Mr. Chairman, Members of the Committee, I appreciate the opportunity to appear today to discuss President Clinton's proposal to ensure the financial well-being of the Social Security and Medicare programs and improve the retirement security of all Americans.

The advent of an era of surpluses rather than deficits has radically transformed our national debate about entitlements. The terms of all of the earlier tradeoffs in the entitlements debate have been eased -- provided we seize the opportunities now available to us. The President's framework for Social Security both recognizes the brighter present reality, and moves us well along the road toward seizing the opportunities currently available, if we can work together on a bipartisan basis.

Today I will first briefly describe the President's program. I will then devote the bulk of my remarks to the issue of the President's proposal to raise the rate of return earned by the Social Security trust funds by investing part of the surplus in equities.

The President's Proposal

According to the Office of Management and Budget, the surpluses in the unified budget of the federal government will total more than $4.8 trillion over the next 15 years. This presents us with a tremendous opportunity. At the same time, we are also facing a tremendous challenge: the aging of the "babyboomers" is projected to put enormous strains on the Social Security and Medicare systems, on which so many retirees depend.

The natural approach would be to take advantage of this opportunity to meet the challenges facing us. This is the objective of the President's plan.

The President's framework devotes 62 percent of these projected budget surpluses to the Social Security system. Of the roughly $2.8 trillion in surpluses that will go to Social Security, about four-fifths will be used to purchase Treasury securities, the same securities that the Social Security system has invested in since its inception. The remaining one-fifth will be invested in an index of private-sector equities. These two actions will reduce the 75-year actuarial gap from its current level of 2.19 percent of payroll by about two-thirds, to 0.75 percent of payroll. And they push back the date at which the Social Security trust funds are projected to be exhausted, from 2032 to 2055.

Substantial as that accomplishment would be, it is critical that we do more. Historically, the traditional standard for long-term solvency of the Social Security system has been the 75-year actuarial balance. A 75-year horizon makes sense because it is long enough to ensure that virtually everyone currently participating in the system can expect to receive full payment of current-law benefits. Attaining this objective will require additional tough choices. But the objective is both important and obtainable. To reach it, the President has called for a bipartisan process. We believe that the best way to achieve this type of common objective is to work together, eliminating the need for either side to "go first."

In the context of that process, we should also find room to eliminate the earnings test, which is widely misunderstood, difficult to administer, and perceived by many older citizens as providing a significant disincentive to work. In addition, it is critical that we not lose sight of the important role that Social Security plays as an insurance program for widows and children, and for the disabled. As President Clinton said last month: "We also have to plan for a future in which we recognize our shared responsibility to care for one another and to give each other the chance to do well, or as well as possible when accidents occur, when diseases develop, and when the unforeseen occurs." That is why the President has proposed that the eventual bipartisan agreement for saving Social Security should also take steps to reduce poverty among elderly women, particularly widows, who are more than one and one-half times as likely as all other retirement age beneficiaries to fall below the poverty line.

In addition to shoring up Social Security, the President's plan would transfer an additional 15 percent of the surpluses to Medicare, extending the life of that trust funds to 2020. A bipartisan process will also be required to consider structural reforms in this program. The Medicare Commission is expected to report soon on these important issues.

The President would also use 12 percent of the surpluses to create retirement savings accounts Universal Savings Accounts or USA accounts and the remaining 11 percent for defense, education, and other critical investments. The President will be announcing further details regarding the USAs soon.

At the same time, the President proposes to strengthen employer-sponsored retirement plans in a variety of ways. The President's budget addresses the low rate of pension coverage among the 40 million Americans who work for employers with fewer than 100 employees by proposing a tax credit for start-up administrative and educational costs of establishing a retirement plan and proposing a new simplified defined benefit-type plan for small businesses. Workers who change jobs would benefit from the budget proposals to improve vesting and to facilitate portability of pensions. In addition, the retirement security of surviving spouses would be enhanced by the President's proposal to give pension participants the right to elect a form of annuity that provides a larger continuing benefit to a surviving spouse and to improve the disclosure of spousal rights under the pension law.

Benefits of the President's Approach

In essence, the President is proposing that we use the Social Security and Medicare trust funds to lock away about three-quarters of the surpluses for debt reduction and equity purchase, and ensure that they are not used for other purposes. This would have three key effects:

• First, it would greatly strengthen the financial position of the government. If we follow this plan, by 2014, we will have the lowest debt-to-GDP ratio since 1917 and will free up a tremendous amount of fiscal capacity. The reduction in publicly held debt will reduce net interest outlays from about 13 cents per dollar of outlays in FY99 to about 2 cents per dollar of outlays in 2014. Under the President's program, the decline in interest expense resulting from debt reduction will exceed the increase in Social Security expense through the middle of the next century.
  

• Second, it would strengthen significantly the financial condition of the Social Security and Medicare trust funds. Indeed, it would extend the life of the Social Security trust funds by more than 20 years, to 2055, and extend the life of the Medicare Hospital Insurance trust funds to 2020. Meeting our obligation to the next generation of seniors should be the number one priority in allocating the surpluses.
  

• And third, it would substantially increase national saving, which must be a priority in advance of the coming demographic shift. By paying down debt held by the public and investing in equities, the President's program will create room for about $3.5 trillion more investment in productive capital. In effect, this will be the reverse of the "crowding out" that occurred during the era of big deficits. With government taking a smaller share of total credit in the economy, interest rates will be lower than otherwise would be the case. The implications of lower interest rates will be profound. Not only will individuals be able to borrow for mortgages, school loans, and other purposes at lower rates, but importantly, businesses will be able to finance investments in productive plant and equipment at the lower rates. And the resulting larger private capital stock is the key to increasing productivity, incomes, and standards of living. Ultimately, one reason why this program is sound economically is that it will result in a more robust private economy, which will expand our capacity to make good on our Social Security and Medicare promises. This increase in public saving also has beneficial implications for our balance of payments side. Reduced government borrowing would lead to a reduced dependence on foreign financing, and an improvement in our status as a net debtor to the rest of the world.

Benefits of USA Accounts

Social Security, strengthening employer-sponsored retirement plans, and creating USA accounts are key pillars of the President's proposal to provide financial security to retirees. We believe that USA accounts will provide a significant stimulus to private savings, by enabling millions of Americans to begin to set aside some money for retirement.

The President's proposal aims to deal more broadly with the challenges of an aging society by expanding individual access to retirement saving. As I noted earlier, the President proposes to devote 12 percent of the surpluses to establishing a new system of Universal Savings Accounts. These accounts would provide a tax credit to millions of American workers to help them save for their retirement. Workers would qualify for a progressive tax credit match against their own contributions. For example, a low-income worker may receive a dollar for dollar match up to a cap. In addition, low- and moderate-income workers will qualify for an additional tax credit, even if they make no contribution themselves.

Overall, the USA program would be considerably more progressive than the current tax subsidies for retirement savings --where higher bracket taxpayers get higher subsidies. This proposal would contribute significantly to national savings, because it will produce retirement savings for millions of low- and moderate-income people who do not have access to pensions. The tax credit match will provide a strong incentive for workers to add their own saving to accounts.

Investing Part of the Surplus in Equities Would Raise the Rate of Return Earned by the Social Security Trust Funds

As I have mentioned, the President has proposed transferring 62 percent of projected surpluses to Social Security, and investing a portion of these transferred surpluses in equities.

To date, the trust funds have been invested exclusively in U.S. Government bonds. While these bonds are essentially risk-free, they have the corresponding downside that they have historically paid a lower rate of return, on average, than other potential investments. Between 1959 and 1996, the average annual rate of return earned on stocks was 3.84% higher than the rate earned on bonds held by the trust funds.

Currently, the pension savings of many upper income Americans are invested in private plans that earn these higher equity returns. The higher equity returns can potentially make it possible for these Americans to have more upon retirement. We believe that it is important to give all Americans, even those of low and modest means, the opportunity to enjoy these potential benefits from stock market performance.

Raising the rate of return on the trust funds would mean that the Social Security system could be brought into long-term actuarial balance with smaller reductions in benefits, smaller increases in revenue, and/or less transfer of surplus. The President's plan for investing in equities will reduce the actuarial gap by an estimated 0.46 percent of taxable payroll -- and thus will close roughly one- fifth of the problem we face over the next 75 years. If one were to try to achieve the same actuarial impact of equity investments through alternative measures, we would have to immediately reduce the COLA on Social Security benefits by 0.3 percentage points. The equity investment in the President's package achieves as much for the financial soundness of the system as would moving the normal retirement age up by about an extra year and one-half for participants who reach age 67 in 2022. If we delayed until 2030 to make the changes necessary to set Social Security back on a sound actuarial footing, the required across-the-board cut in benefits would be 5%.

Investing part of the trust funds in equities would also bring Social Security into line with the "best practice" of both private and public sector pension plans. Among large private-sector defined benefit plans (those with more than 100 participants), more than 40% of total assets were invested in equities in 1993; this number has risen significantly since then. Nearly all state pension plans also now invest in equities. In 1997, state and local government plans invested 64% of their portfolios in equities.

Would Equity Investments Add Risk to the Trust Funds?

I see two broad concerns regarding trust fund investment in equities. These concerns are legitimate, but we believe they are manageable, and should not stop us from achieving the potential enhanced returns of equities.

First, stock returns are more volatile than the returns on the government bonds held by the trust funds. However, the trust funds are well-situated to bear equity risk, because they have long -- or indefinite -- time horizons. The trust funds would be capable of riding out the ups and downs of the market, because they receive the cash flow from payroll taxes, and because of the cushion provided by the trust funds' bond holdings.

More specifically, investing only 15 percent in equities seems to us to be a prudent balance between receiving the potentially greater return from equities and keeping the investment small enough so that the trust funds are not overly exposed. This 15 percent allocation to equities is much smaller than the customary allocation to equities in either public or private pension plans. Moreover, 85% of the trust funds will still be invested as before in risk-free Treasury securities.

In addition, the equity investments and disinvestments that we are proposing will be smoothed in incremental additions over 15 years. In any year, investments or disinvestments are projected to be less than 0.5% of the stock market. Incremental investments and disinvestments -- rather than total divestiture at one time -- will help to mitigate the risk from adverse price movements.

Finally, in the near term, all benefits will continue to be paid out of payroll and other taxes. Furthermore, under current law, even in 2032 payroll and other taxes will be sufficient to pay for the lion's share -- about 72% -- of Social Security benefits. The remaining 28% of benefits will be paid out using the assets of the trust funds. As only 15% of the trust funds' assets would be invested in equities, only about one sixth of this 28% would be backed by equities. In short, even in 2032, only about 4-5% of payments from the trust funds will be backed by private sector investments.

Ensuring the Integrity of Investment Decisions

The second concern is that of political influence on trust fund investment decisions. Any system of collective investment can and must address these concerns. We believe that we can successfully work with Congress to design a system that is free from political influence. We need to strike the right balance, so that we can earn the higher potential returns to equities, by finding a way to take care of these legitimate concerns.

That is why we will work with Congress to design a system that observes five core principles. These five core principles will establish several levels of protection.

First, the share of trust fund assets invested in equities ought to be kept at a very limited level. We have proposed that equity investment be limited to 15 percent of trust fund balances. This will be important to limit the trust funds' exposure to price movements from equity investments, and to ensure that collective investments never account for more than a small fraction of the stock market. During the first years of the program, from 2001 to 2014, Social Security would own, on average, only 2% of the stock market. On average through 2030, Social Security would own approximately a 4% share of the total stock market.

Second, the investments should be independently managed and non-political. We suggest that trust fund managers be drawn from the private sector through competitive bidding and that the trust fund managers be overseen by an independent board. There should be wholly independent oversight of investment, in order to shield the trust funds from political influence.

Third, the sole responsibility of the independent board would be to select private sector managers through competitive bidding. Private sector management will provide a further degree of political insulation. Moreover, Social Security beneficiaries deserve the same efficient management and market returns that people receive for their private pensions and personal savings.

Fourth, equity investments should be broad-based, neutral and non-discretionary. Assets should be invested proportionately in the broadest array of publicly listed equities, with no room for discretion in adding or deleting companies and no room for active involvement in corporate decisions. We have proposed that the funds be invested in a total market index, which would encompass a broad range of stocks. In addition, the managers should be on autopilot in investing the funds; they should have little or no discretion in the investment of trust fund assets, so they cannot "time the market" or pick individual stocks.

As a shareholder the trust funds should be entirely passive. One way to accomplish this might be to mandate that proxies be voted in the same proportions as other shareholders.

Fifth and finally, collective investment needs to be achieved at the lowest cost available. This will be important both to obtain the highest possible returns and to further enhance the system's transparency and independence. Indexed investment is less expensive than active management. In addition, given the large size of the potential equity investments by Social Security, we would expect to pay very low asset management fees.

Let me emphasize our belief that there should be zero government involvement in the investment. We will work with Congress to design a system that is completely insulated from political pressures.

The Experience of State and Local Governments

As I mentioned earlier, virtually all state pension funds now invest in equities. In 1997, state and local government plans invested 64% of their portfolios in equities, up from 56% in 1996. State and local pension plans now hold fully 10 percent of the overall stock market. By contrast, the Social Security trust fund equity investments would total only 15% of the trust funds, and would represent, on average, about a 4% of the equity market.

Some have suggested that the trust funds might fall short of earning market returns, based on the experience of state and local pension plans. I would emphasize first that the experience of state plans is really not directly comparable to what we are proposing for Social Security. State plans do not generally operate under the kinds of restrictions that are envisioned under the President's proposal. That is, the statutes governing state plans do not generally require that investments be made only through indexed funds, with a clear prohibition against adding or subtracting equities from the index. Many state pension plans are actively managed, and some have explicit investment goals. As a result, the experience of these plans may not be relevant as a guide for what Social Security's experience would be.

Our preliminary analysis of the available data suggests that, over the period 1990-1995, public plans actually received returns that averaged two basis points higher than private plan returns (this difference is statistically indistinguishable from zero). Although in earlier periods (from 1968 to 1983) the performance of public pension funds was slightly inferior to that of private pension funds, this difference is also not statistically significant. More importantly, this very slight difference in performance during earlier periods can be explained by the fact that public pension funds generally allocated a far smaller portion of their portfolios to equities, and in some cases were statutorily prohibited from buying any equities.

The returns to trust fund investments to this date would not stack up well in this comparison of earnings of public and private pension funds. Because the trust funds have been invested exclusively in government securities until now, both public and private pension funds would likely have outperformed the rate of return earned on trust fund investments.

Advantages of Collective Investment of Social Security

There are three key advantages to having the trust funds invest collectively in equities for the American people. These advantages relate to the ability of defined benefit plans to bear market risk, minimize administrative costs, and achieve progressivity. Defined contribution plans, such as the proposals for individual accounts, are less able to realize these objectives. In addition, the potential political risk from collective investment in equities through the trust funds is not very different from the political risk that could arise from investing in equities through defined contribution plans.

An advantage of collective investment in equities through the trust funds is that periods of poor equity performance could be spread over many generations of current and future Social Security participants. By contrast, during a market downturn, participants in a defined contribution system could be forced to choose between postponing retirement and a severely reduced retirement income. For example, for the year that ended with the third quarter of 1974, the S&P500 declined by 54 percent in real terms. By placing the risk of a market downturn in the trust funds, we can greatly reduce this risk to beneficiaries. Additionally, we have proposed limiting Social Security's equity holdings to 15% of the trust funds. As I noted earlier, this means that only 4% of benefits payments would be backed by the performance of equities.

The second advantage of collective investment in equities is that the returns to trust fund investments in equities would likely be higher than the returns to equities held in individual accounts. This is primarily because it would be much more costly to administer a defined contribution plan than it would be to administer a defined benefit plan. The trust funds would expect to pay very low asset management fees, because of the large size of the trust fund asset pool. These asset management fees could be comparable to, or lower, than the 1 basis point (0.01%) currently paid by the federal employees' TSP plan for private management of the equity-indexed "C Fund."

By contrast, administrative costs for a system of defined contribution plans held in the private sector could be comparable to the commissions and fees charged by equity mutual funds today. The average equity mutual fund currently charges between 100 and 150 basis points for administrative and investment management services. Costs of this magnitude could significantly reduce the balance that could be accumulated in an individual account. According to our estimates, administrative costs of 100 basis points would reduce by 20 percent the total account accumulations at the end of a 40- year career. Collective investment through the trust funds would avoid the need to pay the administrative costs associated with individual accounts.

The experience of individual accounts in Britain and Chile illustrates how significant these risks and costs can be. In Britain, many personal pension plans take more than 5 percent of contributions in administrative charges.

Chile also has had high administrative costs. According to the Congressional Budget Office (CBO), fees and commissions of the Chilean pension system amounted to 23.6 percent of contributions in 1995. As a result, according to the CBO, Chilean workers who invested their money in an individual account in 1981 received an internal real rate of return of 7.4 percent on that investment through 1995, despite average real returns of 12.7 percent to pension fund investments. Even in the best of circumstances, however, costs will be higher for a system of individual accounts than for collectively investing trust fund assets.

The third advantage of collective investment is that it is progressive. This is one of the most important features of Social Security: benefits are greater, as a percentage of wages, for low-income workers than high-income workers. By investing in equities, we are able to maintain this critical feature of progressivity and avail Americans of modest means of the higher returns that have historically accrued to equities.

In addition to these key advantages, one might note that, with regard to the concern about political influence, this concern also exists for individual accounts. Most individual account proposals have suggested some centralized plan structure, both in order to reduce administrative costs and to help familiarize tens of millions of Americans with the range of possible investment vehicles. These individual account plans would create a large pool of money under a single manager, or a handful of managers. This pool of money would not look very different from the Social Security trust funds. With any centralized pool of assets there is the potential for those pursuing a political agenda to try to influence it.

We can all be encouraged by the history of the Thrift Savings Plan (TSP), whose investments have not been subject to political influence. We believe that some of the features that have protected the TSP system so well are worth emulating. These include the TSP system's independent board, its private sector managers, and the rule that equity investments can only be made by tracking an index.

Conclusion

In conclusion, it will be critical to have the Administration and Congress work together to address the needs of future generations. We need to keep the promises that we have made to retirees, without unduly burdening younger generations. We want to work with you, on a bipartisan basis, to implement the President's program.

I believe that we can find a safe and prudent way to participate in the enhanced returns in equity markets.

Thank you. I would welcome any questions.