Investing Social Security Reserves in Private Securities
Why do the Administration and others believe it would be helpful to diversify the portfolio of assets held by the Social Security trust fund?
October 2015 | by David Delaney
It is an unpleasant yet inescapable reality that there are three, and only three, ways to close Social Security's long run fiscal deficit. Taxes can be raised, benefits can be reduced, or the return on the trust fund's reserves can be increased. Recently, some have suggested that a fourth way exists, one that avoids unpleasant choices. This route would be to devote a portion of the projected budget surpluses to Social Security. However, transferring resources from the government's general accounts to Social Security would only shift the locus of the inevitable adjustments. Rather than boosting payroll taxes or cutting Social Security benefits sometime in the future, income taxes would have to be higher or non-Social Security spending lower than otherwise would be the case.
Because neither the public nor lawmakers have greeted the prospect of higher taxes or reduced spending with any enthusiasm, the option of boosting the returns on Social Security's reserves is worth close examination. While higher returns can not solve the program's long run financing problem alone, they can make the remaining problem more manageable. Since the program's inception, the law has required that Social Security reserves be invested exclusively in securities guaranteed as to principal and interest by the federal government. Most trust fund holdings consist of special nonmarketable Treasury securities that carry the average interest rate of government notes and bonds that mature in four or more years and are outstanding at the time the special securities are issued. In addition to their low risk, these special issues have one clear advantage. They can be sold back to the Treasury at par at any time—a feature not available on publicly held notes or bonds, whose market prices fluctuate from day to day. They also have one big disadvantage—they yield relatively low rates of return.
It is not surprising that, when the Social Security law was enacted, policymakers viewed government securities as the only appropriate investment for workers' retirement funds. They were in the midst of the Great Depression. The stock market collapse and widespread corporate bond defaults were vivid in people's memories. Many believed that a mattress or a cookie jar was the safest place for their savings. For many years, the restriction placed on trust fund investment made little difference because Congress decided, before the first benefits were paid, to forgo the accumulation of large reserves that were anticipated under the 1935 law. Instead, Congress voted in 1939 to begin paying benefits in 1940 rather than 1942, boost the pensions of early cohorts of retirees, and add spouse and survivor benefits. The system was to operate on a pay-as-you-go basis.
Legislation enacted in 1977 called for moving from pay-as-you-go financing to "partial reserve financing" with the accumulation of significant reserves. These reserves failed to materialize because the economy performed poorly. Further legislation in 1983, together with improved economic performance, subsequently led to the steady growth of reserves. By the end of 1998, the program had built up reserves of $741 billion, roughly twice annual benefits. Under current policy, these reserves are projected to grow to more than $2.5 trillion—about 3.4 times annual benefits—by 2010. As reserves have grown, the loss of income to Social Security from restricting its investment to relatively low-yielding special Treasury issues also has increased.
The restriction that has been placed on Social Security's investments is unfair to program participants, both workers paying payroll taxes and beneficiaries. To the extent that trust fund reserve accumulation adds to national saving, it generates total returns for the nation equal to the average return on private investment, which runs about 6 percent more than the rate of inflation. By paying Social Security a lower return—a return projected to be only 2.8 percent more than inflation over the next 75 years—the system denies workers a fair return on their investment. As a consequence, either the payroll tax rate has to be set higher than necessary to sustain any given level of benefits or pensions have to be lower than would be the case if the program's reserves received the full returns they generate for the economy.
The restriction placed on the trust fund's investments has had another unfortunate consequence. It has added considerable confusion to the debate over alternative approaches to addressing Social Security's long-run fiscal problem. Advocates of various privatization plans argue that their approaches are superior to Social Security because they provide better returns to workers. In reality, the returns offered by these structures look better only because the balances they build up are invested not in low-yielding Treasury securities but rather in a diversified portfolio of private securities. If Social Security were unshackled, its returns would not just match, but almost certainly exceed, those realized by the various reform proposals.
There exists a very simple mechanism for compensating Social Security for the restrictions that are placed on its investment decisions. Each year, Congress could transfer sums to the trust fund to make up the difference between the estimated total return to investment financed by trust fund saving and the yield on government bonds. This could be accomplished with a lump sum transfer or by agreeing to pay a higher interest rate—say 3 percentage points higher—on the Treasury securities held by the trust fund. The transfer required to make up the shortfall in 1998, when the average trust fund balance was approximately $700 billion, would have been about $23 billion, more than two and one-half times the amount that is transferred to the trust fund from income taxes on benefits.
While general revenue transfers to social insurance plans are commonplace around the world, they have been controversial in the United States. Some would oppose such a transfer, arguing that general revenue financing would weaken the program's social insurance rationale through which payroll tax contributions entitle workers to benefits. Others would object to the tax increases or spending cuts needed to finance the general revenue transfer. Still others would question the permanence of such transfers, especially if the budget debate begins to focus on maintaining balance in the non-Social Security portion of the budget, out of which the transfers would have to be made.
An alternative approach would be to relax the investment restrictions on Social Security and allow the trust fund to invest a portion of its reserves in private stocks and bonds. Such investments would increase the return earned by the reserves and reduce the size of future benefit cuts and payroll tax increases. Shifting trust fund investments from government securities to private assets, however, would have no direct or immediate effect on national saving, investment, the capital stock, or production. Private savers would earn somewhat lower returns because their portfolios would contain fewer common stocks and more government bonds—those that the trust funds no longer purchased. Furthermore, government borrowing rates might have to rise a bit to induce private investors to buy the bonds that the trust funds no longer held.
Nevertheless, the Social Security system would enjoy the higher returns that all other public and private sector pension funds with diversified portfolios realize.