A champion of social security privatization
In the swell of discussion over social security reform in the US, one voice has consistently cut through the diversity of opinion with the honed edge of hard data. For William Shipman, data is a loyal ally. To critics of the reform – who caution that investing part or all of social security taxes in the markets is just too risky, that it would hurt low-wage workers, that money managers would take too big a cut – his pronouncement that the data he has gathered would disagree is a coup de grâce.
In the US, Congress is finally lumbering toward privatizing social security, but Shipman’s cry has been heard well beyond the US, too. Indeed, it has been heard on every continent but Antarctica, and Shipman, who is a principal at giant fund manager State Street Global Advisors in Boston and a co-chairman of the Cato Institute project on social security privatization, seems as at home in Hungary or Chile – two countries that have gone down the market route – as he is coolly sliding into a Tribeca eatery in pin-stripes.
Just as coolly, he rolls out the all-important data, nuggets from a brace of Cato Institute reports and the book he authored with State Street Corp chief executive Marshall Carter in 1996, Promises to keep: saving social security’s dream. The book is credited with defining the debate’s current terms: In 1950 in the US there were 16 workers per retiree, today there are three and in 2025 there will be two. Under the current system, social security runs out of cash in 2015; the demographics mean payroll taxes would have to go up by 50 percent or benefits would have to be cut by 33 percent. In other words, the money is running out fast and Americans who are paying into the social security system today cannot count on their pay-outs tomorrow. And then people really won’t be happy.
Big hit
The US government’s problem now – in a year that should see the first budget surplus since 1969 – is not a cash flow crisis; it’s the present value of unfunded liability of the old age and survivors insurance (OASI) system. Says Shipman: ‘We’re underwater by $3 trillion, and we need a hit right now. Of course that doesn’t exist. In the long-run, we have to go to markets to solve the problem.’
Shipman is fairly sure the US will pass legislation to reform social security next year. Just how it will look remains open to speculation. ‘There will be some choice for the individual over staying in the existing system or moving to the market alternative,’ he ventures. Out of the current 10.7 percent payroll tax, two to four percent would be invested in the markets, though with some asset allocation restraints in order to help control risk. ‘Depending on the savings rate and the investment return, you have a big chunk of money when you retire. Or a smaller chunk,’ he admits.
But there’s some serious opposition to Shipman’s ideas. Volatility of the market is just one area of concern. Low-income workers, reform critics say, would be hit hard by the loss of social security’s current progressive benefit formula, which redistributes wealth from high wage earners. But Shipman says they win the most. Take a 21 year-old making 50 percent of the average or roughly $13,500, paying 10.7 percent in OASI tax. ‘With very little wiggle room, you’d better make sure this 10.7 percent is well spent.’ How well spent is it under today’s law? When he retires at age 67, this individual will get $841 a month (in today’s dollars) compared to $1,400 a month if part of the tax was invested in a balanced fund with a modest return of 7.8 percent – ‘An extraordinary increase in his well-being,’ comments Shipman.
And it could get even better. The current ‘replacement rate’ for social security benefits is 42 percent, which means a worker gets 42 percent of his final year’s salary in retirement benefits. Shipman envisions a system that would crowd out all manner of defined benefit and defined contribution plans: with a 10 percent savings rate and 10 percent return, today’s 21 year-old making $25,000 a year will have a replacement 200 percent – receiving $50,000 a year as a retiree.
Destination: the world
The idea of investing retirement money in the markets is not without precedent, nor without parallel. Eastern Europe is especially stormy, with Hungary, Poland, Latvia, Kazakstan, Slovenia and Lithuania restructuring state pensions. Lately Shipman has been quizzed by German and Russian journalists interested in their respective countries’ reform efforts.
Chile was the first to tumble in 1981, restructuring a pay-as-you-go system so Chileans could invest in markets, with 25 percent of the labor force jumping aboard in the first month. Just eight years earlier, Chile was the highest per capita recipient of foreign aid in the world – ‘basically a third-world basket-case.’ But over the last eleven years, GDP has grown about seven percent per year, with a savings rate of 26 percent compared to about three percent in the US; Chile now has the lowest unemployment rate in Latin America, virtually no labor unrest, and the pool of wealth built up in the privatized system is roughly 42 percent of GDP. In US equivalent terms, that’s just shy of $3.5 trillion.
‘Sold!’ cry a slew of advocates behind varying degrees of US social security reform, including Shipman’s Cato Institute which has published dozens of reports and raised millions for the cause. Former social security commissioner Robert Ball, who argues for tinkering with the current system without introducing individual accounts, estimates there are 15 different privatization plans already fielded. Meanwhile, detractors such as organized labor and the powerful American Association of Retired Persons have largely been missing from the picture. The AFL-CIO claims it’s a calculated silence, with plans to unleash a last minute advertising blitz as the debate matures this fall.
Razor thin margins
As for Shipman, little digging is needed to uncover the benefit of privatized pensions for State Street – in the US and around the world. ‘The investment management industry is going to be highly competitive, with razor thin margins. The politics demand the cost be kept down, so at the beginning it will be mostly indexed funds.’
There’s the rub: some $207 bn out of State Street’s $471 bn in assets under management is indexed in 54 different countries, making the institutional investor one of the world’s biggest indexers. As Shipman explains, fund management has evolved from an elite profession to a business with tremendous economies of scale. For example, with $25 bn in S&P 500 indexed assets, 93 percent of State Street’s S&P 500 trades are done internally: zero transaction costs, zero market impact and zero brokerage commission. ‘How can you compete with that?’ Shipman challenges.
For public companies – and their investor relations officers – the impact is a little more blurry but probably still beneficial. For a start, as social security benefits rise as a result of potentially higher market returns, corporate liability will fall so companies will have to pay out less in pensions.
Delving deeper, as the proportion of passive, indexed holdings rises, investor relations officers would be able to devote more energy to the pressure points of active managers – which Shipman insists would continue to thrive and cater to specialized interests. And as national savings goes up, as it did in Chile, there would be more funding available for companies. In Hungary, which privatized pensions at the beginning of 1998, as much as $5 bn is expected to pour into the country’s capital market by 2000. Poland, whose equity market is capitalized at around $13 bn, is expecting pension reform to inject up to $2.6 bn in its first year.
However some critics warn of a near-term ‘speculative bubble’ in the US as baby-boomer retirement savings pour into the market, then a collapse as they start withdrawing (see Classical Economics, page 7). Shipman quickly squashes the notion. Out of $3.2 trillion in social security tax collected in 1997, reform proposals would see around $350 bn invested in markets – actually only about 6.3 percent of the NYSE’s trading volume, or 25 minutes out of the six-and-a-half hour trading day.
The main benefit to companies – and stock prices – would be the elimination of a deep-rooted economic distortion, Shipman suggests. ‘Payroll tax causes a distortion because the return on the tax is very low relative to return on markets. If we go to a market-based system, that distortion goes away. Economic growth would be greater as a result of lower taxes. As the economy grows more rapidly, it’s reasonable that earnings would grow more rapidly, stock prices would rise, and the cost of equity financing would be lower. That’s all to the good.’
As the debate over social security reaches boiling point in the US, Shipman will continue to range the globe fanning the flames as best he can. His next stop is Australia to meet with senior government officials. Then it’s off to Poland again. Everyone from Russia to Trinidad and Tobago is examining the issue. Indeed, like El Niño, Shipman’s impact is being felt around the world.