Wednesday, June 12, 2013

Why Low Rates of Return Merit More Social Security Privatization

You know you're a policy nerd when you have a dream, and it consists of a political debate of whether Social Security is a good investment or not. I assume that my subconscious is telling me something, and as such, I figured that I ought to bring that debate to my blog, so here we are.

In the past, I have discussed such Social Security-related issues as erosion of economic freedomcreating further dependency on government, and long-term solvency. Rather than get into a deontological debate about whether we should be coerced to put 12.4% of our earned wages into Social Security or whether one's retirement account should be at the mercy of political whims, what I would like to do today is take a more consequentialist approach and postulate whether Social Security is a sound retirement investment, or if there are alternatives to retirement accounts.

Retirement age and amount of taxes put into the system complicate the analysis, but when looking at the typical American, the average rate of return is about an annual real return of 1.2%. However, this depends on when you retire. As the nonpartisan Congressional Research Service (CRS) points out, if you retire at age 65 in 2003, it takes 17.4 years to break even, and for an individual who retires in 2020, it will take 21.6 years (p. 14).  One can argue that for being a low-risk investment, the rates of return on Social Security are not terrible. However, that assertion takes Social Security out of context, particularly in comparison to other options that provide a better rate of return than Social Security.

In spite of the fluctuations of market cycles, the S&P 500 index shows an average annual rate of return between 5-9%. As the Federal Reserve Bank of St. Louis shows, a private portfolio with diversified stocks has a better payoff than Social Security. If you are looking for something less volatile than the stock market, you can voluntarily put your savings in longer-term Treasury Bonds, for instance, and your rate of return would be higher than what it would be under Social Security. Investing in AAA corporate bonds yields an even higher rate of return than Treasury bonds.

Let's also not forget that it's not just markets that are prone to risk. With markets, at least we know that there are booms and busts, which would make the moral of the story "diversify one's portfolio." The current rates of return on Social Security make the assumption that the status quo of the law will by and large be maintained. Governments are prone to political risk, which means that factors such as demographic shifts, economic stagnation, or insolvency can lead to longer-term problems. Also, the only guarantee the government makes is that the Social Security Administration will invest the Social Security taxes in Treasury bills. The longevity of Social Security is up to 535 politicians in DC, and Social Security is not even a constitutional guarantee (Flemming v. Nestor).

Rather than invest tax dollars in an insolvent system with low rates of return, we should follow the examples of Chile, Sweden, and the United Kingdom and implement policies that ease Americans into privatization of retirement accounts so that we can create a new source of capital, not to mention an increase in national savings. By phasing out Social Security while still providing promised benefits to current retirees, we can reduce the debt burden while simultaneously providing Americans with better retirement prospectives.

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