Social Security Reform: Responding to the Critics

Policy Reports | Social Security

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

Protection against Downside Risk

One way to protect workers against the downside risk is to set the benefit offset to the minimum of the hypothetical account accumulation using the realized government borrowing rate and the PRA. With such a provision, any worker who opens a PRA and invests in a balanced portfolio of stocks and bonds will receive at least the price-indexed Social Security benefit. If this provision is offered, the simulations above and in the Appendix provide estimates of the frequency with which the government receives less than the amount borrowed. Clearly, this provision is not costless to the government, and ultimately to taxpayers. However, this assurance can be thought of as compensation for the reduction in benefits through progressive price indexation.

The government could guarantee this minimum benefit to any worker who invests in a diversified portfolio and does not meet the benefit offset threshold. The portfolio that is assured can be the default option for workers who open a personal account and would have a prescribed portfolio allocation throughout the workers’ lifecycle. Of course, workers who wish to invest more aggressively could do so, but risk the losses that come with the opportunity for higher returns.

"The government could guarantee a minimum benefit to low income workers."

Since the historical data produces few outcomes below the break-even point and the rate of portfolios falling below the break-even point with the simulated data is not excessive, some suggest that guaranteeing the price-indexed benefit would be inexpensive. Others have been much more cautious. 15 Regardless of how one looks at the historical and simulated evidence, the discussion of guarantees ignores two important facts. First, current Social Security benefits are not (and never have been) guaranteed. Second, even if current Social Security benefits were guaranteed, they would have the same implicit costs as the guarantees that are discussed in the context of personal accounts.

This downside risk protection would definitely make the reformed system superior to the current system for low income workers in the event that the reformed system combines personal accounts with progressive price indexing. All workers whose lifetime average earnings are less than the earnings level where indexing starts only have the upside potential of the amount by which their personal account exceeds the benefit offset.

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