Why social security will go to the market
Sunday 12 January 1997
Am I going over the top? I don't think so, but judge for yourselves.
What has happened is this. The US is closer to having a funded state pension scheme than most European countries in that, rather than relying purely on a pay-as-you go system, it has an actual fund into which social security contributions are paid and then invested for the future needs of the payers. There has been considerable pressure in the States for these welfare funds to be invested in equities as well as in government securities, partly because the former generally produce a higher return and partly because there will be a gaping hole in the social security fund unless something is done.
The US social security fund has given a 2.3 per cent real return on investment, whereas a typical fund invested in shares would give a 7 per cent real return. As far as the gaping hole is concerned, well, look at the first two graphs shown here. The number of workers per beneficiary has plunged since the 1960s from five to a little over three, and will fall to fewer than two by the 2020s. Meanwhile, people are living longer and therefore drawing on their pensions for a longer period.
The US is not alone in these problems, but the States, unlike continental European countries, is at least admitting that there is a problem. So Congress appointed the 13-member Advisory Council to assess what should be done. Its findings were published last week.
It could not agree on a single plan and instead presented three options. The first, and least radical, suggested that the basic system should remain the same but with some increases in contributions. This is called the "maintain benefits" plan. However it also proposed that up to 40 per cent of the inflow of funds into social security from payroll taxes should be invested in the market.
The next option, dubbed "individual accounts", also keeps the present system but suggests that there should be an additional 1.6 per cent on the payroll tax which would be invested in the market, under a number of government- administered schemes, but with the individual able to choose which one.
The third option, "personal security accounts", is the most radical. This would allow 40 per cent of each person's social security contributions to be invested by individuals in their own personal retirement accounts. The setting aside of the money would be compulsory but the choice of investment would be up to each individual.
Now, I have no idea which of these plans, if any, is likely to be adopted but it would seem utterly inevitable that US social security funds will, in some measure, be invested in the stock market. All members of the committee were in favour of that. The amount being invested annually under options two and three is shown in the graph. (The amount invested under option one would depend on the proportion of funds that was diverted to the market, which is still very much an open debate.)
As you can see, under the third scheme, by 2010, there would be $4,000bn a year flowing into the US equity market. Even under the second scheme the inflow would be more than $1,000bn. These are very big numbers even in US terms. What, in practice, might this mean?
Any element of investment of social security funds in the market, rather than in government bonds, must be good news for the financial services industry. As you might imagine, there has been a flurry of excitement in the US finance sector at the juicy prospect of investing all that money and the fees this would generate. Unsurprisingly, the notion has aroused some hostility, for not everyone in the US goes a bundle on the level of Wall Street fees. But to focus on this aspect - as much of the comment has done - misses the bigger issue of what any such transfer will do to the price of, and return from, financial securities.
Put at its simplest, a new big wodge of money coming into the stock market year in, year out, will boost the price of existing securities, until there is a corresponding rise in the supply of new securities. That might seem wonderful but, of course, any rise in the price of existing securities means a fall in the return on them.
This is what happened in Japan. The stock market soared but the dividend yield in most cases is below 1 per cent. And if dividend yields are down there is nothing underpinning the capital value if the inflow into the market, for whatever reason, stalls. People in Japan relying solely on equities to pay their pensions have faced a catastrophe. The US does need more savings but it will also have to create new investment vehicles to absorb those savings.
What might these be? The obvious broad area is in the public utilities and in infrastructure. We think of the US as the ultimate capitalist society but, unlike the UK, large elements of the infrastructure are still owned by the public sector: airports, water, power. Expect these gradually to be transferred to private ownership because, with the partial exception of China, the US is the only major part of the world where privatisation has yet to make a big impact. To make the (partial) privatisation of pensions work, the US needs to privatise other parts of the economy.
As far as the rest of the world is concerned, expect the privatisation of state pensions to gather pace. The problem is universal. Actually, the demographic pattern is much worse in other Group of Seven countries than it is in the States, for in the year 2020 the US will have the lowest proportion of people over the age of 65 of any G7 country. (The UK will have the second lowest.)
In the UK, a new Labour government would be very interested in the idea of some kind of compulsory savings scheme: we know that from the interest shown by the party's leader Tony Blair in the Singapore system and from the work of Labour MPs like Frank Field. If the US moves forward, this will give an impetus to Labour's planning.
I would expect that the next country to follow US practice would be Japan, where the ageing demographic pattern is most extreme. Japan is currently deregulating its securities markets, imitating (at least in form) the City of London's "Big Bang" of 1986. Changes to the capital market, making it less rigged, would help it to absorb an additional inflow of savings without the boom/bust cycle of recent years.
Eventually it seems reasonable to expect continental European countries to start to move towards market-funded state pension schemes. Already there is a boom (in most cases from a very low base) in privately-funded pension provision. At some stage in the first decade of the next century, expect France and Germany to shift part of their state pension funds into the equity market too.
One of the extraordinary features of the world at the moment is the pace at which ideas generated in one country transfer to another. Cuts in the top rates of income tax in the United States in the 1970s and privatisation in Britain in the 1980s have both swept the world. Now I suggest that investing state pension money in equities - in effect the privatisation of part of the social security system - is set to do the same.
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