© Evanston Photographic Professor Deborah Lucas

Faculty Research: Deborah Lucas, Finance

A 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.

Although 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."

The fundamental problem, she says, is that workers' taxes cover benefits 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.

Lucas says although privatization would on average increase the expected value 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 securities.

"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 private securities.

"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.

On the 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 says.

Noting that workers bear significant exposure to the stock market indirectly 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.