Academic journal article The McKinsey Quarterly

Banking on US Social Security

Academic journal article The McKinsey Quarterly

Banking on US Social Security

Article excerpt

Private Social Security accounts will challenge financial institutions, but the opportunity is huge--and may be replicable in other countries as they reform their retirement systems.

Last year's presidential campaign in the United States catapulted Social Security reform -- once known as the "third rail" of the country's politics because nobody dared touch it--to the top of the political agenda. Many proposals, including those put forward by President George W. Bush and former Vice President Al Gore last autumn, had at their center the idea of creating private Social Security accounts held in financial institutions and invested in public markets. Reform of the system, with its huge tax revenues of $500 billion a year, is now among the Bush administration's top legislative priorities.

This is a great opportunity for financial institutions--or is it? [1] Some of them should look more closely at the potential impact of creating large volumes of small private accounts. Brokerage houses, retail banks, insurance companies, and mutual-fund managers could all be affected in different ways. The size of accounts, the guarantees required for them, the way they are administered, what investment products are allowed or disallowed--any of these things could turn private Social Security accounts into money losers. And if institutions wait to see how reform takes shape before considering its implications, they will forfeit the opportunity to prepare for it and to influence its direction.

Of course, the case for reform stems from the widespread belief that the US Social Security system can't withstand the mounting pressure of a baby-boomer population aging its way toward retirement. With the number of retired people growing, a smaller number of young workers are shouldering more and more of the burden. This demographic reality is widely shared: the governments of countries as diverse as China, Germany, and Sweden are now debating pension reform. Nowhere is the pressure more intense than in Western Europe, where the demographic shift is taking place faster, the shortfall is larger, and high personal and corporate taxes leave little room for increases. [2]

The pension reform packages of a number of governments have included the investment of funds in public markets as a prominent feature. In certain countries, such as Australia, Chile, and the United Kingdom, these investments are channeled through privately managed accounts; in others, such as Singapore, through government-managed trusts. The innovators have taken different positions on how best to protect beneficiaries and to encourage performance while minimizing costs.

Challenging economics

Since the spectrum of possible Social Security reforms is quite broad, we focused on the Bush and Gore proposals to illustrate what could eventually happen. [3] The new US administration can be expected to frame its legislative proposals around the Bush campaign ideas. And the ideas embodied in Democratic proposals, such as the one Mr. Gore made during last autumn's campaign, will likely be influential in shaping the debate. The Bush and Gore proposals would create 50 million to 110 million private accounts, with as much as $100 billion a year in new funds flowing into the financial markets. [4] Although these figures are small as against the $25 trillion currently invested in US financial markets, they are quite substantial when compared with the average net long-term equity inflow of $225 billion into retail mutual funds since 1997. Eventually, money in private Social Security accounts would accumulate to form large pools of assets--pools larger than today's $2 trillion market for individual retirement acco unts (IRAs) and, in the long term, perhaps constituting as much as 5 to 10 percent of the private financial wealth of the United States.

Would private institutions manage these assets profitably? The new accounts will be equivalent to 25 to 50 percent of the volume of existing mutual-fund accounts, while the assets in the new accounts will be more fragmented and accumulate only slowly. …

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