Can Social Security Privatization Guarantee You More Benefits at a Lower Cost?

By Andrew G. Biggs 

No, but the CBPP’s stance on budget accounting says it can.

There’s a debate going on regarding how government budgets should account for risk. In an article in National Affairs, Jason Richwine and Jason Delisle argue that the federal government should use “fair value” accounting in analyzing the costs of federal guarantees for student loans. Paul Van de Water of the Center on Budget and Policy Priorities (CBPP) has countered that fair-value accounting exaggerates the costs of student loan guarantees because this method tacks on a “risk premium” that the government doesn’t directly pay. CBPP’s stance on fair-value accounting goes against a rising tide of expert opinion that government accounting needs to pay more attention to risk, not less.



I should note that I’ve worked with both Richwine and Van de Water and like and respect both of them. And both sides have their points. But one way to analyze a position is to see whether it leads to absurd results.
To illustrate, imagine a Social Security reform plan in which every worker is given a personal account that is invested in stocks. At retirement, a worker cashes in his account to pay whatever benefit he is promised by Social Security. If his account balance isn’t enough to pay his promised benefit, the government makes up the difference. If his account is more than is needed, then the government takes, say, a quarter of that surplus and the account holder keeps the rest.
Under the approach to budget accounting favored by Van de Water and the CBPP, this Social Security reform plan could guarantee that every worker gets his full benefit while also reducing the budget deficit. Using fair market valuation, by contrast, this plan would cost more than the current system: simply put, a plan that guarantees no less than current-law Social Security, with the probability of getting more, would be more expensive than current-law Social Security that offers you no chance of higher benefits.
The reason for this is that the government’s guarantee would have to be honored in bad economic times, when stock prices have fallen, the economy is weak, and tax revenues are hard to come by. The bonuses from high stock returns, by contrast, would occur when the economy is strong and an additional dollar of revenue isn’t as valuable. If these sorts of guarantees are offered in private financial markets, as I showed in a 2009 article with Clark Burdick and Kent Smetters, they’d be very expensive.

Simply put, a plan that guarantees no less than current-law Social Security, with the probability of getting more, would be more expensive than current-law Social Security that offers you no chance of higher benefits.

The key insight is that just because a guarantee is provided by the government rather than in the private sector, doesn’t mean we can ignore the cost of risk. In both cases, it’s people — not institutions like banks or government — that ultimately pay the cost of such guarantees. For instance, when the federal government honors a guarantee it might have to raise taxes, cut spending on other programs, or borrow and impose these choices on future generations. Likewise, when a private financial institution covers losses, its shareholders or other market participants take a loss. That’s why financial markets would attach a “risk premium” to the cost of a guarantee.
This debate is playing out on a large scale at the state and local level. Pensions run by state and local governments currently use the accounting standards that Van de Water and the CBPP favor. That is, they invest in risky assets like stocks and hedge funds, but treat the returns as if they were guaranteed. Since state and local budgets literally ignore the risk of the plan’s investments and focus only on the expected returns on those investments, the more risk a plan takes the better funded it looks. As a result, state/local pensions take a lot more investment risk than they otherwise would. Ignoring risk has real results, namely that government takes more risk.
But there’s a strong movement that government accounting needs to pay more attention to risk, not less. A recent University of Chicago survey of 35 prominent economists found 98 percent agreed that ignoring market risk understates the costs of providing public pension benefits. The Congressional Budget Office agrees; so does the Federal Reserve, the Bureau of Economic Analysis, and at least one member of the Securities and Exchange Commission. A recent commission established by the Society of Actuaries, on which I served, recommended that pensions supplement traditional measures with figures calculated using a risk-adjusted discount rate.
And it’s not just at the state and local level or with public employee pensions. In a 2004 study, the CBO showed why a fair-value approach to loan guarantees better captures the total costs to the taxpayer. In a 2006 study, CBO applied this logic to guarantees for Social Security account plans, such as the one I describe above. CBO as an institution seems to believe that the fair-value approach provides a fuller view of the overall costs of federal guarantees.
And a full view of the overall costs of a policy is what should guide policymakers. Without that, the almost-certain result is that government will take on more risks that it doesn’t fully understand and the costs of these risks will be shifted to the public. If policymakers can’t understand these issues, they shouldn’t be making these kinds of guarantees.
Andrew G. Biggs is a resident scholar at the American Enterprise Institute.