Privatization Is A-O-(k)
Social Security accounts can survive a nasty downturn.

By Victor A. Canto, La Jolla Economics, and Jake Armstrong
September 5, 2001, 9:00 a.m.

ust as proposals to allow individuals to privatize portions of their Social Security "accounts" have gained momentum, a piece of bad — but inevitable — news may have slammed on the brakes. It was recently reported that for the first time in twenty years the average 401(k) retirement account lost money last year. The losses have led many individuals and politicians to second-guess Social Security privatization. Central to this second-guessing is the fact that, in investments, there can actually be losses — particularly if investment decisions aren't made properly over time.

As the market continued to climb at historically high annual rates over the past decade, individuals increasingly allocated 401(k) money to stocks, failing to heed the advice of advisers and marketing materials that told them to diversify their holdings with debt securities. Now, after a nasty downturn, these same individuals opened their quarterly reports to find that money they put into their retirement fund was actually lost to the market, so to speak. Since it was, for many, the first time they lost money in the market, it really hit home. If they were given control over their Social Security funds (which now never lose to the market) they could find themselves in dire straights.

But there is a silver lining here. The 401(k) decline has many people wondering how much to contribute and where to invest to achieve their retirement objective — they are now actually looking to diversify. Additionally, the news hasn't seemed to dissuade President Bush away from privatization. The special commission he recently appointed to explore ways to carry out his campaign promise to permit Americans to invest a portion of their Social Security benefits will have to address some of these issues.

The Diversification Lifeline
One of the major issues of Social Security privatization is the transition issue, or how to move people onto the system from the present structure. This can be framed in the context of the investment horizon of the individual investor. For example, a person with five years to retire very likely faces a different choice than a person with thirty years until retirement. Investors with different horizons require a range of returns that they can expect to see in the future.

One way to do this is to look into the past and calculate the range of possibilities. If the economy's reaction to policy changes and/or economic shocks is stable, the past may be a reasonable guide for future outcomes. By looking back, one may be able to gauge the range of return possibilities for various asset classes. Once the range of returns is determined, all the investor has to do is select the asset-class mix that will achieve the desired mix of expected return and volatility.

Traditionally, this selection has been based on standard asset allocating models. However, the expected return and risk characteristics of various asset classes depends on the economic environment and the policies being adopted at the time. Thinking of it this way, an investor who pays attention to the policies being enacted should yield higher returns and lower volatility than those whose portfolios use traditional asset allocation procedures.

In short, a forward-looking analysis may be able to identify future shifts in the variance of future returns. By anticipating these shifts, a superior return can be realized for the medium- and short-horizon investor. This can be done by keeping track of the policies being enacted that give rise to alternative economic environments.

The Long and Short of It
The historical experience of the U.S. suggests that for the fixed-income investor, lengthening the maturity of a portfolio produces a higher return without any significant increase in volatility. The data also indicate that the likelihood of achieving positive nominal returns is much higher using equities. As the investor horizon lengthens, the average return for the holding period hardly declines, yet the volatility of the returns declines dramatically.

Thus, if faced with the choice of selecting a single asset, the long-term investor is much better off holding equities. This has some interesting implications for the possibility of the privatization of the Social Security system. The data suggest that expanding the choice of investment alternatives to include equities will greatly enhance the average return while simultaneously lowering the volatility of the portfolio.

In practice, however, there is a time-consistency issue. While it is possible that a passive strategy may be optimal for an investor with a long horizon, say 15 years or more, it may not be optimal for the shorter-horizon investor.

If an investor had the choice to select only one asset for his portfolio, he would only have to know the standard deviation and expected return to make a choice. Furthermore, if the expected return were invariant to the economic environment, then he could base his choice strictly on historical rates of returns. But what if expected returns are not invariant to the economic environment? Could he do better? Yes he could.

The appropriate way is to look for sub-periods that provide a clue as to what return can be expected in relation to the economic environment. This can be done in two ways. One, the investor can look for periods that offer a similar economic environment. Two, he can look for periods that are mirror images of the economic environment. Either way, he can obtain information as to the asset class that's likely to outperform in the economic environment that lays ahead.

This procedure is not one of short-term forecasting, rather it is one of identifying inflection points that will last for more than one year. This is a fruitful process that can be easily implemented and will produce superior results.

Overall, history has given us an excellent guide to getting Social Security privatization not only up and running, but yielding high returns for Americans.