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How Would Financial Risk Affect Retirement Income Under Individual Accounts?

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As their populations grow older, the industrial countries face steep increases in public pension costs. If countries change their pension systems in advance of sharply higher pension costs, it is possible to prepare for the added retirement costs by funding a portion of the future liabilities through increased saving. By boosting capital formation and economic growth, higher saving has the potential to increase the incomes – and the welfare – of future workers and retirees.

This paper considers investment accumulation and pension adequacy in light of financial market risk. We examine two alternative reforms of the U.S. pension system that are aimed at pre–funding part of future pension liabilities and increasing national saving. The first policy expands the role of advance funding in the existing Social Security system by moving toward a policy of tax increases that are large enough to maintain close actuarial balance over a 75–year horizon. Under the alternative policy, the traditional Social Security program adopts pay–as–you–go financing after 2033 and a new system of individual investment accounts is adopted to supplement (reduced) pensions under the traditional system. Advance funding takes place in the new individual investment account system.

The findings reported in this paper show the implications of investing part of the pension fund accumulation in assets, which are subject to significant financial market risk. A major conclusion is that the magnitude of financial risk is empirically quite large. Surprisingly, some of the risks connected with advance funding can be even greater when assets are accumulated within the traditional Social Security program rather than individual investment accounts. Although advance funding in Social Security holds out the promise of raising national saving and future output even more than fund accumulation in individual accounts, the variability of returns on Trust Fund investments can have more far–reaching effects on the aggregate economy, through its potential impact on national savings, returns on capital, and the average wages. For example, a sequence of unexpectedly high investment returns on Trust Fund reserves might induce policymakers to reduce the Social Security contribution rate, lessening the flow of net savings from Trust Fund accumulation. The reduced rate of saving would in turn slow the growth of the capital stock, possibly increasing the real return on capital and reducing still further the required contribution rate for Social Security.

Publications

Social Security sign in a garden

Pension Reform in the Presence of Financial Market Risk

Working Paper by Barry P. Bosworth and Gary Burtless

July 1, 2002
Social Security Card: Senior woman holding card in hand on white background

How Would Financial Risk Affect Retirement Income Under Individual Accounts?

Issue Brief by Gary Burtless

October 1, 2000
Sponsor
U.S. Social Security Administration
Fiscal Year Awarded
2001
Project Code
BC01-05
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