Enron and Social Security Reform

Everyone with an axe to grind is using the example of Enron to grind free markets. And Paul Krugman is doing no less in a December 4, 2001, New York Times op-ed, “A Defining Issue.”

Krugman is using Enron to demonstrate the terrible dangers of “defined contribution” pension plans — like 401(k) plans. You see, some workers invest them in the stock of their employer, and Krugman worries that some of those might turn out to be like Enron. Although he generously admits that “One hopes that corporate collapses will not become commonplace,” nonetheless the risk must be stamped out at all costs, and must certainly not be replicated in the Social Security system by allowing individuals to control the investments of their Social Security accounts.

Why not? Because people might buy the securities of the plan’s sponsor, the United States Government, the way some Enron employees bought Enron stock? But that’s exactly what 100 cents on the dollar of Social Security investments are doing right now — buying Treasury bonds. That’s far worse than some Enron employees buying some Enron stock in their 401(k) that they control. That’s like Enron itself buying Enron bonds and using it to fund its own pension obligations in its “defined benefit” plan, where it’s on the hook to pay contractual benefits to workers.

Krugman wants to go back to the paternalistic world where defined benefit plans are the one and only way retirement savings get invested — where workers have no say in investments — and, by the way, where if the sponsoring employer goes belly-up the consequences can be far worse because no one is there to pay those “defined” benefits. Krugman lauds Social Security as a great defined benefit plan, and rips George W. Bush’s Commission to Strengthen Social Security for advocating that workers should have a choice.

Krugman calls Social Security “…the one great defined-benefit program that remains.” But he ignores the reality that the benefits of Social Security are not really defined at all — unless you mean “defined” by the whim of Congress, who possess unlimited power to alter, reduce, delay, tax, means-test, or even entirely eliminate benefits at any time if they chose to so “define” (and believe me, they have and they will).

Why won’t Krugman try using that massive Ivy League brain of his to propose a good idea that would actually help people in their lives, rather than just column after column endlessly finding fault — nastily, churlishly, contemptuously — with anything that wasn’t legislated by either Franklin Roosevelt or Bill Clinton. Surely they don’t have a monopoly on good ideas. What are his? Does he have any?

The Social Security Debate: A War of Lies

The battle over restructuring America’s Social Security system into individual, privately managed accounts is heating up again. So the winds of change keep blowing, foreshadowing what may be the most profound economic transformation since the Reagan tax cuts of the 1980s.

The battle line was drawn last week over revised budget estimates showing a shrinking federal budget surplus. Democrats charged that the Bush administration is raiding the Social Security cookie jar to create the appearance of any budget surplus at all. The Bush administration countered by declaring their continued support for a Social Security lock box, saying that under no circumstances would they dip into this Social Security Trust Fund. Yesterday the Congressional Budget Office agreed with the Democrats.

But if this is the battle line, it’s a line drawn in shifting sands with a squirt-gun filled with invisible ink. Arguments on both sides of it are fictions built on lies predicated on fantasies.

Of course anything having to do with the federal budget is utter madness. A public company that reported its financials to shareholders the way the federal government reports to citizens would find its CEO and CFO sharing a jail cell. But when it comes to Social Security, you move up into a whole new level of fraud.

Yes, it is the case that the Bush administration has changed the rules by which it characterizes Social Security tax revenues, and without that change, the existing rules would show the budget dipping into Social Security funds.

But that just doesn’t matter. Because the truth and the fact is that there is no such thing as “Social Security tax revenues” and there is no such thing as a “Social Security surplus” and there is no such thing as a “Social Security Trust Fund” and there is no such thing as a “Social Security Lock Box.”

These are just accounting gimmicks. No, they aren’t even that real. They are just words. No, they aren’t even that real. They are just lies.

Truth: all revenues received by the federal government from whatever source is simply interchangeable income, to be spent by the government any old way it chooses.

Truth: there is no Social Security surplus, and never has been. The present value of the system’s liabilities is greater than its assets by trillions of dollars.

Truth: any money invested in Treasury bonds to pay future Social Security benefits — whether in a “trust fund” or a “lock box” or, as Johnny Carson used to say, in a mayonnaise jar on Funk & Wagnall’s porch — isn’t invested at all. It’s just an IOU from the same government that claims it will use the proceeds from that same IOU to pay benefits.

There is only one true “trust fund” or “lock box.” It is the individual, privately managed Social Security account. It would not be the government’s property, subject to the whim of today’s particular accounting maneuvers and spending plans. It would be your property, just like your 401(k) account. Yours to own. Yours to invest. Yours to spend. Or yours to pass on to your children.

It’s tragic that in a matter as important as Social Security privatization President Bush doesn’t have the full courage of his convictions.

Yes, to his credit, last week Bush repeated the familiar warnings that Social Security is facing a crisis, and said that bold action is required. And firmly grasping the highest-voltage third rail of American politics with both hands, he said that his support for private accounts is a political plus, and one of the reasons he was elected, as he put it, was “

Questions & Answers On Privatizing Social Security

Aren’t most people too unsophisticated to manage their private account? This is a valid concern, but there are simple solutions that have worked well over twenty years with 401(k) plans, and they could easily be applied here. First, rudimentary investment education can easily be supplied — mastering a few cookie-cutter basics is enough to equip a newbie to avoid 90% of the pitfalls. Second, professional advice can be provided either through individually tailored services, or by use of collective investment vehicles such as mutual funds. And third, the number of investment choices permitted in the private accounts can be constrained to rule out the really risky stuff.

And as I’ve said before, you’d have to practically try on purpose to have bad long-term results to get outcomes that are as awful as the rates of return produced right now by the existing Social Security system. And those already awful returns are only going to get worse when taxes are inevitably raised and benefits are inevitably cut.

Okay, but what if despite all that some people blow it. Wouldn’t the government have to step in and bail them out? Well, no. Government doesn’t step in today to bail people out who arrange their affairs in such a way that their meager Social Security income isn’t enough to live on.

But wouldn’t it be better to keep risk of investment loss out of the picture entirely? Whatever may be wrong with the existing system, at least the returns are guaranteed. The returns of the existing system — poor as they are — are not by any means guaranteed. They can be reduced, delayed, taxed, or discontinued altogether at any time by the whim of Congress. Social Security participants have no property right or contractual right in their account — in fact, they have no “account” at all in the usual sense. It’s just a welfare program, like food stamps or subsidies to farmers for not growing potatoes.

The financial services industry doesn’t want private accounts, because there would be so many of them — and they’d be so small — that it wouldn’t be profitable to service them. The financial services industry put itself through a decade of competitive paroxysms to win 401(k) business when it was all up for grabs during the 1980s and early 1990s. It is now very well equipped to handle lots of small accounts. If it were not, why would American firms go all the way to Chile to service private retirement accounts there — in a country that is far smaller and far poorer?

Private accounts are just a scam by the financial services industry, designed to drum up business. Well, obviously this objection isn’t raised by the same people who raise the previous one!

Shouldn’t private accounts be modeled on the existing Federal Employee Retirement System (FERS) model? Many people have held up the 401(k)-like plan available to all Federal workers as an ideal private account system. I know that system well, by the way — they used to be my biggest customer when I was with Barclays Global Investors, who managed most of the investments in the plan.

The FERS program is deliciously simple. Employees pay part of their salary into a private account, and the employer (Uncle Sam, in this case) matches it with a contribution of its own. The accounts can be invested in an S&P 500 Index Fund, a Lehman Aggregate Bond Index Fund, or a money market fund.

It’s so simple, all the participants seem to be able to understand it. The funds all have astonishingly low fees because they are so big and so simple. And the bookkeeping is all administered by the Department of Agriculture — you know, the same folks who brought you food stamps. As a libertarian, I’d like to see a plan with more choices. But compared to the current Social Security system, the FERS plan is a dream come true. Social Security reform would do well if it did no more than emulate this winning formula.

What about the “transition costs” of moving from the current system to private accounts?
As I wrote in my column yesterday, “transition costs” are a myth. There would be no transition costs. All costs associated with shutting down the existing system are costs that are already born by maintaining it.

Why should private accounts make the stock market go up, as I have claimed? Stock prices are driven by corporate earnings, not the supply of fresh money in the markets. True, stock prices are driven by earnings. But earnings are driven by the health of the economy, and nothing would promote the health of the economy more than solving the Social Security crisis, and at the same time creating a nation of savers and investors destined to earn higher rates of return over their lifetimes.

But beyond this, there are other factors that influence stock prices besides earnings — especially tax policies that enlarge or contract the fraction of those earnings that investors get to keep, after taxes. Private accounts would be, to some extent, a tax shelter. That would raise the after-tax value to investors of even a static earnings stream. And that would raise stock prices.

If private accounts actually happen someday, which stocks could benefit the most? Fair question — but it’s the wrong one to ask. If we are able to drive a stake through the heart of the vampire that is the existing Social Security system — and thus prevent it from sucking more blood from the neck of the body politic — and replace it with a system of private accounts that can be invested in stocks — and thus ignite a booming economy and a booming market — it won’t even matter which stocks you buy. Just buy stocks.

The views expressed within represent those of the author, and do not necessarily reflect those of Capitalism Magazine’s publishers.

A Cost Benefit Analysis on Privatizing Social Security

In my commentaries this week, I’ve discussed the transcendent importance to the economy and the markets of the potential for restructuring Social Security, to include individually managed private accounts. I’ve talked about some of the myths about Social Security, and I’ve shown how private accounts have worked for public retirement systems in other countries. Today I’m going to take on the most dangerous myth of all — the one that keeps us from reforming our broken Social Security system the way Chile did two decades ago.

I’m talking about the myth of “transition costs” — the myth that it is impossibly expensive to dig out from under the wreckage of today’s bankrupt system, and move to a more robust and sustainable system of private accounts. This myth is especially dangerous because it virtually concedes that moving to private accounts would be a good idea in principle — but, like other good ideas in principle, such as buying a Gulfstream V jet, it would just be too expensive.

The myth of transition costs goes something like this. If today’s workers paid their Social Security taxes into their own private accounts instead of into Social Security’s so-called Trust Fund, in less than five years there would be no money to pay benefits to people who are already retired, and older workers not yet retired but who have paid into the system all their lives. Those people somehow have to get paid — and that’s the cost of transition. Depending on who you listen to, the present value of that cost is anywhere from $4 trillion to $11 trillion.

Why do I say that’s a myth? What’s not factual about it? Actually, nothing — it is perfectly factual. What makes it a myth is that these costs are not “transition costs.” They are simply the value of the obligations of the system, whether there is a transition or not. These costs will have to get paid somehow, someday, by somebody.

To see why I say this, consider a simple thought experiment proposed by Nobel economics laureate Milton Friedman. Suppose that we repealed Social Security this very moment, and paid everyone a Treasury bond equal to the value of his claim on the system. That means you’d get a bond worth the present value of all the payments you can expect to get out of the system over your lifetime, minus the value of all the taxes that you’ll pay into the system. You hold the bonds, or sell them if you want — perhaps using them to create your own personal retirement plan. Friedman says, “The result would be a complete transition to a strictly private system, with every participant receiving exactly what the law promises.”

The perfect transition, right? Everyone has a government obligation equal to the value of the government obligation he has right now under the old system. Nobody’s entitlement changes, and the total value of the government’s obligation doesn’t change, either. There are no losers in the deal. Perfect. The system is now private. And what are the “transition costs”? Zero. Well, not literally zero. I guess it would cost something to print the bonds on fancy paper and mail them to everyone.

Of course, while it would truly cost nothing to privatize the system this way, it would feel as though the costs were enormous. That’s because sending out all those bonds would require that the massive obligations of Social Security be recognized on the balance sheet of the federal government — and right now, they are not.

By keeping these obligations off the books, we commit a collosal act of denial, an act of self-serving magical thinking, through which we choose not to recognize the realities of these obligations, these solemn promises. And then we rail against reforming the system because doing so would cause us to recognize these realities. We call that act of recognition, that act of honesty, that act of integrity… “transition costs.”

And in our denial, with every passing day, the costs of the existing system get higher and higher, as more and more people retire in relation to the smaller number entering the workforce. The sooner we face reality — the sooner we can stop these mounting costs. Let’s start by making a promise to ourselves right now — let’s stop calling them “transition costs.”


The views expressed within represent those of the author, and do not necessarily reflect those of Capitalism Magazine’s publishers.

Lessons from Chile on Social Security

This week I’m focusing on the myths that will keep investors from grasping the risks and opportunities on the road ahead as President George W. Bush pushes for restructuring Social Security — probably with the introduction of private accounts that could be invested in the stock market. Trust me on this — it’ll pay big dividends for you to get ahead of the curve on this one, because nobody is taking it seriously. If it happens, it will mean the biggest economic transformation since the oil crisis of the 1970s — and its impact on the markets will be just as big.

The first myth is that Social Security is so horribly broken, so utterly bankrupt — and yet so utterly ingrained in the American political landscape — that there is nothing we could ever possibly do to restructure it.

Yes, it seems impossible indeed. Especially considering what a poor, backward and underdeveloped country America is. To meet the challenge of restructuring Social Security, we’d have to be a rich, advanced and developed country — like Chile. That’s right, Chile… the third-rate third-world country that brilliantly succeeded in 1981 in a challenge that we haven’t even grasped more than two decades later. 20 years ago Chile completely — and totally successfully — restructured its bankrupt social security system into an exemplary program of private investment accounts, and transformed itself from a nation of serfs into a nation of investors.

Chile started even deeper in the hole than we are. When they implemented their restructuring, the implicit debt of their former system was a crippling 80% of gross domestic product. Here’s how they dug their way out.

First, the Chilean government guaranteed those already receiving benefits that their payments would be unaffected by the restructuring. Second, every worker already contributing to the old system was given the choice of staying in that system or moving to the new one. Those who left the old system got a tradable “recognition bond,” reflecting the value of the claims the worker had already acquired on the old system. The vast majority elected to move to the new system. And third, all new entrants to the labor force were required to enter the new system.

Under the new system, every worker opens a Pension Savings Account (PSA). During his working life, he automatically has 10% of his wages (up to total wages of $22,000 per year) deposited by his employer each month in his PSA — and he’s not taxed on the amount deducted. A worker may voluntarily contribute an additional 10% of his total wages each month, also free of taxes.

The PSAs can be invested in a variety of investment vehicles provided by private investment management companies, including mutual funds, banks, credit unions, and insurance companies. When the worker retires, he may begin to withdraw money from his PSA — at which time he’s taxed on the amount withdrawn, at ordinary income rates depending on his total income at the time. Sounds an awful lot like a 401(k) plan, doesn’t it?

After the first 15 years of operation, Chile’s PSAs had already accumulated over $25 billion, a huge pool of internally generated capital for a developing country with only 14 million people and a GDP of only $60 billion. The system is yielding retirement benefits representing a far greater fraction of lifetime working income, and it requires far smaller fraction of current income to be contributed.

According to Jose Pinera, Chile’s Minister of Labor who masterminded the PSA system and the transition to it,

“When the PSA was inaugurated in Chile in 1981, workers were given the choice of entering the new system or remaining in the old one. Half a million Chilean workers (one fourth of the eligible workforce) chose the new system by joining in the first month of operation alone far more than the 50,000 that had been expected. Today, more than 90 percent of Chilean workers who had been under the old system are in the new system. By 1995, 5 million Chileans had PSA accounts, although not all belonged to active, full-time workers, and therefore not all contribute in any given month.

“The bottom line is that when given a choice, workers vote with their money overwhelmingly for the free market — even when it comes to such ‘sacred cows’ as social security.”

So much for the myth that we can’t fix Social Security. If Chile can do it, we can do it!


The views expressed within represent those of the author, and do not necessarily reflect those of Capitalism Magazine’s publishers.

Privatizing Social Security is Good for the Economy

We may be on the brink of a once-in-a-decade investment opportunity, a rare chance to catch a huge environmental change in the economy and the markets. And it’s still early on this one — you can still catch this one before it becomes part of the conventional wisdom, while the profit opportunities are at their greatest.

The opportunity is the possibility — and I admit that at this point it’s still only a possibility — that President George W. Bush will succeed in his stated intention to restructure the Social Security system to include individually managed accounts that could be invested in the stock market.

Now, most people think Bush’s initiative is just a false alarm, like former President Bill Clinton’s failed attempt to nationalize the healthcare industry at the same early point in his presidency. But if it does happen, it will be one of those exogenous shocks that sets off an investment megawave, for good or for ill — like the oil crisis in the 1970s and the resulting hyperinflation; like the tax cuts and deregulation initiatives in the 1980s, and the resulting restructuring of Rustbelt America; and like the end of the cold war in the 1990s, and the resulting boom in civilian technology.

It’s hard to think about these investment megawaves before they happen, because the politics behind them can be very distracting. So try to forget about how you may feel about the politics of Social Security — just think like an investor: ask yourself what would happen to the economy and the markets if people could invest their Social Security contributions themselves, in individually managed accounts.

The impact would be enormous, because the number of people involved and the number of dollars involved are enormous. That’s because Social Security is the largest government program of any type, anywhere in the world.

Social Security covers 142 million American workers — that’s almost four times the number of workers who are covered by 401(k) retirement plans. Consider what might happen when those 142 million workers are suddenly given individual accounts, and can invest them in the stock market. Of course not all of them will choose to do so. But many will, and we may see a repeat — in an even more extreme form — of the extraordinary market volatility we saw in the late 1990s, when the on-line investing revolution drew millions of individuals into stock investing for the first time.

For 2000, the Social Security system collected $490 billion from payroll taxes and interest on its bond portfolio — that’s about 4-1/2% of America’s gross domestic product, and more than the market cap of General Electric, the world’s most valuable corporation. Right now $358 billion of that is being paid out in benefits, and the remaining $132 billion is invested in Treasury bonds. As soon as any of that $132 billion per year gets redirected to the stock market, the balance of supply and demand between equities and fixed income could shift dramatically — in favor of equities.

Not only would the introduction of individually managed Social Security accounts bring new investors into the equity markets, it would also create incentives for investors already in equities to invest even more. It’s all a matter of taxes. Presumably, contributions to an individual Social Security account would be tax exempt, and investment profits in the account would not be taxed until balances are withdrawn when the investor retires — just the way a 401(k) plan works today. That tax treatment raises the after-tax return on risk-bearing, and makes riskier assets more attractive. That not only causes investors to move from bonds to stocks, but it also causes them to move assets already invested in equities from conservative stocks to aggressive stocks.

These would be the first-order results of creating and funding millions of new stock market investment accounts for millions of new investors, and offering them powerful tax incentives. But the second-order results may turn out to be even more important. Over time, it will almost surely be the case that the investment results in these new accounts will be superior to the returns promised by the existing Social Security system — and if that’s true, the trillions of dollars in new wealth that is created would vastly expand the size and scope of the consumer economy, setting in motion a virtuous circle that would enhance the value of the very equities that were rendered more attractive thanks to the first-order effects.

Why am I confident that the investment results would be better, especially considering that millions of the new individually managed accounts will be in the hands of people who don’t know a stock from a hole in the ground? That’s simple — it’s because the returns from the existing system, when measured as you would measure any other kind of investment, are so blindingly bad that just about anything else would have to be better.

What are the returns? Well, that depends on who you are — whether you are male or female, single or married, one-earner or two-earner — and that raises some very real fairness issues, but let’s leave that aside for the time being. According to the Office of the Actuary of the Social Security Administration For American’s born in 2000, the rate of return on a working lifetime of paying Social Security taxes, and then collecting the promised benefits during retirement, is only 0.86% per year for a single male, only 1.25% for a single female, and 1.88% for a two-earner couple. The single-earner couple makes out the best, with 3.02% — but even that’s nothing to write home about. You’d have to mess up pretty badly in your individual account to get returns that bad over the long term.

So far, all my arguments are for the bullish impacts on the economy and the markets if Bush’s initiative succeeds. Now let’s look at the other side of the coin — the bearish impacts if he fails.

Even the staunchest supporters of the existing Social Security system admit that it will face severe economic challenges at some point in the future, as the number of young workers paying into the system declines in relation to the swelling number of retired workers drawing benefits from it. Under the existing paradigm, there is simply no way to fix that problem with either raising the taxes that young workers pay, or reducing the benefits that the retired workers get. And either way it works out the same: the already horrible rate of return in the system simply gets worse. At some point, it even goes negative. But long before that, the combination of increasingly intolerable burdens on young people and broken promises to old people will induce economic dislocations that will make a fiasco like the savings and loan crisis look like a hayride.

And don’t draw too much comfort from that almost $1 trillion sitting in the Social Security Trust Fund. That’s all invested in Treasury bonds — which makes about as much sense as having the General Motors pension plan invest in bonds issued by General Motors. You can’t collateralize someone’s promise to pay by having him invest in his own bonds — after all, bonds themselves are nothing more than promises to pay.

So in twenty or so years when the Treasury bonds in the Trust Fund have to start getting sold to pay benefits, we’re going to see an awful lot of supply hitting the fixed income markets. We’ll find out what those promises are really worth. And remember, in the end there are only two ways for the government to redeem those bonds — either with taxes, or by running the printing press.

Bush’s efforts to restructure Social Security are going to get covered in the press as grand political melodrama. The financial news will all be about Alan Greenspan’s speeches and guessing whether Cisco’s going to make their quarter. But don’t be fooled by the conventional wisdom — there’s nothing else on the horizon that will have remotely as much impact on the markets over the next decade as what happens with Social Security.


The views expressed within represent those of the author, and do not necessarily reflect those of Capitalism Magazine’s publishers.