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

October 28, 2003 • Social Security Choice Paper No. 31

Advocates of reforming Social Security by allowing workers to privately invest a portion of their Social Security taxes through individual accounts have long argued that private investment would provide a higher rate of return and, therefore, higher retirement benefits than Social Security. After all, in any dynamically efficient economy the return to capital will exceed the return that can be generated by a labor‐​based system such as Social Security. Recently, however, some critics have suggested that that analysis is wrong. Among other things, they suggest that future returns to equity investment are likely to be far below historical rates of return. They also suggest that studies predicting higher returns for private investment do not adequately reflect the risk and administrative costs of those investments or the cost of transitioning to a private system.

However, a closer examination of each of these factors suggests that they are either incorrect or not relevant to comparisons of returns between individual accounts and Social Security. For example, although it is difficult to project future equity returns, the Social Security Administration’s estimate of a 6.5 percent average annual return to equities is well within the range of reasonable financial estimates. Indeed, it may even be low by historical standards. Moreover, returns to private investment through individual accounts should not be risk adjusted. Although investors do consider risk in making investment decisions, that factor is better handled through the use of diversified portfolios than through the arbitrary reduction of expected returns. Finally, although the design of transition financing will affect net returns to individual accounts, it is possible to design a transition that does not reduce those returns. Therefore, it is not necessary to reduce returns to compensate for transition costs.

A fair comparison, therefore, shows that a system of private investment will in fact provide significantly higher rates of return than the current Social Security system, which means that the vast majority of younger workers would be better off switching to such a system.

Media Name: ssp31.jpg

Download the Social Security Choice Paper

About the Author