[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]



 
                    INVESTING IN THE PRIVATE MARKET

=======================================================================

                                HEARING

                               before the

                    SUBCOMMITTEE ON SOCIAL SECURITY

                                 of the

                      COMMITTEE ON WAYS AND MEANS
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED SIXTH CONGRESS

                             FIRST SESSION

                               __________

                             MARCH 3, 1999

                               __________

                             Serial 106-13

                               __________

         Printed for the use of the Committee on Ways and Means




                     U.S. GOVERNMENT PRINTING OFFICE
57-507 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        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
WES WATKINS, Oklahoma                LLOYD DOGGETT, Texas
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
SCOTT McINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida

                     A.L. Singleton, Chief of Staff

                  Janice Mays, Minority Chief Counsel

                                 ______

                    Subcommittee on Social Security

                  E. CLAY SHAW, Jr., Florida, Chairman

SAM JOHNSON, Texas                   ROBERT T. MATSUI, California
MAC COLLINS, Georgia                 SANDER M. LEVIN, Michigan
ROB PORTMAN, Ohio                    JOHN S. TANNER, Tennessee
J.D. HAYWORTH, Arizona               LLOYD DOGGETT, Texas
JERRY WELLER, Illinois               BENJAMIN L. CARDIN, Maryland
KENNY HULSHOF, Missouri
JIM McCRERY, Louisiana


Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.


                            C O N T E N T S

                               __________

                                                                   Page

Advisories announcing the hearing................................     2

                               WITNESSES

U.S. Department of the Treasury, Hon. Lawrence H. Summers, Ph.D., 
  Deputy Secretary...............................................     7

                                 ______

Goldberg, Hon. Fred T., Jr., Skadden, Arps, Slate, Meagher & 
  Flom, LLP......................................................    70
Investors Services of Hartford, Inc., Hon. Maureen M. Baronian...    38
Lehrman Bell Mueller Cannon, Inc., John Mueller..................    87
National Committee Tto Preserve Social Security and Medicare, 
  Martha A. McSteen..............................................    86
Reischauer, Robert D., Brookings Institution.....................    48
Tanner, Michael, Cato Institute..................................    41
Weaver, Carolyn L., American Enterprise Institute................    66
White, Lawrence J., New York University..........................    32

                       SUBMISSIONS FOR THE RECORD

California State Teachers' Retirement System, Sacramento, CA, 
  Emma Y. Zink, statement........................................   110
Century Foundation, New York, NY, statements.....................   111
Credit Union National Association, statement.....................   127
Executive Intelligence Review News Service, Richard Freeman, and 
  Marianna Wertz, statement......................................   128
MFS Investment Management, Boston, MA, David Oliveri, statement..   131
National Conference of State Legislatures, Gerri Madrid and Sheri 
  Steisel; National Association of Counties, Neil Bomberg; 
  National League of Cities, Doug Peterson; United States 
  Conference of Mayors, Larry Jones; Government Finance Officers 
  Association, Tom Owens; National Association of State 
  Retirement Administrators, Jeannine Markoe Raymond; National 
  Council on Teacher Retirement, Cindie Moore; National 
  Conference on Public Employee Retirement Systems, Ed Braman, 
  joint letter and attachment....................................   146
National Taxpayers Union, Alexandria, VA, Peter J. Sepp, 
  statement......................................................   147
Plan Sponsor, Greenwich, CT, Chris Tobe, statement...............   151


                    INVESTING IN THE PRIVATE MARKET

                              ----------                              


                        WEDNESDAY, MARCH 3, 1999

                  House of Representatives,
                       Committee on Ways and Means,
                           Subcommittee on Social Security,
                                                    Washington, DC.
    The Subcommittee met, pursuant to notice, at 10 a.m., in 
room 1100, Longworth House Office Building, Hon. E. Clay Shaw, 
Jr. (Chairman of the Subcommittee), presiding.
    [The advisories announcing the hearing follow:]

ADVISORY

FROM THE 
COMMITTEE
 ON WAYS 
AND 
MEANS

                                                CONTACT: (202) 225-1721
FOR IMMEDIATE RELEASE

February 24, 1999

No. FC-8

              Archer Announces Social Security Hearing on

                    Investing in the Private Market

    Congressman Bill Archer (R-TX), Chairman of the Committee on Ways 
and Means, today announced that the Committee will hold a hearing on 
investing Social Security's Trust Funds in the stock market. The 
hearing will focus on the effects of government-directed and 
individually directed investments. The hearing will take place on 
Wednesday, March 3, 1999, in the main Committee hearing room, 1100 
Longworth House Office Building, beginning at 10:00 a.m.
      
    Oral testimony at this hearing will be from invited witnesses only. 
Witnesses will include experts in Social Security and investment 
policy. 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:

      
    Over the next 75 years, Social Security is expected to face a 
funding shortfall equal to 2.19 percent of taxable payroll. 
Traditionally, the gap between Social Security's income and costs has 
been filled by increasing payroll taxes, reducing benefits, and/or 
borrowing from the public. However, policy experts are now seeking new 
approaches to strengthen Social Security's finances. Leaders of both 
parties, including the President, have supported increasing the 
program's income by investing a portion of Social Security's excess tax 
receipts in the stock market. These surpluses are currently invested in 
special issue Treasury bonds, which earn an average annual yield of 2.8 
percent. According to the President's 1994-96 Advisory Council on 
Social Security, stock investment would earn a real annual yield of 7 
percent.
      
    Although there is agreement that investing in stocks would help 
restore Social Security's long-term solvency, how the investments 
should be directed remains a key focus of debate. The President has 
proposed that a portion of the Trust Funds be invested directly by the 
Federal Government in the private sector. Some Members of Congress and 
other experts argue that investments should be directed by individuals 
through personal retirement accounts. While, in comparison with 
personal retirement accounts, investing a portion of the Social 
Security Trust Funds directly in the private market may reduce 
individual exposure to risk, some experts, including Federal Reserve 
Chairman Alan Greenspan, have warned it would lead to political 
interference in private financial markets and corporate decision 
making.
      
    In announcing the hearing, Chairman Archer stated: ``The 
President's proposal to invest in the private market as a solution to 
Social Security's problem is a breakthrough. While the White House and 
I may differ on who should own and control these investments, we need 
to carefully consider the benefits and risks of each approach as we 
move forward to save Social Security.''
      

FOCUS OF THE HEARING:

      
    The hearing will focus on the economic, political, and social 
effects of private market investing by the Federal Government and by 
individuals.
      

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

      
    Any person or organization wishing to submit a written statement 
for the printed record of the hearing should submit six (6) single-
spaced copies of their statement, along with an IBM compatible 3.5-inch 
diskette in WordPerfect 5.1 format, with their name, address, and 
hearing date noted on a label, by the close of business, Wednesday, 
March 17, 1999, 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 
wish to have their statements distributed to the press and interested 
public at the hearing, they may deliver 200 additional copies for this 
purpose to the Committee office, room 1102 Longworth House Office 
Building, by close of business the day before the hearing.
      

FORMATTING REQUIREMENTS:

      
    Each statement presented for printing to the Committee by a 
witness, any written statement or exhibit submitted for the printed 
record or any written comments in response to a request for written 
comments must conform to the guidelines listed below. Any statement or 
exhibit not in compliance with these guidelines will not be printed, 
but will be maintained in the Committee files for review and use by the 
Committee.
      
    1. All statements and any accompanying exhibits for printing must 
be submitted on an IBM compatible 3.5-inch diskette in WordPerfect 5.1 
format, typed in single space and may not exceed a total of 10 pages 
including attachments. Witnesses are advised that the Committee will 
rely on electronic submissions for printing the official hearing 
record.
      
    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.
      
    3. A witness appearing at a public hearing, or submitting a 
statement for the record of a public hearing, or submitting written 
comments in response to a published request for comments by the 
Committee, must include on his statement or submission a list of all 
clients, persons, or organizations on whose behalf the witness appears.
      
    4. A supplemental sheet must accompany each statement listing the 
name, company, address, telephone and fax numbers where the witness or 
the designated representative may be reached. This supplemental sheet 
will not be included in the printed record.
      
    The above restrictions and limitations apply only to material being 
submitted for printing. Statements and exhibits or supplementary 
material submitted solely for distribution to the Members, the press, 
and the public during the course of a public hearing may be submitted 
in other forms.
      

    Note: All Committee advisories and news releases are available on 
the World Wide Web at ``http://www.house.gov/ways__means/''.
      

    The Committee seeks to make its facilities accessible to persons 
with disabilities. If you are in need of special accommodations, please 
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four 
business days notice is requested). Questions with regard to special 
accommodation needs in general (including availability of Committee 
materials in alternative formats) may be directed to the Committee as 
noted above.
      

                                


                 ***NOTICE--CHANGE IN HEARING STATUS***

ADVISORY
FROM THE 
COMMITTEE
 ON WAYS 
AND 
MEANS

                                                CONTACT: (202) 225-9263
FOR IMMEDIATE RELEASE

February 26, 1999

No. FC-8-Revised

                  Full Committee Hearing on Wednesday,

                   March 3, 1999, on Investing Social

                  Security in the Private Market to be

                     Held at the Subcommittee Level

    Congressman Bill Archer (R-TX), Chairman of the Committee on Ways 
and Means, today announced that the full Committee hearing on investing 
Social Security in the private market, previously scheduled for 
Wednesday, March 3, 1999, at 10:00 a.m., in the main Committee hearing 
room, 1100 Longworth House Office Building, will now be a hearing of 
the Subcommittee on Social Security.
      
    All other details for the hearing remain the same. (See full 
Committee press release No. FC-8, dated February 24, 1999.)
      

                                

    Chairman Shaw. If the Members and guests would take their 
seats, we will convene this morning's hearing. We have a long 
agenda, and we would like to complete it giving adequate time 
to all our guest witnesses this morning.
    Today, we will explore how market investments might improve 
Social Security for women, minorities, and all Americans. The 
benefits of investing are not lost on the American people. A 
new Congressional Research Service study I am releasing today 
estimates that 83.6 million Americans--that is about 1 in 3--
will own stock in 1999. Last weekend, I noted on NBC a news 
story about the growing number of minority households saving 
and investing. In fact, women and hardworking families are 
increasingly recognizing the power of savings and investment as 
part of their retirement planning. Today, 1 in 3 households 
earning between $25,000 and $50,000 own mutual funds, and 53 
percent of all mutual fund investment decisions are made 
entirely or in part by women, who are even more likely than men 
to see retirement as their investment goal.
    As usual, the American people are way ahead of the Congress 
and ahead of the President. When asked last month, everyone--
men, women, Republicans, Democrats, Independents--agreed that 
individuals could properly manage personal retirement accounts 
better than the government if created as part of a Social 
Security reform.
    The numbers weren't even close. Women trusted individuals 
over government by a 2-to-1 margin, and even among Democrats, 
52 percent favored personal savings versus only 35 percent who 
wanted the government to control those investments.
    To his credit, the President proposed a framework for 
modernizing Social Security's financing. He supports market 
investments to boost Social Security returns and new savings 
accounts, and we agree with the President.
    While we disagree with the President about who should own 
and control these investments, we need to carefully consider 
the benefits and risks of each approach as we move forward to 
save Social Security.
    We should all ask ourselves several questions as we listen 
to witnesses today. What role does savings and investment have 
in Social Security's future? If we begin saving real assets, 
who should decide what investments are made, workers and 
families or the government? And, if we choose the investment 
route, what protections, if any, are needed to limit risk, 
prevent fraud, and maintain the security that has been the 
hallmark of Social Security for the past 60 years.
    Getting the right answers to these questions will move us 
another step forward on the path to reform, so let us get to 
business, let us get down to work, and most of all, let us work 
together.
    Mr. Matsui.
    Mr. Matsui. Thank you, Mr. Chairman. I appreciate your 
comments. I appreciate the fact that we are having this hearing 
today.
    As all of us know, Social Security is probably the most 
fundamentally important program that the Federal Government has 
been involved in probably the whole history of our government. 
It provides the safety net for 260 million Americans, past and 
future. It takes care of not only the basic retirement benefits 
of all Americans when they reach 62 or 65 years old, but also 
provides survivors benefits when the breadwinner in the family 
dies. We had a witness that the Chairman was gracious to allow 
about 3 weeks ago who actually testified that without those 
survivors benefits when her father died, she would not have 
been able to attend college. And she is now proceeding to 
graduation. There are 1 million cases like hers.
    It also provides disability benefits for many Americans, 
and in many families, the breadwinner might become permanently 
disabled at a very young age. Social Security takes care of 
that individual's family.
    And so this is an issue of paramount concern I think to all 
of us as Americans and obviously as legislators. And so I 
appreciate the fact that we are finally getting down to the 
issue of how we are going to make sure that we protect the 
Social Security system as we know it.
    We need to move away from the rhetoric and the attacks on 
the President's program and the countercharges, and we need to 
really get down to fundamental business. And it is my hope that 
now we can begin in earnest to talk about these issues.
    And I might point out there was a study that was released 
by the General Accounting Office on Friday that talked about 
the Galveston, Texas, plan, one of the few communities in the 
United States which has its own privatized retirement system. I 
would urge people to look at the GAO study, because it is very 
critical of the Galveston plan.
    And just yesterday, the National Committee To Preserve 
Social Security and Medicare released a study by John Mueller. 
John Mueller is an economist who for the last decade has had 
his own accounting firm. Prior to that, for a number of years, 
he was the chief economist to the Republican Conference, and 
the head of the Republican Conference at the time was none 
other than former Representative Jack Kemp, not one of the most 
flaming liberals in America. And his study which was actually 
commissioned by Martha McSteen, who, as all of us know, was the 
Administrator of the Social Security Administration from 1983 
to 1986, during which time we reformed the system, and who 
happened to have been appointed by none other than President 
Ronald Reagan.
    So this is not a partisan issue. It is an issue I think all 
of us, whether Democrats, Republicans, conservative, liberals, 
or moderates, want to be involved in.
    But I might just point out a couple points in the study 
commissioned by the National Committee To Preserve Social 
Security and Medicare.
    One is that the study has discovered that there are no 
persons currently alive in America today who would benefit from 
privatizing Social Security. In fact, the only winners would be 
realized starting from the year 2025 on. And those winners 
would be single males.
    We are only talking about male individuals born 25 years 
into the future who will benefit from individual accounts. 
Women are losers. Minorities, low-income people, are major 
losers if we should privatize Social Security. And one of the 
big problems, of course, is the fact that those people who are 
trying to make a determination about whether to privatize or go 
with the current system fail to take into consideration that 
when you consider the Social Security benefit structure, you do 
so over a 75-year period, and the growth rate is low over that 
period. Whereas, when it comes to considering investment in the 
equity markets, they use a more recent study of the equity 
markets.
    But last and most importantly, I hope the witnesses, 
particularly in the first panel, will respond to the issue of 
who is going to pay for the transition costs--the $8 trillion 
transition costs that are involved in making sure that current 
and future beneficiaries receive the same level of benefits.
    I might just in closing point out that one witness who will 
testify has said that we need to privatize a significant part 
of the Social Security system. And then buried in the analysis 
there is a temporary tax on the payroll of 1.52 percent, a 
temporary 1.52-percent tax, that is not a major part of the 
program that is being discussed. The temporary tax is for 75 
years. I wish that we in Congress could get by with calling a 
tax of 75 years a temporary tax, but that is a permanent tax. 
And no one is going to be able to convince me otherwise.
    We need to discuss this issue in a rational, intelligent 
fashion. And I look forward to this, and hopefully, this will 
be the start of the kind of dialog that is so necessary if we 
want to protect the Social Security system as we know it. And I 
look forward, as the Chairman said, to Secretary Summers' 
testimony and the two other panels as well.
    Thank you, Mr. Chairman.
    Chairman Shaw. Thank you, Mr. Matsui.
    Our first witness is Hon. Lawrence Summers who is the 
Deputy Secretary of the U.S. Department of the Treasury.
    Welcome. We are pleased to have you at this hearing. Your 
full testimony will be made a part of the record as all the 
witnesses' testimony, and we would welcome you to summarize as 
you see fit.
    Mr. Summers.

STATEMENT OF HON. LAWRENCE H. SUMMERS, PH.D., DEPUTY SECRETARY, 
                U.S. DEPARTMENT OF THE TREASURY

    Mr. Summers. Thank you very much, Mr. Chairman and Members 
of the Subcommittee, for this opportunity to testify on behalf 
of the administration's proposal and to share some of our 
thoughts on the crucial questions you raised in your opening 
statement, Mr. Chairman, regarding the benefits of investment 
of a portion of the trust funds.
    We have a great opportunity in this country right now, with 
$4.8 trillion in surpluses projected over the next 15 years. We 
have a great challenge with an aging society that will put much 
greater pressure on our Social Security and Medicare Programs.
    It is the essence of the President's approach to use the 
opportunity to meet the challenge by contributing the surplus 
to the Social Security Investment Funds and modernizing the way 
in which the Social Security Trust Fund is invested.
    This proposal has the crucial benefit of essentially 
eliminating the national debt sometime between 2010 and 2020. 
That is very important for the future of our country, because 
of what it means for the performance of our economy. The $3\1/
2\ trillion that would otherwise go into the sterile asset of 
government debt will be available to substitute for foreign 
borrowing and trade dislocations, to invest in tools for 
American workers, to invest in new homes for American families.
    It is also very significant to the fiscal foundation of 
this country, because essentially eliminating that national 
debt reduces an amount equal to between 2\1/2\ and 3 percent of 
the GNP that we otherwise have to spend on interest. And that 
is an amount sufficient to meet the challenge of rising Social 
Security costs.
    The President's proposal of contributing the benefits of 
debt reduction to the Social Security Trust Fund assures that 
that fiscal foundation we have laid for solvency turns into a 
legal commitment to meet the obligation to future Social 
Security beneficiaries. The President's proposal thus 
strengthens both our economy and the Social Security system by 
taking advantage of the opportunity of the surplus to meet the 
challenge of an aging society.
    A particular focus of this hearing, Mr. Chairman, is on, as 
you made very clear, the question of the investment of Social 
Security Trust Funds and more generally the best way in which 
to take advantage of the returns that the stock market offers 
for future retirees.
    The administration, as you know in its budget separate from 
its proposal for Social Security, has proposed a system of USA 
accounts that would make universal private pension coverage, an 
insured investment vehicle to permit wealth accumulation for 
all Americans.
    While this, along with other steps to promote pension 
portability and availability, is I think an important step in 
strengthening our overall national retirement security system, 
in the remainder of my opening statement, I want to concentrate 
on the question of investment in equities.
    As Mr. Matsui noted, Social Security has been our most 
successful national social program. And it is very important 
that we preserve it in an effective and strong form.
    Investments in equities can do that. If you look at 
essentially all defined benefit pension plans, whether in the 
private or in the public sector, they take advantage of the 
opportunities that equities offer. They do that because it 
makes possible providing larger benefits with smaller 
contributions.
    The relatively limited proposal that the administration has 
put forward, to invest 15 percent of an augmented trust fund in 
equities, would itself be sufficient to obviate the need for 
what would otherwise be a 5-percent across-the-board benefit 
cut starting in 2030 or a year-and-a-half increase in the 
retirement age.
    Is this something that can work? In terms of risks, we 
believe the risks are easily controlled. The trust fund--only 
15 percent of the trust fund is to be invested in equities. In 
a year like 2030, 72 percent of benefits will come from the 
payroll tax stream. Only 28 percent will come from the trust 
fund. Of that 28 percent, only 15 percent, or about 4 percent 
of the total, will be related in any way to equity investments. 
So the system is secure.
    Can this be done with integrity? We believe that a 
combination of an independent public board, whose only mandate 
is to choose private investment managers whose only freedom is 
to invest in market indices on a nondiscretionary autopilot 
basis, affords the possibility of investment with integrity and 
without interference.
    There has, as you know, Mr. Chairman, been considerable 
discussion of the State and local experience in this regard. 
And I would only note that many of the State and local statutes 
prescribe economically targeted investing or other such 
practices. Whereas, we contemplate legislation that would 
proscribe this; and that the legislation we contemplate, unlike 
any in the State and local experiences, would provide for 
investment only along the lines of market indices with no 
discretion.
    Finally, Mr. Chairman, you raised in your opening 
statement, this is something we can obviously get into more in 
the questions, the issue of collective investment versus 
investment by individuals as part of the Social Security 
system. And I would suggest that a collective investment 
approach has three important virtues relative to an individual 
one.
    First, it is safer for individuals. In 1974, for example, 
the stock market declined by more than 50 percent in real 
terms. Somebody who retired at that moment would see half their 
benefit having eroded. With the defined benefit approach, the 
risks of the stock market would still be there but that would 
be spread over the long term and borne by the Federal 
Government rather than individual beneficiaries.
    Second, administrative costs. Experience with mutual funds 
in the United States, with the private Social Security systems 
in Britain and in Chile, all suggests that the costs of an 
individual approach would be likely to eat up as much as 20 
percent or more of account accumulations over a 40-year period. 
In contrast, Social Security with equity investments would 
continue to pay out 99 cents out of every dollar received in 
the form of benefits.
    Third, a collective approach preserves the basic defined 
benefit progressive structure of Social Security, which has 
been so important in transforming the lot of the Nation's 
elderly, who were the group most frequently in poverty a 
generation ago; and today are the group in our population that 
is least frequently in poverty.
    I might conclude with this thought, Mr. Chairman. The 
benefits of collective investment that I just described are 
often juxtaposed with concerns about the integrity of that 
collective investment. I have suggested that I believe those 
concerns can be addressed with independent management and 
indexing.
    But it is important I think to recognize that any system of 
government-administered individual accounts that apply to 
millions of Americans would still carry with it many of the 
same risks of interference. There would still be the 
possibility of investment rules for the basic equity fund that 
would divert investments into less productive purposes or that 
would prescribe certain forms of investment holding. And so the 
opportunity for the political process to meddle would be there, 
whether it was a nationally run system of individual accounts 
or a collective investment scheme.
    To be sure, I believe those risks can be controlled. But I 
do not believe those risks provide a strong basis for choosing 
between a collective and a more individual approach. Whereas, I 
do believe that the benefits of administrative simplicity, the 
benefits of progressivity, and the benefits of risk sharing do 
mean that in the Social Security pillar of our retirement 
security system, we are best off with an approach like the one 
that the President has put forward.
    Thank you very much for this opportunity, Mr. Chairman.
    [The prepared statement follows:]

Statement of Hon. Lawrence H. Summers, Ph.D., Deputy Secretary, U.S. 
Department of the Treasury

    Mr. Chairman, Members of the Committee, I appreciate the 
opportunity to appear today to discuss President Clinton's 
proposal to ensure the financial well-being of the Social 
Security and Medicare programs and improve the retirement 
security of all Americans.
    The advent of an era of surpluses rather than deficits has 
radically transformed our national debate about entitlements. 
The terms of all of the earlier tradeoffs in the entitlements 
debate have been eased--provided we seize the opportunities now 
available to us. The President's framework for Social Security 
both recognizes the brighter present reality, and moves us well 
along the road toward seizing the opportunities currently 
available, if we can work together on a bipartisan basis.
    Today I will first briefly describe the President's 
program. I will then devote the bulk of my remarks to the issue 
of the President's proposal to raise the rate of return earned 
by the Social Security trust funds by investing part of the 
surplus in equities.

                        The President's Proposal

    According to the Office of Management and Budget, the 
surpluses in the unified budget of the federal government will 
total more than $4.8 trillion over the next 15 years. This 
presents us with a tremendous opportunity. At the same time, we 
are also facing a tremendous challenge: the aging of the 
``babyboomers'' is projected to put enormous strains on the 
Social Security and Medicare systems, on which so many retirees 
depend.
    The natural approach would be to take advantage of this 
opportunity to meet the challenges facing us. This is the 
objective of the President's plan.
    The President's framework devotes 62 percent of these 
projected budget surpluses to the Social Security system. Of 
the roughly $2.8 trillion in surpluses that will go to Social 
Security, about four-fifths will be used to purchase Treasury 
securities, the same securities that the Social Security system 
has invested in since its inception. The remaining one-fifth 
will be invested in an index of private-sector equities. These 
two actions will reduce the 75-year actuarial gap from its 
current level of 2.19 percent of payroll by about two-thirds, 
to 0.75 percent of payroll. And they push back the date at 
which the Social Security trust funds are projected to be 
exhausted, from 2032 to 2055.
    Substantial as that accomplishment would be, it is critical 
that we do more. Historically, the traditional standard for 
long-term solvency of the Social Security system has been the 
75-year actuarial balance. A 75-year horizon makes sense 
because it is long enough to ensure that virtually everyone 
currently participating in the system can expect to receive 
full payment of current-law benefits. Attaining this objective 
will require additional tough choices. But the objective is 
both important and obtainable. To reach it, the President has 
called for a bipartisan process. We believe that the best way 
to achieve this type of common objective is to work together, 
eliminating the need for either side to ``go first.''
    In the context of that process, we should also find room to 
eliminate the earnings test, which is widely misunderstood, 
difficult to administer, and perceived by many older citizens 
as providing a significant disincentive to work. In addition, 
it is critical that we not lose sight of the important role 
that Social Security plays as an insurance program for widows 
and children, and for the disabled. As President Clinton said 
last month: ``We also have to plan for a future in which we 
recognize our shared responsibility to care for one another and 
to give each other the chance to do well, or as well as 
possible when accidents occur, when diseases develop, and when 
the unforeseen occurs.'' That is why the President has proposed 
that the eventual bipartisan agreement for saving Social 
Security should also take steps to reduce poverty among elderly 
women, particularly widows, who are more than one and one-half 
times as likely as all other retirement age beneficiaries to 
fall below the poverty line.
    In addition to shoring up Social Security, the President's 
plan would transfer an additional 15 percent of the surpluses 
to Medicare, extending the life of that trust funds to 2020. A 
bipartisan process will also be required to consider structural 
reforms in this program. The Medicare Commission is expected to 
report soon on these important issues.
    The President would also use 12 percent of the surpluses to 
create retirement savings accounts--Universal Savings Accounts 
or USA accounts--and the remaining 11 percent for defense, 
education, and other critical investments. The President will 
be announcing further details regarding the USAs soon.
    At the same time, the President proposes to strengthen 
employer-sponsored retirement plans in a variety of ways. The 
President's budget addresses the low rate of pension coverage 
among the 40 million Americans who work for employers with 
fewer than 100 employees by proposing a tax credit for start-up 
administrative and educational costs of establishing a 
retirement plan and proposing a new simplified defined benefit-
type plan for small businesses. Workers who change jobs would 
benefit from the budget proposals to improve vesting and to 
facilitate portability of pensions. In addition, the retirement 
security of surviving spouses would be enhanced by the 
President's proposal to give pension participants the right to 
elect a form of annuity that provides a larger continuing 
benefit to a surviving spouse and to improve the disclosure of 
spousal rights under the pension law.

                  Benefits of the President's Approach

    In essence, the President is proposing that we use the 
Social Security and Medicare trust funds to lock away about 
three-quarters of the surpluses for debt reduction and equity 
purchase, and ensure that they are not used for other purposes. 
This would have three key effects:
     First, it would greatly strengthen the financial 
position of the government. If we follow this plan, by 2014, we 
will have the lowest debt-to-GDP ratio since 1917 and will free 
up a tremendous amount of fiscal capacity. The reduction in 
publicly held debt will reduce net interest outlays from about 
13 cents per dollar of outlays in FY99 to about 2 cents per 
dollar of outlays in 2014. Under the President's program, the 
decline in interest expense resulting from debt reduction will 
exceed the increase in Social Security expense through the 
middle of the next century.
     Second, it would strengthen significantly the 
financial condition of the Social Security and Medicare trust 
funds. Indeed, it would extend the life of the Social Security 
trust funds by more than 20 years, to 2055, and extend the life 
of the Medicare Hospital Insurance trust funds to 2020. Meeting 
our obligation to the next generation of seniors should be the 
number one priority in allocating the surpluses.
     And third, it would substantially increase 
national saving, which must be a priority in advance of the 
coming demographic shift. By paying down debt held by the 
public and investing in equities, the President's program will 
create room for about $3.5 trillion more investment in 
productive capital. In effect, this will be the reverse of the 
``crowding out'' that occurred during the era of big deficits. 
With government taking a smaller share of total credit in the 
economy, interest rates will be lower than otherwise would be 
the case. The implications of lower interest rates will be 
profound. Not only will individuals be able to borrow for 
mortgages, school loans, and other purposes at lower rates, but 
importantly, businesses will be able to finance investments in 
productive plant and equipment at the lower rates. And the 
resulting larger private capital stock is the key to increasing 
productivity, incomes, and standards of living. Ultimately, one 
reason why this program is sound economically is that it will 
result in a more robust private economy, which will expand our 
capacity to make good on our Social Security and Medicare 
promises. This increase in public saving also has beneficial 
implications for our balance of payments side. Reduced 
government borrowing would lead to a reduced dependence on 
foreign financing, and an improvement in our status as a net 
debtor to the rest of the world.

                        Benefits of USA Accounts

    Social Security, strengthening employer-sponsored 
retirement plans, and creating USA accounts are key pillars of 
the President's proposal to provide financial security to 
retirees. We believe that USA accounts will provide a 
significant stimulus to private savings, by enabling millions 
of Americans to begin to set aside some money for retirement.
    The President's proposal aims to deal more broadly with the 
challenges of an aging society by expanding individual access 
to retirement saving. As I noted earlier, the President 
proposes to devote 12 percent of the surpluses to establishing 
a new system of Universal Savings Accounts. These accounts 
would provide a tax credit to millions of American workers to 
help them save for their retirement. Workers would qualify for 
a progressive tax credit match against their own contributions. 
For example, a low-income worker may receive a dollar for 
dollar match up to a cap. In addition, low- and moderate-income 
workers will qualify for an additional tax credit, even if they 
make no contribution themselves.
    Overall, the USA program would be considerably more 
progressive than the current tax subsidies for retirement 
savings--where higher bracket taxpayers get higher subsidies. 
This proposal would contribute significantly to national 
savings, because it will produce retirement savings for 
millions of low- and moderate-income people who do not have 
access to pensions. The tax credit match will provide a strong 
incentive for workers to add their own saving to accounts.

   Investing Part of the Surplus in Equities Would Raise the Rate of 
            Return Earned by the Social Security Trust Funds

    As I have mentioned, the President has proposed 
transferring 62 percent of projected surpluses to Social 
Security, and investing a portion of these transferred 
surpluses in equities.
    To date, the trust funds have been invested exclusively in 
U.S. Government bonds. While these bonds are essentially risk-
free, they have the corresponding downside that they have 
historically paid a lower rate of return, on average, than 
other potential investments. Between 1959 and 1996, the average 
annual rate of return earned on stocks was 3.84% higher than 
the rate earned on bonds held by the trust funds.
    Currently, the pension savings of many upper income 
Americans are invested in private plans that earn these higher 
equity returns. The higher equity returns can potentially make 
it possible for these Americans to have more upon retirement. 
We believe that it is important to give all Americans, even 
those of low and modest means, the opportunity to enjoy these 
potential benefits from stock market performance.
    Raising the rate of return on the trust funds would mean 
that the Social Security system could be brought into long-term 
actuarial balance with smaller reductions in benefits, smaller 
increases in revenue, and/or less transfer of surplus. The 
President's plan for investing in equities will reduce the 
actuarial gap by an estimated 0.46 percent of taxable payroll--
and thus will close roughly one-fifth of the problem we face 
over the next 75 years. If one were to try to achieve the same 
actuarial impact of equity investments through alternative 
measures, we would have to immediately reduce the COLA on 
Social Security benefits by 0.3 percentage points. The equity 
investment in the President's package achieves as much for the 
financial soundness of the system as would moving the normal 
retirement age up by about an extra year and one-half for 
participants who reach age 67 in 2022. If we delayed until 2030 
to make the changes necessary to set Social Security back on a 
sound actuarial footing, the required across-the-board cut in 
benefits would be 5%.
    Investing part of the trust funds in equities would also 
bring Social Security into line with the ``best practice'' of 
both private and public sector pension plans. Among large 
private-sector defined benefit plans (those with more than 100 
participants), more than 40% of total assets were invested in 
equities in 1993; this number has risen significantly since 
then. Nearly all state pension plans also now invest in 
equities. In 1997, state and local government plans invested 
64% of their portfolios in equities.

         Would Equity Investments Add Risk to the Trust Funds?

    I see two broad concerns regarding trust fund investment in 
equities. These concerns are legitimate, but we believe they 
are manageable, and should not stop us from achieving the 
potential enhanced returns of equities.
    First, stock returns are more volatile than the returns on 
the government bonds held by the trust funds. However, the 
trust funds are well-situated to bear equity risk, because they 
have long--or indefinite--time horizons. The trust funds would 
be capable of riding out the ups and downs of the market, 
because they receive the cash flow from payroll taxes, and 
because of the cushion provided by the trust funds' bond 
holdings.
    More specifically, investing only 15 percent in equities 
seems to us to be a prudent balance between receiving the 
potentially greater return from equities and keeping the 
investment small enough so that the trust funds are not overly 
exposed. This 15 percent allocation to equities is much smaller 
than the customary allocation to equities in either public or 
private pension plans. Moreover, 85% of the trust funds will 
still be invested as before in risk-free Treasury securities.
    In addition, the equity investments and disinvestments that 
we are proposing will be smoothed in incremental additions over 
15 years. In any year, investments or disinvestments are 
projected to be less than 0.5% of the stock market. Incremental 
investments and disinvestments--rather than total divestiture 
at one time--will help to mitigate the risk from adverse price 
movements.
    Finally, in the near term, all benefits will continue to be 
paid out of payroll and other taxes. Furthermore, under current 
law, even in 2032 payroll and other taxes will be sufficient to 
pay for the lion's share--about 72%--of Social Security 
benefits. The remaining 28% of benefits will be paid out using 
the assets of the trust funds. As only 15% of the trust funds' 
assets would be invested in equities, only about one sixth of 
this 28% would be backed by equities. In short, even in 2032, 
only about 4-5% of payments from the trust funds will be backed 
by private sector investments.

             Ensuring the Integrity of Investment Decisions

    The second concern is that of political influence on trust 
fund investment decisions. Any system of collective investment 
can and must address these concerns. We believe that we can 
successfully work with Congress to design a system that is free 
from political influence. We need to strike the right balance, 
so that we can earn the higher potential returns to equities, 
by finding a way to take care of these legitimate concerns.
    That is why we will work with Congress to design a system 
that observes five core principles. These five core principles 
will establish several levels of protection.
    First, the share of trust fund assets invested in equities 
ought to be kept at a very limited level. We have proposed that 
equity investment be limited to 15 percent of trust fund 
balances. This will be important to limit the trust funds' 
exposure to price movements from equity investments, and to 
ensure that collective investments never account for more than 
a small fraction of the stock market. During the first years of 
the program, from 2001 to 2014, Social Security would own, on 
average, only 2% of the stock market. On average through 2030, 
Social Security would own approximately a 4% share of the total 
stock market.
    Second, the investments should be independently managed and 
non-political. We suggest that trust fund managers be drawn 
from the private sector through competitive bidding and that 
the trust fund managers be overseen by an independent board. 
There should be wholly independent oversight of investment, in 
order to shield the trust funds from political influence.
    Third, the sole responsibility of the independent board 
would be to select private sector managers through competitive 
bidding. Private sector management will provide a further 
degree of political insulation. Moreover, Social Security 
beneficiaries deserve the same efficient management and market 
returns that people receive for their private pensions and 
personal savings.
    Fourth, equity investments should be broad-based, neutral 
and non-discretionary. Assets should be invested 
proportionately in the broadest array of publicly listed 
equities, with no room for discretion in adding or deleting 
companies and no room for active involvement in corporate 
decisions. We have proposed that the funds be invested in a 
total market index, which would encompass a broad range of 
stocks. In addition, the managers should be on autopilot in 
investing the funds; they should have little or no discretion 
in the investment of trust fund assets, so they cannot ``time 
the market'' or pick individual stocks.
    As a shareholder the trust funds should be entirely 
passive. One way to accomplish this might be to mandate that 
proxies be voted in the same proportions as other shareholders.
    Fifth and finally, collective investment needs to be 
achieved at the lowest cost available. This will be important 
both to obtain the highest possible returns and to further 
enhance the system's transparency and independence. Indexed 
investment is less expensive than active management. In 
addition, given the large size of the potential equity 
investments by Social Security, we would expect to pay very low 
asset management fees.
    Let me emphasize our belief that there should be zero 
government involvement in the investment. We will work with 
Congress to design a system that is completely insulated from 
political pressures.

             The Experience of State and Local Governments

    As I mentioned earlier, virtually all state pension funds 
now invest in equities. In 1997, state and local government 
plans invested 64% of their portfolios in equities, up from 56% 
in 1996. State and local pension plans now hold fully 10 
percent of the overall stock market. By contrast, the Social 
Security trust fund equity investments would total only 15% of 
the trust funds, and would represent, on average, about a 4% of 
the equity market.
    Some have suggested that the trust funds might fall short 
of earning market returns, based on the experience of state and 
local pension plans. I would emphasize first that the 
experience of state plans is really not directly comparable to 
what we are proposing for Social Security. State plans do not 
generally operate under the kinds of restrictions that are 
envisioned under the President's proposal. That is, the 
statutes governing state plans do not generally require that 
investments be made only through indexed funds, with a clear 
prohibition against adding or subtracting equities from the 
index. Many state pension plans are actively managed, and some 
have explicit investment goals. As a result, the experience of 
these plans may not be relevant as a guide for what Social 
Security's experience would be.
    Our preliminary analysis of the available data suggests 
that, over the period 1990-1995, public plans actually received 
returns that averaged two basis points higher than private plan 
returns (this difference is statistically indistinguishable 
from zero). Although in earlier periods (from 1968 to 1983) the 
performance of public pension funds was slightly inferior to 
that of private pension funds, this difference is also not 
statistically significant. More importantly, this very slight 
difference in performance during earlier periods can be 
explained by the fact that public pension funds generally 
allocated a far smaller portion of their portfolios to 
equities, and in some cases were statutorily prohibited from 
buying any equities.
    The returns to trust fund investments to this date would 
not stack up well in this comparison of earnings of public and 
private pension funds. Because the trust funds have been 
invested exclusively in government securities until now, both 
public and private pension funds would likely have outperformed 
the rate of return earned on trust fund investments.

         Advantages of Collective Investment of Social Security

    There are three key advantages to having the trust funds 
invest collectively in equities for the American people. These 
advantages relate to the ability of defined benefit plans to 
bear market risk, minimize administrative costs, and achieve 
progressivity. Defined contribution plans, such as the 
proposals for individual accounts, are less able to realize 
these objectives. In addition, the potential political risk 
from collective investment in equities through the trust funds 
is not very different from the political risk that could arise 
from investing in equities through defined contribution plans.
    An advantage of collective investment in equities through 
the trust funds is that periods of poor equity performance 
could be spread over many generations of current and future 
Social Security participants. By contrast, during a market 
downturn, participants in a defined contribution system could 
be forced to choose between postponing retirement and a 
severely reduced retirement income. For example, for the year 
that ended with the third quarter of 1974, the S&P500 declined 
by 54 percent in real terms. By placing the risk of a market 
downturn in the trust funds, we can greatly reduce this risk to 
beneficiaries. Additionally, we have proposed limiting Social 
Security's equity holdings to 15% of the trust funds. As I 
noted earlier, this means that only 4% of benefits payments 
would be backed by the performance of equities.
    The second advantage of collective investment in equities 
is that the returns to trust fund investments in equities would 
likely be higher than the returns to equities held in 
individual accounts. This is primarily because it would be much 
more costly to administer a defined contribution plan than it 
would be to administer a defined benefit plan. The trust funds 
would expect to pay very low asset management fees, because of 
the large size of the trust fund asset pool. These asset 
management fees could be comparable to, or lower, than the 1 
basis point (0.01%) currently paid by the federal employees' 
TSP plan for private management of the equity-indexed ``C 
Fund.''
    By contrast, administrative costs for a system of defined 
contribution plans held in the private sector could be 
comparable to the commissions and fees charged by equity mutual 
funds today. The average equity mutual fund currently charges 
between 100 and 150 basis points for administrative and 
investment management services. Costs of this magnitude could 
significantly reduce the balance that could be accumulated in 
an individual account. According to our estimates, 
administrative costs of 100 basis points would reduce by 20 
percent the total account accumulations at the end of a 40-year 
career. Collective investment through the trust funds would 
avoid the need to pay the administrative costs associated with 
individual accounts.
    The experience of individual accounts in Britain and Chile 
illustrates how significant these risks and costs can be. In 
Britain, many personal pension plans take more than 5 percent 
of contributions in administrative charges.
    Chile also has had high administrative costs. According to 
the Congressional Budget Office (CBO), fees and commissions of 
the Chilean pension system amounted to 23.6 percent of 
contributions in 1995. As a result, according to the CBO, 
Chilean workers who invested their money in an individual 
account in 1981 received an internal real rate of return of 7.4 
percent on that investment through 1995, despite average real 
returns of 12.7 percent to pension fund investments. Even in 
the best of circumstances, however, costs will be higher for a 
system of individual accounts than for collectively investing 
trust fund assets.
    The third advantage of collective investment is that it is 
progressive. This is one of the most important features of 
Social Security: benefits are greater, as a percentage of 
wages, for low-income workers than high-income workers. By 
investing in equities, we are able to maintain this critical 
feature of progressivity and avail Americans of modest means of 
the higher returns that have historically accrued to equities.
    In addition to these key advantages, one might note that, 
with regard to the concern about political influence, this 
concern also exists for individual accounts. Most individual 
account proposals have suggested some centralized plan 
structure, both in order to reduce administrative costs and to 
help familiarize tens of millions of Americans with the range 
of possible investment vehicles. These individual account plans 
would create a large pool of money under a single manager, or a 
handful of managers. This pool of money would not look very 
different from the Social Security trust funds. With any 
centralized pool of assets there is the potential for those 
pursuing a political agenda to try to influence it.
    We can all be encouraged by the history of the Thrift 
Savings Plan (TSP), whose investments have not been subject to 
political influence. We believe that some of the features that 
have protected the TSP system so well are worth emulating. 
These include the TSP system's independent board, its private 
sector managers, and the rule that equity investments can only 
be made by tracking an index.

                               Conclusion

    In conclusion, it will be critical to have the 
Administration and Congress work together to address the needs 
of future generations. We need to keep the promises that we 
have made to retirees, without unduly burdening younger 
generations. We want to work with you, on a bipartisan basis, 
to implement the President's program.
    I believe that we can find a safe and prudent way to 
participate in the enhanced returns in equity markets.
    Thank you. I would welcome any questions.
      

                                

    Chairman Shaw. Thank you, Dr. Summers. I have just a few 
questions. You mentioned in your initial remarks that the 
President's plan would virtually eliminate the national debt. 
Does that include the part of the national debt held by the 
Social Security Trust Fund?
    Mr. Summers. I am sorry, Mr. Chairman. I should have spoken 
more precisely. It would eliminate the debt of the Federal 
Government to the public, which is the debt that potentially 
crowds out other investments and which is the debt that 
represents a fiscal burden on taxpayers.
    The intra-Federal Government securities would still exist, 
but they would simply be there in recognition of a liability 
that is already there for the Federal Government, namely the 
liability to meet future benefits.
    Chairman Shaw. So it is a liability to the general public, 
particularly the working people who have paid into Social 
Security. The debt is still there, and it is a debt to the 
public, is that correct?
    Mr. Summers. There would be no--the--whatever is done, the 
public has an obligation to meet future Social Security 
obligations.
    Chairman Shaw. Yes.
    Mr. Summers. There is no new obligation incurred by the 
public, and the obligation that the public now has to meet a 
national debt, which comprises just under 50 percent of the 
GNP, would be, over time, eliminated, of course, assuming the 
projections came true in the context of the President's 
proposal.
    Chairman Shaw. Dr. Summers, it can be argued that if you 
take the Social Security Trust Fund completely off of budget--
if Congress did it--if the President did it--that we wouldn't 
be looking at a surplus, we would be looking at, indeed, a 
deficit. The math on that is very clear. We all agree that that 
is the case. So it can be argued that the surplus has already 
gone through the Social Security Trust Fund in the form of FICA 
taxes, because that goes into the unified budget. So the 62 
percent that the President runs through the Social Security 
Trust Fund and then comes out the other end, and pays off the 
publicly held debt--in other words, exchanging government-held 
debt for publicly owned debt--that money has already been 
through the trust fund. So what would be the effect if you ran 
it through two or three times before you came to the end game 
of retiring the public debt? That would have the effect of 
putting more IOUs into the trust fund, is that not correct? 
That is a simple ``yes'' answer, I believe. So what we are----
    Mr. Summers. I don't think--I am not 100 percent certain I 
understood the whole question, Congressman, but I don't----
    Chairman Shaw. Well, let me repeat it then.
    Mr. Summers. But I don't think the effects are as you 
describe. I think the effects of the President's proposal would 
be to reduce the interest burden that taxpayers would have to 
finance from its current--from what would have been a level of 
a few hundred billion dollars in 2015 to a number that would be 
a few tens of billion dollars at that time, while at the same 
time, which, in turn, would both provide the increased national 
savings and the increased government budget space to make room 
for meeting our Social Security obligations.
    Chairman Shaw. Let me ask you a question. Let me you ask 
you for just a simple ``yes'' or ``no'' answer. When the 62 
percent goes through the Social Security Trust Fund that has 
the effect of putting more Treasury bills, more IOUs, in the 
trust fund, is that correct?
    Mr. Summers. That is correct.
    Chairman Shaw. And if you were to take that when it comes 
out the other side and run it through there again, it would 
have the same effect, is that not correct? And if you were to 
run it through again, it would have the same effect, is that 
not correct?
    Mr. Summers No, I don't----
    Chairman Shaw. You don't think so. I am a CPA, not an 
economist, so maybe I am looking through more realistic glasses 
than you are. But the question is, I think, a very simple one, 
and one is if you have already double counting, why not triple 
count, if it is going to do any good? Or why not count four 
times if it is going to do any good? I am not trying to trash 
the President's plan. I think that he has opened the door 
toward investment in the private sector, and I compliment him 
for that. And he has come forward with a plan, even though we 
don't have it in the form of legislation. It is not a complete 
plan. I think that he has certainly has made a very material 
contribution to the process that we are going to try to go 
through. But the question of what happens in the year 2013 is 
what bothers me. And that is at the time, whether you say it is 
2013 or 2016, whatever it is, that is the date in which we have 
to start calling in these IOUs, because that is the date that 
the FICA taxes can no longer take care of existing benefits. 
And when you get past that date, the taxpayers are going to 
have to chip in because those IOUs are being cashed in, and 
that is the situation that worries me. And I think when you 
talk about 2030 or 2050, down here at the base, the taxpayers 
have already been skinned by the time you get down to that 
point. At that point, you either have to increase the FICA tax 
or you have to tap into the general fund or you have to get 
more Treasury bills and more IOUs out there to borrow money in 
order to cash in the ones that are in the trust fund. That is 
what is troubling, and that is the problem that I see with the 
President's plan or the primary problem that I see with the 
President's plan.
    Mr. Summers. Congressman, I see and I think understand your 
concern, and let me just respond in this way. Take 2016, at the 
end of the 15-year contribution period that the President 
envisions. You are quite correct that the payroll tax stream in 
that year will not be sufficient to meet the benefits stream. 
And that is why it is contemplated, by the way in the current 
situation without the President's budget as well, that the 
benefits would, at that point, be financed from the trust fund, 
which does, indeed, as you suggest, hold Treasury bills.
    And so you ask the question, well what is there really, 
because in some ultimate sense benefits in 2016 have to be 
financed nationally from resources that we generate in 2016. 
What is important about the President's proposal is that by 
providing for the running down of the national debt, it 
provides an offsetting benefit to taxpayers. That offsetting 
benefit to taxpayers is the fact that they no longer have to 
meet the tax burden that is associated with what would 
otherwise be an interest bill of several hundred billion 
dollars.
    And so the same level of tax effort will make it possible 
to meet the Social Security benefits and provide for the 
continuation of unified surplus. And it is that that is salient 
about the President's proposal. The benefits and the greater 
solvency of Social Security and ability to meet Social Security 
obligations derive from the running down of the national debt. 
Now, some will ask, well, why not run down the national debt 
and not do the business with putting the benefits of running 
down the national debt into the Social Security Trust Fund. And 
I think there are two important virtues of the President's 
approach: one, in a political sense. And I hesitate to give 
Members of this Subcommittee advice on anything political. I 
think it is generally--I think it is generally felt that by 
associating debt reduction with Social Security, we create a 
much stronger and more salient lockbox than would otherwise be 
available to assure the preservation of the surpluses.
    Second, if we do succeed in scaling down very substantially 
our interest costs, there is a question as to where the 
benefits of that should go, and the President wants to make the 
decision now before other temptations tempt that that should go 
to Social Security. And that is what is accomplished by the 
political act, the administrative act of committing those 
surpluses to the Social Security Trust Fund.
    There would be no possibility of triple or quadruple 
counting, because we only have this unified surplus once. We 
have the unified surplus. We make the contribution of the 
unified surplus to Social Security. We are not retiring the 
debt two, three, or four times. And so the only amount that can 
be contributed from the unified surplus to Social Security is 
what comes from the unified surplus and there--that is where 
the President has chosen the 62-percent figure.
    Chairman Shaw. I would respectfully disagree with you that 
there is not double or triple counting here, because if you 
start out with the basic premise that the surplus is caused by 
the excess of FICA taxes over the amount of benefits, then you 
have to say that is where the surplus came from. And if you say 
that is where the surplus came from, then I think that the 
argument is easily made that is already gone through the Social 
Security Trust Fund, and we are just simply running it through 
a second time.
    But let us move on, because there is one other part of your 
testimony that I do want to address. You made three comments 
with regard to an individual retirement or a private savings 
account or whatever you want to call it. Those are good points, 
and those are points that we are discussing; those are points 
that we are also concerned about. And I think those are points 
that we will be able to answer. And if we are able to answer, I 
would want the President and the Treasury to take another close 
look at additional proposals, which would safeguard those 
retirement accounts, and would really hold them separate and 
guarantee the return which would be no less than what the 
beneficiaries are receiving today, adjusted for inflation. And 
if we can do that, and we can also permanently fix Social 
Security in the process, I would hope that the President would 
keep an open mind and take a very close look at this, and 
become an ally in our efforts to try to accomplish these goals.
    I can tell you this Subcommittee desperately wants to work 
with the President in this area, and we will continue our 
efforts to communicate with the President. Anything the 
President sends down, I can tell you, will be received with 
respect and courtesy toward the President, certainly by this 
Subcommittee. We will have thorough hearings on it, as we are 
today, on the President's plan. And we would wish nothing more 
than to work with the President as partners in reforming Social 
Security.
    That should be this President's legacy, and that should be 
the legacy of the 106th Congress.
    Mr. Matsui.
    Mr. Matsui. Thank you, Mr. Chairman. I just want to say 
about you, Mr. Chairman, I have never heard you say anything 
really negative in the sense of the trashing the President's 
plan. I just wanted to acknowledge that, because I have 
concerns about some of our colleagues on your side of the aisle 
in particular, but you yourself have been very, very balanced 
in your approach. I just want to make that statement for the 
record and to you personally.
    Do you support the President's plan?
    Mr. Summers. Yes.
    Mr. Matsui. Do you want to bring it up to the Congress?
    Mr. Summers. Out of--let me just say out of professional 
judgment----
    Mr. Matsui. Let me ask my question. Will you let me ask my 
question?
    Mr. Summers. Excuse me.
    Mr. Matsui. You support the President's plan. You said, 
``yes.'' Now, are you going to put it in legislative language? 
I know there's been some requests for that by some of our 
leadership just for the purpose of perhaps looking at it. Are 
you interested in going beyond the rhetoric or do you want to 
actually introduce it?
    Mr. Summers. I think the President and all of us in the 
administration are engaged in a very active process of 
discussion with Members of Congress in both parties, in both 
Houses, as to how best to take this forward, and whether we----
    Mr. Matsui. In other words, it is not your intent then to 
bring up specific language? I just want to get a sense of where 
you are--because I am getting tired of trying to find out 
whether you are interested or not interested, because we are 
going to start drafting our own plan if, in fact, you are not 
interested. We keep defending your plan, but I want to know 
what you are going to do?
    Mr. Summers. I don't think we have made a definite--I don't 
think we have made a definite----
    Mr. Matsui. Do you support your plan?
    Mr. Summers [continuing]. Decision on that.
    Mr. Matsui. Oh, do you support your plan?
    Mr. Summers. Yes.
    Mr. Matsui. Yes, but you still haven't decided anything 
definite.
    Mr. Summers. About what?
    Mr. Matsui. About how much support you are giving to your 
plan?
    Mr. Summers. Oh, I think we are--I think our support for 
this approach is a total support--is total support for this 
approach, Congressman. And on the question of a specific bill, 
I will have to--we will have to--we will have to come back to 
you.
    Mr. Matsui. So you may change your bill? So I shouldn't be 
so supportive, because in case you pull the rug from under us I 
have to be a little careful, is that what you are saying?
    Mr. Summers. No, I think I am only--not at all--I think the 
commitment to this approach is complete. I think the only 
question is whether embodying it at this point before there has 
been more discussion in a specific legislative draft is 
something that the White House is or is not going to choose to 
do----
    Mr. Matsui. I really don't care, Larry, what you do, 
because whether you introduce your plan or not doesn't make any 
difference. But I wish you would be consistent. That is the 
only thing I am asking in terms of private discussions in these 
matters.
    Let me turn to another subject--the concept of making sure 
that investments in the equity market by the government are 
protected. Undoubtedly, you are working on something there. Is 
that my understanding?
    Mr. Summers. Protecting the investments--absolutely.
    Mr. Matsui. Yes, in other words, so that you don't let a 
political interference occur?
    Mr. Summers. Certainly, we are.
    Mr. Matsui. And how far along are you?
    Mr. Summers. I think we have given a great deal of thought 
to that, and I think we have identified as crucial aspects the 
four protections that I mentioned in my testimony: investment 
on a limited scale; an independent board; a requirement that 
the investment take place by private managers; and that the 
private managers only be permitted to invest in large across-
the-board indices, and not make selections with respect to 
individual securities. And I think those four protections 
embody our basic approach.
    Mr. Matsui. OK, I have no further questions.
    Chairman Shaw. Mr. McCrery.
    Mr. McCrery. Thank you, Mr. Chairman. Mr. Summers, we are--
I was interested in your dialog with the Chairman over the 
double counting and triple and quadruple counting, and I think 
the Chairman was correct in saying that you could if you wanted 
to just take the cash that you get from the Social Security 
Trust Fund, when it initially purchases government securities, 
and purchase another set of government securities, which you 
call for in your plan.
    Then you get more cash, and in your plan you use it to buy 
down the debt, publicly held debt. But you could go ahead, 
reissue it to the trust fund again, if you wanted to. Now, you 
don't call for that, but I think the Chairman is correct in 
saying that you could just add more debt to the trust fund, and 
that would, on paper, solve the Social Security crisis.
    The problem, of course, would come in the outyears, when 
you have to redeem those securities and pay the benefits with 
trust fund moneys. But one thing that I think you need to 
clarify for this Subcommittee, and I think I am right in saying 
this, if I am not, please correct me, but I think in your plan 
there is an explicit link between the amount of debt issued to 
the Social Security Trust Fund and the amount of public debt 
that is retired. Is that correct?
    Mr. Summers. Yes, in the sense that the President's plan 
proceeds by taking the currently projected retirements of 
Federal debt and assuring that 62 percent of those are 
transferred to the Social Security Trust Fund. And now, I may 
have--I may not have fully understood.
    Mr. McCrery. I think it is 62 percent of the anticipated 
surplus.
    Mr. Summers. Of the anticipated surplus, but the surplus--
--
    Mr. McCrery. That would be used to buy down the publicly 
held debt.
    Mr. Summers. If you don't do anything--if nothing happens, 
and the surplus just materializes, what happens is that because 
we have got a surplus, we--debt securities come due, we pay 
them off. And because we have a surplus, we don't issue new 
debt securities, and so the public debt falls.
    Mr. McCrery. Right.
    Mr. Summers. So that sort of happens on autopilot, that the 
public debt falls when you run a surplus, almost by the 
definition of a surplus. What the administration proposes to do 
is to take 62 percent of that reduction in the debt, 62 percent 
of the debt that would no longer be outstanding, and make the 
transfer to the Social Security Trust Fund. Clearly, and 
perhaps this was the point I didn't appreciate sufficiently in 
the Chairman's question, clearly if you simply just made up new 
government bonds and placed them in the Social Security Trust 
Fund that would be some kind of accounting entry that wouldn't 
correspond to any economic reality. The reason the President's 
proposal has economic reality is that what is being put in the 
Social Security Trust Fund is not some figment of the 
imagination. It is a portion of the savings that are being 
realized by running down the debt that is held by the public.
    Mr. McCrery. But is there no explicit link between the 
amount of money that is put into the trust fund and the amount 
of publicly held debt that is redeemed?
    Mr. Summers. Sixty-two percent of the publicly held debt 
that is redeemed is then put in the trust fund.
    Mr. McCrery. Yes, but you said that there was--that you 
hated to advise this Subcommittee on the politics, but that it 
was--that it would be more difficult for us to use the money 
for anything other than reduction of the publicly held debt 
because it was linked to Social Security.
    Mr. Summers. Oh, yes.
    Mr. McCrery. Oh, yes, well----
    Mr. Summers. Right now, what we say is that 62 percent of 
the reduction in publicly held debt goes to the trust fund. In, 
and so when you contemplate the maintenance of the surplus, not 
pursuing new spending policies that would dissipate the 
surplus, the argument can always be made that if you dissipate 
the surplus, then you are disadvantaging the trust fund. That 
money is no longer available for the trust fund. It is no 
longer there for the trust fund.
    On the other hand, if you don't have such a provision, then 
the argument is always there then why don't we just run down 
the national debt a little less and have a new spending program 
or have a new whatever-it-is program. So, in effect, you are 
using the Social Security as a kind of guarantor to assure what 
we would regard as prudent behavior in preserving the surplus 
in the future.
    Mr. McCrery. Well, that is not clear to me at this point, 
at least not from your response. And I don't have time to 
follow up, but let me just point out to you that even though 
you do call for Congress to proscribe some sort of political 
targeting of investments, you obviously know that a law is just 
a law and any future Congress can change the law with a simple 
majority vote. Certainly, those of us who do have some 
reservations about the government investing directly in the 
stock market are not too assuaged by a law being passed, and it 
won't happen.
    Mr. Summers. I can appreciate the concern, and the only 
point I would add on that is as we do with respect to the caps 
in the budget process, there are a variety of kinds of 
procedural protections that can be put in place that would 
require much more than a simple majority. It would require 
extraordinary majorities and so forth to make any kinds of 
changes.
    But I think one also has to rely on, and I think we have 
seen a lot of political experience to suggest this, that once 
one has a set of procedures the idea that Social Security funds 
are being tampered with is one that I suspect would be 
sufficiently politically explosive so as to discourage that 
tendency in the future.
    Mr. McCrery. Thank you.
    Chairman Shaw. Mr. Doggett.
    Mr. Doggett. Thank you very much, Mr. Chairman. Will 
investing 15 percent of the trust fund in the private sector 
increase Social Security administrative costs, since Social 
Security has been so very efficient in the past?
    Mr. Summers. We believe that in contrast to an individual 
account approach that the effects would be very small. The 
costs of managing moneys of this size are in the range of a few 
basis a most; that is to say, less than one-tenth of 1 percent 
annually of the moneys that have been invested.
    And so I think the basic economy, whereby Social Security 
pays out in the range of 99 cents out of every dollar that it 
receives is something that could be preserved.
    In contrast, with even relatively efficient individual 
accounts, you could easily find yourself, and again, I don't 
mean to make a firm estimate because it depends on how it is 
done, in the range of as much as 20 percent of the account 
accumulation over 40 years going to pay various kinds of 
administrative costs. I think if you add the costs all in 
Britain and Chile, the figures are actually somewhat larger 
than 20 percent, although that is something that people argue 
about and no doubt with information technology, there will be 
some possibilities for improvement. But I think the costs could 
be rather large.
    Mr. Doggett. A multitude of voices have expressed concern 
about the declining savings rate in the country. Do you believe 
that the President's proposals for the USA accounts will 
address that concern?
    Mr. Summers. I certainly do believe that in an important 
sense, Congressman, savings, like life insurance, is sold, not 
bought. And you have to provide people with an incentive to 
save for the future. It's something that can be marketed as a 
savings vehicle. You know somewhere in the neighborhood, we are 
refining the estimate of 75 million Americans who have no 
pension, no 401(k), no IRA, and really are not part of that leg 
of that retirement security system. And I think by making these 
savings accounts universal, we can get a lot more people 
started on savings and correct what I think is a perhaps our 
Achilles' heel, along with education issues, in a period of 
remarkable prosperity. In the last quarter of last year, we 
actually had a negative personal savings rate in this country 
for the first time since the Depression. And there is a lot to 
disagree about here, but my guess is on a bipartisan way, we 
ought to be able to agree that that negative personal savings 
rate at a time of plenty is something that we should be working 
to address.
    Mr. Doggett. How do you view the proposal to just take 
Social Security off budget in phases, leaving the trust fund 
interest available, at least on paper, for more spending and 
more tax cuts?
    Mr. Summers. With, to be honest, Congressman, considerable 
concern. I think compared to the approach that the President 
favors, it has at least two important disadvantages. One, it 
would result in less fiscal prudence, more room for dissipating 
the surplus, and as a consequence, leave us with a larger tax 
burden to pay interest bills in the future at the time when our 
society is challenged by aging.
    Second, by not providing in any way for fortifying the 
trust fund with the benefits of debt reduction, it wouldn't do 
anything to strengthen the claim of future Social Security 
beneficiaries, and, therefore, it wouldn't really provide any 
of the kind of credibility and solvency that the system 
requires.
    Mr. Doggett. Thank you very much.
    Mr. Summers. Thank you.
    Chairman Shaw. Mr. Portman.
    Mr. Portman. Thank you, Mr. Chairman. Mr. Secretary, just 
following on to Mr. Doggett's question on personal savings and 
the USA accounts, I couldn't agree with you more, and I think 
this panel, on a bipartisan basis, shares your concern about 
the fact that many Americans do not have a 401(k), do not have 
an IRA, do not save adequately for their retirement, or have 
opportunities to do so. I would respectfully suggest that the 
USA accounts isn't the right way to do that, because I think 
you will find as you do your economic analysis, that will 
displace private savings, and, in fact, won't be leveraging 
those very private dollars about, which should be government 
policy. And we can aggressively go after this problem by 
reforming our pension system, by allowing people to contribute 
more, by offering tax credits, by allowing portability, by 
doing the catchup contributions that you have supported in the 
past. And so I would just say that there may be a better way to 
get at this, another way to skin the cat that is much more 
effective in terms of the taxpayers contribution here. Let us 
not bring the government into a position of taking the place of 
our employers and, instead let us expand private savings. I 
hope you will take a look at that.
    Mr. Summers. Congressman, just on that.
    Mr. Portman. Yes.
    Mr. Summers. We certainly will take a look at all those 
proposals, and I think the vast majority of what you said with 
respect to the private pension system, we would certainly 
support. My only comment on that would be that, for the 73 
million who are now out of the system, I think if anyone wants 
to reach them on a nearly universal basis, some supplement to 
the system is appropriate. But I think it is very important--
and this is something we have been very much focused on--that, 
in the design of any supplement to the system for those people, 
that we not do anything that is other than strengthening the 
existing employer-based system. And that is certainly very much 
a focus of ours.
    Mr. Portman. I think we will find that difficult. And we 
have talked about this before with some of your folks and with 
the Secretary in his testimony here. But we would love to work 
with you on that. I would say also, along the lines of what Mr. 
Matsui said earlier, we would love to see the details on the 
USA account. If it indeed is only for retirement and only for 
an annuity, I think a lot of us would feel differently about 
it.
    And I know there are still decisions to be made and we 
would love to see some legislative proposals on that and to 
work with you on it so it is not for first-time home buyers, it 
is not for education, it is not for other things that--although 
very important--don't help the solvency of the Social Security 
problem or backstop Social Security.
    On your proposal, I think we should respect the ideas and I 
concur with my colleagues who said that, including the 
Chairman. We do have some concerns and one is, as you know and 
you have said and the President has stated many times, this 
does not solve the problem over the 75-year period. It is not a 
proposal to solve Social Security under the timeframe in which 
we have to work.
    Second, the paying down of the debt issue. I have listened 
carefully and we have talked to some of your people about it. I 
have tried to understand this. I think the bottom line is this 
is a policy and a political decision, as you say. If we want to 
reduce debt, we can reduce debt, whether we do it with the 
trust fund or without. Linking it to Social Security may make 
it more likely that, indeed, the benefits of reducing the 
service and the debt go back to the trust fund. It may not.
    These are tough decisions. I don't think it necessarily is 
an integral part of this proposal one way or the other, but I 
would just sort of leave that almost to the side and focus, 
instead, on how do we get to that 75 years.
    On the higher rate of return, I commend the administration 
for doing that. And I think most of my colleagues do, on both 
sides of the aisle. Some of us believe that there are better 
ways to do it in terms of directing it by the individual, but I 
guess the question I would ask you with regard to individual 
accounts, and you have talked about the importance of the 
higher rate. You say there would otherwise have to be a 5-
percent benefit cut, there would otherwise have to be at least 
a year and a half rise in the age, just doing what you all do, 
which is the 15 percent.
    If you indeed believe that the higher rate of return is so 
important, isn't there a way to have the same benefits you talk 
about with regard to the government investing, doing it through 
individuals making that decision, and bringing it back into the 
Social Security system?
    Mr. Summers. There may be. We are certainly opening to 
considering a variety of suggestions that may be put forward. I 
think the concerns that that has to address are that the 
proposal we make preserves the defined benefit structure. So 
that if the stock market goes down 50 percent in some year, it 
is not the retiree whose benefits are getting scaled back by 
one-half.
    Mr. Portman. Yes. I would just say, with regard to that, I 
suppose one could say the same thing about the government-
direct investment, because the stock market will go up and down 
and there is a larger risk pool----
    Mr. Summers. Surely, but the--it is like----
    Mr. Portman [continuing]. But some of these same issues 
would have to be addressed.
    Mr. Summers. Well, I don't think quite, Congressman. It is 
like the difference in the private sector between having a 
defined benefit pension plan and having a defined contribution 
pension plan.
    Mr. Portman. Except that it depends how you set it up, of 
course. If you indeed have the individual making the decision, 
but bring it back into Social Security, taking, as the Chairman 
said earlier, into account a safety net or a floor. There may 
be a way to design it so that you minimize those risks, just as 
you would with investments.
    Mr. Summers. Those are--no. Those are----
    Mr. Portman. It would be directed by the government.
    Mr. Summers  [continuing]. Those are obviously issues that 
would have to be considered. As I say, the focus--the virtues 
that we believe are achieved by the collective investment which 
have to be considered in the context of all approaches, are the 
virtues that the individuals not at immediate risk from the 
fluctuation, the administrative costs virtue, and the 
preservation of an overall progressive structure. And there is 
always the question of what other possible ways are there of 
preserving those things.
    Mr. Portman. OK, my time is up. I would just thank you all 
for keeping this on the table and suggest that, with regard to 
the studies that were referenced earlier, there are various 
ways to do individual accounts, including addressing all three 
of those concerns and I hope that we can work together on a 
bipartisan basis. Otherwise, I don't see us getting to a deal 
this year. I thank the Secretary.
    Mr. Summers. I think we can. I think we can all agree that 
any satisfactory resolution here has to be both bipartisan, 
bicameral, and, if you like, bibranch, involving both the 
executive and the Congress.
    Mr. Portman. Stop there with the ``bi's.''
    Chairman Shaw. Bicameral may be a very hard thing to get 
over.
    Mr. Weller.
    Mr. Weller. Thank you, Mr. Chairman, and Mr. Secretary, I 
want to congratulate you on what I saw is a very flattering 
article in a national magazine. It was a nice photo, as well. 
And I have always wanted to meet somebody who saved, so 
congratulations.
    Mr. Summers. Don't believe everything--with respect, don't 
believe everything you read in the papers, Congressman. 
[Laughter.]
    Mr. Weller. Well. And just building on some of the comments 
by Mr. Portman and some of my colleagues regarding savings, of 
course, as we are talking about Social Security, private 
savings as a supplement to Social Security, of course, I also 
share that concern and I hope, particularly when it comes to 
the idea of a catchup mechanism and IRAs and 401(k)s, 
particularly for working moms who are off a payroll while they 
are home taking care of the kids and have an opportunity to 
make up those contributions later on. I hope we can work 
together in a bipartisan way.
    And I just want to better understand the President's 
proposal regarding Social Security. As I understand it, he 
wants to take 62 percent of the surplus, set that aside until 
we come up with some solution for saving Social Security. And 
then he wants to take 25 percent of the Social Security Trust 
Fund and invest that in corporate America. That is essentially 
the proposal as I understand it. And I am just trying to get a 
better understanding of what the President considers as part of 
the surplus.
    I know my Governor and State legislators would want to ask 
this question. In the President's budget, it is my 
understanding that you want to essentially take about a $5 
billion tax on the States' share of the tobacco settlement. And 
is that part of the surplus?
    Mr. Summers. I am going to have--I apologize, Congressman. 
I am going to have to give you an answer in writing to that 
because I just don't--OK?
    [The following was subsequently received:]

    No, it wasn't part of the surplus. The Administration did 
not propose to collect the money. The basis of the state 
lawsuits against tobacco companies was to recover tobacco-
related costs to the Medicaid program. Because Medicaid costs 
are shared between the Federal government and the state 
governments, the Administration had an obligation under Federal 
Medicaid law to ``recoup'' part of the state settlements. 
Having said that, we had hoped to work with the States and 
Congress to reach an agreement waiving Federal claims to these 
funds in exchange for a commitment by the States to use the 
tobacco settlement payments for certain activities including 
public health and children's programs.
    The Administration was extremely disappointed that the 
Congress failed to require States to use even a portion of the 
funds collected from the tobacco companies to prevent youth 
smoking. Even though 3,000 young people become regular smokers 
every day and 1,000 will have their lives cut short as a 
result, most States still have no plans to use tobacco 
settlement funds to reduce youth smoking. This bill represented 
a missed opportunity by the Congress to protect our children 
from the death and disease caused by tobacco. The 
Administration will closely monitor State efforts in this area, 
and will continue to fight for a nationwide effort to reduce 
youth smoking through counter-advertising, prevention 
activities, and restrictions on youth access to tobacco 
products.
      

                                

    Mr. Weller. OK.
    Mr. Summers. The people at OMB handle the budgetary 
treatment on that and I just don't know the answer. I don't 
know the answer to your question. It is possible that a note 
will be handed to me with the answer to your question, but I 
don't know it.
    Mr. Weller. OK, well. I would like to know that because 
that $5 billion tax on Illinois and other States----
    Mr. Summers. We will get back to you on that.
    Mr. Weller [continuing]. It is my understanding you may 
consider that part of the budget.
    The second is the President proposes $165 billion tax 
increase as part of his budget proposal. Is that tax increase 
part of the surplus?
    Mr. Summers. Well, certainly, all the elements in the 
President's proposal, both the revenue raisers that I think you 
may have been referring to and the targeted tax cuts contained 
in the President's budget all enter into the calculation of the 
unified surplus.
    Of course, the President, just to clarify one point, the 
President's proposal was that he believed we could use 62 
percent as part of a framework for resolving Social Security.
    Mr. Weller. Yes. I understand--excuse me.
    Mr. Summers. But his position continues to be that we 
shouldn't use any of the surplus--I think this is a crucial 
point--we shouldn't use any of the surplus until we are 
successful in finding a framework for resolving Social 
Security.
    Mr. Weller. Well, reclaiming my time, Mr. Secretary, but--
so if Congress did not pass $165 billion in tax hikes, 
essentially you are saying the surplus would be smaller. 
Because you are counting that $165 billion in tax increases in 
the President's budget as part of the budget when you talk 
about the unified----
    Mr. Summers. I am not--I think, clearly, if you didn't pass 
other components, the surplus wouldn't materialize in the way 
you suggested.
    Mr. Weller. OK.
    Mr. Summers. I don't think by the--certainly by the 
definitions we would use, I don't think the President's budget 
contains anything like $165 billion in tax increases. There may 
be differences in how we and you view certain of the items from 
the point of view of accounting, as to whether they are taxed 
or not.
    Mr. Weller. Mr. Secretary, the Joint Committee on Taxation 
has analyzed the President's budget and they said that there is 
$165 billion in what you call revenue raisers, but most people 
call tax increases.
    Mr. Summers. Well, some of that goes, I think, to some of 
the moneys associated with the tobacco settlement, as you 
suggested.
    Mr. Weller. Yes. In trying to better understand the 
President's proposal on Social Security also, so far you have 
declined to actually offer any specifics on a proposal beyond 
its part of the surplus and the trust fund. As I understand it, 
some of the options that Congress and the President have looked 
at and talked about behind closed doors, does the 
administration support or oppose a tax increase as part of the 
Social Security solution? Just support or oppose?
    Mr. Summers. We don't think that is the primary way to go.
    Mr. Weller. OK. Benefit cuts?
    Mr. Summers. We think that it is necessary--we can even go 
a long way, out to 2055----
    Mr. Weller. Just support or oppose.
    Mr. Summers [continuing]. With the administration's 
proposal. The remainder has to be worked out in the bipartisan 
process.
    Mr. Weller. OK. Eligibility age. Do you support or oppose 
changes in that?
    Mr. Summers. All has to be addressed in the context of the 
bipartisan process.
    Mr. Weller. Raising the cap above the $72,000?
    Mr. Summers. Bipartisan process.
    Mr. Weller. OK. So you are open to all these ideas, then, I 
take it? So you are open to cutting benefits----
    Mr. Summers. We believe the primary thrust----
    Mr. Weller [continuing]. You are open to raising taxes?
    Mr. Summers. Well.
    Mr. Weller. How about means testing? Are you open to that 
idea or do you support or oppose means testing?
    Mr. Summers. I think the President has indicated very great 
concerns in that area.
    Mr. Weller. OK.
    Mr. Summers. The remainder, most of the other things you 
have mentioned, I think, are things that could be looked at in 
a bipartisan process.
    Mr. Weller. OK.
    Mr. Summers. But we think the thing to do first is to set 
aside that surplus and get----
    Mr. Weller. To reclaim my time, there are some last couple 
options, Mr. Secretary. Personal accounts as part of Social 
Security. Not as a supplement to, but as part of. Do you 
support or oppose?
    Mr. Summers. Don't have a--not something that can be judged 
in the abstract without looking at whole proposals.
    Mr. Weller. You are open to that. So you are open to tax 
increases. You are open to benefit cuts. You are open to 
changing the eligibility age. Means testing--you don't seem to 
like that idea. You are open to personal accounts. Your 
response to the question.
    Mr. Summers. Open to. We believe the place to go with this 
is 50 years with the President's proposal and it can be a 
bipartisan process behind that. My guess is many, probably most 
of those items on the list would be things that neither nor----
    Mr. Weller. But you are not saying no to any of those 
ideas.
    Mr. Summers [continuing]. Neither we nor other participants 
in a bipartisan process would choose to go, but I don't think 
it is appropriate to start trying to prejudge that. I didn't 
mean to suggest----
    Mr. Weller. OK.
    Mr. Summers [continuing]. I did not mean in any way to 
suggest receptivity to any of those things in my answer, only a 
desire not to prejudge that bipartisan process.
    Chairman Shaw. The time of the gentleman has expired.
    Mr. Weller. Thank you, Mr. Chairman.
    Chairman Shaw. Mr. Tanner.
    Mr. Tanner. Thank you, Mr. Chairman. Mr. Secretary, thank 
you for being here, and I want to follow up on just a couple of 
things and see if we can put it in some sort of perspective. 
You mentioned the two types of debt that comprise the 
``national debt.'' One is interagency debt, that debt that the 
Treasury owes to the Social Security Trust Fund because the 
Social Security Trust Fund transferred FICA taxes to the 
Treasury that were used for some public purpose, consistent 
with the law.
    The other $3.56 trillion is debt that is owed to 
nongovernmental agencies, to people, to banks, to institutions, 
a third of which is owned by foreign interests. Now, as you 
were talking about paying down the debt, I hope you were 
talking about paying down this debt that actually is real, that 
we pay interest on every year; last year to the tune of $246 
billion. That is the debt that is real.
    Now, in terms of this interagency debt. Call it what you 
will. You could call it a certificate, an interest-bearing 
certificate, whatever. What I characterize that as is basically 
a call on future tax dollars that says we are going to honor 
these obligations. You can quantify them with certificates or 
bonds or notes or bills. They could have an interest rate of 20 
percent or an interest rate of 1 percent. It doesn't really 
matter because it is--you can quantify it any way you like, but 
it is a call on future tax dollars to the extent that we have 
Social Security defined benefits in the law, given a person 
reaches a certain age.
    Would you take issue with anything that I have said?
    Mr. Summers. No, I would entirely agree and I thought you 
put it very accurately. And, frankly, Congressman, the next 
time I have occasion to try to explain this, I will steal some 
of what you just said.
    Mr. Tanner. Well. This is homespun logic from my point of 
view because I have to simplify things, I think, so that I can 
understand them and, more importantly, explain to people.
    Now, when we talk about saving Social Security, however one 
characterizes it, if we use the surplus, whether it comes in 
from Social Security FICA taxes, whether it comes in through 
increased income taxes because of the great economy, or 
whatever, there is this finite amount of money coming to the 
U.S. Treasury. If we retire this $3.56 trillion debt, we not 
only are in a better position at some future date when the 
Social Security bubble hits to borrow to pay it and we plus 
have the benefit of whatever interest payments we are then 
saving at that later date because we have paid or redeemed or 
retired this outstanding debt that we have to pay interest on 
every year.
    Now, as it relates to that idea, I want to commend the 
President's plan. I would just simply say, I don't think that 
we go far enough. I realize the political realities, but I 
would like to go much farther and to say all surpluses that are 
being paid into the Social Security Trust Fund now would be 
used to retire this $3.5 or $3.6 trillion debt. That would--you 
don't have to get into double or triple accounting. You just 
say everything that comes in that we don't need, we will begin 
to retire this outstanding indebtedness.
    We will be in a much better position in the future if we do 
that, in my opinion, than if we have an across-the-board tax 
cut. Nobody ever talks about using the surplus, whether it be 
in Social Security or on the budget to pay back some of what we 
have borrowed in the last 20 years. Nobody talks about that, 
but that is what ought to be done. It is what a business would 
do.
    But we have all of these ideas about what we are going to 
do with this great projected surplus, but you very seldom hear 
somebody say, you know what? We ought not to leave this debt to 
our kids. What we really ought to do is pay down some of this 
so we will be in a position to either, one, borrow the money at 
that time in the future when we owe the Social Security Trust 
Fund or we can use the moneys that we have saved on interest to 
do it.
    I wanted to ask one other question about individual 
accounts and about the so-called clawback provision that I have 
read about. I don't understand it. But we can get into that at 
a later time, because I see my time has expired. Thank you for 
being here.
    Mr. Summers. Thank you.
    Chairman Shaw. Mr. Hulshof.
    Mr. Hulshof. Thank you, Mr. Chairman. Mr. Secretary, 
welcome. Following up on my friend from Tennessee's question, 
in his homespun way, which was a good way to define it, you are 
not suggesting, are you sir, that the internal government debt 
is not real? I mean, the fact is that the full faith and credit 
of the U.S. Government supports that internal government debt, 
does it not?
    Mr. Summers. It is a commitment that will surely be 
honored. It is not a commitment that has impacts on the real 
economy in the same way because it is purely intragovernmental, 
just as, for example, there is a big thing about General 
Motors. There is a big difference between debt that General 
Motors shareholders owe the public and debt that Buick owes 
Chevrolet, both of which are internal to General Motors. And 
that is the kind of distinction that I think Mr. Tanner was 
trying to draw in his comments and that I had drawn in my 
earlier comments.
    Mr. Hulshof. And, certainly, recognized that a man of your 
intelligence and expertise in this area and even some Members 
on this Subcommittee that understand that, but back home, when 
people talk about paying down the debt, they don't understand 
sometimes the nuances that we speak of.
    In fact, let me ask you. Last week we had the head of the 
General Accounting Office who testified, perhaps sitting in the 
same seat you are, Mr. Walker, who said that if Congress did 
nothing and allowed current law to operate that the Federal 
debt would be paid down more than if we adopted the President's 
plan. Do you agree or disagree with Mr. Walker's statement?
    Mr. Summers. If Congress did nothing for the next 15 years, 
chose no new spending programs, chose no new tax cut programs, 
indeed, I suspect, the debt would be reduced more rapidly. I 
would, again, defer to others on the political question, but 
would respectfully suggest the possibility that the likelihood 
of Congress doing nothing in the face of multihundred billion 
dollar surpluses is perhaps not so great. And that is why the 
precommitment of the contributions to Social Security that the 
President envisions seem to us to be so very important, both in 
terms of prudent fiscal policy, running down the debt, and in 
terms of what it means to the future of the Social Security 
system.
    Mr. Hulshof. Mr. Secretary, let me follow up on a point 
that you made in your testimony and then my friend from Texas 
made, Mr. Doggett, who has raised some concerns with other 
witnesses and other panels about the administrative costs. You 
mentioned that--and others have pointed out--that the 
administrative costs for personal accounts can be as high as 15 
to 20 percent or you said possibly even higher.
    But is this not the case that back in 1940--and clearly we 
understand now from the trustee's report that the 
administrative costs that the Social Security Administration 
has now is around 1 percent and you mentioned that as well. But 
back in 1940, it is my understanding that the Social Security 
administrative costs were equal to 74 percent of the benefit 
outlays. In fact, a short 5 years after that, these costs had 
fallen--the administrative costs had fallen to about 10 
percent. Do those numbers ring true with you? And I see some 
staff--I thought I saw a head nodding behind you. You may want 
to confer with your staff.
    Mr. Summers. I am not familiar with the 1940 experience, 
but I am familiar with the argument that the costs will come 
down over time. And no doubt there would be some tendency in 
that direction. The system in Chile has been in place for some 
15 years and the costs there are in the range of 20 percent.
    The mutual fund industry has been in place for nearly 50 
years and it continues to be the case that the typical mutual 
fund in the United States involves costs on the order of 100 to 
150 basis points. If you work that out over the 20 years over a 
40-year lifetime, it would represent about 20 percent of a 
lifetime's costs. But, no doubt, there would be some 
improvements and that is something that should be factored in. 
There would also be startup costs that actually aren't 
reflected in the 20-percent figure.
    Mr. Hulshof. OK. With all due regard to the Ranking Member 
who, I think, has been very forceful and has been working on 
this many years, those of us who may ask questions about the 
President's plan not necessarily are trashing or being 
critical, and yet I think there are legitimate questions.
    And probably my final question to you would be this. Social 
Security has always been self-financed. Payroll taxes are 
sacred. And yet it is my understanding--and please correct me 
if I am wrong--that, were the President's plan to be 
implemented, that we would then be using general revenue funds, 
that is income taxes, and no longer would we have this firewall 
or distinction. Is that true? And what are your views regarding 
using general revenue funds to save Social Security?
    Mr. Summers. I think the President's plan with its use of 
unified surpluses does represent an innovation in financing 
Social Security, but one that is very different from general 
revenue financing as it has historically been contemplated. 
Very different because one is not envisioning taking on a new 
set of obligations. Very different because the financial 
contribution is temporary rather than some commitment to the 
tax stream permanently. And very different because what is 
being contributed is a surplus that is being used to directly 
pay for itself, that is it is directly paying for the 
contributions by reducing future interest burdens.
    So, yes, I think it does represent a departure, but I would 
argue an appropriate departure in light of the opportunity that 
is presented by the very large surpluses that we will have, not 
forever, but that we now appear likely to have for some number 
of years going forward.
    Mr. Hulshof. Thank you.
    Chairman Shaw. OK. Dr. Summers, I have one question on an 
area that we haven't covered. In the President's budget, I 
believe he talked about the elimination of the earnings limit 
on Social Security. You have been quoted as to raising the 
earnings limit. What is the position of the administration or 
is the administration open on both areas?
    Mr. Summers. I haven't seen myself quoted. My understanding 
was that our position was that the earning's limit should be 
eliminated.
    Chairman Shaw. OK. I thank you. And I want to thank you for 
your testimony. If there is one thing that I have really gotten 
out of it is that the administration is not drawing lines in 
the sand. And I think that is terribly important that none of 
us draw lines in the sand at this particular point. Your 
openness and frankness to this Subcommittee is appreciated. We 
appreciate your testimony.
    Mr. Summers. Thank you very much, Mr. Chairman. And let me 
just say that I appreciated this opportunity to testify, and I 
neglected in my opening comments to thank Mr. Matsui for his 
role in ensuring that the administration had an opportunity to 
raise many of its concerns in this context. And to look forward 
very much to, as I think we have all emphasized, working on a 
bipartisan basis with you, along with Mr. Matsui and his 
colleagues on these very critical issues. And I think there is 
a lot that we can agree on on a bipartisan basis, but I think 
there are also some very real issues that we are going to have 
to resolve where, at this point, there do appear to be some 
differences in perspective.
    Thank you very much.
    Chairman Shaw. Dr. Summers, if the administration shares 
the goals of Chairman Archer and me as Chairman of this 
Subcommittee, the determination to solve the Social Security 
problem and solve it today, I am convinced that we will do so.
    Thank you very much.
    Mr. Summers. Thank you.
    Chairman Shaw. Next, we have a panel of witnesses. We have 
Lawrence White. Dr. Lawrence White is professor of economics at 
Stern School of Business at New York University; Hon. Maureen 
Baronian, who is vice president and principal of Investors 
Services of Hartford, Inc., Hartford, Connecticut, and is 
former State representative in the Connecticut General Assembly 
and former trustee, Investment Advisory Council in the State of 
Connecticut; Michael Tanner, director, Health and Welfare 
Studies, the Cato Institute; Dr. Robert Reischauer, who is the 
senior fellow, economic studies, at the Brookings Institution, 
a former Director of the Congressional Budget Office; Dr. 
Carolyn Weaver, director of Social Security and Pension 
Studies, the American Enterprise Institute and a former member 
of the Advisory Council on Social Security; and Hon. Fred 
Goldberg, Skadden, Arps, Slate--I am having trouble with this--
Meagher and Flom, former Commissioner for the Internal Revenue 
Service and former Assistant Secretary for Tax Policy of the 
U.S. Department of the Treasury.
    We have all of your written testimony, which will be made a 
part of the permanent record, without objection, and we would 
ask you to proceed as you see fit.
    I would like to make an announcement at this time that this 
Subcommittee will recess at 12 and then reconvene again at 1. I 
hope that doesn't inconvenience any of our witnesses.
    Dr. White.

STATEMENT OF LAWRENCE J. WHITE, PH.D., PROFESSOR OF ECONOMICS, 
         STERN SCHOOL OF BUSINESS, NEW YORK UNIVERSITY

    Mr. White. Thank you, Chairman Shaw, Members of the 
Subcommittee. I am pleased and honored to be invited to testify 
before your Subcommittee today.
    The future of the Social Security Program is one of the 
most important public policy issues that currently face our 
Nation. 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 is also burdened with latent financial problems that 
threaten its future. Further, the basic structure of the Social 
Security Program remains widely misunderstood.
    In my written testimony, I have offered a 12-step plan for 
understanding Social Security, its problems, and some real and 
not-so-real solutions. I will try to summarize that testimony 
this morning.
    First, as Deputy Secretary Summers repeatedly said, Social 
Security is a defined benefit plan. The benefits of a worker 
are linked through a complicated formula to his or her income 
during his or her working life. The structure of this defined 
benefit and strength of this defined benefit program is in the 
Congress' promise to pay those benefits.
    Second, the program, as we all know, is financed through 
wage taxes. It is a pay-as-you-go program. There is no direct 
link between what a worker pays in and what he or she receives 
in benefits. There are no canned goods piling up as resources 
as a result of a worker's contributions. In this context, it is 
the net annual cash flow of the program that is the crucial 
concept. Currently, this net annual cash flow is positive. It 
is running about $80 billion a year. But as Chairman Shaw 
indicated, around the year 2013, that cash flow will start to 
become negative. That is the crucial crunch-point for the 
Social Security Program. Not the year 2032, which is when what 
one often reads, but the year 2013. And for Social Security, 
this is an eyeblink.
    Next, the presence of Treasury bonds in the so-called trust 
fund adds absolutely nothing to the strength of the program. 
They are not canned goods. For this defined benefit program, 
the strength of the Social Security Program is the promise of 
the Congress to make good on promised benefits. In this 
context, as Deputy Secretary Summers indicated, President 
Clinton's proposal to use 2 trillion dollars' worth of future 
surpluses to buy back public debt, debt that is held in the 
hands of the public, is clearly going to provide the kinds of 
beneficial consequences for the U.S. economy that Deputy 
Secretary Summers indicated. It is basically a good idea.
    But then placing those repurchased Treasury bonds in the 
Social Security Trust Funds does absolutely nothing. It does 
not add to the strength of the fund. It is window dressing, at 
best. As Deputy Secretary Summers indicated, it is a marker 
indicating that the repurchasing of the debt is going on.
    Now the plan to purchase about 700 billion dollars' worth 
of private sector securities at least does provide real 
resources for the program. But I think there are real and 
substantial problems to having the Social Security 
Administration do the investing of these $700 billion. There 
are huge problems of choice as to what they should invest in, 
how should they invest. And I think these decisions are subject 
to potential abuse. This worries me greatly.
    Also, and this is an area that has received much less 
attention, to the extent that the Social Security 
Administration would do the investing, they would be limited to 
the 10,000 largest publicly traded companies in the U.S. 
economy. The millions of other smaller enterprises in the 
country that are not publicly traded would see none of this 
investment flow.
    There is another way. It is a personal savings account 
approach that I think would be valuable as a component of the 
Social Security Program. The devil is in the details. I am not 
going to propose a specific plan, but there are two important 
principles that should be observed. First, a PSA Program should 
be voluntary. Second, it should be structured along the lines 
of the current IRA Programs. That means a wide choice of 
investment vehicles and bringing a regulated financial 
institution with fiduciary obligations into the picture.
    This PSA component would allow individuals, families, to 
tailor their choices to their knowledge, their information, 
their age, their family status, their tolerance for risk, and 
other personal considerations. For the less sophisticated, less 
knowledgeable, for risk-averse individuals, there would be the 
familiar FDIC-insured bank account. As of 1991, almost half of 
IRA funds were invested in bank accounts or similar type 
instruments.
    The stock market is not for everyone and an IRA-type 
approach recognizes that. And it would have the advantage that 
these types of investments would be rechanneled by the banks 
and other financial institutions to those millions of smaller 
enterprises that are not going to see a penny out of any Social 
Security Administration-directed investments.
    A potential objection to the PSAs are their transactions 
costs. I do not believe this is a real objection. I am greatly 
impressed with the ability of the private sector financial 
institutions to structure low-cost accounts, perhaps with some 
limitations to deal with the transactions costs problem.
    In summary, Mr. Chairman, 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 for this opportunity.
    I'll be happy to answer questions.
    [The prepared statement follows:]

Statement of Lawrence J. White, Ph.D.* Professor of Economics, Stern 
School of Business, New York University

    Chairman Archer, Members of the Committee: I am pleased and 
honored to be invited to testify before your Committee today.
---------------------------------------------------------------------------
    * During 1995-1996 I was a consultant to the Investment Company 
Institute on the subject of Social Security reform.
---------------------------------------------------------------------------
    The future of the Social Security program is one of the 
most important public policy issues that currently face our 
nation. 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 is also burdened with latent financial problems that 
threaten its future. Further, the basic structure of the Social 
Security program remains widely misunderstood.
    In the interests of advancing the debate, let me offer:

A TWELVE-STEP PLAN FOR UNDERSTANDING SOCIAL SECURITY, ITS PROBLEMS, AND 
                  SOME REAL AND NOT-SO-REAL SOLUTIONS

    ONE To understand what Social Security is, it is useful to 
start by explaining what Social Security isn't. Imagine an 
extremely simple ``retirement plan'': A worker saves 10% of her 
income during each year of her working life and with those 
savings consistently buys canned goods, accumulating them in a 
large closet. Then, during her retirement, she eats the canned 
goods.
    This is clearly a metaphorical retirement plan, with many 
practical drawbacks. But it has two important features: The 
worker has invested in real resources (the canned goods). And 
there is a direct connection between what she has contributed 
to her retirement plan and what she eventually receives from 
it. In the terms of modern pension phraseology, hers is a 
defined contribution pension plan.
    TWO To make the above example slightly more realistic, let 
us instead imagine that the worker, so as to avoid the 
inconvenience of piling up 40 years of canned goods herself, 
pays that same 10% of her income each year to her local grocer, 
who in turn hands her an ``I.O.U.'' for the sum and promises to 
deliver the appropriate amounts of canned goods upon her 
retirement. So long as the grocer remains honest and 
economically viable, this retirement plan is essentially the 
same as the previous one. The worker is still investing in real 
resources, only one step removed: She has claims on real 
resources. And she still has a defined contribution plan.
    THREE It is only a modest modification of step two to have 
the worker instead invest that 10% of her annual income in 
corporate stocks and bonds, which again are claims on real 
resources; or to have her invest in mutual funds, which 
purchase those claims on her behalf; or to have her place her 
annual 10% of her income in a bank, which then lends it out in 
the form of business loans. We have now virtually replicated a 
modern IRA or 401(k) retirement plan, with claims on real 
resources and a defined contribution retirement plan.
    FOUR Contrary to much popular perception, the Social 
Security program bears absolutely no resemblance to the 
retirement plans described in steps one, two, or three. 
Instead, the retirement benefits that a worker is statutorily 
promised are linked loosely, through a quite complicated 
formula, to the wages that she receives during her working 
life. In this important sense, Social Security is a defined 
benefit program.
    FIVE The financing for the Social Security program comes 
from abroadly based tax on wages: 6.2% of a worker's annual 
wages (up to a maximum wage base of $72,600, as of 1999) is 
paid by the worker, and another 6.2% is paid by the worker's 
employer. But there is no direct link between what a worker and 
her employer pay into the program and the benefits that she 
receives when she retires. The money that current workers pay 
into the Social Security system is mostly paid directly out to 
current retirees. It is a pay-as-you-go system. There is no 
piling up of canned goods, or (more realistically) of claims on 
real resources for any worker, as a consequence of that 
worker's Social Security contributions.
    SIX In this pay-as-you-go framework, the ``net'' annual 
aggregate cash flow of the Social Security program--the annual 
wage tax payments into the program, minus the annual payments 
to retirees--is the crucial concept. In recent decades this net 
annual aggregate cash flow has been positive: Workers (and 
their employers) have been paying more into the program than 
retirees have been pulling out. This cash-flow surplus has been 
``transferred'' to the U.S. Treasury and has been used as just 
another source of revenue to support the other spending 
activities of the Federal Government (e.g., defense spending, 
farm subsidies, interest payments on the national debt, etc.); 
in essence, the Social Security cash-flow surplus has been used 
to offset partially the net deficit that the U.S. Government 
has been running on the remainder of its activities. That cash-
flow surplus has not been invested in real resources that would 
be the equivalent of the canned goods of step one or the claims 
on real resources of steps two or three.
    In recognition of these transfers, the Treasury has duly 
created appropriate amounts of special bonds and credited them 
to the Social Security ``Trust Funds.'' The bonds even ``pay'' 
interest (which just involves the creation of still more 
Treasury securities and the crediting of them to the Trust Fund 
account). But the presence of these Treasury securities in the 
Social Security Trust Funds does not add anything real to the 
basic financial position of the Social Security program. The 
statutory promise by the Congress to pay benefits to retirees 
(current and future) is already present. The presence of these 
Treasury securities does not provide the Social Security 
program with any additional real resources that can be used to 
make benefit payments. The Treasury securities are not canned 
goods or claims on real resources; they are just another set of 
promises-to-pay by the Congress.
    Further, even if one thought that the presence of the 
Treasury securities in the Trust Funds did somehow represent a 
stronger commitment by the Congress to make good on its 
promises to retirees, the amounts of Treasury securities in the 
Trust Funds are far short of the sums necessary to fulfill all 
promises to retirees. (This shortfall is due, of course, to the 
pay-as-you-go structure of Social Security: The Treasury 
securities have been created only when the program has run 
aggregate annual surpluses, rather than when the statutory 
obligations to future retirees have been created.)
    SEVEN For this pay-as-you-go structured program, the true 
fiscal ``crunch'' will occur in the year 2013, when the net 
annual aggregate cash flow becomes negative; i.e., when the 
annual payments by workers and their employers fall short of 
the annual payments to retirees. This fiscal pattern will arise 
because of the longer lives of retirees and other demographic 
and economic characteristics of the American population. It is 
at this point that the Social Security program will cease being 
a net surplus program, and fiscal transfers into the program 
will be required. If the statutory promises to retirees are to 
be honored, taxes will have to be raised, or other Federal 
Government spending will have to be reduced, or more Treasury 
debt will have to be issued to the general public (or less debt 
will be bought back from the general public, depending on the 
Federal Government's overall budgetary position at that time). 
Or the promises will have to be modified (e.g., later 
retirement ages, or reduced payment benefits, etc.)
    The presence or absence of the Treasury securities in the 
Trust Funds at this point will make absolutely no difference to 
the true fiscal position of the program or the necessary 
actions that will have to be taken in order to continue to 
honor the statutory promises to retirees.
    This point in time--2013--is only fourteen years away, 
which is a mere ``eyeblink'' for the Social Security program, 
since fundamental fairness requires that any changes to the 
program (e.g., a delay in retirement ages) should be gradually 
phased in, over a long period of time. Also, it is far sooner 
than the year 2032, which is the date on which most media 
accounts of Social Security's problems have focused. This 
latter year is the date when the Trust Fund's Treasury 
securities will be ``exhausted'' (in ``cover'' the net negative 
annual cash flows of the previous two decades). But, again, the 
presence of the Treasury securities will have made absolutely 
no difference with respect to the necessary fiscal actions of 
those previous two decades; and, as of 2032, the net negative 
annual cash flow of the Social Security program will be about 
$750 billion ($250 billion in constant 1998 dollars), or over 
1.8% of U.S. GDP in that year.
    EIGHT An understanding of the Social Security's pay-as-you-
go structure also helps focus attention on what actions 
actually do provide real improvements in the program's finances 
and what actions constitute mere window dressing. For example, 
the Clinton Administration has proposed to use $2.7 trillion of 
federal budgetary surpluses over the next 15 years to support 
Social Security. Of this sum, about $700 billion is to be used 
by the Social Security Administration directly to buy private-
sector securities. The remaining $2 trillion would be used to 
repurchase Treasury securities from the general public, with 
the bonds then being ``deposited'' in the Social Security Trust 
Funds.
    Let us analyze the latter actions first. The use of $2 
trillion to repurchase outstanding Treasury securities is a 
sensible policy action. It will add to the U.S. economy's 
saving rate and encourage greater private sector investment, 
thereby leading to higher levels of productivity, income, and 
wealth. But the placement of the repurchased bonds in the Trust 
Funds is pure window dressing. The presence of extra bonds in 
the Trust Funds will make no difference with respect to the 
actions that must be taken after 2013.
    This perspective also clarifies an often-suggested 
``solution'' to Social Security's problems: raising the 
combined employee/employer tax rate to about 14.4% of the wage 
base (as compared to the 12.4% combined rate today). Contrary 
to the claims of the advocates of this action, this wage-tax 
increase would not permanently solve Social Security's 
problems. It would simply delay by about five years (to 2018) 
the ``crunch'' point at which the net annual aggregate cash 
flows would become negative. This action would achieve nothing 
real for Social Security between now and 2013 (it would just 
increase the net annual aggregate cash-flow surplus of the 
program and add Treasury securities to the Trust Funds). The 
added tax revenues coming into the program would sustain cash-
flow surpluses between 2013 and 2018. But the cash outflows 
after 2018 would then overwhelm this somewhat larger stream of 
cash inflows. 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.
    NINE The proposal to channel $700 billion into stocks and 
bonds is slightly more promising. At least this action would 
channel claims on real resources into the Social Security 
program. But it would not alter the fundamental ``defined 
benefit'' structure of the program.
    Further, as many other commentators have pointed out, 
having the Social Security Administration invest the funds 
(which could eventually total about 4% of U.S. corporate value) 
could potentially open the door to political influence as to 
the choice of companies in which Social Security invests. 
Should the program invest in just the S&P 500? Or in all 
publicly traded companies? What about overseas-based companies? 
What about companies that have been convicted of criminal 
violations? What about tobacco companies? etc. Unfortunately, 
the record of a number of the states in their investment 
policies and actions with respect to state employees' pension 
funds is not reassuring. Perhaps the Federal Government's 
record would be better; but perhaps not.
    Further, should Social Security also invest part of its 
funds in debt securities? What kinds of debt securities? Only 
corporate debt? What about state and local government debt 
obligations? What about securitized home mortgages? Securitized 
commercial real estate mortgages? Securitized credit card debt? 
Securitized auto loans? The varieties of debt securities are 
many, and the advocates of each kind will surely not hide their 
enthusiasm for their variety.
    Another important and unavoidable drawback to this route, 
and one that has gained much less attention, would be the 
restricted investment focus of such a program. Even if the 
Social Security program were somehow able to invest in a broad 
index of all publicly traded companies in the U.S., this focus 
would still restrict the program's investment flows to the 
10,000 or so largest companies in the U.S. Neglected would be 
the millions of smaller enterprises in the U.S. that are not 
publicly traded and that get their financing primarily through 
debt finance--i.e., through loans from banks and other 
financial intermediaries. Until such loans become regularly 
securitized (the way that home mortgage-based securities are 
easily bought and sold today), these millions of smaller 
enterprises will be cut off from the Social Security investment 
flows. And even with securitization, it seems likely that an 
index-fund orientation for Social Security would largely or 
entirely bypass this sector.
    TEN There is another way. A system of personal savings 
accounts (PSAs), as a component of the Social Security program, 
would be a valuable step toward moving the program in the 
direction of a defined-contribution structure that would bring 
greater personal choice and responsibility, while maintaining 
an acceptable level of redistribution.
    A large number of PSA variants have been proposed, and for 
a program as complex as Social Security truly ``the devil is in 
the details.'' Rather than advocate a specific plan, I will set 
forth two important principles that should guide any structure.
    First, a PSA plan should be voluntary. Though many Social 
Security participants will be eager to embrace PSAs, others 
will be reluctant. That choice should be available.
    Second, the PSAs should be structured along the lines of 
the current investment retirement account (IRA) program. That 
is, a wide choice of investment vehicles and instruments, 
including bank accounts and similar depository instruments, 
should be available to PSA 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.
    ELEVEN This broad-choice structure would have many 
advantages. First, it would give participants a wide range of 
opportunity to tailor their investments to their knowledge and 
information, their age and family status, their tolerances for 
risk, 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 those 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. This strong advantage would not be present if 
the Social Security Administration directly invested the funds 
or if PSA participants were limited to a handful of index-fund 
products (as is true for the Thrift Savings Plan that serves as 
the retirement plan for employees of the Federal Government).
    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.
    TWELVE In summary, 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 latent 
problems.
    Reforming the program will not be easy. Social Security is 
complex, and its basic structure is widely misunderstood. 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 Shaw. Thank you, Dr. White.
    Ms. Baronian.

   STATEMENT OF HON. MAUREEN M. BARONIAN, VICE PRESIDENT AND 
  PRINCIPAL, INVESTORS SERVICES OF HARTFORD, INC., HARTFORD, 
 CONNECTICUT; FORMER STATE REPRESENTATIVE, CONNECTICUT GENERAL 
  ASSEMBLY; AND FORMER TRUSTEE, INVESTMENT ADVISORY COUNCIL, 
                      STATE OF CONNECTICUT

    Ms. Baronian. Thank you. Chairman Shaw, Ranking Member 
Matsui, and Members of the Subcommittee, thank you for inviting 
me to be here today. As a member of the Investment Advisory 
Council for the State of Connecticut from 1987 to 1995, I have 
seen firsthand the results of allowing governments to invest 
directly in private equity markets. I can only hope that my 
experiences will help enlighten this Subcommittee as it 
considers President Clinton's proposal to invest a portion of 
the Federal Social Security surplus in private markets.
    Almost 10 years ago, on March 22, 1990, the State of 
Connecticut retirement and trust funds joined with members of 
the United Autoworkers, some existing members of Colt 
management, and a few other private investors to complete a 
buyout of the Colt Firearms division of Colt Industries, Inc. 
In all, the State placed $25 million in State pension funds 
into this buyout: $17.5 million in CF Holding and $7.5 million 
in CF Intellectual Properties which owns the Colt trademark. 
This investment gave the State of Connecticut a 47-percent 
share of Colt Manufacturing.
    Unfortunately, in less than 2 years, on March 18, 1992, CF 
Holding Corp. filed for chapter 11 bankruptcy. Fortunately, the 
State pensions loss was ``limited to only'' $21 million, after 
the Colt trademark was sold to the Economic Development 
Authority of Connecticut 2 years later.
    While it is not uncommon for pension funds to lose money on 
the investments they make, the case of Connecticut's investment 
in Colt is an example where politics, not prudence, led to the 
failed investment.
    For months leading up to the investment, Connecticut 
newspapers were filled with editorials and news reports on the 
financial crisis facing Colt Manufacturing, a company that 
employed 950 people. Colt finances were in disarray, it lacked 
positive cash flow, it had low reserves, and it was suffering 
from a bitter 4-year strike by its labor union which had 
resulted in a $10 million fine by the National Labor Relations 
Board.
    Not only was Colt in trouble, industry analysts pointed to 
a shrinking market for firearms, growing international 
competition, and an increasing threat of liability claims 
against firearm manufacturers. Colt was clearly a failing 
company in a shrinking industry--not exactly the type of 
company a pension manager would normally seek to invest $25 
million.
    Colt's financial problems were well-known to the State and 
to the Investment Advisory Council. In fact, the State Economic 
Development Authority had been trying to find a buyer or 
investor for Colt Manufacturing for years. Unfortunately, no 
venture capitalists or private money managers would touch Colt 
Manufacturing with a 10-foot pole. So why did a majority, 7 out 
of 10, of the Investment Advisory Council, vote in favor of 
investing in Colt Manufacturing? Politics.
    While the supporters of the IAC and the State Treasurer 
wrapped this investment in rhetoric of ``prudence,'' ``due 
diligence,'' and ``careful consideration,'' there was no 
question that the primary reason for this investment was 
political, for example, to save the 950 UAW workers from 
certain unemployment.
    Shortly after the State buyout of Colt, the Hartford 
Courant ran an editorial noting that the State Treasurer, 
Francisco Borges, had told the editors that the Colt investment 
was not, ``to make money for the State, but to save jobs.'' 
Upon announcement of Colt's bankruptcy, Mr. Borges issued a 
press release that bemoaned the bankruptcy of Colt, ``despite 
our best efforts in saving the company from demise or 
dismantling 2 years ago.''
    These two statements are very enlightening--the State's 
investment in Colt was not about higher returns for the State 
pension funds, it was not about sound investment practices, it 
was about saving a company from certain ``demise.'' Like I 
said, it was politics over prudence.
    As a former member of the State of Connecticut's House of 
Representatives and as a firsthand witness of the hearings and 
deliberations of the Investment Advisory Council, I am well 
aware of the difficulty in shielding State investment funds 
from political influence. The failed investment in Colt is only 
the starkest and most dramatic example of the effect of 
politics on investment decisions.
    During my tenure on the IAC, our investment decisions were 
limited by legislative action, by the State of Connecticut 
limiting our investment in companies located in Northern 
Ireland and South Africa, and by rules requiring us to consider 
the ``environmental records'' of companies in which we invest.
    Even more troubling, the influence of State investment 
funds is not limited to the investment decisions of the State, 
but also is affected by the active role of the State in the 
governance of the companies in which the State invests. In 
fact, the State used to have a person in charge of voting the 
State's proxies at shareholder meetings, thus ensuring that the 
State's restrictions on investing in various foreign countries 
or the State's concerns over environmental or other matters 
were heard at such meetings.
    My experience with the State of Connecticut pales in 
comparison to the meddling politics could ultimately play were 
the Federal Government to invest Social Security surpluses in 
private markets. Connecticut's pension was equal to 
approximately $8 billion at the time we invested in Colt--a 
paltry sum compared to the trillions that could ultimately be 
invested by the Federal Government.
    Would the Federal Government be able to resist the 
temptation to invest in suffering steel companies to save jobs? 
Would the government be able to resist the temptation to limit 
its investment to ``union-friendly'' companies? Would the 
government be tempted to meddle in the pay scales of the 
companies it invests in to lower wage disparities between 
management and labor? Would the Federal Government be able to 
add weight to its antitrust cases by threatening to divest in 
companies it files cases against? Or, worse yet, would the 
Federal Government pursue antitrust cases against companies it 
owns share of? I fear not, and for that reason, I strongly 
oppose allowing the Federal Government to invest surplus funds 
in private markets.
    Mr. Chairman, the United States has been a shining example 
of the benefits of the free enterprise system to the rest of 
the world. As a result of the success of our system, countries 
around the world have divested their government's ownership in 
private companies. France is exiting Renault, England has sold 
British Airways, and Germany is divesting in Lufthansa. And 
there are many other examples.
    I am baffled that the President would now move our 
government in the opposite direction and follow the disastrous 
and the discredited example of foreign governments by buying 
shares of private corporations.
    I thank you, Mr. Chairman, and Members of the Subcommittee 
for listening to my testimony.
    Thank you.
    [The prepared statement follows:]

Statement of Hon. Maureen M. Baronian, Vice President and Principal, 
Investors Services of Hartford, Inc., Hartford, Connecticut; Former 
State Representative, Connecticut General Assembly; and Former Trustee, 
Investment Advisory Council, State of Connecticut

    Chairman Shaw, Ranking Member Matsui and Members of the 
Subcommittee, thank you for inviting me to be here today. As a 
member of the Investment Advisory Council (IAC) for the State 
of Connecticut from 1987 to 1995, I have seen first hand the 
results of allowing governments to invest directly in private 
equity markets. I can only hope that my experiences will help 
enlighten this Committee as it considers President Clinton's 
proposal to invest a portion of the federal Social Security 
surplus in private markets.
    Almost 10 years ago, on March 22, 1990, the State of 
Connecticut Retirement and Trust Funds joined with members of 
the United Auto Workers, some existing members of Colt 
management, and a few other private investors to complete a 
buyout of the Colt Firearms Division of Colt Industries, Inc. 
In all, the State placed $25 million in State pension funds 
into this buyout ($17.5 million in CF Holding and $7.5 million 
in CF Intellectual Properties--which owns the Colt trademark). 
This investment gave the State of Connecticut a 47 percent 
share of Colt Manufacturing.
    Unfortunately, in less than two years, on March 18, 1992, 
CF Holding Corporation filed for Chapter 11 Bankruptcy. 
Fortunately, the State Pension's loss was ``limited'' to 
``only'' $21 million--after the Colt trademark was sold to the 
Economic Development Authority of Connecticut two years later. 
While it is not uncommon for Pension funds to lose money on the 
investments they make, the case of Connecticut's investment in 
Colt is an example where politics, not prudence led to the 
failed investment.
    For months leading up to this investment, Connecticut 
newspapers were filled with editorials and news reports on the 
financial crisis facing Colt Manufacturing--a company that 
employed 950 people. Colt finances were in disarray, it lacked 
positive cash flow, it had low reserves, and it was suffering 
from a bitter four-year strike by its labor union which had 
resulted in a $10 million fine by the National Labor Relations 
Board (NLRB).
    Not only was Colt in trouble, industry analysts pointed to 
a shrinking market for firearms, growing international 
competition and an increasing threat of liability claims 
against firearms manufacturers. Colt was clearly a failing 
company in a shrinking industry--not exactly the type of 
company a pension manager would normally seek to invest $25 
million.
    Colt's financial problems were well known to the State and 
to the Investment Advisory Council. In fact, the State Economic 
Development Authority had been trying to find a buyer or 
investor for Colt Manufacturing for years. Unfortunately, no 
venture capitalists or private money managers would touch Colt 
Manufacturing with a ten-foot pole. So why did a majority (7 of 
10) of the Investment Advisory Council vote in favor of 
investing in Colt Manufacturing? Politics
    While the supporters in the IAC and the State Treasurer 
wrapped this investment in the rhetoric of ``prudence,'' ``due 
diligence,'' and ``careful consideration,'' there was no 
question that the primary reason for this investment was 
political--i.e., to save 950 UAW workers from certain 
unemployment.
    Shortly after the State buyout of Colt, the Hartford 
Courant ran an editorial noting that the State Treasurer, 
Francisco Borges, had told the editors that the Colt investment 
was not ``to make money for the state but to save jobs.'' Upon 
announcement of Colt's bankruptcy Mr. Borges issued a press 
release that bemoaned the bankruptcy of Colt ``despite our best 
efforts in saving the company from demise or dismantling two 
years ago.'' These two statements are very enlightening--the 
States investment in Colt was not about higher returns for 
state pension funds, it was not about sound investment 
practices, it was about saving a company from certain 
``demise.'' Like I said, it was politics over prudence.
    As a former member of the State of Connecticut's House of 
Representatives and as a first hand witness of the hearings and 
deliberations of the Investment Advisory Council, I am well 
aware of the difficulty in shielding state investment funds 
from political influence. The failed investment in Colt is only 
the starkest and most dramatic example of the effect of 
politics on investment decisions. During my tenure on the IAC, 
our investment decisions were limited by legislative action by 
the State of Connecticut limiting our investment in companies 
located in Northern Ireland and South Africa, and by rules 
requiring us to consider the ``environmental records'' of the 
companies in which we invest.
    Even more troubling, the influence of state investment 
funds is not limited to the investment decisions of the State, 
but also is effected by the active role of the State in the 
governance of the companies in which the State invests. In 
fact, the State used to have a person in charge of voting the 
States proxies at shareholder meetings, thus ensuring that the 
States restrictions on investing in various foreign countries 
or the States concerns over environmental matters were heard at 
such meetings.
    My experience with the State of Connecticut pales in 
comparison to the meddling politics could ultimately play were 
the federal government to invest Social Security surpluses in 
private markets. Connecticut's pension was equal to 
approximately $8 billion at the time we invested in Colt--a 
paltry sum compared to the trillions that could ultimately be 
invested by the federal government.
    Would the federal government be able to resist the 
temptation to invest in suffering steel companies to save jobs? 
Would the government be able to resist the temptation to limit 
its investment to ``union-friendly'' companies? Would the 
government be tempted to meddle in the pay scales of the 
companies it invests in to lower wage disparities between 
management and labor? Would the federal government be able to 
add weight to its anti-trust cases by threatening to divest in 
companies it files cases against? Or worse yet, would the 
federal government pursue anti-trust cases against companies it 
owns shares of? I fear not, and for that reason, I strongly 
oppose allowing the federal government to invest surplus funds 
in private markets.
    Mr. Chairman, the United States has been a shining example 
of the benefits of the free enterprise system to the rest of 
the world. As a result of the success of our system, countries 
around the world have divested their government's ownership in 
private companies: France is exiting Renault, England has sold 
British Airways, and Germany is divesting in Lufthansa. I am 
baffled that the President would now move our government in the 
opposite direction and follow the disastrous and discredited 
example of foreign governments by buying shares of private 
corporations.
      

                                

    Chairman Shaw. Thank you, Ms. Baronian.
    Mr. Tanner.

   STATEMENT OF MICHAEL TANNER, DIRECTOR, HEALTH AND WELFARE 
                    STUDIES, CATO INSTITUTE

    Mr. Michael Tanner. Thank you, Mr. Chairman, Mr. Matsui, 
and distinguished Members of the Subcommittee. I want to start 
off by saying how pleased I am to have the opportunity today to 
talk to you about Social Security reform and how particularly 
pleased I am that the Clinton administration has had the 
courage to bring this issue forward, to touch the third rail of 
American politics and engender a real debate about the future 
of Social Security. I am also very pleased that the Clinton 
administration has recognized that investment in private 
capital markets must be part of any Social Security reform. 
That said, I must disagree with the details of how the 
President would go about this and that, rather than allowing 
individuals to invest, the President would allow the Federal 
Government to do the investing.
    Allowing the Federal Government to purchase stocks would 
give it the ability to obtain a significant, if not a 
controlling, share of virtually every major company in America. 
Experience has shown that even a 2- or 3-percent block of 
shares can give an activist shareholder influence over the 
policies of publicly traded companies. The result could 
potentially be a Federal Government that intervenes in how 
corporations conduct their affairs, making those decisions on 
the basis of political passions, rather than on the best 
interests of the company, the economy, or the shareholders.
    The experience of State employee pension funds suggests 
that governments have difficulty resisting the temptation to 
meddle in corporate affairs. For example, in the late eighties, 
State employee pension plans in California and New York were 
primarily responsible for the election of a new board chairman 
for General Motors. And according to a 1990 report by the U.S. 
House of Representatives Committee on Labor, State employee 
pension plans were increasingly using their clout and voting 
their shares to influence the corporate role in environmental 
improvement, humanitarian problems, and economic development.
    But even if the government could remain passive, its very 
ownership of large blocks of stock would, in effect, create 
situations favoring certain stockholders and corporate 
managers.
    As the General Accounting Office has pointed out, if the 
government did not exercise its voting rights, other 
stockholders would find their own voting power enhanced and 
could take advantage of government passivity. The GAO also 
warns that regardless of whatever stock voting rules are 
adopted when the program begins, Congress can always change the 
rules in the future. Experience with various budget agreements 
and caps should indicate that no Congress can bind future 
Congresses as to what they may do.
    The second problem is the whole question of social 
investing, which is the question of even if the government can 
avoid directly using its equity ownership to influence 
corporate governance, there is likely to be an enormous 
temptation to allow political considerations to influence the 
type of investments the government makes. I think you have just 
heard an example of that.
    The whole idea of this can best be summed up in a task 
force on social investing convened by Mario Cuomo--then-
Governor Mario Cuomo--of New York, who held that public 
employees were merely one stakeholder in their pensions, along 
with the rest of society and therefore, the trustees of public 
pensions were entitled to balance the interest of society 
against the interests of the public employee.
    Using that criterion, they rejected the idea that 
investments should be made solely on the basis of maximizing 
immediate returns, and instead, should focus on ways to 
maximize the direct and indirect returns to all stakeholders, 
including the larger society and the economy.
    Other States have taken that to heart, and today 
approximately 42 percent of State, county and municipal pension 
systems have restrictions targeting some portion of investments 
to projects designed to stimulate the local economy or create 
jobs. In addition, 23 percent of pension systems have 
prohibitions against specific types of investments, such as 
companies that failed the meet the MacBride Principals in 
Northern Ireland; companies that do business in Libya or other 
Arab countries; companies that are accused of pollution, unfair 
labor practices, failing equal employment opportunity 
guidelines; alcohol, tobacco and defense industries; and even 
companies that market infant baby formula in the Third World.
    In the few moments I have left, I just want to caution 
against one misunderstanding. And that is that the Federal 
Thrift Savings Program can be in any way compared to the idea 
of government investment of Social Security Trust Funds. The 
Thrift Savings Program is a defined contribution program with 
individually owned accounts. Workers have a property right in 
their account, which is not true of Social Security.
    There is the case of Fleming v. Nester in 1960. The U.S. 
Supreme Court held that individuals have no legal right to 
their Social Security benefits. And allowing the government to 
invest a portion of Social Security revenues in capital markets 
would do nothing to change this. Therefore, a government-
invested Social Security Program would be far more akin to the 
defined benefit State employee pension systems that I have been 
describing in which the individual is not the sole interest of 
the investors.
    Because workers have no ownership rights to their pension 
funds, the government has no fiduciary duty to those workers. 
The situation may be even worse than the Social Security 
system, since the exclusive benefit rule, which the IRS imposes 
on State employee systems, would not be applicable to the 
Social Security system.
    Finally, I would just mention that the Thrift Savings 
Program is transparent as a defined contribution program. 
Individual workers can see the result directly of any change in 
government investment. That would not be the case under Social 
Security, where the costs of social investing would be hidden 
within the entire system.
    I thank you very much.
    [The prepared statement follows:]

Statement of Michael Tanner, Director, Health and Welfare Studies, Cato 
Institute

    Mr. Chairman, Distinguished Members of the Committee:
    My name is Michael Tanner and I am the Director of Health 
and Welfare Studies at the Cato Institute, as well as Director 
of Cato's Project on Social Security Privatization. I very much 
appreciate the opportunity to appear before you today and 
discuss the problems inherent in any attempt to allow the 
government to invest Social Security funds in private capital 
markets.
    First, let me begin by saying that I appreciate President 
Clinton's proposal for Social security reform. The president 
deserves enormous credit for having the courage to tackle this 
most contentious of political issues. I also commend the 
president for recognizing that private capital investment must 
be central to any reform of Social Security. That recognition 
could form the basis for moving forward in a bipartisan way to 
ensure that future retirees will be able to retire with the 
same security as their parents and grandparents.
    That said, however, as currently formulated, there are 
serious problems with the presidents proposal and with the 
entire concept of allowing the federal government to invest 
directly in private capital markets. Superficially, that 
approach offers some attraction. It promises the advantages of 
higher returns through private capital investment, while 
spreading individual risk and minimizing administrative costs. 
In reality, allowing the government to control such an enormous 
amount of private investment, in the words of Federal Reserve 
Chairman Alan Greenspan, ``has very far reaching potential 
dangers for a free American economy and a free American 
society.'' \1\

                           The Current System

    Social Security is currently running a surplus. In 1996, 
for example, Social Security taxes--both payroll taxes and 
income taxes on benefits--amounted to $385.7 billion. Benefit 
payments and administrative expenses totaled only $353.6 
billion, resulting in a surplus of $70.8 billion.\2\ Under 
current law, that money must be invested solely in U.S. 
government securities. The securities can be any of three 
types: government securities purchased on the open market; 
securities bought at issue, as part of a new offering to the 
public; or special-issue securities, not traded publicly. In 
actual practice, virtually all the securities purchased have 
been special-issue securities, \3\ which earn an interest rate 
equal to the average market rate yield on all U.S. government 
securities with at least four years remaining until maturity, 
rounded to the nearest one-eighth percent--an average of 
approximately 2.3 percent above inflation.
    By contrast, equities have earned an average 7.56 percent 
real rate of return over the past 60 years. Some have suggested 
that the government should be allowed to invest a portion of 
the Social Security surplus in equities rather than government 
securities, allowing the Social Security system to reap the 
benefits of the higher rate of return.\4\

                   Proposals for Government Investing

    The idea of allowing the government to invest excess Social 
Security funds in private capital markets is not a new one. As 
early as the 1930s, fiscal conservatives warned that unless 
private securities were included in the government's portfolio, 
the trust fund would earn less than market returns. But they 
also realized that if the government invested in private 
securities, it would lead to large-scale government ownership 
of capital and interference in American business. Sen. Arthur 
Vandenberg (R-Mich.) warned that ``it is scarcely conceivable 
that rational men should propose such an unmanageable 
accumulation of funds in one place in a democracy.'' \5\ In the 
end, Congress rejected not only government investing but any 
system of full funding, establishing a pay-as-you-go program in 
which nearly all the taxes paid by current workers are not 
saved or invested in any way but used to pay benefits to 
current retirees.
    Two factors brought the concept of government investing 
back into public debate. First, following a series of Social 
Security reforms in 1983, the Social Security system began to 
run a modest surplus. Second, demographic trends made it clear 
that the program's pay-as-you-go structure was not sustainable.
    Proposals for government investment first appeared in 
legislation in the early 1990. The idea received widespread 
public attention when 6 of the 13 members of the 1994-96 
Advisory Council on Social Security recommended the investment 
of up to 40 percent of the Social Security Trust Fund in 
private capital markets.\6\ As Robert Ball, author of the 
proposal, put it, ``Why should the trust fund earn one third as 
much as common stocks?'' \7\
    However, this approach is fraught with peril.

                          Corporate Governance

    Allowing the federal government to purchase stocks would 
give it the ability to obtain a significant, if not a 
controlling, share of virtually every major company in America. 
Experience has shown that even a 2 or 3 percent block of shares 
can give an activist shareholder substantial influence over the 
policies of publicly traded companies.\8\
    The result could potentially be a government bureaucrat 
sitting on every corporate board, a prospect that has divided 
advocates of government investing. Some have claimed that the 
government would be a ``passive'' investor--that is, it would 
refuse to vote its shares or take positions on issues affecting 
corporate operations. Others, such as the AFL-CIO's Gerald 
Shea, have suggested that the government should exercise its 
new influence over the American economy, claiming that 
government involvement would ``have a good effect on how 
corporate America operates.'' \9\
    The experience of state employee pension funds suggests 
that governments may not be able to resist the temptation to 
meddle in corporate affairs. For example, in the late 1980s, 
state employee pension plans in California and New York 
actively attempted to influence the election of a new board 
chairman for General Motors.\10\ According to a report by the 
U.S. House of Representatives, state employee pension plans are 
increasingly using their clout to influence ``the corporate 
role in environmental improvement, humanitarian problems, and 
economic development.'' \11\
    Supporters of government investment claim that the 
government would remain a passive investor, refusing to vote 
its shares. However, that would require an extraordinary degree 
of restraint by future presidents and congresses. Imagine the 
pressure faced by a congress if the government were to own a 
significant interest in a company that was threatening to close 
its plants and move them overseas at the cost of thousands of 
jobs. Could politicians really remain passive in the face of 
such political pressure?
    Even if the government remained passive, its very ownership 
of large blocks of stock would, in effect, create a situation 
favoring certain stockholders and corporate managers. As the 
General Accounting Office has pointed out, if the government 
did not exercise its voting rights, other stockholders would 
find their own voting power enhanced and could take advantage 
of government passivity.\12\
    The GAO also warns that regardless of what stock voting 
rules are adopted when the program begins, Congress can always 
change the rules in the future.\13\

                            Social Investing

    Even if the government avoids directly using its equity 
ownership to influence corporate governance, there is likely to 
be an enormous temptation to allow political considerations to 
influence the type of investments that the government makes. In 
short, should the government invest solely to earn the highest 
possible return on investments, or should the government 
consider larger political and societal questions?
    The theory behind social investing was perhaps best 
explained in a 1989 report by a task force established by then 
Governor Mario Cuomo to consider how New York public employee 
pension funds were being invested. The task force concluded 
that state employee pension funds should not be operated solely 
for the benefit of state employees and retirees. In the opinion 
of the task force, those employees and retirees were only one 
among several groups of ``stakeholders'' in state employee 
pension programs, others being ``the plan sponsor; corporations 
seeking investment capital from the pension fund; taxpayers who 
support the compensation of public employees, including 
contributions to the pension fund; and the public, whose well 
being may be affected by the investment choice of fund 
managers'' (emphasis added).\14\ Using that criterion, the task 
force rejected the idea that investments should be made solely 
on the basis of maximizing the immediate return to the pension 
trust. Instead, pensions should be invested in a way that 
maximizes ``both direct and indirect returns'' to all 
stakeholders, including ``the larger society and economy.'' 
Therefore, the task force concluded, state employee pension 
funds should be guided into economic development projects 
beneficial to the state of New York.
    Most state employee pension funds are subject to such 
social investing. Alaska may have been the first state to 
require social investing, with a requirement in the early 1970s 
that a portion of state pension funds be used to finance home 
mortgages in the state.\15\ The Alaska example also illustrates 
the dangers of social investing. A downturn in the local real 
estate market cost the fund millions of dollars that had to be 
made up through other revenue sources.
    Throughout the 1970s and 80s, social investment 
increasingly came to be a part of state pension programs.\16\ 
It became a subject of widespread public debate in the mid-
1980s with the question of South African divestment. 
Eventually, 30 states prohibited the investment of pension 
funds in companies that did business in South Africa. Today, 
approximately 42 percent of state, county, and municipal 
pension systems have restrictions targeting some portion of 
investment to projects designed to stimulate the local economy 
or create jobs. This includes investment in local 
infrastructure and public works projects as well as investment 
in in-state businesses and local real estate development.\17\ 
In addition, 23 percent of the pension systems had prohibitions 
against investment in specific types of companies, including 
restrictions on investment in companies that fail to meet the 
``MacBride Principles'' for doing business in Northern Ireland, 
companies doing business in Libya and other Arab countries; 
companies that are accused of pollution, unfair labor 
practices, or failing to meet equal opportunity guidelines; the 
alcohol, tobacco, and defense industries; and even companies 
that market infant formula to Third World countries.\18\
    A nearly infinite list of current political controversies 
would be ripe for such restrictions if the federal government 
began investing Social Security funds. Both liberals and 
conservatives would have their own investment agendas. Should 
Social Security invest in nonunion companies? Companies that 
make nuclear weapons? Companies that pay high corporate 
salaries or do not offer health benefits? Companies that do 
business in Burma or Cuba? Companies that extend benefits to 
the partners of gay employees? Companies that pollute? 
Companies that donate to Planned Parenthood? Investment in 
companies ranging from Microsoft to Nike, from Texaco to Walt 
Disney, would be sure to engender controversy.
    Supporters of government investment suggest two ways to 
avoid the problem of social investing. First, they propose the 
creation of an independent board to manage the system's 
investment, a board that would operate free of any political 
interference. However, Alan Greenspan, who should be in a 
position to know about board independence, has said that he 
believes it would be impossible to insulate such a board from 
politics. Testifying before Congress on proposals for 
government investment, Greenspan warned:

          I don't know of any way that you can essentially insulate 
        government decisionmakers from having access to what will 
        amount to very large investments in American private industry. 
        . . . I know there are those who believe it can be insulated 
        from the political process, they go a long way to try to do 
        that. I have been around long enough to realize that that is 
        just not credible and not possible. Somewhere along the line, 
        that breach will be broken.\19\

    Indeed, the difficulty of shielding investment decisions from 
political considerations was illustrated, unintentionally, by one of 
the supporters of government investment, Jonathan Cohn, writing in The 
New Republic. ``It would be easy to prohibit manipulation of the market 
for political reasons,'' Cohn wrote. ``All you would have to do is 
assign responsibility for the investments to a quasi-independent body, 
then carefully limit how it can make investment decisions.'' \20\ In 
other words, the new agency would be independent except that Congress 
would set restrictions on its investment decisions.
    Supporters of government investment suggest a second means of 
avoiding social investment: the investment would be made only in index 
funds, eliminating the choice of individual stocks. However, that does 
not eliminate social investment questions, since there would remain the 
issue of what stocks should be included in the index, whether an 
existing index or a new one created just for Social Security.

        The Federal Thrift Savings Program: An Imperfect Analogy

    Supporters of government investing often cite the federal 
thrift savings program as an example to show that government 
pension funds can avoid politicization. It is true that, so 
far, the TSP has avoided social investment and interference 
with corporate governance. However, there are several important 
differences between the TSP and a government-invested Social 
Security program.
    Perhaps most importantly, the TSP is a defined-contribution 
program with individually owned accounts. Workers do have a 
property right in their account, which is not true of Social 
Security. In the case of Fleming v. Nestor (1960), the U.S. 
Supreme Court held that individuals have no property right in 
Social Security. Allowing the government to invest a portion of 
Social Security revenues in capital markets would do nothing to 
alter that.
    Therefore, a government-invested Social Security program 
would be far more akin to defined-benefit state employee 
pension plans. A 1990 congressional report concluded that while 
workers acquire an interest in pension funds once they are 
vested, they have no legal ownership rights. The report went on 
to note that it would be equally incorrect to say that 
government ``owned'' the funds because the government's 
discretion in spending or disposing of the funds is limited 
under state trust law and the Internal Revenue Code.\21\ The 
report concludes that there is no exclusive ownership by either 
party,\22\ and that ownership, in any case, may be unimportant 
because ``public defined benefit pensions are entitlements 
granted by governments that can be modified or taken away.'' 
\23\
    Because workers have no ownership right to their pension 
funds, the government has no fiduciary duty to the workers. The 
situation may be even worse for a government-invested Social 
Security system. For all the social investment practices 
discussed above, state employee pension funds have been 
somewhat restrained by the ``exclusive benefit rule,'' an 
Internal Revenue Service ruling that requires tax-exempt trusts 
to operate solely for the benefit of the trustees.\24\ The 
applicability of that rule to government pension funds is 
extremely limited, however, since the tax exemption status of 
the trust is irrelevant. The employer--being the government--is 
already tax exempt. Therefore, the only potential enforcement 
mechanism is for the IRS to disqualify the plan, meaning that 
workers would be taxed on the employer's contribution. Because 
such a penalty would fall on innocent third parties, the threat 
is seldom invoked. It is even more unlikely to be invoked in 
the case of a government-invested Social Security system. It 
would certainly be unfair to do so--to impose a huge new tax on 
every American worker because the government mismanages the 
investment of its funds. Of course, that assumes an IRS 
independent enough to take action against the federal 
government's own investment decisions. As a result, unlike the 
TSP, there appears to be no legal barrier to social investing 
under a government-invested Social Security program.
    Second, as a defined-contribution program, the TSP is 
transparent. Benefits are dependent on the return to their 
investment, not on an arbitrary benefit formula. Therefore, the 
workers have a direct interest in ensuring that investments are 
made solely to maximize their returns. Workers can see exactly 
how an investment decision impacts their retirement benefits. 
Under a government-invested Social Security program, benefits 
would be defined by law and would be only indirectly affected 
by individual investment decisions. Therefore, workers would 
have little incentive to resist social investing. They would 
have no direct interest in whether investments are made solely 
to maximize returns or for other purposes.
    Finally, the TSP is a voluntary program. If workers are 
dissatisfied with investment practices under the program, they 
can refuse to participate. Therefore, fund managers have an 
incentive to maximize returns. Failure to do so will result in 
a loss of business. In contrast, a government-invested Social 
Security system would be mandatory. Workers would be forced to 
continue contributing 12.4 percent of their income to the 
system, no matter how dissatisfied they were.
    Clearly, then, there are both legal and market restraints 
on the TSP that would not exist under a government-invested 
Social Security system. Indeed, the TSP model would seem to 
argue for exactly the opposite, a system of individually owned, 
privately invested accounts. Only such a system would replicate 
the TSP's safeguards--property rights, a fiduciary 
responsibility, transparency, and an ability to remove funds 
from a nonperforming investor.

                             A Nonsolution

    Finally, it is important to recognize that allowing the 
government to invest Social Security funds in private capital 
markets will do nothing to solve most of Social Security's 
problems. Yes, it will help preserve Social Security's 
solvency. But it will do nothing to increase the near zero or 
negative rate of return that can be expected by today's young 
workers. It will do nothing to redress the inequities of the 
current system that penalize working women, the poor, and 
minorities. It will do nothing to give low income workers the 
opportunity to accumulate real wealth. And, it will do nothing 
to give Americans ownership over their retirement benefits.
    The president is right: we need to take advantage of the 
higher rates of return available through investment in private 
capital markets. But that should be done not through government 
investment, but through individual accounts.
    Thank you.

                               Footnotes

    1. Testimony of Alan Greenspan before the Senate Committee on 
Banking, July 21, 1998.
    2. 1998 Report of the Board of Trustees of the Federal Old-Age 
Survivors and Disability Insurance Program (Washington: Government 
Printing Office, 1998).
    3. Robert Myers, Social Security (Philadelphia: University of 
Pennsylvania Press, 1993), p. 142.
    4. Supporters of government investing may actually be understating 
the difference in returns. Under the current system, the interest 
attributed to the government securities does not actually represent a 
cash transfer but is attributed to the Social Security Trust Fund, 
which makes the interest more notional than real. When the time comes 
that payments must be made from the trust fund, the federal government 
will have to appropriate the attributed interest from general revenues. 
Thus, like the government securities themselves, the interest payments 
do not represent real current wealth, merely a promise by the 
government to tax future generations of workers. In contrast, if the 
government invested in equities or other assets outside the government, 
any return would result in a real increase in the system's assets.
    5. Congressional Record, Vol. 81, Part 2, 75th Congress (March 17, 
1937), p. 2324.
    6. Report of the 1994-1996 Advisory Council on Social Security, 
Volume I: Findings and Recommendations (Washington: Government Printing 
Office, 1997), pp. 25-28.
    7. Peter Passell, ``Can Retirees' Safety Net be Saved?'' New York 
Times, February 18, 1997.
    8. Theodore Angelis, ``Investing Public Money in Private Markets: 
What Are the Right Questions?'' Presentation to a conference on 
``Framing the Social Security Debate: Values, Politics, and 
Economics,'' National Academy of Social Insurance, Washington, D.C., 
January 29, 1998.
    9. ``Quoted in Michael Eisenscher and Peter Donohue, ``The Fate of 
Social Security,'' Z Magazine, March 1997.
    10. U.S. House of Representatives, Committee on Education and 
Labor, Subcommittee on Labor-Management Relations, ``Public Pension 
Plans: The Issues Raised over Control of Plan Assets,'' Committee 
Print, June 25, 1990; U.S. House of Representatives, Committee on 
Education and Labor, Public Pension Plans: The Issues Raised over 
Control of Plan Assets, p.49.
    11. Ibid.
    12. General Accounting Office, ``Social Security Financing: 
Implications of Government Stock Investing for the Trust Fund, the 
Federal Budget, and the Economy,'' Report to the U.S. Senate Special 
Committee on Aging, April 1998, p. 62.
    13. Ibid.
    14. Our Money's Worth: Report of the Governor's Task Force on 
Pension Fund Investment (Albany: New York State Industrial Cooperation 
Council, June 1989), p. 20.
    15. Jennifer Harris, ``From Broad to Specific: The Evolution of 
Public Pension Investment Restrictions,'' Public Retirement Institute, 
Arlington, Va., July 1998.
    16. For a thorough discussion of state employee pension systems and 
their investment policies, see Carolyn Peterson, State Employee 
Retirement Systems: A Decade of Change (Washington: American 
Legislative Exchange Council, 1987).
    17. James Packard Love, Economically Targeted Investing: A 
Reference for Public Pension Funds (Sacramento: Institute for Fiduciary 
Education, 1989).
    18. Love, Economically Targeted Investing; Peterson, State Employee 
Retirement Systems.
    19. Testimony of Alan Greenspan.
    20. Jonathan Cohn, ``Profit Motives,'' New Republic, July 13, 1998.
    21. U.S. House of Representatives, Committee on Education and 
Labor, Public Pension Plans: The Issues Raised over Control of Plan 
Assets, pp. 44-46.
    22. Ibid., p. 52.
    23. Ibid., p. 50.
    24. Internal Revenue Manual, Examination Guidelines Handbook, Sec. 
711.1.


                                

    Chairman Shaw. Thank you, Mr. Tanner.
    Dr. Reischauer.

  STATEMENT OF ROBERT D. REISCHAUER, SENIOR FELLOW, ECONOMIC 
                 STUDIES, BROOKINGS INSTITUTION

    Mr. Reischauer. Thank you, Mr. Chairman. I appreciate the 
opportunity to participate in this hearing.
    During the past few weeks, the President's framework for 
dealing with the surpluses project for the next 15 years has 
generated a good deal of controversy and even more confusion. 
For this reason, I have attached to my prepared statement my 
analysis of his proposal, and I ask that this analysis be 
included in the record of this hearing along with the paper 
that my Brookings colleague Shanna Rose has prepared that 
describes how Canada has gone about investing its Social 
Security reserves in equities.
    Overall, I think the President's framework is a prudent 
approach. He would reserve 59 percent of the surpluses 
projected for the next 15 years for debt reduction, or, looked 
at another way, he would channel 71 percent into an improvement 
in the net financial position of the Federal Government. That 
larger estimate adds in the equities purchased for Social 
Security. Looked at still another way, the President would 
reserve 82 percent of the projected surpluses to boost national 
savings.
    Given the inherent uncertainty of budget projections, I 
think the President has been wise to refrain from devoting more 
than a small portion of the projected surpluses to commitments, 
such as tax cuts or spending increases, that from a practical 
standpoint may be politically irrevocable.
    It is an unpleasant yet inescapable reality that there are 
three, and only three, ways to close Social Security's long-run 
deficit: taxes can be raised, benefits can be reduced, or the 
return on the trust fund's reserves can be increased. Given 
this reality, it's important to compare proposals to invest a 
portion of Social Security's reserve in private securities with 
the realistic alternatives.
    While there are legitimate concerns with this option, which 
I will discuss in 1 minute, there are also problems with the 
alternatives, whether they be raising payroll taxes, increasing 
the wage base, increasing the age at which unreduced or initial 
benefits are paid, or reducing the size of the annual cost-of-
living adjustments.
    There are two good reasons why it makes sense to invest a 
portion of the trust fund's reserves in private securities. 
First, such a policy would boost the earnings on the reserves 
and thereby reduce the benefit cuts and payroll-tax increases 
that will be required to deal with Social Security's long-run 
problem.
    Second, easing the restriction that requires Social 
Security to invest its reserves exclusively in government 
securities would provide workers with a fairer return on their 
payroll-tax contributions, one that was closer to the benefits 
that these contributions make to the Nation's economy. To the 
extent that the reserve accumulation adds to national savings, 
it generates total returns for the Nation equal to the average 
return from private investment, which runs about 6 percent 
above the rate of inflation. By paying Social Security a lower 
return, a return that is projected to average about 2.8 
percentage points over the next 75 years, the system denies 
workers a fair return on their contributions.
    However, some legitimate concerns have been raised about 
investing trust fund reserves in private securities. Many fear 
that such investments could disrupt financial markets. Others, 
as you have heard from my colleagues here, are worried that 
politicians in both the executive and legislative branches will 
be tempted to use reserve investment policy to interfere with 
markets or to meddle in the activities of private companies.
    If there were no ways to reduce the risk of political 
interference, to a de minimis level, it would be imprudent to 
propose private investment of a portion of the trust fund's 
reserves. And I would be a strong opponent of such a policy. 
But fortunately, institutional safeguards can be created to 
provide the necessary protections. Such an institutional 
framework should have five elements.
    First, an independent agency, modeled after the Federal 
Reserve Board, should be created and charged with the task of 
managing the trust fund's investments. Second, this agency 
should be required to select, through competitive bids, several 
private-sector fund managers, each of whom would be entrusted 
with investing only a portion of the trust fund's reserves. 
Third, these managers should be authorized only to make passive 
investments, that is, investments in securities of companies 
chosen to represent the broadest of market indexes.
    In other words, there would be no picking and choosing of 
individual stock, and the index would not reflect just a 
portion of the market, such as the Dow Jones or the Standard & 
Poor's 500, but rather, the entire range of stocks that are 
traded on the major exchanges.
    Fourth, Social Security investments should be comingled 
with the funds that private accountholders have invested in the 
same index funds that the managers, chosen by the board, would 
offer to the public.
    And finally, the fund managers should be required to vote 
Social Security's shares solely to enhance the economic 
interest of future Social Security beneficiaries. All of these 
elements should be established in legislation. Of course, any 
law that Congress enacts it can change. But the President would 
have to sign that bill. And I believe that a powerful 
constituency would develop to support a hands-off policy toward 
trust fund investment.
    I believe that this set of institutional arrangements 
should be sufficient to insulate trust fund investment 
decisions from political interference. There are those who 
disagree with this judgment and who think the only way to 
achieve higher returns on Social Security's reserves is to 
place these reserves in the hands of individuals who would 
invest them through personal accounts.
    But that approach raises some very difficult questions, 
such as: Would individual accounts place an unacceptable amount 
of risk on individuals who are ill prepared to bear that risk? 
What would happen to the social assistance now provided through 
Social Security under a system of individual accounts? After 
all, Social Security is the most effective and the least 
controversial antipoverty program that the Nation has. Would 
administrative costs eat up a large portion of the returns in a 
system of personal accounts? The numbers that Secretary Summers 
discussed actually were low compared to the Chilean and British 
experiences. Could the system avoid excessive complexity, and 
would such a system be politically sustainable?
    I think the answers to these questions make personal 
accounts an inappropriate way to provide American workers with 
a secure, predictable, and inflation-protected foundation upon 
which their other retirement income should be built.
    Thank you, and I'll be happy to answer any questions at the 
end of this panel.
    [The prepared statement and attachments follow:]

Statement of Robert D. Reischauer,* Senior Fellow, Economic Studies, 
Brookings Institution

    Mr. Chairman and Members of the Subcommittee, I appreciate 
this opportunity to discuss with you the issues raised by 
proposals to invest a portion of Social Security's reserves in 
private securities. My statement addresses three questions:
---------------------------------------------------------------------------
    * This statement draws on Countdown to Reform: the Great Social 
Security Debate, by Henry J. Aaron and Robert D. Reischauer (The 
Century Foundation Press, 1998). The views expressed in this statement 
should not be attributed to the staff, officers, or trustees of the 
Brookings Institution.
---------------------------------------------------------------------------
     Why do the Administration and others believe it 
would be helpful to diversify the portfolio of assets held by 
the Social Security trust fund?
     What legitimate concerns are raised by investing 
trust fund reserves in private securities? and
     Are there ways to address these concerns?

                   Why invest in private securities?

    It is an unpleasant yet inescapable reality that there are 
three, and only three, ways to close Social Security's long run 
fiscal deficit. Taxes can be raised, benefits can be reduced, 
or the return on the trust fund's reserves can be increased. 
Recently, some have suggested that a fourth way exists, one 
that avoids unpleasant choices. This route would be to devote a 
portion of the projected budget surpluses to Social Security. 
However, transferring resources from the government's general 
accounts to Social Security would only shift the locus of the 
inevitable adjustments. Rather than boosting payroll taxes or 
cutting Social Security benefits sometime in the future, income 
taxes would have to be higher or non-Social Security spending 
lower than otherwise would be the case.
    Because neither the public nor lawmakers have greeted the 
prospect of higher taxes or reduced spending with any 
enthusiasm, the option of boosting the returns on Social 
Security's reserves is worth close examination. While higher 
returns can not solve the program's long run financing problem 
alone, they can make the remaining problem more manageable.
    Since the program's inception, the law has required that 
Social Security reserves be invested exclusively in securities 
guaranteed as to principal and interest by the federal 
government. Most trust fund holdings consist of special 
nonmarketable Treasury securities that carry the average 
interest rate of government notes and bonds that mature in four 
or more years and are outstanding at the time the special 
securities are issued. In addition to their low risk, these 
special issues have one clear advantage. They can be sold back 
to the Treasury at par at any time--a feature not available on 
publicly held notes or bonds, whose market prices fluctuate 
from day to day. They also have one big disadvantage--they 
yield relatively low rates of return.
    It is not surprising that, when the Social Security law was 
enacted, policymakers viewed government securities as the only 
appropriate investment for workers' retirement funds. They were 
in the midst of the Great Depression. The stock market collapse 
and widespread corporate bond defaults were vivid in people's 
memories. Many believed that a mattress or a cookie jar was the 
safest place for their savings.
    For many years, the restriction placed on trust fund 
investment made little difference because Congress decided, 
before the first benefits were paid, to forgo the accumulation 
of large reserves that were anticipated under the 1935 law. 
Instead, Congress voted in 1939 to begin paying benefits in 
1940 rather than 1942, boost the pensions of early cohorts of 
retirees, and add spouse and survivor benefits. The system was 
to operate on a pay-as-you-go basis.
    Legislation enacted in 1977 called for moving from pay-as-
you-go financing to ``partial reserve financing'' with the 
accumulation of significant reserves. These reserves failed to 
materialize because the economy performed poorly. Further 
legislation in 1983, together with improved economic 
performance, subsequently led to the steady growth of reserves. 
By the end of 1998, the program had built up reserves of $741 
billion, roughly twice annual benefits. Under current policy, 
these reserves are projected to grow to more than $2.5 
trillion--about 3.4 times annual benefits--by 2010. As reserves 
have grown, the loss of income to Social Security from 
restricting its investment to relatively low-yielding special 
Treasury issues also has increased.
    The restriction that has been placed on Social Security's 
investments is unfair to program participants, both workers 
paying payroll taxes and beneficiaries. To the extent that 
trust fund reserve accumulation adds to national saving, it 
generates total returns for the nation equal to the average 
return on private investment, which runs about 6 percent more 
than the rate of inflation. By paying Social Security a lower 
return--a return projected to be only 2.8 percent more than 
inflation over the next 75 years--the system denies workers a 
fair return on their investment. As a consequence, either the 
payroll tax rate has to be set higher than necessary to sustain 
any given level of benefits or pensions have to be lower than 
would be the case if the program's reserves received the full 
returns they generate for the economy.
    The restriction placed on the trust fund's investments has 
had another unfortunate consequence. It has added considerable 
confusion to the debate over alternative approaches to 
addressing Social Security's long-run fiscal problem. Advocates 
of various privatization plans argue that their approaches are 
superior to Social Security because they provide better returns 
to workers. In reality, the returns offered by these structures 
look better only because the balances they build up are 
invested not in low-yielding Treasury securities but rather in 
a diversified portfolio of private securities. If Social 
Security were unshackled, its returns would not just match, but 
almost certainly exceed, those realized by the various reform 
proposals.
    There exists a very simple mechanism for compensating 
Social Security for the restrictions that are placed on its 
investment decisions. Each year, Congress could transfer sums 
to the trust fund to make up the difference between the 
estimated total return to investment financed by trust fund 
saving and the yield on government bonds. This could be 
accomplished with a lump sum transfer or by agreeing to pay a 
higher interest rate--say 3 percentage points higher--on the 
Treasury securities held by the trust fund. The transfer 
required to make up the shortfall in 1998, when the average 
trust fund balance was approximately $700 billion, would have 
been about $23 billion, more than two and one-half times the 
amount that is transferred to the trust fund from income taxes 
on benefits.\1\
---------------------------------------------------------------------------
    \1\ This estimate is based on the difference between the estimated 
long-run returns on government securities and private assets, not on 
the actual differences during 1998.
---------------------------------------------------------------------------
    While general revenue transfers to social insurance plans 
are commonplace around the world, they have been controversial 
in the United States.\2\ Some would oppose such a transfer, 
arguing that general revenue financing would weaken the 
program's social insurance rationale through which payroll tax 
contributions entitle workers to benefits. Others would object 
to the tax increases or spending cuts needed to finance the 
general revenue transfer. Still others would question the 
permanence of such transfers, especially if the budget debate 
begins to focus on maintaining balance in the non-Social 
Security portion of the budget, out of which the transfers 
would have to be made.
---------------------------------------------------------------------------
    \2\ General revenues have been used in Social Security in limited 
ways. The allocation of revenues from income taxation of Social 
Security benefits is an application of general revenues. So were 
payments made to provide Social Security earnings credits for the 
military. In addition, when minimum Social Security benefits were 
eliminated in 1981, they were preserved for those born before 1920 and 
financed through a general revenue transfer.
---------------------------------------------------------------------------
    An alternative approach would be to relax the investment 
restrictions on Social Security and allow the trust fund to 
invest a portion of its reserves in private stocks and bonds. 
Such investments would increase the return earned by the 
reserves and reduce the size of future benefit cuts and payroll 
tax increases. Shifting trust fund investments from government 
securities to private assets, however, would have no direct or 
immediate effect on national saving, investment, the capital 
stock, or production. Private savers would earn somewhat lower 
returns because their portfolios would contain fewer common 
stocks and more government bonds--those that the trust funds no 
longer purchased. Furthermore, government borrowing rates might 
have to rise a bit to induce private investors to buy the bonds 
that the trust funds no longer held.\3\ Nevertheless, the 
Social Security system would enjoy the higher returns that all 
other public and private sector pension funds with diversified 
portfolios realize.
---------------------------------------------------------------------------
    \3\ With $3.7 trillion in outstanding debt, an increase in 
borrowing costs of ten basis points (0.1 percentage points) would raise 
annual federal debt service costs by $3.7 billion.
---------------------------------------------------------------------------

 Concerns about investment of trust fund reserves in private securities

    In 1935, Congress ruled out trust fund investments in 
private stocks and bonds for good reasons. First, policymakers 
were concerned that the fund's managers might, on occasion, 
have to sell the assets at a loss, a move that would engender 
public criticism. Second, they feared that if the fund had to 
liquidate significant amounts of securities, these sales might 
destabilize markets, depressing the value of assets held in 
private portfolios and upsetting individual investors. An even 
more important consideration was that they feared that 
politicians--like themselves--might be tempted to use reserve 
investment policy to interfere with markets or meddle in the 
activities of private businesses.
    The concerns that Congress had in 1935 were certainly 
legitimate ones. But conditions have changed over the past 64 
years in ways that reduce their saliency. Stock and bond 
markets are far larger, less volatile, and more efficient now 
than they were in the 1930s. Trust fund investment activities, 
therefore, are less likely to disrupt markets. Moreover, the 
trust fund is unlikely to be forced to sell assets at a loss 
because the fund has significant and growing reserves, most of 
which under the various proposals that call for trust fund 
investment in private securities would continue to be held in 
special Treasury securities. The trustees would almost 
certainly sell the fund's government securities to get past any 
short-run gap between benefit expenses and revenues.
    On the other hand, the pressures special interests place on 
lawmakers and the stresses imposed by reelection are probably 
greater now than they were in the past. For these reasons, many 
justifiably continue to be concerned about possible political 
interference in trust fund investment activities. Chairman 
Greenspan of the Federal Reserve Board has stated that he does 
not ``believe that it is politically feasible to insulate such 
huge funds from government direction.'' Others have been less 
judicious, charging that equity investment by the trust fund 
``amounts to nationalization of American industry'' and ``would 
threaten our freedom.''
    Those who oppose trust fund investment in private 
securities point to the record of some private and state 
government pension funds that have chosen to use social, as 
well as economic, criteria to guide their investment policies. 
In addition, some of these pension funds have voted the shares 
of companies whose stock they own to further social objectives, 
ones that might sacrifice some short- or long-run profits. The 
fear is that the Social Security trustees might be subject to 
similar pressures. Congress could force them to sell, or not 
buy, shares in companies that produce products some people 
regard as noxious, such as cigarettes, alcoholic beverages, or 
napalm. Similarly, Congress could preclude investments in firms 
that engage in business practices some regard as objectionable, 
such as hiring children or paying very low wages in the 
company's foreign factories, polluting the environment, or not 
providing health insurance for their workers. Critics also fear 
that the trust fund might retain shares in such companies and 
use stockholder voting power to try to exercise control over 
these firms.

 Safeguards to protect trust fund investment decisions from political 
                               pressures

    If there were no effective way to shield trust fund 
investment decisions from political pressures, the advantage of 
higher returns that a diversified investment strategy would 
yield would not be worth the price that would have to be paid. 
However, experience suggests both that concerns about political 
interference are exaggerated and that institutional safeguards 
can be constructed that would reduce the risk of interference 
to a de minimis level.
    A number of federal government pension funds now invest in 
private securities. They include the Thrift Saving Plan for 
government workers and the pension plans of the Federal Reserve 
Board, the U.S. Air Force and the Tennessee Valley Authority. 
The managers of these pension funds have not been subject to 
political pressures. They have pursued only financial 
objectives in selecting their portfolios and have not tried to 
exercise any control over the companies in which they have 
invested.
    Of course, the fact that the managers of smaller government 
pension funds have not been subject to political pressures 
provides no guarantee that the much larger and more visible 
Social Security system would enjoy a similar fate. Special 
interests might seek Congressional sponsors for resolutions 
restricting investments more for the publicity such limits 
would provide their cause than for any economic impact the 
directive might have if carried out. In addition, some Members 
might feel obliged to propose restrictions against investing in 
corporations that have been found to violate anti trust laws, 
trade restrictions, workplace health and safety regulations, or 
other federal limits. Political pressures might cause others to 
pressure the trustees to exclude investments in companies that 
have closed a plant in their district and moved their 
production facilities and jobs abroad.
    For these reasons, it would be essential to enact 
legislation that would create a multi-tiered firewall to 
protect trust fund investment decisions from political 
pressures, one that would forestall efforts by Members of 
Congress or the executive branch from using trust fund 
investments to influence corporate policy. The first tier of 
such an institutional structure should be the creation of an 
independent agency charged with managing the trust fund's 
investments. This board--which could be called the Social 
Security Reserve Board (SSRB)--could be modeled after the 
Federal Reserve Board, which for over eight decades has 
successfully performed two politically charged tasks--
controlling growth of the money supply and regulating private 
banks--without succumbing to political pressures. Like the 
governors of the Federal Reserve, the members of the SSRB 
should be appointed by the president and confirmed by the 
Senate. To ensure their independence, they should serve 
staggered terms of at least ten years in length. Congress 
should be empowered to remove a board member from office only 
if that member was convicted of a serious offense or failed to 
uphold their oath of office, not because Congress disliked the 
positions taken by the member. As is the case with the Federal 
Reserve Board, the SSRB should be given financial independence. 
This could be ensured by allowing it to meet its budget by 
imposing a tiny charge on the earnings of its investments. 
Under such an arrangement, neither Congress nor the executive 
branch could exercise influence by threatening to withhold 
resources.
    A second tier of protection should be provided by limiting 
the discretion given to the SSRB. The primary responsibility of 
the board should be to select, through competitive bids, 
several private sector fund managers, each of whom would be 
entrusted with investing a portion of the fund's reserves. 
Depending on the amount invested, somewhere between three and 
ten fund managers might be chosen. Contracts with the fund 
managers would be rebid periodically and the board would 
monitor the managers' performance.
    A third tier of insulation from political pressures should 
be provided by authorizing fund managers only to make passive 
investments. They would be charged with investing in 
securities--bonds or stocks--of companies chosen to represent 
the broadest of market indexes, indexes that reflect all of the 
shares sold on the three major exchanges. In other words, the 
trust fund's investment would be in a total stock market index 
such as the Wilshire 5,000 or Wilshire 7,000 index. If bonds 
were included in the investment mix, the appropriate guide 
might be the Lehman Brothers Aggregate (LBA) index. Unlike 
actively managed mutual funds, there would be no discretion to 
pick and choose individual stocks and, therefore, no window 
through which political or social considerations could enter.
    A fourth layer of defense should be provided by requiring 
that Social Security's investments be commingled with the funds 
that private account holders have invested in index funds 
offered by the managers chosen by the SSRB. These private 
investors would object strenuously if politicians made any 
attempt to interfere with the composition of the holdings of 
their mutual fund.
    Fifth, to prevent the SSRB from exercising any voice in the 
management of private companies, Congress should insist that 
the several fund managers selected by the SSRB vote Social 
Security's shares solely to enhance the economic interest of 
future Social Security beneficiaries.
    To summarize, this set of five institutional restraints 
would effectively insulate fund management from political 
control by elected officials. Long-term appointments and 
security of tenure would protect the SSRB from political 
interference. Limitation of investments to passively managed 
funds and pooling with private accounts would prevent the SSRB 
from exercising power by selecting shares. The diffusion of 
voting rights among several independent fund mangers and the 
requirement that the managers consider economic criteria alone 
would prevent the SSRB from using voting power to influence 
company management. In short, Congress and the president would 
have no effective way to influence private companies through 
the trust fund unless they revamped the SSRB structure. That 
would require legislation which would precipitate a national 
debate over the extent to which government, in its role as 
custodian of the assets of the nation's mandatory pension 
system, should interfere in the private economy. Framed this 
way, there would be strong opposition to such legislation.
    While nothing, other than a constitutional amendment, can 
prevent Congress from repealing a previously enacted law, the 
political costs of doing so would be high. Furthermore, if 
Congress is disposed to influence the policies of private 
businesses, it has many far more powerful and direct 
instruments to accomplish those ends than through management of 
the Social Security trust funds. The federal government can 
tax, regulate, or subsidize private companies in order to 
encourage or force them to engage in or desist from particular 
policies. No private company or lower level of government has 
similar powers.

                               Conclusion

    Allowing the Social Security system to invest a portion of 
its growing reserves in private assets will increase the 
returns on the trust fund balances and reduce the size of the 
unavoidable payroll tax increases and benefit reductions that 
will be needed to eliminate the program's long-run deficit. 
Concerns that political interests might attempt to influence 
trust fund investment decisions are legitimate but 
institutional safeguards can be enacted into law that would 
reduce the possibility of such interference to a de minimis 
level.
      

                                


The President's Framework for the Budget Surplus: What Is It and How 
Should It Be Evaluated?

    The federal budget registered a surplus in fiscal year 
1998, the first in 29 years.\1\ The budget for the current 
fiscal year, 1999, will also end in surplus, producing the 
first back-to-back surpluses since 1956-57. OMB projects that, 
if tax and spending policies remain unchanged (the baseline 
projection), significant surpluses will persist for several 
decades. To ensure that this unexpectedly favorable fiscal 
outlook is neither squandered nor frittered away, President 
Clinton laid out in his fiscal year 2000 budget proposal a 
framework for dealing with the projected surpluses of the next 
15 years. The president's framework, which is multi-faceted and 
complex, has proven difficult for even seasoned budget analysts 
to explain. 
---------------------------------------------------------------------------
    \1\ This note uses the terms ``surplus'' and ``total surplus'' in 
place of the more cumbersome ``baseline unified budget surplus.'' They 
refer to the sum of the Social Security surplus and the surplus in the 
government's other accounts. All of the figures are from OMB.
---------------------------------------------------------------------------

                       The president's framework

    Assuming the economy performs as the Administration 
projects, that OMB's estimates of future mandatory spending are 
correct, and that tax and spending policies are not changed, 
budget surpluses totaling $4.854 trillion will be realized over 
the fiscal 2000 to 2014 period (Table 1). Both Social Security 
and the government's non-Social Security accounts will register 
sizeable surpluses over this period (Figure 1).
      

                                


                          Table 1.--The Baseline Surplus and the President's Framework
                                            (fiscal years 2000-2014)
----------------------------------------------------------------------------------------------------------------
              Baseline Surplus                $ billions       President's Framework      $ billions    Percent
----------------------------------------------------------------------------------------------------------------
Total.......................................      $4,854  Total.........................      $4,854         100
    Non-Social Security.....................     (2,153)    Debt reduction..............     (2,870)          59
    Social Security.........................   (2,701) *    Increased discretionary            (481)          10
                                                           spending.
                                                            USA accounts................       (536)          11
                                                            Equity investments for             (580)          12
                                                           Social Security.
                                                            Added financing costs.......       (387)           8
                                                          Addendum:.....................
                                                            Additional Treasury               $2,184
                                                           securities for Social
                                                           Security.
                                                            Additional Treasury                 $686
                                                           securities for Medicare HI.
----------------------------------------------------------------------------------------------------------------
* Includes $5 billion from the Postal Service.

      

                                

[GRAPHIC] [TIFF OMITTED] T7507.027


    Under the president's framework, 59 percent of this 
projected baseline surplus would be reserved to reduce debt 
held by the public.\2\ The remaining 41 percent would be 
available to commit now to current and future needs. The 
president's budget proposes using this portion of the surplus 
to increase discretionary spending, contribute to new personal 
retirement accounts for workers (USA accounts), and buy 
equities for the Social Security trust fund. Other policymakers 
have suggested that all of the surplus not devoted to debt 
reduction be used to cut taxes or expand discretionary and 
entitlement spending. This would be inconsistent with the 
allocation in the president's framework because the portion of 
the surplus used to buy equities for the Social Security trust 
fund is equivalent to debt reduction. The equities would be 
liquid assets that could easily be sold, and the proceeds used 
to redeem debt. Thus, under the president's framework, only 29 
percent of the surplus is available for such initiatives.
---------------------------------------------------------------------------
    \2\ The percentages used in this note are percents of the baseline 
surplus. The Administration's descriptions of the framework calculate 
percentages of the surplus excluding the added financing costs that 
arise when a portion of the surplus is not used to reduce debt.
---------------------------------------------------------------------------
    Under the president's framework, special Treasury 
securities equal in value to the amount by which debt held by 
the public is expected to be reduced over the 15 year period 
would be credited to the Social Security and Medicare HI trust 
funds (addendum, Table 1). These bonds would be in addition to 
the special Treasury securities the trust funds receive when 
Social Security and Medicare remit their annual surpluses to 
the Treasury. The additional securities credited to the trust 
funds would be registered as budget outlays under a change the 
president proposes to make in current budget accounting 
rules.\3\ The exact amounts that will be credited to the trust 
funds each year will be specified in legislation enacted in 
1999. Therefore, the actual reduction in debt held by the 
public under the president's framework may end up being more or 
less than the value of the securities added to the trust funds. 
If the economy proves to be weaker than expected or 
policymakers boost spending or cut taxes more than the 
president has proposed, the reduction in debt held by the 
public could be considerably smaller than the transfers made to 
the trust funds.
---------------------------------------------------------------------------
    \3\ This change is necessary to ensure that the projected unified 
budget balance is reduced by the transfers and the resources can not be 
spent again. Under current accounting rules, a transfer from the 
general accounts to the trust funds would not affect the balance in the 
unified budget because it would be an outlay from one account and an 
offsetting receipt in another.
---------------------------------------------------------------------------

                 The goals of the president's framework

    The president's framework has at least four different broad 
objectives.\4\
---------------------------------------------------------------------------
    \4\ In addition to these broad objectives, the president's 
framework has objectives that are more tactical in nature such as to 
free up resources for increased discretionary spending after fiscal 
year 2000 and to check the impetus for large across-the-board tax cuts.
---------------------------------------------------------------------------
    First, it is an effort to ensure that a large fraction--
roughly 82 percent--of the baseline surplus projected for the 
next 15 years contributes to national saving by paying down 
debt held by the public, purchasing equities for the Social 
Security trust fund, and boosting the retirement saving of 
workers (USA accounts).
    Second, it is an attempt to establish a budgetary 
environment in which debt reduction is politically sustainable. 
Many believe that, without some restraints, lawmakers will 
enact tax cuts and spending increases that dissipate the 
projected surpluses. To thwart this, the president has wrapped 
his policy of debt reduction in the protective armor of 
initiatives to strengthen Social Security and Medicare.
    Third, the president's framework is an initiative that 
shifts some of the burden for supporting future Social Security 
and Medicare benefits to the government's general funds. This 
is accomplished by crediting the Social Security and Medicare 
HI trust funds with more Treasury securities than the funds--
surpluses warrant. These infusions of obligations mean that 
less of the long-run imbalances between future benefit costs 
and payroll tax receipts in Social Security and Medicare will 
be closed through payroll tax hikes and benefit cuts in those 
programs and more will be financed through slower growth in 
other program spending and higher levels of general taxes than 
otherwise would occur.\5\ The equities purchased for the Social 
Security trust fund will reduce the adjustments that Social 
Security and the balance of government together will have to 
make in the future.
---------------------------------------------------------------------------
    \5\ In the short run, increased borrowing from the public 
represents a third alternative. Such borrowing, however, would lead to 
higher debt service outlays which eventually would require higher taxes 
or spending cuts.
---------------------------------------------------------------------------
    Fourth, the president's framework is an effort to improve 
the prospect that Congress and the president can reach 
agreements on measures that address the long-run solvency 
problems facing Social Security and Medicare. It does this by 
reducing the programs' funding shortfalls through the provision 
of additional bonds to the trust funds. Because the shortfalls 
will be smaller, fewer painful measures--payroll tax increases 
and benefit reductions--will be needed to close the remaining 
imbalances. For example, without the president's infusion of 
extra bonds into the Social Security trust fund, benefit cuts 
and payroll tax increases equivalent to 2.19 percent of taxable 
payroll--a politically undigestible mouthful--would be required 
to close the program's estimated 75 year imbalance. With his 
policy, the adjustments would shrink to a size that lawmakers 
might more readily swallow--about one percent of payroll.
    Some critics have suggested that, by reducing the long-run 
shortfall, the president's framework could undercut the 
pressure on policymakers to act. But the president has not 
claimed that his framework represents a full response to Social 
Security's long-run financial problem. It buys time but does 
nothing to lower future Social Security benefit promises. The 
higher returns earned by equity investments and the interest 
earnings on the additional bonds will boost the program's 
revenues modestly. But, as the president has acknowledged, 
other measures will be needed to complete the package.

   The impact of the president's framework on public debt and Social 
                           Security reserves

    Under the president's proposal, the level of the debt held 
by the public would fall from an estimated $3.670 trillion at 
the end of fiscal 1999 to $1.168 trillion at the end of 2014, 
or from 41.9 percent of GDP to 7.1 percent of GDP, the lowest 
share of GDP since 1917 (Table 2). Whether this represents a 
major or modest reduction depends critically on what one thinks 
would happen to the budget surpluses if the president's 
framework were not adopted. Of the many possibilities, the 
following three scenarios encompass the range of plausible 
alternatives:
     Save Total Surplus. Under this scenario, all of 
the budget surplus would be ``saved,'' that is, used to pay 
down debt held by the public. If this happened, all of the debt 
held by the public would be retired by 2013.
     Save Social Security Surplus. Under this scenario, 
the surpluses in the Social Security accounts would be used to 
pay down debt held by the public.\6\ The surpluses in the non-
Social Security accounts would be devoted to tax cuts and 
spending increases. Debt held by the public would amount to 
$1.149 trillion or about 7 percent of GDP by the end of fiscal 
2014 under this scenario.
---------------------------------------------------------------------------
    \6\ This would net out the $12 billion deficit that the 
Administration projects the non-Social Security accounts will register 
in fiscal year 2000.
---------------------------------------------------------------------------
     Dissipate Surplus. Under this scenario, all of the 
unified budget surplus would be dissipated through tax cuts and 
spending increases. Debt held by the public would not decline, 
but rather would rise a bit to $3.849 trillion for reasons that 
relate to the way credit programs are treated under current 
budget accounting rules.
    Most analysts who are familiar with the pressures facing 
lawmakers consider the ``Dissipate Surplus'' scenario to be the 
most likely. In other words, they believe that most, if not 
all, of the projected budget surplus will be dissipated if some 
enforceable framework for protecting the surplus is not 
enacted. Compared to this situation, the president's framework 
is a model of fiscal prudence. Over the next five, ten, and 
fifteen years, the president's plan would reduce the levels of 
public debt by $464 billion, $1.341 trillion and $2.681 
trillion, respectively, compared to the levels that would exist 
if all of the surplus was dissipated on tax cuts and spending 
increases.
    The president's framework would reduce the level of debt 
held by the public marginally less than would be the case under 
the scenario in which all of the Social Security surpluses were 
devoted to debt reduction. Specifically, public debt in 2004, 
2009, and 2014 would be higher by roughly $249 billion, $317 
billion, and $19 billion, respectively, under the president's 
framework. However, the equity investments provided to the 
Social Security trust fund under the president's framework, 
which are functionally equivalent to debt reduction, would 
amount to $768 billion by the end of 2014.\7\ Counting these 
assets, the net liabilities of the government under the 
president's framework would be lower after 2008 than those 
under the scenario in which the Social Security surplus was 
devoted exclusively to debt reduction.
---------------------------------------------------------------------------
    \7\ This includes investments of $580 billion plus reinvested 
earnings of $188 billion.
[GRAPHIC] [TIFF OMITTED] T7507.026


    The president's proposal would reduce the debt held by the 
public over the next five, ten, and fifteen years by about $364 
billion, $1,068 billion and $1,168 billion less than would be 
the case if all of the total budget surplus were devoted to 
paying down federal debt.
    Reserves in the Social Security trust fund would be larger 
under the president's framework than under any of the 
alternative scenarios because additional Treasury securities 
and equities would be credited to the trust fund and these new 
assets would generate interest, dividends, and capital gains. 
By 2014, the trust fund balance would be augmented by about 
$3.752 trillion.

    General fund support for Social Security and Medicare under the 
                         president's framework

    Some have argued that the president's framework--which will 
credit the Social Security trust fund with equities and the 
Social security and Medicare HI trust funds with special 
Treasury securities in excess of those due them in return for 
their annual surpluses--represents a sharp break with past 
policy, which they interpret as requiring that these programs 
be financed exclusively through payroll tax receipts and 
interest earnings on the trust fund reserves that accumulate 
when payroll tax receipts exceed benefit costs.\8\ The 
additional securities and the equity investments that the trust 
funds will receive represent general fund support for these 
social insurance programs. They will postpone the dates at 
which the trust funds become insolvent. The additional Treasury 
securities will not, however, reduce the size of the 
adjustments that the government will have to make in the 
future, nor will they affect the timing of these adjustments. 
Rather than forcing adjustments--tax increases or spending 
cuts--within the Social Security and Medicare programs, the 
trust funds will redeem their added securities; the Treasury 
will have to come up with the resources by increasing general 
revenues, reducing the growth of non-Social Security, non-
Medicare spending, or borrowing from the public, which would 
push up debt service costs.
---------------------------------------------------------------------------
    \8\ In fact, general revenues have been and are used for Social 
Security and Medicare HI in limited ways. A portion of the income tax 
receipts that derive from including Social Security benefits in the 
taxable income of upper-income recipients is transferred to each trust 
fund. Payments made to provide Social Security earnings credits for the 
military were taken from general revenues. In addition, when minimum 
Social Security benefits were eliminated in 1981, they were preserved 
for those born before 1920 and financed through a general revenue 
transfer.
---------------------------------------------------------------------------
    There are political, historical, and economic 
justifications for the president's proposal to shift some of 
the burden for supporting future Social Security and Medicare 
benefits to general revenues. The political arguments were 
alluded to previously. One is that the transfer of securities 
to the trust funds, which creates a future general fund 
obligation, when combined with the proposed budget accounting 
change, will make a policy of debt reduction politically 
sustainable. A second argument is that by shifting some of the 
burden for adjustments onto the general funds the dimensions of 
the long run problems facing these two programs will be reduced 
to magnitudes that politicians may find more manageable.\9\
---------------------------------------------------------------------------
    \9\ An alternative way of trying to protect Social Security 
surpluses for debt reduction would be to exclude the Social Security 
accounts from all budget discussions and presentations, as former 
Representative Livingston and others have proposed, and focus the 
debate on the on-budget surplus.
---------------------------------------------------------------------------
    The historical justification is that an infusion of general 
revenues represents compensation for the fact that, during the 
early years, Social Security and Medicare payroll taxes were 
used to support benefits that more appropriately should have 
been paid for out of general revenues because these benefits 
were more social welfare than social insurance.
    The 1935 Social Security Act set pensions for those 
retiring during the program's first few decades at very meager 
levels--ones that were commensurate with the modest payroll tax 
contributions the first cohorts of retirees were expected to 
make. The initial beneficiaries in 1942 would have received a 
maximum monthly pension of $25 (in 1998 dollars); the first 
workers to receive full pensions under the 1935 law--those 
turning 65 in 1979--would have received pensions of less than 
$250 a month (in 1998 dollars). Under this parsimonious 
approach, large trust fund balances would have accumulated and 
these reserves would have generated interest income that would 
have helped pay future pensions.
    In 1939, Congress decided to begin paying benefits in 1940 
rather than 1942, raise pensions, and add spouse and survivor 
benefits to the worker pensions established in the 1935 law. 
Benefits for these early cohorts were boosted periodically 
thereafter. These decisions were made to ameliorate a broad 
social problem--widespread poverty among the elderly whose 
earnings and savings had been decimated by the Great 
Depression. The 1939 and subsequent reforms reduced the amount 
of general revenues needed to support the welfare program for 
the aged. They provided income support to millions without the 
stigma of welfare or the inequities associated with the inter-
state differences in welfare payment levels that characterized 
the Old Age Assistance program.\10\ While the arguments for 
providing more generous pensions than the original Social 
Security Act called for to those turning 65 during the four 
decades after 1940 was certainly defensible, it imposed a 
burden on the Social Security system that would have been more 
appropriately placed on general revenues.
---------------------------------------------------------------------------
    \10\ Old Age Assistance (OAA)--which was replaced by the 
Supplemental Security Income (SSI) program in 1974--was an open ended 
federal grant that reimbursed states for a share of their welfare 
expenditures for the indigent aged. Even with the expansion of Social 
Security, OAA provided benefits to more elderly than did Social 
Security until 1949 and distributed more money than the pension system 
did until 1951.
---------------------------------------------------------------------------
    The implementation of Medicare followed a similar pattern. 
Starting in 1966, those age 65 and older who were eligible for 
Social Security benefits--and their spouses, if they were age 
65 or older--became eligible for Medicare benefits even though 
they had not contributed a penny in Medicare payroll taxes to 
the HI trust fund. The first cohorts of workers who will have 
paid HI payroll taxes for their entire careers will become 
eligible for benefits only after 2005.
    An economic justification for some general revenue 
contribution to the Social Security program arises from the 
difference between the benefit Social Security's surpluses 
provide to the nation's economy and the return that is earned 
by the trust fund on its reserves.\11\ Additions to national 
saving generate a real return to the economy of at least 6 
percent. Social Security surpluses, however, earn less because 
the trust fund is required to hold its reserves exclusively in 
special Treasury securities that, over the long run, are 
projected to pay an average real return that is under 3 
percent. To provide workers with a fair return on the portion 
of their payroll taxes that bolsters the trust fund reserves, 
policymakers could allow Social Security to invest its reserves 
in higher yielding assets, agree to pay a higher rate of 
interest on the special Treasury securities held by the trust 
fund, or credit the trust fund with additional bonds. The 
president's framework represents a mixture of the first and 
third of these alternatives.
---------------------------------------------------------------------------
    \11\ This justification is irrelevant for Medicare, both because 
roughly 30 percent of the program is supported through general revenues 
and because the trust fund balances are small and not expected to grow 
significantly in the future.
---------------------------------------------------------------------------

                     The ``double counting'' issue

    Many lawmakers and some analysts have criticized the 
president's framework not only for its complexity but also 
because it engages in what they consider to be ``double 
counting.'' Specifically, they object to the fact that the 
president's plan seems to commit 159 percent of the budget 
surplus--59 percent to pay down debt held by the public; 12 
percent to buy equities for the Social Security trust fund; 29 
percent for USA accounts, new discretionary spending, and 
associated debt service costs; and 59 percent to provide 
additional Treasury securities to the Social Security and 
Medicare HI trust funds (Figure 2). They charge that it is 
budget legerdemain to use the same dollar to both pay down debt 
and boost reserves in the Social Security and Medicare HI trust 
funds, as appears to be the case under the president's 
framework.
    But using budget surplus dollars to redeem debt is 
fundamentally different from devoting these surpluses to tax 
cuts or increased spending. In the latter situations, the 
benefit of the use is external--it flows to taxpayers or 
program beneficiaries. In the case of debt reduction, the 
government is reducing its external liabilities. In effect, it 
is strengthening its balance sheet by buying assets (government 
bonds held by the public). By crediting the trust funds with 
these assets, as is done under the president's framework, the 
benefit of the improvement in the government's balance sheet is 
directed towards preventing future payroll tax increases and 
benefit cuts rather than towards general tax cuts or spending 
increases for other government programs. The exchange, however, 
is not a wash--that is, the increase in the total liabilities 
of the non-Social Security, non-Medicare portion of the budget 
would be modestly larger than the reduction in the program 
adjustments necessary to meet future Social Security and 
Medicare benefit commitments.\12\
---------------------------------------------------------------------------
    \12\ The liabilities would be higher because interest earned on the 
added securities will boost the trust fund's reserves by about $800 
billion over the period. This increase in reserves will not be offset 
by a reduction in public debt.
[GRAPHIC] [TIFF OMITTED] T7507.028

                               Conclusion

    The prospect of growing budget surpluses over the next 
several decades, together with the expiration of the 
discretionary spending caps and pay-as-you-go rules after 
fiscal year 2002, has created a need to establish some 
framework for dealing with the nation's fiscal good fortune. 
Absent such a framework, fiscal discipline could break down and 
a feeding frenzy of tax cuts and spending increases could 
erupt. If so, the surpluses could be dissipated by addressing 
immediate needs that, in retrospect, could appear trivial when 
compared to the priorities that emerge over the next two 
decades.
    The president has proposed one framework for dealing with 
the projected surpluses; other policy makers have put forward 
alternatives. Senator Domenici (R-NM), chair of the Senate 
Committee on the Budget, has recommended that all of the Social 
Security surpluses be reserved for debt reduction and that only 
the projected surpluses in the non-Social Security accounts be 
available for current commitment. Representative Kasich (R-OH), 
chair of the House Committee on the Budget, has suggested that 
commitments can be made now to cut taxes (or increase spending) 
as long as those initiatives (and the resultant financing 
costs) do not absorb more than 43 percent of the projected 
budget surplus for any year.\13\ This percentage is the 
fraction of the aggregate fifteen year surplus that would 
remain, under the president's framework, if the additional 
Treasury securities credited to the Social Security trust fund 
and the equity investments were excluded.
---------------------------------------------------------------------------
    \13\ After their initial statements, Senator Domenici and 
Representative Kasich have been less specific about the parameters of 
their proposals.
---------------------------------------------------------------------------
    Over the next five years, the framework suggested by 
Senator Domenici would make much less available for current 
commitment than would the approaches of the president or 
Representative Kasich. This is because little of the expected 
surplus over the next few years is contributed by the non-
Social Security portion of the budget (Table 3 and Figure 3). 
Over the 2009 to 2014 period, the Domenici framework is the 
most generous because well over half of the projected surpluses 
for that period arise from the non-Social Security accounts. In 
fact, Social Security surpluses peak in 2012 and decline 
thereafter. The president's framework is the most restrictive 
over the entire 15 year period because it commits 71 percent of 
the projected surpluses to debt reduction and equity 
investments for Social Security.

       Table 3.--Resources Available for Current Commitments under Alternative Frameworks for the Surplus
                                    [fiscal years 2000 to 2014 ($ billions)]
----------------------------------------------------------------------------------------------------------------
                                                                    2000-04     2005-09     2010-14     2000-14
----------------------------------------------------------------------------------------------------------------
Save entire surplus.............................................         $ 0         $ 0         $ 0         $ 0
President's framework *.........................................         259         469         676       1,404
Domenici's framework............................................         125         636       1,403       2,164
Kasich's framework..............................................         356         680       1,051       2,087
----------------------------------------------------------------------------------------------------------------
* Excludes debt reduction and equity investment.

      

                                

[GRAPHIC] [TIFF OMITTED] T7507.029

    Projections of federal revenues and spending, even under 
unchanged policy, are notoriously inaccurate. The economy can 
perform significantly better or worse than expected. The 
fraction of economic output represented by tax revenues can 
trend up or down for reasons that are difficult to predict. 
Similarly, spending on entitlement programs such as Medicare 
and Medicaid can speed up or slow down for reasons that are 
hard to explain even in retrospect. Figure 4, which illustrates 
the changes that have occurred over the last four years in the 
Congressional Budget Office's baseline projections, after 
subtracting out the effects of policy changes, underscores this 
reality. While on balance the unexpected shocks of the past 
four years have acted to improve the fiscal outlook, the 
opposite was the case during the 1980s and early 1990s. That 
less fortunate pattern could be repeated in the future. Given 
this uncertainty, the economic benefits of debt reduction, and 
the challenges that the babyboomers' retirement will pose for 
the nation, a framework like the president's represents a 
prudent approach to fiscal policy for the first two decades of 
the 21st century.
[GRAPHIC] [TIFF OMITTED] T7507.030

      

                                


Legislated Changes to the Canada Pension Plan

Shanna Rose *

                   Canada's Retirement Income System

    Canada's  retirement income system has two main components: 
the Old Age Security Program and the Pension Plans. In 1997, 
each program provided approximately $22 billion in retirement 
income.\1\ The government also offers tax-assisted private 
savings in Registered Pension and Retirement Savings Plans.
---------------------------------------------------------------------------
    * Research Assistant, Economic Studies, The Brookings Institution.
    \1\ All monetary figures are expressed in Canadian dollars.
---------------------------------------------------------------------------
    The Old Age Security Program, which guarantees Canadian 
seniors a basic level of retirement income, was established in 
1952, replacing a provincial, means-tested benefit system that 
had existed since 1929. The program consists of Old Age 
Security (OAS), a flat benefit for all Canadians age 65 and 
over who meet residence requirements; the Guaranteed Income 
Supplement, a means-tested benefit for low-income seniors; and 
the Spouse's Allowance, a means-tested benefit for low-income 
spouses of OAS recipients and widows/widowers age 60 to 64.\2\ 
The Old Age Security Program is financed from general revenues.
---------------------------------------------------------------------------
    \2\ In 2001, the OAS and GIS will be consolidated into one benefit, 
called the Seniors Benefit, with stricter means-testing.
---------------------------------------------------------------------------
    The other main component of Canada's retirement income 
system consists of two parallel public pension plans, the 
Canada Pension Plan (CPP) and the Quebec Pension Plan (QPP). 
Both are mandatory, earnings-related social insurance programs 
financed on a pay-as-you-go basis. The CPP applies to all of 
Canada except those living in the province of Quebec. The two 
plans have the same contribution rates and benefit formulas. 
Quebec recently amended its pension plan so as to conform to 
the changes made to the CPP's benefits and contribution rates 
mentioned below. The following discussion of the newly created 
Investment Board, however, applies only to the CPP.

                        The Canada Pension Plan

    Approximately ten million Canadians currently pay into the 
CPP and 3.7 million receive benefits. The early, normal, and 
late retirement ages are 60, 65, and 70, respectively.\3\ The 
CPP provides a pension of 25 percent of the average of the 
contributor's highest monthly pensionable earnings, adjusted 
for growth in wages. The formula for calculating average 
earnings ``drops out'' the years in which the worker earned the 
least (15 percent of all years up to seven years) to account 
for unemployment, school attendance, etc. The formula also 
excludes years of absence from the labor force due to 
disability and child-rearing.
---------------------------------------------------------------------------
    \3\ The pensions of Canadians who continue paying into the CPP 
until age 70 are raised by six percent for each year worked after age 
65. After age 70 Canadians are no longer required to contribute to the 
CPP.
---------------------------------------------------------------------------
    Until now, CPP fund reserves have been invested exclusively 
in nonnegotiable provincial government securities, earning the 
federal long-term bond rate of interest. The CPP presently has 
reserves equal to approximately two years' worth of benefits, 
or nearly $40 billion, as mandated. A 1993 actuarial report 
projected the depletion of the fund by 2015, assuming the 
established schedule of contribution rates was followed.

                Canada Pension Plan Investment Board Act

    In December 1997, following two years of extensive 
nationwide public ``consultations,'' the Canadian Parliament 
passed the Canada Pension Plan Investment Board Act. The 
legislation, effective April 1, 1998, established the Canada 
Pension Plan Investment Board, an independent panel to oversee 
the investment of pension funds in the stock and bond markets. 
The Board will invest the reserve fund in a diversified 
portfolio of securities beginning in February 1999. The new 
investment policy requires the Board to secure the ``maximum 
rate of return without undue risk of loss.''
    The Investment Board will be subject to investment rules 
similar to those governing other Canadian pension funds. The 
Board is permitted to invest as much as 20 percent of its 
assets in foreign securities, although some policy makers want 
to relax this regulation so as to allow the Board to better 
fulfill its mandate to maximize returns. Eventually, the share 
of CPP funds invested in provincial securities will be limited 
to the proportion held by private and provincial pension funds 
in Canada. As a transitional measure, provinces will be given 
the option of rolling over existing CPP bonds, upon maturity, 
for a 20-year term at the same rate of interest they pay on 
their market borrowings. For the first three years, provinces 
will also have access to half of the new CPP funds the Board 
invests in bonds. The Board is required to act as a ``passive'' 
investor for at least the first three years, investing its 
stock holdings in broad market indexes, so as to help smooth 
the transition.
    The Investment Board, which is accountable to the public 
and the government, will provide Canadians with quarterly 
financial statements and annual reports. The Board will also 
hold public meetings in participating provinces at least every 
two years.

                 Appointment of the Board of Directors

    On October 29, 1998, the Canadian Minister of Finance, in 
consultation with participating provincial finance ministers, 
named the 12 directors who will serve on the CPP Investment 
Board. The directors will serve staggered three-year terms. 
Prominent businesswoman Gail Cook-Bennett was selected as the 
chair. Ms. Cook-Bennett holds a Ph.D. in economics from the 
University of Michigan. She is a director of several major 
Canadian companies and served on the Ontario Teachers' Pension 
Plan Board--now one of Canada's largest institutional 
investors--when it was first permitted to invest in equities in 
1990.

                   Concerns about the Investment Fund

    Concerns that the fund will use its market power to 
pressure corporations, or that the fund might succumb to 
pressures to invest in politically favored ventures, led the 
government to postpone the effective date for the CPP 
Investment Board Act from January 1 to April 1, 1998. This 
delay allowed Canada's Senate Banking Committee to hold 
hearings on the development of regulations relating to the 
board's operation.
    Another concern is that the Canadian stock market is not 
broad enough or large enough to deal with all of the new 
pension money that will be generated by scheduled increases in 
contributions. Although only a small trickle of pension funds 
will be available for investment in 1999, the stock fund will 
grow by about $10 billion a year thereafter, according to 
government projections. Canadian stock indexes lack the breadth 
of U.S. indexes, making it difficult for investors to track the 
market accurately. Moreover, many of Canada's largest companies 
are subsidiaries of foreign concerns, the shares of which are 
not traded on the Canadian exchanges.

                        Other Changes to the CPP

    The Canada Pension Plan Investment Board Act is part of a 
broad overhaul of the CPP designed to keep the program solvent 
in the wake of baby-boom retirement. Today, there are about 3.7 
million Canadian seniors; by 2030, there will be 8.8 million. 
According to Prime Minister Jean Chretien, ``this major 
overhaul makes us the first industrialized country to ensure 
the sustainability of its public pension system'' well into the 
21st century. The other major changes to the CPP are outlined 
below.

Changes in the Benefit Structure

    An estimated 75 percent of the changes to the CPP will fall 
on the financing side, and 25 percent on the benefit side. The 
administration and calculation of some benefits will be 
tightened so as to slow the growth of costs. The formula for 
converting previous earnings to current dollars will be changed 
to reduce average pensionable earnings slightly. This change 
will be phased in over two years.
    The administration of disability and death benefits has 
been altered in several ways. Eligibility for disability 
benefits is now contingent on CPP contributions in four of the 
last six years, whereas previously it was contingent on 
contributions in five of the last 10 years or two of the last 
three years. Rather than being based on maximum pensionable 
earnings at age 65, disability benefits are to be based on 
maximum pensionable earnings at the time the disability occurs 
and then price-indexed until age 65. The one-time death benefit 
still equals six times the monthly retirement benefit of the 
deceased worker, but the maximum has been lowered from $3,580 
to $2,500, where it will be frozen (this change was favored 
over the option of eliminating the death benefit entirely). 
Changes have been implemented to limit the extent to which new 
beneficiaries may combine survivor's benefits with either 
retirement or disability benefits.

Changes in Contribution Rates

    Over the next six years, the contribution rate will 
increase from the current 5.85 percent rate to a ``steady-state 
rate'' of 9.9 percent of contributory earnings. This rate is 
shared equally by workers and their employers. By contrast, a 
1995 actuarial report projected that, without any changes to 
the pension plan, the contribution rate would have to rise to 
14.2 percent by 2030. The Basic Exemption, below which no 
contributions are paid, is to be frozen at the current year's 
level of $3,500; this measure will widen the earnings base, 
since the upper limit (currently $35,800, approximately 
corresponding to the average wage) will continue to rise 
according to the established formula. All contributors are to 
receive regular statements about their CPP contributions.
    The Ministers of Finance have the authority to alter 
contribution rates, in connection with a triennial review, 
through regulation. If stocks perform poorly, contributions 
will be increased to offset losses. If the market does well, 
the profits will help obviate future rises in contributions, 
and may even lead to a reduction.

Unchanged Aspects of the CPP

    The future benefits of persons age 65 or older on December 
31, 1997 are unaffected by these changes, as are those paid to 
persons under age 65 who received benefits before January 1, 
1998. The early, normal, and late retirement ages remain 
unchanged. All benefits except the lump-sum death benefit 
remain indexed to inflation.

                      Investment Fund Projections

    The government has projected, based on ``prudent 
assumptions,'' that the new fund will generate an average long-
run return of 3.8 percent above inflation. Within a few years, 
the investment board is expected to become the country's 
largest stock-market investor. The total CPP account is 
projected to grow from $37 billion at the end of 1997 to about 
$90 billion at the end of 2007; of that amount, $60 billion to 
$80 billion would be available for management by the board. By 
2017, the investment fund is expected to have amassed a reserve 
of roughly five years' payout, compared to the current two 
years' worth of benefits, moving the CPP from a pay-as-you-go 
system to a more fully-funded one.
      

                                

    Chairman Shaw. Thank you, Dr. Reischauer.
    Dr. Weaver.

    STATEMENT OF CAROLYN L. WEAVER, PH.D., DIRECTOR, SOCIAL 
 SECURITY AND PENSION STUDIES, AMERICAN ENTERPRISE INSTITUTE; 
    AND FORMER MEMBER, 1994-1996 ADVISORY COUNCIL ON SOCIAL 
                            SECURITY

    Ms. Weaver. Thank you, Mr. Chairman.
    In current discussions of investing Social Security in the 
stock market, the choice between centralized investment and 
personal accounts is sometimes portrayed as a choice between 
two different investment policies, two ways of skinning the 
same cat and improving investment returns for workers.
    When viewed in this way, the debate quickly turns to 
administrative structures and costs. And then it seems logical 
to some to go with centralized investment because it would 
appear easier and quicker and cheaper than turning the problem 
over to 100 million or more people.
    While administrative structures and costs are worthy of 
careful attention, in my view, they distract attention from the 
more fundamental issue, which is whether centralized 
investment, even if cheaper and perfectly managed--and I used 
quotation marks on the word cheaper--can deliver the range of 
economic benefits offered by a system of personal accounts? 
Economic, social, and political benefits, I should say.
    I believe the answer is no. In my written testimony, I 
identify some of the key differences between centralized 
investment and personal accounts and highlight the benefits of 
personal accounts that I believe cannot be achieved through 
centralized investment. I will briefly summarize those now.
    First, personal accounts offer the prospect of higher rates 
of return and more secure retirement incomes for younger 
workers and future generations. Centralized investment offers 
the prospect of more revenue for the trust funds, with no 
assurance that enhanced revenues will flow back to benefit any 
particular worker or cohort of workers.
    Second, personal accounts are built on private ownership. 
Workers would own their contributions and investment earnings. 
Centralized investment would not change the statutory basis of 
workers' claims to future benefits in any way.
    Third, personal accounts would allow low-wage workers to 
accumulate financial wealth through Social Security and share 
in the benefits of capital ownership. With centralized 
investment, Social Security would continue to offer all workers 
long-term benefit promises.
    Fourth, personal accounts would reduce workers' reliance on 
government benefit promises and the political risk to which 
their retirement incomes are now exposed. With centralized 
investment, workers' entire income from Social Security would 
continue to be politically determined.
    In fact, with centralized investments, you would have new 
margins for political influence, those surrounding investment 
decisions on the one hand and, if trust fund reserves are 
swelled through an investment strategy involving centralized 
investment, there would be new pressures to increase benefit 
obligations, the type of pressure that could not come to bear 
on a system of personal accounts funded with workers' 
contributions.
    Fifth, with personal accounts, it is clear who bears the 
risks and reaps the rewards of stock market investment. Workers 
do. These risks would be mitigated by the government safety net 
that buttresses all proposals for personal accounts. With 
centralized investments, it continues to be unstated and thus 
entirely unclear who bears the risks or reaps the reward. 
Financial risks are present under both systems. Spreading or 
sharing them through centralized investment cannot reduce or 
eliminate financial market risk.
    Sixth, personal accounts would allow workers to tailor the 
risk of their investment funds or portfolios to meet their 
personal needs and circumstances, depending on their age, other 
private savings, and the like. With centralized investment, the 
government would impose on workers a level of risk they may be 
ill equipped to bear. This would be most disadvantageous to 
low-wage workers.
    Seventh, personal accounts would create a system that is 
fully funded at all times and immune to the vagaries of 
uncertain demographic trends. Centralized investment leaves our 
quasi pay-you-go system in place and thus leaves Social 
Security exposed to all of the financial dangers to which it 
presently is exposed.
    Eighth, personal accounts would enhance public 
understanding about Social Security and facilitate retirement-
income planning. Workers would have something they could 
understand and buildupon. Centralized investment leaves Social 
Security opaque and would have no effect on workers' ability to 
plan for retirement.
    Finally, even as a means of investing in private markets, a 
system of personal accounts offers clear benefits. It offers an 
inherently decentralized and highly competitive mechanism for 
channeling investment funds into capital markets. Centralized 
investment would require the development of new and untested 
structures that could withstand political pressures to use the 
government's control over large amounts of capital investment 
to affect the distribution of wealth and income in society. 
This is a tall order and one that I believe cannot be filled.
    Before closing, I would like to reiterate and stress a 
point that Michael Tanner made. There has been a lot of talk 
about how the Thrift Savings Plan provides a good model for 
centralized investment and how it is structured to minimize 
political influence. It is critical to note, however, that the 
central defining characteristic of the Thrift Savings Plan, 
which you all well know, is individual accounts that are 
privately owned. It is a voluntary 401(k)-type plan for Federal 
workers.
    The congressional conferees who crafted that original 
legislation made clear that it was ``the inherent nature of the 
thrift plan that precluded political manipulation and the 
private ownership of those accounts,'' not any particular 
structure of investment managers and financial safeguards.
    Thank you.
    [The prepared statement follows:]

Statement of Carolyn L. Weaver, Ph.D., Director, Social Security and 
Pension Studies, American Enterprise Institute; and Former Member, 
1994-1996 Advisory Council on Social Security

    In current discussions of investing social security in the 
stock market, the choice between centralized investment and 
personal retirement accounts is sometimes portrayed as the 
choice between two investment strategies--two ways of improving 
investment returns for workers--in effect, two ways of skinning 
the same cat. When viewed in this way, the debate quickly turns 
to administrative structures and costs. It then seems quite 
natural, to some at least, to conclude that a government-
controlled investment strategy makes sense since it would seem 
to be easier, quicker, and cheaper than turning the problem 
over to 100 million or more people.
    While administrative structures and costs are worthy of 
careful attention, these issues distract attention from the 
more fundamental issue: In particular, can centralized 
investment, even if ``cheaper'' and perfectly managed, deliver 
the range of economic benefits offered by a system of personal 
accounts? I believe the answer is no.
    In the testimony that follows, I identify the key 
differences between personal accounts and centralized 
investment, highlighting the benefits of the former approach 
that can not be achieved with the latter. To avoid confusion, I 
use the term ``personal accounts'' to mean a system of personal 
retirement accounts that are owned by workers, fully funded 
with a share of their payroll taxes, and invested in private 
stocks and bonds. By ``centralized investment,'' I mean a 
government-run program of investing a share of trust fund 
reserves directly in stocks, where the government, or its 
appointed board, decides how much of the reserves to invest in 
stocks, which investment classes or funds to invest these 
monies in, which financial institution(s) to rely on to manage 
how much of the social security portfolio, and how proxies are 
voted, among other important matters.
    The key differences between personal accounts and 
centralized investment are these:
     Personal accounts offer the prospect of higher 
rates of return and more secure retirement incomes for younger 
workers and future generations. Centralized investment offers 
the prospect of more revenues for the trust funds.
     Personal accounts are built on private ownership: 
workers would own their contributions and investment earnings, 
and typically could pass any balances along to heirs. 
Centralized investment would not change in any way the nature 
of workers' claims to future benefits, which is statutory at 
base, not contractual.
     Personal accounts would allow low-income workers 
to accumulate financial wealth and to share in the benefits of 
capital ownership. With centralized investment, social security 
would continue to offer workers, high-and low-income alike, 
long-term promises by government.
     Personal account would reduce workers' reliance on 
long-term benefit promises and the political risks to which 
their retirement incomes are now exposed, risks that currently-
scheduled benefits will not be met in full when they come due. 
With centralized investment, workers' retirement incomes from 
social security would continue to be politically determined.
     With personal accounts, it is clear who bears the 
risks (and reaps the rewards) of stock market investment--
individual workers do. These risks would be mitigated by the 
design of the government safety-net that buttresses all 
proposals for personal accounts. With centralized investment, 
it is unstated and thus entirely unclear who bears these risk 
(or reaps the rewards). Financial risks are present under both 
systems. ``Spreading'' or ``sharing'' risks through centralized 
investment can not reduce or eliminate them.
     Personal accounts would allow workers to tailor 
the riskiness of their investment funds to their personal needs 
and circumstances--their willingness and ability to take risk, 
given their age, their work prospects, their private pensions 
and other savings, and other important factors. With 
centralized investment, the government would decide how much 
risk workers must bear through social security. This would be 
most disadvantageous to low-wage Americans.
     Personal accounts would create a system that is 
fully funded at all times and immune to the vagaries of 
uncertain demographic trends. Centralized investment leaves our 
quasi pay-as-you-go system in place, and thus leaves social 
security exposed to all of the financial dangers (and thus 
political uncertainty) to which it presently is exposed.
     Personal accounts would depoliticize social 
security to a considerable extent. Centralized investment would 
have no effect on the political nature of social security's 
benefit and tax structure and yet would create many new margins 
for political influence--those surrounding investment 
decisions--and, by swelling trust fund reserves, would create 
new pressures to increase benefit obligations.
     Personal accounts would be consistent with 
significant pre-funding of social security and with a 
substantial increase in saving and capital investment. 
Centralized investment, and the structures necessary to 
sustain/regulate it, place sharp limits on the extent to which 
social security can be pre-funded and contribute to national 
saving.
     Personal accounts would enhance public 
understanding about social security and facilitate retirement 
income planning--they would give workers something they could 
understand and build upon. Centralized investment would leave 
social security opaque and have no effect on workers' ability 
to plan for retirement.
     Personal accounts can be structured to respond to 
the changing needs and circumstances of American women. 
Centralized investment would have no impact on social 
security's current (outdated) benefit structure.
    This list, which is not exhaustive, is suggestive of the 
significant benefits that can be expected to flow from a system 
of personal accounts independent of the benefits of such a 
system as a pure ``investment strategy.''
    As a means of investing in private markets, personal 
accounts also offer clear benefits. A system of personal 
accounts would provide an inherently decentralized, competitive 
mechanism for funneling investment funds into financial 
markets, which would allow these funds to flow toward their 
highest valued uses while spurring the development of new 
investment products and services for small savers. Centralized 
investment would require the development of new and untested 
structures that could withstand political pressures to use the 
government's control over investment capital to affect the 
distribution of wealth and income and society. To prevent 
political influence on investments and on matters of corporate 
governance, which would undermine the efficiency of capital 
investment and possibly rates of return on trust fund 
investments, these structures would have to be capable of 
withstanding such pressures on a sustained, long-term basis. 
This is a tall order and one that I do not believe can be 
filled.
    Here it is worth noting that the Thrift Saving Plan for 
federal employees does not provide a model for how centralized 
investment could be organized to minimize the risk of political 
interference, as often suggested by proponents of centralized 
investment. The Thrift Saving Plan is a voluntary pension plan 
for federal employees, whose central defining characteristic is 
that which proponents of centralized investment seek to 
preclude in social security--individual accounts that are owned 
by workers. The TSP is the public-sector counterpart to the 
wildly popular 401(k) plan. Workers decide whether to 
participate, how much to contribute (up to stated limits), and 
how to invest their funds among three investment options. (As 
an aside, the plan has assets that are a small fraction of what 
social security would need to invest.)
    The Congressional conferees who crafted the original 
legislation made clear that it was ``the inherent nature of a 
thrift plan'' that precluded the possibility of ``political 
manipulation.'' In their words, ``...the employees own the 
money. The money, in essence, is held in trust for the employee 
and managed and invested in the employee's behalf.... This 
arrangement confers upon the employee property and other legal 
rights to the contributions and their earnings.''
    This is precisely the kind of plan proponents of personal 
social security accounts would like to see offered to the rest 
of American workers, one based squarely on private ownership 
and real capital investment. Whether the government should 
administer the accounts or narrow the investment options so 
sharply (the typical participant in a 401(k) plan has six or 
more options) are matters worthy of debate, but they are of 
secondary importance to establishing a plan that gives working 
men and women the opportunity to accumulate real financial 
wealth through social security--an opportunity that would be 
denied with centralized investment.
    Ultimately, the debate about whether the government should 
invest in private equity or individual workers should be 
allowed to do so boils down to the question of whether workers 
will be allowed to build financial wealth through social 
security and to capture the benefits of stock market 
participation. With centralized investment, it doesn't matter 
how many ``fire walls'' you build, how ``independent'' the 
investment board is, or whether the government subcontracts 
with one or ten firms to manage one or ten funds, at the end of 
the day, workers would still accumulate benefit promises to be 
made good by future taxpayers, rather than investment funds of 
their own. While proponents of stock market investment--both 
those endorsing personal accounts and those endorsing 
centralized investment--agree on the higher expected returns to 
stocks and on the associated risks, we part company on the 
question of whether these risks should be made explicit, 
whether workers or the government should decide how much risk 
to take, and whether workers or an account in the federal 
treasury should capture the higher expected returns to risk 
taking.

                               Conclusion

    Changes in the economic and demographic landscape since the 
1930s create the need--and the development of modern financial 
markets creates the opportunity--to transform social security 
into a vital program that is of economic value to the workers 
it covers and to the nation as a whole. U.S. financial markets, 
which channel literally trillions of dollars each year into 
productive investments, have developed a wide range of 
investment products and services attractive to ordinary working 
men and women. Allowing workers to invest a portion of their 
social security taxes in private capital markets and to draw on 
these products and services to build retirement protection 
holds the potential for not only enhancing retirement income 
security but also generating a stronger national economy in the 
twenty-first century. The time is right to move away from our 
low-yielding system of income transfers toward a system of true 
retirement pensions--personal retirement accounts fully funded 
with a share of workers' payroll taxes.
      

                                

    Chairman Shaw. Thank you, Dr. Weaver.
    Mr. Goldberg, if you would correct my pronunciation of your 
law firm, I would appreciate it.

STATEMENT OF HON. FRED T. GOLDBERG, JR., SKADDEN, ARPS, SLATE, 
  MEAGHER & FLOM, LLP; FORMER COMMISSIONER, INTERNAL REVENUE 
 SERVICE; AND FORMER ASSISTANT SECRETARY FOR TAX POLICY, U.S. 
                   DEPARTMENT OF THE TREASURY

    Mr. Goldberg. Skadden, Arps is fine, Mr. Shaw. Thank you 
very much.
    Chairman Shaw. Thank you.
    Mr. Goldberg. I believe there are three keys to Social 
Security reform. First, and most important, is keeping faith 
with current retirees and those about to retire. Second, is 
maintaining the basic defined benefit structure and enhancing 
the Social Security safety net. And third, is providing for a 
universal system of private retirement accounts.
    You and your colleagues who endorse PRAs, private 
retirement accounts, as part of an effort to preserve and 
protect Social Security are right on the mark. PRAs should plan 
an important role in shoring up Social Security but they are so 
much more. They will be of most benefit to low-income workers, 
blue collar union members, single parents, working mothers, and 
minorities. And they will create the universal infrastructure 
for future policies to create wealth and opportunity for all 
Americans.
    Now, I agree with those if you direct government investment 
in the markets is a bad idea. Since Dr. Reischauer already has 
been ganged up on, I will forgo the opportunity to beat on what 
I hope is a very dead horse.
    The question that I would like to talk about is that 
private accounts may be a terrific idea, a terrific policy, 
maybe good politics, but at the end of the day the question is 
whether it's possible to institute a workable system. Since 
testifying before this Subcommittee last year, I have had the 
pleasure of working with Professor Michael Graetz of Yale Law 
School on a paper that addresses in detail the design of a 
workable system of private accounts. A copy of that paper, 
which is prepared under the auspices of NBER, National Bureau 
of Economic Research, Inc., accompanies my testimony.
    By building on an existing system, universal private 
accounts can be implemented in a way that minimizes costs, 
distributes those costs fairly, imposes no additional burden on 
employers, meets the expectations of participants for 
simplicity, security and control, and is flexible enough to 
accommodate a wide range of policy choices, and can accommodate 
changes in those policy choices over time.
    Due to time constraints, I won't begin to try to describe 
the system we have laid out in the paper. I would be happy to 
answer questions. I would also be happy to work with you and 
your staff on implementation issues. My testimony addresses 
three particular comments and suggestions we have received 
dealing with flexibility and the like in the light of the 
hearing this morning, I would like to mention two topics 
briefly not covered in my written testimony.
    The first has to do with Secretary Summer's comments about 
the alleged cost of private accounts. He indicated that those 
accounts could cost as much as ``20 percent.'' While I'm not 
sure of the analysis that he has gone through, I believe what 
he is doing is taking all of the costs to administer a given 
year's contribution over a 40-year period and summing those 
costs back to the present without discounting. Now, the math 
may be correct, but that in my judgment is a misleading 
statement.
    If you work through his numbers and if you work through the 
numbers of those who have looked at the cost of administering 
private accounts, including those who question the wisdom of 
that policy on the merits, I believe the universal view is that 
a simple system of private accounts that provides workers with 
some reasonable modicum of choice, safety, and security, and 
ease of understanding can be implemented for a cost of under 50 
basis points a year spread across all accounts. It can be done 
in a price-effective way.
    Second, unfortunately, Mr. Matsui has left, but I would 
like to comment very briefly on the study he referenced about 
how private accounts will benefit no one. It is a terrific 
study. It demonstrates that with the right assumptions, you can 
prove the world is flat. They assume complete privatization, 
they assume all of the burdens of transaction costs are imposed 
on low- and middle-income workers, and, gee, there's a problem, 
right. Well, the Earth is 6 inches by 6 inches and 1 inch deep 
across. It is a flat square. And the reason I mention that is 
that in this discussion it's important to look at assumptions. 
It is very easy for any of us at this table to take any 
proposal, make up the assumptions, and conclude there is no way 
it's working.
    We assume the government's going to pick and choose 
individual stocks. That's a terrible idea. You have, I think, 
honestly tried to come up with safeguards. And if this is going 
to work, I think it's important to get beyond the kind of 
outlyer, assume ridiculous assumptions that prove it won't work 
and get back to the center, where the program can be discussed 
reasonably.
    I am absolutely convinced that thanks to public- and 
private-sector systems and information technology, it is now 
possible to implement a system of private--a universal system 
of private accounts that minimizes costs, distributes those 
costs fairly, imposes no additional burden on employers, and 
meets the expectations of everyday Americans and can 
accommodate whatever policy choices you collectively make with 
respect to funding, with respect to voluntary add-ons, with 
respect to tax-incentive-based add-ons, with respect to 
guaranteed minimum benefits. The technology is there to make 
private accounts work.
    This wasn't true 20 years ago, and it certainly was not 
true in 1935. When we talk about the difficulty of private 
accounts, it's important to put those questions in perspective. 
In 1935, there were no Social Security numbers, there were no 
payroll taxes, there was no computer-based financial 
infrastructure, all records were entered and maintained by 
hand. And yet they made Social Security work. By comparison, 
private accounts are easy.
    If you go back, and you read the debates in the thirties, 
those who opposed private accounts are using exactly the same 
kind of arguments used by those who opposed Social Security in 
1935.
    Thanks to your leadership, thanks to the leadership of the 
administration in coming out with a specific set of proposals, 
many of which I disagree with. But they had the courage to come 
out with something. It is now possible to craft a bipartisan 
package that maintains defined benefits, protects current 
retirees, and has a universal system of private accounts.
    The question should be debated on the merits. Those who 
oppose private accounts should not hide behind the excuse of 
administrative costs.
    Thank you very much.
    [The prepared statement follows. The ``NBER Working Paper 
Series'' is being retained in the Committee files.]

Statement of Hon. Fred T. Goldberg, Jr., Skadden, Arps, Slate, Meagher 
& Flom, LLP; Former Commissioner, Internal Revenue Service; and Former 
Assistant Secretary for Tax Policy, U.S. Department of the Treasury

    Mr. Chairman and Members of the Committee, it is a pleasure 
to appear today on the subject of investing Social Security 
funds in the private capital markets. I have three 
observations:

                            Private Accounts

    There are three keys to Social Security reform: (i) keeping 
faith with current retirees and those about to retire; (ii) 
maintaining the basic defined benefit structure and enhancing 
the safety net; and (iii) private retirement accounts (PRAs). 
You and your colleagues--Republicans and Democrats, 
Representatives and Senators--who endorse PRAs as part of an 
effort to preserve and protect Social Security are right on the 
mark. You deserve public respect and support for your wisdom 
and courage in embracing a concept that was political heresy 
only several years ago. While PRAs figure prominently in the 
debate over Social Security, they are much more. PRAs will be 
of most benefit to low income workers, blue collar union 
members, single parents and working mothers, women and 
minorities; they will also provide the infrastructure for 
policies to create wealth and opportunity for all Americans.

                      Direct Government Investment

    Second, I agree with those who view direct government 
investment in the markets as a bad idea. All human experience 
teaches us that government is certain to misuse its ownership 
of private capital. Maybe not today, maybe not tomorrow, but 
someday for sure. Those who cite experience with the Thrift 
Savings Plan as proof that the government can make direct 
investments without political interference should know better. 
Their failure to cite contrary state experience is, at best, 
misleading. It's also downright silly to suggest that what has 
been true (perhaps), must always be true. Most importantly, 
they fail to acknowledge the obvious--individual workers own 
their Thrift Savings Plan accounts. It's theirs. The funds 
don't belong to the government. This is a primary reason why, 
at least to date, the Thrift Savings Plan has been able to 
resist pressures for politically correct investment policies. 
The Plan is not investing the government's money; it's 
investing the workers' money.

                           A Workable System

    Third, PRAs may be great policy, but the question is 
whether it's possible to implement a workable system. Since 
testifying before this Committee on the subject of private 
accounts last June, I have had the privilege of working with 
Professor Michael Graetz of the Yale Law School on a paper 
addressing in detail the design of a workable system of private 
accounts. That paper is being published in a forthcoming volume 
of papers presented at a conference sponsored by NBER. A 
working draft of our paper accompanies my testimony.
    By building on existing systems, universal PRA's can be 
implemented in a way that: (a) minimizes costs, and distributes 
those costs fairly; (b) imposes no additional burden on 
employers; (c) meets the expectations of participants for 
simplicity, security and control; and (d) is flexible enough to 
accommodate a wide range of policy choices, and changes in 
those choices over time.
    Due to your time constraints, I won't describe the system 
we have proposed, but would be happy to answer any questions 
you have. We would also be happy work with you and your staff 
on implementation issues. In light of recent events and 
comments we have received, however, I would like to mention 
three matters: (i) the need for flexibility, (ii) the role of 
the IRS, and (iii) workers' investment options.

                        The Need for Flexibility

    The wide range of policy recommendations that have surfaced 
during the past year demonstrate that flexibility should be the 
hallmark of any system for implementing private accounts. With 
this in mind, the approach described in our paper would 
accommodate any of the policy choices listed below (reflecting 
a wide range of proponents), and would also accommodate changes 
in those policies over time:
     funding through a carve-out of payroll taxes
     funding from general revenues
     integrating Social Security's traditional defined 
benefits and the returns generated by private accounts (with or 
without guarantees)
     using general revenues to fund universal private 
accounts outside the four corners of Social Security
     any type of funding formula (for example, a fixed 
or progressive percent of covered wages; a fixed or phased-out 
flat dollar amount)
     integrating private accounts with existing 
retirement plans or accounts
     voluntary additional contributions
     tax incentives to encourage additional 
contributions
     spousal rights (at the time accounts are funded, 
on divorce, or at distribution)
     a wide range of investment options and payout 
alternatives.
    While each of us has his or her own views on these policy 
questions, the key is that the implementation of private 
accounts should accommodate any of these choices--and, equally 
important, should accommodate changes in these choices over 
time. The system described in our paper meets these objectives.

                            Role of the IRS

    The IRS receives substantially all of the information 
necessary to set up and fund private accounts, and we have 
recommended that workers select their investment options on 
forms filed along with their tax returns. We believe this 
approach minimizes the burden on workers, places no burden on 
employers, minimizes delays in funding, minimizes costs to the 
Federal government, and maximizes flexibility (e.g., 
progressive funding and tax incentives for voluntary 
contributions).
    It is important to make clear, however, that under the 
system we describe, participants would not deal directly with 
the IRS on any matters relating to their PRAs. Likewise, the 
IRS would not be involved in any way in the ongoing 
administration of accounts or providing information to 
participants.
    We do not share the concern that some have expressed over 
``perception'' problems if workers make investment elections on 
their tax returns. These concerns, however, should not be a 
barrier to the implementation of PRAs. While the IRS already 
collects most of the information necessary for setting up and 
funding PRAs, the idea of having the IRS share that information 
with another Federal agency (such as Social Security) with 
responsibility for setting up and funding private accounts may 
be worth exploring.

                       Worker Investment Options

    Most commentators have recommended one of two approaches to 
providing for investment options. Some have suggested using a 
Thrift Savings Plan model, where workers would be offered a 
limited number of investment alternatives that is easy to 
understand, limits risk, and won't cost much. Others have 
rejected this approach and have suggested instead that workers 
invest in qualified funds sponsored by the private sector. For 
the reasons summarized in our paper, we have rejected this 
``either-or'' approach, and have concluded that a two-tier 
system is preferable. Workers should be permitted to invest in 
a limited number of low cost options sponsored by the Federal 
government and administered by the private sector--workers 
should also be permitted to invest in qualified funds directly 
sponsored and managed by the private sector, subject to 
appropriate regulation.

                               Conclusion

    Thanks to private and public sector systems and information 
technology, it is now possible to implement a system of 
universal private accounts that minimizes costs and distributes 
those costs fairly; imposes no additional burden on employers; 
meets the expectations of everyday Americans for simplicity, 
security and control; and can accommodate a wide range of 
policy choices. This was not true twenty years ago--and surely 
was not true in 1935 when Social Security was first enacted. 
Which brings me to my final observation.
    As noted in our NBER paper, it is important to put the 
administrative challenge of private accounts in perspective. 
Recall what the world was like when Social Security was 
enacted. There were no Social Security numbers. There was no 
payroll tax withholding. Many Americans didn't have a 
telephone. There were no computers--information was entered by 
hand, records were maintained on paper, correspondence was 
delivered by mail. There was no computer-based financial 
infrastructure. Implementing Social Security under those 
conditions was hard; by comparison, implementing universal 
private accounts would be easy. Those who oppose private 
accounts today sound much like those who opposed Social 
Security in 1935.
    Thanks to your leadership--and thanks to the 
Administration's leadership in coming forward with its 
proposals--bi-partisan action can lead to a universal 
infrastructure for the creation of private wealth that will 
benefit all Americans, especially those who've been left behind 
and those who are struggling to make ends meet. Some may oppose 
that policy, but they should do so on the merits, not hide 
behind the excuse of administrative costs.
      

                                

    Chairman Shaw. Well, thank you, Mr. Goldberg, and thank 
this entire panel. We will recess. Those of you on the panel 
that can remain with us, we would appreciate it so that our 
Members can ask questions that might be on their mind or make 
traditional speeches, as we very often do.
    As to the final panel, if for some reason you cannot remain 
with us, your full testimony would be made a part of the 
record. But we are hopeful that you will be able to stay and 
deliver it to us in person.
    We will now recess for 1 hour. We will reconvene at 1 
o'clock in this room.
    [Whereupon, at 12 noon, the Subcommittee recessed, to 
reconvene at 1 p.m. the same day.]
    Chairman Shaw. I apologize. The delay was outside of my 
control. I apologize to you, Mr. Matsui, and to the witnesses. 
Would you care to inquire?
    Mr. Matsui. Thank you, Mr. Chairman. That was quick.
    Let me ask--Mr. Goldberg, I'm sorry I wasn't here for your 
testimony. I had to go out, but you were somewhat critical and 
concerned with the National Committee To Preserve Social 
Security's testimony or at least their study. Could you just 
very quickly reiterate, if you had reiterated, or restate your 
concerns. And, again, I apologize. I wasn't here.
    Mr. Goldberg. Mr. Matsui, my ill-mannered comment was----
    Mr. Matsui. You are never ill-mannered, but just go ahead.
    Mr. Goldberg. They basically--it demonstrates that if you 
make the correct assumptions, you can prove the world is flat. 
And essentially, if you look the modeling that they did, in 
terms of the underlying assumptions, for example, immediate and 
complete privatization, imposing all transition costs on low-
income workers, eliminating survivability of the assets in 
event of early death, they have managed to design a system that 
screws just about everybody. But that is not the point of the 
exercise. The point of the exercise is to look for systems that 
meet the needs of low-income workers and middle-income workers 
and families where the income earner dies at a relatively early 
age. And I think that it reflects a problem in the discussion 
generally, that if the object is to prove, design a system that 
doesn't work, all of us can do that very well.
    Mr. Matsui. Don't get me wrong. I want you to have as much 
time as you want. My time is somewhat limited, although there's 
only two of us here. So maybe not. [Laughter.]
    Let me ask you, though, now I haven't reviewed your plan, 
but just taking the basic assumptions that are made in the 
National Committee's study, one is that there is a unfunded 
liability.
    Mr. Goldberg. That's correct.
    Mr. Matsui. And that unfunded liability, from what I 
understand from Mr. Reischauer--no, I guess it was either Mr. 
Aaron or Mr. Reischauer who said it could be anywhere from $3.5 
trillion to $8 trillion. And I know that Secretary Rubin has 
said it is $8.5 trillion, and he didn't give a range, he just 
said $8.5 trillion.
    These numbers are so large it's hard to even amortize, but 
the individual who came from the American Enterprise Institute, 
Ms. Weaver, I believe it was, she tries to amortize this 
unfunded liability, although she doesn't state what the amount 
is. And she comes to the conclusion that over 75 years you have 
to increase payroll taxes by 1.52 percent. How do you propose 
doing it with your private accounts?
    Mr. Goldberg. Mr. Matsui, in terms of the testimony today, 
what I was talking about was a much more pedestrian set of 
questions about could you do private accounts at all. I think 
that is an important question.
    Mr. Matsui. So OK----
    Mr. Goldberg. But now once you get to the funding issues 
you are raising, the way I see things unfolding at this point 
is that the administration and, on a bipartisan basis, majority 
of the Congress have concluded that somewhere around 60 percent 
of projected surpluses over the next number of years should be 
used to help bolster or shore up Social Security.
    And I think we get into all sorts of arcana about 
accounting and double accounting. I think that is too confusing 
for people. The way I understand what is being said, is we are 
going to take general revenues over the next number of years 
and use those general revenues one way or another to try to 
shore up the Social Security Program by investing in the market 
or by transferring Treasury IOUs or setting up private 
accounts. I believe that that 60 percent of the projected 
surplus would go a long way to solving the actuarial problem.
    Beyond that, it is my judgment that at the end of the day, 
other choices are going to have to be made on the revenue side 
or on the benefits side. But I'm not sure the political process 
can get there yet. But the 60 percent gets you a long way down 
the road.
    I would get there by using them to fund a private accounts 
system for all the reasons I have said. I think the benefits of 
private ownership, the ability to craft policies to help low- 
and middle-income workers--the benefits there are so 
overwhelming, that is the direction I would go in using the 
surplus. At the end of the day, I think we are all going to 
have to make some choices.
    Mr. Matsui. Let me say this, Fred. One of my problems, and 
I again don't know if you have a complete plan in that pamphlet 
you showed. You do or don't?
    Mr. Goldberg. It is just the plumbing. Just how to make 
them work.
    Mr. Matsui. I will tell you what my problem is. And it's 
great. I understand what you are saying now, and I apologize 
for not having been in the room when you testified.
    My real problem is, if you are saying that private accounts 
are good versus the current system, I suppose if you were 
setting the system up from scratch and you didn't have the 
unfunded liability and a few other things, maybe you can even 
make that case, but that's in a vacuum. Right now you have such 
little things as survivors benefits, you obviously have 
disability benefits. Obviously, we are not addressing in your 
pamphlet those issues, and no one is expecting you to, but 
talking about private accounts, individual accounts, in a 
vacuum is like taking the President's program and saying 
because it has deficit reduction it's a great plan. But you 
have got to look at the overall plan.
    See, that's where part of my frustration is. Not at you, 
but just generally in discussing private accounts. My time is 
running out but I want to ask Representative Baronian this 
question: I know that in Connecticut when Colt Manufacturers 
did get a rather sizable investment from the pension program, 
there was a significant amount of interference mainly because 
of the way the pension system was set up. I don't know if it 
currently still is, but the Governor and the Treasurer, who are 
elected officials, had a significant role. And they, in other 
words, had almost the legal ability to interfere. In the PERS, 
California Public Employee Retirement System, back in the 
seventies there was a problem when Treasurer Unruh was the 
State Treasurer, but they really straightened that out through 
legislation.
    And you will find that the PERS system in California is 
pretty free of political interference. Now maybe you haven't 
done that yet in Connecticut. Maybe you have cleaned it, maybe 
you have made the changes after the Colt issue?
    Ms. Baronian. Well, I have to say I think that they did do 
some, but as far as I know--for instance, they have another 
investment, $100 million investment in a piece of real estate 
in downtown Hartford that still hasn't produced any returns at 
all. But what I'm saying is, is that I don't think there's been 
too much done. They had a Connecticut programs fund, and that's 
where this money came out of within the treasury.
    I do believe that they still could interfere with----
    Mr. Matsui. Let me just say this. I believe somebody said 
this at one of the hearings we were at--that I suppose you 
could even interfere with the Federal Reserve Board if we had 
the political will and wanted to make a scene about it. So, if 
you are saying that anything can happen, I agree with you, 
anything can happen. But what Mr. Reischauer and Dr. Aaron and 
a number of others are working on is a way to come up with a 
structure for government investment in the equity markets, a 
fail-safe system that will result in political repercussions 
if, in fact, you violate it.
    And that is why we don't mess around with the Chairman of 
the Federal Reserve Board. There have been attempts over the 
last decade to influence him, but we get criticized for that, 
so we back down. What you want to do is set up a system where 
the political process will insulate the fund managers and the 
investment bankers from that process.
    Now maybe in Connecticut you don't have that. I believe we 
do in California.
    Ms. Baronian. Well, California has a highly sophisticated 
method. I don't believe that the Federal Government would--I 
would like to think that they could--but I doubt it.
    Mr. Matsui. Anybody could make that kind of a statement: I 
wish it would happen but it doesn't happen.
    Ms. Baronian. I don't think you can insulate a board that 
is going to be appointed by politicians. And the Federal 
Reserve has enjoyed hands off with the exception of, probably, 
Richard Nixon, who wanted to do something in 1972.
    But it could happen. And things change. Unless it's in the 
Constitution, legislation can be retracted, corrected, and so 
forth.
    Mr. Matsui. I don't want to belabor this because we are 
going to get circular in our discussion, but even the 
Constitution could be violated. I mean, I can probably cite 
instances. So anything can happen as long as human beings are 
the ones that are conducting life. But the reality is that we 
are trying to insulate the process, and maybe Connecticut 
doesn't work, but in other cases we have seen it work.
    I just want to thank all of you. I know my time is expired.
    Thank you, Mr. Chairman.
    Chairman Shaw. Mr. Doggett.
    Mr. Doggett. Thank you very much. Mr. Tanner, is it your 
view that ideally we should replace the Social Security system 
with a system that relies exclusively on individual accounts?
    Mr. Tanner. Yes it is, as the primary system. And then I 
believe that any safety-net system should be funded out of 
general revenues.
    Mr. Doggett. Basically, a welfare system for meeting kind 
of the basic needs of the poorest people in the society?
    Mr. Tanner. That's right. We should insist that no senior 
should ever fall below a minimally acceptable level of 
retirement. But I believe that the best way to finance such a 
system is taxing across all classes of income and all classes 
of assets, not to focus on a regressive payroll tax as the 
primary way to do that.
    Mr. Doggett. Thank you. Mr. Goldberg, do you share that 
view?
    Mr. Goldberg. No, sir, I do not.
    Mr. Doggett. What is your view about the appropriate mix of 
government involvement and individual decisionmaking?
    Mr. Goldberg. I think that the defined benefit structure, a 
progressive defined benefit structure of the current Social 
Security system is where we have been and where we should stay 
forever. I think it says something about how we deal with each 
other and I think it's terrific. I think over and above that, a 
system of private--a universal system of private accounts that 
puts in place structure for building private wealth for all 
Americans is so important. And I think, with all due respect to 
Congressman Matsui, I think maybe we are being too honest now 
about all of the numbers, and we are not paying enough 
attention to the barriers to wealth creation for workers. So I 
would do both. I would keep your basic program in place----
    Mr. Doggett. Are your comments to be viewed then as an 
endorsement of the President's USA account approach?
    Mr. Goldberg. I think that it is--none of us know what the 
approach is. I think that in the current environment, I think 
that the better place to begin is to try to integrate private 
retirement accounts, a universal system of private retirement 
accounts, as part of Social Security. I think that is going to 
be easier to do. I think it is going to put in place a system 
that is going to be better able to address lots of retirement 
issues that we run into down the road.
    And so I would prefer to link it to retirement.
    Mr. Doggett. You would take it out of the 12.4 percent? 
Part of that you would allocate to individual accounts?
    Mr. Goldberg. I think there are a couple of ways to do it. 
One is to carve out a proportion 12.4 percent. The other way to 
do it is to fund them through general revenues. A third way to 
do them at the end of the day is some combination. And I think 
that the numbers work better than we are giving them credit 
for. I personally think that some adjustments in the benefits 
may ultimately and/or method of revenues need to be addressed. 
That is heresy at this point, but I think at the end of the day 
that's going to be part of the truth.
    But I think the numbers with the surplus let's you keep a 
very strong defined benefit program that enhances the safety 
net at the bottom, let's you fund meaningful private accounts, 
let's you fund those private accounts on a progressive basis, 
such as what Senator Santorum's bill--I think you can do it, I 
think it would be very close.
    Mr. Doggett. You would have to reduce the defined benefits 
under the defined benefit program?
    Mr. Goldberg. I think you may. I think collectively the 
judgment may be that is a good decision. I don't think you have 
to do it. If you don't do it, I don't think you are going to 
get all the way to the end solution. But I think you can get a 
long way toward the end solution without ``cutting benefits'' 
at all. I think you may, as you look at this, you may make the 
judgment at the end of the day that if the private account 
piece is a effective enough, you can make some modest 
adjustments in terms of accelerating the age change to 67, 
adjusting the cap--I know these are terrible things to talk 
about now, and you don't have to do any of them. The point is, 
you can do none of those, you can use the surplus to create 
private accounts to give you an infrastructure to deal with 
issues affecting low- and middle-income workers, and to say we 
have done terrific work. We are not finished, but we have done 
terrific work.
    Mr. Doggett. Let me ask Dr. Reischauer if he agrees with 
that?
    Mr. Reischauer. Basically, no. I think that the foundation 
for retirement income in this country should be a defined 
benefit program. I would agree with Fred, if we had a defined 
benefit program now which I thought was overly generous, but 
the defined benefit program that we do have pays the average 
new retiree something between $9,000 and $10,000 a year, which 
isn't a tremendous amount of money by anyone's standard. This 
is given in the form of an annuity, an inflation-protected 
annuity.
    When we move over to private accounts, there is no 
guarantee that the balances would annuitized or that there 
would inflation adjustment associated with them. And, barring 
the possibility that we funded them out of new revenues, we 
would have to cut back on that basic foundation to finance 
them, that is if we carved them out. Now Fred might be in favor 
of increasing contributions, as we call them, euphemistically, 
rather than taxes, to fund his private accounts. That would be 
a different wrinkle on things. Maybe he and I could reach some 
agreement over this. But I think what we have now is a very 
modest and a very essential program that provides society with 
a lot of benefits as well as individuals with security that 
couldn't be found through private accounts.
    Mr. Doggett. Thank you. Thank you, Mr. Chairman.
    Chairman Shaw. Mr. Doggett. You don't have to rush there. 
There's nothing that says that the legislation could not have 
some safety nets in it itself. I think that the legislation 
could be drawn in such a way that it would fulfill the three 
problems that Dr. Summers referred to in his testimony and that 
you are referring to in yours. These safety nets can be 
designed by the Social Security system. So clearly, we could 
answer your objections in those areas.
    Mr. Reischauer. You could, but a lot of the proposals that 
are out there don't. And you have to ask some more questions 
about the pensions that would be provided through private 
accounts. One of those questions is, how much variability do 
you want to have in your foundation retirement income program 
across cohorts and across individuals within any single cohort? 
In a private account, how much you get out the other end 
depends critically on what you investment choices have been. We 
know that some people are risk averse and some are real risk 
takers. You will find in a private account system that two 
individuals earning exactly the same amount of money, 
contributing the same amount to the system but investing in 
different types of assets, end up with hugely different 
pensions at the end of their working lives.
    Similarly, because of fluctuations in asset values over 
time, you can find that a cohort that retires a few years after 
another cohort, could end up with 40 or 50 percent larger or 
smaller benefits. There is a role for such retirement saving in 
our society, and I am not opposed to it. But we do have 
alternative vehicles. We have private pension plans, we have 
IRAs, we have individual savings, which, if you want to play 
that game, we can encourage.
    Chairman Shaw. Well, in addition to the investment 
philosophy of the individual worker, it also would depend on 
the time picked for retirement. Obviously, in a downturn of the 
market, there would be some problems. But those we certainly 
have to address. We don't want to tell a worker who works with 
his hands that at age 65, 67 or whatever it is, that work a few 
more years and let the stock market go back up. Obviously, we 
have got to address those problems and try to anticipate that.
    And in that regard, Dr. Reischauer, I would appreciate if 
you would make a list of all the objections that you would have 
to the individual accounts so that we might try to address that 
in any legislation that comes out that uses individual 
accounts. The more we can learn about the problems, the more 
warts we can find on our own theories, the more we can 
anticipate and try to correct them in advance. And the more you 
can do that, the more you can bring people along in order to 
try to get a system that answers everybody's problem. I think 
that would be very helpful.
    Mr. Goldberg, we start out by using the surplus. Do you see 
a day, and if so when would this be, that the FICA tax would be 
sufficient so that the surplus would no longer be needed to 
fund the individual retirement accounts?
    Mr. Goldberg. I don't think you get there, Mr. Shaw. I 
think that with the demographics, unless you are talking about 
raising the FICA tax, which I think would be a bad mistake.
    Chairman Shaw. No. We are not.
    Mr. Goldberg. But at the current 12-plus percent, I think 
they--you are going to end up using, if you don't want to 
change revenues and you don't want to change benefits, then, as 
Dr. Reischauer says, you are going to be using general 
revenues, I believe, for the foreseeable future to cover Social 
Security, regardless of how you decide private accounts or 
govern investment.
    I don't think you can get there.
    Chairman Shaw. Mr. Tanner, do you agree with that 
statement?
    Mr. Tanner. Yes, I think that you end up in a situation in 
which you have demographics down the road that an unfunded 
liability that Alan Greenspan estimates at $9.5 trillion. So 
everybody's got a different number. But you have a sufficient 
unfunded liability that the surpluses you have projected until 
2013 will not be enough to deal with that.
    Chairman Shaw. Let me see if I have asked the right 
question. And that question is, that obviously the FICA tax is 
going to be necessary to continue to fund Social Security 
system for those that are already in it, who don't have time to 
build up any individual retirement account. There will come a 
time when the individual retirement accounts would become the 
larger supporter of the retirees. Do you see a situation down 
the line where the FICA tax, having paid over the period of a 
working career, would be sufficient to invest in these equities 
so that the surplus would be freed up? That's the question.
    Mr. Reischauer. We seem to have a little bit of role 
reversal going on here. I think your question is, If somehow we 
could absolve ourselves of the unfunded liability--pay for it 
through income taxes or something else--and say to every 20-
year-old entering the system, we will guarantee you a 
disability insurance policy and you will contribute into a 
private retirement account, would you need a payroll tax as 
high as 12.4 percent to achieve expected benefit levels 40 
years from now? You would need one much lower tax rate.
    Chairman Shaw. You what?
    Mr. Goldberg. You would need a lower--you wouldn't have to 
have 12.4 percent. It could be a much lower number.
    Chairman Shaw. You can see that the FICA tax actually could 
be lowered after a number of years if we create individual 
retirement accounts.
    Mr. Goldberg. But I assume that the $9 trillion of unfunded 
liability was lifted off the system's back somehow. And that is 
a huge assumption.
    Mr. Tanner. One caveat, though, when we are talking the 
$9.5 trillion unfunded liability. That is to preserve the 
current system. If you move to a system of individual accounts, 
where you stop incurring additional debt as of whatever date 
you set, that unfunded liability is actually less than the $9.5 
trillion.
    Chairman Shaw. It would go down in time.
    Mr. Tanner. You wouldn't accumulate----
    Chairman Shaw. The transition period is going to be tough. 
There's no question about that.
    Mr. Tanner. Absolutely. That's a cost that you have run up 
regardless. The cost of moving to the private system should not 
be looked at as a net new cost when you compare it to the total 
unfunded liabilities within the current system. It is a 
actually a smaller cost. In many ways you could liken it to 
refinancing your mortgage, where, if you pay your points up 
front, it is certainly painful to have to do that this year, 
but in the long run, you pay out a lot less because you have 
gotten a lower interest rate. This would be roughly the same 
thing. You would have to move forward in many of those expenses 
and pay them the next 25 or 30 years, but the total amount that 
you pay out will be less under any scenario.
    Thank you.
    Chairman Shaw. Mr. Cardin.
    Mr. Cardin. Thank you, Mr. Chairman. I appreciate all of 
your appearances here today. I think that last round of 
questions is very misleading in many respects. And that is, the 
unfunded liability reflects the current situation. If we were 
to try to set up private accounts, or private plans, or a 
private system, you need to deal with the current liabilities. 
You are not going to put away enough in reserve to deal with 
that, and if you then take away from the 12.4 percent that 
currently is paid into the Social Security trust system, you 
are either going to be increasing your unfunded liability or 
you are going to change the system for the people who are 
currently in the system, which means reduced benefits.
    Mr. Tanner. Only in the short term. In the long term, it 
would be less. For example, if you allowed me out of Social 
Security today into a private system, you would no longer be 
accruing unfunded liability to me, which go on every day that I 
live and pay into the Social Security system. There's an 
increase in unfunded liability.
    Mr. Cardin. If I am 60 years old, and you are saying, Gee, 
I can now go into this new system, thank you, and if I don't go 
into the new system, you are only going to get a 20-percent 
reduction in benefits or some other amount in order to make 
these figures right, that isn't much of a deal for me, at 60 
years of age.
    I understand your point, but I think we make too light of 
the fact of the unfunded liability. It is not as simple, say, 
if we just got rid of it. You can't get rid of it, number one. 
And number two, it affects people at different age brackets 
differently because there are people who are very young, yes, 
who could benefit if they do what you say, but most Americans 
aren't in their twenties and thirties today.
    Most Americans are working and have already paid into the 
Social Security system and are expecting some benefits from 
what they have paid into the Social Security system. And in 
addition to dealing with that age group, you have to figure out 
how to deal with the unfunded liabilities, and if we start 
diverting from the concept that current workers pay primarily 
for people who are retired, it presents a whole set of 
transitional problems.
    Mr. Tanner. What I'm suggesting, Congressman, is that that 
cost you have to bear regardless of whether you move to a 
privatized system or whether you try to preserve the current 
system. The difference is, in the long term, it will always be 
less to move to a privatized system.
    Mr. Cardin. But it is complicated if you take out a dime of 
the 12.4 percent that currently goes into the system. It just 
makes it that much more difficult to meet the future 
liabilities for every dollar you take out of that system.
    Mr. Reischauer. Can I just put a footnote onto this without 
taking away from your time? [Laughter.]
    I disagree with Michael that it would be less in a 
privatized system. There are two questions here. Are you going 
to increase the funding of the system be it privatized or 
collectivized? And second, what are you going to allow the 
reserves, be they held in private accounts or collectively, be 
invested in? If you give Social Security the same freedom to 
invest in a broad spectrum of assets, it is not cheaper to do 
this through private accounts than it is to do it collectively. 
In fact, just the reverse would be the case because 
administrative costs would be less for a collective system than 
for a individualized system.
    Mr. Cardin. I appreciate that.
    Fred Goldberg, I first thank you for--and I have deep 
respect for your views, although I do take issue with your 
citing of the thrift-savings plans as being somewhat irrelevant 
to all of our discussions here today on collective investments. 
And I am somewhat amazed at the concern for collective 
investments by the trustees to get a better return for the 
Social Security system collectively.
    Because it seems to me that is just about risk free as far 
as the system is concerned. Over time, they are going to do 
better, and everyone acknowledges that they will do better. And 
as far as manipulation, you sort of dismissed the thrift 
savings plans, which could be a vehicle for mischief, and has 
not been a vehicle for mischief. And you sort of dismiss the 
recommendations made by Treasury that in setting up these 
accounts, there would be a Federal Reserve-type firewall 
created and that there would be private investment counselors 
who would make all the investments and they could only invest 
in indexed, generic funds.
    Why are you so concerned about that?
    Mr. Goldberg. I really do respect Dr. Reischauer and the 
administration's efforts to create these firewalls. And I think 
that you don't sort of make up arguments to blow them away. It 
is my judgment and observation that at the end of the day, 
despite all of the good faith and all of the efforts that are 
put into place to build the firewall, I believe someday, 
sometime there will be efforts to breach that firewall. I 
believe the efforts to breach that firewall can, in may 
respects, be as harmful as an actual breaching of that firewall 
because of the market uncertainties that they create.
    Mr. Cardin. But it would require a change in underlying 
law, which any Congress can always change any law at any time. 
It can change Social Security at any time. We always run that 
risk that even if we develop whatever plan we want to, the next 
Congress might change that plan. Nothing is ever in concrete, 
and I agree with you that nothing is ever in concrete.
    But if we build these protections in the basic law that we 
create, it just seems to me there is something wrong about 
saying that we have trustees of the Social Security system and 
we don't let those trustees do what any other fiduciary would 
do, and that is, mindful of the purpose of the fund, mindful of 
safety, maximize the return to the system. And we don't let our 
trustees do that. That seems contrary to a fiduciary 
responsibility. That seems like we are manipulating.
    Mr. Goldberg. We are going around in circles. I believe 
that there is a measurable risk that at some point in time the 
government will misuse those funds, and I believe history tells 
us that is actually close to a certainty. But there is a second 
point here that I personally feel more strongly about. This is 
the one chance I believe we collectively, the country, will 
have to make a choice about our collective retirement system. 
And I believe that if we make that choice to say we are going 
to let the government invest in the markets, and we therefore 
are choosing not to create----
    Mr. Cardin. Excuse me, not government, allowing the 
managers or trustees----
    Mr. Goldberg [continuing]. The Dr. Reischauer system, we 
are going to go with that system and there is going to be no 
political interference, terrific. I believe that we are making 
a choice not to create an infrastructure that will let us build 
wealth for all Americans. And I think that the opportunity cost 
in saying we are comfortable with these safeguards and 
therefore we are going to rely on IRAs and Keoughs and employer 
plans and private savings, we will leave 20 to 30 to 40 percent 
of the American people behind forever. And I think this is the 
once chance to say, let's not leave them behind.
    Mr. Cardin. I think we are in agreement. We are in 
agreement. I think we have to strengthen the proposal that the 
President has come in with the universal savings accounts. I 
think we have to make that much more available to all wage 
earners, particularly lower wage earners, so that we do get 
private savings and retirement from private wage earners. I 
think we can do a better job than the President's proposal in 
that regard. So I think we might be in agreement on that.
    But to me that is not inconsistent with preserving the 
basic concept of Social Security and allowing it to be 
adequately financed. And to allow it to get a better return to 
me carries out that objective but doesn't answer your concern 
and my concern about strengthening income security for all 
Americans, particularly those at more modest wages. I don't 
want to lose that opportunity either.
    If we just strengthen Social Security and don't deal with 
the other part, I agree with you.
    Mr. Goldberg. Take Dr. Reischauer's proposal. Give all 
workers, in effect, defined contributions--pieces of that 
single investment portfolio have some kind of guarantee top-out 
that they don't get what they get. Yes, you are getting pretty 
close. But it is theirs. They own it.
    Mr. Cardin. I don't want to agree with everything you just 
said, but I think we are getting closer, and I think that is 
one of the purposes for these hearings, quite frankly. And I 
really do congratulate Chairman Shaw because he has been very 
open to listen to all points of view. And there is certainly a 
lot of merit to increasing more private savings and retirement 
for Americans. I agree with you completely on that point, and I 
don't want to see the debate on Social Security end without us 
first strengthening Social Security, but also dealing with the 
issue that you raise.
    Mr. Chairman, thank you for your patience.
    Chairman Shaw. Thank you, sir. Mr. Tanner.
    Mr. Tanner of Tennessee. Thank you, Mr. Chairman. I'm glad 
we are talking about increasing the national savings rate in 
whatever form. I have just one question, and apologize for my 
lack of understanding. But as it relates to individual 
accounts, I've heard the term ``clawback'' feature at the end 
of the workers days, could any of you all explain what is meant 
by that and how it would operate?
    Mr. Tanner.
    Mr. Michael Tanner. There are essentially two ways to look 
at it. You are targeting a certain level of benefits between 
the private, individual account portion and the government's 
defined benefit portion. That they would in some way total to a 
particular level of benefit. And then you can either raise or 
lower the government portion to reach that level, or you can 
tax back the private portion to bring it down so that the total 
level is in some way. But some way it claws back a portion of 
the benefit from these accounts.
    I think it is a poor way to go because it deprives people 
of the potential higher rates of return that they could get in 
private investment accounts.
    Mr. Reischauer. Let me try and add a little bit to Mr. 
Tanner's----
    Mr. Tanner of Tennessee. Yes, I think this is an important 
point.
    Mr. Reischauer. Establishing private accounts in and of 
themselves does nothing to reduce Social Security's 
expenditures or liabilities. And so some advocates of private 
accounts have said, well, we will let people build up the 
balances in their private accounts and, depending on how big 
those balances are, we will reduce their Social Security 
benefit. And that's the clawback.
    So in Marty Feldstein's plan, you would reduce Social 
Security's payment for an individual by $3 for every $4 
produced by his private account. And this is the way you go 
about solving Social Security's problem in the long run.
    Mr. Goldberg. Mr. Tanner, I might add, and I think Bob's 
description is right. This is not an uncommon mechanism. The 
notion of integrating defined benefit arrangements and defined 
contribution arrangements. The private sector does it. For 
example, they may integrate private-sector retirement plans and 
Social Security, for example. You can integrate defined 
contributions----
    Mr. Tanner of Tennessee. Well, we have setoffs now in 
government programs.
    Mr. Goldberg. You have setoffs now. I think that describing 
it as ``clawback'' has this rather harsh notion to it. I think 
a setoff mechanism or an integration mechanism is a little bit 
more benign.
    Mr. Reischauer. Attacks. [Laughter.]
    Mr. Goldberg. Attacks. That is even uglier in some 
quarters, but----
    Mr. Tanner. There is a difference between two types of 
proposals, one of which adjusts the government-provided Social 
Security level of benefits in comparison to the private 
accounts to ensure that no one falls below an acceptable level 
of benefit. The other, in essence, penalizes people whose 
accounts perform very successfully and who get a very high rate 
of return and claws back a portion of that even in excess of 
what is necessary to do that. And they use that to fund, in the 
Marty Feldstein proposal, part of the transition.
    Mr. Tanner of Tennessee. Yes, I would like to be around 
that day when you take $3 out of every $4 from somebody who 
invested wisely and listen to the proponents who say that is 
all right. I don't know. Thank you.
    Chairman Shaw. There is one provision that I would just 
like to comment on briefly. That is the proprietary interest 
that people would have in their individual retirement accounts. 
If we were to go that route, if someone should die prior to 
receiving the benefits, they would have something that they 
could leave to their heirs.
    Under existing law, there is no vested interest in the 
Social Security system. It is just faith in the political 
process that it is going to be there for you. And that faith 
has been well placed throughout the years. But if you die, you 
not only lose your life, you lose whatever you paid into the 
Social Security system with the exception of certain death 
benefits, which don't compensate you for the amounts that you 
may have invested.
    This type of accumulation of wealth for the lowest income 
people among us is something that this Subcommittee should 
consider in its deliberations of reforming the Social Security 
system.
    This has been an excellent panel. I think all of us have 
benefited greatly by your presence, and we thank you very much. 
And thank you for waiting past the recess.
    The final panel today, is Martha McSteen who is the 
president of the National Committee To Preserve Social Security 
and Medicare, former Acting Commissioner of the Social Security 
Administration, and John Mueller, who is a senior vice 
president and chief economist of Lehrman Bell Mueller Cannon, 
Inc., in Arlington, Virginia.
    We welcome both of you, and thank you for staying with us 
as long as you have. As with previous panels, we have your full 
testimony, which will become a part of the record. And you 
might proceed in the way you see fit.
    Ms. McSteen.

 STATEMENT OF MARTHA A. MCSTEEN, PRESIDENT, NATIONAL COMMITTEE 
  TO PRESERVE SOCIAL SECURITY AND MEDICARE; AND FORMER ACTING 
          COMMISSIONER, SOCIAL SECURITY ADMINISTRATION

    Ms. McSteen. Mr. Chairman, Mr. Tanner. As you know, there 
have been many claims and counterclaims in recent months about 
privatizing Social Security. For the public, and I'm sure many 
Member of Congress, the puzzle has been, which claims are solid 
and sound, and which are less so. More than 1 year ago, the 
National Committee concluded that the most valuable service we 
could provide the country and the Congress regarding Social 
Security was to commission the most rigorous, objective, 
professional, and exhaustive analysis possible of how 
privatization would impact this and future generations.
    The report we released yesterday, ``The Winners and Losers 
of Privatizing Social Security,'' uses the most sophisticated 
computer model in existence, the EBRI/SSASIM model, developed 
by the Employee Benefit Research Institute and the Policy 
Simulation Group. I am pleased the author of our report, 
economist John Mueller, is here to answer your questions about 
its conclusions because they provide a clear and critical 
warning about the Social Security reforms you may consider. 
Some of them, like privatized accounts, sound attractive but 
the numbers we know now simply don't add up.
    Every demographic group alive today would face retirement 
with fewer benefits under a system of privatized accounts in 
large part because of the heavy and inescapable costs of 
financing the transition from Social Security to a privatized 
system. Women, no matter what age, marital status, employment 
history, or income level, comprise the largest group of losers 
from privatization. For African-Americans living today, the 
average household would lose about half of its retirement 
benefits under any plan to privatize Social Security.
    These are burdens and risks that today's and tomorrow's 
retirees should not have to bear, Mr. Chairman.
    [The prepared statement follows:]

Statement of Martha A. McSteen, President, National Committee To 
Preserve Social Security and Medicare; and Former Acting Commissioner, 
Social Security Administration

    Mister Chairman, Congressman Matsui, members of the 
Committee, good morning. As you know, there have been many 
claims and counter-claims in recent months about privatizing 
the Social Security.
    For the public, and I'm sure many members of Congress, the 
puzzle has been which claims are solid and sound and which 
claims are less so.
    More than a year ago, the National Committee concluded that 
the most valuable service we could provide the country and the 
Congress was to commission the most rigorous, objective, 
professional and exhaustive analysis possible of how 
privatization would impact this and future generations.
    The report we released yesterday, ``The Winners and Losers 
of Privatizing Social Security,'' uses the most sophisticated 
computer model in existence--the EBRI/SSASIM model, developed 
by the Employee Benefit Research Institute and the Policy 
Simulation Group.
    I'm pleased the author of our report, Economist John 
Mueller, is here to answer your questions about its 
conclusions, because they provide a clear and critical warning 
about the Social Security reforms you may consider.
    Some of them, like privatized accounts, sound attractive, 
but the numbers--we know now--simply don't add up. Every 
demographic group alive today would face retirement with fewer 
benefits under a system of privatized accounts, in large part 
because of the heavy and inescapable costs for financing the 
transition from Social Security to a privatized system.
    Women--no matter what age, marital status, employment 
history or income level--comprise the largest group of losers 
from privatization. For African-Americans living today, the 
average household would lose about half of its retirement 
benefits under any plan to privatize Social Security.
    These are burdens and risks that today's and tomorrow's 
retirees should not have to bear, Mister Chairman. Thank you 
very much and I would now like to introduce John Mueller, the 
study's author, to address the specifics of the report.
      

                                

    Ms. McSteen. I would like now to introduce John Mueller, 
the study's author, to address the specifics of the report.
    John.

  STATEMENT OF JOHN MUELLER, SENIOR VICE PRESIDENT AND CHIEF 
  ECONOMIST, LEHRMAN BELL MUELLER CANNON,  INC.,  ARLINGTON,  
                            VIRGINIA

    Mr. Mueller. Thank you. Mr. Chairman, Members of the 
Subcommittee. I appreciate the chance to testify on Social 
Security reform. I am especially grateful for your openness, 
Mr. Chairman, in seeking out what you called warts upon the 
private accounts proposal. And I'd like to tell you about a 
couple of them that I found.
    In fact, I'd like to call the Subcommittee's attention to 
what I consider to be a serious problem. To anyone who has 
closely followed the Social Security debate over the years, 
it's become increasingly obvious that the quality of analysis 
has lagged far behind the importance of the subject. Congress 
is being asked to make informed judgments about proposals for 
sweeping changes that would affect the retirement security of 
American families for at least a century, yet most studies 
about who would win and who would lose from such proposals have 
been seriously flawed.
    Claims that most households would fare better if pay-as-
you-go Social Security were replaced by individual retirement 
accounts depend on three basic errors.
    First, projections for returns in the financial markets are 
not consistent with the economic projections for Social 
Security. One example of that was the 1994 to 1996 Social 
Security Advisory Council and its report, which projected, as 
the Social Security Administration does, that future economic 
growth will be about 1.4 percent, down by almost two-thirds 
from the past, but that stock market returns would continue at 
nearly 7 percent on top of inflation.
    The model that we used shows that this implies that the 
stock market would rise over the next 70 years to equal 468 
years' worth of earnings. And by the time some of the people in 
the report retired, it would be selling for 1,063 years' worth 
of earnings, simply because of the inconsistency between those 
two sets of forecasts. It is inadmissible to speak of Social 
Security in the future tense while speaking of the stock market 
in the past tense.
    The second problem, which is also universal, is that 
examples for winners and losers are typically based on what is 
called the ``unisex flat earnings assumption,'' which assumes 
that all workers at every age, men and women, earn the same 
amount of money, and that this is equal to something called the 
average wage index. According to Census data, this assumption 
overstates the average earnings of American women by nearly 100 
percent because that simply does not comport with the facts.
    The third problem with most studies is that the transition 
tax inherent in any move away from pay-as-you-go Social 
Security is understated or even ignored by assuming that 
funding retirement benefits through general revenues is somehow 
less costly than funding it through the payroll tax.
    To correct these errors, I used an advanced Social Security 
policy simulation model called SSASIM. This model was developed 
by Policy Simulation Group, initially under contract with the 
Social Security Administration, and has been intensively 
developed through the efforts and in partnership with the 
Employee Benefit Research Institute. SSASIM is now used by 
several Federal agencies, including SSA, OMB, Treasury, and 
GAO, though not, as far as I know, here on Capitol Hill.
    The study compares the impact of Social Security reform on 
those born in four different years: 1955, which is the middle 
of the baby boom; 1975, the smallest birth year in Generation 
X; 1990, which is the largest birth year in the so-called echo 
of the baby boom; and finally, 2025, to show the longer term 
effect of Social Security reform. I constructed a sample 
population of 128 individuals based on census data, varying by 
sex, marital status, earnings, race, and mortality.
    I compared benefits and rates of return under three 
different plans: one plan for complete privatization phased in 
over one lifetime, and two traditional methods of balancing 
pay-as-you-go Social Security. Comparing the experience of the 
four generations under the three different plans illustrates 
the whole range of policy choices facing the Congress today: 
everything from balancing the current pay-as-you-go system to 
various degrees of partial privatization to complete 
privatization.
    I tested four different sets of assumptions, from the most 
extreme to the most realistic, and conducted 1,000 case random 
simulations for each household. As for the results, SSASIM 
shows, as I mentioned, that the low expected returns for Social 
Security are not due to its pay-as-you-go funding but rather to 
the assumption of slow future economic growth, which would 
equally reduce stock market returns. The model shows that 
future average real returns would have to be about 4.7 percent 
instead of 6.7 percent. And there is a similar problem with the 
assumptions for interest rates.
    The study also shows, however, that for everyone now alive, 
your financial market assumptions don't make much difference. 
Because of the transition tax, every group now alive faces 
substantial losses from partial or full privatization. Those 
born in 2025 could gain only under the most extreme 
assumptions, that is stock market price earnings ratios 
surpassing 1,000. All four birth years would be substantially 
better off with even a scaled back version of the OASI Program 
than with full or partial privatization.
    The largest group of losers is women, including every birth 
year, income class, and marital status. The only groups 
avoiding losses under realistic assumptions would be unmarried 
men and a few high-income, two-earner couples as long as they 
are born far enough in the future to avoid the transition tax. 
These groups would break even.
    Substantial losers include unmarried women, married 
couples, especially one-earner couples, and African-American 
households, among which the largest losses would be for single 
mothers.
    Thank you, Mr. Chairman, I know I have gone over my time 
slightly. I apologize. I would be happy to answer any of your 
questions.
    [The prepared statement follows:]

Statement of John Mueller, Senior Vice President and Chief Economist, 
Lehrman Bell Mueller Cannon, Inc., Arlington, Virginia

    Thank you, Mr. Chairman. I'd like to describe for you a new 
study on ``Winners and Losers from `Privatizing' Social 
Security'' I've just completed. The report is sponsored by the 
National Committee to Preserve Social Security and Medicare. 
This is my fourth paper on Social Security reform sponsored by 
the National Committee.
    For the past decade I've been a principal of a financial-
markets forecasting firm. I first became involved in the issue 
of Social Security reform in the 1980s, when I served as 
Economic Counsel to the House Republican Caucus under Jack 
Kemp. Like many Reagan Republican conservatives, I began with 
the conviction that pay-as-you-go Social Security ought to be 
``privatized.'' But analyzing the facts and sifting the 
arguments turned me around. I was surprised to discover that 
Social Security is one of those cases, like national defense, 
in which the government is necessary to perform a role that the 
private markets alone cannot--in this case, providing the 
``foundation layer'' of retirement security. Social Security 
was never intended to grow so large as to ``crowd out'' 
investment in the private capital markets, or the even more 
important investment in raising and educating future citizens. 
But the current study clearly illustrates why moving in the 
opposite direction--``privatizing'' Social Security--would be a 
big mistake.
    The current project was undertaken in co-operation with the 
Employee Benefit Research Institute (EBRI) and Policy 
Simulation Group. Under Dallas Salisbury, EBRI has performed a 
valuable service to the nation's debate over Social Security. 
As part of its Social Security Project, EBRI has helped to 
develop a Social Security policy simulation model called 
``SSASIM.'' SSASIM has been developed by Martin Holmer of 
Policy Simulation Group, at first under contract with the 
Social Security Administration, then most intensively in 
partnership with EBRI. The National Committee recently joined 
EBRI in its effort effort to develop SSASIM, by funding two 
important features that had not yet been incorporated: the 
model's ability to calculate stock-market returns consistent 
with long-term economic projections, and to include Social 
Security benefits for spouses and survivors of covered workers. 
SSASIM is now arguably the most advanced Social Security policy 
simulation model in existence. Martha McSteen of the National 
Committee asked me to use the model to undertake the current 
study of winners and losers under ``privatization.''
    To anyone who has closely followed the debate over Social 
Security, it has become increasingly obvious that the quality 
of analysis has lagged far behind the importance of the 
subject. Congress is being asked to make informed judgments 
about proposals for sweeping changes that would affect the 
retirement security of American families for at least a 
century. Yet most studies about who would win and who would 
lose from ``privatizing'' Social Security have been flawed by 
at least three serious errors.
    The first error is that projections for returns on stocks 
and bonds are inconsistent with projections for Social 
Security. Projections for Social Security are typically based 
on the ``intermediate'' assumptions of the Social Security 
Actuaries, which envision a sharp slowing of economic growth 
over the next 75 years--partly on the assumption that the 
United States will reach ``zero population growth.'' However, 
projections for the stock and bond markets are usually based on 
the past performance of those markets, during a period when the 
economy and the population were growing almost three times as 
fast. Putting the two together leads to absurd results. Right 
now Wall Street is wondering how long the stock market can 
maintain its record level of about 30 times annual earnings. 
Under the projections adopted by the 1994-96 Social Security 
Advisory Council, the Standard and Poor's 500-stock Index would 
surpass 500 years worth of earnings in the next 75 years. By 
the time some of the people in this study retire, each share of 
common stock would be assumed to be selling for over 1,000 
years' worth of earnings. (See Graph 1.) SSASIM calculates that 
to be consistent with the Actuaries' intermediate economic 
projections, rates of return on common stocks would have to be 
about 2 percentage points lower than the Advisory Council 
projected: 4.7% a year instead of 6.7% a year above inflation. 
In the study I point out a similar inconsistency in the 
projections for bond yields.
[GRAPHIC] [TIFF OMITTED] T7507.019

    The second kind of error concerns the earnings of American 
households. Nearly all examples used in the debate over Social 
Security assume that the average worker--man or woman--has 
earnings at every age equal to something called the ``Average 
Wage Index.'' But Census data show that this is not the case. 
Earnings vary widely by age, sex, marital status, and 
education. Moreover, the average man can expect about 1 in 5 
zero-earnings years, and the average woman about 1 in 3--time 
spent outside the labor market due to unemployment, illness, or 
family responsibilities. Taking these factors into account, we 
find that the average man does have lifetime average earnings 
slightly more than the Average Wage Index--but the average 
women has lifetime earnings equal to about 53% of the Average 
Wage Index (Graph 2). This means that most studies have 
overstated average annual earnings of women by almost 100%. 
This makes a huge difference in calculating benefits under 
Social Security and individual accounts. Yet this erroneous 
method has been widely used even by the Social Security 
Administration.
[GRAPHIC] [TIFF OMITTED] T7507.020

    The third kind of error concerns treatment of the 
``transition tax'' involved in any move away from pay-as-you-go 
Social Security. ``Pay-as-you-go'' means that each generation 
of workers pays for the benefits of its parents. That's why the 
first generations covered by Social Security received rates of 
return far above the long-term average. It also means that if 
pay-as-you-go Social Security were ended, the last couple of 
generations would have to pay twice: they would keep paying for 
their parents' Social Security benefits, while receiving 
drastically reduced benefits, or no benefits, themselves; at 
the same time, they would have to save for their own retirement 
through individual accounts (Graph 3). If pay-as-you-go Social 
Security were phased out over one lifetime, this ``transition 
tax'' would fall partly on the Baby Boom, but especially on 
``Generation X'' and the children of the Baby Boom.
    This ``transition tax'' far exceeds any changes in payroll 
taxes and/or Social Security benefits that would be necessary 
to balance the existing pay-as-you-go system. The reason is 
simple: paying once for retirement is always cheaper than 
paying twice. Those who favor ending pay-as-you-go Social 
Security have resorted to various tricks of creative accounting 
to try to disguise the ``transition tax.'' These techniques 
generally involve income tax credits, or borrowing against 
general revenues, or some combination. But creative accounting 
can only try to disguise the cost of retirement benefits; it 
cannot change that cost by a single penny. Likewise, income-tax 
credits only shuffle the cost around without changing it.
    SSASIM is especially suited to a study of this kind, 
because it permits us to sidestep the errors I've just 
described. First, the model makes it possible to project 
financial market returns that are consistent with projections 
for the economy. The model can also realistically account for 
transaction costs involved in investing in stocks and bonds, 
and in purchasing the private annuities that would have to 
replace Social Security. Second, SSASIM also makes it possible 
to simulate the impact of Social Security reform on American 
households with a high degree of realism, surpassing the ``flat 
unisex earnings'' assumptions of the Social Security 
Administration. Finally, SSASIM has the great virtue of 
requiring you to say exactly how the cost of benefits will be 
paid: no creative accounting tricks are possible. I think 
you'll find that the results of a rigorous analysis of Social 
Security reforms are eye-opening.
[GRAPHIC] [TIFF OMITTED] T7507.021

    The study is divided into two parts (along with appendixes 
examining some of the important issues raised). The first part 
illustrates the basic choices for Social Security reform in 
their effect upon the average benefits and rates of return for 
couples representing four different birth-years (1955, 1975, 
1990 and 2025). Those born in 1955 are the middle of the Baby 
Boom; those born in 1975 are the smallest cohort in 
``Generation X''; those born in 1990 are the largest cohort in 
the ``Echo of the Baby Boom''; and those born in 2025 represent 
the longer-term effects of various kinds of Social Security 
reform. The second part of the study looks at winners and 
losers among households within each of those birth-years or 
``cohorts''--unmarried or married; two-earner or one-earner 
couples; those with average, above-average or below-average 
earnings; and also selected African-American households.
    There are essentially two possible approaches to Social 
Security reform: either balance the current pay-as-you-go 
retirement program, or else replace it with a system of 
individual retirement accounts. Every reform plan does one or 
the other, or else some combination. The current study examines 
the whole range of options, by comparing results under three 
different plans to reform the current OASI (Old Age and 
Survivors Insurance) program.
    The first plan would completely ``privatize'' Social 
Security, by replacing it over the course of one lifetime with 
a system of individual accounts. Initial benefits for new 
retirees would be phased out evenly over 45 years, which means 
that the payroll tax would disappear after about 80 years. At 
first, the total contribution rate would be increased by 2 
percentage points, though it would later fall back to equal the 
current payroll tax rate.
    The couple born in 1955, whom I call John and Debra, would 
therefore live under a partially privatized system--putting 
about 3 percentage points into individual accounts and about 9 
percentage points into Social Security. Their Social Security 
retirement benefits would be just under two-thirds of current 
law. This approximates the various plans to ``carve'' out part 
of workers' contributions for individual accounts to supplement 
reduced Social Security benefits.
    The couple born in 1975, Carl and Amy, would live under a 
mostly privatized retirement system. By the time they retired, 
the payroll tax would have fallen, and account contributions 
risen, by about 3 percentage points. Social Security retirement 
benefits would be reduced by about four-fifths. Plans like the 
Personal Security Accounts (PSAs) favored by some of the Social 
Security Advisory Council members, or the more recent Feldstein 
plan (which would combine investment in individual retirement 
accounts with Social Security benefits reduced from current law 
by 75 percent), would fall somewhere between the experience of 
John and Debra and the one for Carl and Amy.
    The couples born in 1990 (Patrick and Hilary) and 2025 
(Abraham and Dorothy) would receive benefits that depended 
entirely on their individual accounts--similar to plans favored 
by the Cato Institute. The main difference is that the Patrick 
and Hilary, born in 1990, would still have paid substantial 
payroll taxes to fund benefits to earlier retirees, but payroll 
tax rates would almost have disappeared by the time the Abraham 
and Dorothy retired nine decades from now.
    The other two plans are ``traditional'' reforms to balance 
the current pay-as-you-go Social Security system. One 
``traditional'' plan would raise the Normal Retirement Age 
faster and higher than under current law: this was recommended 
by a majority of the 1994-96 Social Security Advisory Council. 
The OASI payroll tax would be maintained at the current rate of 
10.6% until the trust fund fell to one year's reserve; then the 
payroll tax would be adjusted as necessary to keep the system 
in balance.
    The other ``traditional'' plan has two features. First, the 
system would be restored to a pure pay-as-you-go basis by 
cutting the payroll tax rate 20% (just over 2 percentage 
points) immediately; at the same time, benefit formulas for new 
retirees would be scaled back over 45 years until they reached 
80% of current law. Inflation-adjusted Social Security 
retirement benefits would therefore rise, but not as fast as 
under current law. If the trust fund reserve ever fell to the 
minimum one-year reserve, payroll tax rates would be adjusted 
to keep income and outgo in balance.
    Of course, any actual reform plan would be more 
complicated; these were chosen to illustrate the major issues.
    The study examines four different sets of assumptions, from 
the most extreme to the most realistic. The most important 
conclusion from the first part of the study is this: for 
everyone now alive, it doesn't greatly matter what assumptions 
you use about the stock and bond markets. (See Graph 4.) For 
the Baby Boom, Generation X and the children of the Baby Boom, 
not even unrealistically high stock and bond market returns can 
offset the ``transition tax.'' For everyone now alive, both 
average benefits and rates of return are much higher under even 
a scaled-back Social Security system than could be had from a 
partly or fully privatized retirement system.
    The assumptions do make a difference for people who are not 
born yet. The couple born in 2025 would come out ahead under a 
``privatized'' retirement system, if you assumed that the stock 
market's price/earnings ratio will in fact surpass 1,000 years 
worth of earnings. But with reasonable financial asset returns, 
the average couple born in 2025 would be better off with even a 
scaled-back pay-as-you-go Social Security system than with a 
system of individual retirement accounts.
    The second part of the study goes into much deeper detail 
about the impact of the various plans upon a wide variety of 
American households. A sample population of 32 individuals was 
created for each of the four birth-years, using Census data 
about earnings and employment by age, sex, marital status, and 
education level. The individuals are chosen to reflect 
differences in marital status (unmarried individuals or married 
couples); labor market behavior (two-earner couples with wives 
working full-time or part-time, as well as one-earner couples), 
and education levels (average education [some college], high-
school graduates and college graduates). Individuals with 
below-average education and earnings are assumed to have 
higher-than-average mortality (that is, they don't live as 
long), and vice versa.
[GRAPHIC] [TIFF OMITTED] T7507.022

    Three of the 16 pairs of men and women in each birth-year 
are intended to represent selected African-American households 
which may differ from the general population: one unmarried man 
and woman each, and a two-earner married couple (all with 
average education and earnings for African-American men and 
women); as well as a couple intended to represent the most 
economically and socially disadvantaged African-Americans: a 
single mother with children and her separated partner, both of 
whom are high-school dropouts. All the African-American 
individuals are assumed to have significantly higher mortality 
(shorter lives) than the general population with the same 
education and earnings. There are no separate examples for 
college-educated African-Americans, on the assumption that such 
households have socioeconomic characteristics very similar to 
those for other college graduates.
    The results of the second part of the study are richly 
detailed, and bear examining in some detail. However, in 
summarizing the results, I will concentrate on a few overriding 
themes, and focus on the most realistic set of assumptions. 
(See Graph 5.)
    The first important finding is that the largest group of 
losers from ``privatizing'' Social Security would be women. 
This is true for women in all birth-years, all kinds of marital 
status, all kinds of labor-market behavior, and all income 
levels. The main reason is that Social Security was 
specifically designed to protect women in three ways, all of 
which would be eliminated by ``privatization.'' First, Social 
Security benefits are progressive, and at all education levels, 
women have lower average earnings than men. Second, Social 
Security provides the same annual benefits to men and women 
with equal earnings, but women live longer and so collect more 
benefits. Third, Social Security provides benefits for spouses 
of retired workers, as well as survivors benefits, which are 
far more advantageous to women than the private market can 
provide. The study shows that even unmarried women with high 
earnings, and women with high incomes in two-earner families, 
lose from privatization. However, the losses are even greater 
for women who work part-time, intermittently or not at all in 
the labor market.
[GRAPHIC] [TIFF OMITTED] T7507.023

    The second important finding is that, to the degree Social 
Security is ``privatized,'' the current progressivity of 
benefits would be eliminated. The actual progressivity of 
Social Security is rather mild: this is because the 
progressivity of combined taxes and benefits is partly offset 
by the fact that individuals with less education and lower 
earnings tend to have shorter lifespans, so they collect 
benefits for fewer years. Individuals with more education and 
higher earnings tend to live longer and so collect benefits for 
more years. However, Social Security is still progressive, and 
this feature would be eliminated by ``privatization.'' The 
study finds that individuals with lower education and earnings 
will tend to lose more, and individuals with higher education 
and earnings will tend to lose less, from privatization.
    The third important finding is related to the first and 
second; it concerns the relative treatment of unmarried 
individuals and married couples. (Of course, we need to bear in 
mind that fewer than 5% of those who reach retirement age have 
never been married, and perhaps 10% have never had children.) 
``Privatizers'' have claimed that Social Security is biased 
against unmarried individuals. But the study shows that this 
claim is the result of the faulty ``unisex wage'' assumption. 
The facts are more complicated, and much more interesting. 
Unmarried women actually receive a higher rate of return from 
Social Security than most married couples. Unmarried men 
receive a significantly lower rate of return than unmarried 
women, because the men have higher average earnings and don't 
live as long. If we considered husbands and wives separately, 
we would find that married men receive a lower rate of return 
than unmarried men, because unmarried men spend less time in 
the labor market, and so have lower average earnings and 
benefit more from Social Security's progressivity. Viewed as 
individuals, the highest rates of return are received by 
married women--the lower the earnings, the higher the rate of 
return.
    The final important finding concerns how African-American 
families would fare if Social Security were ``privatized.'' A 
recent study sponsored by the Heritage Foundation gained 
notoriety by claiming, against earlier research, that African-
Americans are big losers under Social Security and would gain 
tremendously if Social Security were replaced by individual 
retirement accounts. However, the Heritage Study contained all 
the errors of method outlined earlier--inconsistent 
projections, unrealistic earnings, entirely ignoring the 
``transition tax,'' and a few more besides. The current study 
squarely contradicts the Heritage findings. Of African-
Americans now alive, the average household would lose about 
half the value of its retirement savings if Social Security 
were ``privatized.'' (See Graph 6.) For African-Americans who 
are not born yet, the pattern is like that for the general 
population. The only African-Americans born in 2025 who would 
not lose under ``privatization'' would be unmarried men without 
children: they would receive approximately the same rate of 
return from Social Security or a private retirement account. 
However, under realistic assumptions all other future African-
American households studied would lose from ``privatization''--
including typical two-earner married couples, unmarried women, 
and those with substantially below-average education and 
earnings.
[GRAPHIC] [TIFF OMITTED] T7507.024

    What does the study imply for the future of Social Security 
reform?
    In the first place, the study is a wake-up call to policy 
analysts. Policymakers and the public require much better 
information than they are now getting--about the financial 
markets, about earnings of American households, and about the 
funding of Social Security reform. That information is 
available--but so far, it has not been used.
    Second, the study strongly indicates that policymakers 
should be focusing on fixing the Social Security system, 
instead of getting rid of it. The ``transition tax'' under 
privatization dwarfs any possible cost of balancing Social 
Security. The low future returns predicted for Social Security 
are not due to its pay-as-you-go nature, but simply to the 
projections about the future economy. If the United States is 
in fact about to enter an Economic Ice Age, then the rates of 
return on everything--Social Security, stocks and bonds alike--
are going to be substantially lower than in the past. It must 
be said that in the past few years the economy has not been 
behaving that way. So far, inflation, unemployment and interest 
rates have all been signficantly lower than the intermediate 
projections. The economy has so far most closely resembled the 
Social Security Actuaries' ``Low-Cost'' economic assumptions. 
It would not be surprising if, in the next annual report, the 
Actuaries' intermediate assumptions were modified. However, the 
projections in the current study are based on the 1998 
intermediate projections.
    But this raises an important issue for policymakers. How is 
it possible to set retirement policy when the future is so 
uncertain? As we have seen, even in the long run, the case for 
``privatizing'' Social Security depends entirely on being right 
about a long string of highly specific--and in part, highly 
unlikely--forecasts.
    Most ``traditional'' reform plans have the great advantage 
of not depending on a particular forecast. Unlike 
``privatization,'' they are reversible. If the economy performs 
better than expected, the announced changes in future benefits 
might never have to be enacted; or else, under the ``Low-Cost'' 
assumptions, payroll tax rates might actually have to be 
reduced below current law (Graph 7). But if the economy does 
perform as poorly as projected, a ``traditional'' reform plan 
would provide a reasonable way to balance the current system. 
American families would be prepared long in advance, and any 
surprises would be positive ones.
    Over the years, Social Security has in fact been adjusted 
several times to allow for changing circumstances. Precisely 
because it has been able to cope with such uncertainties, 
Social Security has proven itself to be a ``plan for all 
seasons.''
[GRAPHIC] [TIFF OMITTED] T7507.025

      

                                

    Chairman Shaw. Mr. Matsui.
    Mr. Matsui. Thank you, Mr. Chairman.
    Mr. Mueller, just for historical background, you started 
off saying that you supported individual accounts before you 
actually embarked upon this study. Is that a correct statement? 
Because I want to make sure that, at least on the record, that 
in terms of a bias or an interest that you might have, this is 
one in which there is no question.
    Mr. Mueller. No. That is quite correct, Mr. Matsui. By way 
of background, I worked for Jack Kemp for 10 years, from 1979 
through 1988; from 1981 through 1987, I was the economic 
counsel for the House Republican Conference and in that 
capacity I was asked to look at the privatization proposals, 
which were bubbling up on the Republican side in the 1988 
election cycle. I began, like many Reagan Republican 
conservatives, by considering it self-*evident that Social 
Security should be privatized. And I was quite surprised and 
chagrined when the facts contradicted that position.
    I came, regretfully, to the conclusion that the case for 
privatization had not been well founded, that it is a mixture 
of one part ignorance of the financial markets, one part 
ignorance of the labor markets, and one part wishful thinking. 
And I don't mean that metaphorically. I mean that literally in 
the three areas that I have pointed out today: first, the 
economic and financial-market assumptions that are not 
consistent; second, labor-market assumptions that do not 
conform to reality; and third, the attempts to ignore the 
transition tax.
    So, you are correct. I began making precisely the same 
arguments you have heard from the earlier panel today. I would 
hope, a little bit better, perhaps. But I just had to conclude 
that I was wrong. And my particular conversion doesn't mean 
anything, but I'd like it to point to the facts involved here.
    Mr. Matsui. If I may, and I know the graph over there is a 
little far, and I wouldn't want you to go over there, but the 
blue part of the graph is the current----
    Mr. Mueller. That is, the blue part--perhaps I should set 
up, what all the parts mean.
    Mr. Matsui. Maybe you can explain it briefly.
    Mr. Mueller. That is a bar graph, which shows average 
annual retirement benefits for four couples, each representing 
the average couple born in each of four different years. The 
first group of bars on the left represent John and Deborah, who 
are born in 1955. They are 44 years old this year. The second 
group of bars is for Carl and Amy. They were born in 1975. They 
are 24 years old this year and not married yet. The third group 
of bars is for Patrick and Hillary. They were born in 1990 and 
are all of 9 years old now, and thinking about Social Security 
is probably not on their agenda. The fourth group of bars is 
for Abraham and Dorothy. They will be born in 2025 and will be 
eligible for retirement at the earliest in the year 2087.
    Now, what the four colors represent are four different 
possibilities for Social Security reform. The first two sets of 
bars, those are the blue and the red, represent what the 
different experience would be for each one of those four 
couples under two sets of assumptions, if Social Security were 
privatized within one lifetime, and by that I mean, the initial 
retirement benefit would be phased out evenly over 45 years, 
permitting the payroll tax to disappear after 80 or 90 years. 
John and Deborah, who are 17 years away from retirement, would 
still live under a partially privatized system. They would be 
putting in about 3 percentage points of taxable earnings into 
an individual account. The remaining 9 percentage points would 
be paying the Social Security benefits to existing retirees. 
Their own Social Security benefits would be reduced by 38 
percent from current law.
    Carl and Amy would live under a substantially privatized 
system, receiving Social Security benefits which had been 
reduced, instead of by a little over one-third, by about 80 
percent. So they would be much more reliant on private 
retirement accounts.
    Patrick and Hillary would have to rely entirely on their 
individual accounts, but still would be paying substantial 
payroll taxes. Abraham and Dorothy have pretty much passed the 
transition tax.
    Now the first two bars show what happens under two 
different sets of assumptions for the privatized system. The 
blue bar is what you would get under the most optimistic 
projections for the financial markets. Those include the 
thousand-years'-worth-of-earnings scenario for the stock 
market. The red bar is what you could get under what I found to 
be realistic assumptions. The green bar is what you could get 
under currently promised Social Security benefits. And the 
yellow bar is what would happen under a scaled back Social 
Security system, which was balanced by adopting some of the 
proposals which were mentioned earlier today.
    What the chart shows is that for the first three cohorts or 
birth years, that is, those who are now alive, it doesn't 
matter what you assume for the stock market. The cost of giving 
up Social Security benefits is too great to be made up by any 
stock market assumptions. So everyone now alive would lose. 
It's only a question for the people born in 2025.
    If you assume that in fact the stock market will be worth 
1,063 years' worth of earnings in the year 2087, they come out 
ahead. If you assume that P/E, price-earning, ratios are 
roughly flat between now and then, they would receive lower 
benefits than you would receive from even a pared back Social 
Security system.
    Mr. Matsui. My time has run out. If I may just ask one 
further question, and then I will yield back, with the 
Chairman's permission.
    In terms of the concept of the transition cost, you 
basically have three provisions, the transition cost, the 
modeling of that average person or average family, and then the 
third is the disparity between investment patterns of the 
Social Security system. In other words, investing in the bond 
market, and second investing in the equity markets, and how one 
is, as you suggested, backward and the other one is forward in 
terms of its thinking.
    Those are the three areas, is that correct?
    Mr. Mueller. That's right.
    Mr. Matsui. What is the most significant aspect of all 
this? Is it the transition cost, or is it the latter, disparity 
between bond market and equity market and the assumptions 
behind it?
    Mr. Mueller. For everyone now alive, it is the transition 
cost, which is the problem that the earlier panel was wrestling 
with. I'm grateful that Mr. Goldberg pointed to the importance 
of the assumptions because that is, in fact, the whole point of 
the study, that the assumptions are important. And I think the 
squawks of outrage are due to the fact that the gimmick in this 
study is that there are no gimmicks. What I have done is make 
explicit for each individual what the cost of that transition 
would be. And the cost of ending Social Security is just--the 
cost would be much greater than any possible cost of balancing 
the system.
    Mr. Matsui. I wanted to ask this one last question. In 
terms of the yellow bar, which is using assumptions that are a 
scaledback Social Security plan, which I suppose if you cut 
benefits you would have. Did you figure it to be 80 percent of 
current benefit level?
    Mr. Mueller. Yes. It ultimately reached 80 percent. For the 
baby boomers it would be 92 percent. It would be 84 percent for 
Carl and Amy, and for the last two couples, it would level off 
to 80 percent of currently promised benefits.
    Mr. Matsui. OK. Now compare that with what the privatized 
system. That is what bar? That's the----
    Mr. Mueller. The privatized system under realistic 
assumptions is the red bar.
    Mr. Matsui. Right.
    Mr. Mueller. And you are comparing that with the pared back 
Social Security system is the yellow bar.
    As you can see, the biggest burden of the transition cost 
actually falls on those born in 1975 and 1990, not on the baby 
boom or those born in the future. And for those two cohorts, 
the possible benefits from a partly or completely privatized 
system are less than half of what you would receive from a 
pared back, pay-as-you-go system. It would be a little bit 
higher than that if you adopted the more optimistic financial 
market assumptions, but still substantially lower than the 
pared back, pay-as-you-go plan.
    Mr. Matsui. Thank you very much. Thank you, sir.
    Mr. Mueller. Thank you.
    Chairman Shaw. Mr. Mueller, a couple of questions.
    What has been the performance of the equity markets, the 
stock markets, over the last 20 years in terms of real dollars?
    Mr. Mueller. The last 20 years, it's about 12 percent.
    Chairman Shaw. And, what is your assumption for the next 20 
years?
    Mr. Mueller. For the next 20 years? It's going to be quite 
low. According to SSASIM, the average real equity return in the 
future will be 4.7 percent, but historically, after a period of 
20 years in which you outperform the average by nearly 100 
percent, you have periods where you underperform by an equal 
amount.
    From 1901 to 1921, from 1929 to 1949, and from 1962 to 
1982, in all those 20-year periods, the real return on equities 
in this country, before taxes, was approximately zero.
    Chairman Shaw. So, your assumption is that in the next 20 
years the growth is only going to be a little over one-fourth 
of what it has been in the last 20 years?
    Mr. Mueller. Perhaps one-third.
    Chairman Shaw. Yes. One-third. OK. In the benefits. What 
benefits do you cut?
     Mr. Mueller. I modeled two different possibilities because 
they have been discussed. One was raising the normal retirement 
age according to what is known as the Gramlich Plan, which 
would index the retirement age in the future to rises in 
longevity. The other is----
    Chairman Shaw. How high would you raise it?
    Mr. Mueller. It ultimately goes to age 70. And this is not 
my plan. I modeled it merely for the----
    Chairman Shaw. That's your assumption?
    Mr. Mueller. Right.
    Chairman Shaw. That's what the yellow line tells us?
    Mr. Mueller. I'm sorry?
    Chairman Shaw. That's what the yellow line tells us?
    Mr. Mueller. No. The yellow line is what is called an 
across-the-board plan. That would leave current benefits 
essentially as they are today, except all would be scaled back 
to 80 percent of currently promised benefits over 45 years.
    Chairman Shaw. Well, you are raising--is that the green 
line? Or is that even on there?
    Mr. Mueller. The yellow line.
    Chairman Shaw. Oh, it is yellow. OK. And what other 
benefits would you cut?
    Mr. Mueller. None. It is across-the-board reform.
    Chairman Shaw. OK. You raised the age to 70?
    Mr. Mueller. No. That is a separate reform. Currently, 
under the current system, the normal retirement age is 
scheduled to rise from 65 to 67 in steps. That would remain the 
same, and the only other benefit changes would be across-the-
board benefit changes.
    Chairman Shaw. And what would they be?
    Mr. Mueller. They would be a scaling back over 45 years of 
initial retirement benefits in even percentage amounts until 
initial benefits beginning in the 45th year would be 80 percent 
of what is currently promised under Social Security.
    Chairman Shaw. I think the politics of that are dismal.
    Mr. Mueller. If so, then the politics of the individual 
accounts would be even worse because that promises less than 
half the benefits----
    Chairman Shaw. It's your assumption that the stock market 
is only going to perform at one-third of the level that it has 
for the last 20 years at historical levels, then obviously 
that----
    Mr. Mueller. Well, sir. It is not my assumption. It is the 
assumption of SSASIM. That is one thing that I did not make up.
    Chairman Shaw. Well, somebody did because it hasn't 
happened yet. So someone had to come up with these figures and 
these theories. Obviously.
    Mr. Mueller. The underlying research comes from an economic 
textbook by John Campbell, Andrew Lo, and Craig MacKinlay 
called ``The Econometrics of Financial Markets,'' Princeton 
University Press, 1997. That is the underlying basis for the 
forecast in SSASIM.
    Chairman Shaw. I see. And I would assume that you have read 
forecasts that would be far rosier than that?
    Mr. Mueller. Yes. I have read many rosier forecasts, but 
they are inconsistent forecasts.
    Chairman Shaw. Inconsistent with yours?
    Mr. Mueller. No. Inconsistent with the Social Security 
Administration's intermediate economic assumptions.
    Chairman Shaw. Oh. Then let me ask you another question 
then. If this is the assumption of the Social Security 
Administration, what would be your thoughts with regard to the 
President's plan and investment of the surplus, or portion of 
the surplus, into equities? Have you assessed that plan?
    Mr. Mueller. Not in this paper. If you ask for my opinion, 
I don't think it would make a great deal of difference one way 
or the other. We heard Mr. Summers say this morning that it 
would affect only 4 percent of benefits in the middle of the 
next century. I did think it was interesting though how much 
time was spent, especially in your colloquy with Mr. Summers, 
about the question of the accuracy of the figures.
    I think the difficulty raised by this study for privatizers 
is that I am merely demanding the same sort of fiscal 
responsibility and accounting that you, in my view, are 
correctly asking of President Clinton.
    The common assumption of everyone who was at this table 
before us was that in some form or another, we will be funding 
Social Security through general revenues and that somehow this 
would not show up in the cost of investment for the people who 
were covered by Social Security.
    Now, in my view, all that President Clinton has done is to 
say to the privatizers, ``You say you can fund privatized 
accounts out of general revenues; why can't we fund Social 
Security out of general revenues? If there's no cost, what's 
the problem?'' I think they are both equally off base, but of 
the two, I would say President Clinton is at least less wrong.
    Chairman Shaw. I'm sure he will appreciate that. 
[Laughter.]
    Even with your gloomy predictions of the future as far as 
the stock market is concerned, do you know what the present 
level of return on Treasury Bills to the Social Security 
Administration is in terms of real dollars?
    Mr. Mueller. Are you asking me what his rate-of-return 
assumption is?
    Chairman Shaw. Yes. Do you know what it is?
    Mr. Mueller. I believe it is 2-point-something. That is 
what Mr. Summers said.
    Chairman Shaw. Yes. Well 4 percent is better than 2 points. 
Maybe the President is more right or more wrong.
    Mr. Mueller. Well, it would be except even the 2.8 percent 
would be inconsistent with real growth of the economy equal to 
1.4 percent. The reason is that it is generally agreed by 
macroeconomic theorists that a situation in which the rate of 
interest remains permanently above the rate of economic growth 
is inherently unstable because under those conditions, the 
total burden of debt, both public and private, would mushroom 
indefinitely. And I don't believe that the interest-rate 
assumptions----
    Chairman Shaw. Let me ask you one other question. I think 
it is sort of interesting here.
    I guess that your prediction that the stock market is only 
going to rise at the level of approximately a third of where it 
has risen for the past 20 years would assume that there is 
going to be some dips in the market. That it is not going to be 
a constant upward spiral. Is that correct?
    Mr. Mueller. I would assume so.
    Chairman Shaw. Are you making any predictions as to the 
performance of the market over the next 2 years?
    Mr. Mueller. I do as a professional forecaster. In fact, I 
predicted the 20-percent decline of the market last summer.
    Chairman Shaw. And it didn't last very long, however.
    Mr. Mueller. No, it didn't. But I also predicted the 
recovery. [Laughter.]
    Chairman Shaw. When did you predict the recovery?
    Mr. Mueller. I'm sorry?
    Chairman Shaw. When did you predict the recovery?
    Mr. Mueller. When the market was at its bottom. I am 
willing to supply the report, sir. This will be wonderful 
advertising for Lehrman Bell Mueller Cannon, Inc. [Laughter.]
    Chairman Shaw. Could I ask you what is your prediction for 
the next year?
    Mr. Mueller. I think we are going to have another 
correction in the market, and then it will recover again.
    Chairman Shaw. After it hits the bottom, it will go back up 
again?
    Mr. Mueller. Yes.
    Chairman Shaw. OK. Mr. Doggett.
    Mr. Doggett. Thank you very much. I think that your study 
is very important. I appreciate the work that you have done on 
it. I think you were in the room when Mr. Goldberg, as I 
understood it, suggested you might be a member of the Flat 
Earth Society on these transition and administrative costs.
    I guess the first specific I would want to turn to, as I 
understood his criticism, he said you assumed total 
privatization. That is in error, is it not? You considered two 
options.
    Mr. Mueller. Well, I considered actually all degrees of 
privatization. You could see, again from the earlier panel, 
what my difficulty was. If I took a single plan which was only 
a partially privatized plan, Michael Tanner would say, Oh, but 
our plan at Cato is complete privatization.
    Mr. Doggett. Right.
    Mr. Mueller. If you model complete privatization, then Mr. 
Goldberg says oh, but you didn't model partial privatization. 
So what I did was to take a plan that privatized the Social 
Security Program over one lifetime, and looked at what the 
experience of people born in different years was, because at 
any moment, you could stop the system and say this is our 
partially privatized system.
    If you stopped where the 1955 couple is, you would have 
roughly a one-third privatized system. If you stopped where the 
couple born in 1975 is, you would have roughly a three-quarters 
privatized system. For the other two, it is completely 
privatized, only with two different degrees of paying the 
transition tax.
    So I try to cover all the bases by using three plans, 
experienced by four different generations, with four different 
sets of assumptions.
    Mr. Doggett. There was also the suggestion that over time, 
all these administrative costs will work themselves out. Does 
the experience in other countries suggest that we will ever see 
administrative costs of a fully privatized or partially 
privatized system down at levels that are anywhere near the 
current administrative costs of the Social Security system?
    Mr. Mueller. No. The current annual administrative costs 
for Social Security are equivalent to four basis points or four 
one-hundredths of a percentage point. Mr. Goldberg, in his 
defense, said that he thought we could get costs down to 50 
basis points with private accounts. The difference between his 
assumption and the assumptions in this study is only 50 basis 
points. Right now, the average equity fund costs the average 
shareholder 1\1/2\ percentage points per year. I rather 
charitably assumed that over time, there would be in fact 
efficiency gains and that the annual cost would fall to 100 
basis points. I doubt it would ever go much below that.
    Mr. Doggett. I understand basically the bottom line of your 
analysis is that if you use realistic assumptions, that there 
is no one in this room today or alive on this planet today that 
will come out better under the partial or complete 
privatization plan under either one, than they would under 
Social Security?
    Mr. Mueller. It is certainly true for everyone in this room 
today. I think the planet may go a little far since much of it 
is not covered by the Social Security system.
    Mr. Doggett. Well, we have got people on Social Security I 
guess scattered around the world, literally in this system.
    Mr. Mueller. That's true. But I did find no group now alive 
that would benefit from privatization. In fact, no group that 
could avoid substantial losses from either partial or full 
privatization.
    Mr. Doggett. And it will be those people born, is it after 
2025 or beginning in 2025, a small portion as I understand your 
study, of those that are at the very top of the pyramid of the 
economic scale who are Anglo males who might have some benefit 
if the system were fully or partially privatized after the year 
2025?
    Mr. Mueller. That is correct, if you add the qualifier 
``with the realistic assumptions.'' As the last set of bars 
shows, under the unrealistic assumptions the average person 
born in 2025 could come out ahead. But by those unrealistic 
assumptions, I mean the stock market selling for more than one 
millennium worth of earnings.
    Mr. Doggett. Well, I just hope that the research that you 
have done, and Ms. McSteen, I am really appreciative of the 
role the National Committee has played in getting this research 
to us, that it will form the basis of what should be a truly 
bipartisan effort, but it has to be a bipartisan effort that 
accepts certain principles, one of which, it seems to me, has 
to be that the system which we have had has been one of the 
best the world has ever known. Before we junk it and experiment 
on the American people, we ought to take into consideration 
this simulation, recognize its value, and try to strengthen and 
preserve the system rather than to weaken and destroy it. Thank 
you.
    Mr. Mueller. Thank you.
    Mr. Matsui. The Chair was gracious to give me another 
question. Mr. Mueller, I just wanted clarification or perhaps 
you can even expand on this. For the economic assumptions you 
are using for both the current system minus 20-percent or an 
80-percent benefit level and a privatized system, you are using 
the same inflation rate, the same economic growth rate, the 
same projections. What you are doing is using a different 
assumption in terms of what the economic benefits to the stock 
market would be based upon projections over the long period of 
time that you have done your study, right? Am I understanding 
that correctly?
    Mr. Mueller. That is correct. I was going to say to Mr. 
Shaw in response to his last question that in fact, I do not 
agree with those assumptions, but they happen to be the ground 
rules for the debate. The intermediate economic assumptions of 
the Social Security Administration amount to saying that we are 
about to enter an economic ice age, one key feature of which is 
that we are going to reach zero population growth because the 
birth rate will fall below the replacement rate. That will be 
roughly made up by immigration. But there will be no growth in 
the population beyond mid-century. The only growth in the 
economy would come from a 1-percent annual increase in labor 
productivity.
    You asked me for my opinion. I think that is probably too 
pessimistic. In fact, so far the economy has been behaving more 
like the low cost assumptions. I wouldn't be surprised in the 
least if the actuaries raised their intermediate assumptions in 
the next annual report. All I was insisting on is that if you 
are going to adopt the economic ice age forecast, you can not 
at the same time assume that the stock market is going to be 
flourishing like a hothouse plant.
    Mr. Matsui. What you are saying is that assuming even a 
higher growth rate, the numbers in your graph would be similar 
in terms of who benefits and who doesn't benefit?
    Mr. Mueller. The shape would be the same. What would happen 
is that for each percentage point of higher economic growth, 
you would get a 1 percentage point higher return both in the 
stock market and from Social Security.
    Mr. Matsui. Right. I would just conclude by saying that I 
think you have responded consistently with your testimony, that 
you are using the same basic economic assumptions for the 
equity market, and also the bond market in terms of Social 
Security, and other components Social Security is involved in. 
In other words, you are not saying one has a different growth 
rate than the other.
    Mr. Mueller. That is correct. Right.
    Mr. Matsui. Thank you.
    Chairman Shaw. Just one more question, if you could clear 
up a confusion I have got in my head. You are projecting the 
growth in the stock market of 4 percent, real dollars. We have 
a system now that is making 2.5 percent in real dollars. How 
can you say that 4 percent is not as good as 2.5 percent?
    Mr. Mueller. It is because you don't get the 4 percent. If 
you take the 4 percent, you have to subtract first the 
transaction costs, which are a little over 100 basis points a 
year. In addition, you have to subtract the cost of the lost 
benefits. If you are going to give up all the Social Security 
benefits over a period of 45 years, you have to subtract 
another 2.2 percent from your rate of return. That puts you in 
the hole compared with Social Security.
    Chairman Shaw. How do you figure that?
    Mr. Mueller. It is because if you are giving up Social 
Security benefits--this is the ``clawback'' that the earlier 
panel was talking about--that comes out of your rate of return. 
That is a negative. I mean you are starting in the hole. It is 
so large because in each case we are talking about a benefit 
loss of about 38 percent for the first couple, 82 percent for 
the second couple, and 100 percent for the other two couples.
    Chairman Shaw. Do these examples take into effect that both 
the President's plan and some on the Senate side, as far as 
Republicans are concerned, assume up to an infusion of 62 
percent of the surplus going into the retirement accounts or 
into the Social Security system?
    Mr. Mueller. No, sir. It assumes what the Social Security 
Administration assumes, which is essentially current law. My 
point about the transition tax is that----
    Chairman Shaw. I think all of the witnesses, and I think 
anybody who has studied this at all knows that if we do get 
into some type of personal accounts, that there is going to be 
a transition cost. That transition cost is going to require 
some of the surplus. I think that is a given. We can't go from 
one system to another system without having some type of cost 
to bridge the transition.
    If we do nothing, the system is going to take a huge 
infusion of cash. Once you get into two or three generations 
from now, if you do nothing, our grandchildren will suffer 
greatly.
    Mr. Mueller. I am certainly not proposing to do nothing. 
The whole reason I modeled two different plans for balancing 
pay-as-you-go Social Security was to show that even a pared 
back, balanced Social Security system would give you a higher 
rate of return than you could get from a partially or fully 
privatized system.
    Chairman Shaw. OK. But now your system assumes a greater 
working population and it assumes a smaller than historical 
stock market escalation. Is that not correct?
    Mr. Mueller. It assumes that economic growth will be slower 
and that equity returns will become lower commensurate with 
that lower growth, yes.
    Chairman Shaw. What is your forecast on corporate bonds?
    Mr. Mueller. Corporate bond yields are assumed to equal the 
growth rate of the economy. The Social Security Administration 
assumes that long-term growth of the economy would settle down 
at 4.7 percent. So that is the corporate bond rate assumption.
    Chairman Shaw. So it is about the same as the stock market, 
in your opinion?
    Mr. Mueller. No. I'm sorry, 4.7 percent would be in nominal 
terms. After inflation, it would be 1-point something, less 
than 2 percent.
    Chairman Shaw. Oh. Corporate bond return is going to be 
lower than the Treasury bills?
    Mr. Mueller. No.
    Chairman Shaw. Treasury bills are at 2.5 percent in terms 
of real dollars.
    Mr. Mueller. Well, they are if you have an inconsistent 
forecast for the bond market as well as for the stock market. 
You can not have the burden of debt, public or private, 
compounding at a rate, a real rate of 2.7 percent, while the 
economy is only growing at 1.4 percent. You run into the same 
sort of problem that you do with the price/earnings ratio; in 
this case, the burden of all debt, public and private, would 
mushroom. Under those assumptions, you would have nonfinancial 
corporate debt, which is now at a record 210 percent of GDP, 
going to 16 times GDP. You would have all of the economy being 
eaten up by interest costs, with nothing left over for anything 
else.
    This is precisely the point I am making. These projections 
are not consistent.
    Chairman Shaw. I think if we have proved anything by this 
segment of the hearing, it is why CPAs do not understand 
economists. [Laughter.]
    In any event, we thank you for your input. We do have your 
study and we are analyzing it at this time. I wish we had had 
an opportunity to fully digest it before this hearing.
    [A response from Mr. Mueller to Mr. Matsui follows. The 
attachment is being retained in the Committee files.]

                      Lehrman Bell Mueller Cannon, Inc.    
                                        Arlington, VA 22201
                                                      11 March 1999

Honorable Clay Shaw
Chairman, Social Security Subcommittee
House Ways and Means Committee
Raybum HOB
Washington, D.C. 20515

    Dear Congressman Shaw,

    At the March 3rd Social Security Subcommittee hearing, Congressman 
Matsui asked me to submit a written response to Fred T. Goldberg's 
remarks about my study, ``Winners and Losers from `Privatizing' Social 
Security.'' I request that this response be made part of the published 
written record of the hearing.
    Mr. Goldberg's opening comments on geography were somewhat 
enigmatic, but I took him to mean that anyone who disagrees with Mr. 
Goldberg must believe that the earth is flat. As it happens, my casual 
observations of the horizon from commercial aircraft, combined with 
some basic knowledge of geometry, incline me to endorse Mr. Goldberg's 
general views about the shape of our planet. However, regarding the 
subject of the hearing, Social Security reform, I can agree with Mr. 
Goldberg about only one thing: the critical importance of assumptions. 
The main point of my testimony was that ``privatizers'' necessarily 
require erroneous assumptions to support their case. Mr. Goldberg 
proved me correct on all three points I raised:
    1. a fundamental inconsistency between the ``privatizer'' projected 
returns for Social Security and those for financial assets;
    2. unrealistic assumptions by the ``privatizers'' about earnings of 
American households; and
    3. ``privatizers'' attempts to ignore or conceal the ``transition 
tax'' inherent in any move away from pay-as-you-go Social Security 
toward a partly or fully privatized system.

    1. (In)consistency of financial-market and economic assumptions.

    a. Mr. Goldberg generally objected to my new study's 
projections, including those concerning equity returns, but 
under questioning from the chairman he could not offer any 
projections of his own. If Mr. Goldberg would be kind enough to 
supply the committee with specific 75-year projections for 
average real equity returns and real GDP growth, it should be 
possible to calculate the implied price/earnings ratio, as I 
did for the projections of the 1994-96 Social Security Advisory 
Council. As I showed, those projections implied price/earnings 
ratios surpassing 500 or even 1000 years by the time some of 
the people in the study retired.
    In response to a question from Chairman Shaw, I cited the 
source for these calculations and for the stock market 
projections used in my study. The equity projections are those 
calculated by the SSASIM model to be consistent with the 1998 
Intermediate economic assumptions of the Social Security 
Trustees (which project 1.4% average real GDP growth over the 
next 75 years), upon which projections of returns on Social 
Security are based. As I noted, the SSASIM model is not my own 
creation. SSASIM was developed by Policy Simulation Group, 
initially under contract with the Social Security 
Administration, and most intensively in partnership with the 
Employee Benefit Research Institute (EBRI). SSASIM is being 
used by several Federal agencies (SSA, 0MB, Treasury and GAO) 
to analyze Social Security reform. SSASIM calculates that, 
given the SSA projections for economic (and thus long-term 
corporate earnings) growth, the real rate of return on equities 
would have to fall from about 7% in the past 75 years to about 
4.7% in the next 75 years. I also cited the survey of stock 
market research on which this feature of the model is based.\1\ 
In short, there is a glaring contrast between the 
``privatizers'' projections for the equity market and for the 
economy, the result of a fundamental and indefensible logical 
inconsistency.
---------------------------------------------------------------------------
    \1\ Holmer, Martin, ``New SSASIM Equity Return Stochastic 
Process,'' September 28,1998, Policy Simulation Group, Washington, D.C. 
Holmer cites John Y. Campbell, Andrew W. Lo and A. Craig MacKinlay, The 
Econometrics of Financial Markets, Princeton University Press, 1997.
---------------------------------------------------------------------------
    b. Mr. Goldberg argued that the average transactions costs 
for investments in private accounts would be lower than my 
study assumed. At the hearing, Mr. Goldberg cited a figure of 
50 basis points a year for management fees, and his submission 
suggested a range of 30-50 basis points; the assumption for 
annual management fees I used was 100 basis points. (The 
comparable figure for Social Security is about 4 basis points.) 
Now, the average total shareholder cost ratio for equity funds 
in 1997 was 149 basis points, according to the Investment 
Company Institute.\2\ Therefore, my estimate already assumes a 
further one-third reduction in the average expense ratio. A 
recent study of administrative expenses by the Employee Benefit 
Research Institute (EBRI) cited evidence ``401(k) plan fees 
varied by as much as 300% and can comprise of up to 3-5 percent 
of 401(k) balances per year.'' \3\
---------------------------------------------------------------------------
    \2\ John D. Rea and Brian K. Reid, ``Trends in the Ownership Cost 
of Equity Mutual Funds,'' Investment Company Institute Perspective Vol. 
4 No. 3, November 1998, page 2.
    \3\ Kelly A. Olsen and Dallas L. Salisbury, ``Individual Social 
Security Accounts: Issues in Assessing Administrative Feasibility and 
Costs,'' EBRI Special Report and Issue Brief #203, November 1988, 32.
---------------------------------------------------------------------------
    My study also assumed a 5% ``load'' on the purchase of 
private annuities, which is far below the going rate. But to 
this Mr. Goldberg does not appear to object. In his own 
submission, he writes: ``Because the administrative costs of 
individual annuities may be as much as 5 to 10 percent of the 
purchase price (even without premiums for adverse selection), 
we believe that it is appropriate for retirees who choose to 
purchase such annuities to bear these costs themselves.'' \4\ 
Thus he thinks my estimate may be right, or may be understated 
by as much as 50%.
---------------------------------------------------------------------------
    \4\ Fred T. Goldberg Jr. and Michael J. Graetz, ``Reforming Social 
Security: A Practical and Workable System of Personal Retirement 
Accounts,'' NBER Working Paper 6970, February 1999, 27.
---------------------------------------------------------------------------
    These are the only transactions costs assumed in the study. 
I suggest that it is Mr. Goldberg's estimate that is 
unreasonable. And if ``privatization'' really stands or falls 
on a 50 basis-point difference over management fees, I think it 
reinforces my point: the ``privatizers'' case depends upon a 
highly specific (and in large part highly unlikely) set of 
assumptions.

                2. Unrealistic labor market assumptions.

    Mr. Goldberg touched on this point only indirectly, when he 
claimed that those who would be helped most by ``privatizing'' 
Social Security would be low-income households, blue-collar 
workers and African-Americans. However, he did not cite any 
source for this claim. My study showed that a recent Heritage 
Foundation study making an assertion similar to Mr. Goldberg's 
was based entirely on several errors, including the three 
discussed here (Appendix K, ``A Syllabus of Errors: The Recent 
Heritage Foundation Study''). Whatever the source, Mr. 
Goldberg's assertion necessarily implies unrealistic earnings 
assumptions on his part. My study found that households with 
lower earnings would be hurt more than those with higher 
earnings, in part because (for example) high-school dropouts 
are not employed enough of the time to generate the savings 
claimed by using the faulty ``unisex flat earnings'' 
assumption. But of course, Mr. Goldberg's claim may also partly 
have to do with unrealistic assumptions for returns on 
financial assets, already discussed.

                  3. Ignoring the ``transition tax.''

    a. This is the most important practical question in the 
debate about Social Security reform, because the ``transition 
tax'' dwarfs any possible cost of balancing pay-as-you-go 
Social Security. In general, I believe Mr. Goldberg is confused 
about the transition tax, but he is not alone.
    Every penny of current benefits is paid out of someone's 
current income. This means that for a whole generation, what 
matters is the total amount of retirement benefits, not how 
they are financed. The net ``transition tax'' on a generation 
may be defined as the difference between the Social Security 
benefits it pays to earlier retirees while in the labor force, 
and the (smaller) Social Security benefits it receives during 
its own retirement. This is the point of Graph 3 in my 
testimony, which shows the difference between current OASI 
benefits and benefits received 25 years later (both measured as 
a share of taxable payroll). The graph shows that under 
``privatization in one lifetime,'' the ``transition tax'' rises 
to at least 7% of taxable payroll each year by the year 2030, 
before beginning to decline. The chart stops at 2050 because 
SSA projections only go as far as 2075, but this tax would 
continue for at least 75 years. For an individual or household, 
the calculation is the same, except for secondary differences 
due to any unequal distribution of the burden among workers 
within the generation. (The whole burden is paid by workers: 
see below.)
    Mr. Goldberg asserted that my study arbitrarily assumes 
that the transition cost would fall entirely on lower-income 
households. This is simply incorrect. The burden falls on 
whomsoever loses the Social Security benefits without any 
compensation (or pays extra contributions without extra 
benefits). A relatively larger burden is indeed imposed on 
lower-income families. This is not due to any assumptions on my 
part, but simply to the fact that full or partial 
``privatization'' aims precisely to strip out those components 
of Social Security which favor lower-income families most 
(progressivity of benefits, spousal and survivors benefits).
    Mr. Goldberg strongly implied that the burden of the 
transition cost might be significantly different if it were 
funded out of general revenues. This objection is presumably 
based on the argument that the burden of the payroll tax 
differs from the burden of the income tax. However, the 
argument contains several fatal flaws.
    First, neither Mr. Goldberg nor any other ``privatizer'' 
has produced any figures to support his contention. Rather, all 
``privatizers'' have made the ridiculous assumption that the 
income tax--or borrowing against the income tax--has zero cost 
to anyone. All rates of return calculations in studies 
advocating privatization of Social Security use this absurd 
convention. This is precisely the ``creative accounting'' 
against which I warned, which enjoys no support from any theory 
or evidence. Based on the ``privatizers'' preposterous logic--
which ignores any cost but the payroll tax in calculating rates 
of return--funding Social Security completely through general 
revenues would provide everyone an infinite rate of return.
    Social Security is now financed (in fact, overfinanced) 
through payroll taxes; but using some other means (such as 
current income taxes or current borrowing against future income 
taxes) would not significantly affect the calculation. If 
benefits were instead funded, say, partly through payroll taxes 
and partly through income taxes, then for each individual we 
must subtract part of the payroll tax and add back that 
individual's share of the income tax levy that replaces it. In 
any case, before measuring rates of return for individual 
workers or households, the first requirement is that the whole 
cost must be attributed to someone. This the ``privatizers'' 
fail to do.
    Second, if Mr. Goldberg troubled to do the calculations, he 
would learn that his objection is not merely of secondary, but 
of tertiary significance. Most of the transition ``tax'' under 
partial or full privatization consists of the loss of Social 
Security retirement benefits without a corresponding reduction 
in payroll contributions. (In some proposals, the loss of 
benefits is coupled with an increase in mandatory 
contributions.) It is primarily this loss of benefits--not any 
explicit increase in either payroll or income tax rates--which 
turns part or all of the existing payroll contribution into a 
pure tax. Mr. Goldberg himseif argued that such changes must be 
part of any Social Security reform package. An explicit 
increase in tax rates would only come into play when the 
``privatizers'' seek to make those workers whole again out of 
general revenues. Yet they do not attribute any of that cost to 
anyone, thereby invalidating their calculations. This flaw is 
contained in every single study on privatization of which I am 
aware, for example, from the Cato Institute or the Heritage 
Foundation.
    The third problem with Mr. Goldberg's argument is that the 
whole burden of retirement benefits must be financed out of 
labor compensation--no matter how it is formally financed. In 
the jargon of economists, the ``incidence'' of a tax differs 
from its ``burden.'' For example, half the payroll tax is paid 
by employers: its ``incidence'' is on businesses; yet 
economists generally agree that the ``burden'' of the payroll 
tax actually falls on labor compensation, not on corporate 
profits: it is paid out of income that would otherwise go to 
workers.
    Let us suppose that the payroll tax were completely 
replaced by income tax funding of retirement benefits. By Mr. 
Goldberg's argument at least part of the cost of Social 
Security benefits would be paid out of property compensation 
(interest, dividends, etc.) rather than labor compensation, 
because the income tax falls on labor and property 
compensation, while the payroll tax falls only on labor 
compensation. However, this is not in fact possible. The theory 
of the distribution of income suggests that any shifting of the 
payroll tax burden to owners of property would be offset by an 
approximately equal loss of pretax income by workers. And the 
evidence supports this. I have done extensive analysis of the 
distribution of U.S. national income--both labor compensation 
and property compensation, before and after all Federal, state 
and local taxes and transfer payments--going back to 1929, and 
can show that the theory of income distribution is supported by 
the evidence.
    Mr. Goldberg's real objection, I contend, was to the fact 
that my study allocated the transition cost at all--not to the 
way in which that cost was accounted for. This is exactly the 
sort of ``creative accounting'' by privatizers against which I 
warned in my testimony. It also reveals the great virtue of 
using SSASIM as I did: the user must allocate the transition 
cost to someone. I invite Mr. Goldberg to allocate the 
transition tax in any way he chooses--as long as he allocates 
the whole cost to somebody. He will find that doing so would 
not affect the qualitative results of the study in the least. 
The ``transition tax'' is simply too large to be affected by 
any estimates about its distribution.
    b. Mr. Goldberg objected that my study only modeled a bill 
for complete privatization of Social Security, whereas he, 
personally, was against going beyond partial privatization. Yet 
there was a great deal of disagreement on this point among the 
members of the first panel, ranging from those who are against 
or skeptical of private accounts (Mr. Summers and Mr. 
Reischauer), to those favoring various degrees of partial 
privatization (Ms. Weaver and Mr. Goldberg) to those favoring 
complete privatization (Mr. Tanner).
    Precisely because there is no agreement among 
``privatizers,'' my study was constructed to survey the whole 
range of possible options, from balancing the pay-as-you-go 
system without private accounts, to various degrees of partial 
privatization, to full privatization. I did this by comparing a 
plan to privatize Social Security over one lifetime (roughly 80 
to 90 years) with two plans to balance the pay-as-you-go 
system. As I pointed out in my testimony, and in response to 
one of Congressman Matsui's questions, the experience of those 
born in 1955 involves partial privatization; of those born in 
1975 substantial privatization; and of those born in 1990 and 
2025 complete privatization (the 1990 cohort facing the 
heaviest burden and the 2025 cohort the lightest). Thus no one 
can complain that his or her favorite approach was neglected in 
my study.
    I believe the foregoing thoroughly refutes Mr. Goldberg's 
objections. But before closing I would like to remark on 
another important issue raised by the morning panel March 3rd. 
In his testimony, Professor Lawrence J. White outlined what he 
aptly named the ``canned goods'' theory of investment, his 
lucid metaphor for the ``neoclassical'' economic theory devised 
in the late 19th century. I urge members of the committee to 
compare this explanation with a newer and better grounded 
opposing view, summarized in a paper which I am enclosing 
(``The Economics of Pay-as-you-go Social Security and the 
Economic Cost of Ending It''). Despite their disagreements on 
several points, all members of the moming panel were partisans 
of the ``canned goods'' theory, which argues that the only 
investment that matters to the economy is investment in 
things--so-called ``nonhuman capital.'' All the panelists 
agreed that the funding of Social Security depends on the 
growth of labor compensation--and yet all ignored the past 40 
years of research showing that labor compensation is the return 
on investment in so-called ``human capital'' the size and 
earning ability of the labor force. A large body of research 
shows that investment in ``human capital'' is between two and 
three times as important to economic growth as investment in 
``nonhuman capital.'' The ``transition tax'' is levied 
precisely on the return on such investment, and must tend to 
discourage it. None of the ``privatizers'' take this negative 
impact into account.
    I am grateful to the subcommittee for the opportunity to 
testify on this important question.

            Sincerely yours,
                                               John Mueller
      

                                

    Chairman Shaw. I thank you both for being with us. The 
hearing is now adjourned.
    [Whereupon, at 2:50 p.m., the hearing was adjourned.]
    [Submissions for the record follow:]

Statement of Emma Y. Zink, Chairperson, Teachers' Retirement Board, 
California State Teachers' Retirement System, Sacramento, California

 CalSTRS and Other State and Local Government Retirement Systems Have 
 Met Their Fiduciary Responsibilities to Provide Pre-Funded Retirement 
     Benefits for Millions Of State and Local Government Employees

    In the course of the recent debate over the President's 
proposal for direct investment of a portion of the Social 
Security trust fund in equities, there has been the suggestion 
that public pension plans, including State and local retirement 
systems, have underperformed in their investments because of 
political interference. While we do not intend to inject 
ourselves into the debate over Social Security privatization, 
as one of the largest State retirement systems in the country 
we feel compelled to respond to the suggestion that State and 
local plans and their governing bodies have failed to fulfill 
their fiduciary responsibilities.
    In testimony before the Senate Budget Committee on January 
28, 1999, Federal Reserve Board Chairman Alan Greenspan, in 
discussing the President's proposal for direct investment of 
Social Security trust fund assets in equities, asserted: ``Even 
with Herculean efforts, I doubt if it would be feasible to 
insulate, over the long run, the trust funds from political 
pressures--direct and indirect--to allocate capital to less 
than its most productive use. The experience of public pension 
funds seems to bear this out.'' Chairman Greenspan argued that 
the returns on State and local pension funds are lower than 
private sector counterparts, while conceding that much of this 
disparity would be eliminated were these returns adjusted for 
risk in light of the fact that State and local pension funds 
often are invested more conservatively than private plans. The 
remainder of the disparity, Chairman Greenspan suggested, may 
be ascribed to political interference in the management of the 
State or local pension fund.
    The California State Teachers' Retirement System (CalSTRS) 
covers more than 600,000 active and retired elementary, 
secondary, and community college teachers in California. 
Established in 1913, CalSTRS has successfully provided benefits 
to generations of retired teachers in California. The CalSTRS 
retirement system has assets with a total market value of 
$93.456 billion as of December 31, 1998. Last year, as of June 
30, 1998, CalSTRS collected $1.005 billion in contributions 
from the State, and its investments returned $12.949 billion in 
earnings and asset growth. CalSTRS is essentially fully funded 
(to meet its actuarial accrued liability). Last year, CalSTRS 
paid, on a pre-funded basis, over $3 billion in benefits to 
150,000 retirees and families.
    A twelve-member Teachers' Retirement Board governs CalSTRS. 
The Governor appoints eight members representing active and 
retired teachers, business people from the insurance field and 
commerce banking, or savings and loan field, and a public 
representative to serve four-year terms. Four Board members 
serve in an ex-officio capacity and actively participate in 
Board matters; the State Superintendent of Public Instruction, 
the State Controller, the State Treasurer, and the State 
Director of Finance.
    The Teachers' Retirement Board vigorously discharges its 
fiduciary obligations in the management of the retirement plan 
for the exclusive benefit of its active and retired members. 
Providing retirement security is the driving force of the 
investment policy. To meet this goal of retirement security, 
CalSTRS is dedicated to obtaining the highest possible return 
on its investments of the mandatory employer and employee 
contributions and other fund income, given an acceptable level 
of risk. The CalSTRS Investment Management Plan incorporates 
strategies that implement the Board's investment direction. The 
Board has established safety, diversification, liquidity, and 
structure as the appropriate standards for a complete and 
profitable investment portfolio. Reducing the System's funding 
costs within prudent levels of risk, diversification, and 
reduction of costs associated with managing the System assets 
are measures that have contributed to a solid investment 
portfolio. The Board establishes and regularly reviews the 
asset allocation policy that is designed to meet the investment 
objectives with an acceptable minimum risk.
    We do not wish to become involved in the debate over the 
President's proposal for direct investment of Social Security 
trust fund assets in the stock market. However, we cannot let 
rest any implication from Chairman Greenspan's testimony or 
elsewhere that the Teachers' Retirement Board of the State of 
California or the governing bodies of other State and local 
government retirement systems are failing to live up to their 
fiduciary responsibilities. The members of the California State 
Teachers' Retirement Board take our fiduciary responsibilities 
very seriously, vigorously exercise those responsibilities and 
have fully discharged them.
      

                                


Statement of Century Foundation, New York, New York

Social Security Reform Proposals: How They Stack Up Against Principles 
                           for Prudent Change

    Members of Congress, private organizations, academics, and 
others have put forward widely differing plans for reforming 
Social Security. Many of the details of those proposals are 
complicated and the extent to which they address the primary 
problem confronting the program--a projected shortfall 
beginning in the year 2032--vary considerably.
    To help those who care about the future of Social Security 
understand the most prominent proposals under consideration, 
the Century Foundation is publishing a series of Social 
Security Reform Checklists. Each summarizes the main provisions 
of a particular plan and then assesses whether it adheres to 
seven principles for prudent reform that were developed by a 
panel of leading Social Security experts.

              The Seven Social Security Reform Principles

    1. Social Security should continue to provide a guaranteed 
lifetime benefit that is related to past earnings and kept up-
to-date as the general standard of living increases.
    2. American workers who have the same earnings history and 
marital status, and who retire at the same time, should receive 
the same retirement benefit from Social Security.
    3. Social Security benefits should continue to be fully 
protected against inflation, and beneficiaries should continue 
to rest assured that they will not outlive their monthly Social 
Security checks.
    4. Retirees who earned higher wages during their careers 
should continue to receive a larger check from Social Security 
than those with lower incomes; but the system should also 
continue to replace a larger share of the past earnings of low-
income workers.
    5. Social Security's insurance protections for American 
families, including disability insurance, should be fully 
sustained.
    6. Social Security's long-term financing problem should not 
be aggravated by diverting the program's revenues to private 
accounts and benefits should not be reduced to make room for 
private accounts; any such accounts should be supplementary to 
Social Security, entirely as an add-on.
    7. In addition to securing Social Security as the 
foundation of income support for retirees, their dependents, 
the disabled, and survivors, more needs to be done to encourage 
private savings and pensions.
      

                                


Social Security Reform Check List #1

The Robert M. Ball Plan

                                Overview

    Robert M. Ball, a former commissioner of Social Security, 
advocates a plan that retains Social Security's current 
structure while making a series of adjustments to assure the 
system's long-term financial integrity and giving wage earners 
a way to save additional money for retirement. His plan is 
similar to a proposal endorsed in January 1997 by six out of 
thirteen members of the 1994-96 Advisory Council on Social 
Security. The Ball plan requires only limited benefit cuts and 
tax increases. It would invest a portion of the Social Security 
trust funds, now exclusively comprising U.S. Treasury 
securities, in private equities. All disability and life 
insurance benefits would be maintained at present levels. 
Benefits to retirees would continue to be guaranteed for life 
and indexed for inflation. Those who paid more in payroll taxes 
would continue to receive larger benefit checks, while the 
program would also continue to replace a greater portion of 
wages for low earners than for higher earners. In addition, 
beginning in 2000, wage earners would have the option of 
contributing up to 2 percent of their wages to voluntary 
private savings accounts.

                        Summary of Key Features

    Benefit Changes. The Ball plan would avoid major benefit 
cuts. Like most other reform proposals, however, it does 
include minor changes in the cost-of-living adjustments to 
reflect corrections to the consumer price index recommended by 
the Bureau of Labor Statistics. Those changes, most of which 
are already scheduled to take effect, should reduce annual 
cost-of-living adjustments by about 0.25 percentage points a 
year. The Ball plan would also increase the number of working 
years counted to determine benefit levels from today's 35 to 
38. Adding more years would reduce average benefits by about 3 
percent because the average past salaries that benefits are 
based on would include more years when workers were young and 
earning less--or nothing at all. Those with long absences from 
the workforce--women more commonly that men--would end up with 
the largest reductions.
    Tax Changes. The plan does not include major tax changes; 
but it would raise the ceiling on earnings subject to Social 
Security taxes (currently $68,400 per worker) at a rate faster 
than current law allows. The plan would seek to raise the 
portion of taxable wages from 85 percent of the national 
payroll to 90 percent--the traditional level of the program.
    Structural Changes. The Ball plan would invest part of the 
Social Security trust funds, which now hold exclusively U.S. 
government securities, in stocks beginning in 2000. By 2015, 50 
percent of the trust funds' assets would be invested in a broad 
index of equities. A Federal Reserve-type board would oversee 
these investments.
    The plan would also move toward making Social Security 
universal by including all newly hired state and local 
government employees, some of whom are now covered under 
separate retirement systems. (Federal employees hired since 
1974 are already covered under Social Security.) In addition, 
the Ball plan would allow workers to invest up to an additional 
2 percent of their pay in voluntary supplementary retirement 
accounts administered through Social Security.

                          Evaluating the Plan

    To assess the impact of various proposals to change Social 
Security, The Century Foundation organized a group of experts 
to develop principles for prudent reform. Here's how Robert 
Ball's plan stacks up against those principles:

Principle 1. Social Security should continue to provide a 
guaranteed lifetime benefit that is related to past earnings 
and kept up to date as the general standard of living 
increases.

    Analysis: The Ball plan leaves intact nearly all basic 
features of the current system, including lifetime benefits 
based on past earnings (with adjustment to account for past 
changes in the cost-of-living).

Principle 2. American workers who have the same earnings 
history and marital status, and who retire at the same time, 
should receive the same retirement benefit from Social 
Security.

    Analysis: None of Ball's changes would alter this basic 
feature of the current system. However, workers who chose to 
make use of voluntary supplementary retirement accounts usually 
could expect to receive higher overall benefits than those who 
did not.

Principle 3. Social Security benefits should continue to be 
fully protected against inflation, and beneficiaries should 
continue to rest assured that they will not outlive their 
monthly Social Security checks.

    Analysis: By endorsing modifications to the cost-of-living 
adjustment recommended by the Bureau of Labor Statistics to 
correct for current overstatements of inflation, the Ball plan 
would slightly reduce the amount by which Social Security 
checks are increased each year. Still, this proposal would 
retain the current system's protections against inflation.

Principle 4. Retirees who earned higher wages during their 
careers should continue to receive a larger check from Social 
Security than those with lower incomes; but the system should 
also continue to replace a larger share of the past earnings of 
low-income workers.

    Analysis: Again, the Ball plan maintains the current 
benefit structure of Social Security. Higher earners would 
continue to receive larger benefit checks than lower earners, 
but low-income retirees would receive checks that replaced a 
larger share of their average earnings.

Principle 5. Social Security's insurance protections for 
American families, including disability insurance, should be 
fully sustained.

    Analysis: The Ball plan maintains all of Social Security's 
insurance protections and current benefit levels for the 
disabled and for family members of workers who die.

Principle 6. Social Security's long-term financing problem 
should not be aggravated by diverting the program's revenues to 
private accounts and benefits should not be reduced to make 
room for private accounts; any such accounts should be 
supplementary to Social Security, entirely as an add-on.

    Analysis: The Ball plan would not divert any of Social 
Security's payroll tax revenue into private accounts. However, 
it does feature voluntary add-on accounts that would be 
administered by Social Security and that workers could use to 
build greater retirement savings. The Ball plan would also 
invest a portion of the Social Security trust funds in private 
equities, which historically have increased in value more 
rapidly than the Treasury securities the system now holds. This 
change would potentially help alleviate the long-term financing 
challenge facing the system. But because stocks can lose value 
during particular periods of time, the assets in the trust 
funds might decline during a bear market.

Principle 7. In addition to securing Social Security as the 
foundation of income support for retirees, their dependents, 
the disabled, and survivors, more needs to be done to encourage 
private savings and pensions.

    Analysis: By creating add-on accounts supplementary to 
Social Security, the Ball plan would institute a new mechanism 
for workers to accumulate savings for retirement. This 
provision would be especially beneficial to Americans who have 
no private pensions or other retirement savings options. On the 
other hand, a variety of tax incentives currently in place to 
promote savings, such as tax breaks for individual retirement 
accounts and 401(k) plans, have not been sufficient to induce 
low- and moderate-income households to increase their anemic 
savings rates. It is unclear whether a voluntary program like 
Ball's would create significant new savings.
      

                                


Social Security Reform Check List #2

Two Percent Personal Retirement Accounts

                                Overview

    Harvard economist Martin Feldstein, a former chairman of 
the Council of Economic Advisors, has proposed reforming Social 
Security by creating ``two percent personal retirement 
accounts.'' Feldstein's proposal, unlike most other plans, 
seems painless. It imposes no reductions in Social Security 
benefits or increases in taxes. In fact, its most distinctive 
feature is the creation of a new benefit: a fully refundable 
income tax credit, equal to 2 percent of each worker's earnings 
subject to the Social Security payroll tax that would finance 
new personal retirement accounts. (This tax credit is fully 
refundable because workers with no income tax liability and 
those who owe less than 2 percent of their earnings would still 
receive the full 2 percent contribution to their account.)
    Under the plan, workers would have flexibility to choose 
from a group of regulated stock and bond mutual funds that 
would be administered by private managers. After retirement, 
however, every dollar a retiree withdraws from his or her 
personal account would reduce that retiree's guaranteed Social 
Security benefit by 75 cents. In cases where workers invested 
so badly or the market performed so poorly that little money 
was left in the accounts, they would continue to receive the 
benefits promised under today's system. Social Security's 
projected shortfall in the year 2032 would be deferred because 
the system would presumably owe less money to beneficiaries 
thanks to the accumulations in the investment accounts.

                             The Price-tag

    According to the Congressional Budget Office, which 
recently released a critique of the Feldstein plan, the 
proposed tax credits would cost the government about $800 
billion over the next ten years. Rather than raise taxes or 
reduce government spending over that period, Feldstein proposes 
allocating anticipated federal budget surpluses to pay for the 
tax credit. Whenever federal surpluses become insufficient, 
then Congress would determine how to raise the money. But for 
the near future, Feldstein argues, his proposal could be 
implemented without imposing either benefit reductions or 
revenue increases that other plans for strengthening Social 
Security include.
    Since Social Security faces a projected shortfall in 2032, 
can the system really be strengthened painlessly? The Feldstein 
plan appears to do so by financing the new accounts with the 
surplus in general revenues, as opposed to the payroll tax that 
is dedicated to Social Security benefits, thereby tapping a new 
well of resources for mandatory retirement savings. But because 
current federal budget surpluses reduce the debt, creating a 
new tax credit and diverting the surpluses to private accounts 
would increase the government's long-term obligations and 
interest costs. Therefore, as the report stated, ``The policy 
would implicitly increase the tax burden on future workers if 
no further adjustments were made on the spending side of the 
budget.''

                          Evaluating the Plan

    To assess the impact of various proposals to change Social 
Security, The Century Foundation organized a group of experts 
to develop principles for prudent reform. Here's how the 
Feldstein proposal for 2 percent personal retirement accounts 
stacks up against those principles:

Principle 1. Social Security should continue to provide a 
guaranteed lifetime benefit that is related to past earnings 
and kept up-to-date as the general standard of living 
increases.

    Analysis: Under the Feldstein plan, guaranteed Social 
Security benefits under the current formula, which is based on 
past earnings and takes into account cost-of-living changes, 
would become the minimum that workers receive. The actual 
payments that workers would collect, however, would depend to a 
significant extent on how the investments in their personal 
retirement accounts fared. Because the personal retirement 
accounts would be financed through a flat-rate income tax 
credit of 2 percent, the dollar amount of the contributions to 
the accounts would be higher for workers with larger incomes 
and would rise over time as a worker's earnings grew. 
Therefore, a retiree's total benefits would continue to be 
related to past earnings, although less so than under current 
law because of variations in the investment performance of his 
or her account.

Principle 2. American workers who have the same earnings 
history and marital status, and who retire at the same time, 
should receive the same retirement benefit from Social 
Security.

    Analysis: The Feldstein 2 percent plan would produce new 
disparities in benefits earned by retirees with the same 
earnings history and marital status because some workers could 
be expected to make better investments than others. Variations 
in investment performance would be somewhat limited, however, 
because every extra dollar that workers accumulate in their 
personal retirement accounts would increase the benefits they 
receive by just 25 cents under the plan's formula. 
Distributions would be further reduced by the cost of 
administering the accounts, paying investment management fees, 
and integrating them with the rest of the Social Security 
system. Economist Peter Diamond has shown that the 
administrative costs in countries that have set up individual 
accounts (Britain, Chile, Argentina, Mexico) reduce benefits by 
20 to 30 percent compared to what the U.S. Social Security 
system would pay given the same resources.

Principle 3. Social Security benefits should continue to be 
fully protected against inflation, and beneficiaries should 
continue to rest assured that they will not outlive their 
monthly Social Security checks.

    Analysis: Because the baseline benefit would remain intact, 
beneficiaries would continue to receive some lifetime benefit. 
To date, however, the Feldstein 2 percent personal account plan 
does not specify whether and how the amounts accumulated in 
personal accounts would be converted into monthly payouts. Even 
if beneficiaries were required to annuitize their accounts 
(that is, convert the lump sums into smaller periodic payments 
based on life expectancy levels), the value of those payments 
would be eroded by inflation unless they were indexed to 
increases in the cost of living, as are today's Social Security 
benefits. The Feldstein plan does not indicate that the 
payments would be adjusted for inflation, however. If retirees 
were allowed to withdraw the money in a lump sum, as they can 
with individual retirement accounts, for example, they might 
spend all that money before they die.
Principle 4. Retirees who earned higher wages during their 
careers should continue to receive a larger check from Social 
Security than those with lower incomes; but the system should 
also continue to replace a larger share of the past earnings of 
low-income workers.

    Analysis: When the payouts from personal retirement 
accounts are included, the overall effect of the plan would be 
that higher earners would receive disproportionately greater 
increases in their total benefit package than lower earners. 
Brookings Institution economists Henry J. Aaron and Robert D. 
Reischauer show that a worker with a high income would see 
their combined Social Security and private account payment 
increase by more than twice that of a low-income worker.\1\ 
That would happen mainly because 1) contributions to the 
accounts would be made at the same 2 percent rate regardless of 
income, but 2) guaranteed benefits, which would be reduced at 
the same rate for all retirees, replace a larger share of the 
past earnings of low-income workers. These calculations don't 
factor in the probability that high income workers would invest 
more aggressively and successfully. The bottom line is that 
lower-income workers would benefit less from the proposed 
formula than upper-income workers. (Feldstein has said that 
this problem could be addressed by imposing a modest 
redistributive tax on the investments of higher earners).
---------------------------------------------------------------------------
    \1\ In the table below, Social Security benefits correspond 
approximately to the average replacement rates of low and maximum 
earners--56 percent and 25 percent, respectively. Each worker 
contributed proportionately to earnings. When Social Security benefits 
are reduced by three-quarters of the pension based on the individual 
account, the low earner's pension goes up 12 percent, and the high 
earner's by 21 percent.


----------------------------------------------------------------------------------------------------------------
                                                                 Social     Individual     Total      Change in
                      Average Earnings                          Security     Account      Pension      Pension
----------------------------------------------------------------------------------------------------------------
Low earner--1,000...........................................          560          240          620         +11%
High earner--5,600..........................................        1,375        1,340        1,720         +25%
----------------------------------------------------------------------------------------------------------------


Principle 5. Social Security's insurance protections for 
American families, including disability insurance, should be 
fully sustained.

    Analysis: The Feldstein 2 percent account plan is not 
explicit about what changes, if any, would be made to the 
survivor's and disability features of Social Security. By 
skirting this issue, the plan leaves important questions 
unanswered. For example, if a worker died prematurely and left 
dependents, what formula would be used for paying out the 
proceeds of his or her personal retirement account and 
integrating these funds with Social Security survivor's 
benefits? If workers became disabled, would they be entitled to 
gain access to the investments accrued in their accounts?

Principle 6. Social Security's long-term financing problem 
should not be aggravated by diverting the program's revenues to 
private accounts, and benefits should not be reduced to make 
room for private accounts; any such accounts should be 
supplementary to Social Security, entirely as an add-on.

    Analysis: By creating a new refundable income tax credit to 
finance personal accounts, the Feldstein plan avoids, for now, 
diverting payroll tax revenues earmarked for current benefits 
and the Social Security trust funds. But because the tax credit 
would create a new long-term government obligation, future 
Congresses would need to find a way to pay for the personal 
accounts when and if surpluses run out. One inviting target at 
that point would be the Social Security trust funds themselves, 
which are projected to have accumulated over $2 trillion by 
early in the next century to finance guaranteed payments to the 
baby boomers. Any shifting of assets from the trust funds to 
private accounts would reduce the money available to pay for 
guaranteed benefits in the future. Another ``fix'' would be for 
Congress to allow the national debt to grow to keep the program 
whole.

Principle 7. In addition to securing Social Security as the 
foundation of income support for retirees, their dependents, 
the disabled, and survivors, more needs to be done to encourage 
private savings and pensions.

    Analysis: Initially, the Feldstein plan would neither 
increase nor decrease America's low levels of national savings, 
which many economists believe should be raised to promote 
investment and long-term economic growth. Every federal surplus 
dollar shifted to investment in a personal account would remain 
a dollar saved. To gauge the effect of the plan on national 
savings when and if surpluses run out, one would need to 
predict what actions Congress would take in the absence of the 
plan--which obviously are unknown. Professor Feldstein assumes 
that, without his plan, Congress would spend any anticipated 
surpluses. Under that assumption, his plan would increase 
savings and, consequently, economic growth. But the 
Congressional Budget Office argues, at least as plausibly, that 
the new accounts would lead to higher government budget 
deficits and lower national savings because they constitute a 
new, costly, and unlimited commitment of federal resources.
    Moreover, if the government guarantees prevailing Social 
Security benefits as a baseline regardless of how well each 
worker's personal account performs, it risks encouraging 
workers to take greater, perhaps imprudent risks with their 
investments than they otherwise might. Under that scenario, 
akin to the savings and loan debacle of the 1980s, the 
government's future obligations would be even greater.
      

                                


Social Security Reform Check List #3

The National Commission on Retirement Policy Plan

                                Overview

    The National Commission on Retirement Policy (NCRP), a 
bipartisan group convened by the Center for Strategic and 
International Studies, has endorsed a proposal that would 
fundamentally restructure Social Security. The plan channels 
two percentage points of the current payroll tax (12.4 percent 
of wages, divided equally between workers and their employers, 
with a cap at $68,400 in yearly income) into mandatory 
individual savings accounts. To compensate for the reduction in 
tax revenue and eliminate the projected shortfall in Social 
Security beginning in the year 2032, the NCRP plan cuts 
benefits substantially--in part by increasing the retirement 
age to seventy.

                        Summary of Key Features

    Benefit Changes. According to the Congressional Research 
Service, the NCRP plan would reduce guaranteed benefit levels 
set under current law by 33 percent for an average-wage-earning 
worker retiring at the age of sixty-five in the year 2025. By 
2070, after the plan is fully phased in, benefits for the 
average worker (who retires at sixty-seven) would be 48 percent 
lower than under present law. The specific changes leading to 
those reductions include:
    Raising the normal retirement age from sixty-seven in 2029 
(an increase that is already scheduled to be phased in under 
current law) to seventy. The plan would also increase the age 
of eligibility for reduced benefits from sixty-two to sixty-
five by 2017. Raising the retirement age amounts to cutting 
benefits, since workers will receive lower lifetime benefits.
    Reducing benefits for middle-income and high-income 
retirees. The portion of pre-retirement earnings that Social 
Security pays middle-income beneficiaries would decrease from 
32 percent to 21.36 percent by 2020. For higher-income 
beneficiaries, the reduction would be from 15 percent to 10.01 
percent by 2020.
    Increasing the number of working years counted to determine 
benefit levels from today's thirty-five to forty by 2010. 
Adding more years would reduce benefit levels because the 
average past salaries that benefits would be based on would 
include more years when workers were young and earning less--or 
nothing at all. Those with long absences from the workforce--
women more commonly than men--would end up with the largest 
reductions.
    Reducing benefits to dependent spouses from 50 percent of 
their spouses' benefits to 33 percent.
    Tax Changes. The plan would not increase payroll taxes, 
raise the cap on taxable earnings, or increase the taxation of 
benefits to help close the existing financing gap. But it would 
divert two percentage points of the current payroll tax into 
individual savings accounts.
    Structural Changes. The NCRP proposal's structural changes 
to the Social Security program include:
    Introducing individual savings accounts modeled on the 
Federal Thrift Savings Plan, which allows workers to invest in 
several broad-based funds. At retirement, workers would be 
required to annuitize the majority of funds in their accounts--
that is, convert them from lump sums into monthly payments that 
are made for the duration of their lives.
    Expanding Social Security coverage to include all newly 
hired state and local government employees.
    Creating a new minimum benefit equal to 100 percent of the 
poverty line for those who have spent forty years or more 
working and 60 percent of the poverty line for those with 
twenty to thirty-nine years in the workforce.

                          Evaluating the Plan

    To assess the impact of various proposals to change Social 
Security, The Century Foundation organized a group of experts 
to develop principles for prudent reform. Here's how the 
National Commission on Retirement Policy plan stacks up against 
those principles:

Principle 1. Social Security should continue to provide a 
guaranteed lifetime benefit that is related to past earnings 
and kept up to date as the general standard of living 
increases.

    Analysis: Although the plan retains a guaranteed benefit 
based on a worker's past earnings, the size of that benefit 
would be cut by 33 percent for the average worker retiring at 
65 in 2025. Those reductions would be offset somewhat by 
provisions for new individual savings accounts and minimum 
benefits of 100 percent of the poverty line for those who spent 
forty years or more working and 60 percent of the poverty line 
for those with twenty to thirty-nine years in the workforce. 
But, in the process, benefit levels would become less closely 
tied to past earnings and more dependent on the performance of 
the investments in each worker's individual savings account.

Principle 2. American workers who have the same earnings 
history and marital status, and who retire at the same time, 
should receive the same retirement benefit from Social 
Security.

    Analysis: While workers with similar earnings histories and 
marital status would receive the same, reduced baseline benefit 
from Social Security, the introduction of individual savings 
accounts would produce significant variations in overall 
benefits. Those who enjoyed better luck with their individual 
accounts, who invested more aggressively, and retired when 
their investments were at a peak would receive higher payments 
than workers who invested less wisely, opted for more 
conservative investments, or retired when their investments 
were down.

Principle 3. Social Security benefits should continue to be 
fully protected against inflation, and beneficiaries should 
continue to rest assured that they will not outlive their 
monthly Social Security checks.

    Analysis: Although guaranteed benefits are cut 
substantially under the NCRP plan, they would still be indexed 
for inflation and continue until death. However, payments from 
individual accounts would not be protected against inflation. 
The NCRP plan would require retirees to convert most of their 
individual savings accounts investments into annuities upon 
retirement, but it does not mandate that these annuities make 
payments that are indexed for inflation. Unless workers chose 
to convert the accumulations in their accounts into annuities 
that are indexed for inflation, the value of each payment would 
decline over time as inflation reduced the value of the dollar. 
Today, inflation-adjusted annuities are very expensive and not 
widely available in the private market.

Principle 4. Retirees who earned higher wages during their 
careers should continue to receive a larger check from Social 
Security than those with lower incomes; but the system should 
also continue to replace a larger share of the past earnings of 
low-income workers.

    Analysis: The NCRP changes in the benefit formula would 
result in middle-income and higher-income retirees receiving a 
lower percentage of their past earnings than is currently the 
case. This would represent a substantial cut in their benefits. 
Still, workers who earned more would continue to receive 
somewhat higher benefits than individuals who had lower 
incomes. And the new guarantee of benefits equal to 100 percent 
of the poverty level for workers who spent at least forty years 
in the workforce and 60 percent for those who worked twenty to 
thirty-nine years would offer protection for some low-income 
retirees--though less than the current system does in most 
cases.

Principle 5. Social Security's insurance protections for 
American families, including disability insurance, should be 
fully sustained.

    Analysis: Although the NCRP plan would retain insurance 
coverage for the disabled and for surviving spouses, the 
reductions in guaranteed retirement benefits would dramatically 
reduce protections for workers whose earned income plummets for 
an extended period because of disability. The combination of 
delaying the retirement age, extending the number of working 
years counted in determining baseline benefits, and changing 
the formula for calculating those benefits would especially 
imperil those, like the disabled, who leave the workforce for 
years at a time.

Principle 6. Social Security's long-term financing problem 
should not be aggravated by diverting the program's revenues to 
private accounts and benefits should not be reduced to make 
room for private accounts; any such accounts should be 
supplementary to Social Security, entirely as an add-on.

    Analysis: The NCRP plan imposes significant benefit cuts to 
allow two percentage points of payroll tax revenue to be 
diverted to individual savings accounts. The reduction in 
guaranteed benefits is far greater than the cuts that would be 
needed to assure that the system will be adequately financed 
throughout the next century.

Principle 7. In addition to securing Social Security as the 
foundation of income support for retirees, their dependents, 
the disabled, and survivors, more needs to be done to encourage 
private savings and pensions.

    Analysis: The NCRP plan shifts assets accumulating in the 
Social Security trust funds to individual savings accounts, a 
process that would neither increase nor decrease national 
savings (the combined savings of the government, companies, and 
households), or personal savings levels. Many economists argue 
that increasing the nation's low savings level would help to 
promote long-term economic growth by supplying more capital for 
long-term investment.
      

                                


Social Security Reform Check List #4

The Moynihan-Kerrey Plan

                                Overview

    Senators Daniel Patrick Moynihan (D-N.Y.) and Robert Kerrey 
(D-Neb.) have introduced legislation that would make 
significant changes in Social Security. Their plan would 
establish voluntary private retirement accounts while 
instituting major reductions in guaranteed benefits, a large, 
temporary payroll tax cut, and some tax increases. Most 
notably, the plan would reduce the payroll tax that finances 
Social Security from 12.4 percent (divided equally between 
workers and their employers) to 10.4 percent, giving 
individuals the option of either contributing the two point 
difference to a savings account or keeping one percentage point 
to use as they see fit.
    The guaranteed benefits received by today's retirees, 
currently adjusted for inflation as the consumer price index 
rises, would increase at a slower rate because in calculating 
benefits a percentage point would be subtracted from the rate 
of increase in the Consumer Price Index each year. By the end 
of the average retirement period of twenty years, that change 
alone would leave beneficiaries with monthly checks about 25 
percent below what they would be under current law. Economist 
Alicia H. Munnell of Boston College calculates that by the year 
2070, when all the plan's changes would be fully phased in, the 
cut in guaranteed benefits for a worker with an average 
earnings history who retires at age sixty-five would amount to 
31 percent. That's substantially more than the 25 percent 
across-the-board cut in guaranteed benefits that the government 
estimates will be required in the year 2032 if no changes 
whatsoever are made to Social Security in the interim.

                        Summary of Key Features

    Benefit Changes. In addition to subtracting a full 
percentage point from the rate of increase in the consumer 
price index each year when adjusting retirement benefits for 
inflation, the Moynihan-Kerrey plan reduces benefits in the 
following ways.
    It would increase the age at which full retirement benefits 
could be collected by two months per year from 2000 to 2017, 
and by one month for every two years between 2018 and 2065. 
This means that workers who reach sixty-two in 2017 will not be 
eligible for full retirement benefits until age sixty-eight and 
workers reaching sixty-two in 2065 will only become eligible at 
seventy. Under current law, workers reaching sixty-two in 2022 
will be eligible for full retirement benefits at age sixty-
seven.
    Benefit levels would be based on how much a worker earned 
over the course of thirty-eight years rather than over thirty-
five years, which is the period currently used. On average, the 
change would reduce a worker's retirement benefits by about 3 
percent because it includes in the average the earlier years in 
workers' careers when they likely earned less--or nothing at 
all. Because women are more likely than men to withdraw from 
the workforce for years at a time to raise children, this 
change would affect them disproportionately.
    Tax Changes. The Moynihan-Kerrey plan's payroll tax cut 
would begin in 1999 and last through 2024. After that, the 
payroll tax would increase according to the following schedule:

        from 2025 to 2029, it would rise from 10.4 percent to 11.4 
        percent;
        from 2030 to 2044, it would return to the current level of 12.4 
        percent;
        from 2045 to 2054, it would be 12.7 percent;
        from 2055 to 2059, it would rise to 13.0 percent,
        in 2060 and thereafter, it would be 13.4 percent.

    Other tax increases would be imposed sooner, however:
    The cap on yearly earnings subject to the Social Security 
payroll tax would increase from $68,400 in 1998 to $97,500 in 
2003, and thereafter would be indexed to wage inflation.
    Social Security benefits would become taxable to the extent 
that a retiree's benefits exceed his or her tax contributions 
to the system. This change would result in more extensive 
taxation of benefits than under current law, which taxes only 
half of benefits received by retirees with total yearly incomes 
in excess of $25,000 ($32,000 for married couples).
    Structural Changes. The largest structural change is the 
incorporation of voluntary private retirement accounts. This 
new component of Social Security would give an individual 
earning $30,000 a year--who now pays $1,860 in Social Security 
payroll taxes--the option of investing $600 in a savings 
account or keeping an extra $300 in take-home pay. The 
individual could put the $600 either in investment funds that 
the government now offers to federal employees or in privately 
run accounts. Other structural changes include:
    Newly hired state and local government workers would be 
required to participate in Social Security. They are the last 
group of workers now excluded from Social Security.
    The earnings test, which may reduce current benefits for 
individuals who continue to work after electing to receive 
their Social Security benefits, would be eliminated beginning 
in the year 2003 for all beneficiaries aged sixty-two and over.

                          Evaluating the Plan

    To assess the impact of various proposals to change Social 
Security, The Century Foundation organized a group of experts 
to develop principles for prudent reform. Here's how the 
Moynihan-Kerrey plan stacks up against those principles:

Principle 1. Social Security should continue to provide a 
guaranteed lifetime benefit that is related to past earnings 
and kept up to date as the general standard of living 
increases.

    Analysis: Under the Moynihan-Kerrey plan, guaranteed 
retirement benefits would continue to be based on past 
earnings, adjusted for changes in the cost of living. But those 
benefits would be significantly lower than under reform 
proposals such as those put forward by former Social Security 
commissioner Robert M. Ball or Brookings Institution economists 
Henry J. Aaron and Robert D. Reischauer. That's mainly because 
of the annual one-percentage-point reduction in the cost-of-
living adjustment and the increase in the retirement age.

Principle 2. American workers who have the same earnings 
history and marital status, and who retire at the same time, 
should receive the same retirement benefit from Social 
Security.

    Analysis: While workers with the same earnings history and 
marital status would receive the same guaranteed benefits from 
Social Security, the introduction of personal retirement 
accounts would produce significant variations in overall 
benefits among workers with the same earnings history. Because 
these accounts are voluntary, some workers would choose not to 
participate. (Only 3 percent of Americans earning $30,000 or 
less, for example, have elected to open Individual Retirement 
Accounts despite considerable tax advantages in doing so). 
Moreover, investment returns on the accounts are certain to 
vary widely. Investors with greater financial acumen and better 
luck, and those who retire when investment markets are strong, 
would receive higher payments than workers who invested less 
skillfully or retired during a bear market. As a result, under 
the Moynihan-Kerrey plan, Social Security would more closely 
resemble an investment program than retirement insurance.

Principle 3. Social Security benefits should continue to be 
fully protected against inflation, and beneficiaries should 
continue to rest assured that they will not outlive their 
monthly Social Security checks.

    Analysis: Under the Moynihan-Kerrey plan, Social Security 
would continue to pay guaranteed lifetime benefits indexed for 
inflation. However, by reducing the benefit adjustment tied to 
the consumer price index by one percentage point each year, the 
plan would hurt many low-income elderly who are already 
struggling with rising medical costs (which rise more rapidly 
than the consumer price index). These costs have come to 
consume an ever-growing share of elderly Americans' personal 
expenses--20 percent of such expenses on average and an even 
higher share for poor seniors. Over the past fifteen years, 
adjustments in Social Security benefits have failed to take 
account of this rising burden. As for the assets accumulated in 
private retirement accounts, their value could be significantly 
reduced by a period of high inflation.

Principle 4. Retirees who earned higher wages during their 
careers should continue to receive a larger check from Social 
Security than those with lower incomes; but the system should 
also continue to replace a larger share of the past earnings of 
low-income workers.

    Analysis: The Moynihan-Kerrey plan would retain this 
feature of the current program for determining guaranteed 
benefits.

Principle 5. Social Security's insurance protections for 
American families, including disability insurance, should be 
fully sustained.

    Analysis: The Moynihan-Kerrey plan retains all of the 
disability and survivor's insurance features of the current 
Social Security program.

Principle 6. Social Security's long-term financing problem 
should not be aggravated by diverting the program's revenues to 
private accounts and benefits should not be reduced to make 
room for private accounts; any such accounts should be 
supplementary to Social Security, entirely as an add-on.

    Analysis: By reducing the payroll tax in order to introduce 
personal retirement accounts, the Moynihan-Kerrey plan would 
deplete the asset buildup in the Social Security trust funds. 
This would shift a much greater share of the burden of 
financing Social Security to future workers after the 
retirement of the baby boomers. The benefit cuts will reduce 
those obligations to some extent but cutting revenues to the 
system now will add to, rather than lessen, the challenge of 
keeping Social Security sound in the next century.


Principle 7. In addition to securing Social Security as the 
foundation of income support for retirees, their dependents, 
the disabled, and survivors, more needs to be done to encourage 
private savings and pensions.

    Analysis: The Moynihan-Kerrey plan includes no measures 
that would encourage private savings and pensions. Indeed, 
reducing payroll taxes (which by definition reduces the federal 
surplus or increases the deficit) without requiring households 
to save the money threatens to reduce further the nation's 
already low level of national savings.
      

                                


Social Security Reform Check List #5

The Gramm Plan

                                Overview

    Senator Phil Gramm (R-Tex) is sponsoring a plan to 
transform Social Security by diverting nearly one-fourth of the 
payroll taxes that finance today's retirement insurance system 
into individual investment accounts. Under his proposal, 
workers would have the option of either retaining their current 
Social Security coverage and benefits or electing to shift 
three percentage points of their 12.4 percent Social Security 
payroll tax (split equally between workers and their employers) 
into their own investment account. Workers would not be allowed 
to opt out of the system altogether or transfer a different 
share of their payroll tax into the accounts. Those who opted 
for the investment accounts would be allowed to invest that 
money in a selection of privately managed mutual funds that 
would be certified and regulated by a new government oversight 
board. Initially, the accounts would be restricted so that no 
more than 60 percent of an investment portfolio could be in 
stocks, which can decline precipitously in value.
    Upon retirement, workers with investment accounts would be 
required to convert the accumulated assets into an annuity 
that, like today's Social Security, would provide a lifetime 
monthly payment that increases as inflation rises. After the 
system was fully phased in, retirees who opted for the personal 
accounts would be guaranteed a total monthly benefit equal to 
the guaranteed payment promised under today's system, plus 20 
percent. If the assets accumulated in a retiree's personal 
account proved to be insufficient to pay the full 20 percent 
bonus, the government would make up the difference. Retirees 
who invested more successfully would be entitled to cash out 
any accumulations in excess of the 20 percent bonus as a lump 
sum if they wanted to.
    Senator Gramm claims that his plan would end prospects that 
Social Security will face a shortfall in the year 2032, when 
payroll taxes combined with system's trust fund assets are 
expected to become insufficient to pay guaranteed benefits in 
full. The main reason is that the assets accumulated in the 
private accounts would significantly reduce the benefits that 
the system would have to pay out from the remaining 9.4 percent 
payroll tax and the assets in the Social Security trust funds.

                             The Price-tag

    Diverting three percentage points of the Social Security 
payroll tax into private accounts for every worker who makes 
that choice would significantly reduce the anticipated growth 
in the Social Security trust funds, which currently are 
expected to tide the system over from 2013 to 2032--a period 
when promised benefits are expected to exceed payroll tax 
revenues. Because current retirees will have no private 
accounts to draw on and older workers will have little time to 
accumulate much in their private accounts, maintaining today's 
guaranteed benefits for them while payroll tax revenues decline 
by up to 24 percent (depending on how many workers opt for the 
new system) poses an expensive transition challenge.
    Stephen C. Goss, deputy chief actuary of the Social 
Security Administration, calculates that if all workers opted 
for the private accounts, the cost to the federal budget and 
the Social Security trust funds would be an average of $140 
billion a year from 2000 to 2009. Senator Gramm has said that 
those transition costs could be paid out of projected federal 
budget surpluses. Drawing on surpluses poses problems, however. 
First, surpluses are projected to be adequate to pay for only 
$81 billion of the $140 billion that would be needed. Second, 
if the projected surpluses were to be used to finance the 
transition to the new retirement system, actual surpluses would 
be substantially lower each successive year because the surplus 
from the previous year would not have been used to reduce the 
federal debt and thereby reduce interest obligations. Third, 
the projected federal budget surpluses through 2007 are almost 
entirely attributable to the surpluses in the Social Security 
trust funds. So paying for the transition with budget surpluses 
essentially means depleting 72 percent of the Social Security 
trust funds, which would raise the level of government debt.
    Senator Gramm projects that it would take 32 years before 
his plan would become financially self-sustaining and 50 years 
before the assets accumulated in individual investment accounts 
would be sufficient to generate a benefit equal to 20 percent 
above the level promised by the existing system. If the 
investments in the private accounts don't increase in value as 
rapidly as Senator Gramm predicts--5.5 percent annually over 
and above the inflation rate--the system's long-term financial 
burdens could increase rather than decrease. Senator Gramm also 
claims that the government would gain additional revenues from 
higher corporate tax collections attributable to increased 
corporate profits that would arise from more money flowing into 
capital markets through the private accounts. There is little 
historical evidence, however, that higher levels of market 
capitalization generate increased corporate profits.

                          Evaluating the Plan

    To assess the impact of various proposals to change Social 
Security, the Century Foundation organized a group of experts 
to develop principles for prudent reform. Here's how Senator 
Gramm's proposal stacks up against those principles:

Principle 1. Social Security should continue to provide a 
guaranteed lifetime benefit that is related to past earnings 
and kept up-to-date as the general standard of living 
increases.

    Analysis: Guaranteed Social Security benefits under the 
current formula, which are based on past earnings after taking 
into account cost-of-living changes, would remain the minimum 
that workers would receive if they decided against opening 
their own accounts. If they opted for the accounts, they would 
be guaranteed a 20 percent bonus on top of a benefit that would 
still be based on past earnings. And because the personal 
retirement accounts would be financed through a 3 percent flat-
rate contribution, the dollar amounts flowing into the accounts 
would be higher for workers with larger incomes and would rise 
over time as a worker's earnings grew. Workers who invested so 
successfully that they could collect even more than the 20 
percent bonus would receive benefits less proportionate to past 
earnings, however.

Principle 2. American workers who have the same earnings 
history and marital status, and who retire at the same time, 
should receive the same retirement benefit from Social 
Security.

    Analysis: Workers who elect to open private accounts gain a 
guaranteed 20 percent benefit bonus above the amount that those 
who declined the option would receive. So the same past 
earnings history and marital status would not lead to identical 
benefits for workers who 1) made different decisions about 
whether to open an account and 2) had different degrees of 
investment success. Those who earned more than the 20 percent 
bonus in their accounts would be able to collect the difference 
as a lump sum.

Principle 3. Social Security benefits should continue to be 
fully protected against inflation, and beneficiaries should 
continue to rest assured that they will not outlive their 
monthly Social Security checks.

    Analysis: The Gramm plan stipulates that the accumulations 
in the personal investment accounts would be required to be 
converted to lifetime, inflation-adjusted annuities akin to 
current benefits, and that those payments would be a minimum of 
20 percent higher than the benefits currently promised. 
Although many questions could be raised about whether the plan 
adequately accounts for the cost of financing those benefits, 
the proposal adheres to this particular principle. An important 
ambiguity about the plan remains, however: it is unclear what 
benefits surviving spouses would receive. Under current law, 
survivors receive 100 percent of the benefit that their late 
spouse collected (presuming that benefit was higher then the 
payment the survivor was previously entitled to). The Gramm 
plan, as summarized to date, does not specify what happens upon 
the death of a beneficiary.

Principle 4. Retirees who earned higher wages during their 
careers should continue to receive a larger check from Social 
Security than those with lower incomes; but the system should 
also continue to replace a larger share of the past earnings of 
low-income workers.

    Analysis: Workers whose private accounts grow enough to 
provide more than the 20 percent guaranteed bonus would receive 
larger payments relative to their past earnings than those who 
invested less successfully. In all probability, the most 
prosperous investors will be clustered at high income levels 
because 1) they have much greater experience and familiarity 
with investing, 2) they would have more money in their accounts 
to build on (since the contributions are a flat 3 percent 
rate), and 3) low-income workers with no investment experience 
may be more reluctant to open accounts in the first place.

Principle 5. Social Security's insurance protections for 
American families, including disability insurance, should be 
fully sustained.

    Analysis: The Gramm plan stipulates that the survivor's and 
disability insurance features of the current system would be 
preserved in full. But Social Security actuary Stephen Goss 
points out that the proposal allocates only 1.5 percentage 
points of the 12.4 payroll tax toward maintaining those 
protections, even though that insurance now costs the system 
about twice as much--3 percentage points. Because the plan does 
not provide an explanation of how current disability and 
survivor's insurance could be maintained on half the funding it 
now receives, that aspect of the proposal deserves further 
scrutiny.

Principle 6. Social Security's long-term financing problem 
should not be aggravated by diverting the program's revenues to 
private accounts and benefits should not be reduced to make 
room for private accounts; any such accounts should be 
supplementary to Social Security, entirely as an add-on.

    Analysis: By diverting 3 percentage points of the payroll 
tax financing the current system into private accounts, for 
those who choose them, the Gramm plan compounds the challenge 
of alleviating the long-term financial pressures on Social 
Security. Because current retirees and those now near 
retirement age must continue to receive promised benefits from 
payroll taxes in the years ahead, the cost of creating the new 
accounts will, in essence, deplete the Social Security trust 
funds and the federal budget surplus while increasing the 
national debt and government interest costs. Although the 
accumulations in the investment accounts after several decades 
might indeed be sufficient to finance the more generous 
benefits proposed, that eventuality depends on a variety of 
uncertainties about the number of workers who opt for the 
accounts, the performance of the economy, and investment 
growth. In any case, no one disputes that the cost of making a 
transition to Senator Gramm's system would add to federal 
budgetary pressures.

Principle 7. In addition to securing Social Security as the 
foundation of income support for retirees, their dependents, 
the disabled, and survivors, more needs to be done to encourage 
private savings and pensions.

    Analysis: At first blush, the Gramm plan would seem to 
neither increase nor decrease national savings because payroll 
taxes would be moved from one category of savings--the Social 
Security trust funds--to private savings in the form of the 
personal accounts. But because of the need to finance the 
transition to the new system, the government will either have 
to borrow more, reduce promised Social Security benefits, or 
increase taxes. Increased federal borrowing by definition is 
the same as reduced government savings. And either reducing 
Social Security benefits or increasing taxes would cut the 
amount of money available to households to save.
    The government guarantee of a 20 percent bonus above 
today's benefits for those with investment accounts--even those 
that perform poorly--risks encouraging workers to take greater, 
perhaps imprudent risks with their investments than they 
otherwise might. Under that scenario, akin to the savings and 
loan debacle of the 1980s, the government's future obligations 
could skyrocket since the bonus would be guaranteed whether the 
money was there or not.
      

                                


Issue Brief #8

Investing the Social Security Trust Funds in Stocks

    The Social Security program is running surpluses that, by 
law, must be invested exclusively in U.S. Treasury securities. 
The assets accumulating in the system's trust funds, currently 
in excess of $900 billion and projected to peak at around $3.8 
trillion in the year 2020, are intended to enable Social 
Security to continue paying full benefits well after payroll 
tax receipts are no longer sufficient to pay benefits to 
retirees. One reason why those receipts are expected to fall 
below the system's obligations is the impending retirement of 
the baby boom generation--the enormous cohort of citizens born 
between 1946 and 1964. By 2031, the ratio of Social Security 
beneficiaries to workers is expected to increase from today's 
30 per 100 workers to 50 per 100 workers. In addition, longer 
lifespans largely attributable to improvements in health care 
will increase the financial pressures on the system.
    One proposal for easing those pressures is to diversify the 
holdings in the trust funds from safe but low-yielding Treasury 
securities into stocks, which historically have generated much 
higher investment returns. Indeed, trust fund diversification 
is an important element of President Clinton's Social Security 
reform plan. The rationale is that the change would enable the 
trust funds to grow more rapidly and pay out benefits further 
into the future. (Under current projections, the trust funds 
will be depleted in the year 2032. Thereafter, revenues would 
be sufficient to pay 75 percent of promised benefits). 
Depending on assumptions about the rate of growth in the stock 
market, the overall size of the trust funds, and the portion of 
them that would be invested in stocks, diversification could 
add anywhere from two to 20 years to the lifespan of the trust 
funds.
    It should be noted that neither President Clinton's 
proposal nor anyone else's relies exclusively on trust fund 
diversification to strengthen the finances of Social Security. 
The centerpiece of the President's plan is an infusion of $2.8 
trillion over the next 15 years--or about 62 percent of the 
projected federal budget surplus over that period--into the 
trust funds from the general fund of the Treasury. About $600 
billion of this amount would be invested in stocks, while the 
remainder would be used to retire publicly held debt. The 
administration estimates that shifting additional money to the 
trust funds would delay the date when they would become 
depleted from 2032 to 2049. The investment in the stock market, 
which under the president's plan would increase incrementally 
and would never exceed 15 percent of the value of the trust 
funds, would add five more years.
    Allowing the Social Security trust funds to invest in 
equities has significant consequences for the U.S. economy, the 
federal budget, and the Social Security system.

       How much would diversification strengthen Social Security?

    The projected annual rate of return on U.S Treasury 
securities held in the Social Security trust funds is 2.7 
percent, after inflation. In contrast, stocks generated an 
annual return of about 7 percent above the inflation rate from 
1900 to 1995. If past serves as prologue and stocks continue to 
significantly outperform Treasuries in the future, 
diversification would bolster the trust funds.
    Several variables will affect the extent to which 
diversification ultimately strengthens Social Security:
    Actual rates of return. Century Foundation Research Fellow 
Dean Baker, in a paper titled ``Saving Social Security with 
Stocks,'' points out that stocks may not grow as rapidly in the 
future as they have in the past if consensus forecasts for 
slower future economic growth turn out to be accurate. Social 
Security's trustees project that the U.S. economy will expand 
at an annual rate of less than 1.5 percent a year over the next 
75 years, far below historical levels. The main reason for this 
decline is that the workforce is expected to grow much less 
rapidly than in the past. Since slower economic growth implies 
that corporate profits will increase more slowly, stocks may 
not be able to maintain 7 percent real returns in the future.
    The share of the trust funds to be invested in stocks. The 
Clinton administration has proposed limiting the portion of the 
Social Security portfolio that could be invested in stocks to 
15 percent. Many state and local pension funds, in contrast, 
allocate as much as half their assets to stocks. More extensive 
investment in stocks would create the possibility of higher 
returns for the portfolio as a whole, but it would also expose 
the trust funds to greater risk. During a bear market, a 
portfolio half-invested in stocks would be more likely to 
decline in value than one with only 10 percent in equities.
    Time frames. During particular periods when stocks perform 
poorly, diversification may leave the Social Security trust 
funds with less than they would have if they had remained fully 
invested in Treasury securities. From 1968 to 1978, for 
example, the market fell 44.9 percent in real terms. During the 
twentieth century, average stock prices have failed to 
appreciate over three different 20-year stretches. But over 
longer time frames, stocks have consistently outperformed other 
investments. Because current projections indicate that the 
trust funds will not face a shortfall until 2032, market ups 
and downs over such a lengthy period would be more likely to 
leave a diversified trust fund with more reserves than one 
solely invested in Treasuries.

   Would government ownership of stocks lead to unwelcome political 
                interference in the investment markets?

    Federal Reserve Board Chairman Alan Greenspan and others 
object to diversifying the Social Security trust funds because 
they believe politics will inevitably intrude on decisions 
about how the money is invested. Greenspan argues that instead 
of seeking the highest returns, the managers of the funds will 
be constrained from investing in companies that arouse 
political controversy--say, tobacco companies or firms accused 
of discrimination or union busting. Because the trust funds 
have the potential to become the largest single shareholder in 
the entire stock market, the ultimate fear is that the 
government could significantly affect whether shares of 
different companies rise or fall--undermining the idea of 
freely operating markets.
    Treasury Secretary Robert Rubin and others respond that the 
scenario Greenspan fears can be avoided by erecting barriers 
between Congress and the management of the trust funds. Those 
barriers would include creating an independent board, much like 
the Federal Reserve itself, to oversee the trust funds. Its 
members would be appointed by the president and confirmed by 
the Senate, serving staggered 14-year terms and shielded from 
dismissal from office for political reasons. In addition, the 
power of the board could be limited to selecting fund managers 
who would be required to make only passive investments in 
securities that represent broad market averages--so-called 
``index mutual funds.'' Moreover, Congress could require the 
board to waive its voting rights on shares in the trust funds' 
portfolio to prevent any efforts to influence the management of 
any company. Perhaps the strongest evidence that Social 
Security could keep politics out of the process of investing in 
stocks is the experience of the Federal Thrift Savings plan of 
the Federal Employees Retirement System, which covers 2.3 
million government workers. Since 1984, the plan has invested 
in three different index funds, including a stock fund, without 
taking any action that has reflected a political consideration. 
Francis Cavanaugh, who was executive director of the agency 
responsible for administering the Federal Thrift Savings plan 
from 1986 to 1994, has said that though many individuals and 
groups have attempted to influence the investment decisions of 
the fund, the barriers against such forces have proven 
sufficient. Of course, Social Security's assets are many times 
larger than the $66 billion in the Federal Thrift Savings plan, 
making it a far more conspicuous target for political 
activists.
    Some state and local government retirement funds, most 
notably CALPers in California, play active roles in corporate 
governance. But many other government pension plans are 
required to behave as completely passive investors. And even 
CALPers's energy is usually focused on maximizing shareholder 
value rather than imposing political-based demands on 
companies. If Congress decides that the Social Security trust 
funds should be diversified, examples like the Federal Thrift 
Savings plan and other passive government retirement plans 
would be the most suitable models.

 Would the trust funds' purchase of stocks cause the market to become 
overvalued, running the risk of a disastrous crash in the next century 
                     as the assets are liquidated?

    As large as the Social Security trust funds are expected to 
become, they would still be a relatively small fraction of the 
value of the entire stock market. Based on the assumptions of 
the 1997 report of the Advisory Council on Social Security, 
gradually investing up to 40 percent of the Social Security 
trust funds would produce a stock portfolio of an estimated $1 
trillion (in 1996 dollars) in 2020. Today the capitalization of 
the U.S. stock market is about $12 trillion, and it will grow 
to something like $40 trillion by 2014 according to the 
advisory council forecasts. Under President Clinton's plan, 
which would limit the trust funds' stock holdings to 15 percent 
of assets, Social Security's share of the market would be 
between 3 percent and 4 percent, according to actuary Stephen 
C. Goss of the Social Security Administration. In contrast, 
state and local pension funds held about 9.5 percent of 
corporate equities in 1996. Keep in mind, as well, that Social 
Security's investment in the stock market would occur 
gradually--no more than 0.3 percent of overall stock market 
capitalization in any year. Social Security would not suddenly 
come to Wall Street with a trillion dollar stake to place on 
the table. Similarly, the liquidation of shares in the next 
century to pay benefits to retired baby boomers would be 
gradual.

   Would transaction and administrative costs reduce the benefits of 
                            diversification?

    The administrative and transaction costs of individual 
investment accounts like 401(k)s, IRAs, and other plans where 
each investor has a specified amount of money invested in his 
or her name can add up to about 20 percent. Tracking the value 
of each account, switching funds from investment to investment 
upon request, sending updates to investors, and so forth is 
expensive. In contrast, a large pension fund serving many 
members who are not directly in control of a specified amount 
incurs negligible costs. In the case of the Federal Thrift 
Savings plan--the best existing equivalent of a diversified 
Social Security trust fund--administrative costs amount to a 
scant \1/10\th of 1 percent of assets.

  What would be the impact on the federal budget of diversifying the 
                        trust funds into stocks?

    Investing trust fund assets in equities would have the 
immediate effect of decreasing the federal budget surplus (or 
increasing a deficit if there is one in that year). That's 
because current accounting rules consider stock purchases to be 
a federal outlay, just like spending on roads or tanks. In 
contrast, the current practice of investing excess payroll 
taxes in Treasury securities adds to the federal surplus (or 
reduces deficits). Under President Clinton's plan, the 
contributions to the Social Security trust funds from general 
revenues would be counted as government expenditures even when 
they were not used to buy stocks. The rationale for this rule 
is that those contributions would be earmarked to retire 
publicly held federal debt, substituting government-owned debt 
held by the trust funds in its place.
    The administration claims that its plan would reduce the 
share of publicly owned government debt from about 45 percent 
of the economy to just 7 percent by 2014--a level last reached 
in 1917. Reducing the government's debt to the public, the 
administration and many economists argue, would promote 
investment and economic growth by 1) injecting capital into the 
economy through the purchase of government securities and 2) 
reducing competition that private bond-issuers face in raising 
funds, lowering their borrowing costs and interest rates 
generally. The additional Treasury securities in the trust 
funds would insure that, in the future, the government would 
have to meet its obligations to Social Security before 
appropriations were made to other priorities. These changes, in 
combination with others that Clinton has proposed, would soak 
up the entire projected surplus.

What would be the impact on the economy of diversifying the trust funds 
                              into stocks?

    There is no reason why shifting a share of the trust fund 
reserves from Treasury securities into stocks would either 
increase or decrease economic growth. The change would not 
directly affect national saving, investment, capital stock, or 
production. It is possible that government borrowing rates 
might have to rise slightly to induce private investors to buy 
the securities that the trust funds would be eschewing for 
stocks. And private savers might earn slightly lower returns 
because their portfolios would contain fewer common stocks and 
more government bonds--those that the trust funds no longer 
purchased. Still, most analysts believe that these effects 
would be almost undetectable.
      

                                


Statement of Credit Union National Association

    The Credit Union National Association (CUNA) is pleased to 
submit a statement on the topic of investing Social Security in 
the private market for the Committee's March 3, 1999 hearing.
    CUNA applauds the Committee for tackling the difficult 
issue of the investment of Social Security's trust funds. One 
of the options under consideration is to allow individuals to 
invest a portion of their Social Security funds in ``private 
retirement accounts'' or PRAs. Another option would be for the 
Social Security Administration to invest directly in equity 
markets. CUNA does not have a position on the second of these 
options, but would like to point out that the two options need 
not be mutually exclusive. A Social Security reform package 
could include both some investment by the Social Security 
Administration in equities, and the introduction of private 
retirement accounts.
    If PRAs are a feature of final Social Security reform, and 
CUNA believes the idea has considerable merit, CUNA strongly 
recommends that account holders be offered a wide range of 
investment options, including investments in depository 
institutions, such as credit unions. Investors should not be 
restricted only to financial securities, such as stocks, bonds 
and mutual funds. Many households are comfortable and familiar 
with investments in certificates of deposit in credit unions 
and other depositories. They are completely safe if held under 
$100,000, and offer a variety of return options, many of which 
are fixed and known. We believe this would be good public 
policy for a number of reasons.
    First, different households have very different levels of 
risk tolerance. Not all households will want to be fully 
invested in direct securities all the time. In fact, for some 
house-holds, the lack of a safe harbor among investment options 
would be extremely troubling. More generally, the opportunity 
to structure a diversified portfolio of stocks, bonds and 
certificates of deposit in depository institutions would 
provide the correct level of choice where it properly belongs, 
with the individual investor.
    Second, some concern has been raised about the ability of 
individual investors to manage the risks inherent in 
investments in the stock market. Offering households a safe-
haven option such as shares and deposits in credit unions 
reduces the risk of poor management.
    Third, investors' needs change over their life cycles. We 
certainly do not believe that someone saving for retirement 
should hold all assets all the time in lower-risk, lower-
yielding investments, such as those available from depository 
institutions. However, the closer one gets to retirement, the 
more a portfolio should be weighted to more liquid, safer 
investments. Allowing investment in depository institutions 
would ensure such investments were available to PRA holders.
    Finally, peace of mind is important to investors. This is 
particularly true as one approaches retirement and accumulated 
balances grow relatively large. Consumers trust credit unions. 
Credit union members are as likely to believe that credit 
unions have skilled professional management as banks, and they 
are much more likely (by 54 percent to 31 percent) to believe 
that credit unions provide reliable money-management 
information than banks. (Credit Union Magazine's ``1998 
National Member Survey,'' page 20.)
    Instituting PRAs would make individual investors out of 
many people who had never previously faced the daunting task of 
directing their own investment portfolios. Offering such 
households access to institutions they trust, such as a credit 
union, will make the transition that much smoother.
      

                                


Statement of Richard Freeman and Marianna Wertz, Executive Intelligence 
Review News Service

    The debate that is taking place here today, and around the 
nation this year, on the pros and cons of government- or 
individually-directed Social Security fund flows into the stock 
market, is itself completely wrong in its assumptions, as well 
as its recommendations.
    Firstly, the stock market is, in effect, a bubble of wildly 
inflated values and expectations, and like other bubbles of the 
worldwide speculative financial system of recent years which 
have popped (Russian GKOs, Brazilian debts, Asian ``emerging'' 
markets, etc.), it too cannot last. Proposing or condoning 
throwing more money into the frenzy of stock speculation, is 
the last thing that lawmakers should be doing.
    The most intense argumentation for Social Security flows 
into the stock market comes from Merrill Lynch, State Street 
Bank of Boston, the Cato Institute, and other advocates of 
keeping the bubble going at all costs.
    The real issue before us in 1999, as more of the worldwide 
``casino economy'' blows out, is: how do we intervene to 
protect and restore the functioning of national economies 
serving the public interests, and end the parasitical effects 
of global speculation? In response to this strategic crisis, 
since fall, 1998, over 150,000 people internationally, have 
signed a petition-appeal to President Clinton, to take the step 
of appointing economist Lyndon LaRouche, EIR's founder and 
contributing editor, as economic adviser to the Administration.
    EIR News Service, since its founding over 25 years ago, has 
documented in detail, the growing disparity between the 
increase in money flows into speculative activity, and the 
decline in productive investment flows into infrastructure, 
agriculture, industry, etc., to the point where today, we are 
seeing worldwide financial disintegration, and physical-
economic breakdown. We will gladly make this documentation 
available.
    For the purposes of the specific hearing topic today, 
however, we here provide the following references for the 
Committee, that bear on the point that channeling Social 
Security money into the stock market should NOT be done:
    1. The idea that there is a federal budget surplus is a 
hoax.
    2. The idea that Social Security is not ``solvent'' is a 
hoax.
    Debating the pros and cons of how to put Social Security 
money into the stock market, only serves as an opening for 
extremist privatization schemes, subversive to the national 
interest. On Jan. 19, National Economic Council director Gene 
Sperling demurred that, under the Administration's new, limited 
proposal, the Social Security Trust fund would never have more 
than 15% of its assets in the stock market. [In fact, were $600 
billion to go into the markets over a 15-year period--the State 
of the Union address plan--that would represent one-fifth of 
what the projected asset level of the Social Security trust 
fund is projected to be in fiscal year 2014.] The very next 
day, Rep. Mark Sanford (R-S.C.), the proponent of one of the 
most radical Mont Pelerinite Social Security privatization 
plans, said that the presentation of the Administration plan 
helps clear the way for others in Congress, like himself, to 
now bring forward their plans of how to invest Social Security 
funds into the stock market. The following facts and figures 
show how insane would be this course of action.
    Currently, the Federal budget of the United States has a 
deficit of more than $100 billion, and it will continue to be 
significantly in deficit for the next several years. But, it is 
widely proclaimed in the press and on Capitol Hill that the 
fiscal year 1999 Federal budget (which runs from Oct. 1, 1998 
through Sept. 30, 1999) will run a surplus of $60-70 billion! 
What this refers to, however, is not the actual budget of the 
United States, but a phony construct called the ``unified 
budget.'' This concoction was developed about 15 years ago to 
hide the actual size of the deficits that the U.S. budget is 
running. It figures prominently in the hoax that the United 
States will have a $4.2 trillion budget surplus current over 
the next 15 years.
    Let us first determine what the actual U.S. budget deficit 
is, and then see how the ``unified budget'' has been used to 
distort it. There are two ways to determine the actual budget 
deficit.
    The actual Federal revenue budget of the United States is 
the ``general revenue budget,'' sometimes called the ``on-
budget budget.'' It provides for most of the functions of 
government: education, building infrastructure and public 
works, running the various departments of the Executive branch, 
the military, and so on. Its revenues come from a variety of 
sources: primarily, personal, corporate, excise, and estate 
taxes.
    The Office of Management and Budget (OMB), which reports 
the official budget expenditures, revenues, and deficit, and 
makes future projections, reported its projections of future 
deficits of the ``on-budget budget'' in the official Budget of 
the United States Government, Fiscal Year 1999. This was 
reported in the ``Historical Tables'' appendix to the budget, 
on page 20. The data are presented in Table 1. The OMB 
projected that the ``on-budget'' U.S. budget deficit would be 
$94.7 billion in FY1999, and that the United States would still 
have a deficit of $62.7 billion in FY2003. It does not project 
beyond the year 2003. The size of the deficit may be revised 
downward, after correcting for increased tax revenues, but 
according to the government's own official figures, there is no 
surplus.

     Table 1.--Projected budget deficit of ``on-budget'' U.S. budget
                              (billions $)
------------------------------------------------------------------------

------------------------------------------------------------------------
1999.......................................................        $95.7
2000.......................................................        104.9
2001.......................................................         94.1
2002.......................................................         44.6
2003.......................................................        62.8
------------------------------------------------------------------------
 AAAAA (Source: OMB)


    However, the official ``on-budget budget'' incorporates 
some accounting tricks whose effect are be to still understate 
the actual deficit. To correct that, a budget expert at the 
Congressional Budget Office (CBO) stated that the real budget 
deficit can be derived best by measuring the yearly increase in 
the ``Federal debt outstanding.'' This is the cumulative 
outstanding debt of the United States. It is only increased 
each year for one purpose: because the U.S. Treasury has 
floated new debt obligations to cover that year's budget 
deficit. That is, when expenditures exceed revenues, that 
results in a budget deficit, and the manner by which the 
government covers the gap is by issuing new Treasury debt. That 
increases the Federal debt outstanding for the year. Table 2 
shows the result of using this more accurate method. (In this 
case, the data for this table are taken from the CBO estimate 
of the Federal debt outstanding, because it is more up-to-date 
than the OMB's data.) One can see that the actual U.S. general 
revenue budget deficit for FY1999 will be $119 billion. Though 
this figure may be revised a little downward if tax revenues 
increase, it will exceed $100 billion.

        Table 2.--Projected budget deficit of actual U.S. budget
                              (billions $)
------------------------------------------------------------------------

------------------------------------------------------------------------
1999.......................................................         $119
2000.......................................................          127
2001.......................................................          124
2002.......................................................           82
2003.......................................................           94
2004.......................................................           81
2005.......................................................           72
2006.......................................................           31
2007.......................................................          18
------------------------------------------------------------------------
 AAAAA (Source: CBO, FY 1999 Mid-Session Review)

    How, then, can one transmute an actual U.S. budget deficit 
of $119 billion for FY1999, into a surplus of $60-70 billion, 
as the media, the Congress, and the White House allege? This is 
done by the legerdemain of the ``unified budget,'' whose 
function is to mask the actual budget deficit. What the unified 
budget does is to find various funds that are in surplus, and 
mix them in, quite improperly and illegally, with the actual 
budget deficit, to produce an apparent surplus. This practice 
was started in a major way during the Reagan administration, 
because the administration was wracking up large actual 
deficits.
    The favorite target to mix in with the actual budget 
deficit is the OASDI trust fund, because, since the Social 
Security reforms of the 1980s, this fund has been running 
growing annual surpluses (see below). (OASDI refers to the 
formal name for the Social Security trust fund, which is the 
Federal Old Age and Survivors and Disability Insurance Trust 
Fund, or OASDI.)
    But this is quite illegal. The Social Security trust fund 
has its own dedicated tax, which produces a revenue stream 
earmarked only for the Social Security trust fund's purpose. 
This special tax, by law, cannot be used to fund or to be mixed 
into the revenue stream of the general revenue or ``on-budget 
budget.'' Therefore, the ruse of the ``unified'' budget, which 
says that the actual budget is not in deficit, because we have 
now mixed in the surplus of the OASDI trust fund, is a complete 
fraud. Everyone who works on the budget knows that.
    Let us show how this fraud works in FY1999. As stated above 
(Table 2), the FY1999 actual budget will have a deficit of $119 
billion. Let us assume that tax revenues are higher than 
originally projected, so the deficit is only $100 billion. Now, 
in the current fiscal year, the OASDI trust fund will have a 
surplus of $81 billion. Mixing the two together, one has 
reduced the deficit to only $19 billion. The government also 
adds in, quite illegally, surpluses from other trust funds 
(such as the Highway Trust Fund), and employs other gimmicks. 
Voila! It produces a surplus of $60-70 billion.
    But there is an additional key element in the government's 
work to produce an alleged $4.2 trillion budget surplus over 
the next 15 years: The OMB has incorporated into its budget 
calculations, that U.S. tax revenues will continue to grow at 
an accelerating rate, because of the impact of the U.S. stock 
market bubble in swelling capital gains and other tax revenue. 
Thus, the OMB and all other agencies are counting on the 
continuance of the stock market bubble for revenues, a stinging 
commentary on the state of affairs of the U.S. economy.
    The OMB does not take account of the deepening worldwide 
financial and economic disintegration, which will blow out tax 
revenues, whether generated from the stock market or the real 
economy, and send the budget deficit through the ceiling.
    Thus, the government's estimate of a $4.2 trillion surplus 
is based on fraud combined with fantasy.

                 Myth that Social Security Is Insolvent

    The rationale for diverting Social Security funds to the 
stock market, is that it would generate a higher yield on 
investment, which is alleged to be critical to add some years 
of solvency to the Social Security trust fund (which is 
formally known as the Federal Old Age and Survivors and 
Disability Insurance Trust Fund, or OASDI). However, the OASDI 
trust fund is not in any imminent danger, and investing a 
portion of it in the stock market is not a way to make it 
sound.
    Table 3 shows the CBO's projected Social Security annual 
surpluses. By fiscal year 2008, it is estimated at $186 
billion. During fiscal years 1999 to 2008, the OASDI trust fund 
is expected to build up a cumulative surplus of $1.516 
trillion. The CBO and OMB have not yet publicly released 
figures of what they project the Social Security surplus will 
be for the five fiscal years 2009 through 2013, but were the 
rate of growth assumed for 1999-2008 to continue, the sum for 
those five years would be approximately $1 trillion. Hence, for 
1999-2013, the OASDI projected surplus is $2.516 trillion, or 
three-fifths of the total $4.2 trillion ``budget surplus'' that 
the government is projecting for next 15 years.

           Table 3.--Projected Social Security annual surplus
                              [billions $]
------------------------------------------------------------------------

------------------------------------------------------------------------
1999.......................................................         $117
2000.......................................................          125
2001.......................................................          130
2002.......................................................          142
2003.......................................................          146
2004.......................................................          155
2005.......................................................          165
2006.......................................................          173
2007.......................................................          181
2008.......................................................          186
------------------------------------------------------------------------
Cumulative total, 1999-2008: $1.516 trillion
(Source: CBO, FY 1999 Mid-Session Review)


    Therefore, when the government says that it will 
distribute, out of its imaginary $4.2 trillion surplus, $2.7 
trillion to the Social Security fund over the next 15 years, 
all that it is doing is giving back to the Social Security 
trust fund money that already belongs to the Social Security 
trust fund, i.e., the $2.516 trillion surplus that the Social 
Security trust fund would be building over the next 15 years. 
This act consists of finding the OASDI's surplus, taking it, 
and then giving it back. This is an elaborate ruse, but if the 
government did not use it, it could not so easily pretend that 
it had a $4.2 trillion budget surplus.

                       What Social Security needs

    The main rationale given for investing a portion of the 
Social Security trust fund into the stock market is that this 
will make the Social Security fund ``solvent.'' Otherwise, it 
is claimed, the trust fund would go broke. This story is not 
true, on several levels.
    First, as a result of reforms of the Social Security System 
in the 1980s, the OASDI trust fund was mandated to build up a 
surplus over succeeding years to plan for contingencies. 
According to the mandate, the OASDI trust fund will go through 
three phases. First, by the year 2012, the revenue that the 
fund gets from a special dedicated Social Security payroll tax, 
will not be enough to cover payouts to retirees. At that point, 
the trust fund will also have to rely on the interest income it 
earns from the Treasury bonds it holds. In the second phase, by 
the year 2019, the combined tax income and interest income will 
not be enough to meet payouts to retirees, and the trust fund 
will then have to start drawing down the surplus it has built 
up. In the third phase, by the year 2032, all the trust fund 
surplus will be gone, and the rate of payout to retirees will 
exceed the income from the social security tax and interest. At 
that point, according to the story, the OASDI trust fund is 
broke.
    Keep in mind that this last phase will not be reached until 
one-third of a century from now. The story that the collapse of 
the trust fund is imminent, is hokum. That is a lot of time to 
do something to reverse post-industrial society policies.
    Second, the trust fund, by law (unless it is changed), is 
required to invest all of its money in U.S. Treasury 
securities. They are far sounder than stocks.
    Third, the real issue is economic policymaking. The 
assumption that the OASDI trust fund will go broke by the year 
2032 is premised on the assumption that U.S. GDP will grow by a 
real rate of about 1.9% per year between now and 2032. Were 
real transformation of the physical economy to occur--i.e., 
especially if President Clinton were to appoint Lyndon LaRouche 
as an economic adviser--the growth of the economy would take 
off like a shot.
    The other problem is that there are fewer younger workers, 
as a percentage of the total population, entering the 
workforce. It is the tax contributions of the younger workers 
which helps provide the money needed for retired workers. The 
demographic collapse is simply a part of the economic collapse. 
Were economic growth and optimism to return to the United 
States, families would have more children--not as a result of 
being told to, but as a result of the enjoyment and confidence 
in the future that an advancing economy instills in a family.
    Fourth, despite the official claim, that the purpose of 
putting the money into the stock market is to ``make solvent'' 
the Social Security system, in reality, it would bail out the 
stock market bubble. The Wall Street financier sharks want to 
have that new money in the stock market to prevent the its 
decline and to churn the market higher. They have been pushing 
for the trust fund's money to go into the stock market for 
years. The speculative U.S. stock market bubble is wildly out 
of control. It will pop, and will lose perhaps 50 to 75% of its 
value. The OASDI trust fund is now invested in Treasury 
securities, which, following upon the proper changes in broader 
economic policymaking, are a reliable investment.
      

                                


Statement of David Oliveri, MFS Investment Management, Boston, 
Massachusetts

            The Future of Retirement: Beyond Social Security

    Social Security has long been described as the ``third 
rail'' of American politics: Touch it and you're dead. Today, 
however, doing nothing has far more dangerous consequences. 
When the first wave of baby boomers begins retiring in the next 
15 years, the world's largest governmental program will 
approach bankruptcy, according to the Social Security 
Administration. To restore the public's trust in the federal 
government--and ensure the economic viability of its citizens--
politicians are being forced to toss out conventional political 
wisdom and find a solution.
    Traditionally, Americans have accumulated retirement income 
through a combination of sources including government, 
employers, and individual savings. However, the potential 
insolvency of Social Security and the massive reduction in the 
number of defined benefit plans offered by employers have 
reduced the role of both sources, leaving individual investors 
with virtually the sole responsibility of planning for their 
own retirements. Americans are gearing up for the challenge 
ahead. Indeed, seven of 10 Americans (69%) agree that the trend 
toward individuals taking more responsibility for their 
retirements than in the past is ``more of a good thing than a 
bad thing,'' according to Roper Starch Worldwide, Inc. (Roper 
Starch).
    Not surprisingly, opinion research revealed that retirement 
planning weighs heavily on the minds of most Americans. 
Unfortunately, however, most individuals are woefully 
unprepared to fulfill this obligation. The national savings 
rate, for example, has fallen to its lowest level since the 
Great Depression, according to the National Center for Policy 
Analysis.
    To encourage personal investing, the federal government has 
enacted legislation providing tax incentives for those who 
invest for their retirements. As a result, financial services 
companies have pioneered a vast array of retirement products, 
such as 401(k) plans; Individual Retirement Accounts (IRAs), 
which are funded through annuities and mutual funds; and other 
investment products. These products were originally designed to 
provide investors with supplementary sources of retirement 
income; today, however, they have become the foundations of 
many Americans' retirement portfolios.
    But despite the growing popularity of these retirement 
vehicles, the government has an obligation to preserve the 
legacy of the Social Security system by providing a safety net 
for all Americans, particularly for lower-income citizens. With 
the projected date of its bankruptcy drawing near, the issue of 
how to fix Social Security has been taken off the back burner. 
To date, the debate has been shaped by two radically different 
philosophies. One school of thought is to maintain the current 
Social Security system through a mix of benefit cuts and tax 
increases. The second view is to entirely overhaul the system 
by introducing the concept of mandatory savings, which allows 
participants to invest, own, and manage some or all of their 
contributions through private investment accounts.
    Proponents of the private investment account concept 
contend that unfunded liabilities under the current system will 
have a devastating impact on the American economy during the 
next century. Furthermore, they argue, citizens would achieve 
far better returns on their investments based on the historical 
performance of the stock market. Of course, past performance is 
no guarantee of future results. Opponents counter that 
introducing risks to Social Security could devastate benefits 
in the event of a stock market downturn. They also suggest that 
benefits under a privatized system would be unfairly skewed 
toward higher-income citizens.
    In either scenario, there is little question that the next 
few years will see many hands touching the ominous ``third 
rail'' of American politics. Leadership is needed to energize 
Americans to plan for their retirements and enact reforms that 
deliver retirement security for all citizens in the 21st 
century.

                      The state of Social Security

    The U.S. Social Security system was created in 1935 under 
The Social Security Act to provide economic relief for retired 
citizens in the aftermath of the Great Depression. Two years 
later, the first Federal Insurance Contributions Act (FICA) 
taxes were collected. The program was extended in 1939 to 
provide survivors' benefits to the spouses and children of 
workers. In 1956, it was expanded further to provide disability 
insurance called Old-Age and Survivors Disability Insurance 
(OASDI).
    In the years since Social Security was enacted, the program 
has played an integral part in improving the lives of our 
nation's senior citizens. During the early part of this 
century, most elderly Americans received financial support from 
their extended families. Those who had no families were poor. 
As a result of governmental assistance, the elderly poverty 
rate has dropped sharply. In 1959, the poverty rate was more 
than 35% for retirees. In 1979, it declined to 15.2%, and by 
1996, the poverty rate was down to 11%, according to the Social 
Security Administration.
    True to its goal of providing a safety net, Social Security 
reported that it had lifted 11.7 million elderly people out of 
poverty in 1996 alone. In addition, the program elevated 3.5 
million nonelderly adults and 800,000 children out of poverty. 
The world's largest government program, Social Security spends 
more than $350 billion each year.
    Unfortunately, however, too many Americans began to rely on 
Social Security for a level of financial support that extended 
beyond its original scope. Indeed, economic theorists have 
suggested that these entitlements are directly tied to the 
declining savings rate in the United States. The National 
Summit on Retirement Savings in 1998 reported that this benefit 
has become the single most important source of retirement 
income for 80% of senior citizens. For 18%, it is the only 
source of income.
    The Social Security system was designed as a ``pay-as-you-
go'' system, which means that each generation of workers makes 
contributions to the Social Security Administration, which in 
turn pays the benefits for current retirees. This system, 
dubbed ``an intergenerational transfer of wealth,'' worked well 
in 1940 when America had 159 workers per beneficiary, but 
declining birth rates have caused that ratio to decline 
significantly. Today, there are only 3.3 workers per 
beneficiary, and, by 2060, it is projected that there will be 
1.8 workers per beneficiary. (See Figure 1.) Thus, as most 
Americans have grown to depend on Social Security as a vital 
source of retirement income, the program is approaching 
bankruptcy.
    The resulting fiscal imbalance is largely a function of 
dramatic shifts in the demographics of the American population, 
particularly a vast increase in birth rates between 1946 and 
1964. There are currently over 44 million people who receive 
Social Security benefits, which accounts for approximately 12% 
of the population. When baby boomers begin to retire, that 
figure will move up to about 20%, according to the Heritage 
Foundation. In other words, there will be virtually double the 
number of retired citizens as there are today.
    Furthermore, life expectancies have risen substantially 
since the system was established in 1935. The original 
retirement age for Social Security, 65, was agreed upon when 
life expectancy at birth was 63. Social Security was not 
intended to fund the lengthy retirements of American citizens 
but to support the elderly who lived longer than expected and 
could no longer work. Today, life expectancy is 76 and is 
projected to rise to 81 over the next 75 years. This means that 
Social Security will have to pay benefits to individuals for 18 
more years than it had originally planned. The normal 
retirement age today remains 65 and is scheduled for only a 
slight increase, to 67, under current law.
    To deal with the rising number of retirees, the government 
has increased FICA taxes on workers and employers 36 times 
since 1970. These rates have grown steadily, from 2% in 1940 to 
12.4% today, with most increases being enacted in the past two 
decades. (See Figure 2.)
    In 1983, the National Commission on Social Security Reform 
was created to restore Social Security to solvency. The 
commission called for an increase in the self-employment tax, 
partial taxation of benefits to upper-income employees, 
expansion of coverage to include federal civilian and nonprofit 
organization employees; and an increase in the retirement age 
from 65 to 67, to be enacted gradually beginning in 2000. As a 
result of these reforms, Social Security was declared 
actuarially sound.
    Today, few legislators support the notion that Social 
Security can be saved with these types of minor changes. 
According to the 1998 Social Security Trustees report, the 
annual expenditures of the system will begin to exceed the 
amount of money it will collect in 2013 as the first wave of 
the 77 million baby boomers begins retiring. As a result, the 
Social Security Administration will begin to draw down the 
surplus it has generated since 1984, until 2032, when there 
will be insufficient funds to pay out benefits to citizens.
    If the Social Security program is allowed to continue 
unfettered, it will begin to cause a considerable strain on the 
fiscal stability of the federal government. Pundits fear that 
Social Security and other entitlements will swallow up federal 
revenues, leaving Congress with little discretionary spending. 
Currently, entitlements account for 64% of spending capability. 
Under the Balanced Budget Act of 1995, they would rise to 72% 
of spending by 2002. 
[GRAPHIC] [TIFF OMITTED] T7507.013

[GRAPHIC] [TIFF OMITTED] T7507.014


    Social Security, alone, accounts for approximately 34% of 
entitlement spending. The trust fund is currently running a 
surplus and as a result of contributions from baby boomers will 
continue to do so in the near term. The annual surplus is 
estimated to be nearly $100 billion by 2000, but it is dwarfed 
by an estimated $3 trillion in unfunded liability over the next 
75 years. Moreover, once baby boomers begin leaving the work 
force, the trust fund will be virtually gone by 2029, when 
Americans who are now between the ages of 30 and 50 expect to 
receive their benefits.
    It is important, however, to note that this surplus should 
not be viewed as money that has been tucked away for future 
retirees. The trust is a myth; it contains no money. Instead, 
it consists of nonmarketable IOUs issued by the federal 
government to repay the fund, with interest.
    Budget rules have allowed the government to invest all 
surplus dollars coming into the trust fund in nonmarketable 
special government debt. In other words, the government simply 
collects the trust fund's surplus revenue, replaces it with 
nonmarketable government debt in the same amount, and then uses 
the money from the surplus for other government spending. For 
example, in fiscal year 1997, Social Security's cash surplus of 
$40 billion was used to reduce the $62 billion deficit in the 
rest of the unified budget.
    The projected shortfall will become reality not in the 
distant future, but in the next several decades. If substantial 
changes are not made, by the time baby boomers begin to retire 
revenue will not be adequate to cover costs, and the government 
will have to go deeper into debt, raise taxes, or reduce 
benefits.
    In any event, future generations will be much worse off 
than those that have preceded them. According to Michael 
Tanner, director of health and welfare studies at the Cato 
Institute, today's retirees will generally get back all they 
paid into Social Security plus a modest return on their 
investment. But when today's young workers retire, they will 
receive a negative rate of return--they will get less than they 
paid in.

   The Individual's Increased Responsibility for Retirement Planning

    Traditionally, an individual's financial security in 
retirement has been called a ``three-legged stool'' of Social 
Security benefits, employer-provided benefits, and personal 
savings. However, the uncertainty surrounding Social Security 
has put a tremendous amount of strain on the retirement 
strategies of the American public.
    Moreover, changes in American corporations including 
corporate downsizing have required large companies to restrict 
employee benefits, mainly by replacing the traditional pension 
plans of employees with defined contribution plans. These plans 
remove a considerable financial burden from institutions, many 
of which are more focused on profitability than at any time in 
the past.
    The Pension Benefit Guarantee Corporation (PBGC) estimates 
that the number of current workers participating in pension 
plans has dropped from 29 million in 1985 to fewer than 25 
million in 1994. If this trend continues, PBGC projects that by 
the year 2005 most participants in defined benefit plans will 
be retired. Indeed, the number of plans insured by PBGC has 
decreased from 114,000 in 1985 to only 45,000 today.
    The diminishing responsibility of the federal government 
and employers has placed the burden of retirement planning on 
individuals. For example, a recent survey by Roper Starch 
Worldwide, Inc. found that most Americans (72%) agree that 
``individuals themselves'' are responsible for their own 
retirements. The survey also showed that many individuals 
continue to expect help from sources such as employers (53%), 
financial advisers (42%), the government (36%), insurance 
companies (33%), mutual fund companies (32%), and banks (27%).
    In fact, economic data suggest that individuals are not 
shouldering the burden to the extent necessary to provide for a 
comfortable retirement. For example, the national savings rate 
has declined dramatically in the past 15 years. So far this 
decade, net national saving (excluding depreciation) has 
averaged less than 2% of gross domestic product, down from 5% 
during the 1980s and from about 8% in previous decades. (See 
Figure 3.) Taken at face value, the figures suggest that 
Americans are saving less than at any time since the Great 
Depression.
    Interestingly, most American workers are concerned about 
maintaining their current lifestyles after they retire. Only 
39% of Americans who are not yet retired say they expect to 
have enough income to live comfortably during retirement, 
according to Roper Starch. This proportion is down from 45% in 
1980 and from 51% in 1974. Meanwhile, 36% of respondents are 
uncertain whether they will have enough funds to retire, up 
from 27% in 1980. (See Figure 4.) 
[GRAPHIC] [TIFF OMITTED] T7507.015


[GRAPHIC] [TIFF OMITTED] T7507.016

    All told, the nation is becoming increasingly skeptical 
about the availability of funds for retirement living. Since 
1974, Roper Starch has asked nonretired Americans whether they 
feel they can count on various sources of income in retirement. 
(See Figure 5.) The results reveal a significant decline in the 
proportion of the public saying it feels it can count on 
specific sources of income. The most dramatic declines have 
come for Social Security and pensions from employers. Today, 
just 49% of non-retired Americans say they can count on Social 
Security during retirement, according to Roper Starch. That's 
down by 13 points since 1991 and a staggering 39 points since 
1974. It should be noted, however, that Social Security remains 
the source the public feels it can count on most. Just 39% 
think they will be able to depend on a pension plan provided by 
their employer, down 6 points since 1991 and down 15 points 
since 1974.
[GRAPHIC] [TIFF OMITTED] T7507.017

    Interestingly, while Roper Starch reported declines in 
confidence in sources of retirement income, the only product 
group to show gains were IRAs, 401(k)s, and Keogh plans, up 9 
points since 1991. This finding, according to Roper Starch, 
reflects a much larger trend taking place among Americans: the 
trend of self-reliance. As Americans feel increasingly 
disillusioned by the elite in government and business, they 
increasingly feel they must depend on themselves.

       Filling the Gap: The Proliferation of Retirement Products

    With the assistance of legislation designed to encourage 
retirement saving, the private sector has continually developed 
new products that enable individuals to invest in their own 
retirements. Originally designed as supplemental investment 
vehicles, defined contribution plans, IRAs and annuities have 
become, for many individuals, primary sources of retirement 
income.

Defined contribution plans

    The federal government passed the Employee Retirement and 
Income Security Act (ERISA) in 1974 to empower individuals to 
take more responsibility for their financial well-being during 
their retirement--and to provide regulation to protect their 
assets.
    401(k) plans, the most popular type of defined contribution 
plan, were not included in the original ERISA legislation but 
were added in 1981 as a variation on profit-sharing plans. It 
was not anticipated that these plans would play a major role in 
the retirement security of millions of workers.
    However, the reductions in defined benefit plans since the 
early 1980s have elevated 401(k)s into the fastest-growing 
segment of pension plans. What's more, these plans allow for 
more flexibility than defined benefit plans because they are 
available to all participants, regardless of the worker's 
length of employment. Most employees become eligible to join 
their company's 401(k) plan within six months to one year of 
employment.
    Roper Starch reported that 52% of those surveyed agree that 
employers are responsible for helping individuals prepare for 
retirement. This, with Americans' common belief in personal 
responsibility, would suggest that a 401(k) or similar program 
is what Americans have in mind when they think of the ideal 
retirement plan.
    These plans have quickly become the primary vehicles 
through which individuals contribute to their retirement nest 
eggs. In 1975, for example, the U.S. Department of Labor 
reported that there were 38 million total participants (active 
workers and retirees with vested benefits) in about 310,000 
retirement plans. Of these, 103,000 were defined benefit plans, 
and 207,000 were defined contribution plans. By 1994, there 
were 85 million total participants in approximately 700,000 
retirement plans, of which only 75,000 were defined benefit 
plans and 625,000 were defined contribution plans. Today, 
private retirement plans hold about $3.5 trillion in assets, 
according to the Investment Company Institute (ICI), the mutual 
fund trade organization.
    Mutual funds have become an increasingly popular investment 
vehicle for these plans, representing approximately 16% of all 
total retirement assets in 1997, up from only 6% in 1990, 
according to the ICI. Of the mutual fund industry's $5 trillion 
in total assets, 35% are held in retirement accounts.
    But despite the growth of 401(k) plans as a means of 
planning for retirement, there is much work to be done to 
ensure that the benefits of tax-deferred investing are 
available to all Americans. As opposed to defined benefit 
plans, these investments are not funded by an employer but 
primarily by the discretionary savings of participants 
(although many employers match contributions). This means that 
participation in such plans is far from universal. For example, 
the Employee Benefits Research Institute (EBRI) reported that 
approximately two-thirds of those offered plans actually 
participate, and that retirement benefits are frequently less 
generous than those offered by traditional defined benefit 
plans, depending on the level of employer contributions. An 
EBRI study reveals that the average amount of assets in 401(k) 
accounts is only $29,000 and that half of all accounts have 
less than $10,000. individual retirement accounts (IRAs)

Individual Retirement Accounts (IRAs)

    Under the ERISA legislation of 1974, individuals were 
afforded the opportunity to invest up to $2,000 on a tax-
deferred basis as a supplementary vehicle for retirement 
planning. IRAs have been further expanded to include the Roth 
IRA, which instead of providing for tax-deductible 
contributions allows for tax-free withdrawals, and the 
Education IRA, which allows parents to invest for their 
children's college educations.
    Total assets held in IRAs and Keogh plans (retirement plans 
for the self-employed) reached $1.4 trillion as of year-end 
1996. Between 1985 and 1996, total assets held in IRAs and 
Keogh plans increased 524%, according to the ICI. During 1996 
alone, IRA and Keogh assets rose 15.7%, compared with a growth 
rate of 24.7% between 1994 and 1995, 9% between 1993 and 1994, 
and an average annual growth rate of 18.2% between 1985 and 
1996. The ICI reported that most of the recent growth, however, 
was due to rollovers from qualified retirement plans, not from 
new contributions to the accounts.

Fixed and variable annuities

    Annuities were first introduced in the late 1930s as part 
of Franklin D. Roosevelt's New Deal Program to encourage 
individuals to save for their own retirements. The first fixed 
annuities had guarantees of principal and set rates of return 
offered by the issuing insurance company. In 1952, the first 
variable annuity was created to provide policyholders with more 
control over how their money was invested. Variable annuity 
owners could choose what type of accounts they wanted to invest 
in and often received modest guarantees that their annuity 
value would never fall below what they originally put in the 
account. This guarantee, which is known as a death benefit and 
is not available until the death of the annuitant or the owner, 
depending on the contract, is backed by the claims-paying 
ability of the insurer.
    Sales of variable annuities have exploded in the past 
decade from $9.3 billion in 1987 to more than $87 billion in 
1997, according to the National Association for Variable 
Annuities. These products are generally geared toward a more 
affluent market including individuals who have already 
contributed the maximum amount to both their defined 
contribution plan and IRA.

               Social Security Reform: Proposed Measures

    To date, federal government attempts to assure the future 
financial solvency of Social Security have relied on a 
combination of proposed tax increases and minimal benefits 
cuts. To illustrate the impact of such measures, the following 
is an examination of what would occur if either of these 
traditional options were to be adopted.
    Tax increase. Actuarial estimates in the 1998 report of 
Social Security's Board of Trustees project that the program 
faces a $3 trillion shortfall in funding over the 75-year 
estimating period. If the shortfall were to be met only by 
raising taxes, FICA taxes would immediately have to increase by 
20%, from 12.4% to 14.6%. This tax hike could rise to more than 
50% in the event that it is delayed for another decade, warned 
the Board of Trustees. Likewise, future additional taxes would 
be required to assure the program's solvency beyond the 75-year 
time frame.
    Benefits reduction. If this situation were met by cutting 
benefits across the board, there would have to be a 28% 
reduction in 2032 and even larger reductions in later years 
(ultimately reaching 33% in 2070). These reductions would 
affect both those becoming entitled to Social Security benefits 
in 2032 and later and those already receiving benefits at that 
time, according to the Board of Trustees.
    In either case, economists have warned about the negative 
effect these options would have on the domestic economy. A 
significant tax increase, they believe, would not only serve to 
slow economic growth, it would further reduce the national 
savings rate. They also suggest that benefit cuts could mean 
that, in 2032 and later years, the percentage of elderly people 
living in poverty would rise and that there would be greater 
reliance on welfare programs, diminishing the original intent 
of Social Security.
    Furthermore, there is little support for maintaining a 
``business as usual'' approach with regard to Social Security. 
According to Roper Starch, only one in four Americans would 
prefer to leave the system as is and simply supplement the 
Social Security system with additional taxes as needed.
    In his January 1999 State of the Union address, President 
Clinton called for action to save Social Security by reserving 
the government's surplus until all of the necessary measures 
have been taken to strengthen the Social Security system for 
the 21st century. This surplus is projected by the Federal 
Budget Office to total $679 billion over the next 11 years.
    Some members of Congress have rallied behind the 
president's plea. Rep. Charles Rangel (D-N.Y.) has introduced 
legislation to create a Social Security reserve fund for any 
federal budget surpluses. Similarly, Sen. Ernest Hollings (D-
S.C.) has called for Congress to bar any tax cuts or make any 
new investments with other funds until legislation is enacted 
to make Social Security sound.
    But as the presidential election approaches and the fight 
for the government surplus intensifies, cutting taxes is 
believed to be more likely to take precedence over Social 
Security reform. The budget surplus notwithstanding, more than 
two dozen Social Security reform plans have been designed by 
legislators, private think tanks, and special interest groups.
    Although the goal of all of these proposals is to ensure 
some level of income for retired persons, it is clear that 
individuals will be required to take on much more 
responsibility for their retirements than in the past. 
Government subsidies are being scaled back to bring Social 
Security more in line with its original intent of providing a 
safety net to citizens who have no other form of support. What 
follows are summaries of several key initiatives that have 
framed the Social Security debate as it stands today.

Report of the 1994-1996 advisory council on social security

    In 1994, Donna Shalala, Secretary of Health and Human 
Services, appointed the Advisory Council on Social Security to 
examine ways in which Social Security could achieve financial 
stability over the next 75 years. The 13-member panel, however, 
could not agree on an approach and ultimately submitted three 
separate proposals to Congressional leaders.
    Six of the 13 members agreed to maintain the present Social 
Security system, recommending a blend of cost-cutting and 
revenue-producing measures. Most notably, they suggested that 
the government itself should invest up to 40% of the surplus in 
the Social Security trust fund in stocks. The remaining seven 
members favored mandatory private savings through individual 
accounts, but they vehemently disagreed over whether workers 
should have limited or complete control over these accounts.
    The following is a brief summary of the three proposals of 
the Advisory Council on Social Security. Although these 
measures were never adopted, their findings provide the basis 
of many of the latest proposed bills on Social Security reform.
     Option I: maintenance of benefits. This option 
would maintain the present Social Security system as a defined 
benefit plan. To ensure the system's solvency, it includes 
several revenue-producing measures, such as reducing benefits 
and/or increasing worker contributions and requiring newly 
hired state and local government employees to contribute to the 
system. The plan also favors additional taxes on Social 
Security benefits, among others. Furthermore, it suggested that 
the federal government help bring the program into balance and 
improve the benefits of future generations by investing a 
significant portion of the trust fund's assets in the equity 
market.
     Option II: publicly held individual accounts. The 
second option, endorsed by five members of the council, 
involves significant reductions in the growth of Social 
Security benefits. Specifically, it would reduce the growth of 
benefits to workers at all earnings levels by increasing the 
retirement age and by reducing benefits for middle- and high-
wage workers.
    In addition, this plan would introduce the use of 
individual accounts, or IA plans, as a means of raising overall 
national retirement saving. It would require all workers to 
contribute an additional 1.6% of their annual salaries, which 
would be held by the government in defined contribution 
individual accounts. Individuals would have limited investment 
choices, ranging from a portfolio consisting entirely of bond 
index funds to equity index funds. Upon retirement, the 
government would convert the money that has accumulated in a 
worker's individual account to a single or joint guaranteed 
indexed annuity, which would supplement his or her Social 
Security benefits.
     Option III: two-tiered system with privately-held 
individual accounts. The remaining council members favored 
reforming Social Security by making a substantial portion of 
the new system fully funded. Ultimately, a two-tiered system 
would take the place of the present Social Security system. The 
first tier would provide a flat retirement benefit for workers, 
and the second tier would provide individually owned, defined 
contribution retirement accounts, referred to as personal 
security accounts (PSAs).
    In contrast to the IA plan, the funds in these accounts 
would not be held or managed by the federal government, the 
investment options would be less restricted, and workers would 
not be required to annuitize their accumulations at retirement. 
In addition, the PSAs would be funded with 5% of current FICA 
taxes. Survivors and disability insurance benefits would be 
modified but continue to be financed by the OASDI trust funds 
and administered through the Social Security Administration.
    To bring the current system back into financial balance, 
provisions in the first tier would increase the retirement age 
and extend coverage to newly hired state and local workers. The 
7.4% portion of payroll tax that was not used to fund PSAs 
would finance retirement benefits, spousal benefits, and 
survivors and disability insurance. The cost of transition to 
the new system would call for a 1.52% payroll tax, supplemented 
by added federal borrowing.

Investment account payroll deduction plan--Sen. Daniel Moynihan 
(D.-N.Y.), Sen. Robert Kerrey (D.-Neb.).

    The Investment Account Payroll Deduction Plan involves a 
two-tier system that would allow workers to contribute 2% of 
their annual pay into a private account. The worker would pay 
1% of the contribution, with an equal amount paid by the 
employer. These deposits would be placed in an IRA or sent to a 
newly created ``Voluntary Investment Fund'' to be managed like 
the Thrift Savings Plan available to federal government 
employees. Participation in the private option would be 
voluntary.
    To restore the fiscal strength of the current Social 
Security system, all Social Security benefits in excess of the 
dollar amount of each employee's contributions would be 
taxable, which is similar to the tax treatment of defined 
benefit pension plans. Likewise, cost-of-living increases would 
be based on the Consumer Price Index minus 1%. The program 
would call for minor benefits reductions; however, the existing 
OASDI program would be retained in full. Other adjustments to 
the current Social Security system would include raising the 
normal retirement age to 68 by 2017, with a gradual increase 
thereafter until it reaches 70.
    Under this plan, FICA taxes would decline to 5.2% for 
employees and 6.2% for employers until 2001, when the employer 
tax would fall to 5.2%. By 2025 to 2029, FICA taxes would rise 
to 5.7% for both employees and employers, with further tax 
increases slated for the future. The authors of this plan 
suggest that in 2004 all transitional costs would be recouped.
The social security solvency act of 1997--Rep. Nick Smith (R.-
Mich.).

    Similarly, the Social Security Solvency Act establishes a 
two-tiered system that uses the current benefit structure as a 
safety net. However, this plan gives workers the option to 
invest a substantially larger part of their 12.4% of payroll 
taxes.
    The plan involves mandatory retirement savings with a 
Personal Retirement Savings Account (PRSA), through which 
investors can choose from a range of options. The amount of 
payroll contributions that can be put in a PRSA increases over 
time, starting at 2.5% of wages and growing to 10.2%.
    Under this plan, benefits are gradually reduced for 
individuals making over $50,000 who have received everything 
they and their employer have contributed to Social Security, 
plus interest. It also involves other small reductions in 
benefits; however, existing OASDI benefits would be retained. 
In addition, the normal retirement age would gradually increase 
to 69 between 2003 and 2018. The plan would then index the 
retirement age to reflect increases in life expectancy and 
working careers. Workers would be able to access their PRSAs at 
age 60.
    To finance the transition, the plan would make 
methodological adjustments to the Consumer Price Index, fixing 
the index at 0.15 percentage points below assumptions in the 
1997 Social Security Trustees Report.

The individual social security retirement accounts plan--Rep. 
John Porter (R-Ill.).

    The Individual Social Security Retirement Accounts (ISSRA) 
Plan is another two-tiered system that allows workers to divert 
10% of their pay to a private plan. Participation in this plan 
is voluntary. Social Security benefits would not change for 
workers who decided to remain in the current system.
    For those who chose the private plan, the worker would pay 
5% of the contribution and the same amount would be paid by the 
employer. Voluntary additional employee contributions up to 20% 
of taxable pay would then be permitted. Investment options 
would include government-approved private investment companies. 
Those participating in the plan would also pay 2.4% of their 
salaries annually (split evenly between employer and employee) 
during the first 10 years after election. Retirement age for 
full retirement benefits in either plan would ultimately 
increase to age 70.
    For participants age 30 and older electing private savings 
plans, recognition bonds would be issued to ISSRAs, redeemable 
upon retirement for monthly benefits earned by Social Security 
tax payments under the current system. If, at age 62, a 
participant's ISSRA were not sufficient, the government would 
supplement it with a minimum annuity payment from the general 
funds of the U.S. Treasury. The ISSRA would purchase private 
disability and life insurance for the account holder equal to 
at least the same coverage under Social Security.
    Transition financing would involve, among other things, 
$500 billion (in 1996 dollars) of government bonds issued over 
the first 12 years. Unspecified reductions in other government 
spending of $875 billion would be required.

The personal retirement accounts plan--Rep. Mark Sanford (R.-
S.C.)

    The Personal Retirement Accounts (PRA) Plan involves the 
full replacement of the current Social Security system with 8% 
of pay diverted to a private plan, split evenly between 
employers and employees. It would be mandatory for all workers 
entering the work force in 2000 or later. Those employed before 
then could decide whether to remain in the current Social 
Security system or participate in PRAs. For those participating 
in the new plan, investment options would include low- to 
moderate-risk index funds. The Securities and Exchange 
Commission (SEC), with expanded authority, would regulate these 
funds.
    Workers would continue to pay 5.8% in FICA taxes, split 
evenly between employers and employees, to fund the existing 
OASDI system. The existing disability insurance system would be 
retained, however. PRA trustees would be required to provide 
insurance for any survivors and dependents. Retirement age 
would increase to age 70 by 2029.
    Of note, this plan advocates the dissolution of the Social 
Security trust fund and would pay benefits with general 
revenue. Transition financing has not been determined. The plan 
would establish a Social Security Transition Commission to 
recommend spending cuts, asset sales, debt issuance, or 
increased revenue to fund the transition.

The committee for economic development proposal

    This proposal would require participants to invest 3% of 
their pay into a mandatory private savings plan called a 
Personal Retirement Account (PRA), split between employer and 
employee. The PRA plan would offer broad-based funds managed by 
private companies.
    The 12.4% FICA tax would continue to fund the existing 
Social Security system, which would offer reduced benefits. 
Specifically, replacement rates (the ratio of retirement 
benefits to the last year of earnings before retirement) would 
be reduced by 0.5% per year in the first 14 years and by 1.5% 
in the subsequent 19 years. Furthermore, 85% of all Social 
Security benefits would be taxable. The retirement age would 
also increase to 70.
    Because the present Social Security system would remain 
intact, there would be no transitional costs.
    In addition to these and other massive reform plans, there 
are a number of incremental reform proposals being introduced. 
For example, legislation introduced by Rep. Thomas E. Petri (R-
Wisc.) would establish a retirement account of $1,000 for each 
newborn American. The start-up funds would be derived from the 
sale of government assets and would be invested in the same 
retirement investment funds that are currently available to 
federal employees through the federal Thrift Savings Plan. 
Account holders could voluntarily add up to $2,000 per year, 
tax free, to their retirement accounts.

              The Case of Chile's Pension Savings Account

    The United States is not the first or the only country to 
deal with a fiscal crisis in its social security program. In 
the late 1970s, the government-run pension plan in Chile was on 
the verge of bankruptcy. For reasons similar to those plaguing 
the U.S. Social Security system, Chile had no funded reserves, 
and it had already begun paying more benefits than it was 
collecting in revenue. As this situation worsened, higher taxes 
were the only solution, which stunted job creation. This led 
the Chilean government to scrap its social security system 
altogether and replace it with mandatory private savings.
    Chile's Pension Savings Account (PSA) system was born on 
May 1, 1981. In a radical change from convention, Chile shifted 
the entire responsibility for funding a worker's pension from 
the government to the individual. Indeed, the amount of a 
pension was solely determined by the sum an individual worker 
accumulated during his or her working years. Under this system, 
the government required each worker automatically to put 10% of 
his or her wages into an individual PSA. A worker could 
contribute an additional 10% of his wages each month, also 
deductible from taxable income, as a form of voluntary savings.
    This pension is available to all citizens, including those 
who are self-employed. It is completely portable, meaning that 
it is independent of the company with which a worker is 
employed.
    These savings accounts are funded through a combination of 
more than 20 mutual funds of each worker's choice. These funds 
are managed by private companies called Adminatratoras de 
Fondos de Pensiones (AFPs). These companies can engage in no 
other activities and are subject to government regulation to 
safeguard against fraud and to guarantee a diversified and low-
risk portfolio. Government regulation sets maximum percentage 
limits both for specific types of instruments and for the 
overall mix of the portfolio. Underscoring Chile's desire to 
remove the government from the pension business, there is no 
obligation to invest in government or any other type of bonds.
    Workers are free to change from one AFP to another. For 
this reason, there is competition among the companies to 
provide a higher return on investment, better customer service, 
and a lower commission, according to Jose Pinera, Chile's 
former minister of labor and social security and president of 
the International Center for Pension Reform.
    Participants are given a passbook and receive a quarterly 
statement. They can monitor the performance of their 
investments and can change the level of their contributions 
based on the amount of income they would like to receive and 
the year in which they plan to retire. Contributions are tax 
deductible, and the return on pension savings is tax free. 
Similar to the rules governing defined contribution plans and 
other tax-deferred investments in the United States, taxes are 
paid according to an individual's income tax bracket upon 
retirement.
    The only government subsidy involves providing a minimum 
pension to low-paid workers. Those who have contributed for at 
least 20 years but whose pension funds, upon their reaching 
retirement age, are below the legally defined minimum will 
receive government-sponsored pensions from the state once their 
PSAs are depleted. The minimum pension for an average-wage 
worker is 40% of preretirement income. The PSA system also 
includes insurance against premature death and disability, 
which costs 2.9% of a worker's annual salary and is contracted 
from the AFP to a private insurer.
    Upon retirement, there are two payout options. Under the 
first payout option, a retiree may use the capital in his PSA 
to purchase an annuity from any private life insurance company. 
The annuity guarantees a constant monthly income for life, 
indexed to inflation, plus survivorship benefits. If these 
payments exceed 70% of preretirement income, the worker is 
allowed to take out the excess in the form of a lump sum. The 
second option allows a retiree to leave his funds in the PSA 
and make withdrawals, subject to limits based on the life 
expectancy of the retiree and his dependents.
    During the transition to the new PSA system, all workers 
were given the choice of staying in the government-sponsored 
program. Those who chose the new system were given a 
``recognition bond,'' which was deposited in their new pension 
savings accounts. These bonds were indexed and carried a 4% 
interest rate. Recognition bonds, which are payable when the 
worker reaches the legal retirement age, are also traded on the 
secondary markets so as to allow them to be used for early 
retirement. The choice of whether or not to participate in the 
PSA system was given only to current workers. All new entrants 
into the labor force were required to use the new system.
    As an added incentive to participating in the system, 
workers' gross wages were increased to include most of their 
employers' contributions to the old pension system. As a 
result, salaries for those who moved to the new system 
increased by 5%. Employers continued to pay the difference in 
order to help finance the transition. However, that tax has 
since been phased out.
    More than 40% of the transitional costs were financed 
through the issuance of government bonds at market rates of 
interest. These bonds were primarily purchased by the AFPs to 
fund their investment portfolios. The Chilean government 
projects that this ``bridge debt'' should be completely 
redeemed once it no longer has to fund the pensions of the 
participants in the old government-sponsored system.
    The impact of Chile's pension savings accounts has been 
phenomenal. In the 14 years of its operation, benefits are 
already between 40% and 50% higher than under the government's 
plan. In 1997, PSAs have accumulated an investment fund of $30 
billion, an exceptionally large amount of money for a 
developing country of 14 million people and a GDP of $70 
billion.
    Today, more than 93% of Chileans are in the new system. The 
Chilean government estimates that these workers will be able to 
retire with an average of 70% of pre-retirement income, more 
than three times the amount promised under the old system. The 
average rate of return on investment has been 12% per year, 
which was more than three times higher than the anticipated 
yield of 4%. (Note: This period included the longest bull 
market on record for equities.) Furthermore, the savings rate 
in Chile has increased from 10% in 1986 to 29% in 1996. All 
told, savings for the average Chilean is equal to four times 
his or her annual income, which is quadruple the average in the 
United States, according to Pinera.
    Pension privatization, which has reduced the cost of labor, 
has been credited for pushing the growth rate of the economy 
from a historical 3% per year to 7% on average for the past 12 
years. Chile ranks among the world's fastest-growing economies 
and has the highest credit rating of any Latin American 
country.

                 Privatization: The $10 Trillion Debate

    The fundamental question in the debate over the 
privatization of Social Security is whether individuals would 
be better off directing all or a portion of their FICA taxes to 
private pension accounts of their own. The American public is 
divided on this subject. Roper Starch reported that most favor 
some individual control of Social Security contributions, with 
60% supporting the idea that individuals be allowed to invest a 
portion of their Social Security contributions as they see fit. 
However, there is strong opposition to the government's playing 
the market to any degree. Only 26% support changes that would 
allow the government to invest a portion of Social Security in 
the stock market, and less than 13% support the government's 
investing all of Social Security in the market.
    Proponents of the privatization of Social Security contend 
that the average individual would obtain far higher returns 
than he or she would under the current system. For example, a 
study from The Cato Institute's Project on Social Security 
Privatization revealed that low-income workers born in 1950 can 
expect to receive approximately $631 per month from Social 
Security. But had those investors invested the same amount of 
money in a stock mutual fund, they would have earned upwards of 
$2,419 per month. Moreover, individuals would own their own 
accounts, which would alleviate the federal government of a 
massive liability.
    In contrast, opponents of privatization contend that Social 
Security is not simply an investment vehicle or a pension 
program--and never has been. By design, it's a complex social 
program that involves massive subsidies from the next 
generation of retirees. Privatization would introduce a level 
of risk that could ultimately prove to be harmful to the 
investor. Furthermore, it would allow higher-income individuals 
to make larger contributions over their working lives, thus 
widening the chasm between the rich and the poor.
    However, while past performance is no guarantee of future 
results, based on the historical returns of the stock market, 
returns from privately invested retirement accounts would be 
significantly greater for all wage earners than the benefits 
received from Social Security. For example, a recent article in 
Barron's estimated that a median-wage worker who was born in 
1976 and will retire in 2043 would receive almost three times 
more money through a privatized plan that invested in a 
traditional stock fund than with Social Security based on the 
performance of the S&P 500 Index during that time period. (See 
Figure 6.) For low-income workers, the returns generated from 
stock funds would be 230% higher than those attained from 
Social Security. While there are inherent risks involved in the 
stock market, proponents of reform suggest that based on the 
historical performance of the S&P 500 Index, the higher rate of 
return from stocks would balance the risk of short-term 
fluctuations for long-term investors.
[GRAPHIC] [TIFF OMITTED] T7507.018

    One of the foremost proponents of privatization, Martin 
Feldstein, professor of economics at Harvard University and 
president of the National Bureau of Economics Research, 
estimated that Social Security privatization would raise the 
well-being of future generations by an amount equal to 5% of 
America's gross domestic product (GDP). Although the transition 
to a fully funded system would involve a significant investment 
of capital, he projected that the value of the gain would be as 
much as $10 trillion to $20 trillion.
    Critics of Social Security reform have countered that 
Social Security benefits should not be compared with private 
investment vehicles because the goals are very different. For 
example, insurance aspects of Social Security help skew the 
returns downward. About one-fifth of payouts under Social 
Security go to wives and children of workers who are disabled 
or die before they have been able to contribute to the system 
over a full 40-year career.
    Furthermore, the 68-year-old program has had the backing of 
the federal government and has to date fulfilled its promise to 
the American public. Opponents of privatization have said that 
the government could fix Social Security through a mix of 
benefit and tax reductions. What's more, there is concern that 
investors who retire during an extended bear market will 
achieve significantly less-than-average returns. For example, 
from 1968 to 1978, the stock market as measured by the S&P 500 
Stock Index fell by 44.9% in real terms. People who retired in 
the late 1970s and financed retirement from stock sales had a 
return well below the historical market average. This scenario 
would have a devastating impact on the retirement income of 
lower earners. Opponents argued that the lower one's earnings 
over a lifetime, the more Social Security pensions matter to 
one's retirement security.
    Investor education is another key determinant to the 
success or failure of American workers participating in a 
privatized system. Clearly, investors need sophisticated 
knowledge to invest successfully. Opponents worry that Social 
Security participants lack such knowledge. England's experience 
with social security reform offers a sobering example of the 
consequences of uninformed people investing money in the stock 
market. In 1988, the United Kingdom allowed individuals to opt 
out of its national public pension system and into private 
accounts. Sales agents often gave investors wrong and biased 
advice. These abusive sales practices, coupled with inadequate 
regulation, led to billions of dollars in losses for investors, 
according to SEC Chairman Arthur Levitt in a recent speech on 
Social Security reform at the John F. Kennedy School of 
Government Forum at Harvard University.
    But reform proponents have said that a properly designed 
market-based system would build on the structures already 
developed for defined benefit and defined contribution plans. 
These plans do not require their participants to be highly 
sophisticated investors. For decades, workers of all income 
groups in defined benefit plans have entrusted their pension 
benefits to sophisticated investors, who, for the most part, 
have done very well in fulfilling their fiduciary 
responsibilities. In defined contribution plans where 
individuals have more of the investment responsibility, 
evidence suggests that they are more comfortable if given 
proper investment guidance.
    Opponents have expressed concern that the transitional 
costs associated with privatizing Social Security could be 
burdensome on working Americans. For example, the National 
Committee to Preserve Social Security and Medicare has observed 
that either payroll taxes would have to be increased 
significantly or substantial government debt would have to be 
incurred. The organization estimates that a proposal to divert 
5% of earnings from Social Security to private pensions would 
cost about $2 trillion and require a payroll tax increase of 
1.5%, combined with $1.2 trillion in new government debt.
    Reform proponents contend that the benefits of a privatized 
system would offset any transitional costs. According to a 
study by The Cato Institute, the tax revenues generated from 
the net increase in investment alone would be about $150 
billion in the 10th year from the start of the transition, and 
they would continue to grow as private investments accumulated 
each year. The study estimates that this effect, combined with 
modest spending cuts of about $60 billion per year and modest 
increases in borrowing of about $50 billion per year, would 
yield a positive cash flow for current retirees who depend on 
Social Security. There would be no further spending cuts or 
borrowing by the 15th year after privatization.

                               Conclusion

    The debate over whether or not to privatize Social Security 
will involve considerable compromise from those on both sides 
of the issue. Without clear and effective leadership, the 
ensuing retirement crisis will have a detrimental impact on the 
nation's economy and the quality of the lives of its citizens. 
Whatever the outcome, individuals will be required to assume 
more responsibility for their retirements than the generations 
before them. To encourage saving, regulators, financial 
services companies, and financial advisers must not only 
provide more access to investment products, they must educate 
individuals and provide strategies to help them maintain a 
comfortable lifestyle in retirement. Indeed, for the sake of 
the nation's economy and the quality of the lives of its 
citizens, the debate over Social Security reform and how to 
encourage better retirement planning must take center stage as 
the 21st century approaches.
      

                                

                                                  February 27, 1999
The Honorable E. Clay Shaw, Jr.
Chairman, Subcommittee on Social Security
House Committee on Ways and Means
United States House of Representatives
Washington, D.C. 20515

    Dear Representative Shaw:

    We understand the House Ways and Means Subcommittee on Social 
Security will be holding a hearing on the direct investment component 
of the President's Social Security reform proposal. We have also been 
advised that state and local government pension plans may be 
characterized in this hearing as allowing ``political interference'' in 
their investment decisions.
    We have no position on the President's proposal. However, we 
strongly disagree with the current comments implying we earn a lower 
rate of return due to alleged politicization of investment decisions 
and policies that focus on social factors other than the best interests 
of the plan participants. We strongly believe that public pension plan 
assets are invested in a prudent manner that ensures that plan 
participants receive the benefits to which they are entitled and also 
in a manner that reduces the costs for taxpayer support of the plans.
    Should the Subcommittee find it necessary to raise the issue of the 
investment performance of state and local government pension plans, we 
respectfully request the Subcommittee invite independent experts to 
testify on the rates of return obtained by public pension plans as 
compared to their private sector counterparts over the past several 
years. Such testimony will show that the rates of return achieved by 
public and private plans over these periods are quite similar. 
Furthermore, it will provide the Subcommittee with information based on 
current data.
    Data the Ways and Means Committee has received to date, and relied 
upon by Federal Reserve Board Chairman Alan Greenspan, was based on 
information from the 1960s through the 1980s and showed the rates of 
return for public sector plans trailing by two to three percentage 
points the return rates of private sector plans. Chairman Greenspan 
suggested that some of the disparity might be ascribed to political 
interference in the management of the state or local pension plans. 
This is incorrect. Even the Chairman conceded that much of this 
disparity would be eliminated were these returns adjusted for risk in 
light of the fact that State and local pension funds are often invested 
more conservatively than private plans.
    We believe virtually all of this lag is attributable to the 
investment restrictions imposed on public funds but not on corporate 
plans. As these restrictions have gradually been lifted, public funds' 
performances have grown to become comparable with private pension 
funds. Current data shows that public retirement funds are efficiently 
managed financial institutions with well diversified portfolios that 
have achieved impressive rates of return.
    If the Subcommittee does wish to pursue the issue of state and 
local government pension investment practices, we would appeal for a 
full, fair and complete hearing record. We respectfully request that 
the Committee invite independent experts to testify on the rates of 
return obtained by public pension plans as compared to their private 
sector counterparts over the past several years.
    We would suggest that you call Laurette Bryan and/or John Gruber, 
Senior Vice Presidents of State Street Bank. Their testimony will be 
factually rooted in the actual rates of return experienced and provided 
by scores of the nation's public and private pension plans to their 
institution as well as Chase Manhattan Bank, Citibank, Mellon Bank, 
Northern Trust Company, U.S. Trust, Bank of New York, NationsBank and 
11 other banks. These banks support the Trust Universe Comparison 
Service (TUCS) which produces rates of return and other data that are 
used as the industry standard by which pensions measure their 
performance. (We have attached a summary of these independent findings 
for your review).
    We appreciate your consideration. If you have any questions or 
would like additional information you may contact our legislative 
representatives:
                                   Gerri Madrid/Sheri Steisel,
                                           National Conference of State 
                                               Legislators
                                   Neil Bomberg,
                                           National Association of 
                                               Counties
                                   Doug Peterson,
                                           National League of Cities
                                   Larry Jones,
                                           United States Conference of 
                                               Mayors
                                   Tom Owens,
                                           Government Finance Officers 
                                               Association
                                   Jeannine Markoe Raymond,
                                           National Association of 
                                               State Retirement 
                                               Administrators
                                   Cindie Moore,
                                           National Council on Teacher 
                                               Retirement
                                   Ed Braman,
                                           National Conference on 
                                               Public Employee 
                                               Retirement Systems

Attachment

    [The attachment is being retained in the Committee files.]
      

                                


Statement of Peter J. Sepp, Vice President, Communications, National 
Taxpayers Union, Alexandria, Virginia

    Mr. Chairman and distinguished members of the Committee, I 
am grateful for the opportunity to present the views of the 
300,000 members of National Taxpayers Union (NTU) as you 
consider proposals that would allow the federal government to 
direct and control the investment of Social Security funds in 
private financial markets. As you may know, the vast majority 
of NTU's members are either retirees or middle-class employees 
and business owners working towards retirement. Therefore, the 
issue before the Committee today is of great concern to them, 
and I commend you and your colleagues for recognizing the 
impact of this proposal.

                              Introduction

    No one can deny the central role that individual investing 
has played in lifting the fortunes of millions of middle-class 
families. Nor can one deny increased public anxiety over the 
solvency of federal retirement programs, and the government's 
inability to address the problem.
    These economic and political trends seem to have eluded 
President Clinton and many of his allies in the White House and 
Congress. Under the President's budget proposal, nearly 62 
percent of projected budget surpluses ($2.7 trillion over 15 
years) would be funneled into the porous ``Trust Fund.'' Of 
this, Clinton proposed ``investing a small portion in the 
private sector just as any private or state government pension 
would do.'' This proposal, if enacted, would present the 
greatest threat to the finances of taxpayers and consumers 
since the Administration's attempt to nationalize \1/5\ of the 
nation's economy under the guise of ``health care reform.'' 
There is ample evidence from a range of disciplines to support 
this dire prediction.

    American Investors Are Confident in Themselves, But Not in the 
                               Government

    Perhaps no other economic factor is more responsible for 
the continued prosperity of Americans than the growth of 
individual investments in stock and bond markets. From 1989 to 
1995, the percentage of all families having direct or indirect 
holdings in the stock market rose by one-third, to 40.3 
percent. From 1990 to 1997, mutual fund holdings have increased 
an incredible 500 percent, to more than $3 trillion. But these 
investments have not been fueled by short-term speculation. 
Indeed, most are directed towards long-term gains. Despite 
continued acts of Congress that have narrowed their 
availability and appeal, Individual Retirement Accounts 
contained $1.35 trillion in 1996, double their worth just five 
years before.
    This recent explosion in individual investment has 
financially empowered the middle class more than any other 
income level. Today, half of all families in the $25,000-
$50,000 bracket have holdings in the stock market. For the 
$50,000-$100,000 bracket, the level soars to more than two-
thirds. It is therefore no wonder that this boom in investing 
has been accompanied by an explosion in financial counseling 
services, investment publications, and Internet sites all 
designed to provide consumers with the information they need to 
make rational choices in the stock and bond markets. Americans 
are unquestionably savvier about finance today than at any 
other period in history.
    Yet, the rise in individual investor confidence has 
corresponded with a steady drop in taxpayer confidence in the 
federal government's retirement programs. As early as 1990, 
scientific opinion research by National Taxpayers Union 
Foundation revealed that less than one-fourth of workers under 
age 35 were confident that Social Security would pay the full 
level of benefits promised to them once they retired.
    By 1995, significant pluralities of Americans had warmed to 
the idea of allowing individuals to plan more for their own 
retirements. A Grassroots Research Survey taken in November of 
that year found that 48% of Americans aged 30 to 39 would 
voluntarily withdraw from Social Security, even if they 
received nothing in return for the taxes they had already paid.
    Today, public opinion not only favors individually-directed 
retirement investments, it also opposes government-directed 
schemes. A CNN/USA/Gallup poll conducted in December of last 
year indicated a 64%-33% approval margin for ``individuals 
investing a portion of their savings'' in the stock market as a 
Social Security reform option. An equally lopsided margin--65%-
33%--disapproved of the ``Federal Government investing a 
portion'' of Social Security in the stock market.

          State and Local Investments Have a Tarnished History

    President Clinton unwittingly made the worst historical 
case for a federally-directed investment scheme when he 
referred to the experiences of state and local pension funds. 
The dismal political and financial track record of these funds 
is Exhibit Number One in the case against expansion.
     In 1990, Connecticut Treasurer Francisco Borges 
directed the State Pension Fund to invest $25 million into the 
ailing Colt Firearms Division of Colt Industries, insisting 
that the money was ``not a bailout, not a handout, and not a 
subsidy ... it is a bona fide financially prudent investment.'' 
At the time Borges didn't mention that the state brokered a 
deal with the company's striking union workers for a 13% pay 
raise and $13 million in back wages. Borges later found himself 
in the curious position of supporting a ban on ``assault 
rifles'' while investing in the very company accused by gun 
control advocates of manufacturing the weapons. Colt later 
filed Chapter 11 bankruptcy.
     The Kansas Public Employee Retirement Systems 
(KPERS) has lost between $138 million and $236 million due to 
its Economically Targeted Investments (ETIs). Among the 
System's ``bad picks'' were a seized savings and loan once run 
by the head of KPERS and a now-abandoned steel plant.
     Pennsylvania school teachers and state employees 
have watched helplessly as $70 million of their pension funds 
have been sunk into a new Volkswagen plant, an investment that 
has since lost half its value.
    Rick Dahl, the Chief Investment Officer for Missouri's 
State Employee Retirement System, summed up this sad history 
when he observed, ``Anytime you get a big chunk of money in 
front of politicians, you run the risk of investments made not 
in the best interests of the beneficiaries.''
    Those who consider such a statement to be too harsh should 
examine hard data. In 1998, John Nofsiger found that ETIs and 
other ``socially responsible'' investing practices depressed 
the average annual returns of public retirement funds by 1.5 
percent. Ironically, former Clinton Treasury official Alicia 
Munnell conducted a similar study 15 years earlier that showed 
a 2 percent annual reduction.

           Federal Financial Management Is Likewise Tarnished

    Beneath President Clinton's proposal is a thinly veiled 
contempt for the intelligence of the average American. It is 
based on the claim that the government, but not America's 
taxpayers, can invest budget surpluses wisely.
    Given the plethora of policies that document the federal 
government's penchant for poor financial management, it is 
incredible that the Chief Executive would even imply such a 
thing. While the scope of these hearings do not permit a 
wholesale examination of the government's track record, the 
Administration's analogy forces us to remind the Committee of a 
few examples:
     In 1997, the average default rate on private bank 
loans to homebuyers was 2.8 percent. That same year, defaults 
on government home loans reached 8.1 percent.
     The total national debt owed by the federal 
government is $5.6 Trillion. The total debt owed by consumers 
is $1.235 Trillion.
     Between 1950-97, the average annual return of 
money invested by citizens in the stock market has been 8.7 
percent. The average annual return of the Social Security 
``Trust Fund'' since inception has been 2 percent.
     In 1996, nearly \1/3\ of all citizens audited by 
the IRS were later cleared or were actually given refunds. Yet, 
the IRS has only cleared 1 out of 7 ``audits'' of its own 
books, as conducted by the General Accounting Office.
    Citizens are bombarded virtually every evening with 
newscasts exposing $445,000 outhouses in national parks, $1 
million angora goat subsidies, and other instances of wasted 
tax dollars. But the facts above go beyond the sensational to 
the very fundamental reason why Americans do not--and will 
not--trust the federal government to invest wisely for the 
national interest.

 The Bottom Line: $350 Billion in Lost Returns and a Less Accountable 
                            Political System

    In order to quantify the amount at stake for future 
retirees if President Clinton's proposal is enacted, NTU's 
research staff compared the average rate of return of large 
company stocks over the past 70 years (as estimated by the Bank 
of Boston) to the average loss of return due to the political 
influence on retirement funds (as estimated by Nofsinger and 
Munnell). We then applied those rates to the estimated 15-year 
investment pattern of Social Security Funds provided by the 
White House and the Congressional Budget Office.

NTU determined that the average loss to Americans' retirement 
funds under the President's plan would be $354.53 billion over 
15 years.

    However, the financial ``ripple'' would not end at that 
point. Hundreds of billions of government dollars flowing into 
private companies could give Washington direct control over a 
majority of shares in hundreds of companies. As past experience 
has shown, shareholders with even a 2 or 3 percent bloc of 
shares can significantly influence the policies of publicly 
traded companies. Thus, even investors who are buying shares 
out of their own pockets will see their influence over 
corporate governance diluted. In addition, the sheer volume of 
federal trading would affect returns on private portfolios, 
even those weighted to broader indices. After all, any major 
shareholder who pulls out of a company can depress dividends 
and capital gains for smaller investors.
    Such linkages would likewise prevail abroad. Although the 
government could improve its returns by diversifying into 
foreign stocks and bonds, all sorts of political questions 
would present themselves. If Washington invests in countries 
whose leaders later become corrupt or violent towards U.S. 
military personnel, should the government sell its shares and 
worsen the risk of destabilizing those nations further, or 
should it stand pat and risk bankrolling the regimes?
    Yet, perhaps the most troubling political question lies 
between our own shores. How would massive government investment 
in private companies affect the relationship between elected 
officials and special interests? Based on past experience, the 
impact would be decidedly negative. Corporate Political Action 
Committees could have an increased incentive to contribute to 
government shareholding officials, or those closest to them. 
For their part, federal officials would almost certainly have 
knowledge of impending public policy decisions that could 
affect the health of the companies in which the government owns 
shares. Those concerned with ``campaign finance reform'' and 
``insider trading'' should be alarmed over President Clinton's 
proposal.

    Conclusion--Let Individuals, Not Government, Control the Surplus

    The American people were intelligent and diligent enough to 
produce a booming economy and a burgeoning Treasury in the 
first place. They are likewise intelligent and diligent enough 
to manage their own retirement finances.
    Economic tides will always leave some individuals 
unprepared to retire in financial security. For this reason, 
many citizens support some kind of modest, targeted government 
program to keep the elderly out of poverty. However, Congress 
should not read this public mood--or knee-jerk polls that 
seemingly support the nebulous ``Save Social Security'' 
mantra--as an endorsement for further government meddling in 
the development of a sustainable middle-class retirement 
system. To adapt the words of entitlement expert Pete Peterson, 
Washington must grow up before today's workers grow old--and 
give hard-working Americans they credit they deserve to invest 
budget surpluses individually.
    Once again, I thank you, Mr. Chairman, and the Committee 
for your thoughtful deliberation of this policy matter.
      

                                


Statement of Chris Tobe, Plan Sponsor, Greenwich, Connecticut

  Lessons from Public Pension Plans--Pure Indexing is only choice for 
                    Social Security Stock Investing

    President Clinton outlined a proposal to invest part of the 
Social Security Surplus in stocks. In 1998 summer I co-wrote 
with Dr. Ken Miller for Kentucky Auditor Ed Hatchett a review 
of Kentucky's large public pension plans. As part of that 
review, we surveyed 41 of the largest public pension plans in 
the Country representing $950 billion in assets. These multi-
billion dollar plans are the closest parallels you can find to 
what a stock investment by Social Security would be like.
    This proposal raises many issues. It is not a simple issue 
of privatization. However, I think it can work if we use the 
best examples of what our Public Pensions are doing today. They 
show that adding stocks to investment portfolios give us not 
only the historical higher returns of equities, but also more 
volatility and sticky governance issues that require our 
attention.
    I am analyzing the President's plan of investing 10%-15% of 
Social Security assets directly in the stock market. This in my 
opinion is a very separate issue than the other IRA type 
retirement vehicles being proposed. Under this government 
direction scenario, you primarily need to decide who manages 
the stocks (private or public) and how those managers invest 
the proceeds.

                           Choose Index Funds

    Based on our findings in public pension plans my suggestion 
of how we invest Social Security proceeds is to invest in index 
funds. If you chose this option it matters much less who 
manages the money, only who can do it most efficiently. Public 
Pension plans have used indexing at an increasing rate because 
of its good performance and low cost. More importantly 
indexing, if strictly enforced, rids us of the sticky 
governance issues.
    Active management leads to governance problems whether 
private firms or the government is managing the money. Most of 
us are familiar with the argument being made by political 
conservatives that if the government is the manager, it could 
have undo influence over corporations and be a step toward 
socialism. The conservative nightmare is that a Social Security 
stock selection committee will be made up of Jesse Jackson, 
Ralph Nader, and labor unions making demands on corporate 
management.
    The California Public Employees Pension Plan and others 
have shown that they can hold at bay many of the social 
concerns, while maximizing returns for retirees. However, I 
think the resistance is much stronger for index funds than for 
the actively managed portfolios. We have seen this in New York 
and Florida, which divested Tobacco in their active portfolios 
while keeping them in their index funds.
    Management by private firms is apt to be no better. It's 
susceptible to conflict of interest problems. Let us say an 
Investment firm has the government stock portfolio, but they 
also manage the pension plan of ACME auto. Do you think they 
would dump the stock of ACME auto, causing it to plummet and 
risk losing their business? In addition, the huge size of a 
Social Security portfolio could cause all kinds of potential 
for market manipulations when buying or selling stocks to 
benefit other portfolios or individuals. For example, the 
secretary overheard the portfolio manager say he was going to 
sell GM in the Social Security account. This information would 
be worth billions and is just too tempting.
    An index fund, if adhered to, strictly prevents the 
majority of problems from government interference. It would 
also lower conflicts of interest if private firms were hired. 
Whether run by a neutral Federal Agency like the Federal 
Reserve, or bid out to a private vendor with oversight from a 
Federal Reserve type body, there would be little difference in 
the outcome with an index fund.

                    How to Effectively Run the Index

While indexing is straightforward, it requires crucial strategic 
decisions

    First, you have to choose an index. With this much 
invested, you need to try to have as little effect on the 
market as possible. The index should be a market capitalization 
weighted index like the S&P 500 or Wilshire 5000. This means 
that the fund might hold 100 times more of Microsoft than Apple 
because of their proportionate weight in the stock market. This 
would ensure that the market impact on each individual stock 
would be more or less spread equally across the portfolio of 
500 to 5000 stocks.
    I have argued that the S&P 500 is preferable because it is 
more widely used and is more liquid due to an active futures 
and options market. The Wilshire 5000 however is more 
indicative of the entire stock market in the United States and 
causes less disruption when issues are added or removed.

Lessons From Public Plans--Low Fees

    Our public retirement review included a detailed review of 
the operation of a $3 billion and $1 billion S&P 500 index fund 
by two public funds, and a more general review of public 
pension plans nationally from our survey results of 41 large 
public plans.
    A major finding was that index funds charged very low costs 
and had excellent performance for the 1, 3 and 5-year periods 
ending July 1997. Our reports concluded that both internal and 
external management of S&P 500 index funds could be very 
inexpensive.
    Indeed, outside management fees could actually be negative 
for a large S&P 500 index fund, or at least cost-free. One of 
the reasons for this is securities lending in which the 
underlying stocks are loaned to other investors. While it is 
unclear how and if the Social Security Surplus could be subject 
to securities lending, it could prove very beneficial. It is 
conceivable that private firms would actually pay the 
government to have the Social Security assets and make their 
money off the security lending. This entire issue would need to 
be studied intensely to measure its market impact.
    The cost advantages of indexing, however, go down if you 
deviate from pure indexing. A Wilshire study of the average 
total turnover of the AMA tobacco free indices is greater than 
the turnover for pure indices. This results in increased 
trading costs for the funds. Wilshire predicted higher trading 
costs of $130,000 a year for a $1 billion, S&P 500-index fund. 
The higher turnover is a result of the constant realignment of 
the tobacco free funds due to the over weighting of industries 
resulting from a zero weighting in the tobacco industry.
    Public officials, therefore, need to understand the 
investment cost they are paying to achieve any moral gain. 
Investment restrictions will reduce opportunities for 
outperformance for active managers, increase risk for passive 
managers, generate one-time excess transactions costs, and 
cause measurement problems associated with imperfect 
benchmarks.
    We have analyzed costs for each of these effects.

                      Divestment = Tracking Error

    Divestment of any kind causes tracking error. For our 
report we defined ``Tracking Error'' as the percentage 
difference in total return between an index fund and index it 
is designed to replicate. Our definition, based on Nobel 
Laureate Bill Sharpe's work, holds that even if you beat the 
index you still have tracking error. The objective is to 
exactly match the market, not to attempt to beat it. Exactly 
matching the index lowers the risk of underperforming your 
benchmark.
    Public Funds have a mixed record in this regard. We found 
in our study of Kentucky's two plans that they deviated from a 
pure S&P 500 index portfolio. Kentucky Teachers and New York 
Teachers sold tobacco stocks in both their active and index 
funds. This seemed to be the exception, as New York, Florida 
and Minnesota public employees decided on tobacco divestiture 
only in their active funds, not in their index funds. Even the 
American Medical Association did not sell tobacco stocks from 
its index fund.
    The Kentucky Retirement system dumped stocks in the S&P 500 
that had international headquarters--like Royal Dutch and 
Northern Telecom--and for other reasons. Kentucky Retirement 
suffered significant tracking error to the index. Kentucky 
Teachers, however, despite the divestiture effectively 
minimized their tracking error through constant rebalancing, 
though they suffered minor error on a daily basis.
    We recommend in our report that both Kentucky funds 
reinvest in the under-weighted securities represented in the 
S&P 500 Index fund to reflect the correct weightings. Our 
reasoning was that the index fund needs to function according 
to its established investment policy. Our recommendation 
concerned the efficiency of running an S&P 500-index fund--not 
any social concerns. A pure index fund both reduces fees and 
eliminates the risk of underperforming your index.
    There have been anecdotal reports of good performance by 
socially responsible funds. These reports depend mostly on what 
time period you use. Two studies show tobacco divestiture to 
have a negative effect on returns. One by Wilshire shows lower 
returns over long periods. A study from the Journal of 
Investing concludes: ``The current arguments about whether to 
limit or prohibit pension fund investments in tobacco stocks, 
in contrast to earlier debates about `sin-free' investing, 
focus on investment considerations rather than morality. But 
tobacco divestiture doesn't stand up as an investment decision. 
It doesn't reduce risk in the typical pension fund context, nor 
does it constitute a clever active strategy issued from the 
legislature. We should see tobacco divestiture for what it is: 
a moral decision.''
    On balance, the argument for social investing as a long 
term positive to performance does not seem to hold up under 
careful scrutiny.

      Pure Indexing--Social Security Stock Investings Best Chance

    The best example from Public Pensions is the pure index 
approach. For Social Security stock investing to be accepted, 
it needs to go into index funds with no exceptions, no matter 
the pressure. If states like New York and California and even 
the AMA resist tobacco divestiture in their index funds, so can 
Social Security if and only if it is in an index fund.
    Our large Public plans have led the way in showing how it 
is possible to invest billions in stocks within a Government 
framework. Social Security reform should use the best of these 
examples when formulating how to invest in the stock market by 
using index funds.
    Stock investing by Social Security can work with a pure 
index approach.

An edited version of this article will appear in the April 1999 
edition of Plan Sponsor magazine.

                                   - 
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