Mr. Chairman and Members of the Commission:
My name is Michael Tanner and I am the Director of Health andWelfare Studies at the Cato Institute, as well as Director ofCato’s Project on Social Security Privatization. I very muchappreciate the opportunity to appear before you today and discussthe problems inherent in any attempt to allow the government toinvest Social Security funds in private capital markets.
First, let me begin by saying that I appreciate PresidentClinton’s proposal for Social security reform. The presidentdeserves enormous credit for having the courage to tackle this mostcontentious of political issues. I also commend the president forrecognizing that private capital investment must be central to anyreform of Social Security. That recognition could form the basisfor moving forward in a bipartisan way to ensure that futureretirees will be able to retire with the same security as theirparents and grandparents.
That said, however, as currently formulated, there are seriousproblems with the president’s proposal and with the entire conceptof allowing the federal government to invest directly in privatecapital markets. Superficially, that approach offers someattraction. It promises the advantages of higher returns throughprivate capital investment, while spreading individual risk andminimizing administrative costs. In reality, allowing thegovernment to control such an enormous amount of privateinvestment, in the words of Federal Reserve Chairman AlanGreenspan, “has very far reaching potential dangers for a freeAmerican economy and a free American society.“1
The Current System
Social Security is currently running a surplus. In 1996, forexample, Social Security taxes‐both payroll taxes and income taxeson benefits‐ amounted to $385.7 billion. Benefit payments andadministrative expenses totaled only $353.6 billion, resulting in asurplus of $70.8 billion.2 Under current law, that moneymust be invested solely in U.S. government securities. Thesecurities can be any of three types:
government securities purchased on the open market; securitiesbought at issue, as part of a new offering to the public; orspecial‐issue securities, not traded publicly. In actual practice,virtually all the securities purchased have been special‐issuesecurities,3 which earn an interest rate equal to theaverage market rate yield on all U.S. government securities with atleast four years remaining until maturity, rounded to the nearestoneeighth percent‐an average of approximately 2.3 percent aboveinflation.
By contrast, equities have earned an average 7.56 percent realrate of return over the past 60 years. Some have suggested that thegovernment should be allowed to invest a portion of the SocialSecurity surplus in equities rather than government securities,allowing the Social Security system to reap the benefits of thehigher rate of return.4
Proposals for Government Investing
The idea of allowing the government to invest excess SocialSecurity funds in private capital markets is not a new one. Asearly as the 1930s, fiscal conservatives warned that unless privatesecurities were included in the government’s portfolio, the trustfund would earn less than market returns. But they also realizedthat if the government invested in private securities, it wouldlead to large‐scale government ownership of capital andinterference in American business. Sen. Arthur Vandenberg (RMich.)warned that “it is scarcely conceivable that rational men shouldpropose such an unmanageable accumulation of funds in one place ina democracy.“5 In the end, Congress rejected not onlygovernment investing but any system of full funding, establishing apay‐as‐you‐go program in which nearly all the taxes paid by currentworkers are not saved or invested in any way but used to paybenefits to current retirees.
Two factors brought the concept of government investing backinto public debate. First, following a series of Social Securityreforms in 1983, the Social Security system began to run a modestsurplus. Second, demographic trends made it clear that theprogram’s pay‐as‐you‐go structure was not sustainable.
Proposals for government investment first appeared inlegislation in the early 1990. The idea received widespread publicattention when 6 of the 13 members of the 1994 – 96 Advisory Councilon Social Security recommended the investment of up to 40 percentof the Social Security Trust Fund in private capitalmarkets.6 As Robert Ball, author of the proposal, putit, “Why should the trust fund earn one third as much as commonstocks?“7
However, this approach is fraught with peril.
Allowing the federal government to purchase stocks would give itthe ability to obtain a significant, if not a controlling, share ofvirtually every major company in America. Experience has shown thateven a 2 or 3 percent block of shares can give an activistshareholder substantial influence over the policies of publiclytraded companies.8
The result could potentially be a government bureaucrat sittingon every corporate board, a prospect that has divided advocates ofgovernment investing. Some have claimed that the government wouldbe a “passive” investor‐that is, it would refuse to vote its sharesor take positions on issues affecting corporate operations. Others,such as the AFL‐CIO’s Gerald Shea, have suggested that thegovernment should exercise its new influence over the Americaneconomy, claiming that government involvement would “have a goodeffect on how corporate America operates.“9
The experience of state employee pension funds suggests thatgovernments may not be able to resist the temptation to meddle incorporate affairs. For example, in the late 1980s, state employeepension plans in California and New York actively attempted toinfluence the election of a new board chairman for GeneralMotors.10 According to a report by the U.S. House ofRepresentatives, state employee pension plans are increasinglyusing their clout to influence “the corporate role in environmentalimprovement, humanitarian problems, and economicdevelopment.“11
Supporters of government investment claim that the governmentwould remain a passive investor, refusing to vote its shares.However, that would require an extraordinary degree of restraint byfuture presidents and congresses. Imagine the pressure faced by acongress if the government were to own a significant interest in acompany that was threatening to close its plants and move themoverseas at the cost of thousands of jobs. Could politicians reallyremain passive in the face of such political pressure?
Even if the government remained passive, its very ownership oflarge blocks of stock would, in effect, create a situation favoringcertain stockholders and corporate managers. As the GeneralAccounting Office has pointed out, if the government did notexercise its voting rights, other stockholders would find their ownvoting power enhanced and could take advantage of governmentpassivity.12
The GAO also warns that regardless of what stock voting rulesare adopted when the program begins, Congress can always change therules in the future.13
Even if the government avoids directly using its equityownership to influence corporate governance, there is likely to bean enormous temptation to allow political considerations toinfluence the type of investments that the government makes. Inshort, should the government invest solely to earn the highestpossible return on investments, or should the government considerlarger political and societal questions?
The theory behind social investing was perhaps best explained ina 1989 report by a task force established by then Governor MarioCuomo to consider how New York public employee pension funds werebeing invested. The task force concluded that state employeepension funds should not be operated solely for the benefit ofstate employees and retirees. In the opinion of the task force,those employees and retirees were only one among several groups of“stakeholders” in state employee pension programs, others being“the plan sponsor; corporations seeking investment capital from thepension fund; taxpayers who support the compensation of publicemployees, including contributions to the pension fund; and thepublic, whose well being may be affected by the investment choiceof fund managers” (emphasis added).14 Using thatcriterion, the task force rejected the idea that investments shouldbe made solely on the basis of maximizing the immediate return tothe pension trust. Instead, pensions should be invested in a waythat maximizes “both direct and indirect returns” to allstakeholders, including “the larger society and economy.“Therefore, the task force concluded, state employee pension fundsshould be guided into economic development projects beneficial tothe state of New York.
Most state employee pension funds are subject to such socialinvesting. Alaska may have been the first state to require socialinvesting, with a requirement in the early 1970s that a portion ofstate pension funds be used to finance home mortgages in thestate.15 The Alaska example also illustrates the dangersof social investing. A downturn in the local real estate marketcost the fund millions of dollars that had to be made up throughother revenue sources.
Throughout the 1970s and 80s, social investment increasinglycame to be a part of state pension programs.16 It becamea subject of widespread public debate in the mid‐ 1980s with thequestion of South African divestment. Eventually, 30 statesprohibited the investment of pension funds in companies that didbusiness in South Africa. Today, approximately 42 percent of state,county, and municipal pension systems have restrictions targetingsome portion of investment to projects designed to stimulate thelocal economy or create jobs. This includes investment in localinfrastructure and public works projects as well as investment inin‐state businesses and local real estate development.16In addition, 23 percent of the pension systems had prohibitionsagainst investment in specific types of companies, includingrestrictions on investment in companies that fail to meet the“MacBride Principles” for doing business in Northern Ireland,companies doing business in Libya and other Arab countries;companies that are accused of pollution, unfair labor practices, orfailing to meet equal opportunity guidelines; the alcohol, tobacco,and defense industries; and even companies that market infantformula to Third World countries.18
A nearly infinite list of current political controversies wouldbe ripe for such restrictions if the federal government beganinvesting Social Security funds. Both liberals and conservativeswould have their own investment agendas. Should Social Securityinvest in nonunion companies? Companies that make nuclear weapons?Companies that pay high corporate salaries or do not offer healthbenefits? Companies that do business in Burma or Cuba? Companiesthat extend benefits to the partners of gay employees? Companiesthat pollute? Companies that donate to Planned Parenthood?Investment in companies ranging from Microsoft to Nike, from Texacoto Walt Disney, would be sure to engender controversy.
Supporters of government investment suggest two ways to avoidthe problem of social investing. First, they propose the creationof an independent board to manage the system’s investment, a boardthat would operate free of any political interference. However,Alan Greenspan, who should be in a position to know about boardindependence, has said that he believes it would be impossible toinsulate such a board from politics. Testifying before Congress onproposals for government investment, Greenspan warned:
I don’t know of any way that you can essentiallyinsulate government decisionmakers from having access to what willamount to very large investments in American private industry…. I know there are those who believe it can be insulated from thepolitical process, they go a long way to try to do that. I havebeen around long enough to realize that that is just not credibleand not possible. Somewhere along the line, that breach will bebroken.“19
Indeed, the difficulty of shielding investment decisions frompolitical considerations was illustrated, unintentionally, by oneof the supporters of government investment, Jonathan Cohn, writingin The New Republic. “It would be easy to prohibit manipulation ofthe market for political reasons,” Cohn wrote. “All you would haveto do is assign responsibility for the investments to aquasi‐independent body, then carefully limit how it can makeinvestment decisions.“20 In other words, the new agencywould be independent except that Congress would set restrictions onits investment decisions.
Supporters of government investment suggest a second means ofavoiding social investment: the investment would be made only inindex funds, eliminating the choice of individual stocks. However,that does not eliminate social investment questions, since therewould remain the issue of what stocks should be included in theindex, whether an existing index or a new one created just forSocial Security.
The Federal Thrift Savings Program: An ImperfectAnalogy
Supporters of government investing often cite the federal thriftsavings program as an example to show that government pension fundscan avoid politicization. It is true that, so far, the TSP hasavoided social investment and interference with corporategovernance. However, there are several important differencesbetween the TSP and a government‐invested Social Securityprogram.
Perhaps most importantly, the TSP is a defined‐contributionprogram with individually owned accounts. Workers do have aproperty right in their account, which is not true of SocialSecurity. In the case of Fleming v. Nestor (1960), theU.S. Supreme Court held that individuals have no property right inSocial Security. Allowing the government to invest a portion ofSocial Security revenues in capital markets would do nothing toalter that.
Therefore, a government‐invested Social Security program wouldbe far more akin to defined‐benefit state employee pension plans. A1990 congressional report concluded that while workers acquire aninterest in pension funds once they are vested, they have no legalownership rights. The report went on to note that it would beequally incorrect to say that government “owned” the funds becausethe government’s discretion in spending or disposing of the fundsis limited under state trust law and the Internal RevenueCode.21 The report concludes that there is no exclusiveownership by either party,22 and that ownership, in anycase, may be unimportant because “public defined benefit pensionsare entitlements granted by governments that can be modified ortaken away.“23
Because workers have no ownership right to their pension funds,the government has no fiduciary duty to the workers. The situationmay be even worse for a governmentinvested Social Security system.For all the social investment practices discussed above, stateemployee pension funds have been somewhat restrained by the“exclusive benefit rule,” an Internal Revenue Service ruling thatrequires tax‐exempt trusts to operate solely for the benefit of thetrustees.24 The applicability of that rule to governmentpension funds is extremely limited, however, since the taxexemption status of the trust is irrelevant. The employer‐being thegovernment‐is already tax exempt. Therefore, the only potentialenforcement mechanism is for the IRS to disqualify the plan,meaning that workers would be taxed on the employer’s contribution.Because such a penalty would fall on innocent third parties, thethreat is seldom invoked. It is even more unlikely to be invoked inthe case of a government‐invested Social Security system. It wouldcertainly be unfair to do so‐to impose a huge new tax on everyAmerican worker because the government mismanages the investment ofits funds. Of course, that assumes an IRS independent enough totake action against the federal government’s own investmentdecisions. As a result, unlike the TSP, there appears to be nolegal barrier to social investing under a government‐investedSocial Security program.
Second, as a defined‐contribution program, the TSP istransparent. Benefits are dependent on the return to theirinvestment, not on an arbitrary benefit formula. Therefore, theworkers have a direct interest in ensuring that investments aremade solely to maximize their returns. Workers can see exactly howan investment decision impacts their retirement benefits. Under agovernment‐invested Social Security program, benefits would bedefined by law and would be only indirectly affected by individualinvestment decisions. Therefore, workers would have littleincentive to resist social investing. They would have no directinterest in whether investments are made solely to maximize returnsor for other purposes.
Finally, the TSP is a voluntary program. If workers aredissatisfied with investment practices under the program, they canrefuse to participate. Therefore, fund managers have an incentiveto maximize returns. Failure to do so will result in a loss ofbusiness. In contrast, a government‐invested Social Security systemwould be mandatory. Workers would be forced to continuecontributing 12.4 percent of their income to the system, no matterhow dissatisfied they were.
Clearly, then, there are both legal and market restraints on theTSP that would not exist under a government‐invested SocialSecurity system. Indeed, the TSP model would seem to argue forexactly the opposite, a system of individually owned, privatelyinvested accounts. Only such a system would replicate the TSP’ssafeguards‐property rights, a fiduciary responsibility,transparency, and an ability to remove funds from a nonperforminginvestor.
Finally, it is important to recognize that allowing thegovernment to invest Social Security funds in private capitalmarkets will do nothing to solve most of Social Security’sproblems. Yes, it will help preserve Social Security’s solvency.But it will do nothing to increase the near zero or negative rateof return that can be expected by today’s young workers. It will donothing to redress the inequities of the current system thatpenalize working women, the poor, and minorities. It will donothing to give low income workers the opportunity to accumulatereal wealth. And, it will do nothing to give Americans ownershipover their retirement benefits.
The president is right: we need to take advantage of the higherrates of return available through investment in private capitalmarkets. But that should be done not through government investment,but through individual accounts.
- Testimony of Alan Greenspan before the Senate Committee onBanking, July 21, 1998.
- 1998 Report of the Board of Trustees of the Federal Old‐AgeSurvivors and Disability Insurance Program (Washington: GovernmentPrinting Office, 1998).
- Robert Myers, Social Security (Philadelphia: University ofPennsylvania Press, 1993), p. 142.
- Supporters of government investing may actually be understatingthe difference in returns. Under the current system, the interestattributed to the government securities does not actually representa cash transfer but is attributed to the Social Security TrustFund, which makes the interest more notional than real. When thetime comes that payments must be made from the trust fund, thefederal government will have to appropriate the attributed interestfrom general revenues. Thus, like the government securitiesthemselves, the interest payments do not represent real currentwealth, merely a promise by the government to tax futuregenerations of workers. In contrast, if the government invested inequities or other assets outside the government, any return wouldresult in a real increase in the system’s assets.
- Congressional Record, Vol. 81, Part 2, 75th Congress (March 17,1937), p. 2324.
- Report of the 1994 – 1996 Advisory Council on SocialSecurity, Volume I: Findings and Recommendations (Washington:Government Printing Office, 1997), pp. 25 – 28.
- Peter Passell, “Can Retirees’ Safety Net be Saved?” New YorkTimes, February 18, 1997.
- Theodore Angelis, “Investing Public Money in Private Markets:What Are the Right Questions?” Presentation to a conference on“Framing the Social Security Debate: Values, Politics, andEconomics,” National Academy of Social Insurance, Washington, D.C.,January 29, 1998.
- “Quoted in Michael Eisenscher and Peter Donohue, “The Fate ofSocial Security,” Z Magazine, March 1997.
- U.S. House of Representatives, Committee on Education andLabor, Subcommittee on Labor‐Management Relations, “Public PensionPlans: The Issues Raised over Control of Plan Assets,” CommitteePrint, June 25, 1990; U.S. House of Representatives, Committee onEducation and Labor, Public Pension Plans: The Issues Raisedover Control of Plan Assets, p.49.
- General Accounting Office, “Social Security Financing:Implications of Government Stock Investing for the Trust Fund, theFederal Budget, and the Economy,” Report to the U.S. Senate SpecialCommittee on Aging, April 1998, p. 62.
- Our Money’s Worth: Report of the Governor’s Task Force onPension Fund Investment (Albany: New York State IndustrialCooperation Council, June 1989), p. 20.
- Jennifer Harris, “From Broad to Specific: The Evolution ofPublic Pension Investment Restrictions,” Public RetirementInstitute, Arlington, Va., July 1998.
- For a thorough discussion of state employee pension systems andtheir investment policies, see Carolyn Peterson, State EmployeeRetirement Systems: A Decade of Change (Washington: AmericanLegislative Exchange Council, 1987).
- James Packard Love, Economically Targeted Investing: AReference for Public Pension Funds (Sacramento: Institute forFiduciary Education, 1989).
- Love, Economically Targeted Investing; Peterson,State Employee Retirement Systems.
- Testimony of Alan Greenspan.
- Jonathan Cohn, “Profit Motives,” New Republic, July13, 1998.
- U.S. House of Representatives, Committee on Education andLabor, Public Pension Plans: The Issues Raised over Control ofPlan Assets, pp. 44 – 46.
- Ibid., p. 52.
- Ibid., p. 50.
- Internal Revenue Manual, Examination Guidelines Handbook, Sec.711.1.