Number: RL33007
Title: Individual Accounts: What Rate of Return Would They Earn?
Authors: Brian W. Cashell and Marc Labonte, Government and Finance Division 
Abstract: A recurring question in the debate on adding individual accounts (IAs) to Social Security is how large the typical account would be upon retirement. Making this calculation requires assumptions about the contribution rate, length of time the account was held, and rate of return earned on the account (net any administrative fees and taxes). Because of the power of compound interest, changing the rate of return on the account leads to greatly different outcomes. For example, $1 invested every month for 40 years accumulates to $1,526 if earning 5%, $2,625 if earning 7%, and $4,681 if earning a 9% rate of return. Many estimates of how large the IAs would be have assumed that assets in the account would earn a rate of return equal to the historical average. For example, in the official actuarial estimates of various IA plans, the Social Security Administration actuaries assume that equities will average a rate of return of 6.5% and government bonds will earn 3%. Some proposals assume that the accounts would hold equities (stocks), others bonds, and others some combination of the two. Since stocks historically have a higher rate of return than bonds on average, the rate of return earned by the IA's would increase as the fraction held in equities increased. But is the assumption that future rates of return will mirror historical rates of return a valid one? Or are there ways in which the future may differ from the past that will have a predictable effect on the rate of return? This report analyzes demographic, economic, and financial reasons why the assumption might, or might not, be valid.
Pages: 30
Date: July 25, 2005