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Individual Risk and Intergenerational Risk Sharing in an Investment-Based Social Security Program

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  • Martin Feldstein
  • Elena Ranguelova

Abstract

This paper examines the risk aspects of a fully phased-in investment-based defined contribution Social Security plan. Individuals save a fraction of wages in a Personal Retirement Account (PRA) invested in a 60:40 equity-debt mix and receive a similarly invested variable annuity from age 67. The value of the portfolio follows a random walk with historic (1946-1995) mean log real return of 5.5 percent and standard deviation of 12.5 percent. We study 10,000 stochastic distributions of this process for the 80 year experience from 1998 to 2077. With a nonstochastic 5.5 percent rate of return, individuals could purchase the future benefits promised in the current Social Security law (the benchmark' level of benefits) by saving 3.1 percent of earnings, just one-sixth of the payroll tax that Social Security actuaries project will be needed in the paygo system. A higher saving rate provides a cushion' that reduces the risk of unacceptably low benefits. For example, saving 6 percent implies a median annuity at age 67 or 2.1 times the benchmark benefits and only a 17 percent chance that the annuity is less than the benchmark. In 95 percent of the potential investment experience the annuity exceeds 61 percent of the benchmark benefit. With a 9 percent saving rate (half of the tax rate required in a pay- as-you-go system), there is only a 6 percent chance that the annuity is less than the benchmark and in 95 percent of the potential investment experience the annuity exceeds 92 percent of the benchmark benefit. We also study a modified plan in which retirees face no risk of receiveing less than the benchmark benefit because the government provides a conditional pension transfer to any retiree whose annuity is less in any year than the benchmark level of benefits. With a six percent saving rate, a conditional transfer is required in only about 40 percent of the simulations. The expected value of the transfers is substantially less than the expected incremental corporate tax revenue that results from the Personal Retirement Account saving. Additional tax revenue is needed in fewer than one percent of the simulations. In short, a pure defined contribution plan, with a saving rate equal to one third of the long-run projected payroll tax, invested in a 60:40 equity-debt Personal Retirement Account could provide a retirement annuity that is likely to be substantially more than the benchmark benefit while exposing the retiree to relatively little risk that the annuity will be less than the benchmark. Even this risk can be completely eliminated by a conditional guarantee plan that imposed only a very small risk on future taxpayers.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6839.

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Date of creation: Dec 1998
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Publication status: published as Feldstein, Martin and Elena Ranguelova. "Individual Risk In An Investment-Based Social Security System," American Economic Review, 2001, v91(4,Sep), 1116-1125.
Handle: RePEc:nbr:nberwo:6839

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  1. Martin Feldstein & Andrew Samwick, 1997. "The Economics of Prefunding Social Security and Medicare Benefits," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 115-164 National Bureau of Economic Research, Inc.
  2. Kocherlakota, N., 1995. "The Equity Premium: It's Still a Puzzle," Working Papers, University of Iowa, Department of Economics 95-05, University of Iowa, Department of Economics.
  3. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  4. Laurence J. Kotlikoff, 1998. "Simulating the Privatization of Social Security in General Equilibrium," NBER Chapters, in: Privatizing Social Security, pages 265-311 National Bureau of Economic Research, Inc.
  5. Robert C. Merton, 1983. "On the Role of Social Security as a Means for Efficient Risk Sharing in an Economy Where Human Capital Is Not Tradable," NBER Chapters, in: Financial Aspects of the United States Pension System, pages 325-358 National Bureau of Economic Research, Inc.
  6. Steven Caldwell & Melissa Favreault & Alla Gantman & Jagadeesh Gokhale & Thomas Johnson & Laurence J. Kotlikoff, 1999. "Social Security's Treatment of Postwar Americans," NBER Chapters, in: Tax Policy and the Economy, volume 13, pages 109-148 National Bureau of Economic Research, Inc.
  7. Mark Huggett & Gustavo Ventura, 1998. "On the Distributional Effects of Social Security Reform," Working Papers, Centro de Investigacion Economica, ITAM 9801, Centro de Investigacion Economica, ITAM.
  8. Peter Diamond, 2004. "Social Security," American Economic Review, American Economic Association, American Economic Association, vol. 94(1), pages 1-24, March.
  9. Martin Feldstein & Andrew Samwick, 1996. "The Transition Path in Privatizing Social Security," NBER Working Papers 5761, National Bureau of Economic Research, Inc.
  10. Robert J. Shiller, 1998. "Social Security and Institutions for Intergenerational, Intragenerational, and International Risk Sharing," JCPR Working Papers, Northwestern University/University of Chicago Joint Center for Poverty Research 43, Northwestern University/University of Chicago Joint Center for Poverty Research.
  11. Laurence J. Kotlikoff & Kent A. Smetters & Jan Walliser, 1998. "Social Security: Privatization and Progressivity," NBER Working Papers 6428, National Bureau of Economic Research, Inc.
  12. Henning Bohn, 1997. "Social Security reform and financial markets," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, Federal Reserve Bank of Boston, vol. 41(Jun), pages 193-227.
  13. Feldstein, Martin, 1996. "The Missing Piece in Policy Analysis: Social Security Reform," American Economic Review, American Economic Association, American Economic Association, vol. 86(2), pages 1-14, May.
  14. Martin S. Feldstein & Elena Ranguelova, 2002. "The Economics of Bequests in Pensions and Social Security," NBER Chapters, in: The Distributional Aspects of Social Security and Social Security Reform, pages 371-400 National Bureau of Economic Research, Inc.
  15. Feldstein, Martin (ed.), 1998. "Privatizing Social Security," National Bureau of Economic Research Books, University of Chicago Press, edition 1, number 9780226241012, 01-2013.
  16. Martin Feldstein & Jeffrey B. Liebman, 2001. "Social Security," NBER Working Papers 8451, National Bureau of Economic Research, Inc.
  17. Martin Feldstein, 1997. "Transition to a Fully Funded Pension System: Five Economic Issues," NBER Working Papers 6149, National Bureau of Economic Research, Inc.
  18. Murphy, Kevin M & Welch, Finis, 1998. "Perspectives on the Social Security Crisis and Proposed Solutions," American Economic Review, American Economic Association, American Economic Association, vol. 88(2), pages 142-50, May.
  19. Peter Diamond, 1998. "The Economics of Social Security Reform," NBER Working Papers 6719, National Bureau of Economic Research, Inc.
  20. Martin Feldstein, 1998. "Privatizing Social Security," NBER Books, National Bureau of Economic Research, Inc, number feld98-1, July.
  21. Paul A. Samuelson, 1958. "An Exact Consumption-Loan Model of Interest with or without the Social Contrivance of Money," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 66, pages 467.
  22. Michael J. Boskin & Laurence J. Kotlikoff & Douglas J. Puffert & John B. Shoven, 1987. "Social Security: A Financial Appraisal Across and Within Generations," NBER Working Papers 1891, National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Martin Feldstein, 2002. "Introduction: An American Perspective," NBER Chapters, in: Social Security Pension Reform in Europe, pages 1-8 National Bureau of Economic Research, Inc.
  2. Martin S. Feldstein & Jeffrey B. Liebman, 2002. "The Distributional Effects of an Investment-Based Social Security System," NBER Chapters, in: The Distributional Aspects of Social Security and Social Security Reform, pages 263-326 National Bureau of Economic Research, Inc.
  3. Javed I. Ahmed & Brad M. Barber & Terrance Odean, 2013. "Made poorer by choice: worker outcomes in Social Security v. private retirement accounts," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2013-23, Board of Governors of the Federal Reserve System (U.S.).
  4. Martin Feldstein & Elena Ranguelova & Andrew Samwick, 1999. "The Transition to Investment-Based Social Security when Portfolio Returns and Capital Profitability are Uncertain," NBER Working Papers 7016, National Bureau of Economic Research, Inc.

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