A New Framework for Social Security Reform

For decades, the debate over Social Security has followed a remarkably familiar pattern.

The system faces a long-term financial shortfall. Demographic changes are placing increasing pressure on it. Americans are living longer. The relationship between the number of workers contributing to the system and the number of beneficiaries receiving payments has changed. Eventually, the discussion turns to a relatively predictable collection of remedies.

Discussion has focused on scaring recipients and beneficiaries that their benefit will be cut by slightly over 20%.  Really?  Never as a state legislator did I hear of one proposal that cut government employees’ benefits.  Screams of “it’s unconstitutional” would rind loudly though the Rotunda net that is how we treat our citizens!

Other proposals include raising payroll taxes. increase or eliminate the taxable wage ceiling, raise the retirement age, modify the calculation of benefits or other such measures which pretend to “fix” the problem but merely mask over the complexities of the crisis.

But they begin too far downstream.

Before deciding how much more workers should contribute or how much less beneficiaries should receive, Congress should ask a more fundamental question:

Is Social Security structured and governed in a manner that places the long-term interests of its beneficiaries at the center of financial decision-making?

Social Security has trustees, but those trustees do not possess the investment discretion normally associated with pension fiduciaries. Federal law largely determines the investment policy for them. Trust Fund reserves are invested in interest-bearing obligations of the United States rather than through a prudently diversified portfolio of assets.

That means a Social Security trustee and a conventional pension fiduciary begin with fundamentally different questions.

A pension fiduciary can ask: What prudent investment strategy best serves our beneficiaries over the long term?

A Social Security trustee must first ask: What does federal law permit us to own?

The distinction is not an indictment of the trustees. If trustees are denied the authority to exercise investment judgment, responsibility for the investment structure rests with the law that imposed the restriction.

The problem is therefore structural and structural problems require structural solutions.

The financial crisis of 2008 provides an unusually powerful illustration. The Federal Reserve responded to an extraordinary economic emergency with extraordinary monetary policies, including quantitative easing and exceptionally low interest rates.

The Federal Reserve had a legitimate mission: stabilize the financial system and the broader economy. Social Security had a different legitimate mission: protect the retirement security of its beneficiaries.

The issue is not whether Federal Reserve officials were right or wrong. The problem was not that the Federal Reserve necessarily made the wrong decision for monetary policy. The problem was that Social Security had no ability to make a different investment decision for its beneficiaries.

Its investment structure had already been prescribed by law. As interest rates fell, Social Security could not alter its asset allocation in response. Whatever benefits low rates produced elsewhere in the economy, the Trust Funds necessarily experienced the investment consequences.

That exposes the governance question at the center of this proposal and that is who was sitting at the table solely to represent the beneficiary? The answer – no one!

My analysis estimated that the extraordinarily low-interest-rate environment associated with quantitative easing from 2008 through 2023 produced more than $2 trillion of foregone investment earnings when compared with a 6.5% long-term pension-return assumption.

That estimate should be challenged.

The $2 trillion figure therefore should not be treated as a booked investment loss. It is an estimate of opportunity cost under an alternative investment structure.

Congress should commission an independent analysis establishing appropriate risk-adjusted benchmarks, calculating the consequences of the statutory investment restrictions during the extraordinary monetary-policy period, and publishing the methodology and results.

If independent analysis establishes that national monetary policy imposed a substantial opportunity cost on a retirement trust that was legally prohibited from responding, Congress should then determine whether restitution is appropriate and, if so, in what amount.

Restitution should not be confused with solving Social Security. Restitution addresses the past. It cannot cure demographic imbalance, eliminate market risk or make unsustainable promises sustainable but neither should those realities excuse government from accounting for the consequences of the investment structure it created.

Account for yesterday honestly and design tomorrow more wisely.

The more important reform is prospective.

Social Security needs a governance structure in which independent fiduciaries are explicitly charged with protecting the long-term financial interests of beneficiaries across generations.

Someone needs to occupy that chair. Independent fiduciaries should therefore operate under clearly defined standards of prudence, competence, independence, diversification, transparency, internal control and accountability.

The first reform is not stocks. It is governance.

Diversification is not a free lunch.

Higher expected returns generally require accepting additional risk. Markets decline. Asset values fluctuate. Liquidity matters. Investment expenses matter. Governance failures matter.

Once appropriate fiduciary governance exists, should those fiduciaries be permitted to construct a prudent, diversified portfolio within carefully prescribed safeguards? The framework developed in the Social Security Restitution Act would prohibit direct government investment in individual companies.

Diversification could instead occur through broadly diversified vehicles such as mutual funds, exchange-traded funds, guaranteed insurance products and other authorized pooled investments. Equity interests would be nonvoting so that Social Security assets could not be used by the federal government to influence corporate governance.

Concentration limits would prevent the Trust Funds from becoming dominant investors in individual investment vehicles. Independent reporting, investment-performance measurement, internal controls and audit requirements would provide additional accountability.

The objective is not to increase government’s role in American capital markets. It is to permit prudent diversification while deliberately preventing political control of private enterprise.

Once this investment reform and restitution are completed, other reforms can be made. This sequence is crucial.

No one should claim that investment reform alone solves Social Security.

Demographics remains, benefits and contributions ultimately must be sustainable and the question of private ownership of the individual’s own contributed funds in a mandatory managed portfolio would have to be examined. (As a personal aside, I prefer private ownership but also realize that this is not politically palatable at this point).

But Congress should determine the size of the remaining actuarial problem after examining governance, restitution and prudent investment policy—not before.

That creates a fundamentally different sequence for reform:

1. Establish independent fiduciary representation for beneficiaries.
2. Independently measure the historical opportunity cost of the statutory investment restrictions.
3. Determine whether restitution is warranted.
4. Design prudent investment authority with stringent protections against government interference in capital markets.
5. Establish transparent performance, risk, internal-control and audit standards.
6. Recalculate Social Security’s long-term actuarial position under the reformed structure.
7. Only then determine whether additional changes to taxes, retirement ages or benefits are necessary.

That does not eliminate difficult choices.

It ensures that Americans are asked to make them only after government has examined what it can do better itself.

Social Security is inherently intergenerational. Its Trustees evaluate its finances over a 75-year horizon. Public policy addressing those finances should demonstrate comparable long-term thinking. Moving an exhaustion date several years into the future is not reform if the same crisis simply awaits the next generation.

We cannot solve a 75-year problem with a two-year election-cycle mentality. The goal should not merely be to make Social Security survive the next funding deadline.

The goal should be to create a governance and financial structure capable of serving today’s retirees, today’s workers, their children and workers who have not yet entered the workforce.

Congress does not need to accept this framework today.

It needs to examine it seriously.

Before imposing higher taxes, reduced benefits or later retirement on American workers, Congress should commission an independent examination of Social Security’s governance and investment structure.

That examination should answer five questions:

• Who has an exclusive fiduciary responsibility to Social Security’s beneficiaries?
• What was the risk-adjusted opportunity cost of the Trust Funds’ statutory investment restrictions, particularly during the extraordinary low-interest-rate period?
• Is restitution appropriate, and how should it be calculated?
• Could prudent diversification improve long-term outcomes without giving the federal government political influence over private capital markets?
• After those reforms are modeled, what actuarial shortfall remains?

But government should first demonstrate that it has done everything reasonably possible to improve the stewardship of the resources already entrusted to it.

Generations of American workers have fulfilled their obligation. They deserve an institution governed with the same seriousness with which they funded it.

The principle underlying all five articles in this series ultimately comes down to one sentence:

Every trust has advocates. Every beneficiary deserves one.

Put the beneficiary back at the table.

Fix the governance.

Measure the past honestly.

Protect the future.

Then determine what sacrifices remain necessary.

Don’t mask the problem.

Solve it.