IMPLICATIONS OF SOCIAL SECURITY REFORM ON INTEREST RATES: THEORY AND EVIDENCE

ABSTRACT This article investigates the potential effect that Social Security reform may have on bond and equity returns. We specifically focus on the effect of proposals to shift a portion of the investment of the U.S. Social Security Trust Fund to the equities market. Models are developed to demonstrate the relationship between returns and both the relative size of the Social Security Trust Fund and the portfolio allocation of the Trust Fund. Using these two models, we then show that interest rates will increase from either a decrease in the size of the Social Security Trust Fund or a shifting in the investment mix from bonds to equities. We derive an adjustment factor that relates the magnitude of change in interest rates from either source and use this adjustment factor in conjunction with estimates of the relationship between government debt and interest rates to forecast the potential effect on interest rates from shifting part of the Trust Fund to the equity market. The estimates herein suggest that investing so me of the Social Security funds in equities is not a painless cure-all for the Social Security system and may even have some adverse effects in terms of income transfers from American taxpayers to foreign bondholders. INTRODUCTION The U.S. Social Security Administration has stated that the current Social Security system will not have sufficient funds to provide the projected level of benefits over the next 75 years. The leading edge of the baby-boom generation turns 65 in 2011; two years later the payment of benefits is projected to exceed tax income. By 2024 the total payment of benefits will exceed tax income plus the earnings from the Social Security Trust Fund, which will cause the Trust Fund to decrease in size. By 2037, the OASDI (Old-Age Survivors and Disability Insurance) Trust Fund will be depleted, and future benefits must be decreased by 25 percent to maintain a balance between tax income and benefit payments. In an attempt to maintain a funded Social Security system, several reforms have been proposed. All of these reforms have a number of components, but almost all include some combination that would cut benefits (by increasing the "normal" retirement age, decreasing COLAs, or increasing the penalty for early retirement), increase taxes (by increasing the base payroll tax, increasing the income limit, or imposing a "transitional tax"), or introduce some degree of privatization into the system (by giving individuals some control over how their contributions are invested or shifting Trust Funds into the equities market). (1) This article focuses primarily on shifting a portion of the investment of the Trust Fund into the equities market. Currently, the Trust Fund holds only special U.S. Treasury securities, which yield a relatively low risk-free return. Supposedly, the additional expected return from equities (as compared to U.S. Treasury securities) would then avoid an increase in taxes or decrease in benefits. We demonstrate that this is inaccurate because of the change in interest rates resulting from a shift in the investment of the Social Security Trust Fund. Finally, the results herein focus on the fact that an informed discussion of Social Security reform needs to explicitly take into account the secondary effects of reform--specifically, the effects on interest rates, income tax changes, and income redistribution. As Diamond (1998) has pointed out, the major proposals for reform differ in three areas: (1) defined benefit or defined contribution plan, (2) how the funds are invested, and (3) the amount of funding. The analysis then generally considers the effects of reform on welfare, national savings, labor-supply decisions, capital formation, risk sharing, and other economic activity. One area that has not been thoroughly explored is the effect of reform on asset returns. Often, it is assumed that the magnitude of such an effect will be small. …