The Bush administration would have it that you’re either with it or against it on Social Security reform. The Democrats may have fallen for that but Henry Blodget reckons there is a middle way.
The big debate in the US these days is about how to fix the Social Security retirement system. The concern is that, thanks to the surge created by baby-boomer retirements and the general problem of longer life spans, a declining ratio of workers to those in retirement will eventually cripple the programme.
The Bush administration’s modus operandi for enacting ideological change is to declare a crisis and propose solutions (Iraq is an obvious example). Today’s White House rhetoric, therefore, often implies that Social Security is set to go bankrupt next week instead of simply requiring reduced benefits after an estimated 40 years if it is to be kept from going under.
The administration’s fix is a disguised reduction of benefit growth and the creation of voluntary personal retirement accounts. The Democrats’ response is to deny the problem, advocate tax increases, and/or to suggest that personal accounts will further bloat the nation’s deficit and leave pensioners destitute.
Neither side has dared bring up an idea that was launched during the golden years of the Clinton administration – investing the current Social Security surplus in more than just treasury bonds.
Doomed to investment mediocrity
The problem with implementing the personal account theory is that, for a half-century or so, it would worsen the country’s financial position. It also ignores eons of history demonstrating that most mortals are doomed to mediocrity in their investment decisions.
If people and markets could be counted on to behave as they should, personal accounts would be a lay-up: the 2% expected real return on Social Security contributions invested in treasuries is dwarfed by the 4% to 6% expected real returns on a mix of stocks and bonds, and the difference could offset benefit reductions.
Alas, as a species, we are hardwired to make dumb investing mistakes, and no matter how restricted our personal account choices were, we would probably find ways to keep making them.
For example, we tend to be overconfident about our investing prowess, so too many of us would opt for personal accounts. We also tend to have too much respect for those claiming investment expertise, so we would then sacrifice a portion of our returns to fees and cheerful but lousy advice from the press, Wall Street, our friends, and so on.
In the great tradition of human money management – professional and amateur alike – we would also do a poor job of rebalancing our portfolios. We would probably increase allocations to asset classes when we should be decreasing them (at the end of long bull markets) and decrease allocations when we should be increasing them (at the end of long bear markets). The combined impact of these mistakes would likely, at best, knock a few points off our long-term returns. At worst, it would lead to a taxpayer-financed bailout.
So if personal accounts won’t work, how can we fix the system? By taking the best of both proposals and exhuming the Clintonian idea. Specifically, we can nudge up taxes, slow payout growth, and invest the existing surplus the way most large pools of retirement and endowment capital are invested: in a diversified portfolio of asset classes.
The portfolio would include not just treasuries, but also an appropriate mix of stocks, bonds, private equity, REITs, international securities and even commodities.
The main criticism of this idea is that it would create untenable conflicts and risks and expose our retirement savings to government ineptitude. With the proper controls in place, however, these concerns can be minimized. A well-managed, well-diversified portfolio is less risky than a concentrated one, and if state governments can manage pensions without succumbing to political pressures, so can Washington. Ineptitude is a valid concern – many companies have butchered the pension job – but the risk would be increased, not decreased, by having millions of privately managed accounts.
Learning to live with volatility
The real risk of diversification is that the fund would be exposed to near-term losses. In exchange for increasing expected long-term returns by a point or two, we would have to accept greater near-term volatility (the current bond portfolio is not marked to market). The risk is one of perception: any dip in value would no doubt prompt sound-bite crazed politicians to accuse opponents of blowing the nation’s retirement money. If the paper losses were steep, legislators might panic and revert to the “safety” of strong asset classes – just in time for the inevitable reversion to the mean.
To succeed, therefore, a diversified investment strategy would have to be accompanied by a healthy dose of public education and a longer performance horizon than the average pension fund (which, ludicrously, seems to be managed with an eye toward one-year rather than 20-year returns).
Given that the greed and fear of the average investor is exceeded by the greed and fear of the average politician, this would be asking a lot. But it just might work.
