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The U.S. Social Security system faces a substantial long-term financial shortfall. Some have advocated using personal accounts to help resolve the problem. Others support increasing the extent to which the existing system is prefunded by contributions that are made in advance of benefit payments. It is also possible to combine the two approaches. Much of the academic and policy discussion of these alternatives has proceeded under the assumption that each approach is riskless. Under that assumption, the alternatives generate roughly the same outcomes, so that whichever reform is taken, the results will be similar. But public pension outcomes are not certain; they are subject to a variety of contingencies, stemming from traditional, market-based risks involving uncertain and variable rates of return, to a variety of political-economic risks. This paper demonstrates that the two approaches to Social Security reform can generate very different results when risks are explicitly taken into account. Personal accounts are typically superior in handling the most important politicaleconomy risks. But expanded prefunding of public accounts can be more effective at reducing market-based risks. This finding suggests that any analysis of 237 The Design and Cost of Pension Guarantees kent smetters 8 Parts of this paper circulated under a different title in the past, and helpful comments were received from Martin Feldstein, Bill Gale, Olivia Mitchell, Jan Walliser, and seminar participants at the NBER Summer Institute, Berkeley, Michigan State, World Bank, Philadelphia Federal Reserve Bank, Congressional Budget Office, and the American Economic Association meetings. 08-0238-8 chap8.qxd 3/9/04 10:36 AM Page 237 public pension reform needs to consider explicitly the risks involved rather than just the outcomes that are expected to derive in a fully certain environment. Conceptual Building Blocks The true costs of any promise to pay future benefits must be measured ex ante—that is, before the value of underlying risks is realized. This cost is not likely to be a readily observable variable like, for example, the price of corporate share. As a result, the costs may be inadvertently ignored in comparing the outcomes of different reform options. In fact, the ex ante cost of risks created can be larger than the expected cost of a pension plan. As a result, a pension reform that reduces the expected value of a pension plan’s liabilities might actually increase its true liabilities once risk is taken into account. Funding In 401(k) plans, the contribution level is defined by formula, and the final retirement benefit level is directly tied to the account balance. In contrast, most public pension plans are defined benefit plans, where the value of the retirement benefit is determined by a formula, typically related to years of service, age, and salary. The disconnect between benefit levels and fund values in defined benefit plans has allowed government to set aside an amount of assets for the public pension plan that is less valuable than outstanding promised benefits. These plans are referred to as underfunded. Since an underfunded pension plan does not hold enough assets to meet promised benefits, the government must use tax revenue collected in a given year to help cover benefits paid in the same year. That is, benefits paid to retired generations in each year are paid, in part, using tax revenue collected from the subsequent generations of workers who are employed in the same year. If the pension plan fund has no assets whatsoever, then the pension is known as a pay-as-you-go plan. In that case, benefits paid to retired generations in each year are fully paid using tax revenue collected from subsequent generations of workers employed in the same year. The current U.S. Social Security system is underfunded. While the Social Security trust fund is now worth more than $1 trillion, that represents a small fraction of the system’s outstanding liabilities. Full funding would require an accumulation of another $10.5 trillion in assets under intermediate projections made by the Social Security Trustees. Solvency The U.S. Social Security system is also insolvent over the next seventy-five years. That is, existing projections of payroll tax revenues, plus the combined value of the current trust fund balance and future interest accruals on the balance , are less than legislated benefits over the next seventy-five years. Either 238 Private Pensions and Public Policies 08-0238-8 chap8.qxd 3/9/04 10:36 AM Page 238 [18.116.51.117] Project MUSE (2024-04-19...

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