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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
The SEC Perspective on Investing Social Security
In the Stock Market

Remarks by

Chairman Arthur Levitt

U.S. Securities and Exchange Commission

At the John F. Kennedy School of Government Forum, Harvard University

October 19, 1998

Thank you for that generous welcome. I want to express my thanks to Dean Joe Nye and Graham Allison and to everyone at the Forum for making my day here at Harvard so enjoyable.

For anyone who works at the SEC, coming to Harvard is very much a pilgrimage. It is no exaggeration to say that Harvard University produced the founding fathers of the laws that regulate America's capital markets. Early in 1933, President Roosevelt asked Felix Frankfurter, then a professor at the Law School, to come to Washington and write the nation's new securities legislation.

Frankfurter brought three of his Harvard associates: John Landis, Thomas Corcoran and Ben Cohen. By the end of 1933, each would become a national celebrity and a symbol of the New Deal.

Drafting this historic legislation was, by no means, an easy task for Felix's "Happy Hot Dogs," as they were called. The competing forces of Capitol Hill, the Courts, and of course, those within the industry tested the group's intellect and patience. But they kept their focus on two important goals: to increase both investor protection and investor confidence.

It's fair to say that they succeeded. Today, America's capital markets are the envy of the world. Their resiliency, transparency and efficiency stand second to none. A culture of nondisclosure has been replaced by full-disclosure; reckless self-interest has been tempered by the public interest.

Today, I want to talk to you about the SEC perspective on investing Social Security in the stock market.

Few dispute that Social Security reform is necessary. Social Security benefits are projected to exceed revenue from payroll taxes within 15 years. By 2032, the Social Security Trust Fund is expected to be depleted. Three basic options exist to close this gap between benefits and revenue, and thereby, extend the life of the Trust Fund: reduce benefits, increase revenue, or raise the expected rate of return for contributions through investment in the stock market and other private-sector securities.

Not surprisingly, almost every reform proposal involves some type of market investment. For the most part, these proposals draw upon two basic ideas: (1) having the government invest the Social Security Trust Fund in the stock market; and (2) allowing individuals to invest a certain percentage of payroll contributions in an individual private account.

I am not here today to support any particular proposal or plan to invest Social Security in the stock market. Nor do I assume that some sort of private-sector investment is inevitable. But it is being seriously considered. Earlier this year, the President called for a national discussion on Social Security. And, I believe this is the right time for the SEC to outline areas that have direct relevance to our responsibility, our experience and our expertise.

The SEC's mission is to protect investors. And the potential for investing Social Security in equities raises important issues that go to the very heart of investor protection. This mission – above all – will guide the SEC's thinking as the discussion moves forward.

What we are talking about today is nothing less than a watershed event in how Americans think about retirement security. That security has traditionally been built upon three pillars: Social Security, private pensions and personal savings – each with varying risks and returns.

We have an obligation to think long and hard about the implications of Social Security reform. Investing Social Security in the stock market – by its very nature – involves heightened obligations, difficult questions and new challenges.

Increased risk, through greater choice, holds the potential for greater returns. But uninformed investors often won't be in a position to capture that potential. They risk making poor investment decisions – perhaps even because they fell prey to fraudulent advice or misleading sales practices.

Regulators will need to commit greater resources to combat a potential increase in fraud. They also will need to work to ensure that costs to investors are effectively disclosed. The intersection between corporate governance and government influence may become more complex.

Investor Protection

Let me first talk more specifically about investor protection within the context of privatization. As far as I'm concerned, our nation faces few higher economic priorities than maintaining the integrity of our markets. Without it, that fragile cornerstone of our markets – investor confidence – crumbles under the weight of uncertainty and doubt.

But a great influx of new investors can sometimes test that integrity by providing more opportunities for fraud. That's something we must consider in the context of the Social Security debate.

Some proposals here in the U.S. would have the government administer individual Social Security accounts with limited investment choices. Others would have accounts held with private firms – providing an individual a much broader range of options. But it is likely that giving people the ability to select investment options will provide the unscrupulous with new opportunities to deceive and distort.

If we are to have self-directed individual accounts, we must be ready to undertake an unprecedented level of broad-scale policing of the equity markets. Without such policies, fraud and sales practice abuses may be perpetrated against an army of novice investors. And many of those novice investors are our society's most vulnerable citizens.

One need only look at England's experience with Social Security reform. In 1988, the U.K. allowed individuals to opt out of their national public pension system and into private accounts. In what has become known as the "mis-selling" controversy, high-pressure sales tactics were used to persuade people to switch into unsuitable personal pension schemes.

Sales agents often sought too little information from potential clients – many of whom were teachers, miners and nurses – to be able to give them proper guidance. In too many instances, they gave investors wrong and biased advice. These abusive sales practices, coupled with inadequate regulation, led to billions of dollars in losses for investors.

We all need to consider what steps to take to promote sales practices that benefit everybody's interests, while preventing those practices that hurt investor's interests. Let's take advertising, for instance. I have frequently criticized the focus on performance in mutual fund advertising. I worry that the fund industry is building unrealistic expectations through performance hype. While I am encouraged by progress in this area, it would be unfortunate to see a similar cottage industry created under a system of individual Social Security accounts.

We simply cannot afford to instill in millions of new investors a culture of seeking short-term gain at the expense of long-term solid results. That is not what Social Security is about.

Investor Education

Today, more and more of us are taking responsibility for our own retirement needs. The Internet and other developments in technology have put a wealth of information at the fingertips of investors. In many respects, an era of institutional reliance is ending; an era of self-reliance has begun.

Back when most of us saved at a bank, bought whole life insurance, or had a defined benefit plan, the responsibility for investment decisions was in someone else's hands. But that's no longer true. By entering the less certain world of our capital markets, more than 50 million American investors have assumed higher risk in the hope of higher reward. Now, they must also assume greater personal responsibility.

There is an unacceptably wide gap between financial knowledge and financial responsibilities. Closing this "knowledge gap" is among the most important problems we face today. It becomes even more of an imperative if Social Security is privatized.

I believe there is one word that every person in America has to understand: and that is risk. Risk is an indispensable part of our capital markets. Markets go up and markets go down. Certainly, the last few months have reinforced this point. But, at least based on historical performance, investing over the long-term is relatively smart and safe.

Investors need to understand the relationship between risk and return and the benefits of a diversified portfolio. This is a critical element of making suitable and sound investments at the right time in their lives.

Simply put, managing risk has to be a key part of any plan to publicly invest Social Security. And understanding risk has to be a key part of an investor's education.

There is another word every investor in America needs to understand: cost. Investing in our markets costs money. Executing transactions, sending account statements, even switching investment managers entail expenses that are paid by the investor. And, fees matter to an investor's bottom line. A one percent annual fee will reduce an ending account balance by 17 percent after 20 years.

The SEC has worked with the mutual fund industry to help ensure that these administrative costs are properly and effectively disclosed to investors. But we have a lot of work yet to do. Our research shows that only eight percent of investors say they completely understand the expenses that their funds charge.

Now, consider a system of 140 million individual accounts – one for every American worker. Some plans would put 2 percent of the payroll tax into an individual account. But for the roughly 40 million workers who earn less than $8,500 a year, that equals $170 or less per year. This is not a lot of money from which to build up a portfolio. And, administrative costs may quickly eat into any higher return from individual accounts for lower-income workers.

These issues merit a thorough and detailed questioning: should fees be a flat amount per year, regardless of the size of the account, or a percentage of the account's balance? Would private firms even find it profitable to offer accounts to a great number of workers? Would private firms be forced to open accounts for any interested worker?

I bet that right now many of you are thinking the same thing: if I wanted to hear a bunch of questions – instead of answers – I would have gone to class. Unfortunately, I have found that there are few quick and easy answers to these issues.

But we can look at other countries' experiences for guidance. In Chile – considered the grandfather of Social Security privatization – one study found that fees shaved off almost one-third of the annual return in the first ten years of the system. One-third of these fees came from marketing and sales costs. This is not surprising since another report found that there were more than 20,000 selling agents going from house to house selling funds. Consequently, three out of ten Chilean investors switch fund companies every year.

Administrative costs are also tied to the range of investment options available to investors. For example, some have proposed individual accounts administered by the government that closely resemble the Thrift Savings Plan for Federal employees. Investment choices would be limited to broad market indexes – reducing administrative costs. A privately managed system, on the other hand, could offer individuals a greater range of financial choices – but with higher administrative costs. Thus, there will likely be a trade-off between greater choice and lower fees.

But today, there is a trade-off between ignorance and opportunity. Unfortunately, over half of all Americans do not know the difference between a stock and a bond; only 12 percent know the difference between a load and no-load mutual fund; and only 16 percent say they have a clear understanding of what the Individual Retirement Account is.

This is even more troubling when you consider the new complexities raised by Social Security reform. For example, the current Social Security system provides an inflation-indexed benefit no matter how long you live after retirement. In an individual account system, investors need to recognize that they risk outliving their savings or seeing them eroded by inflation. That's why some proposals would force new retirees to exchange their lump sum savings for an annuity that provides a guaranteed payment over a retiree's life.

These potential investors will have important decisions to make and they need the tools to make them. The government can have all of the resources and power in the world to protect investors. But, such power is useless if investors don't know the basics of saving and investing. No matter how perfect the plan to reform Social Security, it won't be as nearly effective as it could be if investors don't understand their options.

However Social Security is reformed, we know we can lose no time in increasing investor education. How do we do it?

The SEC and a national coalition of government agencies, business groups, and consumer organizations have launched the Facts on Saving and Investing Campaign – to begin to encourage Americans to get the facts they need to save and invest wisely and avoid costly mistakes.

The sad fact is that most Americans have no idea how much money they need to save for retirement. Fifty-five percent have never even tried to figure it out. Let's help them.

I want Americans to hear more about the importance of savings. For example, companies should take a greater role in teaching their workers about saving. It's in the interest of both companies and workers.

Government Influence and the Private Sector

In addition to investor protection and investor education, another aspect of Social Security reform includes the impact of government investment in capital markets.

Those who favor having the government invest the Trust Fund in the stock market point out two major benefits. First, it allows market risk to be spread across society and even across generations. Second, given the economies of scale that the Trust Fund could achieve administrative costs would be significantly lower than for individual accounts.

But, I know some, including Chairman Greenspan, have raised strong objections to the government owning stock in public companies. They point out that this could lead to political interference in deciding which companies to invest in and how those companies are run. Could the government invest in a tobacco company? What about a company that was a toxic polluter a decade ago? More broadly, assuming the government invests in individual equities as opposed to market indexes, would it be able to vote its shares? If so, how?

Canada may offer some lessons here. They have recently created an independent Investment Board to invest their Social Security Trust Fund in private-sector securities. While they won't begin to invest the Trust Fund until early next year, their deliberations and experience will, no doubt, prove informative.

Lastly, while investing the Trust Fund may minimize risk to individual investors, it may have large-scale market effects. While impossible to predict, I think we should consider a number of potential issues.

Would the government have an ever greater incentive to control market fluctuations, if not the market itself? How will the possible increased demand for equities affect the level of corporate investment and its distribution across sectors of the economy? And how will it affect rates of return on different assets?

Again, after hearing all of these questions, some of you may be reminded of this line: "Question everything. Learn something. Answer nothing." I would agree with the first two, but this debate doesn't allow us the luxury of the third.


In the last 70 years, America has experienced two striking trends: the dramatic reduction in the poverty rate among elderly Americans and the remarkable growth in our capital markets. These developments – in no small way – owe their existence to the Social Security Act of 1935 and the securities legislation of 1933 and 1934.

Today, our nation confronts an historic choice: should we meld the protection of Social Security and the vibrancy of our markets? And, I can't help but marvel that this evening, I come to Harvard to speak about this very issue. If the founding fathers of the SEC still inhabit the courtyards and the buildings of Harvard, I hope they are taking note.

Without their passion to put investor interests first, our markets would not be as fundamentally strong and fair as they are. And, I doubt whether anyone would seriously consider investing one of America's most popular and successful anti-poverty programs into the market if that weren't the case.

As the SEC begins to examine different Social Security reform options, our commitment to investor protection will be paramount. And, we will bring that focus to the table as the discussion proceeds whether at the White House Conference in December or in any other venues. I have also asked Commissioner Paul Carey to begin an effort to harness the Commission's resources so we can effectively advise lawmakers.

Whatever the eventual outcome, the SEC will continue to aggressively combat fraud, promote investor education, and diligently work to ensure that our markets remain the most resilient, innovative and transparent in the world.

Thank you.