Academic journal article Chicago Fed Letter

Investing Social Security Trust Funds in the Stock Market

Academic journal article Chicago Fed Letter

Investing Social Security Trust Funds in the Stock Market

Article excerpt

By 2022, Social Security outlays will begin to outstrip its revenues. Because of these deficits, the Social Security Trust is expected to run out of cash in 2034 (see figure 1).1 The source of this problem is Social Security's PayAs-You-Go structure, whereby beneficiaries are paid, not from their own accumulated deposits, but from the contributions of workers who are currently depositing money into the system. As large numbers of the babyboom generation retire, a small number of post-baby-boom workers will be supporting the pensions of this large population.

To avert the predicted bankruptcy, there are three options: 1) increase revenues by increasing the payroll tax and the earnings cap, 2) reduce benefits, and/or 3) increase the rate of return on funds in the Social Security Trust. In this Chicago Fed Letter, we take a closer look at the third option, increasing the rate of return on Social Security funds.

Under current law, the funds that remain after benefits have been distributed are stored in the form of risk-free Treasury securities. In recent history, however, equity investments have significantly outperformed Treasury securities. For example, the afterinflation annual return on Standard & Poor's 500 stocks for the 1947-96 period was 9.5%, while that of longterm Treasury bonds was only 1.8%.1 This difference in returns between stocks and Treasury bonds is known as the equity premium. Capitalizing on the equity premium by investing in stocks has been proposed as a painless way to prolong the viability of Social Security and is the impetus behind many reform packages. Currently, there are three House bills and two Senate bills of this type pending in the 106th Congress. The White House has also informally presented its own reform plan incorporating equities.

The reform plans fall into four categories. The first category comprises plans that dismantle the current Social Security system and replace it with personal retirement accounts.' With these plans, workers are allocated individual retirement accounts in which to deposit a percentage of their earnings. They can invest these funds in a selection of preapproved mutual funds or portfolios offered by precertified institutions. Upon retirement, individuals receive annuities based on their account balances.

The second category maintains the Social Security system but allows for a small part of workers' earnings to be deposited into individual accounts.4 These proposals are modeled after the Federal Retirement Thrift plan available to federal employees. Funds in individual accounts can be invested in preapproved mutual funds, and individual Social Security benefits are reduced by the amount diverted to the personal accounts.

The third class of proposals does not allow for individual accounts but permits the Social Security Trust fund to invest in stocks. An independent board would be established to oversee investments.5

Finally, there is a hybrid type of plan that allows for both individual accounts and a limited amount of investment of the Trust in the stock market.' As with the first two types of plans, individuals can invest money in their individual accounts in preapproved funds, and their Social Security benefits are reduced accordingly. In addition, a prelegislated percentage of the Trust fund would be invested in stocks.

The issue of stock market risk

The above review of the proposals shows that the reformers advocate two ways of increasing returns of Social Security deposits-allowing individuals to use their deposits to invest in the market and permitting the Trust fund to invest directly. Both of these types of proposals make two important assumptions that should be examined more closely.

The first assumption is that investment in equities will generate higher returns than investment in government bonds. While it is true that, historically, the average equity premium has been quite large, these high equity returns do not come without 1st. …

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