Investor Beware:

It has become nearly axiomatic in this country to
argue that everything would be better if it were run like a business. In
response, government has shifted its mission: If it used to operate like Super
Glue, bonding Americans to one another, it is now working more like WD-40,
minimizing friction in the pursuit of individual (and corporate) profit.

Social Security is not only the largest government program but the
embodiment of the Super Glue approach to politics: the ultimate test case for
privatization. The Bush administration proposes to allow contributors to invest a
portion of their public Social Security pensions in the stock market. What a coup
that would be for the WD-40 contingent.

Privatization proponents rest their proposal on three claims: Social
Security funds are comparable to private investments, like iras; since most
Americans manage their own iras, there is no reason they shouldn't manage their
public pensions as well; and given the average returns on American stocks, we'd
all have much more money at retirement if we could take some of our Social
Security fund out of government bonds and put it into the stock market.

This shift could be interpreted as the financial equivalent of "bowling
alone," Robert Putnam's much-quoted phrase about the decline of community life in
the United States. Or you could think of it as the 401(k)-ification of America:
The defined-contribution plan has shifted our view of retirement into something
that is purely an individual matter, rather than a collective one.

A New York Times poll conducted earlier this year indicates that many
Americans are increasingly persuaded by these ideas. Despite the market downturn,
there has been a marked increase in the percentage of Americans who expect to
rely only on their own savings--rather than private pension plans or Social
Security--in retirement. Only 15 percent now believe that Social Security will be
a primary source of their retirement funds. As one survey participant put it,
"These decades to come are going to be more about what you do for yourself, as
opposed to what you allow other people to do for you. It's not pro-government,
not anti-government, just me myself and I." But while Americans may think they
are well prepared to give up a piece of their social safety net, the evidence
from recent economic studies suggests otherwise.

The prospect of higher returns is the main attraction of
privatization, despite the seemingly insurmountable problems of logistics, costs,
and implementation it poses. Belief in this claim seems to be curiously robust,
even in the face of the recent stock-market decline and attempts to explain the
costs, risks, and problems associated with privatization. People have dollar
signs in their eyes, and nothing seems able to dislodge them.

In part, this can be attributed to the increasing displacement of
belief in the public good by belief in the marketplace. The movements to bring
market forces to the management of public schools, Medicare, and electrical-power
transmission are among the most visible recent examples.

The central problem facing these hybrid public-private organizations is
"information asymmetry": Market forces can't bring efficiency if there are large
information differences among sellers and buyers. The classic example is the
purchase of a used car. The seller has more information than the buyer and has no
incentive to tell the buyer the truth. Therefore, the buyer may end up (1) buying
a lemon or (2) spending a lot of time and money on research, both of which offset
the savings from getting a "bargain" on the price.

When you introduce market forces into a formerly public service, you run into
all of these problems of information asymmetry and opportunism. Thus, the key
question for success in any hybrid is: Are citizens prepared to act as informed

In the case of Social Security, support for a privatized system rests entirely
(and often implicitly) on assumptions about public knowledge and competency with
regard to stock investing. But recent studies by economists and finance scholars
suggest that Americans really don't understand the risks associated with stock
investments and stand a good chance of doing worse financially under a hybrid
system than under the current one.

Risk, Return, and Transaction Costs

In the language of finance, the benefits of a privatized
Social Security system depend upon the "equity premium." This is the increased
return that investors can get for investing in risky securities such as stocks as
opposed to risk-free securities such as Treasury bonds. Investors are compensated
for assuming risk; the higher the risk, the greater the compensation.

During the century that just ended, the return on U.S. stock
investments has averaged about 11 percent per year. The U.S. Treasury bonds in
which Social Security funds are invested returned much less--averaging more like
5 percent per year. Offered a choice between the two investments, the answer
seems obvious: Take the higher return.

But of course there is a catch--two catches, in fact. The equity premium is
not guaranteed (if it were, there would be no risk). It is just an average
return, and some individual investors will actually lose money on stock
investments. Not only are the risks of any individual stock unpredictable, but
the historical-average return of U.S. stocks may not apply in a given time
period. A grinding bear market or high inflation around the time you retire could
mean that you have to cash out your portfolio when it's under water. In any case,
the historical-average returns involve periods much longer than the relevant
individual time frame, which is basically the 40-odd years between the start of
one's working life and retirement. That means many of us will not be able to
capitalize on long-range returns; as Keynes put it, "in the long run, we are all

A second, related catch is that once investors capture the equity premium,
they have to be careful not to give it away to their brokers. Trading stocks
incurs transaction costs: Each buy or sell order means paying a commission. These
costs can easily eat up all the gains from a profitable investment. Unless the
government wants to become the world's first no-commission broker, transaction
costs are going to be a serious issue in a privatized Social Security system.

The entire proposition that Social Security participants will come out
ahead financially in a privatized system depends on their knowledge of and ability
to manage investment risk and transaction costs. The evidence on this subject is
not encouraging.

For example, polls conducted to examine Americans' attitudes toward
Social Security privatization have shown that it is alarmingly easy to reverse
support for the proposal by simply mentioning risk. When questions about
privatization are phrased so that they don't mention risk, about 58 percent of
Americans support the proposal. But if the questions are rephrased so that they
mention risk in any way, the results are reversed: 59 percent of respondents
oppose privatization.

Studies of actual investor behavior support the polls. Ordinary individuals
seem to have a polarized response to risk; they become either very conservative
or very risk-seeking. Unfortunately, neither strategy is profitable. Though on
average risk is compensated by return in the stock market, some risks
don't pay off. Rather than being a linear relationship, in which more risk always
pays off with higher returns, the risk-return relationship is more like an
inverted U-shaped curve: Risks pay off up to a certain point, after which they
become a waste of money. As with gambling, most of the fun in investing consists
of locating that fine line between risks that pay off and those that don't.

Unfortunately, the vast majority of people guess wrong. Finance professor
Terrance Odean has found that the portfolios of average American households and
of investment clubs underperform the stock market by about 4 percent annually. In
addition, Odean found that Americans trade their accounts excessively, creating
high transaction costs. Apparently unaware that they were giving away their
profits in the form of commissions, American households turned over their
portfolios--that is, sold existing stocks and bought new ones--at the
astronomical rate of 75 percent per year. Investment clubs weren't far behind,
with a 65 percent annual turnover rate. At the end of the day, they mostly made
money for their brokers. There is no reason to expect that Americans would fare
any better or trade any less in a privatized system.

Of course, an ultraconservative approach to investing doesn't provide much of
an alternative. Several economic studies indicate that the populations most
likely to need Social Security in old age--people of color and women--are also
the least likely to benefit from a privatized system. For example, a study by
economists Nancy Jianokoplos and Alexandra Bernasek indicates that women invest
too conservatively, putting only 40 percent of their investment dollars into
stocks, compared with 46 percent for men. This conservatism doesn't pay off: If a
man and a woman start with equal amounts of investment capital (which is of
course a highly stylized assumption in itself) and invest it according to the
averages over a 20-year period, that 6 percent difference in allocation results
in the woman having 47 percent less money in her retirement fund than the man
has. Thus, conservative behavior in a privatized system may not result in more
retirement dollars for everyone. For the people who need a nest egg most,
privatization may be no better, and perhaps worse, than the current public

This difference doesn't have anything to do with innate characteristics of men
and women--or of blacks and whites--but rather with lack of exposure to
investment opportunities, such as working the kind of job where you get a 401(k)
plan that forces you to learn something about investing. That's how most
Americans got into investing in the first place. But the investing bandwagon that
swept the country during the 1990s left behind large numbers of women, people of
color, and the poor. To correct this problem, the government would have to create
a national investor-education program--an undertaking so costly that the Social
Security trustees warned against it in 1999, saying that the expenses incurred
would almost certainly outweigh the gains from privatization.

Privatization: Ready or Not?

Historically, Social Security has served multiple purposes, providing
savings, insurance, and income redistribution in a single program. Privatization
would shift the program away from redistribution and toward individual savings.
This is part of the larger trend toward distrust of government and detachment
from notions of the common good. In this sense, after years of erosion of
public-sector institutions and faith in their mission, Americans are well
prepared for a hybridized Social Security. More than 20 years of retreat from the
notion of entitlement has changed our expectations and led many of us to accept
the notion that we should individually bear most of the risk and responsibility
for funding our retirements.

But all of us are vulnerable to the possibility of bad luck. Privatization
would introduce a lottery-like element into the system that undercuts security
for everyone. There is no guaranteed profit in the stock market: Neither risk
seeking nor conservatism reliably pays off, and neither investment professionals
nor ordinary Americans have been successful at guessing where stock prices would
go. Americans may think that they know something about investing--remember when
everyone agreed that you couldn't go wrong in dot-com stocks?--but their
confidence, and the confidence of policy makers, is not supported by the evidence.

The evidence suggests that the people who would be most likely to see financial
benefit from privatization in the Social Security system are white, male, affluent,
and young. Unfortunately, recent polls indicate that these are also the people
most likely to say they don't need Social Security and would like to drop out of
the program entirely.

The end of Social Security in its purely public form would mean losses for
Americans that are not just economic but social. In abandoning the largest and
most popular public program that binds us together through its benefits, we would
lose an institutional and economic linchpin of our political community. When
stacked up against the uncertain financial gains from privatization, the benefits
of a public Social Security system look increasingly priceless.

Money and Moral Hazard

Those who favor an end to Social Security as we know it might
want to take another look at the repeal of the estate tax. The two policy
initiatives are linked by their conservative supporters as well as by timing: The
President's Commission to Strengthen Social Security, charged with developing a
privatization plan, met on June 11, just four days after President George W. Bush
signed legislation that will phase out the inheritance tax. The substantive link
between the two initiatives is less often noted: Both address the issues of
financial redistribution and personal responsibility.

Yet despite all that the two initiatives have in common, policy makers
seem to be heading toward diametrically opposed conclusions about them.
Apparently, it is wrong to get money from the government but good to get it from

A major argument for the privatization of Social Security is that the current
system creates "moral hazard"--harming recipients by giving them a perverse
incentive to avoid responsibility for themselves in retirement. By this logic,
the money that Social Security provides encourages workers to spend their
earnings rather than save for old age. Such programs, privatization proponents
argue, breed social pathology by rewarding laziness, incompetence, and an
entitlement mentality.

Students of wealth in America will find this list of character defects eerily
familiar: They practically constitute a job description for the heirs to large
fortunes, known colloquially as "trust babies" or (among twenty-somethings)
"trustafarians." Surely the moral threat posed by Social Security and other
government programs is rivaled only by the threat of trust funds.

Numerous writers on the subject of inherited wealth have noted the devastating
psychological consequences of inheritance, which seems to breed the kinds of
social pathologies among the very rich that conservatives worry about among the
poor and the middle class: lack of initiative or ambition, a sense of being
"owed" by others, and an inability to plan for the future or set goals. Nelson
Aldrich, Jr., heir to one of this country's fabled fortunes, has noted that the
beneficiaries of inherited wealth are often justly accused of being "weak" in
character, "degenerate," and " futility."

"Beneficiaries of Old Money," Aldrich writes, "never feel the bite of costs and
consequences....Their money enables them to be saved from many of the
consequences of their actions, and relatively speaking, from risk itself."
Substitute the words Social Security for money and you have the core
arguments of the Cato Institute and other hard-line proponents of Social Security

People who are worried about the moral hazards of Social Security and other
forms of government help should be trying to clamp down on inherited wealth as
well. They should be instituting the kind of confiscatory policies toward
inheritance that have been established in Europe, to reduce the social
pathologies associated with great wealth. The "help" provided by inheritance is
surely less defensible than that offered by Social Security: at least Social
Security retirement benefits are pegged to some sort of contribution to the
workforce, as well as a working lifetime of payroll taxes. Inheritance is just an
accident of birth.

This is a pressing issue, because concentrated wealth has increased so
dramatically that large inheritances today are no longer the province of a
stratospheric elite but of increasingly large segments of the population.
Whatever limitations the estate tax may have put on the moral hazards of
inheritance are now being eroded by President Bush's decision to start repealing
the tax. It was in recognition of this danger that 100 of the country's
wealthiest citizens--Warren Buffett, Steven Rockefeller, and William Gates, Sr.,
among them--spoke out publicly and vehemently against ending the estate tax. In
testimony before Congress earlier this year, Gates warned that repeal of the tax
would create "an aristocracy of wealth that has nothing to do with merit."

Conservatives were apparently unworried about the danger of inherited wealth
to our nation's moral fiber. So why are they worried about the "moral hazard" of
giving a few hundred dollars a month to retired workers? Personal responsibility,
in the Bush administration, seems to lie in finding an opportunity to inherit.
When Barry Goldwater ran for president and proposed repealing Social Security, he
was lampooned by the cartoonist Herblock, who showed Goldwater, heir to a
dry-goods fortune, lecturing two urchins: "If you had any initiative, you'd go
out and inherit a department store." At the time, Goldwater's views were widely
considered ridiculous. Today they are national policy.