FROM THE OFFICE OF PUBLIC AFFAIRS
November 8, 2004
JS-2117
Remarks of Mark J. Warshawsky
Assistant Secretary for Economic Policy
Keynote Speech for the 14th Annual Investment ActuarySymposium
Boston, Massachusetts
It is a great pleasure to be here this morning and to address a group that shares an interest in some of the primary issues that occupy my time in
MACROECONOMIC OVERVIEW
Overall, the performance of the economy has been impressive, particularly given the unusual succession of negative events it has had to withstand over the past several years. The bursting of the NASDAQ bubble in early 2000 was the beginning of significant weakness that took hold that year. Real GDP declined in the third quarter of 2000 and industrial production began to fall. By March 2001, we had officially entered recession and its effects were compounded by the terrorist attacks of September 11. The economy appeared to be on a recovery path in early 2002, when growing evidence of widespread corporate malfeasance dating back to the late 1990s once again undermined business activity. Slow growth abroad provided an additional headwind and the war with
Fortunately, the combination of rapid monetary policy accommodation and perhaps the most well-timed fiscal policy response in our history resulted in the smallest GDP loss of any recession in the post-World War II era. Additional fiscal policy measures – especially the passage of the President's Jobs and Growth Plan in spring of last year – boosted household incomes to support consumption, offered tax relief on dividends and capital gains for stockholders, and provided large and small businesses with incentives to undertake investments in equipment.
The response to the Jobs and Growth Plan – also known as JGTRRA in
The composition of economic growth has transitioned much as we had hoped. The consumer supported the economy throughout the recession, responding strongly to generous financing incentives offered by the auto industry. More recently, business investment has been the key driver. Real investment in equipment and software has grown at a 13.5 percent annual rate over the last six quarters, supported by rising profits, low interest rates, and declining risk spreads. Investment in structures is also making a comeback, rising in four of the last six quarters.
Along with investment in capital goods, residential investment also continues to be remarkably strong. Demand has held up very well, as 30-year mortgage interest rates have remained below 6 percent, generating record-high home sales so far in 2004.
While low longer-term rates evolved naturally as the economy weakened in 2000 and then were assisted by the Federal Reserve's monetary policy accommodation at the beginning of 2001, continuing low rates are in large measure the response to another hallmark of the current economy: the relative absence of inflation. In the third quarter, prices for personal consumption expenditures excluding food and energy were up at only a 0.7 percent annual rate – the smallest increase in more than 40 years. Low inflation is consistent with the phenomenal growth of productivity that we have witnessed throughout the current business cycle. Since the end of 2000 – a period that includes both recession and recovery – nonfarm productivity has risen at a 3.9 percent annual rate, much faster than the already-strong 2.6 percent pace averaged from 1995 through 2000.
The economy nonetheless faces some headwinds, particularly from oil prices and the trade deficit. Although the oil intensity of U.S. GDP has fallen by nearly half since the first oil shock in the early 1970s, the price of oil remains a key variable in the macro outlook. The Administration authorized the release of oil from the Strategic Petroleum Reserve in response to the temporary reduction in oil production from the
The
Despite these difficulties, it is clear that the economy is now enjoying above-trend, noninflationary growth because of the policies of the past three and a half years. These policies have helped assure strong growth in the future by improving the after-tax rewards to work, increasing the returns to innovation and risk taking, and reducing the cost of equity capital through lower taxes on dividends and capital gains. A tax system that supports greater risk-taking, saving and investment, and innovation means greater productivity and capital accumulation and ultimately a higher standard of living.
Pro-growth policies have yielded a fiscal dividend. Federal revenues have rebounded and growth of outlays has slowed. As a result, the federal deficit for FY 2004 came in at $413 billion, equivalent to about 3.6 percent of GDP, and much below the $521 billion expected in the budget forecast made earlier this year. Overall, the current deficit – though unwelcome – appears manageable compared to deficits in the 4.5 to 6 percent of GDP range at various times in the 1980s and 1990s. With continued economic growth and job creation, along with spending restraint, the President has a plan to cut the deficit in half over the next five years to less than 2 percent of GDP.
The current federal deficit is being interpreted by financial markets, correctly in my view, as a necessary response to a serious but temporary economic situation. Thus, prophecies that the swing from surplus to deficit would result in sharply rising interest rates have failed to materialize. For those who subscribe to the "twin-deficit" theory – that the federal deficit is responsible for the current account deficit which will ultimately lead to high interest rates – there is also an absence of substantiating evidence. While foreign capital flows are volatile from month to month, the reality is that they have been more than sufficient to finance the current trade deficit without higher interest rates.
Financial markets are reflecting the fundamentals of the
Low interest rates have overall been very positive for the economy but they also represent a challenge for defined-benefit pension funding, because they suggest lower rates of returns on bonds and less discounting of future cash flows. This increases plan under-funding and results in a requirement for increased employer pension contributions; such pro-cyclical funding may have in part been responsible for recent business caution in investment and hiring actions. It is therefore extremely important that the issue of pension funding be addressed in a comprehensive fashion. A bit later in my remarks, I will discuss the Bush Administration's approach to these issues.
SOCIAL SECURITY REFORM
President Bush has said that "Social Security is one of the greatest achievements of the American government, and one of the deepest commitments to the American people." The President supports Social Security reform that increases the power of the individual, does not increase the tax burden, and provides economic opportunity for more Americans. Today I want to discuss why reform is needed, why delay is costly, and the important role for personal retirement accounts in that reform.
At the end of 2003, the Social Security program paid about $470 billion in benefits to about 47 million beneficiaries, making it the largest federal transfer program in the
The Social Security system began in the aftermath of the Great Depression with the passage of the 1935 Social Security Act that established the "Old-Age" portion of the program. Initially, the program was intended to provide cash benefits to persons age 65 and over who had made payroll contributions to the system with benefits based on the value of those contributions. Contributions would begin in 1937 and benefit payments would start about five years later. An accumulating trust fund would help pay benefits as the number of beneficiaries increased. Even before the first benefit was paid, however, benefit provisions were expanded in 1939 to include spouses and survivors insurance, the benefit formula was made more generous, and scheduled tax increases were delayed. Disability benefits were added in 1956. Before 1972, benefit increases were made on an ad hoc basis and four double-digit increases occurred between 1968 and 1972 (20 percent in 1972). Though an accumulating Trust Fund was envisioned, the system has operated primarily on a pay-as-you-go basis with a modest Trust Fund having developed in recent years. Therefore, tax increases have been steadily implemented to ensure the continuation of annual benefit payments. But, as I discuss below, the increases fell well short of what would be needed to pay lifetime benefits to a growing and longer-living beneficiary population.
In 1950, there were 16 workers to support every one beneficiary of Social Security. Today, there are only 3.3 workers supporting every Social Security beneficiary. By the time our youngest workers and others now entering the workforce turn 65, there will only be two workers supporting each beneficiary.
Moreover, in 1950, men and women age 65 could expect to live, on average, 12.8 and 15.1 more years, respectively. In the year 2000, life expectancy at age 65 had increased to 15.7 for men and to 19 for women. By 2030, these conditional life expectancies are projected to increase to 17.7 for men and 20.6 for women. Longer lives are clearly a good thing but they do mean a longer period over which Social Security (and Medicare) benefits must be paid.
As a result of these demographic changes and the generosity of benefit payments to prior generations, the current system will not be able to afford to pay the benefits scheduled for our children and grandchildren without enormous payroll tax increases. The Social Security payroll tax, which was 3 percent in 1950, is now 12.4 percent. The Social Security actuaries calculate that, if the system were to continue to operate on a pay-as-you-go basis and pay currently-scheduled benefits, the payroll tax would have to rise gradually, but steadily, to more than 19 percent before the end of the next 75 years.
But financial pressure on the federal budget (hence on taxpayers) begins much earlier. Tax revenue (payroll taxes plus benefit taxes) is expected to fall short of benefit payments less than 15 years from now (in 2018). Under the current Social Security financing structure, this growing annual revenue gap will be made up from federal general revenues for another 24 years (until 2042). After 2042 the authorization to fill the gap from general revenues ends (the Trust Fund is exhausted) and, in the absence of legislation, full benefit payments cannot be made after that time.
The important point is that the Social Security system is significantly under funded – future scheduled revenue will be inadequate to fully pay scheduled benefits. The 2004 Report of the Social Security Trustees estimates that, over the next 75 years, the present value of Social Security's deficit (i.e., the unfunded obligation) is about $3.7 trillion. For perspective, this deficit could be eliminated if payroll taxes were raised immediately by 1.9 percentage points (to 14.3 percent) (and a large Trust Fund would be accumulated) or if all current and future benefits were reduced by 13 percent.
Yet, 75 years, though a seemingly long time, does not capture fully the financial status of the Social Security program. In fact, no fixed finite period will completely embody the financial status of the program because people pay into the system when they are young and receive benefits when they are older and an arbitrary cutoff will miss some taxes and, especially, benefits to be paid. So estimates even over the long period of 75 years include a lot of payroll revenue from future workers who will not begin to receive benefits until after the 75-year horizon. The omission of future benefits is especially critical in an underfunded program facing the retirement of the baby boom generation. In order to get a complete picture of Social Security's permanent financial problem, the time horizon for calculating income and outgo must be extended to the indefinite future. I will note for this audience that Robert Myers, a former chief actuary of Social Security, in his classic book on the program stated that the infinite horizon was the appropriate period of analysis for the program. I am proud that we have been able to add such a measure to the Trustees Report during my tenure at Treasury. Such a calculation is provided in the 2004 Trustees Report which estimates that, for the entire past and future of the program, the present value of scheduled benefits exceeds the present value of scheduled tax income by $10.4 trillion. This is the financing gap that program reforms must ultimately close. To put this in perspective, eliminating the permanent deficit would require an immediate and permanent increase in the payroll tax rate of 3.5 percentage points (to 15.9 percent) (and the accumulation of a massive Trust Fund). Alternatively, all current and future benefits would have to be reduced immediately by 22 percent.
These results make clear that the Social Security system is not financially viable over the long term – it must be fixed – so doing nothing is not an option. How to close the permanent financing gap raises difficult questions over how the burden should be shared across generations. In this context, it is important to recognize that the large unfunded obligations in the system ($10.4 trillion) are in large part the consequence of the past system generosity. From the beginning, the Social Security program made benefit promises to generations that far exceeded the taxes they would pay over their lifetimes. Of course, past generations are past – they cannot contribute to reducing the unfunded obligations. As a consequence, closing the financing gap falls to future generations and this leads to the obvious but very important point that the longer reform is delayed the greater the number of future generations that also become past generations that cannot contribute – that is, delay means a greater burden on current and future generations.
Fortunately, this situation is fixable. The President has issued guiding principles for reforming Social Security. One very important principle is that seniors at or near retirement should be protected from benefit cuts, and that payroll taxes should not be increased.
Another principle is that personal retirement accounts (PRAs) should be made available for younger workers to build a nest egg for retirement that they own and control, and which they can pass on to their children and grandchildren.
Additionally, we must pursue the goal of a permanently sustainable system, eschewing reforms that treat only symptoms and halfway measures. As I noted above, halfway reform simply means a greater burden on future generations.
I would like to focus on the advantages of PRAs. PRAs provide individual control, ownership, and are important vehicles for pre-funding more of our Social Security benefits without encouraging more government spending. PRAs also offer individuals the opportunity to receive the benefits of investing in private-sector markets. Individual control and ownership means that people would be free to pass the value of accounts to their heirs.
Perhaps most importantly, the retirement security of our current young and future workers depends on PRAs. They will allow individuals to save now to help fund their retirement incomes. In principle, that could be done with reforms that save tax revenues in the Social Security Trust Fund. But such "saving" would almost certainly be undone by political pressures to increase government spending and hence produce larger deficits outside of Social Security. The only way to truly save for our retirement and give our children and grandchildren a fair deal is with personal accounts.
The appeal that PRAs have for individuals also serves as an impetus for Social Security reform. Because most people like the idea of ownership and control over their savings accounts, as voters they are more likely to support a reform of this type.
Setting up a new system of personal retirement accounts will require careful planning and the policy options that are chosen could have a significant affect on administrative costs. However, the challenges of reform are outweighed by the need for reform, and the potential benefits are great.
DEFINED BENEFIT PENSION REFORM
I will next discuss private sector defined benefit pension issues, why reform is needed, and provide an overview of what we have identified as important principles for this reform.
Before I discuss these proposals, let me briefly give you some background on the state of the regulatory structure of the defined benefit system.
Defined benefit plan sponsors today are subject to the "ERISA" funding requirements. Under current ERISA funding rules, adequate funding is defined in terms of the actuarial liability based on a specific actuarial funding method. An exception to this general rule occurs if the market value of pension fund assets is less than 90 percent of the current liability. Plans whose funding falls below this threshold are subject to the Deficit Reduction Contribution (DRC) rules which increase required annual contributions.
In addition to providing funding rules, ERISA created the Pension Benefit Guaranty Corporation (PBGC). The PBGC collects insurance premiums from employers that sponsor defined benefit pension plans and it pays monthly retirement benefits to participants of failed plans. Currently, PBGC insures the pensions of 44 million workers and retirees and pays benefits to over 930,000 people from failed plans.
PBGC's financial health suggests that we need to be concerned about the current set of funding rules for plan sponsors, the PBGC premium structure, and the long-term solvency of both PBGC and the defined benefit system.
The PBGC's single employer plan program ended 2003 with a record deficit of $11.2 billion. This deficit is the result of two consecutive years of staggering net losses. While I can't yet discuss 2004 results, it is fair to say that it is likely that the deficit will be higher.
The PBGC deficit will be increasing significantly for this fiscal year as a result of problems with airline company pensions. While the PBGC does have sufficient resources to pay benefits for a number of years, this Administration recognizes we must act now to ensure the longer-term solvency of the pension insurance program.
As I mentioned above, the ERISA funding requirements include a deficit reduction contribution or DRC. The role of the DRC is to act as a minimum threshold for plan funding. Plan funding experience prior to the introduction of the DRC showed that basic system was not effectively leading to funded pension plans. The DRC is a backstop system. Plans that are persistently under funded based on the current liability measure employed by the DRC must make mandatory catch-up contributions. In particular, firms that fall into this category must make up the amount of the obligation that is unfunded over three to seven years.
Thus, the current ERISA system is a balance between a system that has proven to ineffective in inducing firms to fund their pensions because it is effectively riddled with loopholes and a minimum funding backstop which causes contributions of under funded plans to be excessively volatile from year to year. This is certainly not a healthy situation.
Add to this mix a pension benefit insurance system that does not adequately reflect risk in setting premiums and you have a recipe for a significant long-term problem. A properly designed insurance system has various mechanisms for encouraging responsible behavior – dealing with moral hazard - that will lessen the likelihood of incurring a loss and discouraging risky behavior that heightens the prospects of claims. However, the current pension insurance system can be gamed. A weak company will have incentives to make generous pension promises rather than increase wages. Employees may go along because of the federal guarantee. If the company recovers, it may be able to afford the increased benefits. If not, the costs of the increased benefits are shifted to the insurance fund. Similarly, a company may increase asset risk when it is under funded to try to make up the gap, with all the upside gain benefiting shareholders and the downside risk being shifted to other premium payers.
Finally, it is important to note that pension practitioners and CFOs have been preaching for years that limits on maximum deductible contributions are requiring sponsors to manage their funds within a narrow range and that raising the limits on deductible contributions would allow sponsors to build larger surpluses to provide a better cushion for bad times.
Both the current funding rules and pension insurance program lack basic checks and balances. There is too little opportunity for plan sponsors to act responsibly and too little consequence when plan sponsors act irresponsibly.
The goals of pension reform are twofold -- corporate responsibility and retirement security. Simply put, companies should be held accountable to make good on the pension promises they have made to their workers and retirees. The consequences of not honoring these commitments are unacceptable--the retirement security of millions of current and future retirees is put at risk.
Before discussing comprehensive reform, I would like to briefly discuss one important aspect of the proposals that the Administration had already put forward in July of 2003.
As part of the Administration's proposal to improve the accuracy and transparency of pension information we would have required that pension liabilities be measured more accurately. Accurate measurement helps ensure that pension plans are adequately funded to protect workers' and retirees' benefits and also that minimum funding rules do not impose unnecessary financial burdens on plan sponsors. Liability estimates that are too low will lead to plan under funding, potentially undermining benefit security. Pension plan liability estimates that are too high lead to higher than necessary minimum contributions, reducing the likelihood that sponsors will continue to operate defined benefit plans. We therefore proposed that a corporate bond yield curve be used to measure pension liabilities. This proposal has garnered quite a bit of attention in the pension and actuarial communities. Unfortunately this proposal was not enacted, but I still believe it is an important component of pension reform. In my office at Treasury, we have spent time over the past year developing yield curves based on high quality corporate bonds.
At this point, I'd like to discuss fundamental pension reform. Clearly, I think the current pension funding and insurance systems need to be overhauled. We are developing a plan for a pension system that will be less complex, more flexible, logically consistent, and will achieve the goal of improving the security of defined benefit plans. The Administration strongly believes that a reform plan must have several characteristics:
- The proposal will center on the use of real incentives to motivate desired behavior and frees responsible plans from burdensome regulation.
- The proposal will include improvements in pension asset and liability measurement, economically meaningful funding targets, and enhanced disclosure.
- The proposal will provide greater opportunity and incentive for employers to fund up in good times to ensure against economic shocks, and reduce the volatility of minimum required sponsor contributions.
- The proposal will improve the PBGC's ability to deal with firms that fail to make contributions while in bankruptcy; and
- The proposal must include a premium structure for the PBGC that meets its long-term revenue needs and reflects the risks that it covers.
When under funded pension plans terminate, three groups can lose: workers face the prospect of benefit reductions; other companies, including those that are healthy and have well funded plans, may face higher PBGC premiums; and, ultimately, taxpayers may be called upon by Congress to bail out the pension insurance fund, just as was the case more than a decade ago with the savings and loan bailout. This is the unfortunate result of a system that allows – and, one might even argue, sometimes encourages – companies to avoid paying for the promises they have made. This Administration wants to move towards a system that emphasizes employers' responsibility for their pension promises and the empowerment of employees through better information.
TRIA SURVEY
The Terrorism Risk Insurance Program (TRIP) was established by Congress through the Terrorism Risk Insurance Act of 2002 (TRIA). The TRIP is a temporary federal system of shared public and private compensation for insured losses resulting from foreign acts of terrorism. The objectives of the TRIP are:
- to ensure continued widespread availability of property and casualty insurance for terrorism risk; and
- to provide a transition period for private markets to stabilize, resume pricing, and build capacity while preserving state insurance regulation and consumer protection.
I am involved in this issue because my office is conducting a series of nationally representative surveys on TRIA. These surveys will provide data that we will use in preparing a congressionally mandated report on the program that is due next June. As I am sure many of you are aware, TRIA is scheduled to sunset at the end of 2005. While there has been a great deal of discussion about whether TRIA should or should not be extended, the Treasury Department believes it is premature to engage in such discussions until we evaluate the data and issue our report in June of 2005.
Today, after providing a bit of background on the program, I am going to discuss our surveys and why we believe they will be a unique source of information about TRIA.
Insurer participation in the TRIP for covered lines of business is mandatory. Insurers must make TRIA-eligible terrorism coverage available in commercial property, workers compensation, and other liability lines under terms and conditions comparable to coverage for non-terrorism events. It is important to note that does not mean insurers are required to provide such coverage, just to make an offer. There are no federal restrictions on rates or policyholder purchase decisions. However states do not permit the exclusion of terrorism insurance from workers compensation coverage.
In the event of a TRIA certified terrorist event, an insurer's exposure consists of a deductible that is a percentage of the prior year direct earned premiums across all applicable lines (not just terrorism) and a co-payment equal to 10 percent of insured losses above the deductible. Under certain conditions, insurers are also subject to post-event "mandatory recoupment" fees. In 2003 insurer deductibles for TRIA-eligible coverage were 7 percent of total 2002 directly earned premiums. They are now 10 percent of total 2003 directly earned premiums, and in 2005 they will be 15 percent of 2004 directly earned premiums. Total annual liability for the federal government and for insurers jointly is capped at $100 billion.
The Congressionally mandated study has three basic objectives:
- to assess the effectiveness of the Terrorism Risk Insurance Program;
- to evaluate the availability and affordability of terrorism risk insurance for various policyholders, including railroads, trucking and public transit; and
- to assess the capacity of the property and casualty insurance industry to offer terrorism risk insurance after the program sunsets, by law, on
To assess the program's effectiveness in addressing insurance market disruptions and ensuring widespread availability and affordability of terrorism coverage, Treasury must consider changes in TRIA-eligible insurance coverage purchased and premiums for terrorism risk covered by TRIA during the existence of the program, and immediately prior to its establishment. We are conducting panel surveys; that is, we are collecting data repeatedly from the same set of survey respondents, in order to measure year-over-year changes. There are three surveys. The largest is the survey of policyholders. We are also surveying insurers in TRIA-eligible lines. And to learn about the availability of reinsurance for terrorism coverage, for which the temporary federal program substitutes, we are surveying reinsurers. Our general strategy is to observe how policyholders, insurers, and reinsurers' terrorism insurance experience and behavior have evolved over the life of TRIA.
Each survey is collecting information on coverage purchased within broad TRIA-eligible lines as well as other factors that influence the decision to provide or purchase terrorism insurance coverage and the price at which it is purchased or provided. The factors include policyholder and insurer characteristics, overall risk management strategies, and other factors influencing the demand for, and supply of, insurance for non-TRIA terror risks. We believe this detailed micro data will provide us with the information we need to better understand issues related to who takes terrorism coverage, who offers coverage, and at what prices.
Access to a robust reinsurance market is considered an important determinant of the capacity of the property and casualty insurance industry to offer terrorism risk insurance after the program sunsets. We are therefore soliciting data about the reinsurance through both our survey of insurers and our direct survey of reinsurers. Our insurer survey also collects data on the availability of reinsurance for deductibles and co-payments for TRIA-eligible coverage, and for non-certified coverage. Survey data will also be collected from reinsurers to assess their capacity to offer coverage for this risk to primary insurers.
Data collection for the first wave of the policyholder and insurer surveys began last November and ran through mid-April of this year. Slightly more than 33,300 policyholders and insurers were contacted. Response rates have been especially good in the insurer survey. The second wave of data collection for these groups is now underway, and the reinsurers' questionnaire should be in the field in the next week or two.
As I mentioned, I believe the Treasury data will be a unique resource in helping us understand the dynamics of the terrorist risk insurance market. These critical data are not available from any other source. I believe that because we acted in a timely manner to respond to this important charge from Congress and have designed and fielded these detailed multi-year longitudinal surveys, we will have the data we need. Our survey is unique. We are touching on all parts of the market. We believe we have enough detailed information to really learn something new about the determinates of participation in this market. Finally, because we have designed our survey as longitudinal study, we believe we will be able to better assess the dynamics of the markets.
Undertaking any nationally representative survey is a complex and arduous undertaking. In this case, the complexity and difficulty are increased because we are operating under a tight deadline and attempting to get detailed information from three unique groups. Nevertheless we are pleased with our progress to date, and believe, ultimately, we will have a better understanding of the terrorism risk insurance market because of these efforts.
Thanks!
LIFE CARE ANNUITY
Finally, I'd like to conclude with a brief discussion of an insurance product innovation I have been working on for many years – the life care annuity. Use of long-term care by the elderly is projected to double between 2000 and 2050. Financing of long-term care is likely to be a challenge. The life care annuity combines an immediate life annuity with the disability form of long-term care insurance. In return for a single premium, an insurance company would make steady periodic payments to a retired household (individual or couple), and would increase them substantially when a member of the household becomes disabled to the extent that he would require long-term care services.
Such a product could offer economic security for retirees by providing a steady stream of income combined with protection in the event of catastrophic costs associated with disability. The important innovation is that by linking the annuity with the long-term care insurance, we pool populations with two different risks: individuals who are likely to be long-lived and individuals who are in relatively poor health. This pooling allows the integrated product to be sold more cheaply than a comparable life annuity and long-term care insurance policy purchased separately. Another benefit is that the pooling of risks also allows individuals who would not ordinarily pass underwriting for long-term care insurance to be eligible for the product, thus expanding the market.
While the long-term care insurance market is young, I believe the life care annuity could become an important element in financing the long-term care needs of certain elderly populations. Importantly, such an approach would reduce dependence on public programs like Medicaid, and would work well as a distribution mechanism from qualified retirement plans and Social Security PRAs.
There are still several open questions before such a product may be viable. Obviously, in my role as Assistant Secretary, I am not advocating that insurers enter any particular line of business; I leave the private sector to the private sector. I do, however, think this idea is a potentially important innovation that has real societal benefits.
CONCLUSION
In summary, the