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March 2005 -- President Bush's recent emphasis on reforming Social Security to include personal retirement accounts has been welcomed by free market advocates as a needed step toward giving people more control over their own lives.
So far, much of the debate has focused on issues affecting individuals as participants in Social Security, such as what portion of their payroll taxes people should be allowed to invest in personal retirement accounts, how much the government should restrict investment choices in those accounts, and the extent to which Social Security should provide a minimum benefit relating to personal retirement accounts. Most current reform proposals provide that investment choices would not include individual stocks and bonds selected by the holders of personal accounts, but would be limited to diversified funds that invest in a broad range of stocks, bonds, or both. For example, under the Cato Institute proposal, employees would initially have three investment choices. An employee's contributions would be deposited in one of three balanced funds, each highly diversified and invested in thousands of securities. The default portfolio, where one's money would be invested if no choice were made, would have 60 percent stocks and 40 percent bonds. The two other funds would have the same asset classes but with different weights. (See Michael Tanner, " The 6.2 Percent Solution: A Plan for Reforming Social Security. ")
There is another aspect of Social Security privatization that has received little attention in the current debate: Could personal retirement accounts become a vehicle for imposing more government control over business? In 1998, President Clinton, recognizing that the stock market would provide significantly higher long-term returns than the U.S. Treasury bonds in which Social Security contributions were invested, proposed that the Social Security Administration invest directly in the stock market. Free market advocates immediately saw the danger in Clinton's proposal. The Cato Institute's Michael Tanner wrote: "[T]hat approach…is fraught with peril. It could potentially make the federal government the largest shareholder in American corporations, raising the possibility of government control of American business" (" The Perils of Government Investing ," Cato Institute Briefing Paper no. 43, December 1, 1998). Federal Reserve chairman Alan Greenspan said direct government investment in private companies would be "'very dangerous,'" telling Congress: "'I know there are those who believe [government investments] can be insulated from the political process.… I have been around long enough to realize that that is just not credible and not possible. Somewhere along the line, that breach will be broken'" (Andrew Biggs, "No More Secret Lip-Service: The Dems are Mute on Social Security for Good Reason," National Review Online, April 10, 2002).
These concerns are not just hypothetical. There is a long history of activism by state and local pension funds in attempting to control the decisions of the corporations in which they invest. To cite just a couple examples: NYCERS, the New York City Employees' Retirement System, with assets of only $42 billion, has used its clout as a shareholder to compel twenty Fortune 500 companies to prohibit discrimination against employees on the basis of sexual orientation, and CALPERS, the California Public Employees' Retirement System, with assets of only $183 billion, conveniently attempted to sack Safeway's chief executive officer at the same time the union led by CALPERS's head, Sean Harrigan, was waging a strike against Safeway (see Nicole Gelinas, " Corporate America's New Stealth Raiders ," City Journal, , Winter 2005). These activist funds are minuscule compared with Social Security, which holds $1.7 trillion of U.S. government debt. The portion of the total Social Security trust fund invested in personal accounts would grow over time to dwarf the amounts held by CALPERS and NYCERS.
Most advocates of personal retirement accounts appear to take the view that "personal retirement accounts would avoid politicized investing," as Andrew Biggs wrote in early 2002 (Andrew Biggs, " U.S. Social Security Proposal Based on Faith ," Financial Times, April 25, 2002). That may have been true of personal account proposals a few years ago, but is it still true? These early proposals envisioned that people would be given some discretion over their investments.
In response to concerns that people might make risky investments, proposals for personal retirement accounts have evolved toward restricting investment choices to a limited menu of diversified funds (see the Cato Institute proposal mentioned above). This evolution from individual investment choice to a limited menu of pre-selected investment funds is the key factor that might morph Social Security privatization into something akin to the Clinton proposal, because the Social Security Administration would inevitably run the selection process and manage the relationship between the personal accounts and the funds in which they are invested.
Little detail has been provided on how the proposed investment funds would operate, although the Thrift Savings Plan for federal government employees has been mentioned as a model (Karen Tumulty and John F. Dickerson, " The 4% Solution ," Time, February 14, 2005). The Thrift Savings Plan offers participating employees a choice of five funds, all of which are held in the name of the Thrift Savings Plan as a fiduciary for participating employees. These funds are invested as follows: (1) the G fund invests in U.S. government debt; (2) the F fund is designed to track a private-debt index; (3) the C fund is designed to track the Standard & Poor's (S&P) 500 index; (4) the S fund is designed to track the Wilshire 4500 index; and (5) the I fund is designed to track the EAFE international stock index. The Federal Retirement Thrift Investment Board is the asset manager for the G fund and has contracted with Barclays to manage the other four funds, which are invested in mutual funds operated by Barclays for a number of tax-deferred employee-benefit plans. The Thrift Savings Plan investment is a minority of each of these Barclays funds, ranging from 5 percent to 42 percent. The board does not direct Barclays on how to vote the shares of the companies held by these funds. Barclays is merely required to follow the standard requirement applicable to all retirement plan fiduciaries, that is, to vote in the interests of the plan participants and beneficiaries.
If the Thrift Savings Plan is the model for Social Security personal retirement accounts, and it operates without interfering in the governance of the corporations included in these investment funds, then where is the problem? The answer is one of scale. The total value of Thrift Savings Plan assets is only $150 billion, somewhat smaller than that of CALPERS. As noted above, the portion of the total Social Security trust fund invested in personal accounts would grow over time to dwarf this amount.
In structuring personal retirement accounts, Social Security would probably create a separate master fund for each of the limited number of investment choices offered (for example, an investment choice might consist of 60 percent S&P 500 stocks and 40 percent domestic corporate bonds). Each sub-fund (in this example, the S&P 500 portfolio and the corporate-bond portfolio) would be managed by one or more mutual fund companies under contract with the Social Security Administration.
The probable consequences of the limited number of investment choices and the likely size of Social Security's combined personal retirement accounts would be as follows: (1) each sub-fund would eventually be far larger than any fund in the Thrift Savings Plan and larger than most mutual funds; (2) each sub-fund's portion of each contracting mutual fund would be far larger than the Thrift Savings Plan's portions of the Barclays funds (and could well be 100 percent—that is, if a mutual fund company were to create a mutual fund dedicated solely to Social Security); and (3) each individual's personal retirement account would be a tiny fractional interest in these massive funds held by the Social Security Administration as a fiduciary for personal account holders.
The critical point is that, under any scenario, the Social Security Administration would have a dominant role versus the mutual fund companies with which it would contract, and the individuals with personal retirement accounts would have no control over these relationships.
How mutual funds vote the shares of corporations held in their various funds is a matter that has not escaped the government's notice. In early 2003, the Securities and Exchange Commission (SEC) adopted a rule requiring every mutual fund to make available to its own investors detailed information about its votes as a shareholder in every corporation in which it holds stock (rule 30b1-4 under the Investment Company Act of 1940; see www.sec.gov ). The SEC is a regulatory body supposedly concerned with protecting investors in mutual funds by requiring these disclosures to such investors.
By contrast, the Social Security Administration would probably have a more direct interest in the substance of the votes by mutual funds, in the same manner as CALPERS and NYCERS, since it would view itself as a fiduciary for people with personal retirement accounts and might view itself as acting on behalf of everyone in Social Security—that is, "the public" in general. For example, it might require the mutual fund companies it has hired to vote a certain way whenever a particular corporate governance issue arises, or whenever a particular shareholder proposal on an environmental or outsourcing issue is presented. Its ability to enforce these requirements would arise from its ability to replace a noncompliant mutual fund company.
A related concern is that the Social Security Administration may determine that certain corporations—even though they may fall within the initial criteria for investment (such as being included in the S&P 500)—do not meet sufficiently high ethical, corporate governance or environmental standards to merit inclusion in the investment portfolio. Once such a determination is made, the Social Security Administration could direct the applicable mutual fund company to exclude the offending corporation from its fund's portfolio, or face replacement by another mutual fund company.
A combination of these two factors—the power to direct voting by mutual funds and the power to exclude certain corporations from the largest investment pool in the country—would give the Social Security Administration significant power over corporate America, far more than that exercised by the likes of CALPERS and NYCERS.
There are signs that attention is now being focused on these concerns. In the March 3, 2005, issue of The Wall Street Journal, at the end of the lead article entitled "Bush Bid to Fix Social Security Stirs Alternatives," the following appeared: "Under questioning from Rep. John Spratt, a South Carolina Democrat, Mr. Greenspan expressed misgivings about the government's role in administering private accounts under the Bush plan. The Fed chief has long opposed investing the Social Security trust funds in the stock market for fear it would give the government too much influence over corporate governance. Mr. Bush's plan 'is getting very close to that,' Mr. Spratt said yesterday, because the government would pick investment managers, limit workers' choices and oversee the program. Mr. Greenspan agreed: 'It's the one part of what is as yet an unannounced program, which I have certain pause about.'"
American corporations already face a daunting array of legal constraints, some justified, many not. Adding yet another master, masquerading as an "owner," would only further hamper the vitality and creativity of American business.
The advocates of Social Security privatization face an urgent task: to think through the difficult details in order to find a way to keep Social Security privatization from turning into the principal instrument of destruction of the very economic freedom they seek to promote.
Some possible solutions include (1) allowing individuals to invest their personal retirement accounts in individual stocks and bonds that they select, with voting rights passed through to the account holders, and (2) allowing individuals to invest in any already existing stock or bond mutual fund that meets certain objective measures of diversification, also with voting rights passed through to the account holders, possibly with a requirement that no more than a certain percentage be invested in any given type of mutual fund.
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