Arnold Kling  

Actuarial Scoring Errors

Medicaid and Nursing Homes... Who Needs Health Insurance?...

In this essay, I take off on "actuarial scoring" of Social Security plans.

In fact, at a 3 percent real interest rate, it would be irrational for me to switch to using personal accounts! I have some of my portfolio invested in Treasury-indexed securities, earning 2 percent. If instead I can earn 3 percent by sticking with Social Security instead of using a personal account, then I would definitely do that. If I cannot earn a 3 percent risk-free real interest rate anywhere else, and I have to pay a penalty of 3 percent for shifting into personal accounts, I would definitely stick with Social Security!

...On reflection, the amount of damage done by the Social Security actuaries is truly remarkable. Thanks to the actuaries, we have unrealistically optimistic estimates of Social Securities financial condition. We have unrealistically optimistic estimates of the returns on the stock market relative to economic growth. And, finally, we have an unreasonably high interest rate charged to people who switch to personal accounts, making it irrational for most individuals to take advantage of a personal account option were it to be offered.

UPDATE: See Victor's excellent analysis at Dead Parrots

For Discussion. Is it fair to complain that a three percent risk-free real interest rate is too high?

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CATEGORIES: Social Security

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The author at William J. Polley in a related article titled Actuarial assumptions and my beef with H.R. 530 writes:
    Today's best Social Security analysis is by Arnold Kling. By the way, if you don't read his blog, you should. The memorandum to which he refers is can be found at the SSA website. He gets it right. At issue... [Tracked on February 24, 2005 6:17 PM]
The author at The Dead Parrot Society in a related article titled Kling Blasts the Social Security Actuaries writes:
    Arnold Kling's latest TechCentral Station article blasts the Social Security actuaries. The normally mild-mannered Kling suggests that: "Actuarial scoring" of Social Security and the reform proposals is a menace. and he concludes: On reflection, the am... [Tracked on February 25, 2005 11:58 AM]
COMMENTS (8 to date)
James writes:

Is it to wing-nutty to theorize that the whole point of this is to kill post-partum an idea they couldn't abort before birth? Sounds like somebody is trying to make this such a bad deal nobody will want to use it, so that same somebody can later point to the low rate of opt-in and say "I told you so". Crazy?

Bob writes:

Didn't you already answer your own question?

When indexed treasuries yield 2%, yes.

But if you believe that means-tested benefits are inevitable, it would still be rational to switch above a minimum affluence level (with the implicit assumption that it is politicly easier to take away "promised" benefits than to confiscate private accounts).

"Security's critical parameter is the ratio of workers to retirees. As that ratio falls, the ability to use a given tax rate to meet promised benefits declines."

Exactly. And, a drop from 3.4 workers to 2, will call for about a 65% increase in burden on the workforce.

Tom writes:

Is it fair to complain that a three percent risk-free real interest rate is too high?

Of course it is. The break-even interest rate ought to be the effective rate of return for the workers of the next generation, assuming that the payroll tax schedule and base remains unchanged from current law. I believe that rate of return is something like 2 percent, if not less.

Bob Knaus writes:

I think the confusion arises from terms often used to support decision-making, such as "hurdle rate" or "cost of capital". In a standard ROI analysis, you set some arbitrary rate which, if it exceeded, points to the investment as financially sounds. So if the internal rate of return over 10 years is 7%, and your cost of capital is 4%, then you'll make money on your investment.

Pretty straightforward, eh? But real management decisions are seldom made on this basis alone. The spread between cost of capital and return on investment is meaningless without a risk analysis, and without a weighting of qualitative factors.

Same applies to SS actuarial analysis. If you just run the numbers, and zero out the risk, you are purposely sticking your head in the sand. Sorta like presuming that the trailer home sales outfit will, in fact, just keep on paying interest on those 10% notes like they promised. In reality, investing in junk bonds like that is a lot closer to owning equity than debt. Same for the promises implicit in that 3% SS return. You are really investing in the ability of the orgainzation (federal gov't) to continue fleecing taxpayers at the same rate for a long time. That is owning equity, not debt, and you are last in line if they go broke.

I'd rather own my own investments, even if they didn't pay any more, thank you very much.

Capt. Bob Knaus

Jim Glass writes:

As to the nontrivial difference between 3% and 2%, the fact that 2% both has been the historical rate on T-bonds for the last 75 years and is the rate currently projected by the market, and how...

... at a 3 percent real interest rate, it would be irrational for me to switch to using personal accounts!

... I mused about this before, wondering why Karl Rove is such a dummy as to have the Administration keep shooting its own plan in the foot like this.

As noted there, the WSJ noticed this too.

Robert Schwartz writes:

"Is it fair to complain that a three percent risk-free real interest rate is too high?"

If, like Arnold and I, you grew up during the Eisenhower Regency, three per cent, which is what savings and loans paid on passbook accounts, sounds like motherhood, apple pie and chevrolet.

When I was in school about 35 years ago, we used 4% as the risk free long term rate. I think our finance textbook said that a huge study had determined that that was the weighted average for the last century or so.

The decades since then turned into a huge interest rate roller coaster. Rates hit astronomical levels by 1980 (IIRC, Prime at 22%), only to fall fairly steadily for most of the next 20 years.

For the last couple of years we seem to have been in the bottom of the valey. In today's WSJ and the best yield on long TIPS was about %1.8. 10 year treasuries are running around 4% and my broker hates me because I won't buy anything. But if Alan Greenspan does not understand why long rates are staying low despite the Feds efforts to push up short rates, who am I outguess the market. As Yoda said: "it remains a conundrum."

I still haven't answered the question. It is fair to complain about any forcast interest rate because the only thing we can be sure of is that rates will change over time. The intellectually correct method of forecasting is to set-up the model and run monte carlo simulations using randomly generated, but historically conditioned data. A service that will do this for a stock portfolio is:

A couple of observations. First, whatever Paul Krugman says, stocks will out perform T-bonds. They better. If they don't It means that the private economy has grown dismally unproductive and no Social Security reform will save us.

Second. I am in favor of private accounts in the sense that I am in favor of turning social security from a defined benefit plan into a defined contribution plan, That tranformation will prevent future demographic changes from becoming a sword of Damocles over the heads of future generations. It will also allow us to move toward true privatization in the future.

Third, I am against allowing any portion of social security contributions to be invested in anything but T-bonds. The moment they are invested in stocks, we creating an opening for a demagouge to turn a stock market crisis into a political crisis, by calling for government manipulation of the market or even nationalization of private businesses.

Fourth, While we are in transition from defined benefit to defined contribution plans, we need to minimize the cost of the current plan. We must raise the age of full benefits and make all benefits subject to federal income tax.

Lawrance George Lux writes:

I would first like to say your essay is probably the best analysis of distortions in the Private Accounts argument I have read so far.

Is it fair to complain that a three percent risk-free real interest rate is too high?
It is not only fair, but it is intelligent. In fact, a two percent risk-free interest rate is too high, for reason I won't go into here(check my blog tomorrow). A One-percent risk-free interest rate makes Privatization far more attractive in Short-term financing, but makes the current assured Benefits system far more attractive in the Long-term. lgl
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