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Looking towards a sounder social security system.

Most studies show that retirement security ranks as the highest priority in a worker's goals. Much progress has been made with employer-sponsored pensions and other retirement programs. But the Government-sponsored social security system, which was designed to provide a retirement security blanket for all working Americans, has failed to provide workers with adequate supplementary retirement income; the average annual social security payment is $7,600, far below the current poverty level. With the huge surpluses currently being enjoyed by the social security system, we should now be investing a portion of those surpluses into faster growing equities to provide a cushion for the drastic outflows which will occur when the baby boomers begin to retire en masse in the early part of the next century. However, the original Social Security Act mandates that all contributions to the Social Security Trust Funds must be invested in U.S. Treasury securities--no common stocks or corporate bonds.

This paper projects the present assets of the combined social security funds into the future to see how well modern investment management techniques utilizing diversification across the spectrum of investment alternatives might perform compared with the "governments only" investment strategy mandated in the present system. The projections carry the results 78 years into the future through 2070 starting with the actual assets of $280.7 billion in the system at the end of 1991 and using all three of the economic assumptions of the Social Security Trustees from the 1992 annual report.

Senator Daniel Patrick Moynihan recently identified a major immediate problem with Social Security, which is that the system's revenues are being used to fund unrelated Government spending. But that just obscures the more important point that the system costs too much: Social Security and related programs accounted for $345 billion in taxes in fiscal 1990, almost half of all Federal spending aside from the military and interest on the national debt in that year.|1~ In fact, 74 percent of all taxpayers now pay more in social security taxes (including their employer's share) than in personal income taxes. Through the efforts a Senator Moynihan and others, the public is becoming more and more aware that Social Security contributions are not "invested" to finance future retirement benefits. As the General Accounting Office stated in September 1991: "The present situation ... means that the payroll tax is being used, not to make provision for future retirement benefits, but to pay for today's general operations of government."|2~

Even for the highest earning individuals, current benefit schedules call for an annual payment of only $15,326 a year. By comparison, if social security contributions had been invested in private annuities, a retiree would have been able to receive a guaranteed lifetime income of up to $49,509 per year. Even in a savings plan earning only a very conservative 5.5 percent per year, that retirement nest egg would grow to $450,000 over a working lifetime. An average worker with a nonworking spouse could save enough to receive a yearly retirement income of $21,351 and leave $388,000 to their children.|3~ More venturesome savers willing to take on higher risk in pursuit of higher returns would be able to triple this retirement fund according to figures prepared by Ibbotson Associates. Moreover, the risk would be reduced because the accumulations and returns would occur over extremely long time horizons.

If something isn't done--and done soon--our grandchildren may pay as much as 40 percent of their incomes in taxes (including their employer's share and the separate cost of Medicare) beginning in the second decade of the next century to pay for their parents retirement; the social security trustees' own "best" estimate is a 26 percent tax rate. Either tax rate would impede the growth of the economy, and perhaps cause intergenerational hostility.

Modern Asset Allocation

Modern asset allocation, investing across a cross-section of stocks and bonds, is a viable alternative. Significantly, states and municipalities have increasingly adopted flexible investment strategies for their employee plans similar to those used by private corporate pension plans, and have achieved excellent results. According to a study of foreign retirement systems by Leif Haanes-Olsen published in the Social Security Bulletin, even state-run pension plans in Sweden, Quebec in Canada and several other principalities now utilize common stocks along with corporate bonds to fund their public retirement plans.

Chile provides a case study of how a truly free-market economy should organize a social security program. Chile' s program, originally adopted in 1924, became a financial and social disaster decades later, but this changed in 1980. Now, Chileans pay a minimum of one fifth of their wages and salaries into privately administered, individual accounts. A state-sponsored "safety net" assures that poor citizens or workers with low lifetime salaries are guaranteed a minimum pension. Chile's public-private pension funds today total $5.6 billion, or 25 percent of gross national product. Moreover, the "privatized" pension system is a major factor in that nation's continued economic success.|4~

To be sure, there are many who believe the present social security system should be maintained with the trust funds invested solely in U.S. government debt instruments and with social security deficits made up from general revenues. For example, Robert J. Myers, former Chief Actuary for the Social Security System, believes the retirement system should be based on current-cost financing, a "pay-as-you-go plan," with a current fund balance equal to no more than one year's expenditures to provide stability. He believes that investment in other than U.S. government securities is not desirable, from a political, economic and philosophical standpoint.

Others point out that if the Social Security Trust Fund is allowed to invest in stocks, the government would be faced with a major problem in financing its recurring deficits. The government would have to either raise taxes or cut spending to close the deficit shortfall, or the Treasury would have to compete for funds in the private market driving up interest rates on long-term government securities.

But this view overlooks global financial markets. If long bond interest rates rise in the United States, investors around the world will react quickly and buy U.S. treasuries to benefit from higher rates, driving rates down to those prevailing in the market place. Besides, Senator Moynihan points out, the government's use of social security to finance its growing deficit is hardly a justifiable use of public retirement funds. The solution for the deficit problem should be to cut spending and, if necessary, raise general income taxes.


To view the government's deficit problems in isolation also overlooks the fact that most of the state and local government pension funds have shifted their asset allocation from primarily debt to an equities/debt mix over the past quarter century, and the financial markets have adjusted to this shift in asset mix efficiently and with little damage to the economic system or to the government bond market. In other words, private economic and market systems are self-correcting. Hardly impeded by the shift of states and localities to a debt-stock mix, the Treasury's debt outstanding has increased five-fold to over $3 trillion over the past decade. Equities, valued at about the same level, have increased two-fold in the same period.

The Social Security Trust Funds currently own only $300 billion of treasuries or less than 10 percent of the total outstanding, not a large enough holding to cause any major turmoil in the government securities markets if the trust funds were to sell a portion of their holdings. In an expanded portfolio, as contemplated in this paper, it is likely that the Social Security Funds would hold a significant amount of treasuries approaching or exceeding the current holding. Besides, including equities in the Social Security trust funds should help to reduce the overall volatility of the stock market, providing a more reliable source of equity financing for the expansion of new as well as older businesses.

In the early 1980s, the Social Security system faced a crisis situation with insolvency of the various social security trust funds considered imminent. A paper published in Financial Management in 1983 by the author and Susan Malley found that the major reason underlying the precarious condition of the social security system at that time was the system's inbred reliance on a "Treasuries only" investment policy. Had it used a flexible approach including equities as private pension systems do, or some fixed allocation of the fund between equities, governments and corporate bonds, the System would have survived the crises experienced in the early 1980s without the need for additional tax revenues and benefits cutbacks.

The 1983 paper reconstructed the social security accounts using nine alternative asset allocations including one which replicated the actual asset mixes of the private pension funds over the 50 year life of the social security system. The results indicated that had the Social Security funds followed the private pension portfolio mix, assets at the end of 1981 would have been an estimated $94 billion, almost four times actual assets of approximately $25 billion at that time. Had the social security funds been invested entirely in equities, their value would have been an estimated $637 billion. All the models that included some equities did better than those allocation models based on all governments or fixed income securities.

More recent performance indicates that if the social security funds had used flexible asset allocation strategies during the balance of the 1980s, the Social Security trust funds would have reached $343.4 billion in assets by the end of 1991, more than 22 percent greater than the $280.7 billion in assets listed in the Social Security Trustees 1992 Annual Report.

Although rising inflation increased long term interest rates sharply in the 1970s and the early 1980s, Perez-Malley demonstrated that strategies which included equities generally surpassed all-debt strategies substantially in spite of periodic negative equity returns in the 1940s, 1950s, and 1960s and the very severe bear markets for equities in 1973 and 1974 and in 1982. However, Congress decided in 1983 to leave the investment method unchanged and opted instead to raise additional funding of about $165 billion by the end of the decade through a combination of increased taxes and reduced benefits. Since that time, the social security current account has swung from deficit to surplus.

Support for a change to a more flexible investment theory has, however, gradually gained within governmental circles. For example, the Department of Labor in 1979 promulgated new rules under ERISA interpreting the "Prudent Man" Rule governing private pension fund investments so as to permit investments in riskier securities. In the preamble to the regulation, the Department noted that "the relative riskiness of a specific investment or investment course of action does not render |that~ action ... prudent or ... imprudent ... The prudence of an investment decision should not be judged without regard to the role that...action plays within the overall plan portfolio." In other words, the efficient market theory emphasizes the use of dissimilar assets to produce a satisfactory overall rate of return at an acceptable level of risk to achieve the goals of the fund. This is all in marked contrast to the requirement that the present social security funds be invested in U.S. Treasury debt instruments.

As stated at the outset, this paper projects the present assets of the combined social security funds into the future to see how well modern investment techniques utilizing asset allocation strategies might perform compared with the existing "governments only" strategy (See Table II). The present time presents an unusual opportunity for the adoption of a more flexible asset allocation program for the Social Security system. The huge surpluses growing out of the tax hikes of 1983, combined with the more favorable worker and economic demographics projected for the next quarter century, have created a major opportunity for the Social Security system. In effect, these projected "windfall" surpluses create the opportunity of developing a non-politicized system now for handling the fund's projected surpluses within a modern, flexible investment strategy.

Analysis and Interpretation

Table II includes a wide range of expected annual returns, and projects these results to the year 2070 starting with the actual assets of $280.7 billion in the system at the end of 1991. The tables project 15 separate hypothetical results reflecting the effects of three different economic conditions and five different compound rates of return on the portfolio. These projections are compared with the projected assets of the present social security system as set forth in the Trustees' 1992 annual report. Only under the most optimistic assumption (Alternate I) using the governments only investment policy does the social security assets actually survive for the entire 78 year period; under the two less optimistic assumptions, the system falls into deficit in 2036 (Assumption II) and as early as the year 2019 under the most pessimistic assumption (Assumption III).

On the other hand, the flexible asset allocation projections produced positive results in all but three of the fifteen projections, far exceeding the results projected by the Trustees for the present Social Security Trust Funds. Further computer simulations indicated that a portfolio with at least 40 percent allocated to common stocks with the balance in governments would remain solvent until 2070 under all three economic assumptions.

These hypothetical projections could be achieved if the portfolio were diversified into non-government securities. For example, assuming an asset allocation of one-third each in stocks, bonds and cash equivalents, James Farrell, in a study published in the Financial Analyst Journal, recently forecast an 8.6 percent per year return over the decade of the 1990s. Moreover, according to Ibbotson |see Table III~, corporates and common stock achieved rates of return in excess of 10 percent per annum during a recent 50 month period, with a standard deviation of about 3.5 percent per year. Over the past 50 years, corporate bonds have averaged 5.3 percent per annum and common stocks 15.6 percent with a standard deviation of 22.4 percent per annum.

Dennis Logue's comprehensive study of pension plan performance during the very volatile and difficult market years of the 1970s and early 1980s found that corporate pension plans produced an average return of 7.7 percent per year vs. 8.0 percent for a comparable composite market index during the fifteen year period from 1968 to 1983. Performance has improved markedly since then, however, as pension funds adopted more modern allocation strategies. According to data supplied by the Employee Benefit Research Institute, pension plan performance produced an annual average return of 15.3 percent, the same return as for the composite market index for the most recent seven year period ending 1991.|5~
Table 2
Projected Social Security Assets In 2070
(in trillions)
Ending Assets Based on Economic Assumptions:(*)
Social Security
Trustee Projections(**) $20.5 (exhausted (exhausted
 in 2036) in 2019)
Projections Based on Assumed Rates of Return:
6.0% $141.0 $30.1 (exhausted
 in 2030)
7.0% 269.9 89.8 (exhausted
 in 2036
8.0% 517.2 217.0 (exhausted
 in 2052)(***)
9.0% 991.4 480.4 $71.3
10.0% 1899.0 1015.4 296.5
* The economic assumptions involve the government's projections
of changes in the number of workers, price inflation, real-wage
growth, benefit payments, administrative over variables. The
economic conditions range from optimistic (Alternate I) to
pessimistic (Alternate III) with a less extreme middle forecast
embodied in Alternate II.**
** From 1992 Annual Report of the Social Security Trustees,
Table III. B. 2., 180.
*** At an 8.5 percent rate of return, the trust funds would
stay solvent until 2070 with asset of $15.5 trillion.

If nothing is done to adopt a flexible asset allocation strategy, the trust funds will become exhausted by the early part of the next century under two of the three economic scenarios. This will mean another wrenching round of tax increases and benefit cutbacks to bail out the system. The only way to achieve the high rates of return required to prevent exhaustion of the trusts funds is to include equities in the trust fund's portfolio.

Actually, the inclusion of equities in the Social Security Trust Fund portfolios is not as risky as it seems. Under all three of the trustees' economic scenarios, the Social Security System will produce net cash inflows for at least the next ten years under the most pessimistic economic scenario, and over the next quarter century under the most optimistic. These cash inflows will be sufficient to meet benefit payments with the excess available for investment in stocks and bonds. Since stocks have an enviable record in producing superior returns over long time periods--averaging 12.3 percent annually since 1926, nearly three times that of bonds--stocks are ideal for inclusion in the trust fund portfolio. Despite their higher short-term risks, stock performance over time has been far more consistent than their short-term volatility would imply. For example, in only two ten-year periods (1929 through 1938 and 1930 through 1939) did investors lose money in stocks; in the rest, 53 ten-year periods in all, stocks provided a positive return far greater than bonds. Therefore, with time on their side, the Social Security trustees can wait for equities to produce superior future results despite the fact that they are riskier than bonds in the short run.|6~
Table 3
Past Rates of Return and Standard Deviations
 Last 50 Months Last 50 Years
 Mean Standard Mean Standard
 Return Deviation Return Deviation
T Bills -.01% 10.0% 3.4% 3.1%
Governments 10.0 4.1 4.6 5.7
Corporates 11.0 3.4 5.3 5.6
S&P 500 14.0 3.8 15.6 22.4
Source: Ibbotson Associates as updated by the authors.

Converting the Trust Funds

In order to convert the Social Security Trust Funds to a viable, actuarially sound system, the authors propose the following:

(1) Congress should enact legislation directing the Trustees of the Social Security system to adopt a flexible asset allocation program for the investment of the trust funds along the lines of private corporation pension funds.

(2) To avoid any bias or conflicts of interest, the equity portion of the fund should be invested in an index of some broad market index, such as the Standard & Poor's 500 Stock Index. The Social Security System can maintain the mix allocating the fund's assets automatically among individual securities in line with the market index utilized.

(3) As with private pension plans, the social security actuaries should monitor future trends against past investment performance to adjust actuarial assumptions as conditions change. If investment performance exceeds the previous actuarial assumption, then social security payroll taxes could be reduced or benefits increased. Of course, taxes would have to be increased if the actuaries found that investment performance was less than the actuarial assumption. Under our legal structure, a system of automatic tax adjustments would require Congressional action, which while difficult to achieve would provide an efficient and responsive system for assuring benefits to participants.


After weathering the major crises experienced during the transitional years of the 1980s, the Social Security System now has surpluses expected for the next quarter century. Modern security research has demonstrated that the risks of holding equity investments are large over short time periods but decline when returns are stretched out over long time frames. Since the social security funds will have annual surpluses for the next twenty years or more, the timing is ripe for the introduction of a flexible investment program. A flexible asset allocation model, coupled with a long period of cash inflows, offers the possibility of gains that could result in significant benefits leading perhaps to payroll tax reductions or, alternatively, enhanced benefits to retirees.

By adopting a flexible allocation system, Congress would ensure that the Social Security System survives the economic fluctuations of the next century, and deliver decent retirement benefits at an affordable cost for participants.


1. David Boaz, "Privatize Social Security," New York Times, March 21, 1990, p. A27.

2. Christopher Whalen, "Mess With Social Security; Change It From Ponzi Scheme to Private Pension Fund," Barron's, March 4, 1991, p. 10

3. Boaz, op.cit.

4. Whalen, op.cit.

5. A critical assumption of asset allocators is that riskier common stocks will provide higher returns than less risky debt investments over the long term. Proponents point to studies which confirm that over 90 percent of long-term performance is attributable to the overall strategic allocation of funds. Accordingly, asset allocation models balance the risk/reward trade-offs among stocks and bonds and establish asset mix parameters to govern fund investments over five and ten year periods.

In its most modern form, asset allocators have developed tactical models, and pension funds are shifting increasingly to these programs. Tactical strategies rely on computer-run dividend discount models that evaluate a variety of critical market and financial data to project the expected return from stocks compared with bonds, and therefore where to allocate a fund's money. While tactical asset allocation strategies tend to underperform the market in rising markets, they significantly out perform the market when the market is falling, producing an overall net improvement over a complete market cycle. Within the framework of the strategic asset allocation plan, the tactical asset allocation decision determines the "tilt" to the asset mix.

Tactical programs have been available for two decades with the oldest, Mellon Capital, achieving an annual return of 15.7 percent for its model venus 12.7 percent for the Standard & Poor's 500 stock index over that period.

6. The traditional calculation of portfolio return and risk depends upon the correlation among returns, as well as the weights. Constructing portfolios consisting of different types of securities, eg: bonds, stocks and cash equivalents, demonstrates the benefits of asset allocation in smoothing out and improving the long-term performance.

The variation in the returns of the individual securities used in a portfolio will be greater than the weighted average of the variations in returns of each security in an actual portfolio. Consequently, putting many different securities with different risk variables into a portfolio decreases risk.

To avoid all risk, it would be necessary to construct a portfolio with little or no equities concentrating on cash equivalents. For example, a portfolio consisting of 90 percent T-Bills and 10 percent common stocks would have very little risk, 3.2 percent compared with 20.1 percent for a portfolio with a 90 percent weighting in stocks, but the riskless portfolio would produce a rate of return of only 4.6 percent over time; far less than needed to keep the trust funds intact. On the other hand, a risky portfolio with 90 percent allocated in stocks would produce a return of 14.4 percent over time, more than enough to keep the trust funds intact.


1. David Boaz, "Privatize Social Security," New York Times, March 21, 1990, p. A27.

2. Board of Trustees, Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds Annual Reports for selected years, Washington, D.C., U.S. Government Printing Office.

3. Employee Benefit Research Institute, EBRI Quarterly Pension Investment Report, Washington, D.C. (selected issues, 1984-92).

4. James Farrell, Jr., "A Fundamental Approach to Superior Asset Allocation," Financial Analyst Journal, May-June 1989, pp. 32-7.

5.Greenwich Research Associates, Large Corporate Pensions: Report to Participants. Greenwich, CT. (1977-90 issues).

6. Left Haanes-Olsen, Office of International Policy, Social Security Administration, Investment of Social Security Reserves in Three Countries, Social Security Bulletin, February 1990, Vol. 53, No. 2.

7. Roger G. Ibbotson and Rex A. Sinquefield, Stocks, Bonds, Bills and Inflation: The Past and the Future (as updated by authors). Charlottesville, Va., The Financial Analyst Research Foundation (1982).

8. Dennis Logue, et al. The Investment Performance of Corporate Pension Plans. Westport, Conn. 1989.

9. Robert C. Perez and Susan Malley, "Asset Allocation and Social Security," Financial Management, Spring 1983, pp. 29-35.

10. Christopher Whalen, "Mess With Social Security; Change it From Ponzi Scheme to Private Pension Fund," Barron's, March 4, 1991 p. 10.

Robert C. Perez is Associate Professor of Finance and Irene Hammerbacher is Professor of Finance at the Hagan School of Business, Iona College, New Rochelle, New York.
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Author:Perez, Robert C.; Hammerbacher, Irene
Publication:Review of Business
Date:Mar 22, 1993
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