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 fund 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 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. 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. 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 revenues will cover only about 75 percent of expected benefit payments. In short, the program as currently structured is unsustainable. 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 borrowing needed to finance Social Security’s 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. 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. 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 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. 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. 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. Although Social Security is not a pension fund, the experience of public pension funds may yield some insight into the implications of the federal government allowing the Social Security trust fund to invest in the stock market. A public pension fund operates under a legal framework established by its sponsoring government. 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. 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. Finally, the sheer size and scope of Social Security dwarfs U.S. pension funds. 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. 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 Council. 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.