Tuesday, March 29, 2005

The "Problem" with Life-Cycle Funds

by Tom Bozzo

In comments here and at his blog, Bryan Smith takes some time out from waiting for his imminently due baby (arrived since I started this post) to continue our discussion of equity returns in private Social Security accounts.

Comity, if not actually sanity, prevails in Mad City as left and right agree, at least, that insuring stock market returns is not a great idea.

Bryan also wonders why the Bush privatization plan would specify what he suggests might be an "overly conservative" default investment. That has a lot to do with the balancing act fundamental to the anticipated plan.

The Bush plan is not an ordinary retirement savings plan. Rather, it would entail borrowing on the order of $15 trillion to fund the accounts before program cost savings would start to kick in. The debt would, in principle, be paid off via reductions in future tax-funded benefits to the tune of the private account contributions, plus interest. Without the benefit offset, the plan is either a simple add-on costing tens of trillions of dollars over the infinite horizon, or in the Ryan-Sununu flavor an investment insurance system probably also costing many trillions of dollars.

So the benefit offset is needed to avoid colossal program costs that might scare the financial markets, with adverse consequences for the real economy. It's therefore necessary that private account investments have an expected return exceeding the benefit offset, plus any administrative expenses, or nobody would rationally choose the private account. This is a more severe problem for the Bush plan than the relatively common retirement planning failure of investing 401(k) funds in the money market or similar safe investments that will usually have very low real rates of return. (In this context, life cycle funds' returns are not overly conservative.)

Obtaining sufficiently high real returns to clear the benefit offset requires private account holders to assume risk. That creates another dilemma, in that Congress can't stop itself from bailing out private account holders who end up faring less well than under traditional Social Security. Again, any bailout undoes at least a portion of the benefit offset and reifies some transition cost. That, in turn, promotes a default investment choice like the life-cycle account, which gives up some expected return and, the Bush plan's designers would hope, mitigates adverse market outcomes that could be the future political undoing of privatization.

That leads us back to Shiller. Without very high forward-looking stock returns, lower-risk portfolios have difficulty clearing the benefit offset. I should note that this is a problem even with administrative cost estimates (0.3% of assets per year) that appear to be total fantasy, at least in the near term when all of the private accounts would be small.

So the solution, apparently, is to reduce the benefit offset (via Angry Bear) by cutting the interest rate charged on the private account contributions. Apparently, reducing the real interest rate from 3% to 2.7% is the favored option. At least under the assumptions used by the Social Security Trustees to score the traditional program — 3% happens to be the real interest rate for the "intermediate" scenario — this creates an expected cost in the form of subsidizing the borrowing for the private accounts.

A nice irony is that if the interest rate actually is lower, then reality will more closely resemble the far less problematic "low cost" scenario for traditional Social Security. (No, I don't know how sensitive the long-range estimates are to the interest rate assumptions.) Oops, I misread the Trustees' report. The low cost scenario features a higher real interest rate than the intermediate scenario, but a lower nominal rate thanks to lower assumed inflation. See here for the Trustees' interest rate sensitivity analysis.

Next: We'll take a look at alternative plans used by a few local governments in Texas, which have been pushed in some corners of the right blogosphere and subject to some mass media coverage. (See this GAO report [PDF] for a preview of why they do not represent a magical solution.)
Thank you. That's much more lucid than my rant that "it's a negative ROI project."
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