In today’s WSJ, William Shipman and Peter Ferrara have a column criticizing President Obama’s recent and vehement rejection of Social Security private accounts. I agree with Shipman and Ferrara — it’s rather shabby logic from a president of all Americans.

Shipman and Ferrara correctly note that Social Security privatization options provide participants with a choice — opt for private accounts or stay with the traditional system. In other words, people can choose their preferred risk set — political or market. The lesson here is that there’s no avoiding risk.

Shipman and Ferrara suggest that all investments in private Social Security accounts do not have to be in stocks; people can choose bonds as well. Better yet, they can hold the market basket of all stocks and bonds through low-cost index funds and hold some cash. They can select the mix between these elements to optimize the risk-return trade-off given their abilities/​preferences on the two. This investment strategy is transparent and easy to learn; it requires only a modicum of financial literacy.

However, I find their “Joe the Plumber” example unpersuasive. Who cares if investing on the planet Mars yields 50 percent annual returns if we cannot do it unconditionally — that is, without incurring costs that would neutralize its higher-than-Social Security returns? Those additional costs arise from having to borrow to pay existing Social Security beneficiaries their “promised” benefits, and from carrying market risks on personal account portfolios of Martian investments. 

Market risk represents a real cost, even if investments are for the long term. The Shipman/​Ferrara calculations take account of the recent financial crisis. But they don’t take account of the potential for fat tails in the distribution of financial crises going forward. The recent crisis could have been less severe. But what if it had been more severe and had wiped out all savings for many more people? Is there zero risk of such an outcome? A generalization on the basis of just one 40-year record of investment returns is inappropriate and insufficient for ruling out the importance of market risk.

In the authors’ defense, however, is the fact that the historical evidence of market returns is conditional on the existence of Social Security (and Medicare and the rest of the government’s panoply of welfare programs, regulations, etc.). Without such broad and deep government interference in markets, the history of capital returns may have been different: returns may have been smaller (because the economy may have been better capitalized) but also more stable. And correlations between worker average wage growth and capital market returns may also have been smaller, yielding important diversification benefits from a privatized system of retirement saving. But the bottom line is that we just don’t have adequate data of the correct type to make the “analytical” arguments that the authors attempt in their op-ed. 

Shipman and Ferrara (jointly and individually) have never explicated this latter argument clearly. They persist with their “higher-and-sexy-market-returns” argument in support of private Social Security accounts. As such, I’m compelled to say that their argument continues to exhibit a real and serious deficiency.

On balance, however, when faced with two extremes — 1) political risk that the government will muck things up so badly that we and our children will suffer considerably reduced living standards, and 2) market risks that could devastate retirement savings because a recession/​depression wipes out the value of lifetime savings — I would recommend an “interior solution” that straddles both worlds. That is, continue a strictly limited government-run Social Security system and supplement it with a privatized element as many other countries have done, the UK and Australia being important examples. 

Some would say that we have such a system already, in the form of 401k, IRA and other tax-qualified saving plans. However, not all workers have access to 401k plans. And the evidence is that despite those plans, national saving has declined considerably over the last three decades. My analysis suggests that the reason for the decline in saving is the very existence of (supposedly) government-guaranteed Social Security (and Medicare) benefits that lull us into a false sense of security. The key shortcoming is the lack of a system of universal Social Security personal accounts wherein a minimum amount of saving is mandatory (despite government mandates being bad in general). Such a system would provide a vehicle for the rich and the poor alike to partake of the wealth creation process that capital markets can and do provide. 

We’re not there today, and the correct direction from where we are is toward, not away, from Social Security personal accounts.