Privatization’s Poor Return

 

 

 

For more information read "The Retirement Savings Gamble", by Christian Weller

Much of the Social Security privatization debate focuses on the rate of return of private accounts. If President Bush’s proposal becomes law, citizens with private accounts would have to earn at least 3 percent above inflation to have any net gains from their accounts. Even Wall Street agrees that on average, people will have a hard time meeting this target. Entire generations of workers could fall below this threshold because the market did not perform as expected. Whether workers will see rates of return above or below expectations depends on the performance of the economy during their lifetime, and thus on their date of birth – a factor distinctly outside of anyone’s control.

To understand why private accounts need to earn 3 percent above inflation, let’s look at the president’s proposal. People could divert part of their payroll – up to 4 percent of their wages – into private accounts. This money could no longer be used to pay for Social Security benefits. Since benefits for those who are near or in retirement will not be cut, Social Security needs to borrow money to pay all benefits. This debt, with interest, will be charged to the people who diverted money into private accounts. Upon retirement, they will have to repay the debt to Social Security. This is a tax levied on private account holders to repay the additional Social Security debt. The interest charged to private account holders would be equal to 3 percent above inflation. Workers will have to earn at least 3 percent above inflation each year to avoid losing money on this deal.

It is unrealistic and imprudent to expect all private account funds to go into stocks. Instead, most calculations assume that private accounts will be invested half in stocks and the other half in bonds with an average rate of return of 4.6 percent above inflation, after paying a management fee of 0.3 percent of assets each year.

This assumes a rate of return on stocks of 6.5 percent above inflation, which is based on historic experience, but which may be less in the future. Stocks produce a rate of return from appreciation and dividends. Both factors reflect profit growth, which in turn mirrors economic growth. If the economy does well, corporations are profitable and the stock market rises, and vice versa.

The projection that Social Security will need more money in the future, though, rests on the assumption that economic growth for the next 75 years will be about half of what it historically has been. If growth is really going to slow down that much, nobody should expect the stock market rates of return to equal those of the past. A recent survey of economists by the Wall Street Journal found that almost all expected a slowdown in stock market returns, with the majority putting future returns between 4.0 and 4.6 percent.

With a stock market slowdown to 4.5 percent, private accounts could expect to earn only 3.6 percent, which leaves little room for error before people lose money.

Error can come from two sources. First, administrative costs could be larger. In the private market, mutual funds typically charge a little over 1 percent of assets in fees every year. This is similar to the costs of private accounts in countries that have privatized their systems. If the actual costs of managing a large number of small accounts ended up closer to 1 percent instead of 0.3 percent, the costs of their accounts would rise to 3.7 percent annually. Account holders would lose money since they could expect to earn less than they need to pay – 3.6 percent compared to 3.7 percent.

Second, nobody is average. While the market has increased on average by over 6 percent over the past 75 to 100 years, it has also seen extended periods in which rates of return were well below or above that. The market can stay low for long periods of time. At its lowest point, it had an average rate of return over 35 years of 3 percent over inflation. Individual account holders would lose money under this scenario. They would owe 3 percent after inflation on their debt, but they could expect to earn only 2.9 percent after fees on their accounts.

Obviously, periods of low-performing markets will be offset by periods of well-performing markets. The problem, though, is that those who lose in a bear market are not the same people who win in a bull market. Put differently, there will be generations of workers with insufficient retirement savings. This puts future governments in a tough spot. They either have to let workers retire with fewer benefits than they had expected or they have to bail-out underperforming private accounts. Under realistic assumptions, the costs of bailing out future generations could quickly climb into the hundreds of billions of dollars for the next 75 years.

As the debate over Social Security privatization moves forward, it is crucial to understand what those who want to privatize Social Security are really promising. Theirs is a promise of a risky gamble with many pitfalls that could cost future retirees, future governments or both dearly.

Christian E. Weller is senior economist at the Center for American Progress.

For more information:
Read: "The Retirement Savings Gamble"
Or visit our Social Security homepage