Individual Accounts: What Rate of Return Would They Earn?

Publication Date: July 2005

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Economics

Type:

Abstract:

It has been proposed to add individual accounts to Social Security in which investors could hold private securities. Calculations that project the earnings of individual accounts typically presume that they will earn a rate of return equal or close to the historical rate of return. But is there evidence that future rates of return will differ from history in predictable ways?

Since the mid-1990s, equity (stock) prices have been consistently above the historical norm in relation to corporate earnings and dividends. This implies that future rates of return would be below the historical average unless future earnings and dividends grow more quickly than they have been. One reason why current stock prices may be higher and future rates of return might be lower is because of a decline in the equity premium, which is the difference in rates of return between stocks and bonds that investors require to be willing to bear the additional risk of equities. Increasing rates of stock ownership and accessibility for the average investor have suggested to some that the equity premium may have fallen.

The projected decline in the growth of the labor force would reduce the economic growth rate, all else equal. Slower growth in the economy is likely to mean slower growth in corporate earnings, which could lower the rate of return. Ultimately, rates of return are determined by the equilibrium between saving and investment. Many have predicted that the saving rate will decline as the baby boomers begin to draw down their savings to finance their retirement. But at the same time, investment demand is likely to grow more slowly because of the decline in the growth rate of the labor force. If the growth in saving declines more quickly than the growth in investment, rates of return would rise. But the opposite is equally plausible and would lead to lower rates of return.

Under current policy, budget deficits would become much larger in the future, and this would be expected to increase rates of return as deficits "crowd out" private investment. Individual accounts could also influence the national saving rate. If they are deficit-financed, then public saving would fall and private saving would rise, leaving public saving -- and, hence, rates of return -- unchanged. If they are financed through higher taxes or lower spending today, then national saving would rise, and rates of return would fall. However, even if individual accounts left national saving and overall rates of return unchanged, they could push up the demand for stocks, thereby lowering their rate of return, while increasing the supply of U.S. Treasuries, thereby raising their rate of return.

Comparing the rates of return of equities and other securities directly is analogous to comparing apples to oranges. Standard risk adjustment techniques would set the rate of return on equities equal to U.S. Treasuries. This is the only way that a risky return can be directly compared to the risk-free Social Security benefit offsets that accompany the individual accounts. This report will not be updated.