May 4, 2005

According to a column written for the Wall Street Journal by Arthur Leavitt, former chairman of the Securities and Exchange Commission, reducing guaranteed benefits in social security to fund individual retirement accounts is too risky for most individuals. 

Mr. Leavitt cited simulations run by Robert Schiller, a Yale economist, that showed individuals would have been worse off more than 70 percent of the time if they had used private accounts instead of the guaranteed social security benefits that otherwise would have been provided. 

To be sure, a vicious bear market undermined returns on equity in recent years.  But why could that not happen again?  Should individuals accept the added risk to have an opportunity to improve the growth of their retirement nest eggs and to pass that nest egg on to heirs?

Of course, the Schilling simulations not only used some difficult stock market performance (as well as some very good performing years) but they assumed that the private accounts would be funded from the reduced benefits and accumulated interest that otherwise would be purchased by 4 percent contributions by employees.  While I believe the assumed funding for the private accounts used by Schilling is consistent with statements made by the President, no precise financing for the private accounts has been offered by the Bush administration. 

All of which leads to two issues.  Are the additional returns from private accounts over guaranteed social security benefits sufficient to justify additional individual risks?  Furthermore, what do the private accounts do to assure that social security can pay the benefits already promised?

Almost any simulations of historical equity performance cannot provide enough returns for private accounts to allow benefit reductions to those individuals sufficient to meet the unfunded liability of social security and still provide gains for the individual account holders.  In other words, private accounts cannot solve the social security problem under any simulated investment performances on historical data. 

So why are we talking about private accounts as a solution to the social security problem?  Perhaps this is the real reason why the President is having so much trouble convincing the public that private accounts are good for the social security system. 

While I am not surprised that private accounts appear to be more a smoke screen than a solution to social security problems, I am amazed that private accounts cannot outperform the current social security system in more than 70 percent of the cases. 

Almost any professional financial advisor probably would assume that social security could get higher investment returns over time by using a richer choice of investment instruments than the mix of government bonds that currently are credited to the social security surplus.  Then why do so many individual accounts with the opportunity to use more efficient investments than currently employed actually perform worse under simulation than current reality?

My guess is that Schilling is assuming that a portion of the current promised benefits are the alternative to the private accounts.  But we do not have enough funds to meet those promises. This is why we have a social security problem.  If the simulations were adjusted to compare with a likely discount to promised benefits to reflect underfunded programs, I would expect the private accounts would outperform current benefits adjusted for funding shortfalls. 

(I must admit that I am surprised that a former head of the SEC does not have the financial acumen to question the validity of the Schilling simulations.)

However, Leavitt still raises a legitimate point.  Risk is undesirable.  Private accounts are risky.  Many individuals will not do as well with the private accounts as with the guaranteed benefits.  Are the expected returns on private accounts sufficiently high to justify the additional risk?

That is where the analysis really gets interesting.  Who can handle higher risk?  The wealthy.  Therefore, those who already have a nest egg can benefit from the choice offered by individual accounts.  Those who must survive on social security cannot tolerate the risk. 

I would maintain that this argues for better investment of social security surplus without establishing individual accounts.  However, even the best investment of that surplus will not fund all the promised benefits.  Either benefits must be cut (by lowering the payout or delaying the retirement age) or funding must be increased.  When will the President show leadership in outlining a program that really will restore the soundness of social security?


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