Social InSecurity: Looking for Answers in the Equity Markets.

The U.S. Social Security system is expected to be technically insolvent by 2034 or before. Would investing the Social Security trust funds in the U.S. equity markets be a panacea?

Despite President Clinton recently abandoning his longstanding call to invest some of the Social Security trust funds in the stock market, the debate continues. And FEI's Committee on the Investment of Employee Benefit Assets (CIEBA) participates in the discussion. CIEBA recently commissioned research on the impact of various trust fund investment proposals on the U.S. financial markets from four firms: Goldman Sachs, INVESCO, Morgan Stanley Dean Witter and J.P. Morgan Investment Management. The results were presented at "ERISA at 25: Applying the Experience to Social Security Reform," hosted by CIEBA and the Employee Benefit Research Institute.

Perry Johnson, COO of INVESCO Global Strategies, was asked, "Are we already doomed by our demographics?" Here's what he said.

Demographics vs. Economics

Since 1984, as baby boomers hit their prime earnings and savings years, ages 40 to 60, they've had a profound positive impact on our financial markets and the economy. As their retirement savings increased, so did the aggregate equity allocation of all U.S. investors. This, in turn, produced above average returns and significantly increased the size of the equity market relative to the economy. From 1980 to today, for example, the equity market has provided a real rate of return (the return above inflation) of about 13 percent - more than twice its historic average.

This positive impact should continue until 2006, when the ratio of prime savers to the overall population will peak at 36 percent. Then the positive effects on the market will reverse as boomers retire and the cohort moves from being prime savers to dissavers. Above-average equity allocations will slip toward average, then below, as the group's risk tolerance falls. The size of the equity market relative to the rest of the economy will dip below average; market risk premium relative to inflation will rise above average.

The market's forward-looking risk premium (the real return above inflation) is now 3 percent. The proxy we use to estimate its future real return is the current earnings yield (e/p) for the S&P 500, based on the notion that earnings derive from real assets and so should provide a real return above inflation. Historically, the earnings yield has averaged about 6 percent, equal to the market's...