The following column appeared in the May 26, 1997 Portland Business Journal newspaper.
Special to the Business Journal
Oregonians need to get ready for Social Security reform. Just as Oregon secured waivers to run its own experiments with welfare reform and health care, we may have the opportunity to try an alternative to Social Security.
The Oregon Legislature has passed Concurrent Resolution 2, which asks Congress "...to enact legislation amending the Social Security Act to allow the issuance of waivers to the states that will permit the design and implementation of alternatives to Social Security for those who choose to opt out ...." It is time for us to start thinking about how we might handle our new system and what its effects will be.
The questions that are first on peoples' minds seem to be how the transition would work and how financial markets would be affected. The financial issue is important not only to investors but to the general public because of possible impacts on federal debt costs.
Transition details are still to be worked out. Cascade Policy Institute, encouraged by Chile's reform architect José Piñera, first promoted the idea of a state option. It has now begun a study of how Oregon might create a private alternative system. A few guiding principles are critical, whatever the finer details turn out to be. First, all current Social Security recipients will be guaranteed benefits, with no cuts. Also, anyone currently working should be guaranteed the benefits that the current system provides. Chile's new private system was voluntary except for beginning workers. With this protection, Social Security is no longer the "third rail" of American politics.
Workers who opt out of the government-run system will have to pay a portion of their Social Security tax to fund benefits for those who stay in the system. That's the problem when the trust fund is woefully inadequate to pay accrued benefits. But enough of the payroll tax will be left over to allow each person to set up a personal account with an investment manager. We can expect guidelines that would limit investment risk and reduce the potential for fraud and error. Large investment firms, such as Columbia, Fidelity and Vanguard, would probably predominate. (Small investment management firms such as the author's are unlikely to play a role in this mass market business.)
To make up the unfunded liability within the Social Security system, it may not be enough to tax those who opt out. Sale of government assets helped Chile with its transition. Our government's assets, ranging from the radio spectrum to urban military bases to western lands to the Postal Service, could be auctioned off. Although selling assets should not be taken lightly, it's an appropriate measure if necessary to get Social Security onto a sound footing.
How would financial markets react? Oregon alone opting out would hardly cause a ripple in global financial markets. But if the country follows our lead and heads to a private system, here's a rough idea of what we might see.
First, don't worry about the Social Security Trust Fund suddenly dumping its Treasury bonds on the market. That fund, needed to help pay benefits to those who stay in the system, won't be changed.
Over time, the flow of assets into personal retirement accounts would be different than the flow into the Social Security trust fund (currently all invested in Treasury bonds), and this change might affect markets. Exactly how private firms would manage the personal accounts has not been determined. It's likely that large mutual funds would dominate, and that their investment guidelines would mandate diversified portfolios, including bonds. Following common practice, roughly half of the funds would be invested in stocks, and half in bonds. The stocks would include some foreign securities, for perhaps 25 percent of the total stock portfolio. The bond portfolios would include corporate, mortgage-backed and foreign issues, as well as good old U.S. Treasury bonds. As a rough estimate, perhaps half of the bonds would be treasuries.
Changes in how retirement contributions are invested could affect markets over time, depending on the sizes of the flows relative to the sizes of the various markets. Last year the increase in the Social Security Trust Fund for old-age benefits was $56 billion. Let's assume that all of this is diverted to privately managed funds, in the proportions described above. With our rough estimates of asset allocation, that puts $14 billion into non-Treasury bonds, $21 billion into domestic stocks, and $7 billion into foreign stocks, while the remaining $14 billion continues to go into Treasury bonds.
Compare these flows with the size of the underlying markets. Bonds held other than U.S. treasuries are a $4.4 trillion market in this country. The extra funds diverted from Social Security into non-Treasury bonds constitute only three-tenths of 1 percent of the underlying market, hardly enough to be separated out from normal market fluctuations.
What about domestic stocks? The extra $21 billion a year should be compared to the size of the stock market, which was nearly $7.9 trillion at year end. So the added stock investments are just three tenths of one percent of the underlying market. The flow into foreign stocks would be an even smaller percentage.
Funding the federal debt The most significant concern from privatization is funding the federal debt. Roughly $42 billion a year that would have bought Treasury bonds go into other investments. The size of the Treasury debt outstanding is roughly $3.7 trillion (not counting the amount held by various federal trust funds). In one year the diversion to other investments amounts to 1.2 per cent of the underlying market for treasuries. That is inconsequential at first, though the impact may cumulate.
To gauge the magnitude of this $42 billion shift, consider the rising deficit of the early Reagan years. The annual deficit increased by $49 billion in 1982, and by $80 billion the next year. And yet interest rates for Treasury bills and bonds were falling. The rising deficit certainly did not cause the decline in interest rates, but the experience emphasizes that the Treasury market is quite large and able to absorb new supply.
The effect on rates is so small because of the globalization of financial markets. If one country's interest rates creep up a hair, investors around the world shift assets to the higher yield. Investors don't like inflation or prospects for a declining currency, but when these matters are stable, even a slightly higher interest rate can pull in staggering amounts of money.
Oregon's own privatization would have an infinitesimal impact on global markets, because our state constitutes only one percent of the national economy, and an even smaller percentage of the world. So there is no reason from the financial side to hesitate. There certainly are major transition issues to be considered, such as how we treat people who move in and out of Oregon, how we would handle benefits after a serious bear market, or how we protect workers from mismanagement of their pension funds.
The advantages of a private system are significant. It would be on a sound financial footing. The workers would have confidence in the system, confidence they do not have in Social Security. Retirement benefits would be more generous after private management. Benefits would no longer be politically determined.The list of benefits is certainly long enough to justify Oregon's efforts to plan a private alternative to an irresponsible system.