Market Holds Little Risk for Social Security Accounts


Recent declines in the stock market present a challenge to advocates ofSocial Security privatization, who want to let workers invest their payrolltaxes in personal accounts holding stocks and corporate bonds. Indeed, theS&P 500’s 25 percent drop in the past year prompts critics to ask, “Howwould you feel about personal accounts if the market dropped like that justprior to your retirement?”

Such questions are reasonable. And privatization advocates owe it to thepublic to answer them. With President Bush about to convene a commission todesign personal accounts for Social Security, now is a good time to do so.

Supporters of personal accounts saw the market‐​risk issue well before themarkets presented it to them. In 1997, when stock prices were movingever‐​upward, Bill Shipman and Melissa Hieger of State Street Global Advisorsasked in a study for the Cato Institute, “How far would the market have tocrash for a worker to be worse off with a personal retirement account thanunder Social Security?” The answer: very far indeed.

Shipman and Hieger modeled a low‐​wage worker earning $13,365 a year whoenters the workforce at 21 and invests his Social Security taxes in apersonal account holding only stock mutual funds. Because low‐​wage workersreceive the highest relative benefits from Social Security, they would bethe first hurt by a market crash. And under this hypothetical privatizationplan, there is no progressivity and no safety net. So how would this workerfare if the market crashed when he retired? Quite well, it turns out, evenif the market dropped faster and further than in has in recent months.

On average, low‐​wage workers with personal accounts could expect a monthlybenefit 1.8 times larger than the current system, enough to lift millions ofolder Americans out of poverty. It would take a market crash of between 50percent and 70 percent to make these workers worse off than under SocialSecurity. For average‐​wage workers, the market crash would need to be evenbigger.

Is this possible? Anything is possible, but history says such sharp declinesare 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 accountsat 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 lowerbenefits than Social Security.

Moreover, for workers holding a balanced portfolio of 60 percent stocks and40 percent bonds, the stock market would need to be practically wiped outfor them to be worse off. Even if the stock market went out of business onthe day of retirement – if stock investments were literally renderedworthless – the corporate bonds remaining in the average worker’s accountcould still pay higher benefits than Social Security. Over the last year, a60‐​40 fund would have lost less than 10 percent of its value, as the 25percent drop in the S&P 500 was countered by a 13 percent rise in the LehmanBrothers U.S. aggregate bond index. A near‐​retiree with 70 percent bondswould have made money.

Personal accounts don’t produce higher returns because of higher risk, butbecause they save and invest for the future while the current system doesnot. Since Social Security pays each year’s benefits out of that year’staxes, its “return” cannot exceed the 1.4 percent annual projected growth ofpayroll tax revenue. Personal accounts rely on the real return to capital,which has averaged 8.5 percent before taxes over the last 40 years. Stockand bond returns vary, but they do so well above the baseline set by thecurrent system.

If offered the chance to earn market rates of return on my Social Securitytaxes coupled with a guaranteed one‐​quarter drop in the stock market on theday I retired, I’d take it — and be richer for it. How personal accountshandle market risk is a good question. Proponents of privatization knew ithad to be answered. And it has been.