Robert F. Mulligan
Department of Economics, Finance, and International Business
College of Business
Western Carolina University
This is an expanded version of the op-ed piece which appeared as a guest column in the Asheville Citizen-Times, February 22, 1999.
President Clinton's proposal to invest the Social Security Trust Fund in the stock market has set off debates over the merits of the president's proposal, and over the best way to reform the social security system. As presented in the State of the Union address, the proposal seems more a broad outline for reforming the system, requiring further debate and deliberation before any changes can be put in place. The primary objection, raised by Federal Reserve Chairman Allan Greenspan, is that it would be impossible for the government to apolitically administer stock market investments.
In evaluating a proposal for the next stage in the evolution of the social security system, it may be helpful to review how the system has operated in the past. Before the fund was invested in government bonds, all benefits had to be paid out of current receipts, the payments withheld from workers and matched by employers. Any shortfall had to come out of the federal budget, which means shortfalls were funded, directly and immediately, by taxpayers.
Today, because the trust fund holds treasury bonds, the whole fund is lent to the federal government, and eventually the taxpayer will have to finance paying these loans back, with interest. The advantage of investing the trust fund in treasury bonds can be seen by considering how the Fund operated as a pay-as-you-go-system. The government collected our contributions and used them to pay for federal expenditures. This arrangement lowered both the federal budget deficit and our income taxes in the short run, but the government would have had to raise taxes in the long run if it ever had to pay out more in benefits to retirees than it received in contributions from workers. Higher taxes were inevitable under the pay-as-you-go system unless the workforce continued to grow much faster than the retired population.
Today, the Fund's holdings of treasury bonds act as IOUs. The federal government no longer helps itself to any surplus of contributions we pay over benefits we receive, but it can still borrow this money. The interest rate is artificially low, and contributes to lower interest rates on the rest of the public debt, but at some point in the future the bonds will have to be paid off by taxpayers.
From a public finance perspective, pay-as-you-go was better because the government could borrow all social security revenues as they were received, at zero interest. Having the fund invested in government bonds serves to discipline the government by making it face up to its eventual obligation to fund the system, if necessary through raising taxes. It is no coincidence that the era of fiscal responsibility, leading up to the first federal budget surplus in memory, started with the Greenspan Commission's recommendation to invest the Social Security Trust Fund in government bonds.
If President Clinton's proposal were adopted without modification, 62 percent of all government budget surpluses projected for the next fifteen years would be contributed to the social security trust fund - about $15 billion every month. Over fifteen years, the president estimates contributions from the surplus will total $2.7 trillion. This is in addition to contributions from wage earners and their employers. Approximately one-quarter of the contributions from the surplus are to be invested in the stock market to benefit from higher long-term average returns.
The reason the president's proposal improves the solvency of the system is it provides a new source of contributions in addition to those already paid by workers and employers. The amount of the fund to be invested in the high-returning but risky and volatile stock market is relatively low - no more than 15% of the whole fund. This limits the fund's exposure to market downturns, but also limits the extent the fund can benefit from high growth in stock market value. The President's proposal adopts a conservative approach.
Average long-run returns have been approximately 7-10% for the stock market, compared to 2-3.5% for the long term bonds the fund is currently invested in, and 0-3% for short term treasury bills. The stock market is highly volatile, however, and loses a significant part of its value whenever there is a crash or correction. Although the fund would be exposed to market volatility, 85% of the trust fund would still be invested in zero risk, low-interest, long-term government bonds.
The key weakness of the President's proposal as stated, is the absence of an explicit and infallible mechanism to prevent politicizing the trust fund's administration. The risk of introducing politics into the management of such a large block of investment spending, is fraught with perils for account holders' financial welfare, corporations' sound management, overall economic growth and stability, and the very integrity of the democratic process itself. Pretty high stakes.
There is a way to prevent anyone from playing politics with the trust fund and the stock market - a statutory requirement for passive management of the fund's stock portfolio.
The 15% of the Social Security Trust Fund would then be a giant, federally administered stock index fund. Not just a stock fund, but a stock index fund. An index fund holds an equal number of shares of each stock. An example is an S&P 500 index fund which holds equal numbers of shares of each of the 500 S&P stocks. The value of the fund rises and falls with the S&P 500 index.
A Social Security index fund would probably have to hold shares of all stocks listed by NYSE, NASDAQ, and all the regional stock exchanges, to avoid an inappropriate regional bias. The fund would probably require any company it invested in have a five-year track record of being listed on an exchange. This kind of index fund would be even more diversified than any already existing, so one difficulty is it wouldn't correspond to any currently known index.
Greater diversification means greater protection from some kinds of risk, but index funds are vulnerable to losing large chunks of their market value whenever the stock market crashes - there is no protection from that kind of risk, except to stay out of the market. Under the President's proposal, 85% of the fund would remain safe at all times in government bonds.
There are two major problems with the proposal as the President broadly outlined it:
1. Although the stock market has performed well over the long run, and broad-based index funds provide a high level of diversification, protecting against some kinds of risk, the fund would be highly vulnerable to market-wide corrections like those which occurred in 1929, 1987, 1997, and 1998. The impact of these corrections on the economy, acting principally through consumer confidence, would be much worse if the trust fund were invested in the market. Fortunately, the President proposes investing no more than 15% of the fund in the stock market, limiting exposure to this kind of risk. Except for the 1929 crash, the impact of the other corrections on the economy was minor and temporary. (Hopefully that will turn out to be true for the 1988 corrections - it's still too early to be certain.) People might be more prone to panic if the Trust fund lost a significant part of its value overnight without warning, whenever the market takes a dive.
2. By owning stock in corporations, the trust fund, and the account holders who have paid into it, become part-owners of the corporations. Because the Social Security Administration is an agency of the federal government, it will face simultaneous pressure to do three things:
a. The fund would face pressure to act in the best financial interest of account holders, which could lead to fund administrators actively managing the fund, probably with poorer results than passive management. Passively managed index funds outperform most actively managed funds. It would be easy and obvious to adopt a passive management policy, like any stock index fund, but there would always be pressure to weed poorly performing stocks out of the portfolio. If fund managers succumb to this pressure, and if they fail to outperform the market, account holders will be dissatisfied with the system, and because of its size and government sponsorship, the fund will exert an inappropriate and disproportionately large influence over the economy. It is difficulty to foresee how any active management strategy could fail to be politically biased. Even if perfect safeguards and perfect checks and balances could be devised and implemented, and absolutely incorruptible fund managers of total integrity could be found, any active strategy, whether effective or not, could never avoid the appearance of political motivation. The only way to avoid this problem is to make passive management a statutory requirement.
b. The fund will face pressure to satisfy the ethical preferences of the majority of account holders, by divesting unpopular corporations. The majority of account holders might desire to divest tobacco producers, firms with high perceived environmental impact, or firms that do business in or with foreign countries with unpopular policies, e.g., formerly, firms that did business with South Africa under apartheid. Succumbing to this pressure begins to make the fund a political football, though it could enhance fund performance - social responsibility funds recently outperformed the market because they had divested tobacco producers. Here is a potential consequence of the president's proposal which could impair the government's impartiality and fairness far beyond the financial sector. The government would face an incentive to favor firms held by the fund, over the interests of divested firms. If the fund were a sufficiently broad index fund, distributed among all the exchanges and NASDAQ, there would be little incentive to favor one firm over another, except size and growth. The government's incentive then would be to favor large firms over small ones, because the fund's holdings of a large firm would represent relatively more of the fund's value than its holdings of a small firm. The government's performance as fund manager would be enhanced the higher the growth rate of the index. The impact of this incentive can be minimized, but the incentive will always be there, and to pretend otherwise is naïve. Making passive management a statutory requirement would go a long way toward minimizing the impact of this problem.
c. The Fund would also face pressure to respond to preferences of political pressure groups, divesting a different set of unpopular corporations. Various groups would lobby the government in an attempt to have the Trust Fund's stock portfolio serve their political agenda, perhaps with little or no concern for account holders' financial well-being. This would have all the negative impact of responding to account holder preferences, without any likelihood of enhancing fund performance.
Imagine South Africa still operated under apartheid and some of the companies held by the trust fund did business there. The Social Security Administration would face intense political pressure to divest - and if that kind of political pressure, or any kind, cannot successfully be resisted, the fund should stay out of the market. The exclusion against discretionary trading would have to be statutory and it would have to be inviolable.
However, there would be no objection against lobbying for legislation forbidding U.S. publicly traded corporations from trading with an apartheid country, or forbidding any other immoral activity. Partly the issue is the extent political activists will accept the inviolability of the trust fund's financial integrity and the principle of passive management, and seek other media to further their political agendas. Partly the issue is how well the government can adopt and adhere to a statutory exclusion against active fund management, in the face of likely pressure from political activists.
Each of these three pressures - account holders' desire for higher-than-market returns, account holders' political agendas, and non-account-holder's political agendas - will work to undermine the value of the trust fund. If the pressures are not successfully resisted, investing the fund in the stock market could promote economic instability and provide an inappropriate incentive structure for businesses.
If the President's proposal is viewed more as a broad outline than a finished program, then it provides an invaluable opportunity to enhance the system and keep it viable.
The best tactic for the federal government and the Federal Reserve System is to keep the interest rate from falling too much. The influx of the trust fund monies into stocks will put downward pressure on interest rates, encouraging accumulation of low-yielding, relatively unproductive capital equipment. If interest rates fall too much, in the long run, this would harm the nation's productivity and international competitiveness.
Expect passionate debate over the President's proposals over the next few months or years. A better social security system and a better, more efficient, economy are the prizes if we have the patience to hammer out the details.