Reducing the Risk of Investment-Based Social Security Reform

Many governments around the world - including Australia and Britain, Sweden and Mexico, China and Chile - have shifted from pure pay-as-you-go tax financed Social Security pensions to plans that rely in whole or in part on investments in stocks and bonds. There is now active discussion about the desirability of doing so in the United States. The Clinton administration came close to proposing such a plan. President Bush established a bipartisan presidential commission to advise on detailed aspects of such a plan and, after his reelection in 2004, reiterated his intention to introduce legislation to change Social Security in this way. 

Any consideration of introducing an investment-based component into Social Security immediately raises the issue of the risk associated with uncertain asset returns. Some individuals would welcome the opportunity to achieve a higher return on their Social Security contributions even if that entails accepting additional market risk. Others would be reluctant to subject their retirement income to the uncertainty of investment returns. More generally, individuals differ in the extent to which they would accept additional risk in exchange for higher returns.

This paper presents a new market-based approach to reducing the risk of investment-based Social Security that could be tailored to individual risk preferences. With this new form of risk reduction, substituting an investment-based personal retirement account (PRA) for the traditional pure pay-as-you-go (PAYGO) plan could achieve both a significantly higher expected retirement income and a very high probability that the investment-based annuity would be at least as large as the pay-as-you-go benefit. A key feature of the approach developed here is a guarantee that the individual would not lose any of the real value of each year's PRA savings and might be guaranteed to earn at least some minimum real rate of return.