Thank you, Mr. Chairman. I appreciate the opportunity to appear today, just months (I trust) before Congress and the Administration will set about the task of developing comprehensive social security reform legislation. With the retirement of the baby-boom generation beginning in just 10 years, policy makers need to move quickly to shore up the financing of social security, restore public confidence in the long-term viability of the system, and, at the same time, take the steps necessary to create a system of real value for younger people. Traditional "fixes"--reductions in future benefits and increases in the payroll tax designed to restore actuarial balance--are not up to the challenge. They have not offered lasting solutions to the financing problems of the past and will only exacerbate the unfavorable treatment of younger workers and future generations.
In my view, the best way to secure social security in the decades ahead lies in transforming it from a low-yielding system of income transfers into a system of true pensions--personal retirement accounts fully funded with workers' contributions and invested in real capital--buttressed by a government safety net.
Over the past 6-1/2 decades, social security has lifted tens of millions of older Americans out of poverty and made large wealth transfers to many more. It has been able to do so not because of any inherent superiority over other types of retirement programs, but because of its pay-as-you-go method of finance during a finite and now passing time. When social security was relatively young and economic and demographic trends still favorable, pay-as-you-go financing allowed social security to transfer enormous amounts of wealth from younger to older generations at a relatively low tax cost.
As the 1990s come to a close, social security is a mature pay-as-you-go system confronting unfavorable long-term demographic and economic trends. Wealth transfers are fast disappearing and wealth losses are now in the offing for many middle-aged and younger workers. Attempting to sustain the status quo through tax increases or benefit reductions would consign younger workers to lower retirement incomes than are attainable and leave the national economy in a weaker position. Periodic funding crises would become the norm. This fate can be avoided by taking steps now to move toward a savings-based system of personal retirement accounts.
In the testimony that follows, I discuss the general merits of replacing a portion of social security with personal retirement accounts and then present the proposal for Personal Security Accounts (which I helped develop) contained in the final report of the Social Security Advisory Council as an example of how this might be accomplished. I then turn to two issues that must be confronted with any proposal to move toward personal accounts--transition costs and "investor savvy." In particular, how do we meet outstanding benefit obligations to current retirees and older workers and also begin saving for our own retirement? And can American workers really make their own investment decisions? The latter question is particularly salient now, with the stock market experiencing considerable day-to-day volatility.
Social Security Faces More than a Financing Problem
To some people, the long-range deficit is the problem confronting social security. If this were the case, policy makers could just turn to a catalog of spending and revenue options to see which set of policies added up to the right number to close the deficit. Perhaps to be fair, a compromise would be reached in which taxes were raised to meet part of the financing gap and future benefits were scaled back to meet the balance of the gap. This was the approach taken in 1983.
But financing is decidedly not all that ails social security. This is revealed in many ways, including the declining level of public confidence in the future of social security and growing concerns about the value of the system to younger workers; the growing interest in private alternatives to social security, including the reforms undertaken in Chile over a decade ago; and growing concerns about the impact of social security and other entitlement programs on the federal budget, national saving, and economic growth. Social security's financing problem is a manifestation of other, more deep-seated problems that render the same old prescriptions less and less palatable.
For example, under our current social security system, which is financed basically on a pay-as-you-go basis, workers amass claims to future benefits with no real capital backing up these claims. This results in a huge unfunded liability (benefit promises far in excess of assets on hand), estimated by the Social Security Administration actuaries to be on the order of $9 trillion in present value terms.1 This is debt, pure and simple, although it is not included in official federal budget accounts.
By retaining the pay-as-you-go structure, which amounts to an income transfer mechanism from workers to retirees rather than a retirement saving mechanism for workers, workers--and society more generally--forgo the opportunity to invest in real private capital and to earn the higher rate of return it would afford. Under current projections, the best our pay-as-you-go system can offer younger workers, in terms of return on taxes, is determined by the rate of growth of taxable earnings in the economy--projected to be only 1-1/2 percent net of inflation. By contrast, the contribution of a savings-based system to the economic well-being of the nation would be determined by the real pre-tax return to private capital investment, estimated to be on the order of 8 percent to 9 percent net of inflation. The lost income stemming from the opportunity foregone, that of moving toward a fully funded pension system built on real saving and capital investment, is a very real economic cost of perpetuating the status quo.
If not reversed somehow, the loss of potential wealth, particularly among younger workers, will certainly weaken political support for social security. Averaging over the period since 1926, the annual return on equities has averaged about 7 percent, net of inflation, and the average annual return on a mixed portfolio of stocks and bonds has been about 5-6 percent, net of inflation--substantially above what social security can offer. Increasingly, young people ask "Why can't we put our taxes into higher yielding investments?" "Why can't we have retirement savings accounts like IRAs or 401(k) plans?"
Also, social security is running temporary surpluses invested entirely in U.S. government bonds. Only with Congress operating subject to strict budget discipline could this be said to constitute saving that would lighten the burden of future benefits. Social security is thus amassing claims to hundreds of billions of dollars of general revenues yet to be collected, which may well be distorting fiscal decision making and adding to--rather than ameliorating--economic and fiscal woes in future decades. Over the past decade, Senator Moynihan has helped highlight the importance of this problem.
Finally, there have long been concerns about the tenuous link between the taxes an individual pays, at the margin, and the benefits he or she can expect to receive. What is the relationship between benefits and hours worked (or taxes paid)? Does extra work increase future benefits? How knowledgeable are people about this relationship, given the extreme complexity of social security? More recently, concern has been expressed about the effects of the unfavorable relationship between taxes paid and benefits received for middle-aged and younger workers. A weak or non-existent tax-benefit link--or a strong link with a poor return on taxes--distorts the labor supply decisions of workers and the form in which they receive their compensation, resulting in another potentially large source of foregone income and wealth.
Evidently, quite apart from the costs that arise from failing to close trust fund deficits in a timely way, there are real costs to society from failing to reform social security--the costs that arise from the nation's opportunities foregone. Scholarly research by economists Martin Feldstein, Andrew Samwick, and Laurence Kotlikoff, among others, suggests that moving toward a system of personal retirement accounts that are owned by workers and fully funded with a portion of their payroll taxes would result in very large gains in economic well-being. Reforms that deal only with the imbalance of numbers--such as the reforms adopted in 1977 and 1983--would fail to tackle the most important problems confronting social security today and, in so doing, most surely would exacerbate them.
General Support for Advance Funding and Equity Investment
While not all of the members of the Advisory Council shared my concern with the economic consequences of our pay-as-you-go system, we were in general agreement that raising taxes or cutting benefits to restore long-range balance would weaken rather than secure the economic and political foundation of the system in the years ahead. Improving the value of social security to younger workers and future generations was a high priority, and private capital investment was seen to be the key. Beyond this, a majority of members (7 of 13) agreed on: (1) the desirability of moving toward a fully funded component of social security; (2) the hazards of centralizing and politicizing investment decisions; and (3) the powerful effects that private ownership could have in building confidence about the future of social security. In the end, a majority of Council members supported fully-funded personal savings accounts as a key component of long-range reform.
There are many ways that personal accounts might be incorporated into social security--on a limited basis, as in legislation offered by several members of the Senate (including Senators Kerrey, Robb, Moynihan, Breaux, Gregg and others), or on a broad-scale basis, as in Chile and elsewhere in South America. Contributions to personal accounts can be mandatory or voluntary. Workers’ investment options and their withdrawal options at retirement can be limited or quite broad. The government safety-net can take many forms, ranging from a scaled back pay-as-you-go system to a system of well-targeted subsidies for low-wage workers or workers with low account balances. And the cost of ongoing benefit liabilities during the transition to the new system can be met in any number of ways.
The range of options for introducing personal accounts into social security is revealed in part by the reforms already adopted in countries such as Chile, the United Kingdom, and Australia, and in part by the range of legislative proposals and other proposals now in the public domain. The proposal for Personal Security Accounts is something of a hybrid. It incorporates fairly large mandatory individual accounts which substitute for a portion of social security. It gives workers relatively wide discretion in their investment and withdrawal decisions. And it retains a floor benefit for all workers. The transition would be financed by a combination of new (explicit) federal borrowing and a payroll-tax supplement.
Why Personal Accounts Make Sense
Before looking at the PSA plan, it is worth noting, at least in general terms, why moving toward a system of fully-funded personal retirement accounts makes sense. From a purely economic perspective, there is a large body of research that suggests that moving toward a system in which workers save and invest for their retirement would result in substantial improvements in economic well-being. Increased saving and investment would boost labor productivity, resulting in higher wages for American workers and ultimately higher living standards. In addition, due to the much higher rate of return available in private capital markets, workers could expect to accumulate much larger retirement incomes through a savings- and investment-based system than through our wage-based tax-and-transfer system.
A system of personal retirement accounts--privately managed, owned by workers, and fully funded with a portion of their payroll taxes--would have other benefits as well. For example, such a system would create a direct link between the taxes workers pay and the benefits they can expect to receive, that link being the market rate of interest. As with an IRA or 401(k) plan, workers would make regular contributions to their accounts and would have a claim to their contributions and any investment earnings that is secured by the force of law. The linking of taxes and benefits, backed up by private ownership, is the source of three additional economic benefits:
First, payroll taxes would become true contributions, like deferred compensation in the private sector, and would no longer distort the choices workers make about when and how much to work, when to retire, and the form in which they receive their compensation. Workers would gain retirement protection from the first dollar earned. Retirement would become a much more flexible concept, at least in so far as government policy is concerned.
Second, workers would have the peace of mind of knowing that the money they put away for retirement was theirs, period, shielded from political manipulation. This would greatly facilitate long-term financial planning. Presently, workers and their families have little way of gaging what social security will offer decades in the future and thus how much and what kinds of additional financial protection they require. While workers would take on investment risks, risks that would need to be managed effectively, they would shed considerable political uncertainty about the size and cost of future benefits--risks that individuals are powerless to hedge against.
As Nobel Laureate Paul Samuelson once observed, in comparing public pension systems that are pay-as-you-go financed and fully funded, "In an epoch when most social compacts are not worth the paper they are written on, full funding has the virtue that reneging on promises is least likely to be politically feasible."2 With full funding backed up by the force of law, a system of personal accounts would have the virtue that reneging on promises would simply be illegal.
Third, every worker, rich and poor alike, would have the opportunity to accumulate real wealth and to build estates with which to better their own lives and the lives of their children and grandchildren. (Unless prohibited by law, families could inherent any balances remaining in a worker's account at death.) Every worker would be involved directly in the decisions that so vitally influence their future well-being. Opportunities to build and to hold wealth that now exist mainly for higher income Americans would become available to all Americans.
In this latter regard, personal retirement accounts would have important indirect effects on the economy. By transforming social security into a vehicle of wealth creation, personal accounts would give ordinary working men and women a highly visible stake in the U.S. economy. Broader-based support for pro-growth tax and regulatory policies would likely result. At the same time, funds accumulated in personal accounts would reduce the dependence of American workers on federal transfer payments, ultimately relieving pressures on the federal budget and leaving society more flexibility with which to meet future pressing objectives (including national security objectives). With pay-as-you-go financing in place, there always is the temptation--no matter how ill-advised--to increase benefits and shift costs to future generations. Overpromising is far less likely in a system based on saving and capital investment.
In addition, allowing workers to choose how--or with whom--to invest their retirement savings would expand opportunities and spur the development of new products and services. Mutual funds, securities firms, banks and other financial institutions would compete for the right to invest workers' taxes, and, unless prohibited by the government, they would offer a range of investments and investment services from which to choose. Workers would be able to seek out those products and services that best met their needs. Through a highly decentralized system of personal accounts, the funds available for capital investment would flow toward their highest-valued uses, without political interference or manipulation.
Finally, from the narrower perspective of social security financing, a system of personal accounts would fundamentally transform the financing base of at least a portion of social security, eliminating the funding crises that have become the norm. Since personal accounts would be fully funded at all times, they would basically run on automatic pilot. The system's fortunes would no longer be tied inextricably to uncertain demographics and to uncertain political actions and reactions.
Moving toward a system of personal retirement accounts would not get us around the problem of having to dig out from under the debt accumulated under the current system. Meeting ongoing liabilities for older workers and retirees is a given. But personal accounts would create a "light at the end of the tunnel" that does not presently exist--the prospect that social security can provide something of real value to younger workers in the future as it has in the past.
With this as background, the PSA plan provides a concrete example of how personal retirement accounts can be incorporated into social security on a relatively large-scale basis.
The PSA Plan
Under the Personal Security Account (PSA) plan, which was supported by 5 out of 13 Council members, social security would gradually be transformed into a two-tiered system in which roughly half of the retirement program is fully funded through a system of privately-managed, individually-owned retirement accounts. The first tier of the new system would provide a flat retirement benefit for full-career workers which is scaled to years of work and financed on a pay-as-you-go basis. This benefit would be financed (together with disability and survivor benefits) by 7.4 percent of the current 12.4 percent social security payroll tax.3 The second tier would amount to a system of mandatory personal retirement accounts funded with the remaining 5 percent of the payroll tax. These accounts would be managed by private financial institutions.
All workers under 55 would have personal accounts and they would be free to invest them in a wide range of investments and institutions. Workers could begin making tax-free withdrawals at 62--regardless of their income or work status--and would be free to purchase annuities if they wished, but would not be compelled to do so. Any balances remaining at death could be bequeathed to heirs.
Other aspects of the two-tiered system would take several decades to be phased in and would be fully effective only for workers under 25. Retirees and older workers would not be affected by the new two-tiered system.
The PSA plan would turn the vast majority of social security's 130 million taxpayers into investors and, in the next decade alone, release literally hundreds of billions of dollars of payroll taxes for investment in the private sector. As an indication of the magnitudes involved, taxable payroll in the U.S. is now about $3 trillion, 5% of which is $150 billion annually, with the amount of additional money available for investment each year growing at the rate of growth of total wages in the economy. With workers assumed to allocate roughly half of their contributions to equities and half to U.S. government securities, with an average real yield on their PSAs of 3.5%-4.0% (net of administrative expenses), the SSA actuaries projected that, in constant 1995 dollars, the aggregate balance in personal accounts would be close to $6 trillion in 2020 and $10 trillion in 2030.
When fully phased in, workers' personal accounts would be backed up by the first tier benefit, which would ensure all full career workers--high- and low-wage alike--a level of retirement income at or above the poverty level.4 As under present law, this benefit would be cost-of-living adjusted and payable as a monthly annuity until death. The flat benefit is explicitly redistributive toward low-wage workers, intended to ensure that, together with second tier accumulations, all full-career workers, regardless of income level, can expect to receive a minimally adequate retirement income from social security. By minimally adequate we mean enough so that even low-wage workers--and even workers who invest in relatively low-yielding assets--should not have to resort to means-tested poverty assistance. Our expectation is that workers will do considerably better than this.
According to the SSA actuaries, under reasonable assumptions, single workers and two-earner couples would fare better under this plan than they would under either of the other plans offered by the Advisory Council (the "Maintenance of Benefits" plan, endorsed by former Social Security Commissioner Robert Ball and five other members, and the "Individual Accounts" plan, endorsed by the Council Chair, Ned Gramlich, and one other member) or under a shored up pay-as-you-go system. The relatively large personal accounts would fully fund a significant share of social security, bringing forth larger, long-run financial and economic gains. It would do so, moreover, without running the risks of centralizing and thus politicizing investment decisions. Younger workers stand to gain the most, both in terms of expected benefits and increases in national wealth.
Transition Costs
One issue that raises concerns about any proposal for personal accounts is the issue of transition costs. Opponents of personal accounts say that in order to make the transition to the new system, workers would have to pay "twice"--once for their own retirement and once for their elders'. The implication is that the social security tax would have to be doubled or at least increased very substantially, making workers much worse off. This argument is deeply flawed.
In reality, there is a cost to sustaining (or attempting to sustain) the status quo and there is a cost to moving to a system of personal accounts. In the first case, the cost is permanent and brings forth no additional benefits or economic value. In the latter case, the cost is transitional and makes possible the attainment of larger and more secure retirement incomes as well as a stronger national economy. In present value terms, the long-term gains to society would substantially outweigh the transitional costs.
As noted earlier, social security has extended trillions of dollars of benefit promises to current retirees and older workers as well as to younger workers who have already paid into the system. The official government estimate puts the figure at about $9 trillion. These benefit promises are almost entirely unfunded. Short of abrogating on these benefit promises, they must be met--and this is true whether or not social security is privatized or replaced by a system of personal accounts.
There are basically two ways these costs can be met. First, we can do as proponents of the status quo would have us do--keep the social security debt implicit and then do our best to try to prop up the system by raising taxes, cutting benefits, and continuing to shift costs to younger workers and future generations, who already are expected to earn sub-market returns on their taxes. In the face of declining worker-to-beneficiary ratios and slow earnings growth, this is not the most secure basis on which to build a "social compact" or to pin one's hope for retirement income security.
In aggregate dollar terms, the cost of perpetuating the status quo under current official projections is about $3.1 trillion in present value terms. (That is in addition to the roughly $10 trillion we already expect to collect from today’s children and future generations to pay benefits for the current adult population.)5 Under a revised estimate, which takes into account the system’s deteriorating financing picture beyond the actuaries’ 75-year projection period, the deficit would be closer to $4-$5 trillion. This can be thought of as the "transition cost" of sustaining the status quo. Any effort to substantially improve the funding base of social security would increase this cost.
Alternatively, we can take steps now to recognize and begin paying down the implicit debt that will otherwise saddle future generations and start saving for our own retirements. How much of this debt must be recognized depends on how large the personal accounts are (or how much of the system becomes fully funded) and how quickly the accounts are phased in. How quickly the debt is repaid depends on how ongoing benefit liabilities are financed during the transition--either through general spending reductions, the use of federal budget surpluses, the sale of federal assets, some additional borrowing, or, if necessary, increases in federal taxes. Presumably it would be repaid through a combination of these measures. (Nations that have transformed their social security systems to include personal retirement accounts generally have scaled back benefits under the ongoing system as well.) The savings-induced increase in national income that would result from reducing the government’s overall indebtedness (including explicit and implicit debt) would provide another source of financing.
Importantly, "privatizing" a portion of social security does not create transition costs. Privatization creates retirement accounts that are owned by workers, fully funded with a portion of their taxes, and invested in private capital. Because of the higher return to private capital investment, the tax rate (actually the contribution rate, since workers would own the proceeds of their accounts) required to replicate benefits under our current system would be lower than the rate required to meet benefits on a pay-as-you-go basis. Precisely how much lower would depend on expected investment returns, the target level of retirement income, and the certainty with which one wished to achieve that target. In addition to the mandatory saving rate, there would be the cost of meeting outstanding benefits under the current system.
Stated another way, there are no "free lunches." Moving to a savings-based system requires an increase in saving (or a decrease in consumption) by current generations, which generates the larger capital stock necessary to sustain higher expected retirement incomes as well as higher future living standards. This increase in saving is brought about by a combination of paying off (and possibly reducing the size of) the accrued liability and capping the growth of future unfunded liabilities.
In a very real sense, the "transition cost" is an investment in the future, one that can be expected to pay off handsomely. It is the price that must be paid to move to a system that offers much brighter opportunities for workers and for future generations.
Evidently, the argument that workers would have to pay "twice" suggests erroneously that workers would have to pay double the amount they currently do, when in fact, they would pay less for their retirement pensions than they presently do and would bear only a portion of the transition liability. It suggests erroneously that there are no "transition costs" associated with sustaining the status quo, when in fact there are and they are substantial. And it ignores the fact that the costs associated with the transition to a system of personal accounts are just that--transitional--and that they would bring forth substantial economic benefits.
The workers-pay-twice argument also obscures the fact that the risks of additional tax increases (or benefit reductions) down the road are far greater with a shored up pay-as-you-go system than with a system of personal accounts. The reason is the dependence of our current system on uncertain demographic and economic developments. With a system of personal accounts, the contribution rate would be set in the law and known in advance. The transition liability, moreover, would be capped (in present value terms) as of the time of the reform.
With this as background, the transition cost of the PSA proposal, which is spread over 70 years, was estimated by the SSA actuaries to be about 1.5 percent of taxable payroll on an average annual basis. This would be met by a 1.5 percent payroll tax supplement which, because of the relatively heavy benefit costs in the next few decades, would be supplemented by new federal borrowing. Under SSA's projections, this borrowing would equal 1.23 percent of GDP in 1999 and rise to a peak of 1.93 percent of GDP in 2007, then fall gradually to 1% of GDP in 2020 and to zero by 2030. Beyond 2030, social security would improve the overall federal budget relative to present law. In cumulative terms, total borrowing would peak at $2.3 trillion (in constant 1995 dollars) around 2020-2025. This debt would be repaid (with the proceeds of the payroll tax supplement) during the latter part of the 70-year transition period, at the end of which the tax supplement would be repealed.
While much has been said about these transition costs, several points should be noted. First, none of the proponents of the PSA plan supported a payroll tax increase to help finance the continuation of the current structure of benefits or to fund a personal accounts add-on to social security. We supported this tax only as a means of transitioning to a new system, one-half of which would be fully funded through personal accounts.
Here it is worth noting that the 1.5 percent payroll tax supplement bears no relation to the 1.6 percent payroll tax increase contained in the Chairman’s proposal, despite the similarity of their magnitudes. Under the PSA proposal, the payroll tax supplement (with bond financing) is a means to pay off accrued liabilities and to make possible the transition to fully-funded accounts that ultimately comprise half the retirement program. When the transition is passed, there would be no continuing tax liability and personal accounts would be fully funded with 5 percent of earnings. In addition, the 1.5 percent tax supplement is an estimate of the cost of transition based on projections that do not take into account any savings-induced increase in the capital stock or per capita income. If, as we expect, the reforms are beneficial to the economy, the transition tax would be lower. In the case of the Council chairman's proposal, on the other hand, 1.6 percent would be established in the law as the increase in the payroll tax used to fund the individual accounts. These accounts (and the tax) are permanent add-ons to the current retirement program, in contrast to our plan in which the accounts are a substitute for a portion of the program.
In addition, among taxes, we would have preferred a broad-based consumption tax, which would be paid by a broader segment of the population, create fewer labor market distortions, and be consistent with our more general goal of boosting saving. However, since the U.S. does not presently have such a tax, we concluded that the costs of setting up the administrative apparatus and layering this tax on top of the existing income tax structure would surely outweigh the gains. Should the U.S. tax system move in the direction of a consumption base, we would regard this as a highly preferable means of meeting part of the cost of transition.
We also would have preferred to couple general spending reductions with any tax increase. Without having the time, the resources, or the mandate to identify specific spending reduction measures, however, the consensus was that an explicit tax was required to deal forthrightly with the issue of transition costs.
We did believe that debt-financing part of the transition was desirable. This helps spread the burden to future generations, who stand to gain the most from these reforms, rather than concentrating it on today's workers. Also, as discussed further below, this borrowing basically amounts to making explicit a portion of a debt that already exists--in the form of outstanding, unfunded benefit promises--but is not officially recognized in federal budget accounts.
Putting the Borrowing into Perspective
In the current budget climate, it is not surprising that concern has been expressed about a reform plan that involves significant amounts of federal borrowing. It is essential to bear in mind, however, that social security already has amassed a huge debt--on the order of $9-$11 trillion--and annual changes in this debt are ignored in the nation's cash-flow budget. Increasing the funding base of social security involves making explicit a portion of this implicit debt.
To provide some perspective on the amount of borrowing under the PSA plan, Table 1 shows a measure of social security's unfunded liability. Referred to as the system's "closed-group" unfunded liability, it shows benefits projected to be paid to current workers and retirees over the next 75 years in excess of the taxes they are projected to pay (plus the current reserve fund), expressed in present value terms. According to the SSA actuaries', social security is projected to spend $18.6 trillion on benefits to current workers and retirees; this is $8.9 trillion more than the amount already held in reserves plus the taxes they are projected to pay. This implicit debt grew by $836 billion in 1996 alone--which was substantially more than the increase in formal debt issued to the public over the same period. The cumulative increase in social security's implicit debt exceeded $2 trillion in the 5-year period 1991 to 1996; over the period 1986 to 1996, the increase was $3.5 trillion.
The $2.3 trillion in explicit debt envisioned in the PSA plan, accumulated over a 20 to 30 year period, is thus not large in relation to the amount of implicit debt social security accumulates on automatic pilot over much shorter periods of time. (If expressed in present value terms, as are the data in Table 1, the new explicit debt peaks at $650 billion.)
Even in the context of conventional budgeting, the amount of new borrowing is not large by recent historical standards. The increase in debt under the PSA plan is about equal to the amount of federal debt absorbed by financial markets between FY1980 and FY1994 (which was $2.2 trillion in constant 1995 dollars), a period about one-half as long as envisioned in the PSA plan. The issuance of this debt, moreover, would be accompanied by the rapid accumulation of assets in personal accounts, with the total amount of debt always less than and ultimately dwarfed by the balances in personal accounts.
While the impact of the PSA plan on the federal budget is initially negative--and is projected to remain so until 2030--it is critical to consider broader measures to assess the long-term economic consequences of the plan. For purposes of the Advisory Council report, a simple measure of national wealth was developed, which takes into account the increase in private assets under the various plans net of any changes in federal borrowing. It is referred to as a "first order" wealth effect because it does not take into account offsetting actions that might be taken by private individuals or by the federal government.
Using this measure, the cumulative effect of the PSA plan--including the personal accounts, the transition tax and borrowing, and significant reductions in long-range benefits--on the nation's wealth is positive from the start and grows more rapidly than under either of the other two plans. In terms of increasing national saving and raising national wealth, the PSA plan ultimately outperforms the other plans by a significant margin.
In terms of reducing entitlement spending, the PSA plan outperforms the other plans by an even larger margin. For purposes of comparison, the PSA plan reduces long-range benefit costs from a projected $21.3 trillion (in present value terms) to $14.6 trillion, or by about 31.5%. (This option includes a number of changes to reduce the ongoing cost of the program, such as raising the retirement age to 67 then indexing it to longevity, in addition to creating the new tier 1 benefit.) The "Maintenance of Benefits" plan reduces long-range benefits slightly--to $21.2 trillion--and the "Individual Accounts" add-on plan reduces costs to $18.9. Surely, forward-looking financial markets would respond favorably to comprehensive reforms that promised to boost national saving and future national income.
While concerns about transition costs have led some to propose relatively small personal accounts, funded with 2 percent of earnings, smaller accounts means less additional saving and capital investment and thus smaller economic and financial benefits. In my view (and in the view of other proponents of the PSA plan), it is highly desirable to move toward larger personal accounts. Larger accounts offer workers the potential for higher benefits and a better rate of return on their social security taxes, and on net should result in significantly larger economic benefits. In addition, larger accounts would give workers keener incentives to make informed investment decisions and to monitor the performance of their investments. Larger accounts also would be relatively less costly for financial institutions to administer.
Can Workers Make Their Own Investment Decisions?
Another concern raised by critics of personal accounts is that many Americans are inexperienced with investing and would, if left to their own devices, make unwise decisions. The conclusion they draw is that either the government should do the investing, on a centralized basis, or the problem of asset management should be side-stepped altogether by returning to pay-as-you-go financing. Neither is an appropriate response to this ill-defined concern.
To begin, it is worth noting that American workers have never been better positioned to make sound financial decisions. With the introduction of IRAs, 401(k) plans, and other self-directed investment vehicles, workers have gained an enormous amount of experience with making investment decisions. In addition, with the explosion of mutual funds and, in particular, equity index funds, ordinary working men and women do not need to "play the market"--incurring large transactions costs and exposing themselves to excessive risk--in order to reap the benefits of stock market participation. And, no doubt owing to the tremendous competition for new customers and new funds, there is a wealth of financial information available about alternative investment strategies and institutions, and performance ratings are widely available.
While there are workers who own no stocks and who are inexperienced at investing, they represent a declining share of the population. According to a study by NASDAQ, for example, an estimated 43 percent of Americans owned stock in 1997--either directly or indirectly through their pension plans or mutual funds--up from 21 percent in 1990 and 10 percent in 1965.6 A majority of investors were under age 50 and roughly half were not college graduates.
An estimated 40 percent of Americans own one or more mutual funds, with total mutual fund assets (in 1997) topping $4.5 trillion.7 Mutual funds offer men and women from all walks of life a safe, low cost means of investing in broadly diversified portfolios of stocks and bonds. According to a 1996 survey by the Investment Company Institute, 40 percent of mutual fund owners had family incomes below $50,000; 42 percent were not college graduates.
As observed by Walter Updegrave, an associate editor of Money Magazine,
"By making investing so accessible that novices with just a few hundred dollars (in some cases even less) can invest with confidence by phone or through the mail, funds have effectively democratized America’s financial markets. They’ve given Americans of modest means the investing advantages that had once been available only to big institutions or to the wealthy--namely the ability to earn high rates of return by investing in diversified portfolios of stocks and bonds that are chosen and monitored by some of the best professional money managers in the nation."8
Some 35 percent of mutual fund assets come from company pension plans (mainly 401(k) plans) and IRAs--up from 17 percent in 1988 and less than 10 percent in 1983--leading Richard Ippolito to observe that "mutual funds gradually are becoming a dominant vehicle for retirement saving."9 Commenting on the "explosive growth" of mutual funds since the mid-1980s, Peter Fortune, a Boston Federal Reserve Bank economist, attributes "much of this growth" to "the increasing convenience offered to owners of long-term assets."10
On the company pension front, the rapid growth of defined-contribution plans--and especially 401(k) plans--has been transforming the profile of pension coverage in America. Of the roughly 50 million workers with defined contribution plans, roughly half, or 25 million, participate in 401(k) plans--up from 7 million in the early 1980s. With 401(k) plans, workers make voluntary tax-deductible contributions (which employers may match) and decide how to invest their contributions among a set of options offered by employers.11 Total assets of 401(k) plans were $650 billion at the beginning of 1996, projected to increase rapidly in the future.12 According to a 1996 survey by EBRI and the Investment Company Institute, the average account balance was about $29,000. (Long-tenure workers and older workers were found to have much higher balances--exceeding $100,000 for workers with 20 to 30 years of service.)13 Americans have another $1 trillion plus invested in IRAs.14
As noted by Zvi Bodie and Dwight Crane, of the Harvard Business School,
"... the growth of mutual funds and self-directed retirement accounts in the past few decades has transformed the asset holdings of millions of middle-class individuals. In contrast to the period before 1960 when "investing" (as opposed to putting money in savings accounts) was something only wealthy people did, today, millions of middle-income Americans hold a substantial fraction of their accumulated savings in mutual funds and are interested in how best to allocate them across asset classes."15
What do we know about "investor savvy?" For one thing, with a substantial amount of investing taking place through 401(k) plans and mutual funds, a great deal less "savvy" is required than when investing takes place in individual stocks. And with 401(k) plans, there is evidence that workers make reasonable investment decisions.
In a study of TIAA-CREF participants (the staff and administrators of universities, secondary schools, and other non-profit organizations), for example, Bodie and Crane found that participants followed "generally accepted investment principles," meaning, among other things, that they tended to invest more heavily in equities and longer term fixed-income securities and that they held relatively more equity as their wealth rose and relatively less equity as they approached retirement.16 While the population under study was generally better educated and had more experience with self-directed retirement funds, the authors concluded that "given enough education, information, and experience, people will tend to manage their self-directed investment accounts in an appropriate manner."17 Other studies of 401(k) plans also reveal clear and predictable differences in asset allocation by age and income group, with the proportion of assets held in stock funds or company stock declining markedly with age and rising markedly with income.18
Examining aggregate data on portfolio holdings in 1993, Richard Ippolito reports that workers allocated roughly the same share of 401(k) plan assets to equities--about 50 percent on average --as did sponsors of defined benefit plans and other defined contribution plans. He concluded that the rise of 401(k) plans "apparently does not portend dramatic change for asset allocation."19
As for the suggestion that women make inferior investment decisions, evidence on 401(k) plan participation and asset allocation decisions does not appear to support this claim. A study by Robert Clark, Sylvester Schieber, and others reports that women are slightly more likely than men to participate in 401(k) plans; their contribution rates generally are higher; and, when company stock is not offered (men do invest markedly more than women in company stock), women generally hold a higher proportion of their assets in equities. The researchers conclude that women do not "devote a higher percentage of their retirement savings to low-risk/low-return assets" and that "women are as effective in their use of 401(k) plans as their male counterparts."20
None of this is intended to suggest that workers make "optimal" investment decisions. Researchers have neither the models nor the data with which to evaluate this in a rigorous way. And none of this is intended to suggest that with personal accounts everyone will make the best financial decisions, reaping the best possible rates of return. Surely, some workers will take on too much risk; some workers will not take enough--particularly those with the least experience. But good decisions come with education and information, and with experience and learning--all of which would be gained rapidly by workers making regular contributions to personal accounts offered by competing financial institutions. Market returns on workers' accounts would provide steady information on investment performance; the relative success of competing financial institutions would provide valuable information as well.
With regard to allowable investments, the PSA proposal contains only one proviso: that personal accounts be invested in financial instruments widely available in financial markets. While we recognize the government's (i.e., taxpayers') interest in limiting excessive risk taking, there was no consensus about the kinds of restrictions that might be needed or be found cost-effective. (And indeed, the concern expressed most frequently, in financial news and other coverage of retirement income planning issues, is that workers do not take enough risk.) It also was unclear what benchmark one would use to determine whether workers were taking too much or too little risk. Certainly, the "right" way to allocate investments depends not only on one's age and earnings but also on the size and risk-return profile of non-pension assets, among other factors. We also recognized the possibility that with some investment options offered by some institutions, administrative fees could be high in relation to investment returns.
The problem we confronted, as is so often the case with government regulation, was making sure that there was a well-defined problem worthy of federal intervention, that there was a regulatory solution well-tailored to the problem, and that the regulations were likely to result in net economic gains.
In general, we envisioned a regulatory environment consistent with a wide range of choices for workers--for example, a range of options comparable to that now available to workers through 401(k) plans--offered by a wide array of financial institutions competing for workers' business. (My own view is that it would be far preferable to delineate what is not acceptable in the way of investment options or institutions, leaving markets free to develop new ways of delivering retirement income security, than to define what is acceptable, effectively banning everything not so defined and potentially sharply curtailing innovations that could greatly improve the well-being of social security participants.) We were in general agreement that concerns about investment decisions made by unsophisticated investors could be rectified most effectively by an educational effort, not by significantly restricting investment choices or by substituting government decisions for individual decisions.
In the end, there is no getting around the fact that with a system of personal accounts, workers must bear financial risks. These risks can be managed by prudent investment practices. With these risks come the potential for higher retirement incomes. Diversification and patience are the key to long-term retirement income security, a point that the daily ups and downs in the market are, no doubt, reinforcing for experienced and inexperienced investors alike.
There also is no getting around the fact that social security is risky--with respect to benefit levels, taxes, and rates of return. These risks stem not just from uncertain economic and demographic developments but also from uncertain political reactions to them. Unlike financial risks, political risks can not be hedged. And political risks can be very large--as evidenced by the 1977 legislation (and, to a lesser degree, the 1983 legislation), which substantially reduced projected benefit "promises" for younger workers and substantially increased payroll taxes.
One of the features we found most appealing about personal accounts was that workers would own their accounts, and the retirement savings they embody, and thereby would be exposed to much less political risk than under the present system--political risks that, over the next 20, 30, or 40 years could easily dwarf the financial risks of a well-diversified portfolio.
Evidently, the financial risks inherent in an investment-based system (including the safety-net which is likely to buffer workers from poor investment returns) must be balanced against the financial and political risks inherent in our pay-as-you-go system.
Concluding Thoughts
When Congress takes up the issue of social security reform, it will be under pressure not only to close deficits but also to shore up public confidence and restore value for younger workers. Reforms that move in the direction of creating a system of true pensions, with individually-controlled, fully funded retirement accounts, buttressed by a government safety net, hold real promise for the future. American workers would be substantially better off if they were permitted to invest a portion of their social security taxes in private stocks and bonds. The sooner Congress gets around to making this possibility a reality, the better for all concerned.
Carolyn L. Weaver is a resident scholar at AEI.
