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Faculty Research: Deborah Lucas, Finance
private safety net?
Professor Deborah Lucas researches privatizing Social
Security, and finds it a 'risky bet'
While Congress and the president argue over how to narrow
the mammoth funding shortfalls projected to hit Social Security
in coming years, a parallel debate is taking place among
academics. At issue --- can a partial privatization of Social
Security by introducing private accounts alleviate the system's
financial pressures? And would people be better off with
private accounts? Professor
Deborah Lucas, the Donald C.
Clark/Household International Professor of Finance at the
Kellogg School, relishes tackling these questions.
she sees some advantages in a partially privatized system,
Lucas cautions that "privatization is a risky bet,
and certainly no panacea for fixing the system." Her interactions
with the policy world, first as a member of the Social Security
Technical Advisory Panel and then as chief economist at the
Congressional Budget Office, persuaded her that many policymakers
favor privatization for the wrong reasons.
"A common misperception among policymakers is that there
is a free lunch in privatizing," Lucas notes. "Much of the
confusion arises from the apparently low rate of return that
the working population will receive on Social Security taxes
paid, relative to the much higher returns to portfolios invested
in stocks and bonds. Inefficient investment is not the reason
for the low returns. If it were, the problem would be much
easier to fix."
fundamental problem, she says, is that workers' taxes cover
for current retirees, and demographic trends
are putting a squeeze on younger workers. This means that "any
transition to a privatized system would mean the public would
have to spend money investing in its own retirement and at
the same time pay for our current aging population."
Even if a smooth transition to a private system were feasible,
Lucas says, the higher expected returns on stock market investments
come at the cost of higher risk.
"Unresolved in most proposals for private investments,
but critical to a true estimate of their cost, is what would
happen if the stock market crashes? The government would
have to choose between making up the shortfall and allowing
elderly people to live in poverty." Lucas says the introduction
of risk clashes with an earlier vision of Social Security, "which
was conceived as a safety net more than a savings program."
Although many of these problems with privatization are
well understood, she believes that one important problem
has been widely ignored: the way private investments are
accounted for in the federal budget. Federal accounting rules
systematically overvalue risky financial investments, giving
the false appearance of a windfall from private investments.
says although privatization would on average increase the
of budgetary resources, "it would do so
at the cost of exposing the government, future taxpayers
and beneficiaries of federal programs to greater risk. Taking
that risk into account, the effective returns on private
securities would be no greater than the returns on government
"Congress is very sensitive to the budgetary implications
of proposed policy changes," Lucas says, "so getting the
economically right outcome depends on getting the numbers
right." She is optimistic about the prospects for accounting
reform, and sees "real signs of progress." She points to
the railroad retirement system, a parallel structure to social
security, which Congress recently authorized to invest in
"The federal budget agencies came together and were able
to avoid recording those investments as a free lunch," she
says, setting a precedent she hopes will hold up if Social
Security goes down a similar path.
academic front, "the debate centers on more fundamental
questions, since there is wide agreement that there are no
easy fixes." She says economists want to understand who would
benefit from privatization and who would be hurt.
Lucas' academic work on Social Security has focused on
the effect of privatization on the welfare of different types
of workers and what it might do to equilibrium rates of return
on stocks and bonds. Her current work (with co-author John
Heaton), re-examines a conclusion that has been influential
among academics: that the poor are under-invested in the
stock market and so would benefit from privatization. That
conclusion, however, depends on the assumption that poorer
workers are not already exposed to stock market risk, she
that workers bear significant exposure to the stock market
through the labor market and unemployment
risk, Lucas says their work suggests that there "may be little
benefit, and possibly harm" to low-income workers from greater
exposure to the stock market.