Southwest Business and Economics Journal/2010
A Reality-Based Model to Assess the Market Risk of
Privatizing Social Security
Jerry A. Joseph
Indiana University of Pennsylvania
Monsurur Rahman
Indiana University of Pennsylvania
Faye Bradwick
Indiana University of Pennsylvania
Abstract
The debate about whether to privatize part or all of the federal social security
system is not settled. There is still disagreement over a number of issues including the
level of financial risks to which privatization would subject a person, the primary risk
being market risk. Using a model utilizing actual market yields for treasury bonds and
returns for equities achieved during each year of eight 46-year periods and applying
such yields or returns to period-adjusted income during these eight 46-year periods
ending 1999 through 2005, during which time there was a recession and a recovery,
followed by the calculation of the results of purchasing an 18-year annuity at the end of
each period, a picture is developed of what people actually retiring during these years
could have expected to receive had their social security contributions been put into a
private account rather than into social security during their working careers. This
provides additional insight into the levels of risk and the magnitude of monies involved in
the event that the social security system is privatized.
INTRODUCTION
In the continuing debate about whether to privatize the federal social security
system, one of the primary objections made by opponents is that privatization would
subject potential recipients to an unacceptable level of risk due to market volatility.
Much can be found in the literature about the levels of returns afforded by social security,
ranging from a negative return to a low positive return, depending on earnings, marital
status, and whether there is only one or more than one earner. (Ferrara, 1986; Crane,
1997) There is essentially no disagreement about whether social security provides a
return inferior to what would likely be achieved in the market. It has been shown by a
number of researchers to achieve lower returns than either bonds or equities. At best,
recipients of social security upon retirement may receive around 2 to 3% on the money
that was withheld from them, and this is for low wage earners who benefit from the
program’s design to transfer benefits from higher wage earners to them. Higher wage
earners are generally shown to receive a negative return from the social security system.
Concerning the market risk of funds in a privatized system, the literature contains
opinions and studies varying from the AARP’s suggesting that any market-based
approach has great risk akin to the commodities market (FactCheck.Org., January 16,
2005) to studies to quantify market variations found over 10-year periods (Munnell,
2004) in which she found that 25% of the time the return on stocks would be lower than
39
A Reality-Based Model to Assess the Market Risk of
Privatizing Social Security
treasuries, or over 35-year periods in which the lowest 35-year period was one ending in
1982, yielding 3.6%, with the average for such 35-year periods ending between 1961 and
2002 being 7.3%. (National Center for Policy Analysis, January 16, 2003) Another
longitudinal analysis of equity investments shows that during a period of 70 years ending
in 1996, the worst 46-year interperiod, corresponding to the normal working life of
someone contributing to social security, was 7.32% from 1929 to 1974. On the average
over the entire period the return was found to be 10.89%. (Santorum, April 18, 2001)
During the first half of this decade, our economy suffered the effects of, and then
recovered from, a recession. In a previous study (Rahman and Joseph, 2001) used a
model showing the results that would have been obtained from different investment and
income assumptions, using the actual return of two investment scenarios for each year
between 1953 and 1998, and a period-adjusted amount of income for that 46-year
working span. Using the model developed for that study, this study steps through each
year from 1999 through 2006 in 46-year periods. That is, eight individual 46-year
periods whose end years range from 1999 through 2006 are modeled. By stepping the
model through these eight periods a record is developed showing what actual returns
would have been provided to someone retiring during each of the years 1999 through
2006 had they always had their withholdings privatized and invested in either treasury
bonds or in equities. Because this eight-year span includes a recession and a recovery,
this provides a real-life dimension to the debate over privatization and helps demonstrate
the level of risk and potential monetary amounts involved at the individual level.
THE STUDY
The model that is used to step through the eight years in 46-year periods from
1999 through 2006 is constructed as described in the following paragraphs. An example
of the calculations is shown as Table 1, which are the yield/return calculations for the
year 2006. A similar table was constructed for each of the other seven periods ending
1999 through 2005.
The worker, whether male or female, was hypothesized to begin working when
he/she was 20 years old and to work as a single earner until he/she was 65, at which time
he/she would retire. That is, a worker beginning employment at the beginning of 1954
would retire at the end of 1999, and a worker beginning employment at the beginning of
1961 would retire at the end of 2006, with the six intervening 46-year working career
periods starting in 1955 through 1959 and ending in 2000 through 2005, respectively.
Different retirement ages will occur in the future as the system is currently designed, but
for consistency and simplicity these differences were not incorporated in the study.
The level of earnings of the worker over the eight 46-year periods are assumed to
be the OASDI maximum amount of taxable earnings during this time period. This started
at $3,600 in 1954 and ended at $94,200 in 2006. (Social Security Administration, 2007)
Different assumptions of earnings could have been used, but different earnings would not
affect the actual returns of the markets, only the magnitude of the potential payouts.
The actual money invested each year over each of the eight different 46-year
periods was assumed to be 61.8% of the amount that is withheld for social security in
total. The 1.8% is to approximate the amount that actually goes to social security with
the balance going to disabled workers, surviving wives and husbands, children, widowed
mothers, widows and widowers, parents, and special benefits. (Table 616, 1998) The
amount that is withheld in total from a worker’s employment check for social security
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Southwest Business and Economics Journal/2010
varies from 3.0% in 1954 to 6.2% in 2006 for the employee’s portion. The employee’s
withholding is then doubled to account for the employer’s matching portion. The total
amount to be invested in the model is then 61.8% of 6.0% in 1954 and 61.8% of 12.4% in
2006. (SSA Publication No. 05-10003, January 2007)
Investment vehicles were assumed to be either treasury bonds (essentially riskless
except for interest-rate risk) or equities. The treasury bond rate at the end of each year
was used to develop the return for the treasury bond scenario and the change from yearend to year-end in the Dow Jones Industrial Average was used as the return for the equity
scenario.
The return for any given year was calculated using half the withholding for that
year to account for the actual availability of funds for investment for the year of
withholding which was then added to the entirety of the previous year’s total cumulative
amount. The rates applied are as mentioned above for either treasury bonds or equity.
At the time of retirement it was assumed that the retiree would purchase an
annuity for 18 years, which approximates the expected remaining life span for people
who are 65 in 1998. This statistic was not updated for this study to maintain
comparability of results among following years. The rate used in the annuity’s payout is
the average return for treasury bonds from 1999 through 2006, which was 5.21%. This
would undoubtedly differ from year to year and from company to company from which
annuities might be purchased, but for comparability among years, this, quite likely
conservative rate, was used.
DATA ANALYSIS
Since previous studies amply demonstrated that investments in either essentially
riskless vehicles such as treasury bonds or in riskier vehicles, at least short-term, such as
equities both led to substantially superior returns as compared to the social security
system, this study addresses the question of variability of returns and the associated risk
of such investments (market risk) had someone retired during the years from 1999
through 2006. Tables 2 and 3 show the average return for each of the eight 46-year
periods of employment, ending each year from 1999 to 2006. Table 2 shows that the
average yield for treasury bonds over the period from 1954 through 1999 was 6.74% and
that for someone retiring in each ensuing year the average yield showed a steady, small
increase ending at 6.99% in 2006. Table 3 shows more variability, reflecting the effects
of the recession, but in no year was the average return for the eight 46-year periods with
investments in equities less than 7.35%, reaching that in 2005 after the recovery from the
recession and the effects of 911. In each of the eight years the investment return in
equities, the more volatile of the two investment scenarios, exceeds the yield of the
treasury bond scenario.
Tables 2 and 3 also show the cumulative investment amount, the monthly payout
and the annual payout that would be achieved from an annuity over an 18-year period,
assuming that the entire amount of the investment was placed in a costless annuity at
5.21%, the average rate of interest on the treasury bonds over the eight periods. The
cumulative investment amounts in treasury bonds varied from a low in 1999 of $249,291
to a high of $384,811 in 2006. The annual payouts for treasury bonds varied from
$21,372 to $32,990 over the same years. The cumulative investment amounts in equities
varied from a low of $375,577 in 2002 to a high of $581,363 in 2006. The annual
payouts for the same years were $32,199 and $49,841. As was found above with returns,
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A Reality-Based Model to Assess the Market Risk of
Privatizing Social Security
the total cumulative amounts and the annual payouts for the equity scenario exceeds
those of the treasury bond scenario for each year included in the study.
Table 4 shows the actual, annual rates of return for either treasury bonds or the
DJIA in each of the eight years studied. It also shows the change in returns from the
previous year. It can be seen that there is significantly more variation from year to year
in the DJIA annual returns than in treasury bonds, as would be expected. However, over
the eight years from 1999 to 2006, the average returns are about the same, with treasury
bonds somewhat outperforming the DJIA, Also, the average of the change from year to
year, or volatility, almost breaks even for both scenarios even though the range of
volatility from year to year is significantly greater for the equity scenario.
The data in the tables show that while there is significant volatility in the year-toyear returns on equity investments from 1999 to 2006 as represented by the changes in
the DJIA as a proxy for the equity scenario, with the averaging that occurs by annual
investment over the 46-year employment period of the hypothesized worker, regardless
of when this period started, the effect of the variation on the end amount available for
purchase of an annuity is greatly diminished. Rather, because of the greater average
returns over any of the eight 46-year periods, even during the recent recession, the equity
scenario provided returns and total available funds that were superior to those provided
by treasury bonds in each year of the eight retirement years. This superiority of results of
equities is achieved even though the treasury bond rates show very little variation during
the recession. And, it should be remembered that previous researchers have found the
returns of the current social security system to be inferior to either treasury bonds or
average equities in the returns provided by contributions made during a working career.
Consequently, at least during the most recent recession, people retiring would have been
significantly better off, even in the middle of the recession, had they had their
withholdings invested in either treasury bonds or an average mix of equities during their
working years. Further, it is shown that during these particular eight years for retirement
a person would have received greater returns had he/she invested his/her contributions in
equities rather than treasury bonds.
One can imagine, though, the remorse that someone retiring in the equity scenario
after 1999 and particularly in 2002 would feel when they eventually see that they might
have had about $1,500 a month more if they had waited four more years to retire. It
might be hard for that person to take solace in his/her being better off than if he/she had
been in the treasury bond scenario or in the social security system.
LIMITATION OF STUDY
The study encompasses only one period of recession. There might be different
outcomes in other recessionary periods. Further, the results are dependent on the results
of yields of treasury bonds or the equity market and the magnitude of withholdings and
subsequent investments during only the eight 46-year periods beginning in 1954 and
ending in 2006. Results may be different for other 46-year periods.
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Southwest Business and Economics Journal/2010
CONCLUSION
While the years for the hypothesized workers to be retiring were only eight 46year periods for which withholdings were made and invested by the hypothesized worker,
they did include a recent recession and a recovery from that recession. Consequently, by
showing the actual yields and monetary results of retirement under two different
scenarios during these years, with rates based on actual yields for the years involved and
the amounts invested being based on period-adjusted income amounts, general
information is provided about what would have happened to someone actually retiring
during those years had he/she invested his/her contributions into either treasury bonds or
a fund indexed to the DJIA. The study demonstrates that to the extent this recession and
the eight 46-year working periods encompassed by the study are similar to other
recessions and other 46-year working periods, the argument that the variability of bond or
equity markets creates too much risk to allow the privatization of social security is not
supported. Rather, workers are shown to be better off had their withholdings, or savings
equal to withholdings, been invested in either treasury bonds or equities approximating
the DJIA rather than being sent to the social security system.
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A Reality-Based Model to Assess the Market Risk of
Privatizing Social Security
References
Crane, Edward H. (1997). The Case for Privatizing America’s Social Security System.
Address to S.O. S. Retraite Sante, Paris, France, December 10, 1997.
FactCheck.Org. ( January 16, 2005) Social Security Ads: Risk or Protection?
Ferrara, Peter J. (1986). Social Security Rates of Return for Today’s Young Workers.
National Chamber Foundation.
Munnell, Alicia, H. (2004). Risk and Privatized Social Security, The Boston Globe.
December 31, 2004.
National Center for Policy Analysis. (2003) Social Security and Stock Market Risk, No.
429. January 16, 2003.
Rahman, Monsurur & Joseph, Jerry A. (2001). Privatization of Social Security: A Study
of Three Hypothetical Cases, Journal of Accounting and Finance Research,
Volume 9, Number 5, pp. 27-40.
Santorum, Rick. (April 18, 2001) Facts, Not Politics, Drive Social Security Reform,
Tribune-Review.
Social Security Administration. (2006). Your Social Security Statement, Form SSA –
7005-SM-SI(05/06).
SSA Publication No. 05-10003, January 2007.
Table No. 616. (1998). Social Security(OASDI)- Benefits by types of Beneficiary” 1980
to 1998. U.S. Social Security Administration, annual Statistical Supplement to
the Social Security Bulletin.
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Southwest Business and Economics Journal/2010
Table 1: High Wage Earner Investment of 61.8% of OASDI
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A Reality-Based Model to Assess the Market Risk of
Privatizing Social Security
Table 2: Treasury Bond
TOTAL ANNUITIES, AVERAGE RETURNS, MONTHLY
ANNUITY PAYOUTS, AND ANNUAL ANNUITY PAYOUTS
BASED ON YEAR OF RETIREMENT
YEAR
1999
2000
2001
2002
2003
2004
2005
2006
AVERAGE
46-YEAR
RETURN
6.74%
6.80%
6.86%
6.91%
6.95%
6.97%
6.97%
6.99%
TOTAL
AMOUNT
OF
ANNUITY
249,291
267,084
285,852
304,624
324,427
344,554
363,928
384,811
MONTHLY
PAYOUT
OF
ANNUITY
1780.99
1,908.11
2,042.19
2,176.30
2,317.78
2,461.57
2,598.00
2,749.18
ANNUAL
PAYOUT
OF
ANNUITY
21,372
22,897
24,506
26,116
27,813
29,539
31,176
32,990
Table 3: Equity
TOTAL ANNUITIES, AVERAGE RETURNS, MONTHLY
ANNUITY PAYOUTS, AND ANNUAL ANNUITY PAYOUTS
BASED ON YEAR OF RETIREMENT
YEAR
1999
2000
2001
2002
2003
2004
2005
2006
46
AVERAGE
46-YEAR
RETURN
9.67%
8.58%
7.97%
7.56%
8.39%
7.72%
7.35%
7.91%
TOTAL
AMOUNT
OF
ANNUITY
504,823
476,344
445,206
375,577
475,548
494,836
496,174
581,363
MONTHLY
PAYOUT
OF
ANNUITY
3,606.57
3,403.11
3,187.31
2,683.21
3,397.43
3,535.22
3,544.78
4,153.39
ANNUAL
PAYOUT
OF
ANNUITY
43,279
40,837
38,148
32,199
40,769
42,423
42,537
49,841
Southwest Business and Economics Journal/2010
Table 4
ANNUAL RETURNS AND CHANGES IN RETURNS FROM
PREVIOUS YEARS
YEAR
1998
1999
2000
2001
2002
2003
2004
2005
2006
AVG (1999-2006)
TREASURY
BOND
RETURN
5.09%
6.35%
5.49%
5.48%
5.01%
5.11%
4.88%
4.54%
4.81%
5.21%
RETURN
CHANGE
FROM
PREVIOUS
YEAR
1.26%
-0.86%
-0.01%
-0.47%
0.10%
-0.23%
-0.34%
0.27%
-0.04%
EQUITY
RETURN
16.10%
25.22%
-6.18%
-7.10%
-16.76%
25.32%
3.15%
-0.61%
16.29%
4.92%
RETURN
CHANGE
FROM
PREVIOUS
YEAR
9.12%
-31.40%
-0.92%
-9.67%
42.09%
-22.17%
-3.76%
16.90%
0.02%
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A Reality-Based Model to Assess the Market Risk of
Privatizing Social Security
48