January 22, 1999

Senator Daniel Patrick Moynihan
United States Senate
Washington, D.C. 20510

Dear Senator Moynihan:

We are writing to you in reference to your support of a Social Security reform plan which relies in part on the creation of individual accounts. Proponents of individual accounts conventionally assume that money from these accounts which is invested in the stock market will earn a considerably higher real rate of return, usually 7.0 percent a year, than that available from government bonds. This assumption is essential to the projected gains from allowing individual accounts.

As you know, every year the Social Security trustees publish their projections for the program’s solvency in their annual report. This report lays out in great detail the year by year assumptions for wage growth, interest rates, unemployment rates and other economic and demographic factors which form the basis of their seventy-five year projections. This allows policy analysts to review the basis of the projections and to assess their plausibility. The level of detail in the Trustees Report also provides reassurance to the public that the projections for the nation’s most important social program have a realistic foundation.

If the public is to support a Social Security reform proposal that relies on high projected returns in the stock market, it seems incumbent on the proponents of such plans to produce an equally detailed description of their assumptions on stock returns. Specifically, this description would present the year by year assumptions for the two components of the stock return, dividend payouts and capital gains, in precisely the same manner that the Trustees Report currently lays out its assumptions for wage growth or interest rates.

While no one can expect an accurate prediction of capital gains in the year 2010, or dividend payouts in the year 2046, it is also not possible to make accurate predictions of wage growth or interest rates for these years. What is important, is that on average the assumptions for these variables are plausible. Proponents of Social Security reform plans that rely on investing in the stock market should be prepared to have their assumptions subjected to the same degree of scrutiny as the assumptions that form the basis for Social Security projections.

Although the historic rate of return in the stock market has been 7.0 percent, there are serious grounds for questioning whether the stock market will produce the same yields in the future, given both the current record high price to earnings ratios, and the slow economic growth projected by the Social Security trustees.

To be specific, annual dividend payments are averaging under 2.0 percent of the share price. By contrast, over the last seventy years, dividend payments averaged close to 4.0 percent of the share price. The only way the dividend yield can rise significantly is if either share prices fell drastically or if firms radically cut investment spending in order to free up money to increase dividend payments. Neither of these scenarios seems very likely.

The second component of the stock return is the increase in the share price. Share prices are already at record high levels relative to corporate profits. While the price to earnings ratio may well move somewhat higher, very soon it reaches levels that everyone would agree are implausible. For example, in order to produce 7.0 percent returns in an environment where the economy and corporate profits are growing at the rate of less than 1.5 percent annually (the projections of the Social Security trustees), the price to earnings ratio will have to exceed 400 to 1 by the year 2070.

Alternatively, if price to earnings ratios stabilize at their current record high, the rate of growth in stock prices will be exactly the same as the rate of growth of profits, just under 1.5 percent annually. Adding the 1.5 percent rise in share prices to the 2.0 percent annual dividend payout gives an average return of 3.5 percent, roughly half the 7.0 percent assumed in most calculations.

It may be possible to construct a plausible scenario in which stock returns average the 7.0 percent assumed by advocates of individual accounts. But such an account has not yet been produced and until it is, this assumption about rates of return does not deserve to be taken seriously in the Social Security debate.


Dean Baker
Co-Director, Center for Economic and Policy Research
(formerly Senior Research Fellow, Preamble Center)

Mark Weisbrot
Co-Director, Center for Economic and Policy Research
(formerly Research Director, Preamble Center)