Bloomberg’s Josh Barro is the lead writer for the Ticker, Bloomberg View’s blog on economics, finance and politics.
Social Security is the healthiest component of the U.S.’s retirement saving system
Last week I wrote that Social Security is the healthiest component of the U.S.’s retirement saving system and should therefore be expanded. This isn’t a popular position; liberals tend to prefer defined-benefit pensions from employers and conservatives defined-contribution accounts, such as 401(k)s and individual retirement accounts. But the reason Social Security works so well is that it lacks a fundamental problem that undermines the effectiveness of these other retirement vehicles.
Both defined-benefit pensions and defined-contribution accounts are based on a shared and problematic premise: It is possible to set aside x percent of today’s gross domestic product for retirement and generate retirement income from those savings that exceeds x percent of future GDP. This is to be achieved by investing retirement savings in assets that typically grow at a faster rate than the economy as a whole.
Such returns are possible. Some asset classes have long-run rates of return that exceed GDP growth: equities, for example. But the high returns are a compensation procyclical risk: These assets will tend to strongly outperform GDP when the economy does well and significantly underperform it during recessions.
It doesn’t make sense to finance retirement in such a risky way. Retirement savings exist disproportionately for the benefit of people with low or moderate means and a relatively low tolerance for risk. If retirement assets were invested safely, they would not be expected to grow faster than the economy as a whole.
So 401(k) and traditional pensions are both just efforts to finance retirement on the cheap by taking on excessive risk. The problem created by risk manifests itself in different ways with the different vehicles.
That is, private pensions no longer rely on the premise that retirement can be made cheaper through investment in assets that grow faster than GDP. But such a free lunch was what made the plans attractive for employers in the first place, and as employers have faced the plans’ real costs, they have increasingly eliminated them.
In the public sector, the free lunch lives on in the financial statements of pension funds. Governments fund their pensions based on an expected rate of return on a risky portfolio of assets, most commonly between 7.5 and 8 percent a year, far above the roughly 5 percent growth path we might expect for nominal GDP.
All of these options (expanding Social Security or downshifting the risk in other investment vehicles) would cause retirement saving to appear to become more expensive. But it wouldn’t actually make saving more expensive: It would just replace hidden costs created by risk with explicit costs.
Americans would then face a stark reality: Retirement, which is basically just another word for spending the final sixth of your life on vacation, is expensive. I am agnostic on the question of whether people ought to respond by saving more or retiring later. Advocates of later retirement tend to be elite people with jobs that are interesting and not physically demanding. But facing up to the true cost of adequate retirement saving would help Americans make more sound choices about how to deal with the fact that retirement is expensive.