1994-96 Advisory Council
|1994-1996 Advisory Council on Social Security|
Robert M. Ball, Edith U. Fierst, Gloria T. Johnson, Thomas W. Jones, George Kourpias, and Gerald M. Shea
This statement addresses several points made in various parts of the report, primarily in the statements of the other Council members.
1. The criteria to be used in comparing the three proposals:
Our statement titled " Social Security for the 21st Century" gives the reasons we disagree with "replacement rates" and "money's worth" as criteria for comparing the plans, and in this statement we object to the criterion the other members of the Council develop in a section they call "Entitlement Spending Considerations."
In simplest terms they take the position that, regardless of anything else, it is a plus for a plan if it cuts Social Security. They argue that since "entitlement spending" as a whole -- which includes health programs, Social Security and many smaller programs -- is growing at a rate under present law that would result in the unsustainable situation down the road of using up all the currently scheduled tax money available and then some, reducing Social Security is a good idea as such. To reach this conclusion, they add in the interest on what would have to be borrowed if present law for all programs stayed as is and taxes were not raised. They argue that since Social Security is a very large "entitlement program" it would slow the growth of the entitlement category if Social Security were cut. Therefore, they make Social Security cuts an important positive criterion for judging Social Security proposals.
In other words, they assert that less is better regardless of whether Social Security is balanced for the long run with dedicated taxes or not. What matters is that it be balanced at a decreased level of protection regardless of whether people are willing to pay what they need to in order to maintain present levels of protection. Suddenly we are no longer trying to solve a Social Security financing problem but arguing instead that Social Security should be cut because other programs -- mostly the fast growing health programs -- will be spending too much. Without assessing the merits of the current level of Social Security protection as reasonable or unreasonable in terms of what the country wants Social Security to do and what people are willing to pay for, the argument is made that, willy-nilly, Social Security should be cut because when you add a lot of other programs and assume they will not be cut and you add interest to pay for them by borrowing, the total amount is too high.
It is absurd to assume that no cuts will be made in any of these programs and instead that money will be borrowed (not taxes raised) to pay for everything in present law. How does it illuminate the Social Security financing problem we are charged with addressing to offer a picture of the future that depends for its effect on growth in non-Social Security spending and on the assumption that nothing will be done to curb it (although something quite obviously has to be done)? What we have is a projection that has little to do with Social Security and that in order to make a point uses growing interest outlays arising from non-Social Security programs, and that makes the utterly unsupportable assumption that nothing will be done about the projected growth of health spending -- all to suggest that a proper criterion for judging Social Security proposals is how much they cut benefits.
The main factor driving up the combined cost of Medicare and Social Security is not growth in the number of the elderly, which accounts for only one-third of the projected increase in the share of national income claimed by these two programs. The main cause is the expected growth in per capita medical cost, which makes up two-thirds of the projected increase in this share. As Henry Aaron of the Brookings Institution recently wrote in Newsweek (December 9, 1996): "To argue that pension benefits should be cut because of unsustainable projected growth in medical costs seems a bit irrational."
We agree and we utterly reject this notion. Social Security is a program supported by its own dedicated taxes. If people are willing to pay for the present level of protection or more, that should end that particular argument. If the case is to be made that Social Security benefits are too high according to some definition of the proper role of government, then that case should be made, but it is hardly tenable to argue that one proposal is better than another simply because it cuts Social Security more than another.
2. The effect of the various plans on savings:
The other two plans in the Advisory Council Report stress the goal of increasing national saving. We agree that it is an important goal and the MB plan does make a significant contribution to it. In fact, by 2013 the MB plan builds savings to about one-half the level of the IA plan and by 2030 the savings from the MB plan equal nearly two-thirds savings of the IA plan, 27 percent of GDP. We have not thought, however, that saving should be the major goal of Social Security reform, regardless of how it is achieved. The other plans get their greater increases in savings as a result of a substantial tax increase -- 1.6 percent of additional deductions from workers' earnings in the case of the IA plan and a 1.52 percent increase in the payroll tax in the case of the PSA plan. We believe it is wiser to avoid such large and politically unpopular changes in connection with the OASDI program where they are unnecessary and reserve such changes for part of the possible solution of the financing problem of the Hospital Insurance program under Medicare which is supported from the same payroll tax and is much more likely to need such an increase in taxes in the near future.
However, if the country believes that increases in national savings are worthy of such immediate increases in the payroll tax, it does not require the establishment of individual accounts and reduction in Social Security. If a tax increase is wanted to fund Social Security more quickly, adding it to the MB plan will increase investment just as would be the case under the other plans. Moreover, such an increase added to the MB plan would, of course, make it unnecessary to cut benefits by extending the average wage computation period from 35 to 38 years or to schedule the tax increase for 2045 which is now part of the MB plan. But to increase savings the tax increase does not have to be connected to Social Security at all. Any tax increase earmarked to reduce the national debt will do the job.
References to "alleviating labor market distortions" and "other work disincentives" in the statement by the sponsors of the PSA plan do not seem to us defensible. With the PSA plan, the roughly 5 percent tax that finances the flat benefit and the other remaining government benefits is completely a tax. Thus we go from a system with varied implicit taxes (taxes minus increased expected benefits) to one which is half a tax and half no tax (except that people who don't want to save will still view the savings mandate as a tax on work). Whether labor market distortions go up or down under the shift is a subtle issue, which, as far as we know, has not been seriously examined. There would seem to be no basis to claim that the PSA plan improves the labor market.
The statement by the supporters of the PSA plan refers to the financial services business as extremely competitive. There are several possible uses of the term "competitive." The central one usually used for analysis is "competitive" in the sense of approximating an idealized competitive market. One of the features of an idealized competitive market is "the law of one price." The same good sells for the same price in all transactions at a point of time. The mutual fund industry fails this test of "competitive" dramatically. The same portfolio choices are available with widely differing administrative costs. That free entry means the profits from distorting prices are zero does not make the distortions go away. The mutual fund industry is clearly not an ideal competitive market. Presumably the same goes for individuals designing their own portfolios one stock at a time.
The sponsors of the PSA plan apparently agree that the government flat benefit part of their plan is subject to political risk just as they see political risk in the present Social Security system -- that is, whether the government will actually deliver on its promises.
They do not point out, however, that insofar as there is such risk, its distribution is very different in the PSA plan and the MB plan. The PSA plan spreads the risk very unequally per capita, since the flat benefit that is at risk represents a much greater proportion of total benefits for the lower paid. Social Security spreads the risk more in proportion to total benefits. The PSA plan protects the well-off from political risk, but what is proposed for the poor is very much at risk. This part of the plan will not command much support and could easily be means-tested or restricted in other ways. By contrast, Social Security minimizes this risk because all who are covered have a meaningful stake in the system.
We find it extraordinary that the sponsors of the PSA plan propose reducing disability benefits for young workers by as much as 30 percent, not by design, but in their view as the inevitable result of changes they believe are desirable for older workers. "Unfortunately", they say, "to avoid arbitrary notches in benefit levels, any changes in the formula affecting older workers had to affect workers of all ages." Actually what they are talking about here is not a "notch" but a disparity of treatment that would arise between older and younger workers. But, in any event, why is it more important to avoid notches (or such disparity of treatment) than to avoid poverty for young disabled workers?
(a) Would this destabilize the market?
Some of the other members of the Council have argued that our proposal to invest part of the Social Security funds in the private capital markets would have a destabilizing effect on the market even if such investments were passive and representative of the broad market. The proposal we have offered for further study would gradually build to a 40 percent passive indexed equity asset allocation over a 15-year period from 2000 through 2014 (i.e., approximately 2.67 percent of Trust Fund assets reallocated to passive indexed equities each year). This would total approximately $1 trillion by 2015. In comparison, approximately $600 billion was invested in passive equity index portfolios in the U,.S. market at the end of 1995, and this would increase to approximately $5 trillion in 2015 at a 12 percent compound rate of growth (combined total return and new funds allocated to passive equity index strategies). Total U.S. equity market valuation of approximately $8 trillion in 1996 will increase to roughly $60 trillion in 20 years at a compound annual growth rate of 10 percent (combined total return and new funds committed to equity investment).
Why does $1 trillion in Social Security Trust Fund investments destabilize the market when it follows the same strategy with the same investment advisors as $5 trillion in non-Trust Fund passive equity index assets? If Trust Fund passive equity index assets were spread, say, among the top 20 or 25 private sector passive equity index managers, Trust Fund equity assets would be seamlessly integrated into the broad pool of indexed assets in the market. Trust Fund equity assets would not be disruptive, nor would they be a disproportionate share of the market. Further, the proposed Trust Fund passive equity asset allocation of 40 percent is a less severe shift away from the current Treasury debt investment policy than would be experienced with individual accounts, which are expected to hold at least 50 percent of assets in equities. If asset reallocation under individual account proposals would not be disruptive to U.S. debt and equity markets, there is little reason to believe a more moderate asset reallocation by the Trust Fund would be destabilizing.
(b) Which investment approach is more efficient -- individual accounts or central management?
Expenses and transaction cost are likely to erode substantially the investment performance of individual accounts, particularly for low and moderate income workers. Consider a $30,000 per year worker contributing 2 percent to an individual account. The $600 contribution will be eroded by flat dollar account maintenance fees ($30 per year is typical of charges levied for IRAs and Keoghs), sales charges on mutual funds (often 3 percent or more), and expense charges on mutual funds (often 1.50 percent or more for equity mutual funds). This worker's investment selections would have to outperform the market by 5 to 9 percent before expenses in order to equal the market after expenses.
Some argue that competition will lower these expenses to more reasonable levels. This certainly has not been the experience in the mutual fund marketplace. Individuals continue to pay hefty sales charges, operating and investment advisory expenses for funds which usually fail to outperform the market. This apparent irrational behavior may suggest that many investors don't understand the total expenses they are paying, or how poorly their mutual funds are performing relative to the market.
In contrast, Social Security Trust Fund investment in equities could be done very efficiently on a portfolio basis by contracting with private sector passive equity index managers. For example, the Federal Retirement Thrift Savings Plan (TSP) pays 1 basis point investment advisory fees to Barclays Global Investors to manage an $18 billion S&P 500 passive portfolio, and 2 basis points to manage a $3 billion passive indexed bond fund.
(c) Voting rights
As stated in the main body of our report the Social Security fund should be prevented by law from exercising the voting rights derived from their stock ownership and we suggested several ways the voting right issue could be handled, including distributing the proxy votes of Social Security held stocks in accordance with the votes of other stockholders. Another possibility would be to handle proxy voting the way it is done in the TSP. By law the TSP is barred from exercising voting rights, and it delegates that authority to the portfolio manager with a fiduciary requirement to "vote all proxies and address all corporate actions in a manner which will result in maximum financial benefits to TSP participants." This arrangement has worked very well for many years.
(d) Can the hands-off equity index fund principle be maintained?
As we say in our main statement, the ultimate guarantor against political intervention in what we describe as a kind of "blind trust" arrangement for Social Security's investment in private stocks is our competitive political system. Once the policy of nonintervention is established in law and policy, it is unlikely that the political cost of advocating change would be lightly undertaken. Social Security in the past and in the future involves the interests of just about every American family and for one party or faction to advocate change that is seen as damaging to the institution creates a major opportunity for the other political party. It is this competitiveness of our political system that has protected Social Security from radical change for 60 years.
We believe that this democratic control is more powerful than the theoretical risk that anything one Congress sets up another can change. There is tremendous protection for settled policy in a contributory, nearly universal system such as Social Security, once the policy has been agreed to and enunciated in law. The uncertainty of future Congressional activity is much more of a real threat to proposals which start out without substantial support as would be true of the proposal to cut back Social Security to a flat benefit program of interest and usefulness for only those of low income. The substantially reduced protection of the government portion of the IA plan also has this problem: If money's worth analysis raises questions of young workers' loyalty to the present system, how much more is this likely to be the case for a system collecting as much in taxes but over time cutting the average benefit by 30 percent?
(e) Can a reasonable distinction be drawn between financing Social Security partly through equity investment as compared to other government programs?
We believe the answer is yes. Social Security is a huge group insurance and pension fund which is administered by the Federal government as a public utility for the participants. Its investment arrangements can follow those of state retirement system and private pension systems without logically needing to allow Federal programs in general to be financed by equity investment. Thus, as in the case of the Federal Employees Thrift Plan, investment in stocks should be seen as uniquely suited for retirement income, not as a way of financing the general activities of government.