NEW YORK (CNN/Money) -
From an investing perspective, you can hardly call President Bush's proposal for individual accounts wild-child crazy.
Annual costs would be low – 30 cents for every $100 invested. And investment options would be limited to five major index funds and a lifecycle fund, which automatically grows more conservative as investors near retirement.
Still, there's a hurdle workers would have to jump to make the accounts (which would be voluntary) worth their while. They would have to get more than a 6.3 percent average annual return.
Planners and investment data suggest that's doable ... under certain circumstances. And therein lies the rub.
Workers who opt for accounts would see their Social Security benefits reduced by an amount tied to their account contributions plus a rate of return equal to that of the Treasury bond, currently estimated at 3 percent.
So, theoretically, to come out ahead of what he would get under the traditional system, a worker would need to earn an average annual return of more than 6.3 percent: 3 percent Treasury return + 3 percent inflation + 0.3 percent administrative costs = 6.3 percent.
If you're investing over 30 years, that's a fair bet.
Since 1926, for every rolling 30-year period (measured on a monthly basis), a 50-50 portfolio (half stocks, half bonds) earned more than a 6.3 percent annualized return 97 percent of the time, according to Ibbotson Associates. A 60-40 portfolio did so 100 percent of the time.
Over a 20-year period, a 50-50 portfolio accomplished the same thing 78 percent of the time, while a 60-40 mix did so 81 percent of the time.
Going forward, Ibbotson estimates that the long-term annual average return on a 50-50 portfolio will be about 8 percent.
So why worry?
Of course, past performance is no guarantee of future results. And there are many market observers who are not as optimistic that stocks will do as well as they need to in the coming decades to easily best that 6.3 percent hurdle.
Then there's the issue of allocation. The returns cited above assume the money stays invested for the full 30 years and that it is allocated the same way all the time.
That suggests workers would need to rebalance their portfolios at least once a year, if not quarterly. Judging from 401(k) participants' behavior, that's not likely to happen. In 2003, only one in six active participants made transfers, according to Hewitt Associates. In 2000, no more than 30 percent did.
And even though a worker's investment choices will be indexed to the market, "it's wrong to assume you can't lose money or pick inappropriate choices," said certified financial planner Mari Adam. "If you think every one will keep to a 60-40 or 50-50 portfolio, they'll do fine. But they won't."
A worker could, for instance, opt to put all his money in a stock fund or all of it into a bond fund. That lack of diversification can subject him to a much harder landing when those asset classes take a hit.
Which inevitably they will. When that downturn occurs is key, said certified financial planner Steven Kaye. For example, a steep loss in the decade prior to retirement when your account balance is large can be especially hurtful.
Often when investors come up short, "the predominant reason is they're too conservative," Adam said. "I had someone in here the other day who wanted her Roth IRA in cash."
Adam also wonders how taxpayers will be affected when some workers see steep declines in their balances. "(The government) is going to watch people lose 40 percent of their money? I don't buy it," she said.
It's still far too early to assess whether individual accounts overall are a good bet or not.
First, the president's proposal is not necessarily what lawmakers will approve. And even if they do, there are a host of outstanding questions, the answers to which could change the equation completely as to whether or not a worker would benefit from an account.
Among those questions:
Taxes: Right now, if a retiree's total income exceeds a certain level, half of his Social Security benefits are subject to income tax. If his income exceeds another, higher level, 85 percent of his benefits are taxed.
- Will withdrawals from individual investment accounts be taxed?
- If so, what percentage of them will be taxed and will they be taxed as income or capital gains?
Annuities: Under Bush's proposal, workers will be required to annuitize at least a portion of their accounts so that together with their Social Security benefits, they are assured an income above the poverty line.
- What will the annuities cost? That cost needs to be tacked on to the 6.3 percent hurdle for a worker to come out ahead of the traditional system.
- How likely is it a worker will have a significant balance left in his account after annuitizing so that he can, if he chooses, leave it to heirs, which is a much touted benefit of the president's reform proposal?
- Likewise, will there be refund options if a worker dies soon after annuitizing?
Disability and survivor benefits: Dying or becoming disabled in mid-life means there will be significantly less in an account than at retirement. And presumably, the benefit from the system to which a worker and his family would be entitled would be reduced by a formula tied to account contributions.
- What provisions will be made to provide adequate coverage for workers and their families if a worker in midlife is disabled or dies?
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