The $150 Billion Question

The reelection of George Bush and the strengthening of the Republican congressional majority make the privatization of part of the Social Security system a near-certainty.

Unfortunately, the above sentence contains two of the hottest political buttons in American politics. The word "privatization" evokes emotional responses that cleave this nation’s left from its right about as cleanly as any political metric. And Social Security, as we all know, is the original "third rail" of American politics.

I flatter myself that I’m a politically unbiased observer of this issue, since both my Democratic and Republican friends tell me that my views on it are woefully uninformed. So I begin by listing three facts on which all sides can agree:

1. Originally, the system was sold to the public as privatized, but quickly wound up as a social welfare program. Even today, the Social Security Administration mails out individual "account statements," as if each of us had our own separate little brokerage account with them. And yes, to a certain extent, benefits are roughly proportional to "contributions," but there is a strong redistributive element. And the "trust fund," let alone the concept that benefits are paid out of savings, are expensive myths. Social Security is strictly a pass-through system; remove it from the public domain and it becomes easily recognizable as a Ponzi scheme that would take the breath away from even Messrs. Fastow and Ebbers.

2. It follows from #1 above that every dollar of payroll tax diverted into private accounts is necessarily subtracted from the funds normally passed through to current beneficiaries. This money must come from somewhere, and thus far there has been silence on this question from those favoring privatization. The amounts involved stagger the imagination—the total annual inflow into the system is about $750 billion, so if one-fifth of this is diverted into privatized accounts, we are talking about an immediate shortfall of $150 billion per year. This cannot be done without raising revenue from elsewhere; the most reasonable proposals involve the establishment of a national sales tax.

3. The issue of just who manages these accounts has not been addressed by its proponents.

Personally, I’d love to see 2% of my payroll taxes funneled into a private account. That’s because I’m a money manager; I enjoy running money, and I know how to avoid the sand traps. And the mere fact that you’re reading these pages indicates that you’re probably in the same boat. But just who manages the accounts of the folks who flip your burgers, provide your tech support, and teach your kids? More importantly, exactly who is their custodian?

The default answers to these questions are, respectively, those inexperienced folks do (the beneficiaries) and the nation’s largest financial institutions. If so, this would result in the greatest transfer of wealth the world has seen since the Spanish silver armadas. To understand why, imagine that each year you could skim off a few percent of your neighbor’s financial assets. If you were a competent investor, within a very few decades you would become wealthier than him or her. In the very first issue of Efficient Frontier, I laid out the logic of this transfer in a piece entitled "Bequeathing Your Assets to Your Broker." If we are not careful, such a scenario will play out over the entire national financial canvas.

Viewed from the other side of the ledger, toss the following four items into the mix: 3% real returns for stocks, 1% for short-term bonds, a 60/40 portfolio, and 2% to 4% overt and covert expenses from your friendly neighborhood brokerage house or fund company. The result is an after-expenses real return that compares unfavorably to the canned goods in your cellar. Even those of us in the low-expense/multifactor crowd shouldn’t be too snide—if we can get an overall 1% portfolio boost from small and value and cover our expenses with skilled rebalancing, the only path to a small fortune is to start out with one. (Remember that while we’re peddling as fast as we can, real productivity and wages will be increasing by about 2% per year; thus, the best-case scenario is keeping up with the working Joneses, and just barely at that.)

Of course, the country’s wealth would not wind up entirely in the hands of the nation’s brokerages and fund companies. As publicly traded entities, some would be distributed to shareholders in the form of dividends and capital gains, but even more would be wasted on obscene management perks and corporate acquisitions that would make the Time Warner-AOL deal look like a tip at the Olive Garden.

The ensuing damage would be twofold. On the economic playing field, large amounts of the nation’s capital would be suboptimally employed. The social damage would be far greater, as tens of millions of workers faced retirement with systematically looted private accounts. Even if you and I wound up with bulging private coffers from years of low expenses and multifactor exposure, in the end we’d lose most of it bailing out the system’s millions of victims. (Never forget that there will be many more losers than winners, and everyone gets one vote.) Far better to get it right the first time, even if means depriving the greyhounds of wealth and glory.

A grand bargain is called for, which might look something like this: The Left embraces the inevitability of private accounts, in return for which the Right gores the financial-services ox with a uniform and strictly regulated indexed portfolio structure. After retirement, beneficiary assets would then be liquidated for living expenses as well as exchanged in staggered fashion for inflation-indexed fixed annuities, again, under strict government control.

Privatization can work, and one does not need to be a libertarian to realize the empowering nature of individual accounts. But in order to avoid great slaughter, the sheep will have to be separated from the wolves.

Copyright © 2005, William J. Bernstein. All rights reserved.

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