al savings of $3,000 over 46 years earning 10
Table 8
percent per year accumulates to $2.9 million; at
Expense Ratios for Various Mutual Funds and Their Theoretical
8 percent the future value is only $1.4 million.
Portfolio Weights
What may appear to be an insignificant 2 per-
Type
Mutual Fund
Expense Ratio
Weight
cent difference actually reduces one's wealth by
U.S. Stocks
Vanguard Index 500
0.20%
60.0%
more than half.
Foreign Stocks
SSgA Active International
1.00%
10.0%
The critics often seem to be trying to outdo
U.S. Bonds
Dodge and Cox Income
0.54%
12.5%
each other in predicting astronomical fees and
Foreign Bonds
PIMCO Global
0.58%
12.5%
administrative costs. For example, consumer
Money Market
SSgA Money Market
0.38%
5.0%
reporter Trudy Lieberman, writing in The
Nation, suggests management and administra-
For support of these assumed weights, see Gordon P. Goodfellow and Sylvester J. Schieber, "Social
tive expenses in excess of 13 percent!31
Security Reform: Implications of Individual Accounts on the Distribution of Benefits," Pension
Research Council of the Wharton School of the University of Pennsylvania, May 1997, pp. 3638.
However, in reality, the administrative costs of a
market-based system are not likely to be very
high.
aged assets. This assumption is liberal, therefore
The costs associated with a market-based sys-
understating after-cost market returns.
tem are dependent on its structure. To get some
approximation of what they may be, assume that
all investments are in mutual funds, which are
Objection #8: In many cases
relatively high-cost investment vehicles.32
Social Security pays benefits to
Further, they are in five asset classes: U.S.
survivors of deceased workers. In
stocks and bonds, developed world stocks and
a privatized system, survivors of
bonds, and money market instruments.
The term "expense ratio" is an expression of
the family wage earner would be
the costs charged by a mutual fund to its
left financially vulnerable.
investors. These costs include investment advi-
Opponents of privatization point out that
sory fees; deferred organizational costs; ex-
Social Security pays survivors benefits, suggest-
penses for legal, auditing, and financial
ing that in a privatized system, a worker who
accounting services; administrative and custo-
The risk of
dies before retirement would not have amassed
dian fees; as well as many others. Costs are
higher taxes
enough wealth to care for his family members,
deducted from the fund's return and they must
relative to
leaving them financially vulnerable. However, a
be disclosed in the fund prospectus as a matter
closer look at a market-based retirement system
of law. An expense ratio of, say, 1.56 means that
benefits in a
shows that such a system would, indeed, be able
costs are 1.56 percent of the net asset value of
government-
to provide for survivors.
the fund. Put differently, if the fund earned 10
mandated pay-
One of the compelling arguments favoring a
percent, its after-cost annual return would be
market-based system is the benefit of com-
8.44 percent.
as-you-go
pounding investment returns: the concept of
There are many funds that invest in the five
structure is
interest on interest. It is this phenomenon that
asset categories stated above. Table 8 gives one
real,
allows--indeed, is necessary--for the buildup
for each category and its expense ratio in 1997.
of wealth for a secure retirement. It is crucial in
Each fund is listed daily in the Wall Street
significant and
estimating benefits to survivors. Contrary to the
Journal.
certain.
above objection, in a market-based system most
A portfolio containing the above funds,
survivors, as defined by Social Security, will
weighted as shown, would have a cumulative
receive benefits equal to, or greater than, those
expense ratio of 37.9 basis points, or 37.9 one
from Social Security.
hundredths of one percentage point.
When one starts to collect Social Security
There may be other costs in a privatized sys-
benefits, one's spouse, assuming little or no
tem, but they likely would be a fraction of the
earnings history, is eligible to collect about one
expense ratio. But even if we assume they are
half of the retired worker's full benefit. When
high, total costs would be less than one percent
the retiree dies his benefit ends, and the spousal
of managed assets. The relevant consideration is
benefit ends, but a new benefit is paid to the
not the expenses, per se, but the after-cost return
spouse that is ordinarily equal to the deceased
to the investor. For most of the calculations of
worker's retirement benefit. This is called a sur-
investment returns made in this paper, we have
vivor's benefit. At death, therefore, the total that
stipulated that expenses are one percent of man-
13