Social Security reform must ensure that every
American worker can retire with more to show after a lifetime of
work than just memories and a small monthly check from the
government. The best way to do this is to enable all workers, at
every income level, to invest a portion of their existing Social
Security taxes in an account they personally own. That way, they
could benefit from America's dynamic economic growth while building
a retirement nest egg.
However, making the decision to create a
Social Security system that includes personal retirement accounts
is only the first step toward improving Americans' retirement
security. Congress, of course, will have to determine how these
accounts should be structured and regulated. More than anything
else, such decisions will determine whether personal retirement
accounts reach their full potential.
Personal retirement accounts already have
an impressive track record. In a number of countries across the
globe, they are helping people to increase their retirement incomes
while at the same time greatly reducing the cost of the
government-funded system.
The Practical Advantages of Personal
Retirement Accounts.
In addition to restoring fiscal stability to Social Security,
personal retirement accounts would permit workers of all income
levels to participate fully in the growth of the U.S. economy. Over
the 12 months ending on September 2, 1999, Standard & Poor's
S&P 500 stock index went up 34.3 percent. The NASDAQ
composite stock index went up 74 percent. Corporate bonds, as
measured by the Merrill Lynch Corporate Bond index, yield 7.5
percent a year, and the
government's Series I United States Savings Bonds yield 5.05
percent.
A
look at the historical data, including data for years in which
investments performed very poorly as well as those in which they
performed well, shows that stocks average a real return (after
inflation) of 7 percent annually. But Social Security, on which
many low-to-moderate-income workers will rely for much of their
retirement benefits, has average annual real returns of only about
1.2 percent.
Translated into dollars, this means that a
typical family of four, with two working parents, will have
$525,000 less saved up for retirement under the current system than
if they had been able to invest their Social Security retirement
taxes in a personal retirement account.
Criteria for Success or Failure. A growing
number of legislators from both parties have introduced plans that
would allow workers to divert some or all of their Social Security
retirement taxes into some form of personal retirement account. In
recognizing the importance of allowing Americans to increase the
rate of return on the portion of Social Security taxes that funds
their retirement benefits, these plans take a major step toward
increasing retirement security for working Americans and their
families.
However, the success or failure of any
plan that would establish personal retirement accounts will depend
largely on three key decisions:
WHERE WOULD THE MONEY COME FROM?
There are only two realistic sources for
the funds that would go into a Social Security personal retirement
account that is part of Social Security. Essentially, the money
could come from the existing Social Security taxes that an
individual already pays or from new taxes.
Some
lawmakers propose introducing new taxes or earmarking revenue from
the expected budget surpluses to fund the new accounts. These are usually
called "add-on" accounts because the money that goes into them is
in addition to the taxes an individual already pays to Social
Security. Although this method would improve a worker's retirement
income, it means higher taxes and would do nothing to improve an
individual's rate of return on Social Security taxes.
The
alternative is to fund the account with money that has been "carved
out" or diverted from the taxes that now pay for Social Security
retirement benefits. This method would
reduce the income to the Social Security trust fund and take a
significant step toward tackling insolvency even sooner; it also
would make Social Security a much better deal for most Americans.
In addition, diverting part of the existing Social Security tax
would provide a much more stable source of funding that does not
depend on the accuracy of economic forecasts or the ability of
Congress to restrain its spending habits.
Some
legislators have proposed that another alternative might be a
system of voluntary personal retirement accounts that would be a
part of Social Security. In effect, workers
would be allowed to save additional money in these accounts, but
the full amount of their Social Security taxes would still go to
the existing system.
This
approach is very unlikely to be successful. Social Security taxes
are so high that they eliminate the possibility of additional
savings for millions of workers. Faced with the need to pay this
month's mortgage or the children's medical bills, these workers
understandably would choose to meet immediate needs rather than to
save for an event far in the future. Thus, while some Americans
might be able to benefit somewhat from voluntary accounts if they
increased their total savings, most of them either are already
saving this money through an existing investment plan or do not
have the after-tax income to open a retirement account.
How Would Accounts Be Funded?
Add-on Accounts.
A personal retirement account that would be funded by new taxes or
revenues from the budget surplus is called an "add-on" account.
These accounts are not funded by diverting a portion of the
existing tax that pays for Social Security retirement benefits.
Both President Bill Clinton's Universal Savings Account (USA)
proposal, which the White House says will be financed from the
budget surplus, and the Social
Security Guarantee Account plan proposed by House Ways and Means
Committee Chairman Bill Archer (R-TX) and Social Security
Subcommittee Chairman Clay Shaw (R-FL), are types of add-on
accounts.
Although the White House often mentions
the USA plan in discussions of Social Security reform, there
actually is no connection between these accounts and Social
Security. Any amounts accumulated in them would be in addition to
Social Security benefits. On the other hand, the accounts contained
in the Archer-Shaw proposal would, in almost every case, end up
financing a major part of the Social Security benefits that a
worker would have received anyway.
Problem #1: Lower Rate of Return.
The major objection to add-on accounts is that they do nothing
to improve Social Security's poor rate of return and could make the
system an even worse deal. In addition to
paying his or her share of the existing 10.6 percent Social
Security retirement tax, a worker would have to pay enough federal
tax to fund the add-on account. A personal retirement account
funded with an amount equal to 2 percent of a worker's income, such
as that contained in the Archer-Shaw plan, would result in a total
tax burden equal to about 12.6 percent of income.
In
the President's plan at least, the account that is funded by this
extra tax could be expected to raise the worker's retirement
income. But under the Archer-Shaw plan there is almost no way for
an individual to change his or her retirement income unless the
investments in the account do spectacularly well. This is because
Archer-Shaw guarantees that workers will receive their full Social
Security benefits under all circumstances. At the same time, the
individual accounts that are established by this plan are
structured so that it would be very difficult for them to
accumulate enough to increase the worker's retirement benefit
without a high-risk investment strategy. If workers' investments
did not pan out, the government would pay the same retirement
benefit that it would have paid if the accounts had not existed in
the first place, even though
workers would have to pay higher taxes--reducing their rate of
return even more.
Problem #2: Unstable Source of
Funding.
Another major question about add-on accounts is whether there is a
stable source of funding if the money that goes into them comes out
of the expected surplus. Former Congressional Budget Office (CBO)
Director June O'Neill has warned that the era of budget surpluses
could be fairly short, and any long-term
economic forecast is volatile. In August 1998, the CBO projected
the aggregate surplus for fiscal years 1999 through 2008 to be
$1.54 trillion. Just a few months
later, in January 1999, the aggregate projections for the same
period were increased 72 percent to $2.65 trillion. Over the next few
years, these forecasts could just as easily drop--a not
unreasonable prediction in light of Congress's propensity to
spend.
When
the inevitable economic slowdown hits, deficits are very likely to
return. At that point, Congress will have only two options. It can
either end federal contributions to these add-on accounts or
convert them into another expensive entitlement program.
The
retirement security of American workers is far too important to
base on hopes for a future surplus. While it might make sense to
start funding USA accounts with the surplus, Congress should then
shift to funding them with a proportion of the existing taxes that
workers already pay to Social Security. That way, once the
surpluses end, these accounts could continue to grow and, with
them, the retirement incomes of American workers.
Carve-out Accounts.
The other alternative is to fund an individual Social Security
account by diverting, or "carving out," some portion of the 10.6
percent of income (including the part that an employer pays on
behalf of the employee) that Americans now pay for Social Security
retirement benefits. In the legislation introduced by
Representatives Jim Kolbe (R-AZ) and Charles Stenholm (D-TX), and that
introduced by Senators Judd Gregg (R-NH) and John Breaux (D-LA), 8.6 percent of
income continues to go to Social Security, while an amount equal to
2 percent of income funds a personal retirement account.
In
these and similar proposals, the individual worker would own and
receive the full benefits from any money accumulated in the
personal retirement account. The funding of a carve-out is stable
since it uses existing payroll taxes. And because it uses taxes
already being paid by workers, any person paying Social Security
taxes could afford an account.
Challenge #1: Funding Benefits for
Current Retirees.
A carve-out proposal, however, must deal immediately with the
fact that under a pay-as-you-go retirement system, today's Social
Security retirement taxes pay mainly for benefits to current
retirees. Thus, any money that goes into an individual Social
Security account will not be available to fund today's benefits.
This is not a critical problem when Social Security is running a
surplus, as it is now, but a carve-out would cause the surpluses to
end sooner and increase the program's deficit for a time once they
began.
Challenge #2: Avoiding
"Double-Dipping."
As a result, Americans who choose to divert part of their
payroll tax into a personal retirement account should not be
permitted to "double-dip." In other words, they should trade part
of their traditional Social Security benefits in return for the
higher earnings of a personal account. One way to accomplish this
would be to require these workers to give up the proportion that is
equal to the amount of tax diverted. Thus, if 20 percent of a
worker's Social Security retirement taxes (an amount equal to about
2.0 percent of income) was diverted into a personal retirement
account, that worker's monthly Social Security check would be
reduced by 20 percent.
HOW WOULD ACCOUNTS BE STRUCTURED?
The
most important decision that must be made about any Social Security
reform plan that includes personal retirement accounts is how the
investment choices are structured and regulated.
A simple system would give workers the ability to choose from a
limited number of investment choices while also allowing them to
choose a qualified firm to manage those investments.
Limiting Investment Options
There is a good case to be made for
initially offering only about three low-cost investment options in
order to reduce administrative costs and potential investor
confusion. This approach was used successfully in the early days of
401(k) account plans for much the same reason, and as time went on,
additional investments and services were added. For reasons that
will be seen below, these initial investment options should include
a broad-based stock index fund, a corporate bond index fund, and
some sort of government bond fund, perhaps using the new
inflation-indexed Series I U.S. Savings Bonds.
Reducing Administrative Costs.
Initially limiting the number of investment options would have
two advantages. First, studies have shown that administrative costs
are directly related to the complexity of the account and to the
level of services offered. Stock index funds,
which are computer traded, have extremely low administrative costs.
This is also true for corporate bond index funds. Overall, an
account that offers only a few simple investment options, one of
which is a stock index fund, will provide the best trade-off
between potential returns and low administrative costs. A recent
study by State Street Trust shows that personal retirement accounts
could be offered for an annual administrative cost of 0.5 percent
of assets or less.
Reducing Risk.
Second, limiting the number of investment options reduces
risk. Your brother-in-law's hot stock tip is not usually the best
road to retirement security. An index fund would give the returns
associated with the equity markets without the hazard and expense
of picking individual stocks. Regardless of which investment
manager is offering a product, equity funds tied to a specific
stock index are very similar. Studies show that while individual
stocks tend to have wide swings in value, long-term investments
that track the growth of the overall stock market have very little
risk. Studies by Ibbotson Associates, a noted stock market research
company, show that the overall stock market has increased in value
over every possible 20-consecutive-year period since 1926.
Learning to Invest.
Limiting the number of investment choices would also allow people
who are not currently managing their own money to learn gradually
to invest. Since any of the three basic options would earn
substantially more than the current Social Security system does,
any choice would improve their retirement incomes. Those workers
who fail to choose an investment option would go into a default
portfolio made up of 50 percent stock index funds and 50 percent
Series I U.S. Savings Bonds. This would provide Americans of all
ages a mixture of higher investment returns and greater
security.
While the small number of investment
choices available at the program's start may be frustrating to more
sophisticated investors, as the personal retirement account system
matures, additional investment options and services could be made
available without a substantial increase in administrative costs.
This was the case with 401(k) retirement accounts. As the system
developed, investment managers increased both the level of service
and the number of investment options that were available to plan
members. More recently, the law that established the Thrift Savings
Plan for federal workers was amended to increase the number of
investment options from three to five. In the case of personal
retirement accounts, additional investment options should be made
available as soon as cost factors warrant.
Allowing a Choice of Investment
Managers
Over
time, these retirement savings accounts no doubt would attract
hundreds of billions of dollars worth of savings and retained
earnings. This pool of money would almost certainly be too large to
be managed by any one investment manager. For that reason, rather
than having everyone invest in one big stock index fund, as is
currently the practice in the federal Thrift Savings Plan, it would
be better to allow individuals to purchase their stock or bond
index funds from an approved list of investment managers. In the
event that the manager is unsatisfactory for any reason, account
owners should also be allowed to change managers at least
annually.
The
competition among investment managers--the large companies that
handle the investment of large pools of money such as mutual funds
and pension assets--would do more than any other factor to keep the
administrative costs of these accounts low. It would also encourage
the development of new products and services that could make
personal retirement accounts even more valuable to their
owners.
Reducing Political Interference.
In addition, allowing investors to make an individual choice
of investment managers would significantly reduce the probability
of political interference in investment decisions. Allowing a
government agency, no matter how it is structured, to invest Social
Security funds in equity markets sets up a situation in which the
long-term needs of future retirees are likely to be subordinated to
short-term political goals.
However, political influence is possible
even if stock investments were to be limited to index funds
containing 500 or more stocks. Index funds can be developed using
any criteria, and it would be extremely easy to develop, for
example, an index fund of 1,000 stocks that left out tobacco
companies, gun manufacturers, and other companies that had aroused
the ire of organized labor or were deemed to have a poor record on
the environment.
First Steps.
When the system is first launched, it might not be feasible to
allow each person to select his or her own investment manager.
Depending on how a Social Security system with personal retirement
accounts is structured, it could be necessary to allow smaller
accounts to build to a certain amount before they could be
transferred to a private investment manager. It might also take
some time to develop the actual mechanism to transfer both the
existing account and future contributions while still allowing both
to be tracked properly for regulatory purposes. However, these
delays should be temporary and should be overcome within a few
years.
Other countries have adopted such
approaches. In the United Kingdom, for instance, retirement taxes
are collected by the government and kept for a year in a government
bond fund while income data are being collected. Once it is clear
how much is due to each person, both the taxes and the accumulated
interest they have earned while they are in the bond fund are sent
to that individual's investment manager and credited to his or her
specific account.
A
method similar to this could be also used for personal retirement
accounts that are part of Social Security. This would have the
advantage of utilizing Social Security's existing method of
collecting individual income data while still allowing the greatest
number of private investment managers to be involved in the
investment process. The accounts of workers who fail to choose a
private investment manager could be apportioned among managers in
much the same way that many states assign high-risk motorists to
automobile insurance companies.
Protecting Consumers Against Fraud
Existing consumer protection laws should
be more than adequate to prevent the type of mis-selling problems
that hit the British Social Security system several years ago. The
United States has a long tradition of carefully regulating the way
that investments can be sold to consumers, something the British
lacked at the time. If it is required that all financial managers
be licensed and regulated, and if the types of investments that can
be offered to consumers are limited, this problem should not arise.
However, these existing laws should be strictly enforced, and
regulators should be ready to respond to any reports of fraud with
immediate prosecution and recommendations for ways to tighten
consumer protection laws.
HOW WOULD ACCOUNTS BE REGULATED?
The
long-term success or failure of personal retirement accounts would
depend in large part on how they are regulated. Regulation that is
too strict would prevent account owners from earning enough on
their investments for a better retirement income. It could also
discourage private management firms from participating in the
program.
On
the other hand, regulation that is too loose could result in
investment choices that are either too risky or otherwise
questionable for a retirement account. It could also result in
participation by under-capitalized or inexperienced investment
managers. Either overregulation or underregulation could cause the
program to fail.
At
the same time, all types of financial institutions should be
encouraged to set up offices or subsidiaries to manage personal
retirement accounts. This type of business should not be limited to
investment banks or any single group of financial intermediaries.
The American financial markets have become extremely efficient and
cost-effective because they constantly compete with each other, and
this rivalry should also work to the benefit of those who own these
retirement accounts.
Perhaps the most dangerous move would be
to create an entirely new regulator or to give the job to an
existing agency that has no real experience in regulating this type
of investment. In either case, the learning curve would be steep,
and either the program would be unnecessarily delayed or
potentially dangerous gaps in regulatory control could develop.
Additional problems would be created if the agency has a conflict
of interest. For instance, the Social Security Administration not
only has no experience in financial regulation, but also could be
tempted to hinder the development of a system that is in
competition with the existing system.
Criteria for Licensing Investment
Managers.
Only established investment managers who can meet several
strict, but objective, standards should be allowed to accept
retirement savings. This requirement would serve both to protect
investors and to reduce the possibility of political influence in
the licensing of those who could hold and invest personal
retirement accounts. Existing financial regulators have wide
experience in determining whether companies and individuals have
the ability and financial strength to compete successfully. This
knowledge can readily be adapted to the licensing of investment
managers.
In
order to protect both the individual account owner and the Social
Security system, potential investment managers should meet four
major standards:
-
Capital adequacy. The investment
manager should have sufficient capital invested in the firm to
ensure stability and the ability to survive market
fluctuations.
-
Professional expertise. Only
qualified and experienced professionals should be allowed to manage
these retirement savings accounts.
-
Disclosure of fees. All fees and
costs must be clearly disclosed in writing before any money is
accepted.
- Regular statements. All account
owners must receive regular statements in clear and simple language
that discloses the status of their accounts, including the amount
of contributions, the investment options chosen, the rate of return
for each investment option, and the exact amount of any fees that
were paid.
Investment managers should be examined
regularly to ensure that they continue to meet these qualifications
and any other rules that the individual regulator finds to be
necessary. In addition, there could be a requirement that the
principal (but not investment gains) would be covered against loss
by a private insurance policy to provide an additional level of
security and reduce the possibility that individuals will become
anxious because of temporary market dislocations. However, this
insurance would be payable only at retirement, and not triggered
because of market fluctuations.
Avoiding New Levels of
Regulation.
Financial regulation is extremely technical, and regulatory
agencies tend to lack the knowledge needed to fully understand
types of financial institutions beyond those that they regulate.
The daily activities of a bank, for instance, differ greatly from
those of an insurance company or a credit union. To date, no single
regulator has the type of detailed information necessary to
regulate every other type of financial entity.
As a
result, the wisest course could be for the primary regulator of the
financial institution owning the investment manager to handle the
regulation of personal retirement accounts. The imposition of yet
another regulator will only serve to increase the cost to the
account owner without adding any substantial benefit.
Thus, an investment managing service owned
by a securities firm would be regulated by the Securities and
Exchange Commission, while that owned by a national bank would be
regulated by the Office of the Comptroller of the Currency. This
would allow the regulator with the best knowledge of the day-to-day
activities of the investment manager to oversee personal retirement
accounts.
As
Congress shifts to a system of functional regulation, instead of
the existing system of regulating by type of firm regardless of
what types of activities the firm engages in, the regulation of
investment managers should be given to the SEC. However, until that
system is completely in place, consumers would benefit most by
using the existing regulators.
Avoiding Additional Layers of
Complexity.
Current financial law divides the responsibility for
regulating financial institutions according to type. However, the
complex network of financial regulators often overlaps, and in some
situations, any one of several different regulatory agencies could
regulate similar activities.
It
would make little sense to make this often confusing system even
more complex by adding another set of regulators. At the same time,
it will be important to ensure that all financial managers adhere
to the same set of regulations. Requiring a commercial bank that
manages personal retirement accounts to meet stricter standards
than an investment bank or brokerage house would place the
commercial bank at a competitive disadvantage.
Coordinating Regulatory Efforts.
In order to ensure that all types of financial institutions
have an equal opportunity to compete for these accounts, and to
ensure equal levels of consumer protection, regulators should
coordinate their activities. Back in the early 1980s, Congress
established the Depository Institutions Deregulation Council,
consisting of the major depository regulators, to ensure that the
different regulators followed the same set of basic rules. Rather
than create an entire new bureaucracy, each regulator assigned
staff to the council, and each regulator had an equal voice.
A
similar coordinating council should be established for personal
retirement account regulators. Its primary responsibility would be
to determine the basic structure of the regulations and to issue
them for public comment. Once a decision had been reached on key
regulatory issues, it would be up to the individual agencies to
issue the specific regulations that would affect the institutions
under their jurisdiction. However, these regulations would have to
meet the standards contained in the council's drafts. The specific
agencies would also be required to administer them in the same
manner.
Under normal circumstances, this council
would meet quarterly, but its staff could meet as often as
necessary. Its purpose would be to ensure that all types of
investment managing services, no matter which type of financial
institution owned them, would meet the same level of regulation.
While each agency would have the ability to adapt the regulations
to meet the specific circumstances of the entities under its
jurisdiction, none of them could adopt a looser standard than that
agreed upon by a supermajority of the overall council.
Even
if Congress changes the financial regulatory system, the need for a
coordinating council will remain. Although some financial
regulators could be combined at some point, there is little chance
that a single financial regulator will be created, and it is even
less certain that such a super-regulator would be desirable.
WHY THE SOCIAL SECURITY ADMINISTRATION
SHOULD NOT REGULATE PERSONAL RETIREMENT ACCOUNTS
While the Social Security Administration
(SSA) does an admirable job of calculating and delivering benefits
to millions of Americans, it has no experience whatever in
investing. The Department of the Treasury collects taxes for the
SSA, and the Bureau of the Public Debt turns any taxes that are not
immediately spent into special issue Treasury bonds. But at no
point does the SSA have substantive dealings with financial markets
or private-sector financial institutions.
Avoiding a Conflict of
Interest.
In fact, allowing the SSA to regulate personal retirement accounts
could create a conflict of interest. Allowing workers to choose
whether they wish to divert a portion of their Social Security
taxes into such an account or remain in the existing
SSA-administered version would place the two systems in competition
with each other. If the SSA had the ability to regulate personal
retirement accounts, it could be tempted to use its authority to
obstruct the development of these accounts with unnecessarily heavy
regulatory burdens.
As a
result, the SSA should have no role in regulating financial
institutions that manage personal retirement accounts. A massive
bureaucracy that can take years to determine eligibility for
disability claims simply does not have the expertise or ability to
understand the innovative and rapidly changing financial world. The
SSA could add nothing positive either to funds management or to
consumer protection, and it could do a great deal of damage by
misunderstanding the nature of the business.
There may be a good argument for requiring
investment managers to coordinate with the SSA when determining
benefits or recording contributions to personal retirement
accounts, but not for any other activity concerning them.
CONCLUSION
Personal retirement accounts could allow
every worker to participate fully in the growth of the American
economy. However, in order to take full advantage of this
opportunity, the accounts must be funded from a portion of the
existing taxes that go to pay for Social Security retirement
benefits. In addition, the structure and regulation of these
accounts will make the difference between improved retirement
income and unmet expectations.
The
importance of these decisions to the success or failure of Social
Security reform cannot be overstated. While reformers must also
concentrate on macroeconomic concerns such as the effect of reform
on economic growth, the seemingly mundane decisions about
regulators and investment choices will be crucial.
David C. John is Senior
Policy Analyst for Social Security at The Heritage Foundation. He
is the editor of Improving Retirement Security: A Handbook for
Reformers(The Heritage Foundation, 2000).
Endnotes