Friday, January 07, 2005

Who would benefit from private Social Security Accounts?

Social Security provides a low risk, lifelong, inflation adjusted old age insurance benefit as well as disability and survivor benefits. The structure of Social Security old age benefits is an inflation-adjusted annuity.

Private fixed annuities are available now - these annuities provide a fixed lifelong payment, but not a payment that keeps up with inflation. And, these fixed annuities typically have a fairly high cost for a given level of benefit. This issue was studied by CBO when evaluating personal investment accounts as a component of Social Security. Table 1 of that report shows the discount from expected value available with current annuities. The report poses the problem:

If markets for private annuities are imperfect, however, those annuities may be costly or unavailable, and long-run gains from prefunding a privatized social security system may be smaller than suggested in some recent papers.

The conclusion is that private, self selected annuities have a lot of overhead. If annuities are an important component of retirement security, then the cost of converting personal Social Security accounts into annuities, as well as the market timing risks and the inflation risk, have to be compensated for to achieve equal value to traditional Social Security benefits. The overhead for converting to an annuity might be 10 to 20%, and the risks of inflation and of market timing significantly increase the assets required to assure lifelong livings standards.

Who might find the benefit of personal accounts exceeds these risks and costs

As it is currently structured, Social Security provides a secure complement to private retirement savings for those who have sufficient assets. The security of a lifelong, inflation adjusted annuity with survivor benefits allows those with adequate assets to take measured risks with retirement savings, as well as allowing them to plan to leave assets to heirs. Asset allocation models used for defined contribution savings plans like 401Ks build in the presumption of complementary Social Security benefits. Presumably, rational individuals using professional guidance would have to adjust their voluntary personal investment portfolios to achieve the same risk-adjusted profile they've had with a Social Security annuity. If they shift privatized Social Security assets into equities, they'd have to make an equal shift OUT of equity in their voluntary savings, to keep the same balance of risk.

If they trade off SS annuity benefits at a rate equal to the treasury bond yield plus 7/10ths of a percent, and they intend to replace the complementary security of a lifelong annuity, exactly how much more savings would they need to assure their minimum goals would be met?

You certainly wouldn't want to hold treasury bonds in your private Social Security account, since you'd be losing 7/10ths of annual yield at the start, in addition to the loss of the annuity benefit. You'd also lose the 10 to 20% cost for converting the account to annuity upon retirement.

But if you hold more equity in your privatized account, you'd want to adjust your risk in the voluntary savings. You'd need to shift out of equity into bonds there. Whoops! You just lost 7/10ths of a percent of annual yield. And you still have to compensate for the cost of converting to an annuity, plus add additional assets to compensate for the possibility you will outlive the fixed benefit annuity.

So, for those who already have adequate voluntary savings, the value of converting your traditional Social Security benefit into a private account seems questionable. As long as the government can keep its promise to pay, it's quite likely you'd want to stick with traditional benefits.

What about for those who don't have adequate personal savings, or for those who outlive their personal savings?

For those who lack or who have outlived their retirement savings, Social Security provides a safety net, assuring sufficient lifelong income so that most elders are able to maintain living standards above the poverty level.

The evaluation is different here, because there are few assets outside of Social Security to consider. There may be a benefit allowing these individuals to capture the equity premium, but for each dollar shifted out of a guaranteed anuity, there is a much bigger risk. Would we, collectively, require this group to purchase an annuity? Would the annuity have to be inflation adjusted and insured? Would compensating for these risks and costs require a larger program than a basic, simple defined benefit Social Security program?

Might we do better to try to capture the equity premium within the Social Security trust itself, and keep the benefit side of Social Security simple and minimal?


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