Monday, March 21, 2005

Forward-Looking Investment Returns and Social Security Privatization

by Tom Bozzo

Back to business.

In comments to a previous post on privatized Social Security account returns, and also on his own blog, Bryan Smith of Sanity in Mad City pointed to a study by Ibbotson Associates, reported by, suggesting that a balanced stock-bond portfolio would readily clear a 3.3% real return hurdle — the return that would be needed to clear the Bush plan's benefit offset plus annual administrative expenses of 0.3%.*

I couldn't find the research CNN cited at the Ibbotson Associates web site, though it's clear from other research available on the site that Ibbotson does not believe that the equity risk premium has declined markedly, notwithstanding the increase in the market P/E. Ibbotson predicted (in 1999) that the DJIA would reach 120,000 in the mid-2020s, making James K. Glassman and Kevin Hassett look like bears. If he's right, I'll be a happy retiree.

Via Max Sawicky, the Washington Post reports a contrary view from Robert Shiller, the Yale finance professor whose Irrational Exuberance prefigured the tech stock crash. Analyzing a "life cycle" portfolio as has apparently been considered for the private account default, Shiller estimated a median real return of 3.2% for such accounts, which would leave private account holders short of their peers who stuck with traditional Social Security. According to the Post, Shiller's view got a heavyweight endorsement from Wharton's Jeremy Siegel, whose Stocks for the Long Run is a favorite of the bulls.

One interesting thing is that Max had recently reported on attending an AEI seminar in which Siegel had argued for forward-looking stock returns just below historical averages, about 6% real.

According to the Post, Hassett says that Bush administration economists are reconsidering the life-cycle portfolio to add expected return — which, of course, adds risk, too. One political solution appears to be the Ryan-Sununu plan, which proposes to offer carve-out private accounts that insure against downside market risk to the tune of current-law Social Security benefits. I'm with PGL at Angry Bear in thinking that this is a terrible idea.

The question for Bryan (or, given the imminent arrival of Bryan's child, maybe also Joe Malchow or other conservative blog pals not known to me directly) is, does the center-left have to play the curmudgeonly conservative and say that the federal taxpayer has no business insuring equity market returns?
Still no baby. Hopefully he or she will arrive soon!

The Wash. Post article you cite is pretty interesting. I'm surprised that the private investment accounts would use such a seemingly over-conservative investment strategy. Although I do not understand all the details here, the Ibbotson data showed that the market does very well long term even if people are invested more heavily in stocks, which I believe (but might be wrong) is a riskier investment strategy than a "life cycle" portfolio, as far as I understand it.

I'm afraid I don't have an answer for your question, though. It seems pretty stupid to me for Republicans to offer some insurance for making bad investments in a social security private account. This kind of insurance would cost money and increase the real return bar needed to eclipse traditional Social Security. At that point, we might as well just stay with traditional SS. I don't think the market risks in a long-term, diversified portfolio are very high, though, to warrant this type of insurance.

Private Social Security accounts seem like a good idea to me personally in my situation. I'm saving for retirement separately, so even if my private account underperformed traditional Social Security, overall I plan to have a lot more money through savings than via traditional Social Security. I realize that not everyone can save money long term in an add-on way. Maybe they could only allow private accounts for people who are willing to also have an add-on account, if you get my drift. Thus, if real returns underperformed, people who invested in private accounts, but also were required to invest additional money could still end up with as least as much money per month as traditional Social Security would provide (even though it cost them more money over their lifetime). But, it would have the benefit of giving people the potential to end up with a lot more money than traditional Social Security
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