Wednesday, January 19, 2005

Third Rail

George W. Bush has touched the "third rail" of American politics and the big debate is here. Whatever one may think of George W., he deserves much credit.

The Social Security reform discussion has actuarial, economic, political, social, cultural, you-name-it aspects and I see lots of interesting materials almost every day.

Jonathan Clemens in today's WSJ includes some (some) of the basic math that we should be looking at. Here it is.

"Doing the Math on Private Accounts:Why Investors Will Want to Fund Them"

January 19, 2005; Page D1

"You may not like the idea of Social Security private accounts. But you will almost certainly want to fund one.

"I am not arguing that the partial privatization of Social Security is a good idea (I have my concerns), and I am not arguing that private accounts will fix Social Security's financial problems (they won't). But suppose Social Security is overhauled, and suppose, as many pundits expect, that we end up with a mix of traditional Social Security benefits and private accounts, as called for in "reform model 2" suggested by President Bush's 2001 Social Security commission.

"At that point, you will face a critical decision: Should you direct part of your payroll taxes into a private account, or should you continue to put everything into the traditional Social Security system? As best I can figure, it's no contest: You should go for the private account.• Model behavior.

"When I sat down to analyze reform model 2, I thought I was in for some heavy-duty math, comparing potential rates of return. But in fact, the break-even rate of return is built into the model -- and it's so low it makes private accounts look awfully attractive.

"With model 2, you would have the option of putting four percentage points of your payroll taxes, up to $1,000 a year, into a private account. The rest of your payroll taxes would continue to flow into the old system and eventually earn you the right to a monthly check. That check, however, would be smaller than the check you would receive if you continued fully funding the traditional system.

"How much smaller? In calculating the reduction, the Social Security Administration, or SSA, would make two assumptions, explains Jeffrey Brown, a finance professor at the University of Illinois at Urbana-Champaign and a staff member on the 2001 commission.

"First, it would assume that the dollars in your private account grow two percentage points a year faster than inflation. Second, when you claim your traditional benefit, the SSA would assume that you simultaneously took the money in your private account and used it to purchase an immediate annuity that pays a lifetime stream of inflation-indexed income, just like you get from Social Security. The SSA would then reduce your traditional benefit by this hypothetical monthly income.

"Keep in mind that these are just the SSA's assumptions. The SSA won't care how your account has really performed, and it won't insist you buy an inflation-indexed annuity.

"Confused? Maybe an example will help. Suppose that, if you had continued to shovel all your payroll taxes into the traditional system, you would receive $1,500 a month at age 66. But instead, years earlier, you opted for a private account. Based on its two assumptions, the SSA calculates that your private account should generate $500 a month. As a result, the SSA would reduce your $1,500 traditional Social Security benefit by $500, leaving you with $1,000.
Model 2's methodology can also be applied to family and survivor benefits, Prof. Brown says. For instance, if your full Social Security benefit was $1,500 a month and your spouse never paid much into Social Security, he or she would qualify for $750 based on your earnings record. In that case, if your assumed income from your private account was $500, your combined benefit would be reduced to $1,750.•

"Private benefits. The hope, of course, is that your private account will grow to generate more income than the SSA assumes. And there's a good chance it will, because the break-even rate of return -- just two percentage points a year above inflation -- is so low. Indeed, you should be able to beat the break-even with a fairly conservative investment strategy.

"Not being forced to annuitize is also a big advantage, says John Cogan, a member of the 2001 commission and a senior fellow at the Hoover Institution at Stanford University. With your private account, you could delay buying an annuity until your 70s or, if you are in poor health, skip the annuity entirely and instead pass on the money to your heirs.

"Make no mistake: None of this will fix Social Security's financial problems. In fact, the transition to private accounts could create a huge fiscal mess. Instead, the fix for Social Security lies in other solutions, like raising taxes or slowing the growth in traditional benefits.

"Let's say that traditional benefits are pared back, so that your full benefit is reduced from $1,500 to $1,300. In that case, if your private account is assumed to generate $500, you would receive just $800 from Social Security.

"As this example suggests, benefit cuts and tax increases will hit everybody, whether they plunk for private accounts or continue fully funding Social Security. But while the pain will be felt by everybody, only those who opt for private accounts will have the chance to make up the lost ground, by earning more than two percentage points above inflation.

"How easy will it be to beat that threshold? I asked Baltimore fund manager T. Rowe Price Group to calculate the probabilities, by analyzing the historical performance of different investment mixes. The results, shown in the accompanying chart, don't reflect investment costs, and future results could be lower. Still, if history is any guide, the odds of beating the break-even rate look pretty good."