Social Security's Equity Investment Prohibition: Why?

Social Security funds are currently invested solely in U.S. Treasury bonds. However, as these funds are projected to run out in the next decade, there is a growing discussion about whether these monies should be invested in equities to prevent a funding shortfall. While investing in stocks could increase returns and reduce the need for tax hikes or benefit cuts, it also introduces financial and political risks and could interfere with private markets.

Political influence and interference in private markets

To address these concerns, some have suggested that the government take a passive role in investing Social Security funds in equities. This could involve tracking a broad market index and legally requiring investment neutrality to ensure no interference in corporate decision-making. The Federal Thrift Savings Plan, a retirement plan for public employees and military personnel in the US, is cited as a potential model for this approach. In this plan, the government selects the investment options but does not influence the market or corporate decision-making.

However, even with safeguards in place, there is still a risk of political influence and interference. For example, the government could face pressure to bail out individuals who experience substantial losses in the stock market. Additionally, investing Social Security funds in equities could lead to distortions in the market, such as increased management fees and competition with private wealth managers and investors.

Ultimately, while there are potential ways to mitigate the risk of political influence and interference, it is a significant concern that must be carefully considered in the discussion about investing Social Security funds in equities.

Management fees and competition with private investors

Allowing Social Security to invest in equities would incur management fees, which would ultimately be funded by taxpayers. These fees would be required to pay the salaries of fund managers and other professionals involved in the investment process.

Additionally, there is a concern about competition with private investors and wealth managers. If Social Security funds were invested in the stock market, the federal government would become a major player in the market, potentially influencing corporate decision-making and competing with private investors for ownership of stocks. This could lead to distortions in the market and reduce opportunities for private investors.

Some have suggested that the government could take a passive role in investing in equities, such as through index funds, to minimise the potential for interference in the private market. However, even this approach may not be enough to alleviate concerns about competition and market distortions.

Furthermore, allowing Social Security to invest in equities could send a signal to the public that trading bonds for stocks is a way for the government to create "magic money". Critics worry that this could encourage individuals to take on more risk in their own investment portfolios, potentially leading to negative consequences if the market were to experience a downturn.

While investing Social Security funds in equities could potentially lead to higher returns and reduce the need for tax hikes or benefit cuts, it is important to carefully consider the potential drawbacks, including management fees and competition with private investors.

Increased taxation or borrowing to offset macroeconomic benefits

The reduction in general revenues resulting from redirecting Social Security funds into stocks would require increased taxation or borrowing, which would largely offset any macroeconomic benefit. This is because any financial asset is someone else's financial liability. Transferring financial assets from the private market to the government's balance sheet does not increase the net wealth or productive capacity of the economy.

Moreover, borrowing money to invest in stocks for retirement is a risky move, and it is not smart to do so on an economy-wide basis. While a 4% or 5% risk premium can make a big difference over a 30- to 50-year time horizon, there's no guarantee that these terms won't change along the way. This could interfere with Social Security as a guaranteed government program.

In addition, the likelihood of raising taxes to rebuild the trust fund is low, and borrowing to do so does not guarantee any additional resources for Social Security. With costs scheduled to level off, it is hard to argue that today's workers should pay more to build up a trust fund so that tomorrow's workers would pay less.

Furthermore, if Congress is unwilling to raise taxes enough to create a meaningful trust fund, how about borrowing? One proposal suggests that the government borrow about $1.5 trillion and invest those funds in stocks, private equity, and other instruments that offer higher expected returns than interest on government debt. In the meantime, the government would also borrow to cover Social Security's shortfall. After 75 years, money from the trust fund could be used to repay the borrowing that went towards paying benefits.

However, this proposal differs fundamentally from the approach in Canada, which involves actually contributing more money to build up a reserve fund for the future. In contrast, creating a trust fund on borrowed money, which the government must repay with interest, means that the only proceeds are any earnings in excess of the interest paid on the bonds. Fixing Social Security requires real economic changes—cutting benefits or increasing income. This proposal offers nothing except the chance to pocket the return in excess of the bond rate.

Risk of financial loss

Investing in the stock market is riskier than investing in government bonds. Stocks are riskier than government securities, and the additional risk is compensated by higher expected returns. Introducing stocks to the Social Security investment portfolio would increase the overall risk of the portfolio.

While stocks have historically offered investors a better expected rate of return relative to safer assets, such as Treasury bills or bonds, this higher return comes with greater risk. The standard deviation of S&P 500 annual returns was 19.8%, compared to just 3.1% for Treasury bills and 7.8% for 10-year Treasury bonds. Investing in stocks introduces the possibility of substantial losses, and the potential for a market collapse or a prolonged bear market poses a significant danger to the Social Security fund.

Moreover, there is no guarantee that the historical rates of return on equities will continue in the future. As stock market prices are currently extremely high, we could expect several years of lower-than-average returns for equity investors. Therefore, the potential benefits of investing Social Security funds in the stock market are uncertain.

Furthermore, if Social Security funds were invested in the stock market, taxpayers would ultimately bear the downside risk in the event of a sustained drop in the market. This scenario seems inconsistent with the purpose of Social Security, which is to provide a safety net.

Additionally, investing in equities could lead to interference in private markets and send the wrong signal that trading bonds for stocks creates "magic money". Critics fear that equity investment by the government could distort the stock market and corporate decision-making, and create the impression that the government can get rich simply by issuing bonds and buying stocks.

Finally, borrowing money to invest in stocks for retirement is a risky move, whether for an individual or a government. It is essentially a bet on stocks versus bonds, and it is not a smart strategy.

Demographic changes and benefit cuts

The Social Security program faces a funding crisis due to shifting demographics. The aging baby boomer population is resulting in an increasing number of beneficiaries, with 10,000 individuals turning 65 every day. This demographic shift is causing concern about the program's long-term solvency. As a result, there are discussions about potential benefit cuts or tax increases to address the funding shortfall.

The prospect of benefit cuts has sparked interest in exploring alternative investment strategies for Social Security reserves. One proposal suggests investing a portion of the reserves in equities to take advantage of the potentially higher returns compared to safer assets like Treasury securities. This approach could reduce the need for significant tax hikes or benefit cuts in the future. However, critics argue that investing in equities involves greater financial and political risks and could interfere with private markets.

Additionally, there are concerns about the feasibility of investing Social Security reserves in equities at this point. The trust fund is rapidly heading towards depletion, and there is reluctance to raise taxes to rebuild it. Borrowing to invest in equities is seen as a risky proposition, and critics argue that it may not provide any additional resources for Social Security.

In conclusion, demographic changes and the potential for benefit cuts have driven discussions about alternative investment strategies for Social Security. While investing in equities could potentially reduce the need for future tax hikes or benefit cuts, there are concerns about financial and political risks, interference with private markets, and the feasibility of implementing such a strategy given the current state of the trust fund.

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