In 1998, conservative think tank The Heritage Foundation reported that an average American household of two earners with a combined income of $52,000 would pay a total of $320,000 in Social Security taxes over their lifetimes (including their employers’ share), and receive about $450,000 after retiring at age 67. The Foundation suggested that the same funds invested equally in U.S. Treasury bills and equities would grow to $975,000, more than double the return under the existing Social Security program. In 2001, President George W. Bush introduced a “partial privatization” proposal, which initiated an ongoing public debate about the feasibility and wisdom of replacing a portion of the existing U.S. Treasury bonds portfolio with equity investments.
Today, the question remains: Should Social Security trust funds be invested in equities?
The Political Minefield Surrounding Social Security Changes
Since its inception, Social Security has been controversial. Conservatives view it as the nation’s first entitlement program and demand its reform in order to cut the national debt, while liberals and progressives assert that it (along with Medicare, Medicaid, and other federal benefit programs) is a critical element of the American Dream, and advocate higher federal income taxes on the wealthiest citizens.
Today, the future of Social Security is in doubt as the proportion of those receiving benefits – the elderly – continues to grow larger, while the proportion paying for those benefits – the young – is in steady decline. Unlike private profit-sharing plans in which benefits are limited by contributions and investment earnings, Social Security, with its insurance element and cost-of-living adjustment (COLA), requires ever-increasing revenues to maintain promised benefits.
Since the current benefit level cannot be maintained without new revenues, political leaders are in a vise. Raising taxes is always unpopular with the electorate, while the elderly are one of the most potent voting groups in the country. Increasing revenues by raising the investment returns of the two Social Security funds without raising taxes or cutting benefits is the optimum and safest political choice for a politician seeking to return to office.
Historically, the average annual return on the S&P 500 (11.26% from 1928 to 2011) has been more than double the return of the Social Security funds, which is very appealing unless you consider that, on average, stocks lose value every one of four years.
The Promised Land of High-Equity Returns
Social Security was designed to be a “pay-as-you-go” system from its inception. Revenues are collected in the form of payroll taxes, while benefits are paid out simultaneously. In the early years, revenues greatly exceeded payments, so substantial fund balances were created and invested in special U.S. Treasury bonds. As the program has matured, the difference between tax collections and payments has flip-flopped, so the trust funds have ceased to grow, being used to make up the deficit between taxes collected and benefits paid.
For example, in 2011, payroll tax revenues and interest to the OASDI totaled approximately $805.1 billion, while benefit payments and administrative and miscellaneous disbursements were $736.1 billion. The surplus of $69 billion was invested by the Social Security trust funds in special treasury bonds, becoming part of the general revenues of the Federal Government.
At the end of 2011, the OASDI funds were approximately $2.7 trillion. It is this fund balance that many advocate be invested in equities. At 4%, the funds earn about $108 billion annually – and the appeal of doubling those earnings by investing in equities is irresistible.
Public Trust Funds With Equity Investments
Two North American examples of public trust funds with equity investment flexibility are the Canada Pension Plan and the National Railroad Retirement Investment Trust.
The Canada Pension Plan
Canada’s largest single-purpose pension plan was created in 1966, covering every person between the ages of 18 and 70 who earns a salary. It is similar to the U.S. Social Security system in that revenues consist of payroll taxes – 9.9% on incomes up to a maximum of $42,100 collectively paid by employee and employer.
Canada’s largest pension plan is managed by the Canada Pension Plan Investment Board, and had a portfolio of $170 billion at the end of September 2012. Investments include shares in foreign companies, as well as private equity, real estate, and infrastructure. Less than 10% of the portfolio is invested in Canadian companies.
The Canada Pension Plan has had outstanding investment success, “outperforming public pensions elsewhere in the world,” according to CBC News. Many credit the fund’s prosperity to the unlimited freedom of their portfolio advisers to make investment without political pressure. CBC reported earlier this year that the fund’s advisors invest “in a dizzying array of companies – everything from Porsche, Coca-Cola, and the maker of Tootsie Rolls, to more controversial businesses such as alcohol and tobacco firms and some of the world’s biggest weapons manufacturers.”
According to the trustees’ official report, the fund reported an annualized rate of return of 6.6% for the year 2012, 2.5% for the previous 5-year period, and 6.1% for the 10-year period ending the same date, reflecting the turmoil in world markets over the last half-decade. To compare, the average public (state and local government) pension plan in the United States had an annualized 2.0% return for the previous 5-year period and 5.7% for the 10-year period.
The Canada Pension Plan is very similar to the United States Social Security OASDI and has suffered from the same problems – the original level of contributions paid by employers and employees with investment earnings has not been sufficient to make the promised benefits. In 2003, the contribution rate from employer and employee was raised to 9.9% of income from its initial 1.8% contribution level. Existing actuarial assumptions about the future rate of earnings on the trust fund project that the existing arrangement will be stable to the year 2075.
The National Railroad Retirement Investment Trust
Created in 2001 to manage railroad retirement assets, the National Railroad Retirement Investment Trust covered 542,400 retired railroad employees, spouses, and survivors with 230,000 active employees in 2011. Slightly more than $11 billion in benefits was paid in 2011, with an average recipient receiving a greater amount than a Social Security beneficiary due to higher taxes paid by the railroad workers and their employers. At the end of 2011, the trust had more than $24 billion in asset value, which was invested in public and private equity, fixed income, and U.S. and non-U.S. real estate and commodities.
The performance of the trust in its early years allowed employees and employers to reduce their contributions and build a financial cushion. However, in recent years, returns are mixed, with a loss of -0.1% in 2011, an 11.2% gain in 2010, a loss in 2009 of -0.7%, a loss of -19.07% in 2008, and a gain of 16.38% in 2007. The current level of contributions (income) is less than the level of benefits paid, with the deficit being provided by earnings on the trust assets and the trust itself.
Issues in Adding Equity Investments to OASDI Funds
The person who coined the phrase “the devil is in the details” might have had the addition of equity investments to the Social Security trust funds in mind. While the appeal of higher investment returns is evident, the implementation of the practice will require careful thought to overcome the apparent obstacles and avoid unforeseen negative consequences.
Scale of Investment
The combined Social Security trust funds are almost 16 times larger than the Canada Pension Plan, and 112 times larger than the National Railroad Retirement Investment Trust. Investing one-half of the trust funds’ balance would buy all of the stock of Apple ($424 billion), Exxon ($416 billion), and Walmart ($233 billion), with funds remaining to acquire Walgreens ($37 billion), McDonald’s ($93 billion), and The Walt Disney Company ($97 billion).
If invested proportionally in each of the companies composing the Standard & Poor’s 500 market index, the Social Security funds would be each company’s largest single investor, averaging a 20% share of each business. If invested in the companies of the Wilshire 5000 index, the percentage of ownership in each company would drop to slightly more than 17%, a position still greater than virtually any other investor’s in most companies. As the Investment Company Institute reported in 1996, “the sizable portfolio that the SSA would amass would unavoidably thrust it into the role of a significant shareholder of a very large number of companies.”
Some proponents of equity investments have pointed out that state and local government pension funds have owned stock for decades (almost 10% 0f the corporate equity outstanding in 1996) without a negative impact on the companies or on the operations of the free markets. However, their analysis fails to consider that state and local pension funds are not held en masse by a single entity or a few organizations, but by literally hundreds, if not thousands, of separate plans acting independently, much as any other unassociated group of investors with different goals and strategies. Implying that the effects of equity ownership by the Social Security funds is akin to those resulting from the ownership of multiple, diversified, and unrelated pension plans is illogical.
In most cases, the act of investing or divesting an asset is not a factor in the price one pays or receives for the asset, since a single investor represents such a small proportion of the whole. However, in the case of the Social Security funds, any security transaction, whether buying or selling, is visible due to the scale of the order. It would be unlikely, for example, that sufficient sellers of a stock which the trustees might wish to purchase would be available to fill the purchase order, thereby driving the price of stock up – a classic supply and demand situation.
A similar predicament exists when the trust might seek to liquidate its position in a company’s stock – it is unlikely there would be sufficient buyers to handle the large transaction without dropping the price of the security. Furthermore, alert private and professional investors will seek to capitalize by buying or selling before the government’s action can be completed, adding more demand or supply, and multiplying the impact of the trustee’s actions.
In addition, in many cases, open records laws and current S.E.C. regulations require public disclosure (pre-notice) of buys and sales. In plain investor’s language, the funds will likely always pay higher than previous prices when acquiring stock, and receive lower than previous market prices when selling. Neither outcome is a recipe for success, but is rather an incentive to take no action. Effectively, liquidity goes out the window when the size of the investment overwhelms free market dynamics.
No one knows what form of equities might be proposed for fund investment or how the decision to select one investment over another would be made. The Canada Pension Plan and Railroad Investment Trust employ independent investment firms to manage portions of their portfolios, and allow those managers great discretion in the type of investments which they select, including private ventures.
It is unclear whether a similar approach would be politically acceptable for Social Security, particularly stocks in foreign companies, companies whose products have been outsourced overseas with a loss of U.S. jobs, or companies which produce products that some citizens consider immoral or contrary to public interest. If private investment management companies are used, who will make the choice of managers or monitor their results?
Volatility and Portfolio Risk
By nature, equity investments are more volatile than debt instruments. Accordingly, a fund invested in any form of equity (including common stocks, real estate, or commodities) experiences significant variation in market value, thereby affecting the amount of funds available to be withdrawn.
While the stock market return as measured by the Dow Jones Industrial Average (DJIA) has averaged 10% annually over a 10-year period, there were also 1o-year periods with minuscule average returns (less than 1% annually), and plenty of individual years with hefty losses. A review of the Canada Pension Plan or the National Railroad Retirement Investment Trust illustrates the volatility of annual returns in equity portfolios. As a consequence, each fund retains a four- to six-year projected expenditure balance in debt instruments to cover any bad investment results on a short-term basis.
Advocates for allowing Social Security to include equity as possible investments have proposed that such investments be limited to 40% to 50% of each fund’s respective total investments, as is the practice in the Canada and Railroad Retirement funds.
According to the American Association of Retired Persons (AARP), “Having the government in the business of picking winners and losers and voting on corporate proposals is undesirable.” In fact, as major stockholders, the Social Security funds would have major influences on the day-to-day operations of those companies whose stock they own. The right to elect boards of directors and corporate officers would allow trustees to influence corporate policies, perhaps favoring social policy over profits.
For that reason, some have suggested that if equity investments are permitted, Social Security trustees must refrain from voting in corporate elections as a matter of policy. However, this solution – a deliberate decision to forgo shareholder responsibility – would dilute the ability of the private shareholders to replace or control their corporate managers. Since less than 10% of the Canada Pension Plan is in invested in the stocks of Canadian companies, and the actual investment decisions for it and the National Railroad Retirement Investment Trust are made by retained portfolio managers, the question of government control has not arisen.
In the case of the Social Security trust funds, it is unlikely that either scenario is acceptable to believers of free enterprise or the rights of capital.
Government and Private Business Conflict
The United States Government is the largest purchaser of goods and services in the world. Its rules and regulations affect the policies, practices, and profits of large and small companies in every industry and location. Companies that are part-owned by the government may be considered part of the government, which General Motors discovered with the derisive epithet “Government Motors.” Due to the sheer magnitude of the capital to be invested, it is possible that every public company could have the Federal Government as a shareholder.
Since the public would benefit from the theoretical higher returns on those companies in which the OASDI funds have invested, should the companies with a federal investment be favored in public bids and contracts providing even greater sales and profits? Conversely, if those companies are prohibited from doing business with the government, who will supply the goods and services now being purchased from them? These are fundamental issues that should be decided prior to allowing equity investments.
Impact on Federal Debt
Currently, the Social Security funds are invested in U.S. Treasury bonds and are used to fulfill government obligations. Due to the investment by the Social Security trust funds, the monies to the Federal Government would need to be replaced by new buyers in the open market if the trustees were directed to invest in equities.
In addition, Social Security Trusts would be selling their own positions in treasury securities at the same time that the Federal Government would be selling new treasury obligations. The volume of treasury bonds to be sold (the combined Social Security fund sales plus regular U.S. Treasury sales) would imbalance the supply and demand market dynamics, driving the principal value of the bonds lower and interest rates higher in order to attract buyers.
The higher interest rate on the bonds would either be added to the national debt or paid by increased taxes. In other words, selling treasury bonds previously purchased by the OASDI funds and then investing the proceeds in equities (stocks) would simply create costs elsewhere and only postpone dealing with the underlying fundamental problem of national debt and growing entitlements.
However, OASDI equity investments may be politically popular due to the perceived superior investment return of equities, despite its shortcomings and logistical obstacles, and cannot be discounted as the favored approach by the people in Washington in both political parties.
Peter Diamond and John Geanakoplos, economists at MIT and Yale University, respectively, suggested in a 2003 article for “The American Economic Review” that “equity investments by the SSA would increase risky investment, decrease safe investment, raise interest rates, lower expected returns on short-term risky securities, and reduce the equity premium.” It is likely that these same findings remain relevant today. At the same time, it makes financial sense to divert a portion of the Social Security funds into long-term equities if the issues identified above can be resolved.
What do you think? Should your retirement depend upon the volatile returns of the stock market?