Social Security Privatization

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As President Bush continues to push for Social Security privatization, many new issues are surfacing, adding to the already substantial list of costs and risks of privatization. Under privatization, workers would be allowed to divert a large share of the money that currently goes to Social Security into private accounts. The risks of saving for retirement would be privatized. This includes the chance that financial markets will underperform for long periods of time, which is known as market risk. A worker's birth date could determine the size of his or her retirement account. The difference from worker to worker could vary widely. This could result in generations of workers with less money than they thought they would have for retirement and considerably less than they would have under the current Social Security system. Given few alternatives, future governments will be compelled to come to the aid of workers who have saved too little for retirement. Reasonable estimates show that this could add between $600 billion and $900 billion in present value terms to the costs of privatization over the next 75 years.

Considering historical data and reasonable forecasts for the future, this analysis highlights the following points about market risk under Social Security privatization:

Market risk is severe. Depending on a worker's birth date, the retirement benefits generated from putting 10 percent of earnings in a private account for 35 years would have ranged from 100 percent to less than 20 percent relative to pre-retirement earnings.

The extraordinarily high retirement income generated from the booming '90s stock market was the equivalent of winning the generational lottery – unlikely to be repeated regularly. Even under these beneficial circumstances, a privatized system favored by President Bush could have cost the government more than $1 trillion in today's dollars over the past three decades in a government bailout of the Social Security system to assist those who accumulated too little for retirement.

The primary alternative to a government bailout of the Social Security system, older workers working longer, would create enormous labor market pressures. Without changes in wages, the unemployment rate could have approached 13 percent in the past 30 years if older workers had wanted to work longer to compensate for having too few retirement benefits.

Projecting past trends into the future, it is likely that the government will face additional costs to bail out a privatized Social Security system that provides too few benefits. The present value of these additional costs will average between $600 billion and $900 billion over the next 75 years and could exceed $1 trillion.

These numbers show that privatization amounts to a retirement savings gamble, where the winnings are unevenly distributed. Some generations will do poorly, while others could do fine. This asymmetry is also reflected in the government's finances. The government would face the costs if the privatization gamble fails, while it would see few benefits in the years when the privatization gamble's payout is larger than expected.

Market Risks Create Substantial Chance of Too Few Savings

With private accounts, workers face risks that are not part of Social Security (Weller and Wenger, 2004a). An important risk here is the risk that financial markets could stay below their historical averages for long periods of time, which is known as market risk. Although it is theoretically possible to reduce market risk by buying insurance that guarantees a specified rate of return, workers would have to spend large shares of their annual savings on this insurance to see a meaningful rate of return (Lachance and Mitchell, 2003).

When considering stock market fluctuations over time, the average rate of return over a typical working life, approximately 35 years, matters.[1] While the real rate of return of the stock market has averaged 6.6 percent over the past 100 years, its average rate of return over 35-year periods has fluctuated between 3 percent and 10 percent (figure 1). That is, market risk is real because workers can experience long periods of underperforming financial markets while they are saving for retirement.

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[1] All stock prices are based on the S&P 500, and inflation is based on the CPI.