Economic Scene: Market Risks Could Hurt the Social Security Safety Net

By: Hal R. Varian
The New York Times, May 31, 2001


PRESIDENT BUSH'S newly appointed commission on Social Security intends to consider ways to partially privatize the program, perhaps by allowing workers to invest part of their Social Security contributions in stocks.

On the face of it, this looks like a sensible thing: over the last 100 years, the American stock market's average return, excluding dividends, has been about 7 percent a year, which is quite a bit larger than the average Treasury bill return of roughly 3 percent.

Indeed, the Social Security Administration's Office of the Actuary has used this 7 percent figure when projecting forecasts of how the program would fare under various proposed privatization plans.

But, as the mutual fund prospectuses tell us, "past returns may be no guide to future performance." There are plenty of reasons to be suspicious of that 7 percent figure.

Start with volatility. The 7 percent average return hides a lot of fluctuations. Over the last century, stock market earnings have ranged from minus 48 percent in 1931 to plus 49 percent in 1933. True, the market was especially volatile during the Depression, but even in the postwar period returns have ranged from minus 25 percent to plus 40 percent. Given this enormous variability, it's hard to be all that sure the expected yearly return is even positive.

Suppose we make the extreme assumption that the expected yearly return on the market is zero, and the volatility is equal to the historical average. Even with this very low expected return, we would see yearly returns of 7 percent or more about 36 percent of the time. Maybe the stock market isn't that great an investment, and we've just been lucky.

Then there's the market's recent performance. Economists like to think that stock market prices reflect some underlying fundamentals. Over the last 100 years, the ratio of the price of a stock to its current earnings has averaged around 14. Today, the price-earnings ratio for the Standard & Poor's 500 is around 25. This leads financial economists like Robert Shiller of Yale to forecast a large drop in stock prices in the next few years, as these ratios return to normal.

Another way to assess the 7 percent return is to look at other markets around the world to see whether this sort of return is the norm.

Two financial economists, Philippe Jorion and William N. Goetzmann, asked the following question: Suppose your grandfather put $100 into each of the 39 major stock markets in the world in 1921, what yearly return would that investment have earned by the end of the 20th century? The answer is a shocking 3.11 percent essentially the same as the return on United States Treasury bills. This figure represents only the capital gains component of the return, since dividend data is awfully hard to come by, but it is still remarkably small.

On reflection, it's not hard to see the reason for this low return: a lot of bad things happened in the 20th century. The German stock market disappeared twice, in 1931 and in 1944. Most European markets in occupied countries were liquidated during World War II. In the early 1960's, the Egyptian and Argentine stock markets collapsed. In fact, according to Mr. Jorion and Mr. Goetzmann, this nation's stock market is quite an anomaly, scoring the highest of those 39 markets in both longevity and average return. And even the United States market looked pretty shaky in the 30's.

While it is true that the average return on the stock market over the last century has been about 7 percent, we can't be all that confident that this performance will continue in the future. Instead of picking a single forecast about how the stock market will perform, the Social Security commission on privatization should recognize that the return is uncertain. 

The private financial sector routinely uses sophisticated risk-analysis tools like "value at risk," "real options," and "Monte Carlo simulation." The public sector can and should draw on the same tools. Indeed, it would be irresponsible to pretend the stock market has a certain, predictable return of 7 percent a year, given all the evidence to the contrary.

If the commission does do some risk analysis, it would be wise to focus on the pessimistic outlooks.

Social Security was created in 1935 as a safety net. Over the years, as the economy has prospered, it has grown to become the primary source of retirement income for a substantial part of the population. At the same time, private accumulation of retirement savings has virtually disappeared: according to a report from the National Bureau of Economic Research by Steven F. Venti and David A. Wise, the average American at retirement has total financial assets of about $40,000, including company retirement plans and personal savings. If you exclude company retirement plans, the figure drops to $13,000. This is not a good thing. Almost everyone who has looked at the data says Americans should be saving more for retirement.

Social Security will face a significant political challenge when the baby boomers retire in 10 to 15 years. With little in retirement savings, but plenty of power at the ballot box, they will be a potent voting bloc in favor of expanding benefits. The cost of such an expansion will come a decade or two later, when a smaller and smaller fraction of the population will be taxed to support a larger and larger constituency of long-lived retirees.

A dollar invested in Social Security is a bet on the good will of future generations of taxpayers. This is a pretty good bet, but it has its limits, especially if baby boomers try to expand the program sharply. A dollar invested in the stock market is a bet on a company's future profits. This has been a great bet in the past, at least in the United States, but is undeniably risky. 

Perhaps it makes more sense to return to the original model of Social Security as a safety net against poverty, with stock market investments as a separate retirement program, clearly recognized as a risky investment by all concerned.

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