ACRU

Social Security Personal Accounts and the Financial Crisis

This column by ACRU General Counsel and Policy Director for the Carleson Center for Public Policy (CCPP) Peter Ferrara was published March 25, 2011 on Forbes.com.

In a weekly radio address on Aug. 14 of last year, President Obama taunted Republicans on the issue of a personal savings and investment account option for Social Security, which President Bush had campaigned on successfully in 2000 and 2004. Obama said such a personal account option was “an ill-conceived idea … tying your benefits to the whims of Wall Street traders and the ups and downs of the stock market.”

Accusing Republicans of still harboring such heresies, he said he thought the idea “would’ve been put to rest once and for all by the financial crisis we just experienced … after seeing the wealth people worked a lifetime to earn wiped out in a matter of days.” But “some Republican leaders…don’t seem to have learned any lessons from the past few years,” Professor Obama explained.

What Obama left out is that all personal account bills or proposals have simply offered workers a choice — stay with Social Security or save and invest for your retirement through the account. In addition, there would be no change at all for current retirees.

And while Obama’s notion that stock returns are based on “the whims of Wall Street traders” opens new vistas in financial theory, no bill or proposal has required investment of personal account funds in stocks in the first place. So the President need not “fight with everything I’ve got to stop those who would gamble your Social Security on Wall Street” since no one could do that either to current retirees or to future retirees under any personal account proposal.

But let’s suppose a senior citizen retiring at the end of 2009 at age 66 had possessed the freedom to choose personal accounts when he entered the work force back in 1965 at the age of 21. Paying what he and his employer would have otherwise paid into Social Security into his own personal account instead, suppose he was fool enough to invest his entire portfolio in the stock market for his 45-year working career. How would he have fared in the financial crisis, as compared to Social Security? I worked with William Shipman, former principal at State Street Global Advisors, to determine the answer to that question.

Let’s call our hypothetical worker Joe the Plumber. While working, he earned the average income each year for full time male workers. His wife Mary, same age, also earned the average income each year for full time females. She invested in the same personal account with Joe, an indexed portfolio of 90% large-cap stocks and 10% small-cap stocks, earning the exact returns reported each year since 1965.

This average income couple would have reached retirement at the end of 2009 with accumulated account funds, after administrative costs, of $855,175, almost millionaires. Indeed, they were millionaires, but the financial crisis lost them 37 percent of their account funds the year before they retired. This can be considered effectively a worst case scenario, as the couple retired just one year after the worst 10-year stock market performance in American history, from 1999 to 2008.

Yet, their account would still be sufficient to pay them about 75% more than Social Security promises them, increased annually for inflation just like Social Security. This assumes that in retirement the couple switches to a lower-risk, conservative portfolio of government and high grade corporate bonds earning on average a real return of just 3%.

The advantage of personal accounts will be even greater in the future. Social Security promises most young workers today real returns of only 1.5% or less, counting the actuarial value of all promised benefits. For many, the promised returns are zero or negative. If taxes are raised or benefits cut to close Social Security’s long-term financial gaps, as everyone failing to support personal accounts effectively advocates, these returns would be even lower.

In contrast, Joseph and Mary earned an average annual real return on their stock portfolio from 1965 through the financial crisis to the end of 2009 of 6.75%. From 1926 through 2009, the average annual real return on that portfolio was 9.1%.

Despite Professor Obama’s “lessons” from the financial crisis, state and local pension funds, corporate pension plans, the federal employee retirement plans, and the successful Social Security personal account reform adopted in Chile – copied now by other countries – continue to be based on capital investment to finance retirement benefits. Indeed, President Obama’s rhetoric is inconsistent with the very concept of any unfunded liability pension crisis, because it effectively suggests that capital investment to finance retirement benefits is actually not a good idea after all.

But it is simply a mathematical fact that the least expensive way to provide for an almost certain future liability is to save and invest in capital markets prior to the onset of the liability. That is why doing so is so common, and is considered basic, sound practice, including with all insurance reserves, as well as retirement finance.

The real world systems offering personal accounts as an alternative to Social Security all suffered some losses in the financial crisis, but none of them failed and most of the losses have since been recovered, with workers continuing to enjoy far greater long term returns and benefits from the fully funded and invested personal accounts.

In Chile, where virtually all workers by their own individual choice have enjoyed such personal accounts for 30 years now, not a single one of the nearly 20 personal account investment companies among which workers may choose has failed. Moreover, no workers were left to rely on the government safety net guarantee backing up the accounts due to poor investment performance leaving them with less than the old Social Security system promised.

Similarly, in Galveston, Texas, where local government workers in three counties opted for a personal savings and investment alternative to Social Security in 1981 as well, the annual rate of return fell by about half at the lowest point of the financial crisis. But, again, the system survived without real trouble, and the covered workers will prosper going forward along with the recovering economy.

In the analogous Thrift Savings Plan (TSP) for federal workers, 3 of the 6 investment accounts among which workers can choose suffered deep losses during the financial crisis. But none of the funds went “bankrupt,” or lost all of the workers’ money, and those funds have all since rebounded sharply, recovering prior losses.

President Obama considers empowering workers with the freedom to choose such personal savings and investment for their own retirement an “ill-conceived idea.” But that just reflects more of his throwback thinking to the middle of the last century, and beyond, rather than a truly progressive vision which best represents the interests of working people.

Just such a vision will be presented in next week’s column, with a specific proposal to allow workers the freedom to choose personal savings, investment and insurance accounts to finance all of the benefits now financed by the payroll tax, ultimately phasing out that tax entirely.