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Wednesday, May 10, 2006

A Hidden Danger in Privatizing Social Security

Originally Posted: January 16, 2005 -- 8:44 PM
Fool Boards Link: http://boards.fool.com/Message.asp?mid=21919387

This piece speculates how privatizing Social Security contributions could produce unintended, poorly understood changes in investment behaviors that could produce another bubble and destroy billions in retirement dollars.


====================

A few thoughts to consider as the administration beats the drum on the inevitable collapse of Social Security.

We've already conducted a bit of a nationwide financial experiment on privitizing retirement plans. The 401k phenomenon.

401k retirement plans became very popular in the late 80s and early 90s with Fortune 500 companies, partly because they could afford to offer matching as a benefit and partly because many placed the funds for matches in company stock with 3-5 year vesting. 401k programs became TREMENDOUSLY popular with these companies in the 94-96 timeframe, when many companies (IBM, SBC, to name a few) started moving away from traditional fixed payment retirement plans and adopting "cash balance" plans.

At the time, the "cash balance" approach was sold as a way where younger workers could gain more from their years of service as they move from company to company every 3-5 years instead of working for one company for 20-30. With traditional retirement plans, most of the increase in value of the pension benefit occurs in the last 5-7 years of a VERY long stay at the company. Employees who leave with less then 10 years walk away with virtually no benefit so cash balance plans provided better value for "job hopper" employees.

What happened during this period?

BILLIONS of dollars began flowing into mutual funds managed by companies hired to run 401k plans for these companies. Since the mutual funds wanted to provide a better return than a savings account or CD, they felt obligated to invest them in SOMETHING to see if they could get a better return.

The cash kept coming. Since the contributions were based upon fixed percentage contributions of biweekly paychecks, the money kept flowing in regardless of prevailing market conditions. With the continued pressure of inflowing cash, the mutual funds kept trying to keep the money invested.

When you have this much cash sloshing in EVERY day and you keep investing it in the market, it becomes a self-fullfilling version of the rising tide floating all boats. I'm convinced this has a great deal to do with the insane market run-up from 1997 until April 2000.

The problem with this is that a simple, but far reaching regulatory / tax policy change began affecting the investment market by fundamentally altering traditional flows of investment capital. Even long term Wall Street "experts" began viewing the situation as a new world, one where we somehow solved the problem of the business cycle, market fluctuations, etc. Remember how things sounded back then?

This is the problem with making a radical change in Social Security.

Change too many variables at one time and NO ONE will understand the resulting impacts. Some segment of the economy will suddenly become awash in cash that seems to flow in regardless of the economic sense of the business or segment. More cash will flow in, then everyone will throw more of their personal cash in following the "sure thing." Then someone will figure out that selling dogfood on a website doesn't justify a $5 billion valuation or that being a middleman on energy futures provides zero value to the economy and things will collapse.

The problem with Social Security is that it provides critical benefits to EVERY taxpayer in the country. If we distort too much of the investment process in too short a time, the "herd" mentality will take over and take HUNDREDS OF BILLIONS in retirement assets with it. What will we have to show for it? Things like we got from the dot-com bubble. Enough fiber optic capacity for each child in America to download the entire Britney Spears music catalog 10,000 times in a day. New business to business applications that allow companies to share information with systems that cost $6 million to deploy instead of $500,000. (I'm being sarcastic but talk to anyone who worked for these companies during the boom... Much of it was a waste, though great fun.)

Probably the most pointless argument of the current administration? That young workers might only see a 3 percent return on their contributions. The administration is ABSOLUTELY correct that you cannot plan on dropping your retirement dollars in 3 percent returns and retire on it. Hoever, THAT'S NOT THE INTENT OF SOCIAL SECURITY. Social Security is intended to be the bottom tier of your retirement puzzle. If some other pieces of your retirement puzzle don't fall into place, you at least have that SS chunk with it's measly 3 percent "return". (I quote "return" because payouts are not really return on your contributions but funds from current payroll taxes.)

How many employees of Enron, WorldCom and other companies would love to have a measly 3 percent return on THEIR 401k contributions?

As an individual, I have zero confidence that significant Social Security benefits will be paid to me when I retire. However, I'm planning for that and have no problem with that -- I consider myself fortunate that I'm able to save what I think I'll need for a comfortable retirement. In the mean time, if you cut Social Security taxes now to give us a chance to save for ourselves, current yearly budget deficits will SKYROCKET above the already DISASTEROUS $400 billion levels, we'll still owe benefits to current retirees because no one will have the political courage to cut benefits or implement basic means testing to keep Donald Trump and Bill Gates from collecting, and the change in cash flows will likely produce another bubble that will wind up destroying BILLIONS of dollars in retirement savings. Like deja vu all over again.


WatchingTheHerd

"Things really ARE different this time. Just not for the reasons you think." -- WatchingTheHerd