Common Sense on Social Security
A Centrist Perspective on the Social Security Reform Dilemma
Social Security Reform: Breaking the Stalemate
Section 9. Evaluating the Two Arguments
Although both morality plays have important points to make, the strategies they advocate require much closer scrutiny. PRA's have several weaknesses that can't be ignored - inheritance leakage, incentive leakage, pre-retirement portfolio adjustments, and reduced annuity return rates. At the same time, the Trust Fund's alleged advantages as a capital accumulation vehicle may be more apparent than real.
Inheritance Leakage. As each PRA will be individually owned, PRA assets will on the death of an owner be transferred to the owner's heirs. In some cases, the heir will be a spouse; in other cases, the heir might be a niece, a nephew, or a cousin. If the heir qualifies for Social Security Survivors' benefits, the assets they're inheriting are almost sure to count as a partial payment on the Survivors' benefits due from Social Security. But what about the more distant heirs, those who wouldn't qualify for Survivors' benefits? The inheritance is still theirs, of course, since the deceased was entitled to bequeath his assets, including his PRA funds, to whomever he chose. From Social Security's vantage point, however, this inevitably creates a modest amount of "inheritance leakage." According to Social Security actuaries, inheritance leakage is likely to reduce the size of the ongoing PRA asset pool by 21/2%. The Trust Fund is not affected by the inheritance leakage issue, but PRA's most certainly are.
PRA Incentive Leakage. In the Archer-Shaw plan, a dollar-for-dollar offset is envisioned. Every annuity dollar paid to a retiree reduces the size of the Social Security benefit check by one dollar. In effect, there's no incentive at all for the individual employee to earn high returns in his PRA. Economist Martin Feldstein's proposal contains a similar feature, except that his plan reduces Social Security benefits by only 75 cents for each annuity dollar received by the retiree. Feldstein's approach gives employees a bit of an incentive to accumulate funds in their PRA's, while still using a PRA program to generate substantial savings for Social Security. It's not hard to imagine any PRA-based Social Security reform tilting at least a bit in Feldstein's direction. From Social Security's perspective, though, the cost reduction potential of PRA's declines a bit, once the decision is made to add a Feldstein-like incentive feature to a PRA program.
Pre-Retirement Portfolio Adjustments. PRA's suffer from another weakness. As PRA advocates concede, it is imprudent for investors to keep their funds tied up in the stock market right up to the time their retire. Too much risk. During the last five years prior to retirement, PRA's need to adopt a somewhat more prudent bonds-only portfolio strategy. As the rate of return on a bond-only portfolio is somewhat lower than the rate of return on a stocks-plus-bonds portfolio, return rates for PRA's can be expected to decline somewhat as their owners approach retirement. Again, this issue is not one that troubles the Social Security Trust Fund.
Annuity Return Rates. The return rate on PRA assets also stays low throughout the years after retirement. Companies that sell annuities to retirees can't afford to take risks with their assets. They're forced by the logic of the business they're in to invest in bonds whose maturities match the due dates on the payments they'll be making. The post-retirement real return rate on PRA funds is therefore only about 3%, well below the return rate that could be earned in the Trust Fund.
When Henry Aaron and Robert Reischauer evaluate the Trust Fund and PRA's in the quiet of their Brookings Institute offices near Dupont Circle, the superiority of the Trust Fund is easy to demonstrate. If one assumes a 50-50 Stock/Bond portfolio mix for both, the Trust Fund outperforms PRA's by a substantial margin. Trust Fund management fees will be lower, as they regularly point out. Inheritance leakage is not a problem; incentive leakage is not an issue. The Trust Fund doesn't have to adjust to an all-bond portfolio in the years just prior to retirement. Nor does it have to emulate the low yield investment strategy of firms that sell annuities.
Ownership Concentration Concerns. When the scene shifts to the Congress, the picture changes dramatically. What begins on Dupont Circle as a bold, stock-rich Trust Fund morphs quickly into a timid, bond-laden Trust Fund once it reaches Capitol Hill, where Congress has no desire to see the Trust Fund become Wall Street's most dominant player. Even the Nadler plan restricts to 30% the portion of the Trust Fund portfolio that can be invested in stocks. The Trust Fund's economic advantage shrivels if PRA's loaded with stocks are pitted against a Trust Fund weighted too heavily toward bonds.
Long Range Cost Advantages. Even so, the Brookings scholars have made a deeply important point. If their portfolios are similar, a PRA-based solution is markedly more expensive than a Trust Fund-based solution. One can measure the difference by determining the size of the federal subsidy that would be required to put Social Security on the road to lasting solvency. The federal subsidy required to launch Social Security on the road to lasting solvency using PRA's is many times the size of the launch subsidy needed if a stock-rich Trust Fund is used instead.
The bottom line on PRA's and the Trust Fund appears to be that there is no bottom line. If cost-effectiveness is the decisive test, the Trust Fund wins by a substantial margin. If decentralized ownership of stock is the critical test, however, PRA's are undeniably superior.
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