Bush Plan Sharpens Retirement Investing Debate

Even if Americans never get the option -- or burden -- of investing some of their Social Security tax money, the idea still may have served a useful purpose: It could focus many people on the broader issue of where retirement savings belong.

The accepted wisdom is that retirement money should be invested in the stock market, because that’s where you can expect to earn the highest returns in the long term.

But some financial experts say that’s a dangerous assumption rooted in investors’ recent historical experience -- an experience that may tell us nothing about the future, they say.

Egged on by the Social Security privatization debate, academics like Zvi Bodie, a Boston University economics professor, assert that many investors shouldn’t be putting a dime of retirement money in the stock market. That goes for Social Security funds and personal savings alike, he said.

“People are being sold a fallacy -- that in the long run, stocks are safe,” Bodie said.

Experienced investors know the standard pitch: The longer your time horizon, the greater the likelihood that stock returns will beat what bonds, bank savings and money market accounts can provide.

President Bush, who is championing the idea of diverting a share of Social Security payroll taxes into private accounts, said at a recent forum on the subject that Americans should be able to harness “the power of the capital markets” to boost their retirement income. That certainly sounded like an endorsement of the stock market’s long-term promise.

The problem is that blanket statements about the equity market’s historical allure say nothing about the serious risks investors bear if they’re in stocks, Bodie and other critics say.

Those risks became vastly more apparent in the bear market of 2000 through 2002, when the blue-chip Standard & Poor’s 500 index lost nearly 50% of its value. That was a devastating turn for someone who had the majority of his savings in the S&P; 500 and who had hoped to retire at the end of 2002.

No wonder AARP, the nation’s main lobbying group for seniors, has been running ads railing against Social Security privatization, contending that it would turn the system into a venue for gambling.

“If we feel like gambling, we’ll play the slots,” say the middle-aged couple pictured in an AARP ad.

That’s the heart of the debate over Bush’s proposals to overhaul Social Security: Is the program meant to provide a safety net for all retirees -- or should it be structured like any investment account in which people assume the goal is to maximize returns?

For many people, that goal is wrongheaded for their personal investing, and it’s definitely wrongheaded for their Social Security funds, Bodie contends. Maximizing returns often means maximizing risk. If more investors would properly link the two, they would drastically revamp their stock-focused portfolios, Bodie says.

The Commission to Strengthen Social Security, the bipartisan group Bush named in 2001 to propose options for overhauling the system, backed the idea of channeling a portion of Social Security payroll taxes into private accounts that could invest in stocks and bonds.

“Personal accounts would permit individuals to seek a higher rate of return on their Social Security contributions, offering higher total expected benefits to individuals with accounts than those lacking them,” the commission said in its final report. (You can read the entire document at www.csss.gov.)

Today, Social Security taxes are effectively invested in non-marketable Treasury securities -- basically, IOUs from the government.

The commission assumed that, over time, investors could expect to earn a real (after inflation) return of 3% a year on Treasury securities. By contrast, its real-return assumptions were 3.5% a year for long-term corporate bonds and 6.5% for stocks.

On the face of it, those assumptions appear low. The real rate of return on blue-chip stocks over the last 80 years has averaged about 7.4% a year, according to Ibbotson Associates in Chicago. That’s what is left after calculating the gross average annual total return on the S&P; 500, which is 10.4% since 1926, and subtracting inflation, which averaged 3% a year in the period.

The commission’s assumption for stock market returns also may appear conservative because it is well below what equities produced in the 1980s and 1990s, when the gross total return on the S&P; 500 averaged 17.9% a year.

That period is the natural reference point for many Americans because those were the decades in which most became investors. Those 20 years also happened to be the best ever for the stock market, at least measuring back to 1926.

If it happened before, couldn’t it happen again?

It could, of course.

But what if, in the next 20 years, the stock market is capable of generating gross returns averaging just 3.1% a year -- duplicating the experience of the 20-year period of 1929-48?

If inflation averaged 2% a year in the next two decades, and stocks rose 3.1% a year, investors would earn a real return of just 1.1%.

Of course, under that scenario, it’s also possible that people would earn worse real returns in bonds.

Supporters of Social Security private accounts say that if you toss out the doomsday market scenarios, there are ways to structure a portfolio to potentially earn mid- or upper-single-digit returns without undue risk.

Robert Pozen, chairman of mutual fund giant MFS Investment Management in Boston and a member of the Bush commission, suggests an account invested 60% in stocks and 40% in bonds. What’s more, five years before an investor expected to retire, the account would begin scaling back on stocks, shifting more to capital preservation, he said.

(Elsewhere in today’s Business section, Kathy M. Kristof explains another retirement investing idea: so-called life-cycle funds.)

Pozen also points out that the commission recommended funding private accounts with only a portion of Social Security taxes and that investors still could count on some basic retirement benefit from the system regardless of how their private accounts fared.

To opponents of Social Security privatization, the idea of subjecting Americans to any market risk with their Social Security funds is abhorrent.

People already face the vagaries of the marketplace in their personal investments, including those in 401(k) retirement savings plans, as well as in the value of their homes, said Roger Hickey, co-director of the Washington-based Campaign for America’s Future, a group that is battling the Bush administration on privatization.

Social Security “is the one part of the retirement system that gives people real security,” he said.

If it’s true that Social Security isn’t sustainable as currently structured, there are other ways to fix it, privatization critics say. Many of those ideas already have been aired, and the public is sure to hear a lot more in the next few months as the debate ramps up.

Bodie has another idea: He would allow for private accounts, but at least initially the money funneled into the accounts would exclusively be used to buy inflation-adjusted Treasury securities, which would guarantee a certain yield as well as protection against inflation.

That, he says, is what most investors should be doing with their retirement savings: making that nest egg more secure, not less so by taking a chance in stocks.

Investors look back at the 1980s and 1990s and remember that the equity market got better and better, Bodie said. But history shows that “just as things can get better and better for stocks, they also can get worse and worse,” he said.

Robert Arnott, who heads money management firm Research Affiliates in Pasadena, also likes the idea of using private Social Security account funds to invest in inflation- adjusted Treasury bonds.

Many investors already have plenty of money in the stock market, Arnott said, but “most people are woefully underprotected against inflation.”

Will privatization fly? There’s a long runway ahead.

But if nothing else, the Social Security debate may force investors to address three key questions about their financial futures: Are you saving enough? Are you saving it in the right places? And are you comfortable with the level of risk you’re taking in search of decent returns?

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Best and worst 20-year returns

Stocks and bonds are capable of generating spectacular returns over 20-year periods -- they’re also capable of generating very poor returns over that length of time.

Annualized returns by type of asset

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Blue-chip stocks

Best 20 years (1980-1999): +17.9%

Worst 20 years (1929-1948): +3.1%

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Small-company stocks

Best 20 years (1942-1961): +21.1%

Worst 20 years (1929-1948): +5.7%

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Long-term corporate bonds

Best 20 years (1982-2001): +12.1%

Worst 20 years (1950-1969): +1.3%

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Long-term Treasury bonds

Best 20 years (1982-2001): +12.1%

Worst 20 years (1950-1969): +0.7%

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Source: Ibbotson Associates

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Tom Petruno can be reached at tom.petruno@latimes.com.