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Nearly three-quarters of workers who opt for Social Security personal accounts under President Bush's "default" investment option are likely to earn less in benefits than those who stay with the traditional Social Security system, a prominent finance economist has concluded.

A new paper by Yale University economist Robert J. Shiller found that under Bush's default "life-cycle accounts," which shift assets from stocks to bonds over a worker's lifetime, nearly a third of workers would bring in less in benefits than if they remained in the traditional system. That analysis is based on historical rates of return in the United States. Using global rates of return, which Shiller says more closely track future conditions, life-cycle portfolios could be expected to fall short of the traditional system's returns 71 percent of the time.

Continue reading the Washington Post article, "Retirement Accounts Questioned."

The following is the summary from Robert Shiller's complete paper, "The Life-Cycle Personal Accounts Proposal for Social Security: An Evaluation":

This paper evaluates the President’s personal accounts proposal, focusing on the “life-cycle portfolio,” a proposal to balance risks and returns by defaulting younger workers into a higher stock allocation and then shifting more towards bonds as workers approach retirement. The paper includes an analysis of rates of return under the life-cycle portfolio and an analysis of the finance underpinnings of the life-cycle portfolio. The paper finds that the returns to life-cycle portfolios are considerably lower than the rates of return typically used by the Social Security actuaries in evaluating returns for personal accounts that do not have the lifecycle option. In addition, life-cycle portfolios are considerably riskier than what some would think. By suggesting that the life-cycle portfolio is the recommended portfolio for everyone, the plan neglects the variability across workers of economic situations, and of psychological barriers to good financial planning: given the risks, the plan could be disastrous for some workers.

Methodology: The paper uses historical returns from 1871-2004 to assess the President’s personal accounts proposal. It does 91 different simulations for a worker born in 1990 assuming that he or she experiences the actual returns from 1871-1914, 1872-1915, 1873-1916, all the way through 1961-2004. This sample has an average real stock market return of 6.8% annually, slightly above the 6.5% annual return assumed by the Social Security actuaries.

These historical returns are not, however, a good guide to future returns. The United States economy and stock market performed extremely well over the last century. Many factors suggest this lucky experience is not likely to be repeated: most analysts project slower GDP growth in the next century, the risk premium required for investing in equities may have diminished, and the P-E ratio is very high by historical standards.

The Wall Street Journal recently surveyed 10 leading financial economists, the median projection for the stock market real rate of return in this survey was 4.6% above inflation. This is slightly lower than the median real return of 4.8% in a 15 countries from 1900-2000 surveyed by Dimson et. al.

As a result, the paper also use "adjusted" stock market returns designed to match the median stock return in 15 countries from 1900-2000, this is slightly above the return in the Wall Street Journal survey and is a more accurate projection of future returns.

Life-cycle Portfolio: The paper analyzes a range of potential portfolios. The featured portfolio is a "lifecycle portfolio" designed to capture the President’s proposal. According to the President’s plan, workers would be defaulted in a specific mixture of stocks and bonds. At age 47, workers would automatically be shifted into the "lifecycle portfolio" unless they signed a form to opt out. The President has not specified the portfolio allocation of this account, this paper assumes a benchmark portfolio is invested 85% in equities through age 29 and then phase-down to 15% equity investment by age 60.

Key Findings:

• Using historical returns, the life-cycle portfolio loses money 32% of the time (i.e., 32% of the time the internal rate of return is less than the 3% real return required to break even in the proposal). The median rate of return is 3.4% annually.

• Using more realistic adjusted returns, the life-cycle portfolio loses money 71% of the time and has a median rate of return of 2.6%.

Discussion: These rates of return are considerably below the 4.6% that the Social Security actuaries have assumed for. In addition there is considerably more risk than one would generally associate with previous discussions of "lifecycle portfolios." The most important reason this happens is that the life-cycle portfolio is invested in higher-yielding assets in early years and lower-yielding assets in later years. Because contributions are made annually, the returns in later years matter much more (i.e., the return in the first year only affects the first contribution but the return in the last year affects all 44 years of contributions). This effect is heightened because the typical worker reaches peak earnings in his or her fifties.

Other Findings: The optimal portfolio for a worker choosing the personal account as a replacement for much of the guaranteed Social Security benefit is considerably different from the optimal portfolio for a worker investing a 401(k) in addition to Social Security. If you have a Social Security benefit that is not subject to market risk, then you can invest your additional savings in a higher return/risk portfolio. But in the President’s proposal, the investments are replacing a large fraction of the existing Social Security benefit. Thus you would not want to invest them in as risky a portfolio.

A worker that has the correct balanced portfolio of stocks and bonds should not even participate in the accounts. Conditional on participating, he or she should invest entirely in bonds in order to avoid changing their current portfolio. Other psychologically constrained workers might benefit from shifting their portfolios more into equities. Social Security design has to take seriously psychological barriers to enlightened saving and investing; workers not subject to these barriers are very different from workers who already do things right. Overall, any proposals to encourage savings and investment should be designed with a variety of different types of workers clearly in mind.

What the report doesn't mention is the possible future of the bond market. Just last week, when the Japanese prime minister made remarks suggesting the country's central bank could be shifting some of its enormous reserves out of dollars and Treasury securities, the dollar tumbled. A similar situation occured earlier this year when it was thought that South Korea might jettison some of its dollar reserves in favor of other currencies.

China, Japan, Hong Kong, South Korea, and Taiwan together hold 56% of the Treasury securities owned by foreign countries. Many of those securities are held by their central banks. So any significant shift of their reserves out of dollars could spell trouble for both the American currency and the bond market. Consequently, if the personal account system shifts workers to bonds beginning at age 47 and foreign nations get rid of their dollar investments, those workers could end up losing their retirement benefits.

Alan Greenspan, the chairman of the Federal Reserve, has said a shift out of dollars by foreign central banks and foreign private investors should be expected at some time, although he has not said it would necessarily be disruptive.

All in all, private/personal accounts just aren't a good substitute for Social Security.

Click here to view Robert Shiller’s complete paper, "The Life-Cycle Personal Accounts Proposal for Social Security: An Evaluation."