Better than Social Security – Even if the Market Crashes

The philosophical battle over allowing you to invest your Social Security taxes in a market IRA is far from won. But progress is being made.

You can tell because opponents of allowing you the liberty to choose your retirement vehicle have subtly shifted their argument from "you shouldn't be allowed" to "it will never work."

Your retirement savings, they say, are too important to be entrusted to the market, for it is a risky and unreliable place.

So is the market too risky? If the market collapsed the day you retired, would you be out of luck if you had invested in it instead of paying Social Security taxes to the government?

And if all the baby boomers contributed to private retirement accounts instead of paying the Social Security tax, wouldn't that additional money drive stock prices unnaturally high? Then, when they retired and suddenly pulled the money out, wouldn't that cause the markets to collapse?

These are questions that deserve answers as Americans consider whether some or all of the Social Security tax should be invested in private securities markets. Now we have reliable answers, thanks to research done by William Shipman, a principal of State Street Global Advisors. Shipman's conclusion: it would be almost impossible not to do better by investing in securities instead of paying the same amount in Social Security taxes.

The nation's total securities market comprises 90% large companies and 10% small companies. Shipman took a hypothetical portfolio with that 90-10 mix, assumed management costs of 1%, and assumed that the Old Age and Survivors Insurance portion (12.4 of the 15.3% of payroll we pay) of an individual's payroll tax was invested in stocks through the individual's working career. He examined the investment of average-income employees (earning the median income), low-income (half the median) and high-income people (earning the maximum taxable amount).

Shipman calculated what would happen to the retirement income of a person born between 1930 and 1976 if the nation's securities markets collapsed the very day he retired. Shipman found that a low-income worker's retirement income would still be higher than Social Security benefits unless the total wealth of the market fell more than 59% that day, that the average-income worker would do better unless it fell more than 68%, and that the high-income worker would do better unless it fell more than 76%.

To put those percentages into perspective, on the worst single day ever on the New York Stock Exchange, October 19, 1987, its value fell 20%, and on the second worst day, October 28, 1929, its value fell 12%.

Bear in mind that a worker is likely to choose a more balanced portfolio than the one posited above. With such a balanced portfolio, say, 60% in stocks and 40% in bonds, if the stock market (but not the bond market) crashed, the values would have to fall 70%, 91% and 111% (below zero) before the income for the low-, average-, and high-income workers, respectively, would fall to the level of Social Security benefits.

But what about those baby boomers? If they invest those huge amounts in the market instead of paying payroll taxes, won't that cause securities prices to shoot up – and then won't prices collapse when they draw out the money?

Obviously, payroll taxes amount to a lot of money, but Shipman points out that the amount isn't all that much in the context of the total market in securities. The tax for Old Age and Survivors Insurance will collect about $341 billion this year. If all of it were invested exclusively in equities on the New York Stock Exchange, the trading volume would account for only 24 minutes of the exchange's six and one-half hour day.

If the investment followed the more logical course of diversification into U.S. equities, foreign equities, fixed income instruments and cash, the figure would be closer to 12 minutes of trading per day. Not much in the overall market context.

Shipman has performed a real service to those who realize that our present Social Security system must be reformed soon, but who don't want a cure that turns out to be worse than the problem. His findings give strong reinforcement to the idea of establishing individual retirement accounts and phasing out our pay-as-you-go system, and doing it soon.