TCS Daily


Actuarially Unsound

By Arnold Kling - February 24, 2005 12:00 AM

"Enactment of this plan would eliminate the Social Security long-range actuarial deficit and meet the criteria for sustainable solvency. The program would be expected to remain solvent throughout the 75-year projection period and for the foreseeable future beyond.

...the scaled high earner retiring in 2045 and later and experiencing the low yields would beat the CPI-indexed benefit. In addition, by 2055 the maximum earner retiree would even beat the present-law scheduled benefit."

-- memorandum to Representative Johnson from the Chief Actuary of the Social Security Administration.

 

Representative Samuel Johnson (R, Texas) submitted a privatization plan to the Social Security Administration for "actuarial scoring." The results that came back showed that the plan both eliminates the Social Security shortfall and improves returns for workers. In other words, the scorecard for the Johnson plan reads "Giant Free Lunch."

 

"Actuarial scoring" of Social Security and the reform proposals is a menace. The assumptions used in scoring are rigid and misleading. If you want to be in a position to evaluate Social Security reform objectively and accurately, the first thing you have to do is throw out the actuarial analysis. Pay no attention to the "trust fund," the "solvency" of the system, or other noise generated by the actuaries.

 

Looking at Social Security Correctly

 

To view Social Security correctly, always keep in mind that it is a tax-and-transfer system, not a pension system. Because it taxes current workers to pay benefits to current retirees, Social Security's critical parameter is the ratio of workers to retirees. As that ratio falls, the ability to use a given tax rate to meet promised benefits declines. This ratio will fall in the coming years for three reasons: the Baby Boom retirement bulge; a secular decline in the birth rate; and greater life extension -- people living farther past the legal retirement age.

 

The Social Security actuaries have to make demographic projections of the size of the labor force and the number of retirees over the rest of this century. Of all of the estimates that the actuaries have to make, the demographic projections probably are the easiest. Even so, I think that the chances are that the standard methodology severely under-estimates life extension going forward, which would cause the actuaries to under-estimate the shortfalls in the system.

 

A fundamental flaw of Social Security is that the age of government dependency (the legal retirement age) remains fixed, even as we are living longer, working at less physically demanding jobs, and enjoying much better health in our 60's and 70's. That is why so many economists, on all sides of the political spectrum, support raising the legal retirement age and adjusting it regularly as we obtain new information about longevity.

 

Actuarial Nonsense

 

The actuarial scoring of Social Security proposals uses two financial assumptions that I want to criticize here. One of these assumptions biases the analysis in favor of privatization. The other assumption biases the analysis against any reform.

 

The assumption that biases the analysis in favor of privatization is the assumption that investments in the stock market yield a real return of 6.5 percent. This assumption was not controversial when it was adopted, and in fact it was endorsed by a number of economists with a variety of political viewpoints. However, there are many of us who view 6.5 percent stock market growth as unrealistically high relative to 2 percent overall economic growth, particularly when this assumption is extrapolated out for several decades. I drew attention to this issue a year and a half ago in Fighting Murphy (reprinted as "A Social Security Primer" in Learning Economics). I then stated the argument more explicitly in The Ultimate Lockbox. More recently, left-wing economists Dean Baker and Paul Krugman have made a similar argument. Yes, this is an issue on which Krugman and I agree. For a more nuanced analysis, see Brad DeLong, and -- if you can follow it -- the longer paper to which he links.

 

The Real Interest Rate

 

The other assumption that the actuaries make that troubles me is the assumption that the risk-free real rate of interest, meaning the interest rate after you take away inflation, will be 3 percent going forward. I think that this is way too high for a risk-free real interest rate in an economy growing at 2 percent. Moreover, we have a market-based measure of the long-term risk-free interest rate, derived from inflation-indexed Treasury securities. As J. Huston McCulloch's web site shows, that market estimate is closer to 2 percent.

 

What is the difference between assuming a risk-free real interest rate of 3 percent, as the actuaries do, and assuming that the rate is 2 percent, which is what I believe is more reasonable? This sounds like a trivial issue.

 

In fact, the assumption of a 3 percent risk-free real interest rate undermines Social Security reform in a number of ways. For example, it greatly reduces the "actuarial shortfall" of Social Security, making it appear that only small changes are needed to "fix" it.

 

Social Security's cash-flow deficits (the shortfall between taxes under current law and promised benefits) are in the future, and mostly in the distant future. To calculate the "actuarial shortfall," each dollar of future deficits is converted to "present value" by discounting the future dollars at the rate of interest. For example, each $1000 of deficit in 35 years, discounted at a 3 percent real interest rate, is only $355 today. Each $1000 of deficit in 70 years, discounted at a 3 percent real rate, is only $126 today.

 

At a 2 percent interest rate, the "present value" of the future deficits is much higher. Each $1000 of deficit in 35 years becomes $500 instead of $355, and $1000 of deficit in 70 years becomes $250 instead of $126.

 

This 3 percent real interest rate is what the actuaries use to calculate what it would take to make the "Trust Fund" achieve "solvency." It biases policy in favor of short-term fixes, such as tax increases, and against long-term reductions in benefits. At a 3 percent real interest rate, a short-term fix cumulates to a large effect, and a long-term reduction in benefits has relatively little present value. Thus, the 3 percent real rate gives a better "actuarial score" to short-term fixes than to any fundamental Social Security reform.

 

The "transition cost" to partial privatization appears to be much higher at a 3 percent real interest rate than at a 2 percent real interest rate. At a 3 percent real interest rate, the higher short-term deficits that are incurred to fund the transition to private accounts must be offset by very large reductions in future benefits in order to achieve "actuarial balance."

 

What this means is that in order to please the actuarial scorers, those who propose personal accounts have to give account-holders a much worse deal than they deserve. That is, the amount of future benefits that you have to give up in order to get control of your own money is higher than it ought to be.

 

Suppose that taxpayer A decides to divert $1000 of her Social Security taxes into personal accounts, and taxpayer B decides to stick with the current Social Security system. In 30 years, how much less in Social Security benefits should taxpayer A receive than taxpayer B?

 

At a 3 percent real interest rate, you have to cut her benefits by the equivalent to a lump sum of $2427, which is what $1000 would have earned after 30 years at 3 percent. Assuming a 2 percent real interest rate, benefits would be cut by the equivalent to a lump sum of only $1811.

 

In fact, at a 3 percent real interest rate, it would be irrational for me to switch to using personal accounts! I have some of my portfolio invested in Treasury-indexed securities, earning 2 percent. If instead I can earn 3 percent by sticking with Social Security instead of using a personal account, then I would definitely do that. If I cannot earn a 3 percent risk-free real interest rate anywhere else, and I have to pay a penalty of 3 percent for shifting into personal accounts, I would definitely stick with Social Security!

 

Of course, if I believed the actuaries' other assumption, that stocks will earn 6.5 percent real returns in perpetuity, and I were willing to shift all of my portfolio out of risk-free assets, then I might make a profit in personal accounts. However, as long as I want to keep any of my portfolio in risk-free bonds, then I should seek the highest possible returns for those risk-free assets, which means sticking with Social Security. If I choose to invest more in stocks, I should sell some of my Treasury-indexed securities rather than take the deal offered by personal accounts.

 

Damaging Actuaries

 

Do I really believe that Social Security is a fundamentally superior investment? No. However, the terms of the deal being offered for personal accounts artificially turn them into a losing deal. The reason is the unrealistically high risk-free interest rate of 3 percent, which is the rate that the privatization plans would charge me to take my own money today in order to reduce my benefits in the future.

 

Another way to put this is that the interest rate that the government will charge me for shifting funds out of Social Security is much higher than the rate of return I will get for putting funds in to Social Security (the latter might be something close to 1 percent). The 3 percent interest rate that I am to be charged is unreasonably high. Nobody who really wants personal accounts to be successful wants to charge such a high interest rate. The 3 percent rate is dictated by the Social Security actuaries. If the personal account plans do not charge at least 3 percent, then the actuaries will score the plans as "unsound."

 

On reflection, the amount of damage done by the Social Security actuaries is truly remarkable. Thanks to the actuaries, we have unrealistically optimistic estimates of Social Securities financial condition. We have unrealistically optimistic estimates of the returns on the stock market relative to economic growth. And, finally, we have an unreasonably high interest rate charged to people who switch to personal accounts, making it irrational for most individuals to take advantage of a personal account option were it to be offered.

 

The influence of "actuarial scoring" on policy is an arcane subject. Unfortunately, if we do not pay attention to it, we are going to get fleeced.

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