IF YOU’RE SO WORRIED ABOUT SOCIAL SECURITY THAT you stay awake nights, cheer up. A solution is at hand. To assure a good night’s slumber, sit down at bedtime with the report issued last week by the Advisory Council on Social Security. This 752-page, two-volume opus is so complicated, technical and jargon-laden that it makes your average computer instruction manual look like a comic book. The difference is that the numbers in computer manuals are lots smaller.
By now, you’re probably overfamiliar with the details. The council, formed in 1994, was expected to propose rescuing Social Security by raising taxes and trimming benefits. Surprise! Instead of relying on this traditional but painful fix, the council proposed to “reform” the system’s retirement and disability programs by betting trillions of dollars on the stock market. That’s trillions, with a “t.” Talk about the temptations of a bull market. Stocks will be the answer to all our problems, social as well as financial. Rather than bite the bullet on Social Security, we can all chow down on a free lunch. Stock-market profits will keep baby boomers fat and happy in retirement; Gen-Xers won’t be taxed up the wazoo to make the boomers’ golden years glorious. We’ll solve Social Security’s funding problem by letting Americans buy a big piece of America. Ain’t life grand?
But you know what? It’s all fantasy. Pure fantasy. Lots of Americans favor putting some of the funds into stocks. But if we’re silly enough to try it, it won’t work. Let’s back up a bit before ex- plaining why.
The free lunch proposed by the council comes in three varieties, because the members couldn’t agree on the most appetizing dish. The first, which has gotten the most ink, would make the federal government the world’s biggest stockholder. The second would establish a new 1.6 percent tax on Social Security-covered wages and require people to invest the money in one of a half dozen or so government-sponsored funds. The third would require people to save 5 percent of Social Security wages in accounts holding any kind of publicly traded securities they wish, would have Uncle Sam borrow up to $7 trillion to pay benefits to make up for the money that would be invested rather than redistributed to retirees and would finance it all with a 1.52 percent tax on top of the existing 12.4 percent tax. There’s one thing to be said for putting Social Security money in stocks: it puts the entire society in the same boat. The two other plans are honest enough to propose big tax increases and severe cuts in benefits to make the system sound. But these plans raise the prospect of millions of retirees’ ending up near poverty because they messed up their investment accounts. So let’s concentrate on the idea of putting the Social Security fund in stocks, which seems more likely to be taken seriously in Washington than the forced-savings approaches.
What all three plans have in common is that they would throw us willy-nilly into a high-stakes game of retirement roulette, betting the nation’s financial future (or the futures of millions of individual retirees) on the stock market. The council didn’t start out to do this. Initially its members tried to agree on a cuts-and-taxes fix. But some members feared that sharp tax increases and benefit cutbacks would erode Social Security’s political base by making people think the program is a lousy investment.
Enter what some council members called “magic bunnies.” You know, the cute little creatures magicians pull out of hats. The magic was to come from stocks, which historically have produced more money for investors than bonds. (The Social Security fund is required by law to invest only in Treasury bonds.) How did the council’s biggest faction–six of 13 members–decide to put 40 percent of the fund in stocks? “That’s the amount that makes things come out,” says panel member Robert Ball, the former Social Security commissioner who’s pushing this plan hard.
Ball says the idea of buying stocks for Social Security came from a fellow council member, Thomas Jones, president of the giant TIAA-CREF retirement system for universities and nonprofit organizations. It has gotten excellent results from investing $50 billion in a 3,000-stock fund tied to the Russell 3000 index. Jones (who originally thought in terms of 15 or 20 percent stocks) says that 40 percent stocks isn’t at all imprudent. “If it had taken 70 percent stocks, I wouldn’t have recommended it,” he says. By comparison, corporate pension funds typically have about 60 percent of their assets in stocks.
Ball says it’s perfectly safe for Social Security to have its money in the hundreds (or thousands) of stocks that make up an index like the Standard & Poor’s 500 or the Russell 3000. Why does Ball say that’s safe? Because unlike individual investors, the government won’t panic during downturns or be forced to liquidate its holdings at low prices to generate cash. “It would take a major depression for an investment in an index to create a problem,” Ball says. Ball’s sincere–but unfortunately he’s wrong. The Treasury would in fact find itself a few trillion dollars in the hole if stocks merely rose at a rate lower than the council projects.
Here’s the problem. In a triumph of statistics over common sense, the council’s plans all assume that stock prices from here on will rise more quickly than they have in the past. A dubious prospect, considering that stock prices are already at such nosebleed-high levels that even many bulls have gotten nervous stomachs. Stocks have risen about 1,000 percent since the bull market started in August of 1982. But no tree grows to the sky. Except, of course, for simulated trees in computer models.
Even though the long-term trend of stocks is up–look at the graph accompanying this article–prices don’t go up in straight lines. Yes, stocks are up this year, with the Dow Jones Industrial Average having closed at a record 6703.79 on Friday. And yes, 1995-96 was the best two-year period for stocks in either 20 or 40 years, depending on how you measure. But lots of people have forgotten that the three previous years–1992 through ‘94–were a crummy time for stocks.
Anyone who has studied financial history, even a little, gets very nervous when people confidently predict what stock prices will be in 75 years. Betting that stock prices will keep rising rapidly because they have been rising rapidly “is like the guys on Noah’s ark projecting six more weeks of rain on the 39th day,” says Joseph Rosenberg, chief investment strategist at Loews Corp. and one of Wall Street’s most respected investors. “You can’t believe how dumb a government can be.”
Rosenberg points out that stocks don’t necessarily spring back quickly from deep drops the way they did after the 1987 market crash. Stocks didn’t regain their 1929 highs until 1954, Rosenberg notes, and it took almost 10 years for stocks to match the highs they reached in 1973. Then there’s the Japanese stock market, second largest in the world behind the United States. In the late 1980s, the Nikkei 225 Index was rising exponentially, and investors poured in, expecting gains to continue. The Nikkei is down more than 50 percent from its 1988 peak. That means it has to more than double just to get back to where it was eight years ago.
But even absent a 1929, 1973 or Japanese-type disaster, stocks aren’t likely to make the money the council projects.
Here’s why. Combining several different assumptions, the council projects that inflation will be 4 percent a year, bonds will yield 2.3 percentage points more than inflation and stocks will produce 7 percent more. That works out to 6.39 percent for bonds and 11.28 percent for stocks, says Stephen Goss, deputy chief actuary of the Social Security Administration. The stock number includes capital gains and reinvested dividends.
Now, 11.28 percent a year may not strike you as a big hurdle, given that stocks earned three times 11.28 in 1995 and twice as much last year. But it’s a huge number. Tom Jones, the TIAA-CREF president who put stock investments on the council agenda, says his organization expects to earn only 10 percent a year on its stocks. Oops. How can Jones square Social Security’s 11.28 percent with TIAA-CREF’s 10? In an interview, Jones is honest enough to say he can’t. Instead, he talks about the need for “compromises” and “coalitions,” and says the council is being so conservative in other areas that even if stocks don’t make 11.28 percent, things will be OK. With luck, we’ll never have to find out.
Lest you think that TIAA-CREF is run by pessimists, consider corporate America’s expectations of the market. Greenwich Associates, a consulting firm, says the corporate pension managers that it surveyed expect stocks to average 9.6 percent annually for the next five years.
If you can stand a small lesson in statistics-gathering, let’s see where the council’s projection of stocks’ making 7 percent more a year than inflation came from. It’s based on a report by Joel Dickson, a financial analyst at the Vanguard mutual-fund group. Dickson was assigned to figure out how much stocks had made, after inflation, for the longest period he could measure. He decided to go back to 1900. Trouble is, the Consumer Price Index, which is used to peg Social Security benefits to inflation, didn’t exist until 1917. And Ibbotson Associates’ calculation of stock returns, considered the best long-term measure of U.S. stocks, starts only in 1926. So Dickson had to create his own pre-1917 measure of inflation and had to rely on studies by G. William Schwert of the University of Rochester for stock performance from 1900 to 1925. After thus piling assumption on assumption, Dickson decided that 7 percent above inflation for stocks and 2.3 percent for bonds was a reasonable guess. However, he noted clearly in his report to the council that there’s at least a 50 percent chance his numbers won’t be right. Is he counting on 11.28 percent for stocks? “Of course not,” he says with a laugh.
An aside: for this difficult, innovative work, Dickson was paid a whopping $1; Vanguard, which wasn’t involved in his research, kept him on its payroll. Is Dickson’s $1 check hanging in his office? Nope. “I took it home; my cat got to it and bit it in two places,” he says.
The cat ate his paycheck, and maybe my harping on the 11.28 percent projected return for stocks is wasting your time. But look what happens when numbers differ by small amounts over decades. Let’s compare the 11.28 percent a year the council projects with the 10.71 a year that Ibbotson Associates says stocks earned from 1926 through 1996, a 71-year period. Do the math–don’t try it without a compounding calculator–and you see that $1 invested in 1926 had become $1,372 by last Dec. 31. But if stocks had earned the council’s projected 11.28 percent, our dollar would have grown to $1,975. A big difference, eh? It means that if stocks rise for the next 71 years at the Ibbotson rate instead of the council’s rate, Social Security’s stock portfolio would be worth 30 percent less than the council projects.
What terrifies me and many Wall Street types is the prospect of the government pounding into the stock market, running prices to the moon with automatic buying, and then having the market crash on us for some reason that we can’t yet foresee.
It’s one thing for someone like me, who makes a very good living, to bet on the stock market. I can afford to lose. But betting the federal budget on stocks is madness. And forcing millions of people who don’t know stocks from smocks to let the market determine whether their retirement dinners will consist of cat food or caviar doesn’t seem like the way we should treat people. If we’re going to fix Social Security, let’s do the boring, painful things that we know will work. And let’s try to remember the prime rule of economics: there ain’t no such thing as a free lunch.
25% think fixing Social Security should take priority in Washington this year; 33% think improving education should take priority; 61% say they are not confident that Social Security will be able to provide them with income in their retirement; 34% are confident it will. 71% favor letting individuals decide how some of their own Social Security contributions are invested; 50% favor investing revenues in the stock market 61% say they are not confident that Social Security will be able to providethem with income in their retirement; 34% are confident it will.
GRAPH: How high will it go?: Depends on whether you think trees can grow to the sky
ILLUSTRATIONS
VOX POPULI
ORDINARY AMERICANS FIND LITTLE SECURITY IN SOCIAL SECURITY. HOW WOULD YOU ANSWER SOME BASIC QUESTIONS?
IS SOCIAL SECURITY important? Should trust-fund money be invested in stocks, and by whom? Would you pay more taxes or accept lower benefits to save the sytem?
A man-in-the-street survey suggests deep uncertainty about health of our old-age safety net.
Raliitsa Combs, 31 Interpreter, Married Middle Class, Chicago
“Tax money from younger people could be invested in the stock market. They could handle the risk over the long term. Lower income brackets should enjoy the present level of benefits, while people in higher brackets should contribute more to the system and take out less.”
Larry Adams, 55 Cabdriver, Married Income: $30,000, Los Angeles
“Social Security isn’t important to me at all. I have savings for retirement because the system isn’t going to be there when I need it. Soon it won’t exist. The funds should be invested, but only part should go to the stock market.”
Doris Gray, 50 Retired Nurse, Divorced Income: $30,000, Los Angeles
“Instead of putting Social Security revenue in the stock market, I’d rather put mine under my bed. What if the stock market crashes? They should teach kids how to invest from the first grade. People can’t afford bus fare to go to church, and they definitely can’t afford to be taxed more.”
Nkrumah Gowie, 21 Store Clerk, Single Income: $36,000, New York
“I haven’t been paying too much attention to the reform proposals. Social Security probably won’t be there, so I’m not counting on it. It’s obviously not working . . . I’d rather lose the money myself than let the government do it for me . . . I’d be willing to pay a little, but not a lot, more into the system. Cutting wouldn’t be a good idea; people are barely surviving.”
Charleen Morgan, 20 Student, Single Income: $3,000, New York
“Social Security probably won’t exist. I’m paying into nothing. Investing is something I could learn. People want a choice, and they might feel more responsible if something went wrong. I’d be willing to pay more, but not a drastic amount. The idea of benefits being cut is scary.”
Xerxes Bhappu, 45 Sales Manager, Married Income: $100,000, New York
“I think it’s grossly unfair to ask people to pay increased taxes for the same benefits, or take lower benefits when their time comes, in order to save Social Security. The ideal situation would be for people to choose where to invest the money. But they often don’t have specific knowledge, so perhaps a panel of experts should make the choice.”
