September 16, 2002 | Backgrounder on Social Security
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.
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.
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.
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.