The Calculator

I'm friends with several current or former affiliates of the Cato Institute, most of whom (along with a few others) have emailed me regarding my Tapped post on the accuracy of the Social Security calculator you can find on Cato's privatization advocacy site. Since my initial post had some problems, it's worth giving this issue a second go below the fold. First, however, I think it's noteworthy that no one has written in trying to defend the Heritage Foundation's calculator, which makes private accounts out to be a much better deal than does Cato.

Cato wants me to believe that when I reach my Normal Retirement Age (67) in the year 2048, I will have accumulated a private account $521,276 in 2004 dollars if we implement the Cato privatization plan [LINK] today. They further allege that with this $521,276 I will be able to purchase an annuity paying $49,639 per year "fully indexed for inflation."

One question I raised was about the legitimacy of this annuity estimate. My proposed counterestimate, however, was also off the mark. Bruce Bartlett, an economist and no apologist for big government, recommended this calculator as a useful source of information in this regard "from a group with no ax to grind."

By their calculations, a 67 year-old man living in the District of Columbia with $521,276 to spend could purchase a "single lifetime income with no payments to a beneficiary" (which I think is what the Cato site is talking about) worth $3,608 per month, or $43,296 per year. I don't know whether or not that's indexed for inflation. If it is, then it suggests that Cato is off by about 15 percent. If it isn't, then Cato is off by more. But it's also important to keep in mind that this is an estimate of what you could buy with $521,276 in 2004 dollars in 2004. By 2048, technology will have improved and life expectancy at 67 should be higher than it is today, meaning that $521,276 in 2004 dollars will buy me a lower annual payment (in 2004 dollars, all the numbers will be much higher, of course, in nominal dollars) than this.

A far more significant source of disagreement stems from the assertion that I'll have $521,276 in my account by 2048. Cato derives this number because (to quote their website) "individual account accumulation assumes the average rate of return on a 60-40 Stock-Bond portfolio (5.27 percent [above inflation]) minus transaction cost (0.30 percent)." Via email, a Catoite notes that "this is considerably lower than the historical return on stocks of 7 percent per year." But since my portfolio is only 60 percent stock, of course the aggregate return is considerably lower than the historical return on stocks. This is a bit of a red herring. Now I think (hopefully someone will alert me if I'm mistaken) that they get the 5.27 percent figure by assuming that stocks will have an average real annual return of 6.5 percent (this is what the president's privatization commission estimated) and bonds an average real annual return of 3.25 percent (6.5 * .6 + 3.25 * .4 = 5.2). A return of 6.5 percent is not considerably lower than the historical return on stocks. But the estimated figure should be considerably lower than the historical figure for two reasons.

One is that price/earnings ratios have reached a level considerably higher than their historical average. This implies either that stocks are overvalued right now, or else that stocks were undervalued in the past. Either way, it implies slower growth in the future.

The other is that the denominator of the P/E ratio -- earnings -- is related to economic growth. But the future economy is very unlikely to grow as quickly as the economy of the past, primarily because the population will be growing much more slowly. This population-driven slowdown in economic growth is the source of the purported "crisis" in Social Security but its effects will be felt in many areas, including the stock market. Dean Baker has used this information to devise his No Economist Left Behind Test as follows:

President Bush's Social Security Commission assumed that stocks would give an average return of 6.5 percentage points above the rate of inflation over the next seventy five years. The commission uses the Social Security trustees projections, which show that profit growth will average 1.6 percent above the rate of inflation over this period. The current ratio of stock prices to corporate earnings is 25.8 to 1, which means that corporate earnings are on average equal to 3.9 percent of the price of a share of stock.

Use this information to show a set of capital gains and dividends that produces the 6.5 percent rate of return assumed by President Bush's Social Security commission.

By Baker's estimate, the return on stocks will be more like 5 percent than 6.5 percent, which would drive the overall rate of return on my private account to well below 5.2 percent which, thanks to the compound effects, would leave me with considerably less than $521,276 in my account when I reach the age of 67. Baker's precise estimate is, of course, open to question. I have not, however, seen anyone offer a serious reply to this argument that's consistent with the 6.5 percent estimate used by the Commission and, unless I'm mistaken, by the Cato Institute.

And all this is without getting into the issue of administrative costs. For more on that see, e.g., the case of Chile.