Continued Bear Markets Do Not Hurt the Case for Social Security

Report Social Security

Continued Bear Markets Do Not Hurt the Case for Social Security

September 16, 2002 6 min read
Daniel
David John
Former Senior Research Fellow in Retirement Security and Financial Institutions
David is a former Senior Research Fellow in Retirement Security and Financial Institutions.

Critics of Social Security reform claim that the stock market's recent poor performance shows that introducing personal retirement accounts into the Social Security system would be unwise. They are wrong. Even with recent market losses, such accounts would vastly outperform Social Security over time. Moreover, because, as an individual nears retirement, investment portfolios tend to become more diversified with higher proportions of less volatile instruments, such accounts would be less sensitive to market changes than a portfolio that is composed solely of stocks.

Morningstar, Inc., an independent market data and analysis firm, estimates that the value of mutual funds invested in diversified U.S. stocks declined 12.1 percent during the second quarter of 2002. However, not all types of investments went down. Mutual funds containing the lower-risk instruments such as taxable bonds, which are routinely held by those nearing retirement, rose an average of 1.4 percent over that same period, while funds invested in tax-exempt bonds rose 3.2 percent. Series I U.S. Savings Bonds (I Bonds) also saw positive results and will pay 2.57 percent annually (2.0 percent after inflation) through November 1. Thus, even with recent stock fluctuations, the long-term prospects for earnings in personal retirement accounts remain strong.1

The recent poor performance of stocks must also be considered against the high earnings of 1997-1999 and expected future positive returns of investments generally. The return on a prudently mixed portfolio of 50 percent stock index funds and 50 percent government bonds could average 5 percent annually.2

In contrast, a 35-year-old man with average earnings for his age group can expect to "earn" a -0.3 percent return on his Social Security retirement taxes. That is, after paying about $282,000 in taxes over his career, he can expect only $262,000 in benefits. His 32-year-old wife would see a positive rate of return of 1.9 percent annually--still well below even what I Bonds would pay.

Investment Risks Can Be Reduced

In the real world, retirement investments have risk-limiting features to reduce losses from market fluctuations. Such safeguards could be part of Social Security personal retirement accounts as well by incorporating the following features.

  • Different portfolios for older and younger investors. Today, investment advisers regularly structure retirement accounts so that, as workers age, more funds are shifted into fixed-income investments. Through this process, they tend to lock in earnings by decreasing the proportion of investment in stocks. A recent survey of 401(k) plans shows that, compared to investors in their twenties, investors in their sixties invest less of their portfolios in equity funds (44 percent vs. 63 percent) and much more (23 percent vs. 8 percent) in guaranteed investment contracts and similar instruments that pay a fixed interest rate. This model can be applied to Social Security personal retirement accounts as well.


This practice is significant because decreasing the proportion of investment in stocks reduces the potential for short-term loss. Although younger investors need to invest most of their assets in stocks to get higher returns, those who are closer to retirement need to reduce the likelihood that a sudden market shift will affect them. In the second quarter of 2002, older investors nearing retirement whose money was invested 40 percent in stocks and 60 percent in tax-exempt bonds would have seen their assets decline only by about 2.9 percent.

  • Index-type funds rather than individual stocks. Stock index funds that track the entire market are much less volatile than individual stocks and funds that track only one economic sector. On August 21, 2002, Standard & Poor's 500 index rose by 1.3 percent, while Pure Resources, Inc., stock increased by 34.2 percent and Radio Shack stock declined by 16.4 percent. Although individual stocks come and go and individual companies that make up an index change frequently, the index remains more stable.

  • Long-term investments in stocks. Retirement investors should be encouraged to buy and hold stocks for long periods; thus, legislation creating personal retirement accounts should discourage short-term trading. Though stock returns fluctuate widely from year to year, earnings on stocks held for 20 years or more have always gone up. This is significant because retirement assets are usually held for 20 to 40 years. The investment analysis firm of Ibbottson & Associates has found that, since 1926, large company stocks have had returns that varied from +53 percent in 1954 to -43 percent in 1931; when the same stocks were held for 20 consecutive years, they had positive average annual returns, even when the Great Depression was included in the period considered. Holding stocks longer is even better. Jeremy Siegel of the Wharton School at the University of Pennsylvania found that, since 1871, stocks held for 30 years have always outperformed bonds and Treasury bills.3
  • Blended portfolios to smooth out risk and returns. Funds managers should allow workers to invest their retirement account funds in mixed portfolios of stocks and other investments. Such portfolios would ease concerns about market fluctuation, since some money would be invested in safer income instruments. As the demand for retirement investment and annuity products grows, new instruments that combine reduced risk with higher returns are being developed. One securities firm has developed an inflation-indexed annuity with a survivor's benefit. Insurance companies are developing packages that include both investments and life insurance. Any of these products would be suitable for personal retirement accounts.
  • Series I Bonds or similar investments. Legislation creating personal retirement accounts also should allow workers who wish to avoid any risk to invest in U.S. Treasury Series I Savings Bonds, which currently pay 2 percent plus inflation and have no administrative charges.

Conclusion

Retirement investing is different from day trading. It should consist of long-term investments that allow relatively brief downturns to be balanced by more frequent positive returns. Stock investments held for 20 years or longer always have positive average annual returns. The recent stock market losses do not change this fact.

Social Security pays extremely low rates of return and faces significant financial problems. Even with market fluctuations, workers could expect to earn significantly more from personal retirement accounts than they could expect from Social Security, accumulating a nest egg for retirement or to pass on to their families.

It has been said that choosing between higher risk and higher returns is like choosing between eating better or sleeping better. Allowing workers to invest some of their existing Social Security taxes in their own personal retirement accounts would enable them to do both.

--David C. John is a Research Fellow at The Heritage Foundation.



1. Morningstar.com, "2002 Second Quarter in Review, Fund Category Returns," at http://screen.morningstar.com/quarterend/Q22002/QEFundCategoryReturns.html (September 3, 2002). For more information about Series I bonds, see U.S. Department of the Treasury Web site at http://www.publicdebt.treas.gov/sav/sbiinvst.htm (September 3, 2002).

2. Ibbotson & Associates, Stocks, Bonds, Bills and Inflation 2000 Yearbook (Chicago: Ibbotson Associates, 2000), pp. 198 and 208.

3. Jeremy J. Siegel, Stocks for the Long Run (New York: McGraw-Hill, 1998), p. 28.

Authors

Daniel
David John

Former Senior Research Fellow in Retirement Security and Financial Institutions