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Privatization may only add to Social Securities ills. And it won't come free of cost.
Michelle Celarier, CFO Magazine
December 1, 1997
You'd expect businesspeople, if not Alan Greenspan, to favor market-oriented solutions to social problems. So why do both the chairman of the Federal Reserve Board and the Committee for Economic Development (CED), a think tank closely aligned with such corporations as Merck & Co., Shell Oil Co., and Texaco Inc., oppose privatization of Social Security? After all, Wall Street, the Cato Institute, and other bastions of economic conservatism contend that privatization of Social Security is preferable to raising taxes just to plug the current system's financial hole. If nothing at all is done, bulging rolls of retired baby boomers will put the system in the red by the year 2029.
Neither Greenspan nor the CEOs of these three companies are nostalgic for New Dealstyle government programs. Rather, they fear that privatizing the system may harm the financial markets, despite Wall Street's assurances to the contrary. Privatization will "suck a lot of money out of the markets and raise the cost of capital," says Josh Weston, chairman of Automatic Data Processing Inc. (ADP) and of the research and policy committee of the CED. Even if that doesn't happen, corporate opponents worry that it will be vastly more costly to privatize the system than to fix the problem with the existing one, and that much of the additional cost would fall on their shoulders. If these foes of privatization are right, and if, as others suggest, fears over the system's solvency are over-blown in the first place, then this surely is one laissez- faire cure that's worse than the disease.
What could possibly be wrong with turning the government's safety net over to the markets? On the face of it, the idea seems appealing. Instead of paying the current Social Security tax, individuals would contribute a portion to their own individual savings accounts, which most likely would be invested largely in the equity market. Given its historically superior rate of return, that income, in one way or another, would offset the system's looming deficit.
What many proponents of privatization downplay, however, is the huge increase in costs that moving to a privatized system would entail--and the potentially devastating effect such a shift in policy could have on the financial markets. Instead of solving the government's financial problem, privatization could magnify it. "There's no free lunch," warns Dallas Salisbury, president and CEO of the Employee Benefit Research Institute (EBRI), a nonprofit organization in Washington, D.C., that has analyzed the many privatization proposals.
In the first place, in lieu of hefty payroll tax hikes, moving to a privatized system would require massive government borrowing-- somewhere between $4 trillion and $5 trillion, according to EBRI's analysis of several proposals being floated. To lure buyers for the trillions of dollars of new debt generated, the Fed might have to hike interest rates, which could spell an abrupt end to the bull market. Granted, if individuals poured a similar amount into equities, even higher interest rates might not keep prices from continuing their upward trek. But at some point, either rate shock or a withdrawal of money from the market as the baby boomers begin to retire, could set the stage for a devastating market downturn. Would the government then be required to raise taxes or borrow even more to keep the huge pool of retired baby boomers afloat?
"It could be a recipe for a crash," says Edward Gramlich, dean of the University of Michigan's School of Public Policy and chair of the White Houseappointed Quadrennial Advisory Council on Social Security. The council found the problem of fixing Social Security so politically contentious that it could not agree on one proposal, instead offering three earlier this year.
What prompts calls for overhaul is the system's inherent instability. As currently designed, Social Security is not an investment fund, in which workers contribute to their own retirement. Instead, it is a so-called pay-as- you-go system that redistributes wealth both intergenerationally and between classes.
That means that current workers are essentially writing the checks for those now retired. That is accomplished through a payroll tax, the costs of which are split between employee and employer. When looked at as an annualized investment return on what they have contributed over a lifetime of work, the poor receive the most--up to 75 percent-- whereas higher-income workers' returns are negligible.
Much of the fervor for privatization comes out of political opposition to the system's inherent income redistribution and a desire by higher-income workers for more retirement income. In fact, the demographic shift that has occurred with the baby boomers puts this kind of system in shock. "Pay-as-you-go works fine when you have a rapid growth in population and real wages. But all of a sudden, we have neither," explains Gramlich, who notes that returns for both rich and poor are falling. He has suggested a moderate approach that would mandate that a 1.6 percent increase in payroll contributions be put into government-sponsored savings accounts invested in market indexes. Although not really privatization, it would create a fully funded rather than a pay-as-you-go system. To achieve balance, Gramlich would also cut benefits for the wealthy and raise the retirement age. (Gramlich has since been nominated to the Federal Reserve Board by President Clinton.)
Although he believes the current system is flawed because of demographics, Gramlich counsels that there is no immediate crisis. With baby boomers in their peak earning years, Social Security is in current surplus on an annualized basis--at least theoretically. That surplus has been invested in special Treasury securities that the government counts against current spending. Indeed, the surplus is credited with being one of the factors that helped bring the deficit down from $200 billion to $37 billion over the past two years.
The surplus will be used up by 2012, at which point the government will be tapping into the interest, and by 2019 it will begin dipping into the assets. But the system itself won't be in deficit until the year 2029, according to the Social Security Administration's estimates. That's when the tax receipts from a smaller pool of workers won't be enough to pay the benefits for the burgeoning rolls of retirees.
This isn't Chile
The biggest kink in most of the privatization plans being considered is how to get from one system to another. After all, today's retired workers, or those nearing retirement, wouldn't be able to build up any investment income under a privatized system, so their benefits would still have to be paid by someone else. "Who pays for them?" asks ADP's Weston. "The government has to, and nobody really addressed that." All three of the proposals unveiled by the Advisory Council embrace some concept of privatization, if the definition includes investing in the markets. Yet all would finance the transition by raising taxes, or "mandating savings," as Gramlich prefers to call it.
Many privatization proponents point to the Chilean system as a model of successfully overcoming the transition problem. According to José Piñera, a Harvard-educated Chilean responsible for privatizing his country's system as its minister of labor and Social Security, Chile paid for the transition by issuing debt and reducing government waste.
But Chile's situation is vastly different from that of the United States. For one thing, a military dictatorship at the time of the transition, it did not have to worry about political resistance to the imposition of a 10- year surtax to pay down the debt.
Perhaps most significant, at the time it embarked on its program, Chile began running a huge government surplus, in part because it was able to privatize a huge portion of its previously nationalized industries. While the United States has no state-owned industries to auction off, that presents no problem to privatization's most vocal proponents. Jacobo Rodriguez, an associate of Piñera's at the Cato Institute, which promotes full-scale privatization, argues that the United States could sell off government-owned land to accomplish the same task.
While the government has started selling some assets, critics such as Salisbury say the government would be hard pressed to come up with the trillions of dollars necessary without a fundamental change in political values in the country.
How many voters really want to see the national parks sold off to mining companies or other developers? Even Advisory Council member Carolyn Weaver, an economist with the American Enterprise Institute, who, along with employee benefits adviser Sylvester Schieber, put forth the most radical of the three government plans, doesn't consider selling government assets. Weaver and Schieber suggested a 1.7 percent payroll tax increase and new debt of $2 trillion to finance the transition. Benefits would gradually be cut in half, and 5 percent of the total payroll tax would be directed to a privately managed savings account.
Yet even that much privatization is unacceptable to the CED. "To privatize partially or fully would require one generation to pay twice. That generation would have to fund its own retirement and pay for those already retired and in the system," says Bill Beeman, vice president and director of economic studies for the committee. "It's a huge amount," he notes, estimating the government would have to continue spending upwards of $400 billion a year to pay benefits to the current retirees, as well as to aging workers who would not be able to build up an adequate retirement fund.
The alternative to raising taxes high enough to pay off the transition debt is, of course, to borrow the money. The effect that would have on the bond markets is anyone's guess. But capital flows can't help but influence interest rates. James Bianco, research director at brokerage firm Arbor Research & Trading Group Inc., in Barrington, Illinois, predicts that long-term rates could skyrocket if the government were suddenly forced to issue debt on the magnitude of several hundred billion dollars a year. Bianco suggests that an increase of just $100 billion a year could easily translate into an additional "one or two" percentage points. And that's on an annual basis.
Impractical at best
It was this scenario that prompted the strongest opposition to the Schieber-Weaver privatization proposal among CED trustees. "Many of them are conservative, and they rejected it as totally impractical to go to full privatization," says Beeman. Notes Weston: "People get concerned when Alan Greenspan talks about raising interest rates by 25 basis points. If only 25 basis points can affect the economy, the kinds of demands on the bond market we're discussing would be much bigger." Greenspan himself has raised such concerns. In congressional testimony earlier this year, the Fed chairman said he could not support a plan that would raise the national debt by trillions of dollars.
Even so, many policymakers support some type of move toward market investments, because they believe that Social Security would become a better retirement system if a portion of the income were directed into the market. Sen. Bob Kerrey (DNeb.) is currently writing up legislation to change the system. His plan is to move two percentage points of the current payroll tax into a personal investment plan that would be directed by individuals but run by the Social Security Administration, a quasi- privatization scheme. (Gramlich says the Kerrey proposal "would not be politically attractive," because of the types of benefits cuts it involves.)
Clearly, a driving force behind the privatization vogue is the stock market's 20 percentplus returns over each of the past two years. Most market analysts know equity returns of the recent past aren't normal. Over the long run, of course, equities have nonetheless outperformed other investments. William Shipman, co-chairman of the Cato Project on Social Security Privatization and a principal with State Street Global Advisors, calculates that the stock market's real rate of return has averaged 7.6 percent from 1926 through 1996. Even those smaller returns seem good enough to shore up Social Security's dwindling fortunes. Barry Bosworth, an economist at the Brookings Institution, a nonprofit public policy research institute in Washington, D.C., likens the shift to going from a defined benefit pension plan to a defined contribution plan. "When markets are booming, people want defined contribution pension plans."
Given the demographic trends, the most crucial issue in the Social Security debate is whether the returns of the future will equal those of the past. Some analysts don't think it is likely. Dean Baker, of the Economic Policy Institute, a liberal think tank in Washington, D.C., says the Cato analysis of stock market returns troubles him because it projects returns for the future based on the past. "And the only reason why we are even raising questions about Social Security is that we are assuming the future will not be like the past."
How so? If the economy grew at 3.5 percent over the next 75 years, Baker notes, Social Security would be solvent. But the demographics don't augur such a rosy scenario. It is the rather pessimistic economic outlook of the Social Security Administration, which suggests that the United States economic growth will be less than 1.5 percent, that fuels the debate in the first place. If those numbers are accurate, and earnings and economic growth move in tandem, Baker estimates that price/earnings ratios would have to skyrocket for stocks to offer a 7 percent annual return. He calculates that by the year 2015, to get a 7 percent return, the P/E ratio for the universe of U.S. stocks valued by the Federal Reserve Board would have to rise to 35 to 1, and by 2070, it would have to be 480 to 1. Today, the P/E for that universe is about 20 to 1. If the Social Security Administration's estimate of growth holds true, Baker estimates that stock returns would likely decline to 4 percent annually over the next 75 years.
It is conceivable that outrageous P/E ratios could be achieved, at least temporarily, if workers continued to plow their Social Security investments into the stock market. Such a trend is already occurring, to some extent, with increasing mutual fund dominance of the equity markets. If Social Security assets were invested in markets, that trend would be exacerbated. Such assets could account on a yearly basis for more than the total of all mutual fund investments in the market today. During 1997, the taxable payroll subject to the Old Age, Survivors, and Disability Insurance Tax of 12.4 percent (half from employees, half from employers-- all of which goes to pay Social Security benefits) is estimated to be $3.2 trillion. Such an annual inflow, says William Cheney, chief economist for John Hancock Mutual Life Insurance Co., in Boston, represents "relentless net buying for the next 20 years."
Investor psychology has to be factored in, too. Bianco argues that such investors would increase the market's speculative fever because of the way people invest in mutual funds. "People don't buy stocks anymore; they buy the market. They've gotten away from buying stocks of firms that have good management; they buy market indexes, otherwise known as mutual funds." He believes that buying mutual funds "removes value from the equation. Can anyone say what the P/E of a mutual fund is, the price-to-cash-flow of an average stock, or even the manager's name?"
Too much of a good thing
As a result, even higher interest rates might not have much of an effect initially. Some believe it may actually take the baby boomers' retirement to move the markets back to reality. "There's never been a period in which a generation the size of the baby boomers retired at once. All these historical guidelines that show that stocks will outperform bonds are not a very strong basis for forecasts for when all of my generation decides to cash it in," warns the 48-year-old Cheney.
Gramlich argues that the only way to remedy these potential problems is to add to the national savings rate, which is why he is proposing a mandated savings contribution. That might keep interest rates from rising to pay for the transition. But whether it could stop a speculative boom and bust in the stock market is unlikely. Japan's high savings rate did not keep the stock market from losing half its value in recent years. And when the market fell, the country's Social Security system, which had invested in the stock market, suddenly found itself in trouble.
Moreover, in the long run, more savings don't equal higher returns--quite the opposite. Eventually, what economists call the "marginal productivity of capital" takes its toll, and prices that have gotten way ahead of the fundamentals (as reflected in sky-high P/E multiples) come back to earth. "Either escalating demand would suck in marginal offerings or push up P/E ratios," ADP's Weston contends. "Therefore, the returns on equity would be far less than what people thought they were getting. It would create a bad scene."
Even pro-privatization econo-mist Weaver has to admit that "from a longer-term perspective, an increase in capital investment flowing into equities and bonds will have a depressing effect on the real return."
There is another problem in moving to a market- based system: conflict of interest on the part of regulators. Would, for example, the Justice Department pursue Microsoft Corp. over allegations of anticompetitive behavior if the government were a major shareholder? Yet under the proposal of Advisory Council member Robert Ball, a former Social Security commissioner who wants simply to switch some of Social Security's assets from Treasuries to equities to shore up the system's returns, the government--not individuals--would direct the investments. "A nonstarter," says Gramlich, of the proposal.
On the other hand, if individuals have a choice about where to put their investments, those who view Social Security as a method of wealth distribution--social insurance--fear that the more sophisticated, wealthy investors will get the best returns. And even though all plans call for a floor of typically much lower guaranteed benefits, what will happen if there is a collapse of a government-sanctioned fund or a widespread market downturn? It's not hard to imagine a scenario in which there is intense political pressure on the government to provide more than that required under the law.
Back to reality
Such problems lead the discussion back to square one. The Social Security trust fund's aggregate deficit over the next 75 years totals 2.2 percent of anticipated payroll earnings. So a payroll tax increase of 2.2 percent would bring the system in balance without any cut in benefits. Onerous? That's far less than the 4 percent that EBRI estimates it would take to pay down the debt required to finance privatization.
Salisbury believes that such realities are cooling the enthusiasm for privatization. "At the point that people have to internalize the transition costs, they become less interested in privatization," he says. "They don't want to pay higher taxes just to have a private investment account, since they can do that on their own. The only reason people are unhappy with the current program is that it's going to cost them more money to maintain it, and now you're telling them that to change it will cost more money."
As a result, Salisbury contends that the notion is unlikely to win much political support among baby boomers. "The privatization debate is dead," he proclaims. Eventually, something must be done to take care of the Social Security deficit, but whether it's raising taxes or cutting benefits, change won't come easily. "The debate on reform is just beginning," he predicts.