The Heritage Foundation

Executive Summary #1240es on Social Security

December 23, 1998

December 23, 1998 | Executive Summary on Social Security

Executive Summary: Why the Government Should Not Invest Americans' Social Security Money

Over the next 75 years, the Social Security program will face a cash shortfall of more than $20 trillion (in 1998 dollars). If no changes are made in the program's design, bringing Social Security into balance will require a 54-percent increase in payroll tax rates, a 33-percent reduction in benefits, a big hike in the retirement age, or a combination of the three. Yet tax increases and benefit reductions would serve only to exacerbate Social Security's other crisis--its poor rate of return--and make it an even worse deal for American workers. Forcing them to pay more to receive even less hardly represents fair and compassionate public policy.

Faced with this dilemma, many policymakers in Washington are considering a shift from the current "pay-as-you-go" program to a pre-funded system based on private investment. Although this is the correct approach, it is important to make sure that the political process does not hijack the pre-funded system by creating a plan that allows politicians or their appointees to steer investments to politically favorable businesses or to their cronies. As former Clinton Administration Treasury Department official Alicia Munnell warns, a lower return on pension fund investments eventually will require either increased contributions or lower benefit payments to workers.

Federal Reserve Board Chairman Alan Greenspan testified before Congress in July that government-controlled investment approaches pose "very far-reaching potential dangers for the free American economy and the free American society." There are four broad concerns about government-controlled investment:

Concern #1: Government-controlled investing would mean partial nationalization of major businesses, which would allow politicians to have direct involvement in the economy.

Concern #2: Government-controlled investing invites crony capitalism--industrial policy that allows politicians to control the economy indirectly by attempting to pick winners and losers.

Concern #3: Government-controlled investing opens the door to corruption by allowing politicians to steer funds toward well-connected interest groups or campaign contributors.

Concern #4: Government-controlled investing invites "politically correct" decisions because politicians could forego sound investments in unpopular industries (such as tobacco) to steer money toward feel-good causes that are likely to lose money.

To ascertain the risks of allowing government-controlled investing in a reformed Social Security system, analysts have compared the performance of so-called economically targeted investments (ETIs) made by state pension funds with that of traditional investments. John R. Nofsinger of
Marquette University, for example, finds that such policies reduce average annual returns by more than 1.5 percent annually. Others have determined that these investments have returns that average between 1.0 percent and 2.5 percent below those of funds that operate in the best interest of workers.

Consider these notable government employee pension fund miscues:

  • The Missouri State Employees' Retirement System venture capital fund for new businesses was shut down after three years following poor returns and two lawsuits.

  • Pennsylvania school teachers and state employees saw $70 million of their fund invested in a new plant for Volkswagen. Since then, the investment lost more than half its value.

  • Illinois transferred $21 million of workers' money to the state's general budget.

  • The Kansas Public Employees' Retirement System lost $65 million by investing in a state-based Home Savings Association and $14 million by investing in Tallgrass Technologies, and it squandered nearly $8 million in a steel plant. Total losses of workers' money from these ETIs will be between $138 million and $236 million.

  • New York State and City pension funds were pressured in 1975 into buying bonds to avert New York City's bankruptcy, and, in 1976, into buying bonds to bail out four state agencies.

  • The Connecticut State Trust Fund poured $25 million of workers' money into Colt Manufacturing, a local company that went bankrupt three years later.

  • A California state pension system offered $1.6 billion of workers' money to help to balance the state's budget in 1991.

  • The state of Minnesota lost $2 million of workers' money by dumping tobacco stocks.

  • An independent study estimates that non-economic investing by government-controlled pension funds resulted in more than $28 billion in losses between 1985 and 1989.

Because the Social Security system is actuarially bankrupt and will not be able to meet its future obligations, policymakers of all stripes are considering harnessing the power of private investment and compound interest to build retirement security for Americans.

The safest way to protect the money of American workers for their future retirement is to allow them to have a portion of their Social Security payroll taxes invested by professionals from the financial services industry. Not only do these professionals have the knowledge and the incentive to invest the money wisely, they also are legally obligated to act in the best interests of the workers in their fund.

--Daniel J. Mitchell is McKenna Senior Fellow in Political Economy for the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation

About the Author

Daniel J. Mitchell, Ph.D. McKenna Senior Fellow in Political Economy

Related Issues: Social Security