What Should A Privatized Social Security System Look Like?

2008 November 21
by Kyle Bumpus
from → Commentary, Economy

With democrats sweeping into power this last election, the possibility of a privatized social security system being implemented anytime in the near future looks increasingly bleak.  That’s too bad, because a properly-implemented privatized social security system could go a long way towards solving some important problems.  Before the ideologues out there call me a contard and hit the back button, please hear me out.  I think you’ll find privatized social security can be completely consistent with a liberal outlook.

Lessons From Sweden

As it turns out, the U.S. isn’t the first major industrialized economy to toy with the idea of partial privatization of a public pension system.  Reeling from the pressure of mounting pension obligations, the Swedish government in 2000 instituted a system of personal accounts to shore up the treasury’s balance sheet and give Swedish citizens an ownership stake in their own retirement.  There are a few important lessons we should learn from the Swedish experiment before attempting to implement a personal account system of our own.

  • Limit Investment Options – When personal accounts were launched in Sweden, over 400 mutual funds initially participated.  This overabundance of choice paralyzed most Swedes, leaving them unable to make a choice.  Consequently, between 80-90% of all Swedes ended up in the default fund for lack of choosing another.  This same tendency to become paralyzed when confronted with too many options has been prevalent in American 401k accounts as well, so we can be sure the same thing will happen here.  To counter this, investment options should be few in number, preferably much less than 10.
  • Broad Index Funds Only- Throughout the Swedish experiment, there was a strong tendency for Swedish investors to allocate heavily to sectors that had had strong showings in the recent past;  that is, Swedish investors participated in performance chasing and market timing, which is a recipe for disaster.  This tendency could be foiled in a privatized U.S. social security system by offering only broad, total market index funds.  Not only would a portfolio of only broad index funds make it impossible to overweight certain sectors, we wouldn’t have to worry about unscrupulous investment managers gaming the system to earn an unfair profit from a hapless public since index funds are by definition extremely low-cost, bare-bones operations.  Investors would get a good deal even as they were protected from themselves.  In fact, the U.S. Government already has such a high-quality, low-cost-index-fund-based retirement plan in the Thrift Savings Plan for government workers.  It could merely be extended to all Americans.
  • Life-Cycle Funds Only- Unfortunately for Sweden, this program was implemented just before the tech bubble burst, leading to large losses for most investors.  As it turns out, the default fund (which 80-90% of Swedes were invested in, remember), was invested predominantly in the stock market and fell 30% in the ensuing carnage.  That may not be a big deal for a 25 year old just a few years out of school, but it’s huge for a 60 year old nearing retirement.  This teaches us that the default fund should be chosen very, very carefully since most Americans will probably end up invested in it.  The logical choice for a one-size-fits-all default choice satisfying the vast majority of investors’ needs is a life-cycle fund.  A life-cycle fund is simply one that becomes more conservative over time based on a pre-set formula determined by investment professionals.  If all Americans were enrolled in an age-appropriate life-cycle fund by default, that would eliminate 95% of the possible problems with any privatized social security system right there.  Investors would be prohibited from engaging in self-destructive behaviour like chasing returns, market timing, and the like and would be assured of a well-diversified, balanced portfolio to mitigate against permanent loss.  Such an approach would have worked well even in the current crisis.
  • Err On The Side Of Caution – Sweden’s default fund was simply too aggressive for most investors.  The above life-cycle funds should err on the side of caution when making asset allocation decisions.  That is, their overall allocations should be appropriate for the average risk-adverse investor of a given age, not the so-called aggressive investor.  While this does mean less overall growth is possible in personal accounts, it also significantly reduces the chances of catastrophic loss.  After all, social security is supposed to be a safety net.  This arrangement would retain that characteristic, for the most part, since over time a conservatively-allocated portfolio is practically certain to outpace both inflation and the returns possible under the current social security system.

Many critics of the current social security system will balk at these suggestions, saying they don’t go far enough.  In their mind, anything but complete freedom to do what they will with their social security contributions is unacceptable.  Those people will never be convinced.  I think my plan represents a fair compromise between the liberal and conservative positions, balancing the possibility of long-term growth of capital and personal ownership against the need to provide a solid safety net for America’s retirees and protect investors against their own worst instincts.

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4 Responses
  1. 2008 November 21

    I think the entire idea of privatizing any part of Social Security is dead in the water for at least 5-10 years. AARP has been strongly against it from the get go and I’m betting that a lot of folks who supported it have changed their minds based on recent market events. I would love to see a poll taken now.

  2. 2008 November 21

    I agree, we probably won’t year much about it for at least the next 4 years. But it’s never too early to begin planning and debating the merits of such a system, IMO. I think the reality of the situation is that we’ll have no choice but to either privatize part of the system or significantly reduce benefits as costs mount. And I think privatization is a far better alternative than cutting benefits.

  3. 2008 December 2
    Slinky permalink

    Ok, so this system sounds exactly like….a mandatory 401k. In which case, what’s the point? Why would I want to make managing my retirement more complicated by splitting things up into multiple accounts that do the same thing? I don’t get the point of having a system like this.

  4. 2009 May 2
    Rick Beagle permalink

    ROFL! You have to like the timing of this article and what transpired afterwards.

Comments are closed.