Privatization of Public-Sector Pensions
Clark, Robert L., Craig, Lee A., Wilson, Jack W., Independent Review
The U.S. Navy Pension Fund, 1800-1842
Recent projections indicate that expenditures on Social Security retirement benefits will begin to exceed payroll-tax revenues and trust-fund earnings before the year 2020, and the Old Age, Survivors, and Disability Insurance (OASDI) trust fund will be depleted within roughly ten years of that date. If substantial changes are not made in the Social Security system, then expenditures are projected to exceed revenues by more than 5 percent of the payroll covered by the Social Security tax. Numerous analysts, commissions, business groups, and labor organizations have studied this situation and made recommendations for changes in the system. One proposal is for changes in the investment strategy of the OASDI trust fund. Presently, tax receipts beyond current outlays are placed into the trust fired, which is permitted to invest only in special-issue U.S. Treasury "bonds," which are essentially accounting entries in the budget of the U.S. government. Many reformers favor some type of private investment of Social Security funds. Proposals include (1) retaining the current structure of Social Security benefits but investing part of the existing trust fund in private equities and bonds, (2) establishing small individual accounts that would be centrally managed with some or all of the funds being invested in private securities, and (3) directing most of an individual's Social Security taxes into private accounts that would have a wide range of private investment opportunities.
Proponents of investing Social Security funds in private securities point to the higher expected returns compared to current investment practices. If the funds were invested in the equity or liabilities of private corporations and if they earned returns similar to the average returns over the past fifty years, then Social Security recipients could enjoy greater retirement benefits at the same cost, or the same benefits with a lower tax burden, or some combination of the two. Depending on the proposal and the investment strategy, such a change in investment practice could partially alleviate the system's long-run financing problems.
Opponents of investing a portion of Social Security funds in private assets highlight the greater risk associated with private securities relative to federal debt. Those risks include greater variation in year-to-year returns, possibilities of large capital losses, and the risk of fraud and malfeasance in the management of the funds specifically and in financial markets more generally. Inevitably, with private investments some retirees may have lower pension benefits than they would have had if all funds had been invested in government bonds, whereas other retirees will have higher benefits.
The debate over permitting the Social Security trust fund to invest in private securities has proceeded without reference to past U.S. experience with the investment of public pension funds in private securities. Indeed, our review of the literature suggests that participants in this debate have assumed, either implicitly or explicitly, that federal pension funds have never been invested in private assets. But they have been. In the first half of the nineteenth century, a substantial proportion of the assets in the U.S. Navy pension fund were used to purchase equity in private companies.
Although the modern Social Security system dwarfs the nineteenth-century navy pension fund in both size and scope, the issues involved in the coverage and funding of the benefits reflect many of the same concerns facing the Social Security system today, and the history of the navy pension fund provides a case study of the potential problems associated with the investment of public pension funds in private equities. Among those problems are the government's inability to credibly shift the risks associated with privatization to those insured by the fund and the government's tendency to increase the benefits as the fund grows. …