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Christian E. WellerGambling with Retirement: Market Risk Implications for Social Security Privatization

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334

Review of Radical Political Economics, Volume 38, No. 3, Summer 2006, 334-344DOI: 10.1177/0486613406290898

2006 Union for Radical Political Economics

Gambling with Retirement:

Market Risk Implications for Social

Security Privatization

CHRISTIAN E.WELLER

Senior Economist, Center for American Progress, 1333 H Street NW, 10th Floor,Washington, D.C. 20005; e-mail: [email protected]

Abstract

Under Social Security privatization, workers would be allowed to divert some of the money that cur-

rently goes to Social Security into private accounts. This would expose them to market risk, that is, the

risk of a substantial drop in equity prices or of a prolonged bear market. This could result in generations

of workers with less money than they thought they would have for retirement. A privatized system could

require the government to intervene, for example, by expanding social programs. The primary alterna-

tive to a government bailout of the Social Security system, older workers working longer, would create

enormous labor market pressures. Other alternatives, such as working longer or diversification, also

encounter obstacles. Many middle-class families affected by market risk already save too little for retire-

ment, and optimal diversification may prove too costly for many low- and moderate-income households.

JEL classification: E62; G12; H55; J26

Keywords: Social Security; private accounts; stock market risk; public programs

1. Introduction

Under Social Security privatization, workers would be allowed to divert a large shareof the money that currently goes to Social Security into private accounts. Hence, workers

may face the chance of prolonged bear markets, so-called market risk. A workers birthdate could determine the size of his or her retirement account. The difference from worker

to worker could vary widely. This could result in generations of workers with less moneythan they thought they would have for retirement and considerably less than they would

have under the current Social Security system.Market risk is severe. Depending on a workers birth date, if the privatization

approach proposed by President George W. Bushs Commission to Strengthen SocialSecurity (CSSS) had been enacted at the start of the Social Security program, retirementbenefits after thirty-five years would have ranged from less than 20 percent to almost 40

percent of preretirement earnings. In this scenario, a privatized Social Security system

could have cost the government more than $1 trillion in 2004 dollars between 1974 and


3/12

Weller / Gambling with Retirement 335

2004 if the government decided to help out those who accumulated less than expected forretirement.

2. Market Risks and Retirement Savings

With private accounts, workers face risks that are not part of Social Security. An

important risk here is that financial markets stay below their historical averages for longperiods of time, so-called market risk. This risk is real. Although the real rate of return of

the stock market has averaged 6.6 percent during the past 100 years, its average rate ofreturn across thirty-five-year periods has fluctuated between 3 percent and 10 percent(Weller 2005).

Privatization proposals call for part of the payroll tax to go into private accounts. Therest would continue to support Social Security benefits, albeit at lower levels. Many analyses

consider option II of President Bushs CSSS as a sample plan most likely to mirror thepresidents proposal (CSSS 2001; Diamond and Orszag 2002). Under this plan, workers

could invest 4 percent of payroll in private accounts up to $1,000 per year and 2 percentthereafter. The contribution is voluntary, but it is subsidized,1 making it likely that everybody

would invest (Diamond and Orszag 2002). For illustrative purposes, these contributionsare invested in a balanced portfolio, half stocks and half corporate bonds. This also reflectsthe limits a privatized Social Security system would place on investment choices (CSSS

2001; Diamond and Orszag 2002). Additional contributions are credited to the account atthe end of each year. Each year, workers are charged an administrative cost of 0.7 percent

of assets.2 When workers retire, their savings are converted into inflation-adjusted lifetimeannuities, based on the real bond rate at the time of retirement. At that time, workers are

charged 5 percent of their account for converting their savings into annuities. Also, bene-fits for new retirees would grow only at the rate of inflation and no longer at the rate of

wage increases. Thus, the living standard that Social Security benefits would afford work-ers would be frozen at the level of the year the privatization begins. Furthermore, SocialSecurity benefits are reduced by the amount contributed to the private account and

assessed with a real interest rate of 2 percent per year. Thus, workers would receive a loanfrom Social Security for the money they contribute to their private accounts, which they

would have to repay on retiring (Diamond and Orszag 2002). Finally, option II includes aminimum benefit of 120 of poverty (inflation indexed) to a thirty-year minimum wage

worker (Favreault et al. 2004).

1. This subsidy is rather complex. As employees contribute to a private account, a shadow liability

account is established. This liability account is credited with the same amount that is contributed to the pri-

vate account. Each year, the liability account increases by an interest rate that is 2 percent higher than infla-

tion. On retirement, the savings in the private account are offset by the liability account balance. In essence,

employees receive a loan from Social Security to invest in their private account, and this loan is due with inter-

est when they retire. The interest rate on this loan is 2 percent higher than the inflation rate. As long as earn-

ings in the private account are higher than 2 percent plus inflation, employees will actually have some

additional savings. Because the interest rate on the loan is lower than the average long-term rate for bonds,

employees could expect to generate even some additional savings without investing in stock.

2. Experience in U.S. financial markets and with other countries privatization efforts suggests that admin-

istrative costs will be substantially higher than the low cost estimate of 0.3 percent (Favreault et al. 2004).


4/12

336 Review of Radical Political Economics/ Summer 2006

If this plan had been in place since 1940, when Social Security began paying benefits,

and if we start with a replacement rate of 42.5 percentequal to Social Securitys replace-ment rate of average earnings in 2004 (Trustees of the Social Security Administration

2004)the ultimate replacement rates would have ranged from 18 percent in 1978 to 39percent in 1999 (figure 1).

Interestingly, the experience of the past few years was significantly better than what

should typically be expected based on historic trends. To calculate the distribution ofreplacement rates that retirees could expect, 1,000 hypothetical scenarios are created.

In each case, earnings, interest rates, and stock market rates of return are created ran-domly for thirty-five years;3 average life expectancy at age sixty-five is held constant at

16.4 years; and inflation of 4 percent is assumed. Under these assumptions, the possi-bility of having a replacement rate of less than 20 percent has a 9 percent chance, and

the possibility of having a replacement rate of less than 30 percent is slightly greaterthan 50 percent (figure 2). The probability of having a replacement rate of more than40 percent of preretirement income is only 8 percent. Thus, the past few years repre-

sented extraordinary circumstances.

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1974 1979 1984 1989 1994 1999

Year

Percent

real replacement rates

Figure 1.

Real Replacement Rates after Thirty-five Years, CSSS Option II

Source: Authors calculations based on Bureau of Labor Statistics (2004a), Favreault et al. (2004), andShiller (2000).

3. The average nominal earnings growth is 5.4 percent with a standard deviation of 3.9 percent, the aver-

age stock market rate of return is 10.8 percent with a standard deviation of 16.8 percent, and the average inter-

est rate is 6.2 percent with a standard deviation of 3.0 percent. Rates cannot deviate more than one standard

deviation from the average. In each instance, five-year averages are used.


5/12


3. Market Risks and Potential Fiscal Burden

Less than expected retirement income is a result of underperforming markets affectingentire generations. This problem could become too large to ignore. Future governments mayhave to cover the shortfalls, for example by instituting new social programs to support the

elderly. To calculate the costs of a bailout, a minimum level of retirement income needs to beestablished. A reasonable threshold for the privatized Social Security system would be the

replacement rate for average workers that the current Social Security system pays to workersretiring at age sixty-five. Hence, the threshold would be 42.5 percent of an average workers

last earnings before retirement. Based on the distributional assumptions discussed below, athreshold for each quintile in each year is calculated. Under CSSS option II, benefits would

be a reduced Social Security benefit plus private account savings. The replacement rates fromSocial Security vary with income. To model the distribution of income on retirement, it isassumed that the income distribution in the year of retirement reflects the distribution of Social

Security benefits of new retirees, which in turn is assumed to mirror the wage distribution ofthe population as a whole.4 Using the current Social Security formula, an unadjusted replace-

ment rate from Social Security benefits for each quintile is calculated. This replacement rateis adjusted for the benefit cut resulting from the change from wage to price indexation by dis-

counting it each year by the difference between wage and price growth. For each quintile ofthe earnings distribution, the Social Security benefit is compared to the minimum benefit

8.6%

50.9%

7.9%

0.3%0%

10%

20%

30%

40%

50%

60%

probability of 50%

real replacement rates

Figure 2.

Probabilities of Specific Replacement Rates, CSSS, Option II, 2038

4. Average earnings are calculated for each quintile. Annual earnings are calculated as fifty times average

weekly earnings using the Current Population Survey for the years from 1979 to 2003 (Center for Economicand Policy Research 2004). For earlier years, it is assumed that average earnings grew at the rate of average

incomes (U.S. Census Bureau 2004).


6/12


under CSSS option II, and retirees are given the larger of the two. The benefits from privateaccounts, which are offset by the liability account, are added to the Social Security benefit.

The costs of bailouts are calculated as follows. They are the difference between thethreshold and the actual replacement rate times the average income times the number of

people retiring in each quintile.5 The bailout pays new retirees this additional benefit fortheir entire retirement on an inflation-adjusted basis, just like Social Security would.

Hence, the net present value of inflation-adjusted future benefits financed by the bailout iscalculated for each cohort. From 1974 to 2003, the government would have had to bail out

private accounts every single year (figure 3). For a number of years, the bailouts wouldhave exceeded $50 billion (in 2004 dollars) annually. At their lowest point, the bailoutswould still have cost $5.1 billion in 2004 dollars. The sum of all bailouts during the past

thirty years would have totaled $1.1 trillion in 2004 dollars.It seems reasonable to assume that bailouts would occur for several years in a row. For

one, it would be hard for the government to bail out one generation of retirees but notanother. Moreover, even if the government would notice that one generation of retirees is

likely to have less retirement income than they expected, there is little else that can be doneto boost the replacement rate because the government has no direct influence over the

stock market. Third, requiring higher tax rates would leave less money for other forms ofsaving and may not necessarily increase overall retirement wealth.

The results depend on the choice of the threshold replacement rate. There are two pos-

sible objections to using thresholds for each quintile that are tied to an average replace-

ment rate of 42.5 percent. First, one could argue that the government may want to bail out

0

10

20

30

40

50

60

70

1974 1979 1984 1989 1994 1999

Year

Billions$

Figure 3.

Cost of Government Bailouts, CSSS Option II, Constant 2004 Dollars

Note: All figures in billions of 2004 dollars. CPI is used as deflator.

5. The number of people retiring is one-tenth of the number of employees in the age group fifty-five to

sixty-four.


7/12


only lifetime low-income earners. This would, however, create a heavy bureaucratic bur-den. It would also be politically difficult to decide where the income cutoff for bailout ben-eficiaries should be. After all, everybody paid into the system; that is, Social Security is an

earned benefit and not a welfare program.

Second, the initial replacement rate should not be the threshold for the system becausebenefits are being reduced annually. This, however, contradicts the rhetoric of those whofavor privatization. Workers are promised that they could at least make up for the reduc-

tion in Social Security benefits with the savings in private accounts. Consequently, work-ers should expect that their replacement rate will on average at least remain constant.

Furthermore, even if no specific threshold is replaced, the starting replacement rate islikely a good target because it is the benefit level that the first generation under the systemwas actually given. Demands by subsequent generations to see at least the same level of

benefits, relative to their preretirement earnings, could likely only be muted if futureretirees would build up additional savings elsewhere. This is not, however, part of the

Social Security privatization debate. In addition, economic evidence indicates that work-ers will not compensate for the loss of guaranteed Social Security benefits with additional

savings (Bernheim and Levin 1989; Wolff 1988). Last, the mere possibility of futurebailouts reduces peoples incentives to save. Future governments cannot be committed todo nothing if retirees have saved too little. Thus, workers know that if the shortfalls

become large enough in the aggregate, future governments will intervene. As a result, theirincentive to save more outside of Social Security is reduced.

4. Market Risk and Labor Market

Workers may want to work longer if they received less retirement income than theyexpected.6 Working longer is feasible only if employers are hiring older workers at pre-

vailing wages. Historically, it has been the case that would-be retirees would have endedup with less than they expected when unemployment rates were already high. The statisti-cal results show that labor market pressures should be expected to increase exactly when

the labor market is already weak. Consequently, workers who accumulated less thanexpected savings in their retirement accounts would have to either swell the ranks of the

unemployed or put downward pressure on wages. In this regard, the results suggest thatlower earnings precede higher unemployment rates (table 1). That is, when workers stay

in the labor force due to below average rates of return, the unemployment rate is morelikely to be high than low, and wages are likely to hold steady, after their growth has

already slowed due to labor market weaknesses.For purely illustrative purposes, assume that the labor supply increases but that wage

rigidities maintain current wages. The unemployment rate would have risen in every year

between 1974 to 2003 (figure 4).7 In extreme cases, the unemployment rate could have

6. The other adjustment is diversification. The examples discussed earlier are, however, already based on

diversified portfolios, showing that even with diversification, risks remain.

7. All would-be retirees stay in the labor force until the combination of aging, additional savings, and more

earnings on assets generates a replacement rate greater than the threshold. It is assumed that the basic Social

Security replacement rate is not reduced after age sixty-five; that is, delayed retirement credits offset the cuts

to initial benefits resulting from price instead of wage indexation.


8/12


Table 1

Granger Causality Tests for Stock Market Returns, Unemployment, and Earnings

Total Real Year-to-Year

Rate of Average Real

Return Hourly(35-Year Unemployment Earnings

Average) Rate Growth

Unit root test 2.88** 3.34** 3.36**

(January 1948 to (0.04) (0.01) (0.01)

December 2004)

Unit root test 2.62* 2.67* 3.36**

(January 1974 to (0.08) (0.09) (0.01)

December 2004)

Determining variable Test statistics for Granger causality tests (1948 to 2004)

Total real rate of return(35-year average)

3 lags 4.47*** 0.68

4 lags 3.90*** 0.73

6 lags 3.37*** 0.81

Unemployment rate

3 lags 0.57 1.91

4 lags 0.45 1.68

6 lags 1.42 1.53

Year-to-year average real

hourly earnings growth

3 lags 2.08 3.83** 4 lags 1.73 2.83**

6 lags 1.31 2.11**

Determining variable Test statistics for Granger causality tests (1974 to 2004)

Total real rate of return

(35-year average)

3 lags 3.99*** 0.52

4 lags 2.76** 0.33

6 lags 2.08** 0.45

Unemployment rate

3 lags 3.94*** 2.13*

4 lags 3.68*** 1.41

6 lags 2.49** 0.84

Year-to-year average real


3 lags 2.89** 6.27***

4 lags 2.15** 3.89***

6 lags 1.50 2.30**

Determining variable Sum of coefficients for 4 lags (1948 to 2004)

Total real rate of return 0.79*** 0.02

(35-year average)

Unemployment rate 0.00 0.03*Year-to-year average real 0.03 0.07**


(continued)


9/12


risen close to 13 percent. Even if only half of workers had decided to stay in the laborforce, the unemployment rate would still have risen to more than 11 percent in this rather

simple example. Despite its simplifications, this hypothetical scenario demonstrates twoimportant points. First, financial market outcomes can create large labor market pressures,

Table 1

(continued)

Total Real Year-to-Year

Rate of Average Real

Return Hourly(35-Year Unemployment Earnings

Average) Rate Growth

Sum of coefficients for 4 lags (1974 to 2004)

Total real rate of return 0.03** 0.00

(35-year average)

Unemployment rate 0.02*** 0.00

Year-to-year average real 0.01 0.18***


Note: Unit root test statistics are augmented Dickey-Fuller statistics, and values in parentheses areMacKinnon one-sidedp values.* Significant at 10% level.

** Significant at 5% level.

*** Significant at 1% level.

0%

2%

4%

6%

8%

10%

12%

14%

1974 1979 1984 1989 1994 1999

Year

Percent

actual adjusted for savings fluctuations

Figure 4.

Actual and Adjusted Unemployment Rates, CSSS Option II

Note: Adjusted unemployment rate adds the number of additional workers to the number of unemployedand the labor force.

Source: Bureau of Labor Statistics (2004b) and authors calculations.


10/12

and, second, these pressures are likely to be much larger when unemployment is high thanwhen it is low.

5. Additional Savings and Diversification as Potential Alternatives

Workers could also save more outside of Social Security. Workers would have to

increase their savings in reaction to less than expected wealth accumulation. The literatureon the so-called wealth effect does suggest that workers tend to change their consumption

and savings patterns in reaction to changes in their wealth. A good approximation appearsto be that for each dollar wealth increases, workers increase their consumption by threecents (Poterba 2000). The wealth effect, however, only describes changes in savings

behavior around a longer term trend of individual savings. Yet, the longer term trends sug-gest too few retirement savings for many households. For instance, Weller and Wolff

(2005) concluded that among households nearing retirement, between the ages of fifty-sixand sixty-four, 44.1 percent did not have enough retirement savings to replace at least 75

percent of their preretirement income in 2001. The shortfalls in retirement savings areespecially pronounced among those who are disproportionately likely to rely on SocialSecurity as a source of retirement income. In particular, minorities and single women are

likely to see larger shortfalls in retirement savings.Another possibility to reduce the chance of government bailouts could be the reduc-

tion of financial market risks through diversification. The financial economics literaturehas, however, long recognized that workers can reduce market risks only in an incomplete

manner due to high transaction costs and liquidity constraints. The relevant argumentfocuses on the fact that workers receive their labor income predominantly from one source.

Workers can experience unanticipated business cycle shocks to labor income. Importantly,labor income is a nontradable implicit asset. To achieve optimal allocation of householdportfolios, the fact that labor income is nontradable needs to be balanced with other

explicit assets, such as homes, stocks, and bonds (Campbell et al. 1999; Storesletten,Telmer, and Yaron 1998; Viceira 1999; Bodie, Merton, and Samuelson 1991).

Researchers have still found, however, that asset holdings tend to be lower thanexpected (Haliassos and Michaelides 2000; Gomes and Michaelides 2003). This is typi-

cally taken as a sign that workers face two obstacles to optimal diversification. For one,households may not be able to borrow money at the riskless interest rate to purchase the

optimal mix of assets (Constantinides, Donaldson, and Mehra 1998; Bertaut and Haliassos1997), and, second, there may be prohibitively high costs (Vissing-Jorgensen 2002; Yaronand Zhang 2000; Abel 1998). The latter may be especially important for low-income

households, which often do not hold any equities in their portfolios (Vissing-Jorgensen2002; Abel 2000; Haliassos and Michaelides 2000; Campbell et al. 1999). A corollary of

this argument implies that greater volatility in labor income requires more frequent port-folio adjustments, raising costs and reducing stock holdings (Vissing-Jorgensen 2002).

Without efficient diversification, short-term income fluctuations will mean that households

will be less likely to accumulate savings when it is financially most opportune, that is,when asset prices are comparatively low. Because households are typically unable toachieve optimal portfolio allocation to reduce financial and labor market risks at the sametime, the chances of government bailouts will remain.



11/12

6. Conclusion

Under Social Security privatization, workers face the risk that financial markets can

underperform during their working careers. This could happen for entire cohorts of retirees.

Large market fluctuations are unavoidable for individual accounts. These fluctuations cancreate substantial shortfalls in savings for entire generations of retirees. One way to address

this shortfall would be for workers to work longer, which would create enormous labormarket pressures, with much higher unemployment rates or lower wage growth as the

result. To avoid such large labor market pressures, the federal government would likely haveto bail out individual accounts instead. Thus, the government would likely have to imple-

ment financial support programs to avoid spikes in old-age poverty. These bailouts couldcome in a number of forms, such as expanded social programs or direct transfers to account

holders. Thus, privatization would essentially amount to a system of insured gambling, inwhich the government pays the bill if the market underperforms.

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Christian E. Weller is a senior economist at the Center for American Progress in Washington, DC. His workspecializes on retirement income security, macroeconomics, labor markets, and international finance. Priorto coming to American Progress, he worked as research economist for the Economic Policy Institute inWashington, DC, where he remains a research associate.


Documents

Review of Radical Political Economics 2006 Weller 334 44