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of the basic arguments advanced in favor of Social Security privatization
was that, through privatization, the rate of return on Social Security
funds would be higher than what is received under the present system
(generally considered 2%). Opponents of privatization argue that
privatization is a risky scheme and that we are asking retirees
to climb aboard the stock-market roller coaster. (In the recent
Virginia congressional election, the Democratic candidate used that
precise image in a political rally.)
The various
claims and counterclaims are interesting, if not illuminating. It’s
clear that the “roller coaster” problem has two major components:
the steady-state component, which deals with new entrants into the
system, and a transition issue faced by current participants of
the Social Security system.
When asset
managers report performance, a disclaimer always accompanies it.
You’ve all seen it. It states that past performance is no guarantee
of future performance or trends. Nevertheless, the past offers a
good idea of what to expect in the future. This is especially so
if you’re prepared to believe that the economic environment is determined
by policies set by the government. This logic provides a simple
premise.
If government
policies set the stage for the economic environment, and the health
of the economy is linked to market performance, it is then safe
to assume that if the range of policy options remain within the
historical scope, we should expect the return distribution to remain
within the historical range. In this case, past performance may
be a very good guide for the likely range of future performance.
Using history
as a guide, it's apparent that constantly reinvesting assets in
a series of short-term investments will not shield the investor
from below-average returns (below 2%). Which, in turn, suggests
that the “safer investment” is in fact a much “riskier” one. Looking
at the distribution of returns over time, all of the sub-2% holding
periods span the December 1965 to June 1973 period. During most
of that time, the U.S. was under the Bretton Woods gold standard.
It was not until we abandoned gold convertibility that the holding-period
returns increased above the 2% benchmark. The non-randomness of
the distribution points out something that's worth repeating: The
organization of the monetary system determines the inflation potential
of the economy.
Other than
the T-bill, the long bond is the only asset class that falls below
the 2% benchmark. It under-performs in two periods: the holding
periods ending in August 1981 and September 1981. These periods
span the unhinging of Bretton Woods, the U.S. stagflation episode,
Paul Volker’s Fed chairmanship appointment (and the corresponding
change in the Fed’s operating procedures), and the phase-in of the
Reagan tax-rate cuts. At the time, the rise in the inflation rate
and the transition to a price rule had a devastating effect on long-term
government bond returns. During that period, government debt had
junk-bond status. In fact, that’s a bit of an insult to junk bonds.
It’s somewhat
ironic that those who talk about risky investment schemes would
rather have their money locked up in a box or under the proverbial
mattress (or in short- or long-term government securities), when
they have performed so dismally over time. Within fixed income categories,
the data show that intermediate government maturities produce a
higher holding-period return with a lower standard deviation than
short-term government instruments.
In fact, one
can argue that intermediate bonds seem to produce a higher return
for about the same volatility as long-term government bonds. The
only reason to justify holding any fixed income security other than
intermediate fixed income has to be for diversification/risk reduction.
Portfolio
diversification theory shows that managers can either reduce a portfolio’s
volatility or increase its return through the combination of two
or more asset classes. Clearly, those lucky enough to put all their
eggs into the right retirement basket could reap significant benefits.
However, those who put all their eggs in the wrong basket would
be in the hurt locker. (But the data suggest that they would still
do better than the magical 2% return level.) This is why diversification
is a necessary ingredient in the cause of Social Security privatization.
Common sense
suggests that returns alone should not be the sole criterion in
the allocation of retirement assets. Risk must also be accounted
for — and developments in financial economics over the past
three decades provide us with the necessary tools to develop risk-adjusted
returns in a rigorous and systematic way. In general, we are taught
that short-term government securities tend to be the less risky
investment while smaller capitalization stocks tend to be riskier.
However, looking at 40 years of data, just the opposite appears
to be true. That is a shocking and unintuitive result.
If the past
is any guide — and one were to select only one asset class
to invest in — a true privatization of the Social Security
system should allow for investment in small and large capitalization
stocks as a way not only of producing higher returns but also of
reducing portfolio volatility.
In practice,
more than one asset class should be allowed in the portfolio. By
allowing various asset classes into the portfolio, returns can be
enhanced and volatility reduced.
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