The Ever Wise Boonton

One of the common arguments against Social Security is the rate of return. Basically it boils down to “why should I get X% on the money I pay in Social Security Taxes when I can get X+% just putting it in the bank!”

I would like to first explore what the actual rate of return is on Social Security and what it means to have been able to earn something in the past. Social Security for many people will have a positive rate of return and for those who need it most the return will be quite good. Kevin Lansing had an interesting article published by the Federal Reserve Bank of San Francisco back in 1999. http://www.frbsf.org/images/pdfcharts/el99-34.pdf

http://www.frbsf.org/images/pdfcharts/el99-34.pdf shows the real rates of return he found depending on birthdates. In general you are probably look at a real return around 1-2%. Keep in mind that a real rate of return is the rate you actually see minus inflation. This is what the author grudgingly concludes:

The authors find that, under current OASI rules, today's lowest paid workers (those in the bottom 20% of the income distribution based on lifetime earnings) can expect internal rates of return between 4% and 5% after adjusting for inflation (Panel A). Today's middle income workers can expect real rates of return between 1% and 2%. Today's highest paid workers can expect real rates of return below 1% and may even face negative rates of return if born after 1975.

Let’s get to the meat of what returns are. Returns are paid to you by someone else. There is no magic ‘interest fairy’ who rewards you for putting $100 aside. Someone pays you for doing that and the reason they pay you is that they are able to take your $100 and do something with it to not only pay you back your $100 and your interest but also have some profit for themselves.

Imagine the economy that has no money and produces only cookies. Say a cookie baker is hungry. If you lend him ten cookies he will eat them and have the energy to bake 20 cookies at the end of the day. For this he agrees to pay you five cookies in interest. So the economy that starts out with ten cookies in the morning ends the day with 20 cookies…you have 15 (ten cookies plus five interest) and the baker has five of his own. Everyone wins, you are richer and so is the baker. Return wise, economic growth was 100% (ten cookies to twenty cookies) and your return was 50% (ten to fifteen). The balance of the growth was given to the baker.

At some point, total returns are capped at economic growth. A casino generates an average return based on how they set their odds (but they always set the odds so that in the long run they and not you win). Like a casino, however, everyone doesn’t split the loss or gain evenly. Some people win big and others lose big. At the end of the day, if the casino took in net $1M from 1000 people then the average person must have lost $1000. But if one person won $3000 then someone else must have lost more than a simple $1000.

In an economy the returns realized by people is capped by economic growth. If one person is able to get returns larger than the growth of the economy then someone else must be paying for it. This leads to confusion because historical returns for both stocks and bonds make it appear that you can get a better return than economic growth.

The element that is missing is risk. Everything except maybe death and taxes is a risk. All assets carry with them a host of different risks. Cookies can become stale and worthless. Your favorite stock may turn out to have lied about their books like Enron. The gov’t may change the tax laws so you can’t cash in on some really profitable investment without taking a huge tax bite.

Another missing element is realized returns. A stock starts the year at $50 a share and ends it at $100. That’s a 100% return even though the economy only grew at 5%. But what was the realized return? Price quotes for stocks are based on actual sales so we can be sure at the start of the year at least one block of 100 shares was sold for $50 each and at the end at least one block was sold for $100. Someone realized a gain of $5,000. But could the entire economy have pulled off the same trick? No. We know supply and demand will tell us if a huge number of people tried this the price at the beginning of the year would soar. Likewise the price at the end of the year when everyone tries to cash in would be less. The more money that tried to capture this lucky stock the less its paper return would have been.

This doesn’t stop some commentators from saying silly things like “If only people could have taken their social security taxes and brought that stock…they would have had more money in retirement than they would have gotten from social security if they lived to be 190!” What goes for a particular stock also goes for a mutual fund or anything else. If all of Social Security had been ‘invested’ in some mutual fund that yielded 20% returns in the 70’s and 80’s all that would have changed would be that funds real returns.

Realized returns also are the returns that really matter because those returns are what puts food in your mouth. In the example of the stock that went from $50 to $100 in a year, all that tells us that at least one trade happened in the beginning of the year and one at the end. All the people who own the stock during the year will see their ‘balance’ double but that doesn’t become real for them until they actually sell their shares and take the profits.

So in order for private investments to generate realized returns in excess of economic growth to finance retirements other returns have to be less than economic growth…even negative.

This leads me to returns all being equal given risk. There’s a host of different returns at any given time but there’s a trade off with higher returns. They have higher risk. If they didn’t people would sell off their assets and purchase the asset that generated a high return with lower risk. This would increase the price of the asset (thereby decreasing its return) until the return was in line with a low risk-low return asset. If markets work, then returns will fall along a line of increased return to increased risk similar to the CAPM model.

The author concludes that Social Security’s return is inferior:

The "average" U.S. worker faces a rate of return on contributions that is quite low--less than 2% after adjusting for inflation. By comparison, the real yield on a 10-year inflation-indexed Treasury Bond is currently around 3.5%. In addition to being low, rates of return from Social Security must be viewed as risky because they are subject to change from future political actions that will be needed to ensure long-term solvency of the program.

What’s wrong with this? Well Social Security has only political risk and economic risk. Political risk in that the gov’t may change the rules of the game. Economic risk in that the entire economy may not be able to fund benefits in the future.

The 10 year inflation indexed bond has a stated yield of 3.5%. Bonds, however, are no different than stocks. They can increase or decrease in value. The 3.5% yield is only what you earn if you hold it to maturity and the interest doesn’t compound. Every year will have coupon payments that you will hope to invest for at least 3.5% Plus remember transaction fees. While you can purchase bonds directly many times they are sold through brokers and mutual funds. As soon as this happens you incur fees that lower your return. If you do not have enough money to buy a whole bond you have to buy them in a fund which automatically exposes you to fees. For an asset as safe as a 10 year inflation protected T-Bond, we can identify all of Social Securities risk elements:

1. Political risk – That the gov’t may not honor the bond given the horrible state of the overall Federal Budget. That gov’t may ‘change the rules’….it may apply taxes against the interest income of the bond, it may change the rules for capital gains taxes on the bond, and so on.

2. Economic risk – the Economy may collapse leaving the gov’t unable to pay off the bond or its interest.

But the bond also carries two additional risks that social security dodges:

1. Interest rate risk – Interest rates may fall leaving you unable to re-invest your coupon payments at 3.5%.

2. Market risk – The price of this bond goes up and down every day. If you sell the bond before it matures you cannot predict ahead of time how much you’ll receive until you actually do it.
So looking at it objectively it doesn’t appear that the case for Social Security being a raw deal has really been made.

# posted by Boonton @ 1:47 PM