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MR. MATTHEWS: The subtitle of this briefing is, Is the Stock Market the Answer? And so, we've got somebody here now who is going to talk about that.
An expert in this, William Shipman is Principal of State Street Global Advisors, and he is co-chairman of CATO's project for Social Security Privatization. Mr. Shipman has been very active in Social Security reform, testifying before Congress, providing insight to the House Ways and Means Committee, Joint Economic Committee, United Nations on various issues having to deal with policy. He is also the author of the recent book, I think it just came out last year, did it not, "Promises to Keep, Saving Social Security's Dream." And he has co-authored that with another person from the State Street Bank. He is here to talk to us about how the stock market would work and how those issues are going to be resolved. Join me in welcoming Bill Shipman.
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Mr. William Shipman
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Thank you very much. Before I get directly into the stock market let me challenge you to be sensitive to two issues on this debate. One is that the Social Security problem that we face is not peculiar to the United States. Almost every country in the world of any economic size has a social security system. The first one started was Germany in 1889 under Otto von Bismarck, and the last one was the United States, 1935, under President Roosevelt. They are all structured basically the same way. And for the reason that you have already heard, they are all beginning to fall apart because of demographics as well as other issues.
Now as this type of a system falls apart, there are sociological ramifications. In December of '95 I was speaking in Brussels on this issue. At that time Prime Minister Juppe of France mentioned that they would not be able to pay all of the social security benefits that people thought they would receive, and there was civil unrest in France and rioting on the Champs Elysses. I thought that I was fortunate being in Brussels instead of in Paris, but four months later I was in Brussels speaking again on the issue, and my wife was unable to get into one of the museums because it was surrounded, as were other buildings, with barbed wire, because the government in Belgium said that it would not be able to pay all of the social security benefits as stipulated by law.
In Germany, today, roughly 95 percent of retirees' income, gross income is from the social security system. These individuals are extraordinarily vulnerable to any misstep in the system, and their taxes are very high. For all the OECD countries the unfunded liability in their social security systems is greater than the explicit debt of each and every country. In the case of Italy, which is the worst, it is 250 percent of GDP.
So as you hear the debate in this room and as you read and hear the debate around the country in the future, you are not hearing a debate that is idiosyncratic to the United States. You are listening to a dialogue that is affecting people all over the world, and it is extraordinarily important that we solve the problem.
Second is -- the second challenge is very often when this is discussed, people talk about fixing Social Security and when is the crisis, they talk about negative cash flows in 2012, or perhaps 2029 if you include the trust fund and all of these things. I would suggest put that aside and think of it as a bigger issue and have three principles in mind as you think through the problem. In fact, think of the principles as what we're trying to achieve.
The first principle is that in a civil society the elderly are able to retire with financial security and dignity. And the second principle is that the younger workers in society are able to keep the fruits of their labor. And the third is that in achieving both of those principles the economy is not unreasonably or unnecessarily burdened.
So when you hear proposed changes to Social Security, take those changes through those principles, and see if in fact those three principles are met. You'll find very often trying to alter Social Security and have a negative cash flow be sometime in the future as opposed to the present, you tend to violate all three principles. And so, in the work that we have done we have tried to look at the issue from the point of view of meeting all three principles simultaneously not only for this country, but for other countries as well.
Now the Congressmen were talking about the third rail of politics, and as you well know, maybe a year and a half ago, maybe nine months ago in our country this was the third rail of politics. It is interesting to note, and this was brought up earlier as well, the election in the UK is May 1st. Both Labour's Blair and Conservative's Major start debates on issues, perhaps because they really care, but of course what they really do care about is being elected, and both of them have brought up the issue of privatizing their social security system, and I suggest certainly in that country it is no longer the third rail of politics. And if you watch what's happened here already, it is very far from the third rail of politics.
I would suggest probably in a year, maybe in a year and a half, the third rail of politics in the United States would be for the Congressman that has no answer to the problem. And the statesmen and the people that are visionaries on the issue are moving towards reasoned solutions to the problem that exists.
As the debate has moved, one of the things that almost everybody agrees to is that within the solution we have to have some kind of investing. That is to say that we move from a model which is a tax consumption model to one which is a save and investment model. Now there are all sorts of disagreements as to who does the investing, what you invest in, who controls it, how much you save and on, and on, and on. And in the Advisory Council where there are three diff>
So what has happened in this as the debate has moved, markets have become central to the debate. And it is not unreasonable when markets, or when anything as important as Social Security is now discussed and debated, it is not unreasonable for people to be concerned about something about which they know very little perhaps, in this particular case, markets.
As I speak on the issue I come across many objections to the use of markets. Some of them not expressed very often, and I have come up with about eight or so that are expressed frequently, whether I speak about this on the West Coast, or the East Coast, or whether it be from older folks, or from younger folks.
So what we're doing is writing a paper on this. My associate, Melissa Heger and I, we're co-authoring a paper which should be out, I hope in the second quarter of next year. But let me share with you some of the objections that we're hearing, and then give you some of the responses that we're working on so that it can help you when you debate and discuss this, or when you hear reasons why markets wouldn't work.
They come in all sorts of shapes and sizes as to the problems with markets. They include such things that the markets would not be able to handle this huge amount of money. This argument basically is if we were to privatize the system and all this money going into markets during the time that we are saving -- the boomers are saving for their retirement, all this money goes in, and you have this speculative bubble, market prices go through the roof, and then when the boomers retire and withdraw their funds, you have markets go down the chute. That's the concern. Is it valid?
It's certainly valid to voice a concern but is there reason to believe that that kind of volatility would take place because of changing the Social Security system to a savings and investment model.
If you take the full OASI tax, I'm not talking about disability insurance or hospital insurance, the full OASI tax and assume that that is what is invested, and nobody is making that assumption -- Carol is not making it, I'm not making it in the book that we wrote, "Promises to Keep," so I'm taking a stress test if you will -- the total OASI tax which today in 1997, I think is $341 billion. If you assume that that is now invested in the stock market in 1997, that is to say we privatize this year, and you put some constraints as to where it goes -- it can only be invested in the United States. By the way, I'm not arguing for these constraints, I'm just sharing with you a path. All must be invested in the United States. Number two, all the investments must be in equities. Number three, all of those equities must be traded on the New York Stock Exchange.
If that were to happen and nobody is arguing that it should, but if it were to happen it equates to 24 minutes of trading volume a day on the New York Stock Exchange, which happens to be open from 9:30 in the morning until 4:00 in the afternoon.
Now if you make more reasonable assumptions, and that is that the investments would be diversified across stocks and bonds as well as across borders, that is to say that you would invest in US securities as well as securities offshore, in the developed world, the lesser developed world and so on, then you get down to in terms of trading volume per day, or minutes per day, you get down to probably about 10 to 15 minutes a day. And what happens is that every single year it becomes less. There's a technical reason for this but the reality is that the stock market increases more rapidly than the payroll tax and therefore the minutes per day become less.
In about 10 years I would estimate we're talking maybe five minutes of trading volume a day. It is a nit. It is roughly irrelevant.
Another one that comes up -- even if this were not a problem, of course you'd have these enormous administrative expenses and the administrative expenses would take away from the returns, and therefore we certainly cannot have a privatized system.
Well whatever the administrative expenses are, depends upon how you structure the deal, and let me give you a structure. By the way, it's a very expensive structure, but let me share it with you.
We will assume that all of the savings must go into mutual funds. Mutual funds as a pooled investment vehicle are expensive relative to other pools, such as common trust funds and other funds. So we're going to take a high cost. And then, we're going to assume that you invest in US equities, both large companies and small companies, that would be about 3,100 different securities; that you invest in foreign equities in the EFA markets, these are the 20 large economies outside the United States.
We assume further that you invest in a bond fund, a US bond fund and you also invest in a foreign bond fund, and you invest in cash. So now you have a diversified portfolio, stocks, bonds, cash and you're diversified across borders. All of the major economies in the world.
There is a term called the expense ratio and that is what the mutual funds charge to the fund for all of the costs. These costs are investment management fees, custody fees, legal and accounting fees, all the costs associated with the business of managing the fund. If you were to take an aggressive portfolio -- maybe a lot of you in the audience would want this, maybe 70 percent in stocks and 30 percent in bonds and cash, the expense ratio if you look at funds that are available today in the marketplace, the expense ratio would be 37 basis points. What that means is this, you would pay 37 one-hundredths of one percentage point as your cost. That's all.
Now as you move to less aggressive funds and you go from stocks more to cash, the costs go up and they basically stop at 45 basis points. Forty-five one-hundredths of one percentage point. That is the price that clears the market today.
Now there would, perhaps, be some other costs. Wire transfers from your employer to send your money to the fund of your choice and so on and so forth. So what I have done -- and by the way these costs in the industry tend to be a fraction of the expense ratio. I have assumed they are multiple. Be conservative. So I have assumed in a privatized system that the total costs would be roughly 100 basis points or one percentage point per year. And when I give you some return data, which I am going to give to you in a moment, I'm assuming in this that the costs are one percentage point.
Now these costs, I think Social Security's expense ratio is 70 basis points. It's relatively efficient from that point of view, but the expenses per se are not the thing to focus on, because what you care about is your return netted expenses. Social Security is relatively efficient from the point of view of its costs, but the system -- it's not Social Security's fault -- the system, the pay as you go system is horrifically inefficient from the point of view of getting returns, because the return for a youngster entering the labor force today in Social Security is estimated to be roughly zero to negative per year, for each and every year for a 46-year working career, which I can tell you in the market is roughly impossible to pull off. In fact, if I could find somebody that could guarantee me that they could invest in the stock market and earn a return of zero every year I would hire them and I would do the opposite of what they suggest and you would make a lot of money.
The next issue has to do with are markets risky? The answer to the question is yes, they are. There is no question about it. That risk is expressed, I would say, as the probability that you would achieve enough wealth at retirement in order to have a secure stream of benefits when you retire. That's one risk. The other risk is the volatility of the market during the time period in which you invest. Those are basically the two risks.
It was brought out by the Governor about returns over a long period of time. From 1926 through 1996 the worst 46 year period, which is basically a working career now, the worst 46 year period -- by the way juxtapose this against Social Security which is roughly zero to negative per year -- the worst 46 year period was 7.2 percent.
Markets have risks. They are controllable. It's important to juxtapose the risk, not look at it in isolation, but juxtapose the risk to the pay as you go system and that risk has a different peril, which is the probability that while you're in the system that your taxes will go up or your benefits will be cut.
Now from 1950 through 1996 Social Security tax rates went up 17 different times. The wage base on which they were applied went up five different times. The total tax in 1950 was three percent of $3,000 of income. The maximum anybody paid in 1950 was $90. Today the tax rate, the total FICA tax rate is 15.3 percent of $65,400 of income. That tax has gone up in constant dollars or inflation adjusted dollars over 1,000 percent during that time period. Benefits have also gone up but less than 500 percent during the same time period.
So people are paying more in taxes relative to benefits that they receive in the Social Security system and that is a risk as well. You should, in my view, have the freedom of choice and the liberty to choose which risk you want. Choose a Social Security risk if you wish to have that, or choose the market risk if you choose to have that. I think in the case of Chile, in the first month, May of 1981, 25 percent of the labor force chose the market. Now it's roughly 93 percent of the labor force.
At any rate, even if people buy the argument that the market over the long run goes up, they say "Aha, but what happens when I cash in and the market plummets?" It's a reasonable question.
October 19, 1987 was the worst single day in the history of the US stock market. Depending upon the index that you use the market fell roughly 20 percent. The second worst day was in 1929, the market was off about 12 percent. So what Melissa and I have done is tried to figure out how much would the market have to fall for people born 1930 all the way through 1976 if they invested in a portfolio of stocks, and they incurred a 100 basis point or a one percentage point administrative expense.
Now keep in mind the worst day was down 20 percent. For these people, these are low income people making roughly $13,000 a year, on average for these individual born between 1930 and 1976 the market would have to fall, in order for them to get market benefits equal to Social Security benefits, the market would have to fall on that day 60 percent, three times the worst day in history. The probability of the event is not zero, it is the next number to zero.
Now you look at this from the point of view of low income workers or average income workers, or high income workers, and these numbers vary because the amount that you pay in becomes different relative to the amount that you get out.
One of the issues that comes up about we're all in this together -- in Belgium the term is solidarity -- is often I hear that if we go to a market based system, low income people would take it on the chin. Why? Because Social Security has in its benefit formula progressivity. There is no question that a low income worker's initial benefit is higher relative to taxes paid during his or her working career than is the benefit of a high income worker. That is not in dispute. There is some dispute whether the system itself is progressive or regressive, but in terms of the benefit, the initial benefit, it's not in dispute. So people will say these people will get hurt in a market based system.
Now if you take a low income worker today making -- I define low income as 50 percent of the national average wage, so that individual is making about $13,000 today -- when that person retires, based upon today's law --
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-- that's all you've got. Fifty dollars one way or the other means an awful lot to this person.
In a market based system, using conservative estimates, that individual would not receive $810, but about $1,700 a month. It makes no sense, in my view, from the point of view of economics, finance, or compassion, to keep this individual from having the freedom of choice to be able to save and invest for a dignified retirement just like wealthy people can. But the reason that the person can't is because at $13,000 a year of income, they pay off the top 15.3 percent in the FICA tax. In the OASI portion of that tax they receive virtually nothing. Above and beyond that they pay for food, shelter and clothing. As a practical matter, not as a matter of law, but as a matter of fact, they are precluded to have the opportunity to save and invest for their future in the same way that higher income people have that opportunity. It makes no sense to me. I personally think it's cruel that we have a system that does that to these folks.
Another, and this will be the last one I'll get into for the moment, is survivor's benefits. This is a good issue. After all, people do die young. What happens? And obviously, as I have argued, one of the reasons that you do well in a market based system is because you save, and you invest and it's compounding.
Well, if you take your Social Security data, 90 percent of survivors benefits are paid to aged widows and widowers. Now what does that mean? If you take -- by the way most of them are widows. What happens is you assume a widow that has no work history, married, the man has a work history who receives $1,000 a month because of his work history. She gets a spousal benefit of $500. He dies. What happens to her?
First of all his benefit goes to zero, her spousal benefit goes to zero, but she gets a survivor's benefit which is now $1,000. So her benefit doubles but what happens to the family? The family was receiving $1,500 a month. It now receives $1,000 in this case, which is the majority of all the cases, solely because of the fact of the way the system is structured and that the individual has died, loses right off the top one-third of its wealth.
In a market based system this spouse would lose nothing, nothing whatsoever.
Now there are other cases beyond the 10 percent -- I mean beyond the 90 percent where there are children, and in a very rare case it is not zero, but it's rare, there are children of parents -- let's say the father or the mother dies very early. They are out of luck in a market based system in terms of the amount of wealth that has been created. My suggestion, and it's a very small percent -- of the people as well as the dollars -- that they are held whole and that their benefits are paid out of general revenues which would be relatively minor. Certainly extremely minor in terms of our full budget as well as the Social Security expenses.
There are other parts to this and I will share them with you in more detail when the paper is published, but I want you to think about what I started with. The issue is global. It affects a lot of people way outside of this country, and a lot of them are much worse off than we are. And the second thing is, as you think through the issue analytically, remember the objective is not to save Social Security or to kill it, the objective is that the elderly are able to retire, the financial security and dignity, the younger folks in society are able to keep the fruits of their labor. And that by so doing and meeting both of those principles, we do not unreasonably or unnecessarily hurt the economy in the process.
Thank you very much.
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