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trates the broad geographical distribution,

Objection #3: Social Security is

with 64 countries having functioning stock

virtually risk-free because

markets.15

it is backed by the full faith

Given this broad selection, many different

and credit of the government.

portfolios could meet the objectives of return,

diversification, and liquidity. As just one exam-

A market-based system, on the

ple, 60 percent of the portfolio could be invest-

other hand, is inherently volatile,

The benefit

ed in United States stocks. This portion could

subjecting workers to risk which

contain any of about 3,100 different firms (with

increase for

is unnecessary.

many of the stocks traded on the New York

low-income

Stock Exchange), representing both large and

Opponents of privatization often attempt to

workers is

small companies.16 Another 10 percent of the

contrast what they present as a risk-free govern-

portfolio could be comprised of equities of the

achieved

ment Social Security system with an inherently

developed world--the largest economies out-

risky market-based system. They note that the

without

side of the United States. This would account for

current Social Security system is backed by the

redistribution

another 1,100 stocks. U.S. and foreign corporate

full faith and credit of the U.S. government,

and government bonds, equally weighted, could

from high-

whereas a market-based system entails all the

make up an additional 25 percent. The corporate

risks associated with the volatile world of finan-

income

component would represent high-grade, low

cial markets.

workers.

risk of default, bonds. The government bonds

Moving to a privatized Social Security sys-

are backed by the full faith and credit of the sov-

tem is not risk-free. That should be readily

ereign country. The remaining 5 percent could

apparent. But, the current Social Security sys-

be invested in money market instruments

tem is also not risk-free. A comparison of the

including highly rated commercial paper, certifi-

risks inherent in both systems shows privatiza-

cates of deposit, U.S. government and agency

tion to be the safer alternative.

obligations, and other low-risk, highly liquid

In a market-based retirement system workers

paper.

face two different types of risk. One is the prob-

Because returns of the five asset classes do

ability of accumulating the necessary wealth for

not move identically and one asset may be more

a secure retirement through savings and invest-

attractive from time to time, allowance for vari-

ment. The other is the volatility of market

ance in the weights is desirable. The weight of

returns during one's working career and retire-

each asset class can be changed as the investor

ment. In contrast, a government-mandated pay-

nears retirement. For instance, reducing the

as-you-go system subjects workers to the peril

stock component and increasing the money

of political risk--that is, the probability that

market allocation, a common practice as one

benefits will be cut or taxes will be increased. In

nears retirement, would reduce risk. Altering

both structures there is uncertainty.

weights is a trivial portfolio process that delivers

At the inception of a pay-as-you-go system,

non-trivial results.

such as our current Social Security system, risk

Managing this diversity of instruments, rep-

is minimal. All workers begin to pay taxes.

resenting more than 20 countries and thousands

Some are young, just starting their careers; oth-

of securities, is a sophisticated process requir-

ers are close to retiring. On average, they are at

ing experienced professionals. Yet, it is com-

mid-career and pay taxes for half of their work-

mon and successfully practiced by pension

ing lives. During the early stages the return on

funds and investment management firms

investment for older workers is high because

around the world. There is no need for a work-

they pay taxes for a short period but receive

er who chooses the market-based system to

benefits throughout their retirement years.

know how markets work as long as the pension

However, as years pass and the system matures,

system is properly structured and sensible

eventually all workers pay taxes for their entire

guidelines are followed. In fact, most proposals

careers. The return on taxes paid then falls as

for a privatized national retirement system have

tax rates rise and as the periods during which

regulatory elements that restrict investment

taxes are paid also rise.

strategies that are either too risky or that would

The decrease in return is exacerbated by the

be insufficiently aggressive to provide needed

demographic reality of fewer workers support-

retirement benefits.

ing each beneficiary. This ratio has declined

6