Social Security Reform: Responding to the Critics

Studies | Social Security

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


Examining the Options

Table I - Personal Retirement Account Equity Shares

In what follows, we replicate Shiller’s simulations, but with an important difference: instead of using a fixed 3 percent rate of return to calculate the benefit offset, we use the realized return on government bonds. We also evaluate five portfolios — two lifecycle portfolios and three constant allocation portfolios — using several different methods.

Selecting Portfolios . We consider five asset allocations that differ in the ratio of stocks to bonds. Table I presents the proportion of stock at each age for the five portfolios.

  • Lifecycle Fund Based on Shiller: Invested 85 percent in equities through age 29; it gradually falls to 15 percent in equities by age 60. This reflects the allocation rule considered by Shiller. 9
  • More Aggressive Lifecycle Fund: Invested 89 percent in equities through age 29; it falls in six 5-year steps to 47 percent in equities by age 60. The equity to bond allocation is based on the Fidelity Freedom series fund as of December 31, 2004.
  • All Bond Fund: Invested 100 percent in bonds; 50 percent in long-term government bonds and 50 percent invested at the money-market rate.
  • 50/50 Fund: Fixed at 50 percent equities, 30 percent corporate bonds and 20 percent Treasury bonds; it does not vary over workers’ lifecycles. This corresponds to the featured portfolio considered by the 2001 President’s Commission to Strengthen Social Security. 10
  • All Stock Fund: Invested 100 percent in equities throughout the workers’ years in the labor force.

Using Lifecycle Funds . Lifecycle portfolios are often mentioned as a way to address the perceived risks of investing in the stock market. Lifecycle portfolios are funds that automatically reduce the level of risk as the owner ages by gradually reducing the level of stock and increasing the level of bonds over time. The idea is that the portfolio should become more conservative as individuals near retirement. However, lifecycle portfolios have been available for only a few years. It is difficult to evaluate their performance based on the few existing funds over such a short period of time.

"Returns for five hypothetical investment portfolios were calculated for 91 overlapping 44-year periods."

Instead, we examine the historical performance of the U.S. stock and bond markets since 1871 and create two hypothetical portfolios that follow the allocation used by Shiller and the more aggressive allocation identified above. 11 Returns on equities, six-month money market rates and long term government bond returns (all adjusted for inflation) are used to construct returns on our two lifetime portfolios and the other three fixed allocation portfolios.


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