Monetary policy transmission through the consumption-wealth channel : commentary

Paper for a conference sponsored by the Federal Reserve Bank of New York entitled Financial Innovation and Monetary TransmissionMonetary policy ; Consumption (Economics) ; Wealth

Reforming Social Security with Progressive Personal Accounts

The heated debate about how to reform Social Security has come to a standstill because the view of most Democrats (that Social Security must be a defined benefits plan similar in spirit to the current system) seems irreconcilable with the proposals supported by many Republicans (to create a defined contribution system of personal accounts holding marketed assets). We describe a system of "progressive personal accounts" that preserves the core goals of both parties, and that is self-balancing on an ongoing basis. Progressive personal accounts have two critical features: (1) accruals into the personal accounts would be exclusively in a new kind of derivative security (which we call a PAAW for Personal Annuitized Average Wage security) that pays its owner one inflation-corrected dollar during every year of life after his statutory retirement date, multiplied by the economy wide average wage at the retirement date and (2) households would buy their new PAAWs each year with their social security contributions, augmented or reduced by a government match that would add to contributions from households with low lifetime incomes by taking from households with high lifetime incomes. PAAWS define benefits and achieve risk sharing across generations, as Democrats would like, yet can be held in personal accounts with market valuations, as Republicans propose.Social Security, Personal accounts, Risk-sharing

Market Valuation of Accrued Social Security Benefits

One measure of the health of the Social Security system is the difference between the market value of the trust fund and the present value of benefits accrued to date. How should present values be computed for this calculation in light of future uncertainties? We think it is important to use market value. Since claims on accrued benefits are not currently traded in financial markets, we cannot directly observe a market value. In this paper, we use a model to estimate what the market price for these claims would be if they were traded. In valuing such claims, the key issue is properly adjusting for risk. The traditional actuarial approach -- the approach currently used by the Social Security Administration in generating its most widely cited numbers -- ignores risk and instead simply discounts "expected" future flows back to the present using a risk-free rate. If benefits are risky and this risk is priced by the market, then actuarial estimates will differ from market value. Effectively, market valuation uses a discount rate that incorporates a risk premium. Developing the proper adjustment for risk requires a careful examination of the stream of future benefits. The U.S. Social Security system is "wage-indexed": future benefits depend directly on future realizations of the economy-wide average wage index. We assume that there is a positive long-run correlation between average labor earnings and the stock market. We then use derivative pricing methods standard in the finance literature to compute the market price of individual claims on future benefits, which depend on age and macro state variables. Finally, we aggregate the market value of benefits across all cohorts to arrive at an overall value of accrued benefits. We find that the difference between market valuation and "actuarial" valuation is large, especially when valuing the benefits of younger cohorts. Overall, the market value of accrued benefits is only 4/5 of that implied by the actuarial approach. Ignoring cohorts over age 60 (for whom the valuations are the same), market value is only 70% as large as that implied by the actuarial approach.Social security, Market value, Risk adjustment, Actuarial value, Wage bonds, Unfunded obligations

Do the Rich Save More?

The issue of whether higher lifetime income households save a larger fraction of their income is an important factor in the evaluation of tax and macroeconomic policy. Despite an outpouring of research on this topic in the 1950s and 1960s, the question remains unresolved and has since received little attention. This paper revisits the issue, using new empirical methods and the Panel Study on Income Dynamics, the Survey of Consumer Finances, and the Consumer Expenditure Survey. We first consider the various ways in which life cycle models can be altered to generate differences in saving rates by income groups: differences in Social Security benefits, different time preference rates, non-homothetic preferences, bequest motives, uncertainty, and consumption floors. Using a variety of instruments for lifetime income, we find a strong positive relationship between personal saving rates and lifetime income. The data do not support theories relying on time preference rates, non-homothetic preferences, or variations in Social Security benefits. Instead, the evidence is consistent with models in which precautionary saving and bequest motives drive variations in saving rates across income groups. Finally, we illustrate how models that assume a constant rate of saving across income groups can yield erroneous predictions.

Precautionary Saving and Social Insurance

Microdata studies of household saving often find a significant group in the population with virtually no wealth, raising concerns about heterogeneity in motives for saving. In particular, this heterogeneity has been interpreted as evidence against the life-cycle model of saving. This paper argues that a life-cycle model can replicate observed patterns in household wealth accumulation after accounting explicitly for precautionary saving and asset-based means- tested social insurance. We demonstrate theoretically that social insurance programs with means tests based on assets discourage saving by households with low expected lifetime income. In addition, we evaluate the model using a dynamic programming model with four state variables. Assuming common preference parameters across lifetime- income groups, we are able to replicate the empirical pattern that low-income households are more likely than high-income households to hold virtually no wealth. Low wealth accumulation can be explained as a utility-maximizing response to asset-based means-tested welfare programs.

Social Security Money's Worth

This paper describes how three money's worth measures the benefit-to-tax ratio, the internal rate of return, and the net present value are calculated and used in analyses of social security reforms, including systems with privately managed individual accounts invested in equities. Declining returns from the U.S. social security system prove to be the inevitable result of having instituted an unfunded (pay-as-you-go) retirement system that delivered $7.9 trillion of net transfers (in 1997 present value dollars) to people born before 1917, and will deliver another$1.8 trillion to people born between 1918 and 1937. But young and future workers cannot necessarily do better by investing their payroll taxes in capital markets. If the old system were closed down, massive unfunded liabilities of $9-10 trillion would still have to be paid unless already accrued benefits were cut. Alternative methods of calculating these accrued benefits yield somewhat different numbers: the straight line calculation is$800 billion less than the constant benefit calculation we propose as the benchmark. Using this benchmark in a world with no uncertainty, we show that privatization without prefunding would not increase returns at all, net of the new taxes needed to pay for unfunded liabilities. These new taxes would amount to 3.6 percent of payroll, or about 29 percent of social security contributions. Prefunding, implemented by reducing accrued benefits or by raising taxes, would eventually increase money's worth for later generations, but at the cost of lower money's worth for today's workers and/or retirees. Computing money's worth when there is uncertainty is much more difficult unless four conditions hold prices into stocks and out of bonds has no effect whatsoever on money's worth when it i adjusted for risk: a dollar of stock is worth no more than a dollar of bonds. diversification can raise welfare for constrained households, but the exact money's worth must depend on specific assumptions about household attitudes toward risk. Calculations lik the Social Security Advisory Council that attribute over $2.85 of net present va$1 shifted from bonds to stocks completely overlook the disutility of risk. By estimate that a 2 percent of payroll equity fund carved out of social security w present value by about 59 cents per dollar of bonds switched into equities When the likely reductions in income and longevity insurance are factored in privatization and diversification is substantially less than popularly perceived

Reforming Social Security with Progressive Personal Accounts

The heated debate about how to reform Social Security has come to a standstill because the view of most Democrats (that Social Security must be a defined benefits plan similar in spirit to the current system) seems irreconcilable with the proposals supported by many Republicans (to create a defined contribution system of personal accounts holding marketed assets). We describe a system of “progressive personal accounts” that preserves the core goals of both parties, and that is self-balancing on an ongoing basis. Progressive personal accounts have two critical features: (1) accruals into the personal accounts would be exclusively in a new kind of derivative security (which we call a PAAW for Personal Annuitized Average Wage security) that pays its owner one inflation-corrected dollar during every year of life after his statutory retirement date, multiplied by the economy wide average wage at the retirement date and (2) households would buy their new PAAWs each year with their social security contributions, augmented or reduced by a government match that would add to contributions from households with low lifetime incomes by taking from households with high lifetime incomes. PAAWS define benefits and achieve risk sharing across generations, as Democrats would like, yet can be held in personal accounts with market valuations, as Republicans propose