Behind the Numbers: The Privateers' Free Lunch

Behind the various proposals for privatizing Social Security,
in whole or in part, is one seductive assumption. By investing
their savings individually in financial markets, rather than collectively
relying on the Social Security system, workers supposedly will
get a greater return. This premise is the basis of the proposals
by two factions of the Social Security Advisory Council for government-mandated
individual savings. It seems a reasonable belief, particularly
given the stock market's stellar growth in recent years.

But it turns out the claim is based on inconsistent assumptions
about economic growth and stock market returns. The Social Security
Advisory Council's own projections of growth are far too pessimistic
to justify the projections for the stock market. An accurate comparison
of all the costs and returns of private savings plans with the
costs and returns of the existing Social Security system shows
that a mandated savings plan, in which retirees invested their
money individually, would simply not generate higher retirement
income than the present Social Security system.

First, here is a quick primer on the relationship between
corporate profits and the stock market: A shareholder's return
on an investment comes in two parts—dividend payments and the
rise in the price of the stock. Ultimately, both sources of return
depend on the profits per share, since dividends depend on a company's
profits and stock prices depend on a company's ability to generate
future profits. Thus the rise in the value of the market through
time closely reflects the growth in average corporate earnings.

Assuming that labor's share of national income does not change,
profits will grow at the same rate as the economy as a whole.
In the Social Security trustees' "intermediate scenario,"
the standard basis for policy projections, the growth rate through
2005 will average 2 percent a year. It slows to just 1.3 percent
by the year 2020. The average over the whole 75-year period is
projected at just under 1.5 percent.

Those growth figures suggest the likely returns to shareholders
over the next 75 years. As noted, an investor's total return is
a combination of dividend payouts plus stock price increases.
At present, the average price-to-dividend ratio of all stocks
averages 34.8 to 1. This implies a return in dividend payouts
equal to 2.87 percent of an average stock's price. Adding 2.87
percent to projected economic growth rates we find that total
investment return, including both dividends and stock price growth,
averages 4.36 percent a year over the 75-year planning horizon.

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This is where the privateers' case starts to fall apart. Members
of the same Social Security Advisory Council who support privatization
assume a total annual return to stockholders of 7 percent. When
you consider the effect of compounding, the difference in the
two assumptions is dramatic: If the stock market yields an average
return of 7 percent, as the council assumed, $1,000 will grow
to nearly $15,000 after 40 years. But if the expected return is
4.36 percent, as seems more reasonable, it will only grow to $5,530.

How did the council come up with such an optimistic figure? Like
most other conventional analyses, it reflects simple extrapolations
from the past—rather than the council's own projections of the
future. Over the last 75 years, the average real return for stockholders
was close to 7 percent. But that reflected an economic growth
rate of approximately 3.5 percent. However if, as the trustees
project, growth over the next 75 years averages less than 1.5
percent—a decline of more than 2 percentage points—stock price
growth will also decline by roughly 2 percentage points.

Also, the recent steep run-up in stock prices has put prices well
beyond what seems reasonable for the dividends they are paying
out. Over the past 18 years the price of an average share of stock
has risen from just 9 times annual earnings to more than 20 times
earnings. The current dividend-to-price ratio of 2.87 percent
is nearly a full percentage point below the average of 3.65 percent
over the period from 1959 to 1995.

If the projections of overall economic growth in the trustees
report are accurate, the only way the stock market can generate
higher returns than the intermediate-range projection of 4.36
percent over 75 years is if the ratio of share price to company
earnings rises to astronomical levels. For the stock market to
yield the 7 percent the council assumes it will, the price-to-earnings
ratio would have to hit 34 to 1 in 2015, and 485 to 1 by the end
of the planning horizon in 2070, assuming that profits and dividend
payouts grow in tandem with the economy as a whole.

Constant, accelerating increases in stock prices are not altogether
unthinkable—for limited periods of time. The history of capitalism
is marked with speculative bubbles of this sort dating from the
tulip bulb mania in seventeenth-century Holland and the South
Sea Bubble in eighteenth-century England to the run-up of stock
prices in the United States in the 1920s and Japan in the 1980s.
In each of these cases, speculation led investors to bid up the
price of stocks, well beyond the prices that reflected their actual
value—just as commentators as mainstream as Alan Greenspan suggest
is happening in the United States today.

Eventually, however, such bubbles inevitably burst and prices
come crashing down to the point where they reflect underlying
values. Assuming such a correction does occur sometime in the
next 75 years, it's highly unlikely that the prices of stocks
would continue to be so out of synch with corporate earnings.
And unless there is some magical way for corporate earnings to
outpace overall growth, then we're stuck with a rate of return
way below what the council had in mind. Retirees in the mid-twenty-first
century would be far worse off than the council predicts.

The only other way to generate higher market returns would
be for profits to come at the expense of wages—in other words,
stockholders would make more money and workers would make less.
In this generally labor-unfriendly political climate, such a shift
might not seem unlikely. But consider just how large the shift
would have to be. To allow 7 percent shareholder returns, assuming
a constant price-to-earnings ratio, the change in wages would
have to be 37 percent below their current growth path in the year
2035. By 2055, real wages would have to be 82 percent lower than
their projected level in the intermediate scenario—and by 2070
wages would actually be negative! Even a stock market return of
only 6 percent would need to be supported by an 18 percent reduction
in wages by the year 2035.


Keep in mind that we are talking here about average returns. In
any given year, some stocks will do better, some worse. And some
individuals will retire at a point where the market has just taken
a sharp downturn. From 1968 to 1978, the stock market fell by
44.9 percent in real terms. People who retired in the late 1970s
and financed retirement from stock sales had a return well below
the historic market average. Moreover, some individuals, with
bad judgment or bad luck, will end up with stocks that significantly
underperform the market.

There is one more big correction: brokerage fees and commissions.
According to an analysis done for the Social Security Advisory
Council, on average these costs would be just 1 percent of the
value of equities in personal savings accounts, which doesn't
sound all that bad. But in fact, the real cost may be significantly
higher. Brokerage fees on a normal mutual fund cost around 1.5
percent annually. Add to this the cost of the extra regulation
necessary for these government-mandated accounts, and total administrative
expenses become 1.94 percent of equity. In smaller accounts, the
administrative costs would exact an even higher percentage. Insurance
adds yet another cost—an additional 0.10 percent or more to the
cost of administering the funds. Precisely estimating the fees
for the accounts is difficult: For our purposes, we can assume
that the annual fees will be 2.5 percent for a low-wage worker
($12,000 a year), 2 percent for a middle-income worker ($25,000
per year), and 1.5 percent for a high-income worker ($50,000 per

There are exceptional funds, such as the nonprofit Teachers Insurance
and Annuity Association College Retirement Equities Fund (TIAA-CREF),
whose expenses are considerably lower than the average. In principle,
it is possible that strict government regulation could push the
industry costs down to TIAA-CREF levels. However, this would likely
require a confrontation with the financial industry, for whom
these expenses are a way to make money—and it seems unlikely that
Congress and the President would have the political will to do

To further refine our projection of retirement income,
we should also take into account how investors would divide their
holdings between stocks and other assets. The calculations prepared
for the Social Security Advisory Council assumed that 50 percent
of holdings would be in stocks and 50 percent in bonds, which
is roughly how people with 401(k) retirement accounts divide their
assets today. This is a reasonable enough assumption for projecting
average returns, but it is important to note that many workers
at present opt for much more conservative allocations, which involve
holding little or no stock. This reduces risk—but it also lowers
the expected return.

In the trustees' intermediate projections, the expected annual
return from holding bonds is 2.3 percent. Holding bonds through
a bond fund incurs its own expenses: For this analysis, we can
assume that low-income workers pay fees averaging 1.2 percent
of their bond holdings, middle-income workers pay fees averaging
1 percent, and high-income workers pay fees averaging 0.8 percent.


Now, finally, we can see what privatization would actually mean.
The table below, "Privatization: Unhappy Returns," demonstrates
how workers with mandated savings accounts would fare, given the
returns and holding costs for stocks and bonds outlined in this
article. The table also shows the wage that each worker can be
expected to have in their last year of work. The returns range
from 2.2 percent for high-income workers in the optimistic scenario
to just 0.8 percent for low-income workers in the pessimistic


Lifetime Accumulations
Final WageLow ReturnMid ReturnHigh Return
Low Income18,77842,97345,76748,356
Middle Income39,12095,754103,621109,661
High Income78,240208,006225,630239,162
Average Net Returns
Low ReturnMid ReturnHigh Return
Low Income0.79%1.21%1.50%
Middle Income1.14%1.56%1.95%
High Income1.49%1.91%2.20%

The other table, ("Dwindling Pensions") shows
the number of years these sums would support a worker in retirement,
assuming retirement incomes that are respectively 30 percent,
50 percent, and 70 percent of the final year's wage. In the high-return
scenario, the accumulation would be sufficient to support a low-income
worker at 30 percent of their final pay for nine-and-a-half years.
It would support a high-income worker at a 30 percent level for
eleven-and-a-half years. At a 50 percent replacement ratio (the
ratio of retirement income to the worker's final salary), a low-income
worker would have support for 5.5 years and a high-income worker
for 6.6 years. In the low-return scenario, a low-income worker
could only be supported at 30 percent level for 8.2 years, and
a high-income worker for 9.8 years.


Percentage of
Final Wage
Years of Retirement Income
Low Return
Low Income8.24.83.4
Middle Income9.05.23.7
High Income9.85.74.0
Middle Return
Low Income8.95.23.6
Middle Income9.85.64.0
High Income10.76.24.3
High Return
Low Income9.55.53.8
Middle Income10.46.04.2
High Income11.56.64.6
Assumes 2% real return after retirement.
Source: Author's calculations.

According to the trustees, in the year 2040 life expectancy past
age 65 will be 17.2 years for men and 20.9 years for women. Thus
the replacement ratio that could be supported through a 19-year
retirement ranges from 19 percent, in the case of a high-income
worker in the optimistic scenario, to just 14 percent in the case
of a low-income worker in the pessimistic scenario. Putting this
in dollar terms, the replacement ratio for a high-income worker
in the optimistic scenario implies that a worker earning $50,000
a year at the time of their retirement would have a retirement
income of $9,500 per year. The replacement ratio for a low-income
worker in the pessimistic scenario implies that a worker earning
$12,000 at the time of retirement would receive just $1,680 annually.

By comparison, Social Security pays the low-income worker an annual
income equal to 56.7 percent of their final wage. The middle-income
worker would receive 43.9 percent, and the high-income worker
would get 31.4 percent.

It is true that these numbers do not provide a direct basis of
comparison between the two programs since the current Social Security
program will need some modest combination of tax increases and
benefit reductions to remain solvent. Also, most mandated savings
proposals provide for a poverty-level benefit of approximately
$5,000 a year to be paid in addition to whatever money is privately
accumulated. On the other hand, the tax increases specified under
the mandated savings proposals are approximately the same magnitude
as the increases that would be needed to keep Social Security

Yet another important factor in evaluating alternatives is that
Social Security provides its payout in the form of a real valued
annuity, a payment that continues for the life of the worker and
is not diminished by inflation. Annuities are very costly in the
private market, and insurance against inflation is generally unobtainable.
Therefore, for workers seeking a secure retirement, the dollar
sums provided by Social Security significantly understate the
true value of the benefit.

The bottom line is this: When all the correct projections
and assumptions are made, the data show that the accumulations
a privatized system would generate could not sustain a worker
at an income equal to even 30 percent of his or her final wage
for more than 12 years. Even in the most favorable scenario, a
worker can only expect to earn 20 percent per year of what he
or she earned in his final year of employment for the duration
of his retirement.

Of course, it's possible that the council is being too pessimistic
about future growth. But if the economy were to grow at its historic
3.5 percent rate, Social Security revenue would rise and the Social
Security accounts would be much closer to balance—leaving no actuarial
crisis to justify the call for privatization.

Some advocates of government-mandated saving insist that growth
will in fact increase—precisely their new program. Higher rates
of saving will produce higher rates of investment, and hence higher
growth. But shifting Social Security taxes into mandated savings
accounts will not increase the total supply of savings. Despite
this knowledge, many economists have accepted the simple premise
that such a system can generate higher returns for retirees because
of the superior yields of the stock market. But simple arithmetic
proves otherwise. The projections for the stock market are plainly
inconsistent with the projections for growth.

Advocates of privatization frequently accuse their opponents of
ignoring the fiscal realities of Social Security's solvency crisis.
But before the privateers convince America that their path to
reform is the right one, they might want to check their own arithmetic.
There is no free lunch.

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