A quick reminder of how the vague Social Security privatization proposal put forward by the White House is supposed to work. First, everyone's Social Security benefits get cut by 40 percent to bring the program into actuarial balance (this actually cuts benefits by too much, but the White House will need the extra money, as we'll see). Second, the U.S. lets workers divert their payroll taxes into private accounts, and borrows extra cash—$4.5 trillion over the next 20 years—to pay current retirees. Third, the U.S. reduced guaranteed benefits for younger workers even further when they retire, based on how much money those workers put into their private accounts. If your investments get better than a 3 percent return, then you'll earn enough to offset that second benefit cut upon retirement. If they do worse than 3 percent, then you lose.

Note what's involved here: benefit cut #1, a tax hike, and benefit cut #2.** That's important.

Anyway, the White House doesn't want these accounts to be too risky, so they've proposed that the government will handle all your money, and put them in relatively safe "life-cycle" accounts. But now Yale economist Robert Shiller is arguing that the vast majority of "life-cycle" portfolios are unlikely to do better than the necessary 3 percent:

According to U.S. historical rates of return, the life-cycle portfolio fell short of the 3 percent threshold 32 percent of the time, meaning nearly a third of personal account holders would have been better off sticking with the traditional Social Security system. The median rate of return was 3.4 percent....

But [Shiller] also adjusted for what he expects to be lower future rates of investment return by using historic rates of return from international stock and bond markets....The results were not encouraging: The life-cycle portfolio under these adjusted returns lost money compared with the traditional system 71 percent of the time, with a median rate of return of just 2.6 percent.

So 71 percent of private account holders will lose! Although, in truth, nearly everyone loses, and this 71 percent just happens to lose more than others. Refer to my description of the Bush plan above. Shiller's just pointing out that private accounts won't make up the losses from benefit cut #2 described above. But workers will also still suffer from benefit cut #1, and they'll also have to pay off higher taxes thanks to all the borrowing involved in the transition to privatization. So when you factor in all three components of the Bush plan, workers are getting not a 3.4 percent return or a 2.6 percent return, but much, much less.

Of course, the White House could ditch the whole "life-cycle" portfolio idea and let people invest in whatever they want. Then some people will get a high enough return to offset benefit cut #2. Though they'd have to do very, very well to also recoup losses from benefit cut #1 and the tax hike. And, of course, other people would do poorly and end up eating garbage.

**note that benefit cut #1 is bigger than what would be necessary if we did nothing to Social Security and merely cut benefits by enough to remain in long-term actuarial balance. The tax hike ($4.5 trillion over 25 years) is bigger than the tax hike necessary to repay the Trust Fund. How can this be? Well, privatization shifts the costs of generations far in the future onto current workers. To some extent, we're swapping debt tomorrow for debt today, and it all evens out. But that's not much consolation to the workers today who actually have to, you know, pay off that debt.

Continue reading "Many Unhappy Returns"