Financial Markets, Volatility and Pension Funds Public Policy Evaluation and Social Risk

1
Financial Markets, Volatility and Pension
FundsPublic Policy Evaluation and Social Risk

• by
• Mordecai Kurz, Stanford University
• Agostino Gemelli Lecture
• Catholic University of Milan, March 22, 2006

2
Introduction On Public Policy Evaluation

• Complex policy evaluation ideology vs. science
• Discuss in this lecture
• Ideological basis of Conservative Economics
• Case study Social Security debate
• Review politics and proposed solutions
• Once remove ideology, economics is clear

3
Ideology or Science?

• The rise of Conservative ideological agenda
• Common justification for Markets Know Best
• Produce efficient outcome government not needed.
  
• Its outcome is fair you get what you deserve.
• Do Markets Know Best? Not always!!
• Scale economy, Asymmetric Information,
  Externalities.
• Most important here risk and insurance.
• Moral hazard
• Adverse selection
• Correlated risks
• Markets cannot offer inter-generational risk
  sharing

4
Public Policy in the 21th Century

• Old Welfare State is not at center
• Todays problem social Insurance
• Market solutions are inefficient.
• Public intervention for improvement is justified
  by science.
• Social Security an important debate.

5
Social Security

• Social Security and Medicare largest federal
  programs
• Social Security success, big impact, very
  popular
• Pays most income for 2\3 of elderly
• Poverty of elderly is sharply reduced.
• Retirement income linked to wage rate
• At median wage, replacement rate is 40.
• So, what is the problem?

6
Intergenerational Pay-As-You-Go

• For strict Pay-As-You-Go system,
• growth rate calculus
• Benefits Wage Rate Labor force - Retirees
• With stable demography Trust Fund averages out
• Effective inter-generational risk sharing
• The problem of demography
• 1. 1943-1956 Baby Boomers start to retire in 2008
• 2. Secular decrease of Workers/Retirees ratio

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The Problem

• First generations gained. 1937 tax 2 Now
  10.6
• Due to demography, projections today
• By 2018 taxes will be lower than benefits.
• By 2044 trust fund will be out of money
• How to pay for promised benefits?
• Increase tax by 1.9 solves deficit for 75 year
• Added 1.9 tax not sufficient for secular
  sustainability.
• Shortfall 11.6 trillions legacy debt
  value of promises
• Opposition Social Security return should equal
  private!

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The Social Security Rate of Return and the Legacy
Debt

• Projected return on Social Security 1.5
• Private returns and risks
• Real rate
  of return Standard Deviation
• of Returns
• Stock Returns, SP500 7.0
  18.0
• Long Term Treasuries
  2.5 10.0.
• 7 and 1.5 difference is a risk premium
• 2.5 on bonds vs. 1.5 Should they be the same?
• To answer question, I do a virtual privatization.

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Virtually Privatize Only One way

• Issue 11.6 trillion perpetual bonds pay debt.
• No real capital to pay interest on bonds
• Impose tax on asset income to equal interest on
  bonds.
• No private sector gain!!
• Tax reduces rate of return from 2.5 to 1.5.
• With 1.5 return, retirement benefits are the
  same
• Privatization did not accomplish anything!!
• Other Conclusions
• Social Security need not earn market rates
• True privatized retirement needs real capital.
• Social Security provides insurance and equity
  without real capital
• Should we privatize if we had the capital?

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Should We Truly Privatize If Italy Gave the US
11.6 Trillions Gift?

• We would pay off legacy debt with real capital
• Households invest freely and bear all risks
• Government out of retirement business
• As in the 1930s caused poverty of retirees due
  to crash of asset prices
• What is the effects of asset price volatility on
  retirement security?

11
Market Volatility and Retirement

• On average 18 volatility of stock returns and
  10 of bonds
• Tails episodes when real SP500 fell by more
  than 50
• From January, 1906 to January, 1921
  SP500 declined 68
• From January, 1929 to January, 1933
  SP500 declined 62
• From January, 1969 to January, 1982
  SP500 declined 57
• From March, 2000 to May, 2002
  SP500 declined 50
• Replacement rate measures effect of asset price
  volatility
• Burtless (2003) simulations males 1912-2003
  save private assets
• Start work at 22 work 40 years pay 7 to
  retirement accounts retire at 62.

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Simulated Replacement Rates for Individual
Retirement Accounts 1912- 2003
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Volatility and Retirement Security

• Income insecurity would be politically
  unacceptable
• With Italian gift, should we privatize?
• 1. Do not privatize, do not pay off Legacy Debt
• 2. Use gift as endowment to strengthen Social
  Security
• 3. Invest in private assets and reduce payroll
  tax
• 4. Resulting risk shared by all generations
• No Italian gifts must now consider realistic
  plans.

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Solving the Problem Position 1

• Position 1 System works. Fix it so it works
  better.
• Do not propose a single tax to solve problem
• Address specific problems (Diamond and Orszag
  (2004))
• (A) Lower benefits due to increased life
  expectancy.
• (B) Adjustment due to rising earning inequality.
• Low tax on payroll above ceiling of 90,000
• (C) Sharing legacy debt State and Local
  employees pay a small tax.
• (D) Other small adjustments.
• Each small. Phased in slowly after 2012, some
  after 2023.
• Most important START NOW. More expensive later.

15
Solving the Problem Position 2

• Papers like Feldstein and Samwick (2002)
• Compulsory payroll tax\contribution
• Privatization tax incentive for voluntary
  increase private savings.
• Added income offset lower Social Security
  benefits
• Two tiers (with Private Retirement Accounts
  PRA).
• Tier I 60 of regular Social Security, receives
  9.1 of 10.6 tax
• Tier II PRA invested 60 in SP500 and 40 risky
  private bonds
• The PRA
• (A) 1.5 tax is a contribution to PRA linking
  tax to benefits
• (B) An individual must pay added 1.5 cash
  contribution
• (C) This is hardly true Privatization

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Comments On PRA

• Risk and Return No Miracles
• Gain plan keeps promised benefits in
  expectations
• Cost higher risk of future benefits.
• Incentive linkage based on a key claim
• 1.5 tax is like a voluntary contribution to a
  pension plan
• People would thus contribute the added 1.5
• Many doubt size of Incentive Effect (exists in
  Social Security)
• Tax compulsory and PRA has little substitution
  with other assets.
• Most important START NOW. More expensive later.

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Conclusions

• Two economic solutions. None with real
  privatization
• A. Fix Social Security.
• B. PRA used to increase private savings, reduce
  public cost and increase private risk
• Conservative agenda PRA may just be a Trojan
  Horse.
• On Policy and Ideology.
• Public suspicion lead to rejection of the
  Presidents Plan
• Without credibility there is no political
  solution now.
• Science shows publically directed social
  insurance is the solution in the 21th century
  conservative ideology is the problem.