Why Stocks And Social Security Don't Mix

At first glance, the proposals to privatize Social Security and allow individuals to invest their retirement funds in stocks make a compelling case. For the 10 years ended in 1996, inflation reduced purchasing power by 27 percent, but the Standard & Poor's 500-stock index surged almost 200 percent, according to the American Institute of Economic Research.

Social Security funds are now invested basically in long-term Treasury securities earning about 6 percent a year. So even with our economy's low inflation rate, the current return seems miserly compared with the sky-high returns from investments in stocks. But before policy makers rush to endorse any of the investment proposals, they would be wise to consider the ripple effects. In medicine, a drug that reduces the risk of one type of cancer may increase the risk of another; we cannot accept any such trade-off when it comes to privatizing Social Security.

By any objective standard, the stock market is significantly inflated; there is simply too much money chasing too few shares, and pouring many more billions of dollars of Social Security funds into the stock market will only feed the frenzy.

The overheating of the stock market can be gauged by looking at one of the most important measures of share value -- the comparison of share prices with previous-year earnings, the so-called P/E ratio. In the 1950's, P/E ratios for the Dow industrials averaged 14. When the Dow first closed above 9,000 on March 6, the P/E at the end of that week was 21.78. That's high, considering that investors generally feel uncomfortable when P/E's are above a range of 15 to 18, though other factors often come into play.

THERE is little question that a full privatization of Social Security would so further inflate the stock market that the bubble would soon burst, and loudly. Those of us who lived through the Great Crash, or are students of 1929, know that the ripple effect of the Roaring 20's -- the Great Depression -- was certainly not an acceptable trade-off.

And those of us who are seduced by the market's seemingly never-ending climb may be risking the financial security we thought stocks would insure in our retirement. What would have happened had we invested the bulk of our retirement funds in stocks in October 1987, when the Dow began a 40 percent correction? While the compounded growth rate since then has been 16 percent annually, according to the Securities Research Corporation, the average investor unfortunately tends to sell out near the bottom.

Clearly, something must be done, and soon, to shore up Social Security, as benefits will exceed payroll taxes sometime before 2015. Rescue plans range from gradually increasing the retirement age to 67 to raising payroll taxes to reducing benefits for nonworking spouses. But it is privatization that gets the most attention.

Among the advocates of full or nearly full privatization -- either immediate or phased in -- are Martin Feldstein, economics professor at Harvard; Representative Nick Smith, a Michigan Republican who headed a task force on Social Security, and the Cato Institute, a policy research center based in Washington. But if privatization would make the total of $406 billion that workers and employers paid into the system last year available for individuals to invest, just imagine the effect on an already overpriced market.

A proposal advanced by Senators Daniel Patrick Moynihan of New York and Bob Kerrey of Nebraska, both Democrats, is somewhat less dangerous. They propose setting aside 2 percentage points of the total 12.4 percent Social Security tax for individuals to invest in 401(k)-type plans managed by private firms or in three plans set up by the Government. Based on data provided to Senator Moynihan's office by the Congressional Budget Office, that would amount to an average of about $80 billion a year over the next 10 years and higher amounts later. While $80 billion is a small fraction of the $11.3 trillion estimated value of American stocks, such an infusion might be enough to implode the market.

The Social Security Administration says its payments are now the major source of income for 66 percent of all beneficiaries. As more and more people live well into their 80's and 90's, a sound Social Security system is more and more essential. It would be a disaster if our attempts to fix it caused its destruction.