<DOC>
[109 Senate Hearings]
[From the U.S. Government Printing Office via GPO Access]
[DOCID: f:29725.wais]
S. Hrg. 109-554
THE ROLE OF THE FINANCIAL MARKETS
IN SOCIAL SECURITY REFORM
=======================================================================
HEARING
before the
SUBCOMMITTEE ON SECURITIES AND INVESTMENT
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED NINTH CONGRESS
FIRST SESSION
ON
THE ROLE OF THE FINANCIAL MARKETS IN SOCIAL SECURITY REFORM, FOCUSING
ON THE FEDERAL THRIFT SAVINGS PLAN, PERSONAL RETIREMENT SAVINGS
ACCOUNTS, AND RETIREMENT PLAN ADMINISTRATIVE COSTS
__________
JUNE 14, 2005
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina JON S. CORZINE, New Jersey
MEL MARTINEZ, Florida
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Justin Daly, Counsel
Dean V. Shahinian, Democratic Counsel
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
______
Subcommittee on Securities and Investment
CHUCK HAGEL, Nebraska, Chairman
CHRISTOPHER J. DODD, Connecticut, Ranking Member
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
JOHN E. SUNUNU, New Hampshire JACK REED, Rhode Island
MEL MARTINEZ, Florida CHARLES E. SCHUMER, New York
ROBERT F. BENNETT, Utah EVAN BAYH, Indiana
JIM BUNNING, Kentucky DEBBIE STABENOW, Michigan
MIKE CRAPO, Idaho JON S. CORZINE, New Jersey
ELIZABETH DOLE, North Carolina THOMAS R. CARPER, Delaware
WAYNE ALLARD, Colorado
RICK SANTORUM, Pennsylvania
Joseph Cwiklinski, Legislative Assistant
Alex Sternhell, Democratic Staff Director
(ii)
C O N T E N T S
----------
TUESDAY, JULY 14, 2005
Page
Opening statement of Senator Hagel............................... 1
Opening statements, comments, or prepared statements of:
Senator Dodd................................................. 2
Senator Sununu............................................... 21
Senator Reed................................................. 23
Senator Johnson.............................................. 41
WITNESSES
Gary A. Amelio, Executive Director, Federal Retirement Thrift
Investment Board............................................... 4
Prepared statement........................................... 43
Francis Enderle, Managing Director and Chief Investment Officer,
Global Index and Markets Group, Barclays Global Investors...... 5
Prepared statement........................................... 49
Francis X. Cavanaugh, former Director, Federal Retirement Thrift
Investment Board............................................... 7
Prepared statement........................................... 51
Michael Tanner, Director, Cato Project on Social Security Choice. 9
Prepared statement........................................... 57
David C. John, Research Fellow, Thomas A. Roe Institute for
Economic Policy Studies, The Heritage Foundation............... 11
Prepared statement........................................... 59
Jason Furman, Non-Resident Senior Fellow, Center on Budget and
Policy Priorities and Visiting Scholar, Wagner Graduate School
of Public Service, New York University......................... 13
Prepared statement........................................... 64
(iii)
THE ROLE OF THE FINANCIAL MARKETS IN SOCIAL SECURITY REFORM
----------
TUESDAY, JUNE 14, 2005
U.S. Senate,
Subcommittee on Securities and Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 2:07 p.m., in room SD-538, Dirksen
Senate Office Building, Senator Chuck Hagel, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF SENATOR CHUCK HAGEL
Senator Hagel. Good morning, the hearing will come to
order.
For 70 years Social Security has been one of the most
successful and important Government programs in our country.
Almost every American family during this time has been touched
in some way by Social Security.
However, the Social Security system is actuarially
unsustainable as it now exists. The Social Security system is
not in crisis today, but there is clearly a crisis on the
horizon.
America faces a $4 trillion deficit in Social Security over
the next 75 years. In 2017, more money will be paid out of
Social Security than comes in. In 2041, Social Security will be
insolvent. Beyond the next 75 years there is only a black hole
of unfunded liability for future generations.
The longer we wait to address this issue, the more
difficult it will be to protect Social Security and the promise
our Government has made to future generations of Americans.
Today's hearing will examine what role financial markets
will play in Social Security reform. It is important what risks
there are, how they might be managed, what kind of fiduciary
responsibility would be required of Government officials, and
how a personal account system might work.
The Federal Thrift Savings Plan, TSP, provides a model we
can review that gives us a better understanding of these
issues. Since taking effect in 1987, TSP has been a success for
Government employees. Last year, returns on the different
accounts range from just over 4 percent to 20 percent. And over
the last 10 years, the returns have been between 5.5 percent
and 12 percent. Barclays Global Investors is the investment
managing firm for TSP.
Today's hearing will look at the TSP model and focus on the
operational issues that the Federal Retirement Thrift
Investigation Board and Barclays face in managing the TSP
accounts, the different costs and fees associated with the
operation of these accounts, the bidding process that TSP
employs to hire private investment firms, the different
investment options that TSP offers, and how effectively the TSP
model could be applied to broader Social Security reform.
In assessing the role of the financial markets in Social
Security reform, we need to look at the market impact for
private investors. If the Federal Government became a big
operator in the marketplace and had to manage 100 million
accounts, then what impact would there be on the broader
marketplace? What procedures would need to be implemented to
ensure that this impact is minimal and managed?
In 1997, former Senate Banking Committee Chairman Phil
Gramm said that without strict procedures, this would be like
being in a rowboat with an elephant. When the Government moved
in the boat, you would know it. How can we minimize this
impact? Or can we minimize this impact?
I welcome our distinguished witnesses today that will help
us explore these issues and thank them for their important
contributions. Before I ask my distinguished colleague, the
Senator from Connecticut, for his remarks, I would quickly
introduce the panel, and then after Senator Dodd's remarks, we
will address each of your testimonies.
Gary Amelio, the current Executive Director of the Federal
Retirement Thrift Investment Board; Francis Enderle, Chief
Investment Adviser for Barclays Global Investors; Francis
Cavanaugh, Consultant for Public Finance Consulting, and the
former Executive Director of the Federal Retirement Thrift
Investment Board; Mike Tanner, Director of the Cato Institute's
Project on Social Security Choice; David John, Research Fellow
for the Heritage Foundation; and Jason Furman, Nonresident
Senior Fellow at the Center on Budget and Policy Priorities,
and also a Visiting Scholar at New York University's Wagner
Graduate School of Public Service.
Gentlemen, we thank each of you for your time and for your
contributions to this panel, and I would now ask my
distinguished colleague, Senator Dodd, for his remarks.
STATEMENT OF SENATOR CHRISTOPHER J. DODD
Senator Dodd. Thank you very much, Mr. Chairman, and my
apologies to you for arriving a couple minutes late, finishing
up our conference lunches as we do on Tuesdays around here. But
I thank you for doing this.
There are a number of proposals that are kicking around,
including ones that I know the Chairman has proposed, on how to
address the issue of Social Security in the coming years. So, I
think it is highly appropriate that this Subcommittee, which
deals with securities and investment, to hold a hearing on the
Social Security reform debate. It is appropriate and the right
thing to do. In fact, as you have just pointed out, in 1997,
when I was still a Member of this Subcommittee, Senator Phil
Gramm, our former colleague, held a hearing on the very same
subject matter regarding Social Security. In fact, at that
hearing, Mr. Tanner, you testified in 1997.
Mr. Tanner. Yes, sir.
Senator Dodd. How are you doing?
Mr. Tanner. Keeping busy.
Senator Dodd. It has been a long time, 8 years. Welcome
back to the Committee.
Anyway, throughout my tenure in the Senate, Mr. Chairman, I
have always been interested in ways in which we can strengthen
retirement security in the country, including expanding the
individual retirement accounts and improving pension plans. In
fact, one of the first bills I authored as a freshman Member of
this body back in the early 1980's was on individual retirement
accounts. I recall at the time when we offered the legislation,
there was editorial comment that this was only going to serve
my more affluent constituents in Fairfield County. And then
Merrill Lynch did a study back in the early 1980's
demonstrating that even people with incomes of $20,000 were
investing in individual retirement accounts. They were doing it
usually the day before their taxes were due. They were not
taking it earlier in the year because of the lack of disposable
income. But clearly IRAs were a wonderful vehicle for expanding
and increased retirement security.
Any of these financial instruments, of course, in my view
are essential to millions of Americans in helping to provide
for retirement and their family's financial security. Moreover,
they have helped our economy by encouraging private savings,
which have become dangerously low, I might add, in recent
years.
However, let me just say briefly in these opening remarks,
I have deep reservations about the current proposals by the
Administration and others to divert funds from Social Security
into the private marketplace, and let me explain why.
I believe there is legitimacy to the concern that the
Social Security Trust Fund will, over the coming decades, have
some serious financial difficulties. It is altogether
appropriate and not too soon to look at ways to keep Social
Security strong and vibrant for future generations of retirees.
However, in my view, the Administration's proposal is
fundamentally flawed for at least three reasons.
First, by diverting money away from the Social Security
trust fund, I believe we exacerbate the insolvency concerns
rather than improve the health of the fund. Most observers
believe that even under the most dire predictions, about 80
percent of the Social Security trust fund will be in place in
the decades of the 2020's, 2040's, or 2050's, that we will have
about a 20- to 25-percent shortfall that we will have to deal
with. And certainly we need to address that, but I think by
diverting funds away from Social Security, we will make that
problem even more serious.
Second, the proposal of the Administration increases the
national debt by over $5 trillion. Even the Vice President
acknowledges that number. And I do not take lightly the thought
of putting $5 trillion more of debt on our children and future
generations.
Third, in my view the proposal requires a reduction in
guaranteed Social Security benefits for most retirees. Social
Security is critical not only to senior citizens but also to
the fabric of our society. There are approximately 47 million
of our fellow Americans who receive Social Security benefits of
one kind or another. It is the sole source of income for one-
fifth of all seniors and it is the primary source of income for
two-thirds of seniors.
Social Security reduces the poverty rate among seniors from
about 50 percent to about 10 percent in our Nation. Beyond its
retirement benefits, Social Security provides critical support
for the disabled and for the surviving family members of
workers who die. Only about 30 percent of workers would have
access to long-term disability benefits absent Social Security.
I believe that as we address the issues of Social Security
reform, we need to keep a few basic principles in mind. One, do
no harm. The goal is to strengthen Social Security. Let us
agree to strengthen Social Security, not dismantle it by
agreeing not to divert any money out of the trust fund.
Second, we need to create new opportunities in addition to
Social Security to enhance retirement security. For Americans
to save for their retirement, for one, we should do more in
that area. Our national savings rate, as I mentioned earlier,
is abysmally low. We should use the tax code and other means to
reward and incentivize savings and help Americans with their
long-term retirement needs.
Third, we need to come and to work together in a bipartisan
fashion, which we are not doing enough of in this area.
Providing for the retirement of future generations of Americans
is far too important of an issue to become part of a game of
partisan football.
Once again, I want to thank the Chairman, Senator Hagel,
for his thoughtful proposals as he has attempted to address
this issue and for giving this Subcommittee a chance to be
heard on the issue and for inviting such a distinguished panel
of witnesses to share their thoughts. I look forward to their
this.
Senator Hagel. Senator Dodd, thank you.
Let us begin with Mr. Amelio. Again, Mr. Amelio is the
Executive Director, Federal Thrift Retirement Investment Board.
Mr. Amelio, welcome. Thank you.
STATEMENT OF GARY A. AMELIO
EXECUTIVE DIRECTOR,
FEDERAL RETIREMENT THRIFT INVESTMENT BOARD
Mr. Amelio. Thank you. Good morning, Chairman Hagel and
Senator Dodd. My name is Gary Amelio, and I am the Executive
Director of the Federal Retirement Thrift Investment Board, an
independent agency charged with administering the Thrift
Savings Plan. I serve as the managing fiduciary of the TSP.
Prior to my appointment on June 1, 2003, I had 23 years of
private sector experience in the employee benefits industry.
Although the Board has no expressed position regarding
proposals to change Social Security, I am pleased to discuss
TSP operations and investments.
Since 1987, the TSP has grown to 3.4 million participants
with a total of $157 billion in account balances. I often
comment that Congress could not have provided a better
structure when it created the TSP, fashioning the plan with the
goal of providing retirement savings for Federal employees at
low administrative costs, with a limited number of funds that
track broad investment markets. This simplified structure has
protected the plan from political manipulation and,
consequently, enabled the TSP to gain the confidence of Federal
employees and become the largest and, arguably, most successful
defined contribution plan in the world.
The TSP's participation rate significantly exceeds the
industry average, primarily, I believe, because participants
find the plan simple to grasp. The TSP participants also enjoy
low administrative costs. Last year, expenses were just six
basis points or 60 cents for every $1,000, which is rock-bottom
in the industry. I like to say that the TSP is the most
inexpensive legal investment in the world. It might also be the
most inexpensive illegal investment, but we do not have any
data.
Through the years, the TSP and the Congress have worked
together to improve the plan. The TSP recently modernized its
recordkeeping system to accommodate daily valuation, and in the
next couple of months, lifecycle funds will be available to
provide professionally designed asset allocation models
appropriate for participants' investment time horizons.
Last year, Congress improved the plan by approving the
Board's recommendation to eliminate open seasons. In 1986, the
concept of allowing Federal employees to invest in a retirement
savings plan, which included private securities, was untested.
By mandating a sound and simple structure protected from
political manipulation, Congress created a plan which passed
the test, gained the confidence of Federal employees, and
strengthened their retirement security.
This concludes my summary comments, and I ask that my
extensive written statement be entered into the record. I would
be pleased to respond to any questions.
Senator Hagel. Mr. Amelio, thank you. Each of your written
statements will be included for the record, in their entirety.
Mr. Enderle is Chief Investment Adviser, Barclays Global
Investors.
Mr. Enderle.
STATEMENT OF FRANCIS ENDERLE
MANAGING DIRECTOR AND CHIEF INVESTMENT OFFICER
GLOBAL INDEX AND MARKETS GROUP, BARCLAYS GLOBAL INVESTORS
Mr. Enderle. Good afternoon, Mr. Chairman, Senator Dodd. My
name is Francis Enderle, and I am the Chief Investment Officer
for the Global Index and Markets Group at Barclays Global
Investors, or BGI. In that role I am responsible for, among
other things, the oversight of portfolio management in the
United States of all of BGI's index strategies.
We are pleased to be here today to share with the
Subcommittee our expertise in the management of defined
contribution pension accounts, which is derived from our
experience as the external asset manager for the Federal Thrift
Savings Plan, or the TSP, as well as for other numerous public
and private pension plans. We are honored to have served as an
investment manager for the TSP since 1988, a relationship we
have retained in regular, highly competitive bidding processes.
Since our founding in 1971, BGI has remained true to a
single global investment philosophy, which we call ``Total
Performance Management.'' BGI manages performance through the
core disciplines of risk, return, and cost management. The
success of our indexing methodology results from our focus on
delivering superior investment results over time while
minimizing trading and other implementation costs and
rigorously controlling investment and operational risks.
BGI manages four of the five investment options available
for TSP participants: The C, S, F, and I funds. The fifth
option, the G Fund, is managed by the U.S. Treasury. Later this
year, the TSP will be launching a series of lifecycle or
``target horizon'' funds that use the existing five options as
the asset class building blocks with allocations in each
lifecycle fund across these options being determined by an
external vendor.
BGI's services to the TSP are completely focused on our
core expertise--investment management. We do not provide any
other services. We have an extremely effective operating model
developed in conjunction with TSP staff to manage the daily
cashflows into or out of each of the investment options.
The key to BGI's success in index management has been our
ability to minimize implementation and trading costs. High
costs and expenses of investing detract from performance and
investment returns; lower costs increase the investment pool
and put more money long-term into the pockets of investors. Let
me say a few words about how we do this.
Each of our index funds is structured to match the
performance of a specific third-party-designed index. These
indexes are really paper portfolios and do not include any of
the trading costs that real-world investors experience. To
successfully track the index as closely as possible, BGI
strives to minimize the real-world costs through a variety of
highly efficient trading approaches.
The average account size for our U.S. clients is $880
million. Through the size and diversity of our client base, we
are able to match or offset a significant percentage of many of
our clients' buy and sell orders internally, thereby reducing
or eliminating market transaction costs. The internal matching
of buy and sell orders is commonly referred to as ``crossing''
and is conducted and actively monitored by BGI pursuant to the
terms and conditions of an exemption issued by the Department
of Labor.
When we do trade in the markets, we utilize carefully
developed and managed trading strategies. We access all
possible sources of liquidity, including electronic
marketplaces. And we ensure that we receive superior execution.
Indexing is the most cost-efficient and diversified way to
gain exposure to various segments of the capital markets. We
believe index funds are the best core investment for most
investors' portfolios, whether they are the largest pension
fund in the world or an individual investor.
I would now like to make a few comments regarding the
investment-related issues to be considered if the Federal
Government were to legislate individual investment accounts
either as part of Social Security reform or through another
mechanism.
Let me first acknowledge that BGI has built a substantial
part of its business by offering well-managed index strategies
to our clients for more than 30 years. We, therefore, have a
vested interest in the continued growth of index investing. Our
interests aside, we firmly believe that the reason for the
success of these strategies is the simple fact that they
deliver the return of the market index reliably and cost
effectively. In fact, Congress recognized this itself in the
enabling legislation for the TSP.
If a national system of personal accounts were to be
implemented, we would encourage legislators to consider the
following approach that draws on the best practices of
institutional investors.
An array of low-cost, broadly diversified index funds
frequently forms the core investment for institutional pension
plans. For example, the current selection offered to TSP
participants covers all the main asset classes, large and small
capitalization U.S. equities, U.S. fixed income, international
equities, and a stable value option.
We suggest consideration of index portfolios because they
offer three principal benefits to investors: First, they
capture the return of each asset class with a high degree of
precision; second, index funds typically have low asset
management fees compared to actively managed funds; and, third,
index funds have lower relative transaction costs including
communications, bid/ask spreads, and market impact.
The latter point is worth elaborating upon given the
sizable assets that would potentially be invested in personal
accounts. Investing in index funds spreads assets across the
broadest possible array of securities in any asset class,
thereby minimizing the impact of trading large cashflows in the
market on a daily basis. This is not only important for the
investment of new monies into personal accounts, but also for
any trading individuals may initiated in their personal
accounts to reallocate assets among their investment options
over time.
Another investment option to be considered is an array of
so-called lifecycle or ``target horizon'' funds, options that
the TSP will be adding later this year, as I mentioned earlier.
With lifecycle funds, potentially the only choice an investor
needs to make is to select the lifecycle fund with the target
horizon date that most closely matches the investor's date of
retirement. Each lifecycle fund would hold an array of asset
classes with each asset class being implemented with an index
fund. The asset mix within each lifecycle fund would gradually
become more conservative over time as the target horizon date
approached.
Mr. Chairman, we believe that the investment considerations
we have discussed will assist you and others on this Committee
in evaluating the criteria to be used if personal accounts were
to be legislated by Congress as part of revisions to the Social
Security program or in another program. I thank you for the
opportunity to speak with you today, and I look forward to
answering any questions you may have.
Senator Hagel. Mr. Enderle, thank you.
Now we would ask Mr. Francis Cavanaugh to present his
testimony. Mr. Cavanaugh is a Consultant for Public Finance
Consulting and former Executive Director of the Federal
Retirement Thrift Investment Board.
Mr. Cavanaugh.
STATEMENT OF FRANCIS X. CAVANAUGH
FORMER DIRECTOR, FEDERAL RETIREMENT THRIFT INVESTMENT BOARD
Mr. Cavanaugh. Thank you, Mr. Chairman and Members of the
Committee, I welcome this opportunity to discuss the role of
financial markets in Social Security reform. The
Administration's current proposal for Social Security
individual accounts contemplates that private financial
institutions would provide fund management services and
probably other 401(k) plan services, such as investment
education, counseling, and recordkeeping. My comments will
focus on the cost of such services and the problems in
providing them to employees of small businesses.
A critical question, of course, is cost. Individual
accounts are proposed to provide a higher investment return
than would be realized by the Social Security trust fund. On
this basis, individual accounts would not be feasible for the
68 million employees of 98 percent of the businesses in the
United States--that is, the 5.6 million small businesses with
fewer than 100 employees.
To understand the costs of individual accounts of small
businesses, we must first understand why 85 percent of them do
not now have retirement plans for their employees. A major
reason is that the 401(k) industry has found that it cannot
profitably provide services for a company for less than
approximately $3,000 a year, even though they enjoy economies
of scale from combining thousands of employers in their
centralized computer systems. Further significant economies of
scale would not be realized by a central Federal Thrift Savings
Plan-type agency because of the fixed costs of reaching out to
millions of small businesses. Nor can we assume that a new
central Government agency would be more efficient than the
major 401(k) providers who now serve this market.
Thus, the cost per employee of a company with 10 employees
would be $300, or 30 percent of the President's proposed annual
individual account contribution of $1,000, and most U.S.
companies have fewer than 10 employees.
Accordingly, the initial expense ratio for employees of the
average size business would be more than 3,000 basis points, or
100 times the Administration's estimate of 30 basis points.
Obviously, since the administrative costs of individual
accounts would exceed their estimated investment returns,
substantial Government subsidies would be necessary to make
individual accounts attractive to employees of small business.
If all Social Security taxpayers eventually participate in
the individual account program, you would find that the
administrative costs would be more than $46 billion a year--
that is, 155 million Social Security taxpayers times more than
$300 per account--which would be a subsidy to support an
uneconomic function.
In addition to the above costs, which are based on what the
current providers are actually charging for establishing and
servicing 401(k) plans, there are overwhelming practical
obstacles to modeling individual accounts on the TSP or private
401(k) plans.
First, the TSP is administered by just one employer--the
U.S. Government--with an extensive network of agency personnel,
payroll, and systems staff to provide the essential employee
education, retirement counseling, payroll deductions, timely
funds transfers, and error correction functions. These
essential employer services in 401(k) plans could not possibly
be performed by small business employers or by a new TSP
central agency.
Second, the TSP is computerized, like all other large
plans, with investments made promptly after contributions are
deducted from the employee's paycheck. With individual
accounts, it would be up to 22 months after payday under
current Social Security Administration procedures before
individual accounts could be credited and invested.
Third, the TSP is balanced to the penny every day. Social
Security is never balanced. Each year there are billions of
dollars unreconciled discrepancies.
Fourth, the TSP and the Federal employee agencies have a
very effective system of communication. TSP mailings
consistently have reached more than 99 percent of employees,
but 25 percent of Social Security Administration mailings are
returned and marked as undeliverable.
Since individual accounts are certainly not feasible for
employees of small business, the only practical way to give
them higher returns is to invest part of the Social Security
trust fund in equities. The likely increase in trust fund
earnings would be an effective way to help maintain the
solvency of the trust fund. Every State in the United States
has authorized public retirement fund investment in stocks,
which can now be done through broad-based index funds, which
avoid the problem of direct Government control over particular
companies. As shown in my prepared statement, there is even
less Government influence over private companies under the
trust fund alternative than under the TSP or the
Administration's plan.
In conclusion, the Administration's plan for universal
individual accounts is not feasible. The way for the Social
Security system to capture the higher returns available for
investments in stocks is to diversify Social Security trust
fund investments. The trust fund alternative compared to
individual accounts would be less disruptive of financial
markets, would save tens of billions of dollars a year in
administrative costs, and would be effective virtually
immediately rather than the 2009 starting date proposed for
individual accounts. The multitrillion-dollar transition costs
of individual accounts would be avoided completely. The
additional trust fund earnings would go a long way toward
strengthening Social Security finances and would thus reduce if
not eliminate the need for significant tax increases or benefit
reductions.
Thank you for your attention. I will be happy to answer any
questions.
Senator Hagel. Mr. Cavanaugh, thank you.
Mr. Mike Tanner, the Director of the Project on Social
Security Choice, the Cato Institute, an old friend of Senator
Dodd's.
[Laughter.]
Mr. Tanner, welcome.
STATEMENT OF MICHAEL TANNER
DIRECTOR, CATO PROJECT ON SOCIAL SECURITY CHOICE
Mr. Tanner. Thank you, Mr. Chairman and Members of the
Subcommittee, it is a pleasure to be back before the
subcommittee again, and in particular, Mr. Chairman, I would
like to thank you for holding this hearing. I think it is very
important that we move beyond the sterile debate that we have
been having about whether or not Social Security is facing a
crisis or just a big problem and start discussing actual
solutions to the problems that Social Security is facing. That
includes a discussion of how individual accounts might be
structured in ways that can maximize consumer choice and
control while ensuring efficiency, low cost, and preserving an
appropriate measure of worker protection.
Of course, along with my colleagues at the Cato Institute,
I believe that Social Security reform must allow younger
workers to save and invest some of their Social Security taxes
through personal accounts. Such accounts can significantly
contribute to restoring Social Security to permanent
sustainable solvency. But, more important, I believe that
personal accounts are essential to modernizing Social Security
in keeping with such fundamental American values as ownership,
inheritability, and choice.
Now, regarding the subject of this hearing, I think, in
general, economic theory holds that private capital investment
should provide a higher rate of return than a mature PAYGO
Social Security system can provide. I believe that while there
are distribution questions and certainly other issues that must
be addressed, the returns from personal accounts privately
invested will exceed the returns that Social Security will
provide in the future to younger workers, including exceeding
any offset interest rates such as those suggested under the
President's reform proposal.
That said, how personal accounts are structured and the
investment options available to workers can make a significant
difference in the success of any personal account proposal. In
short, details matter.
In designing an investment and administrative structure for
personal accounts, I would urge Congress to be guided by these
basic concerns.
First, simplicity and transparency. Workers should clearly
understand where their money is going and what their options
are. Where personal account plans have encountered
difficulties, such as in Great Britain, it has been primarily
due to overly opaque or overly complex schemes.
Second, balancing risk and return. While market returns, as
I say, are expected to exceed Social Security returns, markets
are not risk free. Of course, I would also note that the
current Social Security system is not risk free. However, many
of the new investors brought into the market through personal
accounts will be inexperienced. Bringing these new investors
into the marketplace is a good thing, but we should recognize
that they will not be sophisticated investors. A personal
account investment plan must offer these individuals some
degree of protection without stifling consumer choice,
overregulating markets, or unduly restricting the potential for
positive returns.
Third, keep administrative costs low. While regulation of
account fees would be unwise, accounts should be designed in
ways that minimize administrative costs. The Social Security
Administration estimates that accounts would cost 25 to 30
basis points to administer, and I believe this is an entirely
reasonable target.
Fourth, limit Government involvement in investment
decisions. Decisions about the investment of the accumulating
retirement funds should be left to private markets and
insulated from Government interference as much as possible. And
I note that Government interference takes place to a high
degree with State, county, and municipal pension funds.
Finally, avoid increased employer burden. Every effort
should be made to avoid any new burden on employers,
particularly small employers.
In my written testimony I have spelled out one possible
structure for meeting these goals. That proposal involves a
centralized colleague point, essentially the current payroll
tax collection mechanism. Treasury would be responsible for
holding the funds until reconciliation takes place with the
funds being held in a money market account on a unitized dollar
basis.
Once reconciliation takes place, Treasury would
electronically transfer the funds to the worker's account.
Initially, a small range of broadly diversified funds would be
the only investment options available, something perhaps
similar to the TSP, perhaps a series of balanced funds, perhaps
a lifecycle fund, the type of options that have been discussed
and are included in many of the proposals up here, including
the Chairman's and Senator Sununu's. However, at some point--
and I think this is essential--a broader range of investment
choices should be opened up to individual investors.
Let me conclude by saying that I believe that Social
Security reform is not an option but a necessity. The program
will begin running a deficit in just 12 years and faces
unfunded obligations of roughly $12.8 trillion in the future.
The need for reform, however, presents us with an opportunity
to create a new and better retirement program for all
Americans, a program that gives workers ownership over their
retirement funds, more choice and control over their money, and
the opportunity to build a nest egg of real inheritable wealth.
Therefore, any Social Security reform should include personal
accounts.
That makes the work of this Committee all the more
important: Getting the design and the structure of the accounts
right. I believe that the structure I have set out today takes
us in that direction, and I look forward to the Committee's
questions.
Thank you very much.
Senator Hagel. Mr. Tanner, thank you.
Mr. David John, Research Fellow, the Heritage Foundation.
Mr. John, welcome.
STATEMENT OF DAVID C. JOHN
RESEARCH FELLOW, THOMAS A. ROE INSTITUTE FOR ECONOMIC POLICY
STUDIES, THE HERITAGE FOUNDATION
Mr. John. Thank you very much for having me, and thank you
for looking into this issue. This is going to be one of the key
issues not just in the Social Security debate but in the
overall retirement security debate. I have a 19-year-old
daughter who just finished her first year of nursing school,
and the simple fact is that when Meredith retires, Social
Security is not going to be able to replace the same amount of
her income as it does for her parents or as it will for me.
Meredith, no matter what, is going to have to save and invest
from day one when she first gets a job in order to come up with
a decent retirement income.
Now, we have a very effective and efficient private
retirement system--401(k)'s, IRA's, et cetera, et cetera. And
it is fairly simple for Meredith to save if she has a 401(k)
and works in a large hospital. But if she is a private-duty
nurse or if she is working essentially for herself, she is
likely to have no choice in the slightest because obviously she
cannot sponsor her own 401(k) plan for, frankly, reasons that
Mr. Cavanaugh mentioned. So a TSP structure not only could
apply to a Social Security account, but it also could be used
in terms of expanding the opportunities of ordinary Americans
to save for retirement.
Now, having said that, let me suggest that the TSP
structure is especially useful for a Social Security account.
It is vastly different from the 401(k) structure that we see in
private business for the simple fact that it is administered
through the tax system. The individual business owner has no
participation in this. The individual business owner would
provide or forward the payroll taxes and income taxes of their
workers to Treasury, just as they do now, and at that point
their responsibility ends. They have no additional costs. They
have no additional participation. It is once the money reaches
Treasury that it is then subdivided and moved into a personal
retirement account, and there are mechanisms to do that
efficiently, and, frankly, that can be done as easily on an
annual basis as it would be on a weekly, a monthly, or a yearly
basis.
Now, Social Security accounts should start slowly, with
limited investment options. This is the way TSP started.
Initially, there was only the G Fund, and the other investment
options were added at a later date. The last two investment
options are relatively recent. A study by State Street Trust,
which is one of the major pension administrators in the
country, looking at a system which, by coincidence, happens to
be the one that most Social Security reformers are talking
about, found that the costs could be somewhere between 0.19
percent of assets under management and 0.35 percent of assets
under management.
Now, what that basically is a very tiny amount, one-third
of 1 percent at the most. Unfortunately, there is no way of
comparing the costs of a 401(k) system or the TSP system to
today's Social Security because when it comes right down to it,
today's Social Security does not have a trust fund of the type
that traditional pension plans have, nor are Social Security
benefits paid out of that trust fund. They are basically paid
on a pay-as-you-go basis. So it is impossible to compare apples
and oranges in this situation.
But what we can say is that a TSP account would be the
lowest-cost opportunity for an individual worker to build
retirement savings. The best way to do that also would be
through a lifespan account--they are alternately called
lifespan, lifestyle; ``life'' is the key element there--which
automatically rebalances the investments starting out with a
more aggressive investment structure when an individual is very
young and moving to a much more conservative structure by the
time the individual reaches retirement age.
There are 55 companies that currently offer lifespan
accounts as part of their 401(k) plans. The initial estimates
show that having a lifespan account actually can increase the
amount of retirement savings that an average worker could have,
including the lower-income workers, by roughly one-eighth. They
do not have to be expensive. Vanguard has an investment in
passively traded index funds, similar to the ones that were
discussed earlier here, and their annual cost is 0.23 percent,
roughly one-quarter of 1 percent of assets under management.
This is not a theoretical question. This is not a question
of millions, billions, and trillions. This affects real people.
My daughter is 19 at the moment. She will retire roughly 10
years after the Social Security trust fund disappears. Under
current law, that means she stands a 30-percent benefit cut in
her Social Security benefits. If we structure soon a retirement
investment plan similar to the TSP system that she could
participate in from day one when she goes to work, she could
end up with significantly higher Social Security benefits than
what she would face right now. In 2040, when Meredith is 56,
under current law the Social Security system--and there will be
trust funds at that point--will take 15 cents on every dollar
of income tax that is collected in that year. Fifty cents of
every dollar collected in income tax that year goes to
Medicare.
Now, unless action is done quickly on Social Security,
Meredith basically faces a choice of funding programs for her
kids and her grandkids or for her parents and grandparents.
That is not a situation she needs to be in.
Action is needed quickly, and practical action that
actually gives her a decent chance to a secure retirement
system.
Thank you.
Senator Hagel. Mr. John, thank you very much.
Mr. Jason Furman, Adjunct Professor, Wagner Graduate School
of Public Service, New York University.
Mr. Furman.
STATEMENT OF JASON FURMAN
NON-RESIDENT SENIOR FELLOW, CENTER ON BUDGET AND
POLICY PRIORITIES AND VISITING SCHOLAR,
WAGNER GRADUATE SCHOOL OF PUBLIC SERVICE,
NEW YORK UNIVERSITY
Mr. Furman. Mr. Chairman, Members of the Committee, thank
you for the opportunity to address the Subcommittee. In
considering reforms that would dramatically change the nature
of Social Security, it is critical to consider how individual
accounts would be administered through the financial system and
how markets would react to the borrowing necessary to finance
accounts.
In my comments today, I would like to focus on four points:
The administrative costs associated with accounts; the
Government staffing required for those accounts; what this
would do to the rate of return that average Americans could
expect through Social Security; and the impact of large-scale
borrowing on financial markets.
First, administrative costs in a private account system
would be at least 10 times as large as the costs under the
current system. In some proposals, administrative costs could
eat up more than one-third of final account balances. Even the
sharpest critics of our current system admit that Social
Security is extremely efficient. Establishing over 100 million
individual accounts for Social Security contributors would
entail substantial new complexities and tasks, including
tracking contributions, allocating them to different
investments, managing assets, and distributing balances at
retirement. All of these new tasks would be in addition to
everything Social Security does today.
The President's account proposal controls administrative
costs by limiting choice and services to a bare minimum,
including establish centralized Government management of the
accounts. According to the Social Security actuaries, even this
barebones system would cost 10 times more to administer than
the current Social Security system. Accumulated over 40 years,
0.3 percent annual sounds very low, but if you accumulate it
over 40 years, it will eat up 7 percent of your ultimate
account balance because that first contribution you pay 30
cents on it year after year. That is compared to 0.6 percent
under the traditional Social Security system, and these
estimates do not even include the cost of starting up accounts,
partially annuitizing account balances at retirement, and many
of the considerations that Mr. Cavanaugh raised in his
testimony.
Even if an individual account plan initially offered only a
few funds, it is likely that political pressure would expand
the options over time, as recommended by the President's Social
Security Commission and Mr. Tanner and Mr. John at this
hearing. Participants might demand more options for managing
their money, and some might object to being required to invest
in a Government-designated allocation of stocks, which includes
companies that, for example, are perceived to harm the
environment or support gay rights. If investment choices were
widened even slightly to address these concerns, costs could
double to about 15 percent of the final account balance.
If the President's Government-organized accounts approach
is rejected and privately organized accounts, like existing
IRA's, are established instead, costs would be even higher. In
the United Kingdom, for example, administrative costs were
eating up a staggering 43 percent of the final account value at
retirement before caps on fees were recently instituted.
My second point: Establishing accounts would require a
substantial increase in Government staffing, likely in the form
of a new Government agency that could be about half the size of
the IRS or the Social Security Administration. The Clinton
Administration Treasury Department found that tens of thousands
of new Government workers would be needed to answer phone
inquiries and process worker choices of fund managers in a
barebones system. With even slightly expanded choice along the
lines of what we have heard advocated today, that number could
triple.
By the end of the first decade of President Bush's
proposal, administrative costs would be running at about $4.4
billion annually, according to the optimistic estimates of the
Social Security actuaries, enough to support about 30,000 new
Government employees in addition to other expenses. By
comparison, currently SSA has a total staff of about 65,000 and
the IRS has a staff of about 100,000.
My third point: When administrative costs are considered,
returns from many participants under a private account system
would be lower than in a reformed system without accounts.
Additional administrative costs associated with individual
accounts are certain. Potential gains from accounts, however,
are uncertain. The President's proposal allows workers to, in
effect, borrow money at the Treasury bond rate and invest it in
a restricted range of funds. At the end of the day, the worker
would have to pay the large administrative costs of managing
this awkward system. Far superior for most workers would be
simply to, if they want to increase their exposure to risk,
reallocate their portfolio, and if they have no exposure to
risk, to do some of the measures that Senator Dodd was talking
about to encourage more investment without replacing part of
the very efficient Social Security system with a substantially
less efficient system.
The administrative costs for the average worker would be
substantial, reducing annual benefits anywhere from $700 a year
to $4,000 a year. That is on top of all the other benefit
reductions the President is proposing. As a result, the Social
Security system would have a lower rate of return for a large
fraction of workers than a system without accounts.
Fourth, the increase in the debt associated with
establishing private accounts would increase the risks facing
financial markets and fiscal policies. Carveout accounts and
add-on accounts that are not paid for both result in
substantial increases in the debt. In the President's plan, the
debt would go up by $5 trillion over the first 20 years.
Economist Martin Feldstein advised President Reagan not to
establish individual accounts, in part because, ``to fund
investment-based accounts would have required a tax increase or
an even larger overall budget deficit.'' According to Harvey
Rosen, who just last week stepped down as Chairman of President
Bush's Council of Economic Advisers, diverting funds into
private accounts would either drive interest rates up, stock
returns down, or some combination of both.
Private accounts could create more difficulties for
beneficiaries in markets than I have time to document. Instead
of proceeding down that road, we can instead modify the current
system to make it sustainably solvent and help make it easier
and more automatic to save through existing IRA's and 401(k)'s
without incurring the costs and risks associated with replacing
Social Security with accounts.
I look forward to the opportunity to discuss this and other
questions with you. Thank you.
Senator Hagel. Mr. Furman, thank you.
Since there are three of us here at this point, I would ask
Senator Dodd if we would do an 8- to 10-minute round, each of
us. Is that acceptable? Then we will keep cycling. I suspect we
may have some other colleagues as well. So we will start with
8-minute rounds of questioning. Thank you.
Mr. Amelio, in your testimony, and in the testimony of each
of you, you have touched upon a fee structure and fees and the
relevancy of that challenge, which I think we all agree is a
big part of any kind of personal account structure. And you had
noted, I believe, Mr. Amelio, that it was six basis points, 60
cents per $1,000, essentially the standard that we have now--or
you have come up with, and, in fact, is the real number for
TSP.
My question is this: What rules or procedures has TSP
implemented to foster responsible fiduciary management and
accountability in relationship to those fees and other parts of
the structure that your colleagues and you have touched upon in
your testimony?
Mr. Amelio. They are 6 basis points and they are coming
down. We anticipate they will possibly be 5 basis points this
year. That comes to approximately $27 per participant. I think
there are 4 reasons that our fees are able to be so low. One is
the girth of the plan. We have a large amount of assets. That
helps to keep the average of the cost sized down. Two, we use
only index funds which are the least expensive investment model
that I think any fiduciary could select for an institution
plan. Three, although it is a daily plan where participants are
allowed to move their money daily, go onto a website and see
their balances, it is a simple plan and that I am very proud
of. We have only 5 investment options, and even when you add
the lifecycle funds they are not funds with a capital ``F,''
they are asset allocation strategies and it is that simplicity
that also helps us to maintain low cost. Fourth is self-
administration. We are large enough that we are able to
administer everything in house. They noted the Social Security
Administration has 65,000 employees. When I came 3 years ago,
we had 108 employees at the TSP. We are down to 89 now. We do
have outside contractors of a couple hundred. Through good
management, we have an independent board, and I think for those
four reasons we are able to maintain the low cost that we have.
Senator Hagel. I am going to ask in a moment Mr. Cavanaugh,
and Mr. Furman especially, to respond to this issue because
they both touched upon it and I think have some different
judgments on what it would take to put 100 million or 200
million accounts online.
But what I want to do is take what you have just said now
and have you respond to this question. Obviously, with a Social
Security account structure we are talking about far more
accounts, and as you have heard the testimony of your
colleagues, specifically Mr. Cavanaugh and Mr. Furman, who
touched upon the kind of administrative costs and
infrastructure that would be required. It has been mentioned in
a couple of the testimonies here, telephone answerers,
handlers, taking inquiries. Relate their testimony and some of
their observations and judgments to what you are doing now, and
then in your mind, what would it take to put 100 million
accounts online?
Mr. Amelio. I need to couch my answers within the confines
of the TSP. I have been advised by our counsel I cannot make
any direct comments about a Social Security proposal. So, I
hope you understand that.
Senator Hagel. Let me make it easier for you and your
attorneys. Let us just take Social Security out of it. What
would it be, 100 million accounts? And let us just take Social
Security out of it so that there is no liability for you. We do
not want that.
Mr. Amelio. Certainly, I understand, and I am not trying to
be evasive.
Senator Hagel. I understand.
Mr. Amelio. We started out about 3 years ago with 200
telephone operators. We have 2.4 million participants. We are
taking that number down probably to about 120 to 140 telephone
operators. The reason we did that, most of our calls are
administrative in nature, dealing with participant loans, and
we toughen the standards for participants to take loans, and so
therefore we were able to cut down.
If you are talking about expanding the participant base it
might look more like private sector plans where the calls are
more investment related. Very few of the calls we get right now
are investment related about the funds. As you get more
investment related, you not only increase the volume of the
calls, but you also increase the length of the call from about
3 minutes on average to 6 minutes, and it necessitates in an
arithmetic calculation all the more operators you need. I would
have to sit down and run the numbers to see how many operators
we would have to add. If we added another 80 million
participants to our plan, I assume it would be a large number.
Senator Hagel. Let me ask you this, you heard again what
Mr. Cavanaugh and Mr. Furman said, and their numbers are pretty
difficult to digest here as far as the reality of if we are
really talking about seriously putting in place 100 million
accounts, and some of the questions and the numbers that they
have brought out. Do you disagree with those numbers? Do you
disagree with those observations or judgments? Is this possible
that we could put online 100 million accounts, and using TSP as
some kind of a general model?
Mr. Amelio. You may have apples and oranges. If you are
talking about adding another 100 million participants to the
plan you have to look at each of the functions. For example--
and we have not really done the demographic study so I want to
be careful here--you have several different segments. The
easiest segment might be adding the participant account for
recordkeeping itself. We have a huge computer and the IT people
would work on it, but perhaps you could actually keep track of
it.
If you go to the separate issue of adding telephone
operators, I think that becomes more complex because you are
talking about a large number of people, time zones, et cetera.
Where it gets even more complex is the collection of the
contributions. Right now we have 130 payroll offices in the
Federal Government. They are all computerized and they remit to
us. On a daily basis we are getting payroll transactions. If
you were adding 100 million people, it would not change as long
as they were still in those 130 payroll offices, but if they
had different payroll offices, paper submissions, it would make
it a lot more complicated.
Senator Hagel. Thank you.
Mr. Enderle, would you respond to that question since you
manage the current accounts now?
Mr. Enderle. I think the key issues, as I think about 100
million accounts, can be split into two components. One is what
Mr. Amelio just responded to as it pertains to the
administration of those accounts. The second has to do with the
actual asset management of those accounts. I think the key
issues that we would need to think about has to do with whether
or not the assets across all those accounts would be aggregated
in some fashion, so that the number of accounts any money
manager would manage would be limited.
So in the case of the current arrangement we have with the
TSP we are currently managing four accounts on behalf of 3.4 or
3.5 million participants, and that type of arrangement is very
leveraging and scaleable.
I think the key issues are how many fund options would be
available and what the asset size would be for each account.
Senator Hagel. Does that include the fee structure too that
we were talking about earlier?
Mr. Enderle. I think the fee structure--I am not in a
position to comment on the fees as it pertains to the costs
associated with administering all the accounts, but more in
respect to the fees that would be applicable to the asset
management side of those assets.
Senator Hagel. Thank you. My time is up.
Senator Dodd.
Senator Dodd. Let us just pick up on that, because I think
that is the point. You are talking about four basic accounts.
It is a number of people but we have really limited choices
under TSP, whereas what we are talking about here in individual
accounts, the choices are far broader than what are offered
under TSP. Is that not correct, Mr. Amelio?
Mr. Amelio. The number of choices for what, Senator?
Senator Dodd. Under the individual accounts that we are
talking about here being proposed under the Social Security
reforms?
Mr. Amelio. I am not sure which proposal you are talking
about.
Senator Dodd. Let me ask Mr. Cavanaugh and Mr. Furman. We
are talking about going from 3\1/2\ million to 100 million
accounts, the Chairman's question, and that is a legitimate
issue. But if you are dealing with limited choices there, then
it is a numerical factor in terms of--where you add the element
of broader choices that we are talking about here where they
have a diversity of the asset management issues that Mr.
Enderle talked about. Then you are adding an element here that
I think goes to some of the cost issues. Maybe Mr. Cavanaugh
and Mr. Furman would like to respond to the question that the
Chairman asked to Mr. Amelio, and how you would respond to that
question.
Mr. Cavanaugh. I think the problem is not the 100 million
accounts. The problem is, whereas the TSP is one employer, the
U.S. Government, when you are talking about individual
accounts, you are talking about 5.6 million employers and small
businesses. You have to deal with each one of them. Part of the
reason why the TSP administrative expense ratio is so low, 6
basis points, is because you have just one employer, and you
have a contained environment. They are Federal employees, they
are already there. When I started the plan, the first thing I
did was to announce to everybody that, hey, I am a wholesaler.
You Federal agencies out there in the field, you are doing the
retail. They had the personnel structure. They had the payroll
structure. They had the systems, electronics, and everything to
do it.
And you, in your statute, when you created the Thrift
Savings Plan, you instructed the Office of Personnel Management
to train trainers in all of these Federal agencies so they
could go back and teach all of the employees all about this
plan. So we wholesaled and we had very low costs. And the
agencies were already in place and there was no problem. That
is essentially why, from my experience in setting the thing up,
costs were so low, and they continue low. I think that is
wonderful, and the agencies have wonderfully cooperated.
All 401(k) plans, including TSP, are employer-sponsored,
employer-maintained, employers have the fiduciary
responsibility. You cannot expect that of 5.6 million small
businesses, barbershops and so on. They just cannot handle it,
and no one is suggesting that they do. So who is going to do
the retail? That is the critical question. It cannot be done by
a new TSP-type central agency in Washington. It cannot be done
by the employers, who now do all the 401(k) plans.
It would have to be done by the financial market, by the
401(k) providers that are now doing it for many companies. But
the 401(k) providers, if you go on their websites, they tell
you that if you have less than 10 employees, forget about it.
There would not be enough employees to spread the cost over.
And 60 percent of American businesses have less than 5, so it
is just not doable. It is entirely different from the TSP which
has nothing to do with it.
Senator Dodd. One of the suggestions you make in your
testimony that I think is not a bad one, as the Chairman goes
forward with this, is to ask people like Citigroup and Fidelity
Investments, Merrill Lynch, State Street Corporation, T. Rowe
Price and others to testify because they are managing these
things and you can get a pretty good read as to how have their
401(k)'s. In your testimony, you said they found that they
cannot profitably provide these services for a company for less
than approximately $3,000 a year even though we have for year
enjoyed economies of scale from serving thousands of employers
and their centralized company systems, but it would be
interesting to hear what they have to say in all of that.
Let me go back to another issue, and Mr. Furman, you may
want to come back and address this in a minute, but let me
raise another issue if I can about the administrative costs.
This is a big point here, and I appreciate you raising it here.
Several of the witnesses obviously have talked about it. Mr.
Cavanaugh in your testimony you go to great lengths to detail
the administrative problems in the proposals of private
accounts, specifically discuss the problem of timing, of
placing contributions into private accounts, stating
``Individual Social Security taxpayers are identified only once
each year with their employer's annual income tax filings, and
it would be up to 22 months after payday under the Social
Security Administration proposal before the individual accounts
could be credited,'' which pose obviously some issues.
Mr. Tanner--and if my reading is incorrect in this, Mr.
Tanner, since we are old friends here, you correct me if--you
generally dismiss these concerns as I read your testimony, and
I quote you here in your testimony. You say that the collection
of payroll taxes, including individual account contributions
would continue to be handled by the employer in much the same
way as today and sent to the Treasury as they are today.
How do you respond to each other? It seems to me he has
raised a very serious issue, you dismiss it as being not
terribly relevant.
Mr. Tanner. I actually agree with his statement. I believe
in my written testimony I state exactly the same thing, that
there is this problem that exists with the current Social
Security system, that until after your W-2 is filed and they
reconcile your W-2 with the contributions as sent in by the
employer, they do not know how much you have paid.
Senator Dodd. Right.
Mr. Tanner. And that is why I have suggested that there be
a centralized collection point that essentially holds that
money until reconciliation takes place. I have suggested that
the best way to do that is to hold it in a money market account
on a unitized dollar basis until reconciliation takes place and
the money can be transferred to your individual account. But
there is this lag, and there is going to have to be some
holding pattern.
I think the centralized collection agency as well relieves
the employer and all these small businesses of any
responsibility for any administrative cost or anything other
than what they do now, which is to pay in a lump sum to
Treasury, which then assumes all the responsibility for the
recordkeeping and the bookkeeping and so on.
Senator Dodd. Who would hold that?
Mr. Tanner. The Federal Government would hold it, would be
the administrator of this fund.
Senator Dodd. Let me jump to, because there is limited time
here, disabled and survivors benefits. I think roughly around
15 million of the 47 million beneficiaries of Social Security
are either disabled or survivors, survivor benefits go to them.
The President's proposal is to encourage, obviously,
individuals to have private accounts, to which they contribute
over their working lifetime. The question arises, in the case
where a person's working lifetime had been cut short, either by
worker's disability or death. According to the Social Security
Administration over 8 million individuals received disability
benefits in April of this year, and over 6.5 million received
survivors benefits. What do these people do under the
privatization plan? Mr. Tanner, what happens?
Mr. Tanner. Under our proposal, which has been introduced
in the House by Representatives Johnson and Flake, and under
most of the proposals that are proposed here, and the
President's, those benefits would remain unchanged and be
continued to be paid out by the Social Security Administration
with no changes of any kind to those proposed----
Senator Dodd. And would the Aadministration still require
the clawback tax of inflation plus 3 percent on those accounts?
Mr. Tanner. Since we are old friends, just to correct you
slightly on that, it is not a clawback, it is an offset, and
the difference is that a clawback depends on how your account
performs, and it penalizes you if your account performs well.
An offset is a preset amount that you are simply giving up in
exchange for your choice of moving into the private account.
They have chosen 3 percent because they believe that is what
Government bonds will be earning as a yield in the future. But
it could be any number, and in fact, I would actually recommend
a lower number than the 3 percent.
Senator Dodd. Can I just ask. Mr. Furman, to make the
comments on the earlier stuff and on this point as well?
Mr. Furman. Yes, two points. One is that TSP only bears the
costs of 6 basis points, but substantial other costs are borne
by Government agencies which are the first point of contact for
most people. As Federal employees, most of your interchanges
about the TSP are with your own office managers. You would have
to mandate that for small businesses, or you would have to pay
that cost in some other way. That is just one of the many
tradeoffs one would have to make if one were to set up
accounts.
In terms of survivors, I would have to differ from Mr.
Tanner, to take Mr. Posen's proposal, for example. That reduces
the benefit factors used to calculate benefits for retirees,
survivors, and people with disability. It makes exactly the
same percentage reduction for all three of those groups.
The President has said that he would protect people with
disabilities, at least prior to them reaching their 60's, at
which point something else might happen, has not said he would
protect survivors, and his chief economic adviser has confirmed
that the same benefit reductions would indeed apply to
survivors as apply to retirees.
Senator Dodd. Thank you, Mr. Chairman.
Senator Hagel. Senator Sununu.
STATEMENT OF SENATOR JOHN E. SUNUNU
Senator Sununu. Thank you, Mr. Chairman.
With regard to the number of options available, I cannot
speak to all the legislation that has been introduced, but let
us be clear. A number of the proposals, the legislation that I
have introduced, approach private accounts directly using the
Thrift Savings Plan model specifically with the number of
accounts offered. We could provide four or five accounts, but
by limiting the number of accounts, as I do in our legislation,
you achieve the scale factors that were talked about by Mr.
Amelio and Mr. Enderle, and this is I think a much more
manageable proposition, and a lot of the straw man approaches
that had been thrown out by critics go away, and I do want to
deal with a couple of those criticisms in detail.
The idea that this is far too expensive for small
businesses. Mr. Cavanaugh, by the arguments that you have put
forward that small businesses will be overwhelmed by the
financial burden of having to sit down with employers and
determine what portion of their payroll tax will be allocated
toward a personal account, sent to Washington, and at a central
location be allocated into one of the narrow choices that were
spoken of. By that rationale, the whole idea of electing to
withhold taxes and determine what the withholding allotment
should be for employers should also be financially
overwhelming, too complicated, and a waste of time and
resources for the IRS. But that is not the case, is it?
Mr. Cavanaugh. I am afraid it is the case because, for
example, last year the Social Security Administration took in
$600 billion in taxes, and about $10 billion of those were
never reconciled for individual accounts.
Senator Sununu. I am talking about withholding taxes on
personal income. Are you suggesting we should get rid of
withholding because it is a waste of Government resources?
Mr. Cavanaugh. No, what I am saying is that----
Senator Sununu. If that is not inefficient and a waste of
Government resources, then why would electing some withholding
for a personal account in those same businesses that do
personal income withholding now, why would that be burdensome
and a waste of resources?
Mr. Cavanaugh. That is the critical question. There is an
enormous difference----
Senator Sununu. That is why I am asking it.
Mr. Cavanaugh. Right now, when the small companies do not
send in the taxes in time--or we find $10 billion at the end of
a couple of years that Social Security cannot reconcile because
of errors on payment--it is not that critical to the Social
Security beneficiaries because of the way SSA measures credits;
it just does not affect them. But when you are talking about
losing investment earnings, if the money is not in day to day
or if it goes into the wrong fund when there is a big
difference between, say, stock returns and bond returns.
I am saying that the present system with the employer just
paying these taxes is not a problem now for IRS or SSA the way
they operate. It is unacceptable for an investment. You cannot
have a financial institution with that low a standard in terms
of accuracy, nonpayment. We have 650,000 businesses go out of
business every year, and when they go out, quite often the
payment of Social Security taxes is at the end of the line.
They have to pay their people and they have to pay their
contractors and so on. How are you going to deal with that?
Senator Sununu. I think that the argument that you just
made has nothing to do with the point you made earlier. What
you are suggesting is a need for accurate accounting in the
asset allocation, and I do not think anyone here would disagree
with that, but that does not speak to the earlier claim you
made that the financial burden would be overwhelming, and I do
not accept that at all, because the best model we have for this
allocation process at the employee level, at that small
business level, is the election to withhold personal income
taxes, which is a system that works, that is efficient. I do
not disagree that we might like the accounting for that to be
even better than it is, but to suggest that it is an unbearable
financial burden simply is not borne out by the evidence.
Mr. Amelio, I want to talk a little bit about lifecycle. I
think it was mentioned by Mr. Enderle. Oftentimes, we hear
critics of the idea of personal accounts use what I will
describe crudely as the argument that Americans are not smart
enough to handle the decision to set aside money into a
personal retirement account, quite simply put. And that we are
going to have people at or near retirement age, at the age of
62 or 63 or 64 suddenly deciding that they want to put all of
their life savings in a high tech stock. I do not believe that
is the case.
I think one of the things we can look to at Thrift Savings
Plan is to try to understand how investors make decisions in
allocating and whether or not they generally follow what would
be called lifecycle investing, whereas as you get closer to
retirement, do individuals tend to put their personal accounts,
their personal savings in less volatile accounts like a
Government bond fund or a municipal bond fund or the like, as
opposed to an equity fund?
What is TSP's history with that? Can you say anything about
the tendency of your customers to pursue lifecycle investing
with or without any regulations or mandates?
Mr. Amelio. I can. I can throw statistics out like crazy. I
brought lifecycle funds. It is my concept and I am very proud
of that. The TSP participants are very much like any 401(k)
plan participant. Nobody means to insult the American public if
they say they are not bright enough or do not understand the
investments. What happens is most people get frustrated. It is
overwhelming. They do not have the time, the desire, et cetera.
What they wind up doing, for example, when I came over, 50
percent of our plan assets were invested in the G Fund. G Fund
is a wonderful fund. It is simply far too conservative for you
to have all of your plan assets in that.
Senator Sununu. So you are suggesting that actually the
inclination of the broad spectrum of Government employees--we
are talking about 3\1/2\ million people; I am sure there are
some that are more financially literate than others--their
tendency is to be too conservative. Given a limited menu of
options, four or five funds, they were actually investing in a
way that is too conservative.
Mr. Amelio. The largest group were too conservative, being
100 percent invested in the G Fund. The next largest group has
what we call the barbell approach. They are putting half of
their account in the G and the other half in the highest risk,
and nothing in the middle. They are off of what investment
professionals--Mr. Enderle could describe this better than I
could--as the efficient frontier. They are either assuming too
much risk for their yield, or they are not getting enough yield
for the risk that they have.
These lifecycle funds are automatic pilot. You go in, it is
professionally managed, and it gets more diversification which
will get them a better yield overall over a working life
expectancy.
Senator Sununu. Mr. Furman, in your testimony--actually, I
want to direct this question to Mr. Amelio because you have
some responsibility on TSP. You suggested that if individual
accounts are instituted and had the political pressure to
include various types of politically oriented funds, that would
be difficult for legislators or policymakers to resist. Again,
I go back to TSP. Have you been able to resist the political
pressure to create all sorts of politically sensitive funds
within TSP?
Mr. Amelio. I have only been here 2 years. The plan has
been very successful since its inception in 1986 in doing that.
I can tell you there is a lot of political pressure right now
to add a REIT fund against the plan fiduciary's desires. We
make no comment on REIT's, as far as it being good or bad, we
just do not want to add one right now, and that is what I am
calling political manipulation.
Senator Sununu. But you have had 20 years experience?
Mr. Amelio. Yes.
Senator Sununu. There are how many funds that are currently
offered?
Mr. Amelio. Five.
Senator Sununu. Five. So, I think it stands to reason if we
are looking at this, not necessarily as the perfect model, but
trying to identify analogies. I would argue that would be
pretty good insulation from an endless proliferation of
politically motivated funds.
Thank you very much, Mr. Chairman.
Senator Hagel. Senator Reed.
STATEMENT OF SENATOR JACK REED
Senator Reed. Thank you very much, Mr. Chairman.
Thank you, gentlemen, for your testimony.
Mr. Cavanaugh, in your written testimony you make a very
interesting and important point that also concerns me with
regard to the President's proposals. Specifically, you point
out that the TSP program allows for emergency withdrawals and
loans on contributed funds. As I understand the President's
proposal, those activities would be prohibited, and I have a
sense that I believe you do too, that it is very difficult to
maintain such a limitation over time, particularly since the
argument is being made insistently, ``It is your money, it is
your money.''
I am just curious. Have TSP participants always been
permitted to make emergency withdrawals and loans on their
contributions? And if not, what caused that phenomenon?
Mr. Cavanaugh. It started out with just loans. IRS, I
think, had problems when the legislation was before the
Congress with regard to withdrawals. But later on the Congress
amended the statute to permit withdrawals, so we have both
loans and withdrawals.
With regard to what you were referring to in my prepared
statement, even though the Administration says this is just for
retirement, the individual accounts will not have any loans or
withdrawals, I just think it is totally unrealistic. Right now,
the reason people cannot take money out of Social Security
before retirement is because they do not have an account there
in their name with their money, there is nothing to take. But
once you have an individual account that is identified to the
individual and they see the balance is building up year after
year.
And then you have some national disaster where people are
starving, their kids cannot go to school, and they are waiting
for emergency relief, and they say, ``I have $20,000 in there
and I cannot wait till retirement, we are dying now.'' I do not
see how the Congress can say no.
Senator Reed. And what would be the consequences of those
types of withdrawals or loans?
Mr. Cavanaugh. They would be dire because you would be
doing it on an ad hoc basis instead of having a system in place
at the beginning as we did for loans and withdrawals
eventually. You would have to be dealing with each case because
you would not have standards. It would be an ad hoc thing, and
as the constituents called into their congressman and said, ``I
need the money,'' and they had a different particular case
problem, that would be sent over to the board. The board would
have to sit down and try to sort it out and be fair to
everybody, and not give to somebody who had the same
circumstances as somebody else that did not get it. You have to
set it up at the beginning.
Senator Reed. Thank you. Now, Mr. Cavanaugh, there is
another issue that we have all talked about. That is the
administrative costs of the various proposals. From your
experience, would the administrative costs of the TSP-type
program increase substantially if it were modified to allow
individual investors to invest specific stocks? Would those
costs go up?
Mr. Cavanaugh. If the TSP allowed specific stocks instead
of just the index fund?
Senator Reed. Right.
Mr. Cavanaugh. Oh, yes, that would be much more difficult
because I think the Congress would provide something in
legislation to make sure people did not go crazy buying penny
stocks and so on. You would have to have standards and then
there would be the whole question of--since the Government is
running this thing--Government involvement in the business of
which particular stocks are eligible and which ones are not.
And there you would get the politics, good stocks, bad stocks
and so on, and so that would be impossible.
Senator Reed. Mr. Tanner, in this regard of operating
costs, you cite administrative costs would be about 25 basis
points, but I presume that is based upon the TSP model which
has about only 5 different options. But then you go on to your
testimony and talk about: At some point a wider range of
choices should be made available; in part this is a simple
matter of increasing consumer choices; one of the most
important reasons for having personal accounts at all is to
give workers more choice and control how they save for their
retirement; and clearly this should be extended as much as
possible.
But it seems to me that as you extend these options you
have to increase to administrative cost; is that accurate?
Mr. Tanner. Yes, I think you are correct, Senator, that in
this additional tier of investment options, administrative
costs would be higher, but no one would be forced to go into
this additional tier of options, and in fact, we expect most
workers would remain in the first tier of very limited set of
options, out of inertia if nothing else, and those low costs
there.
In addition, as long as workers have the free choice of
staying put or of moving back down if administrative costs in
the upper tier become too high, we believe that the competition
from this low-cost, low-choice tier would keep costs down even
at the upper tier, simply because if you priced yourself too
high, workers would not make those choices.
Senator Reed. So you anticipate a multitier, at least a
two-tier system?
Mr. Tanner. Yes. I anticipate that initially workers would
be given a very limited variety of choices, either a TSP type
of model or perhaps three balanced funds, which is in the
legislation in the House that I think is a good model, or
perhaps just a lifecycle fund, but something very limited
initially with a default in case workers make no choices
whatsoever, that there would simply be a default option that
they would fall into. And then once a trigger is reached, say
an accumulation of $10,000 or more in your account, then you
would be able to move, if you chose, to a wider range of
options, or stay put in that first tier.
Senator Reed. Mr. Furman approaches this in a slightly
different way. I think in your testimony, Mr. Furman, you say a
similar point but I think a different emphasis: Estimates that
show low administrative costs for accounts are based on limited
choice and an unprecedented degree of Government
administration, which you observe, Mr. Furman, could prove to
be politically untenable over time.
So your point would be that this expansion, if multitiered,
eventually would be--they would not stay in the lower tier,
they would want the whole----
Mr. Furman. Right. Two points to make about that. It is a
very good question, Senator. Sweden gives you--it still is
government managed, government administrated, and very
centralized--a wider range of choices along the lines of what
Mr. Tanner was just recommending. The average fees there are
0.73 percent per year. Accumulate that over your retirement,
eats up 15 percent of your account. That is about twice as
large as what the actuaries estimate. That is the first point.
The second point is if you think about the politics, the
President's Commission strongly recommended a tier 2 of funds.
They said the Government picking one equity allocation for the
whole country was not a good idea. A lot of advocates of
accounts believe that. If you look at something like Senator
Sununu's plan, it has assets in account of $80 trillion in
2079. That is 200 percent of GDP. Half of those were in the
stock market. That means those accounts in Senator Sununu's
plan would hold the entire United States stock market. To
imagine the entire United States stock market being held in one
Government chosen allocation of stocks, whether it is an index
of anything else, is to me unimaginable.
Senator Reed. Thank you.
A final question. Mr. Cavanaugh, you talk about the Social
Security Trust Fund as an alternative investing in the market
as another approach versus these private accounts. Others have
advocated this, obviously. What do you think are the advantages
and disadvantages as compared to private accounts, of simply,
as many have suggested, allowing the Government to invest a
portion of the Social Security Trust Fund into the market,
getting presumably a higher return with we hope low operation
overhead?
Mr. Cavanaugh. It is a no-brainer in the sense that----
Senator Reed. That is my type of plan.
[Laughter.]
Mr. Cavanaugh. Virtually everybody would agree that a
diversified portfolio is the way to go, particularly with
regard to long-term pension funds, and you should have equity
securities in there and all that. The only argument against the
trust fund investment that is made over the years--and I used
to make it when I was in the Treasury Department, I confess--is
that this would amount to Government ownership of stock, the
means of production, socialism, all that thing.
There might have been some merit to that years ago, but
since then every State in the United States has authorized
pension funds to go into stocks. We are the only ones that do
not. Maybe it is because we know something about what the Fed
is going to do that they do not, but I do not think so. And
ever since we brought in the stock index fund, which the TSP
uses that took care of the problem of Government control over
any one company because you are buying a broad index, you are
not buying a particular stock.
And in my prepared statement that I submitted to the
Committee, there is a chart on there showing that the trust
fund alternative would involve less Government control over
private companies than either the TSP or the Administration's
plan. I go right down the line into every particular. It would
be less. I just cannot believe that old argument. Whatever we
might do with individual accounts, surely, the Social Security
Trust Fund should be diversified like everybody else is doing.
Senator Reed. Thank you, gentlemen.
Thank you very much, Mr. Chairman.
Senator Hagel. Senator Reed, thank you.
Mr. Cavanaugh, I want to just go back and cover one point
in response to a question that Senator Reed asked. The question
was about leakage, and your response that there could well be
great pressure, if we had personal accounts, to open those up
for family emergencies or whatever it is.
We have never had that problem at Social Security to my
knowledge; is that right?
Mr. Cavanaugh. Yes.
Senator Hagel. For 70 years we have never opened it up for
emergencies?
Mr. Cavanaugh. Because there is no individual account to
give to people, so there is nothing that they could claim.
Senator Hagel. But we have never had that issue. I
understand the definition difference, but I believe that should
be pointed out as well, that when the Congress passes a law,
and if we did this, we would certainly mandate what the rules
would be, and I think the President's plan says this clearly.
My plan does. I think the other ones do. And I just wanted to
add that footnote to your response, that certainly that is a
possibility, but I do not think it is a strong enough
possibility to be an overriding factor.
Mr. Cavanaugh. All I can say, Mr. Chairman, is that the
Congress did, in the TSP, say in the statute ``no
withdrawals.'' But later on the pressure was such that the
Congress amended it to permit the withdrawals.
Senator Hagel. We can always amend things, as you know. But
I wanted to at least get the other side of that on the record,
and I appreciate your response.
Mr. Tanner, should we consider other options as we are
looking at how do we reform Social Security, should we reform
Social Security? We all, I think, agree that we are going to
have to address the issue. Are there options other than
personal accounts? Are there investment options or should we
just raise taxes and continue along the course that we are on?
Mr. Tanner. I certainly think that any Social Security
reform is going to have to make some effort to restrain the
growth in future Social Security benefits. I believe that
personal accounts are absolutely essential for the reasons that
I have outlined, particularly ownership, inheritability, and
choice, but they do not solve all the problems with Social
Security's finances. There is going to have to be other
measures taken as well. I think that means that you are going
to have to restrain the growth in Social Security benefits.
But as former President Clinton said, you have very limited
choices when it comes to Social Security. You can raise taxes,
you can cut benefits, or you can invest privately, either
through personal accounts by individuals or through the
Government.
I think Government investing would be very dangerous. You
have to look no further than CalPERS, for example, to see them
trying to interfere with who is going to be the next Chairman
of Walt Disney. Do we really want the Federal Government making
those type of decisions? You can look to State pension funds
and see that about 44 percent of them have targeted investment
requirements saying that you must invest in certain types of
investments, or that they cannot--25 percent have restrictions
saying you cannot invest in certain types of things. My old
friend, Senator Dodd, would be able to tell you about
Connecticut, where they forced the State pension fund to invest
in Colt Industries and the problems that created both in terms
of conflict of interest and in terms of the losses that they
incurred because of that.
I think that when it comes down to a choice between private
investing, between the individual and the Government doing it,
we should definitely side with the individual, but we are also
going to have to do other things as well in terms of
restraining benefit cost and growth.
Senator Hagel. I know the hearing is intended to stay
focused on what we are talking about here, and I will keep
within those boundaries simply because we have a lot of
territory to cover that we have not yet touched upon. But I
think at the end I will do a wrap-up question and ask each of
you what additionally you think we need to do to deal with the
solvency issue of Social Security, aside from what this hearing
is about, and you just alluded to it. You did not specify what
those are. Some of those things are in my bill, but I will ask
each of you at the end if you would offer your thoughts on that
outside of personal accounts or other options for investment
vehicles.
Mr. John, let me ask you the same question that I just put
to Senator Tanner.
Mr. John. I kind of like the idea of Senator Tanner. It has
a nice sound to it.
Senator Hagel. Well, he is close to Dodd, you know.
[Laughter.]
Mr. John. We also believe that Social Security changes must
go along two courses. One is that we strongly support a
personal retirement account for the simple reason that this
gives my daughter the opportunity to do something more than
face a world of higher taxes and lower benefits. I do not see
that as being an attractive Social Security system to leave
her.
Two, it is very clear that we need to change Social
Security's benefits and to bring them closer to what Social
Security can actually afford to pay. As I mentioned, she is
going to be faced with a choice otherwise, especially with a
health care system that is in serious jeopardy, of financing
benefits for her kids or financing benefits for her parents.
There is no way around changing Social Security's benefit
formula, and Social Security's benefit formula has been
adjusted in a number of different times. It is not a program
that sprung full blown from the head of Franklin D. Roosevelt
in 1935. The current benefit structure or benefit calculation
basically dates from Jimmy Carter's era in the late 1970's. It
has been changed a number of different times and it needs to be
changed again.
Senator Hagel. Mr. Furman, I will ask you the same
question, but focus as well on a comment that Mr. John made in
his written comments and he just alluded to, about this
generational choice that we are going to burden our next
generations with? I think the reality of that is becoming
clearer and clearer. I would appreciate your answer in the
context of that as well.
Mr. Furman. There is no question that we face a Social
Security challenge and that it is better to act sooner rather
than later in addressing that challenge. That being said, it is
better to not act at all than to do harm, and to wait and do it
in the right way.
The Social Security benefits are projected to exceed Social
Security revenues so you have to either reduce benefits or
raise revenues. I would recommend adopting a combination of
both of those approaches, as we have done historically.
Historically, we generally have done both when we have gotten
into trouble in Social Security.
In terms of accounts, they do not help with the problem. In
fact, in the short-run they make it worse because they increase
the debt and drain money from Social Security. In the long-run,
they do not help either because these administrative costs we
are talking about today ensure that the new system, the total
amount of resources in that system is less than what the
resources are in the system today because some of those
resources are consumed by administrative costs.
Senator Hagel. I suspect Mr. Tanner and Mr. John do not
agree with your comment. Would you both care to respond to Mr.
Furman?
Mr. John. Just quickly, Senator. The Social Security
Administration Actuary estimates that a personal account
structured as the President would like and with that type of an
investment, would return 4.6 percent after administrative
costs, which would be, according to the President's
calculations, assuming a 3 percent Federal bond rate, which I
think is incorrect, but assuming that would mean that even
after paying costs, that they would be making 50 percent more
than Federal bond rate, which is definitely an advantage. I
mean these administrative costs, under a system that is managed
through the Federal tax system and not through the employer,
would not eat substantial amounts of the investments. I mean
even Mr. Furman's numbers suggest 7 percent. Now, frankly, I am
willing to invest 7 percent or pay 7 percent in costs if I am
going to do 50 percent better than Federal bond rate. It is a
fairly simple choice for me.
Senator Hagel. Mr. Tanner.
Mr. Tanner. I would agree. To some degree you would get
what you pay for. There is no doubt that the administrative
costs of the current Social Security system are extremely low,
but so is the rate of return that people get. There used to be
in East Germany a car called the Trevant that was essentially
made of plastic, and it cost about $500. As soon as the wall
fell, people stopped buying Trevants and started buying
Mercedes Benzes even though they cost more. The reason was it
was a better car. I think people would be willing to bear
somewhat higher administrative fees if they could get a much
higher rate of return from private accounts. At any rate, it
would be a choice.
All the individual account proposals that I know of, I
believe including the Chairman's and Senator Sununu's and those
in the House are voluntary. Individuals could stay in the
current Social Security system if they wished. If they were
worried about these administrative fees they would be able to
stay put, but people would be given the choice of earning a
higher rate of return and paying a little bit more to do so.
Senator Hagel. My bill does that as well.
Mr. Cavanaugh, would you care to comment on any of this?
Mr. Cavanaugh. Yes, on the cost thing. You know, all of
these estimates, the Administration estimate of 3/10ths of 1
percent, of 30 basis points, and the others of 50 and so on,
these are based on the known world of 401(k)'s. That is where
the experience is that people are looking at. What we are
talking about in these proposals by the President is the
unknown world of small business, where you do not have the
experience of administrative costs that relate at all to what
has been done in 401(k)'s. What you have is a market out there
that is telling you, unquestionably, that it cost 3,000 bucks a
year to go into a company and set up a plan. If you have 60
percent of businesses with less than 5 employees, that is 600
bucks a head, and 600 bucks out of the President's proposed
$1,000 contribution is a 60 percent expense ratio.
This is the world we have to look at, and this is why I
suggested in my statement to the Committee to bring in the
401(k) providers, all those firms I mentioned, give them a
specific list of exactly what you want them to do, and based on
their experience and what they are now saying on their
websites, they would have to tell you it is impossible.
Senator Hagel. Mr. Enderle, you know something about that
business. What do you think?
Mr. Enderle. I think it is best to respond, given my area
of expertise really has to do with the management of the assets
as opposed to the administrative costs associated with 401(k)
plans. I think it really comes down to two things. One is what
type of investments are best suited for any type of private
accounts, if it does go in that direction, and two what to do
to minimize the investment related costs associated with those
assets?
I do think that it would be in investors' best interest to
have an array of probably diversified index options that are
both low cost in terms of the cost of trading or the management
fees associated with such index funds, and they are low risk
investments as well.
The other option would be lifecycle which we talked upon as
well, which also can be offered as a low-cost investment
solution which has the benefit of adjusting the asset mix over
time to meet an investor's time horizon.
I think the number of options that are available is going
to be critical because that also would affect the assets under
management for any one fund, and hence would be impacting the
cost structure as well. The issue around how frequently
participants would be able to change their exposure to any one
fund, which would also impact the administrative costs as well
as the management costs.
Senator Hagel. I do not know of anyone's plans that would
have the employer administering anything. The employer is not
administering any of the plans I am aware of, and the plans I
am aware of, they would be modeled after TSP, the same kind of
thing. Obviously, if you have 100 million accounts, I would
assume you would have to bring in others, not just Barclays,
but maybe 5 Barclays. I do not know that, but respond to that,
if you would. You do know something about that.
Mr. Enderle. Sure, I think there are two things to
consider. In terms of, even if we had 100 million accounts, if
the options available to those participants are the same as
what is currently offered to the TSP participants, what
Barclays is managing 4 out of those 5 accounts, that is
certainly very manageable from our standpoint. So it is much
less to do with the number of accounts that are out there and
more to do with the number of investment options that are
available. That would be the thing that I think would determine
how many managers you would need.
Senator Hagel. And we are talking about limited funds here.
Mr. Enderle. That is right.
Senator Hagel. Same thing as we have talked about with TSP.
Mr. Amelio, would you like to respond to any of these
points?
Mr. Amelio. I think I can within the overall concept of
costs. I speak for every plan administrator in America when I
tell you that if you are looking at creating any kind of an
institutional plan, if you want to minimize cost, you cannot
have early distribution options like loans and hardship
withdrawals. I can tell you, I would love to ask Congress to
get rid of the hardship withdrawals and loans from the plan.
They are not a retirement feature. They encourage
participation. It is not feasible. But they add greatly to the
plan expense.
The second thing, I speak for all plan administrators I
think when I say that we are able to maintain our costs because
we keep the plan simple. We have 5 investment options. It is
short, it is sweet. That gains the participants' confidence
level. It also keeps the cost down and it keeps participants
putting money into the plan, and I think that is very
important.
I want to tread lightly on the last one, because I stand in
two shoes. As the fiduciary to the plan, I will obviously stand
up and protect the G Fund because it is a great investment
vehicle for the plan participants, but we are the only plan in
America that has it. No 401(k) plan does. It is Government
securities. It is a special and unusually high interest rate.
But as a plan participant and a taxpayer I take issue with it.
It is costly. It costs the Government a lot. I guess if I were
not a fiduciary but still in my role I might look at just using
a regular money market fund out in the open market which would
reduce the burden on the Government. But that is not my role,
and as a fiduciary I will protect the G Fund, but I throw that
out for your consideration otherwise.
Senator Hagel. Thank you.
Let me ask each one of you what would be your response to
the larger question which we touched on a little bit earlier
this afternoon with some of my colleagues, if we were to set up
100 million accounts. How would the market react to that? No
one can be certain, obviously, but what is your best guess as
to what would happen and would we phase that in, or how would
you do that? Is it dangerous? What kind of risk are we talking
about? Give me your best assessment, realizing that there are
no guarantees and there are so many unknowables, uncertainties,
and uncontrollables which we factor in. But that has been a
question that has been raised by many people, and I would
appreciate your thoughts.
Mr. Furman.
Mr. Furman. Yes. I would focus in answering this question
not on the number of people with accounts, but the total amount
of assets in those accounts. And it is a very important
question because in plans, I believe in your plan, it is about
80 to 100 percent of GDP would be held in accounts, and in
Senator Sununu's it would be 200 percent of GDP. So we are
talking very substantial financial holdings.
Now, there is only a fixed capital stock in the United
States, a fixed amount of human capital, and when you have more
money chasing the same thing, it drives the price of it up. And
the way the stock market works is when the prices of stocks are
higher, that is great for the people that already have them,
but people just coming into the market have to pay more, and
they actually get a lower rate of return going forward. This
process was described----
Senator Hagel. It depends too on the fund. There is an
international fund, for example, and there are high yields and
so on.
Mr. Furman. That is actually a very important question as
to whether you would internationally diversify, and I think it
is a prudent part of anyone's portfolio. This was summarized in
the leading public finance textbook in economics which was
written by Harvey Rosen, who as I mentioned before, just
recently stepped down from the Administration. He wrote: ``In
order to induce private investors to accept Government bonds
that would have been bought by the trust fund, their yield has
to go up, increasing the debt burden on taxpayers, or the yield
on stocks must fall, or both.'' That I think summarizes the
standard textbook economics.
Senator Hagel. Thank you.
Mr. John.
Mr. John. I think there would be two effects. One is you
would see a very positive effect in the markets worldwide
because it would indicate that the United States is actually
serious about dealing with its entitlement spending. That is
something that has been a matter of major concern worldwide. If
you saw what happened--I believe this was earlier this year--
when the South Korean Central Bank was rumored to be
diversifying out of dollars. This is the kind of signal they
need.
And two, as far as assets, the amount of assets under
management in these accounts, I think it would be relatively
small as compared to the overall global level of assets. I mean
currently globally, there is somewhere around $20 trillion in
financial assets out there. There actually is not a fixed
capital stock in the United States. There is a fixed capital
stock on any one day. But as the Washington Post pointed out in
one of its editorials, the value of the stock market, aside
from increases or decreases due to supply and demand, actually
increases and decreases regularly due to companies that merge
and go out of business, companies that issue new rights and
things along that line.
So this is a constantly growing pool of money, and it is
really not possible to limit it to just the United States,
because if you look at the New York Stock Exchange, you will
find companies like Prudential PLC, which is a British
investment company. You find DaimlerChrysler, which of course
is worldwide, so essentially you have to look at the growth of
the worldwide assets.
Mr. Furman. Could I very briefly insert something?
Senator Hagel. Go ahead.
Mr. Furman. The $20 trillion right now is less than 200
percent of U.S. GDP, and we are talking about plans that have
asset holdings of between 100 and 200 percent of U.S. GDP, so
if the Ryan-Sununu plan were in effect today, it would hold 200
percent of GDP in assets. That is the equivalent of about $24
trillion. That would more than exhaust the global asset stock,
and those are very important questions to think about when you
are talking about accounts of that magnitude.
Mr. John. But not overnight. I mean the Ryan-Sununu plan,
hypothetically, if you believed Dr. Furman's numbers, would,
but the thing is, this would not be a matter where on March 31
there is zero and on April 1 or April 2 there would be 200
percent of GDP. And during that period of time the amount of
assets worldwide would continue to grow.
Mr. Furman. Historically, it has grown with GDP, but maybe
it might grow faster than GDP.
Senator Hagel. We will let Mr. Tanner have a turn.
Mr. Tanner. Yes. I was going to say you cannot assume a
static model that just assumes that we are going to have the
same amount of capital stock 75 years from now that we have
today.
If you look at this on a day-to-day basis, the amount of
money going in, even if you took the entire amount of Social
Security taxes and put it in the New York Stock Exchange, it
would be roughly the equivalent of 22 minutes a day of trading.
The U.S. capital markets are enormous. They are going to be
even more enormous 75 years from now even with the
accumulations we are assuming. I do not think we are going to
swamp those markets. If you go to a worldwide basis you are
talking about maybe one-half of 1 percent of worldwide capital
markets right now.
I do think you would have a couple of impacts in the long-
term. You would have what is simply called the ``capital
deepening effect,'' which is that capital flows first to the
best returning investments and then ever lower returning
investments as you go out. If you increase the amount of
capital going to investments, they are going to go to further
and further out to lower returning investments, and the average
rate of return on all investments is going to decline.
Martin Feldstein estimates you would have about a 15
percent decline in the average return on investments, but that
would not occur for about 40 or 50 years. Eventually, you would
see it begin to go down somewhat in terms of average return,
but that would not be an effect on any individual stock price.
What you would also get is that as you increase the pool of
capital, you would actually increase the amount of liquidity in
the markets, and it creates more stability in the markets
because they would be insulated from some of the shock effects.
You can look to Chile for an example of that, where when the
Asian crisis hit, and it really socked most Latin American
markets, Chile, where the accounts manage about 50 percent of
GDP, suffered a much smaller decline in terms of their markets
because of the insulation effect that this amount of capital in
the markets had.
Senator Hagel. Mr. Cavanaugh.
Mr. Cavanaugh. I think your question is what would be the
impact on the economy and financial markets if we had 100
million accounts. There would be no change in the total asset
flow. There is no reason to assume that the money coming in for
Social Security taxes would be any different from what it is
now. What would happen is that instead of all of it going into
Treasury securities, some of it in the individual accounts
would go into market securities, which means the Treasury would
have to borrow more in the market and less from the Trust Fund.
It would be just a swap of securities. There would be no
overall impact on capital. There would be marginal benefits in
terms of a better demand for stocks because people are going
in. Another point is financial institutions generally would be
better off because Social Security historically has been pay-
as-you-go. You just had enough money in to take care of each
year. But because of the 1983 changes, we have been prefunding.
It is now up to $1.5 trillion. In the next few years, it is
supposed to go up to $3, $4, or $5 trillion, by different
estimates.
So all of a sudden the market is interested because before,
the market was not losing a lot of investment opportunities
because the money was just going in and out pretty quickly. But
now that it is building up, we are looking at $1.5 growing to
$3 or $4 trillion, money the market is not going to be able to
get. It just goes all in the Treasury securities. And so that
is an important point from the standpoint of the market. But as
an economist, I would have to say all we are talking about here
is an asset swap. Treasury would just issue more securities in
the market instead of to the Fund. And people who would have
bought stocks would buy less because now these people, Social
Security taxpayers, would be buying more. Not a big deal.
Senator Hagel. Thank you.
Mr. Enderle.
Mr. Enderle. I think in the end it is going to be a
function of the dollar amounts that are going to be affecting
the various markets, and in essence, I think there are going to
be four things that are going to affect the market's reaction
as it relates to the dollar amount that we are talking about.
The first is whether or not the assets are going to be
phased in over time, as opposed to what we mentioned earlier.
It is not going to affect the market or hit the market
overnight. I think that should have a muted impact on the
markets.
The second is the number of options that are available,
especially if we have different asset classes that are
available as options, that would also provide more opportunity
to spread the assets across and, hence, would have a muted
impact on some markets.
The third is whether there is a decision made to implement
the options through index funds, which provides the broadest
diversification for any asset class and hence, would also have
the most limiting impact to any particular market if
implemented through a broad, diversified strategy as opposed to
a narrowly defined strategy.
And then, last, it depends upon what other managers or,
rather, investors are doing. For example, as we talk about baby
boomers retiring and what their investment activity will be
like in the future, it is quite possible that as we invest
assets, say, into the equity market through the private
accounts, there could be offsetting flows that are also
affecting the markets at the same time, where there will be buy
and sell activity such that the total amount that is hitting
the markets could be quite limited as well.
Senator Hagel. Thank you.
Mr. Amelio.
Mr. Amelio. I will give you an analogy and limit my remarks
to your example to the confines of the TSP. If we were to
dramatically increase the number of participants to the TSP
and, hence, the inflow of dollars in, my concern would be the
ability of the funds to absorb that money, at least initially,
into the more limited markets that are available right now.
This would drive our transaction costs in the index funds up
because we have seen it now when we get active trading with our
participants. If one of the markets goes askew, they start to
pull money out, or drive money in. As it drives those
transaction costs up, it pushes our return off of the index. In
other words, the index fund tracks an index such as the
Wilshire 4,500. And to the extent our costs go up, it pushes
our performance number away from the index we perform perhaps
if the costs go up a little worse than the index would because
of those trading costs, and that would be my concern, at least
over the short term, if there was a dramatic increase of flow
of capital. And that is from an administrator's perspective.
Senator Hagel. Thank you.
Let me ask each of you a question I mentioned a few minutes
ago. Aside from personal accounts and your positions that you
have made very clear on personal accounts, each of you, what do
we need to do to assure Social Security's solvency? We will
start with you, Mr. Furman.
Mr. Furman. There are a few plans that I would recommend
that you take a serious look at. One is by economists Peter
Diamond and Peter Orszag, and another is by former Social
Security Commissioner Ball. And what both of them do is
increase revenues and trim benefits. They increase revenues in
a very progressive manner, including raising the cap, applying
a tax above the cap, or using estate tax revenue to help the
solvency of Social Security. And then they make some changes on
the benefit side, including correcting the Consumer Price Index
that is used to adjust for the cost of living. And in the case
of Diamond and Orszag, it applies longevity indexing to
benefits, although it only takes half of the increase in
longevity and applies it to benefits and applies the other half
to the revenue side, which from my perspective is the more
balanced way to deal with longevity than doing it entirely on
the benefit side.
Senator Hagel. And that would be your approach to dealing
with----
Mr. Furman. Those are a number of options that I think
would make a lot of sense in terms of coming up with a plan
that is overall balanced between revenues and benefits,
balanced between people today and people in the future, and
progressive overall.
Senator Hagel. Mr. John.
Mr. John. If I had to take personal accounts off the table,
which, of course, would be very painful----
Senator Hagel. No. I know where you are on personal
accounts. You are one who advocates that personal accounts help
get you to solvency. So, in addition to that, unless you
believe that that is the only answer, what in addition to
personal accounts?
Mr. John. In addition to personal accounts, I would suggest
some form of progressive indexation similar to what the
President has been talking about recently, which would
basically reduce the growth of benefits for upper-income
workers while leaving lower-income workers stable. I think this
is also important because it would remind upper-income workers
that they need to continue to participate in 401(k) and other
private types or employer types of retirement plans.
The second thing I would do, frankly, is to raise the
retirement age, recognizing fully that there are going to be a
certain number of workers in physically demanding jobs that
simply cannot work longer, and those workers are going to be
placed probably on the disability rolls in some way. I would
also put in some form of longevity index in there.
The one thing I have not included is taxes, and for two
different reasons. Number one is that change in payroll taxes
or employment-related taxes could have the result of reducing
job growth, and, frankly, that would be more damaging for the
economy than other things. And number two is that we always
have the unspoken problem, which is Medicare, and that one is
much larger, and I would be hesitant to use up all the tax
options on the easy problem.
Senator Hagel. Thank you.
Mr. Tanner.
Mr. Tanner. I guess I would associate myself completely
with Mr. John's remarks here. I believe that some form of
change from wage indexing to price indexing is a very fair way
of approaching it. I think that probably some longevity
indexing in addition would probably be a good idea. I think the
overall requirement is to reduce and restrain the growth in
benefits, that we simply cannot go on forever increasing the
amount of benefits that we pay to the elderly both through
Social Security and Medicare. There has to, at some level, be
some restraint on the amount of entitlements, and simply
pouring more money into the situation in order to pay ever
larger entitlements I think is a mistake. And particularly I
would like to warn against the idea of raising the cap or
removing the cap on the amount of income subject to the payroll
tax. To do so would give the United States the highest marginal
tax rates in the world. We would actually have higher marginal
tax rates than countries like Germany and Sweden.
I think that is a significant danger of damaging the
economy and job growth, and it might even hurt overall Federal
revenues since there would be an enormous amount of switching
to nonwage compensation and people would simply begin to hide
their income in order to avoid these huge marginal tax rates.
So, I think you would actually end up getting less revenue than
you expect. Even if you took this off altogether, you would
gain something like 7 years of additional cashflow solvency for
Social Security. It is a very high price to pay for very little
gain.
Senator Hagel. Would you include pushing out full benefit
retirement age a year, or would you leave that alone?
Mr. Tanner. I think that it is certainly something that
should be on the table. It is a less favored approach that I
have. I do think that the problem is that for people in
physically demanding jobs or for people like African-Americans
with shorter life expectancies, raising the retirement age
really leaves a hardship for them. I think the longevity
indexing is probably a better way to approach this. It gives
people more options than simply raising the retirement age
would.
Senator Hagel. Thank you.
Mr. Cavanaugh.
Mr. Cavanaugh. I would agree, I think, with most of the
options that Mr. Furman mentioned, ones that have been advanced
by other economists, Peter Diamond and the Brookings
Institution, Henry Aaron, that thing. These are all things that
could be done that would more than offset the actuarial deficit
projected by the trustees for the Social Security Trust Fund.
However, each one of them hurts somebody in terms of
increasing the age, removing the cap, or bringing in State and
local governments. People have problems with all of these
options. The one that I think is the most desirable is if you
did what I suggest with the trust fund investment. If you
invested 50 percent of the Social Security Trust Fund balance
in equities, with the other half in Treasuries or whatever,
that would eliminate approximately one-half of the total
actuarial deficit projected by the trustees.
But I must say that I think the CBO estimate is that the
fund is not going to run out of money until 2052. The trustees
are saying 2041. When I first began to look at this area 9
years ago, the trustees were saying 2027. And then they moved
out in the last 9 years to 2041. I do not think that we can
make substantial policy changes today based on moving targets
like that. We have no idea what the world is going to look like
in 2040 or 2052 with the growth that we have had in
productivity and immigration, women in the labor force, things
that we never could have projected 40 or 50 years ago.
I would be very careful to make drastic changes today based
on these projections, which have proved to be way off.
Senator Hagel. Thank you, Mr. Cavanaugh.
Mr. Enderle.
Mr. Enderle. Given my area of expertise, which is really to
provide technical comments on investment management-related
issue, I am really not, I guess, in the best position to
comment on how best to address the issue of Social Security
solvency type questions.
Senator Hagel. Thank you.
Mr. Amelio.
Mr. Amelio. The Board does not have any position on this
issue, as you can imagine.
Senator Hagel. You are a technician.
Mr. Amelio. Yes.
Senator Hagel. Thank you.
Let me ask one last question, and I do not know if you have
any thoughts on this. But is there anything in particular we
can learn, we should be paying attention to, from other
countries who have gone through this? Chile obviously is an
example that has been used here a couple of times this
afternoon. The United Kingdom, Sweden, and other countries have
had to deal with this. Some have deferred it. Some have dealt
with it fairly successfully. None have gone through it, that I
am aware of, without some ups and downs and adjustments and
calibrations. But as the last question for the six of you,
starting with you, Mr. Furman, anything in particular that we
should be focused on in learning from these other nations that
have gone through something similar?
Mr. Furman. One of the strongest lessons from international
experience is that the administrative costs can tend to be very
high and exceed what people originally expect for them. That is
especially true in a decentralized system like Chile or the
United Kingdom. Administrative costs also go way up if you give
people even the limited set of Government-sponsored choices
that you have in a country like Sweden.
So if there is one lessons from international experience,
it is that a lot of the benefits you think you are going to get
from these accounts come up against the hard reality of how
complicated they are to administer and costly to administer in
practice.
Senator Hagel. Thank you.
Mr. John.
Mr. John. As you look around the world, the first lesson to
come up is do it now. If we look at the Japanese, the Germans,
the French, and the like, who have waited much later in the
demographic positioning than we have, the choices only become
more and more painful. If we look at Australia and Switzerland,
we find that it is actually possible to mandate savings,
whether it is through a personal account attached to Social
Security or some other way. And if you do it soon enough, you
can build significant amounts of assets and reduce the long-
term costs to your society of a pension plan.
If you look at the United Kingdom, you will discover that
you can actually screw up a private pension plan, if you make
it too complex or if you try to micromanage. And if you look at
Germany, in particular, the Riester reforms from about 2001 or
so, you find that if you come up with what is otherwise a good
plan and it is far too complex, nobody is going to understand
it and nobody is going to support it.
Senator Hagel. Thank you.
Mr. Tanner.
Mr. Tanner. My comments would be very similar. I think that
it is very important that any plan that is devised be
transparent and easy to understand for everyone involved. I
think Britain is a classic example of a plan that was overly
complex, opaque; very few people had any idea where their money
was going and how it worked. It was tax credits against
something else, a type of thing that was not necessarily even
connected with your Social Security taxes. You had to be twice
removed from it. And the result led to a great many problems.
The Chilean system I think shows that it can be done. You
have to remember, when Chile did this, this was back when
Brezhnev was the head of the Soviet Union. We did not have
computers. People did things on paper. And yet they were able
to create this type of system, which is remarkably efficient.
The costs today are about 65 basis points for administering
these accounts in Chile, which is higher than here but quite
reasonable. So, I think it proves that it can be done if you
are willing to undertake it.
Senator Hagel. Thank you.
Mr. Cavanaugh.
Mr. Cavanaugh. In response to your question what do we
learn from foreign experience, I think we learn not to do it. I
have a different perception from Mr. Tanner of the Chilean
experience. When that was put in, it was mandatory. Back in
1981, I think they started it. And the only people that did not
have to join it were General Pinochet's officers, the military.
I think they had a little insight into what the plan was about.
As I recall, 40 percent of Chileans, although they were
supposed to go into this thing, opted out because there was
some kind of a back-up thing like Social Security that they
could take instead, and they just went against the law. And The
Wall Street Journal did a survey of the Chilean, the British,
Swedish, and others just a few months ago, and according to
their figures--and I have heard the number in other places--in
the Chilean individual accounts, the financial institution
takes 20 percent off the top right at the beginning. I do not
see how you can get anywhere with that kind of management. As
to the British system, in addition to the problems mentioned by
Mr. Tanner, a few months ago it was noted in the press, because
of the enormous reaction to the way British financial
institutions handled that, there was a class action suit that
they finally settled for $24 billion. In Great Britain, that is
a lot of money. And that is how bad the problem was.
So the United Kingdom is definitely not a model, and Chile,
in my opinion, was a failure.
Mr. Tanner. Mr. Chairman, if I can just correct something
for the record, the Chilean system that was implemented was
voluntary. The military and police were forbidden to go into
the system because they had something similar to a civil
service pension which is linked to your rank and things like
that. They were not part of the Social Security system at that
time. For ordinary workers, it was voluntary. Some 93 percent
of Chilean workers have voluntarily chosen to go into the
system. About 40 percent of workers are not currently
participating because they are in the underground economy, tax
evasion being a time-honored tradition in much of Latin
America. They are simply not on the books and, therefore, they
are not participating in any of the system. They were not
participating in the old Social Security system either since
they were working under the table. But it is entirely a
voluntary system under the system.
Senator Hagel. Thank you.
Mr. Enderle.
Mr. Enderle. My response is essentially the same as to the
previous question in that I am most qualified to respond to any
investment management-related questions for any plan that may
be proposed or considered.
Senator Hagel. Thank you.
Mr. Amelio.
Mr. Amelio. I think the universal comments that I have
experienced at this hearing, other hearings, and other writings
with these plans are that there have been complications and
high costs. I think that only really illustrates what a great
job Congress did in 1986 when they created the TSP. They put
the structure in that stands today, and that is where we are.
And so kudos to that Congress in 1986.
Senator Hagel. A high point to leave this hearing on,
obviously. And I know Senator Dodd was here, Senator Sarbanes,
maybe others, and I shall pass on your congratulations for
their wisdom and direction and leadership.
Gentlemen, you have been very helpful and made significant
contributions, and we will most likely be back in touch with
you at some point. But you have helped us immeasurably, and we
appreciate very much your time and your thoughts.
The hearing is now adjourned.
[Whereupon, at 4:16 p.m., the hearing was adjourned.]
[Prepared statements supplied for the record follow:]
PREPARED STATEMENT OF SENATOR TIM JOHNSON
Thank you, Mr. Chairman, for holding today's hearing. I am proud of
what this Committee has done to enhance our capital markets, which are
the strongest and most efficient in the world. With comprehensive
corporate governance legislation and a fairly comprehensive new
regulatory scheme for the mutual fund industry under our belts, I think
we've made the marketplace a more transparent and secure place. There
is no denying, however, that our marketplace derives its strength on
risk, and I appreciate today's opportunity to look at whether this
concept of risk is appropriate in the context of retirement security.
Since President Bush began his campaign to establish private
accounts within Social Security, support for his plan has declined
significantly. Even members of his own party have voiced their concerns
and outright objections to his plan. It seems that as Americans learn
more about the structure of his plan, more and more people reject it. A
recent Wall Street Journal/NBC poll found that a majority of Americans
think that it is a bad idea to change the Social Security system to
allow workers to invest their Social Security contributions in the
stock market.
Private accounts from the get-go are a bad idea for the Social
Security program. As I traveled recently throughout my State and held
town halls, I shared my thoughts with constituents about the vast new
borrowing that would be required, the inherent risks in a privatization
scheme, and the alarming benefit cuts that will be experienced by all
beneficiaries--irrespective of whether or not they select to have a
private account. As I shared this information, over and over again I
heard the people of South Dakota say--``don't privatize this program.''
Now, I would guess that the hope of some here today is that this
hearing will provide an opportunity to talk about the details of how
private accounts would work, but in my mind, there is no need to even
walk down that road. The underlying principles behind the privatization
concept are flawed, and I think that is where our discussion today
should begin.
As we think about the underlying principles of the President's
plan, we must not forget the intent of the Social Security program--to
provide insurance for unintended events that threaten financial
security, and to provide a secure, guaranteed financial floor for which
all other aspects of retirement planning are built upon. Some things
that we need to consider as we hold this hearing today.
Foreign Debt
The vast new borrowing required by the President's privatization
proposal threatens our standing in the financial markets of the world.
As of the end of 2004, foreign ownership of the debt already reached
almost $2 trillion, or 44 percent of the total held by the public. The
addition of $5 trillion in transition costs over 10 years that is
required by private accounts will threaten the stability of the U.S.
economy. If foreign investors lose faith in our ability to finance this
debt, this could lead to soaring interest rates, a weakening of the
dollar, and even a deep recession or depression.
In the context of today's discussion on the role of our financial
markets in Social Security, one cannot underestimate the threat that
our current $400 billion national deficits pose to the health of our
financial marketplace. Last February, the Korean central bank indicated
that it planned to limit its dollar holdings and purchase different
currencies instead. Following this news, stock prices fell sharply.
Several weeks later, Japan indicated it was looking at limiting its
dollar holdings. What happened? Another terrible day on Wall Street.
Something drastic--like Japan or China selling a large amount of U.S.
dollar holdings--could have a devastating impact on our economy. I have
serious concerns about whether it is prudent to give any foreign
country substantial leverage over the U.S. economy, much less the
retirement security of the two-thirds of our seniors that depend on
Social Security as their primary source of income.
Risk and Rate of Return
While the average real return on long-term government bonds was 2.3
percent, and the annual total rate of return on large corporate stocks
was 7.2 percent between 1926 and 2003, such figures do not account for
the variation in returns for both types of assets over shorter periods
of time. Depending on a worker's birth date, the retirement benefits
relative to preretirement earnings generated from putting one's savings
away for 35 years could have gone from 100 percent to less than 20
percent.
For every dollar deposited in a personal account, a worker's
traditional benefit, delivered in a monthly Social Security check,
would be diminished by a dollar, plus the interest rate the money would
have earned in Treasury bonds. This ``claw-back'' requirement means
that in order to come out ahead of the traditional system, an account
would have to realize returns on investment of at least 3 percent above
the rate of inflation.
When examining past trends, it would not be unlikely that the
government will have to assume costs to bail-out a privatized system
that provides too few benefits. Their will always be the chance that
the market will under perform, and because whole generations would end
up with too few savings in retirement in this scenario, the problem
will be too large for the Government to ignore. A Government bail-out
would be an extremely costly undertaking. For example, when the savings
and loan crisis of the late 1980's occurred, these economic problems of
the past became large enough to justify a bail-out, costing the U.S.
taxpayers over $120 billion.
Administrative Risks/Costs
Most of the financial services industry in the United States is
very effective and sound, but we must remember there are risks and
costs involved in investing in the stock market. Not only the risks
associated with putting money into stocks, but also risk involved in
giving so much financial power to a small group of people. Creating
privatized accounts in the Social Security system, would also lead to
an increase in payments of financial fees to private financial
management companies.
Britain privatized its Social Security system in 1986, allowing
citizens to ``contract out,'' which is their term for putting
government pensions into the stock market. The scheme led the
government pension system in Britain to the brink of crisis. Last year
alone, more than 500,000 people abandoned their private accounts in
favor of the state-managed Social Security system.
Securities fraud loomed large among the problems the British system
faced. In the early 1990's, Britain's financial services regulator, the
Securities and Investment Board, undertook random samples of paperwork
from the insurance industry, which was selling the private accounts to
British citizens.
The regulator found a staggering percentage of private accounts had
been sold to those who would be worse off in retirement as a result.
The public outcry over this ``mis-selling'' scandal forced the
government to establish a review panel that ultimately found the
insurers liable for making people worse off.
Over an 8-year period, 1.7 million people sought and received
compensation that ultimately cost the insurance industry $12 billion.
In addition, hundreds of millions were paid out in fines and penalties.
It was the biggest financial scandal in British history to date.
According to a University of Chicago Study, Plan 2 of the
President's Social Security Commission would result in fees paid to
Wall Street totaling $940 billion. These fees amount to more than 25
percent of the existing deficit in Social Security over the same
period. In Britain, fees to private companies managing these accounts
consumed an average of 43 percent of the value of an individual account
over the course of a 40-year working career.
Not an Investment Program
The President has made it a point to describe Social Security as an
investment program. This message neglects to recognize that about one-
third of payroll taxes go to fund disability and survivors insurance.
Such insurance plans would be extremely expensive to purchase in the
private market. In addition, the program provides protection against
the risks of inflation by the way they are adjusted each year. It is
incorrect to measure the value of an insurance plan based on a rate of
return. For example, when you purchase life insurance, you do not want
a good rate of return, since that money will be made available only in
the event of one's own death--and few people would opt out of a
guaranteed life insurance program because of what potential rate of
return could be realized in the stock market.
It is Not Your Money
The President has spent a great deal of time canvassing the country
telling people about the nest eggs they will be able to call their very
own. The reality is that these accounts will not be ``your'' money.
Not only do beneficiaries have to pay a retirement tax on their
benefits, but the President has not been very clear on the question of
a mandatory annuity. He has indicated that you will be required to
purchase an annuity upon retirement, to assure some regular minimum
payment at the poverty level if your income from other sources is not
adequate. The annuity payment ceases with your death. If there is
anything left in the account after the claw-back has taken its share
and after you have purchased an annuity, if you are required to do so,
that will be yours to take as a lump sum or leave to your heirs. It is
not at all clear where these annuities will come from, but it appears
most likely to be the private sector.
This would mean not only a windfall for companies that were
managing the funds but also mandated annuities being underwritten by
insurance companies. For most people, their accounts are going to be
tiny and will be eaten up by management fees. When you annuitize it,
what you get is very small.
Additionally, the claw-back requirement essentially means that you
are receiving a loan from Social Security for the money you want to
contribute to your private account, which you have to repay upon
retiring. That does not seem to me to be ``your money.''
Deposit Insurance
However strong our capital markets, we are all aware that risk is
inherent to the marketplace. For years, I have pushed to make sure that
those save for retirement have at least one completely safe investment
option: A federally insured account. While there is a place and time
for individuals to invest in the equity and bond markets, there is also
a time and place for them to look to their banks and credit unions for
insured accounts. FDIC and SHARE insurance levels have not kept place
with inflation, and are woefully inadequate to cover the savings needs
of today's retirees. Together with a bipartisan group of Banking
Committee Members, I have advocated an increase in Federal deposit
insurance up to $250,000 for retirement accounts. The demand for such
coverage clearly exists. In fact, some large financial institutions
with multiple charters actually promote offers of nearly a million
dollars in coverage for interest-bearing, personal accounts.
Now, in the context of Social Security reform, I will state here
that I am unequivocally opposed to private accounts. That is not what
Social Security is about, and I believe it is a mistake to go down this
path. However, if the President and the Republican-controlled Congress
are determined to privatize Social Security, then they at least should
make sure that participants are not required to roll the dice with
their nest eggs. Insured accounts should be an integral part of any
privatization scheme, and it is our responsibility to make sure that
insurance levels are adequate to cover the needs of our seniors.
Priorities and In Perspective
Social Security is in need of reforms to ensure its solvency for
generations to come. But major restructuring of the program is not
required. To put the gravity of the problem in perspective, one should
note that the Social Security shortfall will amount to .65 percent of
the GDP over the next 75 years or $3.7 trillion, while the President's
recently enacted tax cuts if made permanent amount to $11.6 trillion
over that same period. Additionally, the Medicare Trustees project that
that Medicare drug benefit will cost 1.4 percent of GDP, or $8.1
trillion over that same period.
There is an inherent disconnect in the push for privatization. The
President has stated over and over that the Social Security Trust Fund
is in immediate ``crisis.'' This manufactured crisis is based in part
on financial assumptions that show a weak future for our economy. At
the same time that he paints this bleak picture, the President has told
the American people that investing the program in stocks is the way to
go because our future economic outlook is bright, with no possibilities
of downturn. We cannot have it both ways.
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PREPARED STATEMENT OF GARY A. AMELIO
Executive Director, Federal Retirement Thrift Investment Board
June 14, 2005
Good morning, Chairman Hagel and Members of the Subcommittee, my
name is Gary Amelio. I am the Executive Director of the Federal
Retirement Thrift Investment Board and, as such, the managing fiduciary
of the Thrift Savings Plan, or TSP, for Federal employees and members
of the uniformed services. I welcome this opportunity to appear before
the Subcommittee on behalf of the Board.
You have invited my testimony as part of your consideration of the
role of the Financial Markets in Social Security Reform. Although the
Board has expressed no view regarding any proposals to change Social
Security, our experience with the TSP may provide some useful
information for the Subcommittee. I am pleased to describe how the TSP
functions in a number of key areas and to discuss how the Congress
addressed important TSP issues in the Federal Employees' Retirement
System Act of 1986 (FERSA).
The TSP is a voluntary savings and investment plan that allows
Federal and postal employees (and, since 2002, members of the uniformed
services) to accumulate savings for their retirement. It offers
employees of the Federal Government the same types of savings and tax
benefits that many private corporations offer their employees under
Internal Revenue Code Section 401(k) retirement plans. The TSP
currently has approximately 3.4 million individual accounts. The Thrift
Savings Fund has grown to $157 billion. Each month, participants add
more than $1.4 billion in new contributions. Participants may invest in
any individual, combination, or all of five investment funds; transfer
their monies among the funds; apply for loans from their accounts;
transfer money into their accounts from other eligible employee plans
or individual retirement accounts; and receive distributions under
several withdrawal options. TSP administrative expenses are borne by
the participants, not by the taxpayers.
The Government-wide Federal Employees' Retirement System (FERS)
employee participation rate is 86.2 percent. TSP participation by Civil
Service Retirement System (CSRS) employees is currently about 66
percent. Additionally, after only 3 years, nearly half a million
members of the uniformed services also now have TSP accounts.
Plan Structure
Employees who are covered by FERS, CSRS, or members of the
uniformed services contribute via payroll allotment to the TSP. The
maximum percentages they may contribute are prescribed by law. These
limits are scheduled to increase next year to $15,000 annually for most
employees and $20,000 annually for those age 50 and over.
FERS employees receive an automatic contribution to their TSP
accounts, paid by their employing agency, which is equal to 1 percent
of their basic pay each pay period. Their employing agency also matches
the first 5 percent of basic pay contributed--dollar-for-dollar on the
first 3 percent and fifty cents on the dollar for the next 2 percent.
CSRS employees and members of the uniformed services receive the same
tax benefits as FERS employees, but receive no automatic or matching
contributions from their agencies.
Governance and Administration
The TSP is administered by the Federal Retirement Thrift Investment
Board, which was established as an independent Federal agency under
FERSA. There are approximately 90 employees of the Agency. Governance
is carried out by six individuals who serve as fiduciaries of the Plan.
Five are part-time Presidential appointees (confirmed by the Senate)
who serve 4-year terms, and the sixth is a full-time executive
director. The latter is selected by the appointees and serves an
indefinite term. Each of these persons is required by FERSA to have
``substantial experience, training, and expertise in the management of
financial investments and pension benefit plans.'' 5 U.S.C.
Sec. 8472(d). With input from the executive director and Agency staff,
the Board members collectively establish the policies under which the
TSP operates and furnish general oversight.
The executive director carries out the policies established by the
Board members and otherwise acts as the full-time chief executive of
the Agency. The Board and the executive director convene monthly in
meetings open to the public to deliberate policies, practices, and
performance.
FERSA provides that all monies in the Thrift Savings Fund are held
in trust for the benefit of the participants and their beneficiaries.
As fiduciaries, the executive director and the Board members are
required to act prudently and solely in the interest of TSP
participants and their beneficiaries. This fiduciary responsibility
gives the Board a unique status among Government agencies.
Congress wisely established this fiduciary structure because it
recognized that all Plan funds belong to the participants, not the
Government, and thus must be managed for them independent of political
or social considerations.
The Conference Report on FERSA, House Report 99-606, dated May 16,
1986, states in the Joint Explanatory Statement of the Committee of
Conference:
Concerns over the specter of political involvement in the
thrift plan management seem to focus on two distinct issues.
One, the Board, composed of Presidential appointees, could be
susceptible to pressure from an Administration. Two, the
Congress might be tempted to use the large pool of thrift money
for political purposes. Neither case would be likely to occur
given present legal and constitutional restraints.
The Board members and employees are subject to strict fiduciary
rules. They must invest the money and manage the funds solely
for the benefit of the participants. A breach of these
responsibilities would make the fiduciaries civilly and
criminally liable.
The structure of the funds themselves prevents political
manipulation. The Government Securities Investment Fund is
invested in nonmarketable special issues of the Treasury pegged
to a certain average interest rate. The Fixed Income Investment
Fund is composed of guaranteed investment contracts,
certificates of deposits or other fixed instruments in which
the Board contracts with insurance companies, banks, and the
like to provide it with a fixed rate of return over a specified
period of time. The Board would have no knowledge of the
specific investments.
Finally, the stock index fund is one in which a common stock
index such as Standard & Poor's 500 or Wilshire's 5000 is used
as the mechanism to allocate investments from the fund to
various stocks.
The investment approach chosen by the conferees is patterned
after corporate, State, and local government, and the few
existing Federal pension funds. Political manipulation is
unlikely and would be unlawful.
As to the issue of Congress tampering with the thrift funds,
the inherent nature of a thrift plan precludes that
possibility. Unlike a defined benefit plan where an employer
essentially promises a certain benefit, a thrift plan is an
employee savings plan. In other words, the employees own the
money. The money, in essence, is held in trust for the employee
and managed and invested on the employee's behalf until the
employee is eligible to receive it. This arrangement confers
upon the employee property and other legal rights to the
contributions and their earnings. Whether the money is invested
in Government or private securities is immaterial with respect
to employee ownership. The employee owns it and it cannot be
tampered with by any entity including Congress.
H.R. Conf. Rep. No. 99-606, at 136-37 (1986), reprinted in 1986
U.S.C.C.A.N. 1508, 1519-20.
In keeping with the intent of Congress that the Plan be
administered in accordance with fiduciary standards derived from those
applicable to private sector employee benefit plans--as distinct from
the usual administration of an executive branch agency--Congress
exempted the Board from the normal budget and appropriations processes
and the legislative and budget clearance processes of the Office of
Management and Budget. The Plan's independence is critical to ensure
the fiduciary accountability envisioned by FERSA. So long as the Plan
is managed by the fiduciaries named in FERSA (the members of the Board
and the executive director) in accordance with the statute's strict
fiduciary standards, Federal employees and members of the uniformed
services can be confident that their retirement savings will not be
subject to political or other priorities which might otherwise be
imposed by these clearance processes.
FERSA protects the Thrift Savings Fund through more than just the
independent fiduciary governance by the Board members and the executive
director. Additional safeguards to protect TSP participants include the
provisions in FERSA relating to (1) the role of the Secretary of Labor
in establishing a program of fiduciary compliance audits; (2) the
requirement that the Board contract with a private accounting firm to
conduct an annual audit of the TSP on the basis of generally accepted
accounting principles; and (3) the participation of the 15-member
Employee Thrift Advisory Council, which includes representatives of the
major Federal and postal unions, other employee organizations, and the
uniformed services.
The Board has benefited greatly from hundreds of audits conducted
by the Department of Labor over the past 17 years. These audits, which
have covered every aspect of the TSP, are reported to the Congress
annually under the Inspector General Act of 1978, as amended.
The accounting firm retained by the Board has conducted annual
reviews as required. The result has been eighteen unqualified audit
opinions.
The Advisory Council meets with the executive director and advises
on investment policy and the administration of the TSP. These meetings
are very helpful in providing the Board with insights into employee
needs, attitudes, and reactions to the various programs undertaken by
the Board.
The TSP also benefits from the cooperation of every agency and
service in the Federal establishment. Although the Board is an
independent body, successful administration of the TSP is highly
dependent upon all Federal agencies and the uniformed services, which
have direct responsibilities under FERSA for the administration of the
TSP.
Plan Services and Benefits
Employees and service members who participate in the TSP are served
primarily by the personnel, payroll, and other administrative employees
in their own agencies. The agencies are responsible for distributing
TSP materials, providing employee counseling, and accurately and timely
transmitting participant and employer contributions and necessary
records to the TSP record keeper. TSP recordkeeping services are
currently provided by the National Finance Center (NFC), which is part
of the Department of Agriculture. The TSP Service Office in New Orleans
performs a wide variety of services for TSP participants.
In addition, the TSP maintains parallel call centers at NFC in New
Orleans, Louisiana, and in Cumberland, Maryland. Participants with
questions may call a toll-free number which routes calls to participant
service representatives at one of these sites. Further, we maintain a
primary data center and a back-up data center.
Actively employed participants may borrow their own contributions
and earnings from their accounts according to rules established by the
executive director and regulations of the Internal Revenue Service.
Participants repay the loans, with interest, and the money is
reinvested in their TSP accounts. A $50 fee is charged to cover the
costs of loan processing.
The other major benefit program is the TSP withdrawal program.
Participants may withdraw funds from their TSP accounts before
separation after reaching age 59 or in cases of financial hardship.
Upon separation, a participant may:
<bullet> withdraw his or her account balance in a single payment (and
have the TSP transfer all or part of the payment to an Individual
Retirement Account (IRA) or other eligible retirement plan);
<bullet> withdraw his or her account balance in a series of monthly
payments (and, in certain cases, have the TSP transfer all or part
of each payment to an IRA or other eligible retirement plan);
<bullet> receive a life annuity; or
<bullet> keep his or her account in the TSP, subject to certain limits.
Participants may also elect a combination of these withdrawal
options.
Communications
The Agency maintains its communication program on a number of
levels within the Federal establishment in order to achieve employee
understanding of the investment choices, benefits, and the
administration of the program. This is especially
important given the voluntary nature of the Plan and the participants'
degree of individual control over investments and benefits.
The communication effort is initiated by the Board for eligible
individuals through the issuance of a ``new account letter'' to each
new participant after the employing agency establishes his or her
account. Employing agencies distribute program information, including
the Summary of the Thrift Savings Plan for Federal Employees, which
provides a comprehensive description of the Plan, as well as booklets
describing the loan program, withdrawal programs, and annuity options
for employees to review at the time they are examining those benefits.
Investment information is provided by the TSP Fund Sheets and the
Managing Your Account leaflet which discusses operations. Copies of
these publications are also available on our website at www.tsp.gov or
through the ThriftLine.
In addition, we issue materials related to specific events. For
example, the TSP Highlights is a newsletter issued with the quarterly
participant statement. Copies of the newsletters, which address topical
items and convey rates of return, are provided on our website.
Participants can also obtain their daily balances from the website,
request contribution allocations and interfund transfers or, in some
cases, loans and withdrawals, and use various calculators located there
as convenient planning tools.
A TSP video is available explaining the basics of the TSP in an
animated format. TSP Bulletins are issued regularly to inform agency
personnel and payroll specialists of current operating procedures. The
ThriftLine, the Board's toll-free automated voice response system, also
provides both general plan and account-specific information.
In connection with new Lifecycle funds we plan to introduce this
summer, we will revise all of our communications materials and feature
the benefits of the asset allocation approach used in ``Life'' funds as
discussed below. We have budgeted $10 million for this major overhaul
of our communications materials.
The Agency also conducts quarterly interagency meetings. These have
proven to be an effective means of communicating program and systems
requirements to Federal agency administrative personnel. These meetings
also allow the TSP to hear and address representatives' concerns and to
incorporate their suggestions in the establishment of TSP policies and
operations.
Investment Funds
The TSP is a participant-directed plan. This means that each
participant decides how the funds in his or her account are invested.
As initially prescribed by FERSA, participants could invest in
three types of securities--U.S. Treasury obligations, common stocks,
and fixed income securities--which differ considerably from one another
in their investment characteristics. In 1996, on the Board's
recommendation, Congress authorized two additional investment funds,
which allow further diversification and potentially attractive long-
term returns. The Small Capitalization Index Investment Fund and the
International Stock Index Investment Fund were first offered in May
2001.
The Government Securities Investment (G) Fund is invested in short-
term nonmarketable U.S. Treasury securities guaranteed by the full
faith and credit of the U.S. Government. 5 U.S.C. Sec. 8438(b)(1)(A),
(e). There is no possibility of loss of princi-pal from default by the
U.S. Government and thus no credit risk. These securities are similar
to those issued to the Social Security Trust Funds and to other Federal
trust funds. See 42 U.S.C. Sec. 401(d) (Social Security Trust Funds); 5
U.S.C. Sec. 8348(d) (Civil Service Retirement and Disability Fund).
The Fixed Income Index Investment (F) Fund, which by law must be
invested in fixed income securities, is invested in a bond index fund,
chosen by the Board to be the Lehman Brothers U.S. Aggregate (LBA)
index. The LBA index represents a large and diversified group of
investment grade securities in the major sectors of the U.S. bond
markets: U.S. Government, corporate, and mortgage-related securities.
The Common Stock Index Investment (C) Fund must be invested in a
portfolio designed to replicate the performance of an index that
includes common stocks, the aggregate market value of which is a
reasonably complete representation of the U.S. equity markets. The
Board chose the Standard & Poor's 500 (S&P 500) stock index in
fulfillment of that requirement. The S&P 500 index consists of 500
stocks representing approximately 78 percent of the market value of the
U.S. stock markets. The objective of the C Fund is to match the
performance of that index.
The Small Capitalization Stock Index Investment (S) Fund must be
invested in a portfolio designed to replicate the performance of an
index that includes common stocks, the aggregate market value of which
represents the U.S. equity markets, excluding the stocks that are held
in the C Fund. The Board chose the Dow Jones Wilshire 4500 Completion
index, which tracks the performance of the non-S&P 500 stocks in the
U.S. stock market. The objective of the S Fund is to match the
performance of the Wilshire 4500 index. The Wilshire 4500 index
represents the remaining 22 percent of the market capitalization of the
U.S. stock market. Thus, the S Fund and the C Fund combined cover
virtually the entire U.S. stock market.
The International Stock Index Investment (I) Fund must be invested
in a portfolio designed to track the performance of an index that
includes common stocks, the aggregate market value of which represents
the international equity markets, excluding the U.S. equity markets.
The Board chose the Morgan Stanley EAFE (Europe, Australasia, Far East)
index, which tracks the overall performance of the major companies and
industries in the European, Australian, and Asian stock markets. The
objective of the I Fund is to match the performance of the EAFE index.
The EAFE index was designed by Morgan Stanley Capital International
(MSCI) to provide broad coverage of the stock markets in the 21
countries represented in the index.
This summer, the TSP will introduce Lifecycle Funds. The Lifecycle
Funds will be invested in various combinations using the five existing
TSP funds. Participants will benefit from having professionally
designed asset allocation models available to optimize their investment
performance by providing portfolios that are appropriate for their
particular time horizon. This is known in the financial world as
investing on the ``efficient frontier.'' We are very excited by the
prospect of providing these funds to participants this summer. We have
placed preliminary information regarding the Lifecycle Funds on our
website, and will be issuing much more over the coming months.
One likely concern associated with a Federal agency's investing in
equities is the potential for the Government to influence corporate
governance questions and other issues submitted to stockholder votes.
FERSA provides that the voting rights associated with the ownership of
securities by the Thrift Savings Fund may not be exercised by the
Board, other Government agencies, the executive director, a Federal
employee, Member of Congress, former Federal employees, or former
Members of Congress. 5 U.S.C. Sec. 8438(f). Barclays Global Investors
(BGI), the manager of the C, S, and I Fund assets, has a fiduciary
responsibility to vote company proxies solely in the interest of its
funds' investors.
The fund assets held by the F, C, S, and I Funds are passively
managed indexed funds; that is, they are invested in portfolios of
assets in such a way as to reproduce market index returns. The
philosophy of indexing is that, over the long-term, it is difficult to
improve upon the average return of the market. The investment
management fees and trading costs incurred from passive management
through indexing generally are substantially lower than those
associated with active management. Passively managed index funds also
preclude the possibility that political or other considerations might
influence the selection of securities.
The manager of the assets held by the F, C, S, and I Funds has been
selected through competitive bidding processes. Proposals from
prospective asset managers were evaluated on objective criteria that
included ability to track the relevant index, low trading costs,
fiduciary record, experience, and fees.
The Board has contracts with BGI to manage the F, C, S, and I Fund
assets. BGI is the largest investment manager of index funds in the
United States, which had over $1.36 trillion in total assets under
management as of December 31, 2004.
The centralized management of TSP investments was carefully
considered in FERSA by Congress. According to the Joint Explanatory
Statement of the Committee of Conference quoted earlier:
Because of the many concerns raised, the conferees spent more
time on this issue than any other. Proposals were made to
decentralize the investment management and to give employees
more choice by permitting them to choose their own financial
institution in which to invest. While the conferees applaud the
use of IRA's, they find such an approach for an employer-
sponsored retirement program inappropriate . . . .
The conferees concur with the resolution of this issue as
discussed in the Senate report (99-166) on this legislation:
As an alternative the committee considered permitting any
qualified institution to offer to employee[s] specific
investment vehicles. However, the committee rejected that
approach for a number of reasons. First, there are literally
thousands of qualified institutions who would bombard employees
with promotions for their services. The committee concluded
that employees would not favor such an approach. Second, few,
if any, private employers offer such an arrangement. Third,
even qualified institutions go bankrupt occasionally and a
substantial portion of an employee's retirement benefit could
be wiped out. This is in contrast to the diversified fund
approach which could easily survive a few bankruptcies. Fourth,
it would be difficult to administer. Fifth, this ``retail'' or
``voucher'' approach would give up the economic advantage of
this group's wholesale purchasing power derived from its large
size, so that employees acting individually would get less for
their money.
H.R. Rep. No. 99-606, at 137-38, reprinted in 1986 U.S.C.C.A.N.
1508, 1520-21.
Investment Returns
By law, TSP investment policies must provide for both prudent
investments and low administrative costs. From the beginning of the G
Fund's existence (April 1987) and the beginning of the F and C Funds'
existence (January 1988) through December 31, 2004, the G, F, and C
Funds have provided compound annual returns net of expenses of 6.7
percent, 7.7 percent, and 12.1 percent, respectively. The related BGI
funds closely tracked their respective markets indexes throughout this
period. Because the S and I Funds were introduced in May 2001, the
Board has no long-term history for them. The indexes which they track,
however, have produced compound annual returns of 11.9 percent and 5.6
percent, respectively, for the 10-year period ending December 2004.
In order to make the performance of the TSP funds more easily
comparable, I have attached a chart which displays the growth of $100
invested in the underlying indexes for 20 years. The chart also
includes the growth related to G Fund securities as well as inflation.
For calendar year 2004, the net Plan administrative expenses were
.06 percent. This means that the 2004 net investment return to
participants was reduced by approximately $.60 for each $1,000 of
account balance. The expense ratio would be approximately .01 percent
higher in the absence of account forfeitures, which offset expenses.
These costs compare very favorably with typical private sector 401(k)
service provider charges.
In summary, I believe that the Thrift Savings Plan has effectively
and efficiently realized the numerous objectives Congress thoughtfully
established for it 19 years ago. To the extent that our experience is
useful to the Subcommittee, I welcome the opportunity to provide any
additional information you may require. I would be pleased to respond
to any questions you or other Members of the Subcommittee may have at
this time.
PREPARED STATEMENT OF FRANCIS ENDERLE
Managing Director and Chief Investment Officer,
Global Index and Markets Group, Barclays Global Investors
June 14, 2005
Good afternoon, Mr. Chairman and Members of the Committee, my name
is Francis Enderle and I am the Chief Investment Officer for the Global
Index and Markets Group at Barclays Global Investors (BGI). In that
role I am responsible for, among other things, the oversight of
portfolio management in the United States of all of BGI's index
strategies.
We are pleased to be here today to share with the Committee our
expertise in the management of defined contribution pension accounts,
which is derived from our experience as the external asset manager for
the Federal Thrift Savings Plan (TSP) as well as for numerous other
public and private pension plans. We are honored to have served as an
investment manager for the TSP since 1988, a relationship we have
retained in regular, highly competitive bidding processes.
I will begin by discussing our investment philosophy and our
structure, both of which are focused on delivering highly reliable, low
cost investment results to institutional investors like the TSP. By
``institutional'' I refer to defined benefit and defined contribution
pension plans sponsored by corporations or public agencies, and to
endowments, foundations, and other similar pools of capital. I will
then say a few words about the services we provide to the TSP, and
elaborate on how we keep the costs associated with trading and
investing as low as possible. I will conclude by turning to the
investment related issues to be considered if the Federal Government
were to legislate individual investment accounts either as part of
Social Security reform, or through another mechanism.
Barclays Global Investors was founded in 1971 as part of Wells
Fargo Bank in San Francisco, California. Today, we are owned by
Barclays PLC, one of the world's leading financial service providers.
We are headquartered in San Francisco with approximately 1,100
employees in California and elsewhere in the United States and 1,100
more employees worldwide serving the needs of our global clients. With
more than $1.3 trillion in assets under management, BGI, together with
its affiliates, is the world's largest index manager. BGI created the
first index strategy in 1971, just one of many financial innovations we
have pioneered.
Since our founding, BGI has remained true to a single global
investment philosophy, which we call Total Performance Management. BGI
manages performance through the core disciplines of risk, return, and
cost management. The success of our indexing methodology results from
our focus on delivering superior investment returns over time while
minimizing trading and other implementation costs and rigorously
controlling investment and operational risks. This approach helps us
avoid investment ``fads'' or a dependence on ``star managers'' or
``stock pickers.'' It has been the foundation for the way we have
managed money for over 30 years and we believe it has served our
clients very well.
As I noted earlier, since 1988 one of those clients has been the
TSP. BGI manages four of the five investment options available for
participants--the TSP C Fund (based on large-capitalization U.S.
equities), the S Fund (based on mid- and small-capitalization U.S.
equities), the F Fund (based on the Lehman Aggregate Long-term Bond
index) and the I Fund (based on the MSCI Europe Australia Far East
(EAFE) index of non-U.S. equities). The fifth option, the G Fund, is
managed by the U.S. Treasury and invests in U.S. Treasury securities.
Later this year, the TSP will be launching a series of lifecycle or
``target horizon'' options that use the existing five options as the
asset class ``building blocks'' with allocations in each lifecycle fund
across these options being determined by an external vendor. I will
describe shortly the structure of these new options, as well as the
benefits they will provide to plan participants.
BGI's services to the TSP are completely focused on investment
management. We do not provide any other services. We have an extremely
effective operating model developed in conjunction with TSP staff to
manage the daily cashflows into or out of each of the investment
options. Each day we receive an instruction for each fund that
aggregates the transaction instructions of all TSP participants placing
orders on that day. In this way, the orders for participants buying or
selling from the same fund are netted against each other and only a
trade for the residual order is placed.
Management of payroll contributions, recordkeeping (for example,
changes made by participants in investment elections), distributions
and communications to participants are handled directly by the TSP or
its other vendors. This is also true for most of our other clients--our
core expertise is investment management, and our comments are provided
principally from this perspective. Minimizing transaction costs in all
our investment activities is a central element, Mr. Chairman, in how we
do our business. In fact, the key to our success in index management
has been our ability to minimize implementation and trading costs. High
costs and expenses of investing detract from performance and investment
returns; lower costs increase the investment pool and put more money
long-term into the pockets of investors. Let me say a few words about
how we do this.
Each of our index funds is structured to match the performance of a
specific index. These indexes (such as the S&P 500 or the MSCI EAFE)
are designed by third-party index providers. However, these indexes are
really ``paper portfolios'' and do not include any of the trading costs
that real-world investors experience. Thus to successfully achieve the
performance target--that is, to track the index as closely as
possible--BGI strives to minimize the ``real world'' costs through a
variety of highly efficient trading approaches.
Through the size and diversity of our client base we are able to
match or offset a significant percentage of our clients' buy and sell
orders internally, thereby reducing or eliminating market transaction
costs. The internal matching of buy and sell orders is commonly
referred to as ``crossing,'' and is conducted and actively monitored by
BGI pursuant to the terms and conditions of an exemption issued by the
Department of Labor.
When we do trade in the markets, we utilize carefully developed and
managed trading strategies and we access all possible sources of
liquidity, including electronic marketplaces. Our trading activities
are supported by a dedicated trading research team, whose sole job is
to develop new trading techniques and strategies to minimize trading
costs. We execute our trades through broker-dealers who have been
prescreened for credit-worthiness, and we rigorously monitor the prices
at which our trades are executed relative to a number of market-related
benchmarks to ensure we are receiving superior execution. We also use
our scale to negotiate low per share commission rates.
The majority of our assets are managed for large institutional
clients such as the TSP and the average account size for our U.S.
clients is $880 million. BGI is able to charge lower investment
management and administrative fees to its institutional clients than a
mutual fund firm geared toward retail investors, where the average
account size is comparatively small. And in dealing with institutional
investors we do not have the costs of retail administrative services
(including shareholder communications and recordkeeping), which also
serve to raise the costs of retail fund managers. By way of example,
the average fee for large-capitalization U.S. equity index portfolios
of $100 million in size that are managed for institutional clients is
0.05 percent versus retail-oriented equity index mutual funds where the
fees average 0.69 percent,\1\ more than 10 times greater than our
expense ratios.
---------------------------------------------------------------------------
\1\ Source: Morningstar, BGI 2/05.
---------------------------------------------------------------------------
Over the course of a long-term investment, lower management fees
and expenses (including trading commissions) can translate into
considerable savings for any investor. Indeed, index investing remains
the most cost-efficient and diversified way to gain exposure to various
segments of the capital markets. We believe index funds are the best
core investment for most investors' portfolios--whether they are the
largest pension fund in the world, or an individual investor.
I would now like to make a few comments regarding investment
management considerations if personal accounts are adopted as part of
any future changes to the Social Security program.
Let me first acknowledge that BGI has built a substantial part of
its business by offering well-managed index strategies to our clients
for more than 30 years. We therefore have a vested interest in the
continued growth of index investing. Our interests aside, we firmly
believe that the reason for the success of these strategies is the
simple fact that they deliver the return of the market index reliably
and cost effectively. In fact, Congress recognized this itself in the
enabling legislation for the TSP, which provides that the four public
market options be invested in portfolios designed to replicate the
performance of an index that is ``commonly recognized'' as reflecting
the performance of each asset class (that is the S&P 500 Index for
large capitalization U.S. equities).
If a national system of personal accounts were to be implemented,
we would encourage legislators to consider the following approach that
draws on the best practices of institutional investors.
An array of low cost, broadly diversified index funds frequently
forms the core
investment for institutional pension plans, both defined benefit and
defined contribution structures. For example, the current selection
offered to TSP participants covers all the main asset classes--large
and small capitalization U.S. equities, U.S. fixed income,
international equities and a stable value option. Other asset classes
could be included but these options would provide the basic ``building
blocks'' and coincide with what one would typically see in a well-
constructed institutional portfolio.
We suggest consideration of index portfolios because they offer
three principle benefits to investors:
<bullet> They capture the return of each asset class (as represented by
a benchmark index such as the S&P 500) with a high degree of
precision;
<bullet> Index funds typically have low asset management fees as
compared to actively managed funds;
<bullet> Index funds have lower relative transaction costs including
commissions, bid/ask spreads and market impact. This is because
index fund investments are spread across a large number of
securities thereby reducing the impact of a portfolio trade on an
individual security relative to what would occur in a more
concentrated portfolio.
The latter point is worth elaborating upon given the sizeable
assets that would potentially be invested in personal accounts.
Investing in index funds spreads assets across the broadest possible
array of securities in any asset class thereby minimizing the impact of
trading large cashflows in the market on a daily basis. This is not
only important for the investment of new monies into personal accounts
but also for any trading that individuals may initiate in their
personal accounts to reallocate assets among their investment options
over time.
Another investment option to be considered is an array of so-called
lifecycle or ``target horizon'' funds, options that the TSP will be
adding later this year, as I mentioned earlier. With lifecycle funds,
potentially the only choice an investor needs to make is to select the
lifecycle fund with the target horizon date that most closely matches
the investor's date of retirement. Each lifecycle fund would hold an
array of asset classes with each asset class being implemented with an
index fund. The asset mix within each lifecycle fund would gradually
become more conservative over time as the target horizon date
approached. For example, a participant who is 30 years of age today and
a set retirement of, for example, age 65 would be invested in a
lifecycle fund with a target horizon date of 2040.
As with the index fund options described earlier, a lifecycle fund
option could also be structured as a very low cost solution to
investors. While a lifecycle fund would not necessarily need to be
invested in index funds, index funds likely provide the lowest cost
solution for each asset class, and assure that the return of each
selected asset class is reliably captured. Participants in each
lifecycle fund would benefit from the fund's gradual evolution to a
more conservative investment risk profile as the participant approached
retirement.
Mr. Chairman, we believe that the investment considerations we have
discussed will assist you and others on this Committee in evaluating
the criteria to be used if personal accounts were to be legislated by
Congress as part of revisions to the Social Security program, or in
another program. I thank you for the opportunity to speak with you
today and I look forward to answering any questions you may have.
----------
PREPARED STATEMENT OF FRANCIS X. CAVANAUGH
Former Executive Director, Federal Retirement Thrift Investment Board
June 14, 2005
Mr. Chairman and Members of the Subcommittee, I welcome this
opportunity to discuss the role of financial markets in Social Security
reform. The Administration's current proposal for Social Security
individual accounts (IA) contemplates that private financial
institutions would provide fund management services and probably other
401(k) plan services, such as investment education, counseling, and
record keeping. My comments will focus on the cost of such services and
the problems in providing them to employees of small businesses.
I am a public finance consultant, but I speak only for myself. I
have no clients with an interest in Social Security individual
accounts. From 1986 until 1994, I was the first Executive Director, and
thus the Chief Executive Officer, of the Federal Retirement Thrift
Investment Board, the agency that administers the Thrift Savings Plan
(TSP) for Federal employees. Before that, I was a financial economist
in the Treasury Department for 32 years, and was the senior career
executive responsible for developing Federal borrowing, lending, and
investment policies, including those for the Social Security and other
Federal trust funds.
The Administration's Proposal
While there is no specific proposal before your Committee, the
Administration's current broad proposal, according to White House
statements and press reports, provides a basis for at least a
preliminary analysis of its feasibility.
The following features of the Administration's approach would have
significant impacts on its feasibility:
<bullet> Social Security individual accounts (IA's) would be voluntary
for all Social Security taxpayers under age 55, but would be
mandatory for employers of employees who chose IA's.
<bullet> A major purpose of IA's would be to encourage savings by young
and low-income workers and employees of small businesses who do not
now have 401(k)s or other pension plans.
<bullet> The maximum amount of an individual's initial annual
contribution to an IA would be $1,000, which would increase by $100
a year, to 4 percent of pay eventually. It would take more than 30
years for the highest income individuals to be able to contribute
the full 4 percent of pay.
<bullet> Eligible investments for IA's would be Treasury securities and
stock and bond index funds, which would be similar to eligible
investments of the TSP.
<bullet> IA's would be centrally managed, apparently by a TSP-like
agency with a part-time board, appointed by the President with the
advice and consent of the Senate, and a full-time executive
director and CEO appointed by the board. Following the TSP model,
the board members and the executive director would be independent
of the administration, and would be fiduciaries required to act
solely in the interests of the holders of the IA's and their
beneficiaries.
<bullet> Unlike contributions to 401(k)'s or to the TSP, IA
contributions would not be eligible for matching contributions or
exclusion from taxable income, and loans or withdrawals before
retirement would not be permitted.
Cost Analysis
A critical question, of course, is costs. IA's are proposed to
provide a higher investment return than would be realized by the Social
Security Trust Fund. Thus IA's would not be feasible if their
administrative costs were so high as to offset the advantage of
diversified investments in stocks and other securities that yield more
than the Treasury securities in the Social Security Trust Fund.
The Administration assumes that IA's would earn an average
investment return of 4.9 percent after inflation, and that
administrative costs of .3 percent, that is, 30 basis points, would
reduce the net return to 4.6 percent, or 1.6 percent more than the
assumed net return of 3 percent on the Treasury securities in the
Social Security Trust Fund. Thus, if one accepts the Administration's
assumptions, IA's would outperform the Trust Fund investments so long
as the administrative costs were less than 1.9 percent. In my view and
that of many other economists, the 4.6 percent assumption is much too
high; indeed, the Congressional Budget Office's estimate of the net
return is reportedly only 3.3 percent.
The Administration's estimate of 30 basis points is optimistically
low; even the Cato Institute, a leading advocate of individual
accounts, estimates IA expenses at 55 basis points. Yet this higher
estimate is also too low. Like so many others I have heard, these
estimates are based mainly on experience with large 401(k)s for large
organizations, like the TSP,\1\ with economies of scale and
comprehensive payroll, personnel, and computerized systems support.
---------------------------------------------------------------------------
\1\ The administrative cost, or expense ratio, of the TSP is 6
basis points.
---------------------------------------------------------------------------
They have little relevance to the likely costs of a universal
system of IA's. More than 85 percent of the 5.6 million small business
employers in this country offer no pension plans at all and,
accordingly, have none of the administrative apparatus to service them.
To understand the costs of bringing IA's to employees of small
businesses, we must first understand why 85 percent of them do not now
have retirement plans for their employees. Fortunately, the 401(k)
industry has already done part of the job for us. Companies like
Citigroup, Fidelity Investments, Merrill Lynch, State Street
Corporation, and T. Rowe Price have been competing for two decades to
provide investment, record keeping, counseling, and other 401(k) plan
services to small businesses. They have found that they cannot
profitably provide these services for a company for less than
approximately $3,000 a year, even though they have for years enjoyed
economies of scale from serving thousands of employers in their
centralized computer systems.\2\ Further significant economies of scale
would not be realized by a central TSP-type agency, because there would
still be millions of small businesses or workplaces to be reached. Nor
can we assume that a new central government agency would be more
efficient than the major 401(k) providers who now serve this market.
---------------------------------------------------------------------------
\2\ Francis X. Cavanaugh, ``Feasibility of Social Security
Individual Accounts,'' AARP Public Policy Institute, Washington, DC,
Sept. 2002, pp. 4-6. The $3,000 charge is still common today. See ``Big
Fees Hit Small Plans: Costs Take Huge Toll on Retirement Accounts of
Firms With Fewer Than 50 Employees,`` Wall Street Journal, Oct. 31,
2004, p. D1.
---------------------------------------------------------------------------
Thus the cost per employee of a company with 10 employees would be
$300, or 30 percent of the President's proposed annual IA contribution
of $1,000--and most U.S. companies have fewer than 10 employees.\3\
---------------------------------------------------------------------------
\3\ See generally U.S. Department of Labor, Pension and Welfare
Benefits Administration, ``Study of 401(k) Fees and Expenses,''Apr. 13,
1998. The study found that average charges by 17 major 401(k) providers
for plans with 100 participants and $2 million in assets ranged from
$114 to $428 per participant, and averaged $264. Id. at 51. Charges
obviously would be much higher for much smaller plans.
---------------------------------------------------------------------------
Even the largest business that is classified as a ``small
business,'' one with 100 employees, would therefore have an expense
ratio of at least 3 percent, which would be 10 times the
Administration's estimate of 30 basis points. And for the 60 percent of
employers in this country that have fewer than 5 employees, the initial
expense ratio would be more than 60 percent, that is, 6,000 basis
points. In fact, commercial 401(k) providers routinely discourage small
businesses from establishing 401(k) plans if they have fewer than 10
employees and, in some cases, fewer than 25 employees.
Obviously, substantial and continuing government subsidies would be
necessary to make IA's attractive to employees of small businesses. If
all Social Security taxpayers participated in the IA program, the
administrative costs would be more than $46 billion a year (155 million
participants times more than $300 per account), which would be a
subsidy to IA administrators for performing an uneconomic function.
These figures are reinforced by a number of studies, including those
cited in a review of administrative costs by the Employee Benefit
Research Institute.\4\
---------------------------------------------------------------------------
\4\ See, for example, Employee Benefit Research Institute, Issue
Brief No. 23, Nov. 1998. See also Ellen E. Schultz, ``Poodle Parlor
Retirement Plans,'' Wall Street Journal, Nov. 13, 1998, p.C1.
---------------------------------------------------------------------------
I recommend that your Committee secure the testimony of individuals
from financial institutions that are actually providing 401(k) services
to the Nation's businesses, large and small. Give them a specific set
of assumptions to cost out that
reflects the makeup of our country's 5.7 million employers subject to
Social Security--of which 98 percent are small business employers of 68
million employees.\5\ Then and only then will you know whether the
Administration's proposal--or anything similar--will produce reasonable
net investment returns, or, in the alternative, how much of a
Government subsidy would be necessary to achieve them.
---------------------------------------------------------------------------
\5\ Patrick Purcell, Congressional Research Service, ``Social
Security Individual Accounts and Employer-Sponsored Pensions,'' Feb. 3,
2005, pp. 3, 5.
---------------------------------------------------------------------------
Critical Administrative Problems
In addition to the above costs, which are based on what the current
providers are actually charging for establishing and servicing 401(k)
plans, there are overwhelming practical obstacles to the creation and
maintenance of IA's. Because President Bush seemed to idealize the
Thrift Savings Plan--the largest of all 401(k)-type plans--as the model
for IA's in his February 2005 State of the Union message--and because
many others have done so as well--I would like to point out the
considerable dissimilarities between the TSP and the administration's
proposal. (Most of these dissimilarities would hold true for a
comparison between any large corporate 401(k) plan and the proposal.)
Too Many Small Employers. The TSP is administered by just one
employer--the U.S. Government--with extensive personnel, payroll, and
systems staffs to provide the essential employee education, retirement
counseling, payroll deduction, timely funds transfers, and error
correction functions. The Thrift Investment Board is only a wholesaler
of services; the Federal employing agencies deal with the individual
employees participating in the plan. In fact, the TSP statute directs
the Office of Personnel Management to provide for the training of TSP
counselors for each Federal agency.
The Administration's plan is intended to reach all employees, but
it makes no provision for the performance of what are now essential
employer functions in 401(k) plans. They could not possibly be
performed by small business employers who are now responsible only for
the relatively simple payroll deduction and transmission of Social
Security taxes to the IRS. Since most businesses have fewer than 10
employees, they do not have the experience or administrative resources
to support the new plan. These are barbershops, beauty salons, garages,
restaurants, laundries, lawn services, households, nanny services, and
other very small businesses that could not be expected to meet the high
fiduciary standards required of those responsible for educating and
counseling employees, for presenting a new plan in the context of the
employer's existing pension or other benefits, and for the timely and
accurate transfer of funds for investment. The new TSP-like agency
obviously could not provide such employer-type services to deal with
tens of millions of diverse employees, either directly or on a contract
basis.
Consider, as but one example of several profound administrative and
legal issues, that about 650,000 businesses go out of business each
year. By whom and how would the enforcement of contributions by
delinquent or bankrupt employers be prosecuted? (Judicial remedies for
denial of TSP benefits must, in general, be pursued by the affected
individual TSP participant in the Federal court system.) For that
matter, by whom and how would breach-of-fiduciary-duty suits be brought
against ``mom-and-pop'' fiduciaries? Can the employer of a housekeeper
or a manicurist be expected to exercise the ``care, skill, prudence,
and diligence'' demanded of every 401(k) plan fiduciary by current law?
\6\ What would be the measure--and the limit--of their personal
liabilities, say, for untimely or inaccurate investment of their
employees' contributions? These questions only scratch the surface of
the inevitable pathology of plan administration--pathology that, even
if represented in small percentages among 155 million Social Security
participants, would result in enormous absolute numbers.
---------------------------------------------------------------------------
\6\ See Employee Retirement Income Security Act (ERISA), 29 U.S.C.
Sec. 1104(a); Federal Employees' Retirement System Act (FERSA), 5
U.S.C. Sec. 8477(b)(1).
---------------------------------------------------------------------------
Untimely Investments. The TSP is computerized, like all other large
plans, with investments made for each employee's account on the same
day that contributions are deducted from the employee's paycheck.
Social Security taxes are deducted on paydays, but many small
businesses send them to the IRS only once each quarter. In 2003, 72
percent of employer reports to the Social Security Administration were
submitted on paper. Moreover, individual Social Security taxpayers are
identified only once each year, with their employer's annual income tax
filings; and it would be up to 22 months after payday, under current
SSA procedures, before individual IA's could be credited.
Furthermore, the Administration's proposal is to pay IA's the same
annual return, regardless of when contributions were actually made
during the year. Thus a contribution in January would not earn any more
than a contribution of a similar amount in December. During a year of
highly volatile markets, the attempted explanation of this provision to
millions of outraged participants with irregular tax payments, because
of illness, seasonal, temporary, or other periods of unemployment,
would be a daunting challenge to the plan's telephone counselors.
Unbalanced Accounts. The TSP is balanced to the penny every day.
The Social Security system is never balanced. Each year there are
billions of dollars of unreconciled discrepancies between Social
Security taxes paid to the IRS and reported to the SSA. These
discrepancies are tolerated because they generally have little impact
on the ultimate calculation of employee benefits. Such discrepancies
are never tolerated by financial institutions responsible for timely
investment of individual funds. Theoretically, IA contribution errors
might be largely corrected by a rigorous examination of employer
records. Yet the error correction procedures, including retroactive
adjustments of investment gains or losses in volatile markets, could
bring the entire system to a screeching halt.
Inevitable Account ``Leakage.'' Unlike the TSP, the
Administration's plan would prohibit loans and emergency withdrawals,
and would require individuals to purchase annuities on retirement. I
find it inconceivable, however, that Congress--or an Administration--
would long be able to resist calls for emergency access to funds before
a worker's retirement, and in lump sum amounts. Suppose, for example,
that an individual has suffered a devastating personal financial loss,
such as thousands experienced in last year's Florida hurricanes in the
destruction of their homes. Would these persons be told that they may
not access their IA balances to mitigate such dire misfortunes? What
about a catastrophic illness, leaving a family's breadwinner unable to
work? Could such persons be denied their account balances to sustain
spouse and children? I do not think so. There are, of course, scores
more such examples, and with 155 million potential participants, you
can be sure that they all would arise. Administering the inevitable
emergency withdrawal or loan program would add enormously to the cost
of the Administration's plan.
Communication Problems. The TSP has a very effective communications
system, because it can rely on the Federal employing agencies to
distribute plan materials and to educate and counsel their employees.
Even so, the TSP found it necessary to have the central recordkeeper
for its 3 million accounts maintain a staff of more than 200 telephone
counselors to respond directly to questions from individual
participants. Since more than 200 million Social Security taxpayers and
retirees eventually would be eligible for IA's, the required number of
telephone counselors would be more than 13,000, based on the TSP
experience, and probably much higher because of the special IA
deficiencies noted above.\7\ Also, TSP mailings consistently have
reached more than 99 percent of participants, but 25 percent of SSA
mailings are returned as undeliverable.
---------------------------------------------------------------------------
\7\ Fidelity Investments, a major 401(k) provider, has estimated
that the administration of a 401(k)-type plan for Social Security
taxpayers would require a total staff of 100,000. See Employee Benefit
Research Institute, Issue Brief No. 23, Nov. 1998, p. 166.
---------------------------------------------------------------------------
Congress would undoubtedly insist that every effort be made to
advise all Social Security taxpayers of the IA benefits Congress
intended to provide them. The TSP sent summary plan documents to all 3
million eligible employees, which required 18 trailer trucks of printed
materials. Similar documents would have to be sent eventually to the
more than 200 million Social Security-covered employees and retirees.
The eventual costs of such massive efforts at this point are
unknown, but they clearly would have a significant impact on IA
expenses.
Small Employer Antipathy. Even if small businesses were able to
perform normal employer functions for IA's, would they want to? IA's
would be voluntary for employees but, if employees elect to have IA's,
mandatory for their employers.
The TSP and 401(k) plans generally are enthusiastically sponsored
and supported by the large employers who offer them as a major benefit
for their employees, and as a means to move away from defined benefit
retirement plans that require employers to bear substantial investment
risks. The major attractions of the TSP and 401(k)'s generally are the
matching employer contributions and the immediate tax benefit from
excluding employee contributions from taxable income. The ability to
borrow or withdraw funds to meet emergency needs is also a significant
benefit. IA's, as currently proposed, would offer none of these
benefits, and would be a relatively unattractive product that employers
might be reluctant to support, especially small employers who do not
have any pension plans. Moreover, it would be unrealistic to expect
small-business employers to act as large corporate employers do in
assuming the costs of investment losses because of, say, employer error
in transmitting funds for timely investment of 401(k) accounts, or for
myriad other commonplace employer errors. These serious concerns for
small businesses would have to be addressed during congressional
hearings on IA proposals.
The Trust Fund Alternative
Since IA's are certainly not feasible for employees of small
businesses--the vast preponderance of the business community--the only
practical way to give them the higher returns available from equity
investments is to invest part of the Social Security Trust Fund in
equities. That way, the overwhelming administrative costs and practical
problems of the Administration's plan would be avoided. The total
administrative cost of having the Social Security Trust Fund invest in
the private funds proposed for IA's would be no more than one basis
point, based on the actual costs of market investments by the Thrift
Savings Plan. The likely increase in Trust Fund earnings would be an
effective way to help maintain the solvency of the Trust Fund without
having to resort to significant increases in Social Security taxes or
reductions in benefits.
Every State in the United States has authorized public retirement
fund investment in stocks. Yet the Federal Government still clings to
the old notion that governments should not have an ownership stake in
private companies, which made some sense when individual stocks were
involved. Today's broad based index funds, however, remove the investor
from direct control over particular companies. Small business employees
should not be denied the benefits of portfolio diversification in the
Social Security Trust Fund simply because the Federal Government has
not kept up with the States in understanding the evolution of financial
markets.
Less Government Influence Over Private Companies. As shown in the
following chart, there is even less Government influence over private
companies under the Trust Fund alternative than under the TSP or the
Administration's plan.
Government Influence Over Private Companies
----------------------------------------------------------------------------------------------------------------
Social Security Trust
Thrift Savings Plan Administration Plan Fund Alternative
----------------------------------------------------------------------------------------------------------------
Selection of stock and bond index Government decides..... Same................... Same
funds.
Selection of fund managers........... Government decides..... Same................... Same
Selection of private record keeper... Government decides..... Same................... N/A
Selection of auditors and consultants Government decides..... Same................... N/A
Selection of annuity providers....... Government decides..... Same................... N/A
Selection of allocations among index Individuals decide..... Individuals decide..... Government decides
funds.
----------------------------------------------------------------------------------------------------------------
N/A--not applicable. (There would be no need for private recordkeepers, auditors, consultants, or annuity
providers for trust fund investments.)
Special Benefits for Trust Fund. Unfortunately, some political
leaders have convinced many of the public that the Social Security
Trust Fund is not really invested because it has been ``looted,'' and
that the Trust Fund consists of ``worthless IOU's.'' Nothing could be
farther from the truth, and such statements betray an apparent
ignorance of Federal finance in our highest circles of government. The
Trust Fund is fully invested in the best securities in the world--U.S.
Treasury obligations. Private trust funds invest in Treasury securities
in the open market, but the Social Security Trust Fund buys its
Treasury securities directly from the Treasury, which is more efficient
than if the Treasury were to issue the securities in the market and
then buy them back for the Trust Fund.
Moreover, the Trust Fund actually gets a much better deal than the
private funds that buy Treasuries in the market. The Trust Fund, by
law, may redeem its securities before maturity at par value, rather
than at the sometimes deep market discounts suffered by private
investors during periods of rising interest rates. Also, since the
Trust Fund gets its securities directly from the Treasury, it avoids
the market transaction costs which private investors must pay. Finally,
the law requires the Treasury to pay the Trust Fund an interest rate on
all of its investments in Treasuries equal to the average yield on
long-term Treasury marketable securities. This is a significant benefit
to the Trust Fund, since long-term rates are generally much higher than
short-term rates. Thus in recent years, private investors have been
earning about 2 percent on their short-term Treasuries, while the
Social Security Trust Fund was earning about 4 percent on effectively
the same maturities. The public seems to be totally unaware of these
subsidies to the Social Security Trust Fund, which have been there for
many decades.
Trust Fund Dedicated to Social Security. The assets of the Social
Security Trust Fund consist of investments in Treasury securities
solely for future beneficiaries. Yet political leaders from both
parties complain that the Treasury has ``spent'' the Trust Fund surplus
on Government programs. What on earth do they expect the Treasury to do
with the money--bury it in the Treasury's back yard? The Treasury also
spends the money it raises by issuing Treasury securities in the
market. Does that mean that the private investors in Treasuries are
also being ``looted'' by the Treasury? Of course not. The scandal would
be if the Treasury left the Trust Fund uninvested and not earning
interest. Then the Secretary of the Treasury would be in effect saying
``I don't owe you,'' and that indeed would be a worthless IOU.
So why do Government officials find fault with perfectly sound
financial practices? From ignorance, as I suggested earlier?--or is it
is because they are trying to hide the real problem, which is the
unique way the Social Security program is treated in the budget? Social
Security expenditures are excluded from the budget and thus from the
restraints on other Government spending, which is proper since they are
entitlements, and cannot be restrained under existing law. But the
Social Security surplus is then, inconsistently, included in the
calculation of the overall budget deficit, for the sole purpose of
appearing to have achieved deficit, and thus spending, reduction. Then,
having committed this accounting farce, officials have the audacity to
complain that the misleading budget treatment of the Trust Fund
surplus--which they could change--makes it available to finance other
programs. The problem here is not the financing of the Trust Fund, but
the political gimmickry of its budget treatment.
Conclusion
In conclusion, the Administration's plan for universal IA's is not
feasible, and it should not survive the process of responsible
Congressional hearings. The only practical way for the Social Security
system to capture the higher returns available from investments in
stocks is to diversify Social Security Trust Fund investments. The
Trust Fund alternative, compared to IA's, would involve less Government
influence over private companies, would be less disruptive of financial
markets, would save tens of billions of dollars a year in
administrative costs, and could be effective virtually immediately,
rather than the 2009 starting date proposed for IA's. The multitrillion
dollar transition costs proposed by IA proponents would be avoided. The
additional Trust Fund earnings would go a long way toward strengthening
Social Security finances, and would thus reduce, if not eliminate, the
need for significant tax increases or benefit reductions.
Thank you for your attention. I would be pleased to answer any
questions.
----------
PREPARED STATEMENT OF MICHAEL TANNER
Director, Cato Project on Social Security Choice
June 14, 2005
Mr. Chairman, distinguished Members of the Committee, I would like
to thank the Committee for holding this hearing and for giving me the
opportunity to appear. In particular, I appreciate that the Committee
is moving beyond the standoff over whether Social Security reform
should or should not include personal accounts to consider how such
accounts might be structured in ways that can maximize consumer choice
and control, while ensuring efficiency, low costs, and preserving an
appropriate measure of worker protection.
Of course, along with my colleagues at the Cato Institute, I
believe that Social Security reform must allow younger workers to save
and invest some of their Social Security taxes through personal
accounts. I believe that such accounts can significantly contribute to
restoring Social Security to permanent sustainable solvency. More
importantly, I believe that personal accounts are essential to
modernizing Social Security in keeping with such fundamental American
values as ownership, inheritability, and choice.
In particular, regarding the subject of this hearing, economic
theory holds that private capital investment should provide a higher
rate of return than a mature PAYGO Social Security system. If one
accepts the Social Security Administration's assumptions about future
bond and stock returns, a balanced portfolio (50 percent stocks, 30
percent corporate bonds, and 20 percent Government bonds) could be
expected to yield a return of 4.9 percent. Subtracting 25 basis points
of administrative costs provides a net yield of 4.65 percent. Shifting
the mix slightly in favor of equities should raise the expected return
to roughly 5 percent. This clearly exceeds the return available from
Social Security, and also significantly exceeds the offset interest
rate suggested under the President's reform proposal.
This is not to say that personal accounts can perform miracles.
They cannot, by themselves, solve Social Security's entire $12.8
trillion funding shortfall. However, workers who choose the personal
account option--and I note that personal accounts are voluntary under
all the major reform proposals--can expect to receive more in
retirement benefits than Social Security can actually pay them.
That said, how personal accounts are structured and the investment
options available to workers can make a significant difference in the
success of any personal account proposal. In short, details matter.
Any retirement system has four important administrative functions:
Collection, transmission, recordkeeping, and money management. First,
there must be a system to collect the retirement funds from the worker.
Next, the funds must be transmitted to an administrator. The
administrator is responsible for keeping records of each worker's
contribution to the retirement program and the benefits that each
worker will eventually receive. Finally, the money has to be invested
and managed between the time it is received and the time it is
disbursed.
In designing an investment and administrative structure of personal
accounts, you should be guided by these basic concerns:
<bullet> Simplicity and Transparency. Workers should clearly understand
where there money is going and what their options are. Where
personal account plans have encountered difficulties, such as in
Britain, it has been primarily do to overly opaque or complex
schemes.
<bullet> Balancing Return and Risk. While market returns can be
expected to exceed Social Security returns, markets are not risk
free. In particular, they offer increased volatility. In addition,
many of the new investors brought into the market through personal
accounts will be inexperienced. A personal account investment plan
must offer these individuals some degree of protection without
stifling consumer choice, over regulating markets, or unduly
restricting the potential for positive returns.
<bullet> Keep Administrative Costs Low. While regulation of account
fees would be unwise, accounts should be designed in ways that
minimize administrative costs. SSA estimates that accounts would
cost 25-30 basis points to administer. This seems like an entirely
reasonable target.
<bullet> Limit Government Involvement in Investment Decisions.
Decisions about the investment of the accumulating retirement funds
should be left to private markets and insulated from Government
interference as much as possible.
<bullet> Avoid Increased Employer Burden. Every effort should be made
to avoid any new burden on employers, particularly small employers.
Possible sources of additional employer burdens would include
higher tax payments, greater complexity in tax calculations, more
extensive recordkeeping requirements, or a requirement to report
information more frequently.
Cato's Project on Social Security Choice has devoted considerable
time and study to these issues. As a result of our work, we believe
that the following structure provides the framework for meeting these
concerns. I do not, by any means, assert that it is the only acceptable
administrative structure. But I believe that any workable
administrative structure that deals with these issues will contain many
or most of the following elements.
First, at least initially, the collection, recordkeeping, and
transmission functions should be handled centrally. The U.S. Treasury
Department through its existing tax collection capabilities is well-
suited for this role. Therefore, I would propose that the collection of
payroll taxes, including individual account contributions, would
continue to be handled by the employer in much the same way as today
and sent to the Treasury as they are today. The only difference would
be that the employer would tell Treasury how much of the total payment
is from employees who have chosen the personal retirement account
option.
One little known facet of the current Social Security system is
that although payroll taxes are collected and paid by employers
throughout the year, the Federal Government will not actually know how
much money was paid on behalf of any
particular worker in 2005 until about September 2006! This makes little
difference under the current Social Security system, but can matter a
great deal with an investment-based system. There will have to be some
mechanism to hold the funds until the contribution is reconciled to the
individual's name using the worker's W-2 form. Moreover, this holding
pool should not be dependent on market timing. The best solution would
be for Treasury, which is already operating as a centralized collection
to transfer all funds designated for account investment to a private-
sector custodian bank, which then invests the total amount in a money
market fund that is always priced at one dollar, a standard industry
convention. The following year, when the contribution is reconciled to
the individual worker the fund's shares are distributed to each worker
representing his contributions and interest credit, and electronically
transferred to the worker's personal account as specified.
Second, because a system of personal accounts would extend
investment opportunities to millions of Americans who do not now
participate in private investment, and are therefore likely to lack
education and experience in choosing investments, a consensus has
developed among account proponents that initial investment options
should be limited both in number and in the amount of risk a worker may
assume. Therefore, most personal account plans call for investment
options to be initially limited to a small number of broadly
diversified funds. This can be done in a number of ways, such as:
<bullet> A small number of index funds each composed of a different
type of investments. For example, the Federal Thrift Savings Plan,
which President Bush has cited as an example, offers a fixed income
fund, a common stock fund, a ``small cap'' stock fund, a Government
bond fund, and an international stock fund. The Chairman's
proposal, S. 540, is also built around this model.
<bullet> A small number of balanced funds, each composed of a different
mix of stocks, Government bonds, corporate bonds, and cash. This
option is included in HR 530 among others.
<bullet> A lifecycle fund that automatically adjusts the mixture of
investments as a person ages. Younger workers would be more heavily
invested in stocks, with the mix changing more heavily to fixed
income assets as the worker nears retirement. The president has
raised the possibility of this option, as has the Chairman. And I
believe it is included in S. 857, sponsored by Senator Sununu.
To make things even simpler for the unsophisticated or apathetic
worker, there should be a default option that would require the worker
to make no decisions whatsoever.
Management of funds should be handled by the private sector on a
contract/bid basis, similar to the way the TSP is currently handled.
Given the amount of investments involved, it may be worth considering
breaking up the management into several pieces each of which would be
put up for bid.
Finally. while it makes sense to limit investment options
initially, at some point a wider range of choices should be made
available. In part, this is a simple matter of increasing consumer
choice. One of the most important reason for having personal accounts
at all is to give workers more choice and control over how they save
for their retirement. Clearly, this should be extended as much as
possible to the array of available investments.
There is also a larger economic reason for eventually expanding the
range of investments. The flow of investments to different sectors of
the economy provides important signals to the economy as a whole.
Creating a large flow of investments that are essentially
``homogenized'' would deprive the market of these vital signals.
Therefore, once a worker has accumulated a ``trigger'' level of
funds, the worker should be free to participate in a much larger range
of investment options, closely approximating the options currently
available under traditional 401(k) plans. Management of funds at this
level would again be through the private sector, with entry open to any
company offering qualified funds. ERISSA offers a reasonable framework
for determining participation and regulation.
This three tier structure--a central collection point and holding
pool, a limited set of initial investment options, and a eventual
expansion to a wider array of investments--can provide workers with the
greatest amount of security while maximizing consumer choice and
control. It would keep administrative costs and the burden on employers
as low as possible. And it would minimize Government interference with
investment decisions.
Works should be able to switch investments, between and within
investment tiers on an annual basis. While an ``open season,'' similar
to that of the FEHBP health plan, is perhaps the most simple approach,
that could lead to an excess of market ``churning'' over a limited
period. An alternative approach would be to allow a worker to switch
investments within a designated period centered on his or her birthday.
There is one other additional point to keep in mind, at all three
tiers, the accounts would be the property of the worker. This ownership
is one of the perhaps the most important reasons for reforming Social
Security, and it is vital that it be maintained as part of any
administrative structure.
Let me conclude by saying that I believe that Social security
reform is not an option, but a necessity. The program will begin
running a deficit in just 12 years and faces unfunded obligations of
roughly $12.8 trillion. The need for reform presents us with an
opportunity to create a new and better retirement program for all
Americans, a program that gives workers ownership of their retirement
funds, more choice and control over their money, and the opportunity to
build a nest egg of real inheritable wealth. Therefore, any successful
Social Security reform should include personal accounts.
This makes the work of this Committee all the more important:
Getting the design and structure of the accounts right. I believe that
the structure I have set out today takes us in that direction. I look
forward to the Committee's questions.
Thank you.
----------
PREPARED STATEMENT OF DAVID C. JOHN
Research Fellow, Thomas A. Roe Institute for Economic Policy Studies
The Heritage Foundation
June 14, 2005
I appreciate the opportunity to appear before you today to discuss
appropriate investments for Social Security Personal Retirement
Accounts. This is an extremely important subject, and I would like to
thank both Chairman Hagel and Senator Dodd for scheduling this hearing.
Let me begin by noting that while I am a Research Fellow at the
Heritage Foundation, the views that I express in this testimony are my
own, and should not be construed as representing any official position
of the Heritage Foundation. In addition, the Heritage Foundation does
not endorse or oppose any legislation.
PRA's should be managed through a simple, low-cost administrative
structure that uses the current payroll tax system and professional
investment managers.
A simple and effective administrative structure is essential to the
success of a PRA system. Probably the simplest and cheapest structure
would be to use the existing payroll tax system. Under today's Social
Security, the employer collects and sends to the Treasury Department
both the payroll taxes that are withheld from an employee's check and
those that are the responsibility of the employer. The payroll tax
money from all of the firm's employees is combined with income taxes
withheld from their paychecks and sent to the Treasury. The money
collected is allocated annually to individual workers' earnings records
after worker income tax records have been received.
Adapting this existing administrative structure to a PRA system
would be easier to implement than other options. Under a PRA system,
the employer would continue to forward to the Treasury Department one
regular check containing payroll and income taxes for all of the firm's
employees. The Treasury would continue to use its existing formula to
estimate the amount of receipts that should be credited to Social
Security and to reconcile this amount annually with actual tax
receipts.
Once the Treasury determines the amount to be credited to Social
Security, it would estimate the portion that would go to PRA's and
forward that amount to a holding fund managed by professionals who
would invest the amount in money market instruments until it is
credited to individual taxpayers' accounts. The money would go to
individual workers' accounts upon receipt of their tax information. It
would then be invested in the default fund, except for workers who have
selected (on their income tax forms) one of the other investment
options, in which cases it would be invested accordingly.
Using Professional Fund Managers. Rather that having the Government
trying to invest PRA money, the agency overseeing the accounts (which
could be the Department of the Treasury, the Social Security
Administration, or an independent board) should contract out fund
management to professional fund managers. This investment management
system is currently used by the Federal Employees Thrift Investment
Board, which administers the Thrift Savings Plan, a part of the
retirement system for Federal employees.
Under this system, management of the specific investment pools
would be contracted out to professional fund managers, who would bid
for the right to manage an asset pool of a certain size for a specified
period of time. The manager could invest the money only as directed by
the agency. The agency would also contract out to investor services
such tasks as issuing regular statements of individual accounts,
answering account questions, and handling transfers from one investment
option to another.
Advantages of this Administrative Structure. Building on existing
structures and contracting out investment management and services
should keep costs to the lowest level possible. In addition, employers
would not have to change their current payroll practices. Using one
central government entity to receive PRA funds also means that
employers would not bear the cost of writing individual checks or
arranging for individual fund transfers for each employee. In addition,
this method allows the PRA contributions of workers who have multiple
jobs to be based on their total income without placing any additional
burden on either the worker or the employers.
From a worker's standpoint, this should be the lowest-cost
structure available. In addition, because workers' PRA contributions
would be distributed to their chosen investment plans only after their
tax information has been received, workers with several jobs during a
year should see contributions based on their total annual incomes.
Developing a simple personal retirement account system with very
low administrative costs would be relatively simple.
State Street Trust, one of the largest managers of retirement
savings, has estimated that administering a personal retirement account
would cost from $3.55 to $6.91 per person annually, based on
proprietary data that the bank accumulated from its experience in
managing a host of pension plans. In terms of the percentage of assets
under management, the annual fee would be only 0.19 percent to 0.35
percent. This fee assumes an annual contribution per worker equal to 2
percent of his or her gross earnings. The cost would drop significantly
if that contribution increased to an amount equal to 4 percent of
earnings or higher. State Street Trust's findings were reviewed and
accepted by the Government Accountability Office as accurate.
This low level of administrative fees would certainly not reduce
the benefits of a PRA. In addition, history shows that administrative
costs are highest when a system is first implemented and start-up costs
must be covered. As time passes, administrative costs decline
significantly. This has been true for 401(k) accounts, the Thrift
Savings Plan (TSP) for Federal employees, and even Social Security. For
example, the administrative costs of 401(k) plans have decreased over
time, despite the plans offering an increasing number of investment
options and a higher level of personal service. Although the costs of
specific plans vary according to each plan's complexity, size, and the
types of investments, many large companies have been able to keep their
administrative costs as low as 0.3 percent by offering only a limited
number of broad-based funds.
The Federal Thrift Savings Plan, a privately managed retirement
plan open only to Federal employees, has experienced a dramatic 76
percent reduction in administrative costs since the system started in
1988. Today, participants pay annual administrative fees that are below
0.1 percent of assets under management. TSP's extremely low
administrative costs are significant, given that many experts expect
that a PRA system would closely resemble the structure and investment
choices found under TSP.
The Social Security system experienced similar reductions in
administrative costs during its formative years. In 1940, when the
system first began to pay benefits, its administrative costs equaled 74
percent of all Old-Age and Survivors Insurance benefits paid. In 1945,
this figure had declined to 9.8 percent. Today, administrative costs
make up only 0.5 percent of payments from the OASI Trust Fund. Even
though this is not a perfect comparison with the other two examples,
given that Social Security's structure has changed over the years, it
does suggest that fees could be very low.
PRA's should be invested in more than just stocks, but stocks are
an essential part of the investment strategy.
Studies that purport to show either PRA's or the Social Security
Trust Fund would have lost money over the past few years if they had
been invested in stock assume that 100 percent of the Trust Fund would
have been invested in stocks, rather than a diversified portfolio that
would have balanced stock losses with gains on bonds or other
investments. They also focus on only the short-term market trends,
ignoring the gains that would result from longer-term investments.
Morningstar, Inc., an independent market data and analysis firm,
estimates that the value of mutual funds invested in diversified U.S.
stocks declined 12.1 percent during the second quarter of 2002.
However, not all types of investments went down. Mutual funds
containing lower-risk instruments such as taxable bonds (which are
routinely held by those nearing retirement) rose an average of 1.4
percent over that same period, while funds invested in tax-exempt bonds
rose 3.2 percent. Thus, in one of the worst quarters for stock
investment, PRA's invested in a diversified portfolio would remain
strong.
Over the long-run, all of these investments did even better. Over a
5-year period including the second quarter of 2002, mutual funds
invested in stocks earned an average of 3.9 percent per year, while
mutual funds invested in taxable bonds and tax-exempt bonds earned an
average of 5.0 percent a year.
PRA's should not be invested solely in stocks. They should instead
be invested in a diversified portfolio of stock index funds and
different types of bond index funds. The default investment for PRA's
should be a lifestyle fund that automatically reduces the proportion of
stocks as the worker gets older, thus locking in past gains and sharply
reducing the chance of major losses in the years approaching
retirement.
A carefully controlled set of investment options should be
developed that includes an appropriate default option.
The investment options available to PRA owners should be simple and
easily understood. While an increasing number of Americans are
investing their money for a wide variety of purposes, a voluntary PRA
system would bring in millions of new investors who may not have any
previous investment experience. In addition, experience from both the
401(k) retirement plans and Federal employees' Thrift Savings Plan
shows that costs are far lower if the plan starts with only a few
investment options and then adds more once the plan is fully
established.
Carefully Controlled Investment Options. All investment options
available under a PRA plan should be limited to a diversified portfolio
composed of stock index funds, government bonds, and similar assets.
Even if they so desire, workers would not be allowed to invest in
speculative areas such as technology stocks or to choose specific
stocks or bonds. Money in a PRA is intended to help to finance a
worker's retirement security, not to be risked on speculative
investments with the hope that taxpayers will support the worker if the
investment fails.
Initially, workers would be allowed to put their PRA contributions
into any one of three balanced and diversified mixes of stock index
funds, government bonds, and similar pension-grade investments.
Although the exact mix of assets would be determined by the central
administrative agency, one fund might consist of 60 percent stock index
funds and 40 percent government bonds, while another might be 60
percent government bonds and 40 percent stock index funds.
The third fund, which would also act as the default fund for
workers who failed to make a choice, would be a lifestyle fund. These
are funds in which the asset mix changes with the age of the worker.
Younger workers would be invested fairly heavily in stock index funds,
but as they age, their funds would automatically shift gradually toward
a portfolio that includes a substantial proportion of bonds and other
fixed-interest investments. This is designed to allow the portfolios of
workers who are far from retirement to grow with the economy and to
allow older workers to lock in that growth by making their portfolios
predominantly lower-risk investments.
Workers would be allowed to change from one investment fund to
another either annually (by indicating their choice on the income tax
form) or at other specified times (by completing a form on the
Internet). They would also receive quarterly statements showing the
balance in their accounts. As with today's Social Security, PRA
accounts are intended strictly for retirement purposes, and no early
withdrawals would be allowed for any reason.
Structuring Accounts to Keep Fees Low. Under a successful PRA plan,
all investments must be approved by the central administrative agency
as being appropriate for this level of retirement investment. That
agency would also ensure administrative costs are kept as low as
possible by awarding contracts to manage investment pools through
competitive bidding and through direct negotiation with professional
funds managers.
Research by State Street Global Investors shows that administrative
costs are lower if workers put all their money in one diversified pool
of assets rather than attempting to diversify their portfolio by
dividing it among several types of assets. For example, a worker who
puts all of his or her money in one fund consisting of 50 percent stock
index funds and 50 percent Government bonds would earn the same as a
worker who places half of his or her money in a government bond fund
and half in a separate stock index fund. However, the first worker
would incur significantly lower administrative costs.
Additional Choices for Larger Accounts. Once a worker's PRA account
reaches a certain size threshold (determined by the central
administrative agency), he or she would have the option to move its
management to another investment manager if that manager offered better
service or potentially higher returns. However, only investment
managers who had meet strict asset and management quality tests would
be allowed to receive these accounts, and the managers would be sharply
limited in the types of investments they could offer. In the event that
the worker is dissatisfied with either the fees or the returns from
these individually managed accounts, he or she could switch back to the
centrally managed funds at any time.
PRA's should be invested in lifespan accounts unless the account
owner chooses another investment.
A key feature of President George Bush's recently announced Social
Security plan is that workers' personal retirement accounts (PRA's)
would be invested automatically in a lifespan fund unless a worker
expressly asked for another arrangement. Lifespan funds adjust (or
``rebalance") a worker's investments as he or she ages. For younger
workers who are far from retirement, a lifespan fund would invest most
of their money in stock index funds--safe funds reflecting the broad
stock market. As these workers grow older, their lifespan funds would
gradually and automatically shift more money into even safer bonds and
other less volatile investments. In short, lifespan funds allow younger
workers to take advantage of the higher returns that stock investments
offer while making sure that the portfolio gets safer and safer as the
worker gets closer to retirement.
Lifespan funds are designed to allow the portfolios of workers who
are far from retirement to grow with the economy and to allow older
workers to lock in that growth by moving their portfolios into
predominantly lower-volatility investments. This means that if the
stock market suddenly declined, workers who invested in a lifespan fund
and were near retirement would have only a tiny part of their PRA's
invested in stocks and thus would not see a significant last-minute
change in the value of their PRA's.
As an example of how these funds would protect workers who are
close to retirement, Morningstar, Inc., an independent market data and
analysis firm, estimated that the value of mutual funds invested in
diversified U.S. stocks declined 12.1 percent during the second quarter
of 2002--one of the worst quarters in recent history. However, not all
types of investments went down. Indeed, mutual funds containing lower-
risk instruments such as taxable bonds (a common investment for those
nearing retirement) actually rose an average of 1.4 percent over that
same period, and funds invested in tax-exempt bonds rose an average of
3.2 percent.
Because a lifespan account would have automatically moved a
worker's PRA almost entirely into bonds when that worker reached
retirement age, a worker with a PRA who retired in the first quarter of
2002 thus would have seen his PRA grow during that last quarter before
retirement. He or she would not have faced losses, even though the
stock market as a whole experienced major declines during that period.
Lifespan funds have been gaining popularity in employer-sponsored
retirement plans, such as 401(k)'s, because they automatically make the
kind of portfolio adjustments that investment professionals recommend
for all workers nearing retirement. At the end of 2004, about 55
companies offered lifespan accounts as part of their 401(k) plans.
Currently, the biggest players in the field are Fidelity Investments,
with a 33 percent market share, and The Vanguard Group, with about 17
percent. Administrative fees depend in a large part on whether the
funds are actively or passively managed. Fidelity, which consists
totally of actively managed funds has an administrative fee of 0.81
percent of assets under management, while Vanguard, which consists
totally of index funds has fees of 0.23 percent of assets under
management. Passively managed index funds are much more suitable for
Social Security accounts than are funds that pick and choose individual
stocks.
For many years, investment advisers have advised workers to
structure their retirement accounts so that more funds are shifted into
fixed-income investments as they age. Advisors recognize that
decreasing the proportion of investment in stocks reduces the potential
for short-term loss. Although younger investors are better off
investing most of their assets in stocks to get higher returns, those
who are closer to retirement need to reduce the likelihood that a
sudden market shift will affect them. Lifespan funds make this
rebalancing process continuous and automatic and would let workers with
PRA's approach retirement with confidence.
Conclusion
Again, thank you for the opportunity to testify before you today.
The success of Social Security personal retirement accounts as a way
for individuals to build sufficient savings to fund a portion of their
retirement benefits will in large part depend on the investment choices
that are available. A simple, low-cost administrative platform would
improve the ability of these accounts to assist individuals in meeting
their retirement goals. Such a system is both feasible and realistic.
Thank you.
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