The Three Percent Solution?
By Arnold Kling
This briefing on the Administration’s proposals for Social Security personal accounts cleared up a number of issues, such as the way that accounts would be administered and the type of investment options available. In both cases, the Federal Employees’ Thrift plan was used as a model.
However, the briefing created some confusion concerning how to adjust Social Security benefits for people who choose to divert some of their payroll taxes into the accounts.
Suppose that worker B chooses to stick with the current system, and worker A chooses to put 30 percent of her payroll taxes into a personal account. Then the logical outcome should be that when they retire worker A gets 30 percent less in retirment benefits than worker B.
That logical outcome can be easily calculated if A and B make permanent decisions at the start of their working lives. But what if worker A only decides at age 45 to use a personal account? Or what if personal accounts were not available historically to worker A, who is now 45 years old and has that opportunity?
In order to adjust worker A’s benefits to make them fair relative to worker B’s benefits, some sort of interest rate or discount factor is going to have to be applied that equates the benefits that A foregoes at retirement to A’s choice to put money into personal accounts when she works. Here is what the briefing says about this:
in return for the opportunity to get the benefits from the personal account, the person foregoes a certain amount of benefits from the traditional system.
Now, the way that election is structured, the person comes out ahead if their personal account exceeds a 3 percent real rate of return, which is the rate of return that the trust fund bonds receive. So, basically, the net effect on an individual’s benefits would be zero if his personal account earned a 3 percent real rate of return. To the extent that his personal account gets a higher rate of return, his net benefit would increase as a consequence of making that decision.
The choice of interest rate involves a trade-off. The lower the interest rate that the Administration and Congress select, the more profitable it will be for individuals to select private accounts. On the other hand, the higher the interest rate that they select, the more fiscally conservative will be the transition to personal accounts.
If the Administration were to choose any interest rate above zero, then they become open to Paul Krugman’s charge that
people are expected to take a loan from the government and use it to buy stocks, and if that turns out to have been a mistake – well, too bad.
Experts usually tell people to plan for their retirement by investing in a mix of stocks and bonds. They disapprove strongly of speculation on margin: borrowing to buy stocks. Yet Mr. Bush wants tens of millions of Americans to do exactly that.
On the other hand, if the interest rate were less than 3 percent, then the “actuarial scoring” of the personalization plan would show that it increases the deficit.
I think that I would have opted for a lower interest rate. I would rather err on the side of giving personal accounts a generous return, and let the “actuarial scoring” take the hit. I think that the real interest rate of 3 percent is too high. I would have picked 2 percent, or perhaps even a lower number, and I think this could be justified on the basis of historical real returns on long-term bonds. Furthermore, the most recent calculation of the yield on inflation-indexed government bonds by J. Huston McCulloch is about 2 percent.
In any case, it strikes me as elementary economics that some sort of interest rate has to be used in the calculation. If Paul Krugman and Peter Orszag want to imply otherwise, then they ought to not to represent themselves in the media as economists.
For Discussion. Should the interest rate be fixed permanently by legislation, be variable based on a formula, or be set periodically be some sort of board?