Shipman: Meltdown Was Perfect Stress Test For Market-Based Pension Reform

Meltdown Was Perfect Stress Test For Market-Based Pension Reform

Writing in Investors Business Daily, Bill Shipman – chairman of CarriageOaks Partners and co-chairman of the Cato Institute Project on Social Security Choice – argues that the market meltdown is evidence in favor of personal accounts, not against them. Bill's piece is below, followed by some notes from me.

We learned a few lessons in 2008. First, markets can decline dramatically everywhere, and all at the same time. Not just stocks, but bonds, commodities, real estate, you name it. Second, a leveraged economy is an ugly thing when the music stops. Third, government amplifies the ugliness by playing favorites. (Housing, for example.) Fourth, irrespective of the global market meltdown, saving and investing still provide greater retirement benefits than does Social Security, and by a lot.

The last lesson may seem counterintuitive, for many pundits suggest that the events of 2008 finally established that free-market Social Security reform is ill-advised. It isn't. Furthermore, 2008 provides an excellent stress test of the reform theory — for it is an almost perfect laboratory condition of what can go wrong.

The U.S. stock market fell by 37% last year, the worst year since 1931 when it plummeted by 43%. Given historical returns, the odds of such a decline were quite low. Not only was this unusual, but for someone set on retiring it was devastating.

The reason is not so much that the market fell so drastically, but rather that it did so when it did. A big portfolio loss is best endured at the beginning of a worker's career, not the end when all the accumulated assets are subject to the decline.

Balanced funds did poorly as well. A portfolio of 70% stocks and 30% bonds dropped 21%. Historically, this decline was also unusual and unusually bad; it was the third-worst year since 1926. And, importantly, this portfolio is one that workers could possibly choose as a replacement for Social Security.

To compare retirement benefits financed from this portfolio to Social Security's benefits, let's assume a worker with a history of average wages retires in 2008 at age 66 and receives his first Social Security check in January 2009. Based on Social Security's benefit formula, his first monthly check is $1,527, or $18,324 for all of 2009.

Under present law this benefit will increase with inflation. If our worker is married, his spouse, who is usually younger , may receive a benefit at the same time even if she does not have any wage history.

Their combined annual benefit of roughly $25,100 will drop by one-third on the death of either family member, and will be zero upon the death of both. These amounts are not guaranteed by the government, and beneficiaries have no legal right to their receipt.

Had it been legal, assume this wage earner chose to invest his past retirement-related payroll taxes in a balanced portfolio of 70% stocks and 30% bonds, and did so for the first 35 years of his working career, rebalancing the portfolio to 70%-30% at the beginning of each new year.

Ten years prior to retirement he adjusted the asset mix to 50%-50%, a common strategy to dampen risk when nearing retirement. Despite the market meltdown, and reasonable investment-related costs, this simple and time-tested strategy provided a $535,000 nest egg at 2008 year's end. At age 66, the Social Security actuaries estimate male/female life expectancy at 83 and 85.

For the market-based strategy to prove successful, the nest egg would have to last until her 85th birthday and pay inflation-adjusted benefits as well. As it turns out, and assuming the historic inflation rate of 3%, it achieved both goals. The nest egg, earning only a 1.7% — cost- and inflation-adjusted — annual return during retirement, lasted to his 90th birthday and her 87th.

Based on his estimated life expectancy of 83, and a reduction in family benefits upon his death at that age, the remaining portfolio lasted to her 94th birthday. If our worker were not married, his assets would have lasted until his 104th birthday.

Unlike Social Security, he owns the assets, which provides him many options. He could bequeath them to his kids or any organization he chooses. He could increase their combined first-year benefit to $30,000 — 19% over Social Security, and raise it each year by inflation — expecting each to live 20 years, marginally longer than their normal life expectancies. He's empowered to make choices — important in itself.

Many wage earners choose to retire at age 62 when they can receive reduced Social Security benefits, albeit for a longer time. For one making this choice at the end of 2008, the market-based system was an even better deal relative to Social Security.

For a single worker, the portfolio would have provided Social Security-equivalent benefits until age 115; if married and both living, until he reaches age 96, and she age 93.

There is no magic as to why the market-based system provides greater retirement income even after a low-probability market meltdown. Because Social Security is a tax-based structure, benefits can increase by no more than taxes increase, which historically has been 1.5% per annum in real terms.

Markets, even though they can be gut-wrenchingly volatile, have done better. Capturing this difference over a full working career is what provides the higher benefits.

Our nation faces many entitlement challenges, some of which may be addressed during President Obama's administration. Hopefully, he will be wise enough to understand the issues involved with Social Security reform. If so, he may accomplish what has eluded all other presidents.

If he is successful in reforming Social Security along market-based principles, his legacy will be extraordinary and unique. He will have understood that 2008's market collapse was a rare opportunity for reform, not an impediment.

The stakes are high. Wish our nation well.

Some thoughts: First, I broadly agree with Bill's points, as I've argued here and here. Neither Bill's exercise nor mine prove anything in an scientific way, but they do indicate that we shouldn't overstate the meaning of recent market events without actually running the long-term numbers. The historical premium paid to stocks over bonds was huge (and my guess is will continue to be strong in the future). Given that, it's pretty hard to produce a scenario where a long-term stock investor goes badly wrong. Second, Bill's exercise basically ignores what are called the "transition costs" associated with personal accounts; meaning, if I invest my Social Security taxes in the market, who's going to pay for current beneficiaries? For accounts to be a good deal while accounting for transition costs, the realized account return doesn't just have to exceed the return paid by Social Security – around 1.5% -- but the return paid on government bonds, which is around 3% above inflation. In my exercise accounts almost always met that goal, but it's definitely a higher bar and can't be done without taking some risk. And risk means, even over the long term, the chance of coming out with less.