Ponder the Privatized Social Security Issue

Some of our leaders have definite ideas abouthow to fix or save Social Security. But presidentshave very little real ability to implementmajor changes, particularly given the vagariesof Congress. In a bolder, less politicized environment,consideration might be given to privatizing part or allof Social Security.

Privatization Pluses

There are several factors for supporting privatization.New money chasing a limited supply of equities hasa tendency to bid up prices. This results in significantcapital gains, which may or may not be taxable whenpaid out as Social Security payments. Price changes alsoimpact our investments in some way. New money canalso encourage new initial public offerings (IPOs) or follow-on offerings of existing equities. IPOs can be one ofthe most profitable investments in the equity market.

Historically, dividend-based investments, particularlygovernment bonds, tend to lose ground when inflationand taxes are considered, while growth stocks have averagedapproximately 10% to 12% per year over the longhaul. These effective rates of return could be skewed byseveral factors, not least of which is the tax basis ofSocial Security withdrawals.

The result:

Each pay period, money will flow into the equitymarkets, resulting in dollar-cost averaging on anunprecedented scale. Record keeping will be complicated.People will probably beforced into a buy-and-hold approach, withchanges only permitted on an infrequentbasis. Many public retirement fundsalready have personal investmentaccounts for their participants.

Reason to Be Wary

As there are two sides to everything,there are arguments to bemade against privatization. Real rates of return arenormally discounted to allow for both taxes and inflation,yet many Social Security recipients don't owemuch, if any, tax on their distribution. This makes thereal rate of return on debt-based investments muchhigher than if taxes are owed.

Eventually, this money that has been poured intoequities will be withdrawn. These withdrawals have thepotential to be massive as succeeding generations retire.Large capital outflow from equities have a tendency todepress prices in a very short time. The stellar performanceof equity markets over the late 1990s was a historicalanomaly. We must be wary that it is not reasonableto depend on this extreme upward trend.

If a large number of new IPOs are issued, clientswith unrealistic expectations could be severely andadversely impacted. There have been many de-listingsand major decreases in value of formerly hot IPOs.Since the investment options for privatized

Social Security accounts will likely besome form of mutual fund, the possibilitythat IPOs will be part of the holdingcannot be ruled out.

People are very unrealistic in theirexpectations about what equity marketswill do. Too often, they chasereturns and pull money out after amajor market downturn, and thenthey stay out of the market during recoveries. This cancause their investments to be worth far less than using dollar-cost averaging and buy-and-hold approaches.

Social Security is a pay-as-you-go system. Anythingheld in individual participant accounts is not available topay obligations to current retirees. Putting part of ourSocial Security contributions into an individual accountcontaining equities has a certain appeal. Congress and thepublic have many factors to consider. Partial privatizationof Social Security is both an interesting exercise and apolitical hot potato. Eventually, some changes are boundto take place. In the meanwhile, the debate goes on.

Ori W. Pagovich is a managing partner of

Gotham Financial Services in New York. He welcomes

questions or comments at 212-340-1050 or

212-253-4020 (fax).