Investing the Social Security trust fund in stocks rather than bonds would be a bad idea.
That’s because equities don’t always outperform bonds over the long term. Social Security could very well end up in worse financial shape if its trust fund is invested in stocks instead of Treasury bonds, in which current law requires it to do.
Proposals to invest some or all of the Social Security trust fund in equities are not new, of course. The occasion to revisit these proposals now is the release earlier this month of the latest actuarial analysis of the Social Security trust fund, which showed that it, unless something changes, Social Security will only be able to pay 77% of scheduled benefits beginning in 2034. Policy options for overcoming this shortfall have focused on either payroll tax hikes or cutting benefits, or some combination of the two.
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Neither of these options is politically feasible, of course, since increasing taxes is considered political suicide and cutting benefits—reneging on the government’s promises—is no less politically toxic. Investing the Social Security trust fund in equities is attractive because it appears to offer politicians an escape from the horns of this dilemma. If the trust fund can earn sufficiently more from stocks than bonds, then neither payroll taxes will have to be raised nor benefits cut.
My argument against these investing-Social-Security-in-stocks proposals is not that stocks are more volatile than bonds. That point has been made many times before, and it is of course true. But supporters of these proposals have a comeback: So long as you hold on for a long-enough period, they argue, stocks almost certainly will outperform bonds. And since funding Social Security is a long-term proposition, stocks’ short-term volatility shouldn’t pose an insuperable obstacle.
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But this is where the supporters of investing-Social-Security-in-stocks proposals are mistaken: Stocks don’t always outperform bonds, even over the long term. Most supporters of investing-Social-Security-in-stocks proposals are guilty of extrapolating only one portion of U.S. history, unwittingly ignoring other periods in which stocks performed less well, relative to bonds.
I base these objections on research conducted by Edward McQuarrie, a professor emeritus at the Leavey School of Business at Santa Clara University, in which he created a database of U.S. stock and bond returns back to 1793. McQuarrie found that there have been three distinct periods in U.S. market history, of more or less equal length, and stocks’ returns relative to bonds were different in each.
These differences are plotted in the accompanying chart. Notice that only in the most recent period, represented by the blue columns, has it been the case that the probability of stocks outperforming bonds grows with the holding period. As you can see, there has been no 30-year or 50-year period since 1943 in which stocks underperformed bonds.
Contrast that experience with the 1794-to-1862 period, represented by the red columns. Notice that, in that period, the odds that stocks would outperform bonds went down as holding period increased. In fact, at the 30-year and 50-year horizons, according to McQuarrie’s data for this period, there was just a 1% chance that stocks would outperform.
The period between these two extremes, from 1863 to 1942 and represented by the green columns in the chart, exhibited yet another pattern. Now there is no relationship between holding period length and the odds that stocks would outperform bonds. Even at the 50-year horizon during this period, for example, there was only a 50% probability that stocks would outperform bonds.
These widely varying odds of stocks outperforming bonds puts in a new light the anxiety many feel about Social Security’s finances. They tear their hair out worrying about the possibility that Social Security would only be able to pay 77% of scheduled benefits beginning in 2034. And, yet, many of them simultaneously propose investing the Social Security trust fund in stocks, which would translate into a far greater degree of uncertainty than exists under current financing arrangements.
In an email, Professor McQuarrie reminded us that supporters of the investing-Social-Security-in-stocks proposals aren’t just guilty of ignoring the pre-World-War II experience with U.S. stocks and bonds. They also are guilty of ignoring the return histories of other countries beside the U.S. That’s a big oversight since, as a general rule, those other countries’ long-term equity returns have been significantly lower than those of the U.S.
The bottom line? When focusing on the entire history of U.S. stock and bond returns since the birth of the U.S., we can see that invest-Social-Security-in-stocks proposals are unacceptably risky. And when we expand our focus to include the full history of stock and bond returns outside the U.S., we discover that these proposals are even riskier.
We should discourage our elected representatives from thinking they can solve the Social Security deficit by shifting the trust fund into stocks.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.