THE NEED TO REFORM the tottering Ponzi scheme that is our Social Security system is widely accepted among policy makers, even if the political willingness to tackle the subject is lacking. Today’s system, in which current workers pay the benefits of current retirees, is going to crash in the next century on the demographic rocks of the Baby Boom’s retirement. And even if somebody can figure out a way to avoid that problem by tinkering at the margins of the system, the fact would still remain that Social Security is a rotten deal — when they retire, people can look forward to a lousy rate of return on the money they have paid in during a lifetime of work.

As for where workers can get a better rate of return, the answer is not, obviously, through the government-run system. The only serious hope is with the private sector, as a host of studies, from The Heritage Foundation, the Cato Institute, other think tanks, congressional committees, and official commissions have concluded. For conservatives, private accounts for individuals, into which people would deposit a portion of the money they currently hand over in payroll taxes, are the best solution. The research persuasively shows that over anyone’s working life, regardless of income level, such accounts, properly invested, will make retirees much better off than even the best they can expect from the current system. The difference can amount to hundreds of thousands of dollars.

The two key words to remember are "properly invested." The benefits that people can realize are not the same as the results they will realize if they fail to follow sound investment advice on how to structure their accounts, how to allocate assets between stocks, bonds and other instruments, how to maintain a diversified portfolio, etc. In fact, most serious plans for partial Social Security privatization include regulatory safeguards designed to steer people in the right direction. In a Cato plan, for example, a national "Board of Trustees" would oversee investment decisions, and the system would require that Americans "invest in only approved asset classes," keep their investments within "maximum percentage limits on each asset class," and change their "portfolio composition as retirement age nears," among other things. The regulations in the Cato plan are not just a nod to the politically achievable — a concession market-minded reformers must make out of the recognition that a wholly unregulated system is a political non-starter. They are also an acknowledgment that sound investing is not something all Americans will do automatically.

In fact, there is a depressingly large and growing body of evidence that given complete freedom to manage their own private Social Security retirement accounts, too many Americans would make poor investment decisions, thereby depriving themselves of some or all of the benefits of privatization. Typically, those who, in the context of Social Security reform, raise concerns about the savviness of Americans as investors are coming from the anti-privatization side of the debate — those who have a political interest in keeping Americans beholden to the government-run scheme, regardless. Their complaints are often no more than a polemical smokescreen for a hidden anti-reform agenda.

But it’s a mistake to dismiss concerns about investor knowledge altogether — a fact that is implicitly acknowledged by the regulations to govern investment decisions in current reform proposals. The reform debate needs to look at where Americans are in terms of their investment knowledge, as well as the political pressures Americans and their elected representatives may try to exert on a partially privatized Social Security system. The case against sticking with the current failing system will be no weaker for the exercise; in fact, a clear-eyed assessment can only strengthen the case for reform by clarifying what is at stake in private accounts.

MANY AMERICANS, ALAS, know little about stocks, bonds, and retirement. This is the conclusion reached by none other than the companies and organizations that would benefit most from a system of private accounts. The Vanguard Group, the National Association of Securities Dealers, the Securities Industry Association, the Investment Protection Trust, Merrill Lynch, Money magazine, and the Securities and Exchange Commission have all done studies or issued reports that reach the same general conclusion. To make matters worse, much of the research over the past five years has focused on the knowledge of individuals who already own stock and are thus presumably more familiar with the workings of financial markets; the research has still found severe financial illiteracy.

According to these sources, for example, a majority of Americans don’t know that stocks have had the best historical returns of all investments. (A quarter of them think that bank certificates of deposit offer the best historical rate of return). More than a third can’t figure out whether $1,000 invested at 8 percent for 30 years would grow to more than $5,000 or less (the answer is more). And those are the better results. Eighty-six percent of Americans don’t know the difference between a growth stock and an income stock. Eighty-eight percent don’t know the difference between a load and a no-load mutual fund. Most Americans don’t know why they should diversify, and 45 percent think diversification "guarantees" their investments won’t fall when the market does.

These facts about public investment knowledge are no fluke. In more than a dozen surveys, performed by reputable firms for a host of organizations with varying interests, Americans have shown generally poor knowledge about retirement and saving.

Whatever the historical origins of this ignorance, the list of problem areas is lengthy. Almost half of investors don’t know what impact mutual fund expenses have on returns. As for government rules that shape individual retirement investing, knowledge is just as murky. Only one in eight knows the eligibility rules for tax-deductible iras. And only two-thirds know the maximum they can contribute to their 401(k) account.

Just how ignorant are some amateur investors? Consider a common problem in defined-contribution plans, such as the 401(k) — where a worker can save a percentage of his pretax earnings in an employer-created account with a number of investment options ranging from money-market and bond funds to individual stocks. Say an investor joins the program at the beginning of a long bull run. Quickly, his $10,000-a-year contributions push his portfolio past six figures. Then the stock market gets the jitters and drops a bit. Confident in the belief that diversification will "guarantee" his savings, our investor is shocked upon receiving his monthly statement to see that his retirement savings have dipped to $80,000. Angry at the turn of events and concerned about further drops, our investor yanks his money out of stocks and sticks them into a nice, safe money-market fund. There the money sits, earning 4 percent annual interest. Meanwhile, stocks bounce back up by 20 percent and our investor misses the rebound.

That happened thousands of times in the summer of 1998 to investors who let world financial problems spook them. If our investor had done nothing — the preferred option of anyone who understands market volatility, diversification, and the need for long time horizons — his portfolio would be intact. However, an ignorant investor can easily find his savings set back by years. Indeed, a recent study by a 401(k) consulting firm showed that average investors in mutual funds cut their return in half by moving in and out of funds rather than standing pat.

The fact is that investing for retirement really does take 40 years, or it ought to, and even when done expertly, includes long periods of what looks like failure (flat or negative returns). The research indicates that many people, not surprisingly, don’t respond well to apparent failure. They have a hard time accepting it as an inevitable element of investing. They want to do something about it, in many cases despite the fact that the right thing to do is nothing. Nor is doing nothing necessarily easy. It’s a choice, like any other, that has to be reaffirmed every day.

NO LESS IMPORTANT than the question of what people know is how they act on what they know. As it happens, a rich vein of research on the way Americans have handled their 401(k)s has been available for more than a decade. This research is particularly valuable, for investor decisions about 401(k) accounts are the best real-world proxy we are likely to find for how people will manage their privatized Social Security funds. The studies — done by private consultants like Hewitt Associates, arms of the government like the Securities and Exchange Commission, and think tanks like the Employee Benefit Research Institute — do not paint a reassuring portrait of how well-equipped some Americans are to handle their retirement cash themselves.

For example, the best analysis of 401(k) asset allocation shows that Americans are placing only between a third and 45 percent of their cash into equity funds. (Another third of 401(k) funds goes into various lower-return, lower-risk categories like bond funds, guaranteed investment contracts, balanced funds and money-market funds.) Expert opinion does vary on precisely what the "right" percentage would be. But it’s clear that to get high returns, less than half is way too low. The Securities and Exchange Commission put it this way: "The public has a ‘play it safe’ approach to investment. People seem so concerned with avoiding investment disasters that they make do with overly conservative investments. Much of the public is intimidated by the stock market and frightened of its volatility."

Similarly, what cash does go into equity funds is not very broadly distributed. According to the Hewitt 401(k) Index, 26 percent is in large-capitalization stock funds (commonly defined as funds that invest in companies valued at $5 billion or more), 5 percent in mid-cap (between $1 billion and $5 billion), 1 percent in small-cap ($1 billion and under), and 3 percent in international funds. Although it is true that during the past few years, in particular, it has certainly been advantageous to have a stock portfolio packed with large firms as their stock prices have skyrocketed, in many other periods, mid-sized and small firms have offered a better return. Not many retirement planners would suggest that clients put three times as much money in large-cap U.S. stocks as in all other categories of equity combined. Nonetheless, this is precisely what many people, perhaps for reasons peculiar to amateur investment psychology, are wont to do.

Even worse, 401(k) participants have a huge appetite for the stock of their own employers. Hewitt reports that 28 percent of balances are in the stock of the participants’ companies. Such a large concentration of retirement savings in a single stock is universally viewed by retirement planners as a mistake, for the simple reason that it is a large and unnecessary risk. While the broad U.S. market has shown steady appreciation for the past century, there is no such record for single stocks.

Nor is the abundance here a product of employee benefit packages in which employers contribute matching funds in the form of stock. A January 1999 Employee Benefit Research Institute (ebri) study shows that even in 401(k) plans where there are no employer-directed contributions, from 20 percent to 33 percent of balances are in company stock. Even among 401(k) participants in their 60s, the group closest to retirement — and therefore the very people who should be taking the smallest risks with their money — 401(k) balances show from 16 percent to 26 percent invested in employers’ stock. The irony is that this decision is fed by the same over-conservative investment philosophy that distorts the rest of participants’ portfolios. An average but somewhat ignorant investor feels that he knows his company and its prospects best. Thus, he feels as safe with his own company stock as he does with a government bond, despite the historically high risk.

The net problem is that too many 401(k) participants hold risky, unbalanced portfolios that might not provide the growth needed to fund an adequate retirement. Moreover, the potential problems people will have in the near-universal privatized Social Security system are probably underestimated by the 401(k) analysis. Overall, 401(k) participants are better educated, more knowledgeable, and better off than Social Security participants in general.

These points are true in general. But when we take people’s real-world behavior into consideration, a slightly different picture emerges. The conservative nature of the public’s investment choices may mean that returns are lower. Worse, with equity funds concentrated for many people in one asset class (large-capitalization stocks) and the stock of their own employer, portfolios for many will be far more volatile than the stock market as a whole. Last year, while the stock market dropped and then rose by more than a fifth, many well-known stocks rose or fell by more than half.

To be sure, some advocates of privatization have tried to incorporate such real-world behaviors into their work. In a 1997 paper by the Cato Institute called "Common Objections to a Market-Based Social Security System: A Response," the authors correctly factor in at least one real-world phenomenon, namely the administrative costs of managing a portfolio (a factor that some early analyses of the benefits of privatization neglected to include). Cato’s updated analysis proposes a portfolio divided 60 percent stock, 40 percent bonds, with 1 percent administrative costs.

The results accurately show that privatizing Social Security would deliver a large financial benefit to just about every investor in possession of such a portfolio. But would most American investors want to maintain such a portfolio? The fact remains that few have shown the willingness to leave as much as 50 percent of their portfolios in stock funds. Nor do such calculations on return take into account the risk that comes from having a quarter of an average portfolio in a single stock — one that, as we have seen, is all too commonly assumed by many investors.

The problems that arise in the way average 401(k) participants order their investments are exaggerated in the case of low-income earners (defined as $40,000 a year or less). Studies by the 401(k) Institute, as well as opinion polls, have shown that these particular investors or potential investors are far more conservative in their investment choices than are others, and far less knowledgeable overall.

Perhaps the most powerful argument made on behalf of privatization is the fabled "minimum-wage millionaire," in which a burger-flipper who invests broadly in the stock market is able to retire, literally, as a millionaire. But if such a minimum-wage worker takes ill-advised risks by buying heavily in Burgerama stock, the result may be very different.

Another pressing question is just how much saving for retirement Americans are really willing to do. No matter how savings is measured, the trend for the past half-century has been down. In 1997, the savings rate fell to its lowest level in 50 years — 3.8 percent. Just between 1987 and 1997, the rate dropped by 28 percent.

The past two decades’ tax history brims with attempts to use tax policy to increase the incentive for saving — Individual Retirement Accounts (created and expanded several times), 401(k) accounts (which came into wide use), and lowered capital gains tax rates all were, in part, attempts to reverse the decline of personal savings in the U.S. The results were nil. Well-off Americans with the most savings simply shifted their account balances around in an effort to capture all the tax advantages.

A primary reason cited by conservatives for the decline of savings is the regressive bite of Social Security taxes as the rates have been repeatedly raised over recent decades. Privatization won’t change that tax bite. It’s also possible that for some, the existence of a private Social Security account will become an excuse for not saving money they might otherwise put away or to save more conservatively. Already, a quarter of those eligible for 401(k) retirement programs choose not to participate. In a system where taxpayers see significant balances building up in their government savings accounts, it would not come as a surprise if some curtail or even suspend their 401(k) and ira contributions, thereby shifting savings, as they have in response to other government attempts to prod the public into increasing its savings.

THE REGULATIONS that govern private Social Security accounts are intended to do the work that investor knowledge will not do for all Americans. Almost every proposal for privatization includes provisions to protect people from swindles and mistakes. A 1997 paper by the Cato Institute cited earlier spells out what those regulations — subject to the approval of a national "Board of Trustees" — would look like:

 Investors can chose from only "approved" asset classes.
 Investors must limit the percentage allocated to each asset class.
 Portfolio composition must change as retirement nears.
 Investors must take enough risk to "reasonably assure the building of wealth."
 Investors can place their accounts only with approved service providers.

There is a risk here as well, namely, government interference in the way these accounts are invested. Federal Reserve Chairman Alan Greenspan testified before Congress that he believes no system could be set up to fully insulate direct government investment in stocks from political pressure. It is easy to see how politics could intrude upon investment decisions in indirect ways as well. Will members of Congress or future administrations be able to restrain themselves from insisting that Social Security participants shouldn’t invest in companies that break U.S. laws, like anti-trust or international sanctions? There will certainly be pressure for such things as a "social conscience" provision in the regulations for "approved service providers" — a provision that might push toward investing in minority-owned business or away from tobacco and gun companies, or towards companies that are expanding their U.S. manufacturing operations and away from companies closing factories in the United States.

Also worth considering are the political pressures regulations may give rise to among investors unhappy with outcomes in the short term. Any system of regulations that forces account holders away from their overly conservative preferences (40 percent stock funds, 60 percent conservative investments) and toward a prudent but more risky allocation of retirement investments — say 70 percent stock funds mixed among large, medium, and small U.S. firms along with some international exposure and 30 percent bonds or other conservative investments — runs a huge political risk. Some account holders are likely to demand "action" — meaning federal financial intervention — during years in which a prudent, professional investment strategy looks like a rout. Regulations or not, some Americans will be reluctant to grit their teeth and watch years of savings disappear in a bear market.

Success, for its part, will bring opposite pressures to bear on retirement fund accounts. Imagine the best-case scenario, in which millions of low-skill workers across the nation enter their 40s and 50s with six-figure, even half-million dollar retirement accounts. Then their kids want to go to college, say, or a relative without health insurance becomes gravely ill, or the investors themselves want to buy their first house. Can a rich retirement system resist becoming the piggy-bank for other worthy causes?

And, of course, the question of how well-prepared Americans are to make the right decisions about their privatized Social Security accounts is hardly the same as asking whether Social Security should be privatized at all. For young Americans, a monkey with a modem and an e-trade account could get a better return investing in stocks than a 20-something can expect from the money he will be forced to "invest" into pay-as-you-go Social Security.

In the end, however, the fact remains that no regulatory system can fully protect people from their folly. And folly, alas, is the word that comes to mind for the way some people currently approach investment decisions. The current system offers no hope of a solution, and privatization will afford virtually everyone with an opportunity to be far better off in retirement than under government run Social Security, at no additional cost to themselves. But it is only an opportunity — one that many people will seize, some will ignore, and some will bungle. There is no use pretending or hoping that bungling won’t happen. In fact, it will be important to take steps to minimize its effects.