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What Will Happen to Social Security after the Election?

“Never let the facts get in the way of a good story.”  This adage may be a good rule of thumb for entertaining guests at a dinner party, but when employed by candidates for public office, it can lead to frustration and confusion.  This fall, for example, many Americans have been trying to make sense of the presidential candidates’ proposals for Social Security and have been wondering whether the next president might enact policies that would jeopardize their expected benefits. 

Both candidates have told “good stories,” promising not only to sustain the current Social Security system but to facilitate additional benefits, in the form of increased Social Security payments (Biden) or reduced taxes (Trump) for certain segments of the population.  What are the facts about the candidates’ plans, the changes that are likely to be made, and whether Americans should be concerned about the future of Social Security?  We attempt to sift through the rhetoric and provide some answers, concluding that while the Social Security system remains in need of significant attention, Americans have reason to feel optimistic that they will be spared of any drastic changes to benefits— not because of, but rather in spite of, the candidates’ campaign promises.

Campaign Promises.  In typical campaign fashion, Joe Biden has proposed changes to Social Security that could best be described as… overly optimistic. In addition to shoring up the Social Security trusts, he has pledged to pursue increased benefits for:

To pay for these changes, Biden has proposed collecting Social Security payroll taxes on all wages over $400k.  (Currently, the amount of wages subject to Social Security payroll taxes is $137,700.)  While this would have a positive impact on cash flow for the Social Security retirement trust, it certainly would not cover both the current shortfall as well as Biden’s proposed changes.

Based on the Republican party platform, Donald Trump also claims a strong commitment to shoring up the current Social Security system.  However, recent policy actions have called that commitment into question.  In August, he announced that payroll taxes could be deferred from September through December of this year, and he called on Congress to forgive those payroll taxes in the interest of stimulating the economy.  He has also suggested that payroll taxes could potentially be eliminated in the future with funding for Social Security coming from the “general fund” (i.e. income taxes) instead.  Fortunately—from the standpoint of Social Security funding—Congress did not enact the payroll tax holiday that Trump had requested.  While the federal government ceased collecting payroll taxes from its workers starting in September, few other employers did, since it seems likely those taxes will have to be repaid by April of next year (according to the IRS).  Like Biden’s proposals to expand Social Security benefits, Trump’s payroll tax holiday idea stands in stark contrast with the stated commitment to ensure adequate funding for Social Security benefits under the current system, especially given that the Social Security trust funds have already taken a significant hit this year with increased unemployment (and thus decreased payroll taxes) since March.

Likely Changes to Social Security.  As evidenced by Biden’s campaign promises and Trump’s efforts to eliminate payroll taxes, there appears to be relatively little political will for the type of Social Security reform that would extend the life of the Social Security trust funds in a meaningful way.  However, the refusal by Congress to grant Trump the payroll tax holiday this fall suggests that at least Congress has recognized the impossibility of having it both ways— winning short-term popularity with increased benefits and ensuring the long-term stability of the Social Security system.  What changes to Social Security are we likely to see, therefore, in the next four years?  Relatively few.  Even considering the impact of COVID-related unemployment on the Social Security trust funds, we still have several years, possibly still more than a decade, before the trust funds are scheduled to run out.  In 1983—the last time Congress enacted major Social Security reform—the trust funds were scheduled to be exhausted in a matter of months.

Concerns about the Future of Social Security.  We have often told our clients that compared to other policy concerns, Social Security is a relatively easy problem.  It’s simply a math problem, which the president and Congress can solve if and when they have the political will to solve it.  And it may take an imminent crisis, as was the case in 1983, to generate that political will.  However, the major reform in 1983—and the minor reforms in 2015—should give retirees some peace of mind in considering who is likely to be impacted by potential changes to the system.  Those most impacted by the reforms were 1) those still working, and 2) those in a high-income tax bracket in retirement.  Changes in 1983 included:  accelerating scheduled payroll tax increases for those still working, increasing the retirement age (gradually over the subsequent decades), and imposing a tax on Social Security benefits for those with income over a certain threshold.  The changes in 2015 eliminated two Social Security claiming strategies but grandfathered in those who were already retired or close to retirement.  In both cases, the government generally aimed to avoid hurting retirees that were already collecting Social Security benefits and could not afford to have the value of those benefits diminished in any way.  We would expect the same to hold true for Social Security reforms in the future.

As we discussed in Part 1 of this post, we at PFS advocate holding diverse stock portfolios—including growth and value stocks, large and small company stocks, U.S. and international stocks.  The distinction between large and small as well as U.S. and international stocks is fairly straightforward and easy to understand.  Many investors, however, are not familiar with the difference between growth and value stocks.  Appreciating the difference (and investing on both sides of the spectrum) could positively impact your portfolio’s volatility and long-term returns.  It could also make you think twice before jumping on the bandwagon of certain U.S. large growth companies, whose prices have skyrocketed in recent years.

Comparing Growth and Value Stocks.  In discussions with clients, we often describe value stocks as belonging to companies that have fallen out of favor or are not in their prime (right now, e.g., oil companies and airlines are a good example).  However, many value stocks are simply companies from which investors don’t expect much growth, but they do expect slow and steady profits (e.g. utilities, car manufacturers).  For example, Toyota would be a value stock, while Tesla would be a growth stock.  Investors expect more future growth out of Tesla.  They expect Toyota to continue selling a lot of cars and making a profit but do not anticipate significant future growth.  In terms of financials, value companies often pay higher dividends (whereas growth companies reinvest more of their profits into the company), and value companies have a comparatively low price-to-earnings ratio.  In other words, the price of the stock is low relative to the amount of earnings that the company has generated in the past year. 

Why Invest in Value Stocks?  Proponents of value stocks argue that value investing just makes logical sense:  if you pay a lower price for something relative to what it’s worth, you can expect higher returns in the future.  Importantly, value stocks also have a strong track record over the long-term.  From 1928 to 2019, value stocks have outperformed growth stocks by over 4 percent annually on average in the United States.  As we demonstrated in Part 1 of this post with respect to small company stocks, there are significant periods of time in which value stocks outperform growth stocks, which is the practical rationale for holding value stocks.  (The same can be said of investing in international stocks versus U.S. stocks, as we discussed in a blog post a few years ago.)

What Does This Mean for Prices of Growth Stocks?  As mentioned above, one piece of information that financial analysts use in determining whether stocks should be considered growth or value is the stock’s price-to-earnings (PE) ratio.  Evaluating PE ratios also may give investors pause right now about investing in particular stocks, including some of the U.S. large growth companies whose prices have soared in recent years.  Returning to the example of Toyota versus Tesla, Toyota currently has a PE ratio of around 8, whereas Tesla has a PE ratio of 1,099.  Therefore, the price of Toyota assumes that the company is worth 8 times the amount of its annual earnings, while the price of Tesla assumes that it’s worth 1,099 times the amount of its annual earnings.  Is Tesla worth that much?  Will it grow enough in the future to merit such optimism?  Perhaps.  But investors have good reason to buy up the Toyotas of the market too, just in case the Teslas of the market don’t live up to the lofty expectations built into their current stock prices.

As any long-time client of PFS could hopefully tell you, we advocate holding diverse stock portfolios—including growth and value stocks, large and small company stocks, U.S. and international stocks.  Holding a diversified portfolio helps lower the overall volatility of the portfolio, and it generally leads to higher investment returns over the long term.  The past few years have tested some investors’ faith in the benefits of diversification across asset classes, however, since U.S. large growth companies have outperformed small, value, and international stocks.  In particular, the surge in the price of tech stocks (such as Apple, Microsoft, and Amazon) has left some investors wondering whether the 100 U.S. large companies of the Nasdaq—or perhaps the 500 U.S. large companies of the S&P 500—are all they need or want in their portfolios.*

Why Bother with Small Company Stocks?  The academic rationale for investing in small company stocks is two-fold.  First, they do tend to be more volatile than large company stocks, so the market rewards investors with greater returns over the long run since they are taking on more risk.  Second, given their size, small company stocks have greater prospects for growth.  Small company stocks are often defined as those with a market capitalization (i.e. total value of their outstanding shares of stock) under $2 billion.  Apple, Microsoft, and Amazon all started out as small company stocks.  The magnitude of growth that those companies have experienced in the past decades cannot be replicated in the future because their value would surpass the size of the global economy.  So, with a diversified portfolio of small cap stocks now, investors may benefit by holding shares of the next big thing—the Apples, Microsofts, and Amazons of the decades to come. 

The practical rationale for investing in small company stocks is that they have higher average returns over the long-term and have performed better than large company stocks over significant periods of time.  This has not been the case lately, but it remains true (even today) if you zoom out to include a longer time frame.  See the charts below for a visual depiction of this trend.  Chart 1 tracks the performance of the Nasdaq 100 (purple), S&P 500 (light blue), and Russell 2000 (dark blue) over the past 10 years.  As mentioned above, during this time period, the U.S. large company stocks in the S&P 500—and particularly, the U.S. large company stocks in the tech-oriented Nasdaq 100—performed better than the 2,000 small and mid-size U.S. companies in the Russell 2000 index. 

Chart 1:  September 2010 to September 2020.

However, turning back the clock another decade, Chart 2 shows the performance of these three indices over the previous 10 years—with the small company stocks in the Russell 2000 significantly outperforming those in the S&P 500 and the Nasdaq.

Chart 2:  September 2000 to September 2010.

What if you put the two time periods together?  Even with the recent surge in prices for many of the tech stocks in the Nasdaq, the performance of the small company stocks in the Russell 2000 is nearly equivalent to that of the Nasdaq 100 over the 20-year time frame, and both indices outpace the S&P 500 by a significant margin, as shown in Chart 3.

Chart 3:  September 2000 to September 2020.

What will the future bring?  At PFS, we continue to believe that small company stocks will perform well over the long term, but we will not try to outguess the market and determine exactly when their growth will accelerate beyond the recently impressive returns of U.S. large company stocks.  (That type of active management typically hurts investment returns over the long term.)  The first few weeks of September have been tougher on U.S. large company stocks than U.S. small company stocks, as seen in Chart 4, but it is far too easy to cherry pick different timeframes to weave different stories about what has happened, is happening, and will happen in the stock market.  At PFS, we would rather assume the challenging task of remaining patient and disciplined in our investment strategy—investing in both the Davids and the Goliaths—to help our clients to be financially successful over the long term.

Chart 4:  September 1, 2020 to September 20, 2020.

*As we have discussed in prior posts, media reports often refer to popular indices, such as the S&P 500 or Dow Jones Industrial Average, when discussing the performance of “the stock market,” but those indices only include a portion of the stocks that would be included in a globally-diversified stock portfolio.  While those indices can serve as a helpful benchmark for discussion of returns, they represent only U.S. large company stocks and are not an accurate proxy for the performance of a well-diversified portfolio that includes stocks of large and small companies, growth and value companies, as well as U.S. and international companies.

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