FOCUS: Bullish on Personal Accounts

By MARK A. SHEPARD

I called the AARP the other day to ask if I could become a member. I was disappointed with the leadership of the lobbying organization formerly known as the American Association of Retired Persons, and I wanted my voice heard. But the nice lady on the phone told me I couldn’t join—not for 32 more years until I turn 50. So I find it ironic that while President Bush’s goal to allow workers to divert some of their payroll taxes into personal retirement accounts (PRAs) will chiefly affect young people like me, the AARP is vehemently opposing them. Indeed, the President has set as a nonnegotiable principle that Social Security benefits will not be altered for Americans 55 and older—so that the vast majority of AARP’s membership will not be affected.

The AARP has said that in opposing voluntary PRAs, it is looking out for its members’ children and grandchildren. But if that is the case, I have a message for AARP: Butt out! We children and grandchildren are adults who can make our own decisions. And many of us will indeed choose to divert some of our payroll taxes into private accounts, because PRAs are highly likely to generate more money for our pensions than the current pay-as-you-go system will.

While PRAs, as the President envisions them, will not solve Social Security’s sustainability problems—this will be the role of tough choices on how to slow the long-term growth in benefits—there are other compelling reasons to implement them. PRAs give Americans greater opportunity to exercise control over their retirement savings, instead of forcing them to buy into the antiquated pay-as-you-go government system. It is this choice that makes PRAs a good addition to Social Security, even if the current system were not in trouble. In addition, the claim that PRAs will hurt Social Security’s finances is wrong. By borrowing to fund PRAs, the government substitutes explicit liabilities (government bonds) for unfunded liabilities (future promised benefits). The total liabilities of the federal government do not change.

Furthermore, it is misleading to cite the short-term increase in government borrowing—the “transition costs”—as a downside to PRAs. Government borrowing hurts the economy because it saps funds from the supply of national savings and thus raises real interest rates, which crowds out private investment. But every dollar the government borrows is transferred into PRAs, which increases the supply of savings by an equal amount. The net effect on national savings is zero.

Given the added choice of PRAs, I would choose to divert as much of my payroll taxes as allowed into stock index funds. Others might choose to stay in the pay-as-you-go system or to invest their PRAs in government bonds because of a highly risk-averse nature. That’s the beauty of a system with more choice. In the end, people can choose the level of risk and thus the level of return that suits them best.

While every worker can decide for himself, I would like to explain why I would divert payroll taxes into a PRA invested in stock index funds. The first is that over long periods, the stock market offers much higher returns for what I find an acceptably low risk. Jeremy Siegel, a finance professor at the University of Pennsylvania, has found that the broad stock market from 1802 through 2003 averaged a 6.8 percent annual real rate of return. While the markets fluctuate from year to year, over all 30-year holding periods since 1802, the lowest annual real return was 2.6 percent, while the highest was 10.6 percent. While past results are no guarantee of future success, the historical data is encouraging.

Under the President’s plan, my PRA investments will have to beat a 3 percent annual real return for me to end up better off. This “offset rate” is designed to be the level of returns on government bonds, so that if I invest only in government bonds, I will end up no worse off. However, by choosing stocks, I accept higher risk for the possibility of higher returns. If stocks match their average historical return, I will end up with a fat bonus of 3.5 percent per year, compounded over 30-plus years of working and saving. This return is not guaranteed, but Siegel estimates that I would have an 84 percent chance of beating the 3 percent offset rate by investing in stocks.

Some inevitably find this risk too high and cite it in opposing voluntary PRAs. But this is a false argument because nobody who finds PRAs too risky is forced to choose them. Only those who want to accept more risk for more return will choose PRAs, and it should not be government’s role to prohibit that they do so.

Besides, there are other reasons that my choosing a PRA makes sense. A PRA protects me from the risk that I will die before retirement age—and receive nothing—by letting me pass it on to loved ones. A PRA lets me receive more of my benefits as a lump sum rather than an annuity, if I so choose. And a PRA protects me from the risk that future politicians will be unwilling or unable to fund my benefits.

I am glad to report that I am joined in this openness to private investment by Democrats like the late Sen. Daniel Patrick Moynihan, former Sen. Bob Kerrey, and even the godfather of Social Security himself. In a 1935 letter to Congress, President Franklin D. Roosevelt, Class of 1904, wrote of his hope for the “promises of private investment and private initiative to relieve the government in the immediate future of much of the burden it has assumed will be fulfilled.” Indeed, President Roosevelt unsuccessfully proposed adding “voluntary contributory annuities by which individual initiative can increase the annual amounts received in old age.” Sound familiar? It looks like we are only about 70 years too late.

Mark A. Shepard ’08 lives in Matthews Hall. He is chair of Republicans for Sound Economic Policy in the Harvard Republican Club.