Thursday, March 24, 2005

Social Security reform to be reformed?

The White House is considering lowering the interest rate used for the benefit offset in its Social Security proposal, the Wall Street Journal reports today.

And well the White House should!

Under its original proposal private accounts would be beneficial only to the extent that investments in them earn more than 3% a year above inflation -- which is assumed to be the rate that will be paid on Treasury bonds. The idea is to prevent the government from losing money on bonds issued to finance current Social Security expenditures when the taxes that otherwise would do so are diverted to private accounts.

But both history and logic say this 3% rate is too high. As noted in a previous post, from 1946 until 2004 the average annualized real return on long-term Treasuries was barely over half that -- less than 1.6%, according to Ibbotson, Jeremy Siegel of Wharton says, "three percent is way too high", and Bill Gross of Pimco (often called the 'Warren Buffett of bonds') says that to get a 3% real return on bonds "you would have to invest in Mexico or Russia".

The 1.4 percentage point difference is no small deal. If you invest at an even rate over 40 years an interest rate that's that much higher increases your final balance by about one-third.

Thus, to overcharge private account holders by that much would be really costly -- turning private accounts into potential money losers, making them so unattractive as to possibly sink the whole scheme.

As the Journal story notes:
... many outside experts say 3% is too high, and will limit the accounts' appeal. They noted Treasury bonds are now expected to return only about 2%, and stocks a few percentage points more. Thus, a private account of half stocks and half bonds would run a significant risk of returning less than 3%, leaving the account-holder worse off than someone who stuck with the traditional benefit.
Indeed. And the other side is already coming out with calculators and papers highlighting exactly this fact.

Even the White House's own Social Security Reform Commission, upon whose analysis the White House's current proposal is based, used a 2% offset in its analysis.

So why did the White House people pick 3% as their offset number?
... the administration picked 3% because Social Security actuaries estimate that figure to be the government's long-term cost of borrowing.
But as we noted in the earlier post, the actuaries say they've done this on the basis of bond returns since 1980 -- which was nearly the exact start date of an historic bull market in bonds, as rates fell from the historic high double digits of the oil crisis years to 2004 historic lows, and bond prices rose accordingly.

It is mathematically impossible for that to happen again from today's low rates. And note -- that period of historic high returns was needed to get the average return from 1946 to 2004 up to 1.6%. So logically, other things being equal, future returns from bonds should be even less than that.

It is hard to overstate the political bungle here. If the White House keeps the offset where it is, the private accounts proposal risks self-destructing. But if it lowers the offset rate towards a more realistic 1.6% or 2%, you know for sure that Paul Krugman and his kin will lead a charge proclaiming that by disregarding the actuaries' 3% projection for future bond returns the White House is willingly leading the government down the road to national bankruptcy -- notwithstanding how they themselves debunk the actuaries' projection of 6.5% future stock returns at every opportunity.

Nevertheless, the White House has to bite the bullet here, and it is good to see it finally getting around to doing so. And what new offset rate is the White House considering?
A former administration official says a change to the offset rate to between 2% and 3% has been discussed, with special attention on 2.7%.
From 3% down all the way to 2.7%? Aiieeee!

Karl Rove, call your office and start getting evil!