By Steven Pearlstein and Spencer Rich
Sixty years ago, with bank failures and a stock market crash having wiped out much of America's savings, the country turned to Washington to give the nation's elderly a guarantee of a decent income in their old age. Their solution was Social Security.
Today, with Social Security's long-term finances in doubt and the stock market at record highs, it is government that is turning to Wall Street for a solution.
All three of the reform proposals coming out of an advisory council on Social Security this week contain the suggestion that some of the program's surplus cash be invested in the stock market until it is needed.
One proposal envisions the government doing the investing from a common pool. Two others recommend that a portion of Social Security contributions be kept in individual retirement accounts that workers could invest and manage on their own.
That would be a sharp change from current practice. Today, Social Security's growing pot of surplus cash is invested exclusively in government bonds, or IOUs, that are virtually risk free but pay interest rates of only about 2 to 3 percentage points above the inflation rate. By comparison, the average return from investing in stocks over long periods has been about 7 percentage points above inflation. The various reform proposals that Washington lawmakers will consider seek to take advantage of those higher returns from stocks.
Economists and actuaries acknowledge the switch could help Social Security avoid some tax increases or benefit cuts necessary to keep the retirement fund solvent in the future. But they also warn that the windfall may not be as large as it first seems and brings with it a set of financial and political risks that should not be overlooked. Here are a few of them:
* Government as Shareholder. The six traditionalists on the advisory council would have the government, rather than individual workers, invest Social Security funds in the stock market.
Critics of this idea recoil at the thought of government entangling itself in ownership and internal affairs of private companies by becoming investors in their stock. They also fear government officials would come under tremendous pressure to steer investments toward socially or politically popular businesses, even if it meant earning a lower return.
But proponents note that government already has mastered the art of passive investment, pointing to the myriad of pension programs run by the federal and state governments for their employees.
* Market Timing. In calculating the benefit of investing Social Security funds in stocks, most analyses are based on the average return the stock market has given all investors since the 1920s.
The problem with long-term averages when the individual is doing the investing, however, is that they are not necessarily achieved every year or even every decade: some periods are marked by bull markets, others by bear markets. But workers do not get the option of deciding, when they reach 65. So, for any group of workers reaching retirement at the same time, there is as good a chance they will be cashing in stock investments when the market is underperforming.
That poses a fundamental question for Social Security based on stock market returns: Should the size of a person's Social Security check depend on the luck of when he or she was born?
* Investor Prowess. Another question, of course, is whether the size of a person's Social Security check should depend on his or her cunning as an individual investor. While about half will outperform the market, the other half will do worse than average.
Critics worry that the rich and well-educated will be the ones beating the average while those who rely most heavily on Social Security the poor and less educated will fall behind.
One way to reduce this risk of unequal outcomes would be to require workers to put Social Security funds only in mutual or index funds that buy large numbers of stocks and tend to perform at or near the average of the whole market. While that approach was favored by some council members, others felt American workers should have the choice of taking greater investment risks if they wanted, so long as they were adequately warned of them.
* Boomer Bulge. One of the big problems facing Social Security is the demographic bulge presented by the baby boomers. If boomers invest a large portion of their retirement funds in the stock market, it could trigger a long bear market when they all go to retire and cash out. One technical adviser to the advisory council predicted stock prices would fall by one-third.
* Robbing the Kitty. In a system in which every worker has an individualized Social Security account, critics argue there will be an irresistible temptation for people to tap into it before retirement to cover other expenses, such as buying a house, financing college educations, or paying major medical bills.
And politicians will be hard-pressed to tell workers with terminal illnesses that they cannot dip into retirement money they may never live to use. To the degree Congress allows any of these types of withdrawals, it will feel pressure to allow all of them, weakening the pension system's financing.
* Cashing Out. A big debate within the advisory council concerned what would happen to individualized accounts once people reach retirement.
One group would allow retirees to do anything they wanted with the money including spending it all at once so long as the traditional portion of Social Security was still sufficient to keep their income above the poverty line.
The philosophy of this faction is that people are capable of managing their finances and do not need the government to save them from temptation.
But a smaller group noted that many workers, when handed lump-sum retirement checks, splurge on cars, boats and vacation homes or increase their everyday standard of living, only to find years later that they have outlived their savings.
They propose that new retirees be required to cash in their account for what is called an annuity, purchased from an insurance company. The annuity would provide them a fixed monthly benefit for the rest of their life, much like the traditional Social Security pension only this time, the size of the pension would be dictated by the success of their investments.
* Wall Street's Take. Any program of individualized Social Security accounts entails considerable additional expense for marketing, administration and money management, a fee that typically runs to 1 percent of the amount of the money being invested. That would add substantially to the administrative costs associated with managing the program, wiping out a large chunk of the investment premium that would be earned by switching from bonds to stocks.
© Copyright 1997 The Washington Post Company