A Gift Suggestion For Paul Krugman

Paul Krugman frets about high brokerage fees ruining the returns on privatized SocialSecurity accounts.  Yes, this is an issue.  However, the scope of the problem can be exaggerated:

Decades of conservative marketing have convinced Americans that government programs always create bloated bureaucracies, while the private sector is always lean and efficient. But when it comes to retirement security, the opposite is true. More than 99 percent of Social Security's revenues go toward benefits, and less than 1 percent for overhead. In Chile's system, management fees are around 20 times as high. And that's a typical number for privatized systems.

Wow!  Twenty times 1% is... 20% !  Of course, "less than 1%" goes to overhead.  Per this summary, the figure for the base fund is about 0.6%.  And of course, a lot of that expense would not be affected by privatization, since it is associated with compliance, eligibility, and benefits to curent retirees.  But 20% is a nice, scary number (and yes, even 12% fund expenses would be ludicrous).

Now, readers in the NY area may wonder whether Chile is really the world leader in providing low cost financial services.  As they ride or drive to Wall Street or midtown Manhattan, it may dawn on them that there are other financial centres:

In Britain, which has had a privatized system since the days of Margaret Thatcher, alarm over the large fees charged by some investment companies eventually led government regulators to impose a "charge cap." Even so, fees continue to take a large bite out of British retirement savings.

A reasonable prediction for the real rate of return on personal accounts in the U.S. is 4 percent or less. If we introduce a system with British-level management fees, net returns to workers will be reduced by more than a quarter.

Hmm, now we are down to just over 1%.  Pretty good progress.  Can we get another bid?

Advocates insist that a privatized U.S. system can keep expenses much lower. It's true that costs will be low if investments are restricted to low-overhead index funds - that is, if government officials, not individuals, make the investment decisions. But if that's how the system works, the suggestions that workers will have control over their own money - two years ago, Cato renamed its Project on Social Security Privatization by replacing "privatization" with "choice" - are false advertising.

Well, allowing people to choose among different plans, as in a typical 401(k), is still choice.

And I promised a gift suggestion.  The Earnest Prof seems oddly uninformed on new developments in low cost index funds, so I suggest that one of his devoted followers buy him a subscription to Smart Money.  He can read about Exchange Traded Funds, and Sector Index funds, and I bet his jaw will drop.

Comments

[Patrick R. Sullivan]

And the system Krugman today is saying "works" he was describing as $10 trillion in debt in 'Fuzzy Math' (2001). He's now saying that we can fix what it ails it by taking money out of left governmental pocket and putting into the right governmental pocket. I hope the parents of Princeton econ majors appreciate the high quality education their kids are getting:

http://flyunderthebridge.blogspot.com/2004/12/walnut-shells-pea-and-paul.html

By the way, since SS isn't an investment vehicle it should have low overhead costs. The CBO has found that money market mutual funds have fees as low as 0.36%

[Paul Zrimsek]

While ETFs are great and I have most of my money in them, they're usually going to be a bit beside the point for private SS accounts; the average worker isn't going to incur a $10 commission every week in order to invest his $20 SS contribution, especially since ETFs don't allow for fractional shares. (Once he's been accumulating savings a while and wants to move a chunk of his savings on a one-time basis, he could very well open a brokerage account and buy a bunch of ETF shares.) The expense ratio of a conventional index fund is plenty low enough for anyone.

[Paolo Thompson]

While fees are generally lower in an index fund than in an actively managed account, do we really want to limit the choice to index funds? There are long periods of time where the index has not done anything, I believe the period from 1960 to 1980 is the one usually mentioned. There are low cost funds out there, such as the American Funds group, that consistently outperform the S&P 500. I say the more choices the investor has the better.

[Paolo Thompson]

Actually, the Dow opened at 1003 in 1972 and closed at 1004 in 1982, to clear up my previous post. It is also true that you would have earned dividends during this preiod, so the lack of change in the index is a little misleading. Full disclosure and all that.

[TM]

The ETFs could get expensive if traded in small and hectic size in individual accounts. However, products like that administered in a 401(k) framework could offer a wide range of low-cost choices.

For example, the Plan could offer a REIT index fund as one choice; individuals could choose that off of the investment menu.

[Joe Mealyus]

"In particular, the public hasn't been let in on two open secrets:

Privatization dissipates a large fraction of workers' contributions on fees to investment companies.

It leaves many retirees in poverty."

Another reason for a Kerry victory? I think if Kerry had won, but this issue was still coming up, Krugman would have written a column with none its current shall-we-say-curious content except for "[Britain's] Pensions Commission warns .... a lot of additional government spending will be required to avoid the return of widespread poverty among the elderly." Then he would have written a column discussing the actual details and pros and cons of how Britain's system has and hasn't worked. This is my belief.

[Ted Barlow]

I don't think that the expense comes from managing the pool of assets- as you say, index funds do that nicely with minimal costs, and even managed funds generally keep expenses under 2%. The expense comes from starting, administering, quality-checking and dispersing assets from 100-200 million little new accounts. If you allow users to actively trade with their assets, there's another large source of costs. It's going to be very, very expensive, any way you slice it.

[Jim Glass]

Krugman is so concerned about fees dropping returns from 4% to 3%, as per the British model, that he completely forgot to mention that returns in the current US model are *guaranteed negative*.

No doubt he couldn't fit it in due to the word count limit.

Nor could he fit in any mention of the functioning US model in the form of the The Federal Thrift Savings Plan, which manages private accounts for with a 0.1% expense rate -- good enough for government employees!

And one more thing: Krugman is either lazy or too busy to do a decent job.

Back when he started at the Times and first began making howling errors of fact, Smartertimes.com I think suggested that it was becayse the Times made a special exception for him and let him carry on a full-time job outside, instead of being a full-time columnist like all the rest of its op-ed people arew required to be. So Krugman relies on Google -- as Krugman himself has said -- and on other people's talking points instead of doing his own work.

This column is a good example. From my own clip files I can show that the entire column just rehashes talking points with these two examples that are a good ten years old, back to when the Advisory Commission of 1994 was examining private investments. And as to one of the examples, at least one subject of the Queen is asking, "Paul Krugman, ignorant or liar?" http://timworstall.typepad.com/timworstall/2004/12/paul_krugman_li.html

Since back then a good 20-odd countries have put personal accounts in social security one way or another. Does Krugman even know? Or is he pretending not to know because their experience is happy?

Surely if he had thought about it Krugman would have related *Sweden's* happy, efficient experience with 2.5% personal ss accounts holding real investments.

Oh, wait ... that would make it apparent that Swedish social policy is too right-wing for US Democrats.

OK, maybe he had a reason for not mentioning it. Never mind.

[TM]

As to how expensive this must be, it seems ot me that ost of the overhead is already in place. Currently, the SSA tracks funds, tracks eligibility, and even keeps track of "my account".

And, in his first sentence, Krugman seems to accept that the correct comparison is to a 401(k) (centrally administered, a few sensible choices, low cost) rather than self-directed IRAs. Bush said something similar at the conference:

THE PRESIDENT: One of the things on personal accounts that listeners must understand is that you cannot take -- if a personal account, in fact, exists, you can't take it to the race track and hope to really increase the returns. (Laughter.) It's not there for the lottery.

In other words, there will be reasonable guidelines that already exist in other thrift programs that will enable people to have choice about where they invest their own money, but they're not going to be able to do it in a frivolous fashion...

Finally, the Bush Commissionin 2001 recommended, as one alternative, something like the Federal Thrift Savings plan.

Now, starting a 401(k) is not exactly terra nova - many, many companies, as well as the Federal Government, already have them. Controlling costs shou;d not be that hard.

[David E...]

More about the 20%. I found an explanation of the 20% that seems reasonable to me. First, the 1% is not comparable to the .18% to 4% annual expense to run your total portfolio. The 1% is the 1 percent cost of the payments made each year. Evidently the Chilean operation costs 20%. This 20 times cost factor does not surprise me because payments out will be complex, and without a lot of expert computer system engineering the costs will be very high. The Devil is in the details.

[Patrick R. Sullivan]

"the Dow opened at 1003 in 1972 and closed at 1004 in 1982"

Yes, but that was because of the novelty, "stagflation". Once Modigliani pointed out to analysts that if they were going to discount profits for inflation they also had to discount corporate debt, the market took off in the 80s.

And Modigliani won the Nobel prize. So, we won't make that mistake again.

[Jim Glass]

"the Dow opened at 1003 in 1972 and closed at 1004 in 1982"

Ten years is not long-term investing.

One who started investing in the market in 1929 just before its collapse, and continued doing so all the way down during the worst days of the Depression and World War II and on, 40 years later in 1969 had made a rich profit indeed.

For the average couple at age 60 the investment horizon is still 30 years. And of course money that will be needed in 10 years or so can be kept in bonds.

SS accounts wouldn't be invested all in stocks any more than other kinds of retirement accounts are.

And as a side note about the Dow index number, it's risen only about 2% real annually over the long run, the rest of the 7% long-run average stock return being dividends, stock buy-backs, etc. So a flat market can be paying gains.

[Max]

I am glad to see Swedish socialism exalted on this site repeatedly by Jim G. I'm here to tell you that if we can have Swedish socialism for the U.S., I for one will happily accede to individual accounts for Social Security. Stöd arbetarna!

[Jim Edholm]

Vanguard Funds and American Funds run managed funds for less than 1% on total assets... and that's with the small amount of money in them today (relative to what would be in them if they got 4% of people's earnings). Krugman -- as usual -- blatantly ignores facts.

[Larry Hughes]

If government officials, not individuals, make the investment decisions, we are embarked on Hayek's "Road to Serfdom."