Why this 'big idea' to fix Social Security relies on a massive stock-market gamble

By Mark Hulbert

From a long-term perspective, the past 50 years of strong market gains are the exception rather than the rule

One plan is for the federal government to put $1.5 trillion in a trust fund that invests in stocks and other risky assets for 75 years.

One of the most dangerous things we can do when planning for our retirement is projecting the recent past into the indefinite future.

It's easy to understand why we might nevertheless do that, of course, since it's far easier to construct a secure retirement financial plan - on paper - if we assume that the stock market's impressive recent returns will persist. But in the real world, overconfidence about future stock-market returns puts us at grave risk of outliving our money.

I'm focusing on this perennial issue because solving Social Security's deficit is likely to be hotly debated in the new Congress. One proposal from several U.S. senators, which they refer to as a "big idea," is to have the federal government put $1.5 trillion in a trust fund that invests in stocks and other risky assets for 75 years, at which point the trust fund repays the U.S. Treasury (with interest) and gives the remainder to Social Security. The senators calculate that this would cover about 75% of the Social Security's projected funding shortfall over the next 75 years.

Crucial to their calculations, of course, is the assumed rate of return over the next 75 years. According to a Congressional Research Service analysis, the senators are extrapolating returns produced from 2003 to 2021. Though it's unclear why they would ignore the two centuries of U.S. history prior to 2003, there can be no doubt that an entirely different conclusion would be reached if all of U.S. history were used to project the future.

This is illustrated by the above chart of the U.S. stock market's inflation-adjusted price-only performance since 1793. You will notice that performance over the past 50 years has been far better than it was before that. For example, the stock market on this inflation-adjusted price-only basis was no higher in October 1982 than it was in September 1906. Ironically, this 76-year period is nearly equal to the 75 years in the senators' proposal.

If the next 75 years are similar to the 1906-'82 period, the stock market's inflation-adjusted total return will be equal to its dividend yield. That's not a very encouraging prospect, since the broad U.S. stock market is yielding less than 1% currently. In that event, the trust fund created by the senators' "big idea" most likely wouldn't have enough money in 75 years to even repay the U.S. Treasury - much less help overcome Social Security's funding shortfall.

Furthermore, this 76-year period is not the longest one in U.S. history in which the stock market went nowhere in inflation-adjusted price-only terms. As the chart shows, the stock market in these terms in 1953 was no higher than where it stood in 1793 - 160 years later. From this long-term perspective, the past 50 years are the exception rather than the rule.

Theoretical objections to extrapolating the recent past

To be sure, the senators have much of academic-finance theory supporting their confidence that stocks will outperform bonds over the long term. Because stocks are riskier than bonds, the theoretical argument goes, they should produce higher long-term returns to compensate equity investors for incurring that additional risk.

There's a sleight of hand in this argument, however, according to Edward McQuarrie, a professor emeritus at the Leavey School of Business at Santa Clara University in California. On the one hand, consider the consequences of admitting that stocks held for the long term are indeed risky. That would mean there's a significant probability they'll lose money over the long term. On the other hand, consider the consequences of denying that there is a significant risk of long-term loss. In that case, stocks' expected return would also need to be low.

McQuarrie says we can't have it both ways. And regardless of how you come down on either side of this dilemma, it's dangerous to bet the future of Social Security on the stock market.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

-Mark Hulbert

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