Saving Social Security: A Better Approach

Abstract

In his February 2002 address to the National Summit on Retirement Savings, President Bush asserted that citizens who invested their Social Security contributions in stocks over the past forty-five years would have more than tripled their retirement benefits, and implied that a similar windfall awaits those who invest their retirement funds in stocks over the next forty-five years. Unfortunately, this is not true.

Privatizing Social Security by allowing individuals to invest in mutual funds cannot raise living standards for future retirees by a factor of three because the expected return of equities, prior to transaction costs and mutual fund fees, has declined to about 8% per annum, and the corrosive effects of these unavoidable frictions will further reduce it to about 6.75% per annum. And, if by chance, the next 45 year period ends in an replay of 1929 or 1999, the retirees of 2047 will face not a comfortable retirement, but penury.

In this article, I argue that investing in mutual funds is a particularly inefficient way to restructure Social Security, and propose a far more effective solution. I show that it does make sense for the Social Security system to invest in stocks and corporate bonds. However, it does not make sense to force each citizen to maintain a private account at a mutual fund, as this induces a substantial drag from transaction costs and management fees, exposes citizens to significant investment risk and precludes the provision of a guaranteed retirement benefit.

I propose that the Social Security system's assets be invested at essentially zero cost by a competitively chosen investment manager in a single giant index fund that holds both stocks and bonds. In combination with an innovative financial instrument known as a swap, this ensures the solvency of the Social Security system and allows for the provision of a guaranteed retirement benefit, while simultaneously protecting it from political manipulation. In addition, it inexpensively affords insurance against a market decline and allows pensions of any kind - defined benefit, defined contribution or cash balance - to be made portable.

Keywords: Social Security, President Bush, Commission, mutual funds, individual accounts, retirement benefits, defined benefit, defined contribution, cash balance, swap

JEL Classification: H55, G23, J32, J26, J38