May 14, 2005

Earlier this week, I mocked a rather sensational editorial on Social Security reform that appeared in Glamour magazine. In particular, I was unimpressed with an Accurate Benefits Calculator that the story cited.

Although they didn't comment on the site, someone from the Center for Economic & Policy Research, which runs the calculator, took offense to my post. Well, actually, took offense is the wrong phrase. They questioned some of my criticisms. I welcome that kind of debate, but I prefer that it takes place on the site. One of the great things about a blog is that you can create a little community that discusses the issues, not just a single person on a digital pulpit. So, I thought I'd publish our email exchanges in the extended entry below and get everyone more involved in the debate.

"John Doe" from the CEPR:

Thank you so much for the plug. We appreciate that here.

It might have been nice to take a little more time noticing things with our calculator. Specifically,

1. The 4.35% return is explicitly documented as to how and why we use such a low rate of return. The growth in stocks is tied directly to growth in GDP. The fact is CBO projects a slowdown in GDP growth, and as a result there will either be a slowdown in the return to stocks or an ever-increasing price-to-earnings ratio. Neither CBO nor the Social Security Administration has been able to justify their 6.5-6.8% return to stocks.

2. Your benefit with the account may in fact be lower than without the account. You are expected to pay back the government every dollar diverted from Social Security, with interest. Plus, the account generates fees. Thus, your account must generate interest well in excess of the Treasury rate in order to produce a net benefit. This is particularly important for "older" workers, meaning those already in the labor force, as they will benefit less from the compounding of interest.

3. The calculator does take into account increases in pay over a working life. Rather than asking every user to input wages for every year, we use a stylized growth in wages. At the minimum, a worker's wages grow in step with the average wage index, and faster than that earlier in working life. The calculator also adjusts for the age of the worker, so a worker entering "36,470" (the estimated average for 2005) but not born until 2035 will still make about an average wage in 2070. This too, is spelled out in the technical notes.

Finally, a more political note. Suppose we all decide we want to retire with income some fraction of the income we receive during our working lives. (Yes, the fractions may vary from person to person, but let us assume that fraction should have no reason to fall over time. Expect people to retire in a style somehow connected to their working life.) Suppose also we live longer and longer. Then we have no choice but to save more and more of our wages in order to fund our retirements. There is nothing special about Social Security in this regard. What you describe is not a problem with the Social Security system than it is with your 401(k) or IRA or your home or any other savings mechanism. If you want more for your retirement, you need to consume less when you work.

You may agree or disagree on the last point, but it would be helpful to become remotely familiar with the calculator before comparing it to animal waste.

Me

I didn't notice any technical notes that explained how wages over time were calculated. My apologies if I missed it.

I have two major problems with your calculator. First, you use the 4.35% rate of return as a default when the PLAN itself uses something different. Don't you think that's a bit misleading? I do. I read several articles about rates of return over time and while there is debate about what rate to estimate, many economists felt that the SSA's rate was certainly reasonable, perhaps not in perpetuity, but that it was a sustainable rate for many, many years. If you want people to evaluate the Bush plan, I think it's only fair to use the Bush estimates.

But finally, I object to the whole idea of comparing what you would get under the current plan to what you'd get under proposed reforms. I think that implies that we can merrily go along under current conditions indefinitely, which isn't true.

I think the calculator and the whole Glamour article are just a tad overly sensational and are built to lead people to a certain point of view, NOT to simply provide information. I have no problem with that (and frankly, I'm not sure what we should do about social security), but I think it's dishonest to pretend you're just disseminating information rather than a supporting a specific view.

CEPR Person

No problem. I just thought you should know that there are detailed notes on the calculations.

The PLAN doesn't contain a specific rate of return on stocks. That's not within the purview of the Social Security Administration. Our point is the predicted return is mathematically inconsistent with the other economic assumptions they make, barring some new and wholly implausible assumptions about either dividends or stock prices. It is not a partisan issue-- it's simply unfair to use those estimates because they appear to be nonsense. If anyone at all can explain how to get to 6.5-6.8% a year through the planning period by projecting capital gains and dividends, we would most certainly love to hear it. We have an outstanding challenge to exactly that (The No Economist/Policy Analyst Left Behind Test)

As to comparison to current benefits, that is the only comparison that may be made. To use payable benefits (without additional taxes or borrowing) as the baseline means that Social Security faces no shortfall whatsoever at any time. It is in balance by definition. Furthermore, the President's plan mandates trillions of dollars in extra spending and trillions more in borrowing not reflected in the calculator. If payable benefits is the baseline, we are being hugely generous the other way, for additional cuts beyond the Pozen indexing would be necessary to bring the system into balance.

As to Glamour, I'm afraid I haven't seen the article, so I cannot comment specifically. I can only say that we have made a concerted effort to make the calculator as accurate as possible given the information brought to the table.

[An additional note... the S&P is up 6% in the last year, true. That's 6% before inflation. CBO projects 6.8% after inflation. If we throw in dividends, the yield on stocks could be as high as 5.8% after inflation. It's also true that 5.8% is almost 1.5% over our long-term projection of 4.35%. But CBO projects GDP growth to be some 2.5-3 times as fast this year relative to the long-term average. It's silly to compare our long-term projection (when growth is slow) to today's relatively fast growth. We don't dispute that stocks could grow faster in the short run, and we certainly take that into account in the calculator.]

At this point, I have to admit that I'm absolutely no expert in stock returns. Although, I did do some research on expected rates when I made my original post. Luckily, we do have someone here who is. And really, that's why I wish things like this took place entirely in the comments. I pulled in our own John Tant and got his take on the debate:

My first blush beef is over his statement "The growth in stocks is tied directly to growth in GDP. The fact is CBO projects a slowdown in GDP growth, and as a result there will either be a slowdown in the return to stocks or an ever-increasing price-to-earnings ratio."

Well, on the first point I disagree, mainly because I don't think there is a solid cause/effect relationship between the two. Correlation...maybe. But that's different than asserting flat out that one is tied to the other. In fact, savvy investors will tell you that when stock prices drop is when you need to start buying them up. Buy low, sell high...one of the most immutable laws of the universe, and one most often ignored by so-called professionals. So people
start buying up these stocks (supply, demand, price goes down demand goes up, etc)...and suddenly stocks are growing. Yes, even though GDP growth is still theoretically slowing down.

Second, why should we care WHAT the CBO is projecting? What's important is what the group is projecting. If they're using the CBO projection then they need to justify why they think that projection is more valid than others. Besides, after 24 straight months of positive job growth, the forecast of a GDP growth slowdown doesn't seem too realistic. I bet if we look at the CBO's forecast history, we'll see it more wrong than right over the years.

I think he also contradicts himself in the follow-up email, by the way. First he says CBO is projecting a GDP growth slowdown. He then turns around and says "But CBO projects GDP growth to be some 2.5-3 times as fast this year relative to the long-term average." Well, is it a slowdown or isn't it? Is the support for a slowdown based on fudging the base year of that "2.5-3 times" rate growth and then comparing it to the long term average? If so, I think that's a little
disingenuous.

And his cite of a PE ratio is intellectual filler. He says a slowdown in GDP growth would possibly result in an increasing PE ratio. But in the 90s, GDP growth was increasing and PE ratios also increased. So either the 90s were an outlier or he is misunderstanding the relationship if any. I don't think it's an outlier, because PE ratios on a whole have been increasing for quite some time. It's one argument that is used to support the idea that the stock market is overvalued. I do have some sympathy for that argument, but on the other hand I have even MORE sympathy for the argument that "value" is only found in "what someone else will pay for something."

Next, let him complain about the S&P 6% growth being before inflation. If he's really thinking inflation is a big worry at this point in time, then he's damaged his own credibility.

For the wage growths (item 3), bottom line he seems to be assuming that if I make an "average" wage in 2005, I'll be making an "average" wage in 2035. I understand the limits of some models, but that single assumption is wrong enough to taint any results that come out of the other end, in my opinion. How does he know what an "average" wage will be in 2070? How does he know what the average wage growth will be between 2035 and 2070? On what basis does he assume that a younger worker will outstrip the average wage rate increase, and how much is he assuming that worker will outstrip it by? All things that he'll
say are explained in the technical notes (which I read, all six pages, and darned if I could see it in the detail he claims it's there...), but at the end of the day we're talking about assumptions plugged in by some research associate at a left-wing think tank.

I could go on and on, so I will.

I plugged in my income in the calculator and chose married. It came back with "This calculator assumes that the spouse makes 1/3 the wages of the primary earner." Huh?!? "If you expect to have more equal incomes, calculate separately as unmarried individuals." But if I do that, doesn't that mess with the other assumptions he cites?

I like the material misdirection at the bottom of the calculator too: "If you received and spent the benefits under the Bush Plan listed above, you could bequest nothing to heirs." Um, as opposed to the current system? Puh-leeze. And what's the point of saying that anyway? It's like saying "If you spend all the money in your bank account, you won't have anything to leave to your heirs. No shit, Sherlock. And if I'm married, projected expenses are going to be lower (don't have to pay two heating bills, you know). But oh no...to get a "realistic" money number I have to calculate myself as single and add in my wife...also calculated in as single.

Sorry this ran longer than the brief snark I was planning on. :)

And if that wasn't enough, John followed up with more info on the relationship between GDP growth & stock returns:

Food for thought on one of the points I brought up (relationship between GDP growth and stock returns):

http://www.socialsecurity.org/daily/07-24-00.html

The "Baker" in the quote is Dean Baker of the Center for Economic and Policy Research...the same think tank who came up with that calculator.

Quote:

As baby boomer retirements and low birth rates reduce labor-force growth to just 0.2 percent annually, total economic growth will decline as well. The critics' argument is simple: Slower economic growth means lower corporate profits, and profits drive stock prices; hence, stocks can't possibly return more than 3.5 percent, placing their long-term returns below today's government bond rate. While even this performance would substantially exceed Social Security's paltry 2 percent return, higher stock returns would speed the transition to personal retirement accounts.

But it's easier to say "slower economic growth equals lower stock market returns" than it is to prove it. Research by Philippe Jorion, professor of finance at the University of California-Irvine, reveals both theoretical and empirical flaws in Baker's argument. Jorion acknowledges the bookkeeping idea that "asset prices should grow at the same rate as cash flows," but in the real world "this relationship. . . may be blurred by a number of factors." A more sophisticated theoretical model shows that returns on capital investments "should be related to real GDP growth per capita, instead of total GDP growth."

Jorion's empirical analysis confirms the theory. Drawing on research on global equity markets he conducted with Professor Will Goetzmann of Yale, Jorion examined the relationship between economic growth and stock returns for 31 countries, ranging from established markets to new economic powers to developing countries. The results directly contradict what Baker's theory would predict. While Jorion found "no observable relationship between stock market returns and GDP growth," statistical analysis revealed that "stock market returns are positively correlated to GDP per capita growth."

For instance, developing economies grew 1.4 percentage points faster than economies of developed countries, but their stock returns averaged 2.6 percentage points below those in the developed world. How could this be? Developing economies expanded through rapid labor-force growth, not productivity improvements. As a result, their GDP growth per capita—and their stock returns—lagged behind those of developed countries. Hence, Jorion concluded, "Lower capital gains are really associated with lower per capita economic growth," not lower total economic growth.

This link between per capita GDP growth and stock returns affects the debate over personal accounts, since the economic slowdown projected by Social Security's trustees stems almost entirely from reduced labor-force growth. Productivity increases – the other main component of economic growth – will remain at the 1969-98 average of 1.5 percent annually and GDP per capita growth will be respectable. Jorion found that a 1 percent change in per capita GDP growth correlates with a 0.7 percent change in equity returns. If true, we can expect future stock returns to be less than one percentage point below their 1926-97 average of 7.2 percent.

People mock blogs, but where else do you get this kind of information? John and the gentlemen from the CEPR both explain their position and back it up with other sources. You'll never see this depth of information and opinion in a newspaper. And maybe that's why their circulation continues to plummet.

Posted by kris at May 14, 2005 01:37 PM

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