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Investing Social Security Reserves in Private Securities

Mr. Chairman and Members of the Subcommittee:

I appreciate this opportunity to discuss with you the issues raised by proposals to invest a portion of Social Security’s reserves in private securities. My statement addresses three questions:

  • Why do the Administration and others believe it would be helpful to diversify the portfolio of assets held by the Social Security trust fund?
  • What legitimate concerns are raised by investing trust fund reserves in private securities? and
  • Are there ways to address these concerns?

Why invest in private securities?

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.

Concerns about investment of trust fund reserves in private securities

In 1935, Congress ruled out trust fund investments in private stocks and bonds for good reasons. First, policymakers were concerned that the fund’s managers might, on occasion, have to sell the assets at a loss, a move that would engender public criticism. Second, they feared that if the fund had to liquidate significant amounts of securities, these sales might destabilize markets, depressing the value of assets held in private portfolios and upsetting individual investors. An even more important consideration was that they feared that politicians—like themselves—might be tempted to use reserve investment policy to interfere with markets or meddle in the activities of private businesses.

The concerns that Congress had in 1935 were certainly legitimate ones. But conditions have changed over the past 64 years in ways that reduce their saliency. Stock and bond markets are far larger, less volatile, and more efficient now than they were in the 1930s. Trust fund investment activities, therefore, are less likely to disrupt markets. Moreover, the trust fund is unlikely to be forced to sell assets at a loss because the fund has significant and growing reserves, most of which under the various proposals that call for trust fund investment in private securities would continue to be held in special Treasury securities. The trustees would almost certainly sell the fund’s government securities to get past any short-run gap between benefit expenses and revenues.

On the other hand, the pressures special interests place on lawmakers and the stresses imposed by reelection are probably greater now than they were in the past. For these reasons, many justifiably continue to be concerned about possible political interference in trust fund investment activities. Chairman Greenspan of the Federal Reserve Board has stated that he does not “believe that it is politically feasible to insulate such huge funds from government direction.” Others have been less judicious, charging that equity investment by the trust fund “amounts to nationalization of American industry” and “would threaten our freedom.”

Those who oppose trust fund investment in private securities point to the record of some private and state government pension funds that have chosen to use social, as well as economic, criteria to guide their investment policies. In addition, some of these pension funds have voted the shares of companies whose stock they own to further social objectives, ones that might sacrifice some short- or long-run profits. The fear is that the Social Security trustees might be subject to similar pressures. Congress could force them to sell, or not buy, shares in companies that produce products some people regard as noxious, such as cigarettes, alcoholic beverages, or napalm. Similarly, Congress could preclude investments in firms that engage in business practices some regard as objectionable, such as hiring children or paying very low wages in the company’s foreign factories, polluting the environment, or not providing health insurance for their workers. Critics also fear that the trust fund might retain shares in such companies and use stockholder voting power to try to exercise control over these firms.

Safeguards to protect trust fund investment decisions from political pressures

If there were no effective way to shield trust fund investment decisions from political pressures, the advantage of higher returns that a diversified investment strategy would yield would not be worth the price that would have to be paid. However, experience suggests both that concerns about political interference are exaggerated and that institutional safeguards can be constructed that would reduce the risk of interference to a de minimis level.

A number of federal government pension funds now invest in private securities. They include the Thrift Saving Plan for government workers and the pension plans of the Federal Reserve Board, the U.S. Air Force and the Tennessee Valley Authority. The managers of these pension funds have not been subject to political pressures. They have pursued only financial objectives in selecting their portfolios and have not tried to exercise any control over the companies in which they have invested.

Of course, the fact that the managers of smaller government pension funds have not been subject to political pressures provides no guarantee that the much larger and more visible Social Security system would enjoy a similar fate. Special interests might seek Congressional sponsors for resolutions restricting investments more for the publicity such limits would provide their cause than for any economic impact the directive might have if carried out. In addition, some Members might feel obliged to propose restrictions against investing in corporations that have been found to violate anti trust laws, trade restrictions, workplace health and safety regulations, or other federal limits. Political pressures might cause others to pressure the trustees to exclude investments in companies that have closed a plant in their district and moved their production facilities and jobs abroad.

For these reasons, it would be essential to enact legislation that would create a multi-tiered firewall to protect trust fund investment decisions from political pressures, one that would forestall efforts by Members of Congress or the executive branch from using trust fund investments to influence corporate policy. The first tier of such an institutional structure should be the creation of an independent agency charged with managing the trust fund’s investments. This board—which could be called the Social Security Reserve Board (SSRB)—could be modeled after the Federal Reserve Board, which for over eight decades has successfully performed two politically charged tasks—controlling growth of the money supply and regulating private banks—without succumbing to political pressures. Like the governors of the Federal Reserve, the members of the SSRB should be appointed by the president and confirmed by the Senate. To ensure their independence, they should serve staggered terms of at least ten years in length. Congress should be empowered to remove a board member from office only if that member was convicted of a serious offense or failed to uphold their oath of office, not because Congress disliked the positions taken by the member. As is the case with the Federal Reserve Board, the SSRB should be given financial independence. This could be ensured by allowing it to meet its budget by imposing a tiny charge on the earnings of its investments. Under such an arrangement, neither Congress nor the executive branch could exercise influence by threatening to withhold resources.

A second tier of protection should be provided by limiting the discretion given to the SSRB. The primary responsibility of the board should be to select, through competitive bids, several private sector fund managers, each of whom would be entrusted with investing a portion of the fund’s reserves. Depending on the amount invested, somewhere between three and ten fund managers might be chosen. Contracts with the fund managers would be rebid periodically and the board would monitor the managers’ performance.

A third tier of insulation from political pressures should be provided by authorizing fund managers only to make passive investments. They would be charged with investing in securities—bonds or stocks—of companies chosen to represent the broadest of market indexes, indexes that reflect all of the shares sold on the three major exchanges. In other words, the trust fund’s investment would be in a total stock market index such as the Wilshire 5,000 or Wilshire 7,000 index. If bonds were included in the investment mix, the appropriate guide might be the Lehman Brothers Aggregate (LBA) index. Unlike actively managed mutual funds, there would be no discretion to pick and choose individual stocks and, therefore, no window through which political or social considerations could enter.

A fourth layer of defense should be provided by requiring that Social Security’s investments be commingled with the funds that private account holders have invested in index funds offered by the managers chosen by the SSRB. These private investors would object strenuously if politicians made any attempt to interfere with the composition of the holdings of their mutual fund.

Fifth, to prevent the SSRB from exercising any voice in the management of private companies, Congress should insist that the several fund managers selected by the SSRB vote Social Security’s shares solely to enhance the economic interest of future Social Security beneficiaries.

To summarize, this set of five institutional restraints would effectively insulate fund management from political control by elected officials. Long-term appointments and security of tenure would protect the SSRB from political interference. Limitation of investments to passively managed funds and pooling with private accounts would prevent the SSRB from exercising power by selecting shares. The diffusion of voting rights among several independent fund mangers and the requirement that the managers consider economic criteria alone would prevent the SSRB from using voting power to influence company management. In short, Congress and the president would have no effective way to influence private companies through the trust fund unless they revamped the SSRB structure. That would require legislation which would precipitate a national debate over the extent to which government, in its role as custodian of the assets of the nation’s mandatory pension system, should interfere in the private economy. Framed this way, there would be strong opposition to such legislation.

While nothing, other than a constitutional amendment, can prevent Congress from repealing a previously enacted law, the political costs of doing so would be high. Furthermore, if Congress is disposed to influence the policies of private businesses, it has many far more powerful and direct instruments to accomplish those ends than through management of the Social Security trust funds. The federal government can tax, regulate, or subsidize private companies in order to encourage or force them to engage in or desist from particular policies. No private company or lower level of government has similar powers.


Allowing the Social Security system to invest a portion of its growing reserves in private assets will increase the returns on the trust fund balances and reduce the size of the unavoidable payroll tax increases and benefit reductions that will be needed to eliminate the program’s long-run deficit. Concerns that political interests might attempt to influence trust fund investment decisions are legitimate but institutional safeguards can be enacted into law that would reduce the possibility of such interference to a de minimis level.


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