Monday, September 19, 2005

I Got Mail! (On Social Security Privatization)

by Tom Bozzo

In another one of these doesn't-happen-every-month events, I got actual questions by e-mail about a week-and-a-half ago from a visitor to the blog writing from the possibly literal frozen tundra of northern Canada (as opposed to the metaphorical frozen tundra a couple hours northeast of Madison), on Social Security privatization. With the privatization effort seemingly DOA as some Congressional Republicans may be worried enough about 2006 to be disinclined to expend political capital as third-rail insulation, it's perhaps not this year's problem. But here goes anyway. The questions:
Would the Bush plan to scrap social security in favour of private savings plans not create a large pool of investment cash in the market? What has the historical record of dumping large pools of cash into the market been, especially on the un-sophisticated investor?

It is my perception that dumping cash into a market is a recipe for fraudulent acts, collusion and corruption, at the expense of the “little guy”. I say this from seeing the results of the savings & loan debacle, the tech bubble and other incidents of cash injections into the market. It seems to me that the result of the introduction of the Bush plan would see Enron-type market manipulation, with the resulting transfer of wealth from the small investor to the institutional investor, leaving the small investor more destitute than without the “privatized” plan.

Am I wrong?
My response was really to the last (recipe for fraud) question. To that, lest anyone think I'm just into this for the Bush-bashing, I replied by way of faint praise:
The short answer to your question is that, while the absence of actual legislation leaves key features of the plan unknown, it probably would be set up initially to minimize the possibilities for outright fraud, mainly by offering a very limited menu of closely overseen funds to start.
Though depending on how the plan were to evolve, we're not necessarily in the clear:
It's reasonable to assume that, over time, a privatized system would face strong political pressure to expand the menu of investment options. I've also read about suggestions that private accounts might be implemented by piggybacking on the existing tax-deferred retirement accounts [401(k)'s, etc.] offered by many private employers. Either would entail considerable risk... It's just hard to say how much, again, in the absence of a specific plan.

I realized later that the response pretty much glossed over the initial questions. The answer to the first one is yes, privatizing Social Security would involve sending big piles of cash into the markets. Strictly speaking, this is true even of goofball ideas like the "personal lockbox" that would, to borrow language from the Heritage Foundation, magically transform the Social Security trust fund's "special issue government bonds" that serve as intragovernmental "IOUs" and thus are "not... assets" into "super-safe government bonds." The irony that the menu of investment choices under any privatized system would be politically sensitive, when a scant few years ago Alan Greenspan helped kill the federal budget surpluses by suggesting that it would be a Bad Thing have the government meddling in markets by way of politically sensitive investments of hypothetical future budget surpluses, is noted.

I'm not a market historian, so I can't really give a good answer to the second question. Clearly, people who end up piling into a stock market boom-bust cycle at the wrong time can end up with big losses. To offer a personal anecdote, thanks to employment timing, I started contributing to my firm's 401(k) plan (invested in an S&P 500 index fund) at the start of 1997 — arguably before the peak of millenial stock market mania. At the bottom in the fall of '02, the investments were worth about 26% less than my contributions in the midst of a roughly two-year stretch when I was "enjoying" negative total returns. These savings have clawed their way back to a modest positive return at this point, but if I'd been counting on compounding of risk-free returns at historical market rates (as, I think, some of the privatization pitches encourage), I'd be disappointed to the tune of a lot of money. I also know personally of retirements that were deferred due to steep losses in portfolios that turned out to have been imprudently concentrated in tech and telecom shares.

There is also an array of problems in selecting appropriate "default" investments for unsophisticated investors, particualrly since in the Bush plan, in contrast to ordinary savings, it's possible to lose money as a result of having a positive but insufficient "real" (inflation-adjusted) investment return. This is because of a guaranteed benefit offset in the plan; with overly conservative investments, it's possible that the offset could exceed the private account proceeds.
Malkiel has several graphics of 10-year return (not, from what I remember, inflation-adjusted) at various P/Es. Let me be polite and say that the numbers are not encouraging.

As the Motley Fool once noted--and they considered this a positive for stock market investment--there are very few specific days on which the market receives most of its gains (think paradigm shift, but in the context of a roulette wheel).

(It's a positive because it leads to their "you've got to be in it to win it" maxim; similarly, if the Fibonacci series ever turns out to be the winning lottery numbers, I will have "lost" that opportunity.)

What would definitely happen is that more money would be available, chasing the same actual value. This is not a recipe by which "historic" returns should be considered a reliable guide. (If you look at historic Government bond returns up through the mid-1960s, you will find a figure less than 4%, since issuing yields were capped at that level. Bonds v. Stocks follows Race as a place where the "historic" comparison (to borrow from LBJ) is that of a healthy runner against one who spent a long time with shackles on both legs.)
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