The Better Deal: Estimating Rates of Return under a System of Individual Accounts

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Advocates of reforming Social Security byallowing workers to privately invest a portionof their Social Security taxes through individualaccounts have long argued that privateinvestment would provide a higher rate of returnand, therefore, higher retirement benefits thanSocial Security. After all, in any dynamicallyefficient economy the return to capital willexceed the return that can be generated by alabor‐​based system such as Social Security.Recently, however, some critics have suggestedthat that analysis is wrong. Among other things,they suggest that future returns to equity investmentare likely to be far below historical rates ofreturn. They also suggest that studies predictinghigher returns for private investment do not adequatelyreflect the risk and administrative costsof those investments or the cost of transitioningto a private system.

However, a closer examination of each of thesefactors suggests that they are either incorrect ornot relevant to comparisons of returns betweenindividual accounts and Social Security. Forexample, although it is difficult to project futureequity returns, the Social Security Administration’sestimate of a 6.5 percent average annualreturn to equities is well within the range of reasonablefinancial estimates. Indeed, it may evenbe low by historical standards. Moreover, returnsto private investment through individual accountsshould not be risk adjusted. Although investors doconsider risk in making investment decisions, thatfactor is better handled through the use of diversifiedportfolios than through the arbitrary reductionof expected returns. Finally, although thedesign of transition financing will affect netreturns to individual accounts, it is possible todesign a transition that does not reduce thosereturns. Therefore, it is not necessary to reducereturns to compensate for transition costs.

A fair comparison, therefore, shows that asystem of private investment will in fact providesignificantly higher rates of return than thecurrent Social Security system, which meansthat the vast majority of younger workers wouldbe better off switching to such a system.

Download the Social Security Choice Paper

ssp31.pdf

Michael D. Tanner

Michael Tanner is director of the Cato Institute’s Project on Social Security Choice and coauthor of A New Deal for Social Security (1998).