How to Privatize Social Security

Alicia H. Munnell and
Alicia H. Munnell Director, Center for Retirement Research at Boston College
R. Kent Weaver

July 9, 2001

In the past few weeks, proponents of Social Security privatization, including members of the president’s commission on Social Security reform, have introduced a new argument for dramatically restructuring the system. They claim that the assets contained in the Social Security trust fund are not “real” but merely IOUs from the government. This assertion is wrong—and would be obviously so if Social Security were able to acquire corporate equities and bonds in the same way that private pension funds, public employee pension funds and the Canada Pension Plan (the Canadian equivalent of Social Security) do.

Holding private-sector assets would produce higher returns for Social Security trust funds. It also would smooth the transition of Social Security from a vehicle that finances government debt to an entity that receives payment from the government.

Those in the privatization lobby oppose broadening investment options for Social Security. They claim that such funds would be subject to political interference and that they would be so big as to disrupt private capital markets. But little evidence supports the first concern, and the latter “problem” easily can be prevented.

State and local pension plan funds, the Federal Thrift Savings Plan for federal employees and the Canada Pension Plan all have achieved excellent financial returns while keeping costs low and avoiding political interference in investment decisions.

How? First, they have explicit organizational mandates to maximize return on contributors’ investment. Second, they have independent boards of trustees, whose members generally serve long terms. Third, they contract out portfolio management on a competitive basis. Finally, they emphasize investment in broad indexed investments.

This is not financial rocket science. With tens of millions of current and future Social Security beneficiaries watching, Congress certainly would maintain a hands-off policy. Once concerns about political interference have been addressed, worries about the size of public investment funds can be resolved in a number of ways.

One answer is to limit the size of a fund, creating new funds that are separately (and privately) managed once the public fund reaches a certain size. This practice is already used in Sweden, which has six funds to manage accumulated surpluses in its partially funded public pension system. The government has put limits on how much of a single firm—and of the total market—can be owned by individual funds and by all the funds collectively.

But how big is too big? One standard would be to limit the size of any one Social Security investment fund to roughly the size of the largest private investment firm. In 1999 Fidelity was the largest, with 3.3 percent of domestic equities, followed by Barclay’s Global Investors with 2.1 percent and State Street Global Advisors with 1.6 percent. Once a Social Security investment fund reached, say, 3 percent of the market, it would not receive any new investment funds from Social Security surpluses. Instead, the government would establish a new investment fund, again privately managed, to receive new funds. A somewhat more convoluted mechanism for limiting size would involve distributing Social Security funds among fund managers in proportion to 401(k) contributions.

While the logistics and costs of establishing and administering a system for Social Security investments are not inconsiderable, they are minute compared with the costs of setting up roughly 100 million individual accounts, many of which would receive small and irregular contributions from low-earners. A system of investing the trust fund reserves in equities would pay out far less in fees than an individual account system—which is why most fund managers favor the latter.

Building up Social Security reserves and investing them in private-sector securities offers the advantages of individual accounts without the risks and costs. It has the potential to increase national saving and offers participants the higher risk-higher returns associated with equity investment.

By pooling investments and keeping transaction and reporting costs to a minimum, collective investment would produce higher net returns than personal saving accounts. But unlike personal saving accounts, a partially funded Social Security program with equity investments ensures predictable retirement incomes by maintaining a defined benefit structure that enables the system to spread risks across the population and over generations.

Alicia Munnell is Peter F. Drucker professor of Management Sciences and director of the Center for Retirement Research at Boston College. R. Kent Weaver is a senior fellow in governmental studies at the Brookings Institution.