Over the long term, stocks have earned a higher rate of return than Treasury bonds. Therefore, many recent proposals to reform Social Security include a stock investment component. In evaluating these proposals, the Social Security Administration's Office of the Actuary (OACT) has generally used a 7.0 percent real return for stocks (based on a long-term historical average) throughout its 75-year projection period. For the return on Treasury bonds, it currently assumes some variation in the initial decade followed by a constant real return of 3.0 percent. Therefore, its current assumption for the equity premium, defined as the difference between yields on equities and Treasuries, is 4.0 percent in the long run. Some critics contend that the projected return on stocks æ and the resulting equity premium æ used by the OACT are too high. Of the three main bases for criticizing the assumptions used by the OACT, by far the most important one is the argument that a constant 7.0 percent stock return is not consistent with the value of today's stock market and projected slow economic growth. The other two arguments pertaining to financial market developments and the marginal product of capital æ have merit, but neither suggests a dramatic change in the equity premium. Given the high value of today's stock market and an expectation of slower economic growth in the future, the OACT could adjust its stock return projections in one of two ways. It could assume a decline in the stock market sometime over the next decade, followed by a 7.0 percent return for the remainder of the projection period. This would treat equity returns like Treasury rates, using different short- and long-run projection methods for the first 10 years and the following 65 years. Alternatively, the OACT could adopt a lower rate of return for the entire 75-year period. While this approach may be more acceptable politically, it obscures the expected pattern of returns and may produce misleading assessments of alternative financing proposals, since the appropriate uniform rate to use for projection purposes depends on the investment policy being evaluated.
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Paper provided by Center for Retirement Research in its series Issues in Brief with number
ib-2.
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