Government Investment of the Social Security Trust Fund

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

Senate Committee on Banking, Housing and Urban Affairs
Subcommittee on Securities

April 30, 1997

Mr. Chairman, distinguished Members of the Committee:

Given Social Security's dire financial condition, there is growing interest in attempting to harness the power of private capital markets to bail out the faltering system. However, despite its surface attractiveness, allowing the government to invest funds from the Social Security trust fund in private capital markets would be a terrible mistake that would have severe consequences for the U.S economy.

It is easy to see why this approach has appeal. The trust fund is currently "invested" in government bonds. Allowing this money to be invested instead in private capital markets would appear to give the trust fund an opportunity to earn a much higher rate of return. Using this return to fill in some of the gap between future revenues and benefits would reduce the need for future tax increases or benefit cuts.

In reality, however, this approach is fraught with danger. Allowing the government to invest the Social Security trust fund in private capital markets would amount to the "socialization" of at least a large portion of the U.S. economy. It would put ownership rights over much of the American economy in the hands of the U.S. government.

At its peak, the Social Security trust fund will contain approximately $2.9 trillion. [1] The total value of all 2,723 stocks traded on the New York Stock Exchange was about $6 trillion at the end of 1995. [2] It is easy to see, therefore, that investing the trust fund would allow the U.S. government to purchase if not a controlling then a commanding share of virtually every major company in America.

Many of the strongest proponents are actually advocates of increasing government control over business. Gerald Shea of the AFL-CIO has said that it would be "good for for corporate governance" if government owned and voted its stock. [3]

Others, recognizing the potential dangers posed by government ownership of such a large portion of the American economy, attempt to allay such concerns some proposals have called for using stock index funds, not actual direct stock investments. [4] Exactly how this would be accomplished has been left vague, but there are essentially two possible approaches. The government itself could establish an index and purchase equal numbers of shares in every stock included in the index. Or the government could purchase shares in an existing index fund, such as Fidelity's Market Index or Vanguard's Index 500.

Government creation of an index fund would do little to avoid the pitfalls of government investment. Government decision makers would acquire property rights in corporate enterprises. Either they would exercise their rights, thus creating a direct political influence in the management of private enterprises, or they would give up the voting rights and other shareholder privileges, thus indirectly enhancing the power of existing shareholders. In either case, ownership of the enterprises would be powerfully influenced by political agents, and the entire arrangement would be financed by the taxpayers. Recall that the Employee Retirement Income Security Act of 1974 (ERISA) places the fiduciary duty on all persons in control of private retirement funds to use such funds in the sole interest of the pension plan participants. This law does not apply to the Social Security Administration. In whose interest, then, will investment and management decisions be made?

Would it make a difference if the government purchased existing index funds from a third party, such as an investment company? Not significantly. In order for the government to purchase shares in an index fund, it would have to do so through either a mutual fund company selling an index fund, which would then purchase actual shares of stocks included in the index, or through some other financial institution creating an index, which would also eventually purchase actual shares. Although the index fund would provide a layer of insulation between the government and the corporations whose stocks were purchased, the problems of control would not be completely avoided.

First, the government will acquire control over the index fund manager itself and thus indirect control over the corporations. If index fund A controls the majority of shares in company B, and the government controls the management of fund A, the government can control company B.

However, even if the government does not attempt to exercise corporate control, there is reason to be concerned over allowing index fund managers to use taxpayer money to increase their ownership of corporate America. The huge number of shares purchased with Social Security money will represent powerful voting blocks, and, in contrast to most stock purchases, they will be uniformly voted. Yet these powerful new stockholders will not answer to anyone and will derive all of their new powers from the aggregated funds of average American citizens. Never in the history of this country has there been a proposal to hand over this much power to unelected officials with this little responsibility attached to it.

In essence, it is being proposed that the federal government use tax money to pick corporate winners and losers. Using funds borrowed from Social Security's future beneficiaries, the government would purchase massive blocks of shares, to be controlled either by the government or by financial institutions that are fortunate enough to receive government contracts for such purchases. It is difficult to imagine a more egregious proposal for "corporate welfare."

With ownership comes control. What if a company whose stock is purchased by the Social Security trust fund decides to move its operations overseas? Should the administrators of the investments of the trust fund remain indifferent to the plight of the company's workers, who after all will be future beneficiaries of the system? Shouldn't the trustees at least attempt to convince the company to retain its American operations? And if the company moves, wouldn't the ownership of shares represent an indirect subsidy to foreign employees extended by the American workers who are losing their jobs to them? What if the company is convinced by the authorities to keep its operations in the United States and this leads to a consistent stream of losses and subpar share performance?

The investment itself provides the opportunity for central planning and control. After all, companies whose stocks are selected will receive a substantial investment boost not available to competitors who are not chosen. This raises a host of questions about what types of investments should be allowed.

For example, cigarette smoking is a major health concern to the nation and to the federal and state governments that spend public money to provide health care for those suffering from smoking-related diseases. Should Social Security be allowed to invest in cigarette companies? Is it appropriate for the Social Security system to offer price support to those shares while Medicare and Medicaid spend their resources in treating patients suffering from the long-term consequences of smoking?

Other controversial issues are easy to imagine. Should Social Security invest in nonunion companies? Companies that make nuclear weapons? Companies that pay high corporate salaries or do not offer health benefits? Companies that do business in Burma or Cuba? Companies that extend benefits to the partners of gay employees? The list is virtually endless.

Public employee pension funds have long been subject to such controversies. [5] For example, at one time more than 30 states prohibited the investment of pension funds in companies that did business in South Africa. Approximately 11 states restricted investment in companies that failed to meet the "MacBride Principles" for doing business in Northern Ireland. [6] Companies doing business in Libya, other Arab countries, and communist states have also been barred from investment. [7] Some states have additional restrictions on investing employee pension funds, including requirements for investing in in-state companies, home mortgages, and alternative energy sources, including solar power. In some states investments are prohibited in companies that are accused of pollution, unfair labor practices, or failing to meet equal opportunity guidelines. Some public employee pension funds are prohibited from investing in the alcohol, tobacco, and defense industries. In a recent example, the city of Philadelphia announced it would sell its employee pension fund's Texaco stock because of alleged racist practices by that company. [8]

Use of a passive index--either one created by the government or an existing one--would reduce, but not eliminate, the problem. There would remain questions about what stocks should be included in the index. Almost inevitably there would be a huge temptation to create a better, more socially appealing index of companies friendly to the public policies of the current administration or the current congressional majority.

Those looking for evidence of this temptation need look no further than attempts by the Clinton administration to force private pension plans to invest a portion of their portfolio in "socially redeeming" ways. [9] Actually, the last days of the Bush administration saw the first exploration of the idea of directing private pension investment. In November 1992, the Labor Department released a report discussing a procedure for valuing the "net externalities" of investments as a way of broadening the prevailing rate test permitted under ERISA to allow for politically targeted investments. The Clinton administration jumped on the idea with undisguised enthusiasm. In September 1993, Olena Berg, the Assistant Secretary of Labor for Pensions and Welfare Benefits, announced an expansive interpretation of the prevailing rate test that would "allow collateral benefits to be considered in making investment decisions." She especially urged pension fund investment in "firms that invest in their own work force." [10]

A year later, in September 1994, Labor Secretary Robert Reich called for investment of a portion of private pension funds in economically targeted investments (ETIs), which would provide such "collateral benefits" as "affordable housing, infrastructure improvements and jobs." [11] Fortunately, Congress has resisted this dangerous idea. But it is clear that some politicians are anxious to gain control over pension investments.

A study by the World Bank of government-managed pension fund investments around the world found that such investments generally earned lower annual returns than privately managed pension investments. [12] The study found that governments generally pursued one of two policies for their investments, both fundamentally flawed.

One policy was to invest heavily in government securities, which earn much lower returns than, for example, in stocks. There are two reasons for this policy. First, there is a cautionary search for safe investments because governments fear the political reaction if a more aggressive investment policy were to lead to adverse results. Second, buying up government debt allows the government to defer the consequences of its own overspending. Indeed, there is evidence that the power to shift government debt into pension funds may actually induce governments to spend and borrow more. [13] Borrowing from the pension fund is less transparent than borrowing from the open capital market.

The other investment policy pursued by government-controlled pension funds is to invest in government-supported projects such as state-owned enterprises or public housing. Again, the result is often extremely low rates of return. In fact, such investments frequently lose money. [14]

Is there a better way to harness the power of private capital markets to guarantee a secure retirement for America's elderly?

Rather than allowing the government to control investments, we should give true power to the people, allowing individually owned and privately managed investment accounts similar to Individual Retirement Accounts (IRAs), and 401(k) and 403(b) plans.

Individuals would be free to invest the money in their accounts--and could probably do so through qualified money management companies--in stocks, bonds, and other investments, with certain limited restrictions to prevent very risky speculation. Government control would be limited to defining the options that could be offered for investment with actual control would remain in the hands of individuals.

This approach has proved highly successful in Chile and in a number of other countries. [15] There has been growing interest in individual private accounts in this country as well: A second option being supported by five members of the Social Security Advisory Council would allow approximately 50 percent of Social Security taxes to be diverted to private accounts. Other proposals in Congress and elsewhere would allow greater or lesser amounts of an individual's Social Security taxes to be privately invested.

Americans have shown themselves willing to embrace such a privatization of Social Security. According to a poll of 800 registered voters conducted by Public Opinion Strategies on behalf of the Cato Project on Social Security Privatization, more than two-thirds of all voters, 68 percent, would support transforming the program into a privatized mandatory savings program. More than three-quarters of younger voters support privatization. Support for privatization cuts across party and ideological lines, particularly among young voters. [16]

If we are truly serious about harnessing the power of private capital markets to solve Social Security's problems, we should allow investment in individual accounts, not a government takeover of capital markets.

Notes

Much of my testimony is drawn from Krzysztof Ostaszewski, "Privatizing the Social Security Trust Fund? Don't Let the Government Invest," Social Security Privatization No. 6, January 14, 1997.

[1]. 1996 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Trust Funds (Washington: Government Printing Office), p. 180, table III.B3. (Intermediate Assumptions, Year 2020).

[2]. 1995 Annual Report of the New York Stock Exchange (New York: New York Stock Exchange, Inc., 1995).

[3]. Michael Eisenscher and Peter Donohue, "The Fate of Social Security," Z Magazine, March 1997, p. 29.

[4]. One can, and academics in the field of finance do, argue whether any additional returns can be earned by using active management instead of market index approaches (see, e.g., Michael C. Jensen, "The Performance of Mutual Funds in the Period 1945-64", Journal of Finance, May 1968; also Robert A. Haugen, Modern Investment Theory, Third Edition (Englewood Cliffs, NJ: Prentice-Hall, 1993). Clearly, utilizing a market index eliminates the costs of active management, thus saving future beneficiaries an amount of about 1 percent of their assets annually. (See Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, Second Edition, [Homewood, IL: Richard D. Irwin, Inc., 1993], p. 111.) However, in this proposal it appears that the use of an index has been guided more by concern for the actual formal ownership of shares than purely by the costs of the option.

[5]. For a thorough discussion of state employee pension systems and their investment policies, see Carolyn Peterson, State Employee Retirement Systems: A Decade of Change (Washington: American Legislative Exchange Council, 1987).

[6]. Roop Mohunlall, et al., The 1989-90 Source Book of American State Legislation, Vol. VI, A Pro-Growth Economic Policy (Washington: American Legislative Exchange Council, 1990), pp. 98-9.

[7]. Carolyn Peterson, State Employee Retirement Systems: A Decade of Change, pp. 63-5.

[8]. Del Jones, "City Pension Fund to Sell Texaco Stock," USA Today, November 22, 1996.

[9]. Cassandra Chrones Moore, "Whose Pension Is It Anyway? Economically Targeted Investments and the Pension Funds," Cato Institute Policy Analysis no. 236, September 1, 1995.

[10]. See, for example, Thomas Jones, "Social Security: Invaluable, Irreplaceable, and Fixable, " Participant, February 1996.

[11]. Robert Reich, "Pension Fund Raid Just Ain't So," letter to the editor, Wall Street Journal, October 26, 1994.

[12]. World Bank Policy Reports, Averting the Old-Age Crisis.

[13]. Ibid., p. 94.

[14]. World Bank Policy Reports, Averting the Old-Age Crisis, pp. 94-95.

[15]. For a description of Chile's system see Jose Pinera, "Empowering Workers: The Privatization of Social Security in Chile," Cato's Letter no. 10, 1996. Other countries following Chile's example include Argentina, Peru, Colombia, Uruguay, and Mexico. In Europe, Britain provides a low minimum benefit through its traditional pay-as-you-go social security system, but has also allowed people to opt out of its benefits above this minimum through contributions to an expanded IRA. Nearly 70 percent of Britons have done so.

[16]. Michael Tanner, "Public Opinion and Social Security Privatization," Cato Institute Social Security Paper no. 5, August 6, 1996.