Social Security Reform: The Effect of Economic Variability on Individual Accounts and Their Annuities

Publication Date: February 2003

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Banking and finance

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Abstract:

Whether proposed as a supplement or as a replacement of part or all of Social Security, individual accounts are a major issue in the debate about reforming the program. The debate usually focuses on philosophical and budgetary issues about the nature of the program and its future role, and on how individual accounts could be financed. However, there is another issue that tends to arise late in the discussion: how would such accounts be disbursed? Because of concern that many recipients could exhaust their accounts and end up with inadequate income, it is often stipulated or suggested that individual accounts be converted into a lifetime annuity ? a stream of payments that continue for as long as the recipient lives.

Converting individual accounts into annuities, particularly ones that would duplicate Social Security's inflation protection, would create its own issues. Typically, an annuity's value is a function of the account assets, the expected lifetime of the annuitant(s), the rate of return, subsequent inflation, and administrative costs. Existing annuity arrangements usually set the rate of return at an interest rate that is fixed at the time of retirement, and almost never offer full inflation protection. Thus, the value of the annuity is subject to multiple variables, most of which depend on economic circumstances. This report examines the potential variability caused by economic conditions by projecting the value of annuities from individual accounts as a proportion of Social Security benefits promised under current law. It does so by duplicating the year-to-year economic conditions (wage and price growth, interest rates, and the return on the S&P 500 stock index) that occurred in the last 76 years. The annuities examined assume workers would pay 2% of their pay into individual accounts for periods of 10, 20, 30, and 41 years (41 years representing a full career).

The results show that the value of individual accounts is highly sensitive not only to investment performance during the accumulation phase but also, if converted to an annuity, to the rate of interest prevailing at the time of retirement. The greatest disparity in annuity values found in this study is for workers who invested entirely in stocks for 20 years. If the economic conditions were the same as in 1955-1974, their annuities would replace 5.7% of their Social Security benefit. However, if the economic conditions were the same as in 1980-1999, their annuities would replace 39.8% of their Social Security benefit, seven times as much. If, instead, workers invested throughout a full career, the maximum disparity would be less (a factor of 4.3, instead of 7). The degree of volatility would be lower if the interest rate for the annuity were variable instead of fixed. Adding bonds to the portfolio also would help to limit volatility in the values of the annuities, but over any appreciable period of time these values would be lower than those produced by an all-stock portfolio.

These results could be interpreted to support both sides of the privatization debate. Opponents could point out that the substantial volatility illustrates the risks and uneven treatment that individual accounts would impose on Social Security recipients. Supporters could claim that, even though there is volatility, in the large majority of cases individual accounts would provide workers with annuities that would be higher than what Social Security would provide under current law.