Briefing Book

White House Conference

Peter Diamond Institute Professor MASSACHUSETTS INSTITUTE OF TECHNOLOGY DEPARTMENT OF ECONOMICS CAMBRIDGE, MASSACHUSETTS 02139-4307 The Trust Fund Should Invest in Stocks and Corporate Bonds Individuals are advised to hold a diversified portfolio when saving for retirement. Corporations are advised to hold a diversified portfolio as backing for their pension liabilities. Yet the Social Security Trust Fund is 100 percent invested in Treasury bonds. By taking on some risk, the Trust Funds can anticipate receiving a higher rate of return over the long haul, and Social Security is indeed here for the long haul. With its ability to spread risk across successive cohorts of workers and retirees, Social Security is better able to take on risky investment than individuals themselves, on average. So there is no economic basis for excluding stocks from the Trust Fund portfolio. Some people fear that the Trust Fund would invest so poorly that the return would be worse than just holding Treasury bonds. And some fear that the Trust Fund would use the voting rights of shares in a way that would be harmful for the economy. These fears can not be considered in a vague setting. Rather, we need to specify, in detail, how the investment decisions and the share voting decisions would be made. Only then can we form a judgment as to how well they would be done. The critical step is to create an institution with independence from the day-to-day political process and with restrictions on how it can act. We have experience with creating such institutions and our experience is excellent. The Fed handles monetary policy, an equally important and controversial activity, with great independence. And the retirement savings plan for federal employees, the Thrift Savings Plan (TSP), handles both investment decisions and share voting without political interference. The key ingredients are (1) a decision-making Board that has financial and appointment independence and (2) a restriction to using broad, widely-used index funds, with the private fund managers, not the Board exercising voting rights. The Board would have financial independence by getting its revenue from charges against the earnings on the funds it manages. The appointments would be for long, overlapping terms, subject to the scrutiny of Congress at the time of nomination, but protected from removal because of policy disputes. The Fed has just these protections, and they work. For restrictions, the Board can only invest in broad, widely-used index funds, run by private fund managers, and selected by competitive bidding; multiple funds would be used to spread the voting power. The shareholder voting rights would be exercised by the private managers who also handle the funds of private investors, necessarily treating them all the same. The fund managers and the investment board would have strict fiduciary duties. The law could empower the Board to inform Congress and the public about any legislation that might adversely affect the Trust Fund. So, we know how to create an institution that will work. In addition, the voting public will want to protect Social Security investment from any interference that might threaten future benefits. Politicians would not interfere with this important and independent function, because the public would not tolerate such interference. This structure can work. Even so, being conservative about a new institution is warranted. One way to be conservative is to limit the size of stock investments. The law could mandate that the Trust Fund not hold more than a certain percentage of any single corporation, 10 percent, for example. As we learn that the political fears are not borne out, we can raise the limit. If stock investment sounds a bit unrealistic, consider that it has worked well for the members of the TSP - they have held the S&P 500 and have had very low administrative costs -considerably lower than the typical 401 (k) plan. And there has been no political interference. So, we can use this model for Social Security with confidence. This approach to tapping into stocks has three large advantages over individual accounts - lower administrative costs, less risk for workers, and no need for a vast new regulatory mechanism to educate new investors and protect them from fraud and misleading selling tactics. (1) The administrative cost of managing Trust Fund investments would be negligible, while 150 million individual accounts would have substantial costs - the impact of even seemingly small fees can be large. For example, an annual maintenance charge of 1 percent, which is less than the 1.5 percent average currently for equity mutual funds, would eat up 20 percent of the system’s benefits. Over the course of a 40-year working career, the average dollar deposited is charged 1 percent 20 times. (2) By spreading the risk over successive age cohorts, workers nearing retirement do not bear a big risk from a sudden stock market decline. And (3) the majority of the public has little experience or understanding of the principles of investment. Beyond learning to avoid fraud and misrepresentation, it is not easy to appreciate the advantages of diversification, understand the details of a risk-return tradeoff, distinguish between real and nominal returns - all of these require education, and education is expensive. Merely sending a pamphlet to every worker will not accomplish much. Trust fund investment in stocks will make Social Security better for workers, while individual accounts are expensive, risky and introduce new problems for both workers and retirees. This statement represents my views and not those of the Massachusetts Institute of Technology.