The Two Biggest Myths About Privatizing Social Security

Authored by: Matt Palumbo

The Social Security (SS) system turned 83 years old on Tuesday, but given the programs fiscal issues, it has few birthdays left to celebrate. When SS was created, it acted as old age survivors insurance, as the average American died before turning 65 (when they’d be eligible for benefits). It wasn’t until LBJ’s war on poverty that SS became the retirement plan we know it as today.

While there were five workers supporting each retiree in the 1950s, there are now fewer than three. Proving that nothing changes in government, the retirement age has remained unchanged as average lifespans now push 80, hence this declining ratio of workers to retirees. In June, government trustees warned that SS will be insolvent by 2034, and only able to pay out 3/4 of what recipients are owed based on how much taxes they paid into the system.

The most common solutions to SS’ fiscal troubles usually center around raising the retirement age, or having the payroll tax apply to all levels of income. While that would close the gap if done correctly, it doesn’t change the fact that SS’ returns are godawful from an investment perspective, or that politicians can raid SS’ trust fund whenever they please (as Bill Clinton did).

Myth #1: It’s a Radical New Idea

Chile privatized their government pension system in 1981, with great success. Workers are required to put 10% of their incomes towards retirement, but unlike our SS system, they’re allowed to invest their money as they like, into a handful of approved stock and bond funds.

The average Chilean worker who retires after 40 years can expect to receive 87% of their prior salary in retirement under the Chilean system. The average U.S. worker receives SS benefits that equal 38% of their prior income (52% for lower-income earners). 

Unlike our ponzi-like system where current recipients are paid by future recipients, the majority of retirement funds paid out under Chile’s system are the result of income earned on investments. One study of returns over a 32 year period in Chile found a 8.7% compound annual return net of inflation, and that 73% of the pension funds workers retire on comes from profit made on investments, with only 27% coming from the principal.

Another benefit of the kind of private accounts Chile has is that when a recipient dies, there’s money left over to pass to their family. That’s impossible in the “pay as you go” system we have.

Australia also has privatized their retirement system, requiring workers to pay 9.5% of their wages into the system (up to 12% in 2020). Savings in Australia equal 130% of GDP, and unlike our SS system, theirs runs large surpluses.

Myth #2: Market Crashes Make it Too Risky

What about market crashes, like in 2008-09 when the stock market lost half its value? For that objection, we need some perspective. Imagine for a second that you were the unluckiest investor in the world, investing your entire life savings at the stock market’s peak in 1929 before the great depression. At the end of a 45 year period in 1974, you would have increased your portfolio in value eightfold, for an annual compounded return of 4.9% after inflation. And that’s an understatement. In reality someone would be contributing to retirement every year, and thus dollar cost averaging their investment during down years.

What if you had to retire after a crash? Someone who invested in 1887 and retired 45 years later in 1932, when the market hit its absolute bottom during the great depression would have a 4.3% average return after inflation. (Source: Pages 29-30) And like the prior example, this is an understatement, as in reality no sane person would be invested in 100% stocks near the end of their career. 

Historically, Social Security’s returns have amounted to 2-2.5%, roughly in line with inflation. In other words, the real return on investment for Social Security contributions is close to zero. This also means that even the worst market timing in history is preferable to SS. 

Source: Social Security Administration

By contrast to SS returns, even corporate bonds tend to yield a similar return after accounting for inflation, while stocks have historically yielded near 6% after inflation.

Australia’s pension system is routinely ranked as the best in the world, and given the facts laid out here, it’s no surprise why.

 

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