by Robert J. Kleine, Vice President and Senior Economist
|This Advisor discusses the implications of various proposals allowing the investment of Social Security Trust Fund monies in the stock market.|
Advisory Panel Report
A 3-member federal advisory panel on Social Security recently issued a long-anticipated report. Although the panel did not recommend bold changes to save the Social Security system, if indeed it needs saving, all members agreed that some portion of the Social Security Trust Fund (SSTF) monies should be invested in the stock market—most likely in a broad-based market index of stocks. The panel was sharply divided, however, on whether investing in the stock market is necessary to save the system and on who should be responsible for managing investments, the individual or the government.
Six members support a plan that would allow the government to invest some Social Security monies in the stock market. The government would be responsible for making up any funding shortfall caused by weak stock market performance. Because the SSTF surplus is now being used to finance current federal programs, this plan would require an increase in government borrowing. Five members favor allowing individuals to invest a portion of their tax payments in stocks and bonds of their choice as is currently done with 401(k) plans. This option would divert into Personal Savings Accounts 5 percentage points of the 12.4 percent payroll tax paid by workers age 54 and younger and their employers. Two members favor a hybrid approach that would raise Social Security taxes by 1.6 percent and require that this money be invested in stock or bond funds approved by the federal government, similar to the way deferred compensation plans are currently managed by governments.
The SSTF currently has a surplus of $550 million (revenue in excess of benefits), and the forecast is that it will increase to $2.8 trillion by the year 2018. With the baby boomers beginning to retire in 2009, however, the surplus will be depleted by 2029 and revenue will cover only three-fourths of benefit costs thereafter. If action is delayed for a number of years, this will become a very serious problem, but if steps are taken soon, only modest adjustments will be needed to correct the problem. This view was reflected by former Social Security Commissioner (and panel member) Robert Ball: “. . . to maintain its long-term health, it requires only a series of modest adjustments to revenues and expenses.”
The exhibit on page 2 shows several measures of projected annual Social Security balances. Note that after running annual surpluses through 2015 (1996 dollars), the annual deficit is $106 billion in 2025 and rises to $421 billion in 2070, which is equal to 2.1 percent of gross domestic product or 5.7 percent of wages subject to the Social Security payroll tax.
Although there is widespread concern among the public about the future of Social Security, no sense of urgency exists among panel members. According to Horace Deets, executive director of the American Association of Retired Persons (AARP), “Social Security is not in crisis. There is no reason to rush reform proposals that would undermine stability of the program.” (The AARP is one of the most powerful lobbying groups in the nation, and without its support, it is unlikely that any changes can be made.) In fact, an increase of 2.2 percentage points in the payroll tax would ensure solvency to at least 2070. This is not an insignificant increase, but neither does it suggest a major crisis.
One way to ensure the financial health of Social Security without increasing taxes is to raise the rate of return on its investments. Currently, all Social Security taxes are invested in federal government securities. The SSTF’s real rate of return has been 2.3 percent, while the stock market’s return, historically, has been 7 percent and even higher in recent years. An increase of even one percent in the rate of return would have a tremendous effect on the SSTF, ensuring its solvency well beyond 2029. Of course, one of the reasons for the focus on the stock market is its recent strong and unprecedented performance. It is unlikely there would be much interest in investing SSTF monies in the stock market if we were in the middle of a 1970’s-style bear market.
The potential for a stock market slump is a concern of some panel members, particularly if individuals are allowed to manage their own investments. What happens if there is a long-term bear market? About 50 percent of U.S. workers have no pension plan and thus need a guaranteed income plan. According to Horace Deets, channeling a portion of payroll taxes into IRA-type investments would be “especially risky for poor and middle-income elderly who rely on Social Security as their main source of income.” He also expressed another concern shared by several members of the panel: These families “would have significantly less to invest than wealthy investors, would pay more in administrative fees, and would be less able to protect themselves against downturns in the market.”
The reaction from the president and Congress to the panel’s report has been one of cautious interest. Rep. Gerald Solomon, however, already has introduced a bill to let the government make stock market investments, but don’t look for quick action on this bill.
Any plan to invest Social Security monies in the stock market could have significant effects on the economy.
- First, the large influx of money could exert upward pressure on stock prices just as 401(k) and other pension fund monies have done in recent years. In 2015, SSTF stock holdings would range from an estimated $600 million to $2.1 trillion (1996 dollars), equivalent to 5–15 percent of the total market value of stocks. In comparison, assets of 401(k) plans quadrupled to $385 billion from 1984 to 1990 and had reached $525 billion in 1994. Over the longer term, however, the value of stocks would continue to be driven by corporate earnings and economic conditions.
A huge run-up in values due to a large influx of funds could set up the market for a huge correction if there is an “excess of exuberance,” in the words of Alan Greenspan.
- Second, the plan to divert current revenue from U.S. Treasury securities to the stock market would increase the need for government borrowing and drive up interest rates, at least in the short term. Higher interest rates would dampen economic growth, thereby reducing Social Security tax collections.
- Third, the plan to allow individuals to invest a portion of current payroll taxes in the stock market would have significant transition costs because the diversion of these revenues would leave insufficient funds to pay the benefits of workers who retire during the next 30 years. A payroll tax increase of 1.5 percent and borrowing of $2.4 trillion (1996 dollars) by 2020 would be required to keep Social Security solvent. Higher interest rates due to increased government borrowing and the tax increase would slow economic growth.
- Fourth, the only plan that would increase savings and investment is the one that would raise Social Security taxes and require that the money be invested in the stock market (as well as fixed-income investments). In essence, this would be a forced savings plan— taxpayers would be forced to save for their future pension needs, presumably for their own good. The strength of this plan is that increased savings and investment lead to higher productivity (through investments in new plants, equipment, and technology), which produces a higher standard of living and higher incomes that, in turn, generate higher Social Security tax collections.
- One final concern about investing Social Security monies in the stock market is the potential effect on government decision-making. Government decisions already affect the market, and the market affects government decisions. But if the government is investing directly in the stock market and workers’ pensions are dependent on the market’s performance, policymakers will be pressured to make decisions based largely on the potential effect on the market. For example, do you send troops to Bosnia if it will cause stock prices to fall, which will be reflected on the quarterly statements of workers’ “Personal Security Accounts”? If you take the long view, you may not be concerned, but most political decisions are based on the short view.
We are disappointed that the panel did not reach consensus on more specific proposals. They did agree on what not to do: A tax increase is not needed, at least in the short term, and Congress should not dictate changes in the Consumer Price Index, suggesting that any necessary changes in the index be left to the Bureau of Labor Statistics (BLS).
We believe the panel should have recommended phasing out the income cap on Social Security taxes, which is $65,400 for 1997. This cap and the flat rate make this tax one of the most regressive. We also believe the panel should have given stronger consideration to changing the annual cost of living adjustment to the Consumer Price Index minus 0.5 percent. It is unlikely that any changes by the BLS will fully adjust for the upward bias of the index.
Finally, we strongly support the recommendation to invest some portion of Social Security monies in the stock market. Our preference would be for a plan that allows, say, 25–50 percent of current taxes to be invested in mutual funds approved by the federal government but managed by the individual. We are concerned, however, about the transition costs of such a plan as discussed earlier. Because of this cost, the only practical approach might be to simply allow the government to invest some portion of Social Security monies in the stock market. We also like the idea of raising Social Security taxes and investing these funds in the stock market because of the positive effects it would have on savings and investment and because it would not divert funds needed to pay current to future obligations, but we have little hope that Congress would ever approve such a plan given its desire to reduce taxes not raise them.
One final point that should be made is that the retirement portion of the Social Security system is in no danger of going bankrupt. Medicare is another problem, and it will have to be dealt with separately. The fact that more young people believe in UFOs than believe they will receive Social Security benefits is a clear indication that much of the public has a limited understanding of the Social Security system. Some changes are needed to ensure long-term solvency, but they do not have to be draconian and are politically achievable.