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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Social Security Privatization

Remarks by

Paul R. Carey

Commissioner, U.S. Securities & Exchange Commission

Before the 11th Annual Conference of the National Academy of Social Insurance, Washington, D.C.

January 28, 1999

The views expressed herein are those of Commissioner Carey and do not necessarily represent those of the Commission, other Commissioners or the staff.

Thank you for the kind introduction and the invitation to speak to you today. Social Security reform is an issue of considerable interest to everyone, and I am pleased to be asked to share my views. To that end, I should note that these are my views and not the views of the Commission.

Last week, the President unveiled his plan to reform Social Security. Others have put forth different proposals, and the debate is clearly underway. I want to stress 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 expense information, and sales practices - - have long been a concern for us.

At Chairman Levitt's request, I am leading the Commission's efforts to provide advice to policy makers on how best to address the investor protection issues that arise under various reform proposals. I would like to speak today about some of the efforts that the Commission's staff is undertaking to better enable us to provide such advice. I will be raising many questions that we are working to answer, and that we think should be addressed in the reform effort. While the reform proposals thus far cover a wide range of topics, almost every reform proposal involves 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 we are analyzing 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 one out of every three households now owns 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 rationale behind diversified portfolio strategies. In addition, investors need to understand that years to retirement should be a factor in determining the appropriate level of risk.

Investors should also understand that the administrative costs of investing in the market will diminish returns. While a one percent administrative fee may sound modest at the time of investment, investors need to realize that this one percent 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. We have much investor education work left to do, however. 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 must 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.

Other issues deserve careful consideration. Policy makers need to decide who should be managing workers' money. For example, would the management of individual accounts be open to all broker-dealers and investment advisers? Or, should criteria be developed to determine who could manage individual accounts? Would limiting the pool of eligible money managers decrease the possibility of sales practice abuses?

Similarly, policy makers will need to decide what investment choices will be permitted. Should an unlimited number of investment choices, ranging from individual stocks, options, bonds and private placements to mutual funds, be permitted? Or, would it 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 the answer is yes, should the finite number of choices be limited to investments like index and money market funds?

We can learn much from the experiences of other countries who have embarked upon privatization. We can look to countries like Chile and Great Britain to learn about some of the benefits that a system of individual accounts can provide. But, we also need to educate our workers so that they do not fall prey to the "misselling" experience that occurred in Great Britain or the excessive switching problem occurring in Chile.

In hopes of avoiding the investor losses that resulted from the "misselling" and switching problems in these countries, 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 considerwhether 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 $8,500 a year in this country. Under the two percent plans, each of these workers would annually contribute $170 or less to an individual account. Would an individual account of this size make 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 we are analyzing in the event that Congress adopts a reform plan that includes 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 of individual accounts. However, this option has served as a lightning rod for criticism. Fed Chairman Alan Greenspan has expressed concerns that the investment decisions for the portion of the trust fund invested in the market might be influenced by political pressures. 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. For example, the portfolio manager could "mirror" the votes of the other shareholders. In simpler terms, the portfolio manager could cast votes in the same proportion as the votes cast by the other shareholders of the issuer. These and other types of voting arrangements are useful to explore and may serve to lessen the potential for misuse of voting powers.

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.

Still more issues deserve consideration. Should the trust fund be subject to protections similar to those of mutual funds, which are subject to regulation under the Investment Company Act of 1940? For example, mutual fund portfolio managers must comply with restrictions on their ability to enter into affiliated transactions with the funds they manage, and must comply with shareholder voting rights provisions. From an investor protection standpoint, we need to consider whether it makes sense for these types of provisions to apply to a trust fund portfolio manager. Similarly, we should think about what qualifications the portfolio manager should possess.


These are challenging and compelling issues. As we all know, there are no easy answers to these questions. But, we continue to believe that any solutions should be guided by the two tenets of investor protection and investor education. While Congress wrestles with the difficult policy issues, weighs the competing interests and strikes the appropriate balances, we are working to ensure that we are prepared to frame the pertinent investor protection issues and propose adequate solutions. We look forward to providing assistance in an appropriate fashion. And, regardless of which path the reform takes, we remain committed to our mandate to protect investors. William O. Douglas, the Supreme Court Justice and the Commission's second chairman, said it best when he said of the SEC, "we are the investor's advocate."