Common Sense on Social Security

A Centrist Perspective on the Social Security Reform Dilemma


Social Security Reform: Breaking the Stalemate

Section 12. A Low Risk PRA Strategy

Now we turn to the drawbacks associated with PRA's. Any decision to adopt PRA's brings with it a long checklist of hazards to be overcome. The PRA cost disadvantage. High management fees. Stock market cyclicality. Unequal stock market returns to different age groups. A weakened status for lower income workers. Longevity risk. Transactional complexity. Political leakage. Sensible solutions for each of these concerns must be found before PRA's can safely be incorporated into any Social Security reform package.

The PRA Cost Disadvantage. As an investment vehicle, PRA's aren't nearly as effective as the Trust Fund. Congress could, of course, respond to the PRA cost disadvantage by simply biting the bullet and subsidizing fully the higher front-end cost of launching a PRA program.

Allowing the Trust Fund to carry half the load is a better choice. This trims PRA responsibilities and limits the impact of the PRA cost disadvantage. It also cuts the cost of the front-end launch subsidy by nearly two-thirds.

Fearful Investors. High Management Fees. If employees are asked by their PRA fund managers to choose from among thousands of mutual funds, they're likely to feel intimidated and frustrated. To head off confusion and insure the highest possible average returns for everyone, Social Security should steer all PRA investors toward index-fund portfolios. An index-fund stock portfolio is a passive investment vehicle that mirrors one of the market indexes, such as the Standard & Poors' 500, or the Russell 2000. Once an index fund has been chosen, no further decision-making is required. Whenever the selection of companies tracked by the index changes, the index fund's portfolio of stocks adjusts accordingly.

Helping every PRA investor earn average returns should be Social Security's only goal. While Garrison Keillor impishly brags that all Lake Wobegon's children are "above average," no PRA program can operate on the fantasy that every investor is meant to earn above-average returns. If index fund portfolios grow 15%, all PRA portfolios should grow by 15% as well. If index fund portfolios grow by 5%, all PRA portfolios should grow by a comparable amount. If every PRA investor merely hits the market average, the PRA program will be an outstanding success.

An emphasis on index funds has two additional benefits. First, it reassures every investor. Choose a reasonable index fund, put your money in, and don't worry about a thing. You'll keep up with the market. Second, it whittles management fees down to a trivial level. Mutual fund investors often pay fees equal to 1.5% of their total assets. On the other hand, the typical index fund investor pays management fees equaling about 0.2% of total assets. Thanks to Social Security's massive bargaining power, fees charged to PRA investors in the future are likely to be lower still - probably no greater than 0.1% of total assets.

Stock Market Cyclicality. Different Rewards for Different Age Groups. Loss of Progressivity. Even if all owners of PRA's follow identical investment strategies, the value of their PRA's at retirement will vary considerably. If history is any guide, stocks owned by an age group lucky enough to retire at the end of a long stock market rise could be three times more valuable than comparable stocks owned by an age group unlucky enough to retire at the end of a severe downturn. (This would certainly have been true over the past seven decades, as Gary Burtless of Brookings has shown.) Some PRA proposals, including the Kolbe-Stenholm plan, view harshly unequal returns as inevitable. Millions of employees and retirees, though, don't think Social Security should be allowed to impose such heavy risks on its participants.

The best way to respond to this concern is with a Cohort Equalization Rule tying the size of each retiree's Social Security check to the size of his or her PRA-financed annuity. The Archer-Shaw plan offers one example of how a Cohort Equalization Rule might work, reducing a retiree's Social Security benefit check by one dollar for every dollar received from a PRA-financed annuity. With a Cohort Equalization Rule in force, members of an age group that's been lucky in the stock market will enjoy higher PRA annuities, but their Social Security checks will be reduced correspondingly. Retirees who belong to an unlucky age group will have smaller PRA annuities, but their Social Security benefit checks will be correspondingly higher. Such a practice appropriately equalizes rewards among all age groups.

A cohort equalization policy is crucial for a second important reason as well. It effectively preserves the progressive character of Social Security's current benefit structure. Benefit schedules for lower income retirees continue to be proportionally stronger than those for higher income retirees, a feature of keen interest to millions of Social Security's lower income participants.

Is a dollar-for-dollar offset politically viable? Probably not. On retirement, PRA owners are likely to insist on a modest additional boost from their PRA assets. Some exemption from the offset will almost certainly be politically necessary. The issue to be settled is the exemption percentage. Feldstein would exempt 25 cents of each annuity dollar. That's probably too high. From Social Security's perspective, a 25 cent exemption diminishes considerably the cost reduction potential of a PRA program. Nor can the thorny issue of unequal rewards be expected to disappear if the exemption is set at 25 cents. Given these concerns, a lower exemption, perhaps 10 cents, would be considerably more prudent.

Equalizing returns among different cohorts won't eliminate stock market risk. The risk simply shifts onto Social Security as a whole, where it becomes an issue for the Trust Fund. If the Trust Fund isn't allowed to grow, what would happen if several cohorts in a row were to get hammered by a declining stock market? A tiny Trust Fund might be too small to cover Social Security's obligations to retirees. The larger the PRA program, the more severe this risk becomes. To be truly effective, a cohort equalization policy must be backed by a strong Trust fund.

One caveat is in order. Social Security shouldn't try to insure foolish investors against the consequences of ill-chosen investment strategies. Only those PRA investors who've had the good sense to invest in index funds should receive the cohort equalization protection outlined here. Not a nickel's worth of additional benefits should be given to anyone foolish enough to have frittered away his PRA on high-risk investments.

Longevity Risk. A new retiree with a PRA faces a timing dilemma. If he cashes in his PRA assets too quickly, he might outlive his savings. If he draws them down too slowly, he might die early, before he's gotten the full benefit of his savings. Henry Aaron of Brookings refers to this as the "longevity risk" dilemma. Privatization advocates respond by recommending the purchase of a lifetime annuity. Are lifetime annuities really the best answer to the timing dilemma?

As suggested earlier, a ten-year annuity is eminently more sensible. Converting a PRA into a fixed, ten-year annuity will produce a monthly annuity payment at least forty percent higher than the amount from a lifetime annuity. With a ten-year annuity policy in force, retirees are much more likely to get back the full value of their PRA assets. The vexing issue of longevity risk is dispelled.

The Cash Transfer and Record-Keeping Problem. The logistics of running an error-free PRA program are anything but simple. When a business withholds 2% of salary for deposit into each employee's Personal Retirement Account, how exactly are the deposits to be handled? Should all business owners be required to send out monthly checks, covering all their various employees, to dozens of different PRA fund managers? Should all PRA fund managers be expected to receive and process deposits every month covering 170 million separate account owners? If carelessly designed, PRA's could easily generate a colossal paperwork nightmare.

If PRA's are teamed with a strong Trust Fund, however, the cash-transfer logistics can be managed much more efficiently. With Social Security farming out the management of its own Trust Fund assets to PRA fund managers, PRA deposits can easily be piggy-backed on top of Social Security's own deposits. Employers continue to make their payments to Social Security much as they do now. Social Security takes responsibility for tracking each employee's choice of a PRA fund manager. Every month, Social Security writes a single check to each PRA fund manager, along with an electronic file detailing how the money is to be allocated, not only among employee accounts, but also to Social Security's own account.

It's the most straightforward solution for an inherently complex problem. And what streamlines it the most is the piggyback relationship. With PRA fund managers also serving as asset managers for Social Security, all stakeholders have a strong incentive to keep the process working smoothly and accurately.

Political Leakage. A grieving family headlines the national news. Their young daughter has died of cancer, but only after a long and heart-breaking illness. Owing thousands in medical bills, Dad and Mom and their two surviving children are days away from being kicked out of their home. Both parents own Personal Retirement Accounts, now worth substantial amounts of money, but the rules say their PRA funds cannot be touched for any reason until they retire. They want their PRA money, and they want it now. The TV news programs have grabbed the story of the anguished family going bankrupt while a heartless Congress denies them access to the funds in their PRA's. What is the Congress to do? Give Dad and Mom the keys to their PRA's? Who would tell the Congress not to?

But think of the pain this creates for Social Security. Once the couple retires, what do they do? Their PRA's have been depleted. Does Social Security then make up the difference? If it does, then the couple has unfairly received a substantial double benefit. If it doesn't, the couple's retirement checks are much smaller than they would have been. Is there any way to prevent families in the throes of emergency from plundering their PRA's?

Catastrophic loss insurance may be the best answer. Add an additional levy to the PRA program in order to provide catastrophic loss coverage for all PRA owners. Adopt a rule that cancels coverage for any policyholder who withdraws funds from his PRA prior to retirement. Then the anguished family has a choice. Tap into their PRA's? Or apply for an insurance payment? Given those two alternatives, they'll pick the insurance settlement. Protected by a catastrophic coverage firewall, Congress won't be nearly as tempted to let anguished families dig into their PRA's prior to retirement.

The cost and risk reduction opportunities are extensive. The subsidy launching cost for PRA's can be cut dramatically by merging them with a strong Trust Fund. Investor anxiety can be reduced, and management fees contained, by insisting on the use of index funds. The risk of stock market cyclicality can be counteracted by the adoption of a Cohort Equalization Rule. The same rule also preserves the progressive character of Social Security's benefit structure. Longevity risk can be cut to almost nothing by adopting a Ten-Year Annuity rule. The headaches associated with tracking PRA deposits for millions of employees can be alleviated if Social Security uses the same firms to manage both PRA and Trust Fund assets. The risk of "political leakage" can be forestalled by linking PRA's with catastrophic loss insurance. The cumulative lesson is indisputable. Yes, PRA's are indeed costly and laden with risk, and, should Congress be unwise enough to package them as a stand-alone investment strategy, their inherent riskiness would exact quite an unpleasant toll. If, however, Congress is shrewd enough to repackage PRA's in a bipartisan format and team them with a strong Trust Fund, their otherwise troubling drawbacks can be minimized quite effectively.


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Revision Date April 13, 2006