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).
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