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Social Security Fix: Migration to Equities

|Includes: KBE, KCE, T. Rowe Price Group, Inc. (TROW), XLF

The problem with reforming Social Security is that it is a confused debate. This is partly a function of Social Security’s size, scope, finance, mission creep and administration since its origin in 1935. In reality, Social Security is effectively the largest insurance operation in the world.

An Insurance Business: The integrity of the Social Security retirement component is based on sound business decisions relating to implementation of actuarial assumptions of its “risk pool”. Simply put, what is the correct premium versus the benefits provided? The corollary to that question is: do you raise premiums or cut benefits?

The Dilemma: In 2024, Social Security benefit costs will exceed Social Security’s tax revenues and Trust Fund income. The program will need to redeem its bonds held by the Treasury to pay benefits at current levels. In 2037, the Trust Fund will be depleted. Social Security will then be able to pay only 78 cents on the dollar.

Key Questions: In a delightful 28 page “cheerfully illustrated” pamphlet put out by the Center for Retirement Research at Boston College, entitled The Social Security Fix-it Book[1], the pros and cons of increased costs or lower benefits are neatly laid out. However, to effectively answer that query the pamphlet poses several key questions in an effort to frame the issues central to a reasoned decision.

1.     “Do we want to keep benefits more or less as currently set? If so, how should the burden be shared? a) By all workers equally, or primarily by those better-off? b) By workers alone, or by taxpayers generally?

2.     Do we want to keep taxes more or less at current levels? If so, how do we cut benefits? a) Target workers with higher benefits? b) If we cut across-the-board, how do we assure people that they won’t fall into poverty in their old age?

3.     Should each generation going forward pay much the same tax and get much the same benefits? a) This requires the current generation to build up a large Social Security Trust Fund that would probably invest in equities. b) Or should our children and grandchildren, who will be richer and live longer, pay much more or get a much smaller benefit?”[2]

A Social Security “Fix”: As more late-seniors become dependent on Social Security benefits as a primary source of income (Social Security accounts for 70% of household income for 70% of the households headed by someone over the age of 80), cutting benefits may be “wrong-headed” and the federal government may just be shifting the burden to another of its agencies.

More Premium, Please: The more likely outcome is: a progressive payroll tax approach, lower benefits for higher wage earners, a long-term rise in the ages of full retirement, and—like the private pension funds—the long-term migration to a full or partial defined contribution retirement system. If we do move to some element of a defined contribution system, then it is likely such funds will be eligible to be invested in equities.

Investment Managers Benefit: The net beneficiaries of a move by Social Security to allow equities as part of the asset mix would be asset managers. One could play an individual investment manager like T. Rowe Price Group, Inc. (NASDAQ:TROW). TROW is a well-run, independent, low leveraged, multi-asset investment manager with a “foot” in the retirement plan business. It is also one likely to be a take-over target.

Another alternative is an ETF like SPDR KBW Capital Markets (NYSEARCA:KCE). KCE invests in the KBW Capital Markets’ Index which in turn owns broker-dealers, asset managers, trust companies, custodian banks, and securities exchanges. KCE is small with less than $50 million in net assets and its average 3 month daily trading volume is 82,898. Larger but less focused on asset management companies are SPDRs Select Financial Sector ETF (NYSEARCA:XLF) or SPDR KBW Bank ETF (NYSEARCA:KBE).

Caveats: The likelihood is that policymakers will end up doing nothing material to change Social Security. Accordingly, in 2037 benefits will be reduced and trail-off further with time. (This is “someone else’s problem”.)

The likelihood that equities will become an eligible asset for Social Security is fairly low. However, even if they don’t, there will be a continued push to relieve SS of its future obligation by encouraging private solutions to the retirement income dilemma.

Joe Eqcome (Disclosure: Long XLF)

[2] Ibid

Disclosure: I am long XLF.

Additional disclosure: I may be buying KCE on any pull back