Social Security Overhaul Plan Leans on a Bullish Market

For Immediate Release:

February 28, 2005


By Mark Whitehouse

The Wall Street Journal

IN SELLING THE idea of private Social Security accounts to Americans, President Bush has repeatedly made a bullish prediction: The stock market will help younger workers get a "better deal" than they would from traditional Social Security.

A number of prominent economists have two problems with Mr. Bush's pitch. First, they say it's too optimistic about the long-term prospects for stocks. Second, it ignores an irrefutable rule of finance: There is no free lunch. Or, put another way, greater returns bear greater risks.

"You can't just sort of invent free return," says William Dudley, chief U.S. economist at Goldman Sachs Group Inc. in New York. "If it was that easy, you wouldn't have a Social Security problem in the first place."

President Bush says that, under his plan, workers who opt for private accounts will be better off than peers who stick with traditional Social Security, as long as the stock and bond mutual funds in the private accounts earn an annual return of three percentage points above inflation. Social Security officials' forecasts for the long-term returns on stocks and bonds make a desirable outcome look highly likely. The program's actuaries predict that over the period of a typical American's career, or 44 years, stocks would return an average of 6.5%, corporate bonds 3.5% and government bonds 3%, all in "real" terms -- that is, after inflation.

Under the actuaries' assumptions, the required portfolio for the personal accounts -- 60% stocks, 24% corporate bonds and 16% government bonds -- would produce a net real return of 4.93%, after a 0.30% management fee. For a 21-year-old entering the work force in 2011, with an average lifetime wage of $57,548 a year, the extra 1.93% return would add up to $133,447 by age 65, according to a model built by Jason Furman, a New York University economist.

Problem is, the forecasts raise some serious doubts -- to say nothing of conflicts. For example, there is that assumption of a 6.5% annual return on stocks. By contrast, the actuaries' prediction that the Social Security system will become unable to pay full benefits in 2042 assumes that the economy will grow at a rate of 1.9% a year between now and then -- a tepid pace that would be unlikely to produce stock-market returns of nearly 6.5%. Many economists are critical of the idea that stock returns can be so high relative to gross domestic product growth. "That stretches the imagination," says David Rosenberg, chief U.S. economist at Merrill Lynch & Co. in New York.

The long-term return on stocks comes from two main sources: growth in corporate earnings and payouts to shareholders, which include dividends and share buybacks. Earnings tend to grow in line with the economy, which means that 1.9% GDP growth typically would produce 1.9% earnings growth. Add to that dividends, which in recent years have averaged about 1.7% of a stock's price, and buybacks, which have averaged about 1%, and the total real return for stocks comes to about 4.6%. Most economists who predict higher stock returns assume higher GDP growth as well.
Administration officials, and economists who support the official forecasts, offer various explanations for the leap to 6.5%. The first is history: From 1802 through 2004, the real return on stocks has averaged 6.8%.

Beyond that, says Jeremy Siegel, a professor at the University of Pennsylvania's Wharton School, two factors can drive future returns. First, companies might experience faster earnings growth because they choose to invest in their businesses instead of paying dividends -- an idea supported by the fact that stocks' current dividend yield of 1.7% is low compared with an average of 5% from 1871 to 1980. Second, U.S. companies can benefit from higher GDP growth in the developing countries where they operate. Together, these factors will help real stock returns reach 6%, says Mr. Siegel, who has written a book on the subject called "Stocks for the Long Run."

Still, corporate earnings can't grow faster than the economy forever. If they did, "then gradually income from the economy would be completely absorbed by the stock market," says Ethan Harris, chief U.S. economist for Lehman Brothers in New York. As for historical stock returns, they have come largely from an increase in share prices compared with earnings, a trend that economists don't expect to continue. The price/earnings ratio today stands at more than 20, compared with a historical average of about 16.

Looked at another way, a P/E ratio of more than 20 means that the market expects stocks to yield less than 1/20 of their price, or less than 5%. That is easier to reconcile with the Social Security actuaries' GDP forecast, and comes very close to 4.81% -- the average estimate among 10 economists polled for this article.

Plugged into the personal-account portfolio, the economists' average forecasts -- 4.81% for stocks, 3.33% for corporate bonds and 2.80% for government bonds -- produce a return of 3.84% after management fees. For the same 21-year-old entering the work force in 2011, that extra return would add up to $48,890 by age 65.
That might look like a good deal. But it ignores the difference in risk between the traditional Social Security plan and investing in a portfolio of stocks and bonds. Under the most recent Social Security-overhaul plan, people who invest in personal accounts will be forgoing a guaranteed 3% real return. That is also the offset rate the government will use to reduce traditional benefit payments coming to those who opt for private accounts.

By contrast, there is no way of knowing exactly what the return on a personal account will be. "If you go into stocks you may outperform, but when you fall short that may hurt a lot," says Mr. Siegel, who supports the idea of private accounts.
The only way to avoid market fluctuations is to invest in a so-called risk-free asset such as inflation-protected Treasury bonds, or TIPS. But at their current yield -- about 1.8% -- TIPS would guarantee a loss.

So unless the government lowers the offset rate or real interest rates increase significantly, personal accounts strike many economists as a poor deal on a risk-adjusted basis. "Would a rational investor borrow funds at a 3% real rate to invest in order to earn a 11/2%-2% real rate?" asked Mr. Dudley of Goldman Sachs in a recent research note. "We doubt it."