Yale School of Management

Yale School of Management Study Models Solvency for Social Security Without Benefit Cuts to Future Retirees

New Haven, Conn., May 9, 2005—President Bush recently announced his proposal for Social Security solvency through “progressive indexing,” or benefit cuts to future generations of retirees. This is indicative of the ongoing reform debates, which have viewed bankruptcy and benefits as necessary trade offs. A new paper from the Yale School of Management outlines an economic model for a solvent system that keeps payouts, and the promised safety net for retirees, intact.

The paper “More Social Security, Not Less” by William N. Goetzmann, Director of the International Center for Finance at the Yale School of Management, argues that the Social Security Trust Fund could be turned into a viable endowment. It explores the feasibility of creating a government-sponsored insurance company, modeled after the government-sponsored mortgage agencies such as Fannie Mae and Freddie Mac, which would be authorized to sell government-insured wage-indexed retirement annuities. This enterprise would assume the current obligations and cash flows of the social security system in exchange for the exclusive right to sell additional insurance contracts.

The paper is available by clicking here >>.

“An endowment administered through a government-sponsored insurance company would do two things,” said Goetzmann. “It would manage its assets to cover all currently promised obligations by rebalancing its portfolio to investments with long-term growth potential, and issue more wage-indexed insurance contracts at market rates that would not only generate profits to help cover the costs of the basic social security liabilities, but would provide a realistic means for savers to plan for the future and avoid the risk of failed personal savings plans.”

Goetzmann conducted an empirical analysis of the liabilities such an agency would face and examined the optimal portfolio of assets required to meet long-term wage indexed liabilities. According to the results, a portfolio with holdings representing 23% S&P, 19% long term government bonds, 30% NCREIF, 13% commodities, and 14% REITs, has the best potential to exceed growth in the wage index, with an expected surplus of 5.2% per year. This portfolio has the probability of achieving a positive return 74% of the time.

The results have a number of implications, regardless of whether a government-sponsored insurance company is established, according to Goetzmann.

“The results suggest that the Social Security Trust Fund’s current investment policy of funding vested liabilities with long-term government bonds is not optimal; they are not a good hedge against growth in the wage index,” he said. “It also indicates that if private accounts are offered as an alternative to the current system, savers should be given the option of investing in assets such as real estate and commodity funds which track the growth of inflation and wages. These alternative asset classes have not been seriously discussed as options for individual investor accounts.”

Despite the recent criticisms of the national mortgage agencies, Goetzmann explains that they are an ideal model for a government-sponsored insurance company that would manage the portfolio of assets. Their structure has proven to be financially feasible, and even lucrative. The same underlying financial innovation that has addressed a demand for housing finance and resulted in homeownership for many could also address the need for pension insurance. And finally, they concentrate liabilities into one agency, which makes it easier to fix payment problems without shifting risk to individuals.

“As all Americans begin to face the prospect of mastering modern portfolio theory in order to manage their individual retirement accounts, it is worth considering that some would prefer to delegate the responsibility to an agency that can deliver what they are expecting from their investments: a future income that maintains a reasonable standard of living. The model of the extraordinarily successful government sponsored mortgage agencies is one that could work for Social Security,” said Goetzmann.

Contact: Tabitha Wilde, Yale School of Management
203-432-6010; tabitha.wilde@yale.edu