The U.S. Social System: An Alternative to Privatization

Charles F. O’Donnell
Joseph W. Ford
Anand Shetty
IonaCollege

I Introduction
         There have been a number of suggestions to invest the OASI trust funds balance in corporate stocks and bonds. Under current law, the social trust fund surpluses can only be invested in government securities. When the social security law was passed in 1935, the law made sense in view of the Great Depression the country was under. The growth of the surplus has initiated a debate that had not existed throughout most of the history of social security: how to invest the OASI surpluses best. This was not an issue when the trust fund was relatively small, having the equivalent of six months to a year’s expenditure in reserve.
     The debate over whether the OASI trust funds should continue to invest only in government securities or should also invest in stocks and bonds has been intense in recent years. Many experts and policy makers want to consider taking advantage of the

…..equity premium, i.e., the historical advantage enjoyed by equity returns over other assets and over wage growth. The Social Security Advisory Council, along with scholars such as Siegal and Ibbotson and Sinquefield, observes that the long-term real return on equities has been approximately 7%, while the long-term real rate of return intermediate government bonds has been about 2.3%. If the equity premium is 4.7%, the extra income provided by equity investment would enable the Social Security system to avoid more draconian increases in payroll taxes or decrease in retirement benefits (Hammond and Warshawsky, p.52).

     In 2002, the OASI Trust Fund was $539.7 billions and the fund ratio was 272 and in 2006 level was $642.3 billion with a trust fund ratio of 361. The intermediate projection of the OASI trust fund is that it grows to $1,122.8 billions in 2014 with a trust fund ratio of 462 (Source: The 2007 Report of the Board of Trustees, p. 53). The authors believe that it is time to consider alternative uses for the OASI trust fund surpluses.
     In the 1994-1996 Advisory Council Report on Social Security Reform, six members proposed a plan called The Maintenance of Benefits (MB). The MB plan called for investing forty percent of the trust funds in stocks by duplicating a broad market index. Unfortunately, the thirteen members of the council could not agree on a single plan to deal with the long-range financial problem (Advisory Council, p. 23-27)
II The Aaron-Reischauer Proposal
     This paper examines the effect of applying a portfolio approach for the investment of the Old Age and Survivors Insurance (OASI) program trust fund. The authors have chosen a proposal by Henry Aaron and Robert Reischauer from their book, Contribution to Reform: The Great Social Security Debate (1998). There have been a number of other proposals for the diversification of the trust funds. As discussed earlier, the Maintenance of Benefit (MB) plan would invest the OASI trust funds in equities from 2000 to 2015 when equities would reach a level of 40 percent of assets in 2015 (Advisory Council, pp.25-27). In June 1995, Robert Ball, a prominent MB member recommended investing “….one-third of Social Security reserves in private equities indexed to the broad market, making sure that fund managers are not empowered to select individual stocks.” (Ball p.2) The funds would be managed by the government.
Aaron-Reischauer recommend that

…..Social Security be partially invested in a broad mix of private securities. Any steps in this direction should proceed gradually and be monitored carefully. A contingency reserve fund equal to one and one-half year’s benefits should be held in ….treasury securities. Half of total reserves would be invested gradually over the next decade or two in a mix of equities that reflected a broad index of domestic stocks. The balance in excess of the contingency fund would be invested in an index of corporate bonds. (Aaron and Reischauer, p.113-114).

     Aaron and Reischauer use the contingency reserve fund of 150 percent of a year’s benefits as a hedge against times when the stock market is doing poorly. As Table 1 shows, the Trust Fund Ratio (TFR) exceeds 150 percent from 2002 to 2035. Therefore, the TFR reserve protects the beneficiaries of OASI when the market is under performing. Another element to consider is the Aaron-Reischauer plan commits half of the balance beyond the contingency reserve to corporate bonds. Historically bonds perform better when the stock market is doing poorly.
     The equity investment would be in a carefully managed broadly indexed fund “….as a way of mirroring the makeup of the U.S. equity market as a whole in order to minimize any political problems that might arise from investment in corporate securities by an agency of the federal government (Hammond and Warshawsky, p. 54). The investment plan is modeled on the operation of the Board of Governors of the Federal Reserve System and the Federal Retirement Thrift Investment Board which is run by an expert investment board. Board members would be appointed by the President with the advice and consent of the Senate. The Social Security Reserve Boards (SSRB) members would be appointed for long terms and their power would be limited to selecting fund managers on the basis of competitive bids and monitoring the performance of those managers. (Aaron and Reischauer, p. 111) Aaron and Reischauer propose that:

fund managers would be authorized only to make passive investments corporate bonds or stocks chosen to represent broad market indexes … merged with funds managed on behalf of private account holders. To present the SSRB or its fund managers from exercising any voice in management of private companies and SSRB share ownership from diluting control of private shareholders, Congress could insist on either of two precautions. It could eliminate voting rights on shares held by the SSRB. Or it could employ a number of fund managers, so that total shares voted by each manager would be less than a target proportion of outstanding stock of any company, say one percent. Furthermore, fund managers would be required by law to vote shares solely in the economic interest of future beneficiaries (Aaron and Reischauer, p. 111, 113.)

III Critiques of the Government Management of the OASI Surplus
     Most of the criticisms of the government management of OASI trust fund surplus are directed at the Maintain Benefits (MB) plan proposed by six members of the Advisory Council because this was the most prominent plan before the Aaron-Reischauer proposal. Much of the criticisms of the Maintain Benefits plan would also apply to the Aaron-Reischauer proposal. The main criticisms of the plans to have the government invest the OASI trust funds in the market are the concerns that the investment on OASI assets in private capital would make the federal government a major investor and that the government might be too involved in corporate governance. There is a philosophical debate as to whether the government should manage the investment or the individual should.
     Mr. Alan Greenspan supported President Clinton’s idea of using much of the surplus to shore up the Social Security reserves but he added that the investment by the government could threaten the economy (Rosenbaum, p. A1). He criticized the investment in the stock market as follows: “I do not believe that it is politically feasible to insulate such huge funds from government direction … I am fearful that we would use those assets in a way that would create a lower rate of return for social security recipients” (Weinstein, p. A25) . Mr. Greenspan is quoted as saying: “Political pressures … could lead to inefficient investments that, in turn, would result in a lower rte of return for retired persons and lower standard of living for all Americans.” (Rosenbaum, p. A21).
     Mr. Greenspan is concerned that the investment of OASI funds in private capital would make the federal government a major investor and that the government might be too involved in corporate governance. For example, he argues that the investment of social securities funds in the stock market “…would arguably put at risk the efficiency of our capital markets and thus, our economy. Even with Herculean efforts, I doubt if it would be feasible to insulate, over the long-run, the trust funds from political pressure …to allocate capital to less that its most productive use.” (Greenspan, p. 191)
     Aaron and Reischauer argue that the SSRB structure as discussed earlier would address these issues. They point out that the managers of the Thrift Savings Board for federal employees, the pension plans of the Federal Reserve System, the U.S. Air Force and the Tennessee Valley Authority have never been accused of trying to exercise control over companies in which they have invested and have pursued only financial objectives in selecting portfolios (Aaron and Reischauer, p. 111).
     The rest of this paper will focus primarily on the Old-Age Survivors Insurance (OASI) program of the United States. We will discuss some of the potential problem facing the system and will propose a program that would protect the future of the program.
     The authors will discuss briefly the plan purposed by President Bush in 2005 to privatize the system. He had first mentioned personal accounts when he was a candidate in the 2000 Presidential election. In 2001, President Bush appointed a commission to strengthen social security and selected supporters of personal accounts to study and report on ways for achieving personal accounts. The commission could not agree on a single proposal, but offered these proposals that were not acted upon. In 2005, the President presented a general outline of his proposal for personal accounts in his State of the Union address (President Bush State of the Union Address, New York Times, February, pp 22-23.) The President toured the country campaigning for his plan but he did not find support and it was never acted upon. In his new budget proposal in 2007, President Bush allocated $29.3 billion to establish private accounts in 2012, with a total $637 billion through 2017. “Bad Faith on Social Security,” is how New York Times described it (New York Times Editorial/Letters, pa. A.4, February 10, 2007)
IV A Plan for Solvency for Social Security    
     Projections for social security are made for the old- age and survivors program (OASI) by the Chief Actuary of Social Security. The projections show that the Social Security Trust fund will be depleted in 2043. The Bush administration and its supporters assert that the social security will go bankrupt in 2018 and argue that this constitutes a crisis in social security. The Bush administration’s projection is based on taxes collected by the program but fail to include the income received from interest earnings on trust fund assets. To address the so-called future insolvency, President Bush proposes privatization of social security with personal investment accounts funded by part of the workers payroll accounts. When the Bush administration said that social security would to bankrupt in 2018, because they considered only the OASI taxes collected but neglected to look at the full assets of social security. The Office of the Chief Actuary of Social Security projects the assets of the fund would be $150 billion in 2005 and $4,483 billion in 2018. The Office of the Chief Actuary and the Congressional Budget Office have made very different proposals on the future of the OASI program. (See Tables 1 and 2).
V Diversification
     A different proposal is presented by Henry J. Aaron and Robert D. Reischauer in their book, Contribution to Reform: The Great Social Security Debtate. Aaron and Reischauer proposed diversifying the investment into a broad range of assets including corporate stock, corporate bonds and treasury bills (Aaron and Reischauer, pp. 111-114). Currently, the OASI assets are only invested in government bonds. The authors and some colleagues have drawn upon the Aaron and Reischauer concept and have developed a plan for diversifying the social security assets. Their paper, The Impact of Diversification on the Future of the U.S. Social Security Program, The Journal of Financial Services Professionals, September 2005, vol. 59, pp. 42-49, presents a variety of investment strategies and analyzes their impact on the trust funds. Their proposal calls for investing 150 percent of the annual expected expenditures (outgoes) in treasury bonds as a contingency reserve. The Trust Fund Ratio (TFR) is the ratio of assets at the beginning of the year to the estimated expenditures for the year multiplied by 100.. If at the beginning of the year the assets were $200 and the expected expenditures are 100, the TFR would be 200. After the investment of the 150 percent of the expected expenditure, the remaining assets would be invested in corporate stocks and bonds. Table 3 shows the application of this theory to the long-range OASI projections by the Office of Chief Actuary using the current program without the investment of the balance in corporate stocks and bonds. At the beginning of the year 2005, trust fund assets would be 1501 billion with a TFR of 341. Under the present system of investing the trust funds solely in government securities without diversification, the Chief Actuary of Social Security projects that in 2043 there would be a balance of $83 billion with a TFR of 2. In the year 2044, bankruptcy is projected. The Office of Chief Actuary estimated that the total income in 2043 is expected to be $2,746 billion and total expenditures are projected to be $3,686 billion for a deficit of $940 billion (Office of the chief Actuary, Social Security Administration, March 28, 2005, Tables 8.3-8.4). Under the current system (Table 3), The OASI fund is invested only in government and the system would be bankrupt after 2043.
     Table 4 shows what would happen when the OASI is invested in corporate stocks and bonds. For this purpose, the table sets aside the 150 percent of the annual expenditures in government securities at 5.8 percent return and 75 percent of the balance would be invested in corporate bonds at 8 percent and 25 percent in stocks at 12 percent yielding an average rate of return of 9 percent. This results in $5785 billion in assets in 2018 and a TFR of 469. The numbers under the old system were $4483 billion and a TFR of 459. The fund would be exhausted at the end of 2043. In Table 4, the fund would have assets of $18,607 and a TFR of 505.
     The results of Table 5 which uses the same set aside but uses a 50 percent in corporate stocks at 12 percent and 50 percent in corporate bonds at 8 percent. This combination would yield assets in 2043 of $30,529 billion and a TFR of 828. (Office of the Chief Actuary, Social Security Administration, March 25, 2005, Table 8.3-8.4)
     We will focus on Table 4 because it is the most conservative projection but also solves the long term solvency of the program. After setting aside, the 150 percent of the annual expected expenditures in treasury bonds, the authors would invest the balance in corporate bonds at 8 percent and 25 percent of the balance in corporate stock at 12 percent yielding an average rate of return of 9 percent. In every year after 2005, the TFR would be increased. In 2010, the TFR would be increased from 437 under the old program to 480 under our plan. In 2043, The old plan would show assets at $83 billion and a TFR of 2, while under our plan the assets would be $18,607 billion and the TFR would be 505.
VI Conclusion
     Earlier in this paper we referred the readers to an article published in the Journal of Financial Services in September 2005. In this article there was evidence that there were gains from expanding the social security assets to include corporate bonds and corporate stocks. Robert Ball, a former commissioner of Social Security, argues that almost all public and private pension plans invest in stocks and bonds, and Social Security beneficiaries should share the same advantage as other plan participants. He states:

Improving investment return for Social Security would not only help eliminate its projected deficit but would also improve the benefit/contribution ratio for younger workers and future generations. If the problem presented for solution is not solely the elimination of the long-range deficit but also the improvement in the Social Security rate of return for young workers, there is an additional important reason for interest in direct equity investment (Ball, 1995)

Ball supports the need for changes in Social Security. He argues that:

we need the basic security that social security uniquely supplies regardless of downsizing, mergers, bankruptcies, the volatility of the job market and the uncertainty of individual investments. Social Security as presently constituted clearly meets the test of what Lincoln described as the legitimate objective of government: to do for a community of people whatever they need to have done but cannot do so well for themselves in their separate and individual capacities. Compulsory individual saving plans do not meet this test. (Ball, 1998, p. 172)

     Robert Myers, a former Chief Actuary of Social Security, argues that the basic structure of OASI should be preserved with necessary adjustments to restore the financial integrity of the program. Myers believes that a privatization of the OASI would lead to the loss of political support for the system by higher income persons and that the “…very praiseworthy sharing of the economic security risk in connection with retirement income need among persons of all income levels will no longer be present. With reference to such partial privatization of the social security, the old statement that oil and water do not mix still holds true” (Myers, p.44). He believes that privatization would destroy social security.
     Our paper provides evidence that the gains from diversifying some portion of the OASI funds into a portfolio of stocks and bonds persists regardless of portfolio mix and variations in the expected rate of return. In addition, the diversification could improve future benefits for recipients and would eliminate the current anticipated deficit, postponing the exhaustion of funds even under the most unfavorable conditions.
     Furthermore, the findings of this paper demonstrate that the diversification of the OASI trust funds by investing in stocks and corporate bonds would guarantee in financial integrity much longer than currently projected and eliminate the projected exhaustion of its trust fund in 2043. The proposed diversification of the OASI trust fund could set a contingency reserve equal to a conservative 150% of the trust fund ratio, invested as usual in government securities. The diversification of the OASI trust fund surplus in a 40/60 mix between bonds and stock would most likely eliminate the projected deficit and would probably lead to higher rates of return for future beneficiaries, except in the extreme case of a significant decline in interest rates over a prolonged period of time.
     The authors share the former Chief Actuary of Social Security Robert Myers’ view that the basic structure of the OASI program should be preserved with the necessary adjustments to restore the fiscal integrity of the program. The Social Security program and the goals of providing economic security and independence have effectively served workers for over seventy years. We believe that there is no immediate crisis, but there is a need for a thoughtful review of the system and we offer our plan for your consideration.

References

Aaron, Henry J. and Robert Reischauer. Countdown to Reform: The Great Social Security Debate.
       New York. The Century Foundation Press, 1998.
Andrews, Edmund L. “Most G.O.P. Plans to Remake Social Security Involve Deep Cuts to Tomorrow’s Retirees.”
       The New York Times, December 14, 2004, p. A22.
Ball, Robert M., “Five Easy Steps: Making Sure the System Endures,” AARP Bulletin (June 1995) p.18
Ball, Robert M. and Thomas N. Bethell, Straight Talk About Social Security,” New York: the Century
       Foundation Press, 1998
“Bad Faith on Social Security” New York Times Editorial/Letters, p. A14, February 10, 2007.
Bush, President George W., “The Text of the President Bush’s State of the Union,” as printed in the
       New York Times, February 3, 2005, p.A22-23.
Congressional Budget Office, “Congressional Budget Office Projection,.” January 2005.
Financial Times, November 28, 2005.
Manley, John, Eleni Mariola, and Charles O’Donnell, “The Impact of Diversification on the Future of the
       U.S. Social Security Program,” Journal of Financial Service Professionals, September 2005,
       Vol. 59, No. 5, pp. 42-49.
Meyers, Robert. “Is the Only Way to Save Social Security to Destroy It?” Benefits Quarterly,
       Third Edition, 1997, Volume 13, Number 3, pp. 40-46..
O’Donnell, Charles F. John Manley, Eleni Mariola, and Joseph Ford, “The Diversification of the Old-Age
       and Survivors Trust Fund,” National Social Science Journal, 22 (2004) p. 93-101
Porter, Eduardo. “A Democrat on Bush’s Social Security Team.” The New York Times, April 30, 2005, pp. A10.
President Bush’s Plan, Q & A: A Plan for Social Security” The New York Times, February 3, 2005, pp. A24.
Rosenbaum, David E. and Robin Tores, “Introducing Private Investments to the Safety Net,”
       The New York Times, February 3, 2005, pp. A1, A24.
The Office of the Chief Actuary, “Long-Range OASI Projections.” Social Security Administration,
       March 28, 2005, Tables 8.3-8.4
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       Washington, U.S. Printing Office, 1997.
“The Robert C. Pozen Plan: Tradeoffs in Social Security,” The New York Times, December 14, 2004, p. A22.
U.S. Congressional Budget Office, “Updated Long-Term Projections for Social Security,” January 2005.

Table 1
Long-Range OASI Projections

• 2018 would be the first year that outgo exceeds income from taxes.
• 2028 would be the first year outgo exceeds income from taxes and interest earnings.
• 2043 would be the first year outgo exceeds income from taxes interest earnings and a portion of the trust funds.
• The trust fund would be exhausted in 2043. At the beginning of 2043, the trust fund balance is projected to be $83 billion and the TFR would be 2. The total income for the year is expected to be $2,746 billion and total expenditures are projected to be $3,686 billion for a deficit of $940 billion.

Source: Office of the Chief Actuary, Social Security Administration, March 28, 2005, Tables 8.3 –8.4.

Table 2
Congressional Budget Office Projections

• 2020 is the first year outflow exceeds income from taxes.
• 2052 is the year the trust fund would be exhausted.
• After this, Social Security spending cannot exceed annual revenues. As a consequence, because dedicated revenues are projected to equal 78 percent of scheduled outlays in 2053, the CBO finds that benefits paid would be 22 percent lower than the scheduled benefits.

Source: Congressional Budget Office, January 2005.

Table 3
Long-Range OASI Projections

Funds will be exhausted by end of 2043: Total Income $ 2,746 billion, Total Outgo $3,686 billion.

Source: Office of the Chief Actuary, Social Security Administration, March 28, 2005, Tables 8.3 –8.4.

Note: The TFR is the trust fund ratio is the ratio of assets at the beginning of the year to the estimated expenditures for the year multiplied by 100. If at the beginning of the year the assets were $200 and the expected expenditures are $100, the TFR would be 200.

Table 4
Long-Range OASI Projections
with Investments in Stocks and Corporate Bonds

Source: Office of the Chief Actuary, Social Security Administration, March 28, 2005. Table 4 is calculated projections by the authors.

Table 2 Assumptions: After setting aside the 150 percent of the annual expenditure in government securities at 5.8 percent, 75 percent of the balance would be invested in corporate bonds at 8 percent and 25 percent in stocks at 12 percent yielding an average rate of return of 9 percent.

Table 5
Long-Range OASI Projections
with Investments in Stocks and Corporate Bonds

Source: Office of the Chief Actuary, Social Security Administration, March 25, 2008, Tables 8.3 –8.4. Calculated projections are by the authors.

Table 5 Assumptions: After setting aside the 150 percent of the annual expenditure in government securities at 5.8 percent, 50 percent of the balance would be invested in corporate bonds at 8 percent and 50 percent in stocks at 12 percent yielding an average rate of return of 10 percent.