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February 11, 2005


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» Social Security from Eric's Random Musings
Okay, let's get something straight. None of the prior political deals worked out for Social Security have achieved solvency. All any of them have done is to delay the day of reckoning by a few years. Remember the hoorah over Social Security a few yea... [Read More]



And this is a perfect example of why none of this should be done by the government. A free market is a perfect example of individuals and chaos coming together to do something that centrally managed economics cannot do. We should do away with Social Security entirely and leave the decision up to the individual.


Index Funds / Index Tracking Funds / Enhanced Index Funds/ Dynamic Index Tracking Funds.....
There are in reality a plethora of strategies available to a fund manager seeking to follow a benchmark index. The real question is how does a Fund Manager first generate his exposure to the benchmark and then hedge his various risks. That is to say, does he or she seek to actually "hold" the index, or does he or she seek to synthetically recreate the index using baskets of derivatives.
If the index funds covered by this seek to replicate the benchmark index by holding the consituents, then in lay terms there should be no problem. The wall of money seeking homes in those eligable indices will drive prices for a while and the amount of money seeking rebalance by a change in the constuents of an Index will drive volatility over a short time horizon after an announcement of a change in the make-up of an index.

The Stochastic RETURN process will not be affected by this long term.

One factor of the volatility of the indices affected, their gamma risks and the memory effects that have been shown to exist in volatility time series, is the leveraging of an index by holders of derivatives written on that index. Even without this proposed legislation, the value of derivatives written on underlying financial assets far exceeds the capitalisation of those assets by several factors. This, coupled with increasingly homogenous views on Risk Management (VaR Limits/Delta and Gamma Limits etc) mean that once a "Jump Event" occurs momentum is achieved very quicky and correlation risks multiply enormously. But this situation is already given. So long as the majority of the money is placed in funds seeking to replicate by holding, then there would be little increase to the volatility characteristics of a major index.

I guess interesting things could happen to the yield gap. But I would guess that so long as the legislation covers Equity AND Bond Indices, all that will happen is that the absolute curves shift shift roughly in parallel.

The strength of liquidity in the US Financial Markets is largely underpinned by the Pension and Mutual Funds. All this would do is release a wall of liquidity in a one off effect. The markets would clear this liquidity fairly quickly without causing major structural changes.

It would be interesting to research the effects of being taken out of a target index after this legislation becomes operative: But then the effects may well then depend on whether or not Enhanced Trackers fall within the act.

The strength of liquidity in the US Financial Markets is largely underpinned by the Pension and Mutual Funds. All this would do is release a wall of liquidity in a one off effect. The markets would clear this liquidity fairly quickly without causing major structural changes.

For those interested in this I d suggest you stop by at the SSRN website (http://papers.ssrn.com) search for abstracts on "Index Funds" or "Index Tracking." Their collection of papers on Quantitative Finance is a very useful resource.


I ll stay out of the political and ethical debate as to whether or not social security should exist in the first place. It's not my country. Only one observation, there is NO way a direct transfer system of social security will ever work in the US - It doesn't work in Europe. So IF you ARE going to have a social security system: This is not such a bad idea.


If the investment options are limited to index funds, there is no reason that the SSA should not continue to operate as the investment manager of the trust fund. Government managed programs (Canadian halth care, Social security, etc.), operate with extremely low administrative overhead compared to private fund managers. This is particularly true in cases, such as this where the range of investment options is limited and selection relatively easy.

Brad Warbiany

Private index funds are also very efficiently managed. A standard actively-managed mutual fund will exist with about a 2% expense ratio. Most index funds, on the other hand, have about a 0.2% expense ratio: i.e. they are managed with 10% of the overhead of an actively-managed fund.

David Foster

If the investments are to be in an index fund representing a "balanced" portfolio of stocks & bonds, there are still many decisions to be made, viz:

1)stock/bond ratio...opinions as to what is "balanced" at the moment probably swing from 80/20 stocks-to-bonds to 20/80 at the other extreme..not to mention decisions about maturities and fixed/floating rate emphasis for the bond portion

2)just US stocks in the index, or international stocks as well?...a case could be made that returns are likely to be higher in countries now entering an accelerated development phase

3)should the stocks be weighted by market capitalization (as most indices are)?..some have argued that this tends to give undue weight to stocks that are overpriced, and that the weights should instead be based on business indicators like net income.


I believe the reason people favor index funds is because the management fees are very low. In Chile and England, the returns on private accounts have been lower than expected because of high management fees, and this has been a problem for the lowest paid workers.

I think the main effect of these retirement accounts would be to bring added stability to the market. Certainly 401K and IRAs have already done this. People are less likely to pull their money in and out of stock funds in 401K or IRAs when the market goes up or down, so this tends to dampen the fluctuations in the market. Also in 401Ks money frequently continues to flow into stock funds, even when the market is going down. The same would be true of these SS private accounts.



No argument on the fee structure of private index funds. I a own a number of them myself. My primary point is narrower.

We don't want to allow private money managers to make the funds available to the private account holders, and take a 5% commission off the top. If the SSA simply makes 5 funds available for purchase (at no cost), that would significantly enhance returns and avoid at least part of the Chile problem.

Alternatively, the SSA could simply invest some portion of the payroll taxes it takes in a social security index fund to give the trust fund some of the benefits of equity appreciation. Of course, this approach would not achieve the goal of the Bush administration (and many here) of dismantling Social Security as a safety net.


Anonymouse111 wrote: "Of course, this approach would not achieve the goal of the Bush administration (and many here) of dismantling Social Security as a safety net."

Nicely done Anony. You have managed to cast the debate into emotional terms that guaruntee that someone will oppose this because you have scared them rather than whether it is a good or bad idea.

The truth is that SS is not a "safety net", some 40% of the population depends on it as their main or sole source of retirement income. As if that isn't bad enough, far more than half the population will get a significant portion of their retirement income from SS. This isn't a "safety net", it's a pension program. A safety net is a mechanism that kicks in to protect someone when bad things happen to them. Unemployment is a great example of a safety net. The truth is that those folks depending on SS for a significant portion (or all) of their retirement income would be much better off with market rates of return for their 6 and a bit percent of their income that are forced to invest. And the economy would be better off for it as well, since that money would be in active circulation as investment capital, rather than being siphoned off and used as "good money after bad" by the Federal government.

SS should be dismantled in any case, but your emotional argument is the typical scare tactics of the left.


Wait a minute Eric. You're the one arguing that "some 40% of the population depends on it as their main or sole source of retirement income." Without Social Security that 40% would not have the means to stay out of poverty. THAT is the very definition of a safety net.

Your assertion that a safety net only "kicks in to protect someone when bad things happen to them" is a nonsequitor. For many who rely on Social Security to stay out of poverty, that reliance is the result of bad decisions, i.e. it is their fault. For others, it may have been an exogenous event, i.e. it is not their fault. But in both cases something "bad" has happened that prevented them from putting away enough to finance their retirement.

I max out my 401k precisely because I don't want to rely on a safety net. But that doesn't mean that Social Security doesn't serve that purpose, or that I, ultimately, won't need to rely on Social Security for that purpose.

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