In the wake of the Enron collapse, opponents of Social Security privatization
have tried to describe private capital markets as "too risky" for
average Americans. However, William Shipman, a former principal with State Street
Global Advisors and co-chair of the Cato Institute’s Project
on Social Security Privatization, writes in the Washington Times, that those arguments misrepresent the American economic system.
President Bush’s Commission to Strengthen Social Security completed its work last month and its findings and recommendations are now public. The report will be a catalyst for a spirited national debate this election year. Indeed, one of the Commission’s findings states "that there be a period of discussion, lasting at least one year, before legislative action to strengthen Social Security."
The discussion undoubtedly will include the wisdom of saving and investing in the stock and bond markets for retirement income. Proponents may argue that doing so will give lower-income workers the opportunity to accumulate wealth-producing assets over which they will have personal property rights. Opponents will likely counter that this is a risky scheme—a ploy by Wall Street to make millions if not billions of dollars. The terms "Wall Street" and "risky scheme" will most likely be uttered together so often and in the same breath that their meanings may become indistinguishable. Be careful.
Saving and investing for retirement income, so-called market-based financing is not a new idea. Employer-sponsored defined benefit (DB) and defined contribution (DC) plans are common and popular. As of year-end 2000 total U.S. pension assets were about $7.2 trillion, with 63 percent invested in stocks. Total worldwide pension assets were $12.2 trillion.
The popularity of market-based financing stems in large part from its efficiency in meeting retirement goals. There is a rule of thumb that one’s retirement standard of living would be comparable to that just prior to retirement if retirement income equaled 70 percent of one’s last year’s wage, a ratio called the replacement rate. Assuming a 45-year working career, a 6 percent saving rate and life expectancy of 20 years at retirement, one’s portfolio would have to earn an average annual real rate of return of 5.6 percent for the entire 65 years to achieve the 70 percent replacement rate. The average of the annual real returns of the U.S. equity market from 1926 through 2000 was 10.1 percent. And the worst return for 65 consecutive years was 8.5 percent. Moreover, a reduced-risk portfolio of 60 percent stocks and 40 percent bonds earned 6.0 percent annually during its worst 65-year period.
Although these historical numbers do not tell what the future will bring, they are useful guideposts. By comparison, Social Security’s present benefit and tax formulas offer a young worker a markedly different future. Earning average wages, working for 45 years and retiring for 20 years, a worker might expect a 37 percent replacement rate at age 65 after having paid a payroll tax of 10.6 percent through his entire career. The 37 percent replacement rate is actually a bit of an overstatement because future payroll tax revenues are not expected to be sufficient to afford it.
As superior as market-based financing appears to be relative to Social Security's pay-as-you-go structure, at least from this narrow analytical perspective, its relative attractiveness is not assured just because historical returns were what they were. The future depends on a much deeper understanding of how market returns are earned.
Wall Street, the so-called risky scheme, is not where wealth is created; it is where it is traded. Wealth is created by ordinary people through their hard work, entrepreneurial spirit, willingness to take risk, and their choice to give up something today in the hope that their saving will pay off in the future. The freedoms to succeed and prosper and, very importantly, to fail and learn from mistakes are environmental necessities for the creation and accumulation of wealth.
Government policies can either nourish or starve this environment. Our system tends to nourish, although not perfectly so. Individuals in America conduct commerce in a framework of the rule of law versus the rule of man, enforceable contracts, a stable currency, relatively stable interest and inflation rates, and—in comparison to most countries—reasonable tax rates. It is our American way of life that allows men and women to create the wealth that is traded on Wall Street. To argue that Wall Street, broadly speaking, is a risky scheme is to argue that our way of life is a risky scheme. It is not so.
We are a free people. And because of this freedom our willingness to take risk is rewarded. Although we have business failures, we have many more successes. They accumulate over time and, thereby, increase further our range of choice. This is a virtuous circle, one that most countries do not share.
Our debate on how best to reform Social Security will be spirited. It is important that all views have the opportunity to be aired. Through this open dialogue and reasoned discourse we will design solutions to strengthen Social Security. President Bush and his Commission members have urged us to get involved. We now have the floor to argue the case that Wall Street is a risky scheme or that, alternatively, it is not because our freedoms allow us to create, accumulate and trade our wealth. Let the debate begin.
