By Jack M. Marco
Advocates of private accounts directed by individuals for a portion of their Social Security benefits should study the experience of Taft-Hartley defined contribution plans in the past decade.
The argument offered by advocates of private accounts is that individual investors, with their investment skills, will exceed the return provided by the Social Security guarantee. The experience of Taft-Hartley DC plans suggests otherwise.
These DC plans are savings plans that supplement defined benefit plans, thus completing the "three-legged retirement stool" of pension, savings and Social Security. The DB plan provides a certain benefit at retirement through advanced funding of employer contributions, and it is insured by the Pension Benefit Guaranty Corp. The DC plans are also funded through employer contributions, but the contributions are placed into individual savings accounts for participants. The amount available from the DC plan at retirement is dependent to a large extent on the investment return earned during the member's working career. The investment model leading up to the mid-1990s for the typical Taft-Hartley DC plan was for the assets to be managed collectively by the plan's board of trustees, with the assistance of professional investment consultants and professional money managers. Those trustee-directed investments produced a fairly consistent return of between 6% and 8%.
The booming stock market of the mid-1990s had some DC plan participants asking for higher returns. Rather than having the trustees manage the assets, they wanted control over their own accounts so they could earn more on their own. Most DC participants preferred to leave the current process alone, but in nearly every case, the proponents of separate investment accounts won the debate with their argument for "self-determination."
It sounded good, but the result was not so good because the average worker is neither comfortable with nor effective at making complex investment decisions.
The discomfort problem became apparent in the transition. Trustees offered a broad range of investment alternatives and allowed the participants to select the investment options for their individual accounts. Typically, only 20% to 30% of the participants actually made a selection, despite a series of mailings and educational meetings that described the alternatives and attempted to educate the members on risk and return. The vast majority opted for the default option — either a portfolio structure similar to the existing trustee-directed investment program or a very conservative portfolio.
Why? The answer was clear: The average worker did not feel comfortable making investment decisions and preferred to have decisions made by the trustees with professional advice. After all, this was the one leg of their retirement stool that was at risk.
Another problem became evident in the quarterly reports produced by DC plan administrators after the downturn in the stock market in 2000, which showed significant losses and, in many cases, caused delayed retirements.
Business schools refer to this problem as the odd lot theory. When institutional — that is, professional — managers trade stocks, it is typically in increments of 1,000 shares — "round" lots. Individuals trade in fewer shares — "odd" lots. The theory goes that if you study the trading activity of the odd-lot traders and do the opposite, you will be a winner. Why?
First, individuals get investment information after the "Street" has already acted on it. Second, individuals are emotional investors who, when they do make choices, select the option that performed best in the previous period and sell the class that lagged. Finally, they lack the important investment discipline to adjust to moving markets by rebalancing portfolios — trimming back the asset class that performed best and adding to the poorer performer.
For example, individuals who selected a 50% stocks/50% bonds balance for their individual accounts in 1996 watched that turn into a 65/35 mix as the tech boom developed. They did not sell stocks and buy bonds to get back to 50/50 before the market declined by nearly half in 2000-2002. At the bottom of this decline, most individuals abandoned stocks, only to miss the next move, a 30% gain in 2003 and 2004.
A typical example of this is shown by the asset allocations of a large DC plan Marco Consulting Group monitors for a client. The allocation to common stock funds for this group in 1997, as the rally began, was at 60.6%. It then rose to 71.2% at the market peak. After the market had bottomed, the participants had reduced their equity allocation to 47.9%. They bought stocks all the way to the top and sold them all the way to the bottom, proving once again the validity of the odd-lot theory.
The whole discussion of private accounts directed by individuals distorts the concept of the three-legged stool by blurring the distinction between savings and Social Security. In retirement planning seminars, I talk about the certainty of the DB plan and Social Security. In the ideal situation, the only risk facing the worker comes from the third leg of the stool, their savings — whether it is a DC plan or personal savings. Individual accounts for Social Security just adds to the risk at retirement. Imagine how long retirement would have had to be delayed if workers suffering through the tech bust had not only their savings at risk, but also their Social Security benefit.
The three-legged stool concept is fundamental to a secure retirement. Over decades, elected representatives have worked to make certain that two legs of this stool — pensions and Social Security — are protected and not at risk to the individual. Reducing the certainty of the Social Security benefit by expecting the average worker to make consistent, sound investment decisions is a mistake, as proven by the experience of Taft-Hartley DC plans in the last decade.
Jack M. Marco is chairman of Marco Consulting Group, Chicago.