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INVESTING RETIREMENT WEALTH: A LIFE-CYCLE MODELDuring the past few decades, American households have begun to display increasing financial sophistication and awareness of rates of return on alternative investments. At the same time the implicit rate of return on contributions to the Social Security system has declined as the system has matured; and this rate of return is projected to decline further in the 21st Century in response to unfavorable demographic trends (Geanakoplos, Mitchell, and Zeldes 1998). Unsurprisingly, politicians and the public have become interested in the possibility of moving to a privatized system in which retirement contributions earn market-based rates of return.
Unfortunately, it is not straightforward to compare alternative retirement systems. Three important issues affect the comparison and invalidate simple rate-of-return calculations. First, the return on the current system is low in part because of the overhang of unfunded liabilities. Past generations have received a gift that must be paid off before the economy can enjoy the steady-state benefits of any new system. Second, capital income taxation puts a wedge between pre-tax and after-tax rates of return. Welfare calculations should take account of the tax revenue generated by capital accumulation (in some systems, this tax revenue is forgiven and private retirement accounts earn higher pre-tax rates of return). Third, returns on alternative financial assets can differ if these assets have different risk characteristics. A valid comparison of rates of return must adjust for risk.
This paper focuses on the last issue, the evaluation of alternative investments with different risk characteristics. From the point of view of households, the current Social Security system represents a defined-benefit pension plan in which income realizations through life are tied to annuity payments in retirement. This is similar to a system in which households are forced to accumulate a riskless asset in a retirement savings account.
Some commentators have recently argued that households would be better off if their retirement savings were invested in risky assets such as equities that have a higher average return. This could be achieved within the present system if the Social Security trust funds were invested in equities; alternatively, within a privatized system, household retirement accounts could include equity investments. If a household can borrow to invest in equities, however, then the accumulation of riskless assets within a Social Security account need not restrict the household’s overall portfolio. The household can undo riskless Social Security accumulation by borrowing outside the retirement account; the household’s overall portfolio can be made just as risky as if the retirement account itself were invested in equities. Thus any claimed benefits for a change in the Social Security system must depend on the presence of portfolio constraints that prevent this sort of asset transformation.