SEC Speech: Social Security Privatization (P. Carey)
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Speech by SEC Commissioner:
Social Security Privatization

by Commissioner Paul R. Carey

U.S. Securities & Exchange Commission

Women in Housing and Finance
Washington, D.C.

January 31, 2001

Thank you, Casey, for the kind introduction. I would like to speak today about Social Security reform: an issue of considerable interest to everyone. To that end, I should note that these are my views and not the views of the Commission.

For some time now, policy makers have been considering how best to reform social security. In light of historical rates of return on stock investments, some have considered investing some or all of the social security trust fund into the market. Others have put forth different proposals. Let me note at the outset that the SEC neither endorses nor opposes any particular Social Security reform proposal. Given that the SEC's mandate is to protect the interests of investors, we are, however, concerned about investor protection.

While Social Security reform has not been a traditional area of expertise for the Commission, many of the issues that arise --such as investor education, financial literacy, corporate governance, disclosure of material information, including administrative costs, and sales practices -- have long been a concern for us.

While the reform proposals cover a wide range of topics, many of them have involved some type of market investment. I will use what I think of as the two benchmarks of the reform debate to illustrate the types of investor protection issues that we are concerned with.

On one end of the spectrum are plans where some of an individual's payroll contributions would be invested in an individual private account. On the other end of the spectrum are plans where the government would invest some or all of the Social Security trust fund into the market. Regardless of which path reform takes, policy makers will need to make decisions about how to resolve basic investor protection issues.

Individual Accounts

First, I would like to discuss the types of issues that should be considered in the event that Congress adopts a reform plan that includes individual accounts. Clearly, investor education should be a key component of any individual account program. An individual account system could involve the creation of some 140 million individual accounts -- one for each American worker. While many of these workers already invest in the market -- indeed, recent statistics show that close to half of all American households now own mutual funds -- many would be new investors. To maximize the success of this type of program, we need to ensure that all investors understand the relationship between risk and return. Investors must understand the rationalebehind diversified portfolio strategies. In addition, investors need to understand that years to retirement is an essential factor in determining the appropriate level of risk.

Investors should also understand that the administrative costs of investing in the market will diminish returns. Jack Bogle, the founder of Vanguard, has called this concept the tyranny of compounding high costs. Now for those of you who think "tyranny" is too strong a word, consider Jack's favorite illustration of what fees can do to your investment over time. A $1,000 mutual fund investment made in 1950 with returns mirroring the S&P 500 would be worth over half a million dollars today. But, after you figure in the compounding costs of mutual funds, conservatively a little under 2 percent, that figure is reduced to just $230,000. In fact, even a modest sounding one percent administrative fee will reduce an ending account balance by 17 percent over a 20-year period.

At the SEC, we have been working with the mutual fund industry to ensure that fees are adequately disclosed to investors. As part of the recently released mutual fund fee study, the staff recommended that the Commission adopt rules requiring disclosure in a table of the actual amount of fees paid based on a hypothetical investment amount. And, if funds aren't tax efficient, investors can lose as well. Recently, the Commission issued a final rule requiring that mutual funds disclose after-tax returns. While tax efficiency may not be an issue for funds held in retirement accounts, it is an issue for those using funds to save for retirement. While we've taken steps to improve fee disclosure, we have much investor education work left to do. Recent surveys indicate that approximately eight percent of investors fully understand the fees that funds charge. Under any system of individual accounts, however, account expenses should be clearly disclosed. Investors must be able to understand the disclosure, so that they can easily compare expenses between investment options. They also need to recognize that switching investments may entail additional expense, thereby diminishing returns.

If lawmakers were to consider putting social security money into the market, other issues deserve careful consideration. Policy makers need to decide who should be managing workers' money. For example, policy makers should consider whether the management of individual accounts should be open to all broker-dealers and investment advisers, or whether criteria should be developed to determine who could manage individual accounts. Another consideration is whether limiting the pool of eligible money managers would decrease the possibility of sales practice abuses.

Similarly, policy makers will need to decide what investment choices will be permitted. On the one hand, an unlimited numberof investment choices, ranging from individual stocks, options, bonds and private placements to mutual funds could be permitted. Or, perhaps it would make more sense from an administrative and investor protection standpoint for the government to designate a finite number of choices as it does in the Federal Thrift Savings Plan. If a TSP plan approach is preferable, should the finite number of choices be limited to investments like index and money market funds?

We should also carefully consider issues like how fees should be structured and how often investors should be permitted to switch investments. Should front-end loads be permitted, or would an annual flat fee be a better option? It is important to consider whether a fee structure might unintentionally reward money managers who convince workers to make frequent investment switches.

Should switches be permitted at any time during the year or perhaps only quarterly or annually? Decreasing the number of times investment switches would be permitted may curb excessive switching, but it would also limit investors' flexibility. An appropriate balance should be struck between permitting flexibility, but discouraging excessive switching. Similarly, permitting greater flexibility could have the unintended effect of encouraging investors to try to take advantage of short-term market fluctuations rather than managing their account with a view to the longer term.

Small accounts present a unique set of issues. Many plans propose diverting two percent of a worker's salary to an individual account. There are roughly 40 million workers earning less than $7,500 a year in this country. Under the two percent plans, each of these workers would annually contribute $150 or less to an individual account. There are roughly 75 million workers earning less than $20,000 a year. Under a two percent plan, these workers would contribute $400 a year or less to an individual account. For smaller accounts, we must remember that there will be a break-even point. We should be mindful that below some threshold account size, administrative fees will outpace investment returns. Policy makers need to consider whether an individual account of this size makes economic sense for both the worker and the money manager? Or, would it make more sense for these workers to invest in a program like the Thrift Savings Plan until their accounts increase in value?

Government Investment of the Trust Fund

Let's now turn to some of the issues that should be analyzed in any plan considering government investment of some portion of the trust fund into the market. Proponents of this approach point out that administrative costs would be lower, and market risk would be spread more broadly, than under a system ofindividual accounts. This approach, however, has drawn its fair share of criticism.

Many wonder who would decide what to buy, and whether there would be political pressure on the government to invest only in companies that produce socially responsible products. Also, critics have asked how the government's shares would be voted.

Some plans envision the government retaining an investment adviser to serve as portfolio manager for the portion of the trust fund assets to be invested in the market. With respect to voting, several arrangements come to mind. The portfolio manager, like portfolio managers of mutual funds, could vote the shares held by the trust fund consistent with its fiduciary duties.

Or, in other words, the portfolio manager could vote the shares in a manner that is in the best interest of its shareholders, without any interference in the process by the government. Other voting arrangements are also possible, such as mirror voting.

With respect to investment choices, some of the concerns raised may be lessened if the trust fund assets were invested in accordance with an already existing index. Or, investment choices could be made pursuant to pre-established investment criteria. Of course, the selection of the portfolio manager and the creation of the investment criteria raise other issues about how these things would be accomplished.

Critics have also raised other important issues. Some worry that government investment of the trust fund assets could provide an incentive for the government to try to control market fluctuations. If the fund invests in individual securities as opposed to an index, should the investments be diversified? Would sufficient quality investments be available given the large amount of money to be invested? We also need to consider whether the massive influx of capital into the market could affect other market activities, like capital formation or the rate of return on investment.


These are challenging and compelling issues for which there are no easy answers. But, we continue to believe that solutions should be guided by the two tenets of investor protection and investor education. While policy makers wrestle with the difficult policy issues and weigh the competing interests, we look forward to contributing to the debate by helping to frame the pertinent investor protection issues and by proposing workable solutions. Regardless of which path the reform takes, we remain committed to our mandate to protect investors.