"Volatile" is a mild adjective to apply to the stock market lately. The Dow is way up; the Dow is way down. The NASDAQ is way down; the NASDAQ is way up. So does that throw cold water on the idea of letting people put part of their Social Security payroll tax into personal retirement accounts to be invested?
Actually, no. Investing in personal retirement accounts is different from day trading or market speculation. Unfortunately, however, it seems that some usually thoughtful people have confused one with the other, so this may be a good time to explain again how personal retirement accounts would work, as envisioned by most of the major reform proposals.
Under most such proposals, when you divert a portion of your Social Security tax into a personal account, that takes control of the money away from politicians and puts it in your hands. But your control is not unrestricted. You must choose one of several private fund management companies to invest and manage your account. The fund management company's control is also restricted by a requirement that your money be invested conservatively, probably in the equivalent of one of several index funds.
Now, let's look at what happens to your account when the market is hot – or cold. Your fund management company can't chase after the latest dot.com skyrocket, or sell off holdings on the basis of the latest rumor. Your account will fluctuate in value from day to day, but it won't provide you with much heart-stopping excitement. Rather, it will just gradually increase in value because it has two important things going for it: a market history of average annual real growth and the power of compounding.
Social Security benefits are based on your best 35 years of earnings. To give you an idea of what private investment of your account for 35 years would mean, researchers at Texas A&M University have calculated that the worst average return on a stock index portfolio over any 35-year period from 1940-1975 to 1963-1998 would have been 4.42% per year (after adjusting for inflation). Add the effect of compounding and your account grows in a hurry.
Still, as investment prospectuses always warn, past performance is no indicator of future results, so most reform proposals call for a safety net – a government guarantee of a minimum retirement benefit, with part of it coming from general revenues, if necessary. That's one reason for the restrictions on investment options; it prevents speculation by an individual who figures that if the speculation goes bad, he or she can still fall back on the government-guaranteed minimum.
If you began today to divert anywhere from 2 to 4 1/2 percentage points of your payroll tax (different plans propose different rates), your personal account obviously will still not have enough in it to pay your entire Social Security benefit when you retire, so a good part of your benefit will continue to come out of the part of the payroll tax that working people are paying to the government. However, the key is that if your personal account grows as expected between now and retirement, the amount the government provides can decrease.
That point will become more and more important. Social Security in its current form is a pay-as-you-go system, meaning today's retirees get their benefits from taxes paid by today's active workers – and the ratio of active workers to retirees is shrinking. Along about 2015, when the payroll tax won't take in enough to pay the benefits, the idea that the difference can come out of the Social Security trust fund is going to run up against a hard reality: the only way the government can redeem those bonds is by higher taxes or borrowing money.
Social Security has a huge unfunded liability in the form of benefits already promised but not yet paid, and it will only grow larger if nothing is done to start funding all or part of retirees' benefits in advance of their retirement. That's the idea behind personal investment accounts.
Surveys show that many young people just entering the workplace are skeptical of ever receiving anything from Social Security. Personal retirement accounts can be the first step in a transition to funded benefits that can save Social Security for them and future generations.
But if you have a personal retirement account that's invested, what about those day-to-day market gyrations? They're pretty much irrelevant to how well your account grows over the months and years.
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The National Center for Policy Analysis is a public policy research institute founded in 1983 and internationally known for its studies on public policy issues. The NCPA is headquartered in Dallas, Texas, with an office in Washington, D.C.