Fixing Social Security
with Social Security IRAs
The President wants to alter Social Security to allow those covered by it to divert a portion of their Social Security contributions to IRAs. The attempt to sell this proposal to the American people will be made on the basis of average market returns over some period or periods of time. You should read my earlier posting entitled, Continuous Income Pricing , in conjunction with this piece.
Investment consultants have always touted average returns. And they always imply that given these averages, any investor can expect to receive similar returns on investments. But is this expectation ever justified?
To find out, you need to understand not only how to calculate an average, but how averages work. All averages work the same way; what they are averages of makes no difference. So consider the following very simple example:
What follows is a table constructed using the following axioms:
1. The number of terms is ten.
2. The sum of those terms is twenty.
3. The average is two.
4. To keep the example simple, only positive whole numbers are used.
Now there are only twenty-eight ways of combining ten positive whole numbers that yield twenty as their sum. Those twenty-eight ways are displayed in the following table, along with the number of terms that exceed the average, the number that match the average, the number that miss the average, and the spread between the largest term and the average.
#>2
#=2
#<2
Spread
1
five 3s
five 1s
5
0
5
1
2
one 4
three 3s one 2 five
1s
4
1
5
2
3
one 5
three 3s six 1s
4
0
6
3
4
two 4s two
3s six 1s
4
0
6
2
5
one 6
two 3s one
2
six 1s
3
1
6
4
6
three 4s one 2 six 1s
3
1
6
2
7
one 7
two 3s
seven 1s
3
0
7
5
8
one 6
one 4 one
3
seven 1s 3
0
7
4
9
one 5
two 4s
seven 1s
3
0
7
3
10
two 5s one
3
seven 1s
3
0
7
3
11
two 5s two
2s six 1s
2
2
6
3
12
one 8
one 3 one
2
seven 1s
2
1
7
6
13
one 7
one 4 one
2
seven 1s
2
1
7
5
14
one 6
one 5 one
2
seven 1s
2
1
7
4
15
one 9
one 3 eight
1s
2
0
8
7
16
one 8
one 4 eight
1s
2
0
8
6
17
one 7
one 5 eight
1s
2
0
8
5
18
two 6s
eight 1s
2
0
8
4
19
one 3
eight 2s one
1
1
8
1
1
20
one 4
seven 2s two 1s
1
7
2
2
21
one 5
six 2s
three 1s
1
6
3
3
22
one 6
five 2s
four 1s
1
5
4
4
23
one 7
four 2s
five 1s
1
4
5
5
24
one 8
three 2s six 1s
1
3
6
6
25
one 9
two 2s
seven 1s
1
2
7
7
26
one 10 one
2
eight 1s
1
1
8
8
27
one 11 nine
1s
1
0
9
9
28
ten 2s
0
10
0
0
60
54
166
280
0.214285714
0.192857143 0.592857143
2 in 10
2 in 10
6 in 10
4 in 10 6 in 10
This table allows us to draw some conclusions and also calculate some probabilities.
1. The number of terms that exceed the average is never greater than the number that miss the average.
2. The larger the spread, the larger the number of terms that miss the average.
3. Assuming that all of these 28 combinations have an equal change of occurring, the probability of
exceeding the average is approximately 2 in 10,
matching the average is also approximately 2 in 10,
missing the average is approximately 6 in 10.
So if someone tells you about the advantages of investing in the market because of some statement about average returns, tell him that only four in ten investors have a change of matching or exceeding it. The other six miss out.
But this, by any means, doesn't tell the full story. Market averages are calculated using the prices of equities bought in any specific period. But that a person pays, say, $100 for a specific stock doesn't mean the seller nets $100. In fact, he never does, because there are transaction fees and perhaps even taxes deducted from that purchase price. So the net return is always less than the selling price. How much less? We don't know, because transaction fees vary among brokers and taxes vary over time. Yet when dealing with retirement income, it's the net that people care about, because that's the amount of money they really get. And don't be fooled by the President's desire to make the tax cuts enacted during the previous term permanent. There is no such thing as a permanent Congressional action. Any future Congress can undo anything a previous Congress has enacted.
So predicting the amount of money you'll get from your Social Security IRA, say, fifty years from today can be likened to predicting what the weather will be on February 26, 2055. How trustworthy is such a prediction?
But even this doesn't tell the whole story.
Average market yields are calculated using nominal dollars. But the value of the dollar tends to fall over time. For instance, if the dollar's value in 1955 is taken as a base, the dollar's real or constant value in 2000 was only $0.12. That's a drop of 88%. So if we assume that you need a net income of $2,000 a month from your IRA to maintain your current standard of living, in the year 2055 you could need $3,760. So look carefully at how the average return is expressed. It can be expressed in different ways. For instance, it can be expressed as the return over an entire period or as the average yearly return over the entire period. But no matter how its expressed, you have to subtract the amount equal to the corresponding inflation rate from it to get the real rate of return.
Now, of course, someone's going to say that still, saving for retirement is better than not saving for retirement. And that's entirely true. The question that has to be answered, however, is this: Is investing in the market the best way to do that saving? Unfortunately, that question cannot be answered with any certainty. We do, however, know this: Some people do make money investing in the market, and some lose money investing in the market. So it would be helpful if we knew how many people netted more money in real dollars than they invested over various periods of time and how many didn't. Unfortunately those figures have either never been collected or never been made public. I wonder why?
Furthermore, there is good reason to believe that this scheme to allow portions of Social Security contributions to be diverted to IRAs has sinister motives. That reason is that neither the Congress nor the Executives of our nation have given themselves retirement plans that depend upon either Social Security contributions or the whims of the market. Their retirement incomes are fixed by laws that they themselves write and are funded from the nation's general fund. And oddly enough, many of these people don't even need retirement plansthey are already worth millions; some were worth millions the day they were born.
So my fellow Americans, be careful, for you are the ones who will pay for whatever the President and Congress do. What happens, be it good or bad, is not going to affect our lawmakers a copper cent's worth. They have guaranteed their own futures. Only yours are at risk. So ask yourselves, why, if our President and lawmakers think this is such a good deal for the country, don't they adopt it for themselves? Make the President and our Congressmen depend on Social Security for their retirement incomes and then see what happens to this proposal. I suspect everyone already knows what that result would be. (2/26/2005)
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