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[Gene GeRue <genegerue AT ruralize.com>]

December 27, 2004, 10:05 a.m.

The Lesson of Thrift

Personal accounts already work (which might be why the critics are so scared).

Critics of the Bush administration plan to reform Social Security with 
personal accounts have a seemingly endless supply of reasons why it can’t 
possibly work. You know the litany: It’s too risky. It’s too expensive. 
It’s too complicated.

The critics never mention that there’s already a government-administered 
retirement system that has shown for over 15 years that personal accounts 
are prudent, inexpensive, and simple. It’s the Thrift Savings Plan of the 
United States federal government, currently serving 3.3 million government 
employees.

The years since Thrift was first offered in 1987 couldn’t make for a better 
laboratory to crash-test a personal-account system. During this period 
there have been both bull and bear markets that were among the most severe 
in history. Through year-end 2003, investments in Thrift personal accounts 
have earned $44.4 billion in profits for system participants — an average 
of more than $13,000 per participant.

Over time and on average, 65 percent of the value of Thrift participant 
accounts has been invested in a special money-market account operated by 
the U.S. Treasury. That’s been responsible for about $20.3 billion of the 
total investment gains. But almost as much — $19.8 billion — came from an 
S&P 500 Index fund. That’s remarkable because, on average, only 30 percent 
of the value of participant accounts has been invested in the S&P 500 fund.

This is a textbook lesson in why it makes sense to invest in equities. Even 
though they are riskier in the short-term, they have a higher expected 
return in the long-term. That’s why the S&P 500 fund has earned just about 
as much for Thrift participants as the plan’s money-market account, with 
only half the money invested.

Yes, after the bubble burst there were three difficult years for stocks — 
2000, 2001, and 2002. In those bear-market years, Thrift participants 
overall lost money in their accounts, with losses in the S&P 500 fund 
overcoming gains in the money-market account (as well as the third fund 
tracking the Lehman). But the non-stock funds did well in those years, and 
2003 was a great comeback year for stocks. (This year has been okay, too). 
So the least-lucky participants, those who started right at the top of the 
market in 2000, have already gotten back to even — on average — and those 
who started even a little earlier or a little later are solidly ahead.

How did Thrift participants react to the bear market? Not a bit like the 
scared rabbits that critics pretend the non-professional investors are. 
They didn’t dump right at the bottom; there were net redemptions from the 
S&P 500 fund in only 1 year — 2001. And when the market finally hit true 
bottom in the early spring of 2003, there were the biggest net 
contributions to the S&P 500 fund in Thrift’s history. Today, 43 percent of 
participant investments are in the S&P 500 fund (with another 10 percent in 
the other two stock funds).

And what about Enron? Don’t the critics always carp that gullible investors 
will lose their retirement fortunes in stocks, like Enron, that suddenly 
implode? Amazingly enough, any Thrift participant who invested in the S&P 
500 Index fund did indeed invest in Enron, because Enron was a member of 
the S&P 500 Index until it was removed in late November, 2001 (after all 
the damage had been done). But Enron was only 1 of 500 stocks, so its risk 
was diversified away, just like the textbooks say.

The use of index funds has other advantages too — advantages that perfectly 
answer the critics of personal accounts. For one thing, index funds are 
simple to understand. Thrift started with one for stocks and one for bonds 
— about as simple as you can get. Two years ago Thrift added two more funds 
— one for smaller company stocks and another for non-U.S. stocks. Still, 
it’s so simple that even the most inexperienced investor can get it.

And index funds are cheap to operate. As I discussed in detail in my column 
last week, investment management fees for index funds are ruinously small 
for the managers. And speaking of cheap, Thrift is a model of efficiency. 
Its administrative costs are only about six one-hundredths of 1 percent of 
invested assets. That compares especially favorably to Social Security, 
which has administrative costs that are more than five-times greater, even 
though you’d think its vast scale would lead to significant economies.

Index funds also have the advantage of being very resistant to meddling by 
government bureaucrats. Critics of personal accounts complain that any 
government-sponsored retirement system creates an irresistible temptation 
for politicians to guide participant dollars toward favored investments, or 
for politicians to grandstand by interfering with corporate governance. 
Indeed, all those things have happened in large pension plans sponsored by 
state governments. But there’s never been a whiff of it at Thrift. That’s 
because investment in simple index funds is clearly mandated in the 
legislation that created it — it would take an act of congress to permit a 
bureaucrat to funnel Thrift money into some pet investment.

Ironically, the Thrift Savings Plan — a perfect model of the future of 
Social Security reform with personal accounts — was created as part of the 
last round of Social Security reform. Legislation passed in 1983 as part of 
the reforms recommended by the Greenspan Commission mandated for the first 
time that federal employees participate in the Social Security system. The 
idea was to force millions of new young participants to move back the day 
when the demographic time bomb threatening Social Security will inevitably 
explode. As you can imagine, federal employees weren’t thrilled, and Thrift 
was part of a complex package of adjustments designed to make them feel 
better about it.

The Thrift Savings Plan proves that there’s nothing too risky, too 
expensive, or too complicated about personal accounts for Social Security. 
So what are the critics really worried about? I think they’re afraid that 
personal accounts are too empowering. Once a nation of voters becomes a 
nation of empowered investors — there’s just no telling what kind of 
empowerment they’ll want next.

— Donald Luskin is chief investment officer of Trend Macrolytics LLC, an 
independent economics and investment-research firm. He welcomes your 
comments at don AT trendmacro.com.

http://www.nationalreview.com/nrof_luskin/luskin200412271005.asp