Advisor Today > > December 2000: Privatized Social Security?

Managing Money: Privatized Social Security?

By Janet C. Arrowood

The pros and cons of a political hot potato

By the time you read this, we will have a new President. And our new leader will undoubtedly have definite ideas about how to "fix" or "save" Social Security. But Presidents have very little real ability to implement major changes, particularly given the vagaries of Congress.

However, in a bolder, less politicized environment, consideration might be given to privatizing part, or all, of Social Security.

Here are the things that recommend privatization:

New money chasing a limited supply of equities has a tendency to bid up prices. This results in significant capital gains (which may or may not be taxable when paid out as Social Security payments*. Price changes also impact our investments in some way.
n New money chasing a limited supply of equities has a tendency to encourage new initial public offerings (IPOs) or follow-on offerings of existing equities. IPOS can be one of the most profitable investments in the equity market*.
Historically, dividend-based investments (particularly government bonds) tend to lose ground when inflation and taxes are considered, while growth stocks have averaged approximately 10-12 percent per year over the long haul. These effective rates of return could be skewed by several factors, not least of which is the tax-basis of Social Security withdrawals.
Each pay period, money will flow into the equity markets, resulting in dollar-cost averaging on an unprecedented scale.
Recordkeeping will be complicated, with the result that people will probably be forced into a "buy and hold" approach with changes only permitted on an infrequent (perhaps quarterly) basis.
Many public retirement funds (such as PERA) already have personal investment accounts for their participants.

And now those things that recommend against privatization:

Real rates of return are normally discounted to allow for both taxes and inflation, yet many Social Security recipients don't owe much, if any, tax on their distributions. This makes the 'real' rate of return on debt-based investments much higher than if taxes are owed.
Eventually, this money that has been poured into equities will be withdrawn. These withdrawals have the potential to be massive as succeeding generations retire. Large capital outflows from equities have a tendency to depress prices in a very short time. The performance of the various equity markets in much of September and October 2000 demonstrate this effect only too clearly*.
The stellar performance of the equity markets over the past several years is a historical anomaly. We must counsel our clients that it is not reasonable to depend on this extreme upward trend.
If a large number of new IPOs are issued, clients with unrealistic expectations could be severely and adversely impacted. Witness the current performance of many formerly high-flying IPOs*. There have been many "de-listings" and major decreases in value of formerly "hot" IPOs. Since the investment options for privatized Social Security accounts will likely be some form of mutual fund, the possibility that IPOs will be part of the holdings cannot be ruled out.
People are very unrealistic in their expectations about what equity markets will do. Too often, they chase returns and pull money out after a major market downturn and then stay out of the market during recoveries. This can cause their investments to be worth far less than using dollar-cost averaging and "buy and hold" approaches.
Recordkeeping will be complicated, with the result that people will probably be forced into a "buy and hold" approach even when common sense dictates selling a particular investment.
Social Security is a "pay-as-you-go" system. Any money held in individual participant accounts is not available to pay obligations to current retirees.

Putting part of our Social Security contributions into an individual account containing equities has a certain appeal. But there are many factors to consider before such a plan should be put before Congress and the public:

How will the long-term performance of the equities markets be impacted?
What will happen to recipients' payments if the equity markets undergo a sustained or sharp downturn?
What are the tax implications?
How will the current recipients be assured that their payments will not be affected without sending the national debt back through the roof?
What will be the impact on programs that are currently funded through Social Security surpluses if part or all of the surpluses suddenly become "untouchable?"
Who will determine the investment options available to participants? Who will manage these options?
Will the recordkeeping requirements make partial privatization cost-prohibitive?

Partial privatization of Social Security is both an interesting exercise and a political hot potato. Eventually, some changes are bound to take place. In the meanwhile, the debate goes on…

*Note that past performance does not indicate what will happen in the future. Always consult a tax specialist about actual tax implications of any investment.

Janet Arrowood is managing director of Denver-based Investment Decisions, Inc., a provider of advanced business and estate planning. She is a registered representative and can be reached at 303-567-0996 or by email at jc_arrow@hotmail.com.

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