In Part 1 of Why Are Social Security Investment Returns So Low?, we looked at how insurance companies work and why they are inherently conservative. Let’s continue by examining Social Security and its investment returns.
Now about those Social Security Investment Returns
Since Social Security (SS) is an insurance program, it follows the principles of insurance companies. The SS program:
- Uses the law of large numbers. Check.
- Matches statistically predictable liabilities (i.e., old age pension payments) against more predictable cash flows. Check.
- Invests heavily in bonds. Check.
By law, the SS must hold investments that guarantee both principal and interest. So, like a private insurance company, the SS Trust Funds holds a mix of bonds. In the case of SS, the program holds short-term and long-term Federal government bonds. And, because they are U.S. Treasury bonds, the risks are very low and therefore produce a lower expected return than both stocks and other types of bonds.
Guarantees and Lower Returns vs No Guarantees and the Potential for Higher Returns
The basic idea behind investing SS or a portion of it in the stock market is to take advantage of the higher returns that stocks have had historically compared to other financial assets (e.g., bonds, cash, gold).
Supporters assert that this will help to ensure the long-term viability of SS and reduce the severity of raising payroll taxes and/or cutting benefits. Opponents contend that doing so will make SS vulnerable to the whims of the market and subject it to broad declines, such as the DotCom bubble of 2000 and Credit Crisis of 2008.
Both appear to make valid points.
Still, in decades past, retirement security was built upon three pillars: 1) SS, 2) private pensions, and 3) personal savings and investments. Each pillar had or has its own degree of risks and returns:
- SS provides a guaranteed base level of income. It was intended to keep retirees out of poverty and provide about 30% to 40% of retirement income. Today, SS is 50% or more of the total retirement income for 65% of recipients age 65 years or older.*
- Pensions offer a second source of mostly guaranteed income. However, since the 1980s, corporations have increasingly shifted from pensions to 401(k)-type plans. Today, about 90% of private sector employees no longer get pensions. Mounds of research reveal that workers have not contributed enough, or invested their 401(k)s effectively. This second leg is more unsecure than previous generations.
- Personal savings and investments have never provided guaranteed income and have always been filled with uncertainty and subject to the ups and downs of the stock market.
What this means is that an increasing number of retirees will be reliant on just the single leg of Social Security.
Remember that the problem with stocks is that their future payout is unpredictable and uncertain. So, if a significant amount of SS was subjected to the stock market, budgeting and managing cash flow for an increasing number of retirees would be even more tenuous than it already is.
* Social Security Administration, Income of the Population 55 or Older, 2012, Table 9A.1, April 2014.