Sunday, December 1, 2013

Does Social Security provide worse returns than the stock market?

Image: Thanks to George W. Bush, a spate of excellent commentary on Social Security privitization was written in 2005.

Updated below, 3/3/14

This question is tangentially related to a post I'm currently working on, so I wanted to address it. However, since much ink has been spilled on this topic, I don't actually have anything to add. Instead, I'll just blockquote a few key arguments.

It's true that the stock market outperformed returns on monies in the Social Security Trust Fund for the years leading up to the Great Recession starting in 2008. But assumptions that the stock market will continue to outperform bonds are fantasy: 
Now it’s true that in the past stocks have yielded a very good return, around 7 percent in real terms — more than enough to compensate for additional risk. But a weird thing has happened in the debate: proposals by erstwhile serious economists such as Martin Feldstein appear to be based on the assertion that it’s a sort of economic law that stocks will always yield a much higher rate of return than bonds. They seem to treat that 7 percent rate of return as if it were a natural constant, like the speed of light.

What ordinary economics tells us is just the opposite: if there is a natural law here, it’s that easy returns get competed away, and there’s no such thing as a free lunch. If, as Jeremy Siegel tells us, stocks have yielded a high rate of return with relatively little risk for long-run investors, that doesn’t tell us that they will always do so in the future. It tells us that in the past stocks were underpriced. And we can expect the market to correct that...
And it's not just Paul Krugman who thinks that 7% returns on stocks will not be true indefinitely. Not even the market thinks the stock market will continue to outperform bonds:
As Paul Krugman has put it, privatizers appear to believe that "it's a sort of economic law that stocks will always yield a much higher rate of return than bonds. They seem to treat that 7 percent rate of return as if it were a natural constant, like the speed of light."

In fact, most investors know such guarantees don't exist, as the market's own behavior shows. The financial services industry is remarkably flexible and is constantly developing new products for investors. If you were so sure stocks would return 6.5 percent after inflation ad infinitum, why not guarantee customers 5 percent after inflation, lock up their money for 10 or 20 or 50 years, and pocket the difference? But such vehicles that guarantee a return on stocks are rare. Fidelity and Janus certainly won't guarantee you returns on equities of 6.5 percent after inflation for 25 years, or five years, or any years...

I asked the options desk at a major Wall Street firm to construct an option that delivered a 6 percent annual return on the S&P 500, with dividends reinvested, for 10, 15, and 20 years (ignoring inflation for the moment). The prices of the options they constructed indicated that investors today believe there is only an 18.8 percent likelihood that stocks will return 6 percent or more annually for 10 years, a 13.3 percent likelihood that they'll do so for 15 years, and a 9.6 percent likelihood that they'll do so for 20 years.
Both of those pieces were written (wisely) in 2005, before the stock market tanked in 2008.

Speaking of the stock market tanking, 401(k)'s lose an amazing amount of their value when the stock market tanks. Social Security doesn't:
President Bush and all who support privatization began with the proposition that private accounts invested in an array of stocks and bonds would outperform the current formula based on wages earned and overall wage appreciation. Well, let's go to the videotape, as they say. Since Jan. 1, 2005, the year President Bush proposed the idea, the Dow Jones industrial average has dropped from 10,783 to around 8,000, a drop of more than 25 percent. OK, we are in a trough after a steep period of appreciation. Fine. Since Jan. 1, 2000, the Dow has dropped from 11,497 to 8,000, a drop of more than 30 percent. So what would this have meant to an average recipient of Social Security?
Let's try to quantify this, albeit roughly. Under the current system, a couple earning a household income of $100,000-$150,000 per year would get slightly more than $3,000 every month in Social Security benefits. And their benefits would be inflation-adjusted every year. Suppose the couple were to invest for retirement in the private markets. With an income of that size, the couple would be able to save about $500,000. As Allan Sloan calculated in Fortune, a couple retiring at age 66 at the end of 2007, having accumulated $500,000 in a private savings account, would have been able to purchase an annuity delivering $3,000 per month until the death of the longest living of the two. In other words, that couple would get an annuity worth about the same amount as their Social Security benefits. A couple retiring at the end of 2008, by contrast, would have been able to purchase an annuity delivering only $2,000 per month—a 33 percent loss. [NOTE: other funds posed 50% losses--CM]
In other words, if Social Security were in private accounts, the payout you'd receive would be more correlated to the timing of your retirement than to anything else. With a privatized system, those retiring in 2007 would have been reasonably pleased—though they still wouldn't have made a windfall compared with normal Social Security benefits—while those retiring now would be devastated, receiving vastly smaller retirement payments.
There really isn't a right answer here. Social Security was certainly a much better deal during the Great Recession, but it wasn't for a couple decades prior. Will Social Security be a better deal than the stock market in the next few decades? I don't know, and neither do you. Yet it's unquestionable that Social Security is extremely low risk* while the stock market is much higher risk. I don't think it's worth it to subject the retirement security of the entire country to that level of risk. Others might beg to differ. Perhaps rich individuals can tolerate a higher amount of risk because they have so much money and are working fun white collar jobs that they don't want to retire from anyway.

*Social Security is so safe for retirees that benefits are automatically adjusted for inflation. Inflation protected benefits in the private market are basically prohibitively expensive for the vast majority of workers. The private market cannot protect against the risk of inflation as well as the federal government.

Update (3/3/14): I realized quite some time after publishing this post that this post cedes the terms of the debate to Social Security privatizers. My argument essentially was "no, the stock market isn't guaranteed to provide better returns." But that misses the point entirely; as I wrote here, the rate of return matters very little in comparison to the pooling of risk. Social Security privatizers want individual retirement accounts, where risk is not pooled. Even if we could somehow guarantee 7% returns on the stock market indefinitely it wouldn't be worth it because the savings from effectively pooling risk more than compensate the decrease in returns (if any). Social Security's strength is not the rate of return--it's the fact that risk is pooled over the entire country. Even if Social Security got worse returns than the stock market, those worse returns are more than compensated by the fact that risk is pooled over the entire country, rather than each person having to fend for themselves. Read that post for far more information on that point.

Of course, as I wrote here, extremely wealthy people don't care about pooling risk because they have no need to; they are so wealthy that their risk of outliving their individual savings is zero. Since they don't have to worry about risk, rate of return is the primary concern. Privatization of Social Security is thus incredibly self-serving. Obviously, what makes most sense for the retirement account of a wealthy financier is certainly not what makes sense for the retirement accounts of people who are not millionaires.

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