[Senate Hearing 109-554]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 109-554
 
                   THE ROLE OF THE FINANCIAL MARKETS
                       IN SOCIAL SECURITY REFORM

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


                                HEARING

                               before the

               SUBCOMMITTEE ON SECURITIES AND INVESTMENT

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                                   ON

 THE ROLE OF THE FINANCIAL MARKETS IN SOCIAL SECURITY REFORM, FOCUSING 
    ON THE FEDERAL THRIFT SAVINGS PLAN, PERSONAL RETIREMENT SAVINGS 
           ACCOUNTS, AND RETIREMENT PLAN ADMINISTRATIVE COSTS

                               __________

                             JUNE 14, 2005

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


   Available at: http: //www.access.gpo.gov /senate /senate05sh.html





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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire        DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina       JON S. CORZINE, New Jersey
MEL MARTINEZ, Florida

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                          Justin Daly, Counsel

                 Dean V. Shahinian, Democratic Counsel

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                 ______

               Subcommittee on Securities and Investment

                    CHUCK HAGEL, Nebraska, Chairman

            CHRISTOPHER J. DODD, Connecticut, Ranking Member

MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
JOHN E. SUNUNU, New Hampshire        JACK REED, Rhode Island
MEL MARTINEZ, Florida                CHARLES E. SCHUMER, New York
ROBERT F. BENNETT, Utah              EVAN BAYH, Indiana
JIM BUNNING, Kentucky                DEBBIE STABENOW, Michigan
MIKE CRAPO, Idaho                    JON S. CORZINE, New Jersey
ELIZABETH DOLE, North Carolina       THOMAS R. CARPER, Delaware
WAYNE ALLARD, Colorado
RICK SANTORUM, Pennsylvania

                Joseph Cwiklinski, Legislative Assistant

               Alex Sternhell, Democratic Staff Director

                                  (ii)


                            C O N T E N T S

                              ----------                              

                         TUESDAY, JULY 14, 2005

                                                                   Page

Opening statement of Senator Hagel...............................     1

Opening statements, comments, or prepared statements of:
    Senator Dodd.................................................     2
    Senator Sununu...............................................    21
    Senator Reed.................................................    23
    Senator Johnson..............................................    41

                               WITNESSES

Gary A. Amelio, Executive Director, Federal Retirement Thrift 
  Investment Board...............................................     4
    Prepared statement...........................................    43
Francis Enderle, Managing Director and Chief Investment Officer, 
  Global Index and Markets Group, Barclays Global Investors......     5
    Prepared statement...........................................    49
Francis X. Cavanaugh, former Director, Federal Retirement Thrift 
  Investment Board...............................................     7
    Prepared statement...........................................    51
Michael Tanner, Director, Cato Project on Social Security Choice.     9
    Prepared statement...........................................    57
David C. John, Research Fellow, Thomas A. Roe Institute for 
  Economic Policy Studies, The Heritage Foundation...............    11
    Prepared statement...........................................    59
Jason Furman, Non-Resident Senior Fellow, Center on Budget and 
  Policy Priorities and Visiting Scholar, Wagner Graduate School 
  of Public Service, New York University.........................    13
    Prepared statement...........................................    64

                                 (iii)


      THE ROLE OF THE FINANCIAL MARKETS IN SOCIAL SECURITY REFORM

                              ----------                              


                         TUESDAY, JUNE 14, 2005

                               U.S. Senate,
         Subcommittee on Securities and Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 2:07 p.m., in room SD-538, Dirksen 
Senate Office Building, Senator Chuck Hagel, Chairman of the 
Subcommittee, presiding.

            OPENING STATEMENT OF SENATOR CHUCK HAGEL

    Senator Hagel. Good morning, the hearing will come to 
order.
    For 70 years Social Security has been one of the most 
successful and important Government programs in our country. 
Almost every American family during this time has been touched 
in some way by Social Security.
    However, the Social Security system is actuarially 
unsustainable as it now exists. The Social Security system is 
not in crisis today, but there is clearly a crisis on the 
horizon.
    America faces a $4 trillion deficit in Social Security over 
the next 75 years. In 2017, more money will be paid out of 
Social Security than comes in. In 2041, Social Security will be 
insolvent. Beyond the next 75 years there is only a black hole 
of unfunded liability for future generations.
    The longer we wait to address this issue, the more 
difficult it will be to protect Social Security and the promise 
our Government has made to future generations of Americans.
    Today's hearing will examine what role financial markets 
will play in Social Security reform. It is important what risks 
there are, how they might be managed, what kind of fiduciary 
responsibility would be required of Government officials, and 
how a personal account system might work.
    The Federal Thrift Savings Plan, TSP, provides a model we 
can review that gives us a better understanding of these 
issues. Since taking effect in 1987, TSP has been a success for 
Government employees. Last year, returns on the different 
accounts range from just over 4 percent to 20 percent. And over 
the last 10 years, the returns have been between 5.5 percent 
and 12 percent. Barclays Global Investors is the investment 
managing firm for TSP.
    Today's hearing will look at the TSP model and focus on the 
operational issues that the Federal Retirement Thrift 
Investigation Board and Barclays face in managing the TSP 
accounts, the different costs and fees associated with the 
operation of these accounts, the bidding process that TSP 
employs to hire private investment firms, the different 
investment options that TSP offers, and how effectively the TSP 
model could be applied to broader Social Security reform.
    In assessing the role of the financial markets in Social 
Security reform, we need to look at the market impact for 
private investors. If the Federal Government became a big 
operator in the marketplace and had to manage 100 million 
accounts, then what impact would there be on the broader 
marketplace? What procedures would need to be implemented to 
ensure that this impact is minimal and managed?
    In 1997, former Senate Banking Committee Chairman Phil 
Gramm said that without strict procedures, this would be like 
being in a rowboat with an elephant. When the Government moved 
in the boat, you would know it. How can we minimize this 
impact? Or can we minimize this impact?
    I welcome our distinguished witnesses today that will help 
us explore these issues and thank them for their important 
contributions. Before I ask my distinguished colleague, the 
Senator from Connecticut, for his remarks, I would quickly 
introduce the panel, and then after Senator Dodd's remarks, we 
will address each of your testimonies.
    Gary Amelio, the current Executive Director of the Federal 
Retirement Thrift Investment Board; Francis Enderle, Chief 
Investment Adviser for Barclays Global Investors; Francis 
Cavanaugh, Consultant for Public Finance Consulting, and the 
former Executive Director of the Federal Retirement Thrift 
Investment Board; Mike Tanner, Director of the Cato Institute's 
Project on Social Security Choice; David John, Research Fellow 
for the Heritage Foundation; and Jason Furman, Nonresident 
Senior Fellow at the Center on Budget and Policy Priorities, 
and also a Visiting Scholar at New York University's Wagner 
Graduate School of Public Service.
    Gentlemen, we thank each of you for your time and for your 
contributions to this panel, and I would now ask my 
distinguished colleague, Senator Dodd, for his remarks.

            STATEMENT OF SENATOR CHRISTOPHER J. DODD

    Senator Dodd. Thank you very much, Mr. Chairman, and my 
apologies to you for arriving a couple minutes late, finishing 
up our conference lunches as we do on Tuesdays around here. But 
I thank you for doing this.
    There are a number of proposals that are kicking around, 
including ones that I know the Chairman has proposed, on how to 
address the issue of Social Security in the coming years. So, I 
think it is highly appropriate that this Subcommittee, which 
deals with securities and investment, to hold a hearing on the 
Social Security reform debate. It is appropriate and the right 
thing to do. In fact, as you have just pointed out, in 1997, 
when I was still a Member of this Subcommittee, Senator Phil 
Gramm, our former colleague, held a hearing on the very same 
subject matter regarding Social Security. In fact, at that 
hearing, Mr. Tanner, you testified in 1997.
    Mr. Tanner. Yes, sir.
    Senator Dodd. How are you doing?
    Mr. Tanner. Keeping busy.
    Senator Dodd. It has been a long time, 8 years. Welcome 
back to the Committee.
    Anyway, throughout my tenure in the Senate, Mr. Chairman, I 
have always been interested in ways in which we can strengthen 
retirement security in the country, including expanding the 
individual retirement accounts and improving pension plans. In 
fact, one of the first bills I authored as a freshman Member of 
this body back in the early 1980's was on individual retirement 
accounts. I recall at the time when we offered the legislation, 
there was editorial comment that this was only going to serve 
my more affluent constituents in Fairfield County. And then 
Merrill Lynch did a study back in the early 1980's 
demonstrating that even people with incomes of $20,000 were 
investing in individual retirement accounts. They were doing it 
usually the day before their taxes were due. They were not 
taking it earlier in the year because of the lack of disposable 
income. But clearly IRAs were a wonderful vehicle for expanding 
and increased retirement security.
    Any of these financial instruments, of course, in my view 
are essential to millions of Americans in helping to provide 
for retirement and their family's financial security. Moreover, 
they have helped our economy by encouraging private savings, 
which have become dangerously low, I might add, in recent 
years.
    However, let me just say briefly in these opening remarks, 
I have deep reservations about the current proposals by the 
Administration and others to divert funds from Social Security 
into the private marketplace, and let me explain why.
    I believe there is legitimacy to the concern that the 
Social Security Trust Fund will, over the coming decades, have 
some serious financial difficulties. It is altogether 
appropriate and not too soon to look at ways to keep Social 
Security strong and vibrant for future generations of retirees. 
However, in my view, the Administration's proposal is 
fundamentally flawed for at least three reasons.
    First, by diverting money away from the Social Security 
trust fund, I believe we exacerbate the insolvency concerns 
rather than improve the health of the fund. Most observers 
believe that even under the most dire predictions, about 80 
percent of the Social Security trust fund will be in place in 
the decades of the 2020's, 2040's, or 2050's, that we will have 
about a 20- to 25-percent shortfall that we will have to deal 
with. And certainly we need to address that, but I think by 
diverting funds away from Social Security, we will make that 
problem even more serious.
    Second, the proposal of the Administration increases the 
national debt by over $5 trillion. Even the Vice President 
acknowledges that number. And I do not take lightly the thought 
of putting $5 trillion more of debt on our children and future 
generations.
    Third, in my view the proposal requires a reduction in 
guaranteed Social Security benefits for most retirees. Social 
Security is critical not only to senior citizens but also to 
the fabric of our society. There are approximately 47 million 
of our fellow Americans who receive Social Security benefits of 
one kind or another. It is the sole source of income for one-
fifth of all seniors and it is the primary source of income for 
two-thirds of seniors.
    Social Security reduces the poverty rate among seniors from 
about 50 percent to about 10 percent in our Nation. Beyond its 
retirement benefits, Social Security provides critical support 
for the disabled and for the surviving family members of 
workers who die. Only about 30 percent of workers would have 
access to long-term disability benefits absent Social Security.
    I believe that as we address the issues of Social Security 
reform, we need to keep a few basic principles in mind. One, do 
no harm. The goal is to strengthen Social Security. Let us 
agree to strengthen Social Security, not dismantle it by 
agreeing not to divert any money out of the trust fund.
    Second, we need to create new opportunities in addition to 
Social Security to enhance retirement security. For Americans 
to save for their retirement, for one, we should do more in 
that area. Our national savings rate, as I mentioned earlier, 
is abysmally low. We should use the tax code and other means to 
reward and incentivize savings and help Americans with their 
long-term retirement needs.
    Third, we need to come and to work together in a bipartisan 
fashion, which we are not doing enough of in this area. 
Providing for the retirement of future generations of Americans 
is far too important of an issue to become part of a game of 
partisan football.
    Once again, I want to thank the Chairman, Senator Hagel, 
for his thoughtful proposals as he has attempted to address 
this issue and for giving this Subcommittee a chance to be 
heard on the issue and for inviting such a distinguished panel 
of witnesses to share their thoughts. I look forward to their 
this.
    Senator Hagel. Senator Dodd, thank you.
    Let us begin with Mr. Amelio. Again, Mr. Amelio is the 
Executive Director, Federal Thrift Retirement Investment Board.
    Mr. Amelio, welcome. Thank you.

                  STATEMENT OF GARY A. AMELIO

                      EXECUTIVE DIRECTOR,

           FEDERAL RETIREMENT THRIFT INVESTMENT BOARD

    Mr. Amelio. Thank you. Good morning, Chairman Hagel and 
Senator Dodd. My name is Gary Amelio, and I am the Executive 
Director of the Federal Retirement Thrift Investment Board, an 
independent agency charged with administering the Thrift 
Savings Plan. I serve as the managing fiduciary of the TSP. 
Prior to my appointment on June 1, 2003, I had 23 years of 
private sector experience in the employee benefits industry. 
Although the Board has no expressed position regarding 
proposals to change Social Security, I am pleased to discuss 
TSP operations and investments.
    Since 1987, the TSP has grown to 3.4 million participants 
with a total of $157 billion in account balances. I often 
comment that Congress could not have provided a better 
structure when it created the TSP, fashioning the plan with the 
goal of providing retirement savings for Federal employees at 
low administrative costs, with a limited number of funds that 
track broad investment markets. This simplified structure has 
protected the plan from political manipulation and, 
consequently, enabled the TSP to gain the confidence of Federal 
employees and become the largest and, arguably, most successful 
defined contribution plan in the world.
    The TSP's participation rate significantly exceeds the 
industry average, primarily, I believe, because participants 
find the plan simple to grasp. The TSP participants also enjoy 
low administrative costs. Last year, expenses were just six 
basis points or 60 cents for every $1,000, which is rock-bottom 
in the industry. I like to say that the TSP is the most 
inexpensive legal investment in the world. It might also be the 
most inexpensive illegal investment, but we do not have any 
data.
    Through the years, the TSP and the Congress have worked 
together to improve the plan. The TSP recently modernized its 
recordkeeping system to accommodate daily valuation, and in the 
next couple of months, lifecycle funds will be available to 
provide professionally designed asset allocation models 
appropriate for participants' investment time horizons.
    Last year, Congress improved the plan by approving the 
Board's recommendation to eliminate open seasons. In 1986, the 
concept of allowing Federal employees to invest in a retirement 
savings plan, which included private securities, was untested. 
By mandating a sound and simple structure protected from 
political manipulation, Congress created a plan which passed 
the test, gained the confidence of Federal employees, and 
strengthened their retirement security.
    This concludes my summary comments, and I ask that my 
extensive written statement be entered into the record. I would 
be pleased to respond to any questions.
    Senator Hagel. Mr. Amelio, thank you. Each of your written 
statements will be included for the record, in their entirety.
    Mr. Enderle is Chief Investment Adviser, Barclays Global 
Investors.
    Mr. Enderle.

                  STATEMENT OF FRANCIS ENDERLE

         MANAGING DIRECTOR AND CHIEF INVESTMENT OFFICER

   GLOBAL INDEX AND MARKETS GROUP, BARCLAYS GLOBAL INVESTORS

    Mr. Enderle. Good afternoon, Mr. Chairman, Senator Dodd. My 
name is Francis Enderle, and I am the Chief Investment Officer 
for the Global Index and Markets Group at Barclays Global 
Investors, or BGI. In that role I am responsible for, among 
other things, the oversight of portfolio management in the 
United States of all of BGI's index strategies.
    We are pleased to be here today to share with the 
Subcommittee our expertise in the management of defined 
contribution pension accounts, which is derived from our 
experience as the external asset manager for the Federal Thrift 
Savings Plan, or the TSP, as well as for other numerous public 
and private pension plans. We are honored to have served as an 
investment manager for the TSP since 1988, a relationship we 
have retained in regular, highly competitive bidding processes.
    Since our founding in 1971, BGI has remained true to a 
single global investment philosophy, which we call ``Total 
Performance Management.'' BGI manages performance through the 
core disciplines of risk, return, and cost management. The 
success of our indexing methodology results from our focus on 
delivering superior investment results over time while 
minimizing trading and other implementation costs and 
rigorously controlling investment and operational risks.
    BGI manages four of the five investment options available 
for TSP participants: The C, S, F, and I funds. The fifth 
option, the G Fund, is managed by the U.S. Treasury. Later this 
year, the TSP will be launching a series of lifecycle or 
``target horizon'' funds that use the existing five options as 
the asset class building blocks with allocations in each 
lifecycle fund across these options being determined by an 
external vendor.
    BGI's services to the TSP are completely focused on our 
core expertise--investment management. We do not provide any 
other services. We have an extremely effective operating model 
developed in conjunction with TSP staff to manage the daily 
cashflows into or out of each of the investment options.
    The key to BGI's success in index management has been our 
ability to minimize implementation and trading costs. High 
costs and expenses of investing detract from performance and 
investment returns; lower costs increase the investment pool 
and put more money long-term into the pockets of investors. Let 
me say a few words about how we do this.
    Each of our index funds is structured to match the 
performance of a specific third-party-designed index. These 
indexes are really paper portfolios and do not include any of 
the trading costs that real-world investors experience. To 
successfully track the index as closely as possible, BGI 
strives to minimize the real-world costs through a variety of 
highly efficient trading approaches.
    The average account size for our U.S. clients is $880 
million. Through the size and diversity of our client base, we 
are able to match or offset a significant percentage of many of 
our clients' buy and sell orders internally, thereby reducing 
or eliminating market transaction costs. The internal matching 
of buy and sell orders is commonly referred to as ``crossing'' 
and is conducted and actively monitored by BGI pursuant to the 
terms and conditions of an exemption issued by the Department 
of Labor.
    When we do trade in the markets, we utilize carefully 
developed and managed trading strategies. We access all 
possible sources of liquidity, including electronic 
marketplaces. And we ensure that we receive superior execution.
    Indexing is the most cost-efficient and diversified way to 
gain exposure to various segments of the capital markets. We 
believe index funds are the best core investment for most 
investors' portfolios, whether they are the largest pension 
fund in the world or an individual investor.
    I would now like to make a few comments regarding the 
investment-related issues to be considered if the Federal 
Government were to legislate individual investment accounts 
either as part of Social Security reform or through another 
mechanism.
    Let me first acknowledge that BGI has built a substantial 
part of its business by offering well-managed index strategies 
to our clients for more than 30 years. We, therefore, have a 
vested interest in the continued growth of index investing. Our 
interests aside, we firmly believe that the reason for the 
success of these strategies is the simple fact that they 
deliver the return of the market index reliably and cost 
effectively. In fact, Congress recognized this itself in the 
enabling legislation for the TSP.
    If a national system of personal accounts were to be 
implemented, we would encourage legislators to consider the 
following approach that draws on the best practices of 
institutional investors.
    An array of low-cost, broadly diversified index funds 
frequently forms the core investment for institutional pension 
plans. For example, the current selection offered to TSP 
participants covers all the main asset classes, large and small 
capitalization U.S. equities, U.S. fixed income, international 
equities, and a stable value option.
    We suggest consideration of index portfolios because they 
offer three principal benefits to investors: First, they 
capture the return of each asset class with a high degree of 
precision; second, index funds typically have low asset 
management fees compared to actively managed funds; and, third, 
index funds have lower relative transaction costs including 
communications, bid/ask spreads, and market impact.
    The latter point is worth elaborating upon given the 
sizable assets that would potentially be invested in personal 
accounts. Investing in index funds spreads assets across the 
broadest possible array of securities in any asset class, 
thereby minimizing the impact of trading large cashflows in the 
market on a daily basis. This is not only important for the 
investment of new monies into personal accounts, but also for 
any trading individuals may initiated in their personal 
accounts to reallocate assets among their investment options 
over time.
    Another investment option to be considered is an array of 
so-called lifecycle or ``target horizon'' funds, options that 
the TSP will be adding later this year, as I mentioned earlier. 
With lifecycle funds, potentially the only choice an investor 
needs to make is to select the lifecycle fund with the target 
horizon date that most closely matches the investor's date of 
retirement. Each lifecycle fund would hold an array of asset 
classes with each asset class being implemented with an index 
fund. The asset mix within each lifecycle fund would gradually 
become more conservative over time as the target horizon date 
approached.
    Mr. Chairman, we believe that the investment considerations 
we have discussed will assist you and others on this Committee 
in evaluating the criteria to be used if personal accounts were 
to be legislated by Congress as part of revisions to the Social 
Security program or in another program. I thank you for the 
opportunity to speak with you today, and I look forward to 
answering any questions you may have.
    Senator Hagel. Mr. Enderle, thank you.
    Now we would ask Mr. Francis Cavanaugh to present his 
testimony. Mr. Cavanaugh is a Consultant for Public Finance 
Consulting and former Executive Director of the Federal 
Retirement Thrift Investment Board.
    Mr. Cavanaugh.

               STATEMENT OF FRANCIS X. CAVANAUGH

  FORMER DIRECTOR, FEDERAL RETIREMENT THRIFT INVESTMENT BOARD

    Mr. Cavanaugh. Thank you, Mr. Chairman and Members of the 
Committee, I welcome this opportunity to discuss the role of 
financial markets in Social Security reform. The 
Administration's current proposal for Social Security 
individual accounts contemplates that private financial 
institutions would provide fund management services and 
probably other 401(k) plan services, such as investment 
education, counseling, and recordkeeping. My comments will 
focus on the cost of such services and the problems in 
providing them to employees of small businesses.
    A critical question, of course, is cost. Individual 
accounts are proposed to provide a higher investment return 
than would be realized by the Social Security trust fund. On 
this basis, individual accounts would not be feasible for the 
68 million employees of 98 percent of the businesses in the 
United States--that is, the 5.6 million small businesses with 
fewer than 100 employees.
    To understand the costs of individual accounts of small 
businesses, we must first understand why 85 percent of them do 
not now have retirement plans for their employees. A major 
reason is that the 401(k) industry has found that it cannot 
profitably provide services for a company for less than 
approximately $3,000 a year, even though they enjoy economies 
of scale from combining thousands of employers in their 
centralized computer systems. Further significant economies of 
scale would not be realized by a central Federal Thrift Savings 
Plan-type agency because of the fixed costs of reaching out to 
millions of small businesses. Nor can we assume that a new 
central Government agency would be more efficient than the 
major 401(k) providers who now serve this market.
    Thus, the cost per employee of a company with 10 employees 
would be $300, or 30 percent of the President's proposed annual 
individual account contribution of $1,000, and most U.S. 
companies have fewer than 10 employees.
    Accordingly, the initial expense ratio for employees of the 
average size business would be more than 3,000 basis points, or 
100 times the Administration's estimate of 30 basis points. 
Obviously, since the administrative costs of individual 
accounts would exceed their estimated investment returns, 
substantial Government subsidies would be necessary to make 
individual accounts attractive to employees of small business.
    If all Social Security taxpayers eventually participate in 
the individual account program, you would find that the 
administrative costs would be more than $46 billion a year--
that is, 155 million Social Security taxpayers times more than 
$300 per account--which would be a subsidy to support an 
uneconomic function.
    In addition to the above costs, which are based on what the 
current providers are actually charging for establishing and 
servicing 401(k) plans, there are overwhelming practical 
obstacles to modeling individual accounts on the TSP or private 
401(k) plans.
    First, the TSP is administered by just one employer--the 
U.S. Government--with an extensive network of agency personnel, 
payroll, and systems staff to provide the essential employee 
education, retirement counseling, payroll deductions, timely 
funds transfers, and error correction functions. These 
essential employer services in 401(k) plans could not possibly 
be performed by small business employers or by a new TSP 
central agency.
    Second, the TSP is computerized, like all other large 
plans, with investments made promptly after contributions are 
deducted from the employee's paycheck. With individual 
accounts, it would be up to 22 months after payday under 
current Social Security Administration procedures before 
individual accounts could be credited and invested.
    Third, the TSP is balanced to the penny every day. Social 
Security is never balanced. Each year there are billions of 
dollars unreconciled discrepancies.
    Fourth, the TSP and the Federal employee agencies have a 
very effective system of communication. TSP mailings 
consistently have reached more than 99 percent of employees, 
but 25 percent of Social Security Administration mailings are 
returned and marked as undeliverable.
    Since individual accounts are certainly not feasible for 
employees of small business, the only practical way to give 
them higher returns is to invest part of the Social Security 
trust fund in equities. The likely increase in trust fund 
earnings would be an effective way to help maintain the 
solvency of the trust fund. Every State in the United States 
has authorized public retirement fund investment in stocks, 
which can now be done through broad-based index funds, which 
avoid the problem of direct Government control over particular 
companies. As shown in my prepared statement, there is even 
less Government influence over private companies under the 
trust fund alternative than under the TSP or the 
Administration's plan.
    In conclusion, the Administration's plan for universal 
individual accounts is not feasible. The way for the Social 
Security system to capture the higher returns available for 
investments in stocks is to diversify Social Security trust 
fund investments. The trust fund alternative compared to 
individual accounts would be less disruptive of financial 
markets, would save tens of billions of dollars a year in 
administrative costs, and would be effective virtually 
immediately rather than the 2009 starting date proposed for 
individual accounts. The multitrillion-dollar transition costs 
of individual accounts would be avoided completely. The 
additional trust fund earnings would go a long way toward 
strengthening Social Security finances and would thus reduce if 
not eliminate the need for significant tax increases or benefit 
reductions.
    Thank you for your attention. I will be happy to answer any 
questions.
    Senator Hagel. Mr. Cavanaugh, thank you.
    Mr. Mike Tanner, the Director of the Project on Social 
Security Choice, the Cato Institute, an old friend of Senator 
Dodd's.
    [Laughter.]
    Mr. Tanner, welcome.

                  STATEMENT OF MICHAEL TANNER

        DIRECTOR, CATO PROJECT ON SOCIAL SECURITY CHOICE

    Mr. Tanner. Thank you, Mr. Chairman and Members of the 
Subcommittee, it is a pleasure to be back before the 
subcommittee again, and in particular, Mr. Chairman, I would 
like to thank you for holding this hearing. I think it is very 
important that we move beyond the sterile debate that we have 
been having about whether or not Social Security is facing a 
crisis or just a big problem and start discussing actual 
solutions to the problems that Social Security is facing. That 
includes a discussion of how individual accounts might be 
structured in ways that can maximize consumer choice and 
control while ensuring efficiency, low cost, and preserving an 
appropriate measure of worker protection.
    Of course, along with my colleagues at the Cato Institute, 
I believe that Social Security reform must allow younger 
workers to save and invest some of their Social Security taxes 
through personal accounts. Such accounts can significantly 
contribute to restoring Social Security to permanent 
sustainable solvency. But, more important, I believe that 
personal accounts are essential to modernizing Social Security 
in keeping with such fundamental American values as ownership, 
inheritability, and choice.
    Now, regarding the subject of this hearing, I think, in 
general, economic theory holds that private capital investment 
should provide a higher rate of return than a mature PAYGO 
Social Security system can provide. I believe that while there 
are distribution questions and certainly other issues that must 
be addressed, the returns from personal accounts privately 
invested will exceed the returns that Social Security will 
provide in the future to younger workers, including exceeding 
any offset interest rates such as those suggested under the 
President's reform proposal.
    That said, how personal accounts are structured and the 
investment options available to workers can make a significant 
difference in the success of any personal account proposal. In 
short, details matter.
    In designing an investment and administrative structure for 
personal accounts, I would urge Congress to be guided by these 
basic concerns.
    First, simplicity and transparency. Workers should clearly 
understand where their money is going and what their options 
are. Where personal account plans have encountered 
difficulties, such as in Great Britain, it has been primarily 
due to overly opaque or overly complex schemes.
    Second, balancing risk and return. While market returns, as 
I say, are expected to exceed Social Security returns, markets 
are not risk free. Of course, I would also note that the 
current Social Security system is not risk free. However, many 
of the new investors brought into the market through personal 
accounts will be inexperienced. Bringing these new investors 
into the marketplace is a good thing, but we should recognize 
that they will not be sophisticated investors. A personal 
account investment plan must offer these individuals some 
degree of protection without stifling consumer choice, 
overregulating markets, or unduly restricting the potential for 
positive returns.
    Third, keep administrative costs low. While regulation of 
account fees would be unwise, accounts should be designed in 
ways that minimize administrative costs. The Social Security 
Administration estimates that accounts would cost 25 to 30 
basis points to administer, and I believe this is an entirely 
reasonable target.
    Fourth, limit Government involvement in investment 
decisions. Decisions about the investment of the accumulating 
retirement funds should be left to private markets and 
insulated from Government interference as much as possible. And 
I note that Government interference takes place to a high 
degree with State, county, and municipal pension funds.
    Finally, avoid increased employer burden. Every effort 
should be made to avoid any new burden on employers, 
particularly small employers.
    In my written testimony I have spelled out one possible 
structure for meeting these goals. That proposal involves a 
centralized colleague point, essentially the current payroll 
tax collection mechanism. Treasury would be responsible for 
holding the funds until reconciliation takes place with the 
funds being held in a money market account on a unitized dollar 
basis.
    Once reconciliation takes place, Treasury would 
electronically transfer the funds to the worker's account. 
Initially, a small range of broadly diversified funds would be 
the only investment options available, something perhaps 
similar to the TSP, perhaps a series of balanced funds, perhaps 
a lifecycle fund, the type of options that have been discussed 
and are included in many of the proposals up here, including 
the Chairman's and Senator Sununu's. However, at some point--
and I think this is essential--a broader range of investment 
choices should be opened up to individual investors.
    Let me conclude by saying that I believe that Social 
Security reform is not an option but a necessity. The program 
will begin running a deficit in just 12 years and faces 
unfunded obligations of roughly $12.8 trillion in the future. 
The need for reform, however, presents us with an opportunity 
to create a new and better retirement program for all 
Americans, a program that gives workers ownership over their 
retirement funds, more choice and control over their money, and 
the opportunity to build a nest egg of real inheritable wealth. 
Therefore, any Social Security reform should include personal 
accounts.
    That makes the work of this Committee all the more 
important: Getting the design and the structure of the accounts 
right. I believe that the structure I have set out today takes 
us in that direction, and I look forward to the Committee's 
questions.
    Thank you very much.
    Senator Hagel. Mr. Tanner, thank you.
    Mr. David John, Research Fellow, the Heritage Foundation.
    Mr. John, welcome.

                   STATEMENT OF DAVID C. JOHN

 RESEARCH FELLOW, THOMAS A. ROE INSTITUTE FOR ECONOMIC POLICY 
                STUDIES, THE HERITAGE FOUNDATION

    Mr. John. Thank you very much for having me, and thank you 
for looking into this issue. This is going to be one of the key 
issues not just in the Social Security debate but in the 
overall retirement security debate. I have a 19-year-old 
daughter who just finished her first year of nursing school, 
and the simple fact is that when Meredith retires, Social 
Security is not going to be able to replace the same amount of 
her income as it does for her parents or as it will for me. 
Meredith, no matter what, is going to have to save and invest 
from day one when she first gets a job in order to come up with 
a decent retirement income.
    Now, we have a very effective and efficient private 
retirement system--401(k)'s, IRA's, et cetera, et cetera. And 
it is fairly simple for Meredith to save if she has a 401(k) 
and works in a large hospital. But if she is a private-duty 
nurse or if she is working essentially for herself, she is 
likely to have no choice in the slightest because obviously she 
cannot sponsor her own 401(k) plan for, frankly, reasons that 
Mr. Cavanaugh mentioned. So a TSP structure not only could 
apply to a Social Security account, but it also could be used 
in terms of expanding the opportunities of ordinary Americans 
to save for retirement.
    Now, having said that, let me suggest that the TSP 
structure is especially useful for a Social Security account. 
It is vastly different from the 401(k) structure that we see in 
private business for the simple fact that it is administered 
through the tax system. The individual business owner has no 
participation in this. The individual business owner would 
provide or forward the payroll taxes and income taxes of their 
workers to Treasury, just as they do now, and at that point 
their responsibility ends. They have no additional costs. They 
have no additional participation. It is once the money reaches 
Treasury that it is then subdivided and moved into a personal 
retirement account, and there are mechanisms to do that 
efficiently, and, frankly, that can be done as easily on an 
annual basis as it would be on a weekly, a monthly, or a yearly 
basis.
    Now, Social Security accounts should start slowly, with 
limited investment options. This is the way TSP started. 
Initially, there was only the G Fund, and the other investment 
options were added at a later date. The last two investment 
options are relatively recent. A study by State Street Trust, 
which is one of the major pension administrators in the 
country, looking at a system which, by coincidence, happens to 
be the one that most Social Security reformers are talking 
about, found that the costs could be somewhere between 0.19 
percent of assets under management and 0.35 percent of assets 
under management.
    Now, what that basically is a very tiny amount, one-third 
of 1 percent at the most. Unfortunately, there is no way of 
comparing the costs of a 401(k) system or the TSP system to 
today's Social Security because when it comes right down to it, 
today's Social Security does not have a trust fund of the type 
that traditional pension plans have, nor are Social Security 
benefits paid out of that trust fund. They are basically paid 
on a pay-as-you-go basis. So it is impossible to compare apples 
and oranges in this situation.
    But what we can say is that a TSP account would be the 
lowest-cost opportunity for an individual worker to build 
retirement savings. The best way to do that also would be 
through a lifespan account--they are alternately called 
lifespan, lifestyle; ``life'' is the key element there--which 
automatically rebalances the investments starting out with a 
more aggressive investment structure when an individual is very 
young and moving to a much more conservative structure by the 
time the individual reaches retirement age.
    There are 55 companies that currently offer lifespan 
accounts as part of their 401(k) plans. The initial estimates 
show that having a lifespan account actually can increase the 
amount of retirement savings that an average worker could have, 
including the lower-income workers, by roughly one-eighth. They 
do not have to be expensive. Vanguard has an investment in 
passively traded index funds, similar to the ones that were 
discussed earlier here, and their annual cost is 0.23 percent, 
roughly one-quarter of 1 percent of assets under management.
    This is not a theoretical question. This is not a question 
of millions, billions, and trillions. This affects real people. 
My daughter is 19 at the moment. She will retire roughly 10 
years after the Social Security trust fund disappears. Under 
current law, that means she stands a 30-percent benefit cut in 
her Social Security benefits. If we structure soon a retirement 
investment plan similar to the TSP system that she could 
participate in from day one when she goes to work, she could 
end up with significantly higher Social Security benefits than 
what she would face right now. In 2040, when Meredith is 56, 
under current law the Social Security system--and there will be 
trust funds at that point--will take 15 cents on every dollar 
of income tax that is collected in that year. Fifty cents of 
every dollar collected in income tax that year goes to 
Medicare.
    Now, unless action is done quickly on Social Security, 
Meredith basically faces a choice of funding programs for her 
kids and her grandkids or for her parents and grandparents. 
That is not a situation she needs to be in.
    Action is needed quickly, and practical action that 
actually gives her a decent chance to a secure retirement 
system.
    Thank you.
    Senator Hagel. Mr. John, thank you very much.
    Mr. Jason Furman, Adjunct Professor, Wagner Graduate School 
of Public Service, New York University.
    Mr. Furman.

                   STATEMENT OF JASON FURMAN

        NON-RESIDENT SENIOR FELLOW, CENTER ON BUDGET AND

            POLICY PRIORITIES AND VISITING SCHOLAR,

           WAGNER GRADUATE SCHOOL OF PUBLIC SERVICE,

                      NEW YORK UNIVERSITY

    Mr. Furman. Mr. Chairman, Members of the Committee, thank 
you for the opportunity to address the Subcommittee. In 
considering reforms that would dramatically change the nature 
of Social Security, it is critical to consider how individual 
accounts would be administered through the financial system and 
how markets would react to the borrowing necessary to finance 
accounts.
    In my comments today, I would like to focus on four points: 
The administrative costs associated with accounts; the 
Government staffing required for those accounts; what this 
would do to the rate of return that average Americans could 
expect through Social Security; and the impact of large-scale 
borrowing on financial markets.
    First, administrative costs in a private account system 
would be at least 10 times as large as the costs under the 
current system. In some proposals, administrative costs could 
eat up more than one-third of final account balances. Even the 
sharpest critics of our current system admit that Social 
Security is extremely efficient. Establishing over 100 million 
individual accounts for Social Security contributors would 
entail substantial new complexities and tasks, including 
tracking contributions, allocating them to different 
investments, managing assets, and distributing balances at 
retirement. All of these new tasks would be in addition to 
everything Social Security does today.
    The President's account proposal controls administrative 
costs by limiting choice and services to a bare minimum, 
including establish centralized Government management of the 
accounts. According to the Social Security actuaries, even this 
barebones system would cost 10 times more to administer than 
the current Social Security system. Accumulated over 40 years, 
0.3 percent annual sounds very low, but if you accumulate it 
over 40 years, it will eat up 7 percent of your ultimate 
account balance because that first contribution you pay 30 
cents on it year after year. That is compared to 0.6 percent 
under the traditional Social Security system, and these 
estimates do not even include the cost of starting up accounts, 
partially annuitizing account balances at retirement, and many 
of the considerations that Mr. Cavanaugh raised in his 
testimony.
    Even if an individual account plan initially offered only a 
few funds, it is likely that political pressure would expand 
the options over time, as recommended by the President's Social 
Security Commission and Mr. Tanner and Mr. John at this 
hearing. Participants might demand more options for managing 
their money, and some might object to being required to invest 
in a Government-designated allocation of stocks, which includes 
companies that, for example, are perceived to harm the 
environment or support gay rights. If investment choices were 
widened even slightly to address these concerns, costs could 
double to about 15 percent of the final account balance.
    If the President's Government-organized accounts approach 
is rejected and privately organized accounts, like existing 
IRA's, are established instead, costs would be even higher. In 
the United Kingdom, for example, administrative costs were 
eating up a staggering 43 percent of the final account value at 
retirement before caps on fees were recently instituted.
    My second point: Establishing accounts would require a 
substantial increase in Government staffing, likely in the form 
of a new Government agency that could be about half the size of 
the IRS or the Social Security Administration. The Clinton 
Administration Treasury Department found that tens of thousands 
of new Government workers would be needed to answer phone 
inquiries and process worker choices of fund managers in a 
barebones system. With even slightly expanded choice along the 
lines of what we have heard advocated today, that number could 
triple.
    By the end of the first decade of President Bush's 
proposal, administrative costs would be running at about $4.4 
billion annually, according to the optimistic estimates of the 
Social Security actuaries, enough to support about 30,000 new 
Government employees in addition to other expenses. By 
comparison, currently SSA has a total staff of about 65,000 and 
the IRS has a staff of about 100,000.
    My third point: When administrative costs are considered, 
returns from many participants under a private account system 
would be lower than in a reformed system without accounts. 
Additional administrative costs associated with individual 
accounts are certain. Potential gains from accounts, however, 
are uncertain. The President's proposal allows workers to, in 
effect, borrow money at the Treasury bond rate and invest it in 
a restricted range of funds. At the end of the day, the worker 
would have to pay the large administrative costs of managing 
this awkward system. Far superior for most workers would be 
simply to, if they want to increase their exposure to risk, 
reallocate their portfolio, and if they have no exposure to 
risk, to do some of the measures that Senator Dodd was talking 
about to encourage more investment without replacing part of 
the very efficient Social Security system with a substantially 
less efficient system.
    The administrative costs for the average worker would be 
substantial, reducing annual benefits anywhere from $700 a year 
to $4,000 a year. That is on top of all the other benefit 
reductions the President is proposing. As a result, the Social 
Security system would have a lower rate of return for a large 
fraction of workers than a system without accounts.
    Fourth, the increase in the debt associated with 
establishing private accounts would increase the risks facing 
financial markets and fiscal policies. Carveout accounts and 
add-on accounts that are not paid for both result in 
substantial increases in the debt. In the President's plan, the 
debt would go up by $5 trillion over the first 20 years. 
Economist Martin Feldstein advised President Reagan not to 
establish individual accounts, in part because, ``to fund 
investment-based accounts would have required a tax increase or 
an even larger overall budget deficit.'' According to Harvey 
Rosen, who just last week stepped down as Chairman of President 
Bush's Council of Economic Advisers, diverting funds into 
private accounts would either drive interest rates up, stock 
returns down, or some combination of both.
    Private accounts could create more difficulties for 
beneficiaries in markets than I have time to document. Instead 
of proceeding down that road, we can instead modify the current 
system to make it sustainably solvent and help make it easier 
and more automatic to save through existing IRA's and 401(k)'s 
without incurring the costs and risks associated with replacing 
Social Security with accounts.
    I look forward to the opportunity to discuss this and other 
questions with you. Thank you.
    Senator Hagel. Mr. Furman, thank you.
    Since there are three of us here at this point, I would ask 
Senator Dodd if we would do an 8- to 10-minute round, each of 
us. Is that acceptable? Then we will keep cycling. I suspect we 
may have some other colleagues as well. So we will start with 
8-minute rounds of questioning. Thank you.
    Mr. Amelio, in your testimony, and in the testimony of each 
of you, you have touched upon a fee structure and fees and the 
relevancy of that challenge, which I think we all agree is a 
big part of any kind of personal account structure. And you had 
noted, I believe, Mr. Amelio, that it was six basis points, 60 
cents per $1,000, essentially the standard that we have now--or 
you have come up with, and, in fact, is the real number for 
TSP.
    My question is this: What rules or procedures has TSP 
implemented to foster responsible fiduciary management and 
accountability in relationship to those fees and other parts of 
the structure that your colleagues and you have touched upon in 
your testimony?
    Mr. Amelio. They are 6 basis points and they are coming 
down. We anticipate they will possibly be 5 basis points this 
year. That comes to approximately $27 per participant. I think 
there are 4 reasons that our fees are able to be so low. One is 
the girth of the plan. We have a large amount of assets. That 
helps to keep the average of the cost sized down. Two, we use 
only index funds which are the least expensive investment model 
that I think any fiduciary could select for an institution 
plan. Three, although it is a daily plan where participants are 
allowed to move their money daily, go onto a website and see 
their balances, it is a simple plan and that I am very proud 
of. We have only 5 investment options, and even when you add 
the lifecycle funds they are not funds with a capital ``F,'' 
they are asset allocation strategies and it is that simplicity 
that also helps us to maintain low cost. Fourth is self-
administration. We are large enough that we are able to 
administer everything in house. They noted the Social Security 
Administration has 65,000 employees. When I came 3 years ago, 
we had 108 employees at the TSP. We are down to 89 now. We do 
have outside contractors of a couple hundred. Through good 
management, we have an independent board, and I think for those 
four reasons we are able to maintain the low cost that we have.
    Senator Hagel. I am going to ask in a moment Mr. Cavanaugh, 
and Mr. Furman especially, to respond to this issue because 
they both touched upon it and I think have some different 
judgments on what it would take to put 100 million or 200 
million accounts online.
    But what I want to do is take what you have just said now 
and have you respond to this question. Obviously, with a Social 
Security account structure we are talking about far more 
accounts, and as you have heard the testimony of your 
colleagues, specifically Mr. Cavanaugh and Mr. Furman, who 
touched upon the kind of administrative costs and 
infrastructure that would be required. It has been mentioned in 
a couple of the testimonies here, telephone answerers, 
handlers, taking inquiries. Relate their testimony and some of 
their observations and judgments to what you are doing now, and 
then in your mind, what would it take to put 100 million 
accounts online?
    Mr. Amelio. I need to couch my answers within the confines 
of the TSP. I have been advised by our counsel I cannot make 
any direct comments about a Social Security proposal. So, I 
hope you understand that.
    Senator Hagel. Let me make it easier for you and your 
attorneys. Let us just take Social Security out of it. What 
would it be, 100 million accounts? And let us just take Social 
Security out of it so that there is no liability for you. We do 
not want that.
    Mr. Amelio. Certainly, I understand, and I am not trying to 
be evasive.
    Senator Hagel. I understand.
    Mr. Amelio. We started out about 3 years ago with 200 
telephone operators. We have 2.4 million participants. We are 
taking that number down probably to about 120 to 140 telephone 
operators. The reason we did that, most of our calls are 
administrative in nature, dealing with participant loans, and 
we toughen the standards for participants to take loans, and so 
therefore we were able to cut down.
    If you are talking about expanding the participant base it 
might look more like private sector plans where the calls are 
more investment related. Very few of the calls we get right now 
are investment related about the funds. As you get more 
investment related, you not only increase the volume of the 
calls, but you also increase the length of the call from about 
3 minutes on average to 6 minutes, and it necessitates in an 
arithmetic calculation all the more operators you need. I would 
have to sit down and run the numbers to see how many operators 
we would have to add. If we added another 80 million 
participants to our plan, I assume it would be a large number.
    Senator Hagel. Let me ask you this, you heard again what 
Mr. Cavanaugh and Mr. Furman said, and their numbers are pretty 
difficult to digest here as far as the reality of if we are 
really talking about seriously putting in place 100 million 
accounts, and some of the questions and the numbers that they 
have brought out. Do you disagree with those numbers? Do you 
disagree with those observations or judgments? Is this possible 
that we could put online 100 million accounts, and using TSP as 
some kind of a general model?
    Mr. Amelio. You may have apples and oranges. If you are 
talking about adding another 100 million participants to the 
plan you have to look at each of the functions. For example--
and we have not really done the demographic study so I want to 
be careful here--you have several different segments. The 
easiest segment might be adding the participant account for 
recordkeeping itself. We have a huge computer and the IT people 
would work on it, but perhaps you could actually keep track of 
it.
    If you go to the separate issue of adding telephone 
operators, I think that becomes more complex because you are 
talking about a large number of people, time zones, et cetera.
    Where it gets even more complex is the collection of the 
contributions. Right now we have 130 payroll offices in the 
Federal Government. They are all computerized and they remit to 
us. On a daily basis we are getting payroll transactions. If 
you were adding 100 million people, it would not change as long 
as they were still in those 130 payroll offices, but if they 
had different payroll offices, paper submissions, it would make 
it a lot more complicated.
    Senator Hagel. Thank you.
    Mr. Enderle, would you respond to that question since you 
manage the current accounts now?
    Mr. Enderle. I think the key issues, as I think about 100 
million accounts, can be split into two components. One is what 
Mr. Amelio just responded to as it pertains to the 
administration of those accounts. The second has to do with the 
actual asset management of those accounts. I think the key 
issues that we would need to think about has to do with whether 
or not the assets across all those accounts would be aggregated 
in some fashion, so that the number of accounts any money 
manager would manage would be limited.
    So in the case of the current arrangement we have with the 
TSP we are currently managing four accounts on behalf of 3.4 or 
3.5 million participants, and that type of arrangement is very 
leveraging and scaleable.
    I think the key issues are how many fund options would be 
available and what the asset size would be for each account.
    Senator Hagel. Does that include the fee structure too that 
we were talking about earlier?
    Mr. Enderle. I think the fee structure--I am not in a 
position to comment on the fees as it pertains to the costs 
associated with administering all the accounts, but more in 
respect to the fees that would be applicable to the asset 
management side of those assets.
    Senator Hagel. Thank you. My time is up.
    Senator Dodd.
    Senator Dodd. Let us just pick up on that, because I think 
that is the point. You are talking about four basic accounts. 
It is a number of people but we have really limited choices 
under TSP, whereas what we are talking about here in individual 
accounts, the choices are far broader than what are offered 
under TSP. Is that not correct, Mr. Amelio?
    Mr. Amelio. The number of choices for what, Senator?
    Senator Dodd. Under the individual accounts that we are 
talking about here being proposed under the Social Security 
reforms?
    Mr. Amelio. I am not sure which proposal you are talking 
about.
    Senator Dodd. Let me ask Mr. Cavanaugh and Mr. Furman. We 
are talking about going from 3\1/2\ million to 100 million 
accounts, the Chairman's question, and that is a legitimate 
issue. But if you are dealing with limited choices there, then 
it is a numerical factor in terms of--where you add the element 
of broader choices that we are talking about here where they 
have a diversity of the asset management issues that Mr. 
Enderle talked about. Then you are adding an element here that 
I think goes to some of the cost issues. Maybe Mr. Cavanaugh 
and Mr. Furman would like to respond to the question that the 
Chairman asked to Mr. Amelio, and how you would respond to that 
question.
    Mr. Cavanaugh. I think the problem is not the 100 million 
accounts. The problem is, whereas the TSP is one employer, the 
U.S. Government, when you are talking about individual 
accounts, you are talking about 5.6 million employers and small 
businesses. You have to deal with each one of them. Part of the 
reason why the TSP administrative expense ratio is so low, 6 
basis points, is because you have just one employer, and you 
have a contained environment. They are Federal employees, they 
are already there. When I started the plan, the first thing I 
did was to announce to everybody that, hey, I am a wholesaler. 
You Federal agencies out there in the field, you are doing the 
retail. They had the personnel structure. They had the payroll 
structure. They had the systems, electronics, and everything to 
do it.
    And you, in your statute, when you created the Thrift 
Savings Plan, you instructed the Office of Personnel Management 
to train trainers in all of these Federal agencies so they 
could go back and teach all of the employees all about this 
plan. So we wholesaled and we had very low costs. And the 
agencies were already in place and there was no problem. That 
is essentially why, from my experience in setting the thing up, 
costs were so low, and they continue low. I think that is 
wonderful, and the agencies have wonderfully cooperated.
    All 401(k) plans, including TSP, are employer-sponsored, 
employer-maintained, employers have the fiduciary 
responsibility. You cannot expect that of 5.6 million small 
businesses, barbershops and so on. They just cannot handle it, 
and no one is suggesting that they do. So who is going to do 
the retail? That is the critical question. It cannot be done by 
a new TSP-type central agency in Washington. It cannot be done 
by the employers, who now do all the 401(k) plans.
    It would have to be done by the financial market, by the 
401(k) providers that are now doing it for many companies. But 
the 401(k) providers, if you go on their websites, they tell 
you that if you have less than 10 employees, forget about it. 
There would not be enough employees to spread the cost over. 
And 60 percent of American businesses have less than 5, so it 
is just not doable. It is entirely different from the TSP which 
has nothing to do with it.
    Senator Dodd. One of the suggestions you make in your 
testimony that I think is not a bad one, as the Chairman goes 
forward with this, is to ask people like Citigroup and Fidelity 
Investments, Merrill Lynch, State Street Corporation, T. Rowe 
Price and others to testify because they are managing these 
things and you can get a pretty good read as to how have their 
401(k)'s. In your testimony, you said they found that they 
cannot profitably provide these services for a company for less 
than approximately $3,000 a year even though we have for year 
enjoyed economies of scale from serving thousands of employers 
and their centralized company systems, but it would be 
interesting to hear what they have to say in all of that.
    Let me go back to another issue, and Mr. Furman, you may 
want to come back and address this in a minute, but let me 
raise another issue if I can about the administrative costs. 
This is a big point here, and I appreciate you raising it here. 
Several of the witnesses obviously have talked about it. Mr. 
Cavanaugh in your testimony you go to great lengths to detail 
the administrative problems in the proposals of private 
accounts, specifically discuss the problem of timing, of 
placing contributions into private accounts, stating 
``Individual Social Security taxpayers are identified only once 
each year with their employer's annual income tax filings, and 
it would be up to 22 months after payday under the Social 
Security Administration proposal before the individual accounts 
could be credited,'' which pose obviously some issues.
    Mr. Tanner--and if my reading is incorrect in this, Mr. 
Tanner, since we are old friends here, you correct me if--you 
generally dismiss these concerns as I read your testimony, and 
I quote you here in your testimony. You say that the collection 
of payroll taxes, including individual account contributions 
would continue to be handled by the employer in much the same 
way as today and sent to the Treasury as they are today.
    How do you respond to each other? It seems to me he has 
raised a very serious issue, you dismiss it as being not 
terribly relevant.
    Mr. Tanner. I actually agree with his statement. I believe 
in my written testimony I state exactly the same thing, that 
there is this problem that exists with the current Social 
Security system, that until after your W-2 is filed and they 
reconcile your W-2 with the contributions as sent in by the 
employer, they do not know how much you have paid.
    Senator Dodd. Right.
    Mr. Tanner. And that is why I have suggested that there be 
a centralized collection point that essentially holds that 
money until reconciliation takes place. I have suggested that 
the best way to do that is to hold it in a money market account 
on a unitized dollar basis until reconciliation takes place and 
the money can be transferred to your individual account. But 
there is this lag, and there is going to have to be some 
holding pattern.
    I think the centralized collection agency as well relieves 
the employer and all these small businesses of any 
responsibility for any administrative cost or anything other 
than what they do now, which is to pay in a lump sum to 
Treasury, which then assumes all the responsibility for the 
recordkeeping and the bookkeeping and so on.
    Senator Dodd. Who would hold that?
    Mr. Tanner. The Federal Government would hold it, would be 
the administrator of this fund.
    Senator Dodd. Let me jump to, because there is limited time 
here, disabled and survivors benefits. I think roughly around 
15 million of the 47 million beneficiaries of Social Security 
are either disabled or survivors, survivor benefits go to them. 
The President's proposal is to encourage, obviously, 
individuals to have private accounts, to which they contribute 
over their working lifetime. The question arises, in the case 
where a person's working lifetime had been cut short, either by 
worker's disability or death. According to the Social Security 
Administration over 8 million individuals received disability 
benefits in April of this year, and over 6.5 million received 
survivors benefits. What do these people do under the 
privatization plan? Mr. Tanner, what happens?
    Mr. Tanner. Under our proposal, which has been introduced 
in the House by Representatives Johnson and Flake, and under 
most of the proposals that are proposed here, and the 
President's, those benefits would remain unchanged and be 
continued to be paid out by the Social Security Administration 
with no changes of any kind to those proposed----
    Senator Dodd. And would the Aadministration still require 
the clawback tax of inflation plus 3 percent on those accounts?
    Mr. Tanner. Since we are old friends, just to correct you 
slightly on that, it is not a clawback, it is an offset, and 
the difference is that a clawback depends on how your account 
performs, and it penalizes you if your account performs well. 
An offset is a preset amount that you are simply giving up in 
exchange for your choice of moving into the private account. 
They have chosen 3 percent because they believe that is what 
Government bonds will be earning as a yield in the future. But 
it could be any number, and in fact, I would actually recommend 
a lower number than the 3 percent.
    Senator Dodd. Can I just ask. Mr. Furman, to make the 
comments on the earlier stuff and on this point as well?
    Mr. Furman. Yes, two points. One is that TSP only bears the 
costs of 6 basis points, but substantial other costs are borne 
by Government agencies which are the first point of contact for 
most people. As Federal employees, most of your interchanges 
about the TSP are with your own office managers. You would have 
to mandate that for small businesses, or you would have to pay 
that cost in some other way. That is just one of the many 
tradeoffs one would have to make if one were to set up 
accounts.
    In terms of survivors, I would have to differ from Mr. 
Tanner, to take Mr. Posen's proposal, for example. That reduces 
the benefit factors used to calculate benefits for retirees, 
survivors, and people with disability. It makes exactly the 
same percentage reduction for all three of those groups.
    The President has said that he would protect people with 
disabilities, at least prior to them reaching their 60's, at 
which point something else might happen, has not said he would 
protect survivors, and his chief economic adviser has confirmed 
that the same benefit reductions would indeed apply to 
survivors as apply to retirees.
    Senator Dodd. Thank you, Mr. Chairman.
    Senator Hagel. Senator Sununu.

              STATEMENT OF SENATOR JOHN E. SUNUNU

    Senator Sununu. Thank you, Mr. Chairman.
    With regard to the number of options available, I cannot 
speak to all the legislation that has been introduced, but let 
us be clear. A number of the proposals, the legislation that I 
have introduced, approach private accounts directly using the 
Thrift Savings Plan model specifically with the number of 
accounts offered. We could provide four or five accounts, but 
by limiting the number of accounts, as I do in our legislation, 
you achieve the scale factors that were talked about by Mr. 
Amelio and Mr. Enderle, and this is I think a much more 
manageable proposition, and a lot of the straw man approaches 
that had been thrown out by critics go away, and I do want to 
deal with a couple of those criticisms in detail.
    The idea that this is far too expensive for small 
businesses. Mr. Cavanaugh, by the arguments that you have put 
forward that small businesses will be overwhelmed by the 
financial burden of having to sit down with employers and 
determine what portion of their payroll tax will be allocated 
toward a personal account, sent to Washington, and at a central 
location be allocated into one of the narrow choices that were 
spoken of. By that rationale, the whole idea of electing to 
withhold taxes and determine what the withholding allotment 
should be for employers should also be financially 
overwhelming, too complicated, and a waste of time and 
resources for the IRS. But that is not the case, is it?
    Mr. Cavanaugh. I am afraid it is the case because, for 
example, last year the Social Security Administration took in 
$600 billion in taxes, and about $10 billion of those were 
never reconciled for individual accounts.
    Senator Sununu. I am talking about withholding taxes on 
personal income. Are you suggesting we should get rid of 
withholding because it is a waste of Government resources?
    Mr. Cavanaugh. No, what I am saying is that----
    Senator Sununu. If that is not inefficient and a waste of 
Government resources, then why would electing some withholding 
for a personal account in those same businesses that do 
personal income withholding now, why would that be burdensome 
and a waste of resources?
    Mr. Cavanaugh. That is the critical question. There is an 
enormous difference----
    Senator Sununu. That is why I am asking it.
    Mr. Cavanaugh. Right now, when the small companies do not 
send in the taxes in time--or we find $10 billion at the end of 
a couple of years that Social Security cannot reconcile because 
of errors on payment--it is not that critical to the Social 
Security beneficiaries because of the way SSA measures credits; 
it just does not affect them. But when you are talking about 
losing investment earnings, if the money is not in day to day 
or if it goes into the wrong fund when there is a big 
difference between, say, stock returns and bond returns.
    I am saying that the present system with the employer just 
paying these taxes is not a problem now for IRS or SSA the way 
they operate. It is unacceptable for an investment. You cannot 
have a financial institution with that low a standard in terms 
of accuracy, nonpayment. We have 650,000 businesses go out of 
business every year, and when they go out, quite often the 
payment of Social Security taxes is at the end of the line. 
They have to pay their people and they have to pay their 
contractors and so on. How are you going to deal with that?
    Senator Sununu. I think that the argument that you just 
made has nothing to do with the point you made earlier. What 
you are suggesting is a need for accurate accounting in the 
asset allocation, and I do not think anyone here would disagree 
with that, but that does not speak to the earlier claim you 
made that the financial burden would be overwhelming, and I do 
not accept that at all, because the best model we have for this 
allocation process at the employee level, at that small 
business level, is the election to withhold personal income 
taxes, which is a system that works, that is efficient. I do 
not disagree that we might like the accounting for that to be 
even better than it is, but to suggest that it is an unbearable 
financial burden simply is not borne out by the evidence.
    Mr. Amelio, I want to talk a little bit about lifecycle. I 
think it was mentioned by Mr. Enderle. Oftentimes, we hear 
critics of the idea of personal accounts use what I will 
describe crudely as the argument that Americans are not smart 
enough to handle the decision to set aside money into a 
personal retirement account, quite simply put. And that we are 
going to have people at or near retirement age, at the age of 
62 or 63 or 64 suddenly deciding that they want to put all of 
their life savings in a high tech stock. I do not believe that 
is the case.
    I think one of the things we can look to at Thrift Savings 
Plan is to try to understand how investors make decisions in 
allocating and whether or not they generally follow what would 
be called lifecycle investing, whereas as you get closer to 
retirement, do individuals tend to put their personal accounts, 
their personal savings in less volatile accounts like a 
Government bond fund or a municipal bond fund or the like, as 
opposed to an equity fund?
    What is TSP's history with that? Can you say anything about 
the tendency of your customers to pursue lifecycle investing 
with or without any regulations or mandates?
    Mr. Amelio. I can. I can throw statistics out like crazy. I 
brought lifecycle funds. It is my concept and I am very proud 
of that. The TSP participants are very much like any 401(k) 
plan participant. Nobody means to insult the American public if 
they say they are not bright enough or do not understand the 
investments. What happens is most people get frustrated. It is 
overwhelming. They do not have the time, the desire, et cetera. 
What they wind up doing, for example, when I came over, 50 
percent of our plan assets were invested in the G Fund. G Fund 
is a wonderful fund. It is simply far too conservative for you 
to have all of your plan assets in that.
    Senator Sununu. So you are suggesting that actually the 
inclination of the broad spectrum of Government employees--we 
are talking about 3\1/2\ million people; I am sure there are 
some that are more financially literate than others--their 
tendency is to be too conservative. Given a limited menu of 
options, four or five funds, they were actually investing in a 
way that is too conservative.
    Mr. Amelio. The largest group were too conservative, being 
100 percent invested in the G Fund. The next largest group has 
what we call the barbell approach. They are putting half of 
their account in the G and the other half in the highest risk, 
and nothing in the middle. They are off of what investment 
professionals--Mr. Enderle could describe this better than I 
could--as the efficient frontier. They are either assuming too 
much risk for their yield, or they are not getting enough yield 
for the risk that they have.
    These lifecycle funds are automatic pilot. You go in, it is 
professionally managed, and it gets more diversification which 
will get them a better yield overall over a working life 
expectancy.
    Senator Sununu. Mr. Furman, in your testimony--actually, I 
want to direct this question to Mr. Amelio because you have 
some responsibility on TSP. You suggested that if individual 
accounts are instituted and had the political pressure to 
include various types of politically oriented funds, that would 
be difficult for legislators or policymakers to resist. Again, 
I go back to TSP. Have you been able to resist the political 
pressure to create all sorts of politically sensitive funds 
within TSP?
    Mr. Amelio. I have only been here 2 years. The plan has 
been very successful since its inception in 1986 in doing that. 
I can tell you there is a lot of political pressure right now 
to add a REIT fund against the plan fiduciary's desires. We 
make no comment on REIT's, as far as it being good or bad, we 
just do not want to add one right now, and that is what I am 
calling political manipulation.
    Senator Sununu. But you have had 20 years experience?
    Mr. Amelio. Yes.
    Senator Sununu. There are how many funds that are currently 
offered?
    Mr. Amelio. Five.
    Senator Sununu. Five. So, I think it stands to reason if we 
are looking at this, not necessarily as the perfect model, but 
trying to identify analogies. I would argue that would be 
pretty good insulation from an endless proliferation of 
politically motivated funds.
    Thank you very much, Mr. Chairman.
    Senator Hagel. Senator Reed.

                 STATEMENT OF SENATOR JACK REED

    Senator Reed. Thank you very much, Mr. Chairman.
    Thank you, gentlemen, for your testimony.
    Mr. Cavanaugh, in your written testimony you make a very 
interesting and important point that also concerns me with 
regard to the President's proposals. Specifically, you point 
out that the TSP program allows for emergency withdrawals and 
loans on contributed funds. As I understand the President's 
proposal, those activities would be prohibited, and I have a 
sense that I believe you do too, that it is very difficult to 
maintain such a limitation over time, particularly since the 
argument is being made insistently, ``It is your money, it is 
your money.''
    I am just curious. Have TSP participants always been 
permitted to make emergency withdrawals and loans on their 
contributions? And if not, what caused that phenomenon?
    Mr. Cavanaugh. It started out with just loans. IRS, I 
think, had problems when the legislation was before the 
Congress with regard to withdrawals. But later on the Congress 
amended the statute to permit withdrawals, so we have both 
loans and withdrawals.
    With regard to what you were referring to in my prepared 
statement, even though the Administration says this is just for 
retirement, the individual accounts will not have any loans or 
withdrawals, I just think it is totally unrealistic. Right now, 
the reason people cannot take money out of Social Security 
before retirement is because they do not have an account there 
in their name with their money, there is nothing to take. But 
once you have an individual account that is identified to the 
individual and they see the balance is building up year after 
year.
    And then you have some national disaster where people are 
starving, their kids cannot go to school, and they are waiting 
for emergency relief, and they say, ``I have $20,000 in there 
and I cannot wait till retirement, we are dying now.'' I do not 
see how the Congress can say no.
    Senator Reed. And what would be the consequences of those 
types of withdrawals or loans?
    Mr. Cavanaugh. They would be dire because you would be 
doing it on an ad hoc basis instead of having a system in place 
at the beginning as we did for loans and withdrawals 
eventually. You would have to be dealing with each case because 
you would not have standards. It would be an ad hoc thing, and 
as the constituents called into their congressman and said, ``I 
need the money,'' and they had a different particular case 
problem, that would be sent over to the board. The board would 
have to sit down and try to sort it out and be fair to 
everybody, and not give to somebody who had the same 
circumstances as somebody else that did not get it. You have to 
set it up at the beginning.
    Senator Reed. Thank you. Now, Mr. Cavanaugh, there is 
another issue that we have all talked about. That is the 
administrative costs of the various proposals. From your 
experience, would the administrative costs of the TSP-type 
program increase substantially if it were modified to allow 
individual investors to invest specific stocks? Would those 
costs go up?
    Mr. Cavanaugh. If the TSP allowed specific stocks instead 
of just the index fund?
    Senator Reed. Right.
    Mr. Cavanaugh. Oh, yes, that would be much more difficult 
because I think the Congress would provide something in 
legislation to make sure people did not go crazy buying penny 
stocks and so on. You would have to have standards and then 
there would be the whole question of--since the Government is 
running this thing--Government involvement in the business of 
which particular stocks are eligible and which ones are not. 
And there you would get the politics, good stocks, bad stocks 
and so on, and so that would be impossible.
    Senator Reed. Mr. Tanner, in this regard of operating 
costs, you cite administrative costs would be about 25 basis 
points, but I presume that is based upon the TSP model which 
has about only 5 different options. But then you go on to your 
testimony and talk about: At some point a wider range of 
choices should be made available; in part this is a simple 
matter of increasing consumer choices; one of the most 
important reasons for having personal accounts at all is to 
give workers more choice and control how they save for their 
retirement; and clearly this should be extended as much as 
possible.
    But it seems to me that as you extend these options you 
have to increase to administrative cost; is that accurate?
    Mr. Tanner. Yes, I think you are correct, Senator, that in 
this additional tier of investment options, administrative 
costs would be higher, but no one would be forced to go into 
this additional tier of options, and in fact, we expect most 
workers would remain in the first tier of very limited set of 
options, out of inertia if nothing else, and those low costs 
there.
    In addition, as long as workers have the free choice of 
staying put or of moving back down if administrative costs in 
the upper tier become too high, we believe that the competition 
from this low-cost, low-choice tier would keep costs down even 
at the upper tier, simply because if you priced yourself too 
high, workers would not make those choices.
    Senator Reed. So you anticipate a multitier, at least a 
two-tier system?
    Mr. Tanner. Yes. I anticipate that initially workers would 
be given a very limited variety of choices, either a TSP type 
of model or perhaps three balanced funds, which is in the 
legislation in the House that I think is a good model, or 
perhaps just a lifecycle fund, but something very limited 
initially with a default in case workers make no choices 
whatsoever, that there would simply be a default option that 
they would fall into. And then once a trigger is reached, say 
an accumulation of $10,000 or more in your account, then you 
would be able to move, if you chose, to a wider range of 
options, or stay put in that first tier.
    Senator Reed. Mr. Furman approaches this in a slightly 
different way. I think in your testimony, Mr. Furman, you say a 
similar point but I think a different emphasis: Estimates that 
show low administrative costs for accounts are based on limited 
choice and an unprecedented degree of Government 
administration, which you observe, Mr. Furman, could prove to 
be politically untenable over time.
    So your point would be that this expansion, if multitiered, 
eventually would be--they would not stay in the lower tier, 
they would want the whole----
    Mr. Furman. Right. Two points to make about that. It is a 
very good question, Senator. Sweden gives you--it still is 
government managed, government administrated, and very 
centralized--a wider range of choices along the lines of what 
Mr. Tanner was just recommending. The average fees there are 
0.73 percent per year. Accumulate that over your retirement, 
eats up 15 percent of your account. That is about twice as 
large as what the actuaries estimate. That is the first point.
    The second point is if you think about the politics, the 
President's Commission strongly recommended a tier 2 of funds. 
They said the Government picking one equity allocation for the 
whole country was not a good idea. A lot of advocates of 
accounts believe that. If you look at something like Senator 
Sununu's plan, it has assets in account of $80 trillion in 
2079. That is 200 percent of GDP. Half of those were in the 
stock market. That means those accounts in Senator Sununu's 
plan would hold the entire United States stock market. To 
imagine the entire United States stock market being held in one 
Government chosen allocation of stocks, whether it is an index 
of anything else, is to me unimaginable.
    Senator Reed. Thank you.
    A final question. Mr. Cavanaugh, you talk about the Social 
Security Trust Fund as an alternative investing in the market 
as another approach versus these private accounts. Others have 
advocated this, obviously. What do you think are the advantages 
and disadvantages as compared to private accounts, of simply, 
as many have suggested, allowing the Government to invest a 
portion of the Social Security Trust Fund into the market, 
getting presumably a higher return with we hope low operation 
overhead?
    Mr. Cavanaugh. It is a no-brainer in the sense that----
    Senator Reed. That is my type of plan.
    [Laughter.]
    Mr. Cavanaugh. Virtually everybody would agree that a 
diversified portfolio is the way to go, particularly with 
regard to long-term pension funds, and you should have equity 
securities in there and all that. The only argument against the 
trust fund investment that is made over the years--and I used 
to make it when I was in the Treasury Department, I confess--is 
that this would amount to Government ownership of stock, the 
means of production, socialism, all that thing.
    There might have been some merit to that years ago, but 
since then every State in the United States has authorized 
pension funds to go into stocks. We are the only ones that do 
not. Maybe it is because we know something about what the Fed 
is going to do that they do not, but I do not think so. And 
ever since we brought in the stock index fund, which the TSP 
uses that took care of the problem of Government control over 
any one company because you are buying a broad index, you are 
not buying a particular stock.
    And in my prepared statement that I submitted to the 
Committee, there is a chart on there showing that the trust 
fund alternative would involve less Government control over 
private companies than either the TSP or the Administration's 
plan. I go right down the line into every particular. It would 
be less. I just cannot believe that old argument. Whatever we 
might do with individual accounts, surely, the Social Security 
Trust Fund should be diversified like everybody else is doing.
    Senator Reed. Thank you, gentlemen.
    Thank you very much, Mr. Chairman.
    Senator Hagel. Senator Reed, thank you.
    Mr. Cavanaugh, I want to just go back and cover one point 
in response to a question that Senator Reed asked. The question 
was about leakage, and your response that there could well be 
great pressure, if we had personal accounts, to open those up 
for family emergencies or whatever it is.
    We have never had that problem at Social Security to my 
knowledge; is that right?
    Mr. Cavanaugh. Yes.
    Senator Hagel. For 70 years we have never opened it up for 
emergencies?
    Mr. Cavanaugh. Because there is no individual account to 
give to people, so there is nothing that they could claim.
    Senator Hagel. But we have never had that issue. I 
understand the definition difference, but I believe that should 
be pointed out as well, that when the Congress passes a law, 
and if we did this, we would certainly mandate what the rules 
would be, and I think the President's plan says this clearly. 
My plan does. I think the other ones do. And I just wanted to 
add that footnote to your response, that certainly that is a 
possibility, but I do not think it is a strong enough 
possibility to be an overriding factor.
    Mr. Cavanaugh. All I can say, Mr. Chairman, is that the 
Congress did, in the TSP, say in the statute ``no 
withdrawals.'' But later on the pressure was such that the 
Congress amended it to permit the withdrawals.
    Senator Hagel. We can always amend things, as you know. But 
I wanted to at least get the other side of that on the record, 
and I appreciate your response.
    Mr. Tanner, should we consider other options as we are 
looking at how do we reform Social Security, should we reform 
Social Security? We all, I think, agree that we are going to 
have to address the issue. Are there options other than 
personal accounts? Are there investment options or should we 
just raise taxes and continue along the course that we are on?
    Mr. Tanner. I certainly think that any Social Security 
reform is going to have to make some effort to restrain the 
growth in future Social Security benefits. I believe that 
personal accounts are absolutely essential for the reasons that 
I have outlined, particularly ownership, inheritability, and 
choice, but they do not solve all the problems with Social 
Security's finances. There is going to have to be other 
measures taken as well. I think that means that you are going 
to have to restrain the growth in Social Security benefits.
    But as former President Clinton said, you have very limited 
choices when it comes to Social Security. You can raise taxes, 
you can cut benefits, or you can invest privately, either 
through personal accounts by individuals or through the 
Government.
    I think Government investing would be very dangerous. You 
have to look no further than CalPERS, for example, to see them 
trying to interfere with who is going to be the next Chairman 
of Walt Disney. Do we really want the Federal Government making 
those type of decisions? You can look to State pension funds 
and see that about 44 percent of them have targeted investment 
requirements saying that you must invest in certain types of 
investments, or that they cannot--25 percent have restrictions 
saying you cannot invest in certain types of things. My old 
friend, Senator Dodd, would be able to tell you about 
Connecticut, where they forced the State pension fund to invest 
in Colt Industries and the problems that created both in terms 
of conflict of interest and in terms of the losses that they 
incurred because of that.
    I think that when it comes down to a choice between private 
investing, between the individual and the Government doing it, 
we should definitely side with the individual, but we are also 
going to have to do other things as well in terms of 
restraining benefit cost and growth.
    Senator Hagel. I know the hearing is intended to stay 
focused on what we are talking about here, and I will keep 
within those boundaries simply because we have a lot of 
territory to cover that we have not yet touched upon. But I 
think at the end I will do a wrap-up question and ask each of 
you what additionally you think we need to do to deal with the 
solvency issue of Social Security, aside from what this hearing 
is about, and you just alluded to it. You did not specify what 
those are. Some of those things are in my bill, but I will ask 
each of you at the end if you would offer your thoughts on that 
outside of personal accounts or other options for investment 
vehicles.
    Mr. John, let me ask you the same question that I just put 
to Senator Tanner.
    Mr. John. I kind of like the idea of Senator Tanner. It has 
a nice sound to it.
    Senator Hagel. Well, he is close to Dodd, you know.
    [Laughter.]
    Mr. John. We also believe that Social Security changes must 
go along two courses. One is that we strongly support a 
personal retirement account for the simple reason that this 
gives my daughter the opportunity to do something more than 
face a world of higher taxes and lower benefits. I do not see 
that as being an attractive Social Security system to leave 
her.
    Two, it is very clear that we need to change Social 
Security's benefits and to bring them closer to what Social 
Security can actually afford to pay. As I mentioned, she is 
going to be faced with a choice otherwise, especially with a 
health care system that is in serious jeopardy, of financing 
benefits for her kids or financing benefits for her parents.
    There is no way around changing Social Security's benefit 
formula, and Social Security's benefit formula has been 
adjusted in a number of different times. It is not a program 
that sprung full blown from the head of Franklin D. Roosevelt 
in 1935. The current benefit structure or benefit calculation 
basically dates from Jimmy Carter's era in the late 1970's. It 
has been changed a number of different times and it needs to be 
changed again.
    Senator Hagel. Mr. Furman, I will ask you the same 
question, but focus as well on a comment that Mr. John made in 
his written comments and he just alluded to, about this 
generational choice that we are going to burden our next 
generations with? I think the reality of that is becoming 
clearer and clearer. I would appreciate your answer in the 
context of that as well.
    Mr. Furman. There is no question that we face a Social 
Security challenge and that it is better to act sooner rather 
than later in addressing that challenge. That being said, it is 
better to not act at all than to do harm, and to wait and do it 
in the right way.
    The Social Security benefits are projected to exceed Social 
Security revenues so you have to either reduce benefits or 
raise revenues. I would recommend adopting a combination of 
both of those approaches, as we have done historically. 
Historically, we generally have done both when we have gotten 
into trouble in Social Security.
    In terms of accounts, they do not help with the problem. In 
fact, in the short-run they make it worse because they increase 
the debt and drain money from Social Security. In the long-run, 
they do not help either because these administrative costs we 
are talking about today ensure that the new system, the total 
amount of resources in that system is less than what the 
resources are in the system today because some of those 
resources are consumed by administrative costs.
    Senator Hagel. I suspect Mr. Tanner and Mr. John do not 
agree with your comment. Would you both care to respond to Mr. 
Furman?
    Mr. John. Just quickly, Senator. The Social Security 
Administration Actuary estimates that a personal account 
structured as the President would like and with that type of an 
investment, would return 4.6 percent after administrative 
costs, which would be, according to the President's 
calculations, assuming a 3 percent Federal bond rate, which I 
think is incorrect, but assuming that would mean that even 
after paying costs, that they would be making 50 percent more 
than Federal bond rate, which is definitely an advantage. I 
mean these administrative costs, under a system that is managed 
through the Federal tax system and not through the employer, 
would not eat substantial amounts of the investments. I mean 
even Mr. Furman's numbers suggest 7 percent. Now, frankly, I am 
willing to invest 7 percent or pay 7 percent in costs if I am 
going to do 50 percent better than Federal bond rate. It is a 
fairly simple choice for me.
    Senator Hagel. Mr. Tanner.
    Mr. Tanner. I would agree. To some degree you would get 
what you pay for. There is no doubt that the administrative 
costs of the current Social Security system are extremely low, 
but so is the rate of return that people get. There used to be 
in East Germany a car called the Trevant that was essentially 
made of plastic, and it cost about $500. As soon as the wall 
fell, people stopped buying Trevants and started buying 
Mercedes Benzes even though they cost more. The reason was it 
was a better car. I think people would be willing to bear 
somewhat higher administrative fees if they could get a much 
higher rate of return from private accounts. At any rate, it 
would be a choice.
    All the individual account proposals that I know of, I 
believe including the Chairman's and Senator Sununu's and those 
in the House are voluntary. Individuals could stay in the 
current Social Security system if they wished. If they were 
worried about these administrative fees they would be able to 
stay put, but people would be given the choice of earning a 
higher rate of return and paying a little bit more to do so.
    Senator Hagel. My bill does that as well.
    Mr. Cavanaugh, would you care to comment on any of this?
    Mr. Cavanaugh. Yes, on the cost thing. You know, all of 
these estimates, the Administration estimate of 3/10ths of 1 
percent, of 30 basis points, and the others of 50 and so on, 
these are based on the known world of 401(k)'s. That is where 
the experience is that people are looking at. What we are 
talking about in these proposals by the President is the 
unknown world of small business, where you do not have the 
experience of administrative costs that relate at all to what 
has been done in 401(k)'s. What you have is a market out there 
that is telling you, unquestionably, that it cost 3,000 bucks a 
year to go into a company and set up a plan. If you have 60 
percent of businesses with less than 5 employees, that is 600 
bucks a head, and 600 bucks out of the President's proposed 
$1,000 contribution is a 60 percent expense ratio.
    This is the world we have to look at, and this is why I 
suggested in my statement to the Committee to bring in the 
401(k) providers, all those firms I mentioned, give them a 
specific list of exactly what you want them to do, and based on 
their experience and what they are now saying on their 
websites, they would have to tell you it is impossible.
    Senator Hagel. Mr. Enderle, you know something about that 
business. What do you think?
    Mr. Enderle. I think it is best to respond, given my area 
of expertise really has to do with the management of the assets 
as opposed to the administrative costs associated with 401(k) 
plans. I think it really comes down to two things. One is what 
type of investments are best suited for any type of private 
accounts, if it does go in that direction, and two what to do 
to minimize the investment related costs associated with those 
assets?
    I do think that it would be in investors' best interest to 
have an array of probably diversified index options that are 
both low cost in terms of the cost of trading or the management 
fees associated with such index funds, and they are low risk 
investments as well.
    The other option would be lifecycle which we talked upon as 
well, which also can be offered as a low-cost investment 
solution which has the benefit of adjusting the asset mix over 
time to meet an investor's time horizon.
    I think the number of options that are available is going 
to be critical because that also would affect the assets under 
management for any one fund, and hence would be impacting the 
cost structure as well. The issue around how frequently 
participants would be able to change their exposure to any one 
fund, which would also impact the administrative costs as well 
as the management costs.
    Senator Hagel. I do not know of anyone's plans that would 
have the employer administering anything. The employer is not 
administering any of the plans I am aware of, and the plans I 
am aware of, they would be modeled after TSP, the same kind of 
thing. Obviously, if you have 100 million accounts, I would 
assume you would have to bring in others, not just Barclays, 
but maybe 5 Barclays. I do not know that, but respond to that, 
if you would. You do know something about that.
    Mr. Enderle. Sure, I think there are two things to 
consider. In terms of, even if we had 100 million accounts, if 
the options available to those participants are the same as 
what is currently offered to the TSP participants, what 
Barclays is managing 4 out of those 5 accounts, that is 
certainly very manageable from our standpoint. So it is much 
less to do with the number of accounts that are out there and 
more to do with the number of investment options that are 
available. That would be the thing that I think would determine 
how many managers you would need.
    Senator Hagel. And we are talking about limited funds here.
    Mr. Enderle. That is right.
    Senator Hagel. Same thing as we have talked about with TSP.
    Mr. Amelio, would you like to respond to any of these 
points?
    Mr. Amelio. I think I can within the overall concept of 
costs. I speak for every plan administrator in America when I 
tell you that if you are looking at creating any kind of an 
institutional plan, if you want to minimize cost, you cannot 
have early distribution options like loans and hardship 
withdrawals. I can tell you, I would love to ask Congress to 
get rid of the hardship withdrawals and loans from the plan. 
They are not a retirement feature. They encourage 
participation. It is not feasible. But they add greatly to the 
plan expense.
    The second thing, I speak for all plan administrators I 
think when I say that we are able to maintain our costs because 
we keep the plan simple. We have 5 investment options. It is 
short, it is sweet. That gains the participants' confidence 
level. It also keeps the cost down and it keeps participants 
putting money into the plan, and I think that is very 
important.
    I want to tread lightly on the last one, because I stand in 
two shoes. As the fiduciary to the plan, I will obviously stand 
up and protect the G Fund because it is a great investment 
vehicle for the plan participants, but we are the only plan in 
America that has it. No 401(k) plan does. It is Government 
securities. It is a special and unusually high interest rate. 
But as a plan participant and a taxpayer I take issue with it. 
It is costly. It costs the Government a lot. I guess if I were 
not a fiduciary but still in my role I might look at just using 
a regular money market fund out in the open market which would 
reduce the burden on the Government. But that is not my role, 
and as a fiduciary I will protect the G Fund, but I throw that 
out for your consideration otherwise.
    Senator Hagel. Thank you.
    Let me ask each one of you what would be your response to 
the larger question which we touched on a little bit earlier 
this afternoon with some of my colleagues, if we were to set up 
100 million accounts. How would the market react to that? No 
one can be certain, obviously, but what is your best guess as 
to what would happen and would we phase that in, or how would 
you do that? Is it dangerous? What kind of risk are we talking 
about? Give me your best assessment, realizing that there are 
no guarantees and there are so many unknowables, uncertainties, 
and uncontrollables which we factor in. But that has been a 
question that has been raised by many people, and I would 
appreciate your thoughts.
    Mr. Furman.
    Mr. Furman. Yes. I would focus in answering this question 
not on the number of people with accounts, but the total amount 
of assets in those accounts. And it is a very important 
question because in plans, I believe in your plan, it is about 
80 to 100 percent of GDP would be held in accounts, and in 
Senator Sununu's it would be 200 percent of GDP. So we are 
talking very substantial financial holdings.
    Now, there is only a fixed capital stock in the United 
States, a fixed amount of human capital, and when you have more 
money chasing the same thing, it drives the price of it up. And 
the way the stock market works is when the prices of stocks are 
higher, that is great for the people that already have them, 
but people just coming into the market have to pay more, and 
they actually get a lower rate of return going forward. This 
process was described----
    Senator Hagel. It depends too on the fund. There is an 
international fund, for example, and there are high yields and 
so on.
    Mr. Furman. That is actually a very important question as 
to whether you would internationally diversify, and I think it 
is a prudent part of anyone's portfolio. This was summarized in 
the leading public finance textbook in economics which was 
written by Harvey Rosen, who as I mentioned before, just 
recently stepped down from the Administration. He wrote: ``In 
order to induce private investors to accept Government bonds 
that would have been bought by the trust fund, their yield has 
to go up, increasing the debt burden on taxpayers, or the yield 
on stocks must fall, or both.'' That I think summarizes the 
standard textbook economics.
    Senator Hagel. Thank you.
    Mr. John.
    Mr. John. I think there would be two effects. One is you 
would see a very positive effect in the markets worldwide 
because it would indicate that the United States is actually 
serious about dealing with its entitlement spending. That is 
something that has been a matter of major concern worldwide. If 
you saw what happened--I believe this was earlier this year--
when the South Korean Central Bank was rumored to be 
diversifying out of dollars. This is the kind of signal they 
need.
    And two, as far as assets, the amount of assets under 
management in these accounts, I think it would be relatively 
small as compared to the overall global level of assets. I mean 
currently globally, there is somewhere around $20 trillion in 
financial assets out there. There actually is not a fixed 
capital stock in the United States. There is a fixed capital 
stock on any one day. But as the Washington Post pointed out in 
one of its editorials, the value of the stock market, aside 
from increases or decreases due to supply and demand, actually 
increases and decreases regularly due to companies that merge 
and go out of business, companies that issue new rights and 
things along that line.
    So this is a constantly growing pool of money, and it is 
really not possible to limit it to just the United States, 
because if you look at the New York Stock Exchange, you will 
find companies like Prudential PLC, which is a British 
investment company. You find DaimlerChrysler, which of course 
is worldwide, so essentially you have to look at the growth of 
the worldwide assets.
    Mr. Furman. Could I very briefly insert something?
    Senator Hagel. Go ahead.
    Mr. Furman. The $20 trillion right now is less than 200 
percent of U.S. GDP, and we are talking about plans that have 
asset holdings of between 100 and 200 percent of U.S. GDP, so 
if the Ryan-Sununu plan were in effect today, it would hold 200 
percent of GDP in assets. That is the equivalent of about $24 
trillion. That would more than exhaust the global asset stock, 
and those are very important questions to think about when you 
are talking about accounts of that magnitude.
    Mr. John. But not overnight. I mean the Ryan-Sununu plan, 
hypothetically, if you believed Dr. Furman's numbers, would, 
but the thing is, this would not be a matter where on March 31 
there is zero and on April 1 or April 2 there would be 200 
percent of GDP. And during that period of time the amount of 
assets worldwide would continue to grow.
    Mr. Furman. Historically, it has grown with GDP, but maybe 
it might grow faster than GDP.
    Senator Hagel. We will let Mr. Tanner have a turn.
    Mr. Tanner. Yes. I was going to say you cannot assume a 
static model that just assumes that we are going to have the 
same amount of capital stock 75 years from now that we have 
today.
    If you look at this on a day-to-day basis, the amount of 
money going in, even if you took the entire amount of Social 
Security taxes and put it in the New York Stock Exchange, it 
would be roughly the equivalent of 22 minutes a day of trading. 
The U.S. capital markets are enormous. They are going to be 
even more enormous 75 years from now even with the 
accumulations we are assuming. I do not think we are going to 
swamp those markets. If you go to a worldwide basis you are 
talking about maybe one-half of 1 percent of worldwide capital 
markets right now.
    I do think you would have a couple of impacts in the long-
term. You would have what is simply called the ``capital 
deepening effect,'' which is that capital flows first to the 
best returning investments and then ever lower returning 
investments as you go out. If you increase the amount of 
capital going to investments, they are going to go to further 
and further out to lower returning investments, and the average 
rate of return on all investments is going to decline.
    Martin Feldstein estimates you would have about a 15 
percent decline in the average return on investments, but that 
would not occur for about 40 or 50 years. Eventually, you would 
see it begin to go down somewhat in terms of average return, 
but that would not be an effect on any individual stock price.
    What you would also get is that as you increase the pool of 
capital, you would actually increase the amount of liquidity in 
the markets, and it creates more stability in the markets 
because they would be insulated from some of the shock effects. 
You can look to Chile for an example of that, where when the 
Asian crisis hit, and it really socked most Latin American 
markets, Chile, where the accounts manage about 50 percent of 
GDP, suffered a much smaller decline in terms of their markets 
because of the insulation effect that this amount of capital in 
the markets had.
    Senator Hagel. Mr. Cavanaugh.
    Mr. Cavanaugh. I think your question is what would be the 
impact on the economy and financial markets if we had 100 
million accounts. There would be no change in the total asset 
flow. There is no reason to assume that the money coming in for 
Social Security taxes would be any different from what it is 
now. What would happen is that instead of all of it going into 
Treasury securities, some of it in the individual accounts 
would go into market securities, which means the Treasury would 
have to borrow more in the market and less from the Trust Fund. 
It would be just a swap of securities. There would be no 
overall impact on capital. There would be marginal benefits in 
terms of a better demand for stocks because people are going 
in. Another point is financial institutions generally would be 
better off because Social Security historically has been pay-
as-you-go. You just had enough money in to take care of each 
year. But because of the 1983 changes, we have been prefunding. 
It is now up to $1.5 trillion. In the next few years, it is 
supposed to go up to $3, $4, or $5 trillion, by different 
estimates.
    So all of a sudden the market is interested because before, 
the market was not losing a lot of investment opportunities 
because the money was just going in and out pretty quickly. But 
now that it is building up, we are looking at $1.5 growing to 
$3 or $4 trillion, money the market is not going to be able to 
get. It just goes all in the Treasury securities. And so that 
is an important point from the standpoint of the market. But as 
an economist, I would have to say all we are talking about here 
is an asset swap. Treasury would just issue more securities in 
the market instead of to the Fund. And people who would have 
bought stocks would buy less because now these people, Social 
Security taxpayers, would be buying more. Not a big deal.
    Senator Hagel. Thank you.
    Mr. Enderle.
    Mr. Enderle. I think in the end it is going to be a 
function of the dollar amounts that are going to be affecting 
the various markets, and in essence, I think there are going to 
be four things that are going to affect the market's reaction 
as it relates to the dollar amount that we are talking about.
    The first is whether or not the assets are going to be 
phased in over time, as opposed to what we mentioned earlier. 
It is not going to affect the market or hit the market 
overnight. I think that should have a muted impact on the 
markets.
    The second is the number of options that are available, 
especially if we have different asset classes that are 
available as options, that would also provide more opportunity 
to spread the assets across and, hence, would have a muted 
impact on some markets.
    The third is whether there is a decision made to implement 
the options through index funds, which provides the broadest 
diversification for any asset class and hence, would also have 
the most limiting impact to any particular market if 
implemented through a broad, diversified strategy as opposed to 
a narrowly defined strategy.
    And then, last, it depends upon what other managers or, 
rather, investors are doing. For example, as we talk about baby 
boomers retiring and what their investment activity will be 
like in the future, it is quite possible that as we invest 
assets, say, into the equity market through the private 
accounts, there could be offsetting flows that are also 
affecting the markets at the same time, where there will be buy 
and sell activity such that the total amount that is hitting 
the markets could be quite limited as well.
    Senator Hagel. Thank you.
    Mr. Amelio.
    Mr. Amelio. I will give you an analogy and limit my remarks 
to your example to the confines of the TSP. If we were to 
dramatically increase the number of participants to the TSP 
and, hence, the inflow of dollars in, my concern would be the 
ability of the funds to absorb that money, at least initially, 
into the more limited markets that are available right now. 
This would drive our transaction costs in the index funds up 
because we have seen it now when we get active trading with our 
participants. If one of the markets goes askew, they start to 
pull money out, or drive money in. As it drives those 
transaction costs up, it pushes our return off of the index. In 
other words, the index fund tracks an index such as the 
Wilshire 4,500. And to the extent our costs go up, it pushes 
our performance number away from the index we perform perhaps 
if the costs go up a little worse than the index would because 
of those trading costs, and that would be my concern, at least 
over the short term, if there was a dramatic increase of flow 
of capital. And that is from an administrator's perspective.
    Senator Hagel. Thank you.
    Let me ask each of you a question I mentioned a few minutes 
ago. Aside from personal accounts and your positions that you 
have made very clear on personal accounts, each of you, what do 
we need to do to assure Social Security's solvency? We will 
start with you, Mr. Furman.
    Mr. Furman. There are a few plans that I would recommend 
that you take a serious look at. One is by economists Peter 
Diamond and Peter Orszag, and another is by former Social 
Security Commissioner Ball. And what both of them do is 
increase revenues and trim benefits. They increase revenues in 
a very progressive manner, including raising the cap, applying 
a tax above the cap, or using estate tax revenue to help the 
solvency of Social Security. And then they make some changes on 
the benefit side, including correcting the Consumer Price Index 
that is used to adjust for the cost of living. And in the case 
of Diamond and Orszag, it applies longevity indexing to 
benefits, although it only takes half of the increase in 
longevity and applies it to benefits and applies the other half 
to the revenue side, which from my perspective is the more 
balanced way to deal with longevity than doing it entirely on 
the benefit side.
    Senator Hagel. And that would be your approach to dealing 
with----
    Mr. Furman. Those are a number of options that I think 
would make a lot of sense in terms of coming up with a plan 
that is overall balanced between revenues and benefits, 
balanced between people today and people in the future, and 
progressive overall.
    Senator Hagel. Mr. John.
    Mr. John. If I had to take personal accounts off the table, 
which, of course, would be very painful----
    Senator Hagel. No. I know where you are on personal 
accounts. You are one who advocates that personal accounts help 
get you to solvency. So, in addition to that, unless you 
believe that that is the only answer, what in addition to 
personal accounts?
    Mr. John. In addition to personal accounts, I would suggest 
some form of progressive indexation similar to what the 
President has been talking about recently, which would 
basically reduce the growth of benefits for upper-income 
workers while leaving lower-income workers stable. I think this 
is also important because it would remind upper-income workers 
that they need to continue to participate in 401(k) and other 
private types or employer types of retirement plans.
    The second thing I would do, frankly, is to raise the 
retirement age, recognizing fully that there are going to be a 
certain number of workers in physically demanding jobs that 
simply cannot work longer, and those workers are going to be 
placed probably on the disability rolls in some way. I would 
also put in some form of longevity index in there.
    The one thing I have not included is taxes, and for two 
different reasons. Number one is that change in payroll taxes 
or employment-related taxes could have the result of reducing 
job growth, and, frankly, that would be more damaging for the 
economy than other things. And number two is that we always 
have the unspoken problem, which is Medicare, and that one is 
much larger, and I would be hesitant to use up all the tax 
options on the easy problem.
    Senator Hagel. Thank you.
    Mr. Tanner.
    Mr. Tanner. I guess I would associate myself completely 
with Mr. John's remarks here. I believe that some form of 
change from wage indexing to price indexing is a very fair way 
of approaching it. I think that probably some longevity 
indexing in addition would probably be a good idea. I think the 
overall requirement is to reduce and restrain the growth in 
benefits, that we simply cannot go on forever increasing the 
amount of benefits that we pay to the elderly both through 
Social Security and Medicare. There has to, at some level, be 
some restraint on the amount of entitlements, and simply 
pouring more money into the situation in order to pay ever 
larger entitlements I think is a mistake. And particularly I 
would like to warn against the idea of raising the cap or 
removing the cap on the amount of income subject to the payroll 
tax. To do so would give the United States the highest marginal 
tax rates in the world. We would actually have higher marginal 
tax rates than countries like Germany and Sweden.
    I think that is a significant danger of damaging the 
economy and job growth, and it might even hurt overall Federal 
revenues since there would be an enormous amount of switching 
to nonwage compensation and people would simply begin to hide 
their income in order to avoid these huge marginal tax rates. 
So, I think you would actually end up getting less revenue than 
you expect. Even if you took this off altogether, you would 
gain something like 7 years of additional cashflow solvency for 
Social Security. It is a very high price to pay for very little 
gain.
    Senator Hagel. Would you include pushing out full benefit 
retirement age a year, or would you leave that alone?
    Mr. Tanner. I think that it is certainly something that 
should be on the table. It is a less favored approach that I 
have. I do think that the problem is that for people in 
physically demanding jobs or for people like African-Americans 
with shorter life expectancies, raising the retirement age 
really leaves a hardship for them. I think the longevity 
indexing is probably a better way to approach this. It gives 
people more options than simply raising the retirement age 
would.
    Senator Hagel. Thank you.
    Mr. Cavanaugh.
    Mr. Cavanaugh. I would agree, I think, with most of the 
options that Mr. Furman mentioned, ones that have been advanced 
by other economists, Peter Diamond and the Brookings 
Institution, Henry Aaron, that thing. These are all things that 
could be done that would more than offset the actuarial deficit 
projected by the trustees for the Social Security Trust Fund.
    However, each one of them hurts somebody in terms of 
increasing the age, removing the cap, or bringing in State and 
local governments. People have problems with all of these 
options. The one that I think is the most desirable is if you 
did what I suggest with the trust fund investment. If you 
invested 50 percent of the Social Security Trust Fund balance 
in equities, with the other half in Treasuries or whatever, 
that would eliminate approximately one-half of the total 
actuarial deficit projected by the trustees.
    But I must say that I think the CBO estimate is that the 
fund is not going to run out of money until 2052. The trustees 
are saying 2041. When I first began to look at this area 9 
years ago, the trustees were saying 2027. And then they moved 
out in the last 9 years to 2041. I do not think that we can 
make substantial policy changes today based on moving targets 
like that. We have no idea what the world is going to look like 
in 2040 or 2052 with the growth that we have had in 
productivity and immigration, women in the labor force, things 
that we never could have projected 40 or 50 years ago.
    I would be very careful to make drastic changes today based 
on these projections, which have proved to be way off.
    Senator Hagel. Thank you, Mr. Cavanaugh.
    Mr. Enderle.
    Mr. Enderle. Given my area of expertise, which is really to 
provide technical comments on investment management-related 
issue, I am really not, I guess, in the best position to 
comment on how best to address the issue of Social Security 
solvency type questions.
    Senator Hagel. Thank you.
    Mr. Amelio.
    Mr. Amelio. The Board does not have any position on this 
issue, as you can imagine.
    Senator Hagel. You are a technician.
    Mr. Amelio. Yes.
    Senator Hagel. Thank you.
    Let me ask one last question, and I do not know if you have 
any thoughts on this. But is there anything in particular we 
can learn, we should be paying attention to, from other 
countries who have gone through this? Chile obviously is an 
example that has been used here a couple of times this 
afternoon. The United Kingdom, Sweden, and other countries have 
had to deal with this. Some have deferred it. Some have dealt 
with it fairly successfully. None have gone through it, that I 
am aware of, without some ups and downs and adjustments and 
calibrations. But as the last question for the six of you, 
starting with you, Mr. Furman, anything in particular that we 
should be focused on in learning from these other nations that 
have gone through something similar?
    Mr. Furman. One of the strongest lessons from international 
experience is that the administrative costs can tend to be very 
high and exceed what people originally expect for them. That is 
especially true in a decentralized system like Chile or the 
United Kingdom. Administrative costs also go way up if you give 
people even the limited set of Government-sponsored choices 
that you have in a country like Sweden.
    So if there is one lessons from international experience, 
it is that a lot of the benefits you think you are going to get 
from these accounts come up against the hard reality of how 
complicated they are to administer and costly to administer in 
practice.
    Senator Hagel. Thank you.
    Mr. John.
    Mr. John. As you look around the world, the first lesson to 
come up is do it now. If we look at the Japanese, the Germans, 
the French, and the like, who have waited much later in the 
demographic positioning than we have, the choices only become 
more and more painful. If we look at Australia and Switzerland, 
we find that it is actually possible to mandate savings, 
whether it is through a personal account attached to Social 
Security or some other way. And if you do it soon enough, you 
can build significant amounts of assets and reduce the long-
term costs to your society of a pension plan.
    If you look at the United Kingdom, you will discover that 
you can actually screw up a private pension plan, if you make 
it too complex or if you try to micromanage. And if you look at 
Germany, in particular, the Riester reforms from about 2001 or 
so, you find that if you come up with what is otherwise a good 
plan and it is far too complex, nobody is going to understand 
it and nobody is going to support it.
    Senator Hagel. Thank you.
    Mr. Tanner.
    Mr. Tanner. My comments would be very similar. I think that 
it is very important that any plan that is devised be 
transparent and easy to understand for everyone involved. I 
think Britain is a classic example of a plan that was overly 
complex, opaque; very few people had any idea where their money 
was going and how it worked. It was tax credits against 
something else, a type of thing that was not necessarily even 
connected with your Social Security taxes. You had to be twice 
removed from it. And the result led to a great many problems.
    The Chilean system I think shows that it can be done. You 
have to remember, when Chile did this, this was back when 
Brezhnev was the head of the Soviet Union. We did not have 
computers. People did things on paper. And yet they were able 
to create this type of system, which is remarkably efficient. 
The costs today are about 65 basis points for administering 
these accounts in Chile, which is higher than here but quite 
reasonable. So, I think it proves that it can be done if you 
are willing to undertake it.
    Senator Hagel. Thank you.
    Mr. Cavanaugh.
    Mr. Cavanaugh. In response to your question what do we 
learn from foreign experience, I think we learn not to do it. I 
have a different perception from Mr. Tanner of the Chilean 
experience. When that was put in, it was mandatory. Back in 
1981, I think they started it. And the only people that did not 
have to join it were General Pinochet's officers, the military. 
I think they had a little insight into what the plan was about.
    As I recall, 40 percent of Chileans, although they were 
supposed to go into this thing, opted out because there was 
some kind of a back-up thing like Social Security that they 
could take instead, and they just went against the law. And The 
Wall Street Journal did a survey of the Chilean, the British, 
Swedish, and others just a few months ago, and according to 
their figures--and I have heard the number in other places--in 
the Chilean individual accounts, the financial institution 
takes 20 percent off the top right at the beginning. I do not 
see how you can get anywhere with that kind of management. As 
to the British system, in addition to the problems mentioned by 
Mr. Tanner, a few months ago it was noted in the press, because 
of the enormous reaction to the way British financial 
institutions handled that, there was a class action suit that 
they finally settled for $24 billion. In Great Britain, that is 
a lot of money. And that is how bad the problem was.
    So the United Kingdom is definitely not a model, and Chile, 
in my opinion, was a failure.
    Mr. Tanner. Mr. Chairman, if I can just correct something 
for the record, the Chilean system that was implemented was 
voluntary. The military and police were forbidden to go into 
the system because they had something similar to a civil 
service pension which is linked to your rank and things like 
that. They were not part of the Social Security system at that 
time. For ordinary workers, it was voluntary. Some 93 percent 
of Chilean workers have voluntarily chosen to go into the 
system. About 40 percent of workers are not currently 
participating because they are in the underground economy, tax 
evasion being a time-honored tradition in much of Latin 
America. They are simply not on the books and, therefore, they 
are not participating in any of the system. They were not 
participating in the old Social Security system either since 
they were working under the table. But it is entirely a 
voluntary system under the system.
    Senator Hagel. Thank you.
    Mr. Enderle.
    Mr. Enderle. My response is essentially the same as to the 
previous question in that I am most qualified to respond to any 
investment management-related questions for any plan that may 
be proposed or considered.
    Senator Hagel. Thank you.
    Mr. Amelio.
    Mr. Amelio. I think the universal comments that I have 
experienced at this hearing, other hearings, and other writings 
with these plans are that there have been complications and 
high costs. I think that only really illustrates what a great 
job Congress did in 1986 when they created the TSP. They put 
the structure in that stands today, and that is where we are. 
And so kudos to that Congress in 1986.
    Senator Hagel. A high point to leave this hearing on, 
obviously. And I know Senator Dodd was here, Senator Sarbanes, 
maybe others, and I shall pass on your congratulations for 
their wisdom and direction and leadership.
    Gentlemen, you have been very helpful and made significant 
contributions, and we will most likely be back in touch with 
you at some point. But you have helped us immeasurably, and we 
appreciate very much your time and your thoughts.
    The hearing is now adjourned.
    [Whereupon, at 4:16 p.m., the hearing was adjourned.]
    [Prepared statements supplied for the record follow:]
               PREPARED STATEMENT OF SENATOR TIM JOHNSON
    Thank you, Mr. Chairman, for holding today's hearing. I am proud of 
what this Committee has done to enhance our capital markets, which are 
the strongest and most efficient in the world. With comprehensive 
corporate governance legislation and a fairly comprehensive new 
regulatory scheme for the mutual fund industry under our belts, I think 
we've made the marketplace a more transparent and secure place. There 
is no denying, however, that our marketplace derives its strength on 
risk, and I appreciate today's opportunity to look at whether this 
concept of risk is appropriate in the context of retirement security.
    Since President Bush began his campaign to establish private 
accounts within Social Security, support for his plan has declined 
significantly. Even members of his own party have voiced their concerns 
and outright objections to his plan. It seems that as Americans learn 
more about the structure of his plan, more and more people reject it. A 
recent Wall Street Journal/NBC poll found that a majority of Americans 
think that it is a bad idea to change the Social Security system to 
allow workers to invest their Social Security contributions in the 
stock market.
    Private accounts from the get-go are a bad idea for the Social 
Security program. As I traveled recently throughout my State and held 
town halls, I shared my thoughts with constituents about the vast new 
borrowing that would be required, the inherent risks in a privatization 
scheme, and the alarming benefit cuts that will be experienced by all 
beneficiaries--irrespective of whether or not they select to have a 
private account. As I shared this information, over and over again I 
heard the people of South Dakota say--``don't privatize this program.''
    Now, I would guess that the hope of some here today is that this 
hearing will provide an opportunity to talk about the details of how 
private accounts would work, but in my mind, there is no need to even 
walk down that road. The underlying principles behind the privatization 
concept are flawed, and I think that is where our discussion today 
should begin.
    As we think about the underlying principles of the President's 
plan, we must not forget the intent of the Social Security program--to 
provide insurance for unintended events that threaten financial 
security, and to provide a secure, guaranteed financial floor for which 
all other aspects of retirement planning are built upon. Some things 
that we need to consider as we hold this hearing today.
Foreign Debt
    The vast new borrowing required by the President's privatization 
proposal threatens our standing in the financial markets of the world. 
As of the end of 2004, foreign ownership of the debt already reached 
almost $2 trillion, or 44 percent of the total held by the public. The 
addition of $5 trillion in transition costs over 10 years that is 
required by private accounts will threaten the stability of the U.S. 
economy. If foreign investors lose faith in our ability to finance this 
debt, this could lead to soaring interest rates, a weakening of the 
dollar, and even a deep recession or depression.
    In the context of today's discussion on the role of our financial 
markets in Social Security, one cannot underestimate the threat that 
our current $400 billion national deficits pose to the health of our 
financial marketplace. Last February, the Korean central bank indicated 
that it planned to limit its dollar holdings and purchase different 
currencies instead. Following this news, stock prices fell sharply.
    Several weeks later, Japan indicated it was looking at limiting its 
dollar holdings. What happened? Another terrible day on Wall Street. 
Something drastic--like Japan or China selling a large amount of U.S. 
dollar holdings--could have a devastating impact on our economy. I have 
serious concerns about whether it is prudent to give any foreign 
country substantial leverage over the U.S. economy, much less the 
retirement security of the two-thirds of our seniors that depend on 
Social Security as their primary source of income.
Risk and Rate of Return
    While the average real return on long-term government bonds was 2.3 
percent, and the annual total rate of return on large corporate stocks 
was 7.2 percent between 1926 and 2003, such figures do not account for 
the variation in returns for both types of assets over shorter periods 
of time. Depending on a worker's birth date, the retirement benefits 
relative to preretirement earnings generated from putting one's savings 
away for 35 years could have gone from 100 percent to less than 20 
percent.
    For every dollar deposited in a personal account, a worker's 
traditional benefit, delivered in a monthly Social Security check, 
would be diminished by a dollar, plus the interest rate the money would 
have earned in Treasury bonds. This ``claw-back'' requirement means 
that in order to come out ahead of the traditional system, an account 
would have to realize returns on investment of at least 3 percent above 
the rate of inflation.
    When examining past trends, it would not be unlikely that the 
government will have to assume costs to bail-out a privatized system 
that provides too few benefits. Their will always be the chance that 
the market will under perform, and because whole generations would end 
up with too few savings in retirement in this scenario, the problem 
will be too large for the Government to ignore. A Government bail-out 
would be an extremely costly undertaking. For example, when the savings 
and loan crisis of the late 1980's occurred, these economic problems of 
the past became large enough to justify a bail-out, costing the U.S. 
taxpayers over $120 billion.
Administrative Risks/Costs
    Most of the financial services industry in the United States is 
very effective and sound, but we must remember there are risks and 
costs involved in investing in the stock market. Not only the risks 
associated with putting money into stocks, but also risk involved in 
giving so much financial power to a small group of people. Creating 
privatized accounts in the Social Security system, would also lead to 
an increase in payments of financial fees to private financial 
management companies.
    Britain privatized its Social Security system in 1986, allowing 
citizens to ``contract out,'' which is their term for putting 
government pensions into the stock market. The scheme led the 
government pension system in Britain to the brink of crisis. Last year 
alone, more than 500,000 people abandoned their private accounts in 
favor of the state-managed Social Security system.
    Securities fraud loomed large among the problems the British system 
faced. In the early 1990's, Britain's financial services regulator, the 
Securities and Investment Board, undertook random samples of paperwork 
from the insurance industry, which was selling the private accounts to 
British citizens.
    The regulator found a staggering percentage of private accounts had 
been sold to those who would be worse off in retirement as a result. 
The public outcry over this ``mis-selling'' scandal forced the 
government to establish a review panel that ultimately found the 
insurers liable for making people worse off.
    Over an 8-year period, 1.7 million people sought and received 
compensation that ultimately cost the insurance industry $12 billion. 
In addition, hundreds of millions were paid out in fines and penalties. 
It was the biggest financial scandal in British history to date.
    According to a University of Chicago Study, Plan 2 of the 
President's Social Security Commission would result in fees paid to 
Wall Street totaling $940 billion. These fees amount to more than 25 
percent of the existing deficit in Social Security over the same 
period. In Britain, fees to private companies managing these accounts 
consumed an average of 43 percent of the value of an individual account 
over the course of a 40-year working career.
Not an Investment Program
    The President has made it a point to describe Social Security as an 
investment program. This message neglects to recognize that about one-
third of payroll taxes go to fund disability and survivors insurance. 
Such insurance plans would be extremely expensive to purchase in the 
private market. In addition, the program provides protection against 
the risks of inflation by the way they are adjusted each year. It is 
incorrect to measure the value of an insurance plan based on a rate of 
return. For example, when you purchase life insurance, you do not want 
a good rate of return, since that money will be made available only in 
the event of one's own death--and few people would opt out of a 
guaranteed life insurance program because of what potential rate of 
return could be realized in the stock market.
It is Not Your Money
    The President has spent a great deal of time canvassing the country 
telling people about the nest eggs they will be able to call their very 
own. The reality is that these accounts will not be ``your'' money.
    Not only do beneficiaries have to pay a retirement tax on their 
benefits, but the President has not been very clear on the question of 
a mandatory annuity. He has indicated that you will be required to 
purchase an annuity upon retirement, to assure some regular minimum 
payment at the poverty level if your income from other sources is not 
adequate. The annuity payment ceases with your death. If there is 
anything left in the account after the claw-back has taken its share 
and after you have purchased an annuity, if you are required to do so, 
that will be yours to take as a lump sum or leave to your heirs. It is 
not at all clear where these annuities will come from, but it appears 
most likely to be the private sector.
    This would mean not only a windfall for companies that were 
managing the funds but also mandated annuities being underwritten by 
insurance companies. For most people, their accounts are going to be 
tiny and will be eaten up by management fees. When you annuitize it, 
what you get is very small.
    Additionally, the claw-back requirement essentially means that you 
are receiving a loan from Social Security for the money you want to 
contribute to your private account, which you have to repay upon 
retiring. That does not seem to me to be ``your money.''
Deposit Insurance
    However strong our capital markets, we are all aware that risk is 
inherent to the marketplace. For years, I have pushed to make sure that 
those save for retirement have at least one completely safe investment 
option: A federally insured account. While there is a place and time 
for individuals to invest in the equity and bond markets, there is also 
a time and place for them to look to their banks and credit unions for 
insured accounts. FDIC and SHARE insurance levels have not kept place 
with inflation, and are woefully inadequate to cover the savings needs 
of today's retirees. Together with a bipartisan group of Banking 
Committee Members, I have advocated an increase in Federal deposit 
insurance up to $250,000 for retirement accounts. The demand for such 
coverage clearly exists. In fact, some large financial institutions 
with multiple charters actually promote offers of nearly a million 
dollars in coverage for interest-bearing, personal accounts.
    Now, in the context of Social Security reform, I will state here 
that I am unequivocally opposed to private accounts. That is not what 
Social Security is about, and I believe it is a mistake to go down this 
path. However, if the President and the Republican-controlled Congress 
are determined to privatize Social Security, then they at least should 
make sure that participants are not required to roll the dice with 
their nest eggs. Insured accounts should be an integral part of any 
privatization scheme, and it is our responsibility to make sure that 
insurance levels are adequate to cover the needs of our seniors.
Priorities and In Perspective
    Social Security is in need of reforms to ensure its solvency for 
generations to come. But major restructuring of the program is not 
required. To put the gravity of the problem in perspective, one should 
note that the Social Security shortfall will amount to .65 percent of 
the GDP over the next 75 years or $3.7 trillion, while the President's 
recently enacted tax cuts if made permanent amount to $11.6 trillion 
over that same period. Additionally, the Medicare Trustees project that 
that Medicare drug benefit will cost 1.4 percent of GDP, or $8.1 
trillion over that same period.
    There is an inherent disconnect in the push for privatization. The 
President has stated over and over that the Social Security Trust Fund 
is in immediate ``crisis.'' This manufactured crisis is based in part 
on financial assumptions that show a weak future for our economy. At 
the same time that he paints this bleak picture, the President has told 
the American people that investing the program in stocks is the way to 
go because our future economic outlook is bright, with no possibilities 
of downturn. We cannot have it both ways.
                               ----------
                  PREPARED STATEMENT OF GARY A. AMELIO
     Executive Director, Federal Retirement Thrift Investment Board
                             June 14, 2005
    Good morning, Chairman Hagel and Members of the Subcommittee, my 
name is Gary Amelio. I am the Executive Director of the Federal 
Retirement Thrift Investment Board and, as such, the managing fiduciary 
of the Thrift Savings Plan, or TSP, for Federal employees and members 
of the uniformed services. I welcome this opportunity to appear before 
the Subcommittee on behalf of the Board.
    You have invited my testimony as part of your consideration of the 
role of the Financial Markets in Social Security Reform. Although the 
Board has expressed no view regarding any proposals to change Social 
Security, our experience with the TSP may provide some useful 
information for the Subcommittee. I am pleased to describe how the TSP 
functions in a number of key areas and to discuss how the Congress 
addressed important TSP issues in the Federal Employees' Retirement 
System Act of 1986 (FERSA).
    The TSP is a voluntary savings and investment plan that allows 
Federal and postal employees (and, since 2002, members of the uniformed 
services) to accumulate savings for their retirement. It offers 
employees of the Federal Government the same types of savings and tax 
benefits that many private corporations offer their employees under 
Internal Revenue Code Section 401(k) retirement plans. The TSP 
currently has approximately 3.4 million individual accounts. The Thrift 
Savings Fund has grown to $157 billion. Each month, participants add 
more than $1.4 billion in new contributions. Participants may invest in 
any individual, combination, or all of five investment funds; transfer 
their monies among the funds; apply for loans from their accounts; 
transfer money into their accounts from other eligible employee plans 
or individual retirement accounts; and receive distributions under 
several withdrawal options. TSP administrative expenses are borne by 
the participants, not by the taxpayers.
    The Government-wide Federal Employees' Retirement System (FERS) 
employee participation rate is 86.2 percent. TSP participation by Civil 
Service Retirement System (CSRS) employees is currently about 66 
percent. Additionally, after only 3 years, nearly half a million 
members of the uniformed services also now have TSP accounts.
Plan Structure
    Employees who are covered by FERS, CSRS, or members of the 
uniformed services contribute via payroll allotment to the TSP. The 
maximum percentages they may contribute are prescribed by law. These 
limits are scheduled to increase next year to $15,000 annually for most 
employees and $20,000 annually for those age 50 and over.
    FERS employees receive an automatic contribution to their TSP 
accounts, paid by their employing agency, which is equal to 1 percent 
of their basic pay each pay period. Their employing agency also matches 
the first 5 percent of basic pay contributed--dollar-for-dollar on the 
first 3 percent and fifty cents on the dollar for the next 2 percent. 
CSRS employees and members of the uniformed services receive the same 
tax benefits as FERS employees, but receive no automatic or matching 
contributions from their agencies.
Governance and Administration
    The TSP is administered by the Federal Retirement Thrift Investment 
Board, which was established as an independent Federal agency under 
FERSA. There are approximately 90 employees of the Agency. Governance 
is carried out by six individuals who serve as fiduciaries of the Plan. 
Five are part-time Presidential appointees (confirmed by the Senate) 
who serve 4-year terms, and the sixth is a full-time executive 
director. The latter is selected by the appointees and serves an 
indefinite term. Each of these persons is required by FERSA to have 
``substantial experience, training, and expertise in the management of 
financial investments and pension benefit plans.'' 5 U.S.C. 
Sec. 8472(d). With input from the executive director and Agency staff, 
the Board members collectively establish the policies under which the 
TSP operates and furnish general oversight.
    The executive director carries out the policies established by the 
Board members and otherwise acts as the full-time chief executive of 
the Agency. The Board and the executive director convene monthly in 
meetings open to the public to deliberate policies, practices, and 
performance.
    FERSA provides that all monies in the Thrift Savings Fund are held 
in trust for the benefit of the participants and their beneficiaries. 
As fiduciaries, the executive director and the Board members are 
required to act prudently and solely in the interest of TSP 
participants and their beneficiaries. This fiduciary responsibility 
gives the Board a unique status among Government agencies.
    Congress wisely established this fiduciary structure because it 
recognized that all Plan funds belong to the participants, not the 
Government, and thus must be managed for them independent of political 
or social considerations.
    The Conference Report on FERSA, House Report 99-606, dated May 16, 
1986, states in the Joint Explanatory Statement of the Committee of 
Conference:

        Concerns over the specter of political involvement in the 
        thrift plan management seem to focus on two distinct issues. 
        One, the Board, composed of Presidential appointees, could be 
        susceptible to pressure from an Administration. Two, the 
        Congress might be tempted to use the large pool of thrift money 
        for political purposes. Neither case would be likely to occur 
        given present legal and constitutional restraints.
        The Board members and employees are subject to strict fiduciary 
        rules. They must invest the money and manage the funds solely 
        for the benefit of the participants. A breach of these 
        responsibilities would make the fiduciaries civilly and 
        criminally liable.
        The structure of the funds themselves prevents political 
        manipulation. The Government Securities Investment Fund is 
        invested in nonmarketable special issues of the Treasury pegged 
        to a certain average interest rate. The Fixed Income Investment 
        Fund is composed of guaranteed investment contracts, 
        certificates of deposits or other fixed instruments in which 
        the Board contracts with insurance companies, banks, and the 
        like to provide it with a fixed rate of return over a specified 
        period of time. The Board would have no knowledge of the 
        specific investments.
        Finally, the stock index fund is one in which a common stock 
        index such as Standard & Poor's 500 or Wilshire's 5000 is used 
        as the mechanism to allocate investments from the fund to 
        various stocks.
        The investment approach chosen by the conferees is patterned 
        after corporate, State, and local government, and the few 
        existing Federal pension funds. Political manipulation is 
        unlikely and would be unlawful.
        As to the issue of Congress tampering with the thrift funds, 
        the inherent nature of a thrift plan precludes that 
        possibility. Unlike a defined benefit plan where an employer 
        essentially promises a certain benefit, a thrift plan is an 
        employee savings plan. In other words, the employees own the 
        money. The money, in essence, is held in trust for the employee 
        and managed and invested on the employee's behalf until the 
        employee is eligible to receive it. This arrangement confers 
        upon the employee property and other legal rights to the 
        contributions and their earnings. Whether the money is invested 
        in Government or private securities is immaterial with respect 
        to employee ownership. The employee owns it and it cannot be 
        tampered with by any entity including Congress.

    H.R. Conf. Rep. No. 99-606, at 136-37 (1986), reprinted in 1986 
U.S.C.C.A.N. 1508, 1519-20.

    In keeping with the intent of Congress that the Plan be 
administered in accordance with fiduciary standards derived from those 
applicable to private sector employee benefit plans--as distinct from 
the usual administration of an executive branch agency--Congress 
exempted the Board from the normal budget and appropriations processes 
and the legislative and budget clearance processes of the Office of 
Management and Budget. The Plan's independence is critical to ensure 
the fiduciary accountability envisioned by FERSA. So long as the Plan 
is managed by the fiduciaries named in FERSA (the members of the Board 
and the executive director) in accordance with the statute's strict 
fiduciary standards, Federal employees and members of the uniformed 
services can be confident that their retirement savings will not be 
subject to political or other priorities which might otherwise be 
imposed by these clearance processes.
    FERSA protects the Thrift Savings Fund through more than just the 
independent fiduciary governance by the Board members and the executive 
director. Additional safeguards to protect TSP participants include the 
provisions in FERSA relating to (1) the role of the Secretary of Labor 
in establishing a program of fiduciary compliance audits; (2) the 
requirement that the Board contract with a private accounting firm to 
conduct an annual audit of the TSP on the basis of generally accepted 
accounting principles; and (3) the participation of the 15-member 
Employee Thrift Advisory Council, which includes representatives of the 
major Federal and postal unions, other employee organizations, and the 
uniformed services.
    The Board has benefited greatly from hundreds of audits conducted 
by the Department of Labor over the past 17 years. These audits, which 
have covered every aspect of the TSP, are reported to the Congress 
annually under the Inspector General Act of 1978, as amended.
    The accounting firm retained by the Board has conducted annual 
reviews as required. The result has been eighteen unqualified audit 
opinions.
    The Advisory Council meets with the executive director and advises 
on investment policy and the administration of the TSP. These meetings 
are very helpful in providing the Board with insights into employee 
needs, attitudes, and reactions to the various programs undertaken by 
the Board.
    The TSP also benefits from the cooperation of every agency and 
service in the Federal establishment. Although the Board is an 
independent body, successful administration of the TSP is highly 
dependent upon all Federal agencies and the uniformed services, which 
have direct responsibilities under FERSA for the administration of the 
TSP.
Plan Services and Benefits
    Employees and service members who participate in the TSP are served 
primarily by the personnel, payroll, and other administrative employees 
in their own agencies. The agencies are responsible for distributing 
TSP materials, providing employee counseling, and accurately and timely 
transmitting participant and employer contributions and necessary 
records to the TSP record keeper. TSP recordkeeping services are 
currently provided by the National Finance Center (NFC), which is part 
of the Department of Agriculture. The TSP Service Office in New Orleans 
performs a wide variety of services for TSP participants.
    In addition, the TSP maintains parallel call centers at NFC in New 
Orleans, Louisiana, and in Cumberland, Maryland. Participants with 
questions may call a toll-free number which routes calls to participant 
service representatives at one of these sites. Further, we maintain a 
primary data center and a back-up data center.
    Actively employed participants may borrow their own contributions 
and earnings from their accounts according to rules established by the 
executive director and regulations of the Internal Revenue Service. 
Participants repay the loans, with interest, and the money is 
reinvested in their TSP accounts. A $50 fee is charged to cover the 
costs of loan processing.
    The other major benefit program is the TSP withdrawal program. 
Participants may withdraw funds from their TSP accounts before 
separation after reaching age 59 or in cases of financial hardship. 
Upon separation, a participant may:

 withdraw his or her account balance in a single payment (and 
    have the TSP transfer all or part of the payment to an Individual 
    Retirement Account (IRA) or other eligible retirement plan);
 withdraw his or her account balance in a series of monthly 
    payments (and, in certain cases, have the TSP transfer all or part 
    of each payment to an IRA or other eligible retirement plan);
 receive a life annuity; or
 keep his or her account in the TSP, subject to certain limits.

    Participants may also elect a combination of these withdrawal 
options.
Communications
    The Agency maintains its communication program on a number of 
levels within the Federal establishment in order to achieve employee 
understanding of the investment choices, benefits, and the 
administration of the program. This is especially 
important given the voluntary nature of the Plan and the participants' 
degree of individual control over investments and benefits.
    The communication effort is initiated by the Board for eligible 
individuals through the issuance of a ``new account letter'' to each 
new participant after the employing agency establishes his or her 
account. Employing agencies distribute program information, including 
the Summary of the Thrift Savings Plan for Federal Employees, which 
provides a comprehensive description of the Plan, as well as booklets 
describing the loan program, withdrawal programs, and annuity options 
for employees to review at the time they are examining those benefits. 
Investment information is provided by the TSP Fund Sheets and the 
Managing Your Account leaflet which discusses operations. Copies of 
these publications are also available on our website at www.tsp.gov or 
through the ThriftLine.
    In addition, we issue materials related to specific events. For 
example, the TSP Highlights is a newsletter issued with the quarterly 
participant statement. Copies of the newsletters, which address topical 
items and convey rates of return, are provided on our website. 
Participants can also obtain their daily balances from the website, 
request contribution allocations and interfund transfers or, in some 
cases, loans and withdrawals, and use various calculators located there 
as convenient planning tools.
    A TSP video is available explaining the basics of the TSP in an 
animated format. TSP Bulletins are issued regularly to inform agency 
personnel and payroll specialists of current operating procedures. The 
ThriftLine, the Board's toll-free automated voice response system, also 
provides both general plan and account-specific information.
    In connection with new Lifecycle funds we plan to introduce this 
summer, we will revise all of our communications materials and feature 
the benefits of the asset allocation approach used in ``Life'' funds as 
discussed below. We have budgeted $10 million for this major overhaul 
of our communications materials.
    The Agency also conducts quarterly interagency meetings. These have 
proven to be an effective means of communicating program and systems 
requirements to Federal agency administrative personnel. These meetings 
also allow the TSP to hear and address representatives' concerns and to 
incorporate their suggestions in the establishment of TSP policies and 
operations.
Investment Funds
    The TSP is a participant-directed plan. This means that each 
participant decides how the funds in his or her account are invested.
    As initially prescribed by FERSA, participants could invest in 
three types of securities--U.S. Treasury obligations, common stocks, 
and fixed income securities--which differ considerably from one another 
in their investment characteristics. In 1996, on the Board's 
recommendation, Congress authorized two additional investment funds, 
which allow further diversification and potentially attractive long-
term returns. The Small Capitalization Index Investment Fund and the 
International Stock Index Investment Fund were first offered in May 
2001.
    The Government Securities Investment (G) Fund is invested in short-
term nonmarketable U.S. Treasury securities guaranteed by the full 
faith and credit of the U.S. Government. 5 U.S.C. Sec. 8438(b)(1)(A), 
(e). There is no possibility of loss of princi-pal from default by the 
U.S. Government and thus no credit risk. These securities are similar 
to those issued to the Social Security Trust Funds and to other Federal 
trust funds. See 42 U.S.C. Sec. 401(d) (Social Security Trust Funds); 5 
U.S.C. Sec. 8348(d) (Civil Service Retirement and Disability Fund).
    The Fixed Income Index Investment (F) Fund, which by law must be 
invested in fixed income securities, is invested in a bond index fund, 
chosen by the Board to be the Lehman Brothers U.S. Aggregate (LBA) 
index. The LBA index represents a large and diversified group of 
investment grade securities in the major sectors of the U.S. bond 
markets: U.S. Government, corporate, and mortgage-related securities.
    The Common Stock Index Investment (C) Fund must be invested in a 
portfolio designed to replicate the performance of an index that 
includes common stocks, the aggregate market value of which is a 
reasonably complete representation of the U.S. equity markets. The 
Board chose the Standard & Poor's 500 (S&P 500) stock index in 
fulfillment of that requirement. The S&P 500 index consists of 500 
stocks representing approximately 78 percent of the market value of the 
U.S. stock markets. The objective of the C Fund is to match the 
performance of that index.
    The Small Capitalization Stock Index Investment (S) Fund must be 
invested in a portfolio designed to replicate the performance of an 
index that includes common stocks, the aggregate market value of which 
represents the U.S. equity markets, excluding the stocks that are held 
in the C Fund. The Board chose the Dow Jones Wilshire 4500 Completion 
index, which tracks the performance of the non-S&P 500 stocks in the 
U.S. stock market. The objective of the S Fund is to match the 
performance of the Wilshire 4500 index. The Wilshire 4500 index 
represents the remaining 22 percent of the market capitalization of the 
U.S. stock market. Thus, the S Fund and the C Fund combined cover 
virtually the entire U.S. stock market.
    The International Stock Index Investment (I) Fund must be invested 
in a portfolio designed to track the performance of an index that 
includes common stocks, the aggregate market value of which represents 
the international equity markets, excluding the U.S. equity markets. 
The Board chose the Morgan Stanley EAFE (Europe, Australasia, Far East) 
index, which tracks the overall performance of the major companies and 
industries in the European, Australian, and Asian stock markets. The 
objective of the I Fund is to match the performance of the EAFE index. 
The EAFE index was designed by Morgan Stanley Capital International 
(MSCI) to provide broad coverage of the stock markets in the 21 
countries represented in the index.
    This summer, the TSP will introduce Lifecycle Funds. The Lifecycle 
Funds will be invested in various combinations using the five existing 
TSP funds. Participants will benefit from having professionally 
designed asset allocation models available to optimize their investment 
performance by providing portfolios that are appropriate for their 
particular time horizon. This is known in the financial world as 
investing on the ``efficient frontier.'' We are very excited by the 
prospect of providing these funds to participants this summer. We have 
placed preliminary information regarding the Lifecycle Funds on our 
website, and will be issuing much more over the coming months.
    One likely concern associated with a Federal agency's investing in 
equities is the potential for the Government to influence corporate 
governance questions and other issues submitted to stockholder votes. 
FERSA provides that the voting rights associated with the ownership of 
securities by the Thrift Savings Fund may not be exercised by the 
Board, other Government agencies, the executive director, a Federal 
employee, Member of Congress, former Federal employees, or former 
Members of Congress. 5 U.S.C. Sec. 8438(f). Barclays Global Investors 
(BGI), the manager of the C, S, and I Fund assets, has a fiduciary 
responsibility to vote company proxies solely in the interest of its 
funds' investors.
    The fund assets held by the F, C, S, and I Funds are passively 
managed indexed funds; that is, they are invested in portfolios of 
assets in such a way as to reproduce market index returns. The 
philosophy of indexing is that, over the long-term, it is difficult to 
improve upon the average return of the market. The investment 
management fees and trading costs incurred from passive management 
through indexing generally are substantially lower than those 
associated with active management. Passively managed index funds also 
preclude the possibility that political or other considerations might 
influence the selection of securities.
    The manager of the assets held by the F, C, S, and I Funds has been 
selected through competitive bidding processes. Proposals from 
prospective asset managers were evaluated on objective criteria that 
included ability to track the relevant index, low trading costs, 
fiduciary record, experience, and fees.
    The Board has contracts with BGI to manage the F, C, S, and I Fund 
assets. BGI is the largest investment manager of index funds in the 
United States, which had over $1.36 trillion in total assets under 
management as of December 31, 2004.
    The centralized management of TSP investments was carefully 
considered in FERSA by Congress. According to the Joint Explanatory 
Statement of the Committee of Conference quoted earlier:

        Because of the many concerns raised, the conferees spent more 
        time on this issue than any other. Proposals were made to 
        decentralize the investment management and to give employees 
        more choice by permitting them to choose their own financial 
        institution in which to invest. While the conferees applaud the 
        use of IRA's, they find such an approach for an employer-
        sponsored retirement program inappropriate . . . .

        The conferees concur with the resolution of this issue as 
        discussed in the Senate report (99-166) on this legislation:

        As an alternative the committee considered permitting any 
        qualified institution to offer to employee[s] specific 
        investment vehicles. However, the committee rejected that 
        approach for a number of reasons. First, there are literally 
        thousands of qualified institutions who would bombard employees 
        with promotions for their services. The committee concluded 
        that employees would not favor such an approach. Second, few, 
        if any, private employers offer such an arrangement. Third, 
        even qualified institutions go bankrupt occasionally and a 
        substantial portion of an employee's retirement benefit could 
        be wiped out. This is in contrast to the diversified fund 
        approach which could easily survive a few bankruptcies. Fourth, 
        it would be difficult to administer. Fifth, this ``retail'' or 
        ``voucher'' approach would give up the economic advantage of 
        this group's wholesale purchasing power derived from its large 
        size, so that employees acting individually would get less for 
        their money.

    H.R. Rep. No. 99-606, at 137-38, reprinted in 1986 U.S.C.C.A.N. 
1508, 1520-21.
Investment Returns
    By law, TSP investment policies must provide for both prudent 
investments and low administrative costs. From the beginning of the G 
Fund's existence (April 1987) and the beginning of the F and C Funds' 
existence (January 1988) through December 31, 2004, the G, F, and C 
Funds have provided compound annual returns net of expenses of 6.7 
percent, 7.7 percent, and 12.1 percent, respectively. The related BGI 
funds closely tracked their respective markets indexes throughout this 
period. Because the S and I Funds were introduced in May 2001, the 
Board has no long-term history for them. The indexes which they track, 
however, have produced compound annual returns of 11.9 percent and 5.6 
percent, respectively, for the 10-year period ending December 2004.
    In order to make the performance of the TSP funds more easily 
comparable, I have attached a chart which displays the growth of $100 
invested in the underlying indexes for 20 years. The chart also 
includes the growth related to G Fund securities as well as inflation.
    For calendar year 2004, the net Plan administrative expenses were 
.06 percent. This means that the 2004 net investment return to 
participants was reduced by approximately $.60 for each $1,000 of 
account balance. The expense ratio would be approximately .01 percent 
higher in the absence of account forfeitures, which offset expenses. 
These costs compare very favorably with typical private sector 401(k) 
service provider charges.
    In summary, I believe that the Thrift Savings Plan has effectively 
and efficiently realized the numerous objectives Congress thoughtfully 
established for it 19 years ago. To the extent that our experience is 
useful to the Subcommittee, I welcome the opportunity to provide any 
additional information you may require. I would be pleased to respond 
to any questions you or other Members of the Subcommittee may have at 
this time.
                 PREPARED STATEMENT OF FRANCIS ENDERLE
            Managing Director and Chief Investment Officer,
       Global Index and Markets Group, Barclays Global Investors
                             June 14, 2005
    Good afternoon, Mr. Chairman and Members of the Committee, my name 
is Francis Enderle and I am the Chief Investment Officer for the Global 
Index and Markets Group at Barclays Global Investors (BGI). In that 
role I am responsible for, among other things, the oversight of 
portfolio management in the United States of all of BGI's index 
strategies.
    We are pleased to be here today to share with the Committee our 
expertise in the management of defined contribution pension accounts, 
which is derived from our experience as the external asset manager for 
the Federal Thrift Savings Plan (TSP) as well as for numerous other 
public and private pension plans. We are honored to have served as an 
investment manager for the TSP since 1988, a relationship we have 
retained in regular, highly competitive bidding processes.
    I will begin by discussing our investment philosophy and our 
structure, both of which are focused on delivering highly reliable, low 
cost investment results to institutional investors like the TSP. By 
``institutional'' I refer to defined benefit and defined contribution 
pension plans sponsored by corporations or public agencies, and to 
endowments, foundations, and other similar pools of capital. I will 
then say a few words about the services we provide to the TSP, and 
elaborate on how we keep the costs associated with trading and 
investing as low as possible. I will conclude by turning to the 
investment related issues to be considered if the Federal Government 
were to legislate individual investment accounts either as part of 
Social Security reform, or through another mechanism.
    Barclays Global Investors was founded in 1971 as part of Wells 
Fargo Bank in San Francisco, California. Today, we are owned by 
Barclays PLC, one of the world's leading financial service providers. 
We are headquartered in San Francisco with approximately 1,100 
employees in California and elsewhere in the United States and 1,100 
more employees worldwide serving the needs of our global clients. With 
more than $1.3 trillion in assets under management, BGI, together with 
its affiliates, is the world's largest index manager. BGI created the 
first index strategy in 1971, just one of many financial innovations we 
have pioneered.
    Since our founding, BGI has remained true to a single global 
investment philosophy, which we call Total Performance Management. BGI 
manages performance through the core disciplines of risk, return, and 
cost management. The success of our indexing methodology results from 
our focus on delivering superior investment returns over time while 
minimizing trading and other implementation costs and rigorously 
controlling investment and operational risks. This approach helps us 
avoid investment ``fads'' or a dependence on ``star managers'' or 
``stock pickers.'' It has been the foundation for the way we have 
managed money for over 30 years and we believe it has served our 
clients very well.
    As I noted earlier, since 1988 one of those clients has been the 
TSP. BGI manages four of the five investment options available for 
participants--the TSP C Fund (based on large-capitalization U.S. 
equities), the S Fund (based on mid- and small-capitalization U.S. 
equities), the F Fund (based on the Lehman Aggregate Long-term Bond 
index) and the I Fund (based on the MSCI Europe Australia Far East 
(EAFE) index of non-U.S. equities). The fifth option, the G Fund, is 
managed by the U.S. Treasury and invests in U.S. Treasury securities. 
Later this year, the TSP will be launching a series of lifecycle or 
``target horizon'' options that use the existing five options as the 
asset class ``building blocks'' with allocations in each lifecycle fund 
across these options being determined by an external vendor. I will 
describe shortly the structure of these new options, as well as the 
benefits they will provide to plan participants.
    BGI's services to the TSP are completely focused on investment 
management. We do not provide any other services. We have an extremely 
effective operating model developed in conjunction with TSP staff to 
manage the daily cashflows into or out of each of the investment 
options. Each day we receive an instruction for each fund that 
aggregates the transaction instructions of all TSP participants placing 
orders on that day. In this way, the orders for participants buying or 
selling from the same fund are netted against each other and only a 
trade for the residual order is placed.
    Management of payroll contributions, recordkeeping (for example, 
changes made by participants in investment elections), distributions 
and communications to participants are handled directly by the TSP or 
its other vendors. This is also true for most of our other clients--our 
core expertise is investment management, and our comments are provided 
principally from this perspective. Minimizing transaction costs in all 
our investment activities is a central element, Mr. Chairman, in how we 
do our business. In fact, the key to our success in index management 
has been our ability to minimize implementation and trading costs. High 
costs and expenses of investing detract from performance and investment 
returns; lower costs increase the investment pool and put more money 
long-term into the pockets of investors. Let me say a few words about 
how we do this.
    Each of our index funds is structured to match the performance of a 
specific index. These indexes (such as the S&P 500 or the MSCI EAFE) 
are designed by third-party index providers. However, these indexes are 
really ``paper portfolios'' and do not include any of the trading costs 
that real-world investors experience. Thus to successfully achieve the 
performance target--that is, to track the index as closely as 
possible--BGI strives to minimize the ``real world'' costs through a 
variety of highly efficient trading approaches.
    Through the size and diversity of our client base we are able to 
match or offset a significant percentage of our clients' buy and sell 
orders internally, thereby reducing or eliminating market transaction 
costs. The internal matching of buy and sell orders is commonly 
referred to as ``crossing,'' and is conducted and actively monitored by 
BGI pursuant to the terms and conditions of an exemption issued by the 
Department of Labor.
    When we do trade in the markets, we utilize carefully developed and 
managed trading strategies and we access all possible sources of 
liquidity, including electronic marketplaces. Our trading activities 
are supported by a dedicated trading research team, whose sole job is 
to develop new trading techniques and strategies to minimize trading 
costs. We execute our trades through broker-dealers who have been 
prescreened for credit-worthiness, and we rigorously monitor the prices 
at which our trades are executed relative to a number of market-related 
benchmarks to ensure we are receiving superior execution. We also use 
our scale to negotiate low per share commission rates.
    The majority of our assets are managed for large institutional 
clients such as the TSP and the average account size for our U.S. 
clients is $880 million. BGI is able to charge lower investment 
management and administrative fees to its institutional clients than a 
mutual fund firm geared toward retail investors, where the average 
account size is comparatively small. And in dealing with institutional 
investors we do not have the costs of retail administrative services 
(including shareholder communications and recordkeeping), which also 
serve to raise the costs of retail fund managers. By way of example, 
the average fee for large-capitalization U.S. equity index portfolios 
of $100 million in size that are managed for institutional clients is 
0.05 percent versus retail-oriented equity index mutual funds where the 
fees average 0.69 percent,\1\ more than 10 times greater than our 
expense ratios.
---------------------------------------------------------------------------
    \1\ Source: Morningstar, BGI 2/05.
---------------------------------------------------------------------------
    Over the course of a long-term investment, lower management fees 
and expenses (including trading commissions) can translate into 
considerable savings for any investor. Indeed, index investing remains 
the most cost-efficient and diversified way to gain exposure to various 
segments of the capital markets. We believe index funds are the best 
core investment for most investors' portfolios--whether they are the 
largest pension fund in the world, or an individual investor.
    I would now like to make a few comments regarding investment 
management considerations if personal accounts are adopted as part of 
any future changes to the Social Security program.
    Let me first acknowledge that BGI has built a substantial part of 
its business by offering well-managed index strategies to our clients 
for more than 30 years. We therefore have a vested interest in the 
continued growth of index investing. Our interests aside, we firmly 
believe that the reason for the success of these strategies is the 
simple fact that they deliver the return of the market index reliably 
and cost effectively. In fact, Congress recognized this itself in the 
enabling legislation for the TSP, which provides that the four public 
market options be invested in portfolios designed to replicate the 
performance of an index that is ``commonly recognized'' as reflecting 
the performance of each asset class (that is the S&P 500 Index for 
large capitalization U.S. equities).
    If a national system of personal accounts were to be implemented, 
we would encourage legislators to consider the following approach that 
draws on the best practices of institutional investors.
    An array of low cost, broadly diversified index funds frequently 
forms the core 
investment for institutional pension plans, both defined benefit and 
defined contribution structures. For example, the current selection 
offered to TSP participants covers all the main asset classes--large 
and small capitalization U.S. equities, U.S. fixed income, 
international equities and a stable value option. Other asset classes 
could be included but these options would provide the basic ``building 
blocks'' and coincide with what one would typically see in a well-
constructed institutional portfolio.
    We suggest consideration of index portfolios because they offer 
three principle benefits to investors:

 They capture the return of each asset class (as represented by 
    a benchmark index such as the S&P 500) with a high degree of 
    precision;
 Index funds typically have low asset management fees as 
    compared to actively managed funds;
 Index funds have lower relative transaction costs including 
    commissions, bid/ask spreads and market impact. This is because 
    index fund investments are spread across a large number of 
    securities thereby reducing the impact of a portfolio trade on an 
    individual security relative to what would occur in a more 
    concentrated portfolio.

    The latter point is worth elaborating upon given the sizeable 
assets that would potentially be invested in personal accounts. 
Investing in index funds spreads assets across the broadest possible 
array of securities in any asset class thereby minimizing the impact of 
trading large cashflows in the market on a daily basis. This is not 
only important for the investment of new monies into personal accounts 
but also for any trading that individuals may initiate in their 
personal accounts to reallocate assets among their investment options 
over time.
    Another investment option to be considered is an array of so-called 
lifecycle or ``target horizon'' funds, options that the TSP will be 
adding later this year, as I mentioned earlier. With lifecycle funds, 
potentially the only choice an investor needs to make is to select the 
lifecycle fund with the target horizon date that most closely matches 
the investor's date of retirement. Each lifecycle fund would hold an 
array of asset classes with each asset class being implemented with an 
index fund. The asset mix within each lifecycle fund would gradually 
become more conservative over time as the target horizon date 
approached. For example, a participant who is 30 years of age today and 
a set retirement of, for example, age 65 would be invested in a 
lifecycle fund with a target horizon date of 2040.
    As with the index fund options described earlier, a lifecycle fund 
option could also be structured as a very low cost solution to 
investors. While a lifecycle fund would not necessarily need to be 
invested in index funds, index funds likely provide the lowest cost 
solution for each asset class, and assure that the return of each 
selected asset class is reliably captured. Participants in each 
lifecycle fund would benefit from the fund's gradual evolution to a 
more conservative investment risk profile as the participant approached 
retirement.
    Mr. Chairman, we believe that the investment considerations we have 
discussed will assist you and others on this Committee in evaluating 
the criteria to be used if personal accounts were to be legislated by 
Congress as part of revisions to the Social Security program, or in 
another program. I thank you for the opportunity to speak with you 
today and I look forward to answering any questions you may have.
                               ----------
               PREPARED STATEMENT OF FRANCIS X. CAVANAUGH
 Former Executive Director, Federal Retirement Thrift Investment Board
                             June 14, 2005
    Mr. Chairman and Members of the Subcommittee, I welcome this 
opportunity to discuss the role of financial markets in Social Security 
reform. The Administration's current proposal for Social Security 
individual accounts (IA) contemplates that private financial 
institutions would provide fund management services and probably other 
401(k) plan services, such as investment education, counseling, and 
record keeping. My comments will focus on the cost of such services and 
the problems in providing them to employees of small businesses.
    I am a public finance consultant, but I speak only for myself. I 
have no clients with an interest in Social Security individual 
accounts. From 1986 until 1994, I was the first Executive Director, and 
thus the Chief Executive Officer, of the Federal Retirement Thrift 
Investment Board, the agency that administers the Thrift Savings Plan 
(TSP) for Federal employees. Before that, I was a financial economist 
in the Treasury Department for 32 years, and was the senior career 
executive responsible for developing Federal borrowing, lending, and 
investment policies, including those for the Social Security and other 
Federal trust funds.
The Administration's Proposal
    While there is no specific proposal before your Committee, the 
Administration's current broad proposal, according to White House 
statements and press reports, provides a basis for at least a 
preliminary analysis of its feasibility.
    The following features of the Administration's approach would have 
significant impacts on its feasibility:

 Social Security individual accounts (IA's) would be voluntary 
    for all Social Security taxpayers under age 55, but would be 
    mandatory for employers of employees who chose IA's.
 A major purpose of IA's would be to encourage savings by young 
    and low-income workers and employees of small businesses who do not 
    now have 401(k)s or other pension plans.
 The maximum amount of an individual's initial annual 
    contribution to an IA would be $1,000, which would increase by $100 
    a year, to 4 percent of pay eventually. It would take more than 30 
    years for the highest income individuals to be able to contribute 
    the full 4 percent of pay.
 Eligible investments for IA's would be Treasury securities and 
    stock and bond index funds, which would be similar to eligible 
    investments of the TSP.
 IA's would be centrally managed, apparently by a TSP-like 
    agency with a part-time board, appointed by the President with the 
    advice and consent of the Senate, and a full-time executive 
    director and CEO appointed by the board. Following the TSP model, 
    the board members and the executive director would be independent 
    of the administration, and would be fiduciaries required to act 
    solely in the interests of the holders of the IA's and their 
    beneficiaries.
 Unlike contributions to 401(k)'s or to the TSP, IA 
    contributions would not be eligible for matching contributions or 
    exclusion from taxable income, and loans or withdrawals before 
    retirement would not be permitted.
Cost Analysis
    A critical question, of course, is costs. IA's are proposed to 
provide a higher investment return than would be realized by the Social 
Security Trust Fund. Thus IA's would not be feasible if their 
administrative costs were so high as to offset the advantage of 
diversified investments in stocks and other securities that yield more 
than the Treasury securities in the Social Security Trust Fund.
    The Administration assumes that IA's would earn an average 
investment return of 4.9 percent after inflation, and that 
administrative costs of .3 percent, that is, 30 basis points, would 
reduce the net return to 4.6 percent, or 1.6 percent more than the 
assumed net return of 3 percent on the Treasury securities in the 
Social Security Trust Fund. Thus, if one accepts the Administration's 
assumptions, IA's would outperform the Trust Fund investments so long 
as the administrative costs were less than 1.9 percent. In my view and 
that of many other economists, the 4.6 percent assumption is much too 
high; indeed, the Congressional Budget Office's estimate of the net 
return is reportedly only 3.3 percent.
    The Administration's estimate of 30 basis points is optimistically 
low; even the Cato Institute, a leading advocate of individual 
accounts, estimates IA expenses at 55 basis points. Yet this higher 
estimate is also too low. Like so many others I have heard, these 
estimates are based mainly on experience with large 401(k)s for large 
organizations, like the TSP,\1\ with economies of scale and 
comprehensive payroll, personnel, and computerized systems support.
---------------------------------------------------------------------------
    \1\ The administrative cost, or expense ratio, of the TSP is 6 
basis points.
---------------------------------------------------------------------------
    They have little relevance to the likely costs of a universal 
system of IA's. More than 85 percent of the 5.6 million small business 
employers in this country offer no pension plans at all and, 
accordingly, have none of the administrative apparatus to service them.
    To understand the costs of bringing IA's to employees of small 
businesses, we must first understand why 85 percent of them do not now 
have retirement plans for their employees. Fortunately, the 401(k) 
industry has already done part of the job for us. Companies like 
Citigroup, Fidelity Investments, Merrill Lynch, State Street 
Corporation, and T. Rowe Price have been competing for two decades to 
provide investment, record keeping, counseling, and other 401(k) plan 
services to small businesses. They have found that they cannot 
profitably provide these services for a company for less than 
approximately $3,000 a year, even though they have for years enjoyed 
economies of scale from serving thousands of employers in their 
centralized computer systems.\2\ Further significant economies of scale 
would not be realized by a central TSP-type agency, because there would 
still be millions of small businesses or workplaces to be reached. Nor 
can we assume that a new central government agency would be more 
efficient than the major 401(k) providers who now serve this market.
---------------------------------------------------------------------------
    \2\ Francis X. Cavanaugh, ``Feasibility of Social Security 
Individual Accounts,'' AARP Public Policy Institute, Washington, DC, 
Sept. 2002, pp. 4-6. The $3,000 charge is still common today. See ``Big 
Fees Hit Small Plans: Costs Take Huge Toll on Retirement Accounts of 
Firms With Fewer Than 50 Employees,`` Wall Street Journal, Oct. 31, 
2004, p. D1.
---------------------------------------------------------------------------
    Thus the cost per employee of a company with 10 employees would be 
$300, or 30 percent of the President's proposed annual IA contribution 
of $1,000--and most U.S. companies have fewer than 10 employees.\3\
---------------------------------------------------------------------------
    \3\ See generally U.S. Department of Labor, Pension and Welfare 
Benefits Administration, ``Study of 401(k) Fees and Expenses,''Apr. 13, 
1998. The study found that average charges by 17 major 401(k) providers 
for plans with 100 participants and $2 million in assets ranged from 
$114 to $428 per participant, and averaged $264. Id. at 51. Charges 
obviously would be much higher for much smaller plans.
---------------------------------------------------------------------------
    Even the largest business that is classified as a ``small 
business,'' one with 100 employees, would therefore have an expense 
ratio of at least 3 percent, which would be 10 times the 
Administration's estimate of 30 basis points. And for the 60 percent of 
employers in this country that have fewer than 5 employees, the initial 
expense ratio would be more than 60 percent, that is, 6,000 basis 
points. In fact, commercial 401(k) providers routinely discourage small 
businesses from establishing 401(k) plans if they have fewer than 10 
employees and, in some cases, fewer than 25 employees.
    Obviously, substantial and continuing government subsidies would be 
necessary to make IA's attractive to employees of small businesses. If 
all Social Security taxpayers participated in the IA program, the 
administrative costs would be more than $46 billion a year (155 million 
participants times more than $300 per account), which would be a 
subsidy to IA administrators for performing an uneconomic function. 
These figures are reinforced by a number of studies, including those 
cited in a review of administrative costs by the Employee Benefit 
Research Institute.\4\
---------------------------------------------------------------------------
    \4\ See, for example, Employee Benefit Research Institute, Issue 
Brief No. 23, Nov. 1998. See also Ellen E. Schultz, ``Poodle Parlor 
Retirement Plans,'' Wall Street Journal, Nov. 13, 1998, p.C1.
---------------------------------------------------------------------------
    I recommend that your Committee secure the testimony of individuals 
from financial institutions that are actually providing 401(k) services 
to the Nation's businesses, large and small. Give them a specific set 
of assumptions to cost out that 
reflects the makeup of our country's 5.7 million employers subject to 
Social Security--of which 98 percent are small business employers of 68 
million employees.\5\ Then and only then will you know whether the 
Administration's proposal--or anything similar--will produce reasonable 
net investment returns, or, in the alternative, how much of a 
Government subsidy would be necessary to achieve them.
---------------------------------------------------------------------------
    \5\ Patrick Purcell, Congressional Research Service, ``Social 
Security Individual Accounts and Employer-Sponsored Pensions,'' Feb. 3, 
2005, pp. 3, 5.
---------------------------------------------------------------------------
Critical Administrative Problems
    In addition to the above costs, which are based on what the current 
providers are actually charging for establishing and servicing 401(k) 
plans, there are overwhelming practical obstacles to the creation and 
maintenance of IA's. Because President Bush seemed to idealize the 
Thrift Savings Plan--the largest of all 401(k)-type plans--as the model 
for IA's in his February 2005 State of the Union message--and because 
many others have done so as well--I would like to point out the 
considerable dissimilarities between the TSP and the administration's 
proposal. (Most of these dissimilarities would hold true for a 
comparison between any large corporate 401(k) plan and the proposal.)
    Too Many Small Employers. The TSP is administered by just one 
employer--the U.S. Government--with extensive personnel, payroll, and 
systems staffs to provide the essential employee education, retirement 
counseling, payroll deduction, timely funds transfers, and error 
correction functions. The Thrift Investment Board is only a wholesaler 
of services; the Federal employing agencies deal with the individual 
employees participating in the plan. In fact, the TSP statute directs 
the Office of Personnel Management to provide for the training of TSP 
counselors for each Federal agency.
    The Administration's plan is intended to reach all employees, but 
it makes no provision for the performance of what are now essential 
employer functions in 401(k) plans. They could not possibly be 
performed by small business employers who are now responsible only for 
the relatively simple payroll deduction and transmission of Social 
Security taxes to the IRS. Since most businesses have fewer than 10 
employees, they do not have the experience or administrative resources 
to support the new plan. These are barbershops, beauty salons, garages, 
restaurants, laundries, lawn services, households, nanny services, and 
other very small businesses that could not be expected to meet the high 
fiduciary standards required of those responsible for educating and 
counseling employees, for presenting a new plan in the context of the 
employer's existing pension or other benefits, and for the timely and 
accurate transfer of funds for investment. The new TSP-like agency 
obviously could not provide such employer-type services to deal with 
tens of millions of diverse employees, either directly or on a contract 
basis.
    Consider, as but one example of several profound administrative and 
legal issues, that about 650,000 businesses go out of business each 
year. By whom and how would the enforcement of contributions by 
delinquent or bankrupt employers be prosecuted? (Judicial remedies for 
denial of TSP benefits must, in general, be pursued by the affected 
individual TSP participant in the Federal court system.) For that 
matter, by whom and how would breach-of-fiduciary-duty suits be brought 
against ``mom-and-pop'' fiduciaries? Can the employer of a housekeeper 
or a manicurist be expected to exercise the ``care, skill, prudence, 
and diligence'' demanded of every 401(k) plan fiduciary by current law? 
\6\ What would be the measure--and the limit--of their personal 
liabilities, say, for untimely or inaccurate investment of their 
employees' contributions? These questions only scratch the surface of 
the inevitable pathology of plan administration--pathology that, even 
if represented in small percentages among 155 million Social Security 
participants, would result in enormous absolute numbers.
---------------------------------------------------------------------------
    \6\ See Employee Retirement Income Security Act (ERISA), 29 U.S.C. 
Sec. 1104(a); Federal Employees' Retirement System Act (FERSA), 5 
U.S.C. Sec. 8477(b)(1).
---------------------------------------------------------------------------
    Untimely Investments. The TSP is computerized, like all other large 
plans, with investments made for each employee's account on the same 
day that contributions are deducted from the employee's paycheck. 
Social Security taxes are deducted on paydays, but many small 
businesses send them to the IRS only once each quarter. In 2003, 72 
percent of employer reports to the Social Security Administration were 
submitted on paper. Moreover, individual Social Security taxpayers are 
identified only once each year, with their employer's annual income tax 
filings; and it would be up to 22 months after payday, under current 
SSA procedures, before individual IA's could be credited.
    Furthermore, the Administration's proposal is to pay IA's the same 
annual return, regardless of when contributions were actually made 
during the year. Thus a contribution in January would not earn any more 
than a contribution of a similar amount in December. During a year of 
highly volatile markets, the attempted explanation of this provision to 
millions of outraged participants with irregular tax payments, because 
of illness, seasonal, temporary, or other periods of unemployment, 
would be a daunting challenge to the plan's telephone counselors.
    Unbalanced Accounts. The TSP is balanced to the penny every day. 
The Social Security system is never balanced. Each year there are 
billions of dollars of unreconciled discrepancies between Social 
Security taxes paid to the IRS and reported to the SSA. These 
discrepancies are tolerated because they generally have little impact 
on the ultimate calculation of employee benefits. Such discrepancies 
are never tolerated by financial institutions responsible for timely 
investment of individual funds. Theoretically, IA contribution errors 
might be largely corrected by a rigorous examination of employer 
records. Yet the error correction procedures, including retroactive 
adjustments of investment gains or losses in volatile markets, could 
bring the entire system to a screeching halt.
    Inevitable Account ``Leakage.'' Unlike the TSP, the 
Administration's plan would prohibit loans and emergency withdrawals, 
and would require individuals to purchase annuities on retirement. I 
find it inconceivable, however, that Congress--or an Administration--
would long be able to resist calls for emergency access to funds before 
a worker's retirement, and in lump sum amounts. Suppose, for example, 
that an individual has suffered a devastating personal financial loss, 
such as thousands experienced in last year's Florida hurricanes in the 
destruction of their homes. Would these persons be told that they may 
not access their IA balances to mitigate such dire misfortunes? What 
about a catastrophic illness, leaving a family's breadwinner unable to 
work? Could such persons be denied their account balances to sustain 
spouse and children? I do not think so. There are, of course, scores 
more such examples, and with 155 million potential participants, you 
can be sure that they all would arise. Administering the inevitable 
emergency withdrawal or loan program would add enormously to the cost 
of the Administration's plan.
    Communication Problems. The TSP has a very effective communications 
system, because it can rely on the Federal employing agencies to 
distribute plan materials and to educate and counsel their employees. 
Even so, the TSP found it necessary to have the central recordkeeper 
for its 3 million accounts maintain a staff of more than 200 telephone 
counselors to respond directly to questions from individual 
participants. Since more than 200 million Social Security taxpayers and 
retirees eventually would be eligible for IA's, the required number of 
telephone counselors would be more than 13,000, based on the TSP 
experience, and probably much higher because of the special IA 
deficiencies noted above.\7\ Also, TSP mailings consistently have 
reached more than 99 percent of participants, but 25 percent of SSA 
mailings are returned as undeliverable.
---------------------------------------------------------------------------
    \7\ Fidelity Investments, a major 401(k) provider, has estimated 
that the administration of a 401(k)-type plan for Social Security 
taxpayers would require a total staff of 100,000. See Employee Benefit 
Research Institute, Issue Brief No. 23, Nov. 1998, p. 166.
---------------------------------------------------------------------------
    Congress would undoubtedly insist that every effort be made to 
advise all Social Security taxpayers of the IA benefits Congress 
intended to provide them. The TSP sent summary plan documents to all 3 
million eligible employees, which required 18 trailer trucks of printed 
materials. Similar documents would have to be sent eventually to the 
more than 200 million Social Security-covered employees and retirees.
    The eventual costs of such massive efforts at this point are 
unknown, but they clearly would have a significant impact on IA 
expenses.
    Small Employer Antipathy. Even if small businesses were able to 
perform normal employer functions for IA's, would they want to? IA's 
would be voluntary for employees but, if employees elect to have IA's, 
mandatory for their employers.
    The TSP and 401(k) plans generally are enthusiastically sponsored 
and supported by the large employers who offer them as a major benefit 
for their employees, and as a means to move away from defined benefit 
retirement plans that require employers to bear substantial investment 
risks. The major attractions of the TSP and 401(k)'s generally are the 
matching employer contributions and the immediate tax benefit from 
excluding employee contributions from taxable income. The ability to 
borrow or withdraw funds to meet emergency needs is also a significant 
benefit. IA's, as currently proposed, would offer none of these 
benefits, and would be a relatively unattractive product that employers 
might be reluctant to support, especially small employers who do not 
have any pension plans. Moreover, it would be unrealistic to expect 
small-business employers to act as large corporate employers do in 
assuming the costs of investment losses because of, say, employer error 
in transmitting funds for timely investment of 401(k) accounts, or for 
myriad other commonplace employer errors. These serious concerns for 
small businesses would have to be addressed during congressional 
hearings on IA proposals.
The Trust Fund Alternative
    Since IA's are certainly not feasible for employees of small 
businesses--the vast preponderance of the business community--the only 
practical way to give them the higher returns available from equity 
investments is to invest part of the Social Security Trust Fund in 
equities. That way, the overwhelming administrative costs and practical 
problems of the Administration's plan would be avoided. The total 
administrative cost of having the Social Security Trust Fund invest in 
the private funds proposed for IA's would be no more than one basis 
point, based on the actual costs of market investments by the Thrift 
Savings Plan. The likely increase in Trust Fund earnings would be an 
effective way to help maintain the solvency of the Trust Fund without 
having to resort to significant increases in Social Security taxes or 
reductions in benefits.
    Every State in the United States has authorized public retirement 
fund investment in stocks. Yet the Federal Government still clings to 
the old notion that governments should not have an ownership stake in 
private companies, which made some sense when individual stocks were 
involved. Today's broad based index funds, however, remove the investor 
from direct control over particular companies. Small business employees 
should not be denied the benefits of portfolio diversification in the 
Social Security Trust Fund simply because the Federal Government has 
not kept up with the States in understanding the evolution of financial 
markets.
    Less Government Influence Over Private Companies. As shown in the 
following chart, there is even less Government influence over private 
companies under the Trust Fund alternative than under the TSP or the 
Administration's plan.

                                   Government Influence Over Private Companies
 
----------------------------------------------------------------------------------------------------------------
                                                                                          Social Security Trust
                                         Thrift Savings Plan      Administration Plan       Fund  Alternative
----------------------------------------------------------------------------------------------------------------
Selection of stock and bond index      Government decides.....  Same...................  Same
 funds.
Selection of fund managers...........  Government decides.....  Same...................  Same
Selection of private record keeper...  Government decides.....  Same...................  N/A
Selection of auditors and consultants  Government decides.....  Same...................  N/A
Selection of annuity providers.......  Government decides.....  Same...................  N/A
Selection of allocations among index   Individuals decide.....  Individuals decide.....  Government decides
 funds.
----------------------------------------------------------------------------------------------------------------
N/A--not applicable. (There would be no need for private recordkeepers, auditors, consultants, or annuity
  providers for trust fund investments.)

    Special Benefits for Trust Fund. Unfortunately, some political 
leaders have convinced many of the public that the Social Security 
Trust Fund is not really invested because it has been ``looted,'' and 
that the Trust Fund consists of ``worthless IOU's.'' Nothing could be 
farther from the truth, and such statements betray an apparent 
ignorance of Federal finance in our highest circles of government. The 
Trust Fund is fully invested in the best securities in the world--U.S. 
Treasury obligations. Private trust funds invest in Treasury securities 
in the open market, but the Social Security Trust Fund buys its 
Treasury securities directly from the Treasury, which is more efficient 
than if the Treasury were to issue the securities in the market and 
then buy them back for the Trust Fund.
    Moreover, the Trust Fund actually gets a much better deal than the 
private funds that buy Treasuries in the market. The Trust Fund, by 
law, may redeem its securities before maturity at par value, rather 
than at the sometimes deep market discounts suffered by private 
investors during periods of rising interest rates. Also, since the 
Trust Fund gets its securities directly from the Treasury, it avoids 
the market transaction costs which private investors must pay. Finally, 
the law requires the Treasury to pay the Trust Fund an interest rate on 
all of its investments in Treasuries equal to the average yield on 
long-term Treasury marketable securities. This is a significant benefit 
to the Trust Fund, since long-term rates are generally much higher than 
short-term rates. Thus in recent years, private investors have been 
earning about 2 percent on their short-term Treasuries, while the 
Social Security Trust Fund was earning about 4 percent on effectively 
the same maturities. The public seems to be totally unaware of these 
subsidies to the Social Security Trust Fund, which have been there for 
many decades.
    Trust Fund Dedicated to Social Security. The assets of the Social 
Security Trust Fund consist of investments in Treasury securities 
solely for future beneficiaries. Yet political leaders from both 
parties complain that the Treasury has ``spent'' the Trust Fund surplus 
on Government programs. What on earth do they expect the Treasury to do 
with the money--bury it in the Treasury's back yard? The Treasury also 
spends the money it raises by issuing Treasury securities in the 
market. Does that mean that the private investors in Treasuries are 
also being ``looted'' by the Treasury? Of course not. The scandal would 
be if the Treasury left the Trust Fund uninvested and not earning 
interest. Then the Secretary of the Treasury would be in effect saying 
``I don't owe you,'' and that indeed would be a worthless IOU.
    So why do Government officials find fault with perfectly sound 
financial practices? From ignorance, as I suggested earlier?--or is it 
is because they are trying to hide the real problem, which is the 
unique way the Social Security program is treated in the budget? Social 
Security expenditures are excluded from the budget and thus from the 
restraints on other Government spending, which is proper since they are 
entitlements, and cannot be restrained under existing law. But the 
Social Security surplus is then, inconsistently, included in the 
calculation of the overall budget deficit, for the sole purpose of 
appearing to have achieved deficit, and thus spending, reduction. Then, 
having committed this accounting farce, officials have the audacity to 
complain that the misleading budget treatment of the Trust Fund 
surplus--which they could change--makes it available to finance other 
programs. The problem here is not the financing of the Trust Fund, but 
the political gimmickry of its budget treatment.
Conclusion
    In conclusion, the Administration's plan for universal IA's is not 
feasible, and it should not survive the process of responsible 
Congressional hearings. The only practical way for the Social Security 
system to capture the higher returns available from investments in 
stocks is to diversify Social Security Trust Fund investments. The 
Trust Fund alternative, compared to IA's, would involve less Government 
influence over private companies, would be less disruptive of financial 
markets, would save tens of billions of dollars a year in 
administrative costs, and could be effective virtually immediately, 
rather than the 2009 starting date proposed for IA's. The multitrillion 
dollar transition costs proposed by IA proponents would be avoided. The 

additional Trust Fund earnings would go a long way toward strengthening 
Social Security finances, and would thus reduce, if not eliminate, the 
need for significant tax increases or benefit reductions.
    Thank you for your attention. I would be pleased to answer any 
questions.
                               ----------
                  PREPARED STATEMENT OF MICHAEL TANNER
            Director, Cato Project on Social Security Choice
                             June 14, 2005
    Mr. Chairman, distinguished Members of the Committee, I would like 
to thank the Committee for holding this hearing and for giving me the 
opportunity to appear. In particular, I appreciate that the Committee 
is moving beyond the standoff over whether Social Security reform 
should or should not include personal accounts to consider how such 
accounts might be structured in ways that can maximize consumer choice 
and control, while ensuring efficiency, low costs, and preserving an 
appropriate measure of worker protection.
    Of course, along with my colleagues at the Cato Institute, I 
believe that Social Security reform must allow younger workers to save 
and invest some of their Social Security taxes through personal 
accounts. I believe that such accounts can significantly contribute to 
restoring Social Security to permanent sustainable solvency. More 
importantly, I believe that personal accounts are essential to 
modernizing Social Security in keeping with such fundamental American 
values as ownership, inheritability, and choice.
    In particular, regarding the subject of this hearing, economic 
theory holds that private capital investment should provide a higher 
rate of return than a mature PAYGO Social Security system. If one 
accepts the Social Security Administration's assumptions about future 
bond and stock returns, a balanced portfolio (50 percent stocks, 30 
percent corporate bonds, and 20 percent Government bonds) could be 
expected to yield a return of 4.9 percent. Subtracting 25 basis points 
of administrative costs provides a net yield of 4.65 percent. Shifting 
the mix slightly in favor of equities should raise the expected return 
to roughly 5 percent. This clearly exceeds the return available from 
Social Security, and also significantly exceeds the offset interest 
rate suggested under the President's reform proposal.
    This is not to say that personal accounts can perform miracles. 
They cannot, by themselves, solve Social Security's entire $12.8 
trillion funding shortfall. However, workers who choose the personal 
account option--and I note that personal accounts are voluntary under 
all the major reform proposals--can expect to receive more in 
retirement benefits than Social Security can actually pay them.
    That said, how personal accounts are structured and the investment 
options available to workers can make a significant difference in the 
success of any personal account proposal. In short, details matter.
    Any retirement system has four important administrative functions: 
Collection, transmission, recordkeeping, and money management. First, 
there must be a system to collect the retirement funds from the worker. 
Next, the funds must be transmitted to an administrator. The 
administrator is responsible for keeping records of each worker's 
contribution to the retirement program and the benefits that each 
worker will eventually receive. Finally, the money has to be invested 
and managed between the time it is received and the time it is 
disbursed.
    In designing an investment and administrative structure of personal 
accounts, you should be guided by these basic concerns:

 Simplicity and Transparency. Workers should clearly understand 
    where there money is going and what their options are. Where 
    personal account plans have encountered difficulties, such as in 
    Britain, it has been primarily do to overly opaque or complex 
    schemes.
 Balancing Return and Risk. While market returns can be 
    expected to exceed Social Security returns, markets are not risk 
    free. In particular, they offer increased volatility. In addition, 
    many of the new investors brought into the market through personal 
    accounts will be inexperienced. A personal account investment plan 
    must offer these individuals some degree of protection without 
    stifling consumer choice, over regulating markets, or unduly 
    restricting the potential for positive returns.
 Keep Administrative Costs Low. While regulation of account 
    fees would be unwise, accounts should be designed in ways that 
    minimize administrative costs. SSA estimates that accounts would 
    cost 25-30 basis points to administer. This seems like an entirely 
    reasonable target.
 Limit Government Involvement in Investment Decisions. 
    Decisions about the investment of the accumulating retirement funds 
    should be left to private markets and insulated from Government 
    interference as much as possible.
 Avoid Increased Employer Burden. Every effort should be made 
    to avoid any new burden on employers, particularly small employers. 
    Possible sources of additional employer burdens would include 
    higher tax payments, greater complexity in tax calculations, more 
    extensive recordkeeping requirements, or a requirement to report 
    information more frequently.

    Cato's Project on Social Security Choice has devoted considerable 
time and study to these issues. As a result of our work, we believe 
that the following structure provides the framework for meeting these 
concerns. I do not, by any means, assert that it is the only acceptable 
administrative structure. But I believe that any workable 
administrative structure that deals with these issues will contain many 
or most of the following elements.
    First, at least initially, the collection, recordkeeping, and 
transmission functions should be handled centrally. The U.S. Treasury 
Department through its existing tax collection capabilities is well-
suited for this role. Therefore, I would propose that the collection of 
payroll taxes, including individual account contributions, would 
continue to be handled by the employer in much the same way as today 
and sent to the Treasury as they are today. The only difference would 
be that the employer would tell Treasury how much of the total payment 
is from employees who have chosen the personal retirement account 
option.
    One little known facet of the current Social Security system is 
that although payroll taxes are collected and paid by employers 
throughout the year, the Federal Government will not actually know how 
much money was paid on behalf of any 
particular worker in 2005 until about September 2006! This makes little 
difference under the current Social Security system, but can matter a 
great deal with an investment-based system. There will have to be some 
mechanism to hold the funds until the contribution is reconciled to the 
individual's name using the worker's W-2 form. Moreover, this holding 
pool should not be dependent on market timing. The best solution would 
be for Treasury, which is already operating as a centralized collection 
to transfer all funds designated for account investment to a private-
sector custodian bank, which then invests the total amount in a money 
market fund that is always priced at one dollar, a standard industry 
convention. The following year, when the contribution is reconciled to 
the individual worker the fund's shares are distributed to each worker 
representing his contributions and interest credit, and electronically 
transferred to the worker's personal account as specified.
    Second, because a system of personal accounts would extend 
investment opportunities to millions of Americans who do not now 
participate in private investment, and are therefore likely to lack 
education and experience in choosing investments, a consensus has 
developed among account proponents that initial investment options 
should be limited both in number and in the amount of risk a worker may 
assume. Therefore, most personal account plans call for investment 
options to be initially limited to a small number of broadly 
diversified funds. This can be done in a number of ways, such as:

 A small number of index funds each composed of a different 
    type of investments. For example, the Federal Thrift Savings Plan, 
    which President Bush has cited as an example, offers a fixed income 
    fund, a common stock fund, a ``small cap'' stock fund, a Government 
    bond fund, and an international stock fund. The Chairman's 
    proposal, S. 540, is also built around this model.
 A small number of balanced funds, each composed of a different 
    mix of stocks, Government bonds, corporate bonds, and cash. This 
    option is included in HR 530 among others.
 A lifecycle fund that automatically adjusts the mixture of 
    investments as a person ages. Younger workers would be more heavily 
    invested in stocks, with the mix changing more heavily to fixed 
    income assets as the worker nears retirement. The president has 
    raised the possibility of this option, as has the Chairman. And I 
    believe it is included in S. 857, sponsored by Senator Sununu.

    To make things even simpler for the unsophisticated or apathetic 
worker, there should be a default option that would require the worker 
to make no decisions whatsoever.
    Management of funds should be handled by the private sector on a 
contract/bid basis, similar to the way the TSP is currently handled. 
Given the amount of investments involved, it may be worth considering 
breaking up the management into several pieces each of which would be 
put up for bid.
    Finally. while it makes sense to limit investment options 
initially, at some point a wider range of choices should be made 
available. In part, this is a simple matter of increasing consumer 
choice. One of the most important reason for having personal accounts 
at all is to give workers more choice and control over how they save 
for their retirement. Clearly, this should be extended as much as 
possible to the array of available investments.
    There is also a larger economic reason for eventually expanding the 
range of investments. The flow of investments to different sectors of 
the economy provides important signals to the economy as a whole. 
Creating a large flow of investments that are essentially 
``homogenized'' would deprive the market of these vital signals.
    Therefore, once a worker has accumulated a ``trigger'' level of 
funds, the worker should be free to participate in a much larger range 
of investment options, closely approximating the options currently 
available under traditional 401(k) plans. Management of funds at this 
level would again be through the private sector, with entry open to any 
company offering qualified funds. ERISSA offers a reasonable framework 
for determining participation and regulation.
    This three tier structure--a central collection point and holding 
pool, a limited set of initial investment options, and a eventual 
expansion to a wider array of investments--can provide workers with the 
greatest amount of security while maximizing consumer choice and 
control. It would keep administrative costs and the burden on employers 
as low as possible. And it would minimize Government interference with 
investment decisions.
    Works should be able to switch investments, between and within 
investment tiers on an annual basis. While an ``open season,'' similar 
to that of the FEHBP health plan, is perhaps the most simple approach, 
that could lead to an excess of market ``churning'' over a limited 
period. An alternative approach would be to allow a worker to switch 
investments within a designated period centered on his or her birthday.
    There is one other additional point to keep in mind, at all three 
tiers, the accounts would be the property of the worker. This ownership 
is one of the perhaps the most important reasons for reforming Social 
Security, and it is vital that it be maintained as part of any 
administrative structure.
    Let me conclude by saying that I believe that Social security 
reform is not an option, but a necessity. The program will begin 
running a deficit in just 12 years and faces unfunded obligations of 
roughly $12.8 trillion. The need for reform presents us with an 
opportunity to create a new and better retirement program for all 
Americans, a program that gives workers ownership of their retirement 
funds, more choice and control over their money, and the opportunity to 
build a nest egg of real inheritable wealth. Therefore, any successful 
Social Security reform should include personal accounts.
    This makes the work of this Committee all the more important: 
Getting the design and structure of the accounts right. I believe that 
the structure I have set out today takes us in that direction. I look 
forward to the Committee's questions.
    Thank you.
                               ----------
                  PREPARED STATEMENT OF DAVID C. JOHN
  Research Fellow, Thomas A. Roe Institute for Economic Policy Studies
                        The Heritage Foundation
                             June 14, 2005
    I appreciate the opportunity to appear before you today to discuss 
appropriate investments for Social Security Personal Retirement 
Accounts. This is an extremely important subject, and I would like to 
thank both Chairman Hagel and Senator Dodd for scheduling this hearing. 
Let me begin by noting that while I am a Research Fellow at the 
Heritage Foundation, the views that I express in this testimony are my 
own, and should not be construed as representing any official position 
of the Heritage Foundation. In addition, the Heritage Foundation does 
not endorse or oppose any legislation.
    PRA's should be managed through a simple, low-cost administrative 
structure that uses the current payroll tax system and professional 
investment managers.
    A simple and effective administrative structure is essential to the 
success of a PRA system. Probably the simplest and cheapest structure 
would be to use the existing payroll tax system. Under today's Social 
Security, the employer collects and sends to the Treasury Department 
both the payroll taxes that are withheld from an employee's check and 
those that are the responsibility of the employer. The payroll tax 
money from all of the firm's employees is combined with income taxes 
withheld from their paychecks and sent to the Treasury. The money 
collected is allocated annually to individual workers' earnings records 
after worker income tax records have been received.
    Adapting this existing administrative structure to a PRA system 
would be easier to implement than other options. Under a PRA system, 
the employer would continue to forward to the Treasury Department one 
regular check containing payroll and income taxes for all of the firm's 
employees. The Treasury would continue to use its existing formula to 
estimate the amount of receipts that should be credited to Social 
Security and to reconcile this amount annually with actual tax 
receipts.
    Once the Treasury determines the amount to be credited to Social 
Security, it would estimate the portion that would go to PRA's and 
forward that amount to a holding fund managed by professionals who 
would invest the amount in money market instruments until it is 
credited to individual taxpayers' accounts. The money would go to 
individual workers' accounts upon receipt of their tax information. It 
would then be invested in the default fund, except for workers who have 
selected (on their income tax forms) one of the other investment 
options, in which cases it would be invested accordingly.
    Using Professional Fund Managers. Rather that having the Government 
trying to invest PRA money, the agency overseeing the accounts (which 
could be the Department of the Treasury, the Social Security 
Administration, or an independent board) should contract out fund 
management to professional fund managers. This investment management 
system is currently used by the Federal Employees Thrift Investment 
Board, which administers the Thrift Savings Plan, a part of the 
retirement system for Federal employees.
    Under this system, management of the specific investment pools 
would be contracted out to professional fund managers, who would bid 
for the right to manage an asset pool of a certain size for a specified 
period of time. The manager could invest the money only as directed by 
the agency. The agency would also contract out to investor services 
such tasks as issuing regular statements of individual accounts, 
answering account questions, and handling transfers from one investment 
option to another.
    Advantages of this Administrative Structure. Building on existing 
structures and contracting out investment management and services 
should keep costs to the lowest level possible. In addition, employers 
would not have to change their current payroll practices. Using one 
central government entity to receive PRA funds also means that 
employers would not bear the cost of writing individual checks or 
arranging for individual fund transfers for each employee. In addition, 
this method allows the PRA contributions of workers who have multiple 
jobs to be based on their total income without placing any additional 
burden on either the worker or the employers.
    From a worker's standpoint, this should be the lowest-cost 
structure available. In addition, because workers' PRA contributions 
would be distributed to their chosen investment plans only after their 
tax information has been received, workers with several jobs during a 
year should see contributions based on their total annual incomes.
    Developing a simple personal retirement account system with very 
low administrative costs would be relatively simple.
    State Street Trust, one of the largest managers of retirement 
savings, has estimated that administering a personal retirement account 
would cost from $3.55 to $6.91 per person annually, based on 
proprietary data that the bank accumulated from its experience in 
managing a host of pension plans. In terms of the percentage of assets 
under management, the annual fee would be only 0.19 percent to 0.35 
percent. This fee assumes an annual contribution per worker equal to 2 
percent of his or her gross earnings. The cost would drop significantly 
if that contribution increased to an amount equal to 4 percent of 
earnings or higher. State Street Trust's findings were reviewed and 
accepted by the Government Accountability Office as accurate.
    This low level of administrative fees would certainly not reduce 
the benefits of a PRA. In addition, history shows that administrative 
costs are highest when a system is first implemented and start-up costs 
must be covered. As time passes, administrative costs decline 
significantly. This has been true for 401(k) accounts, the Thrift 
Savings Plan (TSP) for Federal employees, and even Social Security. For 
example, the administrative costs of 401(k) plans have decreased over 
time, despite the plans offering an increasing number of investment 
options and a higher level of personal service. Although the costs of 
specific plans vary according to each plan's complexity, size, and the 
types of investments, many large companies have been able to keep their 
administrative costs as low as 0.3 percent by offering only a limited 
number of broad-based funds.
    The Federal Thrift Savings Plan, a privately managed retirement 
plan open only to Federal employees, has experienced a dramatic 76 
percent reduction in administrative costs since the system started in 
1988. Today, participants pay annual administrative fees that are below 
0.1 percent of assets under management. TSP's extremely low 
administrative costs are significant, given that many experts expect 
that a PRA system would closely resemble the structure and investment 
choices found under TSP.
    The Social Security system experienced similar reductions in 
administrative costs during its formative years. In 1940, when the 
system first began to pay benefits, its administrative costs equaled 74 
percent of all Old-Age and Survivors Insurance benefits paid. In 1945, 
this figure had declined to 9.8 percent. Today, administrative costs 
make up only 0.5 percent of payments from the OASI Trust Fund. Even 
though this is not a perfect comparison with the other two examples, 
given that Social Security's structure has changed over the years, it 
does suggest that fees could be very low.
    PRA's should be invested in more than just stocks, but stocks are 
an essential part of the investment strategy.
    Studies that purport to show either PRA's or the Social Security 
Trust Fund would have lost money over the past few years if they had 
been invested in stock assume that 100 percent of the Trust Fund would 
have been invested in stocks, rather than a diversified portfolio that 
would have balanced stock losses with gains on bonds or other 
investments. They also focus on only the short-term market trends, 
ignoring the gains that would result from longer-term investments.
    Morningstar, Inc., an independent market data and analysis firm, 
estimates that the value of mutual funds invested in diversified U.S. 
stocks declined 12.1 percent during the second quarter of 2002. 
However, not all types of investments went down. Mutual funds 
containing lower-risk instruments such as taxable bonds (which are 
routinely held by those nearing retirement) rose an average of 1.4 
percent over that same period, while funds invested in tax-exempt bonds 
rose 3.2 percent. Thus, in one of the worst quarters for stock 
investment, PRA's invested in a diversified portfolio would remain 
strong.
    Over the long-run, all of these investments did even better. Over a 
5-year period including the second quarter of 2002, mutual funds 
invested in stocks earned an average of 3.9 percent per year, while 
mutual funds invested in taxable bonds and tax-exempt bonds earned an 
average of 5.0 percent a year.
    PRA's should not be invested solely in stocks. They should instead 
be invested in a diversified portfolio of stock index funds and 
different types of bond index funds. The default investment for PRA's 
should be a lifestyle fund that automatically reduces the proportion of 
stocks as the worker gets older, thus locking in past gains and sharply 
reducing the chance of major losses in the years approaching 
retirement.
    A carefully controlled set of investment options should be 
developed that includes an appropriate default option.
    The investment options available to PRA owners should be simple and 
easily understood. While an increasing number of Americans are 
investing their money for a wide variety of purposes, a voluntary PRA 
system would bring in millions of new investors who may not have any 
previous investment experience. In addition, experience from both the 
401(k) retirement plans and Federal employees' Thrift Savings Plan 
shows that costs are far lower if the plan starts with only a few 
investment options and then adds more once the plan is fully 
established.
    Carefully Controlled Investment Options. All investment options 
available under a PRA plan should be limited to a diversified portfolio 
composed of stock index funds, government bonds, and similar assets. 
Even if they so desire, workers would not be allowed to invest in 
speculative areas such as technology stocks or to choose specific 
stocks or bonds. Money in a PRA is intended to help to finance a 
worker's retirement security, not to be risked on speculative 
investments with the hope that taxpayers will support the worker if the 
investment fails.
    Initially, workers would be allowed to put their PRA contributions 
into any one of three balanced and diversified mixes of stock index 
funds, government bonds, and similar pension-grade investments. 
Although the exact mix of assets would be determined by the central 
administrative agency, one fund might consist of 60 percent stock index 
funds and 40 percent government bonds, while another might be 60 
percent government bonds and 40 percent stock index funds.
    The third fund, which would also act as the default fund for 
workers who failed to make a choice, would be a lifestyle fund. These 
are funds in which the asset mix changes with the age of the worker. 
Younger workers would be invested fairly heavily in stock index funds, 
but as they age, their funds would automatically shift gradually toward 
a portfolio that includes a substantial proportion of bonds and other 
fixed-interest investments. This is designed to allow the portfolios of 
workers who are far from retirement to grow with the economy and to 
allow older workers to lock in that growth by making their portfolios 
predominantly lower-risk investments.
    Workers would be allowed to change from one investment fund to 
another either annually (by indicating their choice on the income tax 
form) or at other specified times (by completing a form on the 
Internet). They would also receive quarterly statements showing the 
balance in their accounts. As with today's Social Security, PRA 
accounts are intended strictly for retirement purposes, and no early 
withdrawals would be allowed for any reason.
    Structuring Accounts to Keep Fees Low. Under a successful PRA plan, 
all investments must be approved by the central administrative agency 
as being appropriate for this level of retirement investment. That 
agency would also ensure administrative costs are kept as low as 
possible by awarding contracts to manage investment pools through 
competitive bidding and through direct negotiation with professional 
funds managers.
    Research by State Street Global Investors shows that administrative 
costs are lower if workers put all their money in one diversified pool 
of assets rather than attempting to diversify their portfolio by 
dividing it among several types of assets. For example, a worker who 
puts all of his or her money in one fund consisting of 50 percent stock 
index funds and 50 percent Government bonds would earn the same as a 
worker who places half of his or her money in a government bond fund 
and half in a separate stock index fund. However, the first worker 
would incur significantly lower administrative costs.
    Additional Choices for Larger Accounts. Once a worker's PRA account 
reaches a certain size threshold (determined by the central 
administrative agency), he or she would have the option to move its 
management to another investment manager if that manager offered better 
service or potentially higher returns. However, only investment 
managers who had meet strict asset and management quality tests would 
be allowed to receive these accounts, and the managers would be sharply 
limited in the types of investments they could offer. In the event that 
the worker is dissatisfied with either the fees or the returns from 
these individually managed accounts, he or she could switch back to the 
centrally managed funds at any time.
    PRA's should be invested in lifespan accounts unless the account 
owner chooses another investment.
    A key feature of President George Bush's recently announced Social 
Security plan is that workers' personal retirement accounts (PRA's) 
would be invested automatically in a lifespan fund unless a worker 
expressly asked for another arrangement. Lifespan funds adjust (or 
``rebalance") a worker's investments as he or she ages. For younger 
workers who are far from retirement, a lifespan fund would invest most 
of their money in stock index funds--safe funds reflecting the broad 
stock market. As these workers grow older, their lifespan funds would 
gradually and automatically shift more money into even safer bonds and 
other less volatile investments. In short, lifespan funds allow younger 
workers to take advantage of the higher returns that stock investments 
offer while making sure that the portfolio gets safer and safer as the 
worker gets closer to retirement.
    Lifespan funds are designed to allow the portfolios of workers who 
are far from retirement to grow with the economy and to allow older 
workers to lock in that growth by moving their portfolios into 
predominantly lower-volatility investments. This means that if the 
stock market suddenly declined, workers who invested in a lifespan fund 
and were near retirement would have only a tiny part of their PRA's 
invested in stocks and thus would not see a significant last-minute 
change in the value of their PRA's.
    As an example of how these funds would protect workers who are 
close to retirement, Morningstar, Inc., an independent market data and 
analysis firm, estimated that the value of mutual funds invested in 
diversified U.S. stocks declined 12.1 percent during the second quarter 
of 2002--one of the worst quarters in recent history. However, not all 
types of investments went down. Indeed, mutual funds containing lower-
risk instruments such as taxable bonds (a common investment for those 
nearing retirement) actually rose an average of 1.4 percent over that 
same period, and funds invested in tax-exempt bonds rose an average of 
3.2 percent.
    Because a lifespan account would have automatically moved a 
worker's PRA almost entirely into bonds when that worker reached 
retirement age, a worker with a PRA who retired in the first quarter of 
2002 thus would have seen his PRA grow during that last quarter before 
retirement. He or she would not have faced losses, even though the 
stock market as a whole experienced major declines during that period.
    Lifespan funds have been gaining popularity in employer-sponsored 
retirement plans, such as 401(k)'s, because they automatically make the 
kind of portfolio adjustments that investment professionals recommend 
for all workers nearing retirement. At the end of 2004, about 55 
companies offered lifespan accounts as part of their 401(k) plans. 
Currently, the biggest players in the field are Fidelity Investments, 
with a 33 percent market share, and The Vanguard Group, with about 17 
percent. Administrative fees depend in a large part on whether the 
funds are actively or passively managed. Fidelity, which consists 
totally of actively managed funds has an administrative fee of 0.81 
percent of assets under management, while Vanguard, which consists 
totally of index funds has fees of 0.23 percent of assets under 
management. Passively managed index funds are much more suitable for 
Social Security accounts than are funds that pick and choose individual 
stocks.
    For many years, investment advisers have advised workers to 
structure their retirement accounts so that more funds are shifted into 
fixed-income investments as they age. Advisors recognize that 
decreasing the proportion of investment in stocks reduces the potential 
for short-term loss. Although younger investors are better off 
investing most of their assets in stocks to get higher returns, those 
who are closer to retirement need to reduce the likelihood that a 
sudden market shift will affect them. Lifespan funds make this 
rebalancing process continuous and automatic and would let workers with 
PRA's approach retirement with confidence.
Conclusion
    Again, thank you for the opportunity to testify before you today. 
The success of Social Security personal retirement accounts as a way 
for individuals to build sufficient savings to fund a portion of their 
retirement benefits will in large part depend on the investment choices 
that are available. A simple, low-cost administrative platform would 
improve the ability of these accounts to assist individuals in meeting 
their retirement goals. Such a system is both feasible and realistic.
    Thank you.
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
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