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 year).

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 it.

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 scenario.



Lifetime Accumulations
  Final Wage Low Return Mid Return High Return
Low Income 18,778 42,973 45,767 48,356
Middle Income 39,120 95,754 103,621 109,661
High Income 78,240 208,006 225,630 239,162
Average Net Returns
    Low Return Mid Return High Return
Low Income   0.79% 1.21% 1.50%
Middle Income   1.14% 1.56% 1.95%
High Income   1.49% 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
30% 50% 70%
Years of Retirement Income
Low Return
Low Income 8.2 4.8 3.4
Middle Income 9.0 5.2 3.7
High Income 9.8 5.7 4.0
Middle Return
Low Income 8.9 5.2 3.6
Middle Income 9.8 5.6 4.0
High Income 10.7 6.2 4.3
High Return
Low Income 9.5 5.5 3.8
Middle Income 10.4 6.0 4.2
High Income 11.5 6.6 4.6
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 solvent.

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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