The Transition to Investment-Based Social Security when Portfolio Returns and Capital Profitability are Uncertain

Abstract

In this paper we study the transition from a pay-as-you-go system of Social Security pensions to an investment-based system in an economy in which portfolio returns and capital profitability are both uncertain.The paper extends earlier studies by Feldstein and Samwick (1997, 1998a,b) that modeled the transition process in a nonstochastic environment and by Feldstein and Ranguelova (1999) that examined the implication of portfolio risk after the transition to an investment-based system has been completed.Our analysis shows that contributions to Personal Retirement Accounts (PRAs) that are less than one-third of the projected pay-as-you-go (PAYGO) tax rate can eventually finance annuity payments that exceed the officially projected level of future Social Security pensions with very high probability.The remaining moderate level of retiree risk can be completely eliminated by a government guarantee that can be provided with very little risk to taxpayers.Although the transition to a pure investment-based system is the natural case to analyze, we also consider a more realistic policy of a transition to a mixed system which in the long run is one-third investment-based and two-thirds pay-as-you-go; this is the stochastic extension of the study by Feldstein and Samwick (1998b).It corresponds to a policy of maintaining the current payroll tax 1 A tax-financed defined benefit plan is of course also subject to the political risk that benefits will be reduced by legislation.See McHale (1998). 5Transition.022699 expected utility function evaluations in section 6 for the basic PRA plans with and without government guarantees.Sections 4, 5 and 6 focus on the transition to a system that is completely investmentbased, i.e., that has completely eliminated any PAYGO component.Analyzing this limiting case provides a useful benchmark because it involves more risk than a mixed system that permanently combines defined benefits financed by government revenue with investment-based PRA annuities. 1 But as a practical matter, the public policy interest in the United States (as well as in Sweden, Australia and elsewhere) focuses on a mixed system that combines pay-as-you go and investmentbased elements.In section 7 we analyze a mixed system in which the PAYGO component in the long run provides a benefit equal to about two-thirds of the projected "benchmark" benefit.We focus on this level of defined benefit because the PAYGO tax required to pay such a benefit is approximately equal to the current 12.4 percent payroll tax.Since preventing an increase in the payroll tax or a decease in projected benefits is a stated goal of current U.S. public policy, this is a particularly interesting case to consider.We begin our analysis of this mixed system in section 7 with the assumption that there is no additional guarantee to retirees, i.e., that they are guaranteed to receive the benefits that can be financed with a 12.4 percent payroll tax but bear the risk of the uncertain return associated with the PRA annuities.We then consider the implications of adding a conditional PAYGO benefit of the type considered in section 5. The Social Security Simulation Model

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