Changing progressivity as a means of risk protection in investment based social security
Download
1 / 25

Changing Progressivity as a Means of Risk Protection in Investment-Based Social Security - PowerPoint PPT Presentation


  • 73 Views
  • Uploaded on

Changing Progressivity as a Means of Risk Protection in Investment-Based Social Security. Andrew Samwick Dartmouth College and NBER October 21, 2006. That’s Quite a Mouthful What Does It Mean?.

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about ' Changing Progressivity as a Means of Risk Protection in Investment-Based Social Security' - willa-mack


An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
Changing progressivity as a means of risk protection in investment based social security

Changing Progressivity as a Means of Risk Protection in Investment-Based Social Security

Andrew SamwickDartmouth College and NBEROctober 21, 2006


That s quite a mouthful what does it mean
That’s Quite a MouthfulWhat Does It Mean?

  • Some proposals to restore solvency combine a scaled-back traditional benefit with a personal retirement account (PRA) invested in financial assets.

  • Financial assets, particularly equities, introduce financial risk.

  • To make reform more feasible, PRAs can be designed to minimize financial risk or mitigate its consequences.


Mechanisms to minimize financial risk
Mechanisms To Minimize Financial Risk

  • Don’t Invest in Equities

    • At the cost of lower expected returns and higher required PRA contributions.

  • Follow Life Cycle Investment Strategies

    • Reduce exposure to equity risk as retirement approaches, by shifting steadily into bonds.

  • Offer a Third-Party Guarantee

    • Specify a minimum rate of return (hard) or a minimum benefit level (easier) that will be achieved by the PRA portfolio.

  • Use Options To Protect Against Low Outcomes

    • Either a put or a put plus a written call


Really all of these are just a version of don t invest in equities
Really, All of These Are Just a Version of “Don’t Invest in Equities.”

  • Life Cycle funds shift to bonds with age.

    • The more interesting question is whether the timing adds value, conditional on the average allocation to equities.

  • With Guarantees:

    • The guarantor funds the guaranteed benefits with bonds, then lets the investor have the maximum of the bonds or the portfolio.

  • With No-Loss Strategies:

    • The investor earmarks a portion of the contributions for bonds to return the nominal (or real) principal.

  • With Pension Collars:

    • The portfolio is (dynamically) equivalent to specified fractional ownership levels in the stock, a bond at the lower limit, and a bond at the higher limit.


What if portfolio restrictions are not feasible or desirable
What If Portfolio Restrictions in Equities.”Are Not Feasible or Desirable?

  • Social Security already provides a benefit floor, and it would continue to do so to some degree in (almost) any reformed system.

  • If Social Security were made more progressive, that benefit floor would increase (in relative terms).

  • This, in turn, would allow us to be less concerned about exposure to equity in the PRAs and to allow them to be less tightly regulated.

  • The paper quantifies how much equity risk we can shed based on how progressive we make the scaled-back traditional benefit.


Varying the progressivity in the scaled back traditional benefit
Varying the Progressivity in the in Equities.”Scaled-Back Traditional Benefit

  • Proportional:

    • Reduce all benefits by 40% across the board.

  • Floors at the 10th or 25th percentile:

    • First move all benefits below the specified percentile up to that percentile’s benefit.

    • Then scale all benefits down by whatever amount is needed to achieve a 40% aggregate reduction.

  • Progressive:

    • First reduce the AIME-to-PIA replacement rates down from {90, 32, 15} to {67.5, 16, 8}

    • Then scale all benefits to achieve a 40% aggregate reduction.

  • Uniform at Mean:

    • Set all benefits equal to 40% of the original mean benefit.


Preview of key results
Preview of Key Results in Equities.”

  • Greater progressivity can substitute for higher equity allocations. Compared to a proportional cut in the traditional benefits:

    • A commonly proposed progressive cut to the traditional benefit allows the worker to shed half the equity risk.

    • A maximally progressive cut to a uniform benefit allows the worker to shed two thirds of the equity risk.

    • Progressivity is more important when the investor is risk averse or the equity premium is lower.

  • But progressivity does not change the desire to invest in equities much.

    • We would observe similar amounts of financial risk in PRA portfolios regardless of how traditional benefits were cut.


Details of the simulation model one cohort of workers
Details of the Simulation Model in Equities.”One Cohort of Workers

  • Start with the age-specific mean and quartiles of covered earnings in Kunkel (1996) for the years from 1980 – 1993.

  • Scale them up to 2003 levels by the growth in the national average wage relative to the base year.

  • Impute a lognormal cross-sectional distribution:

    • Median = exp(m)

    • Mean = exp(m + s2/2)

  • Draw a 10,000 observation sample of wages for 30-year olds based on that distribution.


Details of the simulation method time series earnings process
Details of the Simulation Method in Equities.”Time-Series Earnings Process

  • A deterministic component that mimics the low-education income profile from HSZ (1995).

  • An AR(1) stochastic component to log earnings with r = 0.95 and s drawn from a uniform distribution on [0.05, 0.20]

  • Backcast to 21 and forecast to 67.

  • Even for a single cohort, this is a very stylized model.


Details of the simulation method pra investment returns
Details of the Simulation Method in Equities.”PRA Investment Returns

  • For each observation, at each age, assign a randomly drawn “year” from the Ibbotson (2006) data of asset returns from 1926 – 2005.

  • Make a few additional assumptions:

    • Equity is 75-25 large vs small stocks

    • Govt bonds are equally long-, medium-, and short-term

    • Parameter that varies is share in bonds (assumed 50-50 corporate-government) relative to equity.

  • Keep the variation, but reset the means:

    • Follow SSA’s assumptions when it scores plans: 6.2% equity, 3.2% corp bonds, 2.7% govt bonds (net of 30 basis points in administrative costs)

    • Consider alternative equity means of 5.2% and 4.2%


Details of the simulation model benefit calculations
Details of the Simulation Model in Equities.”Benefit Calculations

  • Traditional Benefit

    • Project the national average wage based on the average wage growth for this cohort over its working career.

    • Use this series and the highest 35 years of earnings to compute the AIME.

    • Use this series to update the bendpoints in the PIA-to-AIME formula and compute benefits.

    • Modify as appropriate to increase progressivity.

  • PRA Benefit

    • Accumulate a 2- or 3-percent contribution on each year of covered earnings.

    • Convert accumulations to a real annuity benefit based on the period life table for 2002.

  • Combine 40% of the first with all of the second.


Figure 1 changing progressivity

These differences are in Equities.”

relatively unimportant.

These differences are

very important.

Figure 1: Changing Progressivity


Figure 2 shifting from bonds to equity

With SSA’s equity premium, in Equities.”

high equity allocations

aren’t the problem.

Figure 2: Shifting from Bonds to Equity


And with 2 off the equity premium

Even these differences in Equities.”

are not particularly large.

And with 2% off the equity premium


Cut by 40% in Equities.”

Increase Progressivity, Decreasing Variation

Decrease Bond Share

Increasing Equity Share

Raising Expected Benefits

Raising Variation


(56 – 10)/90 = 51% in Equities.”

How Much Equity Risk Can Be Avoided?

(72 – 10)/90 = 69%


With less risk aversion, the all-equity portfolio dominates, and greater progressivity would not enable investors to shed much equity risk.


With more risk aversion, the optimal equity portfolio shares fall from 90% to 80% or 70% as progressivity increases, and greater progressivity could enable investors to shed all or almost all equity risk.


Knocking 100 basis points off the equity premium has analogous effects as increasing risk aversion: slightly lower equity allocations are optimal, and all or almost all equity risk could be shed with higher progressivity.


With larger PRAs, optimal equity allocations fall from 90% to 80%, and greater progressivity facilitates shedding about the same proportions of equity risk (half and two thirds).


Life cycle strategies
Life Cycle Strategies to 80%, and greater progressivity facilitates shedding about the same proportions of equity risk (half and two thirds).

  • Start with low bond allocations at young ages, shifting over time to high bond allocations.

    • 5 to 95 in increments of 2% per year

    • 27.5 to 72.5 increments of 1% per year.

  • Compared to a uniform 50% allocation in bonds, these strategies have lower return and lower risk.

    • The average PRA balance grows with age, so equity allocations above 50 multiply smaller balances.

  • In general, these strategies don’t outperform uniform portfolio allocations.

    • With 200 basis points off the equity premium, the second strategy can (mildly) dominate the uniform 50-50 portfolio, which was previously optimal.


Conclusions
Conclusions to 80%, and greater progressivity facilitates shedding about the same proportions of equity risk (half and two thirds).

  • Higher progressivity, in this framework, makes workers better off.

  • It also allows them to maintain expected utility with lower exposure to equity risk.

    • In the baseline, half to two-thirds of this risk can be eliminated.

    • More at higher risk aversion or lower equity premiums, despite lower optimal equity allocations.

  • However, greater progressivity does not reduce their desire to invest in equities much.

  • Life Cycle strategies are of some, but limited, use in improving welfare.


Possibilities for further research
Possibilities for Further Research to 80%, and greater progressivity facilitates shedding about the same proportions of equity risk (half and two thirds).

  • Simulating the portfolio returns

    • Should I be assigning everyone the same sequence of “years” and bootstrapping the results?

  • More sensitivity tests

    • More variety in (deterministic) wage profiles

    • Couples versus single households

    • Multiple cohorts

    • Actual versus hypothetical workers


ad