Investment Firm 'Windfall' from Social Security Privatization Won't Happen
Sometimes an academic study offers much less information than it claims. And sometimes what appears to be an academic study is not a study at all.
Professor Austan Goolsbee of the University of Chicago, who has done respected work on other financial issues, has written a study that claims to prove the system of Social Security personal retirement accounts proposed by Plan II of the President's Commission to Strengthen Social Security would result in an unprecedented "windfall" for financial services firms. Goolsbee's study, "The Fees of Private Accounts and the Impact of Social Security Privatization on Financial Managers," was issued by the university in September 2004.
A closer examination of the study shows it is riddled with errors, unjustified assumptions, and sensational but meaningless numbers.
Fee Level Estimate Far Too High
Goolsbee rejects the 0.3 percent annual administrative fee that the Social Security Administration (SSA) and other reputable experts use to estimate the costs of the personal retirement accounts that would be established under the Commission's Plan II. Instead, Goolsbee claims a 0.8 percent annual fee is more appropriate.
His assumption is simply wrong. Although that fee level would be appropriate for a system of individually managed accounts with a high level of personal services, this is not what the President's Commission to Strengthen Social Security would create. Instead, the commission called for a simple, centralized investment plan modeled after the Thrift Saving Plan that is offered as part of the retirement program for federal employees.
Goolsbee argues a 0.3 percent fee would cover only "individual accounts where there is little or no customer service and where individuals are not allowed to make choices about their investment mix." But that is basically what the commission plan would create, not the sort of accounts Goolsbee envisions in his estimate. Moreover, the SSA and Congressional Budget Office have concluded that even limited accounts could in fact offer their holders some investment choices at the 0.3 percent fee level.
A 1999 study by professional fund managers at State Street Corporation, led by Bill Shipman, estimated a plan similar to the one proposed by the commission would have administrative fees around 0.3 percent. The State Street study is especially important because it estimated the costs of answering phone calls from account holders, developing the necessary computer equipment and programs, providing annual statements, and shifting between investment options.
In short, Goolsbee's administrative cost estimates might be appropriate for one type of personal account structure, but that structure is vastly different from the one he claims to be studying. The President's Commission proposed a system of simple, low-service accounts, for which a 0.3 percent annual administrative fee is more realistic.
Phantom Requirement Assumed
Goolsbee claims the commission's Plan II requires account holders to convert their accounts from a low-cost centralized system to high-cost private management when they reach $5,000 in assets. He uses this to justify his assumption of higher fees.
But Plan II requires no such thing. Instead, it would create a low-cost, centralized system in which workers could remain throughout their careers. And while the plan recommends examining the possibility of moving to private managers, that discussion is put off for the future. And even then, a system based on Plan II would allow such a move if it proved feasible, but it would not require workers to convert their accounts.
Even if a plan allowed workers to move their personal retirement accounts to a private manager at a higher cost, only a few workers would take that opportunity. Only a few of the potential fund managers could offer higher returns, after subtracting the greater administrative fees, than the centralized system could provide. Workers who saw their earnings fall would promptly return to the centralized system.
Moreover, when retirement account holders are faced with choices and are uncertain about what to do, they usually end up doing nothing. Because workers would have to decide affirmatively to use a private funds manager and would not be moved to one automatically, most would do nothing and would therefore remain in the less expensive centralized system.
Ignores Benefits and Improved Security
Goolsbee's calculations also ignore the benefits that would accrue from a system of personal retirement accounts. The first question that should be asked when someone talks about fees is, "What do I get for that money?"
For a younger worker, today's Social Security offers minimal or even negative returns. A 20-year-old male can expect an ultimate annual return on his lifetime of Social Security retirement taxes of 0.85 percent, while a 20-year-old female can expect a return of 1.91 percent. The difference is largely attributable to differences in life expectancy. The female can expect to live until age 84.3, whereas the male can expect to live to age 77.3.
Goolsbee admits that returns for personal retirement accounts would range from 4.6 percent under a 0.3 percent administrative fee to 4.1 percent under his 0.8 percent annual fee. Any positive return would certainly be an improvement for a 20-year-old male, and even the 4.1 percent return is more than twice the return a 20-year-old female could expect from today's Social Security. In addition, both of these individuals would receive retirement benefits based in part on assets they own, rather than depending solely on government promises.
In short, the better return is clearly worth even the exaggerated administrative fee Goolsbee falsely assumes. This is not a case where the funds managers will get fees for doing nothing; their activities will increase individual worker's retirement assets.
Estimates Revenues, Not Profits
Even if Goolsbee's $940 billion estimate of fees paid to financial firms were correct, which it is not, it is still not an estimate of profit. Instead, Goolsbee estimates gross revenues to financial managers. From that number must be subtracted the costs of keeping records on 140 million or more accounts, answering questions from account owners, providing regular statements, processing individual workers' investment changes, doing research into investment options, making trades, etc.
Altogether, this is not a cheap proposition, and significantly, the federal government, not the financial industry, would undertake many of these administrative functions. Only a small portion of the total fees would be left for the financial industry to profit from.
The 1999 study by State Street Trust assumed that, nationally, a personal retirement account system would generate 175 million to 350 million calls a year from account owners--including 26 million to 52 million calls that would have to be handled by humans instead of an automated phone system--14 million investment fund transfers, and more than 140 million annual account statements.
Administrative fees would pay for all of these services. Calling the fees a "windfall gain" is therefore both irresponsible and just plain wrong.
Sensational but Meaningless Numbers
The executive summary of Goolsbee's study is filled with sensational numbers, such as an assertion that administrative expenses for personal retirement accounts would amount to more than 25 percent of Social Security's anticipated deficit over the next 75 years. Goolsbee also makes claims about the impact of his estimated gross fee on financial firms and the costs workers' personal accounts would incur as a result of the administrative fees. Under close examination, however, these numbers mean little or nothing.
Comparing Goolsbee's inflated administrative cost estimate with Social Security's estimated deficit, for example, implies this money could be used to help fix the current program. But the money represented in his administrative fee estimates results only from having personal retirement accounts. Because these accounts grow at least twice as fast as today's Social Security, they produce earnings that can be used to pay administrative fees. Without the earnings from these personal accounts, the money that would be spent on fees simply will not exist and therefore would not be available to fix Social Security.
Similarly, saying the administrative fees are more than eight times higher than financial firms' revenue loss between 2000 and 2002 sounds important until one remembers Goolsbee is comparing vastly different time periods. In other words, all Goolsbee's statement means is that his estimate of total administrative fees over 75 years is eight times higher than the industry's losses over three years. One hopes any industry would earn vastly more over 75 years than it lost over any three-year period.
Finally, stating that any set fee level would reduce a personal account, without considering what would be gained, misses the point. Because administering an investment account is not free, every account has a cost. Even today's Social Security spends 0.6 percent of its outlays (about $250 million in 2003) to administer the program. A more realistic estimate is that fees will reduce the size of an individual's account by 8 percent rather than Goolsbee's estimate of 20 percent. And even that 20 percent is a cheap price to pay if the account earns a return twice that of today's Social Security.
Not an Academic Study
A sure sign that Goolsbee's study was primarily intended to influence the election debate over Social Security is the intemperate language and exaggerated conclusions contained in the executive summary. Stating that the revenues he claims would go to financial managers would be "the largest windfall gain in American financial history," without noting this figure would be gross revenue and not profits, is utterly irresponsible. No real academic study would make such a claim.
Although Goolsbee has produced respected research on fees associated with 529 education investment accounts, the current study is not up to those standards. It is filled with faulty assumptions and sensational numbers designed to confuse the debate over Social Security's future, rather then to educate the public.
David C. John is research fellow in social security and financial institutions in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.