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
Evaluating the President's Approach
Under current law, workers remit their Social Security payroll taxes to the federal government in exchange for a retirement pension, survivors insurance and insurance against disability. Under personal account reforms, workers would release the government from the obligation to pay some of their expected retirement benefits in exchange for the opportunity to redirect some of their payroll taxes to personal accounts.
The Benefit Offset. Most PRA plans propose to accumulate the worker’s personal account contributions in a shadow account by applying a specified interest rate for each pre-retirement year. The monthly life annuity that could be purchased with this hypothetical accumulation is the benefit offset. A worker’s retirement pension would be determined by subtracting the offset amount from his price-indexed benefit and adding his personal account annuity:
Thus, if a worker’s account earns a higher rate of return than the benefit offset amount, he will earn a higher total benefit than if he did not have the account. By contrast, if the worker’s rate of return falls below the offset, he would have been better off without the account.
"As the PRAs grow, the benefit paid by Social Security is reduced (the benefit offset)."
Looked at another way, the benefit offset provides a way to repay taxpayers for the current costs of moving to the new system. From this perspective, the offset is simply a repayment to the government by personal account holders of the money the government loaned them to invest in the stock and bond market. At retirement, workers must repay the loan with interest. 3
If the benefit offset rate is set at the government’s borrowing rate, the effect on the government’s finances is neutral, assuming the government borrows the funds that are ultimately deposited in the accounts. The combination of the new current (explicit) debt and the ultimate offset repays all the borrowing with interest and thus implies no net change in the government’s total debt.
The remainder of this paper examines the likelihood that workers who open a PRA will lose money. That is, we estimate the chance that a worker’s personal account annuity is less than the benefit offset annuity. If so, the new price-indexed benefit would be reduced by the difference and would be smaller than if the worker had not opted for the account.
Criticisms of the Plan Based on Shiller’s Findings. The president’s plan has been criticized in several ways. First, as stated above, some worry that many workers will receive lower benefits because their total account return will fall below the government’s borrowing rate. Second, there is a concern that workers’ investments will frequently earn less than the government borrowing rate.
Shiller raises both issues in a recent study. 4 He assumes that workers invest in “lifecycle accounts,” as has been suggested by the president. These accounts are designed to gradually and automatically reduce the percentage of a portfolio invested in stocks as workers age, allocating more to stocks when workers are young and more to bonds as they near retirement. 5 Using actual historical stock returns dating back to 1871, Shiller finds that 32 percent of the time an account patterned after the president’s will produce returns that fall below the 3 percent assumed for the benefit offset. This implies that one-third of the time new retirees would have to subtract an additional amount from their price-indexed Social Security benefits; thus, they would have lower benefits than if they had not opened an account. Using a lower rate of return on stocks to reflect reduced expectations about future returns, Shiller finds that 71 percent of the lifecycle portfolios fall below the 3 percent break-even point.
An Alternative Benefit Offset Rate. As Shiller noted, the 3 percent benefit offset rate is too high. As a result, it pushes many more portfolios below the break-even point than if a lower return, such as the actual historical government bond rate of return, had been used.
"The size of the benefit offset account used here is determined by the realized rate of interest paid on government bonds."
As evaluated by the Social Security Actuaries, the personal account proposed by the Bush Administration uses the prospective government borrowing rate as the rate of return for determining the benefit offset. 6 However, it is more appropriate to use realized government bond returns — not a fixed rate (for example, 3 percent) — when evaluating the likelihood that a worker’s personal account will accumulate less than the benefit offset. 7 Specifically, if the purpose of the benefit offset is to repay the funds provided to the worker by the government, then the realized bond rate over the worker’s life is the appropriate offset rate. 8