Sunday, March 13, 2005

Stock Market Crashes and Social Security Privatization

by Tom Bozzo

I've had a couple brief exchanges with Bryan Smith of Sanity in Mad City — a great name for a blog, even if we often disagree sharply on what constitutes a sane Madison. Bryan noted my general agreement with the A-list center-to-left economist bloggers and Paul Krugman, and my low opinion of Donald Luskin.

That led me to send him a link to this story (via the Cunning Realist) noting the poor performance of a pair of mutual funds run by a company for which Luskin had been CEO. $1 invested in the larger of the funds as of January 1, 2000 would have been reduced to 43 cents as of the liquidation announcement in early August, 2001. Though in fairness to Luskin, it was not terribly difficult at the time to assemble an internet and/or telecom portfolio with performance on that level. The Fidelity Select Telecommunications Portfolio fund, for instance, returned -37% in 2000, -28% in 2001, and -29% in 2002.

In response, Bryan offered this thought on the effect of stock market disasters on private investment accounts:
Even with the stock market slide in 2000, though, people would have likely still been better off had they been investing money since the 60s and 70s. If you average 7% per year (which I believe is the historical average in the market), even if your account loses 50% during a few bad years, I think you'd still do pretty well. And if there were a more severe drop in the market, the kind that put us in a serious recession or depression, under the current system, I wonder if the government would be able to pay out Social Security in the full amount.
He also was curious about why liberal economists use lower annual returns than privatization advocates.

Four points in response.

1. Averaging 7% annual stock market returns on top of inflation would be great. The trick is finding economic fundamentals that will produce returns of that magnitude. The relatively slow economic growth used to project the long-range finances of Social Security is too low to produce historical returns unless the market price/earnings ratio grows enormously — this is the essence of the Baker-Weisbrot challenge. Liberal economists project slower rates of stock market appreciation because they're consistent with the assumptions used to gauge the health of Social Security.

2. I have nothing against disciplined long-term equity investing, and do so through my own personal retirement account. However, the problem of being caught at retirement in a bust period is serious. Relatively few people accumulate enough financial assets to make the problem one of retiring on a merely large versus a very large income. In fact, people with that level of wealth don't even show up at the level of aggregation of most published household wealth data. (Here's the most recent available household wealth survey data, from 2000.) For most households, the effect of a market crash would be to make a thin financial cushion thinner. There's a diminishing marginal utility of wealth argument to suggest that avoiding that would be more important to the not-rich.

3. The apparent structure of the Bush Social Security privatization plan makes participants particularly vulnerable to market risk at retirement. Using the CEPR calculator, a fully funded PRA under the Bush plan would grow to roughly $107,000 (2005 dollars) by my age-67 retirement in 2035 assuming a 6.8% annual real return on the account. By CEPR's reckoning, this would buy a $557/month single life annuity after management and annuitization expenses have been subtracted off. This is about right based on annuity terms from the TSP, though see here for a problem for those of us in the married single-income minority. This would give me $60/month over the guaranteed benefit offset. The implication is that under the Bush plan, you can't suffer a large market drop prior to retirement, or even much downside variation in the realized (variable) returns, and end up as well off as with the (reduced) guaranteed benefit.

4. A very deep recession or depression would put a big dent in Social Security's cashflow as payroll tax revenues dropped, but equity investors could fare far worse in such a scenario. In the Great Depression, output fell by around 30% from the 1929 peak and had recovered to pre-crash levels around 1939. The DJIA dropped 90% from the 1929 peak and didn't recover to pre-crash levels until late 1954. After more than 15 years, the Nikkei 225 is presently 70% off its 1989 peak. I would assert — and this is the liberal in me speaking — that the ability of vicious bear markets to outlive a retiree points favorably toward public insurance, as the government is best situated to ride out the economic and market cycles. Clearly, government is not constrained to operate within the limits of its tax revenues, and standard arguments in favor of countercyclical fiscal policy would suggest that it shouldn't.
Well at least with Social Security, geezers can eat dog food. There is a good chance with private investments they would literally starve to death. I'm freeze drying some Alpo just in case Bush gets his way and some scoundrels pillage their corporations and their particular stock values plummet in my august years. Poor In Pennsylvania
It is remarkable how some privatization advocates problematize low rates of senior poverty (usually by some sort of class-generational warfare: the young subsidizing those rich seniors), a.k.a. the Social Security program's main success.
As someone who already saw more than half of a TSA which I rolled over penalty-free to my 403b program evaporate thanks to the stock market debacle of a few years ago, you could never convince me to agree to a privatization plan for Social Security. I only wish the universe were the way most Republicans think it is. That's what comes from incestuously myopic living. Most of us who work hard, live thiftily and try to plan for the future are still not in a position to put money at risk. I know that I will be working long past the time when I thought I could retire in order to avoid a subsistence level retirement even as things stand now. I will be in good company, though, because most of my contemporaries (over 50 yrs. of age) will be working right along with me!
A big fat Amen! to posters #1 and #3. There is no protection against deflated markets that crime and corruption can almost instantly produce. The average person doesn't have the time and expertise to specialize so diversification via mutual funding is what they are pretty much left with. Its too bad fixed income people have bills that have to be paid, ain't it? Gee! too bad people can't subsist on 200 calories a day and be happy living in one room, ratty trailers with no air conditioning and running water.
The strongest argument against isn't the "during the Depression..." one, since most people think of that as a one-time thing.

As Warren Buffett noted in Fortune about five years ago, the economy grew great guns from the mid-1960s to the early 1980s. The stock market failed to track it. (Being somewhat older than you, I remember the glorious noises that were made when the DJIA broke 800.)

Those who are arguing today about the phenomenal recent increase in the Dow neglect that the DJIA since January 21, 2001, has risen about 200 points--less than 2% over five years.

These are the people who assume you can make 3% OVER INFLATION in stocks.

Let's not push the "if there's a depression" line; that's "pessimistic" and "defeatist." Let's point out that the fiscal acumen demonstrated by the current administration would have cost us all about 15% so far, with no end in sight...
Excellent points, Ken.

In particular, you're right to emphasize that deep economic contraction a la the Depression is not at all necessary for prolonged weak market conditions. Certainly, Japan's pattern has mainly been one of persistent very slow growth. Also, the dramatic rebound of corporate profits, and respectable GDP growth the last few quarters, has not led domestic stock investors to Nirvana unless they happened to have jumped in right at the 02-03 trough.
Many of the comments here seem to be short-sighted. Sure, if in the year 1999 you would have invested your life savings, you would have lost a butt-load by 2001 and you still wouldn't have recovered. But that's a period of five to six years. Investing in private accounts with a diverse portfolio for up to 45 years, would buffer against likely all market downturns, even severe ones, like the Great Depression and the recessions we've had since.

"Since 1926, for every rolling 30-year period (measured on a monthly basis), a 50-50 portfolio (half stocks, half bonds) earned more than a 6.3 percent annualized return 97 percent of the time, according to Ibbotson Associates. A 60-40 portfolio did so 100 percent of the time." Source here.

At worst, over any 30-year period, you'd do better than Social Security would do (>6.3% rate of return needed), and if you were stock-heavy, you'd do even better than that, including over the Great Depression. The free market is a great wealth generator, and people who are scared to invest over long time periods are missing the boat. If private accounts are voluntary, then people who don't want to "risk it" don't have to. If people want to make extra money, then maybe they should get that choice.
If anyone out there thinks that the Privitization of Social Security is anything but, a give away program to stock brokers who will trade the acciunts and the ultra rich who will ultimatly get taxed to pay for it, is an uninformed person at best and possibly a brain washed individual at worst. Get informed or wake up, or please just don't vote.
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