Would Privatizing Social Security Pay a Higher Rate of Return?

As the Dow Jones Index soared over the last decade, many Americans began to believe that stock markets could do no wrong. The market’s success in generating wealth has stood in sharp contrast to the shaky future forecast for the U.S. Social Security system. Increasing numbers of young workers seriously doubt whether they will ever receive Social Security benefits, and now view Social Security as a vestige of FDR economics better suited to a bygone age. Many suggest that converting Social Security to individual accounts, often called privatization, is the solution.

The pros and cons of Social Security privatization are analyzed in two new Pension Research Council papers by Olivia S. Mitchell of the Wharton School with John Geanakoplos of Yale University and Stephen P. Zeldes of Columbia University. Arguing against critics of the Social Security system, the researchers show that privatization will not necessarily offer higher rates of return to all people in the system. Privatization could offer future workers a better deal than the current system, but only if the way it is funded is changed, and at the cost of lower returns to early beneficiaries of privatized social security.

Started by Franklin Delano Roosevelt in 1935, the US Social Security system began paying retirement benefits to retirees born before the turn of the century, at a time when many had not paid into the system very long. As a result, the first few generations of participants did very well indeed. For example, a worker born in 1876 received an average real annual return of 35 percent on every dollar contributed. But as the system matured returns fell. A worker born in 1920 could expect a return of only 5.7 percent. By the time the last of the Baby Boomers retire in 2026, Social Security is expected to be in an advanced state of disrepair, with too little tax revenue collected to pay promised benefits. The trust fund is adequately financed only until 2032, after which benefits will have to be cut, or taxes increased (or both) to keep the system solvent. This will further depress participants’ estimated returns. Thus, a worker born in 1975 can expect a 1.8 percent annual return, and those born this year a mere 1.5 percent.

Some argue that Social Security privatization will solve this declining return problem. They say that individual accounts invested in the capital market, especially the stock market, will earn returns high enough to offset the pressure of an aging population. Crusaders for a privatized Social Security plan include Republican presidential candidate Steve Forbes, who argued that the average worker retiring today should be allowed to benefit from the historic 9-10 percent annual returns from the stock market.

Mitchell and her colleagues show that the term "privatization" is often misused in popular discourse on US Social Security. Specifically, it is often used to include two related, yet distinct, concepts: prefunding and diversification. Privatization entails replacing the current Social Security program with a prefunded one, where contributions and investments are held in individual workers’ names. Prefunding means raising taxes or cutting benefits in order to lower the amount of implicit debt — the gap between assets in the system and benefits promised to workers– at present, a whopping $9 trillion. Diversification refers to the investment of Social Security funds in a broad range of assets, including private sector stocks and bonds and foreign securities. At present, the Social Security system is mainly unfunded, and assets ($589.1 billion at the end of 1997) are held exclusively in US government bonds.

Mitchell argues "the popular argument for Social Security privatization is misleading because it overlooks the transition costs involved in eliminating the system’s implicit debt, and undervalues the greater risk associated with investments in capital markets." Her analysis indicates that the expected value of stock returns should be adjusted downward to reflect their higher risk (as compared to government bonds). Moreover, when transition costs are factored in, the new taxes needed to fund privatized Social Security while honoring commitments to those who have paid into the present system would wipe out all gains.

Privatization of Social Security may offer several important advantages, including increased portfolio choice, reduced political risk and an intangible increased sense of ownership and responsibility. But the most important economic benefit stems from portfolio diversification. Having individual defined contribution accounts would allow more people to invest in diversified capital markets. The authors conclude that the policy debate should focus on tradeoffs between lower returns for current workers versus higher returns for future workers; the risks and benefits to society of more households holding a diversified portfolio; and the administrative costs associated with individual accounts. Only then will talk of privatized Social Security make the transition from glib generalizations to serious policy.