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Would a Privatized Social Security System Really Pay a Higher Rate of Return

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  • John Genakoplos
  • Olivia S. Mitchell
  • Stephen P. Zeldes

Abstract

Many advocates of social security privatization argue that rates of return under a defined contribution individual account system would be much higher for all than they are under the current social security system. This claim is false. The mistake comes from ignoring accrued benefits already promised based on past payroll taxes, and from underestimating the riskiness of stock investments. Confusion arises because three distinct reforms are muddled. By privatization we mean creating individual accounts (which could, for example, be invested exclusively in bonds). By diversification we mean investing in stocks, and perhaps other assets, as well as bonds; diversification might be undertaken either by individuals in their private social security accounts, or by the social security trust fund. By prefunding we mean closing the gap between social security benefits promised to date and the assets on hand to pay for them. Any one of these reforms could be implemented without the other two. If the system were completely privatized, with no prefunding or diversification, the social security system would need to raise taxes and/or issue new debt in order to pay benefits already accrued. If the burden were spread evenly across all future generations via a constant proportional tax, the added taxes would completely eliminate any rate of return advantage on the individual accounts. We estimate that the required new taxes would amount to about 3 percent of payroll, or about a quarter of all social security contributions, in perpetuity. Unlike privatization, prefunding would raise rates of return for later generations, but at the cost of lower returns for today's workers. For households able to invest in the stock market on their own, diversification would not raise rates of return, correctly adjusted to recognize risk. Households that are constrained from holding stock, due to lack of wealth outside of social security or to fixed costs from holding stocks, would gain higher risk-adjusted returns and would benefit from diversification. If this group is large, diversification would raise stock values, thus helping current stockholders, but it would lower future stock returns, thus hurting young unconstrained households. Overall, since the number of truly constrained households is probably not that large, privatization and diversification would have a much smaller effect on returns than reformers typically claim.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6713.

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Date of creation: May 2000
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Publication status: published as Framing the Social Security Debate: Values, Politics, and Economics, Arnold, R. Douglas,Michael J. Graetz,and Alicia H. Munnell, eds., Brookings Institution Press, 1998, pp. 137-156.
Handle: RePEc:nbr:nberwo:6713

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  1. John Geanakoplos & Olivia S. Mitchell & Stephen P. Zeldes, 1998. "Social Security Money's Worth," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1193, Cowles Foundation for Research in Economics, Yale University.
  2. Olivia S. Mitchell & Flavio Ataliba Barreto, . "After Chile, What? Second-Round Social Security Reforms in Latin America," Pension Research Council Working Papers, Wharton School Pension Research Council, University of Pennsylvania 97-4, Wharton School Pension Research Council, University of Pennsylvania.
  3. Mitchell, Olivia S & Zeldes, Stephen P, 1996. "Social Security Privatization: A Structure for Analysis," American Economic Review, American Economic Association, American Economic Association, vol. 86(2), pages 363-67, May.
  4. Olivia S. Mitchell, 1998. "Social security reform in Latin America," Review, Federal Reserve Bank of St. Louis, Federal Reserve Bank of St. Louis, issue Mar, pages 15-18.
  5. Arthur B. Kennickell & Martha Starr-McCluer & Annika E. Sunden, 1997. "Family finances in the U.S.: recent evidence from the Survey of Consumer Finances," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), Board of Governors of the Federal Reserve System (U.S.), issue Jan, pages 1-24.
  6. Martin Feldstein & Jeffrey B. Liebman, 2001. "Social Security," NBER Working Papers 8451, National Bureau of Economic Research, Inc.
  7. Alan J. Auerbach & Jagadeesh Gokhale & Laurence J. Kotlikoff, 1994. "Generational Accounting: A Meaningful Way to Evaluate Fiscal Policy," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 8(1), pages 73-94, Winter.
  8. Martin Feldstein, 1997. "Transition to a Fully Funded Pension System: Five Economic Issues," NBER Working Papers 6149, National Bureau of Economic Research, Inc.
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Cited by:
  1. Elder, Erick & Holland, Larry, 2000. "Social Security reform: the effect of investing in equities," Financial Services Review, Elsevier, Elsevier, vol. 9(1), pages 93-106, 00.
  2. Kubicek, Jan, 2005. "Contribution rates to funded pension systems in the new member countries," Research in International Business and Finance, Elsevier, Elsevier, vol. 19(2), pages 266-280, June.
  3. Attanasio Orazio P. & Gianluca Violante, 1999. "Global Demographic Trends and Social Security Reform," REVISTA DESARROLLO Y SOCIEDAD, UNIVERSIDAD DE LOS ANDES-CEDE.
  4. Arza, Camila, 2008. "The Limits of Pension Privatization: Lessons from Argentine Experience," World Development, Elsevier, Elsevier, vol. 36(12), pages 2696-2712, December.
  5. Binswanger, Johannes, 2007. "Risk management of pensions from the perspective of loss aversion," Journal of Public Economics, Elsevier, Elsevier, vol. 91(3-4), pages 641-667, April.
  6. Nikola Altiparmakov, 2013. "Is There An Alternative To The Pay-As-You-Go Pension System In Serbia?," Economic Annals, Faculty of Economics, University of Belgrade, vol. 58(198), pages 89-114, July - Se.
  7. Bossi, Luca, 2008. "Intergenerational risk shifting through social security and bailout politics," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 32(7), pages 2240-2268, July.

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