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29–725 PDF 2006

S. HRG. 109–554

THE ROLE OF THE FINANCIAL MARKETS

IN SOCIAL SECURITY REFORM

HEARING

BEFORE THE

SUBCOMMITTEE ON SECURITIES AND INVESTMENT

OF THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

ON

THE ROLE OF THE FINANCIAL MARKETS IN SOCIAL SECURITY REFORM,

FOCUSING ON THE FEDERAL THRIFT SAVINGS PLAN, PERSONAL RETIREMENT SAVINGS ACCOUNTS, AND RETIREMENT PLAN ADMINISTRATIVE COSTS

JUNE 14, 2005

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

Available at: http://www.access.gpo.gov/senate/senate05sh.html

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN E. SUNUNU, New Hampshire

ELIZABETH DOLE, North Carolina

MEL MARTINEZ, Florida

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

JUSTIN DALY, Counsel

DEAN V. SHAHINIAN, Democratic Counsel

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

SUBCOMMITTEE ON SECURITIES AND INVESTMENT

CHUCK HAGEL, Nebraska, Chairman

CHRISTOPHER J. DODD, Connecticut, Ranking Member

MICHAEL B. ENZI, Wyoming

JOHN E. SUNUNU, New Hampshire

MEL MARTINEZ, Florida

ROBERT F. BENNETT, Utah

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

ELIZABETH DOLE, North Carolina

WAYNE ALLARD, Colorado

RICK SANTORUM, Pennsylvania

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

THOMAS R. CARPER, Delaware

JOSEPH CWIKLINSKI, Legislative Assistant

ALEX STERNHELL, Democratic Staff Director

(II)

CONTENTS

TUESDAY, JULY 14, 2005

Page

Opening statement of Senator Hagel ..................................................................... 1

Opening statements, comments, or prepared statements of:

Senator Dodd .................................................................................................... 2

Senator Sununu ................................................................................................ 21

Senator Reed ..................................................................................................... 23

Senator Johnson ............................................................................................... 41

WITNESSES

Gary A. Amelio, Executive Director, Federal Retirement Thrift Investment

Board ..................................................................................................................... 4

Prepared statement .......................................................................................... 43

Francis Enderle, Managing Director and Chief Investment Officer, Global

Index and Markets Group, Barclays Global Investors ...................................... 5

Prepared statement .......................................................................................... 49

Francis X. Cavanaugh, former Director, Federal Retirement Thrift Investment Board ........................................................................................................... 7

Prepared statement .......................................................................................... 51

Michael Tanner, Director, Cato Project on Social Security Choice ..................... 9

Prepared statement .......................................................................................... 57

David C. John, Research Fellow, Thomas A. Roe Institute for Economic Policy

Studies, The Heritage Foundation ...................................................................... 11

Prepared statement .......................................................................................... 59

Jason Furman, Non-Resident Senior Fellow, Center on Budget and Policy

Priorities and Visiting Scholar, Wagner Graduate School of Public Service,

New York University ........................................................................................... 13

Prepared statement .......................................................................................... 64

(III)

(1)

THE ROLE OF THE FINANCIAL MARKETS IN

SOCIAL SECURITY REFORM

TUESDAY, JUNE 14, 2005

U.S. SENATE, SUBCOMMITTEE ON SECURITIES AND INVESTMENT, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC.

The Subcommittee met at 2:07 p.m., in room SD–538, Dirksen

Senate Office Building, Senator Chuck Hagel, Chairman of the

Subcommittee, presiding.

OPENING STATEMENT OF SENATOR CHUCK HAGEL

Senator HAGEL. Good morning, the hearing will come to order.

For 70 years Social Security has been one of the most successful

and important Government programs in our country. Almost every

American family during this time has been touched in some way

by Social Security.

However, the Social Security system is actuarially unsustainable

as it now exists. The Social Security system is not in crisis today,

but there is clearly a crisis on the horizon. America faces a $4 trillion deficit in Social Security over the next

75 years. In 2017, more money will be paid out of Social Security

than comes in. In 2041, Social Security will be insolvent. Beyond

the next 75 years there is only a black hole of unfunded liability

for future generations.

The longer we wait to address this issue, the more difficult it will

be to protect Social Security and the promise our Government has

made to future generations of Americans.

Today’s hearing will examine what role financial markets will

play in Social Security reform. It is important what risks there are,

how they might be managed, what kind of fiduciary responsibility

would be required of Government officials, and how a personal account system might work.

The Federal Thrift Savings Plan, TSP, provides a model we can

review that gives us a better understanding of these issues. Since

taking effect in 1987, TSP has been a success for Government employees. Last year, returns on the different accounts range from

just over 4 percent to 20 percent. And over the last 10 years, the

returns have been between 5.5 percent and 12 percent. Barclays

Global Investors is the investment managing firm for TSP.

Today’s hearing will look at the TSP model and focus on the

operational issues that the Federal Retirement Thrift Investigation

Board and Barclays face in managing the TSP accounts, the different costs and fees associated with the operation of these acVerDate 11-MAY-2000 16:58 Sep 22, 2006 Jkt 025856 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 29725.TXT SBANK4 PsN: SBANK4
2

counts, the bidding process that TSP employs to hire private investment firms, the different investment options that TSP offers,

and how effectively the TSP model could be applied to broader Social Security reform.

In assessing the role of the financial markets in Social Security

reform, we need to look at the market impact for private investors.

If the Federal Government became a big operator in the marketplace and had to manage 100 million accounts, then what impact

would there be on the broader marketplace? What procedures

would need to be implemented to ensure that this impact is minimal and managed?

In 1997, former Senate Banking Committee Chairman Phil

Gramm said that without strict procedures, this would be like

being in a rowboat with an elephant. When the Government moved

in the boat, you would know it. How can we minimize this impact?

Or can we minimize this impact?

I welcome our distinguished witnesses today that will help us explore these issues and thank them for their important contributions. Before I ask my distinguished colleague, the Senator from

Connecticut, for his remarks, I would quickly introduce the panel,

and then after Senator Dodd’s remarks, we will address each of

your testimonies.

Gary Amelio, the current Executive Director of the Federal Retirement Thrift Investment Board; Francis Enderle, Chief Investment Adviser for Barclays Global Investors; Francis Cavanaugh,

Consultant for Public Finance Consulting, and the former Executive Director of the Federal Retirement Thrift Investment Board;

Mike Tanner, Director of the Cato Institute’s Project on Social Security Choice; David John, Research Fellow for the Heritage Foundation; and Jason Furman, Nonresident Senior Fellow at the Center on Budget and Policy Priorities, and also a Visiting Scholar at

New York University’s Wagner Graduate School of Public Service.

Gentlemen, we thank each of you for your time and for your contributions to this panel, and I would now ask my distinguished colleague, Senator Dodd, for his remarks.

STATEMENT OF SENATOR CHRISTOPHER J. DODD

Senator DODD. Thank you very much, Mr. Chairman, and my

apologies to you for arriving a couple minutes late, finishing up our

conference lunches as we do on Tuesdays around here. But I thank

you for doing this.

There are a number of proposals that are kicking around, including ones that I know the Chairman has proposed, on how to address the issue of Social Security in the coming years. So, I think

it is highly appropriate that this Subcommittee, which deals with

securities and investment, to hold a hearing on the Social Security

reform debate. It is appropriate and the right thing to do. In fact,

as you have just pointed out, in 1997, when I was still a Member

of this Subcommittee, Senator Phil Gramm, our former colleague,

held a hearing on the very same subject matter regarding Social

Security. In fact, at that hearing, Mr. Tanner, you testified in 1997.

Mr. TANNER. Yes, sir.

Senator DODD. How are you doing?

Mr. TANNER. Keeping busy.

3

Senator DODD. It has been a long time, 8 years. Welcome back

to the Committee.

Anyway, throughout my tenure in the Senate, Mr. Chairman, I

have always been interested in ways in which we can strengthen

retirement security in the country, including expanding the individual retirement accounts and improving pension plans. In fact,

one of the first bills I authored as a freshman Member of this body

back in the early 1980’s was on individual retirement accounts. I

recall at the time when we offered the legislation, there was editorial comment that this was only going to serve my more affluent

constituents in Fairfield County. And then Merrill Lynch did a

study back in the early 1980’s demonstrating that even people with

incomes of $20,000 were investing in individual retirement accounts. They were doing it usually the day before their taxes were

due. They were not taking it earlier in the year because of the lack

of disposable income. But clearly IRAs were a wonderful vehicle for

expanding and increased retirement security.

Any of these financial instruments, of course, in my view are essential to millions of Americans in helping to provide for retirement and their family’s financial security. Moreover, they have

helped our economy by encouraging private savings, which have become dangerously low, I might add, in recent years.

However, let me just say briefly in these opening remarks, I have

deep reservations about the current proposals by the Administration and others to divert funds from Social Security into the private

marketplace, and let me explain why.

I believe there is legitimacy to the concern that the Social Security Trust Fund will, over the coming decades, have some serious

financial difficulties. It is altogether appropriate and not too soon

to look at ways to keep Social Security strong and vibrant for future generations of retirees. However, in my view, the Administration’s proposal is fundamentally flawed for at least three reasons.

First, by diverting money away from the Social Security trust

fund, I believe we exacerbate the insolvency concerns rather than

improve the health of the fund. Most observers believe that even

under the most dire predictions, about 80 percent of the Social Security trust fund will be in place in the decades of the 2020’s,

2040’s, or 2050’s, that we will have about a 20- to 25-percent shortfall that we will have to deal with. And certainly we need to address that, but I think by diverting funds away from Social Security, we will make that problem even more serious.

Second, the proposal of the Administration increases the national

debt by over $5 trillion. Even the Vice President acknowledges that

number. And I do not take lightly the thought of putting $5 trillion

more of debt on our children and future generations.

Third, in my view the proposal requires a reduction in guaranteed Social Security benefits for most retirees. Social Security is

critical not only to senior citizens but also to the fabric of our society. There are approximately 47 million of our fellow Americans

who receive Social Security benefits of one kind or another. It is

the sole source of income for one-fifth of all seniors and it is the

primary source of income for two-thirds of seniors.

Social Security reduces the poverty rate among seniors from

about 50 percent to about 10 percent in our Nation. Beyond its reVerDate 11-MAY-2000 16:58 Sep 22, 2006 Jkt 025856 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 29725.TXT SBANK4 PsN: SBANK4
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tirement benefits, Social Security provides critical support for the

disabled and for the surviving family members of workers who die.

Only about 30 percent of workers would have access to long-term

disability benefits absent Social Security.

I believe that as we address the issues of Social Security reform,

we need to keep a few basic principles in mind. One, do no harm.

The goal is to strengthen Social Security. Let us agree to strengthen Social Security, not dismantle it by agreeing not to divert any

money out of the trust fund.

Second, we need to create new opportunities in addition to Social

Security to enhance retirement security. For Americans to save for

their retirement, for one, we should do more in that area. Our national savings rate, as I mentioned earlier, is abysmally low. We

should use the tax code and other means to reward and incentivize

savings and help Americans with their long-term retirement needs.

Third, we need to come and to work together in a bipartisan

fashion, which we are not doing enough of in this area. Providing

for the retirement of future generations of Americans is far too important of an issue to become part of a game of partisan football.

Once again, I want to thank the Chairman, Senator Hagel, for

his thoughtful proposals as he has attempted to address this issue

and for giving this Subcommittee a chance to be heard on the issue

and for inviting such a distinguished panel of witnesses to share

their thoughts. I look forward to their this.

Senator HAGEL. Senator Dodd, thank you.

Let us begin with Mr. Amelio. Again, Mr. Amelio is the Executive Director, Federal Thrift Retirement Investment Board.

Mr. Amelio, welcome. Thank you.

STATEMENT OF GARY A. AMELIO

EXECUTIVE DIRECTOR,

FEDERAL RETIREMENT THRIFT INVESTMENT BOARD

Mr. AMELIO. Thank you. Good morning, Chairman Hagel and

Senator Dodd. My name is Gary Amelio, and I am the Executive

Director of the Federal Retirement Thrift Investment Board, an

independent agency charged with administering the Thrift Savings

Plan. I serve as the managing fiduciary of the TSP. Prior to my appointment on June 1, 2003, I had 23 years of private sector experience in the employee benefits industry. Although the Board has no

expressed position regarding proposals to change Social Security, I

am pleased to discuss TSP operations and investments.

Since 1987, the TSP has grown to 3.4 million participants with a total of $157 billion in account balances. I often comment that

Congress could not have provided a better structure when it created the TSP, fashioning the plan with the goal of providing retirement savings for Federal employees at low administrative costs,

with a limited number of funds that track broad investment markets. This simplified structure has protected the plan from political

manipulation and, consequently, enabled the TSP to gain the confidence of Federal employees and become the largest and, arguably,

most successful defined contribution plan in the world.

The TSP’s participation rate significantly exceeds the industry

average, primarily, I believe, because participants find the plan

simple to grasp. The TSP participants also enjoy low administraVerDate 11-MAY-2000 16:58 Sep 22, 2006 Jkt 025856 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 29725.TXT SBANK4 PsN: SBANK4
5

tive costs. Last year, expenses were just six basis points or 60 cents

for every $1,000, which is rock-bottom in the industry. I like to say

that the TSP is the most inexpensive legal investment in the world.

It might also be the most inexpensive illegal investment, but we do

not have any data.

Through the years, the TSP and the Congress have worked together to improve the plan. The TSP recently modernized its recordkeeping system to accommodate daily valuation, and in the next

couple of months, lifecycle funds will be available to provide professionally designed asset allocation models appropriate for participants’ investment time horizons.

Last year, Congress improved the plan by approving the Board’s

recommendation to eliminate open seasons. In 1986, the concept of

allowing Federal employees to invest in a retirement savings plan,

which included private securities, was untested. By mandating a

sound and simple structure protected from political manipulation,

Congress created a plan which passed the test, gained the confidence of Federal employees, and strengthened their retirement security.

This concludes my summary comments, and I ask that my extensive written statement be entered into the record. I would be

pleased to respond to any questions.

Senator HAGEL. Mr. Amelio, thank you. Each of your written

statements will be included for the record, in their entirety.

Mr. Enderle is Chief Investment Adviser, Barclays Global Investors.

Mr. Enderle.

STATEMENT OF FRANCIS ENDERLE

MANAGING DIRECTOR AND CHIEF INVESTMENT OFFICER

GLOBAL INDEX AND MARKETS GROUP, BARCLAYS GLOBAL

INVESTORS

Mr. ENDERLE. Good afternoon, Mr. Chairman, Senator Dodd. My

name is Francis Enderle, and I am the Chief Investment Officer for

the Global Index and Markets Group at Barclays Global Investors,

or BGI. In that role I am responsible for, among other things, the

oversight of portfolio management in the United States of all of

BGI’s index strategies.

We are pleased to be here today to share with the Subcommittee

our expertise in the management of defined contribution pension

accounts, which is derived from our experience as the external

asset manager for the Federal Thrift Savings Plan, or the TSP, as

well as for other numerous public and private pension plans. We

are honored to have served as an investment manager for the TSP

since 1988, a relationship we have retained in regular, highly competitive bidding processes.

Since our founding in 1971, BGI has remained true to a single

global investment philosophy, which we call ‘‘Total Performance

Management.’’ BGI manages performance through the core disciplines of risk, return, and cost management. The success of our

indexing methodology results from our focus on delivering superior

investment results over time while minimizing trading and other

implementation costs and rigorously controlling investment and

operational risks.

6

BGI manages four of the five investment options available for

TSP participants: The C, S, F, and I funds. The fifth option, the

G Fund, is managed by the U.S. Treasury. Later this year, the TSP

will be launching a series of lifecycle or ‘‘target horizon’’ funds that

use the existing five options as the asset class building blocks with

allocations in each lifecycle fund across these options being determined by an external vendor.

BGI’s services to the TSP are completely focused on our core expertise—investment management. We do not provide any other

services. We have an extremely effective operating model developed

in conjunction with TSP staff to manage the daily cashflows into

or out of each of the investment options.

The key to BGI’s success in index management has been our

ability to minimize implementation and trading costs. High costs

and expenses of investing detract from performance and investment returns; lower costs increase the investment pool and put

more money long-term into the pockets of investors. Let me say a

few words about how we do this.

Each of our index funds is structured to match the performance

of a specific third-party-designed index. These indexes are really

paper portfolios and do not include any of the trading costs that

real-world investors experience. To successfully track the index as

closely as possible, BGI strives to minimize the real-world costs

through a variety of highly efficient trading approaches.

The average account size for our U.S. clients is $880 million.

Through the size and diversity of our client base, we are able to

match or offset a significant percentage of many of our clients’ buy

and sell orders internally, thereby reducing or eliminating market

transaction costs. The internal matching of buy and sell orders is

commonly referred to as ‘‘crossing’’ and is conducted and actively

monitored by BGI pursuant to the terms and conditions of an exemption issued by the Department of Labor.

When we do trade in the markets, we utilize carefully developed

and managed trading strategies. We access all possible sources of

liquidity, including electronic marketplaces. And we ensure that we

receive superior execution.

Indexing is the most cost-efficient and diversified way to gain exposure to various segments of the capital markets. We believe

index funds are the best core investment for most investors’ portfolios, whether they are the largest pension fund in the world or

an individual investor.

I would now like to make a few comments regarding the investment-related issues to be considered if the Federal Government

were to legislate individual investment accounts either as part of

Social Security reform or through another mechanism.

Let me first acknowledge that BGI has built a substantial part

of its business by offering well-managed index strategies to our clients for more than 30 years. We, therefore, have a vested interest

in the continued growth of index investing. Our interests aside, we

firmly believe that the reason for the success of these strategies is

the simple fact that they deliver the return of the market index reliably and cost effectively. In fact, Congress recognized this itself

in the enabling legislation for the TSP.

7

If a national system of personal accounts were to be implemented, we would encourage legislators to consider the following

approach that draws on the best practices of institutional investors.

An array of low-cost, broadly diversified index funds frequently

forms the core investment for institutional pension plans. For example, the current selection offered to TSP participants covers all

the main asset classes, large and small capitalization U.S. equities,

U.S. fixed income, international equities, and a stable value option.

We suggest consideration of index portfolios because they offer

three principal benefits to investors: First, they capture the return

of each asset class with a high degree of precision; second, index

funds typically have low asset management fees compared to actively managed funds; and, third, index funds have lower relative

transaction costs including communications, bid/ask spreads, and

market impact.

The latter point is worth elaborating upon given the sizable assets that would potentially be invested in personal accounts. Investing in index funds spreads assets across the broadest possible

array of securities in any asset class, thereby minimizing the impact of trading large cashflows in the market on a daily basis. This

is not only important for the investment of new monies into personal accounts, but also for any trading individuals may initiated

in their personal accounts to reallocate assets among their investment options over time.

Another investment option to be considered is an array of socalled lifecycle or ‘‘target horizon’’ funds, options that the TSP will

be adding later this year, as I mentioned earlier. With lifecycle

funds, potentially the only choice an investor needs to make is to

select the lifecycle fund with the target horizon date that most

closely matches the investor’s date of retirement. Each lifecycle

fund would hold an array of asset classes with each asset class

being implemented with an index fund. The asset mix within each

lifecycle fund would gradually become more conservative over time

as the target horizon date approached.

Mr. Chairman, we believe that the investment considerations we

have discussed will assist you and others on this Committee in

evaluating the criteria to be used if personal accounts were to be

legislated by Congress as part of revisions to the Social Security

program or in another program. I thank you for the opportunity to

speak with you today, and I look forward to answering any questions you may have.

Senator HAGEL. Mr. Enderle, thank you.

Now we would ask Mr. Francis Cavanaugh to present his testimony. Mr. Cavanaugh is a Consultant for Public Finance Consulting and former Executive Director of the Federal Retirement

Thrift Investment Board.

Mr. Cavanaugh.

STATEMENT OF FRANCIS X. CAVANAUGH

FORMER DIRECTOR, FEDERAL RETIREMENT THRIFT

INVESTMENT BOARD

Mr. CAVANAUGH. Thank you, Mr. Chairman and Members of the

Committee, I welcome this opportunity to discuss the role of financial markets in Social Security reform. The Administration’s curVerDate 11-MAY-2000 16:58 Sep 22, 2006 Jkt 025856 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 29725.TXT SBANK4 PsN: SBANK4
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rent proposal for Social Security individual accounts contemplates

that private financial institutions would provide fund management

services and probably other 401(k) plan services, such as investment education, counseling, and recordkeeping. My comments will

focus on the cost of such services and the problems in providing

them to employees of small businesses.

A critical question, of course, is cost. Individual accounts are proposed to provide a higher investment return than would be realized

by the Social Security trust fund. On this basis, individual accounts

would not be feasible for the 68 million employees of 98 percent of

the businesses in the United States—that is, the 5.6 million small

businesses with fewer than 100 employees.

To understand the costs of individual accounts of small businesses, we must first understand why 85 percent of them do not

now have retirement plans for their employees. A major reason is

that the 401(k) industry has found that it cannot profitably provide

services for a company for less than approximately $3,000 a year,

even though they enjoy economies of scale from combining thousands of employers in their centralized computer systems. Further

significant economies of scale would not be realized by a central

Federal Thrift Savings Plan-type agency because of the fixed costs

of reaching out to millions of small businesses. Nor can we assume

that a new central Government agency would be more efficient

than the major 401(k) providers who now serve this market.

Thus, the cost per employee of a company with 10 employees would be $300, or 30 percent of the President’s proposed annual individual account contribution of $1,000, and most U.S. companies

have fewer than 10 employees.

Accordingly, the initial expense ratio for employees of the average size business would be more than 3,000 basis points, or 100

times the Administration’s estimate of 30 basis points. Obviously,

since the administrative costs of individual accounts would exceed

their estimated investment returns, substantial Government subsidies would be necessary to make individual accounts attractive to

employees of small business.

If all Social Security taxpayers eventually participate in the individual account program, you would find that the administrative

costs would be more than $46 billion a year—that is, 155 million

Social Security taxpayers times more than $300 per account—

which would be a subsidy to support an uneconomic function.

In addition to the above costs, which are based on what the current providers are actually charging for establishing and servicing

401(k) plans, there are overwhelming practical obstacles to modeling individual accounts on the TSP or private 401(k) plans.

First, the TSP is administered by just one employer—the U.S.

Government—with an extensive network of agency personnel, payroll, and systems staff to provide the essential employee education,

retirement counseling, payroll deductions, timely funds transfers,

and error correction functions. These essential employer services in

401(k) plans could not possibly be performed by small business employers or by a new TSP central agency.

Second, the TSP is computerized, like all other large plans, with

investments made promptly after contributions are deducted from

the employee’s paycheck. With individual accounts, it would be up

9

to 22 months after payday under current Social Security Administration procedures before individual accounts could be credited and

invested.

Third, the TSP is balanced to the penny every day. Social Security is never balanced. Each year there are billions of dollars

unreconciled discrepancies.

Fourth, the TSP and the Federal employee agencies have a very

effective system of communication. TSP mailings consistently have

reached more than 99 percent of employees, but 25 percent of Social Security Administration mailings are returned and marked as

undeliverable.

Since individual accounts are certainly not feasible for employees

of small business, the only practical way to give them higher returns is to invest part of the Social Security trust fund in equities.

The likely increase in trust fund earnings would be an effective

way to help maintain the solvency of the trust fund. Every State

in the United States has authorized public retirement fund investment in stocks, which can now be done through broad-based index

funds, which avoid the problem of direct Government control over

particular companies. As shown in my prepared statement, there

is even less Government influence over private companies under

the trust fund alternative than under the TSP or the Administration’s plan.

In conclusion, the Administration’s plan for universal individual

accounts is not feasible. The way for the Social Security system to

capture the higher returns available for investments in stocks is to

diversify Social Security trust fund investments. The trust fund alternative compared to individual accounts would be less disruptive

of financial markets, would save tens of billions of dollars a year

in administrative costs, and would be effective virtually immediately rather than the 2009 starting date proposed for individual

accounts. The multitrillion-dollar transition costs of individual accounts would be avoided completely. The additional trust fund

earnings would go a long way toward strengthening Social Security

finances and would thus reduce if not eliminate the need for significant tax increases or benefit reductions.

Thank you for your attention. I will be happy to answer any

questions.

Senator HAGEL. Mr. Cavanaugh, thank you.

Mr. Mike Tanner, the Director of the Project on Social Security

Choice, the Cato Institute, an old friend of Senator Dodd’s.

[Laughter.]

Mr. Tanner, welcome.

STATEMENT OF MICHAEL TANNER

DIRECTOR, CATO PROJECT ON SOCIAL SECURITY CHOICE

Mr. TANNER. Thank you, Mr. Chairman and Members of the Subcommittee, it is a pleasure to be back before the subcommittee

again, and in particular, Mr. Chairman, I would like to thank you

for holding this hearing. I think it is very important that we move

beyond the sterile debate that we have been having about whether

or not Social Security is facing a crisis or just a big problem and

start discussing actual solutions to the problems that Social Security is facing. That includes a discussion of how individual accounts

10

might be structured in ways that can maximize consumer choice

and control while ensuring efficiency, low cost, and preserving an

appropriate measure of worker protection.

Of course, along with my colleagues at the Cato Institute, I believe that Social Security reform must allow younger workers to

save and invest some of their Social Security taxes through personal accounts. Such accounts can significantly contribute to restoring Social Security to permanent sustainable solvency. But, more

important, I believe that personal accounts are essential to modernizing Social Security in keeping with such fundamental American values as ownership, inheritability, and choice.

Now, regarding the subject of this hearing, I think, in general,

economic theory holds that private capital investment should provide a higher rate of return than a mature PAYGO Social Security

system can provide. I believe that while there are distribution

questions and certainly other issues that must be addressed, the

returns from personal accounts privately invested will exceed the

returns that Social Security will provide in the future to younger

workers, including exceeding any offset interest rates such as those

suggested under the President’s reform proposal.

That said, how personal accounts are structured and the investment options available to workers can make a significant difference

in the success of any personal account proposal. In short, details

matter.

In designing an investment and administrative structure for personal accounts, I would urge Congress to be guided by these basic

concerns.

First, simplicity and transparency. Workers should clearly understand where their money is going and what their options are.

Where personal account plans have encountered difficulties, such

as in Great Britain, it has been primarily due to overly opaque or

overly complex schemes.

Second, balancing risk and return. While market returns, as I

say, are expected to exceed Social Security returns, markets are not

risk free. Of course, I would also note that the current Social Security system is not risk free. However, many of the new investors

brought into the market through personal accounts will be inexperienced. Bringing these new investors into the marketplace is a

good thing, but we should recognize that they will not be sophisticated investors. A personal account investment plan must offer

these individuals some degree of protection without stifling consumer choice, overregulating markets, or unduly restricting the potential for positive returns.

Third, keep administrative costs low. While regulation of account

fees would be unwise, accounts should be designed in ways that

minimize administrative costs. The Social Security Administration

estimates that accounts would cost 25 to 30 basis points to administer, and I believe this is an entirely reasonable target.

Fourth, limit Government involvement in investment decisions.

Decisions about the investment of the accumulating retirement

funds should be left to private markets and insulated from Government interference as much as possible. And I note that Government interference takes place to a high degree with State, county,

and municipal pension funds.

11

Finally, avoid increased employer burden. Every effort should be

made to avoid any new burden on employers, particularly small

employers.

In my written testimony I have spelled out one possible structure

for meeting these goals. That proposal involves a centralized colleague point, essentially the current payroll tax collection mechanism. Treasury would be responsible for holding the funds until

reconciliation takes place with the funds being held in a money

market account on a unitized dollar basis.

Once reconciliation takes place, Treasury would electronically

transfer the funds to the worker’s account. Initially, a small range

of broadly diversified funds would be the only investment options

available, something perhaps similar to the TSP, perhaps a series

of balanced funds, perhaps a lifecycle fund, the type of options that

have been discussed and are included in many of the proposals up

here, including the Chairman’s and Senator Sununu’s. However, at

some point—and I think this is essential—a broader range of investment choices should be opened up to individual investors.

Let me conclude by saying that I believe that Social Security reform is not an option but a necessity. The program will begin running a deficit in just 12 years and faces unfunded obligations of

roughly $12.8 trillion in the future. The need for reform, however,

presents us with an opportunity to create a new and better retirement program for all Americans, a program that gives workers

ownership over their retirement funds, more choice and control

over their money, and the opportunity to build a nest egg of real

inheritable wealth. Therefore, any Social Security reform should include personal accounts.

That makes the work of this Committee all the more important:

Getting the design and the structure of the accounts right. I believe

that the structure I have set out today takes us in that direction,

and I look forward to the Committee’s questions.

Thank you very much.

Senator HAGEL. Mr. Tanner, thank you.

Mr. David John, Research Fellow, the Heritage Foundation.

Mr. John, welcome.

STATEMENT OF DAVID C. JOHN

RESEARCH FELLOW, THOMAS A. ROE INSTITUTE FOR

ECONOMIC POLICY STUDIES, THE HERITAGE FOUNDATION

Mr. JOHN. Thank you very much for having me, and thank you

for looking into this issue. This is going to be one of the key issues

not just in the Social Security debate but in the overall retirement

security debate. I have a 19-year-old daughter who just finished

her first year of nursing school, and the simple fact is that when

Meredith retires, Social Security is not going to be able to replace

the same amount of her income as it does for her parents or as it

will for me. Meredith, no matter what, is going to have to save and

invest from day one when she first gets a job in order to come up

with a decent retirement income.

Now, we have a very effective and efficient private retirement

system—401(k)’s, IRA’s, et cetera, et cetera. And it is fairly simple

for Meredith to save if she has a 401(k) and works in a large hospital. But if she is a private-duty nurse or if she is working essenVerDate 11-MAY-2000 16:58 Sep 22, 2006 Jkt 025856 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 29725.TXT SBANK4 PsN: SBANK4
12

tially for herself, she is likely to have no choice in the slightest because obviously she cannot sponsor her own 401(k) plan for, frankly, reasons that Mr. Cavanaugh mentioned. So a TSP structure not

only could apply to a Social Security account, but it also could be

used in terms of expanding the opportunities of ordinary Americans to save for retirement.

Now, having said that, let me suggest that the TSP structure is

especially useful for a Social Security account. It is vastly different

from the 401(k) structure that we see in private business for the

simple fact that it is administered through the tax system. The individual business owner has no participation in this. The individual

business owner would provide or forward the payroll taxes and income taxes of their workers to Treasury, just as they do now, and

at that point their responsibility ends. They have no additional

costs. They have no additional participation. It is once the money

reaches Treasury that it is then subdivided and moved into a personal retirement account, and there are mechanisms to do that efficiently, and, frankly, that can be done as easily on an annual basis

as it would be on a weekly, a monthly, or a yearly basis.

Now, Social Security accounts should start slowly, with limited

investment options. This is the way TSP started. Initially, there

was only the G Fund, and the other investment options were added

at a later date. The last two investment options are relatively recent. A study by State Street Trust, which is one of the major pension administrators in the country, looking at a system which, by

coincidence, happens to be the one that most Social Security reformers are talking about, found that the costs could be somewhere

between 0.19 percent of assets under management and 0.35 percent of assets under management.

Now, what that basically is a very tiny amount, one-third of 1

percent at the most. Unfortunately, there is no way of comparing

the costs of a 401(k) system or the TSP system to today’s Social Security because when it comes right down to it, today’s Social Security does not have a trust fund of the type that traditional pension

plans have, nor are Social Security benefits paid out of that trust

fund. They are basically paid on a pay-as-you-go basis. So it is impossible to compare apples and oranges in this situation.

But what we can say is that a TSP account would be the lowestcost opportunity for an individual worker to build retirement savings. The best way to do that also would be through a lifespan account—they are alternately called lifespan, lifestyle; ‘‘life’’ is the

key element there—which automatically rebalances the investments starting out with a more aggressive investment structure

when an individual is very young and moving to a much more conservative structure by the time the individual reaches retirement

age.

There are 55 companies that currently offer lifespan accounts as

part of their 401(k) plans. The initial estimates show that having

a lifespan account actually can increase the amount of retirement

savings that an average worker could have, including the lower-income workers, by roughly one-eighth. They do not have to be expensive. Vanguard has an investment in passively traded index

funds, similar to the ones that were discussed earlier here, and

13

their annual cost is 0.23 percent, roughly one-quarter of 1 percent

of assets under management.

This is not a theoretical question. This is not a question of millions, billions, and trillions. This affects real people. My daughter

is 19 at the moment. She will retire roughly 10 years after the Social Security trust fund disappears. Under current law, that means

she stands a 30-percent benefit cut in her Social Security benefits.

If we structure soon a retirement investment plan similar to the

TSP system that she could participate in from day one when she

goes to work, she could end up with significantly higher Social Security benefits than what she would face right now. In 2040, when

Meredith is 56, under current law the Social Security system—and

there will be trust funds at that point—will take 15 cents on every

dollar of income tax that is collected in that year. Fifty cents of

every dollar collected in income tax that year goes to Medicare.

Now, unless action is done quickly on Social Security, Meredith

basically faces a choice of funding programs for her kids and her

grandkids or for her parents and grandparents. That is not a situation she needs to be in.

Action is needed quickly, and practical action that actually gives

her a decent chance to a secure retirement system.

Thank you.

Senator HAGEL. Mr. John, thank you very much.

Mr. Jason Furman, Adjunct Professor, Wagner Graduate School

of Public Service, New York University.

Mr. Furman.

STATEMENT OF JASON FURMAN

NON-RESIDENT SENIOR FELLOW, CENTER ON BUDGET AND

POLICY PRIORITIES AND VISITING SCHOLAR,

WAGNER GRADUATE SCHOOL OF PUBLIC SERVICE,

NEW YORK UNIVERSITY

Mr. FURMAN. Mr. Chairman, Members of the Committee, thank

you for the opportunity to address the Subcommittee. In considering reforms that would dramatically change the nature of Social

Security, it is critical to consider how individual accounts would be

administered through the financial system and how markets would

react to the borrowing necessary to finance accounts.

In my comments today, I would like to focus on four points: The

administrative costs associated with accounts; the Government

staffing required for those accounts; what this would do to the rate

of return that average Americans could expect through Social Security; and the impact of large-scale borrowing on financial markets.

First, administrative costs in a private account system would be

at least 10 times as large as the costs under the current system.

In some proposals, administrative costs could eat up more than

one-third of final account balances. Even the sharpest critics of our

current system admit that Social Security is extremely efficient.

Establishing over 100 million individual accounts for Social Security contributors would entail substantial new complexities and

tasks, including tracking contributions, allocating them to different

investments, managing assets, and distributing balances at retirement. All of these new tasks would be in addition to everything Social Security does today.

14

The President’s account proposal controls administrative costs by

limiting choice and services to a bare minimum, including establish

centralized Government management of the accounts. According to

the Social Security actuaries, even this barebones system would

cost 10 times more to administer than the current Social Security

system. Accumulated over 40 years, 0.3 percent annual sounds very

low, but if you accumulate it over 40 years, it will eat up 7 percent

of your ultimate account balance because that first contribution you

pay 30 cents on it year after year. That is compared to 0.6 percent

under the traditional Social Security system, and these estimates

do not even include the cost of starting up accounts, partially

annuitizing account balances at retirement, and many of the considerations that Mr. Cavanaugh raised in his testimony.

Even if an individual account plan initially offered only a few

funds, it is likely that political pressure would expand the options

over time, as recommended by the President’s Social Security Commission and Mr. Tanner and Mr. John at this hearing. Participants

might demand more options for managing their money, and some

might object to being required to invest in a Government-designated allocation of stocks, which includes companies that, for example, are perceived to harm the environment or support gay

rights. If investment choices were widened even slightly to address

these concerns, costs could double to about 15 percent of the final

account balance.

If the President’s Government-organized accounts approach is rejected and privately organized accounts, like existing IRA’s, are established instead, costs would be even higher. In the United Kingdom, for example, administrative costs were eating up a staggering

43 percent of the final account value at retirement before caps on

fees were recently instituted.

My second point: Establishing accounts would require a substantial increase in Government staffing, likely in the form of a new

Government agency that could be about half the size of the IRS or

the Social Security Administration. The Clinton Administration

Treasury Department found that tens of thousands of new Government workers would be needed to answer phone inquiries and process worker choices of fund managers in a barebones system. With

even slightly expanded choice along the lines of what we have

heard advocated today, that number could triple.

By the end of the first decade of President Bush’s proposal, administrative costs would be running at about $4.4 billion annually,

according to the optimistic estimates of the Social Security actuaries, enough to support about 30,000 new Government employees

in addition to other expenses. By comparison, currently SSA has a

total staff of about 65,000 and the IRS has a staff of about 100,000.

My third point: When administrative costs are considered, returns from many participants under a private account system

would be lower than in a reformed system without accounts. Additional administrative costs associated with individual accounts are

certain. Potential gains from accounts, however, are uncertain. The

President’s proposal allows workers to, in effect, borrow money at

the Treasury bond rate and invest it in a restricted range of funds.

At the end of the day, the worker would have to pay the large administrative costs of managing this awkward system. Far superior

15

for most workers would be simply to, if they want to increase their

exposure to risk, reallocate their portfolio, and if they have no exposure to risk, to do some of the measures that Senator Dodd was

talking about to encourage more investment without replacing part

of the very efficient Social Security system with a substantially less

efficient system.

The administrative costs for the average worker would be sub- stantial, reducing annual benefits anywhere from $700 a year to

$4,000 a year. That is on top of all the other benefit reductions the

President is proposing. As a result, the Social Security system

would have a lower rate of return for a large fraction of workers

than a system without accounts.

Fourth, the increase in the debt associated with establishing private accounts would increase the risks facing financial markets and

fiscal policies. Carveout accounts and add-on accounts that are not

paid for both result in substantial increases in the debt. In the

President’s plan, the debt would go up by $5 trillion over the first

20 years. Economist Martin Feldstein advised President Reagan

not to establish individual accounts, in part because, ‘‘to fund investment-based accounts would have required a tax increase or an

even larger overall budget deficit.’’ According to Harvey Rosen, who

just last week stepped down as Chairman of President Bush’s

Council of Economic Advisers, diverting funds into private accounts

would either drive interest rates up, stock returns down, or some

combination of both.

Private accounts could create more difficulties for beneficiaries in

markets than I have time to document. Instead of proceeding down

that road, we can instead modify the current system to make it

sustainably solvent and help make it easier and more automatic to

save through existing IRA’s and 401(k)’s without incurring the

costs and risks associated with replacing Social Security with accounts.

I look forward to the opportunity to discuss this and other questions with you. Thank you.

Senator HAGEL. Mr. Furman, thank you.

Since there are three of us here at this point, I would ask Senator Dodd if we would do an 8- to 10-minute round, each of us. Is

that acceptable? Then we will keep cycling. I suspect we may have

some other colleagues as well. So we will start with 8-minute

rounds of questioning. Thank you.

Mr. Amelio, in your testimony, and in the testimony of each of

you, you have touched upon a fee structure and fees and the relevancy of that challenge, which I think we all agree is a big part

of any kind of personal account structure. And you had noted, I believe, Mr. Amelio, that it was six basis points, 60 cents per $1,000,

essentially the standard that we have now—or you have come up

with, and, in fact, is the real number for TSP.

My question is this: What rules or procedures has TSP implemented to foster responsible fiduciary management and accountability in relationship to those fees and other parts of the structure

that your colleagues and you have touched upon in your testimony?

Mr. AMELIO. They are 6 basis points and they are coming down.

We anticipate they will possibly be 5 basis points this year. That

comes to approximately $27 per participant. I think there are 4

16

reasons that our fees are able to be so low. One is the girth of the

plan. We have a large amount of assets. That helps to keep the average of the cost sized down. Two, we use only index funds which

are the least expensive investment model that I think any fiduciary

could select for an institution plan. Three, although it is a daily

plan where participants are allowed to move their money daily, go

onto a website and see their balances, it is a simple plan and that

I am very proud of. We have only 5 investment options, and even

when you add the lifecycle funds they are not funds with a capital

‘‘F,’’ they are asset allocation strategies and it is that simplicity

that also helps us to maintain low cost. Fourth is self-administration. We are large enough that we are able to administer everything in house. They noted the Social Security Administration has

65,000 employees. When I came 3 years ago, we had 108 employees

at the TSP. We are down to 89 now. We do have outside contractors of a couple hundred. Through good management, we have an

independent board, and I think for those four reasons we are able

to maintain the low cost that we have.

Senator HAGEL. I am going to ask in a moment Mr. Cavanaugh,

and Mr. Furman especially, to respond to this issue because they

both touched upon it and I think have some different judgments on

what it would take to put 100 million or 200 million accounts online.

But what I want to do is take what you have just said now and

have you respond to this question. Obviously, with a Social Security account structure we are talking about far more accounts, and

as you have heard the testimony of your colleagues, specifically Mr.

Cavanaugh and Mr. Furman, who touched upon the kind of administrative costs and infrastructure that would be required. It has

been mentioned in a couple of the testimonies here, telephone answerers, handlers, taking inquiries. Relate their testimony and

some of their observations and judgments to what you are doing

now, and then in your mind, what would it take to put 100 million

accounts online?

Mr. AMELIO. I need to couch my answers within the confines of

the TSP. I have been advised by our counsel I cannot make any

direct comments about a Social Security proposal. So, I hope you

understand that.

Senator HAGEL. Let me make it easier for you and your attorneys. Let us just take Social Security out of it. What would it be,

100 million accounts? And let us just take Social Security out of it

so that there is no liability for you. We do not want that.

Mr. AMELIO. Certainly, I understand, and I am not trying to be

evasive.

Senator HAGEL. I understand.

Mr. AMELIO. We started out about 3 years ago with 200 telephone operators. We have 2.4 million participants. We are taking

that number down probably to about 120 to 140 telephone operators. The reason we did that, most of our calls are administrative

in nature, dealing with participant loans, and we toughen the

standards for participants to take loans, and so therefore we were

able to cut down.

If you are talking about expanding the participant base it might

look more like private sector plans where the calls are more investVerDate 11-MAY-2000 16:58 Sep 22, 2006 Jkt 025856 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 29725.TXT SBANK4 PsN: SBANK4
17

ment related. Very few of the calls we get right now are investment

related about the funds. As you get more investment related, you

not only increase the volume of the calls, but you also increase the

length of the call from about 3 minutes on average to 6 minutes,

and it necessitates in an arithmetic calculation all the more operators you need. I would have to sit down and run the numbers to

see how many operators we would have to add. If we added another 80 million participants to our plan, I assume it would be a

large number.

Senator HAGEL. Let me ask you this, you heard again what Mr.

Cavanaugh and Mr. Furman said, and their numbers are pretty

difficult to digest here as far as the reality of if we are really talking about seriously putting in place 100 million accounts, and some

of the questions and the numbers that they have brought out. Do

you disagree with those numbers? Do you disagree with those observations or judgments? Is this possible that we could put online

100 million accounts, and using TSP as some kind of a general

model?

Mr. AMELIO. You may have apples and oranges. If you are talking about adding another 100 million participants to the plan you

have to look at each of the functions. For example—and we have

not really done the demographic study so I want to be careful

here—you have several different segments. The easiest segment

might be adding the participant account for recordkeeping itself.

We have a huge computer and the IT people would work on it, but

perhaps you could actually keep track of it.

If you go to the separate issue of adding telephone operators, I

think that becomes more complex because you are talking about a

large number of people, time zones, et cetera.

Where it gets even more complex is the collection of the contributions. Right now we have 130 payroll offices in the Federal Government. They are all computerized and they remit to us. On a daily

basis we are getting payroll transactions. If you were adding 100

million people, it would not change as long as they were still in

those 130 payroll offices, but if they had different payroll offices,

paper submissions, it would make it a lot more complicated.

Senator HAGEL. Thank you.

Mr. Enderle, would you respond to that question since you manage the current accounts now?

Mr. ENDERLE. I think the key issues, as I think about 100 million

accounts, can be split into two components. One is what Mr. Amelio

just responded to as it pertains to the administration of those accounts. The second has to do with the actual asset management of

those accounts. I think the key issues that we would need to think

about has to do with whether or not the assets across all those accounts would be aggregated in some fashion, so that the number

of accounts any money manager would manage would be limited.

So in the case of the current arrangement we have with the TSP

we are currently managing four accounts on behalf of 3.4 or 3.5

million participants, and that type of arrangement is very

leveraging and scaleable.

I think the key issues are how many fund options would be available and what the asset size would be for each account.

18

Senator HAGEL. Does that include the fee structure too that we

were talking about earlier?

Mr. ENDERLE. I think the fee structure—I am not in a position

to comment on the fees as it pertains to the costs associated with

administering all the accounts, but more in respect to the fees that

would be applicable to the asset management side of those assets.

Senator HAGEL. Thank you. My time is up.

Senator Dodd.

Senator DODD. Let us just pick up on that, because I think that

is the point. You are talking about four basic accounts. It is a number of people but we have really limited choices under TSP, whereas what we are talking about here in individual accounts, the

choices are far broader than what are offered under TSP. Is that

not correct, Mr. Amelio?

Mr. AMELIO. The number of choices for what, Senator?

Senator DODD. Under the individual accounts that we are talking

about here being proposed under the Social Security reforms?

Mr. AMELIO. I am not sure which proposal you are talking about.

Senator DODD. Let me ask Mr. Cavanaugh and Mr. Furman. We

are talking about going from 31⁄2 million to 100 million accounts,

the Chairman’s question, and that is a legitimate issue. But if you

are dealing with limited choices there, then it is a numerical factor

in terms of—where you add the element of broader choices that we

are talking about here where they have a diversity of the asset

management issues that Mr. Enderle talked about. Then you are

adding an element here that I think goes to some of the cost issues.

Maybe Mr. Cavanaugh and Mr. Furman would like to respond to

the question that the Chairman asked to Mr. Amelio, and how you

would respond to that question.

Mr. CAVANAUGH. I think the problem is not the 100 million accounts. The problem is, whereas the TSP is one employer, the U.S.

Government, when you are talking about individual accounts, you

are talking about 5.6 million employers and small businesses. You

have to deal with each one of them. Part of the reason why the

TSP administrative expense ratio is so low, 6 basis points, is because you have just one employer, and you have a contained environment. They are Federal employees, they are already there.

When I started the plan, the first thing I did was to announce to

everybody that, hey, I am a wholesaler. You Federal agencies out

there in the field, you are doing the retail. They had the personnel

structure. They had the payroll structure. They had the systems,

electronics, and everything to do it.

And you, in your statute, when you created the Thrift Savings

Plan, you instructed the Office of Personnel Management to train

trainers in all of these Federal agencies so they could go back and

teach all of the employees all about this plan. So we wholesaled

and we had very low costs. And the agencies were already in place

and there was no problem. That is essentially why, from my experience in setting the thing up, costs were so low, and they continue

low. I think that is wonderful, and the agencies have wonderfully

cooperated.

All 401(k) plans, including TSP, are employer-sponsored, employer-maintained, employers have the fiduciary responsibility. You

cannot expect that of 5.6 million small businesses, barbershops and

19

so on. They just cannot handle it, and no one is suggesting that

they do. So who is going to do the retail? That is the critical question. It cannot be done by a new TSP-type central agency in Washington. It cannot be done by the employers, who now do all the

401(k) plans.

It would have to be done by the financial market, by the 401(k)

providers that are now doing it for many companies. But the 401(k)

providers, if you go on their websites, they tell you that if you have

less than 10 employees, forget about it. There would not be enough

employees to spread the cost over. And 60 percent of American

businesses have less than 5, so it is just not doable. It is entirely

different from the TSP which has nothing to do with it.

Senator DODD. One of the suggestions you make in your testimony that I think is not a bad one, as the Chairman goes forward

with this, is to ask people like Citigroup and Fidelity Investments,

Merrill Lynch, State Street Corporation, T. Rowe Price and others

to testify because they are managing these things and you can get

a pretty good read as to how have their 401(k)’s. In your testimony,

you said they found that they cannot profitably provide these services for a company for less than approximately $3,000 a year even

though we have for year enjoyed economies of scale from serving

thousands of employers and their centralized company systems, but

it would be interesting to hear what they have to say in all of that.

Let me go back to another issue, and Mr. Furman, you may want

to come back and address this in a minute, but let me raise another issue if I can about the administrative costs. This is a big

point here, and I appreciate you raising it here. Several of the witnesses obviously have talked about it. Mr. Cavanaugh in your testimony you go to great lengths to detail the administrative problems

in the proposals of private accounts, specifically discuss the problem of timing, of placing contributions into private accounts, stating ‘‘Individual Social Security taxpayers are identified only once

each year with their employer’s annual income tax filings, and it

would be up to 22 months after payday under the Social Security

Administration proposal before the individual accounts could be

credited,’’ which pose obviously some issues.

Mr. Tanner—and if my reading is incorrect in this, Mr. Tanner,

since we are old friends here, you correct me if—you generally dismiss these concerns as I read your testimony, and I quote you here

in your testimony. You say that the collection of payroll taxes, including individual account contributions would continue to be handled by the employer in much the same way as today and sent to

the Treasury as they are today.

How do you respond to each other? It seems to me he has raised

a very serious issue, you dismiss it as being not terribly relevant.

Mr. TANNER. I actually agree with his statement. I believe in my

written testimony I state exactly the same thing, that there is this

problem that exists with the current Social Security system, that

until after your W–2 is filed and they reconcile your W–2 with the

contributions as sent in by the employer, they do not know how

much you have paid.

Senator DODD. Right.

Mr. TANNER. And that is why I have suggested that there be a

centralized collection point that essentially holds that money until

20

reconciliation takes place. I have suggested that the best way to do

that is to hold it in a money market account on a unitized dollar

basis until reconciliation takes place and the money can be transferred to your individual account. But there is this lag, and there

is going to have to be some holding pattern.

I think the centralized collection agency as well relieves the employer and all these small businesses of any responsibility for any

administrative cost or anything other than what they do now,

which is to pay in a lump sum to Treasury, which then assumes

all the responsibility for the recordkeeping and the bookkeeping

and so on.

Senator DODD. Who would hold that?

Mr. TANNER. The Federal Government would hold it, would be

the administrator of this fund.

Senator DODD. Let me jump to, because there is limited time

here, disabled and survivors benefits. I think roughly around 15

million of the 47 million beneficiaries of Social Security are either

disabled or survivors, survivor benefits go to them. The President’s

proposal is to encourage, obviously, individuals to have private accounts, to which they contribute over their working lifetime. The

question arises, in the case where a person’s working lifetime had

been cut short, either by worker’s disability or death. According to

the Social Security Administration over 8 million individuals received disability benefits in April of this year, and over 6.5 million

received survivors benefits. What do these people do under the privatization plan? Mr. Tanner, what happens?

Mr. TANNER. Under our proposal, which has been introduced in

the House by Representatives Johnson and Flake, and under most

of the proposals that are proposed here, and the President’s, those

benefits would remain unchanged and be continued to be paid out

by the Social Security Administration with no changes of any kind

to those proposed——

Senator DODD. And would the Aadministration still require the

clawback tax of inflation plus 3 percent on those accounts?

Mr. TANNER. Since we are old friends, just to correct you slightly

on that, it is not a clawback, it is an offset, and the difference is

that a clawback depends on how your account performs, and it penalizes you if your account performs well. An offset is a preset

amount that you are simply giving up in exchange for your choice

of moving into the private account. They have chosen 3 percent because they believe that is what Government bonds will be earning

as a yield in the future. But it could be any number, and in fact,

I would actually recommend a lower number than the 3 percent.

Senator DODD. Can I just ask. Mr. Furman, to make the comments on the earlier stuff and on this point as well?

Mr. FURMAN. Yes, two points. One is that TSP only bears the

costs of 6 basis points, but substantial other costs are borne by

Government agencies which are the first point of contact for most

people. As Federal employees, most of your interchanges about the

TSP are with your own office managers. You would have to mandate that for small businesses, or you would have to pay that cost

in some other way. That is just one of the many tradeoffs one

would have to make if one were to set up accounts.

21

In terms of survivors, I would have to differ from Mr. Tanner,

to take Mr. Posen’s proposal, for example. That reduces the benefit

factors used to calculate benefits for retirees, survivors, and people

with disability. It makes exactly the same percentage reduction for

all three of those groups.

The President has said that he would protect people with disabilities, at least prior to them reaching their 60’s, at which point

something else might happen, has not said he would protect survivors, and his chief economic adviser has confirmed that the same

benefit reductions would indeed apply to survivors as apply to retirees.

Senator DODD. Thank you, Mr. Chairman.

Senator HAGEL. Senator Sununu.

STATEMENT OF SENATOR JOHN E. SUNUNU

Senator SUNUNU. Thank you, Mr. Chairman.

With regard to the number of options available, I cannot speak

to all the legislation that has been introduced, but let us be clear.

A number of the proposals, the legislation that I have introduced,

approach private accounts directly using the Thrift Savings Plan

model specifically with the number of accounts offered. We could

provide four or five accounts, but by limiting the number of accounts, as I do in our legislation, you achieve the scale factors that

were talked about by Mr. Amelio and Mr. Enderle, and this is I

think a much more manageable proposition, and a lot of the straw

man approaches that had been thrown out by critics go away, and

I do want to deal with a couple of those criticisms in detail.

The idea that this is far too expensive for small businesses. Mr.

Cavanaugh, by the arguments that you have put forward that

small businesses will be overwhelmed by the financial burden of

having to sit down with employers and determine what portion of

their payroll tax will be allocated toward a personal account, sent

to Washington, and at a central location be allocated into one of the

narrow choices that were spoken of. By that rationale, the whole

idea of electing to withhold taxes and determine what the withholding allotment should be for employers should also be financially overwhelming, too complicated, and a waste of time and resources for the IRS. But that is not the case, is it?

Mr. CAVANAUGH. I am afraid it is the case because, for example, last year the Social Security Administration took in $600 billion in

taxes, and about $10 billion of those were never reconciled for individual accounts.

Senator SUNUNU. I am talking about withholding taxes on personal income. Are you suggesting we should get rid of withholding

because it is a waste of Government resources?

Mr. CAVANAUGH. No, what I am saying is that——

Senator SUNUNU. If that is not inefficient and a waste of Government resources, then why would electing some withholding for a

personal account in those same businesses that do personal income

withholding now, why would that be burdensome and a waste of

resources?

Mr. CAVANAUGH. That is the critical question. There is an enormous difference——

Senator SUNUNU. That is why I am asking it.

22

Mr. CAVANAUGH. Right now, when the small companies do not send in the taxes in time—or we find $10 billion at the end of a

couple of years that Social Security cannot reconcile because of errors on payment—it is not that critical to the Social Security beneficiaries because of the way SSA measures credits; it just does not

affect them. But when you are talking about losing investment

earnings, if the money is not in day to day or if it goes into the

wrong fund when there is a big difference between, say, stock returns and bond returns.

I am saying that the present system with the employer just paying these taxes is not a problem now for IRS or SSA the way they

operate. It is unacceptable for an investment. You cannot have a

financial institution with that low a standard in terms of accuracy,

nonpayment. We have 650,000 businesses go out of business every

year, and when they go out, quite often the payment of Social Security taxes is at the end of the line. They have to pay their people

and they have to pay their contractors and so on. How are you

going to deal with that?

Senator SUNUNU. I think that the argument that you just made

has nothing to do with the point you made earlier. What you are

suggesting is a need for accurate accounting in the asset allocation,

and I do not think anyone here would disagree with that, but that

does not speak to the earlier claim you made that the financial burden would be overwhelming, and I do not accept that at all, because the best model we have for this allocation process at the employee level, at that small business level, is the election to withhold

personal income taxes, which is a system that works, that is efficient. I do not disagree that we might like the accounting for that

to be even better than it is, but to suggest that it is an unbearable

financial burden simply is not borne out by the evidence.

Mr. Amelio, I want to talk a little bit about lifecycle. I think it

was mentioned by Mr. Enderle. Oftentimes, we hear critics of the

idea of personal accounts use what I will describe crudely as the

argument that Americans are not smart enough to handle the decision to set aside money into a personal retirement account, quite

simply put. And that we are going to have people at or near retirement age, at the age of 62 or 63 or 64 suddenly deciding that they

want to put all of their life savings in a high tech stock. I do not

believe that is the case.

I think one of the things we can look to at Thrift Savings Plan

is to try to understand how investors make decisions in allocating

and whether or not they generally follow what would be called

lifecycle investing, whereas as you get closer to retirement, do individuals tend to put their personal accounts, their personal savings

in less volatile accounts like a Government bond fund or a municipal bond fund or the like, as opposed to an equity fund?

What is TSP’s history with that? Can you say anything about the

tendency of your customers to pursue lifecycle investing with or

without any regulations or mandates?

Mr. AMELIO. I can. I can throw statistics out like crazy. I brought

lifecycle funds. It is my concept and I am very proud of that. The

TSP participants are very much like any 401(k) plan participant.

Nobody means to insult the American public if they say they are

not bright enough or do not understand the investments. What

23

happens is most people get frustrated. It is overwhelming. They do

not have the time, the desire, et cetera. What they wind up doing,

for example, when I came over, 50 percent of our plan assets were

invested in the G Fund. G Fund is a wonderful fund. It is simply

far too conservative for you to have all of your plan assets in that.

Senator SUNUNU. So you are suggesting that actually the inclination of the broad spectrum of Government employees—we are talking about 31⁄2 million people; I am sure there are some that are

more financially literate than others—their tendency is to be too

conservative. Given a limited menu of options, four or five funds,

they were actually investing in a way that is too conservative.

Mr. AMELIO. The largest group were too conservative, being 100

percent invested in the G Fund. The next largest group has what

we call the barbell approach. They are putting half of their account

in the G and the other half in the highest risk, and nothing in the

middle. They are off of what investment professionals—Mr.

Enderle could describe this better than I could—as the efficient

frontier. They are either assuming too much risk for their yield, or

they are not getting enough yield for the risk that they have.

These lifecycle funds are automatic pilot. You go in, it is professionally managed, and it gets more diversification which will get

them a better yield overall over a working life expectancy.

Senator SUNUNU. Mr. Furman, in your testimony—actually, I

want to direct this question to Mr. Amelio because you have some

responsibility on TSP. You suggested that if individual accounts

are instituted and had the political pressure to include various

types of politically oriented funds, that would be difficult for legislators or policymakers to resist. Again, I go back to TSP. Have you

been able to resist the political pressure to create all sorts of politically sensitive funds within TSP?

Mr. AMELIO. I have only been here 2 years. The plan has been

very successful since its inception in 1986 in doing that. I can tell

you there is a lot of political pressure right now to add a REIT fund

against the plan fiduciary’s desires. We make no comment on

REIT’s, as far as it being good or bad, we just do not want to add

one right now, and that is what I am calling political manipulation.

Senator SUNUNU. But you have had 20 years experience?

Mr. AMELIO. Yes.

Senator SUNUNU. There are how many funds that are currently

offered?

Mr. AMELIO. Five.

Senator SUNUNU. Five. So, I think it stands to reason if we are

looking at this, not necessarily as the perfect model, but trying to

identify analogies. I would argue that would be pretty good insulation from an endless proliferation of politically motivated funds.

Thank you very much, Mr. Chairman.

Senator HAGEL. Senator Reed.

STATEMENT OF SENATOR JACK REED

Senator REED. Thank you very much, Mr. Chairman.

Thank you, gentlemen, for your testimony.

Mr. Cavanaugh, in your written testimony you make a very interesting and important point that also concerns me with regard to

the President’s proposals. Specifically, you point out that the TSP

24

program allows for emergency withdrawals and loans on contributed funds. As I understand the President’s proposal, those activities would be prohibited, and I have a sense that I believe you do

too, that it is very difficult to maintain such a limitation over time,

particularly since the argument is being made insistently, ‘‘It is

your money, it is your money.’’

I am just curious. Have TSP participants always been permitted

to make emergency withdrawals and loans on their contributions?

And if not, what caused that phenomenon?

Mr. CAVANAUGH. It started out with just loans. IRS, I think, had

problems when the legislation was before the Congress with regard

to withdrawals. But later on the Congress amended the statute to

permit withdrawals, so we have both loans and withdrawals.

With regard to what you were referring to in my prepared statement, even though the Administration says this is just for retirement, the individual accounts will not have any loans or withdrawals, I just think it is totally unrealistic. Right now, the reason

people cannot take money out of Social Security before retirement

is because they do not have an account there in their name with

their money, there is nothing to take. But once you have an individual account that is identified to the individual and they see the

balance is building up year after year.

And then you have some national disaster where people are

starving, their kids cannot go to school, and they are waiting for

emergency relief, and they say, ‘‘I have $20,000 in there and I cannot wait till retirement, we are dying now.’’ I do not see how the

Congress can say no.

Senator REED. And what would be the consequences of those

types of withdrawals or loans?

Mr. CAVANAUGH. They would be dire because you would be doing

it on an ad hoc basis instead of having a system in place at the

beginning as we did for loans and withdrawals eventually. You

would have to be dealing with each case because you would not

have standards. It would be an ad hoc thing, and as the constituents called into their congressman and said, ‘‘I need the money,’’

and they had a different particular case problem, that would be

sent over to the board. The board would have to sit down and try

to sort it out and be fair to everybody, and not give to somebody

who had the same circumstances as somebody else that did not get

it. You have to set it up at the beginning.

Senator REED. Thank you. Now, Mr. Cavanaugh, there is another

issue that we have all talked about. That is the administrative

costs of the various proposals. From your experience, would the administrative costs of the TSP-type program increase substantially

if it were modified to allow individual investors to invest specific

stocks? Would those costs go up?

Mr. CAVANAUGH. If the TSP allowed specific stocks instead of

just the index fund?

Senator REED. Right.

Mr. CAVANAUGH. Oh, yes, that would be much more difficult because I think the Congress would provide something in legislation

to make sure people did not go crazy buying penny stocks and so

on. You would have to have standards and then there would be the

whole question of—since the Government is running this thing—

25

Government involvement in the business of which particular stocks

are eligible and which ones are not. And there you would get the

politics, good stocks, bad stocks and so on, and so that would be

impossible.

Senator REED. Mr. Tanner, in this regard of operating costs, you

cite administrative costs would be about 25 basis points, but I presume that is based upon the TSP model which has about only 5

different options. But then you go on to your testimony and talk

about: At some point a wider range of choices should be made

available; in part this is a simple matter of increasing consumer

choices; one of the most important reasons for having personal accounts at all is to give workers more choice and control how they

save for their retirement; and clearly this should be extended as

much as possible.

But it seems to me that as you extend these options you have

to increase to administrative cost; is that accurate?

Mr. TANNER. Yes, I think you are correct, Senator, that in this

additional tier of investment options, administrative costs would be

higher, but no one would be forced to go into this additional tier

of options, and in fact, we expect most workers would remain in the

first tier of very limited set of options, out of inertia if nothing else,

and those low costs there.

In addition, as long as workers have the free choice of staying

put or of moving back down if administrative costs in the upper

tier become too high, we believe that the competition from this lowcost, low-choice tier would keep costs down even at the upper tier,

simply because if you priced yourself too high, workers would not

make those choices.

Senator REED. So you anticipate a multitier, at least a two-tier

system?

Mr. TANNER. Yes. I anticipate that initially workers would be

given a very limited variety of choices, either a TSP type of model

or perhaps three balanced funds, which is in the legislation in the

House that I think is a good model, or perhaps just a lifecycle fund,

but something very limited initially with a default in case workers

make no choices whatsoever, that there would simply be a default

option that they would fall into. And then once a trigger is reached,

say an accumulation of $10,000 or more in your account, then you

would be able to move, if you chose, to a wider range of options,

or stay put in that first tier.

Senator REED. Mr. Furman approaches this in a slightly different

way. I think in your testimony, Mr. Furman, you say a similar

point but I think a different emphasis: Estimates that show low administrative costs for accounts are based on limited choice and an

unprecedented degree of Government administration, which you observe, Mr. Furman, could prove to be politically untenable over

time.

So your point would be that this expansion, if multitiered, eventually would be—they would not stay in the lower tier, they would

want the whole——

Mr. FURMAN. Right. Two points to make about that. It is a very

good question, Senator. Sweden gives you—it still is government

managed, government administrated, and very centralized—a

wider range of choices along the lines of what Mr. Tanner was just

26

recommending. The average fees there are 0.73 percent per year.

Accumulate that over your retirement, eats up 15 percent of your

account. That is about twice as large as what the actuaries estimate. That is the first point.

The second point is if you think about the politics, the President’s Commission strongly recommended a tier 2 of funds. They

said the Government picking one equity allocation for the whole

country was not a good idea. A lot of advocates of accounts believe

that. If you look at something like Senator Sununu’s plan, it has

assets in account of $80 trillion in 2079. That is 200 percent of

GDP. Half of those were in the stock market. That means those accounts in Senator Sununu’s plan would hold the entire United

States stock market. To imagine the entire United States stock

market being held in one Government chosen allocation of stocks,

whether it is an index of anything else, is to me unimaginable.

Senator REED. Thank you.

A final question. Mr. Cavanaugh, you talk about the Social Security Trust Fund as an alternative investing in the market as another approach versus these private accounts. Others have advocated this, obviously. What do you think are the advantages and

disadvantages as compared to private accounts, of simply, as many

have suggested, allowing the Government to invest a portion of the

Social Security Trust Fund into the market, getting presumably a

higher return with we hope low operation overhead?

Mr. CAVANAUGH. It is a no-brainer in the sense that——

Senator REED. That is my type of plan.

[Laughter.]

Mr. CAVANAUGH. Virtually everybody would agree that a diversified portfolio is the way to go, particularly with regard to long-term

pension funds, and you should have equity securities in there and

all that. The only argument against the trust fund investment that

is made over the years—and I used to make it when I was in the

Treasury Department, I confess—is that this would amount to Government ownership of stock, the means of production, socialism, all

that thing.

There might have been some merit to that years ago, but since

then every State in the United States has authorized pension funds

to go into stocks. We are the only ones that do not. Maybe it is because we know something about what the Fed is going to do that

they do not, but I do not think so. And ever since we brought in

the stock index fund, which the TSP uses that took care of the

problem of Government control over any one company because you

are buying a broad index, you are not buying a particular stock.

And in my prepared statement that I submitted to the Committee, there is a chart on there showing that the trust fund alternative would involve less Government control over private companies than either the TSP or the Administration’s plan. I go right

down the line into every particular. It would be less. I just cannot

believe that old argument. Whatever we might do with individual

accounts, surely, the Social Security Trust Fund should be diversified like everybody else is doing.

Senator REED. Thank you, gentlemen.

Thank you very much, Mr. Chairman.

Senator HAGEL. Senator Reed, thank you.

27

Mr. Cavanaugh, I want to just go back and cover one point in

response to a question that Senator Reed asked. The question was

about leakage, and your response that there could well be great

pressure, if we had personal accounts, to open those up for family

emergencies or whatever it is.

We have never had that problem at Social Security to my knowledge; is that right?

Mr. CAVANAUGH. Yes.

Senator HAGEL. For 70 years we have never opened it up for

emergencies?

Mr. CAVANAUGH. Because there is no individual account to give

to people, so there is nothing that they could claim.

Senator HAGEL. But we have never had that issue. I understand

the definition difference, but I believe that should be pointed out

as well, that when the Congress passes a law, and if we did this,

we would certainly mandate what the rules would be, and I think

the President’s plan says this clearly. My plan does. I think the

other ones do. And I just wanted to add that footnote to your response, that certainly that is a possibility, but I do not think it is

a strong enough possibility to be an overriding factor.

Mr. CAVANAUGH. All I can say, Mr. Chairman, is that the Congress did, in the TSP, say in the statute ‘‘no withdrawals.’’ But

later on the pressure was such that the Congress amended it to

permit the withdrawals.

Senator HAGEL. We can always amend things, as you know. But

I wanted to at least get the other side of that on the record, and

I appreciate your response.

Mr. Tanner, should we consider other options as we are looking

at how do we reform Social Security, should we reform Social Security? We all, I think, agree that we are going to have to address

the issue. Are there options other than personal accounts? Are

there investment options or should we just raise taxes and continue

along the course that we are on?

Mr. TANNER. I certainly think that any Social Security reform is

going to have to make some effort to restrain the growth in future

Social Security benefits. I believe that personal accounts are absolutely essential for the reasons that I have outlined, particularly

ownership, inheritability, and choice, but they do not solve all the

problems with Social Security’s finances. There is going to have to

be other measures taken as well. I think that means that you are

going to have to restrain the growth in Social Security benefits.

But as former President Clinton said, you have very limited

choices when it comes to Social Security. You can raise taxes, you

can cut benefits, or you can invest privately, either through personal accounts by individuals or through the Government.

I think Government investing would be very dangerous. You

have to look no further than CalPERS, for example, to see them

trying to interfere with who is going to be the next Chairman of

Walt Disney. Do we really want the Federal Government making

those type of decisions? You can look to State pension funds and

see that about 44 percent of them have targeted investment requirements saying that you must invest in certain types of investments, or that they cannot—25 percent have restrictions saying

you cannot invest in certain types of things. My old friend, Senator

28

Dodd, would be able to tell you about Connecticut, where they

forced the State pension fund to invest in Colt Industries and the

problems that created both in terms of conflict of interest and in

terms of the losses that they incurred because of that.

I think that when it comes down to a choice between private investing, between the individual and the Government doing it, we

should definitely side with the individual, but we are also going to

have to do other things as well in terms of restraining benefit cost

and growth.

Senator HAGEL. I know the hearing is intended to stay focused

on what we are talking about here, and I will keep within those

boundaries simply because we have a lot of territory to cover that

we have not yet touched upon. But I think at the end I will do a

wrap-up question and ask each of you what additionally you think

we need to do to deal with the solvency issue of Social Security,

aside from what this hearing is about, and you just alluded to it.

You did not specify what those are. Some of those things are in my

bill, but I will ask each of you at the end if you would offer your

thoughts on that outside of personal accounts or other options for

investment vehicles.

Mr. John, let me ask you the same question that I just put to

Senator Tanner.

Mr. JOHN. I kind of like the idea of Senator Tanner. It has a nice

sound to it.

Senator HAGEL. Well, he is close to Dodd, you know.

[Laughter.]

Mr. JOHN. We also believe that Social Security changes must go

along two courses. One is that we strongly support a personal retirement account for the simple reason that this gives my daughter

the opportunity to do something more than face a world of higher

taxes and lower benefits. I do not see that as being an attractive

Social Security system to leave her.

Two, it is very clear that we need to change Social Security’s benefits and to bring them closer to what Social Security can actually

afford to pay. As I mentioned, she is going to be faced with a choice

otherwise, especially with a health care system that is in serious

jeopardy, of financing benefits for her kids or financing benefits for

her parents.

There is no way around changing Social Security’s benefit formula, and Social Security’s benefit formula has been adjusted in a

number of different times. It is not a program that sprung full

blown from the head of Franklin D. Roosevelt in 1935. The current

benefit structure or benefit calculation basically dates from Jimmy

Carter’s era in the late 1970’s. It has been changed a number of

different times and it needs to be changed again.

Senator HAGEL. Mr. Furman, I will ask you the same question,

but focus as well on a comment that Mr. John made in his written

comments and he just alluded to, about this generational choice

that we are going to burden our next generations with? I think the

reality of that is becoming clearer and clearer. I would appreciate

your answer in the context of that as well.

Mr. FURMAN. There is no question that we face a Social Security

challenge and that it is better to act sooner rather than later in adVerDate 11-MAY-2000 16:58 Sep 22, 2006 Jkt 025856 PO 00000 Frm 00032 Fmt 6633 Sfmt 6633 29725.TXT SBANK4 PsN: SBANK4
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dressing that challenge. That being said, it is better to not act at

all than to do harm, and to wait and do it in the right way.

The Social Security benefits are projected to exceed Social Security revenues so you have to either reduce benefits or raise revenues. I would recommend adopting a combination of both of those

approaches, as we have done historically. Historically, we generally

have done both when we have gotten into trouble in Social Security.

In terms of accounts, they do not help with the problem. In fact,

in the short-run they make it worse because they increase the debt

and drain money from Social Security. In the long-run, they do not

help either because these administrative costs we are talking about

today ensure that the new system, the total amount of resources

in that system is less than what the resources are in the system

today because some of those resources are consumed by administrative costs.

Senator HAGEL. I suspect Mr. Tanner and Mr. John do not agree

with your comment. Would you both care to respond to Mr.

Furman?

Mr. JOHN. Just quickly, Senator. The Social Security Administration Actuary estimates that a personal account structured as the

President would like and with that type of an investment, would

return 4.6 percent after administrative costs, which would be, according to the President’s calculations, assuming a 3 percent Federal bond rate, which I think is incorrect, but assuming that would

mean that even after paying costs, that they would be making 50

percent more than Federal bond rate, which is definitely an advantage. I mean these administrative costs, under a system that is

managed through the Federal tax system and not through the employer, would not eat substantial amounts of the investments. I

mean even Mr. Furman’s numbers suggest 7 percent. Now, frankly,

I am willing to invest 7 percent or pay 7 percent in costs if I am

going to do 50 percent better than Federal bond rate. It is a fairly

simple choice for me.

Senator HAGEL. Mr. Tanner.

Mr. TANNER. I would agree. To some degree you would get what

you pay for. There is no doubt that the administrative costs of the

current Social Security system are extremely low, but so is the rate

of return that people get. There used to be in East Germany a car

called the Trevant that was essentially made of plastic, and it cost

about $500. As soon as the wall fell, people stopped buying

Trevants and started buying Mercedes Benzes even though they

cost more. The reason was it was a better car. I think people would

be willing to bear somewhat higher administrative fees if they

could get a much higher rate of return from private accounts. At

any rate, it would be a choice.

All the individual account proposals that I know of, I believe including the Chairman’s and Senator Sununu’s and those in the

House are voluntary. Individuals could stay in the current Social

Security system if they wished. If they were worried about these

administrative fees they would be able to stay put, but people

would be given the choice of earning a higher rate of return and

paying a little bit more to do so.

Senator HAGEL. My bill does that as well.

30

Mr. Cavanaugh, would you care to comment on any of this?

Mr. CAVANAUGH. Yes, on the cost thing. You know, all of these

estimates, the Administration estimate of 3/10ths of 1 percent, of

30 basis points, and the others of 50 and so on, these are based

on the known world of 401(k)’s. That is where the experience is

that people are looking at. What we are talking about in these proposals by the President is the unknown world of small business,

where you do not have the experience of administrative costs that

relate at all to what has been done in 401(k)’s. What you have is

a market out there that is telling you, unquestionably, that it cost

3,000 bucks a year to go into a company and set up a plan. If you

have 60 percent of businesses with less than 5 employees, that is

600 bucks a head, and 600 bucks out of the President’s proposed

$1,000 contribution is a 60 percent expense ratio.

This is the world we have to look at, and this is why I suggested

in my statement to the Committee to bring in the 401(k) providers,

all those firms I mentioned, give them a specific list of exactly what

you want them to do, and based on their experience and what they

are now saying on their websites, they would have to tell you it is

impossible.

Senator HAGEL. Mr. Enderle, you know something about that

business. What do you think?

Mr. ENDERLE. I think it is best to respond, given my area of expertise really has to do with the management of the assets as opposed to the administrative costs associated with 401(k) plans. I

think it really comes down to two things. One is what type of investments are best suited for any type of private accounts, if it does

go in that direction, and two what to do to minimize the investment related costs associated with those assets?

I do think that it would be in investors’ best interest to have an

array of probably diversified index options that are both low cost

in terms of the cost of trading or the management fees associated

with such index funds, and they are low risk investments as well.

The other option would be lifecycle which we talked upon as well,

which also can be offered as a low-cost investment solution which

has the benefit of adjusting the asset mix over time to meet an investor’s time horizon.

I think the number of options that are available is going to be

critical because that also would affect the assets under management for any one fund, and hence would be impacting the cost

structure as well. The issue around how frequently participants

would be able to change their exposure to any one fund, which

would also impact the administrative costs as well as the management costs.

Senator HAGEL. I do not know of anyone’s plans that would have

the employer administering anything. The employer is not administering any of the plans I am aware of, and the plans I am aware

of, they would be modeled after TSP, the same kind of thing. Obviously, if you have 100 million accounts, I would assume you would

have to bring in others, not just Barclays, but maybe 5 Barclays.

I do not know that, but respond to that, if you would. You do know

something about that.

Mr. ENDERLE. Sure, I think there are two things to consider. In

terms of, even if we had 100 million accounts, if the options availVerDate 11-MAY-2000 16:58 Sep 22, 2006 Jkt 025856 PO 00000 Frm 00034 Fmt 6633 Sfmt 6633 29725.TXT SBANK4 PsN: SBANK4
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able to those participants are the same as what is currently offered

to the TSP participants, what Barclays is managing 4 out of those

5 accounts, that is certainly very manageable from our standpoint.

So it is much less to do with the number of accounts that are out

there and more to do with the number of investment options that

are available. That would be the thing that I think would determine how many managers you would need.

Senator HAGEL. And we are talking about limited funds here.

Mr. ENDERLE. That is right.

Senator HAGEL. Same thing as we have talked about with TSP.

Mr. Amelio, would you like to respond to any of these points?

Mr. AMELIO. I think I can within the overall concept of costs. I

speak for every plan administrator in America when I tell you that

if you are looking at creating any kind of an institutional plan, if

you want to minimize cost, you cannot have early distribution options like loans and hardship withdrawals. I can tell you, I would

love to ask Congress to get rid of the hardship withdrawals and

loans from the plan. They are not a retirement feature. They encourage participation. It is not feasible. But they add greatly to the

plan expense.

The second thing, I speak for all plan administrators I think

when I say that we are able to maintain our costs because we keep

the plan simple. We have 5 investment options. It is short, it is

sweet. That gains the participants’ confidence level. It also keeps

the cost down and it keeps participants putting money into the

plan, and I think that is very important.

I want to tread lightly on the last one, because I stand in two

shoes. As the fiduciary to the plan, I will obviously stand up and

protect the G Fund because it is a great investment vehicle for the

plan participants, but we are the only plan in America that has it.

No 401(k) plan does. It is Government securities. It is a special and

unusually high interest rate. But as a plan participant and a taxpayer I take issue with it. It is costly. It costs the Government a

lot. I guess if I were not a fiduciary but still in my role I might

look at just using a regular money market fund out in the open

market which would reduce the burden on the Government. But

that is not my role, and as a fiduciary I will protect the G Fund,

but I throw that out for your consideration otherwise.

Senator HAGEL. Thank you.

Let me ask each one of you what would be your response to the

larger question which we touched on a little bit earlier this afternoon with some of my colleagues, if we were to set up 100 million

accounts. How would the market react to that? No one can be certain, obviously, but what is your best guess as to what would happen and would we phase that in, or how would you do that? Is it

dangerous? What kind of risk are we talking about? Give me your

best assessment, realizing that there are no guarantees and there

are so many unknowables, uncertainties, and uncontrollables which

we factor in. But that has been a question that has been raised by

many people, and I would appreciate your thoughts.

Mr. Furman.

Mr. FURMAN. Yes. I would focus in answering this question not

on the number of people with accounts, but the total amount of assets in those accounts. And it is a very important question because

32

in plans, I believe in your plan, it is about 80 to 100 percent of

GDP would be held in accounts, and in Senator Sununu’s it would

be 200 percent of GDP. So we are talking very substantial financial

holdings.

Now, there is only a fixed capital stock in the United States, a

fixed amount of human capital, and when you have more money

chasing the same thing, it drives the price of it up. And the way

the stock market works is when the prices of stocks are higher,

that is great for the people that already have them, but people just

coming into the market have to pay more, and they actually get a

lower rate of return going forward. This process was described——

Senator HAGEL. It depends too on the fund. There is an international fund, for example, and there are high yields and so on.

Mr. FURMAN. That is actually a very important question as to

whether you would internationally diversify, and I think it is a

prudent part of anyone’s portfolio. This was summarized in the

leading public finance textbook in economics which was written by

Harvey Rosen, who as I mentioned before, just recently stepped

down from the Administration. He wrote: ‘‘In order to induce private investors to accept Government bonds that would have been

bought by the trust fund, their yield has to go up, increasing the

debt burden on taxpayers, or the yield on stocks must fall, or both.’’

That I think summarizes the standard textbook economics.

Senator HAGEL. Thank you.

Mr. John.

Mr. JOHN. I think there would be two effects. One is you would

see a very positive effect in the markets worldwide because it

would indicate that the United States is actually serious about

dealing with its entitlement spending. That is something that has

been a matter of major concern worldwide. If you saw what happened—I believe this was earlier this year—when the South Korean Central Bank was rumored to be diversifying out of dollars.

This is the kind of signal they need.

And two, as far as assets, the amount of assets under management in these accounts, I think it would be relatively small as compared to the overall global level of assets. I mean currently globally, there is somewhere around $20 trillion in financial assets out

there. There actually is not a fixed capital stock in the United

States. There is a fixed capital stock on any one day. But as the

Washington Post pointed out in one of its editorials, the value of

the stock market, aside from increases or decreases due to supply

and demand, actually increases and decreases regularly due to

companies that merge and go out of business, companies that issue

new rights and things along that line.

So this is a constantly growing pool of money, and it is really not

possible to limit it to just the United States, because if you look

at the New York Stock Exchange, you will find companies like Prudential PLC, which is a British investment company. You find

DaimlerChrysler, which of course is worldwide, so essentially you

have to look at the growth of the worldwide assets.

Mr. FURMAN. Could I very briefly insert something?

Senator HAGEL. Go ahead.

Mr. FURMAN. The $20 trillion right now is less than 200 percent

of U.S. GDP, and we are talking about plans that have asset holdVerDate 11-MAY-2000 16:58 Sep 22, 2006 Jkt 025856 PO 00000 Frm 00036 Fmt 6633 Sfmt 6633 29725.TXT SBANK4 PsN: SBANK4
33

ings of between 100 and 200 percent of U.S. GDP, so if the RyanSununu plan were in effect today, it would hold 200 percent of

GDP in assets. That is the equivalent of about $24 trillion. That

would more than exhaust the global asset stock, and those are very

important questions to think about when you are talking about accounts of that magnitude.

Mr. JOHN. But not overnight. I mean the Ryan-Sununu plan, hypothetically, if you believed Dr. Furman’s numbers, would, but the

thing is, this would not be a matter where on March 31 there is

zero and on April 1 or April 2 there would be 200 percent of GDP.

And during that period of time the amount of assets worldwide

would continue to grow.

Mr. FURMAN. Historically, it has grown with GDP, but maybe it

might grow faster than GDP.

Senator HAGEL. We will let Mr. Tanner have a turn.

Mr. TANNER. Yes. I was going to say you cannot assume a static

model that just assumes that we are going to have the same

amount of capital stock 75 years from now that we have today.

If you look at this on a day-to-day basis, the amount of money

going in, even if you took the entire amount of Social Security

taxes and put it in the New York Stock Exchange, it would be

roughly the equivalent of 22 minutes a day of trading. The U.S.

capital markets are enormous. They are going to be even more

enormous 75 years from now even with the accumulations we are

assuming. I do not think we are going to swamp those markets. If

you go to a worldwide basis you are talking about maybe one-half

of 1 percent of worldwide capital markets right now.

I do think you would have a couple of impacts in the long-term.

You would have what is simply called the ‘‘capital deepening effect,’’ which is that capital flows first to the best returning investments and then ever lower returning investments as you go out. If

you increase the amount of capital going to investments, they are

going to go to further and further out to lower returning investments, and the average rate of return on all investments is going

to decline.

Martin Feldstein estimates you would have about a 15 percent

decline in the average return on investments, but that would not

occur for about 40 or 50 years. Eventually, you would see it begin

to go down somewhat in terms of average return, but that would

not be an effect on any individual stock price.

What you would also get is that as you increase the pool of capital, you would actually increase the amount of liquidity in the

markets, and it creates more stability in the markets because they

would be insulated from some of the shock effects. You can look to

Chile for an example of that, where when the Asian crisis hit, and

it really socked most Latin American markets, Chile, where the accounts manage about 50 percent of GDP, suffered a much smaller

decline in terms of their markets because of the insulation effect

that this amount of capital in the markets had.

Senator HAGEL. Mr. Cavanaugh.

Mr. CAVANAUGH. I think your question is what would be the impact on the economy and financial markets if we had 100 million

accounts. There would be no change in the total asset flow. There

is no reason to assume that the money coming in for Social SecuVerDate 11-MAY-2000 16:58 Sep 22, 2006 Jkt 025856 PO 00000 Frm 00037 Fmt 6633 Sfmt 6633 29725.TXT SBANK4 PsN: SBANK4
34

rity taxes would be any different from what it is now. What would

happen is that instead of all of it going into Treasury securities,

some of it in the individual accounts would go into market securities, which means the Treasury would have to borrow more in the

market and less from the Trust Fund. It would be just a swap of

securities. There would be no overall impact on capital. There

would be marginal benefits in terms of a better demand for stocks

because people are going in. Another point is financial institutions

generally would be better off because Social Security historically

has been pay-as-you-go. You just had enough money in to take care

of each year. But because of the 1983 changes, we have been

prefunding. It is now up to $1.5 trillion. In the next few years, it

is supposed to go up to $3, $4, or $5 trillion, by different estimates.

So all of a sudden the market is interested because before, the

market was not losing a lot of investment opportunities because

the money was just going in and out pretty quickly. But now that

it is building up, we are looking at $1.5 growing to $3 or $4 trillion,

money the market is not going to be able to get. It just goes all

in the Treasury securities. And so that is an important point from

the standpoint of the market. But as an economist, I would have

to say all we are talking about here is an asset swap. Treasury

would just issue more securities in the market instead of to the

Fund. And people who would have bought stocks would buy less because now these people, Social Security taxpayers, would be buying

more. Not a big deal.

Senator HAGEL. Thank you.

Mr. Enderle.

Mr. ENDERLE. I think in the end it is going to be a function of

the dollar amounts that are going to be affecting the various markets, and in essence, I think there are going to be four things that

are going to affect the market’s reaction as it relates to the dollar

amount that we are talking about.

The first is whether or not the assets are going to be phased in

over time, as opposed to what we mentioned earlier. It is not going

to affect the market or hit the market overnight. I think that

should have a muted impact on the markets.

The second is the number of options that are available, especially

if we have different asset classes that are available as options, that

would also provide more opportunity to spread the assets across

and, hence, would have a muted impact on some markets.

The third is whether there is a decision made to implement the

options through index funds, which provides the broadest diversification for any asset class and hence, would also have the most

limiting impact to any particular market if implemented through

a broad, diversified strategy as opposed to a narrowly defined strategy.

And then, last, it depends upon what other managers or, rather,

investors are doing. For example, as we talk about baby boomers

retiring and what their investment activity will be like in the future, it is quite possible that as we invest assets, say, into the equity market through the private accounts, there could be offsetting

flows that are also affecting the markets at the same time, where

there will be buy and sell activity such that the total amount that

is hitting the markets could be quite limited as well.

35

Senator HAGEL. Thank you.

Mr. Amelio.

Mr. AMELIO. I will give you an analogy and limit my remarks to

your example to the confines of the TSP. If we were to dramatically

increase the number of participants to the TSP and, hence, the inflow of dollars in, my concern would be the ability of the funds to

absorb that money, at least initially, into the more limited markets

that are available right now. This would drive our transaction costs

in the index funds up because we have seen it now when we get

active trading with our participants. If one of the markets goes

askew, they start to pull money out, or drive money in. As it drives

those transaction costs up, it pushes our return off of the index. In

other words, the index fund tracks an index such as the Wilshire

4,500. And to the extent our costs go up, it pushes our performance

number away from the index we perform perhaps if the costs go up

a little worse than the index would because of those trading costs,

and that would be my concern, at least over the short term, if there

was a dramatic increase of flow of capital. And that is from an administrator’s perspective.

Senator HAGEL. Thank you.

Let me ask each of you a question I mentioned a few minutes

ago. Aside from personal accounts and your positions that you have

made very clear on personal accounts, each of you, what do we

need to do to assure Social Security’s solvency? We will start with

you, Mr. Furman.

Mr. FURMAN. There are a few plans that I would recommend that

you take a serious look at. One is by economists Peter Diamond

and Peter Orszag, and another is by former Social Security Commissioner Ball. And what both of them do is increase revenues and

trim benefits. They increase revenues in a very progressive manner, including raising the cap, applying a tax above the cap, or

using estate tax revenue to help the solvency of Social Security.

And then they make some changes on the benefit side, including

correcting the Consumer Price Index that is used to adjust for the

cost of living. And in the case of Diamond and Orszag, it applies

longevity indexing to benefits, although it only takes half of the increase in longevity and applies it to benefits and applies the other

half to the revenue side, which from my perspective is the more

balanced way to deal with longevity than doing it entirely on the

benefit side.

Senator HAGEL. And that would be your approach to dealing

with——

Mr. FURMAN. Those are a number of options that I think would

make a lot of sense in terms of coming up with a plan that is overall balanced between revenues and benefits, balanced between people today and people in the future, and progressive overall.

Senator HAGEL. Mr. John.

Mr. JOHN. If I had to take personal accounts off the table, which,

of course, would be very painful——

Senator HAGEL. No. I know where you are on personal accounts.

You are one who advocates that personal accounts help get you to

solvency. So, in addition to that, unless you believe that that is the

only answer, what in addition to personal accounts?

36

Mr. JOHN. In addition to personal accounts, I would suggest some

form of progressive indexation similar to what the President has

been talking about recently, which would basically reduce the

growth of benefits for upper-income workers while leaving lower-income workers stable. I think this is also important because it

would remind upper-income workers that they need to continue to

participate in 401(k) and other private types or employer types of

retirement plans.

The second thing I would do, frankly, is to raise the retirement

age, recognizing fully that there are going to be a certain number

of workers in physically demanding jobs that simply cannot work

longer, and those workers are going to be placed probably on the

disability rolls in some way. I would also put in some form of longevity index in there.

The one thing I have not included is taxes, and for two different

reasons. Number one is that change in payroll taxes or employment-related taxes could have the result of reducing job growth,

and, frankly, that would be more damaging for the economy than

other things. And number two is that we always have the

unspoken problem, which is Medicare, and that one is much larger,

and I would be hesitant to use up all the tax options on the easy

problem.

Senator HAGEL. Thank you.

Mr. Tanner.

Mr. TANNER. I guess I would associate myself completely with

Mr. John’s remarks here. I believe that some form of change from

wage indexing to price indexing is a very fair way of approaching

it. I think that probably some longevity indexing in addition would

probably be a good idea. I think the overall requirement is to reduce and restrain the growth in benefits, that we simply cannot go

on forever increasing the amount of benefits that we pay to the elderly both through Social Security and Medicare. There has to, at

some level, be some restraint on the amount of entitlements, and

simply pouring more money into the situation in order to pay ever

larger entitlements I think is a mistake. And particularly I would

like to warn against the idea of raising the cap or removing the cap

on the amount of income subject to the payroll tax. To do so would

give the United States the highest marginal tax rates in the world.

We would actually have higher marginal tax rates than countries

like Germany and Sweden.

I think that is a significant danger of damaging the economy and

job growth, and it might even hurt overall Federal revenues since

there would be an enormous amount of switching to nonwage compensation and people would simply begin to hide their income in

order to avoid these huge marginal tax rates. So, I think you would

actually end up getting less revenue than you expect. Even if you

took this off altogether, you would gain something like 7 years of

additional cashflow solvency for Social Security. It is a very high

price to pay for very little gain.

Senator HAGEL. Would you include pushing out full benefit retirement age a year, or would you leave that alone?

Mr. TANNER. I think that it is certainly something that should

be on the table. It is a less favored approach that I have. I do think

that the problem is that for people in physically demanding jobs or

37

for people like African-Americans with shorter life expectancies,

raising the retirement age really leaves a hardship for them. I

think the longevity indexing is probably a better way to approach

this. It gives people more options than simply raising the retirement age would.

Senator HAGEL. Thank you.

Mr. Cavanaugh.

Mr. CAVANAUGH. I would agree, I think, with most of the options

that Mr. Furman mentioned, ones that have been advanced by

other economists, Peter Diamond and the Brookings Institution,

Henry Aaron, that thing. These are all things that could be done

that would more than offset the actuarial deficit projected by the

trustees for the Social Security Trust Fund.

However, each one of them hurts somebody in terms of increasing the age, removing the cap, or bringing in State and local governments. People have problems with all of these options. The one

that I think is the most desirable is if you did what I suggest with

the trust fund investment. If you invested 50 percent of the Social

Security Trust Fund balance in equities, with the other half in

Treasuries or whatever, that would eliminate approximately onehalf of the total actuarial deficit projected by the trustees.

But I must say that I think the CBO estimate is that the fund

is not going to run out of money until 2052. The trustees are saying

2041. When I first began to look at this area 9 years ago, the trustees were saying 2027. And then they moved out in the last 9 years

to 2041. I do not think that we can make substantial policy

changes today based on moving targets like that. We have no idea

what the world is going to look like in 2040 or 2052 with the

growth that we have had in productivity and immigration, women

in the labor force, things that we never could have projected 40 or

50 years ago.

I would be very careful to make drastic changes today based on

these projections, which have proved to be way off.

Senator HAGEL. Thank you, Mr. Cavanaugh.

Mr. Enderle.

Mr. ENDERLE. Given my area of expertise, which is really to provide technical comments on investment management-related issue,

I am really not, I guess, in the best position to comment on how

best to address the issue of Social Security solvency type questions.

Senator HAGEL. Thank you.

Mr. Amelio.

Mr. AMELIO. The Board does not have any position on this issue,

as you can imagine.

Senator HAGEL. You are a technician.

Mr. AMELIO. Yes.

Senator HAGEL. Thank you.

Let me ask one last question, and I do not know if you have any

thoughts on this. But is there anything in particular we can learn,

we should be paying attention to, from other countries who have

gone through this? Chile obviously is an example that has been

used here a couple of times this afternoon. The United Kingdom,

Sweden, and other countries have had to deal with this. Some have

deferred it. Some have dealt with it fairly successfully. None have

gone through it, that I am aware of, without some ups and downs

38

and adjustments and calibrations. But as the last question for the

six of you, starting with you, Mr. Furman, anything in particular

that we should be focused on in learning from these other nations

that have gone through something similar?

Mr. FURMAN. One of the strongest lessons from international experience is that the administrative costs can tend to be very high

and exceed what people originally expect for them. That is especially true in a decentralized system like Chile or the United Kingdom. Administrative costs also go way up if you give people even

the limited set of Government-sponsored choices that you have in

a country like Sweden.

So if there is one lessons from international experience, it is that

a lot of the benefits you think you are going to get from these accounts come up against the hard reality of how complicated they

are to administer and costly to administer in practice.

Senator HAGEL. Thank you.

Mr. John.

Mr. JOHN. As you look around the world, the first lesson to come

up is do it now. If we look at the Japanese, the Germans, the

French, and the like, who have waited much later in the demographic positioning than we have, the choices only become more

and more painful. If we look at Australia and Switzerland, we find

that it is actually possible to mandate savings, whether it is

through a personal account attached to Social Security or some

other way. And if you do it soon enough, you can build significant

amounts of assets and reduce the long-term costs to your society

of a pension plan.

If you look at the United Kingdom, you will discover that you can

actually screw up a private pension plan, if you make it too complex or if you try to micromanage. And if you look at Germany, in

particular, the Riester reforms from about 2001 or so, you find that

if you come up with what is otherwise a good plan and it is far too

complex, nobody is going to understand it and nobody is going to

support it.

Senator HAGEL. Thank you.

Mr. Tanner.

Mr. TANNER. My comments would be very similar. I think that

it is very important that any plan that is devised be transparent

and easy to understand for everyone involved. I think Britain is a

classic example of a plan that was overly complex, opaque; very few

people had any idea where their money was going and how it

worked. It was tax credits against something else, a type of thing

that was not necessarily even connected with your Social Security

taxes. You had to be twice removed from it. And the result led to

a great many problems.

The Chilean system I think shows that it can be done. You have

to remember, when Chile did this, this was back when Brezhnev

was the head of the Soviet Union. We did not have computers. People did things on paper. And yet they were able to create this type

of system, which is remarkably efficient. The costs today are about

65 basis points for administering these accounts in Chile, which is

higher than here but quite reasonable. So, I think it proves that

it can be done if you are willing to undertake it.

Senator HAGEL. Thank you.

39

Mr. Cavanaugh.

Mr. CAVANAUGH. In response to your question what do we learn

from foreign experience, I think we learn not to do it. I have a different perception from Mr. Tanner of the Chilean experience. When

that was put in, it was mandatory. Back in 1981, I think they

started it. And the only people that did not have to join it were

General Pinochet’s officers, the military. I think they had a little

insight into what the plan was about.

As I recall, 40 percent of Chileans, although they were supposed

to go into this thing, opted out because there was some kind of a

back-up thing like Social Security that they could take instead, and

they just went against the law. And The Wall Street Journal did

a survey of the Chilean, the British, Swedish, and others just a few

months ago, and according to their figures—and I have heard the

number in other places—in the Chilean individual accounts, the financial institution takes 20 percent off the top right at the beginning. I do not see how you can get anywhere with that kind of

management. As to the British system, in addition to the problems

mentioned by Mr. Tanner, a few months ago it was noted in the

press, because of the enormous reaction to the way British financial institutions handled that, there was a class action suit that

they finally settled for $24 billion. In Great Britain, that is a lot

of money. And that is how bad the problem was.

So the United Kingdom is definitely not a model, and Chile, in

my opinion, was a failure.

Mr. TANNER. Mr. Chairman, if I can just correct something for

the record, the Chilean system that was implemented was voluntary. The military and police were forbidden to go into the system because they had something similar to a civil service pension

which is linked to your rank and things like that. They were not

part of the Social Security system at that time. For ordinary workers, it was voluntary. Some 93 percent of Chilean workers have voluntarily chosen to go into the system. About 40 percent of workers

are not currently participating because they are in the underground economy, tax evasion being a time-honored tradition in

much of Latin America. They are simply not on the books and,

therefore, they are not participating in any of the system. They

were not participating in the old Social Security system either

since they were working under the table. But it is entirely a voluntary system under the system.

Senator HAGEL. Thank you.

Mr. Enderle.

Mr. ENDERLE. My response is essentially the same as to the previous question in that I am most qualified to respond to any investment management-related questions for any plan that may be proposed or considered.

Senator HAGEL. Thank you.

Mr. Amelio.

Mr. AMELIO. I think the universal comments that I have experienced at this hearing, other hearings, and other writings with

these plans are that there have been complications and high costs.

I think that only really illustrates what a great job Congress did

in 1986 when they created the TSP. They put the structure in that

40

stands today, and that is where we are. And so kudos to that Congress in 1986.

Senator HAGEL. A high point to leave this hearing on, obviously.

And I know Senator Dodd was here, Senator Sarbanes, maybe others, and I shall pass on your congratulations for their wisdom and

direction and leadership.

Gentlemen, you have been very helpful and made significant contributions, and we will most likely be back in touch with you at

some point. But you have helped us immeasurably, and we appreciate very much your time and your thoughts.

The hearing is now adjourned.

[Whereupon, at 4:16 p.m., the hearing was adjourned.]

[Prepared statements supplied for the record follow:]

41

PREPARED STATEMENT OF SENATOR TIM JOHNSON

Thank you, Mr. Chairman, for holding today’s hearing. I am proud of what this

Committee has done to enhance our capital markets, which are the strongest and

most efficient in the world. With comprehensive corporate governance legislation

and a fairly comprehensive new regulatory scheme for the mutual fund industry

under our belts, I think we’ve made the marketplace a more transparent and secure

place. There is no denying, however, that our marketplace derives its strength on

risk, and I appreciate today’s opportunity to look at whether this concept of risk is

appropriate in the context of retirement security.

Since President Bush began his campaign to establish private accounts within Social Security, support for his plan has declined significantly. Even members of his

own party have voiced their concerns and outright objections to his plan. It seems

that as Americans learn more about the structure of his plan, more and more people

reject it. A recent Wall Street Journal/NBC poll found that a majority of Americans

think that it is a bad idea to change the Social Security system to allow workers

to invest their Social Security contributions in the stock market.

Private accounts from the get-go are a bad idea for the Social Security program.

As I traveled recently throughout my State and held town halls, I shared my

thoughts with constituents about the vast new borrowing that would be required,

the inherent risks in a privatization scheme, and the alarming benefit cuts that will

be experienced by all beneficiaries—irrespective of whether or not they select to

have a private account. As I shared this information, over and over again I heard

the people of South Dakota say—‘‘don’t privatize this program.’’

Now, I would guess that the hope of some here today is that this hearing will

provide an opportunity to talk about the details of how private accounts would work,

but in my mind, there is no need to even walk down that road. The underlying principles behind the privatization concept are flawed, and I think that is where our

discussion today should begin.

As we think about the underlying principles of the President’s plan, we must not

forget the intent of the Social Security program—to provide insurance for unintended events that threaten financial security, and to provide a secure, guaranteed

financial floor for which all other aspects of retirement planning are built upon.

Some things that we need to consider as we hold this hearing today.

Foreign Debt

The vast new borrowing required by the President’s privatization proposal threatens our standing in the financial markets of the world. As of the end of 2004, foreign ownership of the debt already reached almost $2 trillion, or 44 percent of the

total held by the public. The addition of $5 trillion in transition costs over 10 years

that is required by private accounts will threaten the stability of the U.S. economy.

If foreign investors lose faith in our ability to finance this debt, this could lead to

soaring interest rates, a weakening of the dollar, and even a deep recession or depression.

In the context of today’s discussion on the role of our financial markets in Social Security, one cannot underestimate the threat that our current $400 billion national

deficits pose to the health of our financial marketplace. Last February, the Korean

central bank indicated that it planned to limit its dollar holdings and purchase different currencies instead. Following this news, stock prices fell sharply.

Several weeks later, Japan indicated it was looking at limiting its dollar holdings.

What happened? Another terrible day on Wall Street. Something drastic—like

Japan or China selling a large amount of U.S. dollar holdings—could have a devastating impact on our economy. I have serious concerns about whether it is prudent

to give any foreign country substantial leverage over the U.S. economy, much less

the retirement security of the two-thirds of our seniors that depend on Social Security as their primary source of income.

Risk and Rate of Return

While the average real return on long-term government bonds was 2.3 percent,

and the annual total rate of return on large corporate stocks was 7.2 percent between 1926 and 2003, such figures do not account for the variation in returns for

both types of assets over shorter periods of time. Depending on a worker’s birth

date, the retirement benefits relative to preretirement earnings generated from putting one’s savings away for 35 years could have gone from 100 percent to less than

20 percent.

For every dollar deposited in a personal account, a worker’s traditional benefit,

delivered in a monthly Social Security check, would be diminished by a dollar, plus

the interest rate the money would have earned in Treasury bonds. This ‘‘claw-back’’

requirement means that in order to come out ahead of the traditional system, an

42

account would have to realize returns on investment of at least 3 percent above the

rate of inflation.

When examining past trends, it would not be unlikely that the government will

have to assume costs to bail-out a privatized system that provides too few benefits.

Their will always be the chance that the market will under perform, and because

whole generations would end up with too few savings in retirement in this scenario,

the problem will be too large for the Government to ignore. A Government bail-out

would be an extremely costly undertaking. For example, when the savings and loan

crisis of the late 1980’s occurred, these economic problems of the past became large

enough to justify a bail-out, costing the U.S. taxpayers over $120 billion.

Administrative Risks/Costs

Most of the financial services industry in the United States is very effective and

sound, but we must remember there are risks and costs involved in investing in the

stock market. Not only the risks associated with putting money into stocks, but also

risk involved in giving so much financial power to a small group of people. Creating

privatized accounts in the Social Security system, would also lead to an increase in

payments of financial fees to private financial management companies.

Britain privatized its Social Security system in 1986, allowing citizens to ‘‘contract

out,’’ which is their term for putting government pensions into the stock market.

The scheme led the government pension system in Britain to the brink of crisis.

Last year alone, more than 500,000 people abandoned their private accounts in

favor of the state-managed Social Security system.

Securities fraud loomed large among the problems the British system faced. In the

early 1990’s, Britain’s financial services regulator, the Securities and Investment

Board, undertook random samples of paperwork from the insurance industry, which

was selling the private accounts to British citizens.

The regulator found a staggering percentage of private accounts had been sold to

those who would be worse off in retirement as a result. The public outcry over this

‘‘mis-selling’’ scandal forced the government to establish a review panel that ultimately found the insurers liable for making people worse off.

Over an 8-year period, 1.7 million people sought and received compensation that ultimately cost the insurance industry $12 billion. In addition, hundreds of millions

were paid out in fines and penalties. It was the biggest financial scandal in British

history to date.

According to a University of Chicago Study, Plan 2 of the President’s Social Secu- rity Commission would result in fees paid to Wall Street totaling $940 billion. These

fees amount to more than 25 percent of the existing deficit in Social Security over

the same period. In Britain, fees to private companies managing these accounts consumed an average of 43 percent of the value of an individual account over the course

of a 40-year working career.

Not an Investment Program

The President has made it a point to describe Social Security as an investment

program. This message neglects to recognize that about one-third of payroll taxes

go to fund disability and survivors insurance. Such insurance plans would be extremely expensive to purchase in the private market. In addition, the program provides protection against the risks of inflation by the way they are adjusted each

year. It is incorrect to measure the value of an insurance plan based on a rate of

return. For example, when you purchase life insurance, you do not want a good rate

of return, since that money will be made available only in the event of one’s own

death—and few people would opt out of a guaranteed life insurance program because of what potential rate of return could be realized in the stock market.

It is Not Your Money

The President has spent a great deal of time canvassing the country telling people

about the nest eggs they will be able to call their very own. The reality is that these

accounts will not be ‘‘your’’ money.

Not only do beneficiaries have to pay a retirement tax on their benefits, but the

President has not been very clear on the question of a mandatory annuity. He has

indicated that you will be required to purchase an annuity upon retirement, to assure some regular minimum payment at the poverty level if your income from other

sources is not adequate. The annuity payment ceases with your death. If there is

anything left in the account after the claw-back has taken its share and after you

have purchased an annuity, if you are required to do so, that will be yours to take

as a lump sum or leave to your heirs. It is not at all clear where these annuities

will come from, but it appears most likely to be the private sector.

This would mean not only a windfall for companies that were managing the funds

but also mandated annuities being underwritten by insurance companies. For most

43

people, their accounts are going to be tiny and will be eaten up by management fees.

When you annuitize it, what you get is very small.

Additionally, the claw-back requirement essentially means that you are receiving

a loan from Social Security for the money you want to contribute to your private

account, which you have to repay upon retiring. That does not seem to me to be

‘‘your money.’’

Deposit Insurance

However strong our capital markets, we are all aware that risk is inherent to the

marketplace. For years, I have pushed to make sure that those save for retirement

have at least one completely safe investment option: A federally insured account.

While there is a place and time for individuals to invest in the equity and bond markets, there is also a time and place for them to look to their banks and credit unions

for insured accounts. FDIC and SHARE insurance levels have not kept place with

inflation, and are woefully inadequate to cover the savings needs of today’s retirees.

Together with a bipartisan group of Banking Committee Members, I have advocated

an increase in Federal deposit insurance up to $250,000 for retirement accounts.

The demand for such coverage clearly exists. In fact, some large financial institutions with multiple charters actually promote offers of nearly a million dollars in

coverage for interest-bearing, personal accounts.

Now, in the context of Social Security reform, I will state here that I am unequivocally opposed to private accounts. That is not what Social Security is about,

and I believe it is a mistake to go down this path. However, if the President and

the Republican-controlled Congress are determined to privatize Social Security, then

they at least should make sure that participants are not required to roll the dice

with their nest eggs. Insured accounts should be an integral part of any privatization scheme, and it is our responsibility to make sure that insurance levels are adequate to cover the needs of our seniors.

Priorities and In Perspective

Social Security is in need of reforms to ensure its solvency for generations to

come. But major restructuring of the program is not required. To put the gravity

of the problem in perspective, one should note that the Social Security shortfall will

amount to .65 percent of the GDP over the next 75 years or $3.7 trillion, while the

President’s recently enacted tax cuts if made permanent amount to $11.6 trillion

over that same period. Additionally, the Medicare Trustees project that that Medicare drug benefit will cost 1.4 percent of GDP, or $8.1 trillion over that same period.

There is an inherent disconnect in the push for privatization. The President has

stated over and over that the Social Security Trust Fund is in immediate ‘‘crisis.’’

This manufactured crisis is based in part on financial assumptions that show a

weak future for our economy. At the same time that he paints this bleak picture,

the President has told the American people that investing the program in stocks is

the way to go because our future economic outlook is bright, with no possibilities

of downturn. We cannot have it both ways.

—————

PREPARED STATEMENT OF GARY A. AMELIO

EXECUTIVE DIRECTOR, FEDERAL RETIREMENT THRIFT INVESTMENT BOARD

JUNE 14, 2005

Good morning, Chairman Hagel and Members of the Subcommittee, my name is

Gary Amelio. I am the Executive Director of the Federal Retirement Thrift Investment Board and, as such, the managing fiduciary of the Thrift Savings Plan, or

TSP, for Federal employees and members of the uniformed services. I welcome this

opportunity to appear before the Subcommittee on behalf of the Board.

You have invited my testimony as part of your consideration of the role of the

Financial Markets in Social Security Reform. Although the Board has expressed no

view regarding any proposals to change Social Security, our experience with the

TSP may provide some useful information for the Subcommittee. I am pleased to

describe how the TSP functions in a number of key areas and to discuss how the

Congress addressed important TSP issues in the Federal Employees’ Retirement

System Act of 1986 (FERSA).

The TSP is a voluntary savings and investment plan that allows Federal and

postal employees (and, since 2002, members of the uniformed services) to accumulate savings for their retirement. It offers employees of the Federal Government the

same types of savings and tax benefits that many private corporations offer their

employees under Internal Revenue Code Section 401(k) retirement plans. The TSP

44

currently has approximately 3.4 million individual accounts. The Thrift Savings

Fund has grown to $157 billion. Each month, participants add more than $1.4 billion in new contributions. Participants may invest in any individual, combination,

or all of five investment funds; transfer their monies among the funds; apply for

loans from their accounts; transfer money into their accounts from other eligible employee plans or individual retirement accounts; and receive distributions under several withdrawal options. TSP administrative expenses are borne by the participants,

not by the taxpayers.

The Government-wide Federal Employees’ Retirement System (FERS) employee

participation rate is 86.2 percent. TSP participation by Civil Service Retirement

System (CSRS) employees is currently about 66 percent. Additionally, after only 3

years, nearly half a million members of the uniformed services also now have TSP

accounts.

Plan Structure

Employees who are covered by FERS, CSRS, or members of the uniformed services contribute via payroll allotment to the TSP. The maximum percentages they

may contribute are prescribed by law. These limits are scheduled to increase next

year to $15,000 annually for most employees and $20,000 annually for those age 50

and over.

FERS employees receive an automatic contribution to their TSP accounts, paid by

their employing agency, which is equal to 1 percent of their basic pay each pay period. Their employing agency also matches the first 5 percent of basic pay contributed—dollar-for-dollar on the first 3 percent and fifty cents on the dollar for the

next 2 percent. CSRS employees and members of the uniformed services receive the

same tax benefits as FERS employees, but receive no automatic or matching contributions from their agencies.

Governance and Administration

The TSP is administered by the Federal Retirement Thrift Investment Board,

which was established as an independent Federal agency under FERSA. There are

approximately 90 employees of the Agency. Governance is carried out by six individuals who serve as fiduciaries of the Plan. Five are part-time Presidential appointees

(confirmed by the Senate) who serve 4-year terms, and the sixth is a full-time executive director. The latter is selected by the appointees and serves an indefinite term.

Each of these persons is required by FERSA to have ‘‘substantial experience, training, and expertise in the management of financial investments and pension benefit

plans.’’ 5 U.S.C. § 8472(d). With input from the executive director and Agency staff,

the Board members collectively establish the policies under which the TSP operates

and furnish general oversight.

The executive director carries out the policies established by the Board members

and otherwise acts as the full-time chief executive of the Agency. The Board and

the executive director convene monthly in meetings open to the public to deliberate

policies, practices, and performance.

FERSA provides that all monies in the Thrift Savings Fund are held in trust for

the benefit of the participants and their beneficiaries. As fiduciaries, the executive

director and the Board members are required to act prudently and solely in the interest of TSP participants and their beneficiaries. This fiduciary responsibility gives

the Board a unique status among Government agencies.

Congress wisely established this fiduciary structure because it recognized that all

Plan funds belong to the participants, not the Government, and thus must be managed for them independent of political or social considerations.

The Conference Report on FERSA, House Report 99–606, dated May 16, 1986,

states in the Joint Explanatory Statement of the Committee of Conference:

Concerns over the specter of political involvement in the thrift plan management seem to focus on two distinct issues. One, the Board, composed of Presidential appointees, could be susceptible to pressure from an Administration.

Two, the Congress might be tempted to use the large pool of thrift money for

political purposes. Neither case would be likely to occur given present legal and

constitutional restraints.

The Board members and employees are subject to strict fiduciary rules. They

must invest the money and manage the funds solely for the benefit of the participants. A breach of these responsibilities would make the fiduciaries civilly

and criminally liable.

The structure of the funds themselves prevents political manipulation. The Government Securities Investment Fund is invested in nonmarketable special

issues of the Treasury pegged to a certain average interest rate. The Fixed Income Investment Fund is composed of guaranteed investment contracts, certifiVerDate 11-MAY-2000 16:58 Sep 22, 2006 Jkt 025856 PO 00000 Frm 00048 Fmt 6621 Sfmt 6621 29725.TXT SBANK4 PsN: SBANK4
45

cates of deposits or other fixed instruments in which the Board contracts with

insurance companies, banks, and the like to provide it with a fixed rate of return over a specified period of time. The Board would have no knowledge of the

specific investments.

Finally, the stock index fund is one in which a common stock index such as

Standard & Poor’s 500 or Wilshire’s 5000 is used as the mechanism to allocate

investments from the fund to various stocks.

The investment approach chosen by the conferees is patterned after corporate,

State, and local government, and the few existing Federal pension funds. Political manipulation is unlikely and would be unlawful.

As to the issue of Congress tampering with the thrift funds, the inherent nature

of a thrift plan precludes that possibility. Unlike a defined benefit plan where

an employer essentially promises a certain benefit, a thrift plan is an employee

savings plan. In other words, the employees own the money. The money, in essence, is held in trust for the employee and managed and invested on the employee’s behalf until the employee is eligible to receive it. This arrangement confers upon the employee property and other legal rights to the contributions and

their earnings. Whether the money is invested in Government or private securities is immaterial with respect to employee ownership. The employee owns it

and it cannot be tampered with by any entity including Congress.

H.R. Conf. Rep. No. 99–606, at 136–37 (1986), reprinted in 1986 U.S.C.C.A.N.

1508, 1519–20.

In keeping with the intent of Congress that the Plan be administered in accordance with fiduciary standards derived from those applicable to private sector employee benefit plans—as distinct from the usual administration of an executive

branch agency—Congress exempted the Board from the normal budget and appropriations processes and the legislative and budget clearance processes of the Office

of Management and Budget. The Plan’s independence is critical to ensure the fiduciary accountability envisioned by FERSA. So long as the Plan is managed by the

fiduciaries named in FERSA (the members of the Board and the executive director)

in accordance with the statute’s strict fiduciary standards, Federal employees and

members of the uniformed services can be confident that their retirement savings

will not be subject to political or other priorities which might otherwise be imposed

by these clearance processes.

FERSA protects the Thrift Savings Fund through more than just the independent

fiduciary governance by the Board members and the executive director. Additional

safeguards to protect TSP participants include the provisions in FERSA relating to

(1) the role of the Secretary of Labor in establishing a program of fiduciary compliance audits; (2) the requirement that the Board contract with a private accounting

firm to conduct an annual audit of the TSP on the basis of generally accepted accounting principles; and (3) the participation of the 15-member Employee Thrift Advisory Council, which includes representatives of the major Federal and postal

unions, other employee organizations, and the uniformed services.

The Board has benefited greatly from hundreds of audits conducted by the Department of Labor over the past 17 years. These audits, which have covered every

aspect of the TSP, are reported to the Congress annually under the Inspector General Act of 1978, as amended.

The accounting firm retained by the Board has conducted annual reviews as required. The result has been eighteen unqualified audit opinions.

The Advisory Council meets with the executive director and advises on investment

policy and the administration of the TSP. These meetings are very helpful in providing the Board with insights into employee needs, attitudes, and reactions to the

various programs undertaken by the Board.

The TSP also benefits from the cooperation of every agency and service in the

Federal establishment. Although the Board is an independent body, successful administration of the TSP is highly dependent upon all Federal agencies and the uniformed services, which have direct responsibilities under FERSA for the administration of the TSP.

Plan Services and Benefits

Employees and service members who participate in the TSP are served primarily

by the personnel, payroll, and other administrative employees in their own agencies.

The agencies are responsible for distributing TSP materials, providing employee

counseling, and accurately and timely transmitting participant and employer contributions and necessary records to the TSP record keeper. TSP recordkeeping services are currently provided by the National Finance Center (NFC), which is part of

46

the Department of Agriculture. The TSP Service Office in New Orleans performs a

wide variety of services for TSP participants.

In addition, the TSP maintains parallel call centers at NFC in New Orleans, Louisiana, and in Cumberland, Maryland. Participants with questions may call a tollfree number which routes calls to participant service representatives at one of these

sites. Further, we maintain a primary data center and a back-up data center.

Actively employed participants may borrow their own contributions and earnings

from their accounts according to rules established by the executive director and regulations of the Internal Revenue Service. Participants repay the loans, with interest,

and the money is reinvested in their TSP accounts. A $50 fee is charged to cover

the costs of loan processing.

The other major benefit program is the TSP withdrawal program. Participants

may withdraw funds from their TSP accounts before separation after reaching age

59 or in cases of financial hardship. Upon separation, a participant may:

• withdraw his or her account balance in a single payment (and have the TSP

transfer all or part of the payment to an Individual Retirement Account (IRA) or

other eligible retirement plan); • withdraw his or her account balance in a series of monthly payments (and, in certain cases, have the TSP transfer all or part of each payment to an IRA or other

eligible retirement plan); • receive a life annuity; or • keep his or her account in the TSP, subject to certain limits.

Participants may also elect a combination of these withdrawal options.

Communications

The Agency maintains its communication program on a number of levels within

the Federal establishment in order to achieve employee understanding of the investment choices, benefits, and the administration of the program. This is especially

important given the voluntary nature of the Plan and the participants’ degree of individual control over investments and benefits.

The communication effort is initiated by the Board for eligible individuals through

the issuance of a ‘‘new account letter’’ to each new participant after the employing

agency establishes his or her account. Employing agencies distribute program information, including the Summary of the Thrift Savings Plan for Federal Employees,

which provides a comprehensive description of the Plan, as well as booklets describing the loan program, withdrawal programs, and annuity options for employees to

review at the time they are examining those benefits. Investment information is

provided by the TSP Fund Sheets and the Managing Your Account leaflet which discusses operations. Copies of these publications are also available on our website at

www.tsp.gov or through the ThriftLine.

In addition, we issue materials related to specific events. For example, the TSP

Highlights is a newsletter issued with the quarterly participant statement. Copies

of the newsletters, which address topical items and convey rates of return, are provided on our website. Participants can also obtain their daily balances from the

website, request contribution allocations and interfund transfers or, in some cases,

loans and withdrawals, and use various calculators located there as convenient

planning tools.

A TSP video is available explaining the basics of the TSP in an animated format.

TSP Bulletins are issued regularly to inform agency personnel and payroll specialists of current operating procedures. The ThriftLine, the Board’s toll-free automated

voice response system, also provides both general plan and account-specific information.

In connection with new Lifecycle funds we plan to introduce this summer, we will

revise all of our communications materials and feature the benefits of the asset allocation approach used in ‘‘Life’’ funds as discussed below. We have budgeted $10 million for this major overhaul of our communications materials.

The Agency also conducts quarterly interagency meetings. These have proven to

be an effective means of communicating program and systems requirements to Federal agency administrative personnel. These meetings also allow the TSP to hear

and address representatives’ concerns and to incorporate their suggestions in the establishment of TSP policies and operations.

Investment Funds

The TSP is a participant-directed plan. This means that each participant decides

how the funds in his or her account are invested.

As initially prescribed by FERSA, participants could invest in three types of securities—U.S. Treasury obligations, common stocks, and fixed income securities—

which differ considerably from one another in their investment characteristics. In

47

1996, on the Board’s recommendation, Congress authorized two additional investment funds, which allow further diversification and potentially attractive long-term

returns. The Small Capitalization Index Investment Fund and the International

Stock Index Investment Fund were first offered in May 2001.

The Government Securities Investment (G) Fund is invested in short-term nonmarketable U.S. Treasury securities guaranteed by the full faith and credit of the

U.S. Government. 5 U.S.C. § 8438(b)(1)(A), (e). There is no possibility of loss of

princi-pal from default by the U.S. Government and thus no credit risk. These securities are similar to those issued to the Social Security Trust Funds and to other

Federal trust funds. See 42 U.S.C. § 401(d) (Social Security Trust Funds); 5 U.S.C.

§ 8348(d) (Civil Service Retirement and Disability Fund).

The Fixed Income Index Investment (F) Fund, which by law must be invested in

fixed income securities, is invested in a bond index fund, chosen by the Board to

be the Lehman Brothers U.S. Aggregate (LBA) index. The LBA index represents a

large and diversified group of investment grade securities in the major sectors of

the U.S. bond markets: U.S. Government, corporate, and mortgage-related securities.

The Common Stock Index Investment (C) Fund must be invested in a portfolio

designed to replicate the performance of an index that includes common stocks, the

aggregate market value of which is a reasonably complete representation of the U.S.

equity markets. The Board chose the Standard & Poor’s 500 (S&P 500) stock index

in fulfillment of that requirement. The S&P 500 index consists of 500 stocks representing approximately 78 percent of the market value of the U.S. stock markets.

The objective of the C Fund is to match the performance of that index.

The Small Capitalization Stock Index Investment (S) Fund must be invested in

a portfolio designed to replicate the performance of an index that includes common

stocks, the aggregate market value of which represents the U.S. equity markets, excluding the stocks that are held in the C Fund. The Board chose the Dow Jones

Wilshire 4500 Completion index, which tracks the performance of the non-S&P 500

stocks in the U.S. stock market. The objective of the S Fund is to match the performance of the Wilshire 4500 index. The Wilshire 4500 index represents the remaining 22 percent of the market capitalization of the U.S. stock market. Thus, the

S Fund and the C Fund combined cover virtually the entire U.S. stock market.

The International Stock Index Investment (I) Fund must be invested in a portfolio

designed to track the performance of an index that includes common stocks, the aggregate market value of which represents the international equity markets, excluding the U.S. equity markets. The Board chose the Morgan Stanley EAFE (Europe,

Australasia, Far East) index, which tracks the overall performance of the major

companies and industries in the European, Australian, and Asian stock markets.

The objective of the I Fund is to match the performance of the EAFE index. The

EAFE index was designed by Morgan Stanley Capital International (MSCI) to provide broad coverage of the stock markets in the 21 countries represented in the

index.

This summer, the TSP will introduce Lifecycle Funds. The Lifecycle Funds will

be invested in various combinations using the five existing TSP funds. Participants

will benefit from having professionally designed asset allocation models available to

optimize their investment performance by providing portfolios that are appropriate

for their particular time horizon. This is known in the financial world as investing

on the ‘‘efficient frontier.’’ We are very excited by the prospect of providing these

funds to participants this summer. We have placed preliminary information regarding the Lifecycle Funds on our website, and will be issuing much more over the coming months.

One likely concern associated with a Federal agency’s investing in equities is the

potential for the Government to influence corporate governance questions and other

issues submitted to stockholder votes. FERSA provides that the voting rights associated with the ownership of securities by the Thrift Savings Fund may not be exercised by the Board, other Government agencies, the executive director, a Federal

employee, Member of Congress, former Federal employees, or former Members of

Congress. 5 U.S.C. § 8438(f). Barclays Global Investors (BGI), the manager of the

C, S, and I Fund assets, has a fiduciary responsibility to vote company proxies solely

in the interest of its funds’ investors.

The fund assets held by the F, C, S, and I Funds are passively managed indexed

funds; that is, they are invested in portfolios of assets in such a way as to reproduce

market index returns. The philosophy of indexing is that, over the long-term, it is

difficult to improve upon the average return of the market. The investment management fees and trading costs incurred from passive management through indexing

generally are substantially lower than those associated with active management.

48

Passively managed index funds also preclude the possibility that political or other

considerations might influence the selection of securities.

The manager of the assets held by the F, C, S, and I Funds has been selected

through competitive bidding processes. Proposals from prospective asset managers

were evaluated on objective criteria that included ability to track the relevant index,

low trading costs, fiduciary record, experience, and fees.

The Board has contracts with BGI to manage the F, C, S, and I Fund assets. BGI

is the largest investment manager of index funds in the United States, which had

over $1.36 trillion in total assets under management as of December 31, 2004.

The centralized management of TSP investments was carefully considered in

FERSA by Congress. According to the Joint Explanatory Statement of the Committee of Conference quoted earlier:

Because of the many concerns raised, the conferees spent more time on this

issue than any other. Proposals were made to decentralize the investment management and to give employees more choice by permitting them to choose their

own financial institution in which to invest. While the conferees applaud the

use of IRA’s, they find such an approach for an employer-sponsored retirement

program inappropriate . . . .

The conferees concur with the resolution of this issue as discussed in the Senate

report (99–166) on this legislation:

As an alternative the committee considered permitting any qualified institution

to offer to employee[s] specific investment vehicles. However, the committee rejected that approach for a number of reasons. First, there are literally thousands of qualified institutions who would bombard employees with promotions

for their services. The committee concluded that employees would not favor

such an approach. Second, few, if any, private employers offer such an arrangement. Third, even qualified institutions go bankrupt occasionally and a substantial portion of an employee’s retirement benefit could be wiped out. This is in

contrast to the diversified fund approach which could easily survive a few bankruptcies. Fourth, it would be difficult to administer. Fifth, this ‘‘retail’’ or

‘‘voucher’’ approach would give up the economic advantage of this group’s wholesale purchasing power derived from its large size, so that employees acting individually would get less for their money.

H.R. Rep. No. 99–606, at 137–38, reprinted in 1986 U.S.C.C.A.N. 1508, 1520–21.

Investment Returns

By law, TSP investment policies must provide for both prudent investments and

low administrative costs. From the beginning of the G Fund’s existence (April 1987)

and the beginning of the F and C Funds’ existence (January 1988) through December 31, 2004, the G, F, and C Funds have provided compound annual returns net

of expenses of 6.7 percent, 7.7 percent, and 12.1 percent, respectively. The related

BGI funds closely tracked their respective markets indexes throughout this period.

Because the S and I Funds were introduced in May 2001, the Board has no longterm history for them. The indexes which they track, however, have produced compound annual returns of 11.9 percent and 5.6 percent, respectively, for the 10-year

period ending December 2004.

In order to make the performance of the TSP funds more easily comparable, I

have attached a chart which displays the growth of $100 invested in the underlying

indexes for 20 years. The chart also includes the growth related to G Fund securities as well as inflation.

For calendar year 2004, the net Plan administrative expenses were .06 percent.

This means that the 2004 net investment return to participants was reduced by approximately $.60 for each $1,000 of account balance. The expense ratio would be approximately .01 percent higher in the absence of account forfeitures, which offset expenses. These costs compare very favorably with typical private sector 401(k) service

provider charges.

In summary, I believe that the Thrift Savings Plan has effectively and efficiently

realized the numerous objectives Congress thoughtfully established for it 19 years

ago. To the extent that our experience is useful to the Subcommittee, I welcome the

opportunity to provide any additional information you may require. I would be

pleased to respond to any questions you or other Members of the Subcommittee may

have at this time.

49

PREPARED STATEMENT OF FRANCIS ENDERLE

MANAGING DIRECTOR AND CHIEF INVESTMENT OFFICER,

GLOBAL INDEX AND MARKETS GROUP, BARCLAYS GLOBAL INVESTORS

JUNE 14, 2005

Good afternoon, Mr. Chairman and Members of the Committee, my name is

Francis Enderle and I am the Chief Investment Officer for the Global Index and

Markets Group at Barclays Global Investors (BGI). In that role I am responsible for,

among other things, the oversight of portfolio management in the United States of

all of BGI’s index strategies.

We are pleased to be here today to share with the Committee our expertise in

the management of defined contribution pension accounts, which is derived from our

experience as the external asset manager for the Federal Thrift Savings Plan (TSP)

as well as for numerous other public and private pension plans. We are honored to

have served as an investment manager for the TSP since 1988, a relationship we

have retained in regular, highly competitive bidding processes.

I will begin by discussing our investment philosophy and our structure, both of

which are focused on delivering highly reliable, low cost investment results to institutional investors like the TSP. By ‘‘institutional’’ I refer to defined benefit and defined contribution pension plans sponsored by corporations or public agencies, and

to endowments, foundations, and other similar pools of capital. I will then say a few

words about the services we provide to the TSP, and elaborate on how we keep the

costs associated with trading and investing as low as possible. I will conclude by

turning to the investment related issues to be considered if the Federal Government

were to legislate individual investment accounts either as part of Social Security reform, or through another mechanism.

Barclays Global Investors was founded in 1971 as part of Wells Fargo Bank in

San Francisco, California. Today, we are owned by Barclays PLC, one of the world’s

leading financial service providers. We are headquartered in San Francisco with approximately 1,100 employees in California and elsewhere in the United States and

1,100 more employees worldwide serving the needs of our global clients. With more

than $1.3 trillion in assets under management, BGI, together with its affiliates, is

the world’s largest index manager. BGI created the first index strategy in 1971, just

one of many financial innovations we have pioneered.

Since our founding, BGI has remained true to a single global investment philosophy, which we call Total Performance Management. BGI manages performance

through the core disciplines of risk, return, and cost management. The success of

our indexing methodology results from our focus on delivering superior investment

returns over time while minimizing trading and other implementation costs and rigorously controlling investment and operational risks. This approach helps us avoid

investment ‘‘fads’’ or a dependence on ‘‘star managers’’ or ‘‘stock pickers.’’ It has

been the foundation for the way we have managed money for over 30 years and we

believe it has served our clients very well.

As I noted earlier, since 1988 one of those clients has been the TSP. BGI manages

four of the five investment options available for participants—the TSP C Fund

(based on large-capitalization U.S. equities), the S Fund (based on mid- and smallcapitalization U.S. equities), the F Fund (based on the Lehman Aggregate Longterm Bond index) and the I Fund (based on the MSCI Europe Australia Far East

(EAFE) index of non-U.S. equities). The fifth option, the G Fund, is managed by the

U.S. Treasury and invests in U.S. Treasury securities. Later this year, the TSP will

be launching a series of lifecycle or ‘‘target horizon’’ options that use the existing

five options as the asset class ‘‘building blocks’’ with allocations in each lifecycle

fund across these options being determined by an external vendor. I will describe

shortly the structure of these new options, as well as the benefits they will provide

to plan participants.

BGI’s services to the TSP are completely focused on investment management. We

do not provide any other services. We have an extremely effective operating model

developed in conjunction with TSP staff to manage the daily cashflows into or out

of each of the investment options. Each day we receive an instruction for each fund

that aggregates the transaction instructions of all TSP participants placing orders

on that day. In this way, the orders for participants buying or selling from the same

fund are netted against each other and only a trade for the residual order is placed.

Management of payroll contributions, recordkeeping (for example, changes made

by participants in investment elections), distributions and communications to participants are handled directly by the TSP or its other vendors. This is also true for

most of our other clients—our core expertise is investment management, and our

comments are provided principally from this perspective. Minimizing transaction

50

1Source: Morningstar, BGI 2/05.

costs in all our investment activities is a central element, Mr. Chairman, in how

we do our business. In fact, the key to our success in index management has been

our ability to minimize implementation and trading costs. High costs and expenses

of investing detract from performance and investment returns; lower costs increase

the investment pool and put more money long-term into the pockets of investors.

Let me say a few words about how we do this.

Each of our index funds is structured to match the performance of a specific

index. These indexes (such as the S&P 500 or the MSCI EAFE) are designed by

third-party index providers. However, these indexes are really ‘‘paper portfolios’’ and

do not include any of the trading costs that real-world investors experience. Thus

to successfully achieve the performance target—that is, to track the index as closely

as possible—BGI strives to minimize the ‘‘real world’’ costs through a variety of

highly efficient trading approaches.

Through the size and diversity of our client base we are able to match or offset

a significant percentage of our clients’ buy and sell orders internally, thereby reducing or eliminating market transaction costs. The internal matching of buy and sell

orders is commonly referred to as ‘‘crossing,’’ and is conducted and actively monitored by BGI pursuant to the terms and conditions of an exemption issued by the

Department of Labor.

When we do trade in the markets, we utilize carefully developed and managed

trading strategies and we access all possible sources of liquidity, including electronic

marketplaces. Our trading activities are supported by a dedicated trading research

team, whose sole job is to develop new trading techniques and strategies to minimize trading costs. We execute our trades through broker-dealers who have been

prescreened for credit-worthiness, and we rigorously monitor the prices at which our

trades are executed relative to a number of market-related benchmarks to ensure

we are receiving superior execution. We also use our scale to negotiate low per share

commission rates.

The majority of our assets are managed for large institutional clients such as the TSP and the average account size for our U.S. clients is $880 million. BGI is able

to charge lower investment management and administrative fees to its institutional

clients than a mutual fund firm geared toward retail investors, where the average

account size is comparatively small. And in dealing with institutional investors we

do not have the costs of retail administrative services (including shareholder communications and recordkeeping), which also serve to raise the costs of retail fund

managers. By way of example, the average fee for large-capitalization U.S. equity

index portfolios of $100 million in size that are managed for institutional clients is

0.05 percent versus retail-oriented equity index mutual funds where the fees average 0.69 percent,1 more than 10 times greater than our expense ratios.

Over the course of a long-term investment, lower management fees and expenses

(including trading commissions) can translate into considerable savings for any investor. Indeed, index investing remains the most cost-efficient and diversified way

to gain exposure to various segments of the capital markets. We believe index funds

are the best core investment for most investors’ portfolios—whether they are the

largest pension fund in the world, or an individual investor.

I would now like to make a few comments regarding investment management considerations if personal accounts are adopted as part of any future changes to the

Social Security program.

Let me first acknowledge that BGI has built a substantial part of its business by

offering well-managed index strategies to our clients for more than 30 years. We

therefore have a vested interest in the continued growth of index investing. Our interests aside, we firmly believe that the reason for the success of these strategies

is the simple fact that they deliver the return of the market index reliably and cost

effectively. In fact, Congress recognized this itself in the enabling legislation for the

TSP, which provides that the four public market options be invested in portfolios

designed to replicate the performance of an index that is ‘‘commonly recognized’’ as

reflecting the performance of each asset class (that is the S&P 500 Index for large

capitalization U.S. equities).

If a national system of personal accounts were to be implemented, we would encourage legislators to consider the following approach that draws on the best practices of institutional investors.

An array of low cost, broadly diversified index funds frequently forms the core

investment for institutional pension plans, both defined benefit and defined contribution structures. For example, the current selection offered to TSP participants

covers all the main asset classes—large and small capitalization U.S. equities, U.S.

fixed income, international equities and a stable value option. Other asset classes

51

could be included but these options would provide the basic ‘‘building blocks’’ and

coincide with what one would typically see in a well-constructed institutional portfolio.

We suggest consideration of index portfolios because they offer three principle

benefits to investors:

• They capture the return of each asset class (as represented by a benchmark index

such as the S&P 500) with a high degree of precision;

• Index funds typically have low asset management fees as compared to actively

managed funds;

• Index funds have lower relative transaction costs including commissions, bid/ask

spreads and market impact. This is because index fund investments are spread

across a large number of securities thereby reducing the impact of a portfolio

trade on an individual security relative to what would occur in a more concentrated portfolio.

The latter point is worth elaborating upon given the sizeable assets that would

potentially be invested in personal accounts. Investing in index funds spreads assets

across the broadest possible array of securities in any asset class thereby minimizing the impact of trading large cashflows in the market on a daily basis. This

is not only important for the investment of new monies into personal accounts but

also for any trading that individuals may initiate in their personal accounts to reallocate assets among their investment options over time.

Another investment option to be considered is an array of so-called lifecycle or

‘‘target horizon’’ funds, options that the TSP will be adding later this year, as I mentioned earlier. With lifecycle funds, potentially the only choice an investor needs to

make is to select the lifecycle fund with the target horizon date that most closely

matches the investor’s date of retirement. Each lifecycle fund would hold an array

of asset classes with each asset class being implemented with an index fund. The

asset mix within each lifecycle fund would gradually become more conservative over

time as the target horizon date approached. For example, a participant who is 30

years of age today and a set retirement of, for example, age 65 would be invested

in a lifecycle fund with a target horizon date of 2040.

As with the index fund options described earlier, a lifecycle fund option could also

be structured as a very low cost solution to investors. While a lifecycle fund would

not necessarily need to be invested in index funds, index funds likely provide the

lowest cost solution for each asset class, and assure that the return of each selected

asset class is reliably captured. Participants in each lifecycle fund would benefit

from the fund’s gradual evolution to a more conservative investment risk profile as

the participant approached retirement.

Mr. Chairman, we believe that the investment considerations we have discussed

will assist you and others on this Committee in evaluating the criteria to be used

if personal accounts were to be legislated by Congress as part of revisions to the

Social Security program, or in another program. I thank you for the opportunity to

speak with you today and I look forward to answering any questions you may have.

—————

PREPARED STATEMENT OF FRANCIS X. CAVANAUGH

FORMER EXECUTIVE DIRECTOR, FEDERAL RETIREMENT THRIFT INVESTMENT BOARD

JUNE 14, 2005

Mr. Chairman and Members of the Subcommittee, I welcome this opportunity to

discuss the role of financial markets in Social Security reform. The Administration’s

current proposal for Social Security individual accounts (IA) contemplates that private financial institutions would provide fund management services and probably

other 401(k) plan services, such as investment education, counseling, and record

keeping. My comments will focus on the cost of such services and the problems in

providing them to employees of small businesses.

I am a public finance consultant, but I speak only for myself. I have no clients

with an interest in Social Security individual accounts. From 1986 until 1994, I was

the first Executive Director, and thus the Chief Executive Officer, of the Federal Retirement Thrift Investment Board, the agency that administers the Thrift Savings

Plan (TSP) for Federal employees. Before that, I was a financial economist in the

Treasury Department for 32 years, and was the senior career executive responsible

for developing Federal borrowing, lending, and investment policies, including those

for the Social Security and other Federal trust funds.

52

1The administrative cost, or expense ratio, of the TSP is 6 basis points.

2Francis X. Cavanaugh, ‘‘Feasibility of Social Security Individual Accounts,’’ AARP Public Policy Institute, Washington, DC, Sept. 2002, pp. 4–6. The $3,000 charge is still common today.

The Administration’s Proposal

While there is no specific proposal before your Committee, the Administration’s

current broad proposal, according to White House statements and press reports, provides a basis for at least a preliminary analysis of its feasibility.

The following features of the Administration’s approach would have significant

impacts on its feasibility:

• Social Security individual accounts (IA’s) would be voluntary for all Social Security taxpayers under age 55, but would be mandatory for employers of employees

who chose IA’s.

• A major purpose of IA’s would be to encourage savings by young and low-income

workers and employees of small businesses who do not now have 401(k)s or other

pension plans.

• The maximum amount of an individual’s initial annual contribution to an IA

would be $1,000, which would increase by $100 a year, to 4 percent of pay eventually. It would take more than 30 years for the highest income individuals to be

able to contribute the full 4 percent of pay.

• Eligible investments for IA’s would be Treasury securities and stock and bond

index funds, which would be similar to eligible investments of the TSP.

• IA’s would be centrally managed, apparently by a TSP-like agency with a parttime board, appointed by the President with the advice and consent of the Senate,

and a full-time executive director and CEO appointed by the board. Following the

TSP model, the board members and the executive director would be independent

of the administration, and would be fiduciaries required to act solely in the interests of the holders of the IA’s and their beneficiaries.

• Unlike contributions to 401(k)’s or to the TSP, IA contributions would not be eligible for matching contributions or exclusion from taxable income, and loans or

withdrawals before retirement would not be permitted.

Cost Analysis

A critical question, of course, is costs. IA’s are proposed to provide a higher investment return than would be realized by the Social Security Trust Fund. Thus IA’s

would not be feasible if their administrative costs were so high as to offset the advantage of diversified investments in stocks and other securities that yield more

than the Treasury securities in the Social Security Trust Fund.

The Administration assumes that IA’s would earn an average investment return

of 4.9 percent after inflation, and that administrative costs of .3 percent, that is,

30 basis points, would reduce the net return to 4.6 percent, or 1.6 percent more than

the assumed net return of 3 percent on the Treasury securities in the Social Security Trust Fund. Thus, if one accepts the Administration’s assumptions, IA’s would

outperform the Trust Fund investments so long as the administrative costs were

less than 1.9 percent. In my view and that of many other economists, the 4.6 percent assumption is much too high; indeed, the Congressional Budget Office’s estimate of the net return is reportedly only 3.3 percent.

The Administration’s estimate of 30 basis points is optimistically low; even the

Cato Institute, a leading advocate of individual accounts, estimates IA expenses at

55 basis points. Yet this higher estimate is also too low. Like so many others I have

heard, these estimates are based mainly on experience with large 401(k)s for large

organizations, like the TSP,1 with economies of scale and comprehensive payroll,

personnel, and computerized systems support.

They have little relevance to the likely costs of a universal system of IA’s. More

than 85 percent of the 5.6 million small business employers in this country offer no

pension plans at all and, accordingly, have none of the administrative apparatus to

service them.

To understand the costs of bringing IA’s to employees of small businesses, we

must first understand why 85 percent of them do not now have retirement plans

for their employees. Fortunately, the 401(k) industry has already done part of the

job for us. Companies like Citigroup, Fidelity Investments, Merrill Lynch, State

Street Corporation, and T. Rowe Price have been competing for two decades to provide investment, record keeping, counseling, and other 401(k) plan services to small

businesses. They have found that they cannot profitably provide these services for

a company for less than approximately $3,000 a year, even though they have for

years enjoyed economies of scale from serving thousands of employers in their centralized computer systems.2 Further significant economies of scale would not be reVerDate 11-MAY-2000 16:58 Sep 22, 2006 Jkt 025856 PO 00000 Frm 00056 Fmt 6621 Sfmt 6621 29725.TXT SBANK4 PsN: SBANK4
53

See ‘‘Big Fees Hit Small Plans: Costs Take Huge Toll on Retirement Accounts of Firms With

Fewer Than 50 Employees,‘‘ Wall Street Journal, Oct. 31, 2004, p. D1. 3See generally U.S. Department of Labor, Pension and Welfare Benefits Administration,

‘‘Study of 401(k) Fees and Expenses,’’Apr. 13, 1998. The study found that average charges by

17 major 401(k) providers for plans with 100 participants and $2 million in assets ranged from

$114 to $428 per participant, and averaged $264. Id. at 51. Charges obviously would be much

higher for much smaller plans. 4See, for example, Employee Benefit Research Institute, Issue Brief No. 23, Nov. 1998. See

also Ellen E. Schultz, ‘‘Poodle Parlor Retirement Plans,’’ Wall Street Journal, Nov. 13, 1998,

p.C1. 5Patrick Purcell, Congressional Research Service, ‘‘Social Security Individual Accounts and

Employer-Sponsored Pensions,’’ Feb. 3, 2005, pp. 3, 5.

alized by a central TSP-type agency, because there would still be millions of small

businesses or workplaces to be reached. Nor can we assume that a new central government agency would be more efficient than the major 401(k) providers who now

serve this market.

Thus the cost per employee of a company with 10 employees would be $300, or 30 percent of the President’s proposed annual IA contribution of $1,000—and most

U.S. companies have fewer than 10 employees.3

Even the largest business that is classified as a ‘‘small business,’’ one with 100

employees, would therefore have an expense ratio of at least 3 percent, which would

be 10 times the Administration’s estimate of 30 basis points. And for the 60 percent

of employers in this country that have fewer than 5 employees, the initial expense

ratio would be more than 60 percent, that is, 6,000 basis points. In fact, commercial

401(k) providers routinely discourage small businesses from establishing 401(k)

plans if they have fewer than 10 employees and, in some cases, fewer than 25 employees.

Obviously, substantial and continuing government subsidies would be necessary

to make IA’s attractive to employees of small businesses. If all Social Security taxpayers participated in the IA program, the administrative costs would be more than

$46 billion a year (155 million participants times more than $300 per account),

which would be a subsidy to IA administrators for performing an uneconomic function. These figures are reinforced by a number of studies, including those cited in

a review of administrative costs by the Employee Benefit Research Institute.4

I recommend that your Committee secure the testimony of individuals from financial institutions that are actually providing 401(k) services to the Nation’s businesses, large and small. Give them a specific set of assumptions to cost out that

reflects the makeup of our country’s 5.7 million employers subject to Social Security—of which 98 percent are small business employers of 68 million employees.5

Then and only then will you know whether the Administration’s proposal—or anything similar—will produce reasonable net investment returns, or, in the alternative, how much of a Government subsidy would be necessary to achieve them.

Critical Administrative Problems

In addition to the above costs, which are based on what the current providers are

actually charging for establishing and servicing 401(k) plans, there are overwhelming practical obstacles to the creation and maintenance of IA’s. Because President Bush seemed to idealize the Thrift Savings Plan—the largest of all 401(k)-type

plans—as the model for IA’s in his February 2005 State of the Union message—and

because many others have done so as well—I would like to point out the considerable dissimilarities between the TSP and the administration’s proposal. (Most of

these dissimilarities would hold true for a comparison between any large corporate

401(k) plan and the proposal.)

Too Many Small Employers. The TSP is administered by just one employer—the

U.S. Government—with extensive personnel, payroll, and systems staffs to provide

the essential employee education, retirement counseling, payroll deduction, timely

funds transfers, and error correction functions. The Thrift Investment Board is only

a wholesaler of services; the Federal employing agencies deal with the individual

employees participating in the plan. In fact, the TSP statute directs the Office of

Personnel Management to provide for the training of TSP counselors for each Federal agency.

The Administration’s plan is intended to reach all employees, but it makes no provision for the performance of what are now essential employer functions in 401(k)

plans. They could not possibly be performed by small business employers who are

now responsible only for the relatively simple payroll deduction and transmission

of Social Security taxes to the IRS. Since most businesses have fewer than 10 employees, they do not have the experience or administrative resources to support the

new plan. These are barbershops, beauty salons, garages, restaurants, laundries,

54

6See Employee Retirement Income Security Act (ERISA), 29 U.S.C. § 1104(a); Federal Employees’ Retirement System Act (FERSA), 5 U.S.C. § 8477(b)(1).

lawn services, households, nanny services, and other very small businesses that

could not be expected to meet the high fiduciary standards required of those responsible for educating and counseling employees, for presenting a new plan in the context of the employer’s existing pension or other benefits, and for the timely and

accurate transfer of funds for investment. The new TSP-like agency obviously could

not provide such employer-type services to deal with tens of millions of diverse employees, either directly or on a contract basis.

Consider, as but one example of several profound administrative and legal issues,

that about 650,000 businesses go out of business each year. By whom and how

would the enforcement of contributions by delinquent or bankrupt employers be

prosecuted? (Judicial remedies for denial of TSP benefits must, in general, be pursued by the affected individual TSP participant in the Federal court system.) For

that matter, by whom and how would breach-of-fiduciary-duty suits be brought

against ‘‘mom-and-pop’’ fiduciaries? Can the employer of a housekeeper or a manicurist be expected to exercise the ‘‘care, skill, prudence, and diligence’’ demanded

of every 401(k) plan fiduciary by current law? 6 What would be the measure—and

the limit—of their personal liabilities, say, for untimely or inaccurate investment of

their employees’ contributions? These questions only scratch the surface of the inevitable pathology of plan administration—pathology that, even if represented in small

percentages among 155 million Social Security participants, would result in enormous absolute numbers.

Untimely Investments. The TSP is computerized, like all other large plans, with

investments made for each employee’s account on the same day that contributions

are deducted from the employee’s paycheck. Social Security taxes are deducted on

paydays, but many small businesses send them to the IRS only once each quarter.

In 2003, 72 percent of employer reports to the Social Security Administration were

submitted on paper. Moreover, individual Social Security taxpayers are identified

only once each year, with their employer’s annual income tax filings; and it would

be up to 22 months after payday, under current SSA procedures, before individual

IA’s could be credited.

Furthermore, the Administration’s proposal is to pay IA’s the same annual return,

regardless of when contributions were actually made during the year. Thus a contribution in January would not earn any more than a contribution of a similar

amount in December. During a year of highly volatile markets, the attempted explanation of this provision to millions of outraged participants with irregular tax payments, because of illness, seasonal, temporary, or other periods of unemployment,

would be a daunting challenge to the plan’s telephone counselors.

Unbalanced Accounts. The TSP is balanced to the penny every day. The Social Security system is never balanced. Each year there are billions of dollars of

unreconciled discrepancies between Social Security taxes paid to the IRS and reported to the SSA. These discrepancies are tolerated because they generally have

little impact on the ultimate calculation of employee benefits. Such discrepancies are

never tolerated by financial institutions responsible for timely investment of individual funds. Theoretically, IA contribution errors might be largely corrected by a

rigorous examination of employer records. Yet the error correction procedures, including retroactive adjustments of investment gains or losses in volatile markets,

could bring the entire system to a screeching halt.

Inevitable Account ‘‘Leakage.’’ Unlike the TSP, the Administration’s plan would

prohibit loans and emergency withdrawals, and would require individuals to purchase annuities on retirement. I find it inconceivable, however, that Congress—or

an Administration—would long be able to resist calls for emergency access to funds

before a worker’s retirement, and in lump sum amounts. Suppose, for example, that

an individual has suffered a devastating personal financial loss, such as thousands

experienced in last year’s Florida hurricanes in the destruction of their homes.

Would these persons be told that they may not access their IA balances to mitigate

such dire misfortunes? What about a catastrophic illness, leaving a family’s breadwinner unable to work? Could such persons be denied their account balances to sustain spouse and children? I do not think so. There are, of course, scores more such

examples, and with 155 million potential participants, you can be sure that they all

would arise. Administering the inevitable emergency withdrawal or loan program

would add enormously to the cost of the Administration’s plan.

Communication Problems. The TSP has a very effective communications system,

because it can rely on the Federal employing agencies to distribute plan materials

and to educate and counsel their employees. Even so, the TSP found it necessary

to have the central recordkeeper for its 3 million accounts maintain a staff of more

55

7Fidelity Investments, a major 401(k) provider, has estimated that the administration of a

401(k)-type plan for Social Security taxpayers would require a total staff of 100,000. See Employee Benefit Research Institute, Issue Brief No. 23, Nov. 1998, p. 166.

than 200 telephone counselors to respond directly to questions from individual participants. Since more than 200 million Social Security taxpayers and retirees eventually would be eligible for IA’s, the required number of telephone counselors would

be more than 13,000, based on the TSP experience, and probably much higher because of the special IA deficiencies noted above.7 Also, TSP mailings consistently

have reached more than 99 percent of participants, but 25 percent of SSA mailings

are returned as undeliverable.

Congress would undoubtedly insist that every effort be made to advise all Social

Security taxpayers of the IA benefits Congress intended to provide them. The TSP

sent summary plan documents to all 3 million eligible employees, which required

18 trailer trucks of printed materials. Similar documents would have to be sent

eventually to the more than 200 million Social Security-covered employees and retirees.

The eventual costs of such massive efforts at this point are unknown, but they

clearly would have a significant impact on IA expenses.

Small Employer Antipathy. Even if small businesses were able to perform normal

employer functions for IA’s, would they want to? IA’s would be voluntary for employees but, if employees elect to have IA’s, mandatory for their employers.

The TSP and 401(k) plans generally are enthusiastically sponsored and supported

by the large employers who offer them as a major benefit for their employees, and

as a means to move away from defined benefit retirement plans that require employers to bear substantial investment risks. The major attractions of the TSP and

401(k)’s generally are the matching employer contributions and the immediate tax

benefit from excluding employee contributions from taxable income. The ability to

borrow or withdraw funds to meet emergency needs is also a significant benefit.

IA’s, as currently proposed, would offer none of these benefits, and would be a relatively unattractive product that employers might be reluctant to support, especially

small employers who do not have any pension plans. Moreover, it would be unrealistic to expect small-business employers to act as large corporate employers do in

assuming the costs of investment losses because of, say, employer error in transmitting funds for timely investment of 401(k) accounts, or for myriad other commonplace employer errors. These serious concerns for small businesses would have to

be addressed during congressional hearings on IA proposals.

The Trust Fund Alternative

Since IA’s are certainly not feasible for employees of small businesses—the vast

preponderance of the business community—the only practical way to give them the

higher returns available from equity investments is to invest part of the Social Security Trust Fund in equities. That way, the overwhelming administrative costs and

practical problems of the Administration’s plan would be avoided. The total administrative cost of having the Social Security Trust Fund invest in the private funds proposed for IA’s would be no more than one basis point, based on the actual costs of

market investments by the Thrift Savings Plan. The likely increase in Trust Fund

earnings would be an effective way to help maintain the solvency of the Trust Fund

without having to resort to significant increases in Social Security taxes or reductions in benefits.

Every State in the United States has authorized public retirement fund investment in stocks. Yet the Federal Government still clings to the old notion that governments should not have an ownership stake in private companies, which made

some sense when individual stocks were involved. Today’s broad based index funds,

however, remove the investor from direct control over particular companies. Small

business employees should not be denied the benefits of portfolio diversification in

the Social Security Trust Fund simply because the Federal Government has not

kept up with the States in understanding the evolution of financial markets.

Less Government Influence Over Private Companies. As shown in the following

chart, there is even less Government influence over private companies under the

Trust Fund alternative than under the TSP or the Administration’s plan.

56

Government Influence Over Private Companies

Thrift Savings Plan Administration Plan

Social Security

Trust Fund

Alternative

Selection of stock and bond index funds ... Government decides Same ....................... Same

Selection of fund managers ........................ Government decides Same ....................... Same

Selection of private record keeper ............. Government decides Same ....................... N/A

Selection of auditors and consultants ....... Government decides Same ....................... N/A

Selection of annuity providers ................... Government decides Same ....................... N/A

Selection of allocations among index

funds.

Individuals decide .. Individuals decide .. Government decides

N/A—not applicable. (There would be no need for private recordkeepers, auditors, consultants, or annuity providers for trust fund investments.)

Special Benefits for Trust Fund. Unfortunately, some political leaders have convinced many of the public that the Social Security Trust Fund is not really invested

because it has been ‘‘looted,’’ and that the Trust Fund consists of ‘‘worthless IOU’s.’’

Nothing could be farther from the truth, and such statements betray an apparent

ignorance of Federal finance in our highest circles of government. The Trust Fund

is fully invested in the best securities in the world—U.S. Treasury obligations. Private trust funds invest in Treasury securities in the open market, but the Social

Security Trust Fund buys its Treasury securities directly from the Treasury, which

is more efficient than if the Treasury were to issue the securities in the market and

then buy them back for the Trust Fund.

Moreover, the Trust Fund actually gets a much better deal than the private funds

that buy Treasuries in the market. The Trust Fund, by law, may redeem its securities before maturity at par value, rather than at the sometimes deep market discounts suffered by private investors during periods of rising interest rates. Also,

since the Trust Fund gets its securities directly from the Treasury, it avoids the

market transaction costs which private investors must pay. Finally, the law requires

the Treasury to pay the Trust Fund an interest rate on all of its investments in

Treasuries equal to the average yield on long-term Treasury marketable securities.

This is a significant benefit to the Trust Fund, since long-term rates are generally

much higher than short-term rates. Thus in recent years, private investors have

been earning about 2 percent on their short-term Treasuries, while the Social Security Trust Fund was earning about 4 percent on effectively the same maturities. The

public seems to be totally unaware of these subsidies to the Social Security Trust

Fund, which have been there for many decades.

Trust Fund Dedicated to Social Security. The assets of the Social Security Trust

Fund consist of investments in Treasury securities solely for future beneficiaries.

Yet political leaders from both parties complain that the Treasury has ‘‘spent’’ the

Trust Fund surplus on Government programs. What on earth do they expect the

Treasury to do with the money—bury it in the Treasury’s back yard? The Treasury

also spends the money it raises by issuing Treasury securities in the market. Does

that mean that the private investors in Treasuries are also being ‘‘looted’’ by the

Treasury? Of course not. The scandal would be if the Treasury left the Trust Fund

uninvested and not earning interest. Then the Secretary of the Treasury would be

in effect saying ‘‘I don’t owe you,’’ and that indeed would be a worthless IOU.

So why do Government officials find fault with perfectly sound financial practices?

From ignorance, as I suggested earlier?—or is it is because they are trying to hide

the real problem, which is the unique way the Social Security program is treated

in the budget? Social Security expenditures are excluded from the budget and thus

from the restraints on other Government spending, which is proper since they are

entitlements, and cannot be restrained under existing law. But the Social Security

surplus is then, inconsistently, included in the calculation of the overall budget deficit, for the sole purpose of appearing to have achieved deficit, and thus spending,

reduction. Then, having committed this accounting farce, officials have the audacity

to complain that the misleading budget treatment of the Trust Fund surplus—which

they could change—makes it available to finance other programs. The problem here

is not the financing of the Trust Fund, but the political gimmickry of its budget

treatment.

Conclusion

In conclusion, the Administration’s plan for universal IA’s is not feasible, and it

should not survive the process of responsible Congressional hearings. The only practical way for the Social Security system to capture the higher returns available from

investments in stocks is to diversify Social Security Trust Fund investments. The

57

Trust Fund alternative, compared to IA’s, would involve less Government influence

over private companies, would be less disruptive of financial markets, would save

tens of billions of dollars a year in administrative costs, and could be effective virtually immediately, rather than the 2009 starting date proposed for IA’s. The multitrillion dollar transition costs proposed by IA proponents would be avoided. The

additional Trust Fund earnings would go a long way toward strengthening Social

Security finances, and would thus reduce, if not eliminate, the need for significant

tax increases or benefit reductions.

Thank you for your attention. I would be pleased to answer any questions.

—————

PREPARED STATEMENT OF MICHAEL TANNER

DIRECTOR, CATO PROJECT ON SOCIAL SECURITY CHOICE

JUNE 14, 2005

Mr. Chairman, distinguished Members of the Committee, I would like to thank

the Committee for holding this hearing and for giving me the opportunity to appear.

In particular, I appreciate that the Committee is moving beyond the standoff over

whether Social Security reform should or should not include personal accounts to

consider how such accounts might be structured in ways that can maximize consumer choice and control, while ensuring efficiency, low costs, and preserving an appropriate measure of worker protection.

Of course, along with my colleagues at the Cato Institute, I believe that Social

Security reform must allow younger workers to save and invest some of their Social

Security taxes through personal accounts. I believe that such accounts can significantly contribute to restoring Social Security to permanent sustainable solvency.

More importantly, I believe that personal accounts are essential to modernizing Social Security in keeping with such fundamental American values as ownership,

inheritability, and choice.

In particular, regarding the subject of this hearing, economic theory holds that

private capital investment should provide a higher rate of return than a mature

PAYGO Social Security system. If one accepts the Social Security Administration’s

assumptions about future bond and stock returns, a balanced portfolio (50 percent

stocks, 30 percent corporate bonds, and 20 percent Government bonds) could be expected to yield a return of 4.9 percent. Subtracting 25 basis points of administrative

costs provides a net yield of 4.65 percent. Shifting the mix slightly in favor of equities should raise the expected return to roughly 5 percent. This clearly exceeds the

return available from Social Security, and also significantly exceeds the offset interest rate suggested under the President’s reform proposal.

This is not to say that personal accounts can perform miracles. They cannot, by

themselves, solve Social Security’s entire $12.8 trillion funding shortfall. However,

workers who choose the personal account option—and I note that personal accounts

are voluntary under all the major reform proposals—can expect to receive more in

retirement benefits than Social Security can actually pay them.

That said, how personal accounts are structured and the investment options available to workers can make a significant difference in the success of any personal account proposal. In short, details matter.

Any retirement system has four important administrative functions: Collection,

transmission, recordkeeping, and money management. First, there must be a system

to collect the retirement funds from the worker. Next, the funds must be transmitted to an administrator. The administrator is responsible for keeping records of

each worker’s contribution to the retirement program and the benefits that each

worker will eventually receive. Finally, the money has to be invested and managed

between the time it is received and the time it is disbursed.

In designing an investment and administrative structure of personal accounts,

you should be guided by these basic concerns:

• Simplicity and Transparency. Workers should clearly understand where there

money is going and what their options are. Where personal account plans have

encountered difficulties, such as in Britain, it has been primarily do to overly

opaque or complex schemes.

• Balancing Return and Risk. While market returns can be expected to exceed Social Security returns, markets are not risk free. In particular, they offer increased

volatility. In addition, many of the new investors brought into the market through

personal accounts will be inexperienced. A personal account investment plan must

offer these individuals some degree of protection without stifling consumer choice,

over regulating markets, or unduly restricting the potential for positive returns.

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• Keep Administrative Costs Low. While regulation of account fees would be unwise,

accounts should be designed in ways that minimize administrative costs. SSA estimates that accounts would cost 25–30 basis points to administer. This seems like

an entirely reasonable target. • Limit Government Involvement in Investment Decisions. Decisions about the investment of the accumulating retirement funds should be left to private markets

and insulated from Government interference as much as possible. • Avoid Increased Employer Burden. Every effort should be made to avoid any new

burden on employers, particularly small employers. Possible sources of additional

employer burdens would include higher tax payments, greater complexity in tax

calculations, more extensive recordkeeping requirements, or a requirement to report information more frequently.

Cato’s Project on Social Security Choice has devoted considerable time and study

to these issues. As a result of our work, we believe that the following structure provides the framework for meeting these concerns. I do not, by any means, assert that

it is the only acceptable administrative structure. But I believe that any workable

administrative structure that deals with these issues will contain many or most of

the following elements.

First, at least initially, the collection, recordkeeping, and transmission functions

should be handled centrally. The U.S. Treasury Department through its existing tax

collection capabilities is well-suited for this role. Therefore, I would propose that the

collection of payroll taxes, including individual account contributions, would continue to be handled by the employer in much the same way as today and sent to

the Treasury as they are today. The only difference would be that the employer

would tell Treasury how much of the total payment is from employees who have

chosen the personal retirement account option.

One little known facet of the current Social Security system is that although payroll taxes are collected and paid by employers throughout the year, the Federal Government will not actually know how much money was paid on behalf of any

particular worker in 2005 until about September 2006! This makes little difference

under the current Social Security system, but can matter a great deal with an investment-based system. There will have to be some mechanism to hold the funds

until the contribution is reconciled to the individual’s name using the worker’s W–

2 form. Moreover, this holding pool should not be dependent on market timing. The

best solution would be for Treasury, which is already operating as a centralized collection to transfer all funds designated for account investment to a private-sector

custodian bank, which then invests the total amount in a money market fund that

is always priced at one dollar, a standard industry convention. The following year,

when the contribution is reconciled to the individual worker the fund’s shares are

distributed to each worker representing his contributions and interest credit, and

electronically transferred to the worker’s personal account as specified.

Second, because a system of personal accounts would extend investment opportunities to millions of Americans who do not now participate in private investment,

and are therefore likely to lack education and experience in choosing investments,

a consensus has developed among account proponents that initial investment options should be limited both in number and in the amount of risk a worker may

assume. Therefore, most personal account plans call for investment options to be initially limited to a small number of broadly diversified funds. This can be done in

a number of ways, such as:

• A small number of index funds each composed of a different type of investments.

For example, the Federal Thrift Savings Plan, which President Bush has cited as

an example, offers a fixed income fund, a common stock fund, a ‘‘small cap’’ stock

fund, a Government bond fund, and an international stock fund. The Chairman’s

proposal, S. 540, is also built around this model. • A small number of balanced funds, each composed of a different mix of stocks,

Government bonds, corporate bonds, and cash. This option is included in HR 530

among others. • A lifecycle fund that automatically adjusts the mixture of investments as a person

ages. Younger workers would be more heavily invested in stocks, with the mix

changing more heavily to fixed income assets as the worker nears retirement. The

president has raised the possibility of this option, as has the Chairman. And I believe it is included in S. 857, sponsored by Senator Sununu.

To make things even simpler for the unsophisticated or apathetic worker, there

should be a default option that would require the worker to make no decisions whatsoever.

Management of funds should be handled by the private sector on a contract/bid

basis, similar to the way the TSP is currently handled. Given the amount of investVerDate 11-MAY-2000 16:58 Sep 22, 2006 Jkt 025856 PO 00000 Frm 00062 Fmt 6621 Sfmt 6621 29725.TXT SBANK4 PsN: SBANK4
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ments involved, it may be worth considering breaking up the management into several pieces each of which would be put up for bid.

Finally. while it makes sense to limit investment options initially, at some point

a wider range of choices should be made available. In part, this is a simple matter

of increasing consumer choice. One of the most important reason for having personal

accounts at all is to give workers more choice and control over how they save for

their retirement. Clearly, this should be extended as much as possible to the array

of available investments.

There is also a larger economic reason for eventually expanding the range of investments. The flow of investments to different sectors of the economy provides important signals to the economy as a whole. Creating a large flow of investments that

are essentially ‘‘homogenized’’ would deprive the market of these vital signals.

Therefore, once a worker has accumulated a ‘‘trigger’’ level of funds, the worker

should be free to participate in a much larger range of investment options, closely

approximating the options currently available under traditional 401(k) plans. Management of funds at this level would again be through the private sector, with entry

open to any company offering qualified funds. ERISSA offers a reasonable framework for determining participation and regulation.

This three tier structure—a central collection point and holding pool, a limited set

of initial investment options, and a eventual expansion to a wider array of investments—can provide workers with the greatest amount of security while maximizing

consumer choice and control. It would keep administrative costs and the burden on

employers as low as possible. And it would minimize Government interference with

investment decisions.

Works should be able to switch investments, between and within investment tiers

on an annual basis. While an ‘‘open season,’’ similar to that of the FEHBP health

plan, is perhaps the most simple approach, that could lead to an excess of market

‘‘churning’’ over a limited period. An alternative approach would be to allow a worker to switch investments within a designated period centered on his or her birthday.

There is one other additional point to keep in mind, at all three tiers, the accounts

would be the property of the worker. This ownership is one of the perhaps the most

important reasons for reforming Social Security, and it is vital that it be maintained

as part of any administrative structure.

Let me conclude by saying that I believe that Social security reform is not an option, but a necessity. The program will begin running a deficit in just 12 years and

faces unfunded obligations of roughly $12.8 trillion. The need for reform presents

us with an opportunity to create a new and better retirement program for all Americans, a program that gives workers ownership of their retirement funds, more choice

and control over their money, and the opportunity to build a nest egg of real inheritable wealth. Therefore, any successful Social Security reform should include personal accounts.

This makes the work of this Committee all the more important: Getting the design and structure of the accounts right. I believe that the structure I have set out

today takes us in that direction. I look forward to the Committee’s questions.

Thank you.

—————

PREPARED STATEMENT OF DAVID C. JOHN

RESEARCH FELLOW, THOMAS A. ROE INSTITUTE FOR ECONOMIC POLICY STUDIES

THE HERITAGE FOUNDATION

JUNE 14, 2005

I appreciate the opportunity to appear before you today to discuss appropriate investments for Social Security Personal Retirement Accounts. This is an extremely

important subject, and I would like to thank both Chairman Hagel and Senator

Dodd for scheduling this hearing. Let me begin by noting that while I am a Research Fellow at the Heritage Foundation, the views that I express in this testimony

are my own, and should not be construed as representing any official position of the

Heritage Foundation. In addition, the Heritage Foundation does not endorse or oppose any legislation.

PRA’s should be managed through a simple, low-cost administrative structure that

uses the current payroll tax system and professional investment managers.

A simple and effective administrative structure is essential to the success of a

PRA system. Probably the simplest and cheapest structure would be to use the existing payroll tax system. Under today’s Social Security, the employer collects and

sends to the Treasury Department both the payroll taxes that are withheld from an

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employee’s check and those that are the responsibility of the employer. The payroll

tax money from all of the firm’s employees is combined with income taxes withheld

from their paychecks and sent to the Treasury. The money collected is allocated annually to individual workers’ earnings records after worker income tax records have

been received.

Adapting this existing administrative structure to a PRA system would be easier

to implement than other options. Under a PRA system, the employer would continue

to forward to the Treasury Department one regular check containing payroll and income taxes for all of the firm’s employees. The Treasury would continue to use its

existing formula to estimate the amount of receipts that should be credited to Social

Security and to reconcile this amount annually with actual tax receipts.

Once the Treasury determines the amount to be credited to Social Security, it

would estimate the portion that would go to PRA’s and forward that amount to a

holding fund managed by professionals who would invest the amount in money market instruments until it is credited to individual taxpayers’ accounts. The money

would go to individual workers’ accounts upon receipt of their tax information. It

would then be invested in the default fund, except for workers who have selected

(on their income tax forms) one of the other investment options, in which cases it

would be invested accordingly.

Using Professional Fund Managers. Rather that having the Government trying to

invest PRA money, the agency overseeing the accounts (which could be the Department of the Treasury, the Social Security Administration, or an independent board)

should contract out fund management to professional fund managers. This investment management system is currently used by the Federal Employees Thrift Investment Board, which administers the Thrift Savings Plan, a part of the retirement

system for Federal employees.

Under this system, management of the specific investment pools would be contracted out to professional fund managers, who would bid for the right to manage

an asset pool of a certain size for a specified period of time. The manager could invest the money only as directed by the agency. The agency would also contract out

to investor services such tasks as issuing regular statements of individual accounts,

answering account questions, and handling transfers from one investment option to

another.

Advantages of this Administrative Structure. Building on existing structures and

contracting out investment management and services should keep costs to the lowest level possible. In addition, employers would not have to change their current

payroll practices. Using one central government entity to receive PRA funds also

means that employers would not bear the cost of writing individual checks or arranging for individual fund transfers for each employee. In addition, this method allows the PRA contributions of workers who have multiple jobs to be based on their

total income without placing any additional burden on either the worker or the employers.

From a worker’s standpoint, this should be the lowest-cost structure available. In

addition, because workers’ PRA contributions would be distributed to their chosen

investment plans only after their tax information has been received, workers with

several jobs during a year should see contributions based on their total annual incomes.

Developing a simple personal retirement account system with very low administrative costs would be relatively simple.

State Street Trust, one of the largest managers of retirement savings, has estimated that administering a personal retirement account would cost from $3.55 to

$6.91 per person annually, based on proprietary data that the bank accumulated

from its experience in managing a host of pension plans. In terms of the percentage

of assets under management, the annual fee would be only 0.19 percent to 0.35 percent. This fee assumes an annual contribution per worker equal to 2 percent of his

or her gross earnings. The cost would drop significantly if that contribution increased to an amount equal to 4 percent of earnings or higher. State Street Trust’s

findings were reviewed and accepted by the Government Accountability Office as accurate.

This low level of administrative fees would certainly not reduce the benefits of a

PRA. In addition, history shows that administrative costs are highest when a system is first implemented and start-up costs must be covered. As time passes, administrative costs decline significantly. This has been true for 401(k) accounts, the

Thrift Savings Plan (TSP) for Federal employees, and even Social Security. For example, the administrative costs of 401(k) plans have decreased over time, despite

the plans offering an increasing number of investment options and a higher level

of personal service. Although the costs of specific plans vary according to each plan’s

complexity, size, and the types of investments, many large companies have been

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able to keep their administrative costs as low as 0.3 percent by offering only a limited number of broad-based funds.

The Federal Thrift Savings Plan, a privately managed retirement plan open only

to Federal employees, has experienced a dramatic 76 percent reduction in administrative costs since the system started in 1988. Today, participants pay annual administrative fees that are below 0.1 percent of assets under management. TSP’s extremely low administrative costs are significant, given that many experts expect

that a PRA system would closely resemble the structure and investment choices

found under TSP.

The Social Security system experienced similar reductions in administrative costs

during its formative years. In 1940, when the system first began to pay benefits,

its administrative costs equaled 74 percent of all Old-Age and Survivors Insurance

benefits paid. In 1945, this figure had declined to 9.8 percent. Today, administrative

costs make up only 0.5 percent of payments from the OASI Trust Fund. Even

though this is not a perfect comparison with the other two examples, given that Social Security’s structure has changed over the years, it does suggest that fees could

be very low.

PRA’s should be invested in more than just stocks, but stocks are an essential part

of the investment strategy.

Studies that purport to show either PRA’s or the Social Security Trust Fund

would have lost money over the past few years if they had been invested in stock

assume that 100 percent of the Trust Fund would have been invested in stocks,

rather than a diversified portfolio that would have balanced stock losses with gains

on bonds or other investments. They also focus on only the short-term market

trends, ignoring the gains that would result from longer-term investments.

Morningstar, Inc., an independent market data and analysis firm, estimates that

the value of mutual funds invested in diversified U.S. stocks declined 12.1 percent

during the second quarter of 2002. However, not all types of investments went

down. Mutual funds containing lower-risk instruments such as taxable bonds (which

are routinely held by those nearing retirement) rose an average of 1.4 percent over

that same period, while funds invested in tax-exempt bonds rose 3.2 percent. Thus,

in one of the worst quarters for stock investment, PRA’s invested in a diversified

portfolio would remain strong.

Over the long-run, all of these investments did even better. Over a 5-year period

including the second quarter of 2002, mutual funds invested in stocks earned an average of 3.9 percent per year, while mutual funds invested in taxable bonds and taxexempt bonds earned an average of 5.0 percent a year.

PRA’s should not be invested solely in stocks. They should instead be invested in

a diversified portfolio of stock index funds and different types of bond index funds.

The default investment for PRA’s should be a lifestyle fund that automatically reduces the proportion of stocks as the worker gets older, thus locking in past gains

and sharply reducing the chance of major losses in the years approaching retirement.

A carefully controlled set of investment options should be developed that includes

an appropriate default option.

The investment options available to PRA owners should be simple and easily understood. While an increasing number of Americans are investing their money for

a wide variety of purposes, a voluntary PRA system would bring in millions of new

investors who may not have any previous investment experience. In addition, experience from both the 401(k) retirement plans and Federal employees’ Thrift Savings

Plan shows that costs are far lower if the plan starts with only a few investment

options and then adds more once the plan is fully established.

Carefully Controlled Investment Options. All investment options available under

a PRA plan should be limited to a diversified portfolio composed of stock index

funds, government bonds, and similar assets. Even if they so desire, workers would

not be allowed to invest in speculative areas such as technology stocks or to choose

specific stocks or bonds. Money in a PRA is intended to help to finance a worker’s

retirement security, not to be risked on speculative investments with the hope that

taxpayers will support the worker if the investment fails.

Initially, workers would be allowed to put their PRA contributions into any one

of three balanced and diversified mixes of stock index funds, government bonds, and

similar pension-grade investments. Although the exact mix of assets would be determined by the central administrative agency, one fund might consist of 60 percent

stock index funds and 40 percent government bonds, while another might be 60 percent government bonds and 40 percent stock index funds.

The third fund, which would also act as the default fund for workers who failed

to make a choice, would be a lifestyle fund. These are funds in which the asset mix

changes with the age of the worker. Younger workers would be invested fairly heavVerDate 11-MAY-2000 16:58 Sep 22, 2006 Jkt 025856 PO 00000 Frm 00065 Fmt 6621 Sfmt 6621 29725.TXT SBANK4 PsN: SBANK4
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ily in stock index funds, but as they age, their funds would automatically shift

gradually toward a portfolio that includes a substantial proportion of bonds and

other fixed-interest investments. This is designed to allow the portfolios of workers

who are far from retirement to grow with the economy and to allow older workers

to lock in that growth by making their portfolios predominantly lower-risk investments.

Workers would be allowed to change from one investment fund to another either

annually (by indicating their choice on the income tax form) or at other specified

times (by completing a form on the Internet). They would also receive quarterly

statements showing the balance in their accounts. As with today’s Social Security,

PRA accounts are intended strictly for retirement purposes, and no early withdrawals would be allowed for any reason.

Structuring Accounts to Keep Fees Low. Under a successful PRA plan, all investments must be approved by the central administrative agency as being appropriate

for this level of retirement investment. That agency would also ensure administrative costs are kept as low as possible by awarding contracts to manage investment

pools through competitive bidding and through direct negotiation with professional

funds managers.

Research by State Street Global Investors shows that administrative costs are

lower if workers put all their money in one diversified pool of assets rather than

attempting to diversify their portfolio by dividing it among several types of assets.

For example, a worker who puts all of his or her money in one fund consisting of

50 percent stock index funds and 50 percent Government bonds would earn the

same as a worker who places half of his or her money in a government bond fund

and half in a separate stock index fund. However, the first worker would incur significantly lower administrative costs.

Additional Choices for Larger Accounts. Once a worker’s PRA account reaches a

certain size threshold (determined by the central administrative agency), he or she

would have the option to move its management to another investment manager if

that manager offered better service or potentially higher returns. However, only investment managers who had meet strict asset and management quality tests would

be allowed to receive these accounts, and the managers would be sharply limited

in the types of investments they could offer. In the event that the worker is dissatisfied with either the fees or the returns from these individually managed accounts,

he or she could switch back to the centrally managed funds at any time.

PRA’s should be invested in lifespan accounts unless the account owner chooses another investment.

A key feature of President George Bush’s recently announced Social Security plan

is that workers’ personal retirement accounts (PRA’s) would be invested automatically in a lifespan fund unless a worker expressly asked for another arrangement.

Lifespan funds adjust (or ‘‘rebalance′′) a worker’s investments as he or she ages. For

younger workers who are far from retirement, a lifespan fund would invest most of

their money in stock index funds—safe funds reflecting the broad stock market. As

these workers grow older, their lifespan funds would gradually and automatically

shift more money into even safer bonds and other less volatile investments. In short,

lifespan funds allow younger workers to take advantage of the higher returns that

stock investments offer while making sure that the portfolio gets safer and safer as

the worker gets closer to retirement.

Lifespan funds are designed to allow the portfolios of workers who are far from

retirement to grow with the economy and to allow older workers to lock in that

growth by moving their portfolios into predominantly lower-volatility investments.

This means that if the stock market suddenly declined, workers who invested in a

lifespan fund and were near retirement would have only a tiny part of their PRA’s

invested in stocks and thus would not see a significant last-minute change in the

value of their PRA’s.

As an example of how these funds would protect workers who are close to retirement, Morningstar, Inc., an independent market data and analysis firm, estimated

that the value of mutual funds invested in diversified U.S. stocks declined 12.1 percent during the second quarter of 2002—one of the worst quarters in recent history.

However, not all types of investments went down. Indeed, mutual funds containing

lower-risk instruments such as taxable bonds (a common investment for those nearing retirement) actually rose an average of 1.4 percent over that same period, and

funds invested in tax-exempt bonds rose an average of 3.2 percent.

Because a lifespan account would have automatically moved a worker’s PRA almost entirely into bonds when that worker reached retirement age, a worker with

a PRA who retired in the first quarter of 2002 thus would have seen his PRA grow

during that last quarter before retirement. He or she would not have faced losses,

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even though the stock market as a whole experienced major declines during that

period.

Lifespan funds have been gaining popularity in employer-sponsored retirement

plans, such as 401(k)’s, because they automatically make the kind of portfolio adjustments that investment professionals recommend for all workers nearing retirement. At the end of 2004, about 55 companies offered lifespan accounts as part of

their 401(k) plans. Currently, the biggest players in the field are Fidelity Investments, with a 33 percent market share, and The Vanguard Group, with about 17

percent. Administrative fees depend in a large part on whether the funds are actively or passively managed. Fidelity, which consists totally of actively managed

funds has an administrative fee of 0.81 percent of assets under management, while

Vanguard, which consists totally of index funds has fees of 0.23 percent of assets

under management. Passively managed index funds are much more suitable for Social Security accounts than are funds that pick and choose individual stocks.

For many years, investment advisers have advised workers to structure their retirement accounts so that more funds are shifted into fixed-income investments as

they age. Advisors recognize that decreasing the proportion of investment in stocks

reduces the potential for short-term loss. Although younger investors are better off

investing most of their assets in stocks to get higher returns, those who are closer

to retirement need to reduce the likelihood that a sudden market shift will affect

them. Lifespan funds make this rebalancing process continuous and automatic and

would let workers with PRA’s approach retirement with confidence.

Conclusion

Again, thank you for the opportunity to testify before you today. The success of

Social Security personal retirement accounts as a way for individuals to build sufficient savings to fund a portion of their retirement benefits will in large part depend

on the investment choices that are available. A simple, low-cost administrative platform would improve the ability of these accounts to assist individuals in meeting

their retirement goals. Such a system is both feasible and realistic.

Thank you.

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