[House Hearing, 105 Congress]
[From the U.S. Government Publishing Office]
THE FUTURE OF SOCIAL SECURITY FOR THIS GENERATION AND THE NEXT:
PERSONAL SAVINGS ACCOUNTS AND INDIVIDUAL-OWNED INVESTMENTS
=======================================================================
HEARING
before the
SUBCOMMITTEE ON SOCIAL SECURITY
of the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED FIFTH CONGRESS
SECOND SESSION
__________
JUNE 18, 1998
__________
Serial 105-51
__________
Printed for the use of the Committee on Ways and Means
----------
U.S. GOVERNMENT PRINTING OFFICE
52-578 cc WASHINGTON : 1999
COMMITTEE ON WAYS AND MEANS
BILL ARCHER, Texas, Chairman
PHILIP M. CRANE, Illinois CHARLES B. RANGEL, New York
BILL THOMAS, California FORTNEY PETE STARK, California
E. CLAY SHAW, Jr., Florida ROBERT T. MATSUI, California
NANCY L. JOHNSON, Connecticut BARBARA B. KENNELLY, Connecticut
JIM BUNNING, Kentucky WILLIAM J. COYNE, Pennsylvania
AMO HOUGHTON, New York SANDER M. LEVIN, Michigan
WALLY HERGER, California BENJAMIN L. CARDIN, Maryland
JIM McCRERY, Louisiana JIM McDERMOTT, Washington
DAVE CAMP, Michigan GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota JOHN LEWIS, Georgia
JIM NUSSLE, Iowa RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas MICHAEL R. McNULTY, New York
JENNIFER DUNN, Washington WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio XAVIER BECERRA, California
PHILIP S. ENGLISH, Pennsylvania KAREN L. THURMAN, Florida
JOHN ENSIGN, Nevada
JON CHRISTENSEN, Nebraska
WES WATKINS, Oklahoma
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
A.L. Singleton, Chief of Staff
Janice Mays, Minority Chief Counsel
______
Subcommittee on Social Security
JIM BUNNING, Kentucky, Chairman
SAM JOHNSON, Texas BARBARA B. KENNELLY, Connecticut
MAC COLLINS, Georgia RICHARD E. NEAL, Massachusetts
ROB PORTMAN, Ohio SANDER M. LEVIN, Michigan
JON CHRISTENSEN, Nebraska JOHN S. TANNER, Tennessee
J.D. HAYWORTH, Arizona XAVIER BECERRA, California
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
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C O N T E N T S
__________
Page
Advisory of June 8, 1998, announcing the hearing................. 2
WITNESSES
Boskin, Hon. Michael J., Stanford University..................... 18
Burtless, Gary, Brookings Institution............................ 74
Cavanaugh, Francis X., Chevy Chase, MD........................... 29
Diamond, Peter A., Massachusetts Institute of Technology......... 24
Edelman Financial Services, Inc., Ric Edelman.................... 82
Kolbe, Hon. Jim, a Representative in Congress from the State of
Arizona........................................................ 43
National Association of Manufacturers, Paul R. Huard............. 89
Tritch, Teresa, Money Magazine................................... 86
Watson Wyatt Worldwide, Sylvester J. Schieber.................... 35
White, Lawrence J., New York University.......................... 69
SUBMISSIONS FOR THE RECORD
Institute for Research on the Economics of Taxation, Stephen J.
Entin, statement............................................... 98
Milliman & Robertson, Inc., New York, NY, Michael J. Mahoney,
letter and attachments......................................... 99
THE FUTURE OF SOCIAL SECURITY FOR THIS GENERATION AND THE NEXT:
PERSONAL SAVINGS ACCOUNTS AND INDIVIDUAL-OWNED INVESTMENTS
----------
JUNE 18, 1998
House of Representatives,
Committee on Ways and Means,
Subcommittee on Social Security,
Washington, DC.
The Subcommittee met, pursuant to notice, at 1:02 p.m., in
room 1100, Longworth House Office Building, Hon. Jim Bunning
(Chairman of the Subcommittee) presiding.
[The advisory announcing the hearing follows:]
ADVISORY
FROM THE
COMMITTEE
ON WAYS
AND
MEANS
SUBCOMMITTEE ON SOCIAL SECURITY
CONTACT: (202) 225-9263
FOR IMMEDIATE RELEASE
June 8, 1998
No. SS-18
Bunning Announces Eleventh Hearing
in Series on ``The Future of
Social Security for this Generation and the Next''
Congressman Jim Bunning (R-KY), Chairman, Subcommittee on Social
Security of the Committee on Ways and Means, today announced that the
Subcommittee will hold the eleventh in a series of hearings on ``The
Future of Social Security for this Generation and the Next.'' At this
hearing, the Subcommittee will examine in detail the structure of
personal savings accounts (PSAs) within the Social Security system and
the effects individual-owned investments would have for retirees,
financial markets, the investment community, PSA investors, and
businesses, both large and small. The hearing will take place on
Thursday, June 18, 1998, in the main Committee hearing room, 1100
Longworth House Office Building, beginning at 1:00 p.m.
In view of the limited time available to hear witnesses, oral
testimony at this hearing will be from invited witnesses only.
Witnesses will include economic, investor, investment, and program
experts, along with business representatives. However, any individual
or organization not scheduled for an oral appearance may submit a
written statement for consideration by the Committee and for inclusion
in the printed record of the hearing.
BACKGROUND:
Possible establishment of PSA's as an element of Social Security
modernization has added an additional level of debate regarding the
system's solvency. Two of the three plans advanced by the 1997 report
of the Advisory Council on Social Security proposed PSA's as a
substitute for the shrinking resources available to traditional social
insurance.
Since that time, Members of Congress of both parties, along with
research and public interest groups have set forth plans containing
PSA's as an integral part of Social Security reform. During the
President's first forum on Social Security held in Kansas City, the
President, Members of Congress, and social insurance experts agreed
PSA's deserved further consideration.
Giving individuals investment choices not only would alter the role
of participant workers, but also would incorporate a number of other
institutions which currently have no or limited involvement in today's
traditional Social Security system. Private capital markets, investment
companies, employers, and certain Federal agencies would need to adapt
to become stakeholders in the system.
To date, proposals have varied widely in structure and in recent
months, more details have been reported for public examination. Several
such proposals envision personal investments made through a
centralized, quasi-government organization, similar to the Federal
Employees Thrift Fund. The choice of such investments would be limited
to ``passive'' vehicles, such as stock and bond indexes, to lessen the
influence of government in the private capital markets and businesses.
Other models propose investments more akin to the current Individual
Retirement Accounts, where each investing worker would choose among a
larger array of financial assets through private investment companies.
Each model plan also varies in the way workers receive their funds upon
retirement or disability.
The cost, operation, and regulation of these two diverse models
vary considerably as do the opportunities and risks for the
participants, both as workers and as retirees. In previous hearings,
the Subcommittee has heard from authors of PSA plans. In the upcoming
hearing, economic experts and representatives of institutions who could
become vital components of a new system will discuss the implications
for the economy and stakeholders.
In announcing the hearing, Chairman Bunning stated: ``Personal
savings accounts may be an answer, especially for young people, to meet
the challenge of providing for their own retirement. Someone once said,
`You cannot plough a field by turning it over in your own mind.' We
need to have accurate and expert information about the important
structural elements needed to ensure any new system would actually
work.''
FOCUS OF THE HEARING:
The Subcommittee will receive the views of experts in the field of
investments and capital markets and representatives of institutions
that might become participants in a PSA system. Members of the
Subcommittee would like to hear from each witness regarding: (1) the
effect of Social Security PSA investments on the capital markets, (2)
the cost and administration of PSA's, (3) needed investor education,
and (4) the role of employers, both large and small, in a PSA system.
DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:
Any person or organization wishing to submit a written statement
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2, 1998, to A.L. Singleton, Chief of Staff, Committee on Ways and
Means, U.S. House of Representatives, 1102 Longworth House Office
Building, Washington, D.C. 20515. If those filing written statements
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noted above.
Chairman Bunning [presiding]. The Subcommittee will come to
order.
Today marks our 11th hearing in a series on the future of
Social Security for this generation and the next. At our last
hearing, we heard from a number of those creators of PSAs,
personal savings account, proposals who see the accounts as a
key component in Social Security reform. Today, we'll hear from
experts in the economy, the field of investments and capital
markets, and representatives of institutions who would be key
players in establishing a personal savings account system.
Personal savings account may be an answer, especially for
young people, to meet the challenge of providing for their own
retirement. Someone once said, ``You cannot plow a field by
turning it over in your own mind.'' We need to have accurate
and expert information about the important design elements
needed to ensure any new system would actually work.
While the structure for individual investment is critical,
the success of any system will depend upon cost effective and
responsive administration. Critical to that operation will be
the institutions, many not involved in the Social Security
system today, that would be the nexus between the participating
worker and the government agency that administers the overall
retirement systems.
To ensure a successful operation, the system of personal
accounts must have minimal and equitable administrative cost,
create no undue burden on employers, and make the operation of
the system and the obligation of the investor easy to
understand and use for the participants.
I look forward to hearing the advice of our witnesses today
to help us determine the detailed and practical options that
would be needed to resolve in designing a working of a personal
savings account component as part of Social Security reform.
In the interest of time, it is our practice to dispense of
opening statements, except for the Ranking Democrat Member. All
Members are welcome to submit statements for the record. I
yield to Congressman Kennelly for any statement she wishes to
make.
Mrs. Kennelly. Thank you, Chairman Bunning. And as you have
noted, this is the 11th hearing on the future of Social
Security that this Subcommittee has held. And we've held
hearings on the broad issues related to Social Security, and on
specific proposals to change the system.
In my view, our purposes need to be to strengthen Social
Security for the future. We need to assure that future
generations of workers, retirees, and their families continue
to receive an adequate, guaranteed retirement benefit from
Social Security. We need to assure individuals that they will
receive a benefit that is protected against inflation and will
last a lifetime.
Social Security provides an important protection for
widows, orphans, and the disabled. We need to make sure that
these protections are not eroded. We need to assure that we do
not jeopardize benefits for women who have stayed home for part
of their careers to raise children, or to take care of older
parents.
And finally, we need to assure that any reforms we adopt do
not benefit higher income individuals at the expense of middle-
and low-income individuals. These are important principles that
we have to keep in mind as we progress with our hearings. We
must face up to the demographic challenges before us, but we
must not undermine the protections afforded by the most
efficient program of this century.
Our hearing today focuses on the effects of individual
accounts. A study issued this week by CRS, Congressional
Research Service, analyzes the impact that some individual
account plans will have on Social Security benefits and
protections. The study calculates the size of Social Security
benefit cuts that will occur under three different Social
Security reform plans. The study finds that under a plan in
which 2 percentage points of Social Security revenue is
diverted into individual accounts, Social Security benefits
must be cut significantly.
Today's 38-year-old retiring at 65 in the year 2025 would
have a 33-percent reduction in his Social Security benefit.
Even if an individual account provided an extraordinary rate of
return equal to the past performance of the Standard & Poor's
index, the accumulation in the account would still leave the
38-year-old considerably worse off than he would be today.
Our witnesses today will discuss the impact of individual
accounts on the economy and on individuals. We must take a
careful look at all of these ramifications of these plans
before we will act. I look forward to hearing the testimony of
our witnesses. They will help us examine a wide variety of
topics relating to the impact of individual investment
accounts. We will have the opportunity to learn whether
individual accounts can--in fact--create wealth for individuals
and for the country; whether administrative costs will increase
with the creation of 140 million individual investment
accounts; and whether those administrative costs will reduce
the level of retirement income for average Americans. Can a
model like the Federal Thrift Savings Plan give us any incite
into these issues? How would employers handle these accounts?
Thank you, Mr. Chairman, very much.
Chairman Bunning. Thank you very much. I would like to
enter into the record, by unanimous consent, the Heritage
Foundation paper--white paper--on the CRS Social Security study
at this time.
[The information follows:]
Analyzing the CRS Social Security Study
by William W. Beach and Gareth G. Davis
On June 18, 1998, the Congressional Research Service (CRS)
released an analysis of major Social Security reform
proposals.\1\ The study, requested by Representative Charles
Rangel (D-NY), purports to show that a Social Security reform
plan proposed by Senators Daniel Patrick Moynihan (D-NY) and
Robert Kerrey (D-NE), and a similar plan by Senators Judd Gregg
(R-NH) and John Breaux (D-LA) and Representatives James Kolbe
(R-AZ) and Charles Stenholm (D-TX) (based on a proposal by the
National Commission on Retirement Policy [NCRP]), will result
in large benefit cuts for future retirees. This study has been
used to give the impression that under these two plans--which
both allow for the investment of two percentage points of
payroll taxes in private retirement accounts--workers would be
left with lower retirement incomes. But in accordance with the
instructions given by Representative Rangel, the CRS report
looks only at Social Security benefit changes and ignores the
offsetting retirement income that future retirees would receive
from their private retirement accounts.
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\1\ David Koitz, ``Benefit Analysis of Three Recent Social
Security Reform Proposals,'' Congressional Research Service Memorandum
for Congress, June 16, 1998. The CRS examined three reform proposals,
including one advanced by Robert M. Ball, a former commissioner of
Social Security. The Center for Data Analysis examined only the
proposals by Members of Congress: the Moynihan-Kerrey and the Gregg-
Breaux-Kolbe-Stenholm/ NCRP proposals.
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The report's author drew attention to these ``important
omissions'' in the memorandum of transmission to Representative
Rangel:
As your staff specified, the analysis is confined to the
potential reductions in Social Security benefits prescribed by
the various provisions of the three reform packages.
Accordingly, the memorandum does not examine the impact of the
changes in payroll taxes included in the packages, the
potential benefits or annuities that may result from the
``personal savings'' components of the packages, nor...the
elimination of the Social Security retirement earnings test.
Those using the report to suggest it ``proves''
privatization would hurt most retirees ignore this crucial
omission from the analysis. In fact, if the study is adjusted
for the omission of personal savings income, it shows the
opposite.
A Statistical Analysis of the Report's Findings
To give a proper picture of the effects of these plans on
the retirement income of workers, analysts from The Heritage
Foundation's Center for Data Analysis calculated the amount
that low-, average-, and maximum-wage workers would accumulate
in their private accounts under those two plans. The results of
the Heritage study, summarized in Tables 1 through 3,
demonstrate that under both plans, workers would be likely to
accumulate large amounts in their private accounts by
retirement. These funds would be available as retirement income
at age 65.
Table 1 shows the amount that low-, average-, and maximum-
income 39-year-old workers would accumulate in their accounts
by their retirement in 2025 at age 65. Under the Moynihan-
Kerrey plan, a low-wage worker (earning 45 percent of the
average) could expect to accumulate $31,260 ($12,874 in 1998
inflation-adjusted dollars) by retirement if he or she invested
in an ultra-safe portfolio made up of 50 percent U.S. Treasury
Bonds and 50 percent blue-chip stocks. With a similar
portfolio, the Gregg-Breaux-Kolbe-Stenholm/NCRP plan would
enable the same low-wage worker to accumulate $37,518 ($15,451
in 1998 inflation-adjusted dollars) by retirement. With a 50
percent bond/50 percent equity portfolio, an average-wage
worker would accumulate $69,467 ($28,608 in 1998 dollars) by
retirement under the Moynihan-Kerrey plan. This same worker
would accumulate $83,373 ($34,335 in 1998 dollars) under the
Gregg-Breaux-Kolbe-Stenholm/NCRP plan. A maximum-wage worker
would accumulate $168,078 ($69,219 in 1998 dollars) under the
Moynihan-Kerrey plan and $201,726 ($83,076 in 1998 dollars)
under the Gregg-Breaux-Kolbe-Stenholm/NCRP proposal.
Table 2 shows the annual retirement income that would be
likely to be generated by annuitizing these accumulations at
retirement. Under the Moynihan-Kerrey plan and with a mixed
portfolio of equities and bonds, the low-wage worker's
portfolio could be expected to generate $2,909 ($1,198 in 1998
dollars) per annum; under the Gregg-Breaux-Kolbe-Stenholm/NCRP
plan, it would generate $3,491 ($1,438 in 1998 dollars) in
annual income. With a similar portfolio, the average-wage
worker's account could be expected to earn $6,464 ($2,662 in
1998 dollars) per year under the Moynihan-Kerrey proposal and
$7,758 ($3,195 in 1998 dollars) under the Gregg-Breaux-Kolbe-
Stenholm/NCRP plan.
Table 3 shows the net overall effect on annual retirement
income after offsetting lower Social Security benefits with
retirement income from private savings accounts. With a mixed
portfolio and assuming annuitization of the retirement account,
the retirement income received by a low-income worker would
increase by 4.9 percent over what is promised by Social
Security under the Moynihan-Kerrey plan and by 6 percent under
the Gregg-Breaux-Kolbe-Stenholm/NCRP plan. Under the same
assumptions, retirement income for an average-wage worker would
increase by 10.4 percent over Social Security's benefits under
the Moynihan-Kerrey plan but fall 7.3 percent under the Gregg-
Breaux-Kolbe-Stenholm/NCRP plan. For a maximum-income worker,
retirement income would increase by 26.3 percent under the
Moynihan-Kerrey plan and by 0.8 percent under the Gregg-Breaux-
Kolbe-Stenholm/NCRP plan.
As this analysis shows, the retirement income of a low-wage
worker would be higher than under current law under every
investment portfolio when earnings from the worker's private
account are included.
Under both the Moynihan-Kerrey and Gregg-Breaux-Kolbe-
Stenholm/NCRP plans, a worker earning 45 percent of the average
wage could expect to see his or her retirement income increase
between 5 percent and 6 percent with a mixed portfolio of bonds
and equities. Under the Moynihan-Kerrey proposal, the
retirement income of an average-wage worker would be likely to
increase by between 5.9 percent and 16.4 percent, depending on
the investment options chosen.
Average workers would fare less well under the Gregg-
Breaux-Kolbe-Stenholm/NCRP plan, with income falling by 13.4
percent if the worker invested entirely in Treasury Bonds and
by 7.3 percent if the worker invested in a mixed bond-equity
portfolio. If the worker invested entirely in equities,
however, the income from the private account would more than
offset the 33 percent reduction in benefits proposed by the
plan.
Workers who have incomes above the maximum taxable
threshold (which in 1998 is $68,400) would do well under the
Moynihan-Kerrey plan. These workers generally are better off
under the Gregg-Breaux-Kolbe-Stenholm/NCRP proposal, too,
except for those who invest their payroll taxes entirely in
Treasury Bonds; their net change in retirement income is a
negative 8.4 percent.
Note on Risk
It should be noted that advocates of the current system
argue that Social Security provides ``guaranteed'' retirement
benefits compared with the uncertain level of income that
workers could receive from investing their payroll tax dollars
privately. In no sense, however, can the benefits offered by
the current system be held to be ``safe, reliable or
guaranteed.'' \2\ The Social Security system, as it currently
exists, is estimated by its own actuaries to be underfunded to
the amount of $3.7 trillion and thus is financially incapable
of delivering promised benefits.\3\ Moreover, as the U.S.
General Accounting Office has noted, if the rate of return on
equities fell, then not only would private accounts deliver
less retirement income, but a Social Security trust fund
invested in equities would be unable to pay benefits.
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\2\ Democratic Staff of the House Committee on Ways and Means,
``Response to the Heritage Report on CRS Study,'' June 18, 1998, p. 1.
\3\ U.S. Department of the Treasury, 1997 Consolidated Financial
Statement of the United States Government (Washington, DC: U.S.
Government Printing Office, 1998), p. 63.
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Unlike individually held accounts, moreover, which are
private property and thus constitutionally protected, the U.S.
Supreme Court has ruled that Congress can alter Social Security
benefits.\4\ Workers also run the risk of dying prematurely,
and thus collecting little or nothing in Social Security
benefits. Considering today's demographic conditions, a worker
alive in 1998 and planning to retire at age 65 in 2025 has been
estimated by the National Center for Health Statistics to have
a 16 percent chance of dying before even beginning to collect
retirement benefits.\5\ Only in a small minority of these cases
will the families of these workers be able to collect Social
Security benefits.
---------------------------------------------------------------------------
\4\ Fleming v. Nestor, 363 U.S. 603 [1960].
\5\ Calculated from National Center for Health Statistics, Life
Tables--Vital Statistics of the United States 1994 (1998).
---------------------------------------------------------------------------
Key Assumptions \6\
Rate of Return on Private Accounts: Heritage
analysts calculated the rate of return from three investment
strategies: a portfolio of 100 percent equities, a portfolio of
100 percent Treasury Bonds, and a portfolio made up of 50
percent equities and 50 percent Treasury Bonds. Workers are
assumed to annuitize their accounts at age 65 at the rate of
return prevailing on long-term Treasury Bonds A nominal rate of
return of 6.3 percent (2.8 percent when adjusted for inflation)
on Treasury Bonds was assumed. This is equal to the long-term
interest rate on U.S. government bonds assumed in the 1998
Social Security Trustees' report. A nominal rate of return of
10 percent (6.5 percent after inflation) on equities was
assumed. This rate is below the 7 percent post-inflation rate
of return on equities found to exist by the 1994-1996 Social
Security Advisory Council.\7\ Heritage's assumptions also are
lower than the long-term historical average yield on equities.
Between 1926 and 1997 (a period that includes the Great
Depression and World War II), the rate of return on large
company equities averaged 11 percent, and the return on small
company equities averaged 12.7 percent.\8\
---------------------------------------------------------------------------
\6\ For details on Heritage's calculations of rates of return, see
William W. Beach and Gareth G. Davis, ``Social Security's Rate of
Return,'' Heritage Foundation Center for Data Analysis Report No.
CDA98-01, January 15, 1998.
\7\ Report of the 1994-1996 Advisory Council on Social Security
(January 1997).
\8\ Stocks, Bonds and Bills and Inflation 1998 Yearbook (Chicago,
IL: Ibbotson Associates,1998), p. 122.
---------------------------------------------------------------------------
Reduction in benefits: The reduction in benefits
payable to workers retiring at age 65 in 2025 under each of the
plans was calculated directly from Table 3 of the CRS
memorandum ``Benefit Analysis of Three Recent Social Security
Reform Proposals.'' The percentage reductions in this table
were applied directly against the dollar benefits payable to
low-, average-, and high-wage workers as published in Table
III.B5 of the 1998 Annual Report of the Trustees of the Federal
Old-Age and Survivors Insurance and Disability Insurance Trust
Funds.
--William W. Beach is John M. Olin Senior Fellow in
Economics and Director of the Center for Data Analysis at The
Heritage Foundation.
--Gareth G. Davis is a Research Assistant at The Heritage
Foundation.
Chairman Bunning. We will begin.
Mrs. Kennelly. Mr. Chairman.
Chairman Bunning. Yes.
Mrs. Kennelly. Thank you. I meant to ask that the study
that I referred to that was requested by Chairman Rangel be
entered into the record. May I have that entered in?
Chairman Bunning. Absolutely.
Mrs. Kennelly. Thank you, Mr. Chairman.
[The information follows:]
Benefit Analysis of Three Social Security Reform Plans
by David Koitz, Congressional Research Service, Specialist in Social
Legislation, Education and Public Welfare Division
This memorandum is in response to a request for analysis of
the potential effects on Social Security benefits of three
recent proposals to reform the Social Security system. These
proposals include: (1) S. 1792, the Social Security Solvency
Act of 1998, introduced by Senators Moynihan and Kerrey on
March 18, 1998, (2) a proposal recommended on May 19, 1998 by
the National Commission on Retirement Policy (NCRP), a 24-
member panel created under the auspices of the Center for
Strategic and International Studies, and (3) a recent proposal
by Robert M. Ball, former Commissioner of Social Security. All
three proposals would make numerous changes to Social Security,
on both the tax and benefit sides, and include other provisions
either mandating or permitting the creation of new personal
retirement savings accounts. As specified by the requester, the
analysis is confined to the potential reductions in Social
Security benefits prescribed by various provisions of the three
reform packages. Accordingly, the memorandum does not examine
the impact of the changes in payroll taxes included in the
packages, the potential benefits or annuities that may result
from the ``personal savings'' components of the packages, nor
in the case of S. 1792 and the NCRP plan, the elimination of
the Social Security retirement earnings test. Analysis of all
of these would be necessary to gauge the full effects of the
three plans on the national economy and individual retirement
income. (A number of technical corrections to the memorandum
sent to the original requester are reflected in this general
distribution memorandum).
For the most part, the information provided in this
memorandum is based on descriptions and estimates prepared by
the Office of the Actuary of the Social Security Administration
(SSA). The NCRP plan described here is one of four proposals
priced by the actuaries, referred to as the Individual Savings
Account (ISA) plus 2% plan. It is the one most closely
resembling the NCRP plan released on May 19, 1998. The
actuaries' estimates are contained in various memoranda
summarizing aggregate trust fund impacts (i.e., on overall
trust fund income and outgo) and illustrative benefit and
annuity outcomes for workers with different lifetime earnings
levels. Because the actuarial data are not necessarily
consistent from one memorandum to another, the reader should be
advised that this analysis required some interpolation of the
actuaries' data and should be considered as approximations
only.
Description of the Three Plans
All three plans include revenue increases and benefit
reductions designed to bring the Social Security system into
long-range actuarial balance. The SSA actuaries estimate that
all would do so under the intermediate assumptions of the 1997
Social Security trustees' report. All three plans also include
provisions either permitting or mandating the creation of new
personal retirement savings accounts. A description of the
plans as priced out by the actuaries follows.
S. 1792 reduces the Social Security tax rate by 2
percentage points of taxable payroll (it is currently 12.4% of
pay) in the short run--1 percentage point on employee and
employer each--and then raises it in the long run by 1
percentage point, bringing it to an ultimate rate 13.4% of pay
in 2060 and later. Other measures to generate income for the
Social Security system include: increasing the income taxation
of Social Security benefits by requiring that benefits be taxed
in the same fashion as private defined-benefit pension benefits
(and would be fully effective in 1999); raising the maximum
amount of earnings subject to Social Security taxation in steps
to $97,500 in 2003 (under current law, it is estimated to rise
to $81,900); and extending Social Security coverage to all
State and local government employees hired after the year 2000.
It reduces benefits by: gradually increasing the age for full
Social Security retirement benefits to 68 by 2017 and
eventually to age 70 by 2065 (under current law the full
benefit age would rise to 67 by 2027); extending the period
over which earnings are averaged for benefit computation
purposes from 35 to 38 years by 2002; and permanently reducing
Social Security cost-of-living adjustments (COLAs), as well as
those of other indexed entitlement programs, by 1 percentage
point per year beginning in 1998. This provision also would
constrain the current indexing of income tax brackets (which
would effectively increase income taxes). The bill also would
eliminate the Social Security retirement earnings test for
workers 62 and older. It further would permit workers to put 1%
of pay into a new personal retirement savings account.
Employers would be required to match these contributions.
The NCRP plan reduces the Social Security tax rate on
workers by 2 percentage points and mandatorily redirects the
proceeds into new personal retirement savings accounts
(effective for workers under age 55). It raises the Social
Security system's income by extending Social Security coverage
to all State and local government employees hired after 1999
and crediting certain proceeds from the current income tax on
benefits to the Social Security trust funds that now go to the
Medicare Hospital Insurance (HI) trust fund. It reduces
benefits by gradually increasing the age for full Social
Security benefits to 70 by 2029 and the age for reduced
benefits to 65 by 2017 (up from 62 under current law). After
2029, both would be increased by about 2 months every 3 years.
It also: gradually reduces the top two (of the three) portions
of the Social Security benefit formula from 32% and 15%
respectively to 21.36% and 10.01% by 2020 (the first--90%--
bracket would not be changed); gradually reduces the dependent
spouse's benefit from 50% to 33% of the worker's primary
benefit; extends the period over which earnings are averaged
for benefit computation purposes from 35 to 40 years by 2010;
and reduces Social Security COLAs by .5 percentage points per
year beginning in 1998. The plan also would eliminate the
Social Security earnings test for recipients at or above the
full retirement age (effective in 2003), and create a new
system of ``minimum'' Social Security benefits for workers with
80 or more Social Security ``quarters of coverage.''
The Ball plan increases income to the Social Security
system by: requiring the investment of part of the Social
Security trust funds in equities; increasing the income
taxation of Social Security benefits by requiring that benefits
be taxed in the same fashion as private defined-benefit pension
benefits; raising the maximum amount of earnings subject to
Social Security taxation (such that 87.3% of all earnings in
covered employment would be taxable); and extending Social
Security coverage to all state and local government employees
hired after 1999. It reduces benefits by: extending the period
over which earnings are averaged for benefit computation
purposes from 35 to 38 years and permanently reducing Social
Security cost-of-living adjustments (COLAs) by .3 percentage
points per year. It also would allow workers to put 2% of pay
(which would be over and above their Social Security taxes)
into new personal retirement savings accounts.
The Impact of the Three Plans on Benefit Expenditures Overall
The SSA actuaries prepared estimates of the average 75-year
financial impact of the three proposals on the Social Security
system overall based on the 1997 trustees' report so-called
intermediate assumptions (shown in memoranda dated March 4,
1998 from SSA's actuaries, Alice Wade and Seung An, for the
NCRP proposal; April 27, 1998 from Stephen C. Goss, SSA's
Deputy Chief Actuary, and Alice Wade for the NCRP plan; and May
1998 from Robert M. Ball showing the actuaries' estimates of
his plan). Traditionally, the trustees' intermediate
assumptions are considered their best guess at any given time
about the factors that will affect the future condition of the
system. It should be noted that while the 1998 trustees' report
was released after the preparation of the estimated impacts of
these plans, the intermediate assumptions in the 1998 report do
not noticeably differ from those in the 1997 report.
Traditionally, long-range Social Security income and
expenditure estimates are shown as ``percents of taxable
payroll.'' Taxable payroll is the total amount of wages and
salaries in the economy that are subject to Social Security
taxation. In 1998, for instance, the Social Security system's
costs are estimated to be equal to 11.18% of taxable payroll
and its income, 12.65% of taxable payroll. The following table
(Table 1) summarizes the average 75-year taxable payroll
estimates of the impact of the three proposals under the 1997
trustees' report assumptions.
To summarize the data briefly, the NCRP plan would reduce
projected 75-year average Social Security expenditures by 23%;
S. 1792 would reduce them by 16%; and the Ball plan would
reduce them by 6% (see, for instance, the S. 1792 column in
Table 1--proposed benefit reductions of 2.46% of taxable
payroll divided by projected total current law expenditures of
15.6% of taxable payroll = 16%). The reader should note that
the estimated impact of the proposed changes shown in Table 1
includes the income taxation of Social Security benefits
contained in S. 1792 and the Ball plan (since increasing the
taxation of benefits results in lower after-tax Social Security
benefits).
Table 1. Comparison of Projected 75-year Average Reductions of Social
Security Expenditures Under S. 1792, NCRP, and Ball Plans
------------------------------------------------------------------------
NCRP (In %
Proposal S. 1792 of taxable Ball
payroll)
------------------------------------------------------------------------
Projected income under current law... 13.37 13.37 13.37
Projected expenditures under current 15.60 15.60 15.60
law.................................
Projected 75-year average deficit.... 2.23 2.23 2.23
Proposed income changes.............. -0.21 -1.36 +1.44
Proposed (net) benefit reductions.... -2.46 -3.59 -0.89
Impact on projected 75-year average +2.25 +2.23 +2.33
deficit.............................
Proposed benefit reductions as a 16% 23% 6%
percent of the system's projected
expenditures under current law......
------------------------------------------------------------------------
Illustrative Social Security Benefit Reductions for Low, Average, and
Maximum Earners
The actuaries' memoranda on the various plans contain
illustrative ``initial'' benefit impacts for hypothetical low,
average, and maximum earners who are assumed to work steadily
at those levels throughout their working years (initial
benefits are those paid at the point of retirement). However,
their data are not consistently arrayed from one plan analysis
to the next. With respect to S. 1792, for instance, the
actuaries' memoranda provide benefit illustrations for
retirement at ages 65 in 2025 and 2070. For the NCRP plan, they
provide them for ages 65 and 67 in 5 year increments from 2000
to 2030. Illustrations for later years--out to 2070--are
provided for retirement at age 67 only. Despite these
inconsistencies, the relative magnitude of the reductions that
the plans would make can be observed from the data. The
following table (Table 2) summarizes these estimated benefit
reductions (blank cells in the table indicate the data were not
available from the actuaries' memoranda).
Table 2. Comparison of SSA Actuaries' Illustrative Reductions in Initial Social Security Benefits Projected to
Result From S. 1792, NCRP, and Ball Plans
----------------------------------------------------------------------------------------------------------------
Benefit reduction as % of current law benefit
Year of retirement Age of --------------------------------------------------------
retirement S. 1792 NCRP Ball plan a
----------------------------------------------------------------------------------------------------------------
Low-wage earners b
2010................................... 65 ........... 7% less than 1%
2020................................... 65 ........... 12% less than 1%
2025................................... 65 11% 13% less than 1%
2025................................... 67 ........... 9% between 1 and 2%
2030................................... 65 ........... 19% less than 1%
2030................................... 67 ........... 14% between 1 and 2%
2040................................... 67 ........... 22% between 1 and 2%
2050................................... 67 ........... 25% between 1 and 2%
2060................................... 67 ........... 28% between 1 and 2%
2070................................... 65 22% less than 1%
2070................................... 67 ........... 31% between 1 and 2%
Average-wage earners b
2010................................... 65 ........... 10% less than 1%
2020................................... 65 ........... 33% less than 1%
2025................................... 65 11% 33% less than 1%
2025................................... 67 ........... 29% between 1 and 2%
2030................................... 65 ........... 38% less than 1%
2030................................... 67 ........... 33% between 1 and 2%
2040................................... 67 ........... 39% between 1 and 2%
2050................................... 67 ........... 42% between 1 and 2%
2060................................... 67 ........... 44% between 1 and 2%
2070................................... 65 22% less than 1%
2070................................... 67 ........... 48% between 1 and 2%
Maximum-wage earners b
2010................................... 65 ........... 17% see footnote a
2020................................... 65 ........... 38% see footnote a
2025................................... 65 6% 38% see footnote a
2025................................... 67 ........... 31% see footnote a
2030................................... 65 ........... 42% see footnote a
2030................................... 67 ........... 38% see footnote a
2040................................... 67 ........... 43% see footnote a
2050................................... 67 ........... 45% see footnote a
2060................................... 67 ........... 48% see footnote a
2070................................... 65 14% see footnote a
2070................................... 67 ........... 51% see footnote a
----------------------------------------------------------------------------------------------------------------
a The figures in this column are CRS estimates of the impact of this plan's COLA changes on initial benefits
(which assume BLS will alter the Consumer Price Index, CPI, to correct for an overstatement of inflation of
0.3 percentage points per annum). Although no estimates are reflected for the maximum-wage earner case, the
potential impact of the plan's COLA reductions is the same as shown for the low-and average-wage earner cases.
The impact of the increased wage bases proposed in this plan have not yet been calculated, but they would have
the effect of raising benefits for maximum-wage earners, potentially offsetting the COLA reductions in whole
or part, and in some cases causing higher benefits than payable under current law.
b A low-wage earner is assumed to be someone who always earned 45% of the average wage. An average-wage earner
is assumed to be someone who always earned an amount equal to that incorporated in the average wage series
determined and promulgated for Social Security indexing purposes. A maximum-wage earner is assumed to be
someone who always earned an amount equal to the maximum level of earnings subject to Social Security taxation
(e.g., $68,400 in 1998; this amount, referred to as the taxable earnings base, is indexed and rises annually
at the same rate as average earnings in the economy).
Magnitude of illustrative benefit reductions: To highlight
a number of the key outcomes shown by the actuaries'
projections, the NCRP plan would make the largest reductions in
``initial'' Social Security benefits of the three plans. For
instance, for average-wage earners retiring at age 65 in 2025,
the NCRP plan would reduce current law benefits by 33%; S.
1792, by 11%, and the Ball plan, by less than 1%. In the long-
run (see illustrations for 2070), the NCRP plan would reduce
benefits in a range around 50% for average-and maximum-wage
earners (less for low-wage earners). The following table shows
compressed comparisons of the reductions resulting from the
three plans using the estimated benefit impacts shown in Table
2 (blank cells in the table indicate the data were not
available from the actuaries' memoranda).
Table 3. Illustrative Reductions in Initial Social Security Benefits Projected to Result From S. 1792, NCRP, and
Ball Plans, for Retirements in 2025 and 2070 (Compressed Table 2)
----------------------------------------------------------------------------------------------------------------
Benefit reduction as % of current law benefit
Year of retirement Age of --------------------------------------------------------
retirement S. 1792 NCRP Ball plan a
----------------------------------------------------------------------------------------------------------------
Low-wage earners
2025................................... 65 11% 13% less than 1%
2070................................... 65 22% less than 1%
2070................................... 67 ........... 31% between 1 and 2%
Average-wage earners
2025................................... 65 11% 33% less than 1%
2070................................... 65 22% less than 1%
2070................................... 67 ........... 48% between 1 and 2%
Maximum-wage earners
2025................................... 65 6% 38% .............................
2070................................... 65 14% .............................
2070................................... 67 ........... 51% .............................
----------------------------------------------------------------------------------------------------------------
a The figures in this column are CRS estimates of the impact of this plan's COLA changes on initial benefits
(which assume BLS will alter the Consumer Price Index, CPI, to correct for an overstatement of inflation of
0.3 percentage points per annum). Although ``blank'' cells are reflected for the maximum-wage earner case, the
potential impact of the plan's COLA reductions is the same as that shown for the low-and average-wage earner
cases. The impact of the increased taxable earnings bases proposed in this plan have not yet been calculated,
but they would have the effect of raising benefits for maximum-wage earners, potentially offsetting the COLA
reductions in whole or part, and in some cases causing higher benefits than payable under current law.
Distribution of benefit reductions between low, average,
and maximum earners--S. 1792 looks to be relatively regressive
in its benefit reductions compared to the other plans, i.e., it
looks as if it makes a larger reduction in benefits,
percentage-wise, for low- and average-age earners than it does
for maximum-wage earners. However, this outcome is simply the
result of requiring maximum-wage earners to pay taxes on more
of their earnings than they would under current law. S. 1792
raises the taxable earnings base (the maximum amount of
earnings subject to Social Security taxation) and this in turn
requires not only more taxes to be paid by high earners, but
also more earnings to be credited to their earnings records.
This would give them a higher average monthly earnings level in
the computation of their eventual Social Security benefits, and
thus they would get higher benefits than under current law. As
a result, this provision tends to mitigate the other benefit
reductions contained in S. 1792. If this provision were
ignored, the actuaries' analysis shows that the benefit cuts
would be the same, percentage-wise, for low, average, and
maximum-wage earners.
The NCRP plan would incur the largest benefit reductions of
the three plans. However, the actuaries' analysis shows that
the cuts would be relatively progressive, i.e., low-wage
earners would incur a lower percentage reduction in benefits
than maximum-wage earners.
As with S. 1792, the Ball plan would appear to be
regressive in its benefit impact (although not reflected in the
tables above--see the footnote at the bottom of Table 3)
because of the higher benefits payable in the maximum-wage
earner case. Like S. 1792, the Ball plan would increase the
maximum amount of earnings subject to Social Security taxation
and have the effect of raising benefits for the maximum earner.
Ignoring this provision, the cuts would be very small and
proportional on workers of different earnings levels.
Speed of implementation of benefit reductions--The NCRP
plan would implement its benefit reductions much more rapidly
than S. 1792. As reflected in Table 2, where S. 1792 would
cause an initial benefit reduction of about 11% for an average
wage earner retiring at age 65 in 2025, the NCRP plan would
cause a 10% reduction for a comparable wage earner in 2010--in
other words, it would have approximately the same impact about
15 years sooner. For a 2025 retiree, the NCRP plan would create
a reduction of 33% (roughly three times the magnitude of that
of S. 1792).
The Ball plan's reductions in ``initial'' benefits are
marginal in both the short and long range (although the COLA
reduction could have a noticeable impact on retirees' benefits
late in life, e.g., age 80 or 95--see Table 4).
Important Omissions in Comparisons of ``Initial'' Benefit
Reductions
It is important to recognize that the actuaries'
projections of ``initial'' benefit impacts in the previous
examples do not adequately reflect the impact of various
features of the three plans. Specifically, they do not take
into account (1) the proposed expansion of the taxation of
benefits provided for under S. 1792 and the Ball plan, (2) the
lifetime impact of the respective COLA constraints in the three
plans, and (3) the lengthening of the earnings averaging period
used to compute benefits that the three plans would make. The
omission of these impacts is particularly relevant for the Ball
plan, since without them, only very small reductions in
benefits would appear to result from the plan.
Expansion of income taxation of Social Security benefits--
Both S. 1792 and the Ball plan would expand the number of
people affected by, and increase the amount of, income taxation
of Social Security benefits by (1) eliminating the income
thresholds below which recipients pay no tax on their benefits
and (2) taxing benefits in the same fashion as private defined-
benefit pension plans. S. 1792 would have the changes take
effect immediately. The Ball plan would appear to phase them in
(Mr. Ball's description of the proposal does not mention a
phase in, but the estimated savings shown for the measure
suggest that there would be such a feature). The NCRP plan
makes no change in the taxation of benefits (although it would
credit certain proceeds from the current tax on benefits to the
Social Security trust funds that now go to the Medicare HI
trust fund).
Currently, single retirees with incomes in excess of
$25,000 (counting adjusted gross income and one-half of their
Social Security benefits) pay income taxes on up to 85% of
their benefits (up to 50%, if their incomes fall between
$25,000 and $34,000). Couples with incomes in excess of $32,000
(again counting adjusted gross income and one-half of their
Social Security benefits) pay income taxes on up to 85% of
their benefits (up to 50%, if their incomes fall between
$32,000 and $44,000). Today, approximately 75% of Social
Security recipients pay no income taxes on their benefits, in
large part because their incomes do not reach these thresholds.
With elimination of the thresholds (or income exemptions) many
more recipients would pay taxes on their benefits. In addition,
the amount of benefits that would be taxable would rise in most
instances. Estimates made by SSA's actuaries and the
Congressional Budget Office (CBO) suggest that in a typical
case 95% of benefits would be taxed using private pension rules
(in lieu of the current maximums of 50% and 85%, depending on
income).
The potential impact of these provisions of S. 1792 and the
Ball plan is clearly illustrated by examining the case where
recipients now pay no income tax on their benefits. These
retirees could incur as much as a 14.25% reduction in benefits
(or in the value thereof on an after-tax basis), or, although
unlikely, as much as a 26.6% reduction in benefits depending on
their other income and income tax bracket. The reduction of
14.25% would be the maximum impact if 95% of a recipient's
benefits fell into the first income tax bracket (15%
95% of benefits); the 26.6% reduction would occur if 95% of the
benefits fell into the second income tax bracket (28%
95% of benefits).
While the ``zero bracket amount'' (the combination of
personal exemptions, regular standard deduction, and, if
applicable, additional deductions for the elderly) would cause
these proposals to have little or no impact on the lowest
income retirees, those affected would not be exclusively high-
income retirees. For example, if the proposal were fully
effective in 1998, an age 65 retiree receiving an average
Social Security benefit of $765 a month and having other annual
income $8,000 would pay $1,308 in new income taxes. In other
words, this person would go from paying no income taxes under
current law to $1,308 under the proposal. Counting both the
Social Security benefits and other income, his or her total
income would be $17,180, which is considerably below the
estimated average wage of $27,898 (under the trustees'
intermediate assumptions).
This potential impact of S. 1792 and the Ball plan is not
reflected in Tables 2 and 3 above, and its omission distorts
the potential benefit reductions these plans would make
relative to the NCRP plan. The fact that the current law income
exemptions for the taxation of benefits (i.e., $25,000 for a
single recipient and $32,000 for couples) are not indexed does
mean that a greater proportion of future retirees will find
that at least part of their benefits is taxable. However, it
will take many years before inflation makes these exemptions
meaningless. Assuming the trustees' projected inflation rates,
the zero bracket amount for a single elderly retiree may reach
$20,000 by the year 2025, but the annual benefit for an
average-wage earner retiring at 65 in that year is projected to
be $30,208. Under current law, if this retiree had $20,000 in
other income, $5,438 of his or her Social Security benefit
would be taxable at a 15% rate. The income tax paid on these
benefits would be $816, which means the benefits would be 3%
lower on an after-tax basis. Under S. 1792 and the Ball plan,
$28,000 or more of the benefits would become taxable at a 15%
rate, thereby reducing the value of the annual benefits by
$4,200. This means that the benefits would be 14% lower on an
after-tax basis.
Hence, taking the after-tax effects caused by the increased
taxation of benefits into account narrows the difference in the
size of the cuts between S. 1792 and the NCRP plan, and shows
that the reductions under the Ball plan are not negligible
(albeit still considerably smaller than the other two plans).
COLA reductions to adjust for perceived overstatements of
inflation--All three plans would make reductions in Social
Security COLAs to offset perceived overstatements of inflation
as measured by the BLS's monthly Consumer Price Index (CPI).
This is the index used to adjust Social Security benefits so
that their purchasing power does not decline over the
recipients' years on the benefit rolls. While all three plans
appear to have the same motivation, they assume different
degrees of inflation overstatement by the CPI. S. 1792 assumes
the largest amount--1 percentage point annually. The trustees
assume in their intermediate projections that the CPI will rise
at an ultimate annual rate of 3.5%, and that COLAs of this
amount would be paid annually. S. 1792 would reduce these COLAs
by 1 percentage point annually, in essence, providing estimated
COLAs of 2.5%, instead of 3.5%. The NCRP plan assumes the
overstatement is 0.5 percentage point annually, and therefore
it would provide estimated COLAs of 3%, instead of 3.5%. The
Ball plan assumes the overstatement is 0.3 percentage point
annually, and thus would provide estimated COLAs of 3.2%,
instead of 3.5%.
The real impact of these proposals is not adequately
reflected in measurements of ``initial'' benefit impacts,
particularly when looking at retirements occurring near age 62.
Under current law, ``initial'' Social Security benefits are
adjusted to reflect COLAs granted in and after the year in
which a worker reaches age 62, regardless of whether the worker
joins the benefit rolls in that year (this keeps workers who
delay retirement beyond age 62 in the same position with
respect to inflation as workers who retire at age 62--simply
put, they are not disadvantaged because they didn't retire
early). A worker retiring at age 65, for instance, will have 3
years' worth of COLAs built into his or her ``initial''
benefits at age 65.
This aspect of the COLA reductions in the three plans is
reflected in the actuaries' illustrations of ``initial''
benefit impacts, but the lifetime impacts of these cuts are
not. For instance, under the Ball plan, as illustrated in
Tables 2 and 3, the ``initial'' benefit reduction for an age 65
retiree is less than 1%. This is entirely the effect of
reducing COLAs by 0.3 percentage points for 3 years. However,
by age 80, this retiree's benefits would have been reduced by
0.3 percentage points for 18 years. With current law COLAs
assumed to be 3.5%, this proposal would result in benefit
levels at age 80 that would be 5.1% lower than under current
law and at age 95, 9.1% lower. As reflected in the following
table (Table 4), the late-life impacts of COLA cuts in S. 1792
and the NCRP plans would be considerably larger.
Table 4. Projected Impact on Social Security Benefit Levels From Proposed COLA Reductions Contained in S. 1792,
NCRP, and Ball Plans
----------------------------------------------------------------------------------------------------------------
Benefit reduction at each age as % of current law
benefit payable at that age a
Impact on benefit level at age: --------------------------------------------------------
S. 1792 NCRP Ball plan
----------------------------------------------------------------------------------------------------------------
65..................................................... 2.9% 1.4% 0.9%
67..................................................... 4.7% 2.4% 1.4%
80..................................................... 16.0% 8.3% 5.1%
95..................................................... 27.4% 14.8% 9.1%
----------------------------------------------------------------------------------------------------------------
a Note that these estimates reflect only the late-life impact of the COLA reductions, not the late-life impact
of the plans in their entirety. For instance, the actuaries' memorandum shows that the reductions in benefits
taking all the benefit reduction provisions of S. 1792 into account are 32% and 41%, respectively, at ages 80
and 95.
The SSA actuaries estimate that the reduction in lifetime
benefits is about 3% under the Ball plan, 5% under the NCRP
plan, and 10% under S. 1792.
Taking these lifetime COLAs effects into account again
narrows the difference in the size of the reductions made by S.
1792 and the NCRP plan, and better illustrates the reductions
potentially arising from the Ball plan (although the Ball
plan's reductions still would be much less than those caused by
the other two plans).
The lengthening of the earnings ``averaging period'' for
computing Social Security benefits--Under current law, Social
Security benefits are computed from a worker's earnings record
averaged over a 35-year period. The highest 35 earnings years
are counted. All three plans would lengthen this averaging
period. S. 1792 and the Ball plan would lengthen it to 38
years. The NCRP plan would lengthen it to 40 years. The impact
of this change is not reflected in the actuaries' illustrations
of ``initial'' benefit impacts largely because the
illustrations reflect careers of steady earnings that exceed 35
years. However, the proposal's largest impact would be on
workers with careers of erratic earnings, that may include
significant periods of not working. For instance, a worker
retiring at age 65 in 1998 with a 35-year career of average
earnings would receive a monthly benefit of $938. If the
averaging period were 38 years in length, this worker would
have 3 years of zeros in his or her earnings record, and this
would lower the average earnings level used to compute
benefits. In this example, the worker would receive $885 in
monthly benefits, representing a 6% reduction from the current
law level. If the averaging period were 40 years, the monthly
benefit would be $854, representing a 9% reduction.
Hence, this proposal, as with the proposals to increase the
taxation of benefits and reduce annual COLAs, has the potential
to reduce benefits further than that shown by the actuaries'
illustrative ``initial'' benefit impacts. The actuaries point
this out in their memoranda by stating that even though the
provision would have a negligible impact in the examples they
use, overall the provision would reduce the total benefit cost
of the Social Security system by 3%. Obviously, the longer the
averaging period, the greater the reduction in benefits. In
this respect, the provision in NCRP plan would cause the
largest reductions since it would lengthen the averaging period
by 5 years, whereas S.1792 and the Ball plan would lengthen it
by 3 years.
Conclusion
In summary, using the SSA actuaries' analyses of the
impacts of S. 1792, NCRP, and the Ball plan, the NCRP plan
would cause the largest reductions in benefits for the Social
Security system in the aggregate and as well as in individual
recipient cases generally. S. 1792, however, does make a larger
reduction in annual COLAs and increases the taxation of
benefits (the NCRP plan does not). Thus, it is highly probable
that in many instances the benefit reductions caused by S. 1792
would approach or even exceed the size of those arising from
the NCRP plan. The Ball plan would clearly make the least
reductions of the three plans, but they are not necessarily
negligible as one might deduce from looking only at the plan's
impact on ``initial'' Social Security benefits.
Chairman Bunning. Our first panel we will hear from today
starts with Dr. Michael Boskin, senior fellow from the Hoover
Institute, and Tully M. Friedman, Professor of Economics from
Stanford University; Dr. Peter Diamond, Institute Professor
from the Massachusetts Institute of Technology and, cochair of
the National Academy on Social Security's Panel on
Privatization of Social Security; Francis Cavanaugh, former
Executive Director of the Federal Retirement Thrift Investment
Board; and, Dr. Sylvester Schieber, vice president of Watson
Wyatt Worldwide--that's a mouthful--Member of the Social
Security Advisory Board and former Member of the 1994-96
Advisory Council on Social Security.
Dr. Boskin, if you would begin please.
STATEMENT OF HON. MICHAEL J. BOSKIN, TULLY M. FRIEDMAN
PROFESSOR OF ECONOMICS, AND HOOVER SENIOR FELLOW, STANFORD
UNIVERSITY; AND FORMER CHAIRMAN OF THE COUNCIL OF ECONOMIC
ADVISERS
Mr. Boskin. Thank you, Chairman Bunning, Mrs. Kennelly, and
other distinguished Members of the Subcommittee. It's always a
pleasure to have the opportunity to appear before the Committee
and any of it's Subcommittees. I've been doing this for two
decades in formal sessions such as this, and informal retreats
on trade, tax, and entitlement issues, and I've always found
this Subcommittee to be an arena, despite the various political
issues that arise, where people need to and take the time to
understand the complexities of complex issues.
I want to commend you for your series of hearings. There's
a lot of discussion and argumentation out in the public about
what some programs would do--pro and con--that I think is
overly simplistic. So I applaud your investing this much time
and energy in exploring these important issues.
I want to make three big points and one little one, and
leave much of the fleshing out of the smaller one to questions
and answers. The first big point is to help set the context for
why it's important to seriously consider the adoption of a
personal account, or an individual account, component to Social
Security.
There are those who would argue that Social Security is in
very good shape, it's current operating surpluses demonstrate
that current revenues are exceeding current outlays, that by
the intermediate projections, all we'd have to do is raise
taxes 2.25 percentage points today and we'd have 75-year
actuarial balance. I think that's very misleading--that we'd
still have a large actuarial balance. Thereafter, there is an
enormous unfunded liability in the current projected Social
Security benefit stream several times the current national
debt.
If we wait and do nothing and act passively, or nibble
around the edges and don't do something in the near future, the
types of tax rates we will ultimately wind up with will be on
the order of 50 percent higher than today. And we have a
similar set of issues, not quite as severe, but a similar set
of issues in Medicare. And that is likely to lead us to Western
European style tax rates. The high tax rates in Western Europe
relative to the United States are one of the major reasons why
those several hundred million people have had a stagnant
economy and no net private sector job growth in a quarter
century. I would not like to see a similar fate await us.
There's also considerable evidence that the level and
structure of Social Security are one of the reasons for the low
personal saving rate in the United States and for the
substantial reduction in the labor force participation of
people 55 and over in the United States.
I say these things just to state that there's far more at
stake than just the future of Social Security, as vitally
important as that is. This program is so large and so
important, affecting virtually every American now and in the
future as a taxpayer and potential recipient, or actual
recipient today, that how you deal with this can have major
impacts on our overall economy.
So the impacts of any reforms you take will be direct
through taxes and benefits, and structure of the system, and
also will be spread widely among all Americans through the
impact it has on the economy.
We all know the demographic trends. Most of the emphasis
focuses on the coming of age and the impending retirement of
the baby boom generation. There's also been an enormous
increase in the life expectancy of the elderly. It's going up 1
month a year, every year. So it's like every year we live, we
get a bonus month in expected value terms. That's unambiguously
good news by the way, even though it imposes extra costs on
Social Security.
But it does raise an issue, for example, about how you deal
with people who are very old and whether the system that was
set up at a time when there were very few old people, is the
one we want 20 or 30 years from now.
So I think--and also I would add, that this demography
suggests that if something isn't done now, in the next 1, 2, or
3 years, and we wait until the baby boomers start to retire,
the fraction of voters who will be in the system or about to be
in the system, and hence who will resist any change in their
benefits and try to have any resolution of the long run
actuarial problems be taxes on future workers will go up
precipitously. So I think there's a political urgency of the
problem that is not often appreciated.
I believe personal accounts are a very important,
promising, and perhaps even vital component of an overall
system of Social Security reform. Along with my Stanford
colleague, John Shoven, and Laurence Kotlikoff of Boston
University, at the time of the 1983 reforms, I proposed a
system of personal accounts for some of the same reasons and
some others in a different context than is discussed now.
But I think it is important to establish that the
establishment of personal accounts done properly--and you'll
hear much more of that from the rest of this panel and the
next--has the capacity to increase the saving rate,
particularly among low- and lower-middle-income people who are
liquidity constrained. It is likely therefore to take some
pressure off of Social Security in the long run, as well as to
have some good effects directly on those people.
And, importantly, and I think this is a generic social
comment, I believe it is tremendously important for us to
extend the benefits of asset ownership to those who currently
have or are likely to have very little assets at retirement. I
would say it's analogous to avoid disenfranchising, as has
occurred in Europe, tragically, a large part of the potential
workers from the labor market.
The personal accounts obviously come in many forms. You've
discussed some in previous hearings. There were different
proposals from the advisory council. Most of the discussion
recently limits them to the retirement component of Social
Security, leaving disability, HI, hospital insurance survivors,
and dependents components in the defined benefit system.
And there are many choices and combinations--mandatory or
voluntary contributions made by or through individuals,
employers, collected by the government; funds invested by the
government or contracted out to private financial institutions,
or directly from individuals or employers to private
institutions.
The funding that has been proposed in some instances comes
from an allocation of a part of the FICA tax, and others from
refundable credits from current and projected future budget
surpluses, that is, from general revenue.
Chairman Bunning. I'm going to have to interrupt, because
you have run out of time--if you would wrap up your testimony,
I would appreciate it.
Mr. Boskin. Sure. I would just say that it is important, as
you look at these, and as you decide which of the many
possibilities for establishing personal accounts is the best
system, that you take into account the entire Social Security
system. Do not, as the recent CRS proposal analysis did, ignore
the benefits from the individual accounts when you look at
people's benefits. Do not assume that using the surpluses
doesn't have an opportunity cost in terms of foregone tax cuts
or other uses of those funds.
And in doing so, I believe that you'll come to the
conclusion that personal accounts can be an important component
of Social Security reform that strengthens the system, provides
greater individual incentives, strengthens the economy, and
dramatically reduces the need for very large future tax
increases that would be very damaging for the economy.
Thank you very much.
[The prepared statement follows:]
Statement of Hon. Michael J. Boskin, Tully M. Friedman Professor of
Economics and Hoover Senior Fellow, Stanford University; and Former
Chairman of the Council of Economic Advisers
I. Introduction
Social Security is probably the nation's most popular
social program. It is also one of the sources of the
substantial reduction of the poverty rate among the elderly.
Social Security annually collects hundreds of billions of
dollars in taxes from more than 100 million workers, and pays
benefits to over 40 million retirees, survivors, dependents and
disabled persons. But Social Security also faces severe long-
term challenges. The unfunded liabilities amount to over $10
trillion. If Social security continues on its current pay-as-
you-go basis, it will have to reduce benefits substantially or
raise taxes to a level that is likely to seriously impede the
performance of the economy. For example, waiting passively for
the deficits to occur in about 10 to 15 years, would mean that
payroll tax rates would eventually have to rise to almost 19
percent of payroll. Alternatively, tax revenue would cover only
\3/4\ of projected benefits. An additional large payroll tax
increase would be necessary to cover the remaining unfunded
liabilities in Medicare.
Increases in tax rates of this magnitude would move us
close to Western European levels of taxation. Such high rates
of taxation are a major reason why Western Europe has stagnated
in recent years. In fact, combined with the extremely generous
social welfare payments, heavy handed regulation of business,
and extensive labor mandates, European public policies have
made it virtually impossible to create private sector jobs in
Western Europe. Compared to 1970, there are 35 million more
working age people in Western Europe, but no more private
sector jobs, and vast increases in long-term unemployment. If
we allow ourselves to wait passively and merely raise taxes to
deal with the demographic transition in Social Security and
Medicare, a similar fate may await us.
There is considerable evidence that the level and structure
of Social Security taxes and benefits is also one of the
reasons for the low personal saving rate, particularly for low
income people, and for the substantial reduction in labor force
participation among those over 55. Further, since the payroll
tax comes on top of the income tax, it raises marginal tax
rates which distort decisions even higher.
I raise these issues to reiterate that there is far more at
stake than the future of Social Security in how we go about
strengthening the program without worsening incentives for
employment, saving and production in the private economy.
Demographic trends suggest that it is important to deal
with these problems soon. We are transitioning from a
relatively stable one retiree for every 3\1/4\ workers to about
one for every two. Some say that there's not much of a problem,
a 2.25 percentage point increase in the payroll tax deals with
the 75-year projected actuarial deficit and that is no big
deal. This is both wrong and dangerous.
First, some perspective on the 2.25 percentage points. This
is roughly double the short run temporary defense buildup in
the Reagan years. That buildup, one of the major causes of the
collapse of Communism, was enormously controversial. We have
been overdoing the defense drawdown in the post-Cold War era.
Comparing the two scenarios, something twice as large for 75
years as opposed to half as large and temporary for six or
eight years, underscores how substantial the increase would be.
Second, the 2.25 percentage points is disingenuous. While it is
always difficult to forecast demographic trends in the distant
future, the current projections would leave Social Security
with only enough revenues to pay about three quarters of the
projected benefits for the indefinite future including well
after the 75 year projection horizon. The 2.25 percentage point
payroll tax increase would have to be doubled about to 4.5
percentage points to deal with the problem on a sustained
basis. That amounts to over a 33 percent increase in the Social
Security payroll tax.
Third, as noted above, these figures reflect the gap if the
large tax increase occurred now. If, instead, nothing is done
in this period of short-term ``operating surpluses,'' much
larger tax increases or benefit cuts would have to be
implemented once the Baby Boomers retire. The tax increases or
benefits cuts would not just be much larger, but the political
system would be biased toward tax increases if we wait. That is
because the longer we wait, the larger the fraction of the
voting population that will be receiving, or about to be
receiving, benefits, and unlikely to vote to slow their growth,
as opposed to raising taxes on the next generation to pay for
them.
Finally, any major change in Social Security should be done
gradually with a grace period so that those already retired, or
about to retire, do not suffer any major discontinuity in what
they have come to expect, and, correspondingly, those young and
middle-aged workers can plan for a somewhat different system
over enough years that they can adjust their private saving and
future retirement planning behavior as necessary without any
radical disruption. As can be seen from my remarks, I believe
there is an economic and political urgency to reform,
strengthen and improve the Social Security system.
II. Personal Accounts
As one of the first people to propose a system of personal
accounts, (with my Stanford colleague John Shoven and Boston
University economist Laurence Kotlikoff in the early 1980's)
there are many reasons why I believe it is a good idea to have
a private component of Social Security. These include, but are
not limited to, the following: potential increases in private
and national saving accompanying a likely increase in the
private saving of low and middle income individuals who
currently save very little and have historically arrived at
retirement with very little liquid financial assets. The
additional saving would be good for the economy in general, but
just as important, this would take some pressure off of future
Social Security finances. Perhaps most important, from my
standpoint, are the tremendous societal benefits that could
develop from extending the benefits of asset ownership to those
who currently have, and are likely to have at retirement,
little financial assets. Just as it is important not to
disenfranchise a large segment of the population from the labor
market, as has tragically occurred in Europe, I believe it is
also important that virtually all Americans have some stake in
the capital markets.
Personal savings accounts come in a variety of flavors,
proposals and types. Most of the discussion recently limits
them to part of the retirement component of Social Security,
leaving the disability, hospital insurance, survivors and
dependents components of Social Security in the current defined
benefits system. Participation could be mandatory or voluntary.
Contributions can be made by individuals, employers, or
collected by the government. Funds can be invested by the
government or contracted out to private financial institutions.
This funding comes from dedicating a portion of the current or
projected future payroll tax, or from general revenues
including the projected future budget surpluses. This can be
done by directly establishing individual accounts or by
providing a refundable tax credit for individual contributions.
Each of these characteristics of a personal saving accounts
component of Social Security has pros and cons under different
scenarios. These involve trade offs. For example, the takeup
rate for refundable credits historically has been well under
100%. Importantly, the administrative costs of handling lots of
small contributions might be substantial from the viewpoints of
small businesses with few employees or private financial
institutions administering such accounts. In order to prevent
those with modest contributions because of low earnings or
part-time employment from being priced out of the market or
obtaining (net of fees) lower rates of return, the government
might wish to require private financial institutions to take
all comers with a uniform basis point fee. All current
proposals maintain a defined benefit system, either quite
similar to the current system, or at least sizable minimal
benefit for those whose private accounts have, for whatever
reasons, not accumulated enough to finance a minimal level of
retirement consumption. Where to draw the appropriate tradeoff
between what remains in a payroll tax financed defined benefit
system and a however financed individual retirement defined
contribution system is a question of economics, politics, and
other considerations.
While I strongly favor the establishment of an individual
defined contribution account, it is important not to mistake
the important benefits of such a program with the still larger
set of issues necessary to adequately reform Social Security.
Much of the current debate on establishing personal saving
accounts suggests using the projected federal unified budget
surplus in coming years to get them started (for example with
refundable tax credits). While I believe the case for
establishing individual accounts is strong, it is important to
keep two things in mind: First, the projections of budget
surpluses are exactly that, projections. Second, when
comparisons are made of what is likely to be accomplished with
individual accounts relative to the long run actuarial deficits
in Social Security, or how differently situated individuals and
groups fare with respect to such a program, that the
measurement be done against an appropriate baseline projection.
For example, one proposal establishes two percent individual
accounts with refundable tax credits financed from projected
budget surpluses. Assuming a continued equity premium along
historic lines and a reasonably high fraction invested in
equities, would be sufficient, combined with a high rate of
reduction (say 75 percent) in future Social Security benefits
for each dollar withdrawn from future individual accounts, it
is argued, to finance future benefits without a tax increase.
While I believe it is likely that such a proposal would make a
sizable dent in the long term actuarial deficit, I do not
believe it is certain that it will, and it is very likely that
it will not cure the entire long term actuarial deficit. To do
so, I believe, would require some additional slowdown in the
growth of benefits and/or additional financing.
Third, use of surplus funds for establishing individual
accounts may well be a good idea, but it does not come free. We
should not fall into a trap of mathematical illusion by the
number zero. Projected surpluses are coming from somewhere,
namely tax revenues are exceeding outlays, and included in any
calculation of who wins and loses by how much must be the
opportunity costs of not using the budget surpluses to lower
taxes. Lower taxes, especially lower tax rates, would
strengthen the economy and, of course, are also part of what
households would be giving up in terms of their own private
saving and consumption, if personal accounts are financed by
budget surpluses.
There are two additional concerns that should be kept in
mind with the establishment of personal accounts. First, the
impetus for establishing them has undoubtedly been given a
booster shot by the recent strong performance of the stock
market. This is certainly making the public much more willing
to consider investments in equities themselves, and for Social
Security trust funds and any individual component of Social
Security. Again, it is likely that an equity premium will
continue over long periods of time, but we should be aware that
extrapolating the historical premium, may or may not prove
reasonable.
Second, most younger workers seem to believe that Social
Security is almost certain to go broke. While this is
undoubtedly an exaggeration--see the discussion above--it is
certainly true that the expected returns to each successive
cohort of workers has been declining. The early cohorts of
retirees received tremendous returns on their and their
employers' contributions; large multiples of funds paid in plus
interest. Those early windfalls are gradually dissipating and
turning to returns that are likely to be considerably below
what could be earned in private capital markets. Hence, many
young workers are skeptical of receiving back much of a return,
or even some of the principal, that they paid in on their
Social Security taxes. On the other side of the age spectrum,
however, are many millions of retirees, approximately one-third
of which are not very well off. Any transition from the current
pay-as-you-go financing of Social Security system to a
privatized defined contribution system must account for
continued payments for whatever benefits (I assume not
radically different from current benefits) that current and
about to retire workers will receive. Hence, one cannot
immediately move to a system of defined contribution accounts,
even a modest one of say two or three percentage points of
payroll, without finding additional taxes somewhere. It may be
additional taxes already scheduled or projected in budget
surpluses, but they are additional revenues. For perspective,
moving to a complete funding of the transition to full
individual accounts would require ten trillion dollars in
recognition bonds or massive tax hikes. While some believe that
so-called recognition bonds have very little impact on the
economy, I believe this is a risky assumption.
There are a number of substantive and practical issues
raised by the many proposals to establish personal defined
contribution accounts. Let me briefly mention several. Among
the generic issues are the following:
1) What options should workers have about how to invest
their contributions?
2) What rules govern withdrawals?
3) How should spouses be treated?
4) How can the administrative costs be minimized,
especially those associated with small accounts?
Numerous tradeoffs exist in achieving desired goals. For
example, the more choice afforded workers on their investments,
the more likely that some will do relatively poorly, thereby
increasing pressure to make up the difference later. Clearly,
even minimal education knowledge of the principles of investing
is not universally, or at least likely to be universely
followed. While, in principle, I favor substantial choice, in
practice some guidelines/regulations would have to be imposed.
At the very least, an array of broadly diversified, perhaps
index, fund choices should be available. Withdrawals should
either be in the form of (joint survivor) annuities, or some
minimum balance should be maintained. Care should be taken that
benefits for surviving spouses not be jeopardized, with
contributions sharing and/or some other vehicles.
Finally, I believe administrative costs especially for
small accounts can be a serious problem for small businesses,
low earners and/or private financial institutions. The record
keeping, checking errors, accounting, trustee, legal and
investing costs would be large relative to small periodic
contributions from low earners or part time workers. I believe
technology and financial innovations are driving these costs
down, as the availability of no load mutual funds such as
through Schwab's OneSource, demonstrates. However, I believe it
will be necessary to require financial institutions
administering such accounts to charge the same fees to all
workers irrespective of account size. If the costs are deemed
too high, I believe it is important that any government holding
of the accounts be temporary, with legislated movement to the
private market at a date certain.
Conclusion and recommendations
The long run actuarial problems of Social Security stem
form two primary factors: changing demography and modest
projected long term economic growth. The single best thing we
can do for Social Security's future is to do everything we can
to enhance long run economic growth. Every tax, regulatory,
education, litigation, and trade policy issue that comes before
this Congress has ramifications for the future of Social
Security. We need lower tax rates, more market oriented
education and training reforms, expanded rules based trade
liberalization, serious tort reform and more flexible, less
costly, regulation. Those types of reforms, together with
sensible reforms that bring Social Security and Medicare into
long term actuarial balance while at the very least preventing
the large tax increases that worsen incentives in the economy,
and at the best, actually strengthen incentives, are the most
important thing that can be done to strengthen Social Security
and beyond that the nation's long term economic prosperity.
Thus, while I strongly favor the establishment of
individual accounts, or personal saving accounts, it is
important not to overstate their many potential benefits and
ignore the other financial and structural issues that will have
to be dealt with as part of Social Security reform over time. I
do believe that a sound system of personal security accounts
can be established at a modest rate (perhaps 2 or 3 percentage
points of payroll) and financed and administered in such a way
that the benefits of the program vastly exceed its costs. I
believe the primary benefits would be a modest increase in the
saving rate due to an increase in the saving of low and low
middle income households which are currently saving very
little; taking some of the pressure off the defined benefits
portion of the Social Security system in the future; reducing
the need for future damaging tax increases; sharing the sizable
benefits (but also the risks) of broader asset ownership to
virtually the entire population; and improved intergenerational
equity relative to the current system.
Chairman Bunning. If you have long statements, past the 5
minutes, I would prefer that you enter into the record. Without
objection, we'll enter them in.
Mr. Boskin. I'd ask for mine, please.
Chairman Bunning. OK.
Dr. Diamond, if you would continue.
STATEMENT OF PETER A. DIAMOND, INSTITUTE PROFESSOR,
MASSACHUSETTS INSTITUTE OF TECHNOLOGY
Mr. Diamond. Mr. Chairman, and Members of the Subcommittee,
I'm pleased and honored to be here today. Some advocates look
to individual accounts to substantially--individual accounts
with equity investments, of course--to substantially increase
the rate of return from Social Security, substantially increase
national savings and economic growth. At the same time, some
analysts have looked at investment in equities by the trust
fund and have concluded that's not an improvement in our
retirement income system.
My main message for today is that trust fund investment in
equities and individual account investment in equities are very
similar to each other. And understanding that similarity will
help to understand the role of individual accounts in improving
our retirement income system. They're similar, but not
identical.
There are three important economic differences. One is the
costs are obviously higher with any individual account system
than with trust fund investment in equities. Second, the risk
characteristics put more of the risk directly on those
retiring, if you have individual accounts. And third, the
ability to integrate the retirement income system with the
disability system; the benefits for children who lose parents;
the benefits for divorcees, and elderly divorced women are
among the poorest of our elderly--that integration goes better
in a fully defined benefit system.
But let me focus on the similarities, because that's the
important message I'm trying to bring. Let's trace through what
would happen if the trust fund were to buy equities. If the
trust fund buys equities, it finances that by holding less in
Treasury bonds. The Treasury then has to sell more bonds to the
public.
Where does the public get the money to buy the bonds?
That's easy--it gets the money from having sold the equities to
the trust fund. In other words, this is an asset swap. The
public ends up holding more Treasury bonds and fewer equities;
the trust fund ends up holding more equities and fewer Treasury
bonds. The fact that it's an asset swap means its first impact
on the economy is very small. That doesn't mean there aren't
important effects over time, but that first impact is very
small.
Now let's trace through the same sequence for individual
accounts. Assume that part of the payroll tax revenue goes into
individual accounts, instead of going to the trust fund. What
happens? The trust fund, having less revenue, will hold fewer
Treasury bonds. The Treasury will have to sell more bonds to
the public.
Where will the public get the money to buy those bonds?
They'll get it from having sold equities to the individual
accounts. Once again, it is simply an asset swap. And it has,
to a first approximation, skipping the three elements I
identified to begin with, the same effects.
Individual accounts have the same effects as trust fund
investment in the same portfolio. So individual accounts by
themselves don't increase national savings. And individual
accounts by themselves don't increase a risk adjusted rate of
return on Social Security.
To increase national savings, we need to put new revenue
into the individual accounts. If we devote new revenue to
individual accounts, then we can increase national savings. If
we devote the same new revenue to building up the trust fund,
we get the same increase in national savings. That new revenue
will raise the long run rate of return on Social Security for
our children and grandchildren coming down the road.
But in order to get the new revenue, some people have to be
giving something up today, whether it's a payroll tax increase,
or not getting some tax cut, or benefit from expenditure that
might come from alternative uses of the surplus. And that means
that the rate of return from Social Security goes down for the
people who are financing the new revenue, at the same time that
it goes up for future generations who will be benefiting from
it.
And that analysis holds for individual accounts and holds
for trust fund investment in equities. I could get into the
cost differences and the risk differences, but the light's
already yellow, and this is probably the right time to stop.
[The prepared statement follows:]
Statement of Peter A. Diamond, Institute Professor, Massachusetts
Institute of Technology
Mr. Chairman and Members of the Committee, I am pleased and
honored to have the opportunity to appear before you today to
discuss the topic of individual accounts for Social Security.
My task for today is to discuss the economics of individual
account investment in private securities--and I will focus
particularly on equities. Some people favor individual accounts
for philosophical or political reasons, but I will discuss only
economics. Since equities have had a higher long-run rate of
return than Treasury bonds, individual accounts are seen by
some as a way to increase the rate-of-return from Social
Security.
Social Security investment in equities can be done in three
different ways. We can invest part of the Social Security Trust
Fund in equities, we can set up government-held individual
accounts, similar to the Federal Employees' Thrift Savings Plan
(TSP), and we can set up individual accounts that are held by
private financial institutions, similar to current Individual
Retirement Accounts (IRAs). The three approaches are roughly
similar in how they impact national savings and the rate-of-
return from Social Security (including the individual
accounts). But they differ in their administrative costs,
sharing of market risks, need for worker education, and burden
on employers.
Let me make three points that apply to all three
approaches. First, with all three methods of investing, some
increase in expected returns can be obtained, but only by
taking on more risk. Second, by themselves, none of the methods
directly increases national savings in the short run. Third,
none of them has a large impact on the risk-adjusted rate-of-
return from Social Security. These conclusions hold whether we
create individual accounts or not.
But, there are also important differences among these
approaches. First, Trust Fund investment costs less than
government-held accounts, which, in turn, cost less than
privately-held accounts. Second, workers have more choice with
privately-held accounts than with government-held accounts, and
no choice with Trust Fund investment. Third, stock market risk
is a greater concern with privately-held accounts than with the
narrower range of choice from government-held accounts, and
stock market risk is a greater concern with any individual
account plan than with Trust Fund investment in equities.
Finally, privately-held accounts have a greater need for (and
expense from) worker education than government-held accounts
and both have more need than with Trust Fund investment.
I. National Savings and Rates-of-Return
As has been noted by many analysts, Trust Fund investment
in equities rather than in Treasury bonds does not directly
raise national savings. To directly raise national savings we
need additional net revenue for Social Security, through a tax
increase, benefit cut, coverage expansion, or new source of
revenue. Without additional net revenue, the value of equities
acquired by the Trust Fund is matched by a decrease in the
value of Treasury bonds held by the Trust Fund. Similarly,
without additional net revenue, diverting some payroll tax
revenue into individual accounts leaves less revenue flowing
into the Trust Fund. Without additional net revenue, the value
of bonds and equities acquired by individual accounts is
matched by a decrease in the value of Treasury bonds held by
the Trust Fund. In both cases, the public ends up holding more
Treasury bonds and less equities outside Social Security. Thus,
creating individual accounts without additional net revenue
does not directly increase national savings.
With or without individual accounts, a decrease in Social
Security holdings of Treasury bonds that matches an increase in
the holdings of equities is an ``asset swap.'' That is, the
aggregate effects of the creation of individual accounts is
similar to the effects of a change in portfolio by the Trust
Fund.
As has been noted by many analysts, Trust Fund investment
in equities reduces the projected actuarial deficit and will
increase the expected rate-of-return from Social Security for
future workers. However, in our economy this increase in the
expected rate-of-return comes with an increase in the riskiness
of that return.
Moreover, the added expected return is not enough, by
itself, to raise the future rate-of-return from Social Security
up to the level of market returns. The reason that the rate-of-
return remains below the market return is the presence of an
unfunded liability. The unfunded liability exists because
Congress voted to give retirees in the 1940's and 50's and 60's
and 70's far more in benefits than could have been financed by
the taxes each of these groups paid. On average, these retirees
were much less well off than are current and future retirees.
Most retirees prefer not to live with their children if they
can afford to live separately. So current workers are
benefiting from seeing that their elders have a better standard
of living and that they are capable of living on their own. But
current workers must receive a lower return from Social
Security in order to pay for the higher returns received by
earlier generations.
The same analysis holds for individual accounts. The
creation of individual accounts does not change the history
that leaves Social Security with unfunded liability. The rate-
of-return from Social Security, including both individual
accounts and the financing of the transition, is not increased
by the creation of individual accounts per se.
An increase in the funds for Social Security, whether in
individual accounts or in the Trust Fund, will increase the
rate-of-return from Social Security for future generations. But
this increase only comes at a cost of lowering the rate-of-
return from Social Security for the generations who have to pay
to provide increased funds for Social Security, whether they
pay in the form of increased taxes, new mandated savings,
decreased benefits, or the use of general revenues for Social
Security rather than for tax cuts and other expenditures.
In short, individual accounts without an increase in funds
for Social Security will not directly raise national savings or
increase the risk-adjusted rate-of-return from Social Security.
Increased funding will raise national savings and will
eventually raise the rate-of-return from Social Security, but
only by putting the cost of increased funding on current
workers. Increased funding can be done with or without
individual accounts.
II. Administrative Costs
Most proposals with individual accounts also continue some
defined-benefit retirement program. They also keep Social
Security in place to provide benefits to the disabled and to
young children when a parent dies. Thus, the current
administrative structure and cost of Social Security will
continue into the future. Letting the Trust Fund invest in
equities will add trivially to this cost. The 1994-1996
Advisory Council on Social Security estimated that the
additional cost would be \1/2\ of 1 basis point (\1/2\ of one
one-hundredth of one percent) for the amount invested in
private securities. That is, for each billion dollars invested
in private securities, the annual cost would be roughly
$50,000. This estimate seems roughly right.
Any creation of individual accounts will add to costs,
because of the need for new institutions and because of
duplication of administrative tasks with some proposals. The
size of these additional costs depends on the structure of the
accounts. The overwhelming bulk of the costs associated with
accounts depends on the existence of the accounts, not the
precise value of assets in the accounts. While it is common to
state costs in terms of basis points charged annually on
balances in accounts, I think it is better to think of costs as
dollars per person per year. This cost can then be compared
with the amounts going to the individual accounts. It is
important to remember that the workers covered by Social
Security average much lower earnings than do those covered by
401(k) plans. For example, in 1996, 58 percent of workers
covered by Social Security had annual taxable earnings below
$20,000, and 23 percent had earnings below $5,000.
The TSP cost roughly $23 to $24 per worker in 1997. A
worker earning $27,000 per year (roughly mean earnings), would
deposit $540 per year with 2% accounts. Thus the costs of the
TSP would be 4.4% of the amount deposited. In the vocabulary of
mutual funds, we can consider this a front-load of 4.4%. (TSP
costs would be 2.9% of mean deposits with 3% accounts and 1.7%
with 5% accounts.) Would government-held accounts cost more or
less than TSP costs per worker? It is hard to say, since it
depends on the details legislated--with a bare bones system
some costs would be higher and some costs would be lower
(including the provision of considerably less in services than
TSP offers). This $23 figure strikes me as a reasonable
ballpark number; but it is roughly twice what was assumed by
the Advisory Council on Social Security for government-held
accounts. Let me put this number into two contexts. First, it
would more than double the administrative costs of Social
Security. Second, this front load of 4.4% on a 2% account is
equivalent to a 4.4% cut in this portion of benefits, compared
to what could be financed with the same aggregate portfolio
invested by the Trust Fund.
Privately-held accounts would cost more. How much more
depends on how withheld funds get to financial institutions,
what services are provided and what types of investments people
choose. Taxes could be collected as they are now, with deposits
by the government into the privately-held accounts once a year.
Direct payment to financial institutions by employers or by the
workers themselves would raise costs significantly on firms, on
workers and on financial institutions. The cost of
reconciliation of account deposits with taxes withheld is a
particular problem. Moreover, setting up a system of
reconciliation would duplicate what Social Security already
does in reconciling W-2 forms with both taxes transmitted to
the Treasury and Social Security records. Furthermore, direct
payment to financial institutions would require additional
enforcement efforts on the part of the Internal Revenue
Service.
In thinking about how much private firms would charge
workers for maintaining these accounts, we need to consider
both the direct costs of handling the accounts and the
marketing costs and profits of the firms. As with other
markets, some firms will set low charges and others will set
high charges. The charges will depend on the range of services
provided by the firms, on whether they are allowed to charge
workers when reallocating accounts after a divorce, and on the
regulatory structure placed on these accounts.
It is difficult to know which existing accounts represent
the closest approximation to what these accounts are likely to
cost. Total costs for 401(k) plan administration vary greatly
with the size of the firm and the services provided to workers.
They also include the cost of providing information to comply
with government regulations, some of which would not be present
for Social Security accounts. On the other hand, reconciliation
costs for financial institutions are held down since they
receive all deposits together from the employer and generally
electronically. IRA accounts also have little cost from
reconciliation and they receive less regulation than is likely
for mandatory accounts, since the government would be more
concerned about protecting workers subject to a mandate.
Consideration of either 401(k) or IRA accounts show higher
costs on average than those of TSP, even with the lowest cost
firms. Average charges would be considerably higher than the
costs in the lowest cost firms. And charges would be higher (in
percentage terms) on smaller accounts, unless the government
required firms handling the accounts to offer the same
opportunities to all workers.
A different approach to estimating charges is to consider
foreign experience with privately-held accounts. Costs in Chile
are roughly 20% of deposits each month, equivalent to a 20%
front load. As discussed in the appendix, a 20% front load is
roughly equivalent to a 1% annual maintenance fee for a full-
career worker. A 20% front load or 1% annual maintenance fee
seems to me a reasonable ballpark number for what accounts
would cost in the US, on average, if they were as big as in
Chile -10% of payroll. In Argentina and Mexico, with similar
structures but smaller accounts, the charges are higher in
percentage terms. In the UK, an advanced economy with
privately-held individual accounts, costs are higher than in
Chile. So I think that privately-held accounts would cost at
least 4 times as much as accounts held by the government in a
bare bones system. That is, the part of payroll tax payments
that is used to finance benefits through privately-held
accounts contains a 20% benefit cut compared with what could be
financed by the same aggregate investment in equities by the
Trust Fund.
It is common in discussing individual accounts to focus on
the accounts and to ignore the additional costs that come with
the provision of benefits from the accounts. But it is
retirement income, not fund accumulation, that is the central
purpose of Social Security. That means that accumulations need
to be turned into streams of monthly payments. Annuitization
adds to costs. If accounts are not annuitized, workers and
their families risk outliving their money. So the costs of
annuitization need to be added to the cost of maintaining
individual accounts.
III. Market Risk
Estimates of the market risks associated with individual
accounts depend on how the past is interpreted as a guide for
the future. Estimates of the future performance of the stock
market vary in their assumptions on the possibility of very low
probability very bad events and on the extent to which the
market is currently overvalued, both issues that are in
dispute. What we can say is that a defined-benefit approach has
the ability to spread the market risk across workers of
different ages and different earnings in ways that are not done
with individual accounts.
IV. Worker Choice
With Trust Fund investment, workers would have no
individual choice on how the assets are invested. With
government-held accounts, they would have choice among a small
number of index funds. This allows workers to adjust their
risk/return combinations by varying their relative holdings of
bond and stock accounts. Having privately-held accounts opens
up additional options, such as managed investment in equities,
wider choice of investments abroad, bank CDs, and insurance
company products. Some of this choice will help individual
workers tailor their investments to their attitude toward risk.
However, it is difficult to assess the investment abilities of
different fund managers. And managed accounts have additional
administrative costs and additional brokerage charges. Workers
should be protected from the most risky choices by limiting
investments to widely diversified portfolios or products
guaranteed by sound financial institutions. However, limiting
investment options requires another layer of regulation.
Indeed, it is to be expected that any use of private firms for
mandated accounts will involve additional government
regulation.
V. Worker Education
The wider the array of choices for workers, the greater the
need for worker education. Worker education that really impacts
worker decisions is expensive, an issue that is particularly
relevant when one is thinking about small accounts. It would be
a large burden for firms that do not offer 401(k) plans to
require employers to provide adequate education about
investment to workers.
VI. Conclusion
Considering only the economics of investment policy, Trust
Fund investment in equities can generate higher returns with
lower risks than do individual accounts. It also avoids the
need for additional regulation that would go with private
holding of these accounts. It also represents a system where it
is easier to protect lower-earning spouses and low earners
generally. But it requires a carefully designed institutional
structure for investing well.
Appendix
The wide variety of charges for fund management can be put
into a common frame by comparing the ratio of the account
accumulation available at retirement with a given set of
charges to the account accumulation that would be available if
there were no charges. The charge ratio is defined as the
percentage decline in account value as a result of the charges.
The charge ratio depends on the contribution history of the
worker and the rate of return on the portfolio as well as the
structure of charges. For a worker with a 40-year career,
exponential real wage growth of 2.1 percent per year and a
portfolio that earns a real return of 4 percent per year, a 1
percent management fee reduces the value of the account by
19.6%, roughly 20%. That is, for a worker with a 40-year
career, the average deposit is charged a 1% annual fee roughly
20 times. Higher wage growth reduces the charge ratio slightly,
since more contributions are made later in the worker's career
and subject to fewer annual management fees. A lower management
fee reduces the charge ratio roughly proportionally over the
relevant range.
Charge Ratio
------------------------------------------------------------------------
Interest Wage Career Front Load Mgmt Fee Charge
Rate (%) Growth (%) Length (%) (%) Ratio (%)
------------------------------------------------------------------------
4.......... 2.1 40 0 1 19.6
4......... 2.1 40 0 0.5 10.5
4......... 2.1 40 0 0.1 2.2
4......... 2.1 40 1 0 1
4......... 2.1 40 10 0 10
4......... 2.1 40 20 0 20
------------------------------------------------------------------------
Chairman Bunning. Thank you.
Mr. Cavanaugh, would you proceed.
STATEMENT OF FRANCIS X. CAVANAUGH, FORMER EXECUTIVE DIRECTOR
AND CHIEF EXECUTIVE OFFICER, FEDERAL RETIREMENT THRIFT
INVESTMENT BOARD
Mr. Cavanaugh. Thank you, Mr. Chairman, I'm delighted to be
here. I'll comment briefly on the four issues the Subcommittee
asked me to address.
First, the effect of Social Security PSA investments on the
capital markets would be slight and gradual increases in demand
for corporate stocks and possibly other private investments and
corresponding decreases in demands for U.S. Treasury
securities. As funds are diverted from the Social Security
Trust Fund, which is now invested solely in Treasury
securities, the Treasury will increase it's borrowing in the
private market.
Treasury borrowing costs might increase slightly, but such
increases might be offset in part by savings to the Treasury
from reducing issues to the trust fund on preferential terms.
PSA investments in stock would probably never exceed 2 percent
of the capitalization of the U.S. stock market.
Your second issue, the cost and administration of the PSAs,
needs much more study. It just hasn't been done. This country
has no experience with a mandatory system of individual
accounts dependant upon the performance of very small employers
and very low-income employees.
In 1994, 46 percent of workers for whom Social Security
taxes were paid earned less than $15,000. Assuming 2 percent of
a $15,000 income or $300, were invested annually in the PSA,
the earnings in such a small account would generally be more
than offset by the cost of servicing the account in the first
several years of the plan.
The net earnings of the average PSA would probably never
equal the net earnings of the funds invested in Treasury
securities in the Social Security Trust Fund.
The administration of PSAs for the 140 million Social
Security employees, if modeled after the 2.3 million member
Federal Thrift Savings Plan, TSP, would require at least 10,000
highly trained Federal employees to man the telephones and
answer employee questions.
PSAs would require the cooperation of 6.5 million private
employers, most of whom could not meet TSP reporting standards.
Federal agencies generally report payroll deductions and other
employee data to the TSP on magnetic tape. But over 80 percent
of private employers are still reporting to the Social Security
Administration on paper, an extraordinarily costly and error
prone process. The cost of error corrections, say for failure
to make timely stock market investments, would be more than
many small employers could bear.
Your third issue, investor education, is a statutory
requirement of the TSP. The Office of Personnel Management has
the primary responsibility for training, but the Thrift
Investment Board itself conducts hundreds of training sessions
each year throughout the country for personnel and payroll
officers and individual plan participants.
These sessions, along with the TSP summary plan document,
animated video, investment booklet, pamphlets, posters, and
other materials, require extensive support from the Federal
employing agencies. Such support could not be provided by most
of the 6.5 million employers in the Social Security Program,
given their lack of resources, the relatively low income of the
average private employee, and the language difficulty. Meeting
TSP standards, if possible at all, could be accomplished only
at a price so high as to reduce net investment earnings to
unacceptably low levels.
As to your fourth issue, the role of employers, large and
small, in the PSA system, large employers with competent
personnel, payroll, and systems experts could be expected to
perform the functions now performed for the TSP by the Federal
employing agencies. Yet most private employers have less than
10 employees. Also, household employers who hire part-time
providers of cleaning and other domestic services are obviously
ill-equipped to meet the employee information needs of a PSA
system.
I believe it would be impossible to establish cost-
effective TSP-type PSAs for the Social Security system. That
is, the net investment earnings after administrative expenses
of the PSAs would be less than the net earnings of Social
Security Trust Fund investments in Treasury securities. Nor
would the IRA-type alternative be cost effective, because of
the relatively high administrative costs of small accounts.
The only feasible way for the Social Security system to
benefit from the higher returns offered by the stock market, is
to invest a portion of the trust fund in stocks, which is what
virtually all large public and private pension and retirement
funds have already done.
Thank you.
[The prepared statement follows:]
Statement of Francis X. Cavanaugh, Former Executive Director and Chief
Executive Officer, Federal Retirement Thrift Investment Board
My name is Francis Cavanaugh. I was the first Executive
Director and chief executive officer of the Federal Retirement
Thrift Investment Board (1986-1994), the agency responsible for
administering the Thrift Savings Plan for Federal employees.
Before that, I served in the U.S. Treasury Department (1954-
1986) as an economist and as director of the staff providing
advice on Federal debt management and related Federal
borrowing, lending, and investment policies. I am currently a
writer and public finance consultant. I represent no clients
and speak only for myself.
I am happy to participate in this hearing on the
administrative costs and feasibility of establishing personal
savings accounts (PSAs) within the Social Security system.
Summary
I will comment briefly on the four issues your subcommittee
asked me to address.
First, the effect of Social Security PSA investments on the
capital markets would be slight and gradual increases in demand
for corporate stocks and possibly other private investments and
corresponding decreases in demand for U.S. Treasury securities.
As funds are diverted from the Social Security trust fund,
which is now invested solely in Treasury securities, Treasury
will increase its borrowing in the private market. Treasury
borrowing costs might increase slightly; such increases might
be offset in part by savings to the Treasury from reducing
issues to the trust fund on preferential terms. PSA investments
in stocks would probably never exceed two percent of the
capitalization of the U.S. stock market.
Your second issue, the cost and administration of the PSAs
needs much more study. This country has no experience with a
mandatory system of individual accounts dependent upon the
performance of very small employers and very low-income
employees. In 1994, 46 percent of workers for whom Social
Security taxes were paid earned less than $15,000. Assuming two
percent of a $15,000 income, or $300, were invested annually in
a PSA, the earnings on such a small account would generally be
more than offset by the cost of servicing the account in the
first several years of the plan. The net earnings of the
average PSA would probably never equal the net earnings of the
funds invested in Treasury securities in the Social Security
trust fund.
The administration of PSAs for the 140 million Social
Security employees, if modelled after the 2.3 million member
Federal Thrift Savings Plan (TSP), would require at least
10,000 highly trained Federal employees to man the telephones
and answer employee questions. PSAs would require the
cooperation of 6.5 million private employers, most of whom
could not meet TSP reporting standards. Federal agencies
generally report payroll deductions and other employee data to
the TSP on magnetic tape, but over 80 percent of private
employers are still reporting to the Social Security
Administration on paper, an extraordinarily costly and error
prone process. The cost of error correction, say for failure to
make timely stock market investments, would be more than many
small employers could bear.
Your third issue, investor education, is a statutory
requirement for the TSP. The Office of Personnel Management has
the primary statutory responsibility for TSP training, but the
Thrift Investment Board conducts hundreds of training sessions
each year throughout the country for personnel and payroll
officers and for individual plan participants. These sessions,
along with the TSP summary plan document, animated video,
investment booklet, pamphlets, posters, and other materials,
require extensive support from the Federal employing agencies.
Such support could not be provided by most of the 6.5 million
employers in the Social Security program, given their lack of
resources, the relatively low income of the average private
employee, and the language difficulties. Meeting TSP standards,
if possible at all, could be accomplished only at a price so
high as to reduce net investment earnings to unacceptably low
levels.
As to your fourth issue, the role of employers, large and
small, in a PSA system, large employers with competent
personnel, payroll, and systems experts could be expected to
perform the functions now performed for the TSP by Federal
employing agencies. Yet most private employers have less than
10 employees. Also, household employers who hire part-time
providers of cleaning and other domestic services are obviously
ill equipped to meet the employee information needs of a PSA
system.
I believe it would be impossible to establish cost-
effective TSP-type PSAs for the Social Security system. That
is, the net investment earnings (after administrative expenses)
of the PSAs would be less than the net earnings of Social
Security trust fund investments in Treasury securities. Nor
would the IRA-type alternative be cost-effective, because of
the relatively high administrative costs of small accounts.
The only feasible way for the Social Security system to
benefit from the higher returns offered by the stock market is
to invest a portion of the trust fund in stocks, which is what
virtually all large public and private pension and retirement
funds have already done.
I will now discuss these issues in more detail.
The Thrift Savings Plan or 401(k) Approach
The TSP has 2.3 million accounts and is the largest defined
contribution plan in the nation, although small compared to any
plan for over 140 million Social Security workers. The TSP
record keeper maintains a highly trained staff of 150 persons
to respond to telephone questions from TSP participants. If the
PSA structure were modelled after the TSP, a telephone staff of
at least 10,000 would be necessary, especially since PSA
participants would generally have less education, income, and
employer support than TSP participants.
PSAs in fact could not be modelled after the TSP, which is
structured much like the voluntary 401(k) defined contribution
plans offered by most large corporate employers. The TSP
requires a highly complex central record keeping system, and it
depends on the Federal employing agencies and their expert
personnel, payroll, and systems people to handle its ``retail''
operations throughout the world. This includes the distribution
of TSP forms and other materials, employee education programs,
and individual counselling. Each agency is required to provide
employee counselling on all aspects of the retirement system,
including the TSP, and the Office of Personnel Management is
required under the TSP statute to provide training for the
agency counsellors.
Employers are also responsible for the timely transmission
of data to the TSP record keeper each payday for each
employee's contributions, investment choices, interfund
transfers, loans, loan repayments, withdrawals, and other
essential information to ensure prompt and accurate investment
and maintenance of employee accounts, including the restoration
of employees' lost earnings because of delayed deposits or
other employer error. While PSA proponents may not contemplate
emergency loans or withdrawals, 401(k)s and the TSP permit
them. I believe that it would be politically impossible to deny
emergency access to funds once their ownership is vested in the
names of individual account holders.
Private employers are now required to report individual
Social Security tax information only once a year. Surely there
would be millions of small employers who would be unwilling or
unable to assume the additional administrative burden of PSAs
and the corresponding financial liability, for example, to make
up for lost stock market earnings resulting from employer
failure to process an employee's interfund transfer request on
time.
Even if the 401(k) approach were made workable for PSAs,
perhaps by adopting (politically unpopular) measures such as
exempting small employers or limiting the earnings or options
of very small investors, net investment earnings would probably
still be much less than would have been earned from Social
Security fund investments in Treasury securities. According to
the Social Security Administration, 46 percent of Social
Security workers, including part-time and temporary workers,
earned less than $15,000 a year in 1994. Servicing such small
accounts would entail unacceptably high expense ratios.
A PSA deposit of two percent of a $15,000 income would
produce contributions of $300 in the first year. Assuming the
annual cost of servicing an account is $30 \1\ (or $4.2 billion
for 140 million accounts), then the expense ratio would be ten
percent, or 1000 basis points, compared to the TSP net expense
ratio of 7 basis points in 1997.\2\ That ratio would clearly
exceed the real (after inflation) returns from PSA investments
in a balanced portfolio of stocks, bonds, and other instruments
in the first year of the plan. Moreover, since individuals with
incomes below $15,000 tend to be risk averse and thus avoid
stocks \3\ in favor of lower yielding fixed-income investments,
their net earnings (after expenses) would likely be negative
for several of the early years of the plan.
---------------------------------------------------------------------------
\1\ According to the ``Report of the 1994-1996 Advisory Council on
Social Security, Volume 1'' (Washington, D.C.), 100, $30 per year is
typical of charges levied for IRAs for flat dollar account maintenance
fees.
\2\ The net expense ratio is the gross expense ratio minus
forfeitures and is the administrative charge to TSP participants. For
example, in 1997 the gross expense ratio was .09, and the net expense
ratio of .07 represented a charge to participants of $0.70 for each
$1,000 of their TSP account balances. The expense ratios have declined
steadily since 1988, when the gross ratio was .67 and the net ratio was
.34.
\3\ In 1995, only 6 percent of families with incomes less than
$10,000 and only 25 percent of families with incomes from $10,000 to
$25,000 had any direct or indirect stock holdings. Arthur B. Kennickell
and Martha Starr-McCluer, ``Family Finances in the U.S.: Recent
Evidence from the Survey of Consumer Finances,'' excerpt from Federal
Reserve Bulletin, January 1997, 12.
---------------------------------------------------------------------------
By contrast, and contrary to popular belief, the Social
Security trust fund now receives a relatively attractive net
return on its investments in special issues of Treasury
securities. The average annual interest rate on such issues
over the past 30 years has been approximately 8.3% (about 3%
after inflation). The trust fund is given preferential
treatment, compared to private investors in Treasury
securities: it is not required to pay any brokerage or security
transaction costs, it receives the (higher) long-term interest
rate on its short-term investments, and it is insulated from
market interest rate risk by being guaranteed par value
redemption on securities redeemed before maturity.\4\ These
securities are safer and more liquid than short-term market
instruments such as Treasury bills or bank CDs which pay
substantially lower rates.
---------------------------------------------------------------------------
\4\ Francis X. Cavanaugh, The Truth about the National Debt: Five
Myths and One Reality (Boston: Harvard Business School Press 1996),
158.
---------------------------------------------------------------------------
The IRA Approach
An alternative suggested by some PSA proponents is to
require employees to set up IRA-type accounts at private
financial institutions selected by the employees. Employers
could then be required to send the prescribed percent of pay to
the various financial institutions chosen by each of their
employees. This IRA alternative has the advantage of being much
less burdensome on small employers than the 401(k) approach.
Yet IRAs are generally much less cost-effective than 401(k)s
because the 401(k)s have the advantage of professional fund
management, bargaining power in financial markets, and other
economies of scale. The average annual expense ratio for stock
mutual funds over the past decade has been estimated by
Vanguard at approximately 200 basis points, including
transaction costs,\5\ and the PSA accounts would be much
smaller and thus relatively more costly to maintain.
---------------------------------------------------------------------------
\5\ The Vanguard Group, ``In the Vanguard,'' Summer 1996 (Valley
Forge, PA), 10.
---------------------------------------------------------------------------
As indicated above, a typical PSA might have an expense
ratio of about 10 percent in the first year of the account. It
would take many years before such an account would earn a
reasonable net return after administrative expenses. Over the
past 30 years, the average annual real (after inflation in
excess of 5 percent) return was approximately 3 percent for
Treasury bonds, 6 percent for common stocks, and from 0 to a
minus 1 percent for Treasury bills and various other short-term
instruments, including bank CDs and money market accounts.
Yet many ``risk averse'' low-income PSA investors would
undoubtedly seek the apparent safety and simplicity of a CD or
money market account at their local bank or credit union, which
would have provided over the past 30 years no net return after
inflation (compared to a net 3% return from the Treasury bonds
in the Social Security trust fund). Even under the very
optimistic assumption that PSA investors would in time allocate
their accounts on average one-third to stocks (at 6 percent),
one-third to bonds (at 3 percent), and one-third to CDs (at 0
percent), for an average return of 3 percent after inflation
(but before administrative expenses), those investments could
never catch up with the 3 percent return of the Social Security
trust fund.
The suggestion by some that competition would force
financial institutions to lower costs substantially is
doubtful. The market for personal savings and investments is
already well established and highly competitive. More
aggressive competition for small accounts would add substantial
marketing, promotion, advertising, and high pressure sales
costs.
Also, given the likely concerns about exploitation of small
investors by the sharp practices of many financial advisers and
investment managers, Congress would likely impose new
regulatory burdens which would add to administrative costs.
Congress specifically rejected IRA-type proposals when it
designed the TSP: \6\
---------------------------------------------------------------------------
\6\ H.R. Rep. No. 99-606, at 137-38. reprinted in 1986 U.S.C.C.A.N.
1508, 1520-21.
---------------------------------------------------------------------------
Because of the many concerns raised, the conferees spent
more time on this issue than any other. Proposals were made to
decentralize the investment management and to give employees
more choice by permitting them to choose their own financial
institution in which to invest. While the conferees applaud the
use of IRAs, they find such an approach for an employer-
sponsored retirement program inappropriate.
The conferees concur with the resolution of this issue as
discussed in the Senate report (99-166) on this legislation:
As an alternative the committee considered permitting any
qualified institution to offer to employee[s] specific
investment vehicles. However, the committee rejected that
approach for a number of reasons. First, there are literally
thousands of qualified institutions who would bombard employees
with promotions for their services. The committee concluded
that employees would not favor such an approach. Second, few,
if any, private employers offer such an arrangement. Third,
even qualified institutions go bankrupt occasionally and a
substantial portion of an employee's retirement benefit could
be wiped out. This is in contrast to the diversified fund
approach which could easily survive a few bankruptcies. Fourth,
it would be difficult to administer, Fifth, this ``retail'' or
``voucher'' approach would give up the economic advantage of
this group's wholesale purchasing power derived from its large
size, so that employees acting individually would get less for
their money.
The conferees' concern about giving up ``wholesale
purchasing power'' is very relevant here because investments by
individual accounts, rather than by the Social Security trust
fund, either in bonds or stocks, would be an enormous sacrifice
of wholesale purchasing power.
Of course, the conferees' comments were from the
perspective of the Federal government as an employer; it is not
clear whether Congress would take a more or less paternal view
in the case of Social Security.
The insurmountable problems with the PSA proposals are that
(1) they shift Social Security from central financing to small
individual accounts, thus losing economies of scale, and (2)
they shift the investment risk from the group to the
individual, thus violating the first principle of insurance.
Both economically and administratively, Social Security
taxpayers would be much better off if any stock or other
security investments were made by the collective Social
Security fund, rather than by individual investments. Based on
the assumptions in the 1997 report of the Advisory Council on
Social Security, a gradual investment in stocks of up to 40
percent of the Social Security trust fund would produce a stock
portfolio of an estimated $1 trillion (1996 dollars) in 2014.
Yet the rapid development and growth of a variety of index
funds in the United States and abroad should provide ample
opportunities for substantial diversified investments of Social
Security funds with minimal market impact. The capitalization
of the U.S. stock market today is approximately $12 trillion,
and at the Council's assumed growth rate it would be close to
$40 trillion in 2014. The Council also contemplated investment
in foreign stocks, which would reduce the estimated impact of
Social Security stock investments on the U.S. stock market to
less than 2 percent. (PSA investments of just two percent of
incomes would of course have a much smaller impact on the stock
market.) The Council's assumed 40 percent allocation to
equities is quite modest--a 50 percent allocation would be more
in line with the portfolio mix of other retirement funds. The
TSP currently has 51 percent in equities, and Pensions and
Investments (January 26, 1998) reports that the top thousand
defined benefit plans hold 62 percent of assets in equities and
that the top thousand defined contribution plans hold 65
percent in equities. Based on the Advisory Council's investment
return assumptions, a 50 percent allocation to equities in the
Social Security fund would slightly more than double the
investment earnings of the fund.
To those who say that an individual account approach is
needed to increase real savings in our economy I would say that
such real savings would be significantly reduced by the high
administrative expenses associated with small individual
accounts--greater real savings would be realized by channeling
any increased Social Security taxes into centralized investment
in the Social Security trust fund. To those who say that an
individual account approach is needed to change the income
redistribution or generational effects of Social Security
financing I would say the first priority should be to enlarge
the total Social Security pie, through more rational investment
policies, so that we may better deal with any equity issues--a
rising tide lifts all boats. Then those who would change the
distribution of shares, by income or generation, could do more
for some without hurting others so much.
Even if some sort of PSA is added to the Social Security
system, a large portion (I would suggest up to 50 percent) of
the remaining Social Security trust fund clearly should be
invested in equities, which is what virtually all large public
and private pension and retirement funds now do.
Chairman Bunning. Thank you, Mr. Cavanaugh.
Dr. Schieber.
STATEMENT OF SYLVESTER J. SCHIEBER, PH.D., VICE PRESIDENT,
WATSON WYATT WORLDWIDE; AND FORMER MEMBER, 1994-96 ADVISORY
COUNCIL ON SOCIAL SECURITY
Mr. Schieber. Thank you, Mr. Chairman. I'm also pleased to
appear before the Subcommittee today to talk about this vitally
important issue.
In my prepared remarks, I address each of the major
questions that the Subcommittee put forward. The primary basis
of my comments today will focus on the administrative issues,
and if I have time, I'll speak a bit to the employer issues as
well.
In establishing a PSA system, legislators will have to
create an administrative system and regulatory structure that
is efficient. Here there are two general approaches. First, we
could create a centrally structured system along the lines that
you just heard Mr. Cavanaugh advocate. The second would
establish a regulatory framework for workers to create their
own PSAs through a myriad of investment options available in
the financial markets.
There are two fundamental issues at stake. One is the
desire to minimize administrative costs. The other is the
desire to minimize the intrusion of the Federal Government in
the free operation of businesses and it's citizens in carrying
out their economic activity. These two considerations pull in
opposite directions.
There is no doubt that concentrating the administration of
a personal account program within a single entity would render
potential economies of scale. On the other side, the question
is whether we can craft a system that allows workers' freedom
in setting up their own accounts that have acceptable costs
associated with them.
In my prepared testimony I explore ways to set up a system
of accounts that would give workers more flexibility than a
centrally managed system would. I cannot go into that fully
here.
But to prove that such a system is achievable, we can look
at Australia, which has established a national individual
account system. Under their system, workers accounts tend to be
organized at the employer or the union level. Under their
system--the system is measured by the Australian Bureau of
Statistics--the administrative costs run about 90 basis points
a year, about nine-tenths of 1 percent.
A question raised by the added costs involved in a more
flexible system is why we would to bear such costs, unless they
were absolutely unavoidable. There are two parts to the answer.
The first is an assessment of whether the Federal
Government can be an accumulator of a substantial share of our
capital base. In my prepared remarks, I look at the historical
debate and attempts at funding Social Security. Frankly, I do
not believe that we can prefund these retirement obligations
directly through government accumulation.
The second part of the answer relates to whether it is
desirable to have the Federal Government be a substantial owner
of our private capital base. Again, I do not believe that this
Congress, or any future one, can create a firewall around a
centrally managed fund that will insulate the fund from
political manipulation. I think that's very important.
Undoubtedly, the establishment of a mandated system of
individual retirement accounts will create the need for more
education on investment than is now available. The research
that I have done on 401(k) plans, however, is instructive of
how people actually behave when they have retirement assets
that they control themselves.
Our research indicate that workers in 401(k) plans invest
in reasonable patterns. Older workers invest more
conservatively than younger ones. Low-wage workers invest more
conservatively than high-wage workers. We have found that women
are as effective, if not more so, in their use of 401(k) plans
than their male counterpart.
Our results do not mean that education to the public about
investing will not be a challenge. It does suggest, however,
that it's not an insurmountable one. Indeed, I believe it is
not only doable, I think it is also highly desirable.
Employers' role will depend on the nature that reform
takes. In Australia, the provision of individual accounts is
generally implemented at the employer level. In Chile,
employers have very little role.
One of the things that people are worried about, if we
implement a reform of this sort, is that employers will cut
back on their own commitment to their own plans. As I point out
in my prepared testimony, that really depends on whether or not
the reformed system becomes more generous than the current
system. If it does, it is likely employers will curtail their
plans. If it is not more generous, there is no reason for them
to do so.
In closing though, I think there is one thing everybody
should be aware of. There is some prospect that employer plans
will be curtailed in the future, because they're facing the
same kind of cost pressures that Social Security is facing. And
so I think it makes Social Security reform an even more
important that we figure out how to secure these benefits that
we have been holding out to people. And I frankly believe a
personal account option is a superior way to do that.
Thank you very much.
[The prepared statement follows:]
Statement of Sylvester J. Schieber,\1\ Ph.D., Vice President, Watson
Wyatt Worldwide; and Former Member, 1994-96 Advisory Council on Social
Security
Mr. Chairman, I am pleased to appear before the
Subcommittee on Social Security of the Committee on Ways and
Means today. I am here to discuss the potential structure of
personal security accounts (PSAs) as part of the Social
Security system and the effect that such accounts would have
for financial markets, workers and retirees, and business. As
you are aware, Carolyn Weaver and I, as members of the 1994-
1996 Social Security Advisory Council, authored the PSA
proposal put forward by that Council. Thus, it should be clear
that I come before you as a proponent of the type of Social
Security reform this hearing is meant to explore.
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\1\ The views in this statement are those of the author and do not
necessarily reflect the views of Watson Wyatt Worldwide or any of its
other associates.
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In my testimony today I address a number of the issues you
raised in your letter asking me to testify before you. First, I
will address the potential effect of PSA investments on the
capital markets. Second, I will comment on the potential cost
and administration of PSAs; issue of administration and
management of the accounts. Third, I will discuss the need for
investor education if such a reform model were to be adopted.
And finally, I will evaluate the potential role of employers in
a PSA system.
Given that we are prognosticating about the prospects of a
reform model that has not yet been implemented, I trust you
understand that my testimony about the impacts of the model is
based on observations about how the world as we know it works.
To the extent that reform would change the world, the outcomes
might be different than those I postulate here. However, I do
not believe that they would be wildly so.
The Potential Effects of PSAs on Capital Markets
The capital markets in the United States are the largest in
the world and are among the most highly developed in the world.
Despite their magnitude and state of development, it is likely
that the adoption of a PSA-type policy would affect our
financial markets leading some to voice concerns about the
implications of a policy change of this sort.
One of the concerns often voiced by critics of individual
accounts is that the creation of such accounts and the
investment in them might lead to artificial inflation of asset
prices. Put more directly, the concern is that we would have
more money pouring into the markets driving up the prices of
assets without adding to the underlying value of the assets
themselves. While the adoption of a PSA proposal might have an
effect on market prices at the time it was adopted, over the
longer term the effects on asset prices will be determined by
the productivity of the assets that are owned by the holders of
PSA accounts.
One of the important goals of any Social Security reform
should be the creation of additional saving in our national
economy. To a certain extent, that was an underlying
consideration in the development of each of the proposals put
forward by the 1994-1996 Social Security Advisory Council,
although the potential effects on national saving was highly
varied among the three proposals. In order to understand the
implications of greater national savings on capital markets,
one has to begin by considering what households do with their
income. Essentially, all of their income is allocated to do one
of three things. Some of it is used to buy consumption goods
and services, some is saved, and the remainder is used to pay
taxes. Governments take the taxes and buy consumption or
investment goods and services either directly--e.g., buying
supplies for military operations, building roads, and so
forth--or indirectly--e.g., providing food stamps to needy
people to buy food. Producers and suppliers to the economy
deliver the goods and services that people and institutions
want.
If policymakers adopt a public policy that results in
people saving more of their income, on average, than they had
previously it will mean that they will reduce the amount of
consumption they had been doing, at least for a period of time.
The fundamentals of economics teaches us that as households
reduce consumption and do more saving that it leads to higher
levels of investment in the economy. The added investment, in
turn, results in higher levels of productivity for workers. A
simple example of a carpenter who saves a portion of his
earnings for a period so he can replace his traditional hammer
with an air hammer is but a graphic representation of the
effects of added investment on our economy.
The irony of this classic perception of how economies work
is that as people save and invest more, the expected rates of
return on capital are believed to decline. This is not simply
the perception of some group of economists at one fringe of the
Social Security reform debate. This is exactly the perception
of economists like Barry Bosworth and Gary Burtless at the
Brookings Institution who believe we should stay with the
traditional form of Social Security we now have. It is also the
perception of economists like Martin Feldstein and Andrew
Samwick who have crafted a proposal to replace our current
Social System completely with a system of individual accounts.
Both of these pairs of economists have developed macroeconomic
models that show the effects of increasing national savings
under their perception of how Social Security should be
reformed. Their results predict similar reductions in rates of
return to capital as their proposed reforms are implemented.
More important than their consensus that added national
saving would reduce rates of return to capital is their similar
consensus that the improved productivity of labor that would
result from such a policy will ultimately lead to higher levels
of national output and consumption by households. The wealth of
a nation is ultimately measured by the standard of living that
it can provide its citizens. Standard of living in this context
is nothing more than a measure of general consumption levels.
Another concern about the prospects of implementing a PSA-
type proposal at the national level is that financial markets
might be depressed as the baby boomers reach retirement and
begin to sell off the assets they accumulate during their
working career under such a system. On the surface of it, there
is reason to expect that asset prices might be depressed as the
baby boomers move from the asset acquisition phase of their
lives to the liquidation phase. The problem here is quite
similar to the problem facing Social Security, namely the ratio
of retirees to workers. If workers in the future save at the
same rate as current workers and retirees sell-off assets at
the same rate as current retirees, the current ratio of savers
to sellers will fall by roughly 45 percent between now and
2030. The concern in this area is that this 45 percent shift in
relative demand for assets will result in significant reduction
in asset prices.
For the sake of understanding the implications of this
scenario, assume that asset prices are affected proportionately
in response to this ``hypothesized'' demographic effect on
demand. In other words, assume that asset prices by 2030 are
reduced by 45 percent relative to what they would be if we
could maintain the current demographic structure we now have.
This 45 percent decline would not take place all at once, but
rather would occur over a long period of time, perhaps in the
twenty years 2010-30. Further, the 45 percent decline in asset
prices assumed here is not an absolute decline in prices, but
rather a cumulative 45 percent shortfall realized over a long
period. If the expected total real return on equities over a
normal 20-year interval is 395 percent (8 percent compounded
for 20 years), then this factor might cause the total return to
fall to 217 percent or roughly 5 percent per year. It is
probably more reasonable to interpret the implication of the
demographic trend in this manner (i.e. a couple of decades of
subpar returns) than to predict actual absolute price declines.
There are several reasons to doubt that even this reduction in
the realized rate of return in financial markets will happen.
First, there is the point that we now live in a world
capital market. The elderly baby-boomers do not have to sell
their assets to younger American workers, but rather they can
sell them to any participants in the world capital market. This
may reduce the price pressure on assets somewhat, but its force
will be weakened by the fact that Europe and Japan are all
aging societies just like the US. The only hope that the world
capital market will help is if the developing countries in Asia
(particularly China) become net exporters of capital within the
next 25 years. The relative size of developed economies and the
fact that all such economies are facing the same demographic
problem is reason to be skeptical that the global capital
market point will fully erase the downward pressure on prices
in U.S. capital markets caused by the retirement of the baby-
boomers.
Possibly the most plausible reason that the price pressure
may be alleviated is rational expectations. After all, the
demographic projections that our model is based on are not
exactly private information. To the extent that these factors
are predictable, they are already embedded in asset prices
today. Rational expectations doesn't mean that the pressure for
price declines will not occur, only that it will occur very
gradually and perhaps long before the demographic factors
actually come into play.
Yet another reason why the downward price pressure may not
occur is probably the most important. Corporate assets are not
fixed like land or gold, but rather are cash-generating,
depreciable property. When retirees increase their demand for
cash payouts, firms may respond by reducing investment,
reducing retained earnings and increasing dividends and share
repurchase programs. This means that some asset liquidation can
be achieved without selling assets to the accumulating
generation, but rather by simply paying out a higher fraction
of corporate earnings to existing shareholders. This third
factor could go a long way towards eliminating the downward
pressure on asset prices. It seems quite likely that the net
asset price effect will be rather modest and spread over at
least twenty years.
One ameliorating consideration in all of this is that the
two potential problems just discussed will actually be contrary
forces within the financial markets. The way that added
national savings will reduce rates of return to capital is by
increasing the prices of assets relative to the stream of
income that they generate. For example, a stock that yields $10
per year at a 10 percent rate of return will cost $100. If the
yield is driven down to 5 percent, the price rises to $200--
i.e., $200 x 0.05 = $100 x 0.10. So increases in national
savings will raise the price of assets relative to their yield
while the potential demographic effects on markets will tend to
reduce the price of assets. If we can adopt policies that have
a positive effect on our national savings rate during the
period when baby boomers are going to be naturally selling off
their assets, the two forces should be countervailing. Indeed,
one of the reasons that I supported the Personal Security
Account proposal developed by the 1994-1996 Social Security
Advisory Council was that it had a larger projected net
positive effect on wealth accumulation during the whole of the
baby-boomers' retirement period than either of the other
proposals.
Creating an Administrative Structure for PSA Operations
Another fundamental issue which legislators will face in
establishing a system of individual accounts is in creating the
administrative and regulatory structure that would allow such a
system to operate efficiently. Here the popular thinking about
this structure trends in two distinct directions. The first
would create a centrally administered and managed system
structured along the lines of the Thrift-Savings Plan (TSP)
that is a 401(k)-type plan for federal civilian workers. The
second would establish a regulatory environment that would
define an operating framework for workers to create their own
individual accounts through a myriad of investment options
available in the financial markets.
As I see the evolution of the discussion on this matter, I
believe there are two fundamental issues that will determine
the relative position that various people will take regarding
the two approaches. The first of these is a desire to minimize
costs associated with the operation and administration of a
defined contribution retirement system. The second of these is
the desire to minimize the intrusion of the government in the
free operations of business and citizens in carrying out their
economic activities in accordance with their own individual
interests. These two concerns will likely pull people in
opposite directions in terms of forming their own conclusions
about the best approach to take.
There is no doubt that concentrating the administration of
a personal account program within a single entity or a
relatively small number of entities would render economies of
scale, at least up to a point. Creating and operating any
administrative system results in a certain level of fixed
costs. The larger the group that fixed costs can be spread
across, the less the individual cost applied to any particular
participant. While there is clearly value in minimizing
administrative and investment management fees, the level of
sophistication that exists in investment companies today
suggests that the values of scale from moving to a single
provider of administrative services might be overblown. For
example, there are a number of retail mutual funds available to
the general public today which charge 25 to 30 basis points per
year in fees for managing and administering accounts.
The primary reason that some funds tend to charge
significantly higher fees for investors than those mentioned
typically relates to the degree of active management of the
funds held in the fund. The funds with relatively low charges
tend to be funds that minimize the amount of buying and selling
of individual equities held by the fund. Those that ``churn''
their holdings regularly generally will have relatively high
fees associated with brokerage charges assessed in the normal
buying and selling of financial instruments. One way to deal
with this churning phenomenon is to concentrate investment in a
single managing entity with the contractual or legislated
provision that funds not be churned on a regular basis.
Requiring that all investing is in index funds would be one way
to accomplish this. Another way would be to statutorily limit
the administrative charges that fund managers could charge for
managing the personal accounts. Those limits would essentially
force fund managers to minimize the extent of churning in the
funds that they manage by virtue of the fact that too much
churning would eat up all the administration charges they could
assess against the accounts.
If we were to go to a system of personal accounts that
might be managed by multiple outside vendors, at least two
problems would still have to be dealt with. The first of these
is the general approach of getting contributions to designated
managers on a timely basis. The second is dealing with small
accounts.
Today, half the workforce is covered by an employer-
sponsored retirement plan and the majority of them are now
participating in defined contribution plans where regular
contributions are being made to self-directed individual
accounts. I believe that many workers would prefer to have some
portion of their payroll tax go into 401(k) accounts or similar
plans in which they are already participating. I believe that
most of the vendors now providing self-directed plan
administration would be willing to set up a segregated set of
accounts to take PSA contributions.
While such a system might work for employers already
sponsoring self-directed individual account plans, it probably
would not work for employers without such plans, especially
smaller ones. For such employers a central collection function
would probably be required. Contributions could be collected
throughout the year as payroll taxes are now. The money would
be held in a pooled fund and invested in a reasonable short-
term portfolio of financial instruments. At the point that W-2s
are filed, the cumulative fund for the year could be allocated
to individual accounts and the funds distributed to the
managers designated by the individual worker. Minimal
accounts--say less than $1,000--would be held in the pool until
an appropriate threshold was achieved. Once that level was
achieved, workers could designate that their assets be
dispersed to an approved fund. For simplification purposes,
workers would be restricted to one fund manager other than a
current employer plan in which they might be participating. If
they were not participating in an employer plan, their
accumulated balance would be held by a single fund manager.
Fund managers would have to offer investors multiple investment
options in accordance with rules paralleling the ERISA section
404 (c) rules covering self-directed investment of tax-
qualified defined contribution plan assets.
As noted earlier, allowing investment through an extended
set of investment arrangements will add to the administrative
costs of the system. It is impossible to give a precise
estimate of what such costs might be in advance of the actual
creation of such a system. However, there are cost estimates
for systems that have characteristics somewhat similar to what
is being proposed. Access Research, Inc. estimates that in mid-
1987 asset levels in 401(k) plans stood at approximately $865
billion and that the annual administrative fees for both record
keeping and asset management for the year were $6.7 billion, or
77 basis points--i.e., 0.77 percent.\2\
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\2\ Speech by Robert G. Wuelfing, CEO, Access Research, Inc., at
the 1997 SPARK National Conference, sponsored by the Society of
Professional Administrators and Recordkeepers, Washington, D.C., June
23, 1997.
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Possibly more pertinent than the case of our own voluntary
401(k) system is the national system of mandated personal
accounts in operation in Australia. This system requires that
employers make annual contributions to employee accounts. The
funds themselves tend to be organized at the employer or union
level. The Australian Bureau of Statistics surveys the plans
with a minimum level of asset holdings quarterly--e.g., it
surveyed all the plans holding assets over $10 million
Australian--this is roughly $6 million in US currency at
current exchange rates--in each of the quarters of 1997. For
that whole year, total costs associated with the funds surveyed
were 90 basis points. The costs include record administration,
investment management, and other costs including education
costs. While we do not yet have the detailed breakdown of costs
based on size of plans, we know that there are economies of
scale that can be realized by concentrating workers in larger
plans. It is notable that nearly half of the plans surveyed--46
percent--by the Australian Bureau of Statistics during 1997 had
fewer than 1,000 employees. The model that I envisage for the
United States would have much greater concentration of
participants than the majority of plans that now operate in
Australia.
Throughout the development of the PSA proposal by the
Social Security Advisory Council, all estimates were based on
the assumption that the costs of running the PSAs would be 100
basis points per year. The reason that we chose that level was
that people in the investment industry told us that a statutory
limit of 50 or 75 basis points for administration and
management fees was not unreasonable. They suggested that the
imposition of such a limit would still result in substantial
numbers of providers offering their services to manage the
personal accounts under a PSA-type plan.
A question raised by these potential fees is why we would
want to bear them if a large centrally managed system could
substantially eliminate them. There are two parts to the
answer. The first part is an assessment of whether the federal
government can be an accumulator and holder of substantial
share of the capital base in our economy. In the case of Social
Security this is more than an academic question. The original
Social Security Act passed in 1935 called for significant
funding of the system in accordance with Franklin Roosevelt's
strong feelings on the matter. For a variety of reasons, those
provisions were gradually relaxed through repeated legislative
measures adopted during the late 1930s and 1940s. Once again,
the practical effect of the 1983 Amendments would have been to
prefund a significant portion of the baby boomers' claim on
Social Security by making a substantial addition to national
savings. The net effect of the significant deficits run by the
federal government throughout the 1980s and the first seven
years of the 1990s was to largely dissipate the effect of the
1983 Amendments on national saving. I look at this long history
and question whether any attempt to prefund these retirement
obligations directly through government accumulation can
succeed.
The second part of the answer relates to whether it is
desirable to have the federal government be a substantial
holder of ownership on the capital base of the economy. As we
look around the world, there are national governments that have
routinely used accumulated national retirement savings to
finance ``social'' investment projects. In our own state and
local public retirement plans, we have seen many cases of
investment decisions being made on the basis of political
considerations rather than the economic interests of the plan
participants. I do not believe that this Congress or any other
can create a firewall around a centrally managed fund that will
insulate the fund from future political considerations. I
believe the cost of dispersing these assets is in the long-term
interest of our citizens individually and collectively.
Needed Investor Education in a PSA World
Undoubtedly, the establishment of a mandated system of
individual retirement accounts will create the need for more
widespread education on investment than is now available. Large
segments of the population are totally ignorant of how they
would manage the money that might accumulate under a PSA plan.
Much of this ignorance, however, follows from the simple fact
that many people today have no personal assets to manage. I
believe that it is imminently sensible that people who have no
money and do not anticipate having any in the near future would
spend very much time figuring out how they might invest such
funds if they had them.
The research that I have done on 401(k) plans, however, is
instructive of how people actually behave when they have
retirement assets that they control themselves. We have
recently analyzed plan administration data for a set of 401(k)
plans that do not include company stock as an investment
option. Using these data, we found that workers in their 20s
and 30s held just under 60 percent of their assets in equity
accounts at the end of 1995. For workers in their 40s and 50s,
it was close to a 50-50 split, with the younger group having
slightly more than half in equities, and those in their 50s
having slightly more than half in fixed-income accounts.
Workers in their 60s held roughly 60 percent of their
accumulations in fixed-income assets.\3\
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\3\ Robert L. Clark, Gordon P. Goodfellow, Sylvester J. Schieber,
and Drew A. Warwick, ``Making the Most of 401(k) Plans: Who's Choosing
What and Why,'' paper presented at the 1998 Pension Research Council
Symposium, Forecasting Retirement Needs and Retirement Wealth, April
27, 1997, The Wharton School, University of Pennsylvania, Philadelphia,
Pennsylvania.
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When we looked at variations in investment behavior based
on workers' earnings levels we found that workers at low-
earnings level invested more conservatively than those with
higher earnings. Workers earning under $15,000 invested 45
percent of their assets in equities on average, those earning
$45,000 to $60,000 held 60 percent of their funds in this form,
and those earning over $100,000 held 70 percent this way. While
the portfolio allocations described here might be a bit
conservative in some investment advisors eyes, they are not
wildly off base and the variations by earnings and age level
follow a rational pattern that is consistent with the way
educated investors would invest.
In addition to looking at investment patterns across the
age and earnings spectrums, our recent work also looked at
differences in investment behavior between men and women. Prior
research has found that women demonstrate greater risk aversion
in allocating assets within their self-directed defined
contribution plans than men.\4\ Our analysis of actual plan
data, an advantage over prior research, found that women
generally are not more conservative in their investment
behavior than men when controlling for earnings level, age, and
other important determinants of investment behavior. In
general, our results suggest that women are as effective in
their use of 401(k) plans as their male counterparts. It would
be hard to characterize their investment behavior within plans
as inferior to men, and in certain regards, it appears to be
more rational.
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\4\ For example, see Vickie A. Bajtelsmit and Jack A. Vanderhei,
``Risk Aversion and Pension Investment Choices,'' and Richard P. Hinz,
David D. McCarthy, and John A. Turner, ``Are Women Conservative
Investors?: Gender Differences in Participant-Directed Pension
Investments,'' in Michael S. Gordon, Olivia S. Mitchell, and Marc M.
Twinney, eds., Positioning Pensions for the Twenty-First Century
(Philadelphia: University of Pennsylvania Press, 1997).
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Our results do not mean that education of the public about
investing will not be a challenge. It does suggest that it is
not an insurmountable hurdle. Indeed, it is not only doable, in
a larger context it is probably highly desirable.
The Role of Employers in a PSA System
The role that employers will play in a PSA system will
depend significantly on the nature of the reform that is
adopted. In countries like Australia and the United Kingdom,
the provision of individual accounts is generally implemented
at the employer level. In a country like Chile, where the
system is structured around the individual worker, employers
have a much less significant role.
No matter what structure or approach to such reform might
be adopted, employers will be required to remit the money
collected to finance the system. They will also have to provide
documented information on the covered earnings and level of
contributions for each worker employed during any given year.
For all practical purposes, providing such information is no
different than what they do today.
If we go with a centrally administered system, all
employers will have few obligations above and beyond those of
compliance that is essentially the same as under current law.
If we go with a system that allows employers the flexibility of
allowing their own workers to make contributions directly into
self-directed individual accounts, additional reporting
requirements and administrative mechanisms will be required to
assure that contributions are getting into accounts on a timely
basis as required by law.
In terms of actually setting up and administering plans, my
sense is that the existing section 401(k), section 403(b), and
section 457 plans are a tremendous asset which could be adapted
to meet the needs of nearly half the current workforce. I see
no reason why I couldn't have payroll withholding for my PSA
account into some of the same funds to which I now allocate
401(k) contributions. It would require separate accounting to
keep the funds separate, but that should not be a significant
challenge in this rapidly evolving technical age.
Onc concern that has been voiced about the adoption of PSA-
type reform of Social Security is that some employers might
curtail their own pension or savings plan offerings as
individual accounts begin to develop under a reformed system.
When most employers undertake their own plan designs, they
typically structure them around Social Security so the
combination of Social Security and their own plans give workers
the opportunity to accumulate sufficient assets to maintain
preretirement standards of living. This is accomplished by
designing a set of plans that supplement Social Security at a
level that the combined retirement income will equal some
replacement rate target. The replacement rate is the percentage
of preretirement earnings that is replaced by the various
combined sources of retirement income. These replacement rate
targets typically vary between 60 and 80 percent of
preretirement earnings depending on earnings level, age at
retirement and a host of similar variables.
The implications of Social Security reform for employer-
plan design depends primarily on what happens to benefit levels
from the first tier of our retirement system. In the context of
the PSA proposals, I would characterize the combination of
benefits actually provided through Social Security plus those
provided through mandated individual accounts as coming from
the first tier of the system. If the combination of PSA
benefits and residual benefits provided through a modified
centralized Social Security is roughly equal to current law
benefits, there would be little reason for employers to
significantly modify their own plans. If benefits under the
first tier of the system are larger than current law benefits,
I would expect employers to curtail their own plans. If the
amended system provides lower benefits than the current system,
there will be pressure to increase benefits at the employer
level.
One thing that policymakers should keep in mind regarding
the potential reaction of employers to public policy responses
to an aging society is that the employers themselves are facing
the same set of pressures. As the workforce ages, employer-
based retirement systems are becoming more expensive. This is a
natural phenomenon in the way we fund and account for defined
benefit plans. It occurs naturally in 401(k)-type plans because
older workers contribute at higher rates than younger ones and
most of these plans have employer-matching provisions that
increase sponsor costs as employee contributions rise. Health
benefit programs become more expensive as workforces age. This
is particularly true for health benefit plans that cover
retirees.
Conclusion
The point of the immediately preceding paragraph is that I
believe we are facing the prospect that some employer-sponsored
retirement plans are going to be curtailed in coming years
without regard for what we do on the Social Security front.
Should that scenario come to pass, the securing of benefits
provided through the first tier of our retirement system takes
on even greater importance. I believe that first tier benefits
can only be made more secure through a mechanism of greater
funding that is associated with higher savings rates in the
economy. I believe we can only accomplish such added funding
through a system like the Personal Security Account system that
I helped develop as a member of the 1994-1996 Social Security
Advisory Council.
Chairman Bunning. I would appreciate, for the first panel,
if they would remain here. We have to go vote. We have two
votes, and we will be back as soon as possible. So, we'll stand
adjourned for the time that it will take us to vote and get
back. Thank you.
[Recess.]
Chairman Bunning. The Subcommittee will come to order.
Before we begin questioning the first panel, Congressman
Jim Kolbe from Arizona would like to present his feelings on
this, and we would like to accept them at this time.
STATEMENT OF HON. JIM KOLBE, A REPRESENTATIVE IN CONGRESS FROM
THE STATE OF ARIZONA
Mr. Kolbe. Thank you very much, Mr. Chairman. I appreciate
the indulgence of the very distinguished panel that you have
here, just to be able to make these remarks. I was meeting with
the Speaker earlier when you began your testimony. So, I
appreciate the opportunity to do this right now. I'll be very
brief, if I might include my full statement in the record, I'd
appreciate it, Mr. Chairman.
Chairman Bunning. Without objection.
Mr. Kolbe. Mr. Chairman, I cochair, as I think you may
know, along with Congressman Charlie Stenholm and Senators Judd
Gregg and John Breaux, the National Commission on Retirement
Policy. We have come up with a bipartisan middle-ground
proposal that I think combines the very best features of the
current Social Security system with innovative reforms, that I
think will strengthen retirement security for all workers. I'm
very pleased with the work that we have done.
Today I want to focus, however, on a recent study that was
done--or analysis, would be perhaps a better word--that was
done by the Congressional Research Service, at the direction of
some Members of this Subcommittee, because I think it is so
fraught with errors, not caused by CRS, but by the direction of
the study itself, that I think it must be refuted or an answer
must be placed on the table right away.
Chairman Bunning. Just a moment--I just want you to know
that we entered both the study and the analysis of the study by
Heritage into the record prior to you being here.
Mr. Kolbe. Thank you. I appreciate that. I wasn't referring
to the Heritage study at all. I was referring to the
Congressional Research Service analysis that was done for the
Ranking Member of this Subcommittee.
Just a word about our plan. As I said, it preserves much of
the best features of the current system, but the main feature
of it is the creation of an individual savings account,
personal savings account, through a carve out of 2 percent of
the current 12.4-percent payroll tax, to provide financial
security for all disabled, low-income seniors, as well as for
all other seniors.
Restoring the solvency of Social Security requires some
very tough choices, as this Subcommittee knows very well. And
it requires some tradeoffs. Those who extract specific
components of our comprehensive plan for criticism have an
obligation to suggest other benefit cuts or tax increases to
replace them, without weakening the program solvency.
Now, Mr. Chairman, the CRS report that was released today,
analyzes three Social Security reform proposals: The one done
by the National Commission on Retirement Policy, the one I'm
cochairing; Senators Moynihan and Kerrey's proposal; and the
Social Security Advisory Council proposal prepared by Robert
Ball.
But the restrictions that were placed on the analysis by
the requestor suggests that the study was designed specifically
to discourage or disparage any reform plan that contains a
personal retirement component. What's most troubling to us from
an analytical perspective, is that the request included design
specifications that were concocted--seemed to be concocted--
specifically to promote particular policy views.
Any fair analysis of a personal account policy would
obviously include the income coming from those personal
accounts, and yet, CRS was specifically directed to count
income accruing from the investment of personal accounts as
equal to zero. Whereas, if it was invested by the government in
a government account, it was to be fully counted and funded.
Now, you're talking about starting with more than one hand
tied behind your back when you start with that kind of
analysis. It's a very odd value judgement--that investment in
the private market generates income only when government
controls the investment, but not when an individual does. But
that's exactly what CRS was directed to do.
Putting market forces to work to improve retirement
benefits for workers typically has been discussed as an
either--or proposition--do we allow workers to invest for their
own retirement, or do we entrust the government with that? Our
plan allows individuals to determine their retirement future.
We believe that individual accounts have huge potential
benefits, higher national savings rate, ultimately higher wages
for workers, higher returns on contributions, and hence, higher
benefits for retirees.
The government investment approach, whatever the scale of
it, doesn't address the central concern behind the calls for
personal ownership of the account. And that is namely that
voters should have their own stake in the economy--that
citizens should have their own stake in the economy and more
control over their retirement benefit. The current system
provides a mere statutory right to benefits, which Congress can
cut at any time in the future. Thus, such security is really
illusory.
Mr. Chairman, it's true that current law promises a benefit
that is higher than does our plan for a low-income earner
retiring in 2040. But under current law, the system would be
insolvent before that point, or at best it would only have
enough money to pay less than 75 percent of the benefit
promises. That's a 25-percent decrease in Social Security
benefit. So, by not taking that into account, of what is in
current law, you have again, in another way, completely skewed
the analysis that was done by the Congressional Research
Service.
I mention this, Mr. Chairman, because we really need to
have a comprehensive and honest and open dialog on this subject
next year. And we're not going to be helped when we have this
kind of thing going on--when people approach it from the very
beginning with, from an ideological standpoint, to disparage
one kind of provision or another. We need to be able to look at
all the different provisions.
I'm pleased to say that the administration has kept an open
mind on this. And I would hope that Members of the Congress
would do that as well. Because this is going to be the single
most important debate, as I think you know, next year, that
this Congress is going to take up. And I want to commend you
and your Subcommittee for having this hearing today.
The full testimony will go into some analysis of the CRS
study. We have asked for a revision based on comparing apples
to apples, so that you'll be comparing real things here when
they revise it, and I think you'll find that it's a completely
different study the next time it comes out.
And with that, Mr. Chairman, I thank you for your time.
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Chairman Bunning. Thank you, Mr. Kolbe. I will tell you
this: Before we are finished the hearings that we are having on
these issues, we will have a total package to look at, and it
won't be skewed one way or the other.
Mr. Kolbe. I thank you very much.
Chairman Bunning. Now we'll get back to our first panel and
our questions to our first panel. Let me address an open
question to the first panel.
We have heard a lot about investment risk and rates of
return. However, one very apparent, but not qualified, risk is
political risk, which certainly exists in the taxpayer's mind.
As we will hear later, we have taken the surplus FICA receipts,
spent them on other parts of government, and given the trust
funds an IOU that has a nice coupon rate, but can only be
redeemed at the cost of increased taxes or Federal
indebtedness.
Younger generations of workers who die early know other
political risks from a system that may return very little to
them through the current system structure. Therefore, this
political risk exists and is real, as market risk are real.
Private investors have some control over their risk and
cost in their portfolios, even when it is through a 401(k)
plan. What controls over political risk does a FICA taxpayer or
a retiree have in the system? All of you want to take a shot at
that, or one person? If we eventually decide on some kind of
private investment account.
Mr. Diamond. It seems to me that political risks come in
two forms. One form is when the outside environment, whether
it's economic or demographic changes, then existing
institutions have to adapt to them. And exactly how that
happens is going to depend on some future Congress and nobody
today can predict what a future Congress is going to do. And
so, that's some political risk.
The second form of political risk is that the legislation
can put in train political forces that weren't there without
the legislation that can then change the environment and
result, as we have seen in the past, with slow or sometimes
even rapid reversals by Congress, as Congress, as it were,
unleashes the political forces and responds. Because Congress,
of course, is responsive to the American public. And it's that
responsiveness, of course, which is what makes Social Security
not a wildly dangerous risk for people.
It's called an entitlement program for a good reason. As
long as the American people feel strongly entitled to it,
Congress isn't going to take it away on a whim. But Congress
will have to respond to a changing environment, changing
demographic environment, changing economic environment.
Chairman Bunning. That's why we're doing these hearings,
and hopefully we'll get an answer out of them.
Mr. Diamond. And political risks are there with individual
accounts, and they're there with a pure defined benefit system,
and they're there with a mixed system.
Let's take a mixed system, because that's what's really on
the table, such as the one that Congressman Kolbe talked about.
If payroll tax revenue starts growing more slowly, and the
Office of the Actuary comes in and says the residual defined
benefit program is in actuarial imbalance, Congress will need
to do something about it. What Congress will do will be
different from what Congress would have done if the individual
accounts hadn't been set up. But it may have exactly as big a
problem anyway. So the same amount of risk may be there,
concentrated on one part of the income distribution--benefit
distribution--rather than the whole thing.
Chairman Bunning. Dr. Diamond, I'd like to get some others.
Thank you. Mike?
Mr. Boskin. Yes, Mr. Chairman, I think that there are three
political risks that I think are very severe. One is I think it
is very unlikely that very large surpluses can accumulate for a
very long time without being spent on other things, as is
happening currently with the short-run operating surpluses in
Social Security. If we're contemplating building this to
trillions of dollars, I believe that that will put great
pressure to do something else and perhaps squander those
resources. I think that is a history of what's gone on when
States have tried to run surpluses for a span of time, they
found it very difficult to do so.
Second, I believe that there is political risk that if this
sort of thing is done inside the government, that there are
corporate governance issues that would be very, very--potential
very troubling if the government owned a sizeable fraction of
equities, even if was limited in any individual firm. And when
there was a fad, or an issue, or a sanction, or something going
on, there would be tremendous pressure to do that. Now the TSP
has some good procedures to resist that, and Mr. Cavanaugh is
to be commended for his role in that.
The third thing is I think most people, ranging from my
Stanford students to most people I've talked to in the general
public about this, trust something being their own money,
rather than something sitting in the government that they're
going to get later. I think there's a big difference by
generations. It's partly your generational experiences, it's
partly most people realize that if they're already retired,
there won't be radical changes in their Social Security. When
you start to go down the age distribution, most people believe
that if they keep on the current path that the system will be
means tested, something will happen to it and they will get
nothing. And I think they're probably right about that.
Chairman Bunning. Thank you. Let's see.
Mr. Schieber. One of the--can I speak to that?
Chairman Bunning. Let me--I'll get in trouble with the rest
of my panel if I go past my time. Mr. Christensen.
Mr. Christensen. Thank you, Mr. Chairman. Dr. Boskin, I
want to ask you about this testimony we heard from Dr. Diamond
concerning the asset swap. The whole idea of there being new
revenue, then there would be some advantages. This was kind of
the first time I've heard this kind of direction in terms of
not saying that there would be a benefit here for the American
investor, for the retiree. Would you address specifically Dr.
Diamond's testimony, where you disagree, if you do, and where
he has erred.
Mr. Boskin. Well, I think as far as he had time to go, he
is correct. I think he's partly correct. I think for some
people, there will be an increase in saving and there will be
an increase therefore in investment in the economy and other
good things will happen. I think for some people, this will be
rearranged. So I think he is partly correct.
Mr. Christensen. When we're talking about assets----
Mr. Boskin. I think Chairman Greenspan has tried to make--
--
Mr. Diamond. There are two issues here. One issue is
whether you put in new revenue and does all the new revenue
show up as additional savings or do people, knowing that they
have more, cut back on their own savings. If all you've done is
shift some of the funds, and cut back on the defined benefits
to match that, then people don't have additional amounts out
there, it doesn't represent additional savings, and there isn't
any effect at all. If we get the kind of increase in confidence
that's been described here, then that would be a reason to cut
back on savings. So unless there's new revenue, the creation of
the individual accounts by themselves, as was said, as Alan
Greenspan has pointed out, focusing on trust fund investment--
but the same point holds with individual accounts--unless
there's new revenue, it's an asset swap, whether it's
individual accounts or not.
Mr. Christensen. Dr. Schieber.
Mr. Schieber. I think they both have summarized the issue.
Mr. Christensen. For people who are liquidity constrained,
low-income people who save nothing, of whom there are
unfortunately there are too many. Their individual account--
mandatory individual accounts--would change their behavior.
Mr. Diamond. Let me--again, we're not disagreeing.
Mandatory individual accounts on top of everything else will
change their behavior. That means a new revenue source.
Individual accounts which are just a shift out of the defined
benefits they would get, will not change their behavior.
Mr. Boskin. Let me try to be clear. The missing item is--
compare two systems. One is where you allocated projected
surpluses, which hopefully will materialize to establish
individual accounts. So that's basically taking a tax cut,
giving it to people, and saying, you now must save it. So it's
going into savings.
Alternatively, suppose instead of that, you took 2
percentage points of the FICA tax and put it over there, there
would be savings there, but unless you made up--and this is the
new revenue Peter's talking about--the 2 percentage points in
the FICA tax or cut the benefits somehow so there wasn't a 2
percentage point gap on the FICA side, then you'd get the
saving here and the dissaving over here, and they match. That's
what he's trying to say.
Is that clear?
Mr. Christensen. So there's more agreement than
disagreement here.
Mr. Diamond. Absolutely. We're the cochairs of the National
Academy of Social Insurance Panel on Privatization of Social
Security. We're hoping to have a report out in September, and
we've yet to disagree on anything except whether there should
be individual accounts. [Laughter.]
Mr. Christensen. Thank you, Mr. Chairman.
Chairman Bunning. Just a small difference of opinion. Mr.
Collins will inquire.
Mr. Collins. Thank you, Mr. Chairman. Mr. Boskin, I'm one
of those individuals who feels like the money that's been
abducted from my payroll check all these years is my money too.
I someday want a return on it. If I should cease before the
time that I'm eligible, I feel like my estate should have that
return. So I think it's time we took a real look at Social
Security.
You mentioned that there's an unfunded liability out there
of some $10 trillion. Explain where you get that figure please.
Mr. Boskin. There are many figures out there, and there are
many different concepts. As a rough general approximation, if
you take the projections of future benefits and discounted them
back to the present based on the intermediate assumptions about
wage growth, and so on, and the demography, and the projections
of what current tax revenue would yield, and discounted that
back to the present, there would be about a $10 trillion gap,
or more, depending on how you dealt with--how far out you went
on a variety of other----
Mr. Collins. I understand that. But there's one figure that
you haven't laid out there. How long are you projecting that?
What period of time?
Mr. Boskin. Well, most of these projections are either
the--the different studies either look at the 75-year period of
Social Security, which ignores the fact that there would be an
additional large problem thereafter, with benefits able to be--
only three-fourths benefits financeable by current taxes. Or,
they have a specific reposal, for example, switched to--like
Cato Institute, or somebody else--switch to individual account
now. Maybe starting at a certain age, and phased in over a
certain time profile. And we still have to pay the benefits to
retirees or people soon to retire, and what's the difference.
And so the number can be smaller or larger.
Mr. Collins. But you're talking about $10 trillion over a
75-year period. I mean, it sounds a lot more severe when you
say $10 trillion unfunded liability, than it does if you say
$10 trillion over 75 years. That's quite a difference in the
concept of how you look at the $10 trillion. That difference in
that concept can have a difference in how you determine what
you're going to do about the generations behind my generation.
I'm of the World War II generation. And how are you going to
address their Social Security benefits in the future, as well
as add deposits today? It could have a significant difference
in how you approach this.
Mr. Boskin. That's fair enough. But the $10 trillion, which
could be still larger, depending on how you define things,
should be compared for example to the current explicit national
debt, which is about half that size. So it's a stock that--so
if we tried to finance this under these projections for the
future, under many of these plans--full privatization plans--
you'd have to issue $10 trillion worth of bonds.
Mr. Collins. $10 trillion is also close to the figure we
just dealt with for a 5-year budget proposal, and where we
carved out 1 percent savings. So, it's how you look at $10
trillion.
Mr. Boskin. It's certainly $10 trillion over an economy
that will be vastly larger than that.
Mr. Collins. We won't debate that any further. Mr. Diamond,
you mentioned that the unfunded liability exists because
Congress voted to give retirees of the forties, fifties,
sixties, and seventies, far more in benefits than could have
been financed by the taxes each of these groups paid. Based on
that range of beneficiaries, how long would it take them to
actually get in return the funds that they had put into the
trust fund, that have been deducted from their payroll checks.
Mr. Diamond. I don't have a figure on that cohort by
cohort. That analysis, which is done by John Geanakopolos,
Olivia Mitchell, and Steve Zeldes, will appear in a volume from
the conference of the National Academy of Social Insurance,
just to get another plug in.
Mr. Collins. So you don't really have a figure?
Mr. Diamond. It just accumulates up, but there is a graph
that breaks it down separately, cohort by cohort--that is, the
people who were born in a particular year. Look at the taxes
they all paid--everyone born that year--and the benefits.
Mr. Collins. I have one more question. But you don't have
any figures. You have a figure of speech, rather than figures.
What about today. What about a young person entering the work
force today. Say they pay the average--or pay the maximum--
throughout their working lifetime. Based on maximum
participation, how long would it take them to receive their
benefits?
Mr. Diamond. I don't have that number, sir. You can get
that.
Mr. Collins. Thank you, Mr. Chair.
Chairman Bunning. Mr. Portman.
Mr. Boskin. I can give you the answer to that. Longer than
their life expectancy. They expect to get back less than they
pay in--they and their employers pay in.
Mr. Collins. That's right. That's kind of the way it was
set up in 1935, was it not?
Mr. Portman. Thank you, Mr. Chairman, and thanks for having
these hearings. This is the second one of our hearings on
individual accounts.
And it's interesting in the interim, since our last one, we
had a meeting in my district of the Committee for Responsible
Budget. This was an exercise in hard choices. Some of you may
have been involved in that. Almost every group from AARP to the
Concord Coalition was engaged in it. And in our little group,
which was about 117 people, we broke out into 16 groups, 73
percent of the groups favored some form of personal individual
accounts. And they were given information on what some of the
choices would be if you went to individual accounts.
And I think the figures around the country are comparable
to that. Maybe 73 percent is a little on the high side in my
area, but it goes to what Michael Boskin was talking about
earlier, which is, as folks look at this and begin to think
about the alternatives, and particularly the alternative of the
status quo, individual accounts, I think, are becoming more and
more popular. This was a day long session where we actually
went into some detail.
My question though is related to individual accounts and
the current employer based pension system, rather retirement
saving systems we have through our employers, which is really
the third leg of the stool as we say. Social Security being
one, and personal savings being another. The third, and one
that I'm particularly concerned about because it's not growing
as fast as it should, is employer based coverage.
I wonder whether an individual account could be part of
someone's 401(k), or profit sharing plan, or simple plan for a
small business, and how we could do that. I don't know if any
of the gentleman here have spent any time looking at this
issue. But the notion would be, I guess, to either set up a new
form of account, which might have some more parameters than a
current 401(k) might, or simply to allow rollover between the
individual account and the 401(k). To maximize the return, to
really take advantage of compound interest rates, and to
simplify it, so you have one account, and to encourage more and
more smaller businesses to have retirement savings plans.
Mr. Schieber. There's a couple of issues there. One is if
you're going to have these accounts, you're probably going to
end up with a mandated savings program if you're replacing part
of--you're carving out part of Social Security. The 401(k)
system is still a voluntary system, and there's a question of
whether you want to comingle voluntary money and mandatory
money. Because, if you comingle the two types of money and
somebody wants to withdraw some of their voluntary money as
they're allowed to do so under current law, then you're going
to create a very complex situation for figuring out which is
apple and which is orange.
Mr. Portman. Money being fungible.
Mr. Schieber. Right. It seems to me though that there is
some possibility that you could have a system where, in cases
where employers do have 401(k) plans, that you could give
employees access to the similar kinds of accounts through
exactly the same vendors. The vendors would have to keep track
of these two sets of money separately. But you could actually
run the administration of these quite together. So I think
there is some prospect of doing that.
Mr. Portman. Are there some efficiencies to be gained by
running, as you say, the administration together?
Mr. Schieber. Well certainly there would be. I mean, you've
got communications programs built around it. You've already got
withholding mechanisms built in, you've got reporting
mechanisms for the employees. Most employees--we work with
employers all the time--when they move from one employer to
another, in most cases they want to move their 401(k) money
from one plan into the next plan, because they don't want to
run a half dozen different set of investment funds themselves.
It's a convenience issue. I think there are some very
significant prospects something like that might evolve. I do
think you would have to keep the money segregated, at least for
accounting purposes.
Mr. Portman. Any other thoughts from the panelists?
Mr. Boskin. I think it's an interesting idea. I think that
there are a couple of things to be aware of. One is that the
takeup rate for 401(k)s has been under 100 percent, and many
American companies, including ones that I am involved with,
have had active education programs to boost the rates up, which
have been successful. But they are still under 100 percent.
It may be we could build out from there and the prospect of
having this mandatory system would--may, in fact, have the
effect of making it easier for some people at the margin to
graft on a private pension, where it doesn't exist now. That
might offset the tendency that was mentioned earlier for the
private sector to pull back if there was a mandatory government
account.
Mr. Diamond. I'd like to add one small point on that. A
major cost in running any system, current Social Security
system, 401(k)s, any of them, is reconciliation. Making sure
that the money that's withheld from a worker shows up in the
right workers account, and the accumulations show up.
The way to hold down reconciliation costs in the aggregate
is by using uniform systems. As soon as you start setting up
different systems for different groups of workers, then you'll
start to raise, I think, overall costs and you may raise them
more because of the lack of uniformity than you gain from the
synergism of having a single intermediary handling both of
them. So I think one has to be very careful to look at the
whole system.
Mr. Portman. Just one quick point, Mr. Chairman, which is
that we may argue for the simplification and the streamlining
on the pension side, and more uniformity that many of us have
been pushing for. And there might be a way to complement the
two and get this synergism.
Thank you, Mr. Chairman.
Chairman Bunning. We'll go around one more time, because I
want to be able to submit to you all, questions in writing that
we would like for you to respond to. Because, we do have
another panel to follow you, and I don't want to go 6 o'clock
this evening.
Dr. Boskin, in assessing the solutions to Social Security
solvency problems, what pools in terms of analysis are
important to Congress? What budgetary and economic questions
must be answered at a very minimum to ensure that correct
analysis is made?
Mr. Boskin. Well, I think that you need to have a
comprehensive accounting of what's going on in all parts of the
system. As was mentioned earlier when Congressman Kolbe was
here, you can't just take a look at the current system and
ignore the benefits that may accrue in the individual account
system, and so on.
You have to take account as we move through time if there's
a plausible--if there are additional revenues and additional
national saving, there may be beneficial economic effects of
that, that we have to figure how we're going to account for it
which is not currently the norm in the way that the scoring
agencies think about these things.
We're also going to have to reconcile the kind of
procedures that are used at the CBO and Joint Tax Committee,
which primarily looked at 5- and 10-year horizons, and the
Social Security actuaries who are commonly looking at 75-year
horizons. Although CBO has started to look at 20- and 30-year
horizons now.
I think we need to reconcile demographic projections. The
Census Bureau believes there will be a lot more 100-year-olds
out there several decades from now than the Social Security
Administration. I think it's important to know why.
All these things are important, and you need to be aware of
the sensitivity when compounded for decades, only a small
difference can make.
Mr. Diamond. Mr. Chairman, could I add just something quick
on that. There's a tendency to focus on the main projection.
But of course there are risks around--market risk and political
risks. We're better at quantifying market risks than we are at
political risks. And I think it's terribly important to use
what the finance community calls risk adjustment to convert the
expected value of returns into what it's worth to people when
you correct it for the risks involved.
Chairman Bunning. Thank you. Mr. Cavanaugh, you stated that
PSA investment in the private market would probably never
exceed 2 percent. What leads you to that conclusion?
Mr. Cavanaugh. I was referring to the fact that the PSA
investments would not exceed 2 percent of the capitalization of
the U.S. stock market, because that was one of the questions
that you raised. And that's based on, as I indicated at some
length in my prepared statement, which I submitted for the
record, a couple of different plans.
The one plan that would have the greatest impact on the
stock market would be the one that involved investing up to 50
percent of the fund the Social Security Trust Fund in equities.
That would come to around 2 percent of the total stock market
in the year 2014, based on assumptions by the Advisory Council
on Social Security. Given the fact that the capitalization of
the U.S. stock market right now is about $12 trillion, if you
use their assumptions and project out to 2014, it comes to
almost $40 trillion. Their plans for investing the Social
Security Trust Fund would have $1 trillion in stocks out of $40
trillion, or 2\1/2\ percent.
And the PSA proposal would be less than one-half of that,
because presumably in the personal savings account we're
assuming what most people propose, and that would be 2 percent
of payroll going into it. So that's how you come to the less
than 2 percent.
Chairman Bunning. Is there anybody else that would--go
ahead, Mr. Christensen.
Mr. Christensen. Dr. Boskin, I wanted to ask you, how would
you go about assessing a risk adjusted rate of return? Mr.
Cavanaugh in his written testimony talked about an adjusted
risk rate of return. What would your comments be on that, and
then I want to ask also Mr. Cavanaugh?
Mr. Boskin. Well, the first thing is I think you'd have to
specify all the classes of risk. All the investment options
have risks in various forms, including Treasuries. Although we
expect the government not to default, and in the short term,
there's very little inflation risk. So there are standard
procedures that are used.
If the investments are broadly diversified by supposition
or by regulation, you can reduce that somewhat. But
technically, what you're doing is you're looking at the
covariance of the returns--and I don't want to get too
technical here--there are ways to do that.
So I think another way of saying what Professor Diamond was
saying is, if you took what might happen in the future under
many or most scenarios, for example, investing in equities
would do a lot better than investing in Treasuries or in bonds.
But in some, in a smaller fraction, they might do worse. And so
he wants that accounted for in some way.
Mr. Chistensen. I think it was Dr. Diamond who talked about
this adjusted also. Maybe you could comment on it, Dr. Diamond.
Mr. Diamond. No, I think that's fine. There are simulation
models and Dr. Schieber has one of them, and EBRI has one,
which project out returns on stocks and returns on bonds, based
on the pattern of statistical variation in the past. And then
you can calculate, if you have this portfolio, 90 percent of
the time you'd do better than all bonds, and 10 percent of the
time you'd do worse. Or if you have that portfolio, it's 50-50,
and you get a spread, and you find out both the probability of
doing better and the probability of doing worse, and you can
compare any two different portfolios in that way.
Mr. Christensen. I'm just trying to pick up some hints
here, so when I can take some of this advice and take it into
the market now. [Laughter.]
All these suggested risk on the equity markets, I want to
make sure we try it out before we take it to the next step.
I want to ask Mr. Cavanaugh if there's a downturn in the
stock market, will the investors in the Thrift Savings Plan be
adversely affected so that there retirement is greatly reduced?
If there is, how would you go about taking this in terms of
moving on to the next step with this proposal, if there's a
downturn in the stock market?
Mr. Cavanaugh. If there's a downturn in the stock market,
how would we go about doing what, sir?
Mr. Christensen. Will the investors in the Thrift Savings
Plan fund be adversely affected, so that their retirement is
greatly reduced?
Mr. Cavanaugh. Yes, of course that risk is there and you
have great volatility in the stock market that you don't have
in the bond market, and that goes to the previous matter you
were discussing. There's no way that you can eliminate that
risk.
But generally, what financial analysts or advisors would
say, the way to minimize it is to make sure that you're not
putting an awful lot of money into the market or taking an
awful lot of money out at just the wrong time. And the way to
avoid that is what they call dollar cost averaging. In other
words, you put in a little bit every week or every month, and
then when you're taking it out, you do the same. You spread it
out and you're less likely to get caught.
Mr. Christensen. Dr, Schieber, you shake your head on
dollar cost averaging.
Mr. Schieber. Well, people to a certain extent naturally
insure themselves against the market. If you look at how people
invest 401(k) money, and I think that's one place you can look
to see how people behave, what we see is that younger people
tend to invest far more aggressively than older people. For
people in their twenties, typically they will have over 60
percent of their assets in equities. By the time they get into
their sixties, it's down to 40 percent or less. They are
insuring themselves against the market.
I think it also goes to the issue of how you design your
reform. And there are ways, by establishing floor benefits and
so forth, that you can keep people at the bottom end of the
income spectrum from taking on too much financial market risk.
In the final analysis though--FDR said it when he was signing
the original Social Security Act in 1935 he said, we cannot
insure all of the people in this country against all of the
vicissitudes of life all of the time.
We've got tremendous political risk in this system right
now. It's significantly underfunded. If you look at the kinds
of bills that Senator Kerrey and Senator Moynihan have put
forward, they are saying that there is some probability, maybe
fairly significant, that benefits are going to be reduced--
that's a risk.
Now the question is how we can diversify that in a
reasonable fashion and protect people who are most vulnerable.
Mr. Christensen. Thank you, Mr. Chairman.
Chairman Bunning. Mr. Collins.
Mr. Collins. Thank you, Mr. Chairman. Mr. Boskin, I want to
go back to you and this $10 trillion. You just blew my skirt up
with that $10 trillion. [Laughter.]
Let me ask you my question first. Do you have a schedule of
years that the liability becomes a liability, and each year
thereafter, for that 75 years? Do you have such a schedule? I
think it would be very helpful.
Mr. Boskin. Yes, and the Social Security Administration has
it. What this does is it takes this year by year and then it
discounts it back to the present. I may have a graph with me.
If I do, I'm going to pass it up. I may--I did bring this with
me--you'll be interested.
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Mr. Collins. We keep talking about investments. Investments
worry me too, as an individual. It worries me from the
standpoint that I may not have the best knowledge of how to
invest, and I would say that probably runs concurrent with a
lot of other people in the country.
However, I do have faith in accounts that are interest
bearing. And if we stay focused on the generation behind us,
and how we can solve this problem for them, we also look back
at how we solve other problems in other areas of financial
services, like the savings and loans, and we agree and confess
that we have to belly up to the bar and pay that bill.
Then we can cover that liability, and yet ensure for young
people, that they are going to actually get a return on the
moneys that are deducted from their payroll checks. And if we
do it right, I think we can reduce the amount of money that we
are deducting, leaving them more of their income to direct in
different type of investments.
Mr. Boskin. I agree with that.
Mr. Collins. Thank you. Thank you, Mr. Chairman.
Chairman Bunning. Mr. Portman.
Mr. Portman. Thank you, Mr. Chairman. I have a very general
question and it may not be one where there will be a long
answer here this afternoon, but perhaps those who are
interested could get back to me. It goes to the basic approach
one might want to take. And Dr. Boskin and I had a chance to
talk about this recently.
But, looking at the Kolbe proposal, it's a percent of the
payroll tax that would be taken out and invested as an
individual account or a private savings account. Most of the
payroll tax would continue to go to the government under the
current system.
Another alternative being talked about, I think Mr. Ball's
approach to this would be allowing the trust fund itself to
invest in the private market, to a certain extent in the
capital markets.
Another alternative that I just wanted to get your input
on, if I could, would be to back up for a moment and say, in a
sense, could you combine the two by allowing individual
accounts, perhaps along the lines of some of the models we've
seen in South America.
The notion is the highly regulated individual account where
I, as a payroll taxpayer, would be paying into the system just
as I am now, but it would go into my account. It would be
highly regulated by the government in the sense I'd be very
limited in terms of decisions I could make. But I could make
decisions within certain parameters.
And the government would have it all. The government would
hold it all, and money being fungible as we said earlier, the
government would then be able to pay it's liabilities over this
transition period. But I would have the personal decision to
make as to how I would invest it in this kind of mutual fund or
that kind of mutual and safer or more risky investment.
I just wondered if you could talk a little about that. It
is, in a sense, a third way that I haven't heard much
discussion about today. Dr. Schieber?
Mr. Schieber. It certainly is a third way. I guess there is
some skepticism as to whether or not the Federal Government, as
this fund began to accumulate and build and get very large, and
it would get extremely large, whether or not the Federal
Government could hold the dam, because there's a lot of uses
for money.
Mr. Portman. Are you concerned about Congress allowing
first time home buyers, or folks who are interested in
education, IRAs, to use these funds? Is that the sort of
concern?
Mr. Schieber. It goes beyond that. It's problems like
Medicare that need financing. We undoubtedly will go through
periods where it looks like some people aren't getting enough
in retirement income and maybe we can embellish those benefits.
When we have a downturn in the economy, maybe we will need to
give people some slack on payroll taxes. There's a long history
of this having been done.
The original act called for the system to be significantly
funded. All throughout the thirties and forties, we stepped
back on that. If you look at the experience of the 1983
amendments, there are many analysts who believe that the
exercise of building up the trust fund we have right now was
not an act of national saving. There's a question of whether or
not we can create saving in this economy in that kind of
mechanism.
Mr. Portman. I guess I want to hear from others if they
have comments. But my response would be, in part, that even
with individual accounts, as 2 percent as Mr. Kolbe is talking
about, Congress can always go back and change the parameters of
that. Also, the rest of it, whether you view it as 6.2 or 12.4
percent, remains in the government to be moved around as you
say.
And finally, it would be different in kind from the way
Social Security was initially established, because there would
be an individual account where you would have the ability as an
investor to be able to determine where it went, and you'd be
getting a statement monthly, and so on. Rather than having it
going into an amorphous trust fund.
Mr. Schieber. As Michael Boskin indicated earlier, he put
together a proposal several years ago that would have had
individual account. My recollection was those were more
notional, unfunded accounts than real accounts. I mean, you
could convert the current system into an account based system
without doing any funding.
Mr. Portman. But you wouldn't have any investment.
Mr. Schieber. You wouldn't have any investment.
Mr. Portman. Any other comments?
Mr. Boskin. Two quick comments about that. One is, I've
always thought one of the problems with Social Security is that
we are not providing people with enough and accurate
information. There have been some improvements made in the last
few years--I want to say in the last decade or so.
But many people aren't aware that the benefit projections
are projections and would assume current law plus massive tax
increases to fund them. Many people aren't aware of the
different types of things they're insured against with
survivors, and disabilities, and so on, other than very
generally. And the kinds of statements you get are not
sufficient, in my opinion.
So that's something that I think ought to be done, and
could be done, independent, even if there were no funding
problems or any reforms being considered.
With respect to the point you made though, I view the
tradeoff in the following way. I do believe there would be a
very big difference in people's minds about having an account
at a private financial institution, whether the money was sent
by their employer, whether they put it in, whether it was done
in some more cost effective way than a bunch of individuals
trotting up with small amounts at Schwab, or Fidelity, or
Vanguard, or many banks, or whatever it happened to be, then
something that, even though their name was on it and was a
separate part of the statement, was inside the government. I
think people would have a different reaction to that.
I would favor the former, but it's going to be more costly
to do, unless we figure out mechanisms to reduce the cost to a
tolerable amount.
Mr. Diamond. In contrasting these----
Mr. Portman. Dr. Diamond, I think I've exceeded my time
here. We either can speak afterwards, or if you could give me
your written comments, I'd appreciate it. Thank you.
Chairman Bunning. I wouldn't tell Dr. Boskin that in the
year 2000, everyone who has an account for Social Security over
age 25, will be receiving an annual statement of how much
they've put in, what their projected benefits will be.
Mr. Boskin. I think that's a major step forward. I proposed
this 20 years ago in the 1982 Advisory Commission, which led to
the 1983 amendments.
Chairman Bunning. You weren't Chairman of the Social
Security Subcommittee at the time, so it didn't take effect.
Mr. Boskin. No. I commend you for doing that. When it has
your projected benefit, what will it say about the unfunded
liabilities?
Chairman Bunning. Probably nothing.
Mr. Boskin. That's a big concern of mine.
Chairman Bunning. I understand that. But at least we're
making the first step in the right direction.
Mr. Boskin. I commend you for that. It's very important.
Chairman Bunning. We want to thank you all for being here.
We appreciate your input. And we will ask for the second panel
to take their seats. Thank you.
Dr. Lawrence White, professor of economics from the Stern
School of Business at NYU; Dr. Gary Burtless, senior fellow
from the Economics Study Program at the Brookings Institution;
Ric Edelman, chairman and chief executive officer with Edelman
Financial Services; Teresa Tritch, senior editor from Money
Magazine; and Paul Huard, senior vice president of policy and
communication at the National Association of Manufacturers.
Dr. White.
STATEMENT OF LAWRENCE J. WHITE, PH.D., PROFESSOR OF ECONOMICS,
STERN SCHOOL OF BUSINESS, NEW YORK UNIVERSITY
Mr. White. Thank you, Mr. Chairman. I am very pleased and
honored to be here and to have been invited to address this
Subcommittee.
As all of you know, the Social Security Program has been a
valuable and popular program. It's been a valuable source of
old age and disability support. But its structure has created
serious financial problems. These problems have various
manifestations. You've been talking about some of them: The
unfunded liabilities; the negative expected discounted real
returns of many of today's workers, or the equivalent
unfavorable money's worth ratios; or, as yet another
manifestation, the direct financing of the program as a self-
contained entity faces serious future problems.
Those problems are going to arise at a much sooner date
than many of the media reports would indicate. Since this is a
pay-as-you-go program, the problems will manifest themselves in
terms of the annual net cash flows of the program, and those
will begin to be negative in the year 2013. That's the year in
which the Congress will have to find alternative ways of
supporting the program because the program itself will be
running net negative on an annual basis.
2013: A mere 15 years away, which, for Social Security, is
like an eye blink. This is the year in which either other taxes
will have to be raised or other spending curtailed or other
borrowing increased. This is much sooner than the year 2032,
which is the year that the media focuses on. That's a
meaningless year in terms of the real consequences for the
program.
I believe that a PSA, a personal savings account component,
is a very desirable part of the overall reform of the Social
Security Program. Further, I am convinced that a broad choice
PSA program, basically structured the way that the current
investment retirement account, IRA, program is structured, is
the direction to go. This broad choice direction would have a
number of desirable features. First, it would give participants
a wide range of opportunity to tailor their investments to
their tolerances for risk, for their knowledge and information,
their age and family status, and other personal considerations.
It would be especially valuable for the participants who
are less financially sophisticated, less knowledgeable, perhaps
quite risk averse. They could, as is possible in the IRA
program, choose a bank account; a certificate of deposit; a
credit union account; a savings institution account; or an
insurance company's, similar vehicle for their investments. It
is instructive that, as of 1996, over a quarter, 26.3 percent,
of the funds in IRAs were invested in such funds. As recently
as 1991, this figure was almost half, 47 percent.
Second, a broad-based program would bring a regulated
financial institution into the picture, since the regulated
financial institution would be the place, the first point of
contact, for the investment of such funds. And, with the
regulated financial institution would come its fiduciary and
advising obligations to the participants.
Third, it would bring the creative and competitive forces
of the financial services sector into the picture to devise
appropriate instruments and educate the program's participants.
Fourth, to the extent that participants do choose the bank
accounts or similar instruments offered by financial
intermediaries, this route will provide a financing channel for
the millions of small enterprises in the U.S. economy that are
not publicly traded, that would not benefit from the
investments in index funds that would be a consequence of a
more centralized financing mechanism. These are the millions of
small enterprises that rely on bank finance or similar types of
financial intermediary finance. There are only about 10,000
publicly traded companies in the U.S. economy. These are the
larger enterprises; they are the ones who would benefit from
investments in index funds. A broad-choice program would bring
the other millions of enterprises into the picture as well.
A potential negative consequence is the transactions costs
of broad based plan. I am convinced that there are ways of
dealing with this problem. The competitive forces of the
financial services sector will help deal with it. The IRA
program manages to deal with it. The Federal Government could
be an accumulator to help buildup sufficient balances.
In summary, Mr. Chairman, the problems are serious. Reform
is necessary. A broad-choiced PSA component should be part of
that reform. The time to act is now. Thank you very much; I'll
be happy to answer questions.
[The prepared statement follows:]
Statement of Lawrence J. White,\1\ Ph.D., Professor of Economics, Stern
School of Business, New York University
Chairman Bunning, Members of the Subcommittee: I am pleased
and honored to be invited to testify before your Subcommittee
today.
Summary
The future of the Social Security program is an important
public policy issue for this Congress, and for the nation as a
whole, to tackle. The program has been a valuable source of
old-age and disability support for tens of millions of
Americans. It has had a substantial and worthwhile
redistributive component. But it has also evolved into a
program with substantial problems.
---------------------------------------------------------------------------
\1\ During 1995-1996 I was a consultant to the Investment Company
Institute on the subject of Social Security reform.
---------------------------------------------------------------------------
As a pay-as-you-go system, it has not contributed to--and
has probably subtracted from--the domestic savings available to
finance investments in the U.S. economy. With its history of
past policy changes and changing demographics, it has developed
serious financial problems. These problems have various
manifestations: a net excess of discounted promised benefits
less discounted taxes (net unfunded liability) of about $3
trillion; a declining expected real return or even negative
return for many or most of today's workers, in terms of their
expected discounted contributions and expected discounted
benefits (equivalently, a decline in the ``money's worth''
ratios); and the projected direct financing problems of the
program as a self-contained entity.
It is this last manifestation--the program's direct
financing problems--that has attracted the most attention. But
these problems will be reached at a much sooner date--2013--
than most media reports have indicated. These difficulties will
arise because the program has been on a pay-as-you-go basis,
with no systematic investment of participants' contributions in
real investment resources.
The solution to the Social Security programs financial
problems must involve a widespread set of changes, including an
expansion of the contribution base, an increase in retirement
eligibility ages, modifications to the cost-of-living
adjustments to benefits, and the institution of individual or
personal savings accounts (PSAs). I believe that voluntary PSAs
are an important part of that solution.
A PSA component that is modelled on the way that investment
retirement accounts (IRAs) are currently handled would be a
desirable direction for the program. A voluntary PSA component
with a wide choice of investment vehicles and instruments, plus
the involvement of regulated financial institutions with
fiduciary obligations, reaches the proper tradeoff of choice,
tolerances for and exposure to risk, and responsibility.
By allowing individuals to place their PSAs in FDIC-insured
bank deposits or similar instruments (as is currently the case
for IRAs), the PSA component would permit unsophisticated or
extremely risk-averse individuals to participate in a way that
would be comfortable for them. Equally important, the savings
that would be channeled through such instruments would become a
potential source of finance for the millions of small
enterprises in the U.S. that are not publicly traded. These
enterprises rely largely on debt finance through banks and
other financial intermediaries. A program that restricted PSAs
only to index funds would mean that, at best, only the 10,000
or so publicly traded companies in the U.S. would benefit from
the finance made available through the program. The remaining
millions of smaller enterprises in the U.S. would be deprived
of this financial flow.
The problems of the Social Security program are serious and
require serious attention. Because any changes in the program
must be phased in gradually, the Congress must pass the
appropriate legislation promptly. Delay can only increase the
costs and the difficulties of making the eventually necessary
reforms.
Social Security's Financial Problems
The financial problems of the Social Security program as a
self-contained system are real. They will arise because it is a
pay-as-you-go system. Today's workers' contributions are
largely paid out to today's retirees. As the number of retirees
continues to mount relative to the working population, the
program will begin to experience annual net negative cash
flows. The ``intermediate'' projection of the Board of Trustees
of the Social Security program, in their 1998 Report, predicts
that these annual net negative cash flows will begin to occur
in 2013 and will grow ever larger in the following years. Even
the ``optimistic'' projection of the Trustees predicts that
these annual net negative cash flows will begin in 2018.
Under this pay-as-you-go program, there is no systematic
investment of an individual's contributions in real investment
resources. Any current surplus of cash intake over cash
outflow--in 1997 this cash-flow surplus was about $45 billion--
has been transferred to the Treasury and used to cover the
other expenses of the U.S. Government. The funds have not been
systematically invested in real resources. The so-called Trust
Funds do not represent any claim on real resources. They are
simply an accounting of the past cash-flow surpluses of the
program, plus notional interest. Since the cash-flow surpluses
have long ago been spent, the apparent accumulations in the
Trust Funds simply represent the recognition of these past
surpluses and the promise by the Congress that future
appropriations will be made to cover future deficits in the
program. But such promises are no stronger or weaker than the
promises of the Congress generally to support the program. The
presence of the Trust Funds adds nothing of real value to those
promises.
Consequently, the year when the annual cash flows of the
program become negative--2013--is the time when the real
financing problems for the program will arise. It is the time
when the program will no longer be making a net contribution to
the other operations of the Federal Government but will instead
will be a net drain and will require the Congress to curtail
other spending, raise other taxes, or increase net borrowing.
Indeed, one might argue that the effective financial ``crunch''
for the Federal Government will come sooner, around 2008, when
the annual net cash-flow surplus of the Social Security program
will begin to decline sharply and will offer less help in
covering the other expenditures of the Federal Government.
In either case, whether the date is 2008 or 2013, this is
much sooner than the year 2032, which is when the Trust Funds
will be ``exhausted'' and is the year on which most media
reports have focused as the date when the program will become
``insolvent.'' Since there are no real resources in the Funds,
the date of their ``exhaustion'' is a meaningless benchmark. It
only indicates the point at which the accumulated net negative
cash flows (after 2013) will have just equaled the earlier (pre
2013) accumulated net surpluses (plus notional interest). In
2032 the annual net negative cash flow of the Social Security
program will be about $750 billion ($250 billion in constant
1998 dollars), or more than 1.8% of U.S. GDP in that year.
This same logic indicates why an often-advocated ``easy
fix'' to the Social Security program--to increase the workers'
and employers' wage contributions by about two percentage
points (i.e., to raise the aggregate contribution rate to about
14.4% of the wage base from its current 12.4%)--would not solve
the system's fundamental problems. Unless the extra
contributions were invested in real resources, this ``fix''
would only delay the onset of the annual net negative cash
flows by about five years, to 2018. And the additional tax on
wages would make the hiring of labor more expensive, add to the
distortion of labor markets, and drive more employment
arrangements ``off the books'' and into the gray or underground
economy.
Because the problems of the Social Security program are
severe and because the program's self-contained financial
problems will arise soon--within the next ten to fifteen
years--and because gradual transitions are a necessary and
legitimate part of any changes in the program (since it is
fundamentally unfair to tell a 55 year old worker that his/her
retirement benefits will be appreciably different from what he/
she had earlier been promised), the time to begin making
adjustments in the program is today.
Personal Savings Accounts
As was mentioned above, personal savings accounts (PSA) are
just one component of the modifications that must be made to
the Social Security program. But they are a vital part of those
changes. They would represent the first step toward moving the
program away from its defined-benefit structure, with that
structure's attendant short- and long-run financial problems,
and toward a defined contribution structure that would bring
greater personal choice and responsibility, while maintaining
an acceptable level of redistribution, and that could
contribute toward national saving and real investment rather
than detracting from them.
A PSA plan is far preferable to any plan that would simply
have the Social Security Administration itself invest some or
all of the cash-flow surpluses in private-sector securities.
The latter plan would bring the Federal Government into far too
much involvement in investment choices (only the S&P 500? all
publicly traded companies? what about foreign companies? what
about companies that have been convicted of criminal
violations? what about tobacco companies? etc.) and potential
conflicts of interest. Also, such investments would neglect the
millions of enterprises in the U.S. that are not publicly
traded. These problems are serious ones that the Federal Thrift
Savings Plan, that applies to federal workers' pensions, do not
adequately handle. They would be intolerable for the much
larger sums that the Social Security Administration would be
investing.
A number of PSA-type plans have been proposed. For a
program that is as complicated as the Social Security program,
truly ``the devil is in the details.'' Instead of advocating
any specific plan, I will set forth a set of principles that
should guide any specific structure.
1. A PSA plan should be voluntary. Though many program
participants would surely be eager to create and participate in
a PSA component of their Social Security contribution, others
will surely be reluctant and would prefer to stay with the
program that they know and trust. So long as the choices are
clear, this alternative should be available. This will help
avoid the unfortunate political ``poster'' stories of the
reluctant PSA participant who then invests in high-risk
investments that subsequently prove worthless.
Though the preservation of this type of choice may make the
program more complicated and could lead to problems of adverse
selection and of maintaining the redistributive aspects of the
program, I believe that the benefits would exceed the costs.
2. The PSAs should be patterned along the lines of the
current investment retirement account (IRA) structure. That is,
a wide choice of investment vehicles and instruments should be
available to the program participants; and the PSA should be
registered at a regulated financial institution, such as a
bank, a savings institution, a credit union, an insurance
company, a stock brokerage firm, or a mutual fund company.
This broad-choice structure would have many advantages.
First, it would give participants a wide range of opportunity
to tailor their investments to their tolerances for risk,
knowledge and information, age and family status, and other
personal considerations. This broad-choice structure would be
especially valuable for the less sophisticated, less
knowledgeable or very risk-averse participants who would prefer
to keep their PSAs in a familiar FDIC-insured bank account or
similar instrument. It is noteworthy that as of 1996, over a
quarter (26.3%) of the funds in IRA plans were in deposits in
banks, thrifts, or credit unions or in similar instruments in
insurance companies; as recently as 1991 this percentage was
47%.
Second, it would bring a regulated financial institution,
with fiduciary obligations and responsibilities, into the
picture. Advising the customer as to the suitability of
proposed investments with the customer's other circumstances is
a major such responsibility. It is noteworthy that there have
been no reported scandals or political calls for reform with
respect to the way that the IRA program is structured.
Third, it would provide strong incentives for the creative
and competitive forces of the financial services sector to
develop appropriate investment instruments and to educate the
program's participants as to the merits of those instruments.
Fourth, to the extent that individuals would choose to
invest their funds in bank accounts or similar vehicles, this
route would provide a financing channel for the millions of
enterprises in the U.S. that are not publicly traded and that
would not benefit from investments in any form of index fund
that is restricted to purchasing the securities of publicly
traded companies.
There are currently only about 10,000 companies in the U.S.
that have publicly traded securities. An index fund would
necessarily be restricted to their securities. But there are
millions more of smaller enterprises in the U.S. that get their
financing primarily through debt finance--i.e., through loans
from banks and other financial intermediaries. In turn, it is
deposits in banks and other financial intermediaries that
provide the ultimate source of the debt financing. Indeed, it
is this financing channel that has received extensive political
and media attention in the recent past during periods of
perceived ``credit crunches.''
A PSA structure that preserved bank accounts and similar
vehicles as acceptable investments would keep this channel of
finance available for smaller enterprises. By contrast, a PSA
plan that was patterned along the Federal Thrift Savings Plan
and that restricted participants to only a handful of index
funds would have none of these desirable properties. A
participant could not choose the familiar bank deposit. And the
resulting flow of capital and finance would be distorted to
favor the larger enterprises in the U.S. over all of the rest.
A potential drawback to a wide-choice PSA structure might
be the transactions costs of maintaining these accounts. I am
not convinced that this would be an insurmountable barrier.
First, with a wide range of instruments and vehicles open to
participants, there would be competition among providers to
offer low-cost accounts, perhaps in return for agreed-upon
restricted ability to move funds around, as is the case for
bank certificates of deposit. The prospects for attracting
these flows, present and future, should be an attractive one
for many financial institutions. Second, as an interim measure
for low income workers whose PSA contributions might initially
be small, the Federal Government might stand ready to serve as
the accumulator of, say, the first three years of PSA
contributions, after which they would revert to the IRA-like
structure described above.
The Transition
There are few free lunches to be had, and the financing of
the Social Security program is certainly no exception. The
diversion of participants' contributions into PSAs would leave
a financing gap with respect to the current basic pay-as-you-go
structure. The current federal overall budgetary situation,
with projected surpluses for the consolidated budget, provides
an excellent opportunity for making the necessary start on
financing this transition.
A frequently stated fiscal goal in the current environment
is that the projected budgetary surpluses should be used to
``strengthen Social Security.'' Unfortunately, within the
framework of the current pay-as-you-go structure, there is no
direct way that the surpluses can be used to strengthen the
finances of the Social Security program. But, with a PSA
component to a reformed Social Security structure, the
surpluses could be used to help finance the transition.
Equivalently, as part of the overall reform of the program the
budget surpluses could be used to finance the PSAs directly
while workers' contributions continued to be used to cover the
payouts to current retirees.
Conclusion
The Social Security program is a major feature of today's
economy. Current retirees rely on it; future retirees expect
it. But the program does have serious problems.
Reforming the program will not be easy. It is complex;
there are many vested interests that will be affected by any
changes. But reform is necessary.
A central component of any reform should be a system of
voluntary personal savings accounts (PSA) accounts that are
patterned on the current investment retirement accounts (IRAs),
with a wide choice of instruments and vehicles and the
involvement of a regulated financial institution. These PSAs
would serve as the basis for bringing the Social Security
program into a better funded position and for allowing the
program to make a greater contribution to this country's
saving, investment, and efficient use of resources.
Procrastination and delay in instituting reform of the
Social Security program can only make the necessary eventual
reforms more costly and more difficult. I urge the Congress to
act quickly.
Thank you. I will be happy to answer questions.
Chairman Bunning. Thank you, Dr. White.
Dr. Burtless.
STATEMENT OF GARY BURTLESS, PH.D., SENIOR FELLOW, ECONOMIC
STUDIES PROGRAM, BROOKINGS INSTITUTION
Mr. Burtless. Thank you for the invitation. I'll confine my
remarks to just a couple of points. First, the nation's
interest in replacing part or all of traditional society
security with a system of individual accounts is driven by a
widespread recognition that rates of return on contributions to
Social Security are going down and eventually may reach 1 or
1.5 percent for a typical worker. Americans compare this with a
situation in which, in the last 15 years--the period ending in
January of this year--they could have earned 13.3 percent after
subtracting for the influence of inflation, on stock market
investments.
Advocates of individual retirement accounts sometimes
suggest that we can eliminate or reduce the traditional system
in which workers' rate of return will be negative or very low
with a new system in which they can get these high rates of
return if we establish individual accounts. This beguiling
invitation is based on a fundamental confusion. About 90
percent of the contributions we make for Social Security each
year go directly to pay for benefits to our parents and
grandparents, to our disabled relatives, and to the dependents
of retirees and disabled people. We're going to have to make
payments to these people for the next 40 or 50 years regardless
of anything we do about establishing individual accounts. So
there's no way we're going to earn 8 percent, 10 percent, or
even 2 percent on this part of our contributions. They're going
to pay for current benefits; they cannot be used for
investments in stocks, bonds, real estate, or any other thing
your stockbroker might want to sell you.
The only questions are: A. How can we invest the surplus of
contributions over current benefit payments? And, B. How can we
change things so the surplus gets bigger or lasts longer? The
answer to question A is that we can certainly invest the
surplus in assets that earn a higher expected rate of return.
All we have to do is change the assets that we permit the
Trustees to invest in, expand the menu of alternatives to
include mortgage debt, corporate bonds, and equities.
The answer to question B, how can we increase the size of
the surplus, is also obvious. We must either cut benefits or
increase contributions and we must do so fairly soon. The
crucial issue is: How much of each of these things should we
do? Increase contributions or cut benefits?
My second point: The claim that individual accounts can
yield workers a rate of return of 7 or 8 percent on their
contributions must be assessed against the risk of investments
in individual accounts. Bear in mind that the 13.3-percent real
return we saw in the 15-year period ending January was far
above the average 15-year return that U.S. equity markets have
yielded over the last 130 years. In the 15-year period that
ended in January 1982, for example, the annual real return on
stock market investments held for 15 years was 0.7 percent.
That's why in 1982, when Social Security faced a financing
crisis, we didn't hear lots of discussion about how attractive
the stock market looked as an alternative to Social Security.
No one was going to talk about stock market investments when
stock market returns had been negative over such a long period.
Since 1871, there have been 113 15-year periods over which
we can calculate the real rate of return on $1.00 invested in
U.S. equities. In six of those periods, the returns were
negative. In eight, the return was 13 percent a year or higher.
So clearly the recent return has been exceptional. The
arithmetic average of the 15-year returns was 6.6 percent.
Many people mistakenly think that these ups and downs in
the stock market average out over time, assuring that people
who invest for long periods will be assured a high rate of
return. But that's not true. If you happened to retire in 1931
or in 1975, your stock market assets would've purchased a lot
less in the way of retirement consumption for you. That simply
follows from the fact that the assets that you'd accumulated
over your life fell substantially in value in a very short
period of time--the last 2 or 3 years of your career.
The chart at the end of my table tries to perform
calculations showing you what the replacement rate of a pension
invested in stock market individual accounts would have been
for workers retiring after a 40-year career ending in 1910,
1911, and so on up through 1997. The message of that chart is
clear. These investments do not yield a highly secure
retirement income. The average rate of return is good. It's
just that in a 1- or 2-year period, the pension that you can
accumulate if you invest in the stock market, or any other
portfolio for that matter, can go up and down a lot. I don't
think that the mandatory public pension system should force
people to rely heavily on that kind of a system. Thank you.
[The prepared statement follows:]
Statement of Gary Burtless,\1\ Ph.D., Senior Fellow, Economic Studies
Program, Brookings Institution
Social Security's Financing Problem
Most Americans recognize that Social Security faces a long-
term financing problem. Many workers under 35 believe the
problem is so severe they will never receive a Social Security
check.
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\1\ The views expressed are solely my own and should not be
ascribed to the staff or trustees of the Brookings Institution.
---------------------------------------------------------------------------
Young workers lack confidence in Social Security because
they do not believe future workers will be willing to shoulder
the higher payroll taxes that will be needed to keep the
program solvent. I think they are wrong, but their fears are
not unreasonable. For almost two decades many influential
opinion leaders and elected officials have fiercely criticized
any increase in taxes, even when it was plain that future
Social Security revenues will fall far short of promised future
benefits. If the Congress and public are opposed to boosting
taxes today, when the tax increase required to eliminate Social
Security's long-run deficit is relatively small, will they be
willing to raise taxes after 2020, when the required tax
increase would be far larger? Younger workers and many opinion
leaders evidently do not think so.
The simplest and best solution to Social Security's
financing problem is to trim promised benefits and increase
payroll taxes one or two percentage points. It would be
sensible if major steps along these lines were taken well in
advance of 2010 when the Baby Boom generation begins to retire.
Although it is not necessary that future benefits be reduced or
taxes hiked immediately, it is desirable that decisions about
future benefits and taxes be made as soon as possible. The
OASDI Trustees' intermediate assumptions imply that the Trust
Funds will be depleted shortly after 2030. The youngest Baby
Boom workers will be in their middle 60s when that year
arrives. If workers are to plan sensibly for their retirement,
it is critical to inform them what combination of reduced
benefits or higher taxes they will face over their careers.
The long-run threat to Social Security solvency has
prompted many people to offer novel solutions to the financing
problem. Some proposals are aimed at reducing or eliminating
the role of Social Security in protecting the incomes of the
disabled and retired elderly. Others have the simpler goal of
improving the financial performance of the Social Security
Trust Funds by permitting Trust Fund reserves to be invested in
equities or other high-yielding assets.
Individual Accounts
One of the most widely discussed reform plans is to scale
back traditional Social Security benefits and replace them
fully or partially with a privately managed system of
individual retirement accounts. Such accounts could be run
independently of traditional Social Security or as an
additional component of the existing system. Proponents of
individual accounts offer three main arguments for moving
toward individual pension accounts:
It can lift the rate of return workers earn on
their retirement contributions
It can boost national saving and future economic
growth
It has practical political advantages in
comparison with reforms in existing public programs that rely
on higher payroll taxes or a bigger accumulation of public
pension reserves
Moving to a system of large individual accounts must
overcome a big financial hurdle, however. The existing Social
Security system has already accumulated huge unfunded
liabilities to workers who are already retired or who will
retire in the next couple of decades. To make room for a new
individual account system, the Nation must find public funds to
pay for existing Social Security obligations while still
leaving young workers enough money to deposit in new retirement
accounts. This requires scaling back current obligations--by
cutting benefits--or increasing total contributions from
current workers. A large-scale individual account system would
almost certainly require major new public borrowing. The
country has struggled for the past decade to eliminate the
federal deficit, so many voters will be angry to see that
accomplishment thrown away in order to make room for a new
system of individual accounts.
As noted, proponents of individual accounts claim both
economic and political advantages for their favorite plans. In
the remainder of my testimony, I focus on the economic aspects
of such proposals.
Individual saving accounts can boost workers' rate of
return by allowing their retirement contributions to be
invested in private assets, such as equities, which yield a
better return than the assets held by Social Security. Returns
can be boosted still further if the U.S. government borrows on
a massive scale to pay for past public pension liabilities,
allowing workers to invest a larger percentage of their wages
in high-yielding assets. Exactly the same rate of return can be
obtained, however, if the existing Social Security system is
changed to allow reserves to be invested in high-return private
assets. Put simply, the rate-of-return advantage claimed for
individual accounts could be duplicated by the present system
if its investment options were expanded.
By shifting the retirement system away from pay-as-you-go
financing and toward advance funding, a system of individual
accounts could boost national saving. Such a move will require
a consumption sacrifice, either through a cut in benefits or a
hike in combined contributions to the old and new retirement
plans. Individual account plans that do not impose a
consumption sacrifice will not achieve a higher saving rate.
Higher national saving can also be achieved by reforming the
present Social Security system. The crucial change in policy is
the move toward more advance funding, not the move to
individual accounts. Thus, the claimed economic advantages of
individual retirement accounts can be obtained in either a new
individual account system or with a slight modification of the
existing Social Security system.
In an individual account system workers would be free to
decide how their contributions are invested, at least within
broad limits. Some proponents of individual account plans
suggest that contributions should be collected by a single
public or semi-public agency and then invested in one or more
of a limited number of investment funds. A worker might be
given the option of investing in, say, five different funds--a
money market fund, a stock market index fund, a real estate
investment trust, a corporate bond fund, and a U.S. Treasury
bond fund. By pooling the investments of all covered workers in
a small number of funds and centralizing the collection of
contributions and funds management, this approach minimizes
administrative costs but it limits workers' investment choices.
Another strategy is to allow mutual fund companies, private
banks, insurance companies, and other investment companies to
compete with one another to attract workers' contributions in
hundreds or even thousands of qualified investment funds. This
strategy would permit workers unparalleled freedom to invest as
they choose, but the administrative, enforcement, and selling
costs of such a system would be very high, substantially
reducing the rate of return workers earn on their investments.
Transition to an Individual Account System
Individual account plans differ from traditional Social
Security in two important ways. First, the worker's ultimate
retirement benefit depends solely on the size of the worker's
contributions and the success of the worker's investment plan.
Workers who make larger contributions receive bigger pensions,
other things equal. Workers whose investments earn better
returns will get much larger pensions than workers who invest
poorly. Second, in an individual account system pensions will
be paid out of large accumulations of privately owned savings.
In contrast, current Social Security pensions are financed
mainly by the payroll taxes of active workers. This difference
between the two kinds of system implies that the savings
accumulation in an individual-account plan would be many times
larger than the accumulation needed in pay-as-you-go Social
Security.
Because the connection between individual contributions,
investment returns, and pension benefits is very
straightforward in a defined-contribution individual account
program, the system offers less scope for redistribution in
favor of low-wage workers. Pensions financed out of individual
investment accounts are based solely on deposits into the
accounts (which are strictly proportional to workers' earnings)
and on the investment performance of the accounts.
Redistribution in favor of low-wage or other kinds of workers
must take place outside these accounts. In contrast, the Social
Security pension formula explicitly favors low-wage workers and
one-earner married couples in order to minimize poverty among
elderly and disabled people who have worked for a full career.
To duplicate Social Security's success in keeping down poverty
among the elderly and disabled, an individual account system
must supplement the pensions from the individual accounts with
a minimum, tax-financed pension or with public assistance
payments.
The United States cannot immediately scrap its public
retirement system and replace it with a private system. At the
end of 1997, almost 44 million Americans were collecting
benefits under Social Security. About 2.3 million workers began
to collect new retirement or disability benefits during the
previous twelve months. Even if the country adopted a new
individual account system for workers under 45, people who are
already collecting Social Security or who will begin collecting
within the next few years will continue to receive Social
Security checks for several decades. Public funds must be
appropriated to pay for these pensions, regardless of the
system established for workers who will retire in the distant
future.
Risks of Individual Accounts
The deficit risk
The need to pay for the pensions of people who are already
retired or near retirement age poses a challenge to all plans
for establishing mandatory individual retirement accounts.
Money must be found for existing pension liabilities at the
same time workers will be asked to contribute to the new type
of pension account. Because active workers will be required to
finance pensions for retired workers and old workers nearing
retirement, they may resent the obligation to pay for their own
retirement pensions through contributions to new individual
accounts.
Some individual account plans would fund new retirement
accounts by diverting a small part of the present payroll tax
into private retirement accounts. In 1997, Social Security tax
revenues exceeded OASDI benefit payments by $44 billion, or a
bit more than 1% of taxable earnings. Thus, 1% to 1\1/2\% of
the 12.4% payroll tax could be invested in individual
retirement accounts while still leaving enough taxes to pay for
current pension payments. This source of financing for the new
accounts will not last forever. Even if workers under age 45
were completely excluded from collecting Social Security
pensions, benefit payments will exceed Social Security taxes by
around 2015. In addition, workers must contribute much more
than 1\1/2\% of their wages if they hope to accumulate enough
private savings to enjoy a comfortable retirement. Thus, the
strategy of diverting a small part of Social Security taxes can
only work if current benefits are scaled back (yielding a
surplus in Social Security long after 2015) or if private
pension accounts provide only a modest supplement to Social
Security pensions.
More ambitious individual account plans would require
borrowing or new federal taxes to pay for existing Social
Security liabilities. These plans would divert half or more of
the present Social Security payroll tax into private retirement
accounts. The Social Security benefits promised to young
workers (for example, those under age 45) would be slashed. A
high rate of contributions into the new private accounts would
be needed to ensure that enough money is accumulated to pay for
reasonable pensions. However, the diversion of payroll taxes
would starve the Social Security system of revenue, forcing the
program to run huge deficits. To cover these deficits Congress
would be forced to raise taxes or borrow funds. The need for
extra taxes or borrowing would shrink as pensioners collecting
Social Security are eventually replaced by pensioners who
receive benefits from the new private accounts, but this
process would not be complete for several decades. In the
interim, the federal government would need to impose extra
taxes (temporarily replacing most of the lost Social Security
taxes) or run large deficits in order to cover the shortfall in
the remaining Social Security program.
Investment risk
The most frequently mentioned advantage of individual
accounts is that they would permit workers to earn a much
better rate of return than they are likely to achieve on their
contributions to traditional Social Security. I have heard it
claimed, for example, that workers will earn less than 0% real
returns on their contributions to Social Security, while they
could earn 8% to 10% on their contributions to an individual
retirement account if it is invested in the U.S. stock market.
This comparison is highly misleading. First, the claimed
return on Social Security contributions is too low. Some
contributors will earn negative returns on their Social
Security contributions, but on average future returns are
expected to be between 1% and 1\1/2\%, even if taxes are
increased and benefits reduced to restore long-term solvency.
Second, workers will not have an opportunity to earn the
stock market rate of return on all of their retirement
contributions, even if Congress establishes an individual
account system in the near future. As noted above, more than
nine-tenths of workers' contributions to Social Security are
immediately used to pay benefits to disabled and retired
workers and the dependents of deceased workers. Even if a new
individual account system is established, workers (or other
taxpayers) will be obliged to pay the cost of these promised
benefits. Thus, the amount of surplus funds available to invest
in the stock market is 1\1/2\% of a worker's pay rather than
the full 12.4% of payroll that is deducted for Social Security
contributions. Workers' overall rate of return on their
contributions to the retirement system will be an average of
the return obtained on their contributions to individual
accounts and the return earned on their contributions to
whatever remains of the traditional Social Security system. For
most current workers, this overall rate of return will be much
closer to the current return on Social Security contributions
than it is to 8%.
Advocates of individual retirement accounts often overlook
the investment risk inherent in these kinds of accounts. All
financial market investments are subject to risk. Their
returns, measured in constant, inflation-adjusted dollars, are
not guaranteed. Over long periods of time, investments in the
U.S. stock market have outperformed all other types of domestic
U.S. financial investments, including Treasury bills, long-term
Treasury bonds, and highly rated corporate bonds. But stock
market returns are highly variable from one year to the next.
In fact, they are more variable over short periods of time than
are the returns on safer assets, like U.S. Treasury bills.
Many people mistakenly believe the annual ups and downs in
stock market returns average out over time, assuring even the
unluckiest investor of a high return if he or she invests
steadily over a four- or five-decade period. A moment's
reflection shows that this cannot be true. From January 1973 to
January 1975 the Standard and Poor's composite stock market
index fell 50% after adjusting for changes in the U.S. price
level. The value of stock certificates purchased in 1972 and
earlier years lost half their value in 24 months. The average
real rate of return on a worker's lifetime investments in the
stock market plunged more than 3 percentage points (from 8.6%
to 5.3%) in a very short period of time. For a worker who
planned on retiring in 1975, the drop in stock market prices
between 1973 and 1975 would have required a very drastic
reduction in consumption plans if the worker's sole source of
retirement income depended on stock market investments.
I have made calculations of the pensions that workers could
expect under an individual account plan using information about
annual stock market performance, interest rates, and inflation
dating back to 1871.\2\ I start with the assumption that
workers enter the workforce at age 22 and work for 40 years
until reaching their 62nd birthdays. I also assume they
contribute 2 percent of their wages each year to their
individual retirement accounts. Workers' earnings typically
rise throughout their careers until they reach their late 40s
or early 50s, and then wages begin to fall. I assume that the
age profile of earnings in a given year matches the age profile
of earnings for American men in 1995 (as reported by the Census
Bureau using tabulations from the March 1996 Current Population
Survey). In addition, I assume that average earnings in the
economy as a whole grow 1% a year.
---------------------------------------------------------------------------
\2\ Stock market data are taken from Robert J. Shiller, Market
Volatility (Cambridge, MA: MIT Press, 1989), Chapter 26, with the data
updated by Shiller. Inflation estimates are based on January producer
price index data from 1871 through 1913 and January CPI-U data from
1913 through the present. Bond interest rates are derived using 1924
through 1997 estimates of the average long-bond yield for U.S. Treasury
debt; yield estimates before 1924 are based on yields of high-grade
railroad bonds.
---------------------------------------------------------------------------
While it would be interesting to see how workers' pensions
would vary if they altered the percentage of contributions
invested in different assets, in my calculations I assume that
all contributions are invested in stocks represented in the
Standard and Poor's composite stock index. Quarterly dividends
from a worker's stock holdings are immediately invested in
stocks, too. Optimistically, I assume that workers incur no
expenses buying, selling, trading, or holding stocks. (The
average mutual fund that holds a broadly diversified stock
portfolio annually charges shareholders a little more than 1%
of assets under management. Even the most efficient funds
impose charges equivalent to 0.2% of assets under management.)
When workers reach their 62nd birthdays they use their stock
accumulations to purchase a single-life annuity for males. To
determine the annuity company's charge for the annuity, I use
the Social Security Actuary's projected life table for males
reaching age 65 in 1995. To earn a secure return on its
investments, the annuity company is assumed to invest in long-
term U.S. government bonds. I assume that the annuity company
sells a ``fair'' annuity: It does not earn a profit, incur
administrative or selling costs, or impose extra charges to
protect itself against the risk of adverse selection in its
customer pool. (These assumptions are all unrealistic. Annuity
companies typically charge an amount that is equivalent to 15%
of the selling price of annuities to cover these items.) My
assumptions therefore yield an overly optimistic estimate of
the pension that each worker would receive.
The attached chart shows the replacement rate for workers
retiring at the end of successive years from 1910 through 1997.
The hypothetical experiences of 88 workers are reflected in
this table. The worker who entered the workforce in 1871 and
retired at the end of 1910, for example, would have accumulated
enough savings in his individual retirement account to buy an
annuity that replaced 19% of his peak lifetime earnings (that
is, his average annual earnings between ages 54 and 58). The
worker who entered the workforce in 1958 and retired at the end
of 1997 could purchase an annuity that replaced 35% of his peak
earnings. The highest replacement rate (40%) was obtained by
the worker who entered the workforce in 1926 and retired at the
end of 1965. The lowest (7%) was obtained by the worker who
entered work in 1881 and retired in 1920. Nine-tenths of the
replacement rates shown in the chart fall in the range between
10% and 37%. The average replacement rate was 20.7%. (For
workers retiring after 1945 the replacement rate averaged
25.3%.)
[GRAPHIC] [TIFF OMITTED] T2578.001
The principal lesson to be drawn from these calculations is
that individual retirement accounts offer an uncertain basis
for planning one's retirement. Workers fortunate enough to
retire when financial markets are strong can obtain large
pensions; workers with the misfortune to retire when asset
prices are low can be left with little to retire on. The
biggest pension shown in the chart is more than 5 times larger
than the smallest one. Even in the period since the start of
the Kennedy Administration, the experiences of retiring workers
have differed widely. The biggest pension was 2.4 times the
size of the smallest. In the six years from 1968 to 1974 the
replacement rate fell 22 percentage points, plunging from 39%
to 17%. In the three years from 1994 to 1997 it jumped 14
percentage points, rising from 21% to 35%. Social Security
pensions have been far more predictable and have varied within
a much narrower range. For that reason, traditional Social
Security provides a much more solid basis for retirement
planning and a much more reliable foundation for a publicly
mandated basic pension.
The uncertainty of individual account pensions is
understated in the chart, because it does not take account of
the effects of inflation in years after a worker retires. In
benign periods, such as the 1950s or the past few years, U.S.
inflation has been low and fairly stable. In other periods,
such as the 1970s and early 1980s, inflation has been high and
erratic. Social Security has spared pensioners from the adverse
effects of major jumps in inflation, because benefit payments
are indexed. If workers were forced to buy annuities from
private firms, this kind of inflation protection would be much
harder to obtain. Workers could see big drops in the purchasing
power of their annuities when prices started to rise rapidly.
Individual retirement risk
The calculations shown in the table refer to the
experiences of workers who consistently invest 2% of their
wages in an indexed portfolio of U.S. equities. This investment
strategy on average has yielded the highest pension of the
alternative investment strategies open to most U.S. workers. If
instead the worker had invested a fixed percentage of
contributions to corporate or U.S. Treasury bonds, the ultimate
pension would have been lower, because the rate of return
associated with the alternative strategy is lower than it is
when all contributions are invested in equities. Of course,
many workers, especially low-wage workers, are too risk averse
to invest all their contributions in equities. They would
instead invest some or all of their contributions in bonds or
even short-term Treasury bills. Workers who selected a lower-
return strategy would receive lower pensions than shown in the
chart. Some workers might even earn negative returns if they
withdrew their investments from stocks or long-term bonds at
inopportune times.
The risk that workers might choose a particularly bad
investment strategy does not arise under the present Social
Security system. That system provides a minimally adequate
pension for nearly all workers who make contributions over a
full career, regardless of the individual worker's investment
expertise. In my view, that is appropriate in a mandatory
public pension. The mandatory pension should provide a secure
and adequate retirement income regardless of a worker's
investment expertise. If voters or taxpayers are concerned
about the low rate of return earned under the present Social
Security system, then the investment strategy of the Social
Security Trust Funds should be changed to permit the funds to
be invested in higher yielding assets. All of us should
recognize, however, that this new investment strategy will
expose the Trust Funds to greater short-run risk.
Conclusion
The debate about reforming Social Security should not begin
with exaggerated fears about an impending financing ``crisis''
in the program, but with a reasoned view of the role played by
Social Security in protecting the living standards of the old
and disabled. For people who are (or expect to be) very well
off, the role of Social Security may not be very important. For
the great majority of old and disabled Americans, however, the
program provides a large percentage of retirement income. Low-
income American families containing a person over 64 derive
more than three-quarters of their cash income from Social
Security. Even among most nonpoor elderly families, more than
half of income is derived from Social Security. A large
percentage of nonpoor families would be poor were it not for
Social Security pensions.
Social Security also provides workers a crucial protection
against financial market risk. It is worth remembering that
when the system was established in 1935, many industrial and
trade union pension plans had collapsed as a result of the 1929
stock market crash and the Great Depression, leaving workers
with no dependable source of income in old age. The private
savings of many households was wiped out as well. Given these
circumstances, it is hardly surprising that a public pension
plan, backed by the taxing authority of the federal government,
was found to be preferable to sole reliance on individual
retirement plans. Financial market fluctuations continue to
make private retirement incomes uncertain. As a result, the
argument for a continued role for traditional Social Security
is strong, even for workers who earn middle-class wages
throughout their careers.
The only practical way to reduce the burden on future
workers of paying for retirement benefits is to raise future
national income. This can be accomplished within the context of
retirement policy by increasing national saving, either in the
private sector or in the public sector. Many proposals to
``fix'' the Social Security financing problem by introducing
individual retirement accounts boost private sector saving but
simultaneously increase the federal deficit by an equivalent
amount, leaving national saving unchanged. Some advocates of
private pensions have suggested that part of the current Social
Security payroll tax be diverted to private pension accounts,
thus boosting private saving. Unless federal spending is cut
sharply at the same time, this strategy will simply increase
the size of the federal deficit, reducing government saving.
The best way to improve the welfare of both young workers
and future retirees is to boost national saving so that there
will be more future income to divide between future workers and
retirees. Some individual retirement account plans can
accomplish that goal, but most would not--and many would
actually reduce aggregate saving. I cannot see how elimination
or sharp curtailment of Social Security pensions could ever
improve the prospects of today's younger workers. Their welfare
and confidence in the system could be improved if pensions and
contribution rates were promptly adjusted to keep Social
Security's promises in line with its future revenues.
Chairman Bunning. Mr. Edelman, go ahead.
STATEMENT OF RIC EDELMAN, CHAIRMAN AND CHIEF EXECUTIVE OFFICER,
EDELMAN FINANCIAL SERVICES, INC., FAIRFAX, VIRGINIA
Mr. Edelman. Mr. Chairman, thank you very much for allowing
me to testify today. I'm honored to be here.
My perspective comes as one who practices in the financial
planning environment. I'm also one of the most active financial
educators in the field between two radio and two television
shows, teaching at Georgetown, and doing seminars across the
country, and two bestselling books. I spend a lot of time with
ordinary consumers in addition to my financial planning
practice.
My perspective is a little bit different. The benefits are
obvious, and I don't think we need to belabor the point
terribly much, but I do want to specifically cite five
particular groups that are going to benefit dramatically from
the concept of establishing PSAs with the Social Security
system. The first, obviously, is the money management industry
overall which gets to manage and invest all that money and earn
asset management fees. Financial advisors such as myself will
have a field day. I mean, you'll make me rich, so thank you
very much in advance.
The financial education field will also do extraordinarily
well in terms of teaching consumers how to handle this money in
books and tapes and seminars and all of the activities from
that industry. The financial media will also do extremely well.
They'll have tons to write about for years to come. And the
advertising industry will also do extraordinarily well as they
do all of the printing and buying all the ad time and the
advertisement placements in magazines, radio, and television,
and so on. So the trickle-down theory at its best, I think, can
be well suggested from establishing PSAs.
Unfortunately, there's a major flaw in the effort. The vast
majority of Americans do not know how to invest. When I first
came upon the concept of privatizing the Social Security
system, it seemed that the original notion was to take x
percentage of the FICA contributions, and put them into the
stock market in order to get a higher rate of return--which may
or may not exist in the first place. Well, how did we go from
the notion of putting some of the Social Security Trust Fund
into stocks to the notion of, well, let's let individual
consumers make the decision of how that money is to be
invested, which is what the PSA concept does?
If we allow consumers to have control over their own
decisions, two things are going to happen. Number one, they're
going to make the wrong investment choices in a great majority
of the time, just as they do currently with their IRAs and as
they do currently with their 401(k)s. And, second, they will
change their investment decisions at precisely the wrong period
of time, such as immediately following a stock market crash, or
immediately on the bad news of something that has happened in
the marketplace. Take a look at the topsy-turvy aspects going
on in the markets right now.
In fact, it raises one question I have in my mind which has
been suggested earlier. If we weren't experiencing an 18-year
bull market that we have been currently enjoying since the
early eighties, would we even be talking about the idea of
putting some of the money into the stock market?
The question was asked earlier: What are the political
risks associated with this decision? Well, there are none, as
long as the stock market performs very nicely. But what happens
if the stock market drops 3,000 points because of something
happening in Japan, with Alan Greenspan rushing to the White
House to confer with the President about what to do next and
consumers who are placing their Social Security money into the
stock market suddenly want to withdraw that money as quickly as
they had been so happily ready to add it? The sudden decrease
or the outflow of money from the stock market would have a
tremendously detrimental effect on the overall stock market
and, as a result, the economy as a net effect.
Therefore, I would like to suggest an alternative proposal
that I think might allow us to have our good news and avoid the
bad news. And that is to establish a system that is similar to
that used by the Federal Campaign Contributions. We currently
allow taxpayers every year when they do their tax return to
choose whether or not they want to put $3 of their tax payment
into a segregated fund that the Federal Government controls.
The Federal Election Commission, FEC, takes those $3 and
allocates them to the candidates under a system established by
the government. Consumers have no say over how the $3 is spent
after they decide to put in the $3.
We could do the same thing with a different system. Allow
workers on their W-9 every year to determine how much of their
money they want to put into stocks, up to a limit set by
Congress, such as 2 percentage points of the FICA payment. Once
the consumer makes that election, it's then up to the
government, through a system similar to the FEC, to make the
decision of how that money is going to be invested. Don't leave
it up to individual consumers. As much as I personally and
professionally would enjoy that decision, I don't think it's in
the best interests of consumers.
This would be extremely easy to administer. The systems are
already in place on the W-9. And we need to do one final thing:
Make it a one-way trip. Once money is going into the stock
market, the ability to remove it because of fears over current
or future market conditions must not occur or we will be
contributing to a topsy-turvy marketplace that will cause
significant problems in the future. Thank you very much.
[The prepared statement follows:]
Statement of Ric Edelman, Chairman and Chief Executive Officer, Edelman
Financial Services, Inc., Fairfax, Virginia
I am honored to be appearing before you and the
Subcommittee today. The issue you are considering today--
whether to place a portion of the Social Security Trust Fund's
assets into the stock market--is both an exciting and a
sobering one, and I am both pleased and relieved that the
Congress has sought input from someone like me who is so
intimately involved in the field of personal finance.
My perspective comes from my activities both as a provider
of financial services and as one of the nation's best-known
educators in the field of personal finance. By way of
background, I am the author of two New York Times bestsellers,
The New Rules of Money and The Truth About Money. My award-
winning radio program, ``The Ric Edelman Show,'' is heard on
WMAL in Washington, DC and WLS in Chicago. I also host the
national television show ``Money University'' on America's
Voice cable network, write a syndicated column, publish a
newsletter, and run a major advice area for America Online. I
am on the faculty of Georgetown University, and my company,
Edelman Financial Services, Inc., manages $900 million in
client assets, establishing my firm as one of the largest
financial planning companies in the nation.
Because of my background, it might at first appear that I
would be strongly in favor of placing a portion of the money
collected from Social Security taxes into the stock market.
And, of course, to a large extent this is correct. However, I
am also extremely concerned about several of the proposed ways
this might be enacted, for as much as there is opportunity
offered by the proposals, there is substantial risk for America
embedded in those proposals as well. Please allow me to
elaborate on these opportunities and risks, and offer a
proposal that can best take advantage of the former while
minimizing the latter.
To anyone working in the financial services industry, the
opportunities are very real, and it is easy to see why I and
others in my field would jump at the chance to manage these
retirement assets. The advantages are clear:
Billions of dollars would flow into the stock
market. This can only cause stock prices to rise--and rise
dramatically.
The inflows would be based on periodic investments
from payroll reductions. Referred to in financial circles as
Dollar Cost Averaging, this is widely regarded as perhaps the
most effective long-term investment strategy known. Therefore,
sustained higher stock prices over the long run are virtually
certain.
If these massive investments are handled on an
individual level, five major industry sectors will enjoy
tremendous profits, which will serve as a huge catalyst for
supporting the entire American economy:
--First, the money management industry will earn enormous
fees by investing and managing these assets. I am referring to
mutual funds, annuities, institutional money managers, clearing
firms, banks, insurance companies and brokerage firms. My
esteemed colleague from Charles Schwab, who joins me today on
this panel before you, would be counted in this group. Make no
mistake: placing a portion of Social Security's assets in
stocks would be the biggest payday in Wall Street history.
--Financial advisors would become the nation's hottest new
profession (if it isn't already). There will be incredible fee
and commission income from advising consumers on how to invest
their Social Security assets, and whereas I placed Schwab in
the first group, I place myself solidly in this group. If you
enact this proposal, let me be the first to thank you in
advance for helping me and all financial advisors to become
rich, or rather, even richer.
--The burgeoning financial education field, of which I am a
part, and which currently is a small cottage industry, would
become a major metropolis. Tens of millions of workers would be
new targets for educational products and services.
--The financial media, which is very well represented today
by Money Magazine, would find a treasure chest of new
information to convey to its readers. They'll have plenty to
write about for a long time.
--The advertising industry would receive its biggest bonus
since prescription drug advertising hit television. Whereas
currently Wall Street attempts to reach only the affluent, who
have assets to invest, this proposal would place investable
assets into the hands of virtually every working American. Wall
Street will want to reach those consumers, and this means
unmatched spending on advertising, marketing, promotional and
public relations campaigns. This represents the trickle-down
theory at its best.
As exciting as all of these benefits appear, the total
result is even more exciting. Individual Americans would become
more educated about investing. They would become more involved
in their own financial future--a fundamental principle on which
this great nation was founded. American entrepreneurial and
business opportunity would be greatly expanded. And the overall
U.S. economy would strongly benefit.
Of course, there is no such thing as reward without risk,
and I would like to caution the Subcommittee of the three
predominant dangers of this proposal.
First, the majority of Americans--again, the majority of
Americans--do not know the proper way to invest, nor do they
know how to hire and work with a financial advisor. They do not
understand such fundamental investment basics as the power of
compounding, or diversification. Consequently, many would be
exposed to fraud and abuse--and the nation simply cannot afford
to take these risks with the Social Security Trust Fund.
Furthermore, I can tell you from experience that most Americans
tend to emphasize risk over performance when it comes to
investing. This means that, left to their own discretion, far
too many Americans would invest their assets in the wrong asset
classes, defeating the goal of improved performance that this
privatization issue seeks to achieve.
Second, just as the great inflow of dollars in the stock
market would be beneficial, great, sudden outflows would be
disastrous. And if you give individual consumers the
opportunity to withdraw their Social Security assets from
stocks, such outflows would be certain to occur, for consumers
tend to act emotionally with their investments.
On this point, I am very concerned that this proposal has
surfaced at this time. Is it a coincidence that the stock
market has been enjoying its biggest gain in history? Over the
past 16 years, the Dow Jones Industrial Average has grown ten-
fold, and aside from three very short-lived declines, consumers
would be hard-pressed to recall the last time that stocks
failed to rise dramatically in value.
My concern is that much of the fuel driving the proposal to
place a portion of the Social Security Trust Fund's assets into
stocks stems from consumer attitude. Consumers have been
watching stocks and mutual funds rise sharply, while bonds and
bank accounts have been languishing due to sharply decreasing
interest rates. Indeed, during the same period of time that the
Dow has risen from 800 to 9000, CD interest rates have fallen
from 16% to 4%. Thus, stock investors have been richly rewarded
while conservative savers have been left behind.
Today, too many consumers believe that stock prices only
rise. What will be the sentiment when stocks fall? What happens
when--not if--the nation enters a true bear market--something
that hasn't happened for nearly 30 years? If the Congress is
going to permit Social Security assets to be invested into
stocks, then it must make this a one-way trip. Investor
sentiment must not drive this decision today, nor should
changing attitudes because of the current condition of the
economy cause a change in our commitment in the future.
Otherwise, the proposal you are considering today will cause
great damage to this nation in decades to come.
And third, there would be massive inefficiencies and
conflicts of advice as each organization strives to capture the
attention--and the assets--of American workers. The
contradictory advice that will emanate from the financial
community will create confusion among consumers, and too many
of them will consequently make the wrong investment decision--
with disastrous results. The goals of the Congress can be
achieved just as effectively without the activities of these
various special interest groups.
Therefore, as much as I personally and professionally would
like to see Congress turn over a portion of the Social Security
assets to individuals for them to manage as they see fit, I
cannot ethically and morally support such a position. Instead,
I propose the following to Congress:
Without question, do allow a portion of the Social Security
Trust Fund to be invested into the equity markets. The economic
realities of today demand this. However, do not allow
individual consumers to decide how to their portion is to be
invested, for Americans have proved time after time that they
do not know how to properly manage their money. Still, because
I firmly believe in the individual rights of Americans, their
individual participation in this matter is critical. I thus
propose the following:
Prior and existing Trust Fund assets should not be
invested into equities.
A portion of new contributions to the Trust Fund
should be directed toward equities. Congress should determine
the maximum percentage. I recommend no more than 25% of future
contributions.
Each American worker should declare what portion
of their current Social Security contributions they wish to be
invested into stocks, up to the maximum percentage determined
by Congress. This election would be made annually on each
worker's W-9 form.
Each annual election must be irrevocable, meaning
that workers will not be able to rescind their previous W-9
declaration, and such designated monies must not be withdrawn
from the stock market until the assets are needed to make
payments to Social Security beneficiaries. Withdrawals or
redemptions for any reason--and especially because of concerns
over current market conditions--must be strictly prohibited.
The Federal Government, in a manner established by
Congress, would be responsible for investing the equity portion
of the Trust Fund into a broadly-based equalization
(unweighted) index comprising at least 2,500 U.S. stocks. A
capitalization-weighted index must not be used. As explained in
my book, The New Rules of Money, index funds that mimic the S&P
500 Stock Index are poor investments, for the following
reasons:
--In a capitalization-weighted index, like the S&P 500, the
biggest companies have the biggest effect on the index, instead
of each stock having an equal effect. For example, a 10% gain
by the #1 company would have a much bigger impact on the index
than a 10% gain by the smallest company. It also means that the
index would buy more of the biggest stocks than the smallest
stocks. And the higher a company's stock price gets, the more
the index fund would buy it. It sounds bizarre, but it's true:
Index funds buy more of a given stock merely because the stock
has already risen in value.
--Because index funds tend to hold disproportionate amounts
of stock--holding much more stock of big companies than it
holds of little ones--it's impossible to maintain a balanced
portfolio. If a stock grew in price, a typical money manager
might want to sell some of it. But in a capitalization index
fund, you can't. Instead, the fund will buy even more--at the
new higher prices. This explains why S&P Index funds have as
much money invested in the 50 biggest stocks as in the other
450 combined. The result is that such index funds make money
only if the biggest stocks make money, because big gains in
little stocks don't make much difference. Thus, index investors
were lucky in 1996: six of the S&P 500's biggest stocks
collectively produced 26% of the index's total gain. Put
another way, just 1.2% of the holdings produced 26% of the
profits, while the other 494 stocks in the index earned the
rest. The Congress must not create an investment whose results
are so dependent on such lopsided performance.
The format I propose here is similar to that currently used
by the Federal Election Commission:
Previously-received federal revenue is not used
for federal matching contributions.
Congress determines the maximum annual allowable
contribution by each taxpayer; currently set at $3.
Each taxpayer chooses whether or not to make this
contribution.
Once the election is made, taxpayers cannot change
their mind.
The Government determines how the assets are to be
``invested,'' or distributed, among the candidates. The
individual consumer plays no role in this decision.
The Campaign Contribution program is very efficient and
effective, and a similar program can be created as easily by
the Social Security Trust Fund.
Thank you very much for this opportunity to participate in
this important process.
Chairman Bunning. Thank you.
We are going to recess to go vote. I apologize, Ms. Tritch,
but we have to go to the floor and we'll be back as soon as
possible. We stand in recess.
[Recess.]
Chairman Bunning. The Subcommittee will come to order.
We were about to hear from Ms. Tritch.
STATEMENT OF TERESA TRITCH, SENIOR EDITOR, MONEY MAGAZINE, NEW
YORK, NEW YORK
Ms. Tritch. Mr. Chairman, thank you for the opportunity to
appear before you today to discuss personal savings accounts
within Social Security. I've been asked to address two related
issues. First, whether Americans in general are currently
knowledgeable enough about financial markets to make sound
investing decisions and, if not, what would be required to
raise American's financial IQ to a level at which they could be
reasonably secure about investing their tax dollars on their
own?
Much of the survey data and anecdotal evidence on investor
preparedness points to one conclusion: That is, overall,
individuals are ill-equipped to make fundamental decisions
about investing. A case in point. In 1996 and, again, in 1998,
Money magazine and the Vanguard Funds Group tested the basic
investing knowledge of roughly 1,500 people who own mutual
funds directly or through a retirement plan at work. In 1996,
the average test score was 49 out of 100; in 1998, investors
averaged 51 out of 100, performances that deserve an F even by
today's liberal grading standards. Clearly, if individuals who
have money in mutual funds fail a test on investing basics, one
can only assume that the roughly 60 percent of Americans who
have no such investments are even less informed.
The negligible improvement in test scores from 1996 to 1998
is especially dismaying when you consider that during that
time, investors poured more than $700 billion into mutual
funds. Many proponents of Social Security privatization have
equated individual's increased participation in the market with
increased financial sophistication, but as the Money-Vanguard
data shows, increasing participation in the markets does not
necessarily correlate to investor savvy. Rather, individuals
may be fooled by the long-running bull market into believing
they possess an investing prowess that has, in fact, never been
tested by adverse market and economic conditions.
Worse, investing experience that is confined to boom times
can actually engender or reinforce faulty investing beliefs.
The top four wrongheaded attitudes I've encountered are the
notions that stocks, particularly U.S. blue chips, are the only
place to be invested; that market downturns are rare, brief,
and relatively painless; that fees and expenses are unimportant
in determining one's investment return; and that inflation is
not a threat. Unfortunately, misperceptions like these are
fueling, at least in part, the current enthusiasm for
individual Social Security accounts.
That said, I believe the task of turning each American
worker into a savvy investor would be unduly burdensome for the
individual and for the government. So, if individual accounts
become part of Social Security, I believe that Americans would
be best served by embedding sound investing basics in the rules
of the program itself.
For example, participation in individual accounts would
have to be mandatory, thus circumventing the need to convince
people to participation. Investing options would have to be
limited to those that have easily explainable risk-reward
profiles and low fees, such as a stock index fund, a government
bond fund, and a money market fund. There would also need to be
a prohibition against early withdrawals, since tapping one's
account before retirement defeats the compounding on which the
success of the account depends. The government should make no
guarantee against loss, but could seek to provide a cushion by
requiring employers to match employees contributions.
By structuring individual accounts this way, the government
will mirror much of the investor education that private
companies have already undertaken. Thank you again for your
time and attention.
[The prepared statement follows. Attachments are being
retained in the Committee files.]
Statement of Teresa Tritch, Senior Editor, Money Magazine, New York,
New York
Mr. Chairman and Members of the Committee,
Thank you for the opportunity to appear before you today to
discuss the topic of personal savings accounts within Social
Security. I have been asked to address two related issues:
First, whether Americans, in general, are currently
knowledgeable enough about financial markets to make sound
investing decisions
And, if not, what would be required to raise Americans'
financial IQ to a level at which they could be reasonably
secure about investing their Social Security tax dollars on
their own.
Investor Preparedness
Much of the survey data and anecdotal evidence on investor
preparedness points to one conclusion. That is, overall,
individuals are ill-equipped to make fundamental decisions
about investing. A case in point:
In 1996 and again in 1998, Money magazine and the Vanguard
Funds Group tested the basic investing knowledge of roughly
1,500 people who own mutual funds directly or through a
retirement plan at work. In 1996, the average test score was 49
out of 100; in 1998, investors averaged 51 out of 100--
performances that deserve an F even by today's liberal grading
standards. I'll offer some details later. But clearly, if
individuals who have money in mutual funds fail a test on
investing basics, one can only assume that the roughly 60% of
Americans who have no such investments are even less well-
informed.
The low test scores--and their negligible improvement from
1996 to 1998--are especially dismaying when you consider that
during that time, investors poured more than $700 billion into
mutual funds--and for the first time in a generation, Americans
had more of their assets invested in stocks than in their
houses. Many proponents of Social Security privatization have
equated individuals' increased participation in the markets
with increased investor savvy. But as the Money/Vanguard data
show: Increasing participation in the markets does not
necessarily correlate to financial sophistication. Rather,
individuals may be fooled by the long-running bull market into
believing they possess an investing prowess that has, in fact,
never been tested by adverse market and economic conditions.
This sentiment was echoed last May by Securities and Exchange
Commission chairman Arthur Levitt. He told a group of equity
portfolio managers--quote--``The financial literacy of
Americans has not kept pace with the growth of the fund
investments or investor satisfaction.''
Worse, investing experience that is confined to boom times
can actually engender or reinforce faulty investing beliefs:
The top four wrongheaded attitudes I've encountered are the
notions that stocks--particularly U.S. blue chips--are the only
place in which to be invested; that market downturns are rare,
brief and relatively painless; that fees and expenses are
unimportant in determining one's investment return; and that
inflation is not a threat. Unfortunately, misperceptions like
these are fueling, at least in part, the current enthusiasm for
individual Social Security accounts--especially among young and
surely untested investors who are among the greatest proponents
of privatization.
A few of the specific areas in which participants in the
Money/Vanguard survey exhibited surprising ignorance shed light
on the question of whether individuals really grasp what they
are being asked to give up in the current system by undertaking
private accounts.
For example, the test found widespread confusion about how
to calculate basic performance gauges, such as total return and
real return. Such ignorance could lead individuals astray as
they weigh the pros and cons of individual accounts. That's
because one of the main arguments for individual accounts has
been the relatively poor return that Social Security offers
younger workers on their tax dollars. Those calculations
generally fail to include the value of disability and survivor
benefits under Social Security or the savings to workers due to
the fact that Social Security spares them from having to
contribute to their own parents' support.
On a related matter, 40% of testakers were unaware of the
effect of a fund's operating costs on their returns, namely,
that every cent a fund charges comes right out of their
investment. (This finding echoes a similar result in a joint
study conducted in 1995 for the SEC and the Office of the
Comptroller of the Currency, which found that more than 80% of
fund investors could not give an estimate of expenses for their
largest mutual fund; and of them, only 43% even knew their
largest fund's expenses at the time they first invested in the
fund.) Without that understanding, investors are in no position
to evaluate the potential returns in an individual account--let
alone compare that account with the current system. This is
especially true if, as has been estimated, administrative costs
for individual accounts amount to a minimum of one percentage
point a year. According to Peter Diamond at MIT, that alone
would total a 20% hit against one's savings over a 40-year work
life.
Finally, almost half of investors mistakenly believed that
diversification guarantees that their portfolio won't suffer if
the market falls. It's crucial that investors understand that
nothing can guarantee against loss in the stock market and that
their return depends on what they buy, when they buy it and
when they sell it--and the fees they pay along the way.
Investor Education
That said, I believe the task of turning each American
worker into a savvy investor would be unduly burdensome for
both individuals and the government. Thus, if individual
accounts become part of Social Security, I believe that
Americans would be best served by embedding sound investing
basics in the rules of the program itself. For example,
participation in individual accounts should be mandatory, thus
circumventing the need to convince people to participate.
Investing options should be limited to those that have easily
explainable risk/reward profiles and low fees, such as a stock
index fund, a government bond fund and a money market fund.
There would also need to be a prohibition against early
withdrawals, since tapping one's account before retirement
defeats the compounding on which the success of the accounts
depends. The government should make no guarantee against loss,
but could seek to provide a cushion by requiring employers to
match employees' contributions.
By structuring individual accounts this way, the government
will mirror much of the investor education that private
companies have already undertaken. These initiatives have
centered on encouraging employee participation in employer-
provided retirement savings plans; explaining the relationship
between risk and reward, with an eye toward increasing
employees' comfort with investing in stocks while stressing the
need for asset allocation; and warning about the dangers of
tapping one's savings before retirement.
Thank you for your time and attention.
Chairman Bunning. Thank you very much.
Mr. Huard.
STATEMENT OF PAUL R. HUARD, SENIOR VICE PRESIDENT, POLICY AND
COMMUNICATIONS, NATIONAL ASSOCIATION OF MANUFACTURERS
Mr. Huard. Thank you, Mr. Chairman, on behalf of the
National Association of Manufacturers, its 14,000 members and
18 million people, employed in manufacturing. We appreciate
this opportunity to express our views.
We do not believe that the Social Security system as
presently constituted is demographically sustainable. We
believe that people who think so are indulging in a large
number of rosy scenarios. We think the truth is that people
will live longer than is currently being estimated, because
medical science will continue to prolong life. We think that
taxes will have to be raised more than is being projected in
order to keep the system viable. Ultimately, if the Social
Security system is not transformed from its present format, it
will eat the U.S. economy alive. That being the case, the
entire incoming tax receipts of the Federal Government will
have to be used to pay out entitlements whether it's Social
Security retirement, Social Security Medicare, or Medicaid.
We believe that the Social Security system should be
transformed into a two-part system which continues to provide,
as it presently does, a tax financed safety net of minimum
benefits. The portion of tax receipts currently being put into
the so-called Social Security Trust Fund should, in fact, be
contributed to a system of personal retirement accounts. We
believe such retirement accounts should be owned by their
beneficiaries. Title to those funds should not be in the
government nor should the government manage the funds. We
believe collection remittance and reporting of allocations for
these accounts should be based as much as possible on the
current payroll tax mechanisms which are well-known to
employers and which could be handled with a minimum of
administrative expense.
And, finally, we believe that a robust system of private
employer-sponsored retirement plans should continue to be
encouraged by Federal tax policy. With that, I would submit the
balance of my testimony for the record and, in the interests of
time, be glad to answer any questions.
[The prepared statement follows:]
Statement of Paul R. Huard, Senior Vice President, Policy and
Communications, National Association of Manufacturers
Summary
Social Security reform is a necessity. Under a reformed
system, a safety net will remain, as protection against poverty
in old age. However, the safety net should emphasize its role
as social insurance, not a source of defined benefits. Reform
presupposes contributions of funds currently, for accumulation
as necessary to provide retirement income. The defined
contribution model for employer plans under ERISA provides the
appropriate means of pre-funding. Accordingly, Social Security
reform requires creation of a system of personal retirement
savings accounts. Under such accounts, employees would enjoy an
ownership interest in a pool of assets invested directly in
publicly traded securities, specifically identifiable to the
accounts of individuals. Personal accounts would exist
separately from the current system of employer-sponsored
retirement plans. Social Security reform is in large measure
dependent on private plans, and federal policy should encourage
expansion of the qualified-plan system. The payroll tax
provides the appropriate platform for employer compliance with
the requirements for contributions to personal accounts.
Thank you Chairman Bunning. I am Paul Huard, Senior Vice
President for Policy and Communications of the National
Association of Manufacturers. I am pleased to represent the NAM
today in testifying before this subcommittee.
This afternoon I shall make observations with respect to
the following issues:
The attitude of employers toward Social Security
reform, and the necessity that sources of retirement income be
funded in advance;
Employer support for a system of employee-owned
personal savings accounts;
Continuing employer commitment to the existing
system of employer-sponsored retirement plans; and,
Mechanical and practical considerations incident
to a personal account system, and the requirement that employer
obligations under such a system be based on the existing rules
for collection, deposit, and reporting of payroll taxes.
The NAM
The National Association of Manufacturers is the oldest
broad-based trade association in the nation. Founded over a
hundred years ago, the NAM encompasses 14,000 member companies
which account for 85-percent of goods manufactured in the
United States. NAM members range in size from companies with
fewer than 50 employees to those with more than 100,000.
NAM members consider the reform of Social Security a top
priority. Members recognize unreformed federal entitlement
programs as the greatest threat to the economic health of
American businesses. Absent entitlement reform, the unfunded
obligations of the government will tax the growth out of the
economy; tax the jobs out of the economy; and finally, make it
extremely difficult for U.S. employers to compete in both
domestic and foreign markets.
Because of the importance of the issue to member companies,
the NAM became a leader among trade associations in addressing
Social Security reform. In 1995, the NAM formed a task force to
examine the dimensions of the Social Security issue and to
consider potential remedies. Last year, the task force
presented its recommendations to the NAM Board of Directors,
which approved a ``Statement of Principles for Social Security
Reform.'' To the best of our knowledge, the NAM was the first
employer group in the country to reach such a consensus on the
fundamental aspects of reform.
In testimony before this subcommittee in July of last year,
then NAM Chairman Warren Batts discussed the ``Principles,''
and the salutary effect of Social Security reform on U.S.
economic growth.
This afternoon, I represent American manufacturers in
making comments on Social Security reform with a focus on
personal retirement savings accounts.
Employers and Social Insurance
NAM member companies recognize the role of a ``safety net''
against poverty in old age. And while such a federal program
should continue, it should emphasize the New Deal concept of
``social insurance'' against poverty in retirement, purchased
through payroll taxes.
In the decades since the New Deal, Social Security has come
to represent not insurance protection, but a system of
``benefits,'' to which virtually all persons in the workforce
are entitled, regardless of need. However, as amply
demonstrated by students of the issue, demographic factors will
not allow the current schedule of benefits to continue. If the
safety net is to remain viable, we must ``decouple'' social
insurance from accrual of retirement income.
To do so will strengthen the safety net dramatically, by
reducing the insurance risk that the federal government
assumes. Whether the safety net were needs based, or provided
through a ``first tier'' of defined benefits, the ability of
the federal government to satisfy its promise is greatly
enhanced by a system of personal accounts through which
retirement income needs are pre-funded.
Reform Means a Funded System
Anyone who operates a business enterprise recognizes the
necessity of accumulating resources of current worth in order
to satisfy projected needs--a future liability is offset by
assets currently in hand. In the same manner, individuals and
families recognize the necessity of saving now, for cash needs
in the future.
With respect to Social Security reform, current
accumulation of assets is not enough. The experience of
employers in providing pension benefits to employees has shown
the insufficiency of mere accumulation in view of future
liabilities. In this regard, the promises made to employees for
their retirement income presuppose not only the creation of
reserves, but segregation of the funds that will provide such
income. The Employee Retirement Income Security Act of 1974
made fund segregation a federal mandate, by requiring not only
pre-funding, but creation of a trust to hold the assets.
Social Security reform requires an equivalent mandate. We
must accumulate funds currently, segregate those funds, and
provide for growth of the funds through investment returns.
In dealing with funding, a caveat is in order.
As noted, ``reform'' implies a funded system. But a system
remains unfunded if the only assets dedicated to future needs
are projected surpluses in the federal budget. To this effect,
one well might ask, ``What assets?'' Projected federal
surpluses simply aren't assets. ``Reform'' based on unrealized
improvements in the federal balance sheet is less a promise of
retirement income to individuals than it is a plea by the
federal government for an expanded line of credit.
Personal Retirement Savings Accounts
NAM member companies endorse Social Security reform based
upon a system of ``personal retirement savings accounts.'' In
this regard, the term means vested rights of ownership by an
individual in specified assets, accumulated through periodic
contributions and investment earnings. While the assets
attributable to each account would be pooled for investment
purposes, an account would represent the individual's legal
right to specific marketable securities that are identifiable
to the account.
Start-up of a system of personal accounts might require
that the federal government temporarily hold assets in gross,
unallocated to the accounts of individuals. In a similar
manner, continuing administration of a system of personal
accounts might of necessity involve a federal escrow or sub-
account to hold periodic contributions pending allocation. In
any event, the operation of a functioning personal account
system would require that the government transfer the
contributions as quickly as possible to private-sector asset
managers. Such managers would hold and invest the assets, as
fiduciaries, for the benefit of the specific individuals on
whose behalf contributions were made. Individuals would possess
a legal right to assets held on their behalf, NOT a right to
assets held legally by the federal government.
The obvious model for a personal account system is a
defined contribution retirement plan (such as a 401(k) plan),
sponsored by an employer, and subject to ERISA. In this regard,
a plan sponsor is required to segregate contributions from its
own funds as quickly as possible, and to forward the assets to
an investment manager. The manager invests the assets in
publicly traded securities, and simultaneously allocates the
amount of the employer's contribution to the accounts of
individual employees.
The NAM and others in the business community would
vigorously oppose asset management subject to discretionary
authority of an agency of the federal government.
The Role of Employer-Sponsored Retirement Plans
Employers endorse Social Security reform that emphasizes
and strengthens current federal policy in favor of employer-
sponsored retirement plans. Savings for retirement through
qualified plans has proven highly successful, with
approximately half the U.S. workforce participating in such
arrangements. That such individuals are less dependent on
Social Security and less likely to need a safety net is
obvious. Accordingly, federal policy should encourage even
greater coverage by employer-sponsored plans. Creation of new
plans and increased savings under existing plans can only
reduce financial pressure on the Social Security system and
ease implementation of reforms.
Practical Concerns of Employers under Social Security Reform
Employers endorse Social Security reform that recognizes
the necessity of a limited role for employers.
Common to virtually all the reform proposals currently
under consideration is creation of personal savings accounts
for employees, administered apart from employer-sponsored
retirement plans or individual retirement accounts. But such
proposals, of necessity, rely upon employers as agents for
collecting and transmitting funds subsequently allocated to
individuals' accounts.
In order to implement a personal-account system quickly and
efficiently, the administrative aspects of reform should be
attached to the existing system for payroll tax collection,
deposit and reporting. Employers and employees alike understand
the procedures for withholding and reporting FICA taxes. Most
importantly, it appears that existing accounting and computer
systems used by employers for payroll tax compliance could
accommodate the additional requirements for personal retirement
savings accounts fairly easily. Employers would withhold
employee contributions to accounts no differently than employee
FICA is withheld. Likewise, no new procedure is required for
employer contribution to such accounts or for deposit of taxes.
Indeed, the efficiency of the present system for collection of
payroll taxes is among the principal reasons that personal
accounts are administratively feasible.
Employees could receive documentation of amounts
contributed to their accounts by means of a slightly revised
Form W-2. If a reformed system allowed additional voluntary
employee contributions, it appears that employees could make
elections in this regard through a revised Form W-4. Such
changes, accomplishing in large measure the mechanical
requirements for personal accounts, would seem to impose only
modest alterations upon the present payroll tax compliance
system.
Existing civil penalties and criminal sanctions for payroll
tax non-compliance would assure persons in the workforce, no
less than federal regulators, that employers made contributions
to personal accounts as specified. Enforcement of such
proscriptions by the Internal Revenue Service is automated and
highly efficient.
Additional Thoughts on the Mechanics of a System of Personal Accounts
Although employers endorse personal accounts as a means of
achieving Social Security reform, they recognize significant
practical issues that the Congress must address.
The technology necessary to management of personal
accounts is already in wide use. However, the capacity of such
technology would have to be expanded enormously in order to
accommodate a personal account for each individual in the U.S.
workforce.
Management of data with respect to contributions
and earnings is an accounting function, separate and apart from
asset management, which constitutes an investment function.
Costs for accounting are separable from costs for investing. It
seems a virtual certainty that accounting for individual
accounts would remain with an agency of the federal government.
As noted above, employers would support Social Security reform
only if asset management and investment were performed by
private-sector financial institutions, subject to rules
governing fiduciaries.
Use of the existing payroll tax system for
collection of contributions to personal accounts presupposes
that employers would remit amounts to depositary banks as under
the current system. Such deposits would continue to be made in
gross and without allocation. Subsequent allocation to
individual accounts would be preformed by the government agency
specified in the statute.
In the first few years of a personal account
system, the investment choices available to individuals would
be limited, with reports of contributions and earnings made
infrequently. Greater investment choice and more frequent
reporting would become common as the system matured. Employer
experience with 401(k) plans is highly analogous.
Chairman Bunning. Thank you very much. I'm going to ask one
question and I'd like a yes or a no answer from each of the
panelists. Do you favor retaining the status quo on Social
Security without any options for taxpayers to invest part of
their contributions?
Mr. White. No, Mr. Chairman.
Mr. Burtless. It depends.
Chairman Bunning. It's a pretty obvious, easy question. We
have to do it, every day. Next, Mr. Edelman.
Mr. Edelman. No, Mr. Chairman.
Ms. Tritch. No.
Mr. Huard. No.
Chairman Bunning. OK. If you're opposed to personal
accounts, how should the system be changed to ensure its
survival? Or should it? Dr. White.
Mr. White. If I'm opposed? I just indicated in my
testimony----
Chairman Bunning. That's you're not opposed.
Mr. White. I am not opposed.
Chairman Bunning. So all of you think----
Mr. Edelman. I am opposed to private savings accounts
because I do not believe that ordinary consumers can make the
right decisions.
Chairman Bunning. OK. What system would you replace it with
in order for its survival?
Mr. Edelman. What I would suggest is that the money--that x
percentage of the contributions be segregated and diverted into
an equities fund. Let Congress choose what that percentage
ought to be. The number I hear most often is 2 percent--2
percentage points. But that money should be placed into an
index fund, not a cap-weighted index fund, but an equalization-
weighted fund, and managed by an organization established by
Congress so that the individual decisions of where that money
is to be invested is up to the individual consumer.
Chairman Bunning. OK. Then, since you are the only one who
opposed, the same question goes to you again. What events or
policies would you possibly change--would possibly change your
position as far as personal investment accounts?
Mr. Edelman. In order for me to change my position, I would
want to see dramatic improvements in consumer education on
personal finance. We need to begin teaching personal finance in
schools on a mandatory basis. We need to have competency
testing, just as we do on reading and writing and math skills.
So that once we are convinced and assured that the ordinary
general population is able to make intelligent, long-term
investment decisions, I would feel much more comfortable giving
them PSA accounts for Social Security.
Chairman Bunning. Let me ask you the question, because it's
going to become a reality very shortly: There's going to be
some bills dropped in the hopper that will say to us, take part
of the surplus and add it onto the Social Security system as we
know it now and start a personal savings account for each
individual that's in the Social Security system. Give me your
thoughts on that. All right. Mr. Huard.
Mr. Huard. I think that's the wrong approach. I think, as
Dr. Burtless pointed out, what we have currently is a system of
intergenerational wealth transfer. I think a far better use for
the surplus is to fund the transition. If you divert x percent
of the current payroll tax in the private savings accounts, you
are not going to have enough to pay current benefits. It seems
to me that what you need to do is divert the surplus to finance
the transition and pay the current beneficiaries who are
entitled to what the system has promised them.
Because that's the real problem here in going to a system
of personal accounts. You're going from a system where each
retiring generation is riding on the backs of the succeeding
generations to a system where generations are paying or
prefunding their own retirement. Well, you've left the stranded
generation in the middle, and I think you need to use the
surplus to finance their benefits.
Chairman Bunning. Anybody else want to--go ahead, Ms.
Tritch.
Ms. Tritch. I think that the idea of starting a newborn out
with a retirement account of $1,000 and $500 a year as you go
along until the child is 5 sounds good because you get a very
graphic example of what compounding can do to a relatively
small sum of money, but is that really the way that we want to
be spending our money? Is that really where the priorities
should be?
I don't think that, by severing somehow the retirement
savings from what someone earns during their working life, is
necessarily going to help people in the long-run or make the
system more understandable. So I would be opposed to starting
out a savings account at an age that's far before someone even
joins the work force. I also wanted to clarify my position on
one thing. I'm not opposed to individual accounts at this point
because I think this is a very healthy debate. As I think I
indicated in my testimony, I don't think that individuals, by
and large, are ready to take on this responsibility.
Chairman Bunning. Mr. Collins to inquire.
Mr. Collins. Thank you, Mr. Chairman. A lot has been said
about individual accounts. Maybe I've just been mislead all my
working life, but I thought I had an individual account at the
Social Security Administration. I have an individual Social
Security number and I hope somebody over there has been
crediting my account with the moneys deducted from my payroll
check over the last 40 years. So I'm under the assumption I do
have an individual account.
And Mr. Huard, I like what you talk about with the surplus
and how to address the uses of that surplus and the shortfall
and the liability. But I disagree with you that the problem is
because people are living longer. That's not the problem with
the Social Security system.
The problem goes back to what was pointed out in the
earlier panel. A lot of the liability is caused by the fact
that retirees in the forties, fifties, sixties, and the
seventies are receiving more benefits than they paid for.
That's the flaw in the system--beneficiaries receiving or
received more in benefits than they paid in. Now that's a
transfer of money and under the Constitution of the United
States, I don't believe the Congress really has the legality to
transfer money from one individual to another. But that's what
has happened over the years and that's the reason we need to
straighten out these individual accounts to make sure that each
individual understands how much they have in there and, if
you're going to have safety nets as this was extolled under as
a safety net, then that safety net--those funds should come
from the General Fund, not from other people's investment into
their Social Security account.
That's what's wrong with the Social Security system. It's
not that people are living longer. That's great that people are
living longer. Many of them stay productive for years and years
after the retirement age.
But the problem goes back to how Congress has handled this
in the past with the benefit program and Congress has got to
deal with the benefit program in the future. And you have to
deal with it from two funds: The funds that are paid by the
individual into the Social Security accounts that are
accredited to their account. You also have to deal with it with
surplus General Funds, or you're going to have to cut some
other spending somewhere else to have the General Fund because
these promises have been made to these people. Those benefits
have been created and established and they're going to have to
be paid. Thank you, Mr. Chairman.
Chairman Bunning. Thank you, Mr. Collins. I have introduced
a bill to take the surplus and wall it off in a special
account, and not do anything with it until we have a final
settlement on what we want to do on Social Security.
That does a couple of things. Now we just recycle excess
FICA taxes out and pay for other things. We have an IOU with
the Treasury. But if you put it in a special Treasury account
that would be available to lower the liability and lower the
debt, which is good, when we come up with a solution, long-term
solution, to the Social Security system.
Tell me what you think of that. It's not going anywhere,
but, I mean, I put it in, but the leadership doesn't like it.
Mr. Huard. Well, I think as a temporary, transitional
solution, it has a lot to recommend it. One of the concerns we
have is that the surplus is available while we're trying to
move toward a solution of the Social Security problem and a
reform system. As you know, we hope the reformed system will
ultimately include personal accounts. Unfortunately, these
surpluses are out there and Congress is tempted to use them for
something else: Fixing the marriage penalty or spending more on
Medicare.
Chairman Bunning. If it's laying around, we might use it.
Mr. Huard. Yes. So I'd certainly prefer that these
surpluses, as you suggest, be walled off so that they are
available. Because there is going to be a significant
transition problem if you move to a system of personal
accounts. I will give Dr. Burtless credit, he is quite right:
The current money coming into the system is going right back
out again, by and large, maybe 10 percent of it isn't. And if
you start to divert some of that money into personal accounts,
you've got to have another source of money to pay the promised
benefits. I think using the surplus for that, walling it off,
would be a fine idea.
Chairman Bunning. Well, I look to have a solution within
the next 2 years, so it wouldn't be a long term. It would be a
total of about $200 billion over the next 2 years is just about
what the surplus is going to be. But the fact of the matter is,
there's an awful lot of people that want to spend it and do
other things with it.
Go ahead, Dr. White.
Mr. White. Mr. Chairman, first, with respect to your
statement that you hope to have a solution within 2 years: As
my grandmother would have said, from your lips to God's ear. I
certainly hope that is the case. However, though, in your
terms, walling off the surplus would be a fiscally responsible
thing to do, since it would benefit the U.S. economy by raising
national saving, it wouldn't help fix the problems of the
Social Security system. It doesn't do anything for the system
because it doesn't address the pay-as-you-go nature of the
system. When you go to fix the system in 2 years, the fact that
you will have piled up some extra IOUs from the Treasury won't
provide you with any extra real resources.
Chairman Bunning. No, no, no. You missed the point. You
can't----
Mr. White. The economy will be a little richer----
Chairman Bunning. You can recycle it out in new IOUs.
Mr. White. But you're not collecting bushels of wheat or
barrels of oil.
Chairman Bunning. No, but you're collecting interest on the
money.
Mr. White. You're only getting more IOUs from the Treasury,
Mr. Chairman.
Chairman Bunning. OK.
Mr. Burtless. I don't understand the proposal, because what
you just said suggests that you would not hold this surplus in
a form that is interest bearing.
Chairman Bunning. You would hold it in government bonds,
real government bonds, that are interest bearing.
Mr. Burtless. But if the government has got bonds, then it
has also obtained cash in exchange for those bonds. If you
were--you're not proposing, I take it, that the Social Security
Trust Funds just give up the interest on----
Chairman Bunning. No, no.
Mr. Burtless. OK. So the proposal, then, is that the
government cannot do anything but retire outstanding public
debt with it.
Chairman Bunning. That's the exact----
Mr. Burtless. I think that there is one--I agree that that
would add to national saving and in that respect it would be a
good thing to do. I don't think we should just try to do it in
1 year, however. I think we should phase it in.
Chairman Bunning. No, I think it should be until we finally
get a settlement.
Mr. Burtless. But there is one confusion that a lot of
people have and that is, somehow, if they buy another kind of
assets, like a corporate bond, the corporation is not somehow
spending that money. But the corporation is not putting it in a
safety deposit box. The corporation is doing something with any
money you lend to it, too.
Chairman Bunning. Generally, reinvesting it, yes.
Mr. Burtless. We hope what the corporation does is a good
thing with its money; and similarly, we hope the Federal
Government does good things with its money. It spends it in a
good way.
Chairman Bunning. Anyone else?
Mr. Edelman. Mr. Chairman, I like the idea of anything that
provides for long-term savings that is for retirement purposes,
which is why I have concerns over new easings of IRA withdrawal
provisions for some home ownership or for paying for college
and hardship withdrawals and such. Anything we do that would
divert money from the future into today's needs is something
that will haunt us in the future. So your notion of walling it
off and leaving it specifically for future need can only be
healthy. Unfortunately, it's going to take another generation
to enjoy your benefit and does the Congress and administration
have that vision?
Chairman Bunning. You know, I was in the investment
business for 25 years before I came to Congress. There is a
great concern on the cost-to-benefit ratio in personal or
private investment accounts. What do you think would be the
interest rate that we'd have to arrive at to offset whatever
costs are involved if, in fact, we pulled it completely out of
government. In other words, into, Mr. Edelman, you'd handle all
of the accounts for Social Security.
Mr. Edelman. Can I? Great.
Chairman Bunning. Yes. [Laughter.]
What would be the cost per individual? What is your cost
factors now?
Mr. Edelman. Right now, it's typical to say that consumers
are spending, on average, 1.5 percent per year in asset
management fees.
Chairman Bunning. One to 1.5?
Mr. Edelman. Right, so you need to make 1 to 1.5 percent a
year to break even. And then you've got to factor in inflation.
That you have to do whatever inflation's doing to break even.
And then, on a net tax environment--that's not typically an
issue on the tax-deferred vehicle such as Social Security Trust
Funds, but you would then have to overcome the tax liability as
a third break even. In the private sector, it typically works
out to 3, 4, or 5 percent, depending on the inflationary
environment.
Chairman Bunning. Do any of you know what it costs right
now in a thrift savings accounts?
Mr. Edelman. It's about $25 or $30 per worker.
Chairman Bunning. Per year.
Mr. Edelman. Per year. Per year. Now you divide that number
into the amount of money the typical worker is putting into the
account, and it works out to about a 4- or 4.5-percent cost.
Chairman Bunning. Four to 4.5, so it's----
Mr. Edelman. It depends--if you were to aggregate----
Chairman Bunning. I'm sure it's higher than a private
investment----
Mr. Edelman. As a share of new contributions, not on the
total value, but as a share of the money going in. Call it like
a front-end load in a mutual fund, 4 or 4.5 percent.
Chairman Bunning. Generally, thrift savings money that we
in the Federal Government or most people put in is nontaxed
going in but only taxed coming out. So there would be no cost
going in, it would be only on the back end of it that you would
pay taxes.
Mr. Edelman. And you have inflation to deal with.
Chairman Bunning. I want to thank you all for being here.
We want to submit other questions to you for your written
response. Thank you. We appreciate your testimony.
Mr. White. Thank you, Mr. Chairman.
Mr. Edelman. Thank you.
Chairman Bunning. The Subcommittee stands adjourned.
[Whereupon, at 3:35 p.m., the hearing was adjourned,
subject to the call of the Chair.]
[Submissions for the record follow:]
Statement of Stephen J. Entin, Executive Director and Chief Economist,
Institute for Research on the Economics of Taxation
Distorted Picture of Three Social Security Reform Plans
At the request of Representative Charles Rangel (D-NY), the
Congressional Research Service prepared and released a
narrowly-targeted study comparing reductions in Social Security
benefit outlays that would occur under three proposals to
reform the Social Security System. (``Benefit Analysis of Three
Recent Social Security Reform Proposals,'' David Koitz, June
16, 1998.) The Congressman's staff specified that the study
examine only the benefit reductions, omitting other features of
the plans from the analysis. This has led to a distorted
picture of the relative impact of the plans on workers and
retirees.
The Ball plan, recommended by part of the 1995 Social
Security Advisory Council, would trim benefits modestly. It
would avoid deeper benefit cuts by increasing income taxation
of benefits (another form of benefit cut), raising the amount
of income subject to the payroll tax, and investing some of the
trust fund in the stock market. The Moynihan-Kerrey bill would
trim benefits more deeply; it would initially cut the payroll
tax 2 percentage points (although raising it in distant
decades) and encourage people to save up to 2 percent of
payroll, which they could then invest in the securities of
their choice. The National Commission on Retirement Policy
would cut the payroll tax by 2 percentage points and mandate
that the money be placed in personal saving accounts in
exchange for deeper cuts in Social Security benefits; the
expected returns on the accounts would more than offset the
additional reductions in direct benefit payments under any
sensible projection, and leave retirees better off than
patching the current system.
Comparing the effects of the Ball plan and the two plans
with personal saving accounts requires looking, in each case,
at all the taxes individuals must pay and the combined
retirement benefits they would receive from Social Security and
the personal savings. Looking only at the change in the level
of benefits paid by the government and ignoring the replacement
income provided by the personal saving accounts presents a
highly distorted and one-sided picture of the outcome of the
reforms for individuals. In effect, it is a half-truth, a cost-
benefit analysis that looks only at the costs and ignores the
benefits.
CRS complied with the specification of the request, but
took great pains to warn, in the first paragraph, that it
results in a partial analysis:
``As your staff specified, the analysis is confined to the
potential reductions in Social Security benefits prescribed by
various provisions of the three reform packages. Accordingly,
the memorandum does not examine the impact of the changes in
payroll taxes included in the packages, the potential benefits
or annuities that may result from the ``personal savings''
components of the packages, nor ... [where applicable] ... the
elimination of the Social Security retirement earnings test.
Analysis of all of these would be necessary to gauge the full
effects of the three plans on the national economy and
individual retirement income.''
The aging population will guarantee that workers will get
extremely low yields on the pay-as-you-go Social Security
System in the future. By contrast, there has been no extended
period of time in the Nation's economic history when returns on
private sector saving and investment did not exceed these
projected Social Security System returns. Other things equal,
plans with personal saving accounts can provide higher
retirement incomes at less cost to future workers than any mere
patch job to the current system.
The Moynihan-Kerrey bill and the NCRP plans have their own
strengths and weaknesses, and neither goes far enough to take
advantage of the full benefits of personal saving. Nonetheless,
to judge the relative merits of these plans vis-a-vis the Ball
proposal solely on the basis of the amount of Social Security
benefit reductions they provide is not fair and not
informative.
Milliman & Robertson, Inc.
Actuaries and Consultants, New York, NY
June 15, 1998
A. L. Singleton
Chief of Staff
Committee on Ways and Means
U.S. House of Representatives
1102 Longworth House Office Building
Washington, DC 20515
Dear Mr. Singleton:
Milliman & Robertson, Inc. (M&R) hereby submits the enclosed as our
written statement for the printed record of the June 18, 1998 hearing
of the Subcommittee on Social Security.
M&R conducted an analysis of a Social Security personal savings
account proposal on our own behalf and we are pleased to share our
findings with the Subcommittee, other Members of Congress, and the
public. In conducting our study, we developed a computer simulation
model that can be modified to analyze other options.
Our study examined the Social Security Advisory Council's proposal
to partially privatize Social Security through personal savings
accounts (PSAs). We used a stochastic model to show the probability of
various results vis-a-vis current Social Security. We found that there
is great variability in potential results under PSAs compared with the
benefits that would be paid under the current Social Security program.
Typical wage earners, in particular, have a significant chance of
receiving less than current Social Security, and conservative investors
are likely to do much worse than the current system.
For your information, M&R is a national firm of actuaries and
consultants, with offices in 26 U.S. cities and in Bermuda and Japan,
serving the full spectrum of business, governmental, and financial
organizations. Internationally, M&R is the U.S. and Japanese member of
the Woodrow Milliman network, a formal alliance of leading independent
actuarial and consulting firms operating in more than 100 offices in 31
countries throughout the world.
Please do not hesitate to contact me if you have any questions
about our study or if we can be of any assistance in your efforts to
study Social Security reform options.
Sincerely,
Michael J. Mahoney, F.S.A.
Privatizing Social Security: Expected Benefits Come with Uncertainty
by Gerald Cole,\1\ LL.B., Peter R. Hardcastle, F.I.A., and Stephen A.
White, F.S.A.
The national debate on how best to ``save'' Social Security
has begun in earnest. President Clinton is holding town
meetings throughout the U.S., key congressional leaders have
expressed their desire for Congress to tackle the issue now,
and numerous bills have been introduced. The debate centers
around two competing approaches to the problem. One would
partially or fully privatize Social Security by creating
individual accounts, while the other would modify the present
system to restore actuarial soundness. The results of the
debate will profoundly affect how future generations achieve
retirement security.
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\1\ Gerry Cole is a special counsel in M&R's Washington, D.C.-based
Employee Benefits Research Group; Peter Hardcastle is a consulting
actuary in the Washington, D.C. office; and Steve White is a consulting
actuary in the Seattle office.
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Social Security needs to be ``saved'' because of changes in
the make-up of the U.S. population. Under the current system,
retiree benefits are funded directly from payroll taxes, on a
pay-as-you-go basis. While each retiree under the system is
supported by three workers today, by the middle of the next
century, each retiree will be supported by about two workers.
There are two main premises to the individual account
argument. First, the system should be prefunded, with
contributions invested in financial assets that produce a
higher rate of return than that inherent in the current system.
Second, the government should not invest in equities, which are
the primary source of greater investment returns. Therefore,
the only way to take advantage of the greater rates of return
offered by equities is to create individual accounts.
To contribute to the discussion, we analyzed the effects
the individual account approach would have on different
workers. We specifically examined the personal security account
(PSA) proposal advocated by several members of the most recent
Social Security Advisory Council (SSAC). Issues raised by this
PSA proposal also apply to other privatization options.
Our analysis shows that moving from the current Social
Security system to individual accounts under the PSA proposal
is likely to improve retirement benefits for many workers. Such
a system, however, entails the risk of considerable variability
in the level of potential retirement benefits. We found that in
many cases, the retirement benefits of typical workers would be
worse under the PSA option than under the current system. Not
surprisingly, high-paid workers fare better than typical-wage
workers. Single workers and two-earner households also fare
better than single-earner households do.
The PSA proposal also brings risk to the economy as a whole
as vast sums of money are borrowed to finance the transition to
a funded retirement system. The end result could be positive if
most workers are better off at retirement and if the final
system is less influenced by political considerations and
demographic trends. Policymakers must recognize at the outset,
however, that results for individuals and for our economy are
far from certain.
The Social Security Problem
The most recent projections show the Social Security trust
fund exhausted by the year 2032, with payroll taxes beyond that
point sufficient to pay only about 75% of the benefits promised
under the current system. The importance of Social Security as
the bedrock of retirement security is not in doubt. For nearly
60% of the country's current retirees, Social Security is a
major source of income. Even among current workers, who expect
to receive less than their parents and grandparents under
Social Security, 22% believe the program will provide a major
source of their retirement income and another 52% believe it
will be a source.
The nation's demographics will make providing current-
program benefits over the long term unaffordable at today's
contribution rates. The demographic time bomb is caused by
three significant factors: increased life expectancy, the large
cohort of aging baby boomers, and the reduction in U.S. birth
rates.
This dramatic demographic shift means that there is a
critical economic fact underlying the Social Security debate.
The increase in the retiree population will trigger a shift of
consumption from the working population to the retired
population. Regardless of how this is funded by individual
accounts or by increased taxes the result is a zero-sum game
unless the reforms chosen for Social Security or changes
elsewhere in government policy increase the rate of economic
growth.
The PSA Option
The PSA proposal supported by five of the 13 SSAC members
would change the current system from one in which each worker
receives a guaranteed lifetime benefit with automatic cost-of-
living increases to a new system in which each worker would
have an individual account. Five percent of each worker's pay
would be redirected from Social Security taxes (under the
Federal Insurance Contributions Act, or FICA) into the new
accounts. Ultimately, retirement income would consist of a
guaranteed base benefit of $410 (in 1996 dollars) plus the
amount accumulated in the individual account.
The transition to the PSA plan will require additional
financing because current Social Security obligations must be
funded from another source if 5% of current FICA taxes is
diverted to individual accounts. The PSA plan thus calls for a
1.52% increase in payroll taxes over a 72-year period to meet
this transition cost. In the short term, this increase will
still be insufficient to meet current obligations, so the
proposal requires additional federal borrowing that will peak
at $1.9 trillion (in 1995 dollars). Initially, the additional
borrowing is equal to a 3.5% payroll tax (5% minus 1.52%). The
annual borrowing declines over time, and the debt is retired in
the latter part of the 72-year period.
The selling point of the PSA proposal is the assumption
that it improves the rate of return on workers' contributions
to the system, thereby making Social Security a ``better
deal.'' In its analysis, the SSAC assumed that the accounts
annually earned the historical average rate of return on their
investments. Thus, the portion of the portfolio invested in
equities was assumed to earn a steady 7% real rate of return
(i.e., after taking into account the effects of inflation
reducing the worth of money) each and every year. But this type
of analysis does not measure the probability of investments
actually earning the stipulated rate of return. First, returns
that average 7% might not produce equivalent results due to the
timing of the returns. Four years of 15% returns followed by
one year of a 25% loss does not yield the same balance as five
years of 7% returns, even though both accounts can be said to
have averaged 7% over the five-year period. Second, there is no
guarantee that equity real returns will average 7% in the
future, particularly for any specific period of time.
M&R's Analysis
To quantify the potential variability of benefits under the
PSA proposal, we calculated and compared probability
distributions for total PSA benefits and for current Social
Security benefits. Exhibit 1 is a compilation of our study's
results. In our analysis, the PSA benefits are fully phased in;
that is, the transition period is not considered. Benefits are
compared with the current Social Security program without
changes. Because the current program is not balanced over the
long term, we recognized that today's payroll taxes would have
to be raised by roughly 2% to make this a valid comparison.
Our analysis took into account the following factors:
Income Level
Typical-wage earner--one who at age 23 earns 73% of the
average wage of worker covered by Social Security and whose
earnings rise to 106% of average wages at age 39 and continue
at that level until retirement.
High-wage earner--one who always earns more than the Social
Security taxable wage base.
Family Status
Single (unmarried) worker.
Worker with a nonworking spouse (or a spouse whose work
history is sporadic).
Two-working spouse family. In the case of the typical-wage
two-worker family, we assumed that one earned 80% of the
primary wage earner.
Asset Allocation
100% equities.
100% bonds.
50% equities and 50% bonds.
Expected Financial Returns
Projected returns for stocks and bonds were generated from
historical expected returns and standard deviations. We also
modeled the returns on equities under the following two
assumptions:
Investment expenses reduce the gross real rate of return by
1%. This is in line with the 401(k) plan experience.
Expected returns are reduced by an additional 1%, so that
the expected net real rates of return are 2% lower than the
gross historical rates. This scenario illustrates how results
might change if future equity returns are lower over time than
historical averages.
Our analysis compares the value of the benefits at normal
retirement age. For this purpose, the value of the PSA account
balance is simply the accumulated balance at retirement. To
calculate the value of monthly Social Security benefits from
the current system, as well as the flat PSA monthly benefit, we
used an annuity factor based on a realized interest rate (or
rate in excess of inflation and expenses of paying annuities)
of 2.75%. A real rate is appropriate because benefits are
increased with inflation and the rate used is consistent with
historical averages of real returns on bonds.
Other assumptions we made are explained with Exhibit 1. For
each sample worker, results are stated for five percentiles,
ranging from the 10th to the 90th percentile. The 50th
percentile represents the median: half of the time the worker/
family would receive more, and half of the time less, than the
amount shown.
Summary of Results
The Typical-Wage Worker
In our most optimistic scenario, a typical-wage two-worker family
that invested entirely in equities and that realized returns consistent
with historical returns has a 50% chance of receiving at least 50% more
in benefits under the PSA arrangement than under the current Social
Security program. This same family has less than a 25% chance of
receiving less than the current Social Security benefit and a 25%
chance of receiving 235% or more than the current Social Security
benefit.
On the other hand, if this same family invests solely in bonds, the
expected results are shockingly different. The median benefit is only
86% of current Social Security, with a 25% chance of receiving 78% or
less and a 25% chance of receiving 97% or more of the current Social
Security benefit. Investing half of the account in equities improves
the results to a median of 113% of Social Security using historical
assumptions, with a 25% chance of receiving less than 95% and a 25%
chance of receiving at least 142%. If the spouse is nonworking, the
results are much worse. If the account of the worker with a nonworking
spouse is invested 50% in bonds and 50% in equities, the median is 89%
of current Social Security.
The High-Wage Worker
For the high-wage earner, the PSA proposal yields better results,
but again the expected benefits will be less than under current Social
Security if the PSA is invested only in fixed-income instruments. The
median result for a family of two high-wage earners invested 100% in
equities is approximately twice the level of current Social Security
benefits. If the allocation is 50% equities and 50% bonds, the median
benefit is 36% greater than Social Security.
Winners, Losers, and Uncertainty
Not surprisingly, PSA comparisons look better for high-wage earners
than typical-wage earners. The results also illustrate the following:
The allocation to equities is a critical factor in the comparison.
Projected PSA benefits are much better with a 100% equity allocation,
but are generally worse than the current system with a 100% bond
allocation.
Projected PSA benefits for single workers are very consistent with
those for two-earner families, particularly in the typical-wage
category.
Projected PSA benefits for one-earner families are less favorable
than results for single workers and two-earner families because of the
subsidy in the current Social Security system for nonworking spouses.
For accounts fully invested in equities, an additional 1% reduction
in the expected equity return has a significant effect on projected
benefits, with median results roughly 10% 20% lower than without the
reduction.
More than anything, however, the projections illustrate the
variability in expected results under the PSA system. Under a 50/50
stock/bond allocation, projected results for the typical-wage two-
earner family range from 84% of the current system at the 10th
percentile to 190% at the 90th percentile. Relative to the current
system, the volatility in this scenario is mostly positive. But even
upside volatility has some disadvantages. Generally, a retiree who
receives 25% more than under the current system would gladly accept the
change; however, that same retiree would still be disappointed if he or
she had anticipated even higher benefits five years earlier and then
experienced a market downturn.
Experience with employer-sponsored defined contribution retirement
plans tells us that individual accounts have unpredictable benefits.
Although this variability is a concern with such plans, the problem
becomes magnified for Social Security. For participants in 401(k)
plans, the individual account provides a retirement benefit on top of
the Social Security foundation. Many employees also are covered by a
defined benefit pension plan. Having a Social Security base allows
workers to take more risks and accept more variability in their
individual accounts. If a large part of the Social Security benefit is
provided through individual accounts, the variability in total
retirement benefits becomes much greater. And for the large part of the
population that retires with nothing but Social Security, variability
in account balances will be very unsettling.
The other big risk, and one that is not reflected in our analysis,
is individual mortality risk. Under the current system, Social Security
benefits are guaranteed for life, but under an individual account
system, individuals run the risk that they will outlive their account
balance. This risk can be managed by requiring individuals to purchase
an annuity at retirement or by restricting the rate at which retirees
can withdraw money from their individual accounts, but these will not
be popular options. Both the mortality risk and the investment risk
point to potential disadvantages of the PSA option relative to the
defined benefit nature of the current system.
Our analysis illustrates the individual risks incorporated in the
PSA option. Nonetheless, projected benefit comparisons look favorable
for most cases, and many workers would trade some amount of risk for
higher expected benefits. Our numerical analysis tells only part of the
story, though. A complete analysis must also address macroeconomic
issues that relate to the underlying investment return assumptions, as
well as the impact of Social Security privatization on the economy as a
whole.
The Drivers of Higher Returns
There is a basic concept at the core of all privatization
proposals: fund Social Security obligations in advance and
invest the contributions privately in stocks and bonds to earn
higher rates of return than those implicit in the current
Social Security system. In a pure pay-as-you-go system, in
which a portion of workers' pay is transferred to retirees each
month, the aggregate real rate of return on contributions over
time will equal the real growth in wages. The SSAC assumed real
wages will grow at 1.5% per year. This rate, combined with the
oncoming demographic changes, results in a low aggregate rate
of return for the current system. Add to this the fact that the
current Social Security benefit formula favors lower-paid
workers, it is not surprising that projected real return rates
for higher-paid workers are negative.
Financial assets, on the other hand, have historically
produced much higher returns. The SSAC assumed future real
returns for invested assets would be 7% for equities and 2.3%
for fixed income, assumptions that are consistent with
historical returns. Using these assumptions, the path to
increasing returns for Social Security appears clear. Projected
returns will be higher as prefunding increases, particularly as
more of this prefunding is invested in equities.
A Bigger Picture to Consider
If Social Security is considered in the same terms as a
private pension plan, the case for prefunding and investing in
equities seems obvious. Prefunding has certainly lowered the
long-term costs of private pension plans, and aggressive
allocation of the assets in equities has resulted in lower
costs and/or higher benefits in the long run. But because
Social Security is not a private pension plan, nor was it
designed to be one, there is a need to step back and look at
the big picture.
The central problem facing the current system is the aging
of the population. Prefunding or investing in equities will not
prevent the population from aging. Regardless of how much
people save or invest in equities, more of society's resources
will be dedicated to retirees. Prefunding merely dictates how
assets are transferred to retirees (e.g., dividends instead of
taxes); there will still be one group that is working and one
that is not.
In this aggregate sense, changes in Social Security can
help to meet the retirement needs of society as a whole only to
the extent they expand the economy and thereby enlarge the
amount of total resources available for everyone, including the
aged population. Thus, prefunding Social Security can be
beneficial only if it increases the overall rate of national
savings and only if the higher savings lead to economic growth.
Increased Savings
There is no magic to increasing savings. For society as a
whole, just like for individuals, savings require sacrifices.
For Social Security, this means taxes must be increased and/or
benefits must be reduced and these actions must not be offset
elsewhere in the economy (i.e., additional contributions to
Social Security must not lead to reduced savings outside of
Social Security).
The PSA proposal incorporates a plan for ``additional
savings,'' but on a fairly limited basis. On the surface, the
5% contribution to individual PSAs appears to be additional
savings, but this is a redirection of contributions that is
partially funded by the additional borrowing by the federal
government. The actual increase to savings in the short term is
equal to the 1.5% net increase in taxes.
The call for this small ``additional savings'' increase
under the PSA proposal is not surprising. Contribution
increases and benefit decreases are difficult political issues.
These are the only options, however, if the nation wants to
move toward a more prefunded Social Security that can generate
better returns.
Economic Growth
Most economists agree that additional savings will increase
economic growth by increasing investment. Having more resources
can lead to business creation and expansion. One way of
increasing savings available for investment is to reduce
government borrowing to finance current operations. The
Congressional Budget Office, for example, projects that
balancing the budget and keeping it in balance, thereby
increasing the availability of capital to the private sectors,
would result in a 12% increase in per capita gross national
product (GNP) by 2030. Simply maintaining the ratio of the
deficit to GNP would still yield a 10% increase in per capita
GNP.
Even with increased savings, however, there is no guarantee
of economic growth. Moreover, there is no guarantee that the
additional investments will be used as efficiently as current
investments are. To the extent that additional savings merely
serve to bid up the prices of current stocks, nothing will have
been accomplished except to increase the rates of returns on
equities in the short term and set them up for disappointing
long-term returns when the savings are withdrawn to pay for
retirement. The additional savings also might be used to fund
marginal business enterprises that would otherwise not receive
capital and would very likely be less profitable than other
businesses.
Allocation in Equities
In all privatization proposals, estimated rates of returns
are higher as the proportion of savings allocated to equities
increases. Certainly this is borne out in our analysis. Based
on historical returns for equities, this is a reasonable
conclusion. The cumulative result is less obvious, however,
when looking at the big picture.
In the PSA proposal, the money to invest in equities is
financed in large part through increased government borrowing.
This leveraging may produce higher Social Security rates of
returns at the expense of returns on other investments. More
borrowing will likely drive up interest rates, increasing the
cost of government and business investment. The end result
could be improvements for the Social Security system but a zero
= sum gain for society as a whole.
We must also consider whether equity returns will suffer if
the supply of investment options cannot keep up with the demand
from investors. Mutual fund money continues to pour into
equities, and pension fund allocations to equities are
increasing rather than decreasing. If Social Security
contributions are added to the mix, will we have too much of a
good thing, particularly when the baby boomers start to sell
retirement assets? If the answer is no, then the projected
benefits of the PSA proposal would likely come to pass. But if
the answer is yes, then the result could be disappointment for
individuals counting on their PSAs to provide them a secure
retirement.
Risk, Returns, and Sacrifice
If the nation commits to the additional taxes and borrowing
in the PSA proposal, if historical return assumptions are borne
out over time, and if the changes do not adversely affect other
areas, then the PSA proposal can provide advantages over the
current system. In the long term, funding retirement benefits
at a lower cost level may be possible under the PSA option if
individuals make a major commitment to equities. Even then, if
the economy experiences a prolonged bear market, such as that
which occurred during the 1970s, some participants may end up
worse off at retirement than under the current Social Security
system.
Policymakers need to remember that Social Security
privatization cannot be done in isolation. There is a need to
study the implications on larger and more complex questions:
What are the economic effects of the additional government
debt that will be required to fund the transition?
How will long-term equity returns be affected by a large
influx of money generated by Social Security privatization?
How will the demographic changes ahead (more retirees,
fewer workers) affect financial investment returns?
These questions cannot be answered definitively, but they
illustrate the fact that privatization brings added economic
riskas well as potential rewardsand that these risks have
implications beyond the Social Security system alone.
Conclusion
Privatizing Social Security may be a success for many
people, but is not the panacea some have made it out to be.
Average-wage earners, who have historically had a low tolerance
for risky investments, may well end up worse off than under the
current system. As Social Security is moved from a pay-as-you-
go to a prefunded system, one generation must ``pay twice'' to
fund the benefits for the prior generation as well as its own.
Whether the sacrifice is worthwhile will depend on whether
additional growth is generated. Mere asset price inflation,
while satisfying for the present, does not mean that true gains
in GDP wealth are realized. In time, such asset price inflation
may spill over into general inflation, undoing the benefits of
buying capital assets in the first place. Only production can
be consumed, investment does not cure the demographic problem.
We studied the PSA proposal as one of many privatization
approaches still to come. The PSA option calls for a mild
direct sacrifice, reflected in the additional payroll tax of
1.52%. By incorporating government borrowing, the 1.52% tax
extends for 72 years, effectively spreading the transition
period over two working generations. But the effect of the
massive additional federal borrowing is not reflected under the
PSA proposal. Will this additional debt retard economic growth?
If so, then the PSA proposal will not achieve its goals.
Other proposed privatization changes include no tax
increases. Higher levels of federal debt and more money
invested in equities are postulated to solve the imbalance. But
the result will be less sacrifice and more risk. The complex
questions raised above become magnified.
We can recognize these tradeoffs in all privatization
proposals. Proposals with less risk must entail large tax
increases to pay for the transition. By contrast, proposals
with little or no transition pain must assume greater risks,
particularly if they are centered on a large scale borrowing to
invest in the equity market.
Perhaps the best solution for Social Security is to
increase economic output so that the nation can allocate more
to retirees and still maintain workers' standards of living.
Even this result, however, might not eliminate the
intergenerational battles as workers resist having the
productivity gains of their generation devoted to maintaining
the standard of living for a growing retiree population.
Clearly, Social Security is headed for major problems if we do
nothing. There will be no easy solutions.
PSAs Risky for the Average Joe and Josephine
To measure the investment variability of the PSA proposal,
we created a computer model that generated rates of return for
equities and bonds using historical probabilities. Our model
can be adapted to analyze other reform proposals. The computer
ran the model 1,000 times (that's like throwing dice 1,000
times and keeping track of each result). The results were then
ranked from lowest to highest. This allowed us to determine
what percentage of the time a given return would be realized.
We then expressed the results as a percentage of the benefit
the participant would have received under the current Social
Security program.
We tested the effect of a fully phased-in PSA proposal so
that none of the benefits would be based on the current system.
We then looked at two different wage earners, a typical-wage
earner and a high-wage earner. We also studied situations in
which the wage earner was single and situations in which the
wage earner was married with a nonworking spouse or married
with a working spouse. We analyzed the results for three
different investment portfolios: 100% equities; 100% fixed
income; and 50% equities and 50% fixed income.
As Exhibit 1 illustrates, we found that married workers
with nonworking spouses with typical earnings patterns have
only a 25% chance of receiving slightly more than they would
get from current Social Security if they were invested equally
in stocks and bonds. The median result for this couple was 89%
of current Social Security. If we further assume that the
average real rate of return on stocks is 1% lower than the
historical average, these families have a 50% chance of
receiving 85% or less of the current Social Security benefit.
If that couple invested very conservatively and kept all its
money in bonds, expected benefits ranged from a low of 62% of
current Social Security to a high of 86% of current Social
Security. This demonstrates the critical importance of
substantial exposure to equities to have even a chance of
financially coming out ahead.
By contrast, under the more conservative assumptions about
returns on equities, the two-earner family that invested
equally in equities and bonds had a 75% chance of receiving at
least 90% of current Social Security benefits and a 50% chance
of receiving 106% or more than current Social Security
benefits. Once again though, if the two-earner family kept all
of its investments in bonds, it had 75% chance of receiving
less than current Social Security. As expected, the high-wage
earner group did even better because of the current Social
Security system's bias toward benefits for lower-wage earners.
Exhibit 1: Expected Returns under the PSA Proposal vs. Social Security
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Asset Allocation \1\
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Percentile Equities Equities \2\
Equities Bonds & Bonds Equities \2\ Bonds & Bonds
----------------------------------------------------------------------------------------------------------------
.......... 100% 100% 50%/50% 100% 100% 50%/50%
----------------------------------------------------------------------------------------------------------------
PSA Returns as a percentage of
Current Social Security
Benefits
Typical-Wage Earner
Single 10% 86% 71% 84% 79% 71% 81%
25% \3\ 108% 78% 96% 95% 78% 91%
\4\ 50% \3\ \4\ \4\ 86% \3\ \4\ \3\ \4\ 131% \4\ 86% \3\ \4\ 108%
156% 116%
75% \3\ 251% 98% \3\ 148% \3\ 206% 98% \3\ 136%
90% \3\ 444% \3\ 111% \3\ 199% \3\ 342% \3\ 111% \3\ 181%
Married, with Nonworking 10% 71% 62% 70% 66% 62% 67%
Spouse
25% 85% 66% 77% 77% 66% 74%
\4\ 50% \3\ \4\ \4\ 71% \4\ 89% \4\ 98% \4\ 71% \4\ 85%
114%
75% \3\ 172% 78% \3\ 109% \3\ 144% 78% \3\ 102%
90% \3\ 290% 86% \3\ 140% \3\ 227% 86% \3\ 129%
Married, Both Working 10% 85% 72% 84% 78% 72% 80%
25% \3\ 105% 78% 95% 94% 78% 90%
\4\ 50% \3\ \4\ \4\ 86% \3\ \4\ \3\ \4\ 127% \4\ 86% \3\ \4\ 106%
149% 113%
75% \3\ 237% 97% \3\ 142% \3\ 194% 97% \3\ 132%
90% \3\ 412% \3\ 109% \3\ 190% \3\ 317% \3\ 109% \3\ 173%
----------------------------------------------------------------------------------------------------------------
High-Wage Earner
Single 10% 91% 67% 88% 79% 67% 82%
25% \3\ 128% 77% \3\ 109% \3\ 107% 77% \3\ 100%
\4\ 50% \3\ \4\ \4\ 90% \3\ \4\ \3\ \4\ 165% \4\ 90% \3\ \4\ 128%
207% 141%
75% \3\ 363% \3\ 110% \3\ 192% \3\ 282% \3\ 110% \3\ 172%
90% \3\ 700% \3\ 132% \3\ 276% \3\ 527% \3\ 132% \3\ 245%
Married, with Nonworking 10% 68% 53% 66% 60% 53% 62%
Spouse
25% 90% 59% 78% 77% 59% 73%
\4\ 50% \3\ \4\ \4\ 67% \4\ 98% \3\ \4\ 113% \4\ 67% \4\ 90%
138%
75% \3\ 234% 79% \3\ 129% \3\ 184% 79% \3\ 117%
90% \3\ 440% 92% \3\ 181% \3\ 334% 92% \3\ 162%
Married, Both Working 10% 88% 65% 85% 76% 65% 79%
25% \3\ 123% 75% \3\ 105% \3\ 102% 75% 97%
\4\ 50% \3\ \4\ \4\ 87% \3\ \4\ \3\ \4\ 159% \4\ 87% \3\ \4\ 123%
198% 136%
75% \3\ 348% \3\ 106% \3\ 183% \3\ 271% \3\ 106% \3\ 165%
90% \3\ 675% \3\ 126% \3\ 265% \3\ 501% \3\ 126% \3\ 235%
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\1\ Assumes expenses of 1.0% for equity investments and 0.5% for bond investments.
\2\ Assumes average equity returns are 1% lower than the historical average.
\3\ Wage earners who can be expected to receive benefits under the PSA proposal that are equal to or greater
than under an unchanged Social Security program.
\4\ Median.
PSA Projection Assumptions
Sample Participants
Born in 1976, entering workforce in 1998, with PSA
changes fully phased-in in 1998
Typical-wage earner
--Earnings at age 22 equal 70% of national average wage,
increasing gradually to 100% of national average wage at age 33
and 106% of national average wage at age 39; earnings remain at
106% of national average wage until retirement
--Spouse earnings equal to 80% of earnings for primary
wage-earner
High-wage earner
--Earnings at or above Social Security wage base for all
years
--Spouse earnings at or above Social Security wage base for
all years
Unemployment
Probability of unemployment reflected each year,
with average unemployment of 6.0%
Additional maternity unemployment of 5.0% for
spouse earnings up to age 35
Gross Investment Returns
Equity real returns:
--expected return 6.0% and 7.0%
--standard deviation 19.7%
Fixed real returns:
--expected return 2.3%
--standard deviation 9.5%
Correlation coefficient between equity real
returns and fixed real returns: .31
Investment Expenses
Equities: 1.0%
Fixed: .5%
Inflation
Mean: 3.6%
Standard deviation: 4.1%
Serial correlation: .54
Wage Increases
Annual increase in national average wages: 1.5%
Annuity Conversion to Compare PSA Balances with Annual Annuities
Real interest rate: 2.75%
Mortality: UP94 mortality table developed by the
Society of Actuaries, projected forward with projection scale
AA. (Note: This mortality table projects longer lifetimes than
the Social Security ``best estimate'' mortality assumption,
which many actuaries view as overly optimistic. Using the
Social Security assumption increases the relative value of PSA
benefits by about 5%.)
[Additional attachments are being retained in the Committee
files.]
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