Rates of Return on Private Accounts

Paul Krugman suggests:
Schemes for Social Security privatization, like the one described in the 2004 Economic Report of the President, invariably assume that investing in stocks will yield a high annual rate of return, 6.5 or 7 percent after inflation, for at least the next 75 years. Without that assumption, these schemes can't deliver on their promises. Yet a rate of return that high is mathematically impossible unless the economy grows much faster than anyone is now expecting

To get a 6.5 percent rate of return, you need capital gains: if dividends yield 3 percent, stock prices have to rise 3.5 percent per year after inflation

The actuaries predict that economic growth, which averaged 3.4 percent per year over the last 75 years, will average only 1.9 percent over the next 75 years....But privatizers need that high rate of return (6.5%) for 75 years or more.

It really is that stark: any growth projection that would permit the stock returns the privatizers need to make their schemes work would put Social Security solidly in the black.


Estimating the Real Rate
of Return on Stocks
Over the Long Term (commisioned by the SS Advisory Board)
in the historical data summarized by
Siegel, there is strong evidence that the stock market is mean-reverting. That is, periods of
high returns tend to be followed by periods of lower returns. This suggests that the arithmetic
average return probably overstates expected future returns over long periods

The randomness in stock returns is extreme. With an annual
standard deviation of real return of 18%, and 100 years of past data, a single year.s stock
return that is only one standard deviation above average increases the average return by 18
basis points. A lucky year that is two standard deviations above average increases the average
return by 36 basis points. Even when a century or more of past data is used, forecasts based
on historical average returns are likely to change substantially from one year to the next.

Professor Andrew A. Samwick
Director, The Nelson A. RockefellerCenter at Dartmouth College

Krugman's calculations hold that dividend yields will remain at about 3 percent over the projection period. This generates an exploding PE ratio. Instead, the inconsistency he is pointing out might be rephrased as:

"Because of the low rate of economic growth, those holding to a 6.5 percent return are assuming an unrealistically high dividend yield."
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All approach the Problem from a different prospective, providing valuable information, but lacking consideration of what the Author considers the basic problem. Here is what the Author considers important:

Longevity--People have to be paid Benefits for as long as they live (Read Arnold Kling at Econlog). The Lifespan Curve is flattening, and has been since the 1970s, this because the easy extensions of life have been accomplished(Arnold disagrees). It has been proven by many Studies that Working, or Working longer, shortens Lifespan due to the stresses imposed on the human body. People to be paid Benefits are likely to die younger than the statistical average. The Lifespan Curve is flattening and likely to continue to remain static. Statistical implication states People receiving Benefits will start to decline in number by Y2046.

P/E ratios--The Price/Earnings ratio has been a traditional 14--which equates a doubling of the Investment every fourteen years. The advent of current Tax credits, IRAs, Koughs, and 401ks has raised Demand for Financial Paper (Stocks and Bonds) , with resultant rise in the P/E ratio to approximately 20; this equaling twenty years to double the Investment. Corporate Executives and Employees have been eager for Stock Grants and Options, because of the rise in price of these Instruments; causing a spread issuance of such Instruments inducing a reduced Earnings because of multiplicity--spread of Profits across greater shares. How much will Private Accounts raise the Price of Financial Paper, and how much will Earnings drop in the supply of the additional Financial Paper? A P/E ratio of 24 will be less than the rate of Inflation; a P/E ratio of 26 will be less than the rate of expected economic growth.

Medicare and Medicaid--An expansion of Both at the current 7% per year, or the expected 8% per year, could not be paid for even with P/E ratio of 14, given at rate of economic growth of 1.9%--or even an economic growth rate of 3.5%. Private Accounts for Social Security, or even Health Accounts, will not do any good for Medicare or Medicaid. Medicare and Medicaid benefits must be limited in yearly coverage.

Conclusion:
Private Accounts will not begin to improve the Shortfall in the Social Security Trust Fund; it will actually only worsen an Accounts imbalance. A switch from Wage indexing to Price indexing SS Benefits will not change either the above effect of Private Accounts, or more than maginally alter the Accounts imbalance of the Trust Fund; it will increase the financial instability of the Elderly at about four times the rate of reduction of Benefit--Bad Call. Samwick proclaims Private Accounts will cut Government expenditure; patently false, Minimum guarantees of Benefits and rising Costs will increase Government expenditures--vastly increased by Debt-financing of Private Accounts. lgl