Social Security “Risk”: What’s Really True?

February 3rd, 2005

Is equity investment of Social Security funds in private/personal accounts "risky"? Or will it save the system? What should true conservatives be in favor of? Many of the arguments on both sides are based on wrong assumptions or form specious conclusions.

The first question, on equity investments:
Would long-term, well-diversified equity investments provide higher returns than treasury bonds?

Answer: if long-term historical experience is any predictor of the future, absolutely yes. Over the long term, equity returns consistently outpace bond returns—especially U.S. government bonds. The compounded advantage of these greater returns is profound, and could greatly contribute to the money available for Americans’ retirement down the road.

Key caveat: the possibility of a major meltdown of equity markets equivalent to 1929—a decades-long dip in equity values and returns, personal and corporate income, employment, etc. But if that occurs, Social Security and the whole national budget that’s been borrowing from Social Security (and the world economy as a whole) will be in desperate straits anyway. The trust fund wouldn’t be able to meet its obligations. Since this possibility is an equal risk either way, it doesn’t argue for or against equity investments.

Paul Krugman (an economist and columnist) challenges the notion of greater future equity returns in a February 1 NYT OpEd. He argues that:

1. "In the long run, profits grow at the same rate as the economy."

2. "economic growth, which averaged 3.4 percent per year over the last 75 years, will average only 1.9 percent over the next 75 years."

The first proposition isn’t true, even though it seems to make perfect sense.

Whether you look at a 25-, 50- 75- or 100-year period, real equity returns have consistently outpaced real GDP growth by several percentage points–both domestically and in almost every other market worldwide. (See this PDF file, especially figure 1 on page 17. This document also gives possible reasons, for the curious, why Krugman’s seemingly sensible proposition isn’t true. Interestingly, Krugman’s papers are cited more than once—significantly in the conclusion.)

Krugman’s argument is downright level-headed compared to Barry Schwartz’s, though. I’ve commented on that in a previous post.

The second question, on private/personal accounts: Are these more "risky" than the collective Social Security trust fund?

Answer: Yes, but not in the way that anti-privatization activists say.

The risk is not that people who invest in equities via private/personal accounts will get less than they would in the current system. Absent a meltdown, they will get more. The risk is that they will get less than other people. Re-using an analogy from a previous post: it’s bothersome when the person next to you on the plane paid less than you did for the same seat. But it’s even more bothersome if everyone on the plane—you included—paid more for their seats.

Final question: Can we take advantage of equities’ greater returns, and provide them equally to all participants?

Answer: Yes. By investing some trust-fund monies in equities. All participants—and the federal budget—would benefit from the greater returns.

This would also save the costs of managing all those private/personal accounts. That’s not just government management and accounting expenses, but accounting expenses for every person filing a tax return that includes earned income, every year. I haven’t seen an estimate of these costs, but they have to be huge.

Various presidents have proposed various versions of this investment scenario over the years, but they’ve always been shot down—often for partisan political reasons, but also because of concerns about political manipulation of the money management. Which raises a key issue.

Problem: Who manages the money?

Answer: That’s a tough question.
Any method for allocating the investments—whether they’re President Bush’s personal/private accounts, or trust-fund monies—will have major financial, social, and political effects. Some asset classes would be favored, others not. The devil, as always, is in the details.

Congress could legislate extremely rigid and mechanistic investment allocation methods, but that legislation would itself be highly charged, politically. The main alternative would be some kind of commission that would set investment allocation rules and methodologies (within guidelines set by Congress). The concern is that such a commission could be highly politicized in the future—pressured to make particular decisions in the runup to an election, for instance.

The Fed is a good model for this kind of commission. It has managed in most cases—aside from some egregious gaffes by Alan Greenspan over the last few years—to avoid major involvements in the political fray. But it would be far more difficult to manage equities in the trust fund without succumbing to political pressure. With billions of dollars in play—over time, trillions—and a far more complex set of decisions to make (not just the target rate), it’s hard to imagine that politicians would be able to resist efforts to interfere, or that administrators could steadfastly resist that interference.

Perhaps Congress should include a provision in any equity-investment legislation making it illegal for members of the legislative or executive branches to communicate with those administrators in any way—much like ad reps at a magazine or newspaper being forbidden to talk to editors (sadly, a not-very-common but also not-unheard-of restriction).

That hardly seems likely to happen. Congress has a very poor record of restricting its own perquisites and prerogatives.

But as far as we can tell from President Bush’s current skeletal description of his proposed system, the risk of political manipulation is equally great with either the trust-fund or the private/personal system. With that being equal, true conservatives should be in favor of investing some trust-fund monies in equities.

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