My name is Michael Tanner and I am the Director of Health and Welfare Studies at the Cato Institute, as well as Director of Cato’s Project on Social Security Privatization. I very much appreciate the opportunity to appear before you today and discuss the problems inherent in any attempt to allow the government to invest Social Security funds in private capital markets.
First, let me begin by saying that I appreciate President Clinton’s proposal for Social security reform. The president deserves enormous credit for having the courage to tackle this most contentious of political issues. I also commend the president for recognizing that private capital investment must be central to any reform of Social Security. That recognition could form the basis for moving forward in a bipartisan way to ensure that future retirees will be able to retire with the same security as their parents and grandparents.
That said, however, as currently formulated, there are serious problems with the president’s proposal and with the entire concept of allowing the federal government to invest directly in private capital markets. Superficially, that approach offers some attraction. It promises the advantages of higher returns through private capital investment, while spreading individual risk and minimizing administrative costs. In reality, allowing the government to control such an enormous amount of private investment, in the words of Federal Reserve Chairman Alan Greenspan, “has very far reaching potential dangers for a free American economy and a free American society.“1
The Current System
Social Security is currently running a surplus. In 1996, for example, Social Security taxes‐both payroll taxes and income taxes on benefits‐ amounted to $385.7 billion. Benefit payments and administrative expenses totaled only $353.6 billion, resulting in a surplus of $70.8 billion.2 Under current law, that money must be invested solely in U.S. government securities. The securities can be any of three types:
government securities purchased on the open market; securities bought at issue, as part of a new offering to the public; or special‐issue securities, not traded publicly. In actual practice, virtually all the securities purchased have been special‐issue securities,3 which earn an interest rate equal to the average market rate yield on all U.S. government securities with at least four years remaining until maturity, rounded to the nearest oneeighth percent‐an average of approximately 2.3 percent above inflation.
By contrast, equities have earned an average 7.56 percent real rate of return over the past 60 years. Some have suggested that the government should be allowed to invest a portion of the Social Security surplus in equities rather than government securities, allowing the Social Security system to reap the benefits of the higher rate of return.4
Proposals for Government Investing
The idea of allowing the government to invest excess Social Security funds in private capital markets is not a new one. As early as the 1930s, fiscal conservatives warned that unless private securities were included in the government’s portfolio, the trust fund would earn less than market returns. But they also realized that if the government invested in private securities, it would lead to large‐scale government ownership of capital and interference in American business. Sen. Arthur Vandenberg (RMich.) warned that “it is scarcely conceivable that rational men should propose such an unmanageable accumulation of funds in one place in a democracy.“5 In the end, Congress rejected not only government investing but any system of full funding, establishing a pay‐as‐you‐go program in which nearly all the taxes paid by current workers are not saved or invested in any way but used to pay benefits to current retirees.
Two factors brought the concept of government investing back into public debate. First, following a series of Social Security reforms in 1983, the Social Security system began to run a modest surplus. Second, demographic trends made it clear that the program’s pay‐as‐you‐go structure was not sustainable.
Proposals for government investment first appeared in legislation in the early 1990. The idea received widespread public attention when 6 of the 13 members of the 1994–96 Advisory Council on Social Security recommended the investment of up to 40 percent of the Social Security Trust Fund in private capital markets.6 As Robert Ball, author of the proposal, put it, “Why should the trust fund earn one third as much as common stocks?“7
However, this approach is fraught with peril.
Allowing the federal government to purchase stocks would give it the ability to obtain a significant, if not a controlling, share of virtually every major company in America. Experience has shown that even a 2 or 3 percent block of shares can give an activist shareholder substantial influence over the policies of publicly traded companies.8
The result could potentially be a government bureaucrat sitting on every corporate board, a prospect that has divided advocates of government investing. Some have claimed that the government would be a “passive” investor‐that is, it would refuse to vote its shares or take positions on issues affecting corporate operations. Others, such as the AFL-CIO’s Gerald Shea, have suggested that the government should exercise its new influence over the American economy, claiming that government involvement would “have a good effect on how corporate America operates.“9
The experience of state employee pension funds suggests that governments may not be able to resist the temptation to meddle in corporate affairs. For example, in the late 1980s, state employee pension plans in California and New York actively attempted to influence the election of a new board chairman for General Motors.10 According to a report by the U.S. House of Representatives, state employee pension plans are increasingly using their clout to influence “the corporate role in environmental improvement, humanitarian problems, and economic development.“11
Supporters of government investment claim that the government would remain a passive investor, refusing to vote its shares. However, that would require an extraordinary degree of restraint by future presidents and congresses. Imagine the pressure faced by a congress if the government were to own a significant interest in a company that was threatening to close its plants and move them overseas at the cost of thousands of jobs. Could politicians really remain passive in the face of such political pressure?
Even if the government remained passive, its very ownership of large blocks of stock would, in effect, create a situation favoring certain stockholders and corporate managers. As the General Accounting Office has pointed out, if the government did not exercise its voting rights, other stockholders would find their own voting power enhanced and could take advantage of government passivity.12
The GAO also warns that regardless of what stock voting rules are adopted when the program begins, Congress can always change the rules in the future.13
Even if the government avoids directly using its equity ownership to influence corporate governance, there is likely to be an enormous temptation to allow political considerations to influence the type of investments that the government makes. In short, should the government invest solely to earn the highest possible return on investments, or should the government consider larger political and societal questions?
The theory behind social investing was perhaps best explained in a 1989 report by a task force established by then Governor Mario Cuomo to consider how New York public employee pension funds were being invested. The task force concluded that state employee pension funds should not be operated solely for the benefit of state 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 the pension fund; taxpayers who support the compensation of public employees, including contributions to the pension fund; and the public, whose well being may be affected by the investment choice of fund managers” (emphasis added).14 Using that criterion, the task force rejected the idea that investments should be made solely on the basis of maximizing the immediate return to the pension trust. Instead, pensions should be invested in a way that maximizes “both direct and indirect returns” to all stakeholders, including “the larger society and economy.” Therefore, the task force concluded, state employee pension funds should be guided into economic development projects beneficial to the state of New York.
Most state employee pension funds are subject to such social investing. Alaska may have been the first state to require social investing, with a requirement in the early 1970s that a portion of state pension funds be used to finance home mortgages in the state.15 The Alaska example also illustrates the dangers of social investing. A downturn in the local real estate market cost the fund millions of dollars that had to be made up through other revenue sources.
Throughout the 1970s and 80s, social investment increasingly came to be a part of state pension programs.16 It became a subject of widespread public debate in the mid‐ 1980s with the question of South African divestment. Eventually, 30 states prohibited the investment of pension funds in companies that did business in South Africa. Today, approximately 42 percent of state, county, and municipal pension systems have restrictions targeting some portion of investment to projects designed to stimulate the local economy or create jobs. This includes investment in local infrastructure and public works projects as well as investment in in‐state businesses and local real estate development.16 In addition, 23 percent of the pension systems had prohibitions against investment in specific types of companies, including restrictions 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, or failing to meet equal opportunity guidelines; the alcohol, tobacco, and defense industries; and even companies that market infant formula to Third World countries.18
A nearly infinite list of current political controversies would be ripe for such restrictions if the federal government began investing Social Security funds. Both liberals and conservatives would have their own investment agendas. 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? Companies that pollute? Companies that donate to Planned Parenthood? Investment in companies ranging from Microsoft to Nike, from Texaco to Walt Disney, would be sure to engender controversy.
Supporters of government investment suggest two ways to avoid the problem of social investing. First, they propose the creation of an independent board to manage the system’s investment, a board that would operate free of any political interference. However, Alan Greenspan, who should be in a position to know about board independence, has said that he believes it would be impossible to insulate such a board from politics. Testifying before Congress on proposals for government investment, Greenspan warned: