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Comment: Social Security Reform

Thomas W. Jones

Council on Foreign Relations

November 15-16, 1996

Much has been written recently about a looming Social Security crisis as Baby Boomers age, the ratio of workers to beneficiaries declines, and life expectancy increases. There is also alarm, with which I agree, at the projected rate of growth in Medicare spending from 1.71 percent of gdp in 1996 to 2.41 percent in 2010; 3.13 percent in 2020; 3.92 percent in 2030, and 4.59 percent of gdp in 2050. This is a serious problem, and I presume that we will take steps to control public spending on medical care similar to actions by the private sector to control medical benefits spending by corporations. The techniques include managed care, competition among insurance carriers, and increased deductibles and copayments for fee-for-service indemnity coverage. It would seem appropriate to extend the medical benefits reforms widely adopted in the private sector for active workers whose payroll taxes fund Medicare, so that they also covered Medicare beneficiaries.

Social Security "Crisis" Rhetoric Should Be Toned Down

Social Security is not facing a "crisis" and is not going "bankrupt." fica payroll tax revenues will exceed benefit payments until approximately 2013; fica revenues plus Trust Fund interest earnings will pay full current-law benefits until 2020; and fica revenues plus Trust Fund principal will pay full benefits until 2029. Even after the Trust Fund is exhausted in 2029, continuing fica revenue will pay approximately 75 percent of current-law benefits through 2070.

Can any private corporate pension fund claim to meet comparable standards of funding security? Would we use the words "crisis" or "bankrupt" to describe a corporate pension plan that was 100 percent funded for the next 33 years, and 75 percent funded for the following 40 years? Should we call the Social Security Trust Fund a scam and suggest that the government ious it holds are not real assets, but then call the same full faith and credit obligations of the U.S. government the safest of all investment securities when they are Treasury bonds held by a mutual fund?

The public would be better served if the advocates of Social Security privatization moderated their language. The continual drumbeat of misinformation is probably one reason polls show declining confidence in Social Security, especially by generation-Xers. Our national debate should focus on how to increase national savings and improve economic growth. If we can achieve 2.7 percent annual real gdp growth in the next 20 years--the same as we averaged from 1975-95--rather than slowing to the 2 percent annual real gdp growth projected by the Social Security Trustees, Social Security will be in a long-term surplus position rather than a deficit.

Moderate Adjustments Can Restore Balance

There are four changes that can be made to the Social Security law--all of them entirely consistent with tradition--that will substantially reduce the long-term deficit, postponing the projected date of trust fund exhaustion by two decades. These proposals do not require increasing Social Security payroll taxes, and they reduce benefits only moderately (3 percent on average):

  • Beginning with new hires, extend Social Security coverage to the 3.7 million state and local workers (about one-fourth of all state and local employees) not now covered by the program.

  • Increase, from 35 to 38 years, the period over which average indexed wages are computed and which in turn forms the basis for determining benefit amounts.

  • Change the policy governing taxation of Social Security benefits so that the income tax is applied individually to benefits in excess of what the worker paid in (as is now done with other contributory defined-benefit plans), with revenues from the tax deposited in the Social Security trust fund as under present law.

  • A related change that we recommend--although we would not put it into effect until Medicare is refinanced--is to redirect to Social Security the revenues from taxation of Social Security benefits that currently go to the Medicare Hospital Insurance (hi) fund.

    Still another change, and one that requires no change in the law, is to adjust Social Security's long-term forecasting to take into account the 0.21 percent downward correction to the Consumer Price Index (cpi) that was announced by the Bureau of Labor Statistics (bls) in March 1996.

    Taken together, these changes reduce the long-term deficit from 2.17 percent of payroll to 0.8 percent, moving the date of anticipated trust fund exhaustion from 2030 to 2050.

    Let the Trust Fund Invest Like a Pension Plan

    Since Social Security in the past has never developed a reserve for advance funding, the rate of return on the contingency reserve has made little difference in long-range financing, and the fund has been invested in government securities paying a low return equal to the average on all long-term outstanding debt of the United States. Now that the system is rapidly moving toward partial advance funding, with a large accumulation anticipated, the rate of return does make a major difference.

    Nearly all private and public pension plans in the United States have investment policies that diversify across asset classes including corporate equity and debt securities. If any other major pension plan had a long-term investment policy of 100 percent Treasury debt, as does Social Security, it would probably be accused of violating its fiduciary duty.

    A relatively conservative investment policy asset allocation of 40 percent corporate equities and 60 percent debt securities (Treasury, corporate, and U.S. agency) would substantially improve the Trust Fund investment rate of return. The U.S. stock market has a historical average real rate of return of 7 percent, which is substantially higher than the 2.3 percent real rate of return the Trust Fund is projected to earn from its Treasury debt portfolio.

    The Trust Fund is ideally situated to pursue a steady long-term investment strategy. It could build gradually to a 40 percent equity allocation over a 15 year period by reallocating 2.67 percent of assets each year to a passive total market index portfolio. And it could maintain the equity portfolio over a very long horizon since annual cash flow requirements for benefit payments could be met largely from interest earnings on the debt portfolio and ongoing payroll tax revenues.

    A steady long-term investment strategy pursued by the Trust Fund as a defined benefit pension plan would probably achieve results superior to what most people would achieve under the proposed individual account alternatives. Individual accounts would have very wide variance in returns, determined by investment selection, timing of investments, timing of withdrawals, and levels of expenses and transaction costs. The central question is whether efficient investment performance is more likely to be achieved by a Trust Fund portfolio policy or by individually directed accounts, especially for workers who are most dependent on an adequate Social Security retirement income stream. Approximately half of all U.S. workers lack pension coverage, and they are predominantly in the bottom half of the income distribution. Many of these low- and moderate-income workers have little investment experience or sophistication. They are heavily dependent on Social Security retirement benefits, and it would be unwise to expose their benefits to the risks of individual account investment performance.

    A relatively conserva

    The benefits of investing 40 percent of Social Security's reserves in stocks are very substantial. First, it reduces the 75-year deficit by 0.82 percent of payroll, so that when added to the other proposals previously outlined, it completely eliminates the deficit. Beyond that, the combination of partial advance funding and investment in stocks greatly improves the benefit/contribution ratio for younger workers and future generations.

    Individual Accounts vs. Trust Fund Investment Efficiency

    Expenses and transaction costs are likely to erode substantially the investment performance of individual accounts, particularly for low and moderate income workers. Consider a $30,000 per year worker contributing 2 percent to an individual account. The $600 contribution will be eroded by flat dollar account maintenance fees ($30 per year is typical of charges levied for iras and Keoghs), sales charges on mutual funds (often 3 percent or more), and expense charges on mutual funds (often 1.5 percent or more for equity mutual funds). This worker's investment selections would have to outperform the market by 5(9 percent before expenses in order to equal the market after expenses.

    Some argue that competition will lower these expenses to more reasonable levels. This certainly has not been the experience in the mutual fund marketplace(individuals continue to pay hefty sales charges, operating and investment advisory expenses for funds which usually fail to outperform the market. This apparently irrational behavior may suggest that many investors don't understand the total expenses they are paying, or how poorly their mutual funds are performing relative to the market.

    In contrast, Social Security Trust Fund investment in equities could be done very efficiently on a portfolio basis by contracting with private sector passive equity index managers. For example, the Federal Retirement Thrift Savings Plan (tsp) pays 1 basis point investment advisory fees to Barclays Global Investors to manage a $18 billion S&P 500 passive portfolio, and 2 basis points to manage a $3 billion passive indexed bond fund.

    The TSP is also an appealing example of how to handle proxy voting. By law, TSP is restricted from exercising voting rights, and it delegates that authority to the portfolio manager(with a fiduciary requirement to "vote all proxies and address all corporate actions in a manner which will result in maximum financial benefits to tsp participants." This arrangement has worked well for many years.

    Some argue that Social Security Trust Fund investment in equities would destabilize the market, even if such investments were passive. The actual proposal which I support is to gradually build to a 40 percent passive indexed equity asset allocation, over a fifteen year period from 2000 through 2015 (i.e., approximately 2.67 percent of Trust Fund assets reallocated to passive indexed equities each year). This would total approximately $1 trillion by 2015. In contrast, approximately $600 billion was invested in passive equity index portfolios in the U.S. market at the end of 1995, and this would increase to approximately $5 trillion in 2015 at a 12 percent compound rate of growth (combined total return and new funds allocated to passive equity index strategies). Total U.S. equity market valuation of approximately $8 trillion in 1996 will increase to roughly $60 trillion in 20 years at a compound annual growth rate of 10 percent (combined total return and new funds committed to equity investment).

    Why does $1 trillion of Social Security Trust Fund investments destabilize the market when it follows the same strategy with the same investment advisors as $5 trillion non-Trust Fund passive equity index assets? If Trust Fund passive equity index assets were spread among the top twenty or twenty-five private sector passive equity index managers, and if voting rights were delegated to those managers, Trust Fund equity assets would be seamlessly integrated into the broad pool of indexed assets in the market. Trust Fund equity assets would not be disruptive, nor would they be a disproportionate share of the market. Further, the proposed Trust Fund passive equity asset allocation of 40 percent is a less severe shift away from the current Treasury debt investment policy than would be experienced with individual accounts, which are expected to hold at least 50 percent of assets in equities. One individual account proposal contemplates new Treasury borrowing of $2 trillion in 1996 dollars ($15 trillion in nominal dollars at the peak), in addition to 50 percent equity allocation. If asset reallocation under individual account proposals would not be disruptive to U.S. debt and equity markets, there is little reason to believe a more moderate asset reallocation by the Trust Fund would be destabilizing.

    Summary

    Approximately half of all workers in the United States lack pension plan coverage, and they are predominantly low- and moderate-income. Social Security is the only retirement plan for many of these workers. It is the indispensable safety net which supports their efforts to lead dignified lives in retirement. It is this reliance on Social Security that makes it unwise to subject their retirement income to the wide variability that would result from privatized individual accounts. It is nice to talk about average equity market rates of return, but those averages are meaningless as a statement of probable results for any individual investor. A few workers might achieve outstanding investment performance; many more would probably experience high expenses and transaction costs, and below-market investment performance (a majority of professional money managers usually underperform relative to the market).

    It is extremely important that Social Security, the platform for all retirement planning, continue in the form of a defined-benefit plan(that is, a plan promising specified benefits that are not affected by market fluctuations. This provides a solid foundation for individuals to take investment risks with their defined contribution retirement plans and personal savings. Moderate reforms can sustain Social Security fiscal soundness. Our most important national policy need is to increase our savings rate in order to achieve greater economic growth.