How to Screw Up Social Security

Fortune issue: March 15, 1999


How to Screw Up Social Security

First Principles

By N. Gregory Mankiw

Having trouble saving for your retirement? Try this simple solution: Borrow some money at 7%, buy stocks that return 10%, and pocket the 3% difference. Still running short? Don't worry--just do it again.

This is, of course, ridiculous advice. Buying equities with borrowed money is a risky strategy, and no one should do it without understanding those risks. But this is in effect what President Clinton proposes we do as a nation. He wants to "save Social Security" in part by selling some government bonds and using the proceeds to invest in stocks.

It is easy to see why he'd be tempted: Over the President's lifetime, stocks have outperformed bonds by a large margin, on average--about 6% per year. And over the past decade, the gap has been even larger. Owning bonds seems like a sucker's bet. Why not return the Social Security system to solvency by taking advantage of the huge equity premium? (Hell, while we're at it, why not fund the Pentagon, welfare, and Amtrak by buying stock on margin?)

Alan Greenspan has objected to this idea, fearing that if the government owned a large share of corporate America, capital would be allocated on political rather than economic grounds. There's another problem, however, a problem pointed out in the fine print in most mutual fund ads: "Past performance cannot guarantee future results." Sadly, the SEC does not require a similar disclaimer on State of the Union addresses.

So let's consider the downside. Suppose the federal government put some of the Social Security trust fund in equities. Now suppose that the next decade turns out less like the early 1990s and more like the early 1930s, when the Dow Jones industrial average fell from 381 to 41--or like Japan today, where the stock market is still at less than half the level it reached a decade ago. What would happen?

Clearly, Social Security would be in big trouble. Not only would baby-boomers be starting to retire, automatically boosting government spending on retirement programs, but the market collapse would likely coincide with a recession, reducing tax revenue. With the trust fund drained by low stock prices, Social Security benefits would almost certainly be cut. A lot.

One might argue that this downside isn't so bad. After all, the President proposes to invest only 15% of the trust fund in stocks--much less than the typical private pension plan. But this overlooks the fact that because the government taxes capital gains and 401(k) distributions, it already has a large implicit position in equities. Indeed, that position is one reason for the current budget surplus; if the stock market tanks, the budget will swing back toward deficit, even without a direct government holding of equities.

Although the downside risk is far from negligible, it could still be a risk worth taking. Buying stocks rather than bonds does work out, on average, and we would be irrational to avoid risk at all costs. But there are several reasons to think it's a bad bet.

First, it seems an unlikely coincidence that the President's proposal comes on the heels of several years of truly exceptional stock returns. If we take a look at history, however, the stock market isn't nearly as impressive: In the 19th century, the average premium for investing in stocks over bonds was less than 3%.

Second, the stock market's historical performance reflects a large amount of good luck. We live in the world's richest country, at the end of the most prosperous century ever; it should come as no surprise that the market has done so well. The future may give us a similarly lucky draw, but let's not count on it.

Third, some economists see the large historical equity premium as an anomaly that's already been corrected. Most measures of stock market valuation are now at historical extremes. Perhaps this is because investors, realizing stocks were undervalued in the past, have corrected the problem. If so, stocks are unlikely to keep outperforming bonds by the same margin.

None of this means equities should be excluded from the debate over Social Security reform. But the risks of holding equities should be brought into the open and stressed. One advantage of privatization proposals, advocated by many members of Congress, is that they are clear about where the risk would fall.

The President's plan, by contrast, emphasizes the upside of equity ownership without mentioning the downside--just the way they'd do it in Vegas.


N. GREGORY MANKIW is an economics professor at Harvard and the author of Principles of Economics.