Thursday, March 24, 2005

USATODAY.com - Public cool about heart of Bush's Social Security plan

There are things that I just do not understand. From Yesterday's USA Today:

USATODAY.com - Public cool about heart of Bush's Social Security plan: "The heart of President Bush's plan for Social Security, allowing younger workers to create personal accounts in exchange for a lower guaranteed government benefit, is among the least popular elements with the public"

"Younger workers would have the option of investing a portion of their payroll taxes on their own and would receive a lower guaranteed government benefit when they retire. Supporters of the plan argue that earnings on the investments would make up the difference."

Huh? Obviously Social Security is in the news every hour, but somehow people are still not getting the message.

More important than when the money is going to run out (For instance, yesterday we heard that Social Security is probably going to run out of money by 2041), is how low of returns one gets from social security.

Michael Tanner of the Cato Institute
writes the following:
"While "the term “rate of return” may be slightly misleading when applied to Social Security. Indeed, some observers object to the entire concept of applying rate-of-return analysis to Social Security....most economists attribute an “implicit” rate of return to Social Security, based on a comparison of a person’s contributions (taxes) and benefits. This rate of return can be summed up as the average interest rate that a person would have to earn on his or her contributions to pay for all of the benefits that he or she will receive from Social Security, or more technically, “the constant discount rate that equates the present discounted value of contributions
with the present discounted value of benefits.” It is important to note that this rate of return has nothing to do with the interest attributed to “assets” held by the Social Security Trust Fund."
The result of his analysis?
"We can assume that workers retiring today receive a rate of return of approximately 2 percent and that future retirees will receive even lower rates of return."
Yes I understand risk aversion, but wow. The people who are against reform must expect to be hit by the sky every time they go outside.

Now of course, this does not mean guaranteed. For instance recently the Christian Science Monitor reported the case of Stanley Logue a 1994 retiree who was getting more through social security than he would have had he invested on his own. Why? Timing. He invested when market went sideways or down. But as I tell people all the time, you can not manage to the exception. (indeed, a much more common "exception" can be seen by examining what happens when someone who has paid into the social security system and dies early.)

In a related note, Auburn's Jonathan Godbey (who has been described as a "financial genius"--yeah it was by his wife) recently gave his class a cool assignment. They had to compare how much they could expect under the current plan vs if they were allowed to invest 4% in private accounts. The results of course suggest that private accounts increase retirement income substantially. He will be updating this in the near future by examining it for each year of retirement to capture the magnitude of the Logue Exception.

So what will happen? I have no idea, but do not necessarily disagree with Tom Morgan (who many of you may hear on the radio) who published an interesting article on how he things the reform movement could play out. The short version of his view: higher taxes, lower payments, and a voluntary private account program.

Stay Tuned...

11 comments:

Jonathan Godbey said...

Godbey is a financial genius!

Fantonim said...

I don't understand the hype about the Social Security, if it is only expected to run dry in 2041. What about Medicare and Medicaid. This article here says the Medicare will run dry in 2020!!!! Why not concentrate on more pressing issues....?

P.S. Professor, I am a student of finance in Toronto, come visit my blog fantonim.blogspot.com!!

Anonymous said...

Anyone that still thinks private accounts are a good thing should read this paper by Robert Shiller:
http://www.irrationalexuberance.com/shillersocsec.doc

Anonymous said...

Here's a pretty informative article on the subject from USATODAY:

Most Americans no good at investing

Anonymous said...

Shiller does not make a convincing case against private accounts. If anything, they should not charge the 3% "margin".

He shows that the market performs well. He does not mention that 1)SS benefits will drop by 25% by the time today's 20s retire, 2) the potential to use derivatives to insure against mkt risk, 3) the potential for much greater returns in China/India while downgrading the U.S., or 4) if the economy slows and the mkt underperforms then SS will go broke sooner.

I expected better work from Shiller.

Anonymous said...

In replying to the previous post I would say the following:

1) I believe Shiller is focusing on private accounts and leaving out the impact of the shortfall since, whether there is a shortfall or not, the impact of market returns on private accounts will be a major factor in the success of the program.

2) Use of derivatives has not been mentioned, to my knowledge, in the private account debate. If used, let's hope this is an automatic feature since the average taxpayer doesn't have a clue how this works. I must confess that I would have to pull a book off the shelf to understand how this could work and I don't think I would ever attempt to do it myself. Anyway, wouldn't derivatives lower the return somewhat as the price for the downside protection?

3) I agree China and India have great PROMISE. However,
a) As developing economies, risk will be higher in those markets, leading to more volatility than in the US.
b) How many taxpayers will invest part of their private account contributions outside the US?
c) For those that do, home market bias would likely prevent allocations being shifted as dramatically as they would need to be to benefit from the higher return.

4a) "if the economy slows….then SS will go broke sooner ": the SS trustees intermediate assumptions (leading to trust fund exhaustion in 2041) assume a low rate of growth, somewhat (I don't recall the figure) lower than the long term average, so the current projection is already conservative. If the future growth rate of the economy is even slower then SS will indeed go broke sooner.

4b) "if….the mkt underperforms then SS will go broke sooner". Huh? Lower market returns will not change SS tax paid into the system and the SS "Trust Fund" doesn't depend on market return. It is true that the yield on the bonds in the trust fund provides income to the fund and therefore helps determine the exhaustion date.

Privatize said...
This comment has been removed by a blog administrator.
Privatize said...

In reply to comment 6:
1) Shiller calls the SS benefit "guaranteed" and "not subject to market risk" p.3 Not true. Projections show a 25% reduction in benefits. PSA win by 20%+.

2) Derivatives would lower the return just like insurance premiums. Not hard to do at all. It's a simple risk aversion question. There is a lot of work showing that "life cycle" accounts underperform stocks plus some puts. I think Zvi Bodie has done the best work, not sure??

3)Shiller makes a big deal of lowered forecasts for U.S. returns and of bad past international returns. To be intellectually honest he needs to present international forecasts (which would be higher) or confine his analysis to the U.S. alone. He claims that we should consider international returns to lower the performance of past returns but is silent when they raise future projections.

4)The SS Trust Fund is sensitive to the market but not directly. The market will underperform if earnings are lower than expected. Lower earnings are a result of lower economic growth. Lower growth means less employment. Less employment means fewer workers paying into the system which means it goes broke sooner. Revised lower forecasts earlier this month moved the "run-dry" date from 2042 to 2041.

Can you give me a scenario in which the market would not perform well but employment stays high enough to fund SS?

What about the generational wealth PSAs would create?

If you were starting from scratch would you choose the current SS plan or one with PSAs?

I posted comment 5.

ReformSS said...

Privatize, I want to make it clear that I am not attacking you directly, just the idea of private accounts. The point by point rebuttal could be mistaken for a personal attack and that certainly wasn’t the intention. Nor it is my intention in this post.

1) In both instances where Shiller referred to “guaranteed benefits” he was not arguing that the “benefits are guaranteed”. For example, in the first instance he wrote, “…the offset has the effect of drastically reducing the guaranteed conventional Social Security benefit”. In other places he refers to "conventional" or "traditional" benefits instead.

On the other hand, the benefit is "guaranteed" in the sense that, under current law, retirees will receive a defined benefit, albeit one that declines markedly after 2041 and then slowly thereafter. Private accounts and other changes to SS will split current and future workers into various groups, each with different SS benefit outcomes. All groups with private accounts, regardless of retirement date, will see the “traditional” benefit reduced. His point in the quote above.

BTW, I am in the group likely to receive full benefits for the duration of my retirement, unless I am fortunate enough to live past my 91st birthday. For me, I don't see any effect, positive or negative, from private accounts – excepting any repercussions from the government borrowing to finance them. My concern is about the effect on future generations.

2) My point about derivatives was that the average taxpayer doesn't understand either risk or derivatives. The level of knowledge (or lack thereof) is a crucial point that hasn't received enough attention in this debate.

3) Shiller uses forecasts for lower US returns that I've seen before so seeing them again wasn't a surprise. Let’s be honest. Any forecast of future returns is subject to considerable error. Any forecast of returns over the next 75 years is especially susceptible to error. Of course, we have no choice but to speculate and I think there is reason to be concerned about future returns given the demographics, current US debt levels, etc.

But, even if we ignore forecasts for future returns and look at the other set of numbers Shiller generated, those from unmodified historical data, the picture is not entirely rosy. Shiller wrote:

"When historical U.S. returns are used for the analysis, the baseline life-cycle portfolio is at best disappointing, at least compared with the rhetoric that has characterized much of the advocacy for the personal accounts. The real internal rate of return is only 3.4% a year, only slightly above the offset rate of 3%. While the median final portfolio value (after offset) is positive, the portfolio value is rather small, only $15,172 (net of the reduction in the traditional benefit). The portfolio value after offset is hardly a windfall. The lifetime annuity value of $15,172 is about $1,000 a year. Compare this with the benefits for our "scaled medium earner." Those benefits are promised to be $21,770 under the current schedule, are $15,934 on the "payable" baseline (which assumes benefits are paid from payroll taxes after the trust fund is exhausted), and would be $14,025 with price indexing. Any of these conventional Social Security benefits would dominate the median extra annuity income created by the personal account. Moreover, there is a substantial probability that the worker will actually lose from having participated in the program. The portfolio minus offset winds up with negative value (after offset) 32% of the time."

4) You asked “Can you give me a scenario in which the market would not perform well but employment stays high enough to fund SS?”

Actually, no. But that wasn't the point. The specific point was that the two were not directly connected.

Additionally, you asked two more important questions, let’s call then items 5 and 6.

5) You asked, “What about the generational wealth PSAs would create?”

Assuming that generational wealth was created, private accounts could be a good thing. The takeaway from Shiller’s paper is that it is likely that there will be winners AND losers. Generational wealth created for some, but not others.

6) You asked: “If you were starting from scratch would you choose the current SS plan or one with PSAs?”

Honestly, this is a tough question. Especially, without definitive details of a plan. But, knowing what we know now, if I were starting from scratch, I might be inclined towards support for fixing social security in a way such that the problem would be considered resolved over the very long term (unlike the last “fix”). This would create what could really be called a "guaranteed" benefit. Then, knowing the level of benefits with as much certainty as is possible regarding something 40-50 years in the future, I would know the rest was up to me and I hope I would act accordingly.

The bottom line is that I strongly believe replacing a portion of traditional SS with private accounts is not the best answer. We should remember that SS is about insurance against poverty and was never intended to build generational wealth. Also, in part SS is a transfer of wealth from the more fortunate to the less fortunate. Taking money out of SS to fund private accounts reduces its ability to perform this important function. Private accounts do make sense as add-ons to traditional social security which was part of the original vision for SS that didn’t survive the initial debate in the 1930’s.

I look forward to reading more analysis from the financial community. Regardless of whether one agrees with Shiller or not, the more light shed on this subject the better. I expect an avalanche of papers when a definitive plan is created. This can't happen too soon.

Privatize said...

Thanks for pointing out that this is not personal. I do not wish to attack you either but I'm happy to attack the math. ;)

1) On p. 3 under "Other Findings" Shiller clearly asserts that SS benefits are guaranteed. He even suggests that one must alter one's portfolio because it is no longer riskfree. Taking Shiller's worst case, doesn't it beat current SS's -20% or worse return?

2) The average taxpayer doesn't understand actuarial science but still has car inbsurance. Same thing here.

3) True we must speculate on future returns. Certainly( bad choice of words?), the market will have a better risk/return profile over the next 75 years than from 1871 to 1945. The Fed has much more data to develop policy with. There's a much smaller chance of a gold crisis, depression, etc. Even if it doesn't the all-stock portfolio only "loses" 2% of the time. That's less risk than the current plan.

4) The correlation b/w the market and the economy is precisley the point. Shiller ignores it but reality does not. If the PSAs perform poorly then SS inflows will not be sufficient to fund benefits. Benefits will then be cut by more than 25%. The 100% stock option "loses" only 2% of the time. (p.19)

5) Generational wealth will be created. If a retiree and spouse die there is nothing for the next generation under current SS. As I understand it, with PSAs the heirs get what's in the account. Is this correct? If we had done this over the last 75 years, imagine the money available to today's young, working poor. So what if it were not the original intent?

6) Why transfer wealth if you can create it?

To be against PSAs one must believe that more wealth is created by investing in Treasury securities than stocks.

As you point out PSAs were part of the original plan. What was the original payroll tax? Doesn't this bring us closer to the original?

ReformSS said...

1) As I understand it that would not always be the case. If the traditional benefit is to be reduced by an amount equal to a 3% return on the private account contributions (in the current plan that’s called the clawback), a market return of less than 3% will make the account holder worse off. After 2041 this reduction would be made to the reduced traditional benefit!

There is another issue. For some number of taxpayers the value of the private account would not offset the loss in benefits. They may be better off, but will they be as well off as they assumed. I’m sure we both know that the average private account holder is going to be looking for something a lot better. Given the way this is being sold to the public, many people will probably be looking for a combined benefit that exceeds a properly funded traditional SS program alone.

2) If implementing a strategy to “insure” returns (by whatever means) is a simple as checking a box on a form then my concern vanishes. Even better, insurance could be the default and the taxpayer would have to opt out. That is actually better than car insurance since with car insurance you have all those pesky options to deal with.

3) I agree that some economic shocks that have occurred in the past are unlikely to recur in the future. Certainly a depression like the one that occurred in the 1930’s is next to impossible but a severe recession is still possible. And, we may be more vulnerable in this era of terrorist attacks than we ever were in the cold war days. Soviets bluster aside, they weren’t about to do anything that would trigger a retaliatory strike from the US. So, the risk of significant economic shocks has not fallen to zero. Whether or not the current and future risk is lower will only be known after the future becomes the past.

4) Of course I agree that there is a correlation between the market and the economy. My quibble was regarding a direct link between the market and SS. Anyway, regardless of private accounts, SS inflows will not be sufficient to fund benefits and benefits will be cut. That is unless the program is fixed - permanently. What are the odds of that happening? Your guess is a good as mine.

5) As I understand it, the account holder doesn’t always get the entire value of the account. If required, a sufficient amount to provide a lifetime benefit that is above the poverty level is removed and annuitized. Whatever remains can be passed on. And let’s not forget the 3% clawback (jeez, I hate that term).

Think about this from the perspective of a low income worker. Their traditional benefit is reduced in the clawback. Then, for some, a portion of the private account balance is taken out and annuitized. Assuming that they require both the traditional payments and annuity payments to survive, how much is left to pass on? I many cases nothing may be left to pass on. In a way the promise of passing on wealth to their heirs is a cruel joke for the low income worker.

The WSJ reported on March 24th that: “National Economic Council director Allan Hubbard said in an interview yesterday that the administration is "open-minded" about a lower percentage "offset" than 3%.” Seems that the administration is listening to the debate and they may want to sweeten the pot. Stay tuned. Perhaps there is a way to make private accounts acceptable to all.

6) I would agree that if we can reliably create and transfer wealth, we should do that. My concern and I believe this is Shiller’s concern also, is that this may not happen for some unknown number of future retirees and their heirs.

Finally, I need to correct one thing I wrote previously. Even though I am only 54, I guess I can still claim that I had a "senior moment" while writing my last post. Or, perhaps I have just been watching too many talking heads on TV rather than sticking to reading the facts:)

Obviously, private accounts will not automatically affect benefits paid to those choosing traditional social security. As long as the government borrows to make up the shortfall, money will not be transferred from the system. Borrowing is certainly likely in the short term. But what about the long term? There are two concerns. First, how long will this borrowing continue? After all, it will become very expensive before the private account owners begin to retire in sufficient numbers for the "clawback" to significantly reduce traditional benefits paid. Second, once such a fundamental change is made to the program, does that open the door to other changes? Call this the slippery slope concern. I don't see that there is any guarantee that private accounts won't eventually reduce the money available to pay benefits to traditional SS retirees.