Common Sense on Social Security
An Independent Resource on Social Security Reform Options

An overpriced stock market can soak up more investment from Social Security, but its long-run returns are certain to be somewhat lower. An underpriced stock market is sure to have much higher returns, but it won't be able to absorb as much Social Security investment.

The Stock Market's Size/Return Paradox
Steven H. Johnson, Director
Common Sense on Social Security

There's a big secret hiding in the background of the Social Security debate. The stock market isn't really the huge sock under the mattress that some conservatives believe it to be. In fact, the stock market is rooted in paradox. The larger it grows today, the smaller its profit potential over the long run. Conversely, the greater its long-run profitability, the smaller it has to be now. Call this the Size/Return Paradox.

Here's how it works.

The total size of stock market is connected to GDP (gross domestic product). Nothing surprising here. After all, stock prices are ultimately based on expected growth in corporate revenues and corporate earnings, values which in turn are nested within GDP and closely linked to expected GDP growth rates.

The comparison between total market capitalization and total GDP is an indicator worth watching. From 1925 through 1995, total market capitalization relative to GDP averaged a moderate 65%, with the Market Capitalization-to-GDP ratio slipping to 35% at its low point, and climbing to 105% at its high.

Also connected to GDP is the total volume of dividend payouts to stockholders. This volume typically runs about two and a half percent of GDP, regardless of what's happening to stock prices.

Weave these together and the paradox begins to materialize: When stock prices and Market Capitalization-to-GDP ratios are low, dividend rates rise. For example, when dividend payouts are 2.5% of GDP and stocks are 35% of GDP, the dividend yield rate can hit 7.1%. (2.5 35 = 5.7) The stronger the dividend yield rate, the faster investors can grow their portfolios with reinvested dividends. And the stronger the compound growth rate for stocks will be, a point that's critically important in Social Security calculations.

Conversely, when stock prices and Market Cap-to-GDP ratios are high, dividend yield rates turn anemic. When stocks are worth 100% of GDP, the dividend yield falls to two and a half percent. Compound growth rates for investors shrink accordingly.

For seventy years, with moderate stock prices and healthy dividend yields, an investor's real return potential in the stock market was quite good. Seven percent returns were available to anyone who regularly invested in an S&P; 500 Index Fund and reinvested all dividends. On an inflation-adjusted basis, S&P; stock prices grew 2.3% a year. Dividend yield rates averaged 4.6% a year. Those who reinvested all dividends were, therefore, likely to earn real returns of seven percent a year. (Mathematically speaking, 1.023 x 1.046 1.07.)

Moderate price levels and high dividend rates were the essential ingredients of seven percent real returns on the S&P; 500 portfolio. These two ingredients were, on average, just what the stock market served up to investors from 1925 through 1995. Call this the "Small but Profitable" stock market scenario.

Now let's examine the implications for Social Security reform. Suppose, for argument's sake, that Social Security reform results in the creation of PRA's (Personal Retirement Accounts) for all employees. One percent of your salary is deposited in your PRA, and invested exclusively in stock index funds. Your PRA grows during your working years, and is then drawn down when you retire.

As your PRA savings grow, what kind of returns are you likely to enjoy? Three percent? Five percent? Seven percent? More?

And, importantly, what percent of the stock market will end up belonging to the nation's PRA's? Neither question can be answered without first making a guess as to the future size of the stock market. Will conditions in tomorrow's stock market once again comply with the "Small but Profitable" scenario?

If the "Small but Profitable" scenario does hold, your all-stock PRA will earn seven percent returns. At retirement, if you've been stashing your one percent into your PRA for at least forty years, your accumulated investment will be worth 130% of your final year's salary. Not a bad return on one percent of your earnings.

And total PRA assets will likewise be quite substantial. Added all together, the total value of all stocks held in Personal Retirement Accounts would equal 31% of total GDP. In the "Small but Profitable" scenario, however, recall the stock market's average value: 65% of GDP. And then compare the two magnitudes.

A total stock market worth 65% of GDP. PRA-held stocks equaling 31% of GDP. The result is startling, is it not? A seemingly trivial one percent of payroll, when invested solely in stocks, would enable Social Security-inspired PRA's to soak up nearly half the stock market!

Now imagine the alternative. In the "Larger but Less Profitable" scenario, the Market Cap-to-GDP ratio is double its historical average. Stock prices remain high for decades to come. Dividend yield rates are, therefore, half what they used to be. The long term investor is lucky to earn returns of five percent.

The second scenario is no fantasy. Relative to GDP, today's stock market is indeed worth more than twice its historic average. Dividend yields have indeed been hammered.

What happens in the second scenario? When you retire, your accumulated investment isn't nearly as large, equaling only 75% of your final year's salary. Total stocks accumulated in all PRA's are worth somewhat less as well, equaling only 20% of GDP in value.

Given that the Market Cap-to-GDP ratio is much higher in this scenario, PRA's collectively own less than a sixth of the total stock market, a much smaller amount than in the first scenario.

One-sixth of all stocks is not so bad. The PRA total ownership factor is no longer quite so intimidating. Unfortunately, the return factor has taken quite a hit.

The Size/Return Paradox is gravity. There's no escape from it. A larger market absorbs investment more readily, but delivers lower long run returns. A smaller market delivers better returns, but can't absorb nearly as much investment.

The implications for Social Security? In the overheated imagination of the modern conservative, Social Security is totally replaced by a universal system of PRA's. But this, it must be said, is only a fantasy. PRA-based stock investments can safely finance about a fifth of Social Security's long run benefit obligations, but that's about the limit. And the more overpriced the market is, in years to come, the less we can expect from PRA's.

Common Sense on Social Security
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Revision Date April 13, 2006