With the stock market suffering its worst decline since the crash of 1929, some critics are saying it's crazy to partially privatize Social Security. "After what's happened to the stock market in the last few weeks, we think it's a terrible idea," says Senate Majority Leader Tom Daschle. Economist Paul Krugman, a columnist for the New York Times, warns that Americans are too vulnerable to market fluctuations and, thus, privatizing Social Security makes "no sense."
Yet despite today's market, the long-term benefits of investing in stocks and bonds far outweigh the arguments for leaving Social Security the way it is. In fact, short-term market behavior has little to do with the logic of why Social Security is in trouble and how it can be fixed.
Social Security finances retirement benefits by taxing workers' wages. Holding the tax rate constant, total benefits can increase by no more than payroll increases. That has been about 1.6 percent per year. It's the rough equivalent of a portfolio of stocks and bonds that earns 1.6 percent. If one were to save $1,000 yearly for a 44-year working career and earn this rate of return, accumulated wealth would be about $63,000. Over the last 75 years the compounded annual real return from a balanced fund of 70 percent stocks and 30 percent bonds was 6.2 percent. Saving $1,000 per year for 44 years at this rate of return would result in about $211,000. This comparison is a glimpse comparing pay-as-you-go to market-based financing. But Social Security has other problems.
Keeping payroll-tax rates reasonable requires taxing many workers for each person who gets benefits. This ratio is set by life expectancy and the birth rate. If life expectancy increases or the birth rate falls, then the relative number of workers declines. There were 16 workers per beneficiary in 1950; today there are only 3.4. Because of this and to pay promised benefits, the maximum payroll tax increased about 1,200 percent during this same period. And now Social Security's actuaries report that there will be as few as 2.1 workers per beneficiary by 2030. A pay-as-you-go system is unable to meet its long-term commitments in the face of these demographics unless taxes are raised further or benefits are cut. That makes market-based financing more attractive.
Although it's true that higher rates of return yield greater wealth, neither comes without risk. For example, the stock market went into a dismal spiral each year from 1929 through 1932, shrinking an initial investment of $100 to $36. Yet for the full 44 years starting in 1929, the average of the market's annual returns was about 11.5 percent, or 9.2 percent inflation-adjusted. Short-term risk, longer-term reward. Since World War II there have been only two occasions during which the market fell for two consecutive years-1973 and 1974, and 2000 and 2001-culminating in losses of 41 and 21 percent, respectively. Yet for the full period 1973 through 2001 the average annual compounded return was 12 percent, about 6.5 percent after adjusting for inflation. Again, short-term risk and longer-term reward.
For Social Security to pay a higher return than a market-based system, the growth rate of wages paid into Social Security must exceed the rate of return from market investments over an individual's working lifetime. Since 1926, there has never been a 44-year working lifetime when wages grew faster than a reasonable market fund of 70 percent stocks and 30 percent bonds. The result is that pay-as-you-go programs like Social Security pay lower benefits at higher cost than market-based alternatives.
Social Security reform is on the national political agenda. In a surreal sort of way it may be fortuitous that we are debating the idea of moving to market-based financing during the worst stock market crash since the Great Depression-the event that led to the enactment of Social Security. But do the math. Bull market or bear market, people who invest in stocks and bonds for retirement will be wealthier than those who rely on Social Security.