Wednesday, January 19, 2005

Another Endorsement for Private SS Accounts

Larry Kudlow actually found an economics professor at Princeton who enthusiastically supports private investment accounts for younger workers in Social Security. Link. If somebody in the Ivy League supports it, can you imagine how broad the potential support is out in the heartland if it is explained properly.
According to Malkiel, from 1926 to the present, yearly stock market returns have averaged about 10 percent pre-inflation and 7 percent after-inflation. The absolute worst return for a 25-year investor who started in 1929 was 6 percent; for a 35-year investor it was 8 percent.

Malkiel wrote in the Wall Street Journal this week that “Long-term investors can invest in the stock market with considerable confidence that they can earn a rate of return far above the 1% to 2% return afforded by the Social Security system.”

This is an important defense of personal accounts. Malkiel is the former chairman of the president’s Council of Economic Advisors. He is also the former chair of the Princeton economics department. Yes, believe it or not, there’s an Ivy Leaguer in favor of Bush’s reform plan. As such, Malkiel brings enormous credibility to the issue.

The Princeton professor also recommends periodic contributions to Social Security in the form of “dollar cost averaging.” Long-term investors who started in the market in 1929 and acted this way got returns averaging 7 to 10 percent yearly as the minimal low end of their historical performance. Malkiel recommends asset diversification among stocks, bonds, and real estate, along with “rebalancing” over time. In other words, younger workers should have more stocks than bonds in their personal accounts and older workers more bonds than stocks. Setting up stream-of-income annuities for the retirement years avoids the pitfalls of taking everything out of the market at a bad time (like 1929 or 2000-01).

I heartily agree with the professor, and I would like to add several points to back him up.

The AARP ads about 'risky' investments, are looking at the situation where a large lump sum is invested all at once, and is then sold all at once some time later. This can lead to a large profit or to a loss. However, this is not how retirement funds are invested. We are talking about 3% out of every pay period over decades.

In the stock market, risk is a function of time, and an inverse function at that. In other words, the longer the time horizon, the lower the risk. The professor points out that the average return over the last eighty years is 10%, but one must also look at the volatility, which is the primary measure of risk. If you look at all one-year sub-periods, the average return is 10%, but the range is huge, more than + or - 40%. If we look at all 10-year sub-periods, the average return is still 10%, but the range is down to near + or - 20%. As the professor points out, for 25 and 35 years, the average return is 10%, but the downside is now only 4% and 2% respectively. There has never been a period of 25 or more years, in which stock market returns were as low as those of Social security, much less negative.

The second point deals with the schedule at which the money is invested. For a salaried employee, the identical amount would be invested every pay period. This is true "dollar cost averaging." Let us look at a worker who is putting in $100 every pay period, and over three successive pay periods, the stock index mutual fund he is buying is priced at $11.00, $9.00, and $10.00 per share. The average price of this fund over the period is exactly $10.00 per share. In the first period, the worker buys 9.091 shares at $11.00 per share, in the second period 11.111 shares at $9.00 per share, and in the third period 10.000 shares at $10.00 per share. In all, he or she purchased 30.202 shares for $300.00. This is an average cost of $9.93 per share. Because dollar cost averaging guarantees that you buy more shares when the market is low and fewer shares when the market is high, it absolutely guarantees that your average cost will be lower than the average price of the fund. This puts the odds further in you favor.

Now let us look at a practical scenario. A man starts work at 20 and retires at 65. He will put money into his account for 45 years. To keep the computation simple, let's assume that his earnings remain flat, and he invests $100 per month over the entire period. At 3% invested, this corresponds to a gross pay of $3,333 per month. If he were to get the 10% annual return computed by Professor Malkiel, he would retire with a little over $1 million in his account. If he then made the assumption that he would not live beyond 105, and drew money out at a rate that would deplete the account in 40 years, his draw would be a little over $8,800 per month. What do you think the odds are that Social Security would be paying this amount out. The fact that his monthly retirement draw is 88 times his monthly investment, means that in our current pay-as-you-go system, we would need 88 workers for every retired person, rather than the two that are expected soon.


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