The privatization of any social program always brings a hot debate between conservatives, liberals and, well, anyone in the middle. Many free market minded individuals think Social Security should be privatized while liberals say no way. Who is right and is it even possible to privatize such a huge chunk of the Federal pie?
First, let’s answer whether or not Social Security could be privatized. The answer is simple, it cannot be and privatization will never, ever happen. Why? Anyone who has been alive for more than 15 years knows that the federal government takes a nice chunk of your paycheck for FICA, basically Social Security and Medicare/Medicaid, but what they do not know, usually, is that the Social Security portion does not go where you might think. There is no actual account for your Social Security benefits, instead you build up credits and your payout is determined by the age at which you retire. The size of your check will vary some depending how long you have worked and how much you put into the system. This is a very 30,000 foot view.
You receive credits into your Social Security account and not a “cash balance” report because there is no cash actually in your account. Believe it or not the government borrows against Social Security assets all the time and gives you an I.O.U. instead. The Social Security Administration is now cashing in some of those I.O.U.s because they are now broke. You should know this because it means that if the cash flow into Social Security was ever stopped, the whole house of cards would come crashing down. In effect, your entitlement program is the largest Ponzi Scheme in the history of scams. It is for that very reason Social Security will never be privatized because all of the lies would be exposed. But, what if we could privatize it?
Is it a good idea to privatize Social Security? That is a complex question and I am inclined to say yes, but with severe limitations. I do not think it is a great idea to put it into an account with only equities because people do dumb things when equities are involved. I believe that using a deferred income annuity product would be the best option or some other type of account that has guarantees attached to it. An income annuity would give the investor much higher lifetime income than you might think. I am also inclined to believe that insurance companies would create a product that would create a greater stream of lifetime income than what Social Security could ever provide.
However, I think some products should never be considered as an investment option. I believe products that involve higher fees should be excluded such as equity index annuities and variable annuities. I am a believer in variable annuities, but I feel that the current product fees are too prohibitive to make them a suitable option; a new one would have to be created. I am not a believer in equity index annuities, call me crazy but monthly or daily averaging which intentionally lowers the rate of return is not a good idea and then throw on caps, yields or spreads and you have a product that is just not good. I am sure someone will disagree with me about indexed annuities, but that is their opinion and I have not seen a product I actually like. Plus when you exclude the dividends for these products, it will drastically underperform the market rate of return. In short, these types of insurance products, which I am sure are valuable, are just too complex for a self directed Social Security account and I do not have faith in the government to choose the best products if it is allowed.
I think a hybrid product with a living benefit, which would pay out 5% for as long as the owner lives regardless of account value, might be a decent option. They have a lower cost compared to a variable annuity, but provide similar lifetime income guarantees. These accounts also would mandate an asset allocation model that would have to be adhered to or all guarantees are off. Contrary to belief, asset allocation did work throughout the market crisis. Yes, you took a loss even in a diversified portfolio, but a balanced fund only lost 19% and has a standard deviation of 12.7, not bad.
If privatization of Social Security were to happen, it would lead to bad products being created since the government has no sense of what is and what is not a good investment for people. It would also lead to great confusion by investors since many have no idea how any type of guaranteed products work or their drawbacks. There is also the possibility that if/when we have another meltdown in the markets, the losses incurred by investors would bankrupt insurance companies or whoever is offering guarantees. It is clear that traditional pension funds have not worked; the taxpayer is already making good on those guarantees, which leads me to believe that any type of equity investment options is simply a bad idea.
The only feasible option for privatizing Social Security would be using a traditional income annuity. The risk is manageable and the returns are predictable as well. However, this is all a moot point because it will never, ever, happen simply because if the government did not receive that income from your paycheck they would fold. While I think some investors would benefit from this, the larger population would not and the only real winner would be Wall Street, as usual.