COUNTERCOLUMN: All Your Bias Are Belong to Us

Two of the world's top financial thinkers have weighed in on Social Security reform.

Bill Gross, the 800 pound gorilla of the bond market, citing Rob Arnott of Research Affiliates, LLC, expresses skepticism:

"Pre-funding these systems...is basically irrelevant...It matters little whether the system is pre-refunded with Treasury bonds or privately held stocks. The truth is that both of these assets represent a call on future production. If that production could possibly be saved, like squirrels ferreting away nuts for a long winter, then Treasury IOUs or corporate stocks might make some sense. But they can't. Future healthcare for boomer seniors can only be provided by today's teenagers, twenty-somethings, and even the yet to be born. We cannot store their energy for a rainy day.

...As Chart I points out, the ratio of retirees to workers - the dependency ratio - soars from 0.2 retirees for every worker to 0.35 over the next 20 years or so. There's your problem, and neither privatization nor any goodly number of government bonds deposited in the Social Security trust fund can solve it."

I'd say "read the whole thing, but with Gross you are usually better off skipping the first two paragraphs.

The URL is http://www.pimco.com/PIMCO_US.Site/Template/LateBreakingCommentary.aspx?NRMODE=Published&NRORIGINALURL=%2fLeftNav%2fLate%2bBreaking%2bCommentary%2fIO%2f2005%2fIO_Feb_2005%2ehtm&NRNODEGUID=%7bDE7ABDBC-7DDA-4CD7-934A-C7E2BFFFFB26%7d&NRCACHEHINT=Guest

Gross is right. If we try to convert the current "pay as you go" system to the fully funded model, it STILL relies on the continued productivity of future generations of workers, because if their productivity falls flat on its face, then equity values collapse, along with corporate bond prices, and along with tax revenues.

Could it happen? Sure. But that's not an argument for keeping everything within Treasuries, because you're ultimately exposed to the same risk. If U.S. worker productivity collapses, taking equities and bond prices down simultaneously, the ability of the U.S. government to fund its huge entitlements will then be called into question, and the value of U.S. Treasuries will plunge and interest rates will soar. Or, more likely, taxpayers will repudiate the debt to America's retirees.

Either way, retirees lose, and sheltering them from securities markets for fear of a productivity collapse won't shelter them from very much at all.

Rather, the risk of a U.S. productivity collapse is an argument for expanding the investment pool to include global investments - including foreign bonds and stocks.

Let's face it...if the US should falter, the rest of the world will be happy to pick up the slack. The world will continue to generate and build wealth. And that's a bet I'm comfortable making.

Moreover, if we're so concerned about the Chicoms holding so much treasury debt over our heads like the Sword of Damocles, then expanding U.S. ownership of a diverse pool of foreign debt as a diversifier against U.S. markets can't be a terrible thing.

And if the whole world craps out simultaneously, well, then we've got bigger problems than retiree concerns then, and it will be time for them to go back to work, anyway, digging mass graves.

As an added benefit, over and above the diversification benefit, diversifying globally will also serve to dilute the erasure of the small-company risk premium, which is actually my biggest concern about a TSP-style Social Security plan.

The second heavyweight to weigh in is William Bernstein, an indexing and asset allocation guru and one of the big influences on my own investment thinking, though not on my Social Security writing.

Like me, he's suspicious of Wall Street, and is vigilant against the Street's tendency to set fees at a 1-2% level which will rape investors of half their returns or more over a 40 year career.

Viewed from the other side of the ledger, toss the following four items into the mix: 3% real returns for stocks, 1% for short-term bonds, a 60/40 portfolio, and 2% to 4% overt and covert expenses from your friendly neighborhood brokerage house or fund company. The result is an after-expenses real return that compares unfavorably to the canned goods in your cellar. Even those of us in the low-expense/multifactor crowd shouldn’t be too snide—if we can get an overall 1% portfolio boost from small and value and cover our expenses with skilled rebalancing, the only path to a small fortune is to start out with one. (Remember that while we’re peddling as fast as we can, real productivity and wages will be increasing by about 2% per year; thus, the best-case scenario is keeping up with the working Joneses, and just barely at that.)

Of course, the country’s wealth would not wind up entirely in the hands of the nation’s brokerages and fund companies. As publicly traded entities, some would be distributed to shareholders in the form of dividends and capital gains, but even more would be wasted on obscene management perks and corporate acquisitions that would make the Time Warner-AOL deal look like a tip at the Olive Garden.

URL: http://www.efficientfrontier.com/ef/105/goldrush.htm

But eventually, like, me, he comes to believe that such a plan is workable: IF we place strict limits on Wall Street scumminess, and IF we take steps to protect investors from the disruptive swings of market sentiment they themselves create. This is, to me, essentially the same as looking at Social Security as an insurance program rather than as an investment program - even if we use individual accounts. Require sound asset allocation principles, and the judicious use of annuities to provide a floor income for the life of the retiree and his or her survivor.


Fortunately, that seems to be the way the debate is headed.

More from Bernstein:

A grand bargain is called for, which might look something like this: The Left embraces the inevitability of private accounts, in return for which the Right gores the financial-services ox with a uniform and strictly regulated indexed portfolio structure. After retirement, beneficiary assets would then be liquidated for living expenses as well as exchanged in staggered fashion for inflation-indexed fixed annuities, again, under strict government control.

Privatization can work, and one does not need to be a libertarian to realize the empowering nature of individual accounts. But in order to avoid great slaughter, the sheep will have to be separated from the wolves.

Amen.

Splash, out

Jason