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Social Security Money's Worth

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

This paper describes how three money’s worth measures – the benefit-to-tax ratio, the internal rate of return, and the net present value – are calculated and used in analyses of social security reforms, including systems with privately managed individual accounts invested in equities. Declining returns from the U.S. social security system prove to be the inevitable result of having instituted an unfunded (pay-as-you-go) retirement system that delivered $7.9 trillion of net transfers (in 1997 present value dollars) to people born before 1917, and will deliver another $1.8 trillion to people born between 1918 and 1937. But young and future workers cannot necessarily do better by investing their payroll taxes in capital markets. If the old system were closed down, massive unfunded liabilities of $9-10 trillion would still have to be paid unless already accrued benefits were cut. Alternative methods of calculating these accrued benefits yield somewhat different numbers: the straight line calculation is $800 billion less than the constant benefit calculation we propose as the benchmark. Using this benchmark in a world with no uncertainty, we show that privatization without prefunding would not increase returns at all, net of the new taxes needed to pay for unfunded liabilities. These new taxes would amount to 3.6 percent of payroll, or about 29 percent of social security contributions. Prefunding, implemented by reducing accrued benefits or by raising taxes, would eventually increase money’s worth for later generations, but at the cost of lower money’s worth for today’s workers and/or retirees. Computing money’s worth when there is uncertainty is much more difficult unless four conditions hold, namely optimization, time homogeneity, stable prices, and spanning. Under these conditions, the diversification of social security investments into stocks and out of bonds has no effect whatsoever on money’s worth when it is properly adjusted for risk: a dollar of stock is worth no more than a dollar of bonds. When spanning fails, diversification can raise welfare for constrained households, but the exact money’s worth must depend on specific assumptions about household attitudes toward risk. Calculations like those of the Social Security Advisory Council that attribute over $2.85 of net present value gain to each $1 shifted from bonds to stocks completely overlook the disutility of risk. By contrast, we estimate that a 2 percent of payroll equity fund carved out of social security would increase net present value by about 59 cents per dollar of bonds switched into equities, instead of $2.85. When the likely reductions in income and longevity insurance are factored in, the net advantage of privatization and diversification is substantially less than popularly perceived.

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Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 98-27.

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Date of creation: Aug 1998
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Handle: RePEc:wop:pennin:98-27
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  1. Robert A. Moffitt, 1984. "Trends in Social Security Wealth by Cohort," NBER Chapters, in: Economic Transfers in the United States, pages 327-358 National Bureau of Economic Research, Inc.
  2. Martin Feldstein, 1997. "Transition to a Fully Funded Pension System: Five Economic Issues," NBER Working Papers 6149, National Bureau of Economic Research, Inc.
  3. Olivia S. Mitchell & Stephen P. Zeldes, 1996. "Social Security Privatization: A Structure for Analysis," NBER Working Papers 5512, National Bureau of Economic Research, Inc.
  4. 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.), issue Jan, pages 1-24.
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  6. James E. Duggan & Robert Gillingham & John S. Greenlees, 1993. "Returns Paid To Early Social Security Cohorts," Contemporary Economic Policy, Western Economic Association International, vol. 11(4), pages 1-13, October.
  7. Olivia S. Mitchell & James M. Poterba & Mark J. Warshawsky, . "New Evidence on the Money's Worth of Individual Annuities," Pension Research Council Working Papers 97-9, Wharton School Pension Research Council, University of Pennsylvania.
  8. Martin Feldstein & Andrew Samwick, 1997. "The Economics of Prefunding Social Security and Medicare Benefits," NBER Working Papers 6055, National Bureau of Economic Research, Inc.
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  15. Olivia S. Mitchell & Flavio Ataliba Barreto, . "After Chile, What? Second-Round Social Security Reforms in Latin America," Pension Research Council Working Papers 97-4, Wharton School Pension Research Council, University of Pennsylvania.
  16. Michael J. Boskin & Laurence J. Kotlikoff & Douglas J. Puffert & John B. Shoven, 1986. "Social Security: A Financial Appraisal Across and Within Generations," NBER Working Papers 1891, National Bureau of Economic Research, Inc.
  17. Andrew Abel & Gregory N. Mankiw & Lawrence H. Summers & Richard Zeckhauser, . "Assessing Dynamic Efficiency: Theory and Evidence," Rodney L. White Center for Financial Research Working Papers 14-88, Wharton School Rodney L. White Center for Financial Research.
  18. Steven Caldwell & Melissa Favreault & Alla Gantman & Jagadeesh Gokhale & Thomas Johnson, 1998. "Social Security's Treatment of Postwar Americans," NBER Working Papers 6603, National Bureau of Economic Research, Inc.
  19. Kotlikoff, Laurence J, 1989. "On the Contribution of Economics to the Evaluation and Formation of Social Insurance Policy," American Economic Review, American Economic Association, vol. 79(2), pages 184-90, May.
  20. Olivia S. Mitchell & Gary S. Fields, 1983. "The Economics of Retirement Behavior," NBER Working Papers 1128, National Bureau of Economic Research, Inc.
  21. Olivia S. Mitchell, 1998. "Social security reform in Latin America," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 15-18.
  22. Thompson, Lawrence H, 1983. "The Social Security Reform Debate," Journal of Economic Literature, American Economic Association, vol. 21(4), pages 1425-67, December.
  23. Diamond, P. A., 1977. "A framework for social security analysis," Journal of Public Economics, Elsevier, vol. 8(3), pages 275-298, December.
  24. Panis, C.W.A. & Lillard, L.A., 1996. "Socioeconomic Differentials in the Returns to Social Security," Papers 96-05, RAND - Labor and Population Program.
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