Privatizing Social Security: who would invest the money?

Social Security's dire financial problems are being acknowledged by even the most die-hard supporters of the system. According to the 1996 report of its Board of Trustees, Social Security will be insolvent by the year 2029, down from 2030 in the 1995 report. This represents the eighth time in 10 years that the insolvency date has been brought forward.

Unless the system is reformed, it will be forced to raise taxes or slash benefits. Because both of those choices are likely to be politically unpopular, defenders of the current system have had to scramble for other ways to restore the program to solvency. One proposal gaining in popularity is to have the government invest funds from the Social Security trust fund in private capital markets.

The reasoning is that private capital markets earn a much higher rate of return than the government bonds that currently make up the trust fund. As former Social Security Commissioner Robert Ball asks, "Why should the trust fund earn just one-third as much as common stocks?"

Despite the surface attractiveness of such a plan, however, allowing the government to invest the trust fund would be a terrible mistake that could have severe consequences for the U.S. economy. It would amount to the "socialization" of at least a large portion of the U.S. economy and put ownership rights over much of the economy in the hands of the government.

Socialist economies are characterized by three basic tenets: government ownership of means of production, central economic planning, and government management of labor resources. The proposed investments of the Old Age, Survivors, and Disability Insurance (OASDI) trust funds in the stock market bring the nation closer to each of the three tenets.

Government ownership

At its peak, the Social Security trust fund will contain approximately 2.9 trillion dollars. The total value of all 2,723 stocks traded on the New York Stock exchange was about six trillion dollars at the end of 1995. It is easy to see, therefore, that investing the trust fund would allow the U.S. government to purchase, if not a controlling interest, then a commanding share of virtually every major company in America.

Many of the strongest proponents of investing the trust fund in the stock market have recognized the potential dangers posed by government ownership of such a large portion of the American economy. To allay such concerns, some proposals have called for using stock index funds, not actual direct stock investments. Exactly how this would be accomplished has been left vague, but there essentially are two possible approaches. The government could establish an index and purchase equal numbers of shares in every stock included in it, or the government could purchase shares in an existing index fund, such as Fidelity's Market Index or Vanguard's Index 500.

Government creation of an index fund would do little to avoid the pitfalls of government investment. Government decision-makers would acquire property rights in corporate enterprises. Either they would exercise their rights, thus creating a direct political influence in the management of private enterprises, or they would give up the voting rights and other shareholder privileges, thus indirectly enhancing the power of existing shareholders. In either case, ownership of the enterprises would be influenced powerfully by political agents and the entire arrangement would be financed by the taxpayers.

The Employee Retirement Income Security Act of 1974 (ERISA) places the fiduciary duty on all persons in control of private retirement funds to use such funds in the sole interest of the pension plan participants. This law does not apply to the Social Security Administration. In whose interest, then, would investment and management decisions be made?

Many Western European governments once were owners of large enterprises through nationalization and still are minority -- and sometimes majority -- owners of them. State-owned enterprises are the dominant force in underdeveloped economies, and investment of the "provident funds" in Singapore and other African and Asian nations largely is government-directed. Because of negative experience with government ownership, though, the worldwide movement has been away from such ownership toward privatization, through selling shares to the public. Proposals to allow the government, via the Social Security trust fund, to purchase stock go directly against this trend and back to the early 20th century, when government ownership was hailed as more rational than the "anarchy" of the market.

It would not make a significant difference if the government purchased existing index funds from a third party, such as an investment firm. This would have to be done either through a mutual fund company selling an index fund, which then would purchase actual shares of stocks included in the index, or some other financial institution creating an index, which also would purchase actual shares eventually. Although the index fund would provide a layer of insulation between the government and the corporations whose stocks were purchased, the problems of control would not be avoided completely.

First, the government would acquire control over the index fund manager itself and thus indirect control over the corporations. If index fund A controls the majority of shares in company B and the government controls the management of the fund, it can control the company.

Even if the government does not attempt to exercise corporate control, there is reason to be concerned over allowing index fund managers to use taxpayer money to increase their ownership of corporate America. The huge number of shares purchased with Social Security money would represent powerful voting blocs and, in contrast to most stock purchases, they would be voted uniformly. Yet, these powerful new stockholders would not have to answer to anyone and would derive all of their new powers from the aggregated funds of American citizens. Never in the history of the U.S. has there been a proposal to hand over so much power to unelected officials with this little responsibility attached to it.

In essence, it is being proposed that the Federal government use tax money to pick corporate winners and losers. Using funds borrowed from Social Security's future beneficiaries, the government would buy massive blocks of shares, to be controlled either by the government or by financial institutions that are fortunate enough to receive government contracts for such purchases. It is difficult to imagine a more egregious proposal for "corporate welfare."

Central planning

With ownership comes control. What if a corporation whose stock is purchased by the Social Security trust fund decides to move its operations overseas? Should the administrators of the investments of the trust fund remain indifferent to the plight of the company's workers, who, after all, will be future beneficiaries of the system? Shouldn't the trustees at least attempt to convince the firm to retain its American operations? If the company does move, wouldn't the ownership of shares represent an indirect subsidy to foreign employees extended by the American workers who are losing their jobs to them? What if the company is convinced by the authorities to keeps its operations in the U.S., and this leads to a consistent stream of losses and subpar share performance?

The investment itself provides the opportunity for central planning and control. Companies whose stocks are selected will receive a substantial investment boost not available to competitors that are not chosen. This raises a host of questions about what types of investments should be allowed.

For example, cigarette smoking is a major health concern to the nation and to the Federal and state governments that spend public money to provide care for those suffering from smoking-related diseases. Should Social Security be allowed to invest in cigarette companies? Is it appropriate for the Social Security system to offer price support to those shares while Medicare and Medicaid spend their resources in treating patients suffering from the long-term consequences of smoking?

Other controversial issues are easy to imagine. Should Social Security invest in nonunion companies? What about those that make nuclear weapons, pay high corporate salaries or do not offer health benefits, do business in Cuba, or extend benefits to the partners of gay employees? The list is virtually endless.

Public employee pension funds long have been subject to such controversies. For example, at one time, more than 30 states prohibited the investment of pension funds in firms that did business in South Africa. Those doing business in Libya, other Arab countries, and communist states also have been barred from investment.

Some states have additional restrictions on employee pension funds, including requirements for investing in home mortgages, in-state companies, and alternative energy sources, including solar power. In some states, investments are prohibited in companies accused of pollution, unfair labor practices, or failing to meet equal opportunity guidelines. Some public employee pension funds are prohibited from investing in the alcohol, tobacco, and defense industries. In 1996, the city of Philadelphia announced it would sell its employee pension fund's Texaco stock because of alleged racist practices by that company.

Use of a passive index-either one created by the government or an existing instrument -- would reduce, but not eliminate, the problem. There would remain questions about what stocks should be included in the index. Almost inevitably, there would be a huge temptation to create a better, more socially appealing index of businesses friendly to the public policies of the current administration or Congressional majority.

Even if the proposed Social Security investments in stocks are meant to be passive with respect to social policy, it is nearly impossible to imagine such a position being sustainable in the long run. There is an old Polish proverb that says: "Do not give a man a hammer without expecting him to look for a nail."

Those looking for evidence of this temptation need look no further than attempts by the Clinton Administration to force private pension plans to invest a portion of their portfolios in "socially redeeming" ways. Actually, the last days of the Bush Administration saw the first exploration of the idea of directing private pension investment. In November, 1992, the Labor Department released a report discussing a procedure for valuing the "net externalities" of investments as a way of broadening the prevailing rate test permitted under ERISA to allow for politically targeted investments. The Clinton Administration jumped on the idea with undisguised enthusiasm. In September, 1993, Olena Berg, the Assistant Secretary of Labor for Pensions and Welfare Benefits, announced an expansive interpretation of the prevailing rate test that would "allow collateral benefits to be considered in making investment decisions." She especially urged pension fund investment in "firms that invest in their own workforce."

A year later, in September, 1994, Labor Secretary Robert Reich called for investment of a portion of private pension funds in economically targeted investments, which would provide such "collateral benefits" as affordable housing, infrastructure improvements, and jobs. Congress has resisted this potentially dangerous idea, but it is clear that some politicians are anxious to gain control over pension investments.

It is true that some private pension plans and investment companies face similar issues. Many firms offer "socially responsible" funds, which some investors choose. However, most clients impose on private companies and investment professionals with whom they deal a fiduciary duty to invest solely in their best interest. Furthermore, these private enterprises do not have the power to change laws that affect them, whereas the political agents influencing the Social Security trust fund investment strategy likely will have the power to enact statutes that affect the system. Finally, if the customers of a private investment firm do not approve of its policies, they can and do move their funds to another firm.

The message of capital markets, so often repeated by investment advisers, is that, over the long run, stocks are the best investments. They do pose risks, but over time the power of compounding stock market returns is astounding. Accordingly, supporters of government investment have decided that there is a simple answer to Social Security's problems -- buy stocks!

What is missing in this simplistic approach is an understanding of the cause of stock market returns. Stocks make money because companies make money. A report released by the McKinsey Global Institute in 1996 shows that the gross national savings and investment rates in the U.S. are far lower than those in Germany or Japan. Yet, between 1974 and 1993, the U.S. created $26,500 of new wealth per person (in 1993 prices, measured by households' net financial wealth), while Germany created $21,900 and Japan $20,900. How can a nation produce more wealth with lower savings and investment? The McKinsey researchers point toward higher productivity of capital in the U.S. Their estimate states that American industry enjoyed an average return on capital of nine percent over that period, compared with about seven percent in Germany and Japan.

One can not brush this finding off by suggesting greater utilization of capital at the expense of labor in the U.S. because American labor productivity also is higher than that of Germany or Japan. The McKinsey report further examines the reasons for greater American productivity. The major finding is that the way managers run companies can be extremely important. Americans are more creative and ingenious in their management, marketing, and financing practices. They face greater competition and lower barriers to entry. Moreover, strong pressures from investors and very efficient capital markets in the U.S. force managers to concentrate on financial performance, which causes them to evaluate carefully whether the project they intend to invest in truly creates value.

Consider the collapse of the command economics of the former Soviet Bloc. Economists James Gwartney and Richard Stroup point out that the communist economies had among the highest recorded rates of economic investment in history, all of them guided by central governments. Yet, those massive investments turned out to produce little economic growth or wealth. This poor performance by managers in command economies stands in stark contrast with the achievements of their American counterparts.

What is the reason for this dramatic difference in results? Were the managers in the Soviet Bloc stupid, or was there a greater, systemic reason for the difference? There is no evidence that American managers intrinsically are smarter than their Soviet counterparts were. In reality, there are several reasons for the difference, including the lack of both private property and a consistent legal system. Another important reason is the fact that, in command economies, not only does government give a job to everyone (full employment), but all management appointments become political.

Aggressive, creative managers rarely are the ones who carry the most favor with the government. When ownership becomes political, managers whose visions differ from those of the government no longer have their jobs. On the other hand, managers with little vision, but with political connections, maintain a firm hold on their positions.

In the free market system, managers who fail to produce are threatened by the market for corporate control -- i.e., by hostile takeovers. The market for corporate control is a force for change and innovation that would be weakened or even removed completely by government ownership of large blocks of shares. Whose side will the Social Security trust fund vote its shares with: a rogue corporate raider using billions of dollars of junk bond financing to fire well-known and respected managers of major corporations who just happen to have had a bad streak of 17 consecutive quarterly losses or the unlucky managers?

The apparent purpose of allowing the government to invest the trust fund is to take advantage of the higher returns from private capital markets. There is strong evidence, though, that the government's investment policy substantially could undercut the returns it otherwise might expect to receive. High capital market returns in the U.S. are derived from the high productivity of capital and the efficiency of the markets. Investment of the Social Security trust fund in private capital markets will hurt both of these sources of American economic performance; capital will be less productive and markets will be less efficient.

A 1994 study by the World Bank of government-managed pension fund investments around the world found that they generally earned lower annual returns than privately managed pension investments. It showed that governments generally pursued one of two policies for their investments, both fundamentally flawed.

One was to invest heavily in government securities, which earn much lower returns than, for example, stocks. There are two reasons for this policy. First, there is a cautionary search for safe investments because governments fear the political reaction if a more aggressive investment policy were to lead to adverse results. Second, buying up government debt allows the government to defer the consequences of its own overspending. Indeed, there is evidence that the power to shift government debt into pension funds actually may induce them to spend and borrow more. Borrowing from the pension fund is less transparent than doing so from the open capital market. In many cases, such borrowing is not even reported as public debt. and the interest rate may be lower.

This already is occurring with the Social Security trust fund. The current surplus is used to purchase Federal Treasury obligations that are credited to the Social Security trust fund. The government then utilizes the money it has borrowed from the trust fund to meet current operating expenses.

The other investment policy pursued by government-controlled pension funds is to invest in government-supported projects such as state-owned enterprises or public housing. Again, the result often is extremely low rates of return. In fact, such investments frequently lose money. Moreover, government investment leads to greater government involvement in that economy that could, in turn, lead to policies that slow economic growth and reduce the return on capital for all investors, including the government itself.

There are numerous studies showing that, in an efficient market, returns from stocks are determined by two factors: interest rates and the effectiveness of economic projects undertaken by the enterprises whose shares investors purchase. Stocks are not goods -- they merely are conduits, exchanging current cash flows for future ones. Investing Social Security assets in stocks would harm both market efficiency, causing large amounts of money to be invested without duly diligent reviews of companies, and economic investment effectiveness, by removing incentives for the managers of those firms to perform. Thus, not only would Social Security trust fund investments in stocks not perform as well as expected, but all stock market investors and the national economy would suffer.

American stock exchanges are reputed to be the most efficient in the world. Passive government stock investments would harm the market efficiency achieved by the vigilance of active money managers and would raise the cost of capital, relegating the U.S. to the ranks of mediocre economies.

The proposal to invest Social Security funds in the stock market endangers the very source of the strength of the American economy. The U.S. still enjoys the highest productivity of capital and labor in the world. These are key advantages enjoyed by American workers and savers in the new, competitive global economy. We can not afford to lose them.

Money to the people

There is a better way to harness the power of private capital markets to guarantee a secure retirement for America's elderly. Rather than allowing the government to control investments, true power should be given to the people, allowing individually owned and privately managed investment accounts similar to Individual Retirement Accounts (IRAs) and 401 (k) and 403(b) plans.

Individuals would be free to use the money in their accounts for stocks, bonds, and other investments, with some restrictions to prevent very risky speculation. Government control would be limited to defining the options that could be offered for investment, while actual control would remain in the hands of individuals.

This approach has proved highly successful in Chile and a number of other countries. There has been growing interest in individual private accounts in this country as well. An option being supported by members of the Social Security Advisory Council would permit approximately 50% of Social Security taxes to be diverted to private accounts. Other proposals in Congress and elsewhere would allow greater or lesser amounts of an individual's Social Security taxes to be invested privately.

If we are truly serious about harnessing the power of private capital markets to solve Social Security's problems, we should allow investment in individual accounts, not a government takeover of capital markets.

COPYRIGHT 1998 Society for the Advancement of Education
COPYRIGHT 2000 Gale Group