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Snapshot for December 22, 2004.

Private accounts:  The ‘spicy sauce’ to sell deep benefit cuts

Like a cafeteria selling a cheap cut of meat by serving it in spicy sauce, proponents of deep cuts in Social Security benefits are masking their sour taste with the artificial sweetener of private accounts. The possible long-term shortfall in the Social Security system as it currently stands would require modest increases in revenue or cuts in benefits.  However, the President has stated he will not increase revenues, leaving only benefit cuts to balance the system.

Indeed, in its primary plan, President Bush’s commission on Social Security proposed to slash the guaranteed portion of Social Security by 16% for people who retire in 2022 and who had previously opted for private accounts; the cuts would increase to 40% for those who retired in 2042 and by 62% for those in 2075.  To sell those deep cuts, the commission touted the benefits of private accounts, which would require the federal government to borrow several trillion dollars over the next three or four decades.  (The additional borrowing would stop once benefit reductions exceeded the new funds going into private accounts.)

Even with the commission’s overly optimistic projections of returns on private accounts, future retirees would lose big under the commission’s plan.  The combined income from guaranteed benefits and these new private accounts would fall 7%, 12%, and 23% short of the benefits scheduled under current law for 2022, 2042, and 2075, respectively.  By their own admission, the commission’s privatization proposal would cut benefits significantly.

But the cuts are even deeper than the President’s commission admits.  Privatization proponents have argued that the stock market yields much greater returns to savings than the treasury notes currently held by the Social Security trust fund.  A higher rate of return reflects differences in the willingness of investors to accept the risk of stock ownership over the certainty the U.S. government will pay its debts.  Over the last two decades, the prices of stocks have risen much faster than the underlying corporate profits on which their value is based.  As a result, the price-to-earnings ratio has risen well above historic norms.  Economists at the Federal Reserve and elsewhere have concluded that the higher price-to-earnings ratio today makes sense only if investors require a smaller risk premium than in the past.  But that means that the difference in the expected returns on stocks compared to bonds has narrowed relative to past historical averages used by the commission in its projections. 

Economists at Goldman Sachs (GS) have found that the commission used excessively high returns in their projections for both stocks and bonds.1  Using more plausible assumptions about returns and the fact that people are willing to pay to reduce risk, the GS economists have estimated a more realistic risk-adjusted return of 2.7% on personal accounts, far less than the 4.6% used by the commission.  They find that a medium income, one-earner couple in 2075 would receive $600 a month in annuity income from a personal saving account-barely half as much as the $1,167 projected by the commission.  When added to the $1,156 guaranteed benefit proposed by the President’s commission, that generates a monthly total of $1,755—42% less than the $3,009 anticipated under Social Security current law.  That’s a much larger reduction than the 23% cut under the commission’s overly optimistic assumptions.

All told, the meat in this proposal is bad, and even the sweetener isn’t what it at first appears to be.

Notes:
1. Goldman Sachs, US Economics Analyst, “Social Security Reform: No Free Lunch,” December 17, 2004.

Today’s Snapshot was written by EPI Research Director  Lee Price with research assistance from David Ratner.