Mr. Chairman, my name is Stephen Moore and I am Director ofFiscal Policy Studies at the Cato Institute. In keeping with thenew truth in testimony rules, let me first say that the CatoInstitute does not receive a single penny of government funds.
Thank you for the opportunity to comment today on the future ofSocial Security. I wish to commend this Committee for itswillingness to explore the long term prognosis for SocialSecurity.
As everyone on this Committee knows, the long term financialoutlook for Social Security is bleak. Depending on how it ismeasured the unfunded liability of the system ranges from $3trillion to $5 trillion. This is much like a second national debt.Yet the financial sustainability of Social Security could beassured with a series of conventional reforms that include raisingpayroll taxes and reducing future benefits. Though young people, ofcourse, are none too enthusiastic about these "pay more in, getless out" solutions.
But the major point that I wish to communicate to you thismorning is that the case for converting Social Security into asystem of Personal Security Accounts (PSAs) is notprimarily based on the system's financial problems. Thereal economic and political crisis looming overSocial Security relates to the issue of rate of return. For babyboomers and especially for Generation X workers, Social Securityoffers a low rate of return--even negative for many workers.
I would ask each of you to review for a moment the attachedcharts from a recent Cato Institute study. They compare the rate ofreturn for Social Security versus investment in private capitalmarkets? The data was compiled for the Cato Institute by BillShipman principal of State Street Global Advisors in Boston. It hasbeen reviewed by professional actuaries and certified asaccurate.
To derive an estimated rate of return from capital markets inthe future, the study assumes that over the next forty to fiftyyears, workers will be able to obtain a rate of return in capitalmarkets equal to the average historical rate of return on bonds andstocks from the past 70 years (1926-95). For stocks that annualhistorical rate of return has been 10 percent (nominal); while forbonds the return has been 6 percent (nominal). (Incidentally, overthe past twenty years, the financial markets have far exceeded thehistorical average.
The chart shows that a typical baby boomer born in 1950, willpay over his or her lifetime several hundred thousand dollars morein payroll taxes (plus interest and a normal rate of real return)than the benefits he or she receives.
But the real losers are those in the Generation X cohort--orthose born after 1970. These young workers can expect to pay $2 to$5 of taxes (including the foregone normal rate of return on thosedollars) for every dollar in benefits collected. Or to state thepoint differently: if Congress were to allow a 25 year old workingwoman today to invest her payroll tax contributions in privatecapital markets, her retirement benefit would be two to five timeshigher than what Social Security is offering. For our youngworkers, these are very powerful numbers.
Consider the situation of a low wage worker--someone whoselifetime salary is near the minimum wage. Because of theprogressive benefit feature of Social Security, this is typicallythought to be the worst case scenario for personal securityaccounts. It turns out that based on current law, for that workerSocial Security promises an annual benefit of roughly $9,000 a year(1995 dollars). If that money were invested in private markets in aportfolio with half stocks and half bonds, the worker would receivean annual benefit upon retirement in the form of an annuity ofalmost $20,000 per year--or well over twice what Social Securityoffers. If the money were put entirely into stocks, the workerwould have an annual benefit of more than $25,000--or three timeswhat Social Security offers.
Not every worker, obviously will obtain the "average" rate ofreturn. By definition, some workers will do better, some will doworse. But under a PSA system, Congress could place reasonablerestrictions on how the money were invested, to protect againstlosses. For example, Congress might restrict the investments to aselect number of mutual funds, where a certain portion of the fundis invested in corporate bonds and treasury bonds. Hence, low-wageworkers who might not know much about financial markets, would notchoose individual stocks. But a critical point here is that even ifthese accounts were restricted to an unrealistically risk-averseportfolio, in this case 100 percent corporate bonds, the rate ofreturn would still be higher than underSocial Security. In fact, it is virtually impossible to constructan investment scenario where even the lowest income worker doesbetter under Social Security than under a PSA.
So here is the critical point for the members of this Committeeto bear in mind when crafting proposals for the future of SocialSecurity: even if the trust fund were entirely solvent--and even ifevery dollar of promised benefits were to be paid with no taxincreases--the system would be a bad deal for our youngworkers.
Now let's return to the situation of a low-wage worker. I havediscovered in conversations with members of Congress and withworking Americans that there is an understandable concern about howthis will impact our lowest income workers who are most likely todepend exclusively on Social Security payments when they retire. Tobe viable, any PSA plan must make these most disadvantaged workersbetter off, not worse off. The chart presented above actuallyunderstates the advantage of SocialSecurity privatization to the poor and to minorities. The reasonthat it understate the benefits of PSAs to the poor and minoritiesis that these are the workers who are most likely to have startedtheir working years at an earlier age, to have worked more yearsover their career, and to die earlier after retirement. Forprecisely these reasons, even accounting for the progressive natureof the benefit structure, low-income and black workers actually payin the most relative to the benefit they forego from a privatesystem.
Social Security offers the worst rate of return for that part ofthe population that it is supposedly most benefited from thesystem: minorities and the poor. Moreover, it is precisely becausethe poor elderly tend to have no other source of retirement income,that they stand to gain the most from a privatized system thatwould yield them a 30 to 50 percent higher monthly payment.
I have attached for the record a recent Cato study by mycolleague Michael Tanner that explains in greater detail why thepoor would gain the most from PSAs.
Incidentally, the Tanner study is also relevant to the spuriousargument that workers can not be given the right to opt out of thesystem because of an "adverse selection" problem. There is noadverse selection problem associated with a voluntary SocialSecurity Personal Security Account plan, since with very fewexceptions, every worker in America would be financially better offinvesting in private capital markets than by staying in the currentsystem.
The argument is sometimes made that there are always risksinvolved in investing money privately. The stock market doesn'talways go up in the short term--though in the long term it must orAmerica will be a very poor country in the next century. Rates ofreturn are not guaranteed. Stock markets crash. Bear in mind,however, that the historical rate of return assumed in thisanalysis takes into account the Depression-era stock market crash,the 1987 crash and the decade long sag in the market from the late1960s to the early 1980s.
So yes, there are investment risks associated with PSAs. Butremember, from the point of view of the worker, there are also hugepolitical risks associated with staying in the government-runSocial Security system. There is the risk that benefits will be cutin the future or that the payroll tax will be raised.
In fact, I would maintain that given the current financialplight of Social Security, it's a virtual certainty that Congresswill enact either or both of these Social Security "reforms."Hence, the rate of return comparisons presented above are anunlikely "best-case scenario" for Social Security. The chartsassumes that no change in promised benefits and no change in thepayroll tax rate will occur over the next forty years.
Even the staunchest opponents of privatization and the mostvocal advocates of maintaining the structure of the current systemagree that benefits and taxes need to be revised. Former SocialSecurity Commissioner Robert Ball, a leading foe of privatization,advocates a slight rise in the payroll tax, an increase in theretirement age, and other assorted reductions in future benefits.Each of the proposals advocated by the Advisory Council suggestedbenefit reductions and future tax increases.
It is imperative for this Committee to understand a criticalpoint about the future of Social Security: any orall of the conventional "fixes" to the program will only make thesystem a worse deal for young people.
Consider, for example, the proposal to raise gradually thepayroll tax by two percentage points (above the current 15.3percent rate) and a gradual rise in the retirement age beforecollecting benefits (as is now being considered for Medicare). Ifthis combination of reforms were enacted, rather than paying $2 to$5 of taxes for every dollar of benefit received, our young workerwould now pay $3 to $6 of taxes for every dollar of benefit.
This is why all conventional fixes, if they arenot tied to an exit strategy that allows young workers to capturethe returns from private markets, are a bad deal for theyoung. This also explains why the 18-30 year old demographicgroup is the most enthusiastic about a private alternative toSocial Security. A personal security account (PSA) system is theonly option available to Congress that improves the financialsituation of young workers. All of the rest of the leadingproposals make the young financially worse off.
I believe that most of the members of this Committee would be infavor of moving gradually to a PSA system if there were a way to doso without blowing a hole in the deficit. We all agree thatbenefits to current retirees (and soon to be retirees) cannot andshould not be cut. We must keep the promises that have been made toseniors.
If we allow workers to place all or a portion of payroll taxrevenue into private accounts, and we continue to pay benefits tothe elderly, then the budget deficit will rise in the shortterm.
To overcome this paradox the members of this Committee must keepin mind that the $3 trillion of unfunded Social Securityliabilities are sunk costs. Sunk costs are sunk. The liabilitieswill need to be paid off regardless of whether Social Security isprivatized or not. PSAs simply push those liabilities forward,making them transparent, so they are recognized and dealt withtoday, not 25 years from now. The budgetary impact of PSAs is theequivalent of paying off a future liability immediately, ascompanies often do to get unfunded pension liabilities off theirbooks.
Much of the problem stems from the fact that the United Statesgovernment is about the only institution in the world that stilluses a cash-flow accounting system. If the federal government ranits books--using accrual accounting--as every business does, all ofthe bookkeeping problems with Social Security PSAs would disappear.Tax revenues would decline, but so would offsetting futureliabilities--because today's workers would no longer beaccumulating rights to benefits. If any individual worker wished toexit from the system and stop paying the tax, then the financialimpact on the system would be roughly a wash--unless that workerpays more into the system than he gets out of it. If the workercould be impelled to pay the government to get out of the system,then the impact on the government's balance sheet would bepositive.
And herein lies the way out of the dilemma facing Congress. Itstarts with the recognition that the financing problem ofconverting to a privatized Social Security system is a short-termcash-flow problem, not a balance sheet problem. From a publicpolicy standpoint, what Congress should be primarily concerned withis how to improve the federal government's balance sheet. It turnsout that the gains are so large from privatization of SocialSecurity--Martin Feldstein of the National Bureau of EconomicResearch estimates that the net economic benefit from SocialSecurity privatization is $10 trillion--that a plan could easily bedevised whereby the gains are shared by the government and theworker--to the benefit of both.
Here is one potential method of sharing the gains. What if weoffered the following deal to every American worker? If you promiseto forfeit any claim on Social Security benefits--even those youhave already accumulated--we will let you invest all of your futurepayroll taxes into private markets. Since the rate of return is somuch higher in the private markets than with Social Security, manyworkers would gladly accept this deal. It turns out, for example,that the age of ambivalence between staying in the system andcontinuing to pay the tax, versus forfeiting future benefits andputting the subsequent payroll tax revenues into a PSA, is roughly40 years old--for an average income worker.
For a worker just now entering the workforce, the decision wouldbe clearcut. For example, take a typical female worker who juststarted working and earns a salary of $22,500, which will go upwith the rise in average wages over her lifetime. When she retiresSocial Security will pay her a $12,500 annual benefit in today'sdollars--assuming no change in benefits. If she were permitted tosimply place her payroll taxes in a mutual fund with a 7 percentreal rate of return (the average rate over the past fifty years),she would have a nest egg worth $800,000 to $1 million atretirement age. This would allow the worker to draw a $60,000benefit per year until death (assumed at age 80). This is five times higher than what Social Security offers forthe same level of investment.
For workers in their 20s and 30s the rate of return is so muchhigher in private markets than under Social Security that mostwould be willing to pay in effect an exit tax for the right toinvest payroll tax payments privately. The exit fee is theforfeiture of benefits already accrued. There is no adverseselection problem under this scheme because the government makesmoney on every worker who opts out--regardless of their income.
How big are the gains to the government from this opt-outtransition system? Bill Shipman and Marshall Carter with StateStreet Global Advisers calculate that if every worker under 40opted out, the reduction in the unfunded liability of SocialSecurity would be on the magnitude of $1 to $1.5 trillion. Hence,up to one-third of the current unfunded liability would beeliminated through this transition plan.
In summary, allow me to enumerate the economic advantages ofconverting out of our pay-as-you-go government-run Social Securitysystem to a program of PSAs:
1) Privatization offers a much higher financial rate of returnto young workers than the current system.
2) Privatization gives workers--rather than politicians--controlover their own retirement nest egg. The funds deposited in privateretirement accounts, are funds that can never be easily taken awayby the government.
3) A privatized system will increase worker ownership inAmerican businesses and assets. This is a "share the wealth"strategy that will help create a nation of capitalists and raisethe level of savings and investment.
4) Privatization is the equivalent of a tax cut for workers.Currently the Social Security payroll tax is treated by many youngworkers as simply a tax, not a deferred form of compensation. Thetax reduces their take-home pay--and thus reduces the incentive towork. Since the privatization option deposits these funds into apersonal account, they are now "owned" by the worker.
5) The increased flow of funds into private capital markets willreduce the cost of capital, and thus increase capital formation,business creation, and ultimately wages and living standards.
6) By sharing the trillions of dollars of economic gains fromthe higher rate of return from private accounts, Congress couldadopt a strategy that would improve the financial status ofindividual workers and the federal government. This establishes awin-win situation for the government and the worker.
Thank you again for the opportunity to testify before thisCommittee.