March 9, 1999

Individual Accounts and Social Security:
Does Social Security Really Provide a Lower Rate of Return?

Executive Summary
by Peter Orszag(1)

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Proponents of individual accounts often compare the potential rate of return on such accounts to the rate of return on Social Security contributions. They conclude that workers would enjoy a higher rate of return under a system of individual accounts.

For example, the commentator James Glassman has noted, "Returns to the investment portion of Social Security are extremely low. For persons born in 1960, returns are estimated at between 1 percent and 2 percent in real (inflation-adjusted) terms…By contrast with Social Security, the real returns to large-capitalization stocks between 1926 and 1997 have averaged 7.2 percent."(2)

Despite its apparent plausibility and widespread use by many proponents of individual accounts, this simple rate-of-return comparison is misleading. In a recent and important set of papers, economists John Geanakoplos, Olivia Mitchell, and Stephen Zeldes demonstrate that the comparison is fundamentally flawed because these two rates of return are not comparable.(3) Their papers demonstrate that when analytically accurate comparisons are undertaken, the widely trumpeted gaps between rates of return for individual accounts and returns for Social Security contributions essentially disappear. They write: "A popular argument suggests that if Social Security were privatized, everyone could earn higher returns. We show that this is false...the net advantages of privatization and diversification are substantially less than popularly perceived."(4)

This conclusion is not ideologically motivated. At least one of the co-authors of these papers, Olivia Mitchell, is a supporter of individual accounts. The papers are not a product written by individuals who oppose such accounts and set out to weaken the case for them. Furthermore, other economists — including quite conservative ones — have reached the same analytic conclusions as Geanakoplos, Mitchell, and Zeldes.(5)

Research show that when analytically accurate comparisons are under-taken, the widely trumpeted gaps between rates of return for individual accounts and rates of returns for Social Security contributions essentially disappear.

The Geanakoplos, Mitchell, and Zeldes papers highlight the flaws in the simple rate of return comparison. The findings and implications of their analysis include:

In summary, the simple rate-of-return argument that many proponents of individual accounts use is biased. It either mistakenly counts the cost of Social Security benefits that must be paid to current retirees as costs only under Social Security and not under a system of individual accounts or it inappropriately compares the return on additional funding for individual accounts to the return on existing contributions to Social Security (or commits both errors). Such arguments also usually ignore differences in administrative cost and risk, both of which are higher under individual accounts than under Social Security.

As an example of how the rate-of-return differential between Social Security and individual accounts is more apparent than real, consider the report of the 1994-1996 Advisory Council on Social Security. The members of the Advisory Council were unable to reach agreement on the role of individual accounts. The Council split into three factions, each with a significantly different set of recommendations regarding individual accounts:

The three plans thus adopted very different approaches to individual accounts, from no individual accounts (under the Maintain Benefits plan) to relatively large individual accounts (under the Personal Security Accounts plan). The simple rate-of-return comparison — which emphasizes that the historical rate of return on the stock market is substantially higher than current and future rates of return on Social Security contributions — would suggest that these plans should produce significantly different rates of return.

But despite the sharply different treatment of individual accounts in the three proposals, their estimated rates of return are very similar. Consider, for example, an average two-earner couple born in 1997. According to projections made by the Social Security actuaries and published in the Advisory Council report, the real rate of return for such a couple would be:

To those who are accustomed to using the simple rate-of-return comparison and who assume individual-accounts plans produce a much higher rate of return, these results must come as a shock. Yet the similar rates of return across plans with very different approaches to individual accounts, especially when the returns are adjusted for differences in risk, is precisely what one should expect when the analysis is undertaken in a rigorous manner.

Individual accounts have a wide variety of costs and benefits, all of which deserve careful scrutiny in the current debate. But the simple rate-of-return comparison promoted by some advocates of individual accounts confuses rather than informs the debate.


1. Dr. Peter R. Orszag is President of Sebago Associates, Inc., an economics consulting firm, and lecturer in economics at the University of California, Berkeley. He previously served as Special Assistant to the President for Economic Policy and as Senior Economist on the Council of Economic Advisers from 1995 to 1998. He is conducting work for the Center on Budget and Policy Priorities on Social Security issues.

2. James Glassman, "Can Americans Handle Their Own Retirement Investing Choices?" Testimony before the Committee on Commerce, U.S. House of Representatives, July 24, 1998, page 1.

3. John Geanakoplos, Olivia S. Mitchell, and Stephen P. Zeldes, "Would a Privatized Social Security System Really Pay a Higher Rate of Return?" in R. Douglas Arnold, Michael J. Graetz, and Alicia H. Munnell, eds., Framing the Social Security Debate: Values, Politics, and Economics (Brookings Institution Press: Washington, 1998), also available as NBER Working Paper Number 6713, August 1998; and John Geanakoplos, Olivia Mitchell, and Stephen P. Zeldes, "Social Security Money's Worth," available as NBER Working Paper Number 6722, September 1998, and in Olivia S. Mitchell, Robert J. Myers, and Howard Young, Prospects for Social Security Reform (University of PA Press: Philadelphia, 1999)

4. Geanakoplos, Mitchell, and Zeldes, "Social Security Money's Worth," op.cit., pages 2-3.

5. As one example, Kevin Murphy and Finis Welch argue that "many of the touted gains to privatization are more apparent than real, and any gains have more to do with the details of what is done (whether private or public) than with privatization per se." Kevin Murphy and Finis Welch, "Perspectives on the Social Security Crisis and Proposed Solutions," American Economic Review, May 1998, page 142.

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