Recs

0

Opportunity Knocks

Is it me, or have we heard more about Social Security in the past month or so than we have in the previous four years? With the election behind us, President Bush is moving forward with his "Ownership Society," and Social Security reform is a central feature of this vision. A key component of any reform proposal will be private accounts, which will allow individuals the option to divert a portion of their payroll taxes into a professionally managed investment fund.

So how is this going to affect your retirement? It depends on whom you talk to. Proponents of private accounts are quite bullish. They feel the plan will not only save Social Security, but also allow individuals to benefit from the superior returns provided by equities. Opponents of the reform argue that private accounts will increase the funding difficulties of traditional benefits and expose retirees to the volatility of equities markets. They have a point, in the sense that only a year of bad returns could wreak unrecoverable havoc on a retiree's portfolio. And this risk is far from confined to investors daring to gamble on fly-by-night penny stocks. Recall that just a few years ago -- in 2001 -- some of the most well-known, widely held stocks of the day stumbled mightily:

  • Sun Microsystems (Nasdaq: SUNW  ) : down 50.21% in 2001
  • JDS Uniphase (Nasdaq: JDSU  ) : down 78.45%
  • Oracle (Nasdaq: ORCL  ) : down 46.68%

Admittedly, a retiree wouldn't likely hold large concentrations of these stocks under any system. Even a moderate holding in these positions, though, could have caused a retiree enough losses to clip more than a few extra coupons.

The crisis
But investing offers no free lunch, and there has been a lot of talk lately about the serious crisis facing Social Security. Just recently, the Trustees of the system declared: "We do not believe the currently projected long run growth rates of Social Security and Medicare are sustainable under current financing arrangements."

Surprisingly, Americans actually pay more in payroll taxes than they receive in benefits at the moment, with the surplus going into a trust fund. This trust fund is currently invested in short-term government securities and will continue to grow in the short term, but will eventually be exhausted by 2042, according to the Trustees (the Congressional Budget Office estimate is 2052). After this date, the Trustees forecast that tax revenues will only be able to fund 73% of scheduled benefits. The Cato Institute predicts that payroll taxes will have to increase from the current 12.4% to as much as 18.9% by 2077 in order to fund existing benefits.

How did we get ourselves into this jam? There are several reasons for this apparent difficulty (I use the word apparent, as quite a few commentators believe the crisis has been overstated). The baby boomers are about to retire and the proportion of the population over 65 is rising. More importantly, the replacement rate, which is the percentage of pre-retirement salary that you receive in retirement, is increasing, thus placing greater burdens on the system. Basically, Social Security is paying out larger benefits in relation to previous salaries than ever before. You don't have to be a genius to figure out that we need to raise taxes, slow the increase in benefits, or increase returns on the trust fund in order to keep Social Security viable. How many politicians do you know who are willing to propose the first two options?

The proposal
Social Security is in trouble, and the president will be proposing private accounts as a solution. What will this reform look like? I think we have a good idea. Back in 2001, the Presidential Commission to Strengthen Social Security issued a report with several highly detailed recommendations. Many observers believe that the Commission's proposal entitled "Reform Model 2" is likely to be the template for the president's plan.

Reform Model 2 would allow workers not yet 55 to redirect 4% of their income, up to $1,000, into a personal account (the figure of $1,000 would be indexed to wage growth). In exchange for their private account, workers' traditional Social Security benefits would be offset "by the amount of personal account contributions compounded at a real interest rate of 2 percent." How does this work in practice? If you contribute a dollar to a private account, your future Social Security benefit will be reduced by a dollar plus 2%. In other words, as long as the private account yields a return higher than 2%, you'll be better off.

The Commission estimates that under this plan, the benefit of a low-wage worker in 2052 would be 75% higher. It would be necessary, however, to link traditional benefits to price inflation rather than wage inflation. Wage inflation has been higher than price inflation in prior years, and the Social Security Administration predicts it will exceed price inflation by one percentage point yearly over the next 75 years, meaning indexing to wage inflation will yield higher benefits. Also, in order to manage the transition costs, Treasury funds would be needed from 2025-2054. Overall, the Commission believes its plan would eliminate deficits and make the program sustainable for the next 75 years.

Post-reform retirement
Let's just assume that Reform Model 2 becomes law in 2005 -- a big assumption. How will this affect your retirement? Well, if you are 55 or older, the answer is not much at all. If traditional benefits become indexed to price inflation rather than wage inflation, this will be a reduction in benefits, but it will not be significant in the short term.

How about those under-55s who choose the option of a private account? Would they be wise to jump whole-hog into high growth stocks like Taser (Nasdaq: TASR  ) and Overstock.com (Nasdaq: OSTK  ) ? No. It's likely that individuals with private accounts will only be allowed to invest in a list of approved mutual funds. It's also likely that low-cost index funds will be prominent among the featured funds.

What about those under-55s who just want to keep their traditional Social Security benefits? According to Reform Model 2, you would be allowed to opt for traditional benefits. But here's where things get tricky. There's no doubt that traditional benefits would be reduced somewhat. We know, for example, that the provision for changing how the benefits are indexed would reduce them in the long term. How much is hard to say. It is also not clear whether or not the government would want to phase out the traditional benefits option somewhere down the line.

A good thing or a bad thing?
From a pure investing perspective, private accounts appear to be attractive. We know that equities have returned an annual rate of 10.5% over the last 75 years or so. That rate of return has the potential to greatly increase benefits for long-term savers. But what happens to those retirees who build up a sizeable fund and then blow it?

A recent article by The Wall Street Journal discussed how many individuals have mismanaged their 401(k) plans, and one wonders if we would need to guarantee a minimum benefit for those retirees. This creates what economists call moral hazard, a situation in which an individual has an incentive to make risky investments, knowing a guarantee is in place. One solution might be to require individuals to purchase an annuity from providers like TheHartford (NYSE: HIG  ) or AIG (NYSE: AIG  ) , but these products are viewed as somewhat expensive and unsuitable for retirees with a below-average life expectancy.

The third pillar
We'll have to wait for the next Congress to see how the private account reform will play out. One thing's for certain, however: Individuals are going to have to take more responsibility for their retirement. For better or worse, the New Deal-style pay-as-you-go Social Security system is likely to be revised in a way that will require individuals to take on more risk. This has already happened in the workplace, where Americans have largely given up defined benefit plans in return for 401(k)s, which also demand that individuals take on more risk, albeit with the hope of obtaining greater returns.

With all this uncertainty, individuals would be wise to bolster what is often referred to as the third pillar of retirement (Social Security is the first pillar; the company pension is the second pillar). The third pillar involves IRAs and other individual accounts, which are designed to give more flexibility when investing for retirement.

Whether we like it or not, it looks like we can't count on the government or our employers to provide us with guaranteed, inflation-proof cash flows during the course of our retirements. It's time for all of us to redouble our efforts at retirement planning. As Yogi Berra once said, "you've got to be careful if you don't know where you're going, because you might not get there."

For additional articles on this topic, click:

Be sure to also check out our discussion board on Social Security Reform.

Looking to take greater control of your retirement, Reform Model 2 or not? Try ourRule Your Retirementnewsletter. You can check it out to your heart's content free for 30 days.

John Reevesdoes not own any of the companies mentioned in this article. The Motley Foolhas a disclosure policy.


Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

DocumentId: 494559, ~/Articles/ArticleHandler.aspx, 7/25/2014 8:00:52 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

John Reeves
TMFBane

John is a senior editor focusing on investigations and financial reform. He's been with the Fool for almost ten years.

Today's Market

updated Moments ago Sponsored by:
DOW 16,960.57 -123.23 -0.72%
S&P 500 1,978.34 -9.64 -0.48%
NASD 4,449.56 -22.54 -0.50%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

7/25/2014 4:00 PM
AIG $54.16 Down -1.01 -1.83%
American Internati… CAPS Rating: ****
HIG $35.25 Down -0.62 -1.73%
Hartford Financial… CAPS Rating: ****
JDSU $11.85 Down -0.04 -0.34%
JDS Uniphase Corp CAPS Rating: ****
ORCL $40.33 Down -0.14 -0.35%
Oracle CAPS Rating: ****
OSTK $16.59 Up +0.40 +2.47%
Overstock.com CAPS Rating: *
TASR $11.49 Up +0.05 +0.44%
Taser Internationa… CAPS Rating: ****

Advertisement