Risk and privatized Social Security

WITH Social Security facing a 75-year deficit, the traditional way to regain solvency would be to increase revenues or reduce benefits. Some reform proposals, however, suggest that investing Social Security contributions in stocks may be a painless way out. Stocks do have higher expected returns, but they also have much greater risk.

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How to account for this risk is emerging as one of the thorniest issues in the Social Security debate. It is nonetheless clear that reporting only the higher returns on stocks, without accounting for the risk, seriously overstates the contribution of private account plans to retirement security.

The leading private account proposal, from the President's Commission to Strengthen Social Security, demonstrates why the treatment of risk is so important. The plan has two components. The first slows spending by indexing future benefits to the growth of prices rather than wages. As wages have historically risen at a faster pace than prices, Social Security benefits will replace a constantly declining share of pre-retirement earnings. This projected decline in replacement rates more than eliminates the entire 75-year deficit.

The second component allows workers to put about 3 percent of their payroll tax in a private account and receive a smaller traditional benefit when they retire.

The extent to which the commission's combined traditional and private account benefits fall short of those scheduled under present law depends on two factors. The first is whether the worker opts for the private account, which is voluntary in this plan.

For those who do opt for private accounts, the projected benefit reduction hinges on the treatment of market returns. If the higher market returns associated with stocks are fully adjusted for risk and the projections use a "riskless" rate of return, the pattern looks very similar to the reductions in traditional benefits. If returns are not risk adjusted, the projected reductions are substantially smaller.

Everyone agrees that historically stocks have produced higher returns than bonds. Moreover, everyone agrees that over the long run people will probably end up with more money investing with stocks. The key word, however, is "probably." Stocks are much riskier than bonds. Looking back, for any given 10-year period, investors had a 25 percent chance of realizing lower returns from a portfolio of Standard and Poor's stocks than from a portfolio of government bonds.

Thus, people who need a specific amount on a given date cannot rely on stocks to produce the required sum. To reflect the cost of this risk, the Congressional Budget Office reports only the risk-adjusted numbers for projected balances in Social Security reform proposals. The Social Security Administration reports projected balances based on both an all-bond portfolio and a portfolio including stocks.

The federal government has also confronted the issue of stock investment in the context of the Railroad Retirement System. In 2001, Congress authorized the National Railroad Retirement Fund to invest in corporate stocks, among other assets. The shift meant that government scoring agencies, such as the Office of Management and Budget and the Congressional Budget Office, had to determine the appropriate treatment of the expected higher returns, and higher risks, for projections of trust fund balances.

In each case, the agency decided to ignore the higher expected returns on stock investments and project returns at the long-term Treasury rate over the budgetary planning period. They, in effect, assumed that the higher expected return on stock was precisely offset by its additional risk.

The upshot of this discussion is that using historical rates of return on stocks, without any adjustment for risk, is clearly improper and overstates the contribution of private accounts to retirement security. But projecting future balances in personal accounts on the assumption that the assets are invested entirely in bonds isn't intuitive either.

We desperately need some agreed upon mechanism to adjust projected returns for risk in order to evaluate the merits of alternative Social Security proposals.

Alicia H. Munnell is professor of management sciences at Boston College's Carroll School of Management.