Cato Policy Report, January/February 1999
The Cato Institute and Forbes ASAP sponsored the second annual Conference on Technology and Society, “Washington, D.C., versus Silicon Valley,” in San Jose, November 19–21, 1998. Following are excerpts from the panel on “Money Management, Capital Flows, and Social Security in Cyberspace.” The speakers are Scott Cook, chairman of Intuit Corp.; José Piñera, the architect of Chile’s privatized social security system and co-chairman of Cato’s Project on Social Security Privatization; and Jeff Maggioncalda, president and CEO of Financial Engines. These speeches and the rest of the conference videos can be viewed with RealPlayer video at www.novell.com/webcast/.
Scott Cook: A recent survey showed that more Americans in their 30s believe in UFOs than believe that Social Security will be there for their retirement. That shows great wisdom because they are probably right. There may be UFOs, but there is no way Social Security will be there for their retirement. This is not a small problem. Social Security is by far the largest government program, the one that affects every worker, and it is broken.
Let’s go through some of the numbers. When the Social Security program was started, the maximum tax you’d pay was $60 a year. That was 60 years ago. Now, the maximum is $8,109. It is, for two-thirds of Americans, more than their federal income tax. Meanwhile, the program has made $9.5 trillion in promises it can’t keep.
The problem is demographics. In 1950 there were 16 workers for every recipient. Social Security is a pay-as-you-go program, not a funded investment program. So the ratio of workers to recipients is key. It’s about three now, and in a couple of decades it will be two workers supporting every retiree.
Now, what’s the return you get for the $8,000 contribution you put in each year if you’re at the maximum? Well, you get less than 2 percent. That’s worse than stocks, worse than bonds, worse than mutual funds, worse than passbook savings. In fact about the only interest rate in the world that is comparable is the measly interest rate you get on a checking account. And that’s if the government honors its promises, which it can’t.
So what’s the rationale for this program? Some people say it protects the needy. Let’s think about that. First of all, this is a regressive tax—it taxes most highly the people with the lowest incomes because taxable income is capped. For us CEOs, it’s a microscopic amount of money. For the people who work in our tech support center, it’s an immense tax. What’s more, the people who get hurt most by Social Security in its current form are, in fact, the poor and minorities. Why? Because poor and minority workers pay a higher percentage of their incomes: they start work earlier in their lifetimes, so they have more years during which they are paying a higher percentage of their incomes, and they live for a shorter period of time, so they collect less.
Let’s not even focus on the numbers for a minute; let’s focus on the morality. What the Social Security system does is turn our retirees—our parents and their peers—into a nation of welfare recipients, dependent on the government dole for their economic livelihood. Think what that does to their incentives and their belief in free markets. Once you’ve determined that your livelihood is a function of the government dole, you rally to protect that dole. And thus, in many people’s view, the most powerful lobby in Washington is the American Association of Retired Persons.
So how do we fix the system? There are proposals to increase taxes or reduce benefits. The payroll tax of 12.4 percent would have to increase by almost 50 percent, to almost 20 percent, to make up the shortfall. Or you’d have to cut benefits by almost a third when the real return on Social Security is already less than 2 percent. If you apply either of those fixes, the return goes negative.
Another option is to have the government invest the Social Security tax revenue in stocks. Unfortunately, that leaves the current system in place. It’s still a welfare system. You have the government in control of the largest investment fund in the world. Now, how fairly and wisely do you think the political system would allow the federal government to invest in company stocks? You can bet it won’t be an economically rational system.
The problem with all three of those solutions is that they are not the fundamental change that is needed. They are a Band-Aid on a failure. The fundamental problem is that our retirement is being provided for through a state monopoly, through socialism instead of free enterprise, through welfare instead of individual responsibility. What’s needed is a much more substantial fix.
José Piñera: The good news is that there is a solution: allow workers to opt out of the pay-as-you-go (paygo) government system. Every worker should be given the choice of either staying in the government-run system or opting out with his FICA taxes—12.4 percent of his wages, adding employer and worker contributions—and investing that money in a private individual retirement account. Invested in an adequate portfolio of bonds and shares, that money will get positive returns and therefore grow exponentially during the entire working life of 40–45 years, so that every worker will accumulate wealth as he grows old.
Some of you may be thinking, “Well, but that is impossible.” That’s exactly what they told me 18 years ago when as secretary of labor and social security in Chile I proposed to do precisely that. And we did it. In 1980 we approved a bill giving every Chilean worker that choice. In the first month of the new system, 25 percent of the labor force decided to leave the government system and move to the private one. At the end of the first year 70 percent of the workers had moved, and today 93 percent of Chilean workers carry around a retirement passbook and are share-holders of Chilean and international companies.
Now, some people might say, “Well, okay, the system of private individual retirement accounts works, but how do we do the transition from the current system?” Yes, the transition entails a challenge, since there are complex financial and political issues. To explain the alternatives I used this metaphor in Chile 18 years ago: “The government-run paygo system is like the Titanic. The workers are passengers and the ship is going directly toward the iceberg of an aging population.” The proof of the iceberg is not just the financial imbalance of the system but the low and eventually negative rate of return that young workers will get from their FICA taxes. Whatever you do in terms of fixes of the current system—increasing payroll taxes, reducing benefits, increasing the retirement age—diminishes that rate of return and aggravates the problem for young workers. So there is really no solution within the paygo system, because that system is structurally flawed since it destroys the essential link that should exist between contributions and benefits, ultimately between effort and reward. The only thing you can do is to slow the speed of the ship going toward the iceberg and in that way prolong the agony.
So when people tell me that it’s very difficult to change from one system to another— to take the passengers from the Titanic to a nearby ship, the system of private individual accounts—my answer is yes, it is difficult to transfer passengers in high seas from one ship to another. But let me tell you something: it is much easier to do it before you collide with an iceberg. So you have to do it. The issue is now or later. The United States still has 10–12 years before the final collision, when the baby-boomers begin to retire and the system runs out of money.
In Chile we followed three transition rules. First, we guaranteed benefits to the elderly. It is the decent thing to do. You cannot tell an 80-year-old widow that because the founder of the paygo system, Prussian chancellor Otto von Bismarck, was dead wrong, her benefits will be reduced next month. Promises must be kept. Second, all new entrants to the labor force go into the new system. The door of the old system had to be closed because it would have been irresponsible to go on adding to a system that we knew was unfunded and unsustainable. The third rule—the silver bullet in terms of the political economy of the transition—was to give every worker who already was in the social security system the choice I mentioned before. To those who decided to move out, we gave a “recognition bond” recognizing their accrued rights under the paygo system. Now, since the government does not have that money today, the paygo system is totally unfunded, that recognition bond is a zero-coupon bond that the government will pay only when the person reaches retirement age. But the worker has a government security that is tradable in the market, and in this way he cuts the link with the paygo system the moment he moves out. When he reaches 65 he has both the accumulated money in the new account and the proceeds of the recognition bond.
Now let me explain why I believe the technological revolution that is transpiring here in Silicon Valley gives a turbo-charge to this proposal of individual retirement accounts. In Chile 18 years ago people would say, “How will the private sector manage millions of accounts on a daily basis?” At that time, of course, the industry of processing information was in its infancy. Today the question is a joke. Probably with a laptop computer you can manage all the accounts of every worker in the country—well, at least in my small country of 6 million workers. You may need a somewhat bigger computer in your country. But I have no doubt that, with the advance in microchips, Moore law, and all that, managing a hundred million accounts may be a challenge but not a problem. And the costs of doing it are going down at incredible speed.
Second, some people in this country have told me, “The idea is good, but people don’t know how to manage money.” I am always puzzled that they trust people to choose among contending presidential candidates with positions on complex domestic and foreign affairs, but they don’t trust them to invest their own money. Whenever someone tells me that I ask, “Is it you that doesn’t know how to manage your money?” And they always answer, “Of course I know; it’s my neighbor who doesn’t.” That is nonsense. People are born free and with an immense capacity to learn; they manage those challenges that are essential to their daily lives. A proof: those millions that are now deciding on their 401(k) or IRA accounts. The Internet will be a very useful tool in this education process.
The third concern is market risk. What if shares go down? First, the perspective of a retirement system should be the long run, the entire working life, and shares have always gone up substantially, say 10 percent a year on average, in a period of 40–45 years. Now, if you want to sleep better even though at the cost of eating a little less in the future, you can decide to put your whole portfolio in Treasury bills. Today you can get a long-term rate of 5 percent. So with, say, inflation prospects of 1.5 percent, you can lock in for 30 years a 3.5 percent real rate of return guaranteed by the U.S. government. That’s much better than the zero real rate of return that the paygo system will entail for workers entering the labor force today. And as we have seen, there are companies that are able to advise people online about the most adequate risk-reward portfolio at a very low cost. The Internet will allow people to choose portfolios and constantly revise them to exactly match their preferences about risk and old age and their views about the market.
Fourth, the paygo system depends on workers’ paying a payroll tax. But as more people will work and earn money in cyberspace, the government will lose the ability to tax those earnings. The artificial and so-called intergenerational contract, which incidentally I have never been able to read and do not know who signed for me, will simply collapse as a result of the free decisions of people.
Finally, the Web is a great tool to mobilize the grassroots and develop pressure for change. At www.socialsecurity.org, Cato has a Web site with an interactive calculator that allows visitors to calculate the extraordinary benefits to every one of them of introducing a system of private individual accounts. Every visitor is transformed into a militant for change. Some people are realizing that. Some time ago I met a high official of the Social Security Administration. He said jokingly, “I am mad at you for two reasons. First of all you’re taking away my job. Second, Cato has taken the domain name socialsecurity, so whenever anyone goes online to learn about Social Security they’re going to a site that argues that the country should do away with government-run Social Security!” I laughed and answered, “Well, you are giving me another reason why we should privatize the system. You are so slow and we are so fast. You should have been the first ones to register that name. But we did it. Socialsecurity.org is ours. But let me give you an idea: you can still register titanic.gov.”
Jeff Maggioncalda: I want to discuss the realities of individuals (a) having control over decisions and (b) being faced with the complexity of making investment decisions.
The prospect of millions of people making investments for their retirement is not entirely new; we’ve had individual retirement accounts and 401(k) plans for quite some time. And to some degree they can be thought of as an experiment in what might happen if we were to privatize a large body of assets like Social Security. At Financial Engines, we’ve developed some technology that will help in what I think is a democratization of high-quality investment advice.
Financial Engines was founded by Bill Sharpe, who is a Nobel laureate in economics at Stanford University. He developed most of the underpinnings of modern portfolio theory, and he spent a couple of decades advising the largest pension fund managers in this country who are faced with the same basic responsibility that 401(k) participants are: how do you invest a pool of assets in order to fund some future liability? We are working with money managers who represent over 8 million participants in 401(k) plans.
Our solution to the problem that individuals are having investing their money is to package a lot of the techniques that have been delivered to fund managers and make the package available to individuals. The package doesn’t just help them pick better funds. The technology frames the problem differently, so that what you can look at is not so much the specific products you need to buy as the outcomes that might result from selecting those products. So you can focus on the way you want to live, and we as an investment manager or investment adviser recommend the product set that most optimally will deliver that outcome.
The fundamental question that people really care about is, Am I going to reach my goals? That’s why people invest. Investing, I believe, is not an end unto itself, although right now most of the people out there who are carefully managing their investments are hobbyists. They love the sport of investing. The majority of people don’t. They wish they didn’t have to. They just want to be able to get some certainty that they’re going to have enough money to be comfortable when it comes time to retire.
What Financial Engines does may seem radical to the individual, but it’s consistent with what the largest pension fund managers have been doing for a long time. We assess liability. We frame the problem in terms of the amount of retirement income you as an individual want every year in today’s dollars.
The next thing we do is look at the specific investments in an individual’s household portfolio, including more than 9,500 mutual funds and 5,500 stocks that we track on an ongoing basis. And then we simulate how those specific investments might perform over the time that is relevant to you. We’ll forecast the chance that the specific investments that you own will allow you to retire with the amount of income you want. And this is all consistent with what we know as professionals about the way the markets work. But of course there are lots of other possibilities for market performance. We generate thousands of different possibilities— high inflation, low inflation, bear markets, bull markets, bonds do well, bonds don’t do well, and so forth—and we look at the way your specific set of investments would have fared in all of these different scenarios. And so rather than doing what most software does today, which is allow you to put in one expected rate of return that is the same for every single year, we show you that there’s a range of returns and there are certain scenarios under which you’re not going to fare very well.
We can tell you that there’s a chance you’ll reach your goal, say, a 45 percent chance. We can also tell you what the downside risk is. There is a 5 percent chance that, when you retire, you’ll have less than X to live on. And if you’re uncomfortable with that outcome, we give you a very straightforward way to change your decisions. So, for instance, you might say, “Let me try decreasing my risk.” Then we give specific fund recommendations and show you what the new outcomes are. So you’ve just taken less risk, but then you’re likely to have less income in retirement than you want. So you might say, “Let me try increasing my savings.” We show you what the consequence of that is. And now with two clicks of the mouse, you’ve totally changed the outcomes of your investment decisions. You’ve received specific fund advice and you’ve improved your chances of success from 45 percent to 90 percent. And what you’ve had to do is save a lot more money. But if you’re risk averse, you should have the option of doing that. And if you’re risk seeking, you should be able to take a lot of risks and save less money. And ultimately, we believe, if individuals understand the impact of their decisions, they’ll come up with much more efficient solutions because the solutions are tailored to the individual preferences of the investor.
Our software asks for personal information about yourself, the annual retirement income that you want, and your portfolio. Then the Forecast section tells you the chance, based on what you’re doing right now, that you’ll reach your retirement income goal. Next the Advice section recommends a set of specific investments that are optimal for your preferred level of risk, given your age and everything else; the Advice section also takes into account the fact that you already own certain stock and funds in certain accounts. So our advice is entirely personalized to your total household portfolio.
This article originally appeared in the January/February 1999 edition of Cato Policy Report.