Relationship Between the Welfare State and Crime

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Mr. Chairman, distinguished Members of the Committee:

I am Michael Tanner, director of health and welfare studies atthe Cato Institute and director of Cato's Project on SocialSecurity Privatization. I want to thank the committee for theopportunity to testify on what may be one of the most importantpublic policy issues facing this country at the 20th century drawsto a close.

In less than two weeks, Social Security will celebrate its 60thanniversary. As it does so, it is an institution in profoundcrisis. According to a recent public opinion poll, more youngAmericans believe in UFOs than believe they will receive theirSocial Security benefits.(1) The unfortunate fact is that, whiletheir views on extraterrestrial visitation may be problematic,their opinion on Social Security may be perilously close tocorrect.

Recently, the government's own actuaries reported that theSocial Security Trust Fund will go broke in 2030.(2) However, thisestimate itself may be unduly optimistic because the SocialSecurity Trust Fund is really little more than a polite fiction.For years, the federal government has used the Trust Fund todisguise the actual size of the federal budget deficit, borrowingmoney from the Trust Fund to pay current operating expenses andreplacing the money with government bonds. The real crisis starts,therefore, not when the trust funds run out, but when they peak andstart to decline. At that point the trust funds must start turningin bonds to the federal government to obtain the cash needed tofinance benefits. But the federal government has no cash or otherassets to pay off these bonds. It can only obtain the cash byborrowing and running a bigger deficit, increasing taxes, orcutting other government spending.

Even if Social Security's financial difficulties can be fixed,the system remains a bad deal for most Americans, a situation thatis growing worse for today's young workers. Payroll taxes arealready so high that even if today's young workers receive thepromised benefits, such benefits will amount to a low, below-marketreturn for those taxes. Studies show that for most young workerssuch benefits would amount to a real return of one percent or lesson the required taxes. For many, the real return would be zero oreven negative. These workers can now get far higher returns andbenefits through private savings, investment, and insurance.

In a forthcoming study for the Cato Institute, financial analystWilliam Shipman considers the potential investment return under avariety of scenarios.(3) Mr. Shipman considered the examples ofboth high and low income wage earners born at three different dates(1930,1950, and 1970). Shipman then compared the social securitybenefits that the individual would receive with the potentialreturn that the individual would have received if he or she hadbeen allowed to invest an amount equivalent to the payroll tax ineither stocks or bonds.

If, as is likely, the system's impending financial crisis forcesreforms such as raising the retirement age, means-testing benefits,or increasing the payroll tax, Social Security will become an evenworse investment for today's young workers.

The only viable alternative that will continue to guarantee thatolder Americans will be able to retire with dignity is to privatizethe Social Security system.

What would a privatized system would look like? While it is notnecessary at this point to go into all the details of how such asystem would function, the logical alternative would be some formof mandatory savings program.(4) For example, the 11.2% payroll taxthat is the combined employer-employee contribution to OASDI, theOld-Age and Survivors Insurance and Disability Trust Fund portionof the Social Security program, could be redirected toward aPersonal Retirement Account (PRA) that is chosen by the individualemployee.

Under this scenario, Personal Retirement Accounts would operatesimilar to current Individual Retirement Accounts (IRAs).Individuals could not withdraw funds from their PRA prior toretirement, determined either by age or PRA balance requirements.PRA funds are the property of the individual. Upon death, remainingfunds would become part of the individual's estate.

PRAs would be managed by the private investment industry in thesame way as 401k plans or IRAs. Individuals would be free to choosethe fund manager that best met their individual needs and couldchange managers whenever they wished. The government wouldestablish regulations on portfolio risk to prevent speculation andprotect consumers. Reinsurance mechanisms would be required toguarantee fund solvency. One way to protect against excess riskwould be to have PRA fund balances reported in two categories. Allfunds up to a calculated minimum requirement would be designated as"Basic" fund balances.

"Basic" fund balance limitations would be calculated bydetermining 110% of the present value of the actuarially-determined retirement annuity necessary to provide a real monthlyincome after retirement equivalent to the current national minimumwage. The future annuity cash flow could be discounted using thecurrent 1-year T-Bill rate, providing an expected real rate ofreturn without long-term inflationary expectations. "Basic" fundbalances would be subject to asset allocation restrictions thatwould limit the risk to which they could be subjected. For example,there may be a limitation on how much of the portfolio could beplaced in common stocks.(5) Funds accumulated above the "Basic"fund balance would be reported as "Discretionary" fund balances."Discretionary" PRA balances would not be subject to the assetallocation restrictions of "Basic" balances and would, therefore,be eligible for a wider range of investment options.

In addition, the government could maintain a safety net,guaranteeing a minimum pension benefit. The minimum pension couldbe set to a benchmark such as the minimum wage. If upon retirementthe balance in an individual's PRA is insufficient to provide anactuarially-determined retirement annuity which would provide areal monthly income equal to the minimum wage, the government wouldprovide a supplement sufficient to bring the individual's monthlyincome up to the level of the minimum wage. Given historic rates ofreturn from the capital markets, even a minimum wage earner willreceive more than this minimum from the new system if he or sheparticipates their entire life. Therefore, in the absence of amajor financial collapse, the safety net would be required for fewaside from the disabled and others outside the workforce.

Those presently in the workforce would have the option ofremaining in the current Social Security system or switching to thenew private system. Individuals entering the workforce afterimplementation of the private system would be required toparticipate in the new system. Thus, the current system wouldeventually be phased out.

It is important to realize that the idea of privatizing SocialSecurity is not completely untested. Chile's Social Security systempredated ours, having started in 1926. By 1981, Chile faced thesame difficulties as presented by the U.S. Social Security systemtoday. In response, Chile privatized its system.(6)

The new Chilean system which went into effect on May 1, 1981, isa true "defined contribution" pension plan with mandatorycontributions of 10% of earnings for program participants. Thepension available from the system is simply that which isactuarially computed from the accumulated contributions.

When the new system began, those in the old system were giventhe option of switching to the new. After 1982, all new employeeswere required to join the new system. As of 1992, approximately90-95% of all persons under the old system had shifted.

Contributions to the system are paid entirely by the employee,with no employer payroll tax to support it. At the initiation ofthe system, however, all employers were required to give a wageincrease of 18% to all employees, approximating the increased costto the worker but less than the reduced cost to the employer of thenew system.

Pension funds are invested in security portfolios administeredby private organizations known as "Adminstradoras de Fondos dePensiones" (administrators of pension funds, or AFPs). Twenty-oneAFPs, which compete with each other on the basis of investmentreturns and service, are closely regulated, complying withgovernment mandated financial and investment requirements. Eachworker chooses the AFP in which he wants to participate, and maytransfer fund balances at his own discretion up to four times peryear. Like any other mutual fund, the AFP invests fund balances ina portfolio of securities, and charges the portfolio anadministrative fee for its services. Fees are a combination of aflat monthly percentage plus a percentage of earnings, and the AFPfee charges are well publicized so that individual workers mayconsider the charges in their choice of funds. Fees average 1% oftotal wages, down from more than 2% since the system was started.Several of the funds, in fact, are owned and operated by U.S.investment firms. Provida, with 25% of the system's assets and thelargest AFP, is 42% owned by New York- based Bankers Trust(acquired as part of a $45 million debt-for- equity swap in 1986),and Santa Maria, the second-largest AFP, is 51% owned by Aetna Life& Casualty of Hartford, Connecticut.

AFP asset allocation, however, is strictly regulated by thegovernment. Portfolios must consist of no less than 50% investmentin government obligations, "agency" issues of othergovernment-guaranteed securities leaving no more than 50% of theportfolio that may be invested in private-sector securities. Commonstocks may comprise a maximum of 30% of the portfolio (with no morethan 7% of the total in any one company and no more than a 7% stakein any particular company). Finally, only stocks on agovernment-approved list may be purchased. No foreign securitieshave made the list.

The entire system provides for automatic market indexation bytranslating contributions into investment units. Investment unitvalue is calculated similarly to a mutual fun Net Asset Value(NAV), taking the total current value (in pesos) of the total fundsof the AFP divided by the total number of investment units of allmembers at a point in time.

Minimum retirement ages are 65 for men and 60 for women.Participants may, however, retire earlier if the pensions payableis at least 50% of their average earnings over the previous 10years and 100% of the legal minimum monthly wage. Three alternativemethods for determining the pension value are available at theparticipant's discretion:

  • The accumulated contributions may be used to purchase a lifeannuity from a private insurance company. Annuities ;must begovernment approved and must include survivor benefits fordependents.
  • The retiree may elect to receive a pension paid from the AFPdirectly. It is calculated using the life expectancy of the familygroup applied to the balance remaining in the account, whichcontinues to earn income based on the AFP's performance.
  • A partial withdrawal may be used to purchase a private annuitywith the remaining paid out directly from the AFP.

Perhaps the most innovative feature was the means by which theChilean government sought to provide for transition to the newsystem. The government issues "bonos de reconocimiento"(recognition bonds), which effectively recognize the value of theobligation incurred by the government (the taxpayers) to those whohave participated in the old system.

"Bonos" are available to any worker who had at least 12 monthsof contributions to or coverage under the old system in the 60months prior to the start of the new system. The calculation of the"bonos" due an individual system participant is technicallycomplex, but provides the financial mechanism for the transition tothe new system. An alternative method of calculation allows anyonewho contributed to the old system after July, 1970, to receivevalue for the participation. "Bonos" are essentially governmentbonds that pay 4% annual interest and add to the accumulatedcontribution value of the AFPs at the time of retirement. Intereston the bonds is paid out of the government's general revenue fundand is in no way supported by the new pension system.

Finally, a minimum retirement pension is payable to individualswith at least 20 years of contributions to the old and new systemscombined. Disability cases have a two year contributionrequirement. The minimum pension is set at 85% of thegovernment-mandated monthly minimum wage, but does not apply toworkers in the "informal" labor market who have never contributedto a plan. Disability and survivor benefits are not paid from the10% contribution to the AFP. An additional required contribution(variable by AFP and averaging about 1.5%) is collected by the AFPsand paid to private insurance companies to purchase privateinsurance coverage for the group of workers contributing to thatAFP.

The success of Chile's public pension privatization can bemeasured in many ways. Whereas in the late 1970s there werevirtually no savings, now the cumulative assets managed by AFPs areabout $23 billion or roughly 41 percent of GDP. During the pastdecade Chile's Real GDP growth has averaged over 6 percent, morethan double that of the U.S. And for the five years ending 1994 theannualized total return of the Chilean stock market was 48.6percent versus 8.7 percent for the U.S. But most important,beneficiaries are receiving much higher benefits. Since theprivatized system became fully operational, the average rate ofreturn on investment has been 13 percent per year. As a result, thetypical retiree is receiving a benefit equal to nearly 80 percentof his average annual income over the last 10 years of his workinglife, almost double the U.S. replacement value. Chile's reforms areseen as such a huge economic and political success that countriesthroughout Latin America, including Argentina, Peru, and Columbia,are beginning to implement similar changes.(7)

Obviously the Chilean model cannot be directly imported to theUnited States. There are many differences between the two countrieseconomies and cultures. In addition, there are areas where the CatoInstitute believes the Chileans were to restrictive or made othererrors. However, the Chilean experience shows that theprivatization of Social Security can be carried outsuccessfully.

The most difficult question for any proposed privatization ofSocial Security is the issue of the transition.(8) Put quitesimply, regardless of what system we choose for the future, we mustcontinue benefits to today's recipients.

At the same time, however, we should understand that the designof a new system has nothing to do with the liabilities that(rightly or wrongly) have been accrued in the past. Thegovernment's obligation to current (and even future) retirees isunchanged by a decision to privatize the system. What does changeis the willingness to acknowledge currently unfunded liabilities.The commitments entered into by the federal government as a resultof spending current Social Security receipts are what financialeconomists call a sunk cost. The liability has already accrued andexists whether we privatize the system or not. In the future thegovernment, if it is to honor its commitments, will be forced toeither tax or borrow additional funds from the private sector tofinance the cash outflows necessary to meet these obligations.

Still proponents of privatization bear the responsibility forsuggesting funding mechanisms for the transition. The reality isthat the transition will probably involve some combination of fourapproaches.

The first of these is a partial default. Any change in futurebenefits amounts to a partial default. This could range from suchmild options as raising the retirement age, reducing COLAs, ormeans-testing benefits to "writing off" obligations for individualsunder a certain age who opt into the private system.(9)

For example, any individual under the age of thirty who choosesthe private system may receive no credit for past contributions toSocial Security.

The second solution to the problem of unfunded liabilities isone that provides for the recognition of the present value of thoseliabilities in the form of government bonds to be issued to currentsystem participants and taxpayers. Once we have decided on theextent of the limited defaults the system will tolerate, it is nota difficult calculation to determine the moral (if not legal) stakeeach working American currently has in the implied promise of thecurrent Social Security system to each of us. The system currentlycalculates a figure known as a "Primary Insurance Amount" (PIA)based on a review of the taxpayer's average monthly earnings fromemployment covered by the program. "The PIA is the benefit for asingle retired worker who starts receiving his monthly SocialSecurity check at the normal retirement age."(10) Normal retirementage is now 65, but will rise to 66 in 2008 and to 67 in 2027 (andcould, as above, rise further with further system defaults).Benefit computations are based on earnings during the 35 years ofhighest covered earnings up to age 62 (or the worker's age when heor she applies for benefits, whichever is later), and the wages ineach year of the earnings record before age 60 are multiplied by anindex factor to take into account the growth in national averageearnings since that year. The result is the individual's "averageindexed monthly earnings" (AIME), which is then multiplied bypercentages that are weighted to favor low-income earners tofinally determine the Social Security benefit.

The AIME can be used to calculate for each American worker todayhis or her expected retirement benefit given tax "contributions" tothe system to date. Current retirees' benefits are, of course,already determined. The present value of the actuarially-calculatedannuity due each system participant may then be easily calculateddiscounting at the T-Bond rate, and each system participant can beissued zero-coupon T-Bonds maturing at their projected retirementdate. The bonds would be placed in each individual's PRA.

It is important that these zero-coupon Treasury securities thenbe allowed, in turn, to trade on the secondary market. Within thelimitations already described for Basic fund balances, both currentretirees and prospective retirees should immediately begin topersonally manage their PRAs according to their own riskpreferences, thus increasing the diversification benefits ofindividual PRA portfolios and maximizing personal liberty.

A third method of financing the transition would be continue asmall portion of the current payroll tax. For example, workerscould be allowed to invest 10 percent points of the current 12.2percent OASDI payroll tax, with 2.2 percentage points continuing tofund a portion of current benefits.

Finally, Congress could identify additional spending cuts anduse the funds to pay for the transition cost. For example, the CatoInstitute has identified more than $80 billion in corporate welfarethat could be eliminated.(11)

In conclusion, we must realize that Social Security is anunfunded pay-as-you-go system, fundamentally flawed and analogousin design to illegal pyramid schemes. Government accounting createsthe illusion of a trust fund, but in fact the government spendsexcess receipts immediately. The liabilities already created areunrecognized by the government accounting system, but representsunk costs that cannot be recovered. Only adjustments in spendingpatterns can pay for those commitments. The choice remaining isbetween continuing to support a bankrupt system, or building afinancially sound structure for the future.

Only private pensions with individual property rights toaccumulated fund balances can create a secure pension system.Evidence of such a system's effectiveness is available from theexample of Chile, which privatized its system in 1981. The plan hasbeen a success but stops short of full privatization. Various planshave been proposed for the U.S., but each suffers the effects ofcompromise with central-planning approaches.

A plan that achieves the dual objectives of security andpersonal liberty would divert current OASDI payments to privatePersonal Retirement Accounts, similar to Individual RetirementAccounts (IRAs), managed by the financial securities industry.Modern risk-management methods should be used to minimize risk forthe portion of the account necessary to finance minimum retirementneeds. Personal risk preferences should be allowed to guide theinvestment of fund balances in excess of the minimum.

Transition to a new system requires a recognition of currentintergenerational commitments and makes choices that minimizetransactions costs as we liquidate obligations to ourselves andintegrate system liabilities into a privatized financialstructure.

Thank you, I look forward to answering you questions.

Notes

  1. "Generation X Believes UFOs but Laughs at Social Security,"Washington Times, September 27, 1994.
  2. 1995 Annual report of the Board of Trustees of the FederalOld-Age and Survivors Insurance and Disability Trust Funds(Washington, DC: Government Printing Office, April 11, 1995).
  3. William Shipman, "Retiring With Dignity: Social Security vs.Private Markets," Cato Institute Social Security Paper no. 2,August 14, 1995.
  4. For a detailed discussion of what a privatized Social Securitysystem may look like, see Karl Borden, "Dismantling the Pyramid:The Why and How of Privatizing Social Security," Cato InstituteSocial Security Paper no. 1, August 14, 1995.
  5. There are many possible formulas to restrict such risk. Forexample, Karl Borden proposes the following: 100% of basic fundbalances could be invested in a diversified portfolio of corporateand government bonds with a portfolio duration matched to a plannedretirement age. No bond rating requirements would apply, butdiversification must be adequate to eliminate 95% of non-systematicrisk from the portfolio. No more than 25% of the fund could beinvested in government securities, "agency" issues, orgovernment-guaranteed debt. Up to 50% of the portfolio could beinvested in diversified funds of equity securities. Equitysecurities would be limited to those traded on the New York,American, or NASDAQ exchanges, and portfolios must be sufficientlydiversified to eliminate 95% of non-systematic risk. Althoughinvestment in broad-based index funds would be permitted, notrading in derivative securities would be allowed other than thosenecessary for hedging strategies associated with reducing cashdemand risks and smoothing variances from index returns. Systematicrisk for eligible portfolios would be limited to a portfoliomaximum beta of 1.05.
  6. For details od Chile's experience with privatizing SocialSecurity, see Jose Pinera and Mark Klugmann, "The Chilean PrivatePension System," International Center for Pension Reform, Santiago,Chile, 1995; Luis Larrain, "Social Security Reform," in ChristianLarroulet, ed., The Chilean Experience: Private Solutions to PublicProblems (Santiago, Chile: Center for International PrivateEnterprise, 1991); Marco Santamaria, "Privatizing Social Security:The Chilean Case," Columbia Journal of World Business, (Spring1992); Robert Myers, "Chile's Social Security Reform After 10Years," Benefits Quarterly, (Third Quarter 1992);

Michael D. Tanner

Subcommittee on Social Security and Family Policy
Committee on Finance
United States Senate