Social Security Benefit Uncertainty under Individual Accounts

I. INTRODUCTION Various Social Security reform proposals put forth in recent years have included individual accounts. Two of the three reform options offered by the 1994-1996 Advisory Council on Social Security (1997) incorporated such accounts. One Advisory Council option included mandatory individual accounts requiring workers to contribute an additional 1.6% of payroll, invested in indexed bond or equity funds managed by the federal government. Another option included a two-tiered system with privately held Personal Security Accounts (PSAs) that would allow workers to contribute five percentage points of their payroll tax to their PSA where it could be invested in "financial instruments" (Advisory Council on Social Security, 1997, p.30). The Kolbe-Stenholm 21st Century Retirement Security Act (Kolbe and Stenholm, 2002) proposal for Social Security reform includes an Individual Security Account (ISA) to which workers would contribute 3 percent of the first $10,000 of income plus 2 percent above $10,000, investing the funds in stocks, bonds, or government debt. Most recently, the President's Commission to Strengthen Social Security (CSSS) presented three proposals that all included a version of voluntary individual investment accounts; details are discussed in Section II. These proposals often tout expected rates of return (based on historical experience) that would lead to higher overall retirement income for Old-Age Insurance (OAI) worker beneficiaries who participate in the individual accounts. For example, based on Social Security Administration (SSA) estimates, the CSSS report (2001) shows that prototypical workers are expected to be better off under a system with individual accounts, even in cases where the current-law benefit is reduced in order to eliminate the projected funding gap in Social Security. However, reporting only expected benefits under individual accounts using average historical rates of return ignores the risk associated with investing in private securities, as noted by Feldstein and Rangulova (2001). One approach to controlling for the increased risk in evaluations of individual account proposals is to use a lower (appropriately risk-adjusted) rate of return. An alternative approach, which is used here, is to first generate sequences of future returns for private securities using Monte Carlo simulation, then solve for benefits under each sequence of future returns, and finally analyze the distribution of benefit outcomes across simulations. The latter is preferable because it acknowledges the higher expected return from investing in private securities, but it also produces direct measures of the increased risk (e.g., the probability that benefits are actually lower under the proposed alternative). (1) The investment risk considered in this article is modeled on the principle that underlies the most basic CSSS approach to individual accounts. Participants contribute a fixed fraction of their current-law payroll tax to the individual account and in return they promise to give up a fraction of their existing current-law scheduled benefit at retirement. The amount by which the scheduled benefit is reduced equals the tax diverted to the individual account, accrued forward at a designated "offset" rate, usually the government bond rate plus or minus a wedge. Therein lies the investment risk--participants are better off if and only if their accounts earn more than the designated offset rate. The results show that the expected benefit gain is positive for a 2 percent individual account carve-out with a simple benefit offset using the SSA assumptions for the expected rates of return on stocks and bonds, but the standard deviation of that gain is much larger than the gain itself. Although expected gains from individual accounts are uncertain, it is important to keep in mind that even without individual accounts, future current-law benefits are uncertain because key determinants such as future real wage growth and inflation are uncertain. …