2004.
- Robert J. Shiller “The Life-Cycle Personal Accounts Proposal for Social Security: An Evaluation,” March 2005.
- We also conducted additional simulations based on an alternative bootstrapping procedure, simulations which assume that returns are distributed log normally, and a simulation that allows for variable wages over the investment period. Those results appear in Rettenmaier and Wang (2005).