Where is the Real Risk in Retirement?

by Michael Tanner

Michael Tanner is director of health and welfare studies at the Cato Institute.

"Privatizing Social Security is too risky," warn critics of reforming the retirement program. "You just can't trust the stock market." But that seriously misstates both the risks of privatization and those of remaining with the current Social Security system.

With the release this month of a report by the Social Security Advisory Council, the debate over Social Security's future has been joined. Many, recognizing the current system's precarious state, want to privatize Social Security, allowing younger workers to divert all or part of their payroll taxes to individually owned, privately invested accounts similar to individual retirement accounts or 401(k) plans. In response, critics of privatization (several found in this discussion thread) have mounted a scare campaign, suggesting that privatization puts workers’ future retirement at risk.

But are stocks really risky? In any given year, stocks can go up, but they can also go down. For the last several years the stock market has been riding a wave of expansion. Undoubtedly, there will eventually come a correction.

But the year-to-year fluctuations of the market are irrelevant. What really counts is the long-term trend of the market over a person's entire working lifetime, in most cases 45 years. Given that long-term perspective, there has been no 20-year period in which the average investor would have lost money by investing in the U.S. stock market. Even the worst period in U.S. history, including the Great Depression and the 1929 crash, produced a positive real return of more than 3 percent. The average 20-year real rate of return has been 10.5 percent.

As Sen. Robert Kerrey (D-Neb.) explains, "History shows conclusively that long-term investment in the stock market is safe and profitable."

What about the person who retires the day before the market falls, critics ask. Well, to begin with, that person would have already benefited from market gains in the years before his retirement. The falling market will take away some of his gains, but by no means all of them. Moreover, there is no reason why he would have to withdraw all of his money during the market downturn. He could simply keep most of his money in his Social Security account and wait for the inevitable market recovery.

By comparison, relying on the current Social Security system is extremely risky. Because Social Security is at its core a political system, future benefits are dependent on political decisions. Indeed, the Supreme Court has ruled, in the case of Nestor v. Fleming that individuals have no right to Social Security benefits based on the taxes they've paid. Congress and the president can change or reduce Social Security benefits any time they choose. A young worker entering the Social Security system is gambling on what benefits a Congress and president will decide to provide 45 years from now.

For example, Congress is currently debating whether to adjust the way the consumer price index (CPI) is calculated. If Congress were to adopt the proposals of the Boskin commission to reduce the CPI by 1.1 percent, the average Social Security recipient would lose $5,000 in lifetime benefits. Other suggested changes to Social Security, such as raising the retirement age or means testing, would also reduce benefits. Increasing payroll taxes--as has already been done 17 times since the system's inception--produces similar results.

Moreover, even if there were no reduction in benefits or increase in taxes--an impossibility given Social Security's looming financing shortfalls--Social Security is an extremely bad investment for most young workers. In fact, according to a study by the nonpartisan Tax Foundation, most young workers will actually receive a negative return on their Social Security taxes--they will get less in benefits than they paid in taxes. Some studies indicate that a 30-year-old two-earner couple with average income will lose as much as $173,500. One would have to be a very bad investor indeed to do worse than Social Security.

Where then lies the real risk? Is it riskier to rely on markets that have never failed to produce positive long-term results or on a politically dependent intergenerational transfer that is financially insolvent and guaranteed to lose money for most workers? Given the choice, I think I know where most young workers would rather put their money.

This article originally appeared in the Colorado Springs Gazette Telegraph on February 12, 1997