What Should You Do If Social Security Offers Private Accounts?

This article offers a glimpse at how Social Security “private accounts” might work and what you should do if private accounts become part of the Social Security system. We’ll leave the vexing questions regarding whether private accounts are good social policy to the political arena and focus on how private accounts might affect our clients if they come into effect.

Participation is optional
Most experts think the Bush Administration wants to model private accounts after the plan described in the President’s 2002 Commission to Strengthen Social Security. According to this plan, workers who are under 55 would have an option to redirect a portion of their Social Security taxes to private accounts dedicated to their retirement, and to direct how this money is invested. Initially, the limit would be 4% of a worker’s salary, up to $1,000. This represents about one third or less of the total 12.4% Social Security tax paid by workers and their employers. The small limit might be expanded in the future.

Broad inexpensive index funds
Workers would have limited control over how to invest money in their private accounts. They would probably have a short list of broadly diversified index funds, offered by the Social Security Administration but run by private money management firms. The thinking regarding these options is that such funds would limit the possibility of investors making bad mistakes and ruining their retirements. Plus, large index funds are inexpensive to manage. The goal is to keep expenses at a low 0.30%, which would be quite reasonable. However, this will limit investment performance to a mundane level.

Break-even rate
Workers who contribute to private accounts will receive a proportional reduction in their benefits from the traditional Social Security system. Therefore, in order for workers to benefit from private accounts, they will have to earn a greater rate of return on their contributions. This “break-even” rate will be the annual inflation rate (historically, 3.1%) plus 3% per year. If workers earn more than the break-even rate, they will have a greater retirement income than under the traditional system. If they earn less, they will have a smaller retirement income.

Obviously, workers who choose to participate in private accounts need to find investments that are expected to earn more than the break-even rate, and that means stocks. The numbers below show that safe investments, like bonds and treasury bills, are not likely to make the grade.

Annual % Rate
(1926 through 2000)
Inflation3.1%
Treasury Bills3.8%
Long-Term Government Bonds5.3%
Long-Term Corporate Bonds5.7%
Large Cap Stocks11%
Small Cap Stocks12.4%

We think this means that younger workers (up to age 50) should participate in private accounts. They have the time to withstand the ups and downs of the stock market and thus can tolerate the risk. We note that the average annual return for investors who bought and held stocks for ten-year periods exceeded the average inflation rate over those ten-year periods by at least 3%, in 77% of the cases. Given that only one third or less of a worker’s Social Security benefit would be in a private account, the risk of loss is low and the potential for gain is high.

Older workers should be careful. The time until they retire is shorter, so their risk is greater. We think that workers who will depend on Social Security for a major portion of their retirement income, and those who are uncomfortable with the stock market, should not participate in private accounts. The certainty of the existing Social Security system and its protection against inflation are too valuable for these people to give up.

Older workers with greater retirement resources should consider private accounts. However, we are concerned about protecting them against big drops in the stock market just before their retirement. The proposed plan may force many people to annuitize (lock in) the value of their private accounts at retirement, thus preventing them from waiting for an eventual stock-market recovery. We will be watching this issue closely.