Reform Is Good, But PSAs Are Not So Good

By ARTHUR LEVITT JR.
Mr. Levitt is a former chairman of the SEC.
April 26, 2005; 

President Bush's proposal to create private savings accounts out of traditional Social Security has inflamed political passions on both sides of the aisle. One perspective, however, has been shortchanged in debate: Although this may be the single biggest change in a generation in how Americans save for retirement, few have looked at the plan through the eyes of the investor.

One of the most remarkable developments that I have witnessed over my 40 years working in and around Wall Street -- a trend I saw accelerate during my tenure at the SEC -- was the opening up of our capital markets and the accompanying potential for wealth creation to millions of Americans. The president's Personal Savings Account plan promises to give millions more the opportunity to join this investor class. It stands to boost overall financial literacy and could encourage Americans to invest and save more.

But as any financial planner will tell you before committing to any investment option, a plan needs to be judged ultimately by its risks, its potential returns, and how the mix of the two fit the goals of an investor. As currently structured, the PSA plan avoids some of the pitfalls seen when the U.K. undertook a similar reform almost two decades ago. In particular, by limiting investment options and placing its administration in the hands of the federal government, this plan would curb the potential for excessive fees, fraud, and shady sales practices. In addition, by making the default investment for these accounts a life-cycle fund that is both diversified and adjusted to reflect an investor's changing tolerance for risk over their lifetime, the PSA plan decreases the likelihood that novice investors will make spectacularly bad choices.

Yet there are other, more fundamental, aspects of the PSA proposal's structure that merit serious concerns: The funds deposited in a PSA account are not free money. Every dollar you take out of traditional Social Security and put into a PSA must be paid back out of your Social Security benefit -- plus interest. If this sounds a lot like margin investing, it should not be a surprise since the PSA plan is modeled on that concept: A worker investing in a PSA would hope -- like a margin investor -- that assets accrued were greater than debts (money lent plus interest). If not, he would end up with a smaller Social Security benefit than if he stayed in the traditional system. To come out ahead, then, an investor would have to earn a rate of return that exceeds the interest of the loan, plus expenses.

Could one make this return within an acceptable degree of risk? According to a study by Robert Shiller of Yale, the answer is: not that often. Using adjusted stock market data to reflect the expected decreases in future market rates of return, he found that investors would do worse in the default life-cycle portfolio of the PSA accounts than in traditional Social Security 71% of the time, leaving an average worker with $2,000 less in annual benefits. Even if one opted out of the default and decided to invest entirely in stocks, this riskier strategy would not guarantee coming out ahead: Prof. Shiller predicts a worker would lose money 33% of the time.

Borrowing against one's Social Security to invest in the markets is a risky strategy that would only make sense for certain high net-worth investors who can afford to lose their entire investment. Prof. Shiller's calculations demonstrate that for the majority of workers who make less than $50,000 a year, the PSA is not a good investment not just because the odds of coming out behind are high, but also because these investors very likely may have nothing to fall back on if they lose that money.

While I do not think that his PSA plan is a good deal for investors, opponents must give President Bush credit for bringing this discussion about Social Security's future to the fore. There is a long-term financing problem, and we should make the tough decisions now so our children won't have to. We also should follow his call to encourage Americans to save and invest more, and there are steps we can take to do this that do not imperil Social Security's solvency:

• First, by switching the default option for 401(k) participation to automatic enrollment, we could boost participation in these plans to between 85% and 95%. Also, we can steer workers out of risky and costly investments and boost retirement savings for millions by setting the default investments for 401(k) plans to low-cost, diversified index funds -- a smart way to begin.
 
• Second, for those who are not offered 401(k)s, the IRS should permit taxpayers to split their tax refund into more than one account. As the Brookings Institution's Retirement Security Project notes, with the average tax refund amounting to about $2,000 or 5% of median income, refunds can be a large source of savings. Right now, taxpayers can have the IRS directly deposit a refund into one bank account. Yet, many people need a portion of this money immediately so they choose to save none of it in a retirement account. By allowing taxpayers to split their refunds, we would enable them to deposit a portion in a checking account to cover immediate expenses and a portion in a tax-preferred savings account for retirement.
 
• Third, Congress should make it easier for companies to provide unbiased, third-party financial education. Currently, most employers avoid giving investment advice in order to avoid exposing themselves to fiduciary liability. Congress should explore clarifying the provisions of the Erisa law to encourage employers to provide much-needed, non-conflicted investment advice.
 
These proposals to boost retirement savings enjoy bipartisan support. Congress should move on solutions such as these, and then work on a separate track with the administration to devise a plan of sensible changes -- such as increasing wages subject to the Social Security tax, adding newly hired state and local workers to the Social Security system, or improving the long-term fiscal health of the country -- that can guarantee Social Security's solvency for decades to come.

I have spent a good deal of my life encouraging Americans to become investors, yet I don't believe Social Security is the way to do so. For me, this is a financial question as much as it is a philosophical one. As a society, are we prepared to replace the basic, guaranteed retirement benefit of Social Security with the potential of greater risk and -- to be fair -- greater reward of an investment account? Let's keep Social Security intact, and at the same time, encourage more Americans to invest for their retirements. We can do both.