Government July 1998

Nine Misconceptions About Social Security

To take a voguish example: Privatize Social Security? Any money saved would be eaten up in Wall Street transaction costs, including million-dollar salaries

7. If people invest their money themselves, they will get a higher return than if they leave it with the government.

This may be true for some people, but it cannot be true on average, for much the same reasons as noted above. Some people may end up big winners by picking the right stocks, but if the national saving rate has not increased, the economy will not have increased its growth rate, and the economic pie will be no larger in the future with privatization than it would have been without it. Thus high returns for some must come at the expense of others. In fact, since the cost of operating a retirement system is so much greater through the financial markets than through the Social Security system, the average person will actually be worse off.

Some advocates of government-mandated saving plans argue that individual investors can get real returns of seven percent on money invested in the stock market (the historical rate of return), and that this would ensure a comfortable retirement for everyone. Certainly people have gotten far better returns in the market in the past few years, but if Social Security projections are accurate, such rates of return cannot be sustained. Profits can rise only as fast as the economy grows (unless wages fall as a share of national income, which no one is projecting). If stock prices maintain a fixed relationship to profits, then stock prices will grow at the same rate as the economy. The total return will therefore approximate the ratio of dividends to the stock price (currently about three percent) plus the rate of economic growth (two percent over the next ten years, but projected to fall to 1.2 percent in the middle of the next century). This means that the returns people can expect from investing in the stock market will be five percent in the near future and 4.2 percent later in the next century. For stock prices to rise enough to maintain a real return of seven percent, price-to-earnings ratios would have to exceed 400:1 by 2070.

8. The Consumer Price Index overstates the true rate of increase in the cost of living. Social Security recipients are therefore getting a huge bonanza each year, because their checks are adjusted in accordance with the CPI.

There is considerable dispute about the accuracy of the CPI. The Boskin Commission, which was appointed by the Senate Finance Committee to examine the CPI, stated in its final report, in 1996, that overall the CPI had been overstating the cost of living by 1.3 percentage points a year. However, the Bureau of Labor Statistics found that the CPI understated the cost of living when compared with an index that measured the cost of living for the elderly. This is because the elderly spend an unusually large share of their income on health care and housing, which have risen relatively rapidly in price. Questions remain about the accuracy of the CPI, and they cannot be resolved without further research.

However, one point is clear. If the CPI has been overstating inflation, then future generations will be much better off than we imagined. If inflation has been overstated, then real wage growth must have been understated, since real wage growth is actual wage growth minus the rate of inflation. If we accept the Boskin Commission's midrange estimate of CPI overstatement, average real wages in 2030 will be more than $54,000 (measured in today's dollars). If the commission's high-end estimate is right, average wages will be nearly $65,000. By 2050 average wages will be at least $82,000 and possibly as much as $108,000.

Another implication of a CPI that overstates inflation is that people were much poorer in the recent past than is generally recognized. This conclusion is inescapable: if the rate of inflation is lower than indicated by the CPI, then real wages and living standards have been rising faster than is indicated by calculations that use the CPI. If wages and living standards have been rising faster than we thought, then past levels must have been lower. Projecting backward, the Boskin Commission's estimate of the overstatement of the CPI gives a range for the median family income in 1960 of $15,000 to $18,000 (in today's dollars)—or 95 to 110 percent of income at the current poverty level.

If the Boskin Commission's evaluation of the CPI is accepted, any assessment of generational equity looks very bad from the standpoint of the elderly: they lived most of their lives in or near poverty. And the future looks extremely bright for the young. Average annual wages in 1960, when today's seventy-three-year-olds were thirty-five, was between $10,006 and $11,902 in today's dollars. Average annual wages in 2030, when today's newborns are thirty-two, will be between $54,000 and $65,000 in today's dollars. Such numbers make it hard to justify cutting Social Security for the elderly in order to enrich future generations, on the grounds of generational equity.

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