What happens with the privatization of Social Security? At first it seems like a great idea. Any prospectus from just about anywhere boasts of historical yields far more than the 3 percent annual percentage rate (APR) the Social Security Trust Fund currently averages (Business Week, 09/06/2004). Why shouldn't Americans take control of their own investment decisions and reap some of those appealing 12 percent, 20 percent, 32 percent yields?

In the same issue of Business Week, Treasury Department's John Snow said that Americans are intelligent enough to evaluate choices and then choose to privatize social security.

Without question, Social Security's 3 percent yield is abysmal. Anyone could do as well by putting the money in a Certificate of Deposit and letting it ride. What's worse, with annual inflation rates between 3 percent and 4 percent, it appears that Social Security is simply not keeping up. Individual investors are in even worse shape, averaging 1.5 percent APR, half of what Social Security is making. Their money is actually losing value and buying less over time. How could this be?

George W. Bush said during the presidential debates, �You should have the freedom to invest your own money. I trust you to control your future; my opponent trusts the government.�

The stock market is a game, a financial casino. Like any game there are rules, but the rules are not spelled out in a stock market's version of Hoyle's. The players have to figure them out. Privatization would invite a lot of new players who do not know the rules. Who would they ask but none other than the ones most likely to profit from their ignorance?

Rule #1: Play only if you can afford to lose.

Money can be made, but only by risking money whose loss is no big deal. The big boys win some and lose some. Overall, they hope to win more than they lose. The more risk, the greater potential return, but also the greater potential loss. The little investors cannot afford to risk their future.

�The money that workers pay into Social Security is needed for current benefits. If the $1.5 trillion is taken from Social Security and put into private stock market accounts, then benefits will have to be cut sharply, even for current recipients. More of the retired, the disabled and the widowed will be forced to live in poverty. And Social Security will no longer protect against poverty with a guaranteed benefit. They need a sure deal and Social Security right now provides a protected fixed income in the future. The benefits are guaranteed and they are adjusted to inflation� (Weller & Wenger, 2004).

An editorial in the November 29 issue of Business Week implied that the government would have to make rules to protect the financially unsophisticated new investors from losing everything. Will the only difference between a government plan with government regulation and a private plan with government regulation be ownership of the money?

Rule #2: Buy low, sell high.

The little investors get snookered by the ups and downs of the stock market. They observe the price of a certain stock on the rise, so they buy, hoping it will continue to rise, not realizing the rise is being fueled by the big boys who bought cheaply just a day or so before. The stock goes up a little bit more in response to demand by the little guys, then comes to a screeching halt before heading downward. Then the little guy gets scared and sells before he loses any more money. The upshot is a net loss aggravated by two commissions (one for the purchase and one for the sale) paid to a stockbroker, not to mention the periodic account maintenance fees.

Rule #3: Buy and hold.

Historically, the most successful investors were those who purchased stock certificates, stuck them in a shoe box, and forgot them for 20, 30, 40 years. One reason the little investors are getting only a 1.5 percent return today is that they try to time the market like the big boys. By the time a little guy hears a hot tip, or even a good idea, it's over. The little guys end up paying more for their stocks. The big guys already purchased when the price was low, and their purchases drove up the price for the little guys. Same goes for advise to sell. By the time the little guys hear it, the price has been driven down by early selling by the big guys. So the investors that can least afford it buy higher and sell lower. In Las Vegas it might be okay to brag about winning $1,000 while neglecting to mention that the win cost $1,200. Such accounting is fatal to a retirement account.

Rule #4: Sooner or later, you are playing with real money.

Even if the little investor manages to invest soundly with a decent yield, all of those earnings are merely scratchings on paper until the stock is sold and the gain captured. What will happen when the baby boomers all start selling their stocks at once to fund their retirements at the same time pension funds are also selling their stocks?

�The 76 million Americans born between 1946 and 1964 have strained every system they've encountered: sending school enrollments soaring in the 1950s and 1960s and prompting new school construction, flooding the job market in the 1970s and slowing wage growth, buying homes in the 1970s and contributing to soaring real estate prices, and, most recently, purchasing stocks through 401(k)s, thereby fueling the great bull market of the late 1990s. So what happens when boomers go cash out their investments to pay for their retirements? . . . the massive sell-off of pension and retirement funds as baby boomers retire could depress investment values� (Perry, 2003).

Prices are likely to fall and the nest eggs may lose value precipitously (Parker, 2000). Who is supposed to buy the stocks that retirees want to sell besides current workers, who may or may not be in a position to buy those stocks? Many financial planners advise withdrawing 7 percent of the accumulated funds per year throughout retirement. But with privatization, withdrawals at half that rate (or less) would be required (Cooley, Hubbard, & Walz, February 1998) in order to assure that the retirement fund does not run out. The dilemma is that withdrawals of 3 percent-4 percent might not be enough to live on (Bernstein, 2001).

Stocks are often promoted for retirement accounts based on historical returns. But there is a reason why every prospectus warns that historical yields do not guarantee future performance. There is no historical precedent for the �planned waves of stock selling that virtually all retirement plans are designed to do� (Parker, 2000).

Furthermore, the actual money any one worker pays into Social Security is not salted away in individual accounts. It is transferred to today's retirees. The projected benefit statement workers get every year from the Social Security Administration is not like a bank statement. That money is not really there, not really available. Today it takes three workers to support one retiree. In about 40 years, 1.5 workers will have to support each retiree.

Thornton Parker (2000) points out that the stocks-for-retirement plan is �really a pyramid scheme� where an �expanding base� (the boomers) �pay to the early participants, giving the impression that the asset has a good return. At some point the base stops expanding, revealing the true nature of the scheme.� The base has stopped expanding as evidenced by the concern over the future solvency of Social Security.

While it is true that private investments offer higher rates of return than Social Security, the investments utilized by stock-based IRAs, pension funds, and 401(k)'s serve a different purpose than Social Security. Stock-based IRAs, pension funds, and 401(k)'s are exposed to market risk, but as Weller and Wenger (2004) point out,

�You can�t compare Social Security to a mutual fund. Social Security offers a guaranteed benefit, protected against inflation for as long as you live after retirement. No mutual fund does that. As Enron�s workers and investors found out, risk means a life�s savings can disappear overnight. Private savings are an important part of any retirement plan�but Social Security has to provide a basic guaranteed benefit without stock market risk. And Social Security is also an insurance plan for younger workers against death and disability, something no mutual fund offers.�

It is ironic that while companies boast of double-digit stock returns, individual small investors investing in those stocks average 1.5 percent. Little investors may think they are investing in a company when they buy stock. But instead money is merely passed from stockholder to stockholder. None of it actually goes to the company. Bush wants workers to invest 2 percent of their 12.4 percent payroll taxes in stocks. That money is likely to end up in the pockets of the big investors and stockbrokers, setting up not only baby boomers, but also their children and grandchildren, for a financial catastrophe.

Sources:

Bernstein, W.J. (2001). The Retirement Calculator from Hell. Efficient Frontier from www.efficientfrontier.com retrieved 11/28/2004.

Business Week, September 6, 2004.

Business Week, November 29, 2004.

Cooley, Hubbard, & Walz, February 1998, AAII Journal.

Parker, Thornton. (2000). What if Boomers Can't Retire? Berrett-Koehler: San Francisco.

Perry, Ann. (2003). The Wise Investor. Random House: New York.