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Tuesday, June 14, 2005

How personal accounts might be structured


Michael Tanner, Director, Cato Institute Project on Social Security Choice

before the Committee on Banking, Housing and Urban Affairs
Subcommittee on Securities and Investment

June 14, 2005


Social Security reform must allow younger workers to save and invest some of their Social Security taxes through personal accounts. I believe that such accounts can significantly contribute to restoring Social Security to permanent sustainable solvency. More importantly, I believe that personal accounts are essential to modernizing Social Security in keeping with such fundamental American values as ownership, inheritability, and choice.

In particular, regarding the subject of this hearing, economic theory holds that private capital investment should provide a higher rate of return than a mature PAYGO Social Security system. If one accepts the Social Security Administration's assumptions about future bond and stock returns, a balanced portfolio (50 percent stocks, 30 percent corporate bonds, and 20 percent government bonds) could be expected to yield a return of 4.9 percent. Subtracting 25 basis points of administrative costs provides a net yield of 4.65 percent. Shifting the mix slightly in favor of equities should raise the expected return to roughly 5 percent. This clearly exceeds the return available from Social Security, and also significantly exceeds the offset interest rate suggested under the president's reform proposal.

This is not to say that personal accounts can perform miracles. They cannot, by themselves, solve Social Security's entire $12.8 trillion funding shortfall. However, workers who choose the personal account option-and I note that personal accounts are voluntary under all the major reform proposals-can expect to receive more in retirement benefits than Social Security can actually pay them.

That said, how personal accounts are structured and the investment options available to workers can make a significant difference in the success of any personal account proposal. In short, details matter.