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Social Security, stocks link carries risk

Third in a series of occasional articles examining the economic and political stakes involved in the Bush administration's proposed overhaul of Social Security.

Over the past 80 years, owning stocks has been a good deal for investors. On average, stocks have returned about 10 percent a year since 1926.

So if Americans invest in stocks through private accounts as part of an overhaul of the Social Security system, they can expect returns of around 10 percent, right?

Not necessarily, say many academics and economists, who concede that while market investments may perform well in the future, good returns are far from guaranteed.

''It is not as if they are a fact of nature," said Robert Shiller, a Yale University economist.

Over the long run, the ''total return" from stocks (meaning their dividends plus price appreciation) easily beat more conservative investments like government bonds. But stocks have higher risk. And when those risks are properly accounted for, say economists, the returns don't look anywhere near as good.

''Focusing solely on the expected return to stocks, without adjusting for risk, overstates the contribution of private accounts to retirement income security," wrote Alicia Munnell in a recent paper called, ''Yikes! How To Think About Risk." Munnell is the director of Boston College's Center For Retirement Research.

If stocks are a sure thing, Munnell argued, then the government should go out and borrow money, invest the proceeds in stocks, and use the profits to eliminate taxes and the federal deficit. The fact that the government would never consider such a policy, says Munnell, is an acknowledgement of the risks stocks carry.

In his State of the Union message tonight, President Bush will make another pitch for the creation of private accounts as the centerpiece of Social Security reform. The president envisions diverting a portion of Social Security taxes into personal investment accounts. These would give Americans control over more of their retirement savings, in keeping with the administration's philosophy of an ''ownership society." But the notion that private accounts would leave Americans better off is also part of their appeal.

''A system of private accounts will provide significantly higher rates of return than the current Social Security system, which means that the vast majority of younger workers would be better off switching," wrote Michael Tanner of the Cato Institute in a paper titled ''The Better Deal." Cato is a Washington think tank that has supported privatizing Social Security for 25 years. The traditional Social Security system provides a rate of return of about 2 percent a year, according to analysts.

Tanner concedes that investing in stocks involves risk. But he insists that by diversifying their holdings -- owning a mix of stocks and bonds -- investors can minimize those risks over time.

William Shipman, another Cato specialist on Social Security, says if history is a guide, returns on private accounts will be far superior to those offered by traditional Social Security.

Academics and policy specialists aren't the only ones who are divided over how to account for the risk. Government agencies have had to confront the same question and they have arrived at completely different solutions.

The Social Security Administration, in an analysis of recommendations made by President Bush's Commission to Strengthen Social Security in 2002, concluded that stocks would continue to earn nearly 10 percent a year in the coming decades.

But when the Office of Management and Budget looked at a very similar issue in 2001, it was not as optimistic. OMB had to evaluate the implications of stock investments by the National Railroad Retirement Fund. Over time, it concluded, stocks could only be guaranteed to provide the same return as ultrasafe government bonds (about 5 percent). In effect, the agency decided that the higher returns from the stock market were offset by the higher risks.

Finance specialists may disagree about the risks that come with investing in stocks, but they generally agree what those risks are. They include:

 Poor future market performance. Shiller is the first to admit that US stocks have been a great investment up until now. But he sounds like a typical stock market prospectus when he warns that past performance is no guarantee of future results. ''Just because the 20th century was good for stocks doesn't mean the 21st century will be," said Shiller. Unless corporate earnings rise very strongly for a long period of time, pessimists say, stock prices will advance more slowly than in the past.

 Timing problems. In March 2000, the Standard & Poor's 500, a good gauge of the whole stock market, reached a top of 1,527. Two and a half years later, the S&P bottomed out at 776, a decline of 49 percent. Gary Burtless, an economist at the Brookings Institution in Washington, looked at similar market swings throughout history and asked: What would happen to workers who retired at the peaks and troughs, assuming they took their money out of the stock market on the day they retired and purchased annuities -- products that pay investors a fixed amount of money each month for the rest of their lives. ''Workers fortunate enough to retire when financial markets are strong obtain big pensions," he concluded, while ''workers with the misfortune to retire when markets are weak can be left with little to retire on."

Waiting for a poor stock market to turn into a strong stock market sometimes requires a good deal of patience. In 1982, for example, the major stock market averages were no higher than they were in 1966. While an affluent person might have enough money from other sources to wait until the market bounces back, a low-income person would not have that flexibility, noted Munnell.

Shipman of the Cato Institute says critics of Social Security private accounts are making too much of market swings. Even investors with the bad luck to retire when markets are down, he argues, will still earn far better returns than Social Security can provide. ''Is the objective to have higher retirement income or to make sure everyone's income is the same?" Shipman asks.

 The risk of bad decisions. In her 2004 book about 401(k) plans, ''Coming Up Short," Munnell found that many unsophisticated investors make poor choices when handed the responsibility for managing their money. Some invest too aggressively; others invest too conservatively. ''Many participants are at risk for ending up with unacceptably low retirement income," she wrote.

The Bush administration has said it wants to limit investment options to a handful of safe choices. Investors who don't want to make any choice at all would automatically be put into a so-called ''life-cycle" fund, which would invest in a blend of stocks and bonds. In December, the president said he would not let people invest ''in a frivolous fashion."

In the end the dispute about risk is like many of the disputes that surround Social Security: It is less about the facts than the proper way to interpret the facts. The critics of private accounts say supporters are overselling the benefits of investing in markets. The other side says the critics are overselling the risks of investing.

Charles Stein can be reached at stein@globe.com.Previous articles on this topic appeared on Jan. 14 and 30.

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