Market Holds Little Risk for Social Security Accounts
Recent declines in the stock market
present a challenge to advocates of
Social Security privatization, who want
to let workers invest their payroll
taxes in personal accounts holding
stocks and corporate bonds. Indeed, the
S&P 500’s 25 percent drop in the past
year prompts critics to ask, “How
would you feel about personal accounts
if the market dropped like that just
prior to your retirement?”
Such questions are reasonable. And
privatization advocates owe it to the
public to answer them. With President
Bush about to convene a commission to
design personal accounts for Social
Security, now is a good time to do so.
Supporters of personal accounts saw the
market-risk issue well before the
markets presented it to them. In 1997,
when stock prices were moving
ever-upward, Bill Shipman and Melissa
Hieger of State Street Global Advisors
asked in a study for the Cato
Institute, “How far would the market
have to
crash for a worker to be worse off with
a personal retirement account than
under Social Security?” The answer:
very far indeed.
Shipman and Hieger modeled a low-wage
worker earning $13,365 a year who
enters the workforce at 21 and invests
his Social Security taxes in a
personal account holding only stock
mutual funds. Because low-wage workers
receive the highest relative benefits
from Social Security, they would be
the first hurt by a market crash. And
under this hypothetical privatization
plan, there is no progressivity and no
safety net. So how would this worker
fare if the market crashed when he
retired? Quite well, it turns out, even
if the market dropped faster and
further than in has in recent months.
On average, low-wage workers with
personal accounts could expect a monthly
benefit 1.8 times larger than the
current system, enough to lift millions
of
older Americans out of poverty. It
would take a market crash of between 50
percent and 70 percent to make these
workers worse off than under Social
Security. For average-wage workers, the
market crash would need to be even
bigger.
Is this possible? Anything is possible,
but history says such sharp declines
are unlikely. A 20 percent decline in
the S&P 500, like that of October 19,
1987, or of the month of October 1929,
would not have put personal accounts
at a disadvantage. Even the worst three-
month period in S&P 500 history,
with a 38 percent decline, would not
make a personal account pay lower
benefits than Social Security.
Moreover, for workers holding a
balanced portfolio of 60 percent stocks
and
40 percent bonds, the stock market
would need to be practically wiped out
for them to be worse off. Even if the
stock market went out of business on
the day of retirement – if stock
investments were literally rendered
worthless – the corporate bonds
remaining in the average worker’s
account
could still pay higher benefits than
Social Security. Over the last year, a
60-40 fund would have lost less than 10
percent of its value, as the 25
percent drop in the S&P 500 was
countered by a 13 percent rise in the
Lehman
Brothers U.S. aggregate bond index. A
near-retiree with 70 percent bonds
would have made money.
Personal accounts don’t produce higher
returns because of higher risk, but
because they save and invest for the
future while the current system does
not. Since Social Security pays each
year’s benefits out of that year’s
taxes, its “return” cannot exceed the
1.4 percent annual projected growth of
payroll tax revenue. Personal accounts
rely on the real return to capital,
which has averaged 8.5 percent before
taxes over the last 40 years. Stock
and bond returns vary, but they do so
well above the baseline set by the
current system.
If offered the chance to earn market
rates of return on my Social Security
taxes coupled with a guaranteed one-
quarter drop in the stock market on the
day I retired, I’d take it—and be
richer for it. How personal accounts
handle market risk is a good question.
Proponents of privatization knew it
had to be answered. And it has been.
Andrew Biggs
Social Security Analyst
The Cato Institute
Washington
This article also appeared in the The Buffalo News on April
15, 2001.
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