Interview ¦ August 9, 1999
Where's the Payoff? Wall Street spent millions to promote the privitization of Social Security-an idea going increasingly awry

By Rose Darby & Michelle Celarier

In recent years prominent Wall Street executives have argued that privatizing Social Security and investing the funds in the stock market would save the Depression-era retirement system, which by some calculations could be insolvent by the year 2034. Quietly bankrolling think tanks, research and public policy forums, in addition to spending millions of dollars in Congressional political contributions, Wall Street made sure it shaped the debate.

The financial industry had ample economic incentive: By putting only a small portion, say 5%, of Social Security funds in the market, Wall Street could potentially earn $240 billion in fees over a little more than a decade, according to David Langer, chairman of the Employee Benefit Committee of the American Academy of Actuaries. Langer, who runs his own actuarial consulting firm, is a critic of Social Security's privatization. His opinion has been sought by Congress during several hearings to balance the overwhelmingly pro-privatization debate. Langer bases the $240 billion number on a 1% management fee.

Today, however, Social Security reform and partial privatization isn't looking nearly so lucrative. And even though President Clinton considers it the number one policy concern facing the country, Social Security privatization appears to have receded into the background. A number of proposals are stuck in Congress, and Wall Street has cooled on the idea. Indeed, one of the industry's most vocal supporters of privatization, Marshall Carter, chairman and chief executive officer of pension fund manager State Street Corp. has retreated publicly, due in part to criticism from the AFl-CIO, which controls billions of dollars in pension funds.

And earlier this year, a group of prominent Wall Street economists, including those at Goldman, Sachs & Co. and Morgan Stanley Dean Witter, ran the numbers and concluded that the investment in the stock market would do little to shore up the system, primarily because the return on equities is expected to decline in the years ahead.

But perhaps the biggest negative, from Wall Street's point of view, is that managing the assets associated with the partial privatization of Social Security is turning into what looks to be a business of low fees and high costs. It may be just a tough negotiating posture, but recently some of the most staunch Wall Street proponents of Social Security's privatization have been bemoaning the high administrative costs associated with various plans. And last, but certainly not least, the money Wall Street stands to gain under some of the current proposals looks downright puny. Depending on the size of the fees-ranging from 3 to 25 basis points-total fees over 13 years would come to something between $3 billion and $24 billion-a far cry from $240 billion.

Losing enthusiasm
What happened? As William Cheney, chief economist at John Hancock Mutual Life Insurance Co., puts it, "The devil really is in the details."

The current debate started when President Clinton appointed a 1994-96 Advisory Council on Social Security to study ways to avert a shortfall without raising new taxes. In 1997, that group presented three reform proposals, none of which they could agree on. The issue was backburnered, but surfaced again this year during Clinton's State of the Union address. At that time, he presented reform of Social Security as the most pressing issue facing the nation and offered his own plan. Since then, a number of Congressional proposals have been put forth. Though they differ slightly, with some reducing benefits, most of them plan to direct into the markets only 2 percentage points of the 12.4% for each employee now paid into Social Security.

"Compared to some of the euphoria of two or three years ago from various investment firms and Wall Street, even if they still advocate reform, most are talking about it in a more guarded and limited way," says Dallas Salisbury, president of the Employee Benefit Research Institute in Washington, D.C. After studying exactly how complex, expensive, and time consuming the process could be, those in Congress and even the biggest advocates of privatization are having second thoughts. "In the process, they're trying to make sure that they manage expectations," he says.

The public's expectations have built up over time, in large part due to the aggressive campaign by banks, insurance companies, and Wall Street firms to sell the notion of Social Security's privatization. And while current proposals appear to hold pretty small potatoes for Wall Street, nothing should be ruled out because nothing yet has been passed, says Edith Rasell, economist at the Economic Policy Institute in Washington, D.C., a non-partisan, non-profit economic research organization. "Potentially, there is a lot of money to be made," says Rasell, "which is why Wall Street and the financial industry have put so much money into this debate." The most to gain

Indeed, those who have the most to gain have given nearly $53 million to national parties and federal candidates since 1989, according to Common Cause, a public service group that monitors campaign contributions. "It would mean billions of dollars of new investments for Wall Street," says Common Cause President Ann McBride, noting that the number one policy debate in Washington during this Congressional session has been privatization or partial privatization of Social Security. Contributions from Wall Street interests included more than $37.4 million in soft money and $15.5 million in political action committee (PAC) contributions over the past decade.

Wall Street's most generous donors have been Morgan Stanley, Goldman Sachs, Merrill Lynch & Co., J.P. Morgan and Salomon Smith Barney. Contributions are fairly evenly split between Republicans, who got $29.4 million, and Democrats, who got $23.5 million.

Particular generosity has been shown to the most powerful policymakers in the committees that oversee Social Security-the House Ways and Means and the Senate Finance Committees-according to Common Cause. House Ways and Means Committee members received on average more than $33,000 in PAC contributions from securities firms, or almost three times more than the $12,000 other House members took in on average since 1989. Senate Finance Committee members received more than $68,000 in PAC contributions on average from securities firms, or about twice as much as their Senate colleagues who received an average of $32,000 each over a 10-year period. In addition, some of the congressmen sponsoring Social Security reform legislation received substantial amounts.

Besides making direct political contributions, various financial services firms and banks have financed think tanks, research projects and public-policy forums that promote privatization. State Street, which manages $485 billion in assets, including index funds, has been the most prominent, with Chairman Carter co-authoring a book, "Promises to Keep: Saving Social Security's Dream" with William Shipman, a principal with State Street Global Advisors, its money management arm.

State Street has been a major financial backer of the Cato Institute, the libertarian think tank that has endorsed full-scale privatization of Social Security, with Cato officials even calling for a sale of federally-owned parks to pay for the costs if necessary. Shipman is co-chairman of the Cato Project on Social Security Privatization.

Back in 1996, the Cato Institute received $2 million to be spent over a three-year period to fund research conferences and other activities involving groups, members of Congress and their staffs. In addition to State Street, contributors included American International Group Inc.; American Express Corp., and discount brokers Quick & Reilly Group Inc.

Neither Shipman nor Carter are currently making policy statements, as the institution has determined to lower its public profile on the contentious issue. The latest statement from Carter, in March, stated "we must take steps to preserve Social Security's broad benefit to America's workers" and applauded the work by both Clinton and the Republican and Democratic leadership in Congress.

Another prominent Wall Street Social Security policy wonk is PaineWebber Group Inc. Chairman and Chief Executive Officer Donald Marron. Marron is co-chairman of the National Commission on Retirement Policy, a 24-member bipartisan panel of experts from the public and private sectors established by the Center for Strategic and International Studies. That group has put forth a comprehensive plan that became the crux of legislation sponsored by Senators John Breaux (D., La.) and Judd Gregg (R., N.H.) and in the House of Representatives by Jim Kolbe (R., Ariz.) and Charles Stenholm (D., Texas). The Gregg/Breaux proposal has gotten two new Senate sponsors, John Kerry (D., Mass.) and Charles Grassley (R., Ohio). and now goes by the name Breaux/ Gregg/Kerry/Grassley.

These proposals have also been endorsed by the Concord Coalition, another pro-privatization group that is co-chaired by Blackstone Group Chairman Peter Peterson. Peterson, a former U.S. Commerce Secretary under President Nixon, has also written extensively on the impending bankruptcy of Social Security and how privatization will save it. A tax or not?

A major distinction between the plans Wall Street favors, and those it does not, is that they reduce benefits, which is politically unpalatable to President Clinton and others, such as unions and senior citizens groups. Instead, Clinton has proposed transferring a portion of the projected federal budget surplus to the Social Security trust fund. Under the Clinton plan, part of the trust fund would be invested in the stock market and workers could create government-matched savings incentive accounts called Universal Savings Accounts (USA). The current debate in Washington has centered around whether to use the surplus for Social Security, as Clinton wants, or give citizens a tax break.

Historically, the FDR New Deal program of Social Security has been a means of income redistribution, with the wealthiest getting the lowest rate of return for their contributions and the poorest receiving a higher rate of return, given their smaller lifetime contributions. Thus, part of the ideological debate about privatizing Social Security centers around whether the plan is a savings plan or a progressive form of taxation.

"If it's a tax, then it will simply get raised over the years as all taxes do," says PaineWebber's Marron. Alternately, he suggests, "We're all paying 12.4% between ourselves and our employers, so is this the government's money, or is it really our money because it's a savings plan?" Marron argues that because there is a Social Security trust fund (although it consists of I.O.U.s from the government), it is a savings plan. As a result of this view, he says the commission concluded that "some of that money (about 2%) really ought to get a market rate of return, that it should be invested in various forms, and that eventually it should go to the citizen in a lump sum at retirement."

Two other plans, one introduced by Sen. Patrick Moynihan (D., N.Y.) and Sen. Kerry, and another introduced by House Ways and Means Committee Chairman Bill Archer (R.,Texas) and Rep. E. Clay Shaw (R., Fla.), have also been introduced. Archer/Shaw would create individual Social Security guarantee accounts for each employee. Instead of taking it out of the current 12.4% Social Security tax, as do other plans, Archer/Shaw's proposal is an add-on, funded with an income tax credit of 2% of Social Security taxable earnings. Under this proposal individuals would have no control over their portfolios, but assets would be invested in a mix of 60% in equity index funds and 40% in bond index funds.

At this point, however, prospects are not good for any of these proposals. "As we head toward the end of the 1999 legislative season, the only two proposals with leadership endorsement are the President's plan and Archer/Shaw," explains EBRI's Salisbury. "And, even those proposals don't look like they are going to be able to get a consensus."

Pleasing no one
The plans please neither the liberal critics of privatization nor its Wall Street proponents. Even though all the plans only involve what could be called a thimble-full of privatization, they contain more privatization than is acceptable to organized labor, House Democrats, and a fair number of Republicans, Salisbury adds. On the other side, none of the current proposals hold much appeal for the financial industry, given the relatively small fees likely to be associated with managing the money.

Indeed, many financial industry proponents of privatization have suddenly begun questioning the administrative costs of the huge network of individual accounts required by these proposals. "Even those who believe this type of reform is a good idea recognize there is a real question whether or not you could actually make this system work," says Salisbury. With the need for over 150 million accounts and millions of low wage earners putting 2% of already limited salaries into them each year, it could take some time before enough cash is built up to even be managed effectively by a mutual fund company. "It could be many, many years before investment firms could take on such accounts on a profitable basis," he adds.

Among the Wall Street proponents who have warned about these huge costs are PaineWebber's Marron, who has acknowledged that there are real questions about whether such plans are administratively work. And in April, State Street's Shipman presented a new report at a Cato Institute meeting on how to make such a system feasible. Shipman declined to comment, but attendees at the meeting said he explained it would have to have very limited numbers of investment options, in contrast to previous Cato positions, and it would have to be done with a build-up in government accounts until they were large enough for a private firm to profitably manage them.

Another administrative detail is who will collect the money and who will look after compliance to make sure that employers and employees pay their requisite share, notes John Hancock's Cheney. Under the current Social Security system, employers send in payroll taxes at various intervals, depending on the size of the workforce and other variables. But in the case of individual accounts being invested in the stock market, a manager must know exactly which accounts hold how much and how much should be invested where.

Also, if payroll tax money is being sent to a private investment manager instead of to the government, the question arises as to who monitors that process to determine that the money has actually been sent and who will have authority for policing tardy or unscrupulous employers.

And who will police the money managers? Already, Securities and Exchange Commission Chairman Arthur Levitt has raised concerns about potential abuses. In an editorial for the Washington Post on Nov. 16, 1998, Levitt wrote, "A system of self-directed individual accounts would require an unprecedented level of broad scale policing of the equity markets. Otherwise, fraud and sales practice abuses could be perpetrated against society's most vulnerable investors."

A matter of basis points
Then there's the issue of Wall Street's fees. "Because Social Security deals with millions of tiny contributions, some accounts would presumably be so small that in any normal financial services situation fees would probably be larger than the account balances," points out John Hancock's Cheney.

When the financial services industry contemplated past proposals, some money managers were champing at the bit to oversee what might have been a grand national 401(k) type plan. However, many observers believe that various proposals may be tried on an incremental basis, instead of one sweeping plan upon which everybody agrees. "One can imagine a progression of little bits being chipped out of proposals and little changes being made that evolve in a particular direction," says Cheney. "And, if the process starts off on a very small scale, in a half-hearted way, it's not going to get people on Wall Street very fired up."

Most of today's proposals call for investment in index funds, a notoriously low margin business. What's more, the prospect of managing them under government guidelines implies fees would be forced rather low. Previous plans suggested a 1% management fee, but observers believe the final number will end up being much lower. The Gregg/ Breaux/Kerry/Grassley proposal is silent on the fees issue. But a cue may be taken from the other proposals. The Moynihan/Kerry proposal is modeled after the Thrift Savings Plan, the government's 401(k) type plan for all federal employees. It is managed by Barclays Bank, which earns a pidding 5-6 basis points to administer the plan. The Archer/Shaw plan specifically calls for a fee of 25 bps.

If these numbers weren't enough to chill Wall Street's ardor for Social Security's privatization, another cold shower came in the form of Wall Street's own review of the long-term economic implications of Social Security's privatization. Earlier this year, The Committee on Investment of Employee Benefit Assets (CEIBA), a group made up of the senior officers of the nation's largest pension funds, asked four of Wall Street's top economists to study the issue.

William Dudley, managing director and director of U.S. economic research at Goldman Sachs; Richard Berner, chief U.S. economist at Morgan Stanley; Will Brown, managing director and chief economist at J.P. Morgan; and J. Perry Johnson, chief operating officer at Invesco Global Strategies, were each asked to do independent studies on the effects of reallocating some portion of Social Security into the stock market over time. Their conclusions were presented in a single report.

"One of the key findings was that while reinvestment of Social Security into the U.S. stock market will help save Social Security , it won't help by the degree to which many of the currently available studies indicate," says Britt Harris, president of GTE Investment Management Corp. and chairman of CEIBA's investment subcommittee.

The executive summary of the CEIBA report concludes that "equity investment is not sufficient to prevent insolvency-nor is it the most important factor in determining the status of trust fund finances."

Part of the problem, according to Harris, is that most currently available studies and government estimates on this subject use assumptions about stock market returns that are just too high. They typically use an equity risk premium-the return on equities over government bonds-of 6% to 7% to figure market returns over the next 20 to 30 years since that's the rate that equities earned over government bonds in the past. But few predict the trend will continue.

"Each one of the economists disagreed, saying the future equity risk premium will be half to one-third what it has been historically," explains Harris. The CIEBA sponsored analysis indicates that a risk premium of between 1% and 3% is likely. "Since the higher rate has been the rate used in a lot of studies, the degree to which investment in stocks will solve the Social Security problem has probably been exaggerated."

The reason? Just as Social Security's future is apparently threatened by demographics, so are stock market returns, according to the Wall Street economists. As the baby boomers have moved into their 40s, their collectively large investments into the stock market have pushed up the equity risk premium. "They've increased the aggregate of equity allocation of all investors," explains Invesco's Johnson, author of one of the studies, "and returns on equities have been above average." That trend should continue until around 2006, he adds.

The baby boomer conundrum
But when these same baby boomers begin to retire, and take their money out of the stock market, returns should start to decline. "In essence, we've had a very positive tail wind for our financial markets and the economy for the 20 years leading up to 2006," says Johnson. "And, we are going to have a head wind from around 2006 and beyond as a substantial portion of the population retires and draws money out of the equity market."

The Wall Street economists also predicted a modest rise in interest rates, 20 to 30 bps, by shifting the money into the equity market, and a risk that the equity markets will under perform Treasury bonds over the next 20 or 30 years. The group concluded that equity investing under most scenarios would delay the technical insolvency of Social Security by between four and fourteen years, but that a 20% to 30% correction in the U.S. stock market over the next five years would accelerate insolvency by a year or two.

As the CIEBA sponsored report suggests, the entire analysis of Social Security's impending doom, and the ability of the stock market to save it, is based on certain assumptions on both stock market returns and economic growth. It's not just the high stock market returns that are suspect, however, but Social Security's own predictions of insolvency by 2034.

The Social Security program provides benefits today for more than 45 million people, or nearly one in every six Americans. In 1998 alone, nearly $265 billion was paid out. Benefits are funded through payroll taxes, which currently bring in more than is needed. In fact, the entire surplus being battled over in Congress right now consists of about $70 to $75 billion in excess Social Security payments. All excess revenue is invested in U.S. Treasury bonds and the interest received is deposited in the Social Security trust fund, to be used for future benefit payouts.

Despite today's healthy surplus, the Social Security trustees have warned there may be a potential shortfall in benefits as the babyboomers retire. The first baby boomers will turn 62 in 2007 and over the next 20 years after that roughly 36% of the U.S. population will retire. According to the 1999 Social Security Administration Trustees' Report, annual income from payroll taxes and interest should outstrip the amount needed for benefits until around 2013, when it will be necessary to begin drawing on reserves in the trust fund. But by 2034, the report estimates the fund will be broke, adding that a simple increase in payroll taxes of 2.7 percentage points at that time would ward off any further Social Security insolvency for the next 75 years.

Social security privatization critic Langer argues that analysis is incorrect, saying that the actuarial variables used by the Social Security Administration to project future economic growth, such as gross domestic product, mortality, disability and productivity rates, have become increasingly conservative. "The more conservative they make these assumptions, the more costly the Social Security program looks and the less promising it looks financially," says Langer. So far, these assumptions have understated economic growth. For the past 75 years, GDP growth has been 3.2% on average, while Social Security's trustees, who include the Treasury Secretary, assume a GDP growth rate of 1.5% over the next 75 years. Such a bleak future would, of course, hasten Social Security's demise.

Using these projections, privatization's most resolute Wall Street proponents have scared the public into believing that insolvency is around the corner, according to Langer. "What they did was try to blacken the eye of Social Security first because it was considered the third rail and you couldn't touch it. They did that by saying it's going bankrupt," he says. "You have a very sophisticated assault going on against Social Security paid for by groups including the Concord Coalition, which was created by the Blackstone Group's Pete Peterson, and State Street Bank & Trust's Marshall Carter and William Shipman." All three declined to be interviewed.

Langer still argues that the chief beneficiary of Social Security's privatization will be Wall Street. "Because there are very big dollars involved for Wall Street the public has been led to believe that there is a problem with Social Security and that it must be modified, " he says. "I would liken what is going on to a very sophisticated Ponzi scheme. Except what Ponzi did was criminal and the way Wall Street is doing it is within the law."

He uses the Ponzi analogy because he believes the public has been led to believe that if Social Security monies are invested in the stock market, the returns will be higher than today's benefits. Those analyses use a high risk premium to get there. For example, the Archer/Shaw proposal is able to avoid cutting benefits by using a 4.5% risk premium, which all the Wall Street economists involved in the CIEBA study think is too high. Ironically, however, the proponents of privatization call the current system a Ponzi scheme, arguing that today's young workers are putting money in and will get nothing at the end.

Ultimately, even Wall Street's best and brightest have not been able to agree about the effects and effectiveness of privatizing some portion of Social Security. The debate is sure to continue. As Morgan Stanley's Richard Berner puts it, "Unfortunately, this is not like physics."

Table 1
Wall Street's Largesse Political contributions from the securities industry (January 1, 1989 to November 23, 1998)*

(as of 9/30)
Democrats Republicans Total Soft & PAC Money
MSDW $1,319,686 $1,641,205 $2,960,891
Goldman Sachs $1,810,107 $1,020,924 $2,831,031
Merrill Lynch $640,750 $2,138,921 2,779,671
J.P. Morgan $1,119,075 $1,297,460 $2,416,535
Salomon SB $1,023,706 $1,134,279 $2,157,985
Bond Mkt Assoc. $825,454 $946,386 $1,771,840
Investment Co. Institute $891,072 $809,320 $1,700,392
Paine Webber $561,390 $955,111 $1,516,501
Lazard Freres $1,093,750 $295,600 $1,341,309
CSFB $574,825 $766,484 $1,341,309
Bear Stearns $604,047 $646,263 $1,250,310
Securities Industry Assoc. $517,301 $497,267 $1,014,568
*Total includes contributions from subsidiaries and executives Source-Common Cause, Washington, D.C.

Supporting the Privatizers
Wall Street contributions to Congressmen who oversee Social Security
(January 1, 1989 to December 31, 1998)

House of Representatives Contribution
Bill Archer (R., Texas)*
Chairman, House Ways & Means Committee
Charles Rangel (D., N.Y.)**
Member, House Ways & Means Committee
Clay Shaw (R., Fla.)*
Member, House Ways & Means Committee
Chairman, House Subcommittee on Social Security
Charles Stenholm (D., Texas)*
Member, House Agriculture Committee
Jim Kolbe (R., Ariz.)*
Member, House Appropriations Committee

Senate Contribution
Max Baucus (D., Mont.)**
Member, Senate Finance Committee
John Breaux (D., La.)*
Member, Senate Finance Committee
Member, Senate Subcommittee on Social Security &
Family Policy
Phil Gramm (R., Texas)**
Member, Senate Finance Committee
John Gregg (R., N.H.)*
Member, Senate Appropriations Committee
Member, Senate Budget Committee
Member, Senate Government Affairs Committee
Daniel Patrick Moynihan (D., N.Y.)* **
Member, Senate Finance Committee
*Sponsor of partial privatization of Social Security legislation
**As of November 23, 1999 Source: Common Cause, Washington D.C.