Freeman

IT JUST AIN'T SO

Private Investment Is More Risky than Social Security?

Social Security Offers Terrible Returns

AUGUST 01, 2000 by ANDREW BIGGS

Filed Under : Social Security

The week ending April 14 witnessed a 6 percent drop in the Dow Jones Industrials Index, while the NASDAQ fell a precipitous 26 percent. The markets are sure to bounce back, but could the lasting victim be the movement to privatize Social Security? Opponents of privatization, which would let workers invest in personal retirement accounts holding stocks and bonds, hope so. They were filled with glee at the recent market volatility.

William Raspberry, columnist for the Washington Post, typified this view, saying that the “wild fluctuation of stock prices should have cooled the ardor of those free-enterprisers who want to privatize Social Security.” Raspberry acknowledges that, over time, the stock market always trends upward. “But suppose the market dropped 500 points (or that your portfolio lost a comparable amount of its value) and stayed down—not forever, of course, but for, say, half a year after your retirement. You might find yourself longing for the good old days when your Social Security payment was guaranteed by the government.”

Okay, let’s suppose the market did drop 500 points. In fact, let’s assume that the Dow dropped 5,000 points, half its current value, on the very day a worker retired. How would a worker, currently 40 years old and earning $25,000 annually, fare under personal retirement accounts as compared to Social Security?

When he retires, that worker can expect to receive Social Security benefits worth approximately $1,100 per month in today’s money, assuming full benefits can be paid. Of course, after 2015, when benefits owed exceed payroll taxes collected, full benefits cannot be paid unless taxes are increased or other spending is cut. But let’s assume that the extra money needed to cover Social Security’s long-term unfunded liability—all $20 trillion of it (in 2000 dollars)—is donated by a generous benefactor and that full benefits can be paid without increasing taxes a penny.

Now let’s assume that the same worker invested the retirement portion of his payroll taxes (10.6 percent of wages up to $76,200) in stocks and earned the same returns that the market has produced since 1802: 7 percent annually in real terms. If he worked 45 years, he would retire with $838,000 in his account.

Assuming he remained fully invested in the Dow index until retirement, a drop of 5,000 points would cut his account balance in half. In addition, let’s suppose that workers do not have the option to wait out a market downturn or to withdraw funds from their account over time. They are required to annuitize their personal accounts on the day they retire, whether the market is a bull or a bear.

Despite all this, even if the market dropped by 5000 points, cutting his savings in half, the worker’s account balance would still be enough to purchase a joint-and-survivor annuity paying over $2,700 monthly, almost two-and-a-half times what Social Security would pay. In fact, it would take a market crash of over 80 percent—substantially greater than that of October 1929—for a personal retirement account to pay less than what Social Security promises (but cannot pay).

Historical Average

Moreover, this example assumes that the market returns only the historical average before its crash. History shows that most large market declines are preceded by equally large market advances. In this case, the account balance would likely be even higher.

In addition, we also assume that the worker remains 100 percent invested in equities until the day he retires. Had he practiced life-cycle investing, in which he would move to less volatile investments such as corporate or government bonds as he neared retirement, his exposure to a sudden market decline would be greatly diminished.

Critics of Social Security privatization are correct that the stock market is volatile over the short term. In their best single year stocks gained 66 percent in value, while losing 40 percent in their worst. But investing for retirement is about the long term. Over 30 years, stocks’ best average annual return was 10.6 percent in real terms, while their worst performance was a 2.6 percent annual profit. In other words, if you held a balanced portfolio of stocks over 30 years you never lost money.

The same cannot be said for “safe” government bonds, which lost money in the post-war period as inflation ate away at their value. Nor can it be said for Social Security, which in the future will pay many workers a negative rate of return. As Wharton School professor Jeremy Siegel has shown, despite their daily ups and downs, over long holding periods stocks actually have smaller variations in returns (are less “risky”) than corporate or government bonds.

Even after hearing all this, some may still prefer not to invest in stocks. Guess what? To beat Social Security, they don’t even have to. The bipartisan 1994-1996 Advisory Council on Social Security estimated that even if Social Security could pay full benefits forever without raising taxes, a typical 27-year-old single worker would receive an annual return of just 1.7 percent. Even investing only in ultra-safe inflation-indexed Treasury bonds, currently paying 3.9 percent annually, would double that worker’s retirement income. Plus, workers would have a true legal guarantee of repayment, which Social Security does not provide. Investing in higher-yielding stocks and corporate bonds, ordinary workers could save enough to leave large inheritances to their heirs.

No one except day traders likes market volatility. But it would take a pretty large market drop, larger even than the crash preceding the Great Depression, to make Social Security a better deal than personal retirement accounts.

—Andrew G. Biggs

Cato Institute

ASSOCIATED ISSUE

August 2000

comments powered by Disqus

EMAIL UPDATES

* indicates required

CURRENT ISSUE

December 2014

Unfortunately, educating people about phenomena that are counterintuitive, not-so-easy to remember, and suggest our individual lack of human control (for starters) can seem like an uphill battle in the war of ideas. So we sally forth into a kind of wilderness, an economic fairyland. We are myth busters in a world where people crave myths more than reality. Why do they so readily embrace untruth? Primarily because the immediate costs of doing so are so low and the psychic benefits are so high.
Download Free PDF

PAST ISSUES

SUBSCRIBE

RENEW YOUR SUBSCRIPTION

Essential Works from FEE

Economics in One Lesson (full text)

By HENRY HAZLITT

The full text of Hazlitt's famed primer on economic principles: read this first!


By FREDERIC BASTIAT

Frederic Bastiat's timeless defense of liberty for all. Once read and understood, nothing ever looks the same.


By F. A. HAYEK

There can be little doubt that man owes some of his greatest suc­cesses in the past to the fact that he has not been able to control so­cial life.


By JEFFREY A. TUCKER

Leonard Read took the lessons of entrepreneurship with him when he started his ideological venture.


By LEONARD E. READ

No one knows how to make a pencil: Leonard Read's classic (Audio, HTML, and PDF)