United States General Accounting Office

GAO Report to the Special Committee on

Aging, U.S. Senate

April 1998 SOCIAL SECURITY

FINANCING

Implications of

Government Stock

Investing for the Trust

Fund, the Federal

Budget, and the

Economy

GAO/AIMD/HEHS-98-74

GAO United States

General Accounting Office

Washington, D.C. 20548

Accounting and Information

Management Division

B-274811 

April 22, 1998

The Honorable Charles E. Grassley

Chairman

The Honorable John B. Breaux

Ranking Minority Member

Special Committee on Aging

United States Senate

This report responds to your request that we study the implications of having the Social

Security trust fund invest in the stock market. As requested, we assessed the impact of

government stock investing on (1) the Social Security trust fund, (2) the U.S. economy, and

(3) the federal budget.

As agreed with your office, unless you publicly announce the contents of this report earlier, we

plan no further distribution until 30 days from the date of this letter. At that time, we will send

copies to the Chairmen of the House and Senate Committees on the Budget, the Senate

Committee on Finance, and the House Committee on Ways and Means; the Director of the

Office of Management and Budget; the Secretary of the Treasury; the Commissioner of the

Social Security Administration; the Chairman of the Securities and Exchange Commission; and

other interested parties. Copies will also be made available to others upon request.

Please contact Mr. Posner at (202) 512-9573 or Ms. Bovbjerg at (202) 512-5491 if you have any

questions concerning this report.

Paul L. Posner

Director, Budget Issues

Accounting and Information Management Division

Barbara D. Bovbjerg

Associate Director, Income Security Issues

Health, Education, and Human Services Division
Executive Summary

Purpose The Social Security program faces a long-term financing challenge,

primarily due to changing demographics. In response, reform advocates

have suggested numerous options to curb benefits or increase revenues.

One proposed option is to invest Social Security funds in the stock market

with the intention of earning higher returns. To better understand the

potential implications of stock investing for the federal government, the

Senate Special Committee on Aging asked GAO to address the impact of

government stock investing on (1) the investment earnings, investment

risk, and financial solvency of the Social Security trust fund, (2) national

saving and the financial markets, including implementation issues

presented by the government selecting and managing its stock portfolio,

and (3) the federal budget and federal debt.

This report addresses only indirectly the broad issue of Social Security’s

long-term financing needs and does not evaluate any specific Social

Security reform package or address proposals to establish

individually-owned accounts. Rather, as discussed with Committee staff,

to fully identify the effects of government stock investing, GAO studied

changing trust fund investment policy in isolation from any other program

changes in Social Security. In its analysis, GAO generally reviewed the

literature on financial markets, Social Security, and federal budgeting and

interviewed finance, budget, and program experts in government and the

private sector. To illustrate how alternative policies could affect the trust

fund’s financial outlook, the Social Security Administration’s (SSA) Office

of the Chief Actuary, at GAO’s request, simulated the potential outcomes of

two stock investment scenarios using the Social Security Trustees’ 1997

intermediate actuarial assumptions.

Background Social Security’s long-term financing problem is caused primarily by the

aging of the U.S. population. According to Social Security’s actuarial

estimates, the number of workers supporting each Social Security

beneficiary is projected to drop from 3.3 to 2.0 between 1997 and 2030—a

decline of nearly 40 percent. Beyond 2030, the proportion of the

population that is elderly is expected to continue growing due to relatively

low birth rates and increasing longevity.

Currently, Social Security’s tax revenue each year exceeds benefit

payments, and the trust fund, by law, invests the resulting cash surplus in

U.S. government obligations. The trust fund also receives interest income

from the Treasury that is credited in the form of additional Treasury

securities. Beginning in about 2012, according to Social Security actuarial

Page 2 GAO/AIMD/HEHS-98-74 Social Security Financing
Executive Summary

projections, the program’s annual tax revenue will be insufficient to pay

yearly benefits. To cover the cash shortfall, the trust fund will begin

drawing on the Treasury, first relying on its interest income and eventually

drawing down its assets. Regardless of whether the trust fund is drawing

on interest income or principal to make benefit payments, the Treasury

will need to raise the required cash through some combination of

borrowing from the public,1

 spending cuts in other federal programs, or

revenue increases. In 2029, the trust fund is projected to be exhausted.

After that, Social Security taxes are projected to cover only about

75 percent of promised benefits.

In response to Social Security’s long-range financing problems, the

1994-1996 Advisory Council on Social Security (the Advisory Council)

suggested a variety of specific changes. One proposal advanced by 6 of the

Advisory Council’s 13 members suggested that along with a number of

benefit and tax changes, policymakers consider allowing the trust fund to

invest in stocks. Supporters of this approach have pointed out that

investing in the stock market is standard practice for state and local

government and private sector pension funds. Overall, pension funds held

about 60 percent of their assets in stocks and these holdings accounted for

about a quarter of total U.S. stock holdings—valued at $12.8 trillion—at

the end of the third quarter of 1997.

The seven other members of the Advisory Council opposed government

investment in the stock market. They believed that there would be

tremendous political pressures to steer the Social Security trust fund’s

investments to achieve other economic, social, or political purposes rather

than basing decisions solely on the expected risk and return. Also, there

was concern that if the government exercised its stock voting rights, it

might influence individual companies or industries.

To assess the implications of changing Social Security’s investment policy,

it is important to understand how Social Security fits within the federal

budget and its influence on overall fiscal policy. Within the federal budget,

Social Security is a trust fund account that authorizes the Treasury to pay

Social Security benefits as long as the account has a balance. Social

Security is the largest federal trust fund with fiscal year 1997 outlays of

$365 billion and a fund balance of $631 billion invested in Treasury

securities. While the trust fund’s Treasury securities represent assets for

Social Security, they are future claims against the Treasury. Today, Social

1

If the unified budget were in surplus, then financing the excess benefits would require less debt

redemption, rather than increased borrowing.

Page 3 GAO/AIMD/HEHS-98-74 Social Security Financing
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Security’s surplus tax revenue is invested in Treasury securities and is

spent to finance other governmental activities, thereby reducing the

Treasury’s need to borrow from the public. Although the Social Security

trust fund is technically excluded from the budget, its finances contribute

to the government’s impact on the economy. Therefore, Social Security is

included, along with all other federal programs, in the commonly used

“unified” budget measure. The unified budget is the means to measure the

government’s current draw on financial markets. However, in considering

the long-range implications of federal policies, it is also useful to consider

the impact that Social Security’s temporary surplus has on the

government’s unified budget. Social Security’s current cash surplus

partially offsets the deficit in the rest of the government’s accounts.2

Social Security has an important influence on the government’s overall

fiscal position, which, in turn, affects national saving, a key determinant of

long-term economic growth. The nation’s saving is composed of the

private saving of individuals and businesses and the saving or dissaving of

all levels of government. In general, government budget deficits subtract

from national saving by absorbing funds that otherwise could be used for

private investment, while government surpluses add to saving. Raising

saving and investment levels would improve the long-term productivity of

the economy, thereby boosting economic growth. The most direct way for

the federal government to contribute to national saving and long-term

economic growth is to achieve and maintain a balanced budget or a

surplus. A bigger economic pie would make it easier for future workers to

meet the dual challenges of paying for the baby boomers’ retirement while

achieving a rising standard of living for themselves.

Results in Brief Allowing the Social Security trust fund to invest in the stock market is a

complex proposal that has potential consequences for the trust fund, the

U.S. economy, and federal budget policy. For the Social Security trust

fund, stock investing offers the prospect of higher returns but greater risk.

Higher investment returns would allow the trust fund to pay benefits

longer, even without other program changes. However, if stock investing is

implemented in isolation, the trust fund would inevitably have to liquidate

its stock portfolio to pay promised benefits, and it would be vulnerable to

losses in the event of a general stock market downturn. Although stock

investing is unlikely to solve Social Security’s long-term financial

2

Interest credited on the trust fund’s Treasury securities has no current effect on the unified federal

deficit because it is a payment from one part of the government to another part.

Page 4 GAO/AIMD/HEHS-98-74 Social Security Financing
Executive Summary

imbalance, it could reduce the size of other reforms needed to restore the

program’s solvency.

Beyond the clear trade-off between greater risk for the prospect of higher

returns, the government would face other implementation issues inherent

in owning and managing a stock portfolio. Proposals for government stock

investing typically suggest investing passively in a broad-based stock index

to reduce both costs and the risk that the government would control

individual companies. Index investing would help achieve these goals, and

it would reduce but not eliminate the possibility of political influence over

stock selections. However, because index investors cannot alter their

portfolio composition to increase financial performance, the government

would have a stronger incentive to actively exercise the voting rights of its

sizable stock portfolio. This issue would raise concerns about potential

federal involvement in corporate affairs, and could prove more difficult to

resolve since even choosing not to vote would affect corporate

decision-making by enhancing the voting power of other shareholders or

investment managers.

For the federal budget, stock investing would have the immediate effect of

increasing the reported unified deficit or decreasing any reported unified

surplus because, under current budget scoring rules, stock purchases

would be treated as outlays. Any money used to purchase stocks would no

longer be invested in Treasury securities, reducing the Treasury’s available

cash and more clearly revealing the underlying financial condition of the

rest of the government. If after accounting for this effect the federal

government were in a deficit, the Treasury would need to borrow from the

public to replace cash used to buy stocks unless offsetting spending or

revenue actions were taken.

Without compensating changes in fiscal policy, stock investing would not

significantly alter the impact of federal finances on national saving and the

economy. To cover a deficit, the government would issue additional

Treasury securities to the public, but it would offset this action by

purchasing stocks from other investors. This asset shuffle could lead to

higher stock prices and higher interest rates, undercutting somewhat the

potential gain from stock investing and increasing the government’s cost

of borrowing. Even with such price effects, the government could still

come out ahead by investing in stocks. However, any higher returns

earned by the government would otherwise have accrued to other

investors. In short, by itself, government stock investing would have no

appreciable effect on future national income.

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Although the immediate budgetary effect of investing in stocks would be

to increase unified deficits or decrease unified surpluses, stock investing

might indirectly lead to changes in federal fiscal policy that could increase

national saving. By making Social Security’s surplus unavailable to the

Treasury, stock investing could focus more attention on the budgetary

imbalance that exists when this temporary source of funds is excluded.

Increased attention could prompt policymakers to address this imbalance

by cutting spending or raising revenue. Such fiscal actions could boost

national saving and long-term economic growth. Of course, regardless of

any change in Social Security’s investment policy, policymakers could

decide to achieve a budget balance or surplus without relying on Social

Security’s surplus.

GAO’s Analysis

Potential Returns and

Risks for the Social

Security Trust Fund

The Social Security trust fund could expect to earn more by investing in

the stock market but would have to accept greater risk. Under current law,

the trust fund invests solely in U.S. government obligations and, under the

Social Security Trustees’ intermediate assumptions, is expected to earn

2.7 percent after inflation over the long term. Historically, returns on

stocks have exceeded returns on Treasury securities over the long term,

averaging about 7 percent after inflation. However, stock returns are

highly variable from year to year, and there have been years in the past

with negative returns.

To illustrate how much the trust fund might invest in the stock market,

GAO developed (1) an aggressive scenario of investing Social Security’s

future annual cash surplus and interest, while maintaining a contingency

reserve of special Treasury securities equal to at least a year’s

expenditures, and (2) a more conservative scenario of investing only

Social Security’s cash surplus and selling stocks first to finance Social

Security’s expected cash deficit. Under these scenarios, Social Security’s

cash surplus would not be available to finance other government

operations. Under the aggressive scenario, the Treasury also would have

to raise additional cash to finance interest payments to the trust fund.

Under the aggressive scenario, assuming the historical average stock

return, the trust fund’s exhaustion could possibly be delayed by about a

decade, from 2029 to 2040. This potential delay well into the baby

Page 6 GAO/AIMD/HEHS-98-74 Social Security Financing
Executive Summary

boomers’ retirement years would result only from the Social Security trust

fund investing aggressively in the stock market. The trust fund would

invest more than 70 percent of its assets in the stock market, which would

be a dramatic shift from investing solely in Treasury securities. Under the

cash surplus scenario, still assuming the historical average return, the

possible delay in the trust fund’s exhaustion would be only 3 years.

The possible delay resulting from any stock investment scenario would be

significantly shorter if the future stock returns are lower than the

historical average of 7 percent after inflation. As an illustration, if the

future return on stocks is 1 percentage point lower, the delay in the trust

fund’s exhaustion under the aggressive scenario would be reduced to only

6 years. The delay under the cash surplus scenario assuming the real

return is 1 percentage point lower would be 2 years. The results of these

simulations illustrate some outcomes associated with two stock

investment alternatives; they should not be interpreted as forecasts and

are not intended to represent the full range of possible outcomes for the

Social Security trust fund.

The only way for the Social Security trust fund to earn the higher returns

possible with stock investing is to take on greater risk. The primary risk

that the trust fund would face is the possibility of loss in the event of a

general stock market downturn (market risk). Depending on the

composition of its portfolio, the trust fund could also face losses from a

heavy investment in a group of companies or an industry susceptible to

the same economic dynamics (concentration risk). Diversifying the stock

portfolio, for example by investing in an index representative of the broad

market, would reduce the risk of loss associated with individual

companies or an industry segment performing poorly.

If stock investing is implemented in isolation from other program changes,

the trust fund would face the certain need to liquidate its assets to pay

benefits with no certainty about what future stock prices would be or

whether it could recover amounts invested. The more the trust fund is

counting on stock sales to raise cash, the greater its vulnerability in the

event of a general market downturn. Stock investing conceivably could be

implemented in combination with other changes that increase Social

Security’s funding. As part of a broader package, which is what the

Advisory Council suggested, stock investing could complement traditional

reforms in that higher stock returns could reduce the size of benefit cuts

and/or tax increases.

Page 7 GAO/AIMD/HEHS-98-74 Social Security Financing
Executive Summary

Impact on Economy and

Financial Markets

The economic effect of government stock investing would likely be

minimal because stock investing by itself does not increase national

saving. In the absence of further deficit reduction, the Treasury would

have to borrow from the public to offset the Social Security’s stock

purchases, yielding no additional national saving.3

 The net effect would be

that private investors would end up with fewer stocks and more Treasury

securities, while the government would have stocks and fewer of its own

securities. This asset shuffle means that any higher returns earned by the

government would otherwise have accrued to other investors. In short, by

itself, government stock investing would have no appreciable effect on

future economic growth.

Financial market analysts and economists believe that this asset shuffling

between the government and other investors could increase stock prices

and interest rates, undercutting the potential gain from stock investing and

increasing the government’s cost of borrowing. Price effects could begin

even before the government announces its stock investment policy,

reducing the potential gain to the government from stock investing. Higher

interest rates would increase the cost of government borrowing, even as

higher stock prices would reduce the government’s expected return on its

stock investments. The magnitude of price changes is uncertain and could

be small. Long-term changes in asset prices are unpredictable and would

depend, in part, on the response of other borrowers and investors to the

short-term price effects of government stock investing. Although Social

Security’s stock portfolio would likely be larger than that of any other

single investor, its size in comparison to the whole stock market would

likely be relatively small.

Benefits and Limitations of

Stock Indexing

Proposals for government stock investing typically recommend investing

in a broad-based stock index to diversify the government’s stock portfolio,

reducing the likelihood of concentrating investments in individual

companies, and to reduce administrative costs. Still, index investing could

create price effects of its own as the government would have to purchase

new stocks added to an index or sell stocks deleted from the selected

index. Analysts have found significant price changes in stock prices of

companies added to or deleted from the Standard & Poor’s 500 index,

which represents about two-thirds of the U.S. stock market.

3

This statement applies in a situation where the federal government has a unified budget deficit after

investing in the stock market. If, instead, the government ended up with a unified surplus, the cash

used to purchase stocks would not be available to reduce the level of debt held by the public.

Page 8 GAO/AIMD/HEHS-98-74 Social Security Financing
Executive Summary

Index investing does not eliminate the possibility that nonfinancial

objectives would influence stock selection. For example, the government

could start with a broad-based index and modify it to target investments

that offer competitive returns and also achieve social goals. Alternatively,

the government could choose to disinvest in specific companies or sectors

of the economy that are in conflict with government policies. Critics have

expressed concerns that pressures to include or exclude stocks for

nonfinancial reasons might reduce the rate of return on the government’s

portfolio and hinder the overall economic efficiency of capital markets.

Some analysts believe that it might be possible to establish in law that

investments be made solely for the financial benefit of Social Security

participants and not for other social objectives. They cite as an example

the federal Thrift Savings Plan, which is managed solely in the interest of

participating federal employees and their beneficiaries.

Regardless of the type of indexing strategy the government adopts,

policymakers would need to decide how to handle the stock voting rights

for the government’s portfolio. Because index investors as a general rule

do not alter the portfolio composition to increase financial performance,

they have a stronger incentive to exercise stock voting rights actively.

Instead of selling stocks of an underperforming company, an index

investor can choose to participate in corporate decisions that might

enhance the company’s performance. However, critics have expressed

concern that the government’s right to vote its sizable number of shares

would allow it to influence corporate decisions. To blunt such concerns,

the government’s stock voting rights could be restricted by statute, but any

restriction would need to be designed carefully. For example, simply

prohibiting the government from exercising its voting rights would favor

other stockholders or investment managers by effectively increasing their

voting rights.

Effects of Government

Stock Investments on the

Federal Budget and Fiscal

Policy

In the short term, stock investing would increase the reported unified

deficit or decrease any unified surplus because, under current budget

scoring rules, stock purchases would be treated as budget outlays. The

magnitude of the change in the reported deficit/surplus could exceed

$100 billion annually, depending on how much the trust fund invested in

stocks. If after accounting for this effect the government were in deficit,

the Treasury would have to borrow more from the public, unless action

were taken to reduce other spending or raise revenues.

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Executive Summary

Any increased borrowing from the public would be offset by reduced

borrowing from the Social Security trust fund, leaving the federal

government’s gross debt largely unchanged. More important, the reported

decline in the government’s budget balance caused by stock investing

would not significantly affect national saving. While any federal borrowing

from the public would absorb money from capital markets, the trust fund’s

stock investments would offset this effect by adding money to the

markets. As a result, the government’s fundamental fiscal position would

be largely unchanged.

While stock investing would have a negative effect on the budget

deficit/surplus today, over time its impact on the unified budget could

largely be neutral. As with any budget outlay, the purchase of a stock

would mean money flowing out of the government and, thus, the reported

budget deficit/surplus would deteriorate. However, the sale of a stock

would mean money flowing back into the government. So, when Social

Security begins running cash deficits in the future, it could sell stocks to

finance benefits, rather than drawing on the Treasury. This approach

would result in smaller future budget deficits or larger future budget

surpluses than under current policy. This longer term improvement could

offset the near-term deterioration in the deficit/surplus. Indeed, on

balance, the government could actually come out ahead in the long term if

its stock earnings were to exceed any increase in federal borrowing costs

that might result from a stock investing policy. However, without any

accompanying action to raise national saving, the government would be

capturing a portion of stock returns that would otherwise have accrued to

private investors.

Whether the short-term increase in reported budget deficits or the decline

in reported budget surpluses would lead to any changes in fiscal policy is

unclear. Since stock investing would not substantially change the impact

of federal finances on the economy, policymakers might decide to

maintain fiscal policy as is. Since the government acquires a financial asset

when it buys stock, the case could be made that the purchase should not

be treated as a budget outlay. Policymakers could choose to change

budget scoring rules to explicitly recognize the distinct nature of stock

purchases. However, such a change would conflict with the way other

asset purchases are treated in the budget. Generally, asset purchases are

scored as outlays.4

 In addition, creating different budget scoring rules for

stocks would also raise some complicated technical issues, such as how to

4

Major exceptions include debt transactions, such as those that occur when Social Security invests

funds in special Treasury securities, and cases in which the government purchases an asset that is

considered equivalent to cash.

Page 10 GAO/AIMD/HEHS-98-74 Social Security Financing
Executive Summary

recognize changes in their market values. If, despite these considerations,

stock purchases were not treated as outlays, stock investing would have

no major impact on the reported budget deficit or surplus.5

If current budget scoring rules were maintained, stock investing would

make more visible the underlying condition of the government’s finances

excluding the Social Security surplus. Currently, in the unified budget

presentation, the Social Security surplus masks the financial status of the

rest of the government. By helping to finance current spending, Social

Security’s cash surplus may result in the government spending more or

taxing less than it would if these funds were not available to finance other

programs.6

 By making at least part of Social Security’s surplus unavailable

to the Treasury, stock investing would reduce or eliminate the masking

effect. In effect, stock investing would make the unified budget measure

look more like the “on-budget” measure that excludes Social Security’s

finances. If Social Security’s cash surplus and its interest were invested in

stocks, the “new” unified budget measure would virtually match the

on-budget measure.7

Even though stock investing does not change the government’s fiscal

position, the higher reported deficits or lower reported surpluses that

result could indirectly lead policymakers to change fiscal policy by

focusing more attention on the budget imbalance that exists when Social

Security’s surplus is excluded. Policymakers could react to a higher

unified deficit by cutting spending and/or raising taxes. Or, if stock

investing were expected to reduce or eliminate a unified budget surplus,

instead of creating or adding to a unified budget deficit, policymakers

might be reluctant to enact tax cuts or additional spending. In this case,

fiscal restraint might not promote higher saving, but it would avoid policy

actions that could cause saving to decline.

5

Even if stock purchases were not treated as outlays, stock investing could result in minor changes in

the budget deficit/surplus (e.g., interest costs on any additional borrowing from the public).

6

This masking effect could have important implications for any Social Security reforms. Reforms that

increase the size of the Social Security surplus would not necessarily improve the long-term picture for

the budget as a whole. A larger Social Security surplus might serve to intensify the masking of the

financial condition of the rest of the government. If policymakers responded to a larger trust fund

surplus by exercising less restraint in the rest of the budget, the improvement in Social Security’s

finances would not contribute to increased national saving. Instead, it would only allow the trust fund

to build up more claims on the Treasury without enhancing the nation’s ability to meet these future

claims.

7

In addition to Social Security, the on-budget deficit excludes the operations of the U.S. Postal Service.

However, this amount is very small in comparison to Social Security.

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Though stock investing could help highlight the budget shortfall that exists

when Social Security’s surplus is excluded, it represents a circuitous way

of essentially duplicating an existing measure—the on-budget deficit. If

policymakers wanted to take actions to boost national saving, they

certainly could do so directly by running annual surpluses in the unified

budget and devoting the surplus funds to reducing the level of outstanding

debt held by the public. If the government ran a unified budget surplus

equal to Social Security’s cash surplus, the Treasury would no longer need

to rely on Social Security revenues to finance federal spending on other

activities. While attaining and sustaining surpluses could prove extremely

challenging, such a policy would strengthen the fiscal position of the

government and, by promoting higher saving, better position the economy

to handle the baby boomers’ retirement costs.

Agency Comments GAO requested comments on a draft of this report from the Commissioner

of the Social Security Administration, the Secretary of the Treasury, the

Chairman of the Securities and Exchange Commission, and the Director of

the Office of Management and Budget or their designees. These agencies

provided technical comments from their staffs, which were incorporated

where appropriate.

Page 12 GAO/AIMD/HEHS-98-74 Social Security Financing
Page 13 GAO/AIMD/HEHS-98-74 Social Security Financing
Contents

Executive Summary 2

Chapter 1 

Introduction

18

Social Security’s Financing Challenge Primarily Caused by

Demographic Trends

18

Stock Investing Suggested to Help Solve Social Security’s

Financing Problem

20

Objectives, Scope, and Methodology 23

Chapter 2 

The Federal Budget,

the Economy, and the

Social Security Trust

Fund

27

Social Security Trust Fund Is a Budget Account 27

Social Security’s Current Investment Policy 29

Social Security’s Place Within the Federal Budget 32

Federal Fiscal Policy and National Saving 33

Chapter 3 

Balancing Potential

Returns and Risks for

the Social Security

Trust Fund

35

Special Treasury Investment Policy: Low Returns and Minimal

Risk

36

Stock Returns Have Been Higher but Are More Uncertain 38

Higher Returns Could Delay Exhaustion of the Social Security

Trust Fund

44

Stock Investing Entails Greater Risk 48

Stock Investing Could Complement Other Social Security

Reforms

51

Chapter 4 

Economic and Market

Effects of

Government Stock

Ownership

53

Economic Effects Would Likely Be Minimal 53

The Government Could Become the Largest Stock Investor 55

Benefits and Limitations of Stock Indexing 56

Page 14 GAO/AIMD/HEHS-98-74 Social Security Financing
Contents

Chapter 5 

Effects of

Government Stock

Investments on the

Federal Budget and

Fiscal Policy

64

Impact of Stock Investing on Reported Deficits/Surpluses 65

Indirect Impact of Government Stock Investing on Fiscal Policy

Is Unclear

68

Appendixes Appendix I: Assumptions Used in Estimating How Higher Returns

Affect the Social Security Trust Fund

72

Appendix II: Government Stock Investing and Federal Budgetary

Accounting

77

Appendix III: Major Contributors to This Report 80

Related GAO Products 82

Tables Table 1.1: Asset Mix of Private Sector and State and Local

Government Pension Funds

21

Table 2.1: Maturities of Treasury Securities Held by Selected

Trust Funds

29

Table 3.1: Best and Worst Returns on Large Company Stocks and

Long-term Government Bonds for Varying Investment Periods

From 1926 Through 1996

41

Table 4.1: Top Five Pension Funds and Money Managers Ranked

by Total Assets

56

Table I.1: Nominal Yields on Special Treasury Securities and on

Stocks Assuming 7 Percent and 6 Percent Real Yields From 1998

Through 2011

74

Table I.2: Key Dates Under Current Law and Two Stock

Investment Scenarios

75

Figures Figure 1.1: Social Security’s Projected Cash Surpluses and

Deficits as a Percentage of GDP

19

Figure 1.2: Canadian Pension Plan to Invest in Stocks 23

Figure 2.1: Projected Buildup in Social Security Reserve 31

Figure 3.1: Annual Returns on Large Company Stocks in

Comparison to the Annualized Average Return for 1950 through

1996

39

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Contents

Figure 3.2: Estimated Trust Fund Assets Under Current Law and

Two Alternative Stock Investment Scenarios

46

Figure 4.1: Examples of Widely Recognized Stock Indexes 57

Figure 4.2: Overview of the Federal Thrift Savings Plan 61

Figure 5.1: No Net Change in National Saving with Government

Stock Investing

67

Abbreviations

CBO Congressional Budget Office

DI Disability Insurance

ERISA Employee Retirement Income Security Act

GDP gross domestic product

OASDI Old-Age and Survivors’ and Disability Insurance

OASI Old-Age and Survivors’ Insurance

OMB Office of Management and Budget

S&P 500 Standard and Poor’s 500

SEC Securities and Exchange Commission

SSA Social Security Administration

TSP Thrift Savings Plan

Page 16 GAO/AIMD/HEHS-98-74 Social Security Financing
Page 17 GAO/AIMD/HEHS-98-74 Social Security Financing
Chapter 1 

Introduction

The Social Security program faces a long-term financing challenge

primarily due to changing demographics. In response, numerous options

have surfaced to reduce benefits or increase revenues. One proposed

option is to invest a portion of the Social Security trust fund1

 in the stock

market with the intention of earning higher returns. To better understand

the potential implications of the federal government investing in the stock

market, the Chairman and Ranking Member of the Senate Special

Committee on Aging asked us to analyze how such a proposal would affect

the Social Security trust fund, the U.S. economy, and the federal budget.

Social Security’s

Financing Challenge

Primarily Caused by

Demographic Trends

Social Security’s long-term financing problem is primarily caused by the

aging of the U.S. population. As the baby boom generation retires, labor

force growth is expected to slow dramatically. According to Social

Security’s intermediate actuarial projections, the number of workers

supporting each Social Security beneficiary is projected to drop from 3.3

to 2.0 between 1997 and 2030—a decline of nearly 40 percent.2

 Beyond

2030, the population is expected to continue aging due to relatively low

birth rates and increasing longevity. These demographic trends will

require substantial changes in Social Security benefits and/or revenues.

Without such changes, Social Security tax revenues are expected to be

insufficient to cover benefit payments in about 2012, less than 15 years

from now. To cover this annual cash shortfall, the trust fund will begin

drawing on the Treasury, first relying on its interest income and,

eventually, on its assets.3

 As shown in figure 1.1, the trust fund’s annual

cash deficits will grow rapidly, reaching a projected 1.6 percent of the

nation’s gross domestic product (GDP) in 2028. The trust fund is projected

to be exhausted by 2029 and, after this point, Social Security’s annual tax

1

Social Security consists of two separate trust fund accounts: Old-Age and Survivors Insurance (OASI),

which funds retirement and survivor benefits, and Disability Insurance (DI), which provides benefits to

disabled workers and their families. These two accounts are commonly combined in discussing the

Social Security program. For the purposes of this report, any reference to the Social Security trust

fund refers to the combined OASDI trust funds.

2

Throughout this report, we relied on data from The 1997 Annual Report of the Board of Trustees of

the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, hereafter “the 1997

Trustees’ Report.” Under the Social Security Act, the Board of Trustees is required to report annually

to the Congress on Social Security’s financial and actuarial status. We used the intermediate

assumptions, which reflect the Board of Trustees’ best estimate. Due to the inherent uncertainty

surrounding long-term projections, the Trustees’ report also includes two other sets of assumptions, a

high cost and a low cost alternative.

3

Regardless of whether the trust fund is drawing on its interest or principal to pay benefits, the

Treasury will need to raise the required cash.

Page 18 GAO/AIMD/HEHS-98-74 Social Security Financing
Chapter 1 

Introduction

revenues will cover only about 75 percent of expected benefit payments.

In short, the program as currently structured is unsustainable.4

Figure 1.1: Social Security’s Projected Cash Surpluses and Deficits as a Percentage of GDP (1997-2029)

Surplus

Deficit

1997 2012 2029

-2

-1.5

-1

-0.5

0

0.5

1

Percentage of GDP

Note: Calendar year data.

Source: GAO analysis of 1997 Trustees’ Report, intermediate assumptions.

These trends in Social Security’s finances will place a significant burden

on future workers and the economy. Without major policy changes, the

relatively smaller workforce of tomorrow will bear the brunt of tax

increases, spending cuts, or borrowing5

 needed to finance Social Security’s

4

Retirement Income: Implications of Demographic Trends for Social Security and Pension Reform

(GAO/HEHS-97-81, July 11, 1997).

5

If the unified budget were in surplus, then financing Social Security’s cash deficit would result in less

debt redemption rather than requiring increased borrowing.

Page 19 GAO/AIMD/HEHS-98-74 Social Security Financing
Chapter 1 

Introduction

cash deficit. In addition, the future workforce also would likely be affected

by any reduction in Social Security benefits or increased payroll taxes

needed to resolve the program’s long-term financing shortfall.

Stock Investing

Suggested to Help

Solve Social Security’s

Financing Problem

In its report to the Social Security Commissioner, the 1994-1996 Advisory

Council on Social Security (“the Advisory Council”) offered three

alternative reform proposals. While the Advisory Council could not agree

on a single plan for dealing with Social Security’s difficulties, the members

did agree that investing in the stock market would yield higher returns for

financing retirement benefits. One approach was to maintain Social

Security’s current benefit and taxation structure and allow the government

to invest directly in the stock market. The other two approaches would

significantly restructure Social Security and allow stock investing through

accounts owned and controlled by individuals.

The “Maintain Benefits” plan—supported by 6 of the Advisory Council’s 13

members—recommended a traditional package of tax and benefit

changes. These changes were projected to solve about two-thirds of Social

Security’s long-term financing problem. To close the remaining gap, the

plan called for studying the possibility of allowing the Social Security trust

fund to invest in the stock market. According to the plan’s estimates,

gradually investing up to 40 percent of the Social Security trust fund in

stocks could obviate the need for further tax increases or benefit cuts. The

plan also outlined that the government’s portfolio would be passively

managed and selected using a broad market index (“indexing”).

The seven other Advisory Council members opposed government

investment in the stock market. They believed that there would be

tremendous political pressures to steer the Social Security trust fund’s

investments to achieve other economic, social, or political purposes rather

than basing decisions solely on the trust fund’s expected risk and return.

Even the Maintain Benefits proponents were concerned about how to

handle the government’s stock voting rights so as to neutralize the

potential effect on individual companies or industries.

Pension Funds Invest in a

Mix of Assets

The Advisory Council’s Maintain Benefits plan pointed out that although

investing in the stock market would be a new concept for Social Security,

it is a standard practice for public and private sector pension funds.

Pension funds invest in a wide mix of assets, often placing a majority of

their funds in the stock market. Pension funds accumulate substantial

Page 20 GAO/AIMD/HEHS-98-74 Social Security Financing
Chapter 1 

Introduction

assets from contributions by employers and employees to finance future

retirement benefits. Investment earnings on these funds contribute

considerable revenue and reduce the amount of money that would

otherwise have to be contributed to pay pension benefits. In determining

how to allocate their portfolios among different types of assets, pension

funds must balance the trade-off between earning a good long-term return

and minimizing the risk of loss. As of the third quarter of 1997, private

sector pension funds had $3.5 trillion in assets, and state and local pension

funds had $2 trillion.6

 Overall, pension funds held about $3.4 trillion in

stocks, or about 60 percent of their total assets. Pension funds own about

a quarter of total U.S. stock holdings, valued at $12.8 trillion at the end of

the third quarter of 1997.7

 U.S. government securities accounted for about

15 percent of pension funds’ holdings. Pension funds also invest in

mortgages, real estate, and other assets, including venture capital. Table

1.1 illustrates the mix of assets held by private sector as well as state and

local government pension funds as of the third quarter of 1997.

Table 1.1: Asset Mix of Private Sector

and State and Local Government

Pension Funds

Percentages

Asset type Private sector

State and local

governments

U.S. and foreign stocks 62 61

U.S. government securitiesa 12 15

Corporate and foreign bondsb 9 9

Cash and short-term

instruments

5 4

Other investments 12c 11

aIncludes U.S. Treasury and agency securities.

bMunicipal securities represent less than 0.5 percent of pension assets. Pension funds as a whole

do not invest in municipal securities issued by state and local governments. Most municipal

securities are exempt from federal income taxation, and their yield is lower than that of Treasury

securities with the same maturity.

cIncludes 7 percent in contracts with private insurance companies.

Source: Flow of Funds Accounts of the United States, Federal Reserve statistical release for the

third quarter of 1997, tables L.119 and L.120, p.76.

Although Social Security is not a pension fund, the experience of public

pension funds may yield some insight into the implications of the federal

6

Flow of Funds Accounts of the United States, Federal Reserve statistical release for the third quarter

of 1997, tables L.119 and L.120, p. 76.

7

Flow of Funds Accounts of the United States, Federal Reserve statistical release for the third quarter

of 1997, table L.213, p. 90.

Page 21 GAO/AIMD/HEHS-98-74 Social Security Financing
Chapter 1 

Introduction

government allowing the Social Security trust fund to invest in the stock

market.8

 A public pension fund operates under a legal framework

established by its sponsoring government.9

 A government may choose to

restrict its public pension fund from investing heavily in risky assets. Also,

a government may use public pension investments to further other policy

objectives. Moreover, some state and local pension plans actively

participate in the management decisions of the companies in which they

invest by exercising their shareholder voting rights.10

The Advisory Council’s Maintain Benefits plan pointed out that, in fact, a

few federal pension plans invest in assets other than Treasury securities.

Most notably, the federal employees’ Thrift Savings Plan (TSP) has

passively-managed indexed stock investments similar to those that have

been proposed for Social Security. However, in one major aspect, the

Thrift Savings Plan is not comparable to the Social Security trust

fund—federal employees, not the government, own and control the

investment of their individual account balances. For this reason, the

transactions of TSP are not included in the unified federal budget.

There are other limits to comparing the Social Security trust fund to

pension funds. Although Social Security resembles a traditional pension

plan in that retirement benefits are based on earnings and work time, the

Congress has the ability to change the legislation governing benefits at any

time. Social Security is not just a retirement program—it is also a social

insurance program with additional goals for income redistribution and

protection for survivors, dependents, and disabled workers. Moreover,

Social Security is financed largely on a pay-as-you-go basis, whereas

pension plans are generally funded in advance.11 Finally, the sheer size and

scope of Social Security dwarfs U.S. pension funds.

8

For further information, see (1) Paul Zorn, 1995 Survey of State and Local Government Employee

Retirement Systems (The Public Pension Coordinating Council, 1996), (2) Catherine Baker Knoll, “The

Knoll Survey of State Public Pension Funds Investment Policies and Practices,” presented at the

National Association of State Treasurers Public Pension Fund Conference (1995), (3) Olivia S. Mitchell

and Ping Lung Hsin, “Public Pension Governance and Performance” (National Bureau of Economic

Research Working Paper No. 4632, January 1994), and (4) Girard Miller, Pension Fund Investing

(Chicago, Illinois: Government Finance Officers Association, 1987).

9

See Cynthia L. Moore, Protecting Retirees’ Money: Fiduciary Duties and Other Laws Applicable to

State Retirement Systems, 3rd ed. (National Council on Teacher Retirement, 1995).

10See Roberta Romano, “Public Pension Fund Activism in Corporate Governance Reconsidered,”

Columbia Law Review, Vol. 93, No. 4 (1993), pp. 795-853.

11The Employee Retirement Income Security Act of 1974 (ERISA) requires private sector pension plans

to be funded on a sound actuarial basis. ERISA does not apply to state and local pension plans; their

funding requirements are set by their sponsoring governments. See Public Pensions: State and Local

Government Contributions to Underfunded Plans (GAO/HEHS-96-56, March 14, 1996) for a discussion

of funding of these plans.

Page 22 GAO/AIMD/HEHS-98-74 Social Security Financing
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Introduction

Given that Social Security is national in scope, the experiences of central

governments in other nations may yield insights. As described in figure 1.2,

Canada is implementing a new investment plan allowing its national

program that provides retirement and disability benefits to invest in

stocks.

Figure 1.2: Canadian Pension Plan to Invest in Stocks

The Canadian Pension Plan (CPP) is broadly similar to the U.S. Social Security program. 

It provides a basic retirement benefit for all Canadian workers and their families, as well

as benefits in the event of serious disability or death. Like Social Security, it is financed

by a payroll tax on workers and their employers and interest earned on the program's

assets. In 1997, Canada announced reforms intended to ensure the CPP's financial

sustainability for future generations through a combination of revenue increases,

spending cuts, and higher investment earnings. Currently, the CPP invests in provincial

government debt securities. Under the new policy, the CPP will invest in a diversified

portfolio with the objective of earning a higher rate of return. The CPP will be allowed

to invest in stocks, with some portion of its assets in foreign stocks. To ensure

accountability to the public and governments, the CPP will publicly disclose its

investment policies and issue periodic financial reports. For additional details on the

CPP reforms, see the Canadian Pension Plan's site on the Internet at <http://www.cpprpc.gc.ca/> and David W. Slater, "Prudence and Performance: Managing the Proposed

CPP Investment Board," C.D. Howe Institute Commentary 98 (Toronto, Canada: C.D.

Howe Institute, October 1997)

Objectives, Scope,

and Methodology

To better understand the implications of the Social Security trust fund

investing in the stock market and of the federal government owning and

managing a portfolio of stocks, we considered three different perspectives:

the trust fund, the U.S. economy, and the federal budget. At the request of

the Senate Special Committee on Aging, we specifically addressed the

impact of government stock investing on (1) the investment earnings,

investment risks, and financial solvency of the Social Security trust fund,

(2) national saving and the financial markets, including implementation

issues presented by the government selecting and managing its stock

portfolio, and (3) the federal budget and federal debt.

We reviewed the final report of the 1994-1996 Advisory Council on Social

Security as well as the technical reports and presentations to the Advisory

Page 23 GAO/AIMD/HEHS-98-74 Social Security Financing
Chapter 1 

Introduction

Council.12 Our report, however, neither evaluates the Advisory Council’s

specific government investment proposal nor addresses its other

proposals to establish individually-owned accounts. To fully understand

the effects of government investing in stocks, we also studied such a

change in trust fund investment policy in isolation from any other program

changes in Social Security. Therefore, our report is limited to an analysis

of altering Social Security’s investment policy and only indirectly

addresses the broader issue of the program’s long-term financing needs.

For the trust fund analysis, we concentrated on the potential returns and

risks of stock market investing for Social Security in isolation from other

program changes. We researched economic and finance literature and

interviewed market experts in both academia and the private sector to

identify historical stock return data and major trends that could affect

future stock performance. Also, we identified the general risks inherent in

stock market investing and attempted to distinguish risks unique to the

Social Security trust fund investing in the stock market in isolation from

other program changes. As a point of comparison, we also examined

pension literature and research documenting the general investment

practices of public pension plans, but a detailed discussion of those

practices was beyond the scope of this report.

We simulated two stock investment scenarios to illustrate how changing

the investment policy can affect the future outcome for the Social Security

trust fund. We developed an aggressive scenario where the trust fund

would maintain a reserve of Treasury securities equal to at least

100 percent of annual expected expenditures and invest its future annual

cash surplus and interest earned on its Treasury securities in the stock

market. We also tested a more conservative scenario investing only Social

Security’s annual cash surplus in the stock market. The simulations use

the historical average real return on stocks that the Advisory Council

assumed in estimating future stock performance as well as its assumption

about administrative costs on the trust fund’s investments. At our request,

the Social Security Administration’s (SSA) Office of the Chief Actuary

simulated the potential effect on the trust fund of these two investment

scenarios using the Social Security Trustees’ 1997 intermediate

assumptions about future program revenues and expenditures as well as

their demographic and economic assumptions. We did not audit or

validate SSA’s actuarial projections. For details of the simulation

assumptions, see appendix I.

12Report of the 1994-1996 Advisory Council on Social Security, 2 vols. (Washington, D.C.: Government

Printing Office, 1996).

Page 24 GAO/AIMD/HEHS-98-74 Social Security Financing
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Introduction

Simulations are useful for comparing alternative investment policies

within a common framework; however, they should not be interpreted as

forecasts of future stock performance. In light of the uncertainty about

future stock returns, we also tested a stock return that is 1 percentage

point lower than the historical average. This alternative return is intended

only to demonstrate that stock investment simulation results are sensitive

to the rate of return assumed. The results of our simulations are not

intended to represent the full range of expected future returns on stocks

or possible outcomes for the Social Security trust fund.

For the market analysis, we considered (1) the potential impact of

government stock investing on national saving as well as the financial

markets, (2) the benefits and limitations of an indexing investment

strategy typically proposed for government stock investing, and

(3) implementation issues the government would face in selecting and

managing its stock portfolio. We also reviewed economic and finance

literature pertaining to saving, asset prices, and market behavior in

general. To identify specific market effects that could result from

government stock investing and other implementation issues, we

interviewed officials at the Department of the Treasury, the Securities and

Exchange Commission (SEC), and the Federal Retirement Thrift

Investment Board as well as economists and finance experts in academia

and the private sector. We reviewed records of congressional hearings,

studies, and articles pertaining to the concept of the government investing

in private financial markets.

For the budget perspective, we considered the short- and long-term fiscal

effects of stock market investing for the federal budget and federal debt.

To address these questions, we surveyed the literature on Social Security

and the federal budget and interviewed Social Security officials and

federal budget experts from the Office of Management and Budget (OMB),

the Congressional Budget Office, and the Congressional Research Service,

as well as private organizations.

While this report focuses on stocks, there are other investment options

beyond Treasury securities. A number of policymakers and Social Security

reformers have offered proposals to allow Social Security to invest in

other assets, such as bank certificates of deposit, municipal bonds, and

corporate bonds. The choice of the most appropriate investment policy is

a decision to be made by the Congress and the President after weighing

the potential returns and risks of various asset types.

Page 25 GAO/AIMD/HEHS-98-74 Social Security Financing
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Introduction

We performed our work from September 1996 to January 1998 in

accordance with generally accepted government auditing standards. We

requested comments on a draft of this report from the Commissioner of

SSA, the Secretary of the Treasury, the Chairman of SEC, and the Director of

OMB. Staff from these agencies provided technical comments, which we

incorporated in the report as appropriate. We also received comments

from other experts in budget policy and Social Security financing and have

incorporated them as appropriate.

Page 26 GAO/AIMD/HEHS-98-74 Social Security Financing
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The Federal Budget, the Economy, and the

Social Security Trust Fund

Any analysis of changes in Social Security’s investment policy must

recognize the role of Social Security in the federal budget and the

economy. Within the federal budget, Social Security is a trust fund

account. It is also the single largest spending program in the budget. The

Social Security trust fund currently receives more tax revenue each year

than is needed to pay current benefits. The resulting cash surplus, by law,

is invested in Treasury securities, which reduces the Treasury’s need to

borrow from all other sources to finance spending on other governmental

activities. While the trust fund’s Treasury securities represent assets for

Social Security, they are future claims against the Treasury. Social

Security’s size means not only that it dominates the budget but also that

any program reforms could have significant implications for the national

economy. A critical factor to consider in looking at those implications is

how changes in Social Security might affect national saving, which is a key

determinant of long-term economic growth.

Social Security Trust

Fund Is a Budget

Account

Social Security is a trust fund account within the federal budget.1 Trust

funds are budget accounts that are used to record receipts and

expenditures earmarked for specific purposes and designated as “trust

funds” by law. Most federal trust funds, including Social Security, do not

have the fiduciary relationships that characterize private trust funds. The

Office of Management and Budget (OMB) summarizes the differences

between federal and private trust funds as follows:

“The beneficiary of a private trust owns the trust’s income and often its assets. A custodian

manages the assets on behalf of the beneficiary according to the stipulations of the trust,

which he cannot change unilaterally. In contrast, the Federal Government owns the assets

and earnings of most Federal trust funds, and it can unilaterally raise or lower future trust

fund collections and payments, or change the purpose for which the collections are used,

by changing existing law.”2

As OMB’s description makes clear, the Congress has the ability to alter the

legislation establishing trust fund revenues and spending. For example, the

Congress has made a number of changes to Social Security since the

1

Of the federal budget’s approximately 1,300 accounts, about 180 are trust fund accounts. For more

details on trust funds, see David Koitz and Dawn Nuschler, Federal Trust Funds: How Many, How Big,

and What Are They For? (Congressional Research Service, 96-686 EPW, August 30, 1996); Analytical

Perspectives, Chapter 17, “Trust Funds and Federal Funds” (Washington, D.C.: Government Printing

Office, February 1998); and Social Security: The Trust Fund Reserve Accumulation, the Economy, and

the Federal Budget (GAO/HRD-89-44, January 19, 1989). For more details on budget accounts in

general, see Compendium of Budget Accounts: Fiscal Year 1998 (GAO/AIMD-97-65, April 1997) and

Budget Account Structure: A Descriptive Overview (GAO/AIMD-95-179, September 18, 1995).

2

Analytical Perspectives, p. 321.

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The Federal Budget, the Economy, and the

Social Security Trust Fund

program’s inception in the mid-1930s, either to expand the program or

strengthen its financial condition.

Federal trust fund income and expenditures are typically recorded by

posting special interest-bearing nonmarketable securities to the Treasury’s

accounts. These special securities represent obligations that the

government has issued to itself. Therefore, from the standpoint of the

Treasury, they are not assets, but, instead, future claims. For the Social

Security trust fund, special Treasury securities do represent assets—they

signify a reserve of budget authority for meeting its benefit obligations. As

long as the Social Security trust fund has a balance, the Treasury is

authorized to make payments on the trust fund’s behalf. When a trust fund

runs an annual surplus as is currently the case with Social Security, its

balance of Treasury securities increases. When a trust fund runs an annual

deficit as has recently been the case with Medicare’s hospital insurance

fund,3

 it redeems some of its Treasury securities in order to pay benefits,

and its balance declines.

Social Security and Federal

Retirement Trust Funds

Have Long-term

Perspective

Social Security and federal retirement trust funds differ from other federal

trust funds in that they necessarily have a long time horizon. Workers

covered by Social Security and federal retirement programs build up their

eligibility for benefits in the present and receive benefits in the future

when they retire. This long-term view is reflected both in the annual

projections for Social Security and federal retirement funds, which look

several decades into the future and, to some extent, in the longer

maturities of the special Treasury securities that the funds hold. (See table

2.1.) For example, 78 percent of special Treasury securities held by the

Social Security trust fund and 68 percent in the civil service retirement

fund were due to mature after 2005. In contrast, all special Treasury

securities held by the transportation trust funds are due to mature before

2001, reflecting a shorter term outlook. Since financial experts agree that a

successful stock investing strategy should be grounded in a long-term

outlook, the idea of government stock investing could be considered more

appropriate for retirement-oriented accounts.

3

Annual outlays for Medicare’s Hospital Insurance trust fund exceeded annual income, including

credited interest, in fiscal years 1995, 1996, and 1997. These deficits required the fund to draw down its

balance of Treasury securities.

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The Federal Budget, the Economy, and the

Social Security Trust Fund

Table 2.1: Maturities of Treasury

Securities Held by Selected Trust

Funds Percent of Treasury securities due to

mature in the period Trust fund budget

account

Total

holdings

(dollars in

billions) 1997-2000 2001-2005 After 2005

Social Security’s Old

Age Survivors’ and

Disability Insurance trust

fund

$631 6 16 78

Civil Service Retirement

and Disability Fund

$398 13 19 68

Military Retirement Fund $126 11 38 51

Bank Insurance Fund $26 46 46 8

Airport & Airways and

Highway trust funds

$29 100 0 0

Source: Bureau of the Public Debt, Government Account Series, Monthly Principal Outstanding

Report, September 30, 1997.

While federal employee retirement funds share with Social Security the

long-term outlook that is a prerequisite for stock investing, Social

Security’s greater size and prominence mean that more attention has been

focused on changing its investment policy. Social Security is the largest

federal trust fund—in terms of both annual spending and account balance.

With fiscal year 1997 outlays of $365 billion, the fund accounts for over

one-fifth of all federal spending and is the largest single item in the federal

budget. At the end of fiscal year 1997, the Social Security trust fund held

$631 billion of special Treasury securities (39 percent of all outstanding

Treasury securities in the Government Account Series).

Social Security’s

Current Investment

Policy

Traditionally, Social Security has been financed on a pay-as-you-go basis

under which each current working generation pays for the benefits of the

retired generation. In this type of system, annual revenues and benefit

payments are roughly equal, while a contingency reserve is maintained to

weather short-term events such as economic downturns. However, during

the late 1970s and early 1980s, Social Security’s expenditures regularly

exceeded revenues, causing a rapid decline in the fund’s balance and

raising concerns about the program’s solvency. In response, the Congress

passed reforms in 1977 and 1983 that together were intended to assure

Social Security’s solvency for a 75-year period. These reforms included

both tax increases and reductions in benefits, such as raising the normal

retirement age for future workers. In enacting the 1983 reforms,

policymakers erred on the side of caution by using fairly pessimistic

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The Federal Budget, the Economy, and the

Social Security Trust Fund

assumptions for the short term. As a result, annual surpluses turned out to

be larger than anticipated.4

 One of the goals of the reforms was to restore

Social Security’s contingency reserve. According to analysts of Social

Security, a prudent reserve ranges from 1 to 1-1/2 year’s worth of

anticipated spending.

A combination of annual cash surpluses in recent years and the interest

credited on its Treasury securities has brought the Social Security trust

fund to the top of this range. As shown in figure 2.1, the trust fund’s

balance as a percentage of expected annual benefits is projected to

continue growing until it peaks in 2011 at over 2-1/2 years’ worth of

expected benefits. At this level, the fund balance would substantially

exceed the reserve recommended for short-term contingencies. In theory,

this “excess” amount could be used to help cover some of the costs of the

baby boomers’ retirement. However, this amount is relatively small when

compared to Social Security’s expected future costs.

4

For more details on the intent of the 1983 reforms, see David Stuart Koitz, Social Security Financing

Reform: Lessons From the 1983 Amendments (Congressional Research Service, 97-741 EPW, July 24,

1997).

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The Federal Budget, the Economy, and the

Social Security Trust Fund

Figure 2.1: Projected Buildup in Social Security Reserve (1997-2012)

1997 2000 2005 2010 2012

0

50

100

150

200

250

300

Assets as a percentage of projected annual spending

Contingency reserve of 150% Assets in excess of reserve

Source: 1997 Trustees’ Report, intermediate assumptions.

The Social Security trust fund, by law, must invest in “interest-bearing

obligations of the United States or in obligations guaranteed as to both

principal and interest by the United States.” This investment policy,

described more fully in chapter 3, dates back to the program’s origin in

1935 and is intended to ensure the safety of the trust fund’s assets.

Treasury securities are widely considered to be a risk-free investment in

the sense that the federal government has never defaulted on its debt

obligations and is not expected to do so in the future. Throughout its

history, the Social Security trust fund has invested mostly in a special type

of Treasury security that cannot be sold on the open market. The trust

fund’s Treasury securities represent a reserve for the program, allowing

Social Security to pay benefits as long as it has a balance in its account.

When the trust fund needs to draw down its balance, the Treasury must

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The Federal Budget, the Economy, and the

Social Security Trust Fund

obtain the necessary money to repay the trust fund by borrowing from the

public, unless the Congress and the President take offsetting actions to

raise taxes or cut spending.

The trust fund’s special Treasury securities earn interest credits at a

statutory rate linked to market yields. These interest credits take the form

of additional Treasury securities and add to the trust fund’s balance. In

recent years, interest credits have accounted for a growing share of annual

trust fund income. Between calendar years 1985 and 1996, the trust fund’s

interest credits grew from 1 percent of its total income to 9 percent. By

2012, interest credits are projected to rise to 14 percent of total income.

While the interest is added to tax revenues in assessing the finances of the

Social Security trust fund, the cash surplus is more meaningful in the

broader budgetary and economic context.

Social Security’s Place

Within the Federal

Budget

Social Security is not included in the measure of the federal budget that is

used as the basis for the budget controls under the Budget Enforcement

Act. This measure is known as the “on-budget” deficit.5

 However, Social

Security’s “off-budget” status does not change the impact that its finances

have on the government’s overall fiscal position, as explained in the

following passage from a Congressional Budget Office (CBO) report:6

“Social Security’s benefits alone account for more than one-fifth of federal spending, and

its payroll taxes account for about one-fourth of government revenues. Therefore, most

economists, credit market participants, and policymakers, when they seek to gauge the

government’s role in the economy and its drain on the credit markets, look at the total

budget figures—including Social Security.”

As indicated by CBO, Social Security is included in the most commonly

used measure of the government’s financial balance, known as the unified,

or “total,” budget deficit/surplus.7

 The unified budget measure includes all

federal spending and revenue and generally approximates the amount of

annual federal borrowing from the public. Including the Social Security

cash surplus in the unified budget means that it partially offsets a deficit in

all other government accounts. For example, in fiscal year 1997, a

5

Social Security was legally removed from all calculations of budget totals by the Budget Enforcement

Act of 1990 (Public Law 101-508). For further details on Social Security’s budgetary treatment, see

David Koitz, Social Security: Its Removal From the Budget, and Procedures for Considering Changes to

the Program (Congressional Research Service, 93-23 EPW, Revised January 4, 1993).

6

The Economic and Budget Outlook: Fiscal Years 1999-2008, Congressional Budget Office,

January 1998, p. 34.

7

Unless otherwise noted, any reference to the deficit in this report means the unified budget deficit.

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The Federal Budget, the Economy, and the

Social Security Trust Fund

$62 billion cash deficit in other government accounts was offset by a

$40 billion cash surplus in Social Security, resulting in a unified budget

deficit of $22 billion. The interest credited to the trust fund does not

currently affect the unified deficit because it is an internal transaction of

the government. One part of the government (the Treasury) credits the

interest to another part (the trust fund), so the two transactions offset one

another and there is no net budgetary effect.8

Since Social Security’s annual cash surplus is available to the Treasury to

help finance current spending, it reduces the Treasury’s need to borrow

from other sources.9

 Treasury borrowing from Social Security and other

federal trust fund accounts is referred to as “debt held by government

accounts.” Treasury borrowing from all other sources (e.g., individuals,

pension funds, and financial institutions) is called “debt held by the

public.” Together, these two types of debt comprise the gross federal

debt.10 Debt held by the public is a more commonly used measure because

it best represents the current impact of past federal borrowing on the

economy. In contrast, debt held by trust funds is an internal government

transaction that has no current impact—its economic effects are not felt

until a trust fund needs to draw on its Treasury securities to make

program expenditures.11

Federal Fiscal Policy

and National Saving

As described above, Social Security’s finances have a significant influence

on the government’s overall fiscal position. The government’s fiscal

position, in turn, affects national saving, which is a key determinant of

long-term economic growth. Saving is that portion of income not used for

current consumption. The nation’s saving is composed of the private

saving of individuals and businesses and the saving or dissaving of all

levels of government. In general, government budget deficits subtract from

national saving by absorbing funds that otherwise could be used for

private investment. Conversely, government budget surpluses add to

8

Besides interest credited to trust funds, other intragovernmental transactions (such as the payments

from the Treasury’s general fund to Medicare’s Supplementary Medical Insurance trust fund) also do

not affect the government’s current borrowing requirement.

9

If, as currently projected, the federal government experiences a period of unified budget surpluses,

the Treasury would essentially no longer need to borrow additional funds from other sources except to

roll-over existing debt. In this case, at least a portion of Social Security’s cash surplus could be used to

reduce the level of debt held by the public. In any case, by law, the Social Security trust fund would

continue to invest in Treasury securities as long as Social Security were in a surplus position.

10With a few minor exceptions, the gross debt is the measure that is subject to the debt limit.

11For further information on federal debt, see Federal Debt: Answers to Frequently Asked Questions

(GAO/AIMD-97-12, November 27, 1996).

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saving. In the case of the federal government, surpluses allow the

government to pay off some of its maturing debt, thereby reducing the

outstanding level of debt held by the public and freeing up additional

funds for private investment.

Since the 1970s, private saving has declined, while federal budget deficits

have consumed a large share of these increasingly scarce savings. In

recent years, federal deficits have declined sharply from the levels of the

1980s and early 1990s, freeing up some additional funds for investment.

Nevertheless, total national saving and investment remain significantly

below the levels of the 1960s and 1970s. Raising saving and investment

levels would improve the long-term productivity of the economy, thereby

boosting economic growth.

The most direct way for the federal government to contribute to increased

saving and long-term economic growth is to achieve and maintain a

balanced budget or a budget surplus. While such a fiscal policy would

raise the government’s contribution to national saving, it would probably

not raise total national saving dollar for dollar. The overall impact on

national saving depends on how consumers respond to the government’s

fiscal actions. For example, cuts in federal spending or increased taxes

could cause a reduction in private saving that would diminish the total

impact on national saving.

While additional fiscal restraint would probably reduce consumption in

the short term, it would promote higher living standards over the long

term. In a report issued last fall and in subsequent testimony, we found

that alternatives to current fiscal policy that emphasize additional restraint

could, over the long term, significantly boost per capita GDP.

12 Taking

actions to increase the size of the future economy is particularly important

because of the aging population. A bigger economic pie would make it

easier for future workers to meet the dual challenges of paying for the

baby boomers’ retirement and achieving a rising standard of living for

themselves.

12Budget Issues: Analysis of Long-Term Fiscal Outlook (GAO/AIMD/OCE-98-19, October 22, 1997) and

Budget Issues: Long-Term Fiscal Outlook (GAO/T-AIMD/OCE-98-83, February 25, 1998).

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the Social Security Trust Fund

Designing an investment policy for the Social Security trust fund involves

balancing potential returns and risks. Currently, the Social Security trust

fund, by law, invests in securities backed by the federal government and

receives a relatively low return with minimal risk. Investing in the stock

market offers the prospect of higher returns but greater risk.

The higher returns possible with stock investing would allow the trust

fund to pay benefits longer, even without other program changes.

Assuming the historical average rate of return, investing Social Security’s

future annual cash surplus and interest on its Treasury securities in the

stock market could delay the trust fund’s exhaustion by about a decade.1

 If

only Social Security’s cash surplus is invested, then the possible delay in

the trust fund’s exhaustion would be reduced to 3 years. It is also

important to recognize that any possible gain for the Social Security trust

fund from a stock investment scenario would be significantly less if future

stock returns fall below the historical average. The only way for the trust

fund to earn the higher returns possible with stock investing is to take on

greater risk. Diversifying the stock portfolio would reduce the risks

associated with individual stocks, but the trust fund would still be

vulnerable to loss in the event of a general stock market downturn.

Stock investing, by itself, is unlikely to solve Social Security’s long-term

financing problem. If stock investing is implemented in isolation from

other program changes, the trust fund would face the certain need to

liquidate its assets to pay benefits with no certainty of what future stock

prices would be. The more the trust fund is counting on stock sales to pay

promised benefits, the greater its vulnerability in the event of a general

stock market downturn. In the future, the trust fund would be less

vulnerable to the necessity of selling stocks at a loss if a stock investment

policy were implemented in combination with other program changes that

improve Social Security’s financing. As part of a package, investing in

stocks could increase the trust fund’s expected investment income and

reduce the size of benefit cuts and/or payroll tax increases.

1

We assumed that the trust fund would continue to hold enough Treasury securities as a contingency

reserve to equal at least 100 percent of the next year’s expected expenditures.

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Special Treasury

Investment Policy:

Low Returns and

Minimal Risk

Under the current law, the Secretary of the Treasury—managing trustee

for the trust fund—is required to invest in special Treasury securities

unless the Secretary determines that purchasing marketable Treasury and

agency securities is “in the public interest.” In the past, the Treasury

Department has, at times, determined that such purchases would be in the

public interest, although such purchases have been rare.2

 With the practice

of investing in special Treasury securities, the Social Security trust fund

receives a relatively low return with minimal risk.

By law, the interest rate on special Treasury securities is equal, at the time

of issue, to the average market yield on outstanding marketable

government securities not due or redeemable for at least 4 years.

According to the Congressional Research Service’s analysis of the law and

practice governing Social Security’s investment policy, this statutory rate

was intended to confer neither an advantage nor a disadvantage on the

trust fund.3

 From the trust fund’s perspective, the statutory rate represents

a longer-term interest rate, and long-term interest rates have historically

been higher than short-term rates. From the government’s perspective, the

statutory rate was intended to approximate the cost of long-term

borrowing from the public.4

Like Treasury securities sold to the public, special Treasury securities are

backed by the full faith and credit of the U.S. government and are viewed

as having no risk of default. Although it cannot sell its holdings in the open

market, the Social Security trust fund faces no liquidity risk because, by

law, it can redeem special Treasury securities before maturity without

penalty. This liquidity feature is particularly important for the trust fund if

it needs to dip into its assets to cover a payroll tax shortfall during a

general economic downturn. Moreover, redeeming special Treasury

securities before maturity presents no risk of loss due to interest rate

fluctuations because the trust fund can recover the par value plus accrued

interest. In contrast, the trust fund would have to sell marketable Treasury

securities at the market price—which fluctuates inversely with market

interest rates. The market price of a Treasury security falls when the

current interest rate on Treasury securities of equal maturity rises. Selling

2

As of 1996, marketable Treasury securities represented only 0.009 percent of the trust fund’s holdings.

3

Geoffrey Kollmann, Social Security: Investing the Surplus (Congressional Research Service, 91-129

EPW, January 27, 1991).

4

The average nominal interest rate on new special Treasury securities issued in 1996 was 6.6 percent.

The average nominal rates for marketable medium- and long-term Treasury securities outstanding in

1996 was 6.5 percent for Treasury notes issued with a term of at least 1 year but not more than 10

years, and 9 percent for Treasury bonds with a term of more than 10 years.

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marketable Treasury securities before maturity when market interest rates

are rising could result in a sizable loss. In practice, the Treasury has

allowed the Social Security trust fund to redeem its special Treasury

securities at any time to pay benefits but not to do so solely for the

purpose of maximizing the trust fund’s return.

Like any investor, the Social Security trust fund faces the risk that its

investment returns will be eroded by inflation. This is a particular concern

given that Social Security benefits are indexed for inflation. Social Security

beneficiaries receive an annual cost of living adjustment that is normally

based on the Consumer Price Index. Under the intermediate scenario for

the next 75 years, which the Trustees regard as their “best estimate,” the

ultimate nominal interest rate assumed over the long term is 6.2 percent,

while annual inflation is assumed to be 3.5 percent. Thus, the trust fund is

expected to receive an ultimate real (after inflation) interest rate of

2.7 percent on its Treasury holdings.

Although the current debate focuses on allowing the Social Security trust

fund to invest in the stock market, there also are investment options

within the federal government. Although the trust fund is not specifically

authorized to do so by the Social Security Act, it may purchase securities

issued by the Government National Mortgage Association, the Federal

National Mortgage Association, and other Federal farm and home credit

entities.5

 The Advisory Council’s Maintain Benefits approach suggested

considering such investments to increase the trust fund’s return. Agency

securities typically pay more because they are not uniformly guaranteed as

to principal and interest and there is some risk of default. And, like

marketable Treasury securities, agency securities would expose the trust

fund to potential losses due to fluctuating market prices.

Another option could be to change the statutory rate of interest for special

Treasury securities. For example, the Congress could raise the rate by a

fixed percentage or link the rate to a stock market index, such as the

Standard and Poor’s index of 500 large stock companies (S&P 500). The

interest premium in excess of the average rate Treasury pays on debt held

by the public would represent a general revenue transfer to the Social

5

The Social Security Act requires that the Secretary of the Treasury invest trust funds in

“interest-bearing obligations of the United States or in obligations guaranteed as to both principal and

interest by the United States.” Although certain federally sponsored agency obligations do not meet

these criteria, the Secretary may invest in such obligations based on a 1966 opinion of the Attorney

General. The opinion held that notwithstanding the absence of statutory language pledging the “faith”

or “credit” of the United States, agency guaranties or other contractual liabilities issued in pursuance

of an agency’s statutory functions constitute “general obligations of the United States backed by its full

faith and credit.” Op. Atty. Gen. 327 (1966).

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Balancing Potential Returns and Risks for

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Security trust fund. Increasing the rate credited to the Social Security trust

fund account would appear to boost the program’s finances inasmuch as

the trust fund’s balance would increase. However, crediting more interest

to the trust fund would not generate revenue for the government, so the

government’s capacity to finance retirement benefits would be unchanged.

Stock Returns Have

Been Higher but Are

More Uncertain

Historically, the rates of return on stocks have exceeded interest rates on

Treasury securities, although stock returns are more variable. According

to an analysis prepared for the Advisory Council, real yields on

stocks—i.e., adjusted for inflation—have averaged about 7 percent.6

 In its

deliberations, the Advisory Council agreed to use this rate in estimating

average future yields on stocks. Of course, an average return over a long

period of time obscures the reality that stock returns fluctuate

substantially from year to year, and there have been years in the past with

negative returns. Figure 3.1 shows the annual returns—not adjusted for

inflation—for large company stocks from 1950 to 1996. Actual nominal

returns varied widely from the annualized average return over the period

and ranged from a low of –26.5 percent in 1974 to a high of 52.6 percent in

1954.

6

Joel Dickson, “Analysis of Financial Conditions Surrounding Individual Accounts,” Report of the

1994-1996 Advisory Council on Social Security, Volume II, pp. 484-488. The stock market realized an

annualized real yield of approximately 7 percent from 1900 to 1995.

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Figure 3.1: Annual Returns on Large Company Stocks in Comparison to the Annualized Average Return for 1950 Through

1996

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

-40

-20

0

20

40

60

Percentages

Annual return Annualized average

Note: Large company stock returns are based upon the S&P 500 index; before 1957, the index

consisted of 90 of the largest stocks. The total annual return reflects capital appreciation and

cash income during the year, assuming any income is reinvested, and does not reflect any

transaction costs. The annualized average return for the period was 12.8 percent. This compound

annual rate reflects the return over the period figured on a constant year basis, which is not the

same as the arithmetic average of rates for each year.

Source: Stocks, Bonds, Bills, and Inflation 1997 Yearbook. Used with permission. Copyright 1997

Ibbotson Associates, <www.Ibbotson.com>. All rights reserved. (Certain portions of this work

were derived from copyrighted works of Roger G. Ibbotson and Rex Sinquefield.)

Ibbotson Associates, Inc. has granted permission solely for display in this medium and any

copying, printing, modifying, distributing, disclosing transferring, displaying in another medium or

format, or incorporating in another, of any portion of this work is expressly prohibited.

Page 39 GAO/AIMD/HEHS-98-74 Social Security Financing
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Balancing Potential Returns and Risks for

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According to an analysis by the Congressional Research Service,7 the

annualized average return for the S&P 500 since 1950 was almost twice the

average rate credited on the Social Security trust fund’s Treasury

securities.8

 Although the 30-year moving average of the S&P 500 since 1970

consistently outperformed the Treasury returns credited to the Social

Security trust fund, the 10-year moving average of the S&P 500

underperformed the trust fund’s Treasury returns at times. Again, a

long-term average return does not reflect fluctuations in year-to-year stock

returns. In fact, nominal stock returns were less than the Social Security

trust fund’s annual yield in 17 years from 1950 to 1996—more than

35 percent of the time.

Short-run fluctuations generally are less of a concern for a long-term

investor who buys and holds investments. Table 3.1 illustrates the actual

best and worst nominal returns on stocks as well as long-term government

bonds for investment periods ranging in duration from 1 year to 20 years.

An investor would face uncertain returns in the short term given that

annual returns range widely and were negative in nearly 1 out of 4 years.

Likewise an investor can lose money selling marketable government bonds

before maturity because of bond price fluctuations. As table 3.1 shows, the

range between the best and the worst returns narrows as the investment

time horizon lengthens.9

 Given that from 1926 to 1996, there was no

20-year period with a negative stock return, an investor might reasonably

expect to earn a positive return over 20 years.

7

Statement of David Koitz of the Congressional Research Service before the Subcommittee on Social

Security of the House Committee on Ways and Means on April 10, 1997, at a hearing on the future of

Social Security.

8

According to the Congressional Research Service’s analysis, since 1950, the annualized average

nominal return for the S&P 500 was 11.36 percent assuming annual administrative costs of 1 percent,

compared to 5.96 percent for the trust fund’s nominal yield.

9

The variation of returns around the expected average can be quantified in statistical terms, such as

the standard deviation. For more data about stock and other asset returns, see Stocks, Bonds, Bills,

and Inflation Yearbook (Chicago, Illinois: Ibbotson Associates).

Page 40 GAO/AIMD/HEHS-98-74 Social Security Financing
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Balancing Potential Returns and Risks for

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Table 3.1: Best and Worst Returns on

Large Company Stocks and Long-term

Government Bonds for Varying

Investment Periods From 1926

Through 1996

Large company stock returns

Long-term government bond

returns

Percentages

Investment

period Worst Best Worst Best

1 year –43.34 53.99 –9.18 40.36

10 years –0.89 20.06 –0.07 15.56

20 years 3.11 16.86 0.69 10.45

Notes: Annual compound rates of return were calculated for overlapping holding periods from

1926 through 1996. For the 71 1-year holding periods, annual returns on large company stocks

and long-term government bonds were positive in 72 percent of the years. For the 62 10-year

holding periods, returns were positive in 97 percent of the periods for large company stocks and

in 98 percent for long-term government bonds. For the 52 20-year holding periods, returns on

large company stocks and long-term government bonds were positive in every period.

Source: Stocks, Bonds, Bills, and Inflation 1997 Yearbook. Used with permission. Copyright 1997

Ibbotson Associates, <www.Ibbotson.com>. All rights reserved. (Certain portions of this work

were derived from copyrighted works of Roger G. Ibbotson and Rex Sinquefield.)

Ibbotson Associates, Inc. has granted permission solely for display in this medium and any

copying, printing, modifying, distributing, disclosing transferring, displaying in another medium or

format, or incorporating in another, of any portion of this work is expressly prohibited.

Future Stock Returns Are

Uncertain

There is no guarantee that investing in the stock market, even over 2 or 3

decades, will yield the long-run average return. According to economic

and financial literature, there are reasons to believe that future stock

returns could be less than the historical average.10 Also, as discussed in

chapter 4, government investing by itself could affect stock prices and

returns at least in the short run. While the average historical stock return

is commonly used in assessing future stock performance, assuming a

moderately lower return could also be consistent with the expected

economic and demographic outlook.

An investor entering the market at today’s high stock prices may earn less

than the long-term historical average. Two fundamental measures for

evaluating stock prices are the dividend yield—the ratio of annual

dividends to stock prices—and the price-earnings ratio. According to an

analysis of historical stock performance, returns on stocks over 10-year

periods have been well below average when the dividend yield was low

10For example, see John E. Golob and David G. Bishop, “What Long-Run Returns Can Investors Expect

from the Stock Market?” Federal Reserve Bank of Kansas City Economic Review, Vol. 82, No. 3 (Third

Quarter 1997), pp. 5-20 and John H. Cochrane, “Where is the Market Going? Uncertain Facts and Novel

Theories,” Economic Perspectives, Vol. XXI, Issue 6 (November/December 1997), pp. 3-37.

Page 41 GAO/AIMD/HEHS-98-74 Social Security Financing
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and the price-earnings ratio was high.11 Indeed, the stock market has been

at record high levels in recent years, and the dividend yield is below

long-run historical values.12 Likewise, the price-earnings ratio is well above

its long-run average. Some analysts have estimated that recent

price-earnings ratios would be consistent with a 1 percentage point

decline in the long-run return on stocks; in other words, future stock

returns could decline from the historical real average of 7 percent to

6 percent over the long run.13

Another factor that may affect future stock returns is that the U.S.

economy is expected to slow as the population ages. The rate of national

saving and the growth in real wages and productivity, factors that relate to

economic growth, have slowed notably in the past two decades.14 Social

Security’s Trustees assume future growth in the GDP will slow as the baby

boom generation retires and relatively fewer young people begin work.

Whereas the economy grew at an average real rate of 2.2 percent from

1989 to 1997, real economic growth under the Trustees’ intermediate

scenario is assumed to be 2.0 percent annually over the next decade and

then to slow to 1.3 percent by 2020. Some economists have estimated that

the macroeconomic and demographic outlook would be consistent with

long-run stock returns lower than the historical average.15

Another uncertainty is whether the baby boomers’ retirement might affect

the stock market. As they retire, baby boomers are expected to sell stocks

to finance consumption, and private pension plans likewise will sell stocks

to finance retirement benefits. The Advisory Council’s technical panel

reported that selling pressure resulting from the sheer number of the baby

boom retirees could possibly depress stock prices but that estimating any

baby boom price effect would be highly speculative. Given that the

financial markets and investors anticipate the aging of the population,

asset prices may adjust downward gradually beforehand rather than

11Burton G. Malkiel, A Random Walk Down Wall Street (New York City, New York: W.W. Norton &

Company, 1996), pp. 384-389.

12Golob and Bishop, pp. 7-8, estimated that whereas the dividend yield for the S&P 500 had averaged

about 4 percent since the 1950s, this ratio dropped below 2 percent for the first time in 1996 and has

remained below 2 percent most of the time since then.

13Golob and Bishop, pp. 13, 14, and 16.

14See Retirement Income: Implications of Demographic Trends for Social Security and Pension Reform

(GAO/HEHS-97-81, July 11, 1997).

15Golob and Bishop estimated that macroeconomic trends could reduce stock returns over the next

decade by about one-half a percentage point, for a long-run real return of 6.5 percent. A 1997 report for

the Twentieth Century Fund/Economic Policy Institute, Saving Social Security With Stocks: The

Promises Don’t Add Up, estimated that given the Trustees’ other assumptions, future stock returns

could be as low as 4.0 percent.

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dropping abruptly when the baby boomers begin retiring. Also, some

analysts, including those we interviewed, suggest that global demand for

stocks could offset any baby boom price effect. For example, investors

from countries with relatively younger populations might invest in the U.S.

stock market to save for their own retirement even as the baby boomers

are selling their stocks.

While future returns on stocks might reasonably be expected to be less

than the historical average, analysts, including those we interviewed,

expect stock returns to be higher than those on Treasury securities over

the long term. How much higher is uncertain. The spread between the

rates of return on stocks and Treasury securities has been shrinking.

Historically, stocks have earned higher rates of return than those of

Treasury securities to compensate for the additional risk associated with

stocks. This “equity risk premium” has declined since the 1950s from about

7 percent to around 3 to 4 percent today.16 It is unclear whether this

change will be long-lasting or whether the equity premium will decline

even further. Some economists have suggested that the shrinking risk

premium reflects a structural change in that the economy appears less

susceptible to recessions.17 To the extent that corporate profits fluctuate

with general economic conditions, fewer downturns translate into less

volatility in corporate earnings. If investors perceive that the outlook for

corporate earnings is more certain and that stocks may be less risky than

they have been historically, stock investing might carry a lower premium

and, therefore, relatively lower returns. The uncertainty about the risk and

size of the risk premium have implications for analyzing the benefits of a

stock investment proposal.18

Although investors believe that over the long run stock returns will always

be higher than bond returns, one study has questioned this conventional

wisdom.19 According to standard analytical models, stocks are virtually

certain to outperform bonds over a long enough investment period.

However, extrapolating from these standard models, the study estimated

that a stock portfolio has a 32 percent chance of underperforming a bond

16For an historical examination, see Olivier J. Blanchard, “Movements in the Equity Premium,”

Brookings Papers On Economic Activity, 2:1993, pp. 75-118.

17Goldman Sachs, “The Equity Risk Premium and the Brave New Business Cycle,” U.S. Economics

Analyst, No. 97/8, February 21, 1997.

18For further reading, see Jeremy J. Siegel and Richard H. Thaler, “Anomalies: The Equity Premium

Puzzle,” Journal of Economic Perspectives, Vol. 11, No. 1 (Winter 1997), pp. 191-200.

19Martin Leibowitz and William Krasker, “The Persistence of Risk: Stocks Versus Bonds Over the Long

Term,” Financial Analysts Journal, November/December 1988, pp. 40-47.

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portfolio over a 10-year horizon. Even over a 30-year investment time

horizon, there is still about a 20 percent chance that a bond portfolio

would provide a higher return. As this study indicates, investing in the

stock market does not ensure a higher return than might be possible

investing in government and corporate bonds.

Higher Returns Could

Delay Exhaustion of

the Social Security

Trust Fund

If the stock market continues to outperform Treasury securities, the Social

Security trust fund could increase its investment revenue with a stock

investment policy. The higher returns possible on stocks would allow the

Social Security trust fund, even without other program changes, to pay

benefits longer before depleting its assets.20 The potential gain from stock

investing would depend on both how much the Social Security trust fund

invests in the stock market and how much future stock returns are.

According to the Trustees’ 1997 intermediate estimate, the trust fund

expects to collect roughly $30 billion more in cash than is needed to pay

benefits each year from 1998 until 2008 and continue to receive some

excess cash until 2012. In addition, the interest credited on the trust fund’s

special Treasury securities was roughly $40 billion in 1997. Given that the

Social Security trust fund’s balance, beginning in 1997, was expected to

exceed 150 percent of its annual expenses,21 the trust fund theoretically

could start investing in stocks in 1998. Under the Trustees’ intermediate

projections, the trust fund does not anticipate that it would need to tap its

investment income and assets to pay current benefits for nearly 15 years.

We developed two scenarios to illustrate the trust fund’s potential gain

from stock investing. Under an aggressive scenario, the trust fund would

invest both its future annual cash surplus and interest in the stock market,

while maintaining a contingency reserve of special Treasury securities

equal to at least 100 percent of the next year’s expected expenditures. We

also tested an alternative scenario under which only Social Security’s cash

surplus would be invested in stocks, and Social Security’s cash deficit,

beginning in 2012, would be financed from stock earnings and sales. At our

request, the Social Security Administration’s Office of the Chief Actuary

simulated the potential effect on the trust fund of these two investment

scenarios using the Trustees’ 1997 intermediate assumptions. The

simulations use the 7-percent real yield on stocks assumed by the Advisory

20This statement would also apply to other assets, such as corporate bonds, which could yield

potentially higher returns than the current statutory policy of investing solely in Treasury securities.

21As discussed in chapter 2, a balance of 100 to 150 percent of anticipated annual spending is

considered a prudent contingency reserve.

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Council in estimating future stock performance. This historical average

stock return is 4.3 percentage points higher than the trust fund expects on

its special Treasury securities. In the simulations, stock earnings are

assumed to be reinvested in the market unless the trust fund needs cash to

pay benefits or to invest in Treasury securities to maintain a 100-percent

contingency reserve. The simulations also reflect the Advisory Council’s

assumption that annual administrative costs for the trust fund’s stock

holdings would be 0.5 basis points.22 See appendix I for further discussion

of our assumptions.

Figure 3.2 shows the estimated trust fund assets under the aggressive

investment scenario compared to the cash surplus scenario as well as to

the current statutory policy of investing solely in special Treasury

securities. These simulation results illustrate some outcomes associated

with our two alternative stock investment policies. They should not be

interpreted as forecasts and do not represent the full range of possible

outcomes for the Social Security trust fund.

22A basis point is 1/100 of 1 percentage point, so one-half of a basis point is 0.00005.

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Figure 3.2: Estimated Trust Fund Assets Under Current Law and Two Alternative Stock Investment Scenarios

1998 2029 2032 2040

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

Dollars in billions

Current law Aggressive scenario Cash surplus only

Note: Assets at the beginning of year.

Source: Social Security Administration.

Assuming the historical 7 percent real yield on stocks, investing both

Social Security’s future annual cash surplus and the interest on its

Treasury securities in the stock market could delay the projected

exhaustion of the trust fund for about a decade, from 2029 to 2040. This

potential delay would extend the trust fund’s life well into the baby

boomers’ retirement years.23 However, this delay results from a scenario

representing an outer bound of how much the trust fund might invest in

the stock market. Under the aggressive scenario, the trust fund would hold

only enough Treasury securities to cover its contingency needs and would

amass a sizable stock portfolio. Within 5 years, the trust fund would have

about $500 billion invested in the stock market. Stocks as a share of the

23In 2040, the oldest baby boomers would be 94 years old and the youngest would be 76 years old.

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trust fund’s portfolio would peak in 2017 at more than 70 percent. While a

70 percent stock allocation is not necessarily unsound from an investment

perspective, it would be a dramatic shift from investing solely in Treasury

securities.

In nominal dollars, the trust fund’s stock holdings under the aggressive

scenario would peak in 2025 at about $4 trillion.24 According to Social

Security’s Trustees, the ratio of trust fund assets at the beginning of a year

to that year’s expected expenses is a useful measure of the trust fund’s

asset level. At their peak, the trust fund’s stock holdings would represent

about twice Social Security’s expected expenses in 2025.25 By 2034, the

trust fund’s assets would drop to about 150 percent of expected annual

expenses. At that time, the trust fund would still have more than $1.5

trillion—about one-third of its portfolio—in stocks. In 2036, the trust fund

would liquidate all of its stocks, and its special Treasury securities would

drop below a 100 percent contingency reserve level.

If only Social Security’s cash surplus were invested, still assuming a 7

percent real rate of return, then the trust fund’s projected exhaustion

could be delayed by only 3 years, from 2029 to 2032. This scenario is

somewhat more conservative; the trust fund would invest less than half as

much as under the aggressive scenario. Within 5 years, the trust fund’s

stock investments would be about $200 billion. Stocks as a share of its

portfolio would peak at about 35 percent, which is conservative in

comparison to the 60 percent held by state and local government pension

plans as a whole. The trust fund’s stock holdings, in nominal dollars,

would peak in 2017 at approximately $1.2 trillion, an amount roughly

equivalent to that year’s expected expenses. In 2024, the trust fund would

liquidate all of its stocks, but its special Treasury securities would still

represent more than 150 percent of the next year’s expected expenses. In

2028, however, the trust fund’s balance would drop below a 100 percent

contingency reserve level.

Again, these estimates of the potential delay of the trust fund’s exhaustion

were based on a 7 percent average real return on stocks. The possible gain

for the Social Security trust fund would be significantly less if future stock

returns are lower than this historical average. As an illustration, if the

future real return on stocks is 1 percentage point lower, the aggressive

24Nominal asset levels are not comparable over time due to inflation, economic growth, and growth in

the Social Security program.

25Total assets, including special Treasury securities, would be approximately $6.1 trillion—about three

times expected expenses in 2025.

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scenario would extend the trust fund’s life by not 11 years, but only 6 years

to 2035. Again assuming the real return on stocks is 1 percentage point

lower, the possible delay under the cash surplus scenario would not be 3

years, but only 2 years to 2031. These results demonstrate the sensitivity of

the rate of return assumption and are not intended to represent the worst

or the most likely outcomes for the trust fund.

Stock Investing

Entails Greater Risk

Investing in the stock market involves a clear trade-off. In exchange for

the prospect of higher returns, the trust fund must accept greater risk. The

trust fund would face greater uncertainty about its future returns and even

the chance of losing money. Under the current policy, the trust fund

receives a relatively low rate investing in Treasury securities but can

readily liquidate its special Treasury holdings to pay benefits. In contrast,

the trust fund would face uncertainty as to the amount or timing of future

stock earnings and dividends. Moreover, just as the trust fund expects to

liquidate its Treasury securities to pay benefits, it would have to sell its

stocks to get cash to pay benefits. There is no certainty about what stock

prices would be when the trust fund has to sell or whether it could recover

amounts invested.

The primary risk that the trust fund would face is “market risk,” or the

possibility of financial loss caused by adverse market movements. When

the stock market drops, prices of stocks—regardless of their individual

quality—fall and can stay depressed for a prolonged period of time.

Fluctuations in overall market rates of interest can affect the stock

market, and rising interest rates tend to depress stock prices. Market risk

does not disappear over time. Although a long investment time horizon

provides more time to recover from short-term fluctuations, an investor

also would have more time to encounter a prolonged stock market

downturn.

Depending on the composition of its stock portfolio, the trust fund could

also be exposed to “concentration risk,” or the potential loss resulting

from a heavy investment in a group of related companies or an industry

susceptible to the same economic dynamics. Like any investor, the trust

fund would face “default risk,” or the exposure to loss due to an individual

company failing.

Diversification Reduces

Default and Concentration

Risk

According to portfolio theory, diversification reduces risk. Diversifying a

stock portfolio across companies and industries reduces both default and

concentration risk. Diversification also reduces the risk that the portfolio’s

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return will vary widely from the expected market return. Indexing,

discussed in more detail in chapter 4, is one way to broadly diversify a

stock portfolio and to match the approximate market return. Under the

Advisory Council’s Maintain Benefits approach, the trust fund would

invest in stocks indexed to the broad stock market.

A diversified stock portfolio, however, does not protect against the risk of

a general stock market downturn. An investor can shield against stock

market risk by diversifying into other types of assets, such as corporate

bonds. Also, one way to mitigate U.S. stock market risk is to diversify into

international markets. To minimize exposure to short-term stock market

fluctuations, an investor can hold less risky, albeit lower-yielding, assets to

cover liquidity needs in the short run.

Social Security Trust Fund

Would Be Vulnerable to

Stock Market Risk

Higher stock returns could delay the trust fund’s exhaustion, but, without

other program changes, the trust fund inevitably will have to liquidate its

stocks to pay benefits. Social Security’s tax revenues are projected to be

inadequate to cover annual benefits beginning in 2012. To pay benefits

after that point, the trust fund will have to draw upon its investment

earnings and eventually its assets to cover the shortfall. Riding out a

general stock market downturn could be difficult for the Social Security

trust fund as it faces a cash deficit and growing numbers of retirees. The

trust fund might have to sell its stock holdings at a loss to raise cash to pay

benefits. The more the trust fund is counting on stock sales to finance

current benefits, the greater its vulnerability in the event of a general stock

market downturn.

Conceivably, the trust fund could draw on its contingency reserve to avoid

selling its stocks at a loss during a general market downturn. Once the

trust fund depletes its special Treasury holdings though, it would be

wholly subject to the vagaries of the stock market to get cash needed to

pay benefits. Under such circumstances, a contingency reserve of 100 or

even 150 percent of expected annual expenses may be inadequate for the

trust fund to ride out a prolonged market downturn.

Again, if stock investing is implemented in isolation from other program

changes, the trust fund would have to liquidate a sizable stock portfolio.

The size of the trust fund’s stock holdings as a share of the stock market

and possible price effects are discussed further in chapter 4. In the

simulations, the liquidation of the trust fund’s stock portfolio would

coincide with the baby boomers’ retirement. A sustained stock market

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downturn during this period not only would decrease the value of the trust

fund’s stock holdings but would affect retirees’ personal savings as well.

A General Stock Market

Downturn Could Coincide

With a Social Security Tax

Shortfall

The degree of risk facing the Social Security trust fund under a stock

investment policy would depend, in part, on the relationship between

stock returns and the trust fund’s predominant revenue source—payroll

taxes. Like stock returns, payroll tax revenues fluctuate with changes in

overall economic conditions. If stock returns tend to be high when payroll

tax revenues drop, the trust fund theoretically could reduce its overall risk

by diversifying into stocks. If, however, stock returns move in tandem with

payroll tax revenues and tend to fall during recessionary periods, the trust

fund would face greater risk investing in stocks. A general stock market

downturn coinciding with a payroll tax shortfall would exacerbate Social

Security’s need for cash to pay benefits. One economic study, done from

the perspective of the government as a whole, concluded that stock

returns and tax revenues are positively correlated.26 The Advisory

Council’s technical panel reported in September 1995 that further research

on the relationship between stock returns and payroll tax revenues is

critical in evaluating whether stock investing is appropriate for the Social

Security trust fund.

Who Bears the Investment

Risk of the Social Security

Trust Fund?

The Social Security trust fund could expect to earn a higher return by

diversifying into stocks, but it is reasonable to anticipate that its return

could be lower than the long-term average market return.27 As our

simulations illustrate, as long as its return on stocks is greater than the

expected return on special Treasury securities, the trust fund would be

able to pay benefits longer than is possible under the current investment

policy. If, however, the real return on stocks over the next 20 or 30 years

averages less than the expected return on Treasury securities or is

negative, the trust fund would be exhausted sooner than in 2029,

exacerbating Social Security’s long-term financial imbalance.

The increased risks associated with the Social Security trust fund’s stock

investments would be borne collectively through the government and

ultimately by taxpayers. According to recent research, the increased risk

26Henning Bohn, “Tax Smoothing with Financial Instruments,” The American Economic Review, Vol.

80, No. 5 (December 1990), pp. 1217-1230.

27This discussion focuses on the real possibility that the trust fund would earn less than the 7 percent

real return assumed by the Advisory Council and used in our simulations. Alternatively, it is

theoretically possible that the trust fund could earn more.

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of any shortfall if stock investing does not work as expected would be

borne largely by future taxpayers.28 Even if the trust fund earns more

investing in stocks, the full gain may not accrue to future generations. The

prospect of higher returns from stock investing, as shown in our

simulations, could be used to delay benefit reductions or tax increases for

current generations; or, there even could be pressure to cut Social Security

taxes or raise benefits now.

Stock Investing Could

Complement Other

Social Security

Reforms

Investing in the stock market is one option to increase the trust fund’s

revenues, but by itself, is not the solution to Social Security’s financing

problem. Stock investing would have a relatively modest impact on

long-term solvency as long as Social Security remains largely a

pay-as-you-go program. Restoring Social Security’s long-term solvency will

require some combination of benefit reductions and revenue increases.29

Recent reform proposals, such as those the Advisory Council suggested,

would increase the funds set aside to pay for future Social Security

benefits. As part of a reform package that moves towards more advance

funding, stock investing could have a more significant effect on Social

Security’s long-term financing.

Stock investing could complement traditional reforms in that higher stock

returns could serve to reduce the size of benefit cuts and/or tax increases

needed to restore Social Security’s financial solvency. Increased funding

generated by other program reforms could be invested in the stock market

to earn a higher rate of return, further boosting Social Security revenues.

Typically, reform proposals incorporating stock investments envision that

the Social Security trust fund would hold its stock portfolio and mainly

draw on its stock earnings. In this context, the trust fund would be less

vulnerable to the risk inherent in liquidating stocks to pay promised

benefits.

However, caution is warranted when counting on future stock returns in

designing a Social Security reform package. If stocks do not deliver the

expected returns, then Social Security could again face a financial

shortfall, and the trust fund might have to quickly sell its stocks to pay

28For research on intergenerational risk-sharing, see (1) Henning Bohn, “Social Security Reform and

Financial Markets,” Social Security Reform: Links to Saving, Investment, and Growth, Federal Reserve

Bank of Boston Conference Series No. 41, June 1997, (2) Kent Smetters, “Investing the Social Security

Trust Fund in Equities: An Option Pricing Approach,” Congressional Budget Office Technical Paper

1997-1, August 1997, and (3) Peter A. Diamond, “Macroeconomic Aspects of Social Security Reform,”

Brookings Papers on Economic Activity, 2:1997.

29Social Security: Restoring Long-Term Solvency Will Require Difficult Choices (GAO/T-HEHS-98-95,

February 10, 1998).

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benefits. In light of the variability of stock returns and the range of

possible outcomes for the trust fund, investing in the stock market may

not necessarily bolster public confidence in Social Security’s finances.

Even if the trust fund earns a solid return over the long haul, short-term

fluctuations could heighten public concern about the stability of the

program’s financing.

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The economic effects of government stock investing would likely be

minimal because stock investing by itself does not increase national

saving.1

 Without additional saving, government stock investing might

improve the finances of the Social Security trust fund, but it would not

increase the size of the economy because it would represent an asset

shuffle between the government and private investors. This asset shuffle

would likely be accompanied by changes in bond and stock prices that

might, to some extent, undercut the government’s expected gains on stock

investments and increase the government’s cost of borrowing. While

government stock investments might be small in relation to the total stock

market, the federal government could become the largest single investor

within a few years.

Investing in a broad-based index to diversify the government’s portfolio

would reduce the risk of losses and administrative costs, but it has price

effects of its own and its potential to prevent the use of nonfinancial

objectives in stock selection is limited. Even if the government chooses an

indexing strategy to select its stock investments, the issue of how to

handle stock voting rights remains. The perception of political influence

over the government’s stock investments could undermine public

confidence in the government’s handling of Social Security’s finances.

Economic Effects

Would Likely Be

Minimal

The economic effects of government stock investing would likely be

minimal because stock investing by itself does not increase national

saving.2

 Without additional national saving and investment, government

stock investing might improve the financial position of the Social Security

trust fund but would not increase the productive capacity of the economy.

There would be no additional saving because, without other changes in

federal spending or revenue, the Treasury would have to borrow more

from the public to offset Social Security’s stock purchases.3

 On balance,

1

The economic effects of allowing the trust fund to invest in other non-Treasury assets, such as bank

certificates of deposit or municipal bonds, would be similar to the effects that are described in this

chapter for stock investing.

2

See (1) Alan Greenspan, “Remarks at the Abraham Lincoln Award Ceremony of the Union League of

Philadelphia,” December 6, 1996, (2) Congressional Budget Office, Implications of Revising Social

Security’s Investment Policies, September 1994, (3) “Economic Challenges of an Aging Population,”

Chapter 3, The Annual Report of the Council of Economic Advisers, February 1997, and (4) Eric M.

Engen and William G. Gale, “Effects of Social Security Reform on Private and National Saving,” Social

Security Reform: Links to Saving, Investment, and Growth, (Federal Reserve Bank of Boston,

Conference Series No. 41, June 1997).

3

This statement applies in a situation where the federal government has a unified budget deficit after

investing in the stock market. See chapter 5 for a complete discussion of the budgetary effects of

government stock investments and the implications for federal fiscal policy and government saving.

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private investors would end up with fewer stocks and more government

bonds, while the government would then hold some stocks and fewer of

its own bonds. Any higher returns earned by the government would

otherwise have accrued to other investors. So, while the public might gain

by a higher return to the trust fund, people would have to accept a lower

return on their privately held assets.

There may also be offsetting increases and decreases in income to

investors, the Social Security trust fund, and the U.S. Treasury due to

changes in interest rates and stock yields. According to analysts, the asset

shuffling between the government and other investors could lead to higher

stock prices and interest rates. The magnitude of price changes is

uncertain and could be small. Any price effects might occur even before

the government starts buying shares of stocks.4

 In the stock market, the

new government demand for stocks could tend to increase stock prices,

inducing some private investors to sell stocks to the government. In the

bond market, the Treasury likely would have to issue additional bonds to

the public to substitute for Social Security’s stock investments. This

increase in Treasury borrowing from the public could tend to reduce bond

prices or, equivalently, raise their rate of interest, which would raise

federal interest costs.5

 These changes would tend to redistribute income to

a degree, but would not provide the public in general with any additional

income.

The initial effects of price changes could be reduced as firms increase

their equity financing and foreign buyers increase their purchases of U.S.

securities. Looking to the future when members of the baby-boom

generation reach retirement, analysts have expressed concern that at

about the same time that the Social Security trust fund expects to liquidate

its assets, pension funds, which have been a major source of national

saving, are expected to become enormous net sellers of assets.6

Unexpected, sizable stock sales by pension funds and the government,

such as those described in the investment scenarios discussed in chapter

4

According to financial market analysts, stock markets are reasonably efficient in that stock prices

would incorporate any relevant information about government stock investing as soon as it is publicly

available. See Hendrik S. Houthakker and Peter J. Williamson, The Economics of Financial Markets

(Oxford, New York: Oxford University Press, 1996).

5

Higher interest rates would be paid on debt roll-overs and new borrowing. According to the Treasury,

$3 trillion of marketable debt is held by private investors, about one-third of which matures within 1

year and over half of which matures within 2 years.

6

See (1) Sylvester J. Schieber and John B. Shoven, “The Consequences of Population Aging on Private

Pension Fund Saving and Asset Markets,” National Bureau of Economic Research Working Paper No.

4665, March 1994, and (2) Report of the 1994-1996 Advisory Council on Social Security, Volume II, 

pp. 56-58.

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3, could tend to depress stock prices. It is difficult to predict precisely how

stock prices and interest rates might be affected by the simultaneous sales

of pension fund and Social Security’s stock holdings more than a decade in

the future.

The Government

Could Become the

Largest Stock Investor

Proponents of government stock investing and some analysts believe that

investing some Social Security funds in equity securities would not have a

major disruptive effect on the stock market.7

 According to an analysis

prepared for the Advisory Council, Social Security’s stock portfolio under

the Maintain Benefits plan would probably account for a relatively small

share of the stock market. The Advisory Council’s analysis estimated that

the share would be less than 3.5 percent of the value of all stocks,

assuming that the stock market would grow at the real stock yield of

7 percent.8

 Starting with the stock market value of $12.8 trillion at the end

of the third quarter of 1997 and using the Advisory Council’s assumption

about market growth, our aggressive scenario would peak at about

3.5 percent of the stock market.

While the government’s investments might be small in relation to the stock

market, their size would probably be larger than the investments of other

investors. Under our aggressive investment scenario, the federal

government could become the largest single stock investor within several

years. If the Social Security trust fund invests both its future cash surplus

and interest in the stock market, assuming a 7 percent real rate of return,

the federal government’s stock portfolio would be estimated at more than

$80 billion by the end of 1998, more than $170 billion by year-end 1999, and

nearly $275 billion by year-end 2000. As a point of comparison, table 4.1

shows the five largest pension funds and money managers. The largest

money manager held $522 billion at the end of 1996, and the largest

pension fund held almost $128 billion as of September 30, 1997.

7

See (1) Robert M. Ball, Edith U. Fierst, Gloria T. Johnson, Thomas W. Jones, George Kourpias, and

Gerald M. Shea, “Social Security for the 21st Century,” in Report of the 1994-1996 Advisory Council on

Social Security, Volume I, pp. 83-86, (2) P. Brett Hammond and Mark J. Warshawsky, “Investing Social

Security Funds in Stocks,” Benefits Quarterly (1997), and (3) Francis X. Cavanaugh, “The National

Debt and Social Security,” chapter 8, The Truth About the National Debt (Boston, Massachusetts:

Harvard Business School Press, 1996).

8

The Advisory Council’s analysis started with a stock market value of $8 trillion. P. Brett Hammond

and Mark J. Warshawsky, in “Investing Social Security Funds in Stocks” (1997), compared government

stock investments to the indexed equity portion of the stock market and concluded that there may be a

need to strengthen the institutional capacity of this portion of the stock market before proceeding with

a large Social Security investment program.

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Table 4.1: Top Five Pension Funds and

Money Managers Ranked by Total

Assets

Dollars in billions

Pension fund/money manager Total assets

Top five pension funds/sponsorsa

California Public Employees $128

New York State Common $96

General Motors $91

California State Teachers $79

Florida State Board $72

Top five money managersb

Fidelity Investments $522

Barclays Global Investors $386

Prudential Insurance $333

State Street Global $301

Bankers Trust $227

aTotal assets at September 30, 1997.

bTotal assets at December 31, 1996.

Source: Pensions & Investments, May 12, 1997, and January 26, 1998.

Benefits and

Limitations of Stock

Indexing

Proposals for government stock investing typically recommend investing

in a broad-based stock index to diversify the government’s stock portfolio,

reducing the likelihood of concentrating investments in individual

companies, and to reduce administrative costs. Purchasing stocks listed in

an index is a form of passive investing that seeks to match the

performance of the group of securities listed in a market benchmark, or

index. Figure 4.1 defines several widely recognized stock indexes, such as

the Dow Jones Industrial Average, S&P 500, and Wilshire 5000.

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Figure 4.1: Examples of Widely Recognized Stock Indexes

Stock managers that pursue an indexing strategy must determine which stock index

to replicate. Two widely recognized indexes are the Dow Jones Industrial Average

(DJIA) and the Standard & Poor's 500 index (S&P 500). The stocks in these indexes

are chosen by the staff of Dow Jones and Standard and Poor's, respectively, who

occasionally add and delete individual companies or even entire industry groups

from their indexes. The DJIA is constructed from 30 of the largest blue-chip

industrial companies traded on the New York Stock Exchange. The S&P 500

represents a sample of 500 major U.S. and foreign corporations, such as General

Motors, Philip Morris, and Royal Dutch Petroleum. The S&P 500 includes stocks

from the two major national exchanges and the over-the-counter market, and

represents about two-thirds of the U.S. stock market value. The Wilshire 5000 Index

is a broader and more diversified index of all regularly traded U.S. common stocks,

including the stocks in the S&P 500. Specific indexes also cover foreign stock

markets, such as the Morgan Stanley Capital International Europe, Australia, and

Far East (EAFE) index.

Indexing Would Reduce

Some Risks

Indexing reduces risk or exposure to loss associated with an individual

company failing and industry-specific downturns. The securities held in a

broadly-based indexed portfolio would represent many different sectors of

the economy and many individual companies. This diversification reduces

the risk that any loss related to the performance of an individual security

or group of securities would greatly affect the overall performance of the

portfolio. In spite of the diversification benefits of indexing, stock

investing would still be riskier than the government’s current investment

in special Treasury securities. Inclusion in a stock index does not

represent any guarantee about a company’s future performance, and

indexing across the stock market will not reduce the government’s risk of

loss in the event of a general stock market downturn.

Indexing Would Reduce

Administrative Costs

Index investing has grown more popular in recent years as empirical

studies have shown that active stock managers generally underperform

the stock market due to their high transaction costs. Active managers

incur higher expenses in the process of doing research and trading the

stocks of companies or industries that could be undervalued or offer good

growth potential. In contrast, index managers generally do not research

individual companies, and the securities in an index are not changed

frequently, both of which result in lower trading costs. As a result, the

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costs of managing an index of large company stocks, like the S&P 500,

typically average about 10 basis points, while the active management

equivalent may cost 40 to 50 basis points or more when all costs are

included.9

Most of the cost of managing an S&P 500 index fund is attributable to the

cost of maintaining thousands of shareholder accounts. With government

stock investing there would be only one account to maintain; thus, it

would incur negligible costs as a percentage of assets. For this reason, the

Advisory Council assumed that annual administrative costs on the

government’s stock investments would be only one-half a basis point of

total assets.10

Active managers may have an advantage over index managers in selecting

small and medium corporations because data on these companies are less

widely available, giving active managers with research capabilities more

opportunity to find companies with growth potential. Also, index

managers that try to match an index of small companies will incur larger

transaction costs than a large company index because the stocks tend to

be lower priced and less liquid.

Indexing Creates Price

Effects of Its Own

Large company indexes, like the S&P 500, have become vulnerable to price

disruptions as they have become more popular. Studies have shown that

newly included companies in the S&P 500 tend to appreciate in price by

about 5 percent simply because they become part of the index. This occurs

because managers who run index funds linked to the S&P 500 have to

purchase the stocks of the new companies in the index so that their

performance will continue to replicate the S&P 500. Additions and deletions

from certain indexes, like the Dow Jones Industrial Average and S&P 500,

represent staff’s judgments about an individual company’s relative

standing and do not necessarily reflect a change in its financial outlook.

Choosing a broader market index, like the Wilshire 5000, could reduce

price distortions somewhat by diversifying across thousands of medium

and small capitalization corporations. Investing in a broad-based market

9

For example, the federal Thrift Savings Plan’s (see figure 4.2) 1997 total expenses divided by the

average monthly fund balance were 7 basis points for the government securities fund, 7 basis points

for the stock index fund, and 8 basis points for the bond index fund.

10According to Joel Dickson’s analysis prepared for the Advisory Council, fees charged for managing a

broad stock index within the Maintain Benefits plan could be less than 1 basis point; moreover, if the

investment managers are allowed to earn profits through securities lending activities, management

expenses could be bid down to zero. Report of the 1994-1996 Advisory Council on Social Security,

Volume II, p. 487.

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index, however, could lead to active selection of stocks by the government

and/or its stock managers. Managers that track the performance of a broad

market index typically engage in sampling among thousands of small

capitalization stocks to reduce transaction costs. For example, Vanguard’s

Wilshire 5000 index replicates the top 1,400 companies and takes a sample

of the rest of the companies.

Nonfinancial Objectives

Could Still Influence Stock

Selection Under Indexing

Analysts and critics of government stock investing have expressed

concern that political objectives would influence Social Security’s

investments.11 While indexing greatly reduces this possibility, it does not

eliminate it because the government, as the owner of the investments,

would be able to drop or add shares of certain companies from a stock

index to achieve other public goals. The Congress could start with a broad

indexing strategy to reduce price distortions and the possibility of owning

a significant percentage of the shares of any individual company. The

Congress could then modify the index’s composition to target investments

that could offer competitive returns while providing other social benefits.12

Additionally, a tailored index could automatically exclude stock

investments in companies engaged in activities that are in conflict with

government policies. For example, some state governments have been

disinvesting from tobacco companies because they are pursuing a lawsuit

against them. According to critics of government stock investing,

pressures to exclude or include stocks for nonfinancial reasons might

reduce the rate of return on the government’s portfolio and hinder the

overall economic efficiency of capital markets.

The issue of how to select stock investments also emerged when the

federal employees’ Thrift Savings Plan (TSP) was created (see figure 4.2).

To eliminate political influence in TSP’s stock investment decisions, the

Congress restricted TSP investments to widely recognized broad-based

stock indexes, prohibited TSP board members and employees from

exercising stock voting rights, and subjected TSP board members and

11A restriction to invest only in publicly listed stocks would automatically favor the group of large,

publicly held corporations over thousands of small and medium businesses that do not have publicly

held stock. See Lawrence J. White, “Investing the Assets of the Social Security Trust Funds in Equity

Securities: An Analysis,” Investment Company Institute Perspective, May 1996. Other critics include

(1) Joan T. Bok, Ann L. Combs, Sylvester J. Schieber, Fidel A. Vargas, and Carolyn L. Weaver,

“Restoring Security to Our Social Security Retirement Program,” Report of the 1994-1996 Advisory

Council on Social Security, Volume I, 1997, (2) Michael Leidy, “Investing U.S. Social Security Trust

Fund Assets in Private Securities,” IMF Working Paper 97-112, and (3) Gene Steuerle, “Investing Social

Security Surpluses in the Stock Market,” Tax Notes, April 3, 1995.

12See Theodore J. Angelis, “Investing Public Money in Private Markets: What Are the Right Questions,”

Framing the Social Security Debate: Values, Politics, and Economics, (National Academy of Social

Insurance Conference, January 29-30, 1998).

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Government Stock Ownership

employees to strict fiduciary rules. These fiduciary rules require board

members and employees to invest the money and manage the funds solely

for the benefit of the owners of the funds—the participating federal

employees and beneficiaries. Board members and employees cannot

consider nonfinancial objectives, such as job creation and environmental

protection, in selecting stocks, and the portfolio composition is

automatically determined by the stock index chosen. Breaching their

fiduciary duty would expose board members and employees to civil and

criminal liabilities.

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Figure 4.2: Overview of the Federal

Thrift Savings Plan

The Thrift Savings Plan (TSP) is a retirement savings and investment

plan for federal employees authorized by the Congress in 1986. The

TSP is administered by an independent agency, the Federal Retirement

Thrift Investment Board, which is charged with operating it prudently

and solely in the interest of TSP participants and their beneficiaries.

The Congress originally established three TSP investment funds: the

Government Securities Investment Fund (G Fund), the Common Stock

Index Investment Fund (C Fund), and the Fixed Income Investment

Fund (F Fund). The G Fund, like Social Security, invests in short-term

nonmarketable U.S. Treasury securities that earn the average of market

rates of return on U.S. Treasury marketable securities with 4 or more

years to maturity.

The C Fund is invested primarily in a commingled stock index fund that

consists of common stocks of all the companies represented in the

Standard & Poor's 500 (S&P 500) stock index. The F Fund is invested

in a debt index fund that is designed to measure the performance of the

major bond markets in the United States. TSP participants allocate

their entire account balance among these three investment funds and

can make interfund transfers. The Congress in 1996 approved two

additional stock index funds for TSP, namely, an index of all companies-

-other than the S&P 500 companies--actively traded in the U.S. stock

markets, and an index of major foreign corporations. 

The TSP Board has contracted with Barclays Global Investors, N.A., to

manage the C and F Fund assets. These assets are passively managed,

which means that Barclays' managers seek to match the performance of

the indexes by buying and holding the securities in each index. TSP

assets are invested in funds in which the assets of public and corporate

tax-exempt employee benefit plans are commingled. Barclays keeps

separate accounting records for each plan. Because the C and F Fund

assets are held in trust by Barclays, they are not assets of Barclays and

cannot be used to meet the financial obligations of Barclays or any

related companies.

Some analysts believe that TSP’s fiduciary rules may not be applicable to

government stock investing. The government owns the assets in the Social

Security trust fund, and the Congress would be able to define the federal

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government’s “best interests.”13 Other analysts believe that it might be

possible to establish in law that investments be made solely for the

financial benefit of Social Security participants and not for other

economic, social, or political objectives. And, analysts believe that the

Congress could establish an investment policy board, similar to TSP’s

board, subject to strict fiduciary rules when investing and managing the

government’s money.

Complexities of Stock

Voting Would Remain

Under Indexing

Even if the government chooses an indexing strategy to select its stock

investments, the issue of how to handle stock voting rights remains. In

general, because index investors cannot alter their portfolio composition

to increase financial performance, they have a stronger incentive to

actively exercise stock voting rights. Instead of selling stocks of an

underperforming company, an index investor can choose to participate in

corporate decisions that could enhance the company’s performance.

However, critics have expressed concern that the government’s right to

vote its sizable number of shares would allow it to influence corporate

decisions.14

To blunt critics’ concerns about potential federal meddling in corporate

affairs, the government could choose not to exercise its stock voting

rights. The Congress could, by statute, expressly prohibit the government

from directly exercising voting rights associated with its ownership of

securities or delegating these rights to stock managers. However,

prohibiting the exercise of voting rights by the government or its stock

managers would, in effect, create a situation favoring certain stockholders

and corporate managers. If, for example, the government does not

exercise its voting rights, other stock owners would have their own

unencumbered voting rights increased and could conceivably act in ways

that take advantage of the government’s passivity. Also, no matter what

stock voting policy is chosen when the government begins investing,

policymakers could change the rules for stock voting rights in the future.

Despite these complexities, analysts and Maintain Benefits plan

supporters believe that some features of TSP might be used to achieve

neutrality of Social Security investments in matters of corporate policy.

13Securities and Exchange Commission economists suggested that appropriate safeguards to preserve

the integrity of stock markets against politically motivated investments should be in place before the

government invests in the stock market.

14Even a 2 or 3 percent block of shares could allow substantial influence over the policies of publicly

traded companies. An activist shareholder can disproportionately magnify the power of small holdings

in a company. See Angelis, pp. 26-27.

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For example, voting on Social Security stock might be done, as for TSP, by

investment managers according to their own guidelines. Since delegating

the government’s stock voting rights would shift the government’s sizable

voting rights to its selected managers, Maintain Benefits plan supporters

have suggested spreading the government assets among many stock index

managers.15

Investing in stocks or other assets outside the government would be a new

concept for the Social Security trust fund. How the government chooses to

handle the implementation issues associated with stock investing would

affect the public’s perception of such a new investment policy. If political

factors appear to influence stock selection, stock voting, or the selection

of stock managers, the public confidence in government’s handling of

Social Security’s finances could be undermined.

15Spreading the government’s stock portfolio among many managers might also help to address a

concern raised by Securities and Exchange Commission economists that government stock investing

could have an impact on competition and efficiency in the stock market because the federal

government’s stock managers would have enormous clout through their ability to place billions of

dollars in orders to purchase and sell shares of stocks.

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on the Federal Budget and Fiscal Policy

Under current budget scoring rules, in the short term stock investing

would increase the reported unified deficit or decrease any reported

surplus, because stock purchases would be treated as budget outlays. Any

money used to purchase stocks would no longer be invested in Treasury

securities, reducing the Treasury’s available cash and making the resulting

budget measure look more like the on-budget deficit that excludes Social

Security’s finances. Each dollar invested in stocks is $1 less available to

the Treasury to finance other government spending or reduce debt held by

the public. If after accounting for this effect the federal government were

in deficit, the Treasury would need to borrow from the public to replace

cash used to buy stocks, unless offsetting spending or revenue actions

were taken. Despite the change in the reported deficit/surplus, stock

investing would not significantly change the government’s fiscal position.

Any additional borrowing from the public would be accompanied by less

borrowing from Social Security, leaving the federal government’s gross

debt largely unchanged. And, more important, the government’s impact on

the economy would not change significantly because the effects on

national saving of additional borrowing from the public would be offset by

the purchase of stocks.

Whether the higher reported deficits or lower reported surpluses would

lead to changes in fiscal policy is unclear. Since the change in the

deficit/surplus would not alter the government’s fiscal position,

policymakers might choose to maintain the status quo in fiscal policy. In

fact, recognizing that purchasing stocks means acquiring financial assets,

they might consider changing budget scoring rules so that stock purchases

would not count as budget outlays. If scoring rules were changed in this

way, the reported deficit/surplus would not be significantly affected by

stock investing. Alternatively, the higher reported deficits or lower

reported surpluses could make more visible the underlying condition of

the government’s finances excluding the Social Security surplus and

prompt policymakers to initiate compensating spending or revenue

actions. If so, such fiscal actions could raise national saving. Or, if the net

effect of stock investing were to reduce or eliminate an anticipated unified

surplus, policymakers might be reluctant to devote surplus funds to

additional spending or tax cuts. In this case, fiscal restraint might not

promote higher saving, but it would avoid policy actions that could cause

saving to decline.

Of course, if policymakers wanted to take actions to promote higher

national saving, they could certainly do so directly by running annual

surpluses in the unified budget and devoting the surplus funds to reducing

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the level of outstanding debt held by the public. While sustaining surpluses

would likely prove challenging, such a policy would strengthen the

government’s fiscal condition and enable it to better handle the baby

boomers’ retirement costs.

Impact of Stock

Investing on Reported

Deficits/Surpluses

Under current budget scoring rules, stock purchases would be treated as

budget outlays. Therefore, in the short term, investing surplus Social

Security funds in stocks would make unified budget deficits larger or

unified budget surpluses smaller.1

 Each dollar invested in stocks is $1 less

available to the Treasury to finance other government spending or reduce

debt held by the public. If, after accounting for the effects of stock

investing, the government were in deficit, the Treasury would have to

borrow more from the public, unless action were taken to reduce other

spending or raise revenues. If, instead, after adjusting for the effects of

stock investing, the government were running a budget surplus, the

Treasury would have less cash available to reduce debt held by the public.

Depending on how much the Social Security trust fund invests in stocks,

the impact on the budget deficit or surplus could be substantial. If Social

Security’s cash surplus were invested, the government’s budgetary balance

would be expected to decline by about $30 billion to $35 billion2

 annually

for the next several years.3

 For example, the $8 billion surplus that the

Congressional Budget Office (CBO) projects for fiscal year 19984

 would be

eliminated, leaving a deficit of about $25 billion in its place. If the trust

fund were to also invest its annual interest, the change in the annual

deficit or surplus could exceed $100 billion a year. Under current CBO

projections, investments of this magnitude would prevent the realization

of any unified budget surpluses over the next decade.5

 However, as

discussed below, this deterioration in the reported deficit/surplus would

not significantly affect the government’s fiscal position, and, over the long

term, the effect of stock investing on the reported deficit/surplus could

largely be neutral.

1

Since, in the short term, stock investing would worsen the reported budgetary balance of the

government, it could also change a unified surplus into a deficit depending on the size of the initial

surplus and the amount that Social Security invests in stocks.

2

GAO analysis of 1997 Trustees’ Report, intermediate assumptions.

3

This amount excludes the effects of the additional interest payments to the public from any increased

borrowing.

4

Congressional Budget Office, An Analysis of the President’s Budgetary Proposals for Fiscal Year 1999,

March 1998.

5

Ibid.

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Higher Short-term Deficits

Under Stock Investing

Would Not Significantly

Affect National Saving

Higher short-term deficits would mean more borrowing from the public

and less borrowing from the Social Security trust fund.6

 This shift from

one type of debt to another would not significantly change the federal

government’s gross debt.7

 However, the annual change in the gross debt is

generally less noticeable than the annual change in borrowing from the

public,8

 which is reflected in the unified deficit. It is the unified deficit that

is most commonly used by policymakers, analysts, and the media because

it best reflects the current impact of federal borrowing on the financial

markets and the economy. Therefore, changing Social Security’s

investment policy would increase the type of federal borrowing that is

most closely monitored.

Although stock investing would increase federal debt held by the public, it

would not by itself significantly affect national saving. Ordinarily,

government deficits reduce national saving because government

borrowing absorbs money that would otherwise have been available for

private investment. Therefore, the current unified deficit measure closely

approximates the economic effects of federal borrowing. However, under

stock investing, although the reported deficit would increase, the

government’s draw on capital markets would not. While the additional

federal borrowing from the public would absorb money from capital

markets, the trust fund’s stock investments would add funds to the

markets. This new flow of money from the trust fund would offset the

additional borrowing from the public, resulting in no significant net

change in the annual funds available for private investment.9

 (See figure

5.1.)

6

This section discusses stock investing’s impact in an environment of budget deficits. Although the

effects of stock investing in a budget surplus environment would differ technically, they would be the

same conceptually. For example, if after accounting for stock investing, the government were still in a

surplus, it would potentially have cash available to reduce the level of debt held by the public.

However, this result does not change the fact that the immediate effect of stock investing is to remove

cash from the Treasury, which means that, absent stock investing, the government would have had

more money available for such debt reduction.

7

If the government borrowed more from the public in response to government stock investing, the

federal government would pay more interest to the public while crediting less to the trust fund. This

change in interest flows would probably have no significant effect on the gross debt.

8

The debt limit provides an exception to this statement, because it applies not just to debt held by the

public, but to nearly all of the gross debt. In this case, changes in the gross debt are more noticeable

than changes in debt held by the public.

9

As long as the government were in a deficit position, the Treasury would have to borrow more to pay

the interest costs on additional borrowing from the public. This borrowing to pay interest would

slightly reduce national saving.

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Figure 5.1: No Net Change in National Saving With Government Stock Investing

Social Security

trust fund All other government accounts

U.S. Treasury

$1 (in stock

investments) $1 (in Treasury

borrowing)

National saving

Note: Figure excludes the effects of additional interest paid to the public.

Long-term Effects of Stock

Investing on Reported

Deficits/Surpluses Could

Largely Be Neutral

While stock investing would have a negative effect on the budget

deficit/surplus today, over time its impact on the unified budget could

largely be neutral. As with any budget outlay, the purchase of a stock

would mean money flowing out of the government and, thus, the reported

budget deficit/surplus would deteriorate. However, the sale of a stock

would mean money flowing back into the government. So, when Social

Security begins running cash deficits in the future, it could sell stocks to

finance benefits, rather than drawing on the Treasury. This approach

would result in smaller future budget deficits or larger future budget

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surpluses than under current policy. This longer-term improvement could

offset the near-term deterioration in the deficit/surplus.

Because it is impossible to predict the precise effects of stock investing, it

is important to qualify any discussion of its fiscal impact. For example,

over the long term, stock investing could have at least a slight positive

effect on the federal government’s finances if the earnings on stock

investments exceed any potential increase in federal borrowing costs.10 If

the federal government borrows from the public to replace cash used to

purchase stocks, it could put upward pressure on interest rates. Even a

small rise in interest rates could significantly increase federal interest

costs because of the size and structure of the outstanding debt held by the

public. About $1 trillion of the federal government’s outstanding debt

securities are rolled over every year. Higher interest rates would affect

these roll-overs, as well as the additional debt issued to cover the stock

purchases.11

If the federal government’s stock earnings did exceed any increased

borrowing costs, the government would benefit from an improved

budgetary position. However, any such gain to the government would not

increase national income. If the federal government were investing in

stocks without taking other actions designed to raise national saving, it

would be capturing a portion of stock returns that would otherwise have

accrued to private investors, who would now own fewer stocks and more

Treasury securities. In short, simply altering the ownership of stocks and

bonds between the public and private sectors would not boost long-term

economic growth.

Indirect Impact of

Government Stock

Investing on Fiscal

Policy Is Unclear

Whether the short-term increase in reported budget deficits or decline in

reported budget surpluses would lead to changes in fiscal policy is

unclear. Since stock investing would not substantially change the impact

of federal finances on the economy, policymakers might choose to

maintain a status quo fiscal policy. Changing budget scoring rules to

exclude stock purchases from budget outlays would be consistent with

this approach because it would result in no significant change in the

10Stock investing would have several additional effects on federal spending and revenue. These effects

would be relatively small and could have either a positive or negative net impact on the budget

deficit/surplus. For example, the investment earnings on the government’s stock portfolio would be

exempt from taxation. However, the additional interest income earned by federal bondholders would

be subject to taxation.

11Higher interest rates would also affect any new issues of the nonmarketable Treasury securities held

by the Social Security trust fund or any old issues that are rolled over.

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reported deficit/surplus. If budget scoring were not altered, however,

stock investing would more clearly reveal the budget imbalance that exists

when Social Security’s temporary surplus is excluded. The greater

visibility of this imbalance could lead to further actions to restrain federal

spending or increase revenues, which could boost national saving. Of

course, stock investing would be a very indirect way of prompting

additional actions to raise national saving. If policymakers choose to enact

additional fiscal restraint, they can do so directly without any changes in

the way the unified budget deficit/surplus is presented.

Stock Investing Could

Prompt Change in Budget

Scoring Rules

While stock investing could lead to additional federal borrowing from the

public, the additional borrowing would not substantially reduce the pool

of funds available for private investment. Any increased borrowing would

be largely offset by the government’s stock purchases. Since stock

investing does not significantly alter the impact of the government’s

finances on the economy, policymakers might decide to maintain current

fiscal policy as is. In fact, they could choose to change budget scoring

rules to explicitly recognize the distinct nature of stock purchases. Since

the government acquires a financial asset when it buys stock, one could

argue that the purchase should not be treated as a budget outlay.

However, such a determination would conflict with the way other asset

purchases are treated in the budget—they are generally scored as outlays.12

And, in addition, creating different budget scoring rules for stocks would

also raise some complicated technical issues, such as how to recognize

changes in their market values. To some extent, new budgetary scoring

procedures would have to be developed for handling stocks. If, despite

these considerations, stock purchases were not treated as outlays, stock

investing would have no major impact on the reported budget deficit or

surplus.13 (For additional details on stock investing and budgetary

accounting, see appendix II).

12Major exceptions are debt transactions (for example, when Social Security invests in special

Treasury securities) and cases in which the government purchases assets that are considered

equivalent to cash.

13If stock purchases were not treated as outlays, stock investing could still result in minor changes in

the budget deficit/surplus. For example, if stock investing resulted in additional borrowing from the

public, the associated interest costs would increase budget outlays and, hence, the deficit.

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Financial Status of

Government Excluding

Social Security Surplus

Would Be More Visible

Under Stock Investing

If current budget scoring rules were maintained, stock investing would

make more visible the underlying condition of the government’s finances

excluding Social Security’s temporary surplus. Currently, in the unified

budget presentation, the Social Security surplus masks the financial status

of the rest of the government. By helping to finance current spending,

Social Security’s cash surpluses may result in the government spending

more or taxing less than it would if these surpluses were not available to

finance other programs.14 Stock investing, by removing surplus Social

Security funds from the Treasury would reduce or eliminate the masking

effect, making the unified budget measure look more like the on-budget

measure that appears in budget documents but is not widely used. If Social

Security’s cash surplus plus interest were invested in stocks, the “new”

unified budget measure would virtually match the on-budget measure.15

The masking that occurs under current policy is an important budgetary

issue because of its implications for the future. Social Security’s surpluses

are temporary; when they disappear, there will be relatively fewer funds

available to support other government activities. At that time, the federal

government would need to find an alternative source of funds if it wanted

to maintain the same amount of spending. As the trust fund slips into

deficit and begins drawing on the Treasury in increasing annual amounts,

the challenge of financing the rest of the budget would intensify. (See

figure 1.1.) The fiscal choices needed to redeem the trust fund’s Treasury

securities could be especially difficult because the need to make such

trade-offs may not be well understood by the public. Current fiscal policy

may be creating the misleading impression that today’s spending levels

and commitments can be maintained indefinitely without additional

revenues or borrowing from the public. More clearly acknowledging the

government’s budgetary status excluding Social Security’s surplus, rather

than deferring that recognition until the trust fund begins drawing on the

Treasury, could dispel this impression.

Our concern about the impact of Social Security’s temporary surplus on

the unified budget does not imply that the program’s revenues and

14This masking effect could have important implications for any Social Security reforms. Reforms that

increase the size of the Social Security surplus might not necessarily improve the long-term picture for

the budget as a whole. A larger Social Security surplus might serve to intensify the masking of the

financial condition of the rest of the government. If policymakers responded to a larger trust fund

surplus by exercising less restraint in the rest of the budget, the improvement in Social Security’s

finances would not contribute to increased national saving. Instead, it would only allow the trust fund

to build up more claims on the Treasury without enhancing the nation’s ability to meet these future

claims.

15In addition to Social Security, the on-budget deficit excludes the operations of the U.S. Postal

Service. However, this amount is very small in comparison to Social Security.

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expenditures should be excluded from the budget. The unified budget,

which includes Social Security, is the way to measure the current impact

of the federal government’s finances on the nation’s economy. However, in

considering the long-range implications of government policies, the

temporary nature of the Social Security surplus suggests that an

alternative presentation would more clearly reveal the underlying nature

of federal commitments. Such a presentation would help today’s

decisionmakers better understand the long-term budgetary condition and

underlying commitments of the federal government.

Higher Reported Deficits

or Lower Reported

Surpluses Could Influence

Fiscal Policy

Even though stock investing does not alter the government’s fiscal

position, it could indirectly lead to changes in fiscal policy by focusing

more attention on the budget imbalance that exists when Social Security’s

surplus is excluded. Policymakers could react to a higher unified deficit by

cutting spending and/or raising taxes. Such fiscal restraint could

contribute to a higher level of national saving. Or, if the net effect of stock

investing were to reduce or eliminate an anticipated budget surplus,

policymakers might be reluctant to devote surplus funds to additional

spending or tax cuts. In this case, fiscal restraint might not promote higher

saving, but it would avoid policy actions that could cause saving to

decline.

Though stock investing could help highlight the budget shortfall that exists

when Social Security’s surplus is excluded, it represents a circuitous way

of essentially duplicating a measure that already exists: the on-budget

deficit. If policymakers wanted to take actions to boost national saving,

they could certainly do so directly by running annual surpluses in the

unified budget and devoting the surplus funds to reducing the level of

outstanding debt held by the public. If the government ran a unified budget

surplus equal to Social Security’s cash surplus, it would mean that the

Treasury would no longer need to rely on Social Security revenues to

finance federal spending on other activities. While attaining and sustaining

such surpluses would likely prove challenging, such a policy would

strengthen the fiscal condition of the government and, by promoting

higher saving, better position the economy to handle the baby boomers’

retirement costs.

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Appendix I 

Assumptions Used in Estimating How

Higher Returns Affect the Social Security

Trust Fund

At our request, the Social Security Administration’s (SSA) Office of the

Chief Actuary simulated the potential effect of higher returns of stock

investing on the Social Security trust fund. Simulations are useful for

comparing alternative investment policies within a common framework

but should not be interpreted as forecasts given the range of uncertainty

about the amount and timing of any Social Security stock investments as

well as about future stock returns and potential economic changes in

response to government stock investing. While this report discusses

potential investment alternatives, it does not suggest any particular course

of action, since the choice of the most appropriate investment policy is a

decision to be made by the Congress and the President.

Stock Investing in

Isolation From Other

Program Changes

We examined the potential effect of stock investing in isolation from other

changes in the Social Security program. At our request, the SSA actuaries

used the Social Security Trustees’ 1997 intermediate assumptions about

future tax revenues, benefit expenditures, demographic trends, and

economic growth. Under the Trustees’ 1997 intermediate estimate, the

trust fund’s balance of special Treasury securities at the beginning of 1998

was expected to be equivalent to about 165 percent of estimated

expenditures in that year. Given that a level of 100 to 150 percent is

suggested as a prudent contingency reserve, we assumed that the Social

Security trust fund could begin investing in the stock market in 1998. The

trust fund, assuming no program changes, expects to collect more cash

from Social Security tax revenues than is needed to pay benefits each year

until 2012. At that point, Social Security’s tax revenue will be insufficient

to pay benefits each year, and the trust fund will finance the program’s

cash deficit by drawing on its investment income and eventually depleting

its assets.

We assumed that the trust fund would continue to hold a contingency

reserve equal to at least 100 percent of the next year’s expected

expenditures. Moreover, we assumed that the contingency reserve would

continue to be in the form of special Treasury securities, given that stock

prices are highly variable in the short term. Under the Trustees’ 1997

intermediate estimate, the trust fund’s balance of special Treasury

securities at the beginning of 1998 was expected to be more than

$647 billion. This balance would be adequate as a contingency reserve of

at least 100 percent of annual expenditures for about 10 years. However,

as the baby boomers begin collecting benefits, Social Security’s annual

expenditures will increase, and the trust fund will need an increasingly

larger amount of Treasury securities for its contingency reserve. At our

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Assumptions Used in Estimating How

Higher Returns Affect the Social Security

Trust Fund

request, the SSA actuaries assumed that the trust fund’s minimum reserve

of special Treasury securities would equal 100 percent of the combined

annual costs of Social Security’s two trust fund accounts: Old-Age and

Survivors’ Insurance (OASI) and Disability Insurance (DI). Combining these

accounts results in a shorter stock investment period than if the two

accounts were treated separately in determining the 100 percent reserve.

On a separate basis, the OASI trust fund account could hold more stocks for

a longer period, but the DI trust fund account is expected to be exhausted

in 2015 under the Trustees’ 1997 intermediate assumptions. In the past, the

DI trust fund account has received additional financing through a

reallocation of a portion of Social Security taxes from the OASI trust fund

account.

Stock Return

Assumptions

The potential gain from stock investing would depend on what future

stock returns are. To illustrate the potential effect of higher returns on the

Social Security trust fund, we used the 7 percent real stock yield assumed

by the Advisory Council in estimating future stock performance. To

illustrate how changing the stock return assumption affects the estimated

delay in the trust fund’s exhaustion, we also tested a real stock yield,

which is 1 percentage point less than the historical average. This

alternative return is intended only to demonstrate that stock investment

simulations are sensitive to the rate of return assumed and does not

represent the lower bound of a confidence interval of expected returns.

The 7 percent long-term historical average return on stocks is

4.3 percentage points more than the ultimate 2.7 percent yield on special

Treasury securities under the Trustees’ 1997 intermediate assumptions.1

The real stock yield of 6 percent is 3.3 percentage points greater than the

expected yield on special Treasury securities. We also used the Advisory

Council’s assumption that the trust fund’s annual administrative costs

would be 0.5 basis points,2

 which reduces the spread between the real

yields on stocks and Treasury securities by 0.005.3

 Based on the Trustees’

1997 intermediate assumption for inflation, the ultimate nominal yield on

special Treasury securities would be 6.29 percent. Thus, the ultimate

1

The 7 percent real stock yield was 4.7 percentage points greater than the 2.3 percent yield expected

under the Trustees’ 1995 assumptions, which were used in the Advisory Council’s analysis.

2

In its analysis, the Advisory Council assumed that the annual administrative costs would apply to the

trust fund’s entire asset balance and not just to its stock holdings.

3

The spread over the real yields on Treasury securities would be 4.295 percent under the 7 percent real

stock return assumption and 3.295 percent under the 6 percent assumption. The spread between the

nominal yields is slightly higher.

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Appendix I 

Assumptions Used in Estimating How

Higher Returns Affect the Social Security

Trust Fund

nominal yields on stocks would be 10.74 percent (assuming a 7 percent

real yield) and 9.70 percent (assuming a 6 percent real yield). Under the

Trustees’ intermediate assumptions, the yields on special Treasury

securities are expected to be higher than the ultimate rate over the next

decade or so. Likewise, the nominal stock yields over these years are

higher than the ultimate stock yield assumptions, as shown in table I.1.

Table I.1: Nominal Yields on Special

Treasury Securities and on Stocks

Assuming 7 Percent and 6 Percent

Real Yields From 1998 Through 2011

Percentages

Year

Special

Treasury yield Inflation

7 percent real

stock yield

6 percent real

stock yield

1998 7.41 3.2 11.84 10.81

1999 7.30 3.2 11.74 10.70

2000 7.23 3.4 11.67 10.64

2001 7.15 3.5 11.60 10.56

2002 7.09 3.5 11.54 10.50

2003 7.04 3.5 11.49 10.45

2004 6.98 3.5 11.42 10.39

2005 6.91 3.5 11.36 10.33

2006 6.85 3.5 11.29 10.26

2007 6.73 3.5 11.18 10.14

2008 6.62 3.5 11.07 10.03

2009 6.51 3.5 10.96 9.92

2010 6.40 3.5 10.85 9.81

2011 6.29 3.5 10.74 9.70

Source: SSA based on 1997 Trustees’ intermediate assumptions about yields on special Treasury

securities and inflation.

Stock Investment

Scenarios

The potential gain from stock investing also would depend on how much

the Social Security trust fund invests in the stock market. We developed an

aggressive scenario investing all future amounts beyond a 100 percent

contingency reserve level and a more conservative scenario investing only

Social Security’s cash surplus. Under the aggressive scenario, the trust

fund would hold its balance of special Treasury securities constant as of

the beginning of 1998. From 1998 until 2008, all of Social Security’s cash

surplus and the interest on its special Treasury securities would be

invested in the stock market. Beginning in 2008, the trust fund would need

to begin investing more in Treasury securities to maintain a 100 percent

reserve level. Under the cash surplus scenario, the trust fund would invest

in the stock market until 2012 and then it would begin drawing on its stock

Page 74 GAO/AIMD/HEHS-98-74 Social Security Financing
Appendix I 

Assumptions Used in Estimating How

Higher Returns Affect the Social Security

Trust Fund

earnings and sales to finance Social Security’s cash deficit. In both

scenarios, stock earnings are reinvested in the market unless the trust

fund needs cash to pay benefits or to invest in Treasury securities to

maintain its contingency reserve.

Table I.2 shows, under current law and the two stock investment

scenarios, the years when (1) the trust fund would be exhausted, (2) its

asset level would fall below 100 percent of expected annual expenditures,

and (3) its asset level would fall below 150 percent. These simulation

results illustrate some outcomes associated with two alternative

investment policies. These results should not be interpreted as forecasts

and do not represent the full range of possible outcomes for the Social

Security trust fund.

Table I.2: Key Dates Under Current

Law and Two Stock Investment

Scenarios Trust fund

exhausted

Assets less than

100 percent of

annual outgo

Assets less than

150 percent of

annual outgo

Current law 2029 2025 2022

Aggressive scenario

7 percent real yield 2040 2036 2034

6 percent real yield 2035 2032 2029

Cash surplus scenario

7 percent real yield 2032 2028 2026

6 percent real yield 2031 2027 2025

Source: SSA, Office of the Chief Actuary.

In our opinion, the aggressive scenario represents the outer limit of how

much the Social Security trust fund might invest in the stock market.

Hypothetically, the trust fund could redeem its existing balance of

Treasury securities to invest more in the stock market now. Or the trust

fund could hold an amount of Treasury securities less than 100 percent of

expected annual expenditures. We do not believe either of these scenarios

would be sound from an investment perspective. Under the aggressive

scenario, the trust fund’s stock holdings would peak at more than

70 percent of its portfolio. A scenario investing even more in stocks would

increase the trust fund’s exposure to the risk of loss in the event of a

general stock market downturn. Moreover, the trust fund would not hold

enough Treasury securities to maintain an adequate reserve to cover

unforeseen liquidity needs.

Page 75 GAO/AIMD/HEHS-98-74 Social Security Financing
Appendix I 

Assumptions Used in Estimating How

Higher Returns Affect the Social Security

Trust Fund

There are also other reasons why we question whether it would be feasible

to invest more than under the aggressive scenario. For one, under the

Trustees’ 1997 intermediate estimates, the trust fund’s special Treasury

securities at the beginning of 1998 were expected to be approximately

$647 billion, which is equivalent to about 5 percent of U.S. stock holdings,

valued at $12.8 trillion as of the third quarter of 1997. Attempting to rapidly

shift the trust fund’s existing balance into the stock market would magnify

any upward pressure on stock prices resulting in the short term from

government stock investing. Finally, the aggressive scenario presents

budgetary challenges: Social Security’s cash surplus would not be

available to finance other government activities, and the Treasury would

have to raise additional cash to finance interest payments to the trust fund.

The trust fund reinvesting its existing balance in the stock market would

create another budgetary challenge—the Treasury would have to repay

money previously borrowed from the trust fund.

The cash surplus scenario is somewhat conservative. The trust fund’s

stock holdings would peak at about 35 percent of its portfolio, which is

conservative in comparison to the 60 percent held by state and local

pension funds as a whole. Also, under the cash surplus scenario we

specified, the trust fund would sell its stocks first to finance Social

Security’s cash deficit even before tapping the interest on its special

Treasury securities. It is possible to construct a more conservative

investment scenario, for example, by limiting stock holdings to a lower

percentage of the trust fund’s portfolio. Alternatively, it is possible to

construct a less conservative cash surplus scenario. The trust fund could

draw on its special Treasury securities in excess of the contingency

reserve level instead of selling its higher-yielding stocks first. Under this

less conservative scenario, investing Social Security’s cash surplus in the

stock market, still assuming a 7 percent real yield, would delay the trust

fund’s exhaustion until 2034. This result is 5 years longer than expected

under current law and 2 years longer than is possible under the more

conservative scenario.

Page 76 GAO/AIMD/HEHS-98-74 Social Security Financing
Appendix II 

Government Stock Investing and Federal

Budgetary Accounting

While the costs of government stock investing would show up immediately

under the current budgetary accounting system, the potential benefits

would not appear for several years or more. This discontinuity between

costs and benefits would make it difficult for policymakers and the public

to evaluate a stock investment policy. Changing the budgetary accounting

rules for stock purchases to exclude them from government outlays could

alleviate the confusing budget signals that would arise under current

scoring methods. However, changing the scoring treatment would also

eliminate the clearer view of the government’s finances excluding the

Social Security surplus that would otherwise result under stock investing.

Alternatively, supplemental information on the stock portfolio could be

used to track changes in its value.

Stock Purchases

Would Increase

Budget Outlays

The federal budget is largely cash-based. Receipts are recorded when

received and outlays are recorded when paid, without regard to the period

in which taxes and fees were assessed or the costs incurred. According to

budget experts that we interviewed, the purchase of stocks, like any other

purchase, would be treated as an expenditure or cash outlay. In this way,

stock purchases increase federal spending and, therefore, raise the

reported unified budget deficit or lower the reported surplus.

While budget analysts consider a stock purchase to be an expenditure, the

issue is less clear when viewed from the perspective of Social Security.

The trust fund is not spending more money; it is simply investing in a

different asset. Why would choosing a different asset increase federal

spending? The answer lies in the distinct nature of each type of asset

transaction. Purchases are generally treated as budget outlays. However,

the trust fund’s purchase of a Treasury security is a debt transaction. Such

transactions do not constitute outlays or receipts; if they did, the budget

would approximately be balanced by definition. In addition to debt

transactions, another exception to the general treatment of purchases as

outlays applies to assets that are equivalent to cash.1

 Stock purchases do

not fall under either of these exceptions: they are not debt transactions

and budget analysts do not consider them to be equivalent to cash because

they are not as liquid and their value fluctuates.

Any income from dividends on stocks or sales of stock would be counted

as offsetting receipts, i.e., it would reduce total spending. However, in the

case of dividends, any reinvestment would be treated as additional

spending. So, on balance, a policy of reinvesting dividends would have no

1

For example, gold is considered a cash-equivalent asset.

Page 77 GAO/AIMD/HEHS-98-74 Social Security Financing
Appendix II 

Government Stock Investing and Federal

Budgetary Accounting

immediate impact on the budget deficit or surplus as the effects on

spending would offset one another.

Potential Gain From

Stock Investing Would

Not Be Visible in the

Short Term

In addition to its cash-based nature, federal budgeting has a relatively

short-term focus—generally 1 to 5 years. Together, these factors would

tend to obscure the potential benefit of stock investing. Most of the stock

purchases would occur over the next 10 to 15 years, while any revenue

gains would likely be concentrated in later years. Thus, any long-term

benefits would not be immediately visible. The budget would not reflect

any change in value of the stock portfolio until the trust fund sells its

stocks. In the short-term, then, stock investing might not look particularly

attractive—cash would go out to purchase stocks, but little or no new cash

would come in to the Treasury.

The long-term signals sent by stock investing could also be confusing to

policymakers and the public. When the trust fund sells stocks in the future

to help pay benefits, the cash proceeds would appear in the budget as

revenue, but it would not be clear how much the stocks had gained or lost

in value.

Budgetary accounting rules could be changed to avoid these confusing

signals, but such a change could carry costs as well as benefits. For

example, if government stock investing were scored under different rules

than other types of federal spending, stock purchases could be excluded

from government outlays. As noted previously, the purchase of stock does

not have the same effect on the economy as other types of federal

spending. Different treatment in the budget would underscore this

distinction. However, creating different rules for stock purchases would

also undermine the possible incentive for addressing the deficit that exists

when Social Security’s surplus is excluded from the government’s

finances. If stock purchases were not treated as outlays, Social Security’s

surpluses would continue to obscure the size of this deficit. Counting

stock purchases as outlays, as current scoring requires, would make this

deficit more visible.

Instead of changing budgetary accounting procedures to deal with stock

purchases, it might be preferable to provide additional information on a

government stock portfolio as supplementary budget data. The Social

Security Trustees already issue annual reports that include information on

trust fund assets. These reports could be expanded to include an annual

statement of the government’s stock portfolio that would contain

Page 78 GAO/AIMD/HEHS-98-74 Social Security Financing
Appendix II 

Government Stock Investing and Federal

Budgetary Accounting

information such as the amounts invested, the nature of the investments,

and the change in market value of the holdings. In addition, similar

information could be included in the budget documents themselves.

Page 79 GAO/AIMD/HEHS-98-74 Social Security Financing
Appendix III 

Major Contributors to This Report

Accounting and

Information

Management Division,

Washington, D.C.

Jose Oyola, Assistant Director

MaryLynn Sergent, Senior Evaluator

Boston Field Office Andrew D. Eschtruth, Evaluator-in-Charge

Health, Education,

and Human Services

Division, Washington,

D.C.

Barbara D. Bovbjerg, Associate Director

Francis P. Mulvey, Assistant Director

Michael Packard, Economist

Ken Bombara, Economist

Ken Stockbridge, Senior Evaluator

Page 80 GAO/AIMD/HEHS-98-74 Social Security Financing
Page 81 GAO/AIMD/HEHS-98-74 Social Security Financing
Related GAO Products

Budget Issues: Long-Term Fiscal Outlook (GAO/T-AIMD/OCE-98-83, February 25,

1998).

Social Security: Restoring Long-Term Solvency Will Require Difficult

Choices (GAO/T-HEHS-98-95, February 10, 1998).

Social Security Reform: Demographic Trends Underlie Long-Term

Financing Shortage (GAO/T-HEHS-98-43, November 20, 1997).

Budget Issues: Analysis of Long-Term Fiscal Outlook (GAO/AIMD/OCE-98-19,

October 22, 1997).

Retirement Income: Implications of Demographic Trends for Social

Security and Pension Reform (GAO/HEHS-97-81, July 11, 1997).

Compendium of Budget Accounts: Fiscal Year 1998 (GAO/AIMD-97-65,

April 1997).

Federal Debt: Answers to Frequently Asked Questions (GAO/AIMD-97-12,

November 27, 1996).

Public Pensions: State and Local Government Contributions to

Underfunded Plans (GAO/HEHS-96-56, March 14, 1996).

Budget Account Structure: A Descriptive Overview (GAO/AIMD-95-179,

September 18, 1995).

(935214) Page 82 GAO/AIMD/HEHS-98-74 Social Security Financing
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