April 16, 2002

Aug 2004 Note: While some details
of this anlysis are now dated,
the main themes are still valid.

Highlights

Simcivic Update #5 uses the Social Security Solvency Simulator to test the Cato Institute's plan for privatizing Social Security.

Cato – a leading conservative think tank – wants a private investment option offered to all workers, financed by a 10% PRA payroll tax, with the Social Security tax trimmed to 2.4% and devoted solely to disability coverage. Cato has created an online Social Security benefits calculator designed to show individuals how they'll benefit from privatization.

Are the benefits of Cato's strategy real? Or merely imaginary? We use our own Simulator to find out.

A Two Percent Mixed Fund Option. We begin slowly, with a 2% PRA payroll tax. And we split PRA funds 50-50 between stocks and bonds. We do follow Cato's suggested 7% ROI for stocks. The Simulator suggests that PRA's will end up owning more than half the entire stock market.

A Two Percent All-Stock Option. Next we switch to an all-stock investment strategy – a scenario highlighted on Cato's benefit calculator. Our Solvency Simulator indicates total stock ownership peaking at more than three times the stock market's likely value – clearly impossible, but nonethless the logical outcome of Cato's approach.

A Ten Percent All-Stock Option. Finally we test the full Cato plan – a 10% PRA tax, fully invested in stocks earning seven percent real returns. In Cato's clearly imaginary economy, PRA stock ownership peaks at almost eighteen times the stock market's likely value.

Is There Any Way to Make the Cato Strategy "Work"? There is, if PRA assets are invested overwhelmingly in bonds – but federal "transition" subsidies are astronomically high for six decades.

Cato Ducks the Scaling-Up Question. The Cato Institute regularly paints a glowing picture of the retirement wealth that awaits an individual investor once full privatization is adopted. But Cato never addresses the Real World issue: Can investment scenarios that seem so promising for individual accounts be "scaled up" to serve an entire workforce of 150 million-plus? As the Simulator vividly demonstrates, the answer is No.

Introduction

The Cato Institute is one of Washington, D.C.'s leading conservative think tanks. For the past several years, Cato has conducted an active publicity campaign in favor of Social Security privatization – not for current retirees, whose benefits Cato would somehow protect – but for younger workers. (Cato's Privatization Proposal.)

Cato believes that younger workers should be given the opportunity to divert most of their Social Security payroll tax into private accounts. For every worker who chooses the private account option, Cato would split the 12.4% Social Security payroll tax into two parts. 10% would go into the employee's PRA (personal retirement account), while 2.4% would continue to go to Social Security, primarily for disability insurance.

[Half of Social Security's 12.4% payroll tax is currently paid by employees, the other half by employers.]

The Cato Institute offers an online benefits calculator, authored by Peter Ferrara and William Rule. If you input your age, your annual earnings, your marital status, and your spouse's earnings, Cato's calculator will show you how much you supposedly stand to gain from privatization.

Is the Cato Institute on the right track?

The Cato Calculator

The Cato benefits calculator makes an important pair of opening assumptions.

First, Cato recommends that its users select a real rate of return on stocks of 7%. ("Real" = adjusted for inflation)

Users can go higher than 7%, if they wish – all the way to 10%.

Secondly, Cato recommends a payroll investment rate of 10%, with the Social Security tax rate trimmed back to 2.4%. (The following image is excerpted from Cato's benefits calculator.)

Accept these two recommendations – a 7% real ROI on stocks, a 10% PRA tax on payroll – and Cato's calculator paints quite a sunny picture of the benefits a young person can expect to enjoy when retirement rolls around.

The graph delivers a simple message: If the nation signs up for Cato's plan, individual workers who invest in mixed funds (50% stocks, 50% bonds) will more than double their likely retirement benefits. Those who sign up for all-stock investment funds will enjoy retirement benefits nearly five times higher than Social Security delivers.

Using the Simulator to Test Cato's Numbers

Simcivic's Simulator makes it possible to test the Cato strategy. To avoid generating graphs which pop entirely off the page, we won't start by diverting a full 10% of the nation's taxable payroll into Personal Retirement Accounts. We will start more modestly, with a 2% payroll tax for PRA's.

On the Simulator's Taxes page, we insert the following inputs. And we click "Settings OK."

We will match Cato's 7% real return rate on stocks. We open the Assumptions Page, select the following settings for stocks and bonds, then click "Settings OK."

And we'll prepare to test Cato's mixed fund scenario, 50% stocks, 50% bonds. Go the Simulator's Funding Page, select these settings, then click "Settings OK."

Now we click "Run the Numbers." What happens?

A 50-50 Stock-Bond Fund with a 2% PRA Tax

As Chart 1A shows, total PRA assets grow in value fairly steadily.Half the assets are stocks, equaling 25% to 30% of GDP in value; the other half are bonds.

What does this mean? So what if PRA-owned stocks are equal in value to 25% or 30% of GDP. Is that good? Is that bad?

It's time to ask the question that Cato never asks: What is the historic relationship between the total value of all U.S. stocks and the size of the U.S. GDP? In other words, what is the historic Market Capitalization-to-GDP Ratio?

In Chart 4, the Simulator provides an answer. In the image below, we show the first part of Chart 4, the historic Market Cap-to-GDP Ratio, calculated through 2001 from Federal Reserve and Commerce Department data. From the mid-1920's (not shown) through the mid-1990's, this ratio fluctuated between 35% and 105% of GDP, averaging about 65%.

If history is a guide, a PRA-owned stock pool worth 30% of total GDP is likely to represent a very sizeable chunk of the entire stock market, especially when the stock market is in one of its Trough Phases. (1974 – 1984 was the most recent Trough Phase.)

Our Solvency Simulator contains a stock market simulator of its own (see the right hand side of Chart 4). Some users will be concerned about the possible impact of future stock market fluctuations, we reasoned, and we built in a pair of thirty-five year cycles, complete with Growth, Plateau, Crash, and Trough phases that resemble the market's behavior during the last seventy-plus years.

[The Assumptions Page offers the user two options for future Market Cap-to-GDP Ratios – cyclical and steady.]

Chart 5, "Stock Assets as Pct of Market Capitalization," reflects the results. If the Market Cap-to-GDP Ratio is low enough to sustain a long-run real return of 7%, even a PRA program that's only half invested in stocks is likely to acquire a substantial share of the total stock market.

What About an All-Stock PRA Program?

Next, let's test the impact of an all-stock PRA program, using Cato's recommended 7% return assumption. In the interests of changing one variable at a time, we stay with a 2% PRA tax, one-fifth of Cato's recommended level.

We begin by adjusting the stock/bond mix (Funding Page).

We click "Settings OK." We click "Run the Numbers."

Chart 1A, "Total Assets as a Percent of GDP," instantly shows the results.

Total PRA-held assets now peak at about 150% of GDP, and, since all assets are now invested in stocks, this means that PRA-held stocks grow in value to 150% of GDP in the second half of the century.

The Simulator's Results Page shows the (imaginary) consequences of such a PRA plan.

Note the line that reads: "Stocks: Peak Share of Market Capitalization 315%."

This tells us that a PRA program, if it could be run according to Cato's assumptions, would at some point own stocks worth 315% of the total U.S. stock market.

What If We Plug Half the Inheritance Leak?

In its pitch for PRA's, the Cato Institute website assures its readers...

If "you own it" and "you control it", Social Security can't tell you what to do with it when you die. Your can bequeat your PRA funds to whomever you choose, and the recipients are under no obligation to redeposit your inheritance in their own PRA's. So what if the inheritance leak rate from PRA's reaches 100%? The money belongs to its owners. Period.

In our previous calcuations, we therefore set the default rate for inheritance leakage at 100%. The Simulator didn't recycle a single inherited PRA dollar into anyone else's PRA account.

Is that assumption realistic? It may not be. Suppose we now test a more optimistic view. Let's imagine that fifty percent of all PRA dollars will be recycled into other PRA's upon the deaths of their owners. To reflect this posibility, we adjust the inheritance leakage settings on the Assumption page...

We hit "Settings OK." And, once again, we hit "Run the Numbers."

And Chart 1A shows an even more dramatic spike in PRA assets – which, as we recall, are exclusively invested in stocks.

Total PRA stock ownership – were it possible – would rise into a range equaling 175% to 200% of GDP. The Results Page indicates that PRA buying power will at some point be strong enough to acquire 358% of the total stock market. With our PRA Inheritance Leak partially plugged, the Cato scenario becomes even more far-fetched.

And What If 10% of Payroll Were Invested in PRA's?

And now we're ready to test Cato's default recommendation. Suppose we now raise the 2% PRA tax to 10%, as Cato recommends? Suppose we quintuple the size of the PRA program that the Simulator has just been modeling for us? With all funds invested in stocks? Earning 7% real returns?

The reader may want to try it. We won't go through all the steps – since most of the graphs literally jump off the page. But we will show the Market Capitalization figure from the Simulator's Results page...

Note the PRA program's peak ownership capability – stocks worth 1792% of the entire stock market. Cato apparently sees no flaw in a strategy that entails all-stock PRA's buying up the entire U.S. stock market almost eighteen times over.

(One might think that Cato has now topped out. Not the case. Is Cato prepared to go further? In fact, yes, Cato is. A 7% return rate for stocks is NOT the top end of the Cato scenario. As noted, Cato's benefits calculator allows for the possibility of 10% real lifetime returns. Consider the possibilities . . . . )

Is There Any Way to Make Cato's Strategy Work?

It is almost impossible to design a workable strategy using Cato's starting point – a Social Security payroll tax of 2.4% and a PRA rate of 10%. With the Simulator's help, we'll give it a try.

One must first trim the stock portfolio. For most investors, a 30-70 stock-bond mix. For those approaching retirement, a 20-80 stock bond mix. For retirees, 0% in stocks, 100% in bonds.

One must also assume a 5% real return for stocks. (A real ROI of 5% is considerably more realistic than a real ROI of 7%, for reasons set forth in the Common Sense on Social Security article "Are Seven Percent Returns Realistic?")

Benefits must also be trimmed. Let's assume a benefit rate of 85%, with the phasedown beginning in 2010 and ending in 2060. In order to benefit from the Simulator's most straightforward graphs, we'll pretend that PRA annuity payments are to be fully coordinated with Social Security benefit payments.

It further helps to assume a faster growth rate. Instead of the Trustees' 1.6% GDP real growth rate, we'll turn to the Simulator's Assumptions Page and pick a 2.1% GDP growth rate as our best guess.

In order to be as realistic as possible, we also set the inheritance leak rate at 50%, with spouses, children, and grandkids recycling 30%, 15%, and 5% of all PRA inheritance funds into their own PRA's.

Finally, we check the Federal Subsidy choice, turning it on. (Taxes Page)

And, with all preparations in place, we click "Run the Numbers."

Result? PRA stock ownership remains within hypothetically feasible limits, peaking at 62% of total market capitalization. (PRA bond ownership – which the Simulator doesn't try to estimate – is also extraordinarily high.)

The toughest kick in the stomach is the size of the "transition" subsidy.

Chart 3B dramatizes the magnitude of the subsidy, with the red bars representing Federal subsidies to Social Security. The subsidy grows to 3.5% of GDP by 2025 – most likely requiring a federal budget increase of about 17% – and doesn't drop below 1% of GDP until after 2050.

For this Cato-like privatization strategy to work, roughly 17% of the Federal Budget must be allocated to Social Security for three straight decades, followed by another three decades of slowly declining subsidies.

Can the Cato strategy "work"? As a recent president might have said, that all depends on what the meaning of "work" is.

Is Cato On the Right Track?

The Cato Institute invariably frames the privatization question from the perspective of the individual investor.

Would a single individual have accumulated significant retirement capital if she had invested 10% of her income in a stock market index fund, year after year, from age 20 to age 65? And patiently reinvested all her dividends? Yes. Of course she would have. And, over the past several decades, her real return on investment might well have averaged seven percent. It's an attractive scenario.

Cato has devised a number of enticing techniques for utilizing the individual investor scenario to dramatize Social Security's apparent inferiority.

But Cato never takes the next step, never asks the "scaling-up" question, never tosses its privatization suitcase to the 800-pound gorilla. Can the "Individual Investor Scenario" be scaled up to serve the entire workforce? Can such a scenario be effective for 150 million flesh-and-blood investors simultaneously? As effective as it would have been for Cato's single hypothetical investor of yesteryear? Cato doesn't ask. Cato doesn't tell.

The Cato Institute puts its reputation behind the proposition that full privatization is the dream solution for Social Security. If the stock market could be cloned, again and again, and then sold off, repeatedly, to a nation of PRA owners, Cato's strategy might make sense. But the stock market can't. And Cato's strategy doesn't.

Steve Johnson, President
Simcivic.org

In principle, Simcivic.org neither favors nor opposes Personal Retirement Accounts. As the people of this great nation wrestle with the difficult issue of Social Security reform, PRA strategies based on rigorous analysis will certainly deserve consideration. Simcivic.org is opposed, however, to reform notions – like Cato's – that lack a rational foundation.

Stay Tuned for Future Simcivic Updates

• MIT's Nobel Prize-winning economist Franco Modigliani wants Social Security's Trust Fund to invest in the stock market.

Is Professor Modigliani on the right track?

Is Robert Johnson's wealth-building strategy on the right track?

Is Dean Baker on the right track?

• In a PRA system, says Brookings' Gary Burtless, the least fortunate age groups will retire with much smaller savings than the most fortunate.

Is Gary Burtless on the right track?

• The Social Security Administration uses a calculation called "actuarial balance" as its main solvency yardstick.

Is the SSA on the right track?

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