Tuesday, December 8 , 1998

Downside

For some, common stocks have the same role as aspirin in the army or chicken soup from your mother: whatever ails you, stocks will make it better.

The most current example: stocks will fix Social Security.

Thats what we are witnessing with multiple proposals to privatize Social Security by diverting a portion of our employment tax contributions to private accounts. The private accounts, in turn, could be invested like 401(k), 403(b), and SEP-IRA accounts. They would be owned and directed by workers. Supporting studies regularly show that while current retirees are receiving an extraordinary return on their employment tax payments, future retirees will have negative returns and would be better off investing for themselves.

In fact, the advocates of privatization have overlooked a major issue: what you receive in Social Security benefits can be known in advance. What you may accumulate in private account benefits will depend entirely on your investment results and what happens in the financial markets as you retire. Convert your employment tax contributions to a private account and some people will do well and some wont.

Thats financial freedom

Some people believe you should have financial freedom, no matter what. I dont agree. While the market can, and should, solve a major portion of the retirement income puzzle, the roots of Social Security are in a public consensus that provides a broad level of basic support for elderly people in this society. It was always intended that most retirement income come from personal savings and, perhaps, a corporate pension plan.

The privatization proposals reduce that basic societal support. More important, actual retirement income will become more uncertain.

If we look at the differing results in 401(k) plans, the top 20 percent will likely retire will over 100 percent of pre-retirement income while the bottom 20 percent will retire with only 13 percent of pre-retirement income. (This was discussed in an earlier column, Sunday, September 6, available at www.scottburns.com/980906SU.htm.) Just as defined contribution savings plans with uncertain results have been displacing defined benefit pension plans with fixed benefits, the privatization of Social Security would increase the uncertainty of retirement income still further.

How much?

It all depends on how the money is invested. One source of information is Milliman and Robertson, an actuarial consulting firm. They are an unlikely source for this information since A. Haeworth Robertson, one of the firms founders and the Chief Actuary of the Social Security Administration from 1975 to 1978, has been an active proponent of Social Security reform for decades, not years. Most of the investment community proponents are Johnny-come-latelies to the issue.

To study the effects of privatization, the firm built a computer simulation to compare investment results for different asset class portfolios with projected Social Security benefits for workers at different income levels and different marital conditions. To provide realistic measures, they assumed investment management expenses of 1 percent annually for equities and half a percent for fixed income, amounts that are common for large 401(k) plans.

Using rate of return probabilities, they found that while some workers would receive higher benefits under a privatization plan, a significant number would receive lower benefits. More important, while Social Security provides disproportionately higher benefits for lower income workers in single income households— a socially important goal— privatization works in the opposite way, providing higher benefits to higher income workers in dual earner households. Some sample figures, shown as percent of Social Security benefits, are shown below.

Privatization for Typical-Wage Earner Couple with a Non-earning Spouse

Percentile All Stocks All Bonds 50/50 Stocks/Bonds
10 71% 62% 70%
25 85% 66% 77%
50 114% 71% 89%
75 172% 78% 109%
90 290% 86% 140%

Source: Milliman and Robertson

Privatization for a High Earner Married Couple, Both Working

Percentile All Stocks All Bonds 50/50 Stocks/Bonds
10 88% 65% 85%
25 123% 75% 105%
50 198% 87% 136%
75 348% 106% 183%
90 675% 126% 265%

Source: Milliman and Robertson

As you can see, there is a 50 percent chance that a typical wage earner who invests in a 50/50 portfolio of equities/fixed income will receive only 89 percent of Social Security benefits, or less, while the high earner two income couple has a 50 percent chance of receiving 136 percent of Social Security benefits, or better. (Interested readers can see the full set of figures by visiting the Milliman and Robertson website at: www2.milliman.com/milliman/publications/perspectives/per02u.htm.)

More important, both groups can have the results reduced if their long term returns are reduced by only one percent. This is significant since the average domestic equity fund has trailed the Standard and Poors 500 index by 4.11 percent a year over the last 15 years.

What does it all mean?

Rich people can, and do, live well with uncertainty. But Social Security was not created to benefit rich people. It was created to provide a socially acceptable floor on income for everyone who worked.

My suggestion: Instead of converting Social Security into an investment program, lets eliminate the employment tax for the second earner in two-earner households, liberalize existing tax deferred savings programs, encourage greater employer support of those programs, and reduce taxes on the money when it is withdrawn.

Who knows, it might even promote marriage.