How can the U.S. transition to personal public private social security saving accounts
How Can the U.S. Transition to PersonalPublic-Private Social Security SavingAccounts?Options for “risk-averse” investors in a post-crisisworldMatias H. Zelikowicz (Duke University)+ =
2Table of ContentsI. Introduction1. Overview of Problem and Context: Trouble in ParadiseII. Different Pension Arrangements in the United States1. Types of Retirement Plans2. Funding of Pension Plans3. Organization of Pension PlansIII. Problems With Social Security and State Pensions1. Demographic Challenges2. The Numbers at the U.S. State Level: “State of Denial”3. Diagnosis of the Problem: Government and Market FailureA. Information Asymmetries: “My Financial Advisor Needs Advice”B. Macroeconomic Dynamics: Hedge Funds Can Not Hedge RiskC. Federal Reserve: “The Blind Leading The Blind”D. Problems Inherent in Representative Democracy4. Past Attempts to Solve the Problem
3IV. The Dilemma of Investment Choices1. “To Risk or Not to Risk”A. Low Interest Rates: Cash is Not KingB. Mutual Funds: Costs and BenefitsV. The Ryan Plan1. Problems With The Ryan PlanVI. Personal Public- Private Social Security Accounts (PPPSSS)1. Market Linked CDs: Is Equity Investment Without Market Risk Possible?A. Most Popular MLCD StructuresB. Performance of MLCDs: Historical ResultsC. Drawbacks of MLCDsD. Addressing the Drawbacks of MLCDs Inside PPPSSS Accounts2. How Do PPPSSS Work?VII. Final Remarks and ConclusionVIII. AnnexesIX. Bibliography
4Abstract:The main purpose of this paper is to provide an overview of the fiscal sustainability challenges and demographicpressures that social security and state pension plans confront in the United States. The paper then describes aspecific plan for the partial privatization of the pay-as –you-go (PAYG) social security program, and a transition topersonal public-private social security saving accounts (PPPSSS). Finally it describes the specific investment choicesthat would be available inside PPPSSS accounts.
5I. Introduction1. Overview of Problem and Context: Trouble in ParadiseAfter the devastating effects of the Great Depression, the creation of the Social Security systemin 1935 made the prospects of a comfortable retirement a reality for most workers in theUnited States and other industrial countries. Nonetheless, the latest financial crisis andrecession has further exposed the need for reform of a pension system that was already undersignificant stress.The main purpose of this paper is to provide an overview of the fiscal sustainability challengesand demographic pressures that social security and state pension plans confront in the UnitedStates. The paper then describes a specific plan for the partial privatization of the pay-as –you-go (PAYG) social security program, and a transition to personal public-private social securitysaving accounts (PPPSSS). Finally it describes the specific investment options that would beavailable inside PPPSSS accounts. The paper is organized as follows. Section II describes thedifferent pension arrangements in the United States, beginning with its financing, and thenturning to their organization. Section III describes the problems and challenges with the PAYGsocial security system, state pensions, and the past attempts to solve the problems. Section IVdiscusses the problems with the current type of investments available in most retirement plans.Section V discusses the Ryan Plan as one of the alternatives to reform the PAYG social securitysystem and some of the problems with it. Section VI makes the case for the partial privatizationof the social security system, discusses its implementation, and the investment options thatwould be available inside the PPPSSS accounts. Section VII contains some concluding remarks.
6II. Different Pension Arrangements in the United States1. Types of Retirement PlansThe objective of a pension system is to “create a mechanism for consumption smoothing, and ameans of insurance”1. In the United States, pension provision is comprised not only by socialsecurity, but also state pensions, private defined benefit (DB) pensions, traditional IRAs, RothIRAs, SEP-IRAs, employer based defined contribution (DC) pensions such as 401(k) and 403 (b)plans, and non-qualified 457 plans for state employees, among others (see Annex 1 for adescription of the different retirement plans).In a perfect world scenario, retirement needs will be met by voluntary arrangements; however,due to social reasons (poverty relief) and investors’ shortsightedness, government involvementhas played a major role in the system not only through the establishment of social security, butalso by providing tax incentives for private and public retirement plans.2. Funding of Pension Plans in the United StatesPensions in the United States are either fully funded or PAYG.With a fully funded scheme, “pensions are paid out of a fund built over a period of years from itsmembers’ contributions. On the other hand, with a pay-as-you-go scheme, (most countries run theirpublic pensions on a PAYG basis) pensions are paid out of current income…From an aggregateviewpoint; we simply are taxing one group of individuals and transferring the revenues to another.”21Barr, Nicholas, and Peter Diamond. “The Economics of Pensions.” Oxford Review of Economic Policy 22.1 (2006): 15-39.2Barr, Nicholas, and Peter Diamond. “The Economics of Pensions.” Oxford Review of Economic Policy 22.1 (2006): 15-39.
7Nevertheless, it is important to highlight that despite these polar opposites, notional or partial fundingstructures are very much a part of the pension system.3. Organization of Pension PlansWithin the two ways of financing pensions, there are three common ways to organize them:Defined-contribution, defined-benefit, and notional defined-contribution. To begin with, in adefined contribution scheme, members make fixed contributions into an account; thesecontributions are accumulated in the account as well as the return on investments. In a definedbenefit scheme (they can be run by the government or a private employer), a worker’s pensionis based on his wage history and length of service. Lastly, a notional defined-contributionscheme shares some characteristics of the fully funded and PAYG schemes. In this type ofscheme, benefits will on the hand depend on the accumulation of contributions, and on theother hand, it is similar to a PAYG scheme since it is also unfunded. This is due to the fact that,current contributions go to pay for the current benefit of pensioners. In the public sector,tensions have derived from defined benefits plans due to the fact that the risk of adverseoutcomes falls on current taxpayers.III. Problems with Social Security and State PensionsThe tension that has arisen from PAYG systems such as social security and some nationalpension plans is born out of the fact that; pensions are paid out of current income, the taxing ofone group of individuals (currents workers) and the transferring of the revenues to another(retirees) has to be balanced because if you tax the working population excessively, the risk of“tax revolts” or political costs may be too high.
81. Demographic ChallengesWhen President Franklin D. Roosevelt signed the Social Security Act in 1935, social security wasset up as a “pay-as-you-go” (PAYG) program in which today’s workers are paying for thebenefits to today’s pensioners and other beneficiaries through their payroll taxes. According tostatistics that describe the historical trends in the dependency ratio3, “in 1940, there were 42workers per retiree; in 1950, the ratio was 16-to-1; today, there are 3.3 workers per retiree,and within 40 years, it’s projected that there will be just two workers per retiree.”4This is asignificant development because the numbers of taxpayers that support the current system arediminishing every year.At the present rate, as life expectancies continue to rise, the system will not be able to sustainitself into the future without major reform. Moreover, in the U.S., the share of population aged65 or over accounts for 18.6% and “is projected to nearly double between 2000 and 2050… Thesharpest effects will generally be felt over the next two to three decades, as the baby-boomgeneration reaches retirement age.”5These demographic trends are very concerning becauseage dependency ratios are a measure of the age structure of the population; consequently, asthe number of individuals that are likely to be “dependent” on the support of a smaller pool oftaxpayers increase, the system will be under an even bigger stress.3Age dependency ratios are a measure of the age structure of the population. They relate the number of individuals that are likely to be“dependent” on the support of others for their daily living. OECD. "Society at a Glance: OECD Social Indicators 2006 Editionhttp://www.oecd.org/dataoecd/4/24/38148786.pdf4“Age Dependency Ratios and Social Security Solvency.” CRS Report for Congress, 27 Oct. 2006. Web http://aging.senate.gov/crs/ss4.pdf.5Whiteford, Peter, and Edward Whitehouse. “Pension Challenges and Pension Reforms in OECD Countries.” Oxford Review of Economic Policy22.1 (2006): 78-94. Print
9Today, “more than 30 million Americans depend on social security to provide a significant shareof their retirement income”6and this number will continue to grow as the baby-boomergeneration retires in record numbers in years to come. As a result, social security will go intodeficit in 2017 (Graph 1 shows social security’s long term fiscal outlook).Graph 1: Social Security from Surplus to Deficit7Demographic pressures also threaten the fully funded system. In this scenario tensions arisefrom the fact that life-cycle investment requires investment in risk free assets (usuallygovernment bonds) toward the end of the lifecycle of a retiree, but when those bonds mature,the government needs to tax current workers in order to redeem those bonds; thus, the systemin a way resembles the PAYG. The main difference is that in a fully funded system, tax increasescan be delayed for a few years until a large portion of the populations enters the last stages of6Ryan, Paul. A Roadmap For Americas Future. http://www.roadmap.republicans.budget.house.gov/plan/#retirementsecurity7"State of the Unions Finances a Citizens Guide." Peter G. Peterson Foundation Our America.
10the retirement investing cycle. In other words, it can only be delayed until investors allocate alarge portion of their savings into government bonds.Moreover, many governments whether at the state or federal level not only have been ignoringtheir explicit (formal) debt commitments and liabilities such as the bonds that they issue, butthey also have been reluctant to address the implicit unfunded liabilities (i.e. pensions) becausethey depend on the social covenant agreed upon with the citizenry. According to the PetersonFoundation, on January of 2008, the implicit liabilities of the U.S. to Medicare, Medicare andSocial Security account to 42.9 trillion dollars.8This phenomenon will have to be reversedbecause if the U.S. government does not take a proactive approach to dealing with its fiscalimbalances, it runs the risk that markets and “bond vigilantes” will take the lead, and this willbe potentially devastating.2. The Numbers at the U.S. State Level: “State of Denial”On the state pension side, the trend is not very encouraging either; according to estimatesprovided by Joshua Rauh from the Kellogg School of Business and Robert Novy-Mark from theUniversity of Rochester, “state’s pension shortfall may be as much as $3.4 trillion, andmunicipalities have a hole of $574billion…If pension promises are kept, this will place immensestrain on taxes since several states have promised annual payments that will absorb more than30% of their tax revenue”9. Moreover, the enormity of this number has made some forecasters8States of the Union’s Finances A Citizen’s Guide. Print. Peter G. Peterson Foundation, March 20099“A Golden-plated Burden.” The Economist Magazine 16 Oct. 2010: 95-96.
11such as Meredith Whitney10proclaim that the state’s troubled fiscal situation can potentially bea source of systemic risk for the financial system in a not too distant future.In response to this dire situation, “lawmakers and governors in many states, faced with hugeshortfalls in employee pension funds, are turning to a strategy that a lot of private companiesadopted years ago: moving workers away from guaranteed pension plans and toward 401 (k)type retirement savings plans. For instance, Utah lawmakers voted last year to make a partialchange over to a 401 (k) plan, following in the footsteps of Alaska, Colorado, Georgia, Michigan,Ohio and several other states, which offer at least some version of it. The push to switch to401(k)-type plans comes overwhelmingly from Republicans, who see them as moreindividualistic and free market. Democrats generally oppose the change, partly because theirunion allies are eager to keep traditional plans.”11However, some states have expressed concerns with the strategy of moving to fully fundeddefined contribution plans. For instance, Georgia realized that having people solely in a 401(k)plan could be a risky proposition. In this type of plan, “‘Investors have sole control and theymight lose a lot of money’, said Pamela L. Pharris, executive director of the Employees’Retirement System of Georgia, adding that such people ‘eventually might become dependenton the state. Many workers don’t know how to invest, many don’t contribute enough to their401(k)s, and many cash out much of what’s in their 401(k) long before they retire, leaving themtoo little to live on when they retire’.”1210Meredith Whitney is the CEO of Meredith Whitney Advisory Group, LLC, a macro and strategy-driven investment research firm.11Greenhouse, Steven. "Pension Funds Strained, States Look at 401(k) Plans." http://www.cnbc.com/id/4184428412Greenhouse, Steven. "Pension Funds Strained, States Look at 401(k) Plans." http://www.cnbc.com/id/41844284
12At the same time, many critics argue that the welfare state will not be able to maintain thecurrent pension systems in an era where high debt to GDP ratios, combined with low rates ofgrowth have alarmed financial market actors and ordinary citizens (see Graph 2 for adescription of GDP growth, debt to GDP ratios, and borrowing costs on sovereign issued debtfor the U.S. and other OECD countries).Graph 2: The End of the Spending Road?To make matters worse, due to the nature of pensions which promise to pay employees wellinto the future, “such future liabilities have to be valued, using a discount rate to reflect whatthey are worth in today’s money. The higher the discount rate the lower the present value. Theexpected return on the assets is often around 8%...however; such returns will be hard to comeby in the future.”13This approach presents ethical and financial problems because the proper13“A Gold plated Burden.” The Economist Magazine 16 Oct. 2010: 95-96. Print.
13practice for states would be to use the risk free rate when discounting liabilities. The commonpractice by states; however, has been to erroneously use the average rate of returns onequities (around 8 percent) as a discount rate. More importantly, “a state pension fund mayachieve the desired returns by investing in the stock market, but if it does not work out, thestate must still pay its pensioners.”14This panorama is particularly worrisome because onaverage, neither traditional nor more diversified portfolios reached 8 percent in the period thatgoes from 1994 to 2010 (see Graph 7 for a description of stock market average returns).3. Diagnosis of the Problem: Government and Market FailureIn the paradigm of pension economics it is difficult to make predictions. The presence ofmacroeconomic shocks, “black swans” (outlier events that have an extreme impact),demographic shocks, political risks, management risk and investment risk in private and publicschemes, the one certainty in the system is that current production and high levels of output inthe future must be preserved in order to support the fundamental structure of the system. Thebasic characteristic of the retirement system whether it is PAYG or fully funded is that there are“simply financial mechanisms for organizing claims on…future output.”15When it comes to the diagnosis of the looming crisis in the social security system in the U.S, wefind a variety of government and market failures. To begin with, in the realm of market failures,we encounter information asymmetries and macroeconomic dynamics. In the domain ofgovernment failures, we encounter problems inherent in representative government.14“A Gold plated Burden.” The Economist Magazine 16 Oct. 2010: 95-96. Print.15Barr, Nicholas, and Peter Diamond. "The Economics of Pensions." Oxford Review of Economic Policy 22.1 (2006): 15-39. Print.
14A. Information Asymmetries: “My Financial Advisor Needs Advice”Due to the existence of imperfect consumer information (information asymmetries), it isdifficult for consumers to know exactly how much to save or the performance overtime ofpresent investments.The complexity of solving information asymmetries is difficult to address for the averageconsumer because of the prevalent financial illiteracy. According to a study conducted by Orzagand Stiglitz, “over 50 percent of Americans do not know the difference between a stock and abond.”16Moreover, not only the most vulnerable in society suffer the adverse consequences ofmarket volatility, financial professionals also have a difficult time making sense of financialevents and macroeconomic developments; thus, this panorama helps explain the devastatinglosses experienced in 2008 and the first quarter of 2009.Moreover, the system does not provide any mechanisms to guide consumers in the selectionprocess of choosing financial advisors and portfolios. Thus, the process is heavily influenced bybiases that could end up being very costly for consumers. For example, a growing literatureshows that households are prone to behavioral biases in choosing portfolios, and althoughfinancial advisors can in theory help mitigate these biases, especially given the competitivemarket environment in which they participate; “advisor’s self-interest, may lead to them givingfaulty advice… Advisors encourage chasing returns, push for actively managed funds, and evenpush them [on clients] who begin with a well-diversified low fee portfolio.”1716Barr, Nicholas, and Peter Diamond. "The Economics of Pensions." Oxford Review of Economic Policy 22.1 (2006): 15-39. Print.17Sendhil, Mullainathan. Markus, Noth. Antoinette Schoar. Scholarly Paper. “The Market for Financial Advice: An Audit Study”.
15B. Macroeconomic Dynamics: Hedge Funds Can Not Hedge RiskThe difficult task of achieving returns and maximizing alpha even escapes the mostsophisticated of investors and money managers; for example, “six in ten hedge funds lostmoney in 2011, Asia-based funds suffered the worst performance, declining 5.70 percent.European funds declined 2.45 percent. US funds lost 0.50 percent.”18Even the hedge fundlegend John Paulson who is known in the industry for achieving large profits for shorting thesubprime mortgage market in 2007 had to apologize to his investors for his funds poorperformance in 2011, which he characterized as "the worst in the firms 17 year history.Paulson Advantage Fund lost 32.57% and the Advantage Plus Fund, which uses leverage, wasdown 45.35%.” 19It is important to emphasize that these results were particularly unexpectedby investors in a year in which, despite the volatility, the S&P 500 ended flat.Moreover, only “one in four managers beat the major stock indexes in 2011, as an intenselyvolatile market environment drove an aversion from risk that left many dangerously exposedduring pullbacks and woefully flatfooted during rallies. As a result, only 23 percent of large-capmanagers beat the Standard & Poors 500.”20The aversion to risk in turn “helped drive upcorrelation; or the tendency of different asset classes as well as individual stocks to move upand down in tandem, making diversification and hedging more difficult and limiting returns.18Carney, John. "Six in Ten Hedge Funds Lost Money in 2011." http://www.cnbc.com/id/4593073819Rubin, Scott. "John Paulson Apologizes to Investors for Dreadful Year." http://www.benzinga.com/media/cnbc/11/11/2158762/john-paulson-apologizes-to-investors-for-dreadful-year20Cox, Jeff. "Market Pros Had Bad Year, So Why Not Just Buy Index Fund?" http://www.cnbc.com/id/45524957
16After coming through the Great Recession, most active managers are going to err on the side ofcaution.” 21On a historical basis, the argument that money managers and financial experts can consistentlyoutperform the market is not very encouraging either. For instance, “mutual funds haveunderperformed benchmark portfolios both after management expenses and even gross ofexpenses... Moreover, while considerable performance persistence existed during the 1970s[among money managers], there was no consistency in fund returns during the 1980s”22.During the crisis of 2008, almost every asset class with the exception of low paying U.S.Treasury bonds suffered losses. For instance, “of the almost 5000 U.S. mutual funds specializingin stocks, only one was in the black (positive returns)… the average return for stock funds wasminus 39 percent.”23As these numbers indicate, it was almost impossible in 2008 to avoid themacroeconomic dynamics.C. The Federal Reserve: “The Blind Leading the Blind”The inability of retail investors, sophisticated institutional investors, money managers andhedge fund managers to understand economic events, was also shared by members of theFederal Reserve. For instance, Chairman Ben Bernanke and other top officials of the U.S. centralbank missed the nations oncoming financial crisis, “believing as late as December 2006 that the[housing] market was stabilizing. Policymakers were also far too sanguine about the potentialthreat housing posed to financial markets. Six months before the first cracks began to appear in21Cox, Jeff. "Market Pros Had Bad Year, So Why Not Just Buy Index Fund?" http://www.cnbc.com/id/4552495722Burton, Malkiel. “Returns from Investing in Equity Mutual Funds 1971 to 1991”. Journal of Finance, Volume 5023Larry, Light. Book, “Taming The Beast”, 13
17the financial system, the U.S. central bank appeared largely unaware of the severity of the risksfacing the economy. ‘We are unlikely to see growth being derailed by the housing market,’Bernanke said in March 2006, presiding over his first meeting as Fed chairman. Later in theyear, when home sales and prices had already extended their drop, officials appeared tobelieve the worst was over.”24As shown above, the tentacles of complicated macroeconomicdynamics can affect the most informed government officials and policymakers.D. Problems Inherent in Representative GovernmentIn democracies, “voting serves as the mechanism for combining the preferences of individualsinto social choices.”25In the realm of pension economics, “Representatives often face thedilemma of choosing between actions that advance their conception of the good of society andactions that reflect the preferences of their constituencies.”26Reforming the current socialsecurity pension system could prove to be very costly for politicians who want to be reelectedto office or elected to it because the perception is that under any type of reform to the statusquo, they would have to oppose the interests of key stakeholders such as elderly voters, whoare one of the most responsive blocks of voters and are more likely to participate in electionsthan younger voters.It is precisely this panorama of high political risks which helps explain the perpetuation of thebureaucratic paralysis when it comes to reforming social security.24Reuters. "Ahead of Crash, Fed Saw Little Threat from Housing." http://www.cnbc.com/id/4597512325Weimer, David, and Aidan Vining. Policy Analysis Concepts and Practice. Print., 15726Weimer, David, and Aidan Vining. Policy Analysis Concepts and Practice. Print., 164
184. Past Attempts to Solve the ProblemA number of reforms have been enacted in the United States to alleviate the problems of thepension system. To begin with, the full pension age was increased from 65 to 67. Furthermore,changes in adjustment for early/late retirement and cuts in future public pension benefits havealso been enacted27.Secondly, there has been a shift toward defined contribution pensions. According to datacompiled by the U.S. Department of Labor, “defined benefit plan assets in 2005 accounted for21 percent of private sector employer-sponsored plan assets, down from 32 percent in 1992-1993, while defined contribution plan assets rose over the same period from 35 to 42 percentof private sector retirement plan assets. At the end of 2006, defined benefit plans had grown to2.3 trillion [dollars], but defined contribution plan assets and IRA assets totaled 4.1 trillion and4.2 trillion [dollars] respectively.”28However, there is no empirical data that provides conclusiveevidence that funding has a significant advantage over PAYG; furthermore, “its allegedsuperiority in handling demographic and economic risk, as well as in signaling future pensioncosts, is difficult to justify” 29.In 2005 the administration of George W. Bush put social security reform at the top of hisdomestic policy agenda for his second term as president. His initiative was defeated and itnever gained public support.27Pearson, Mark. "A Decade of Pension Reforms: the Impact of Future Benefits." Social Policy Vision and Reality (2008): 1-35. Print.28Hubbard, Glenn R., Michael F. Koehn, Stanley I. Ornstein, Marc Van Audenrode, and Jimmy Royer. “The Mutual Fund Industry Competitionand Investor Welfare.” New York: Columbia Business School, 2010: 14. Print.29Hemming, Richard. "Should Public Pensions Be Funded?" International Social Security Review 52.2/99 (1999): 1-29: 3. Print.
19Advocates of social security privatization typically note that if the average worker was allowedto invest the Social Security payroll taxes paid by him and his employer in a 401(k) type ofaccount earning historically average returns, he or she would retire in a better position thanthat afforded by social security. Moreover, they argue that even if the current system could besustained “the real rate of return for current workers is only about 1 percent to 2 percent peryear, and the expected rate of return for today’s children is expected to fall below 1 percent.”30However, opponents of privatization point out that “the public looks at social security as thefoundation of retirement security. Its role is to be something that a worker can absolutely counton to keep him out of destitution if all else fails. Its role is not to offer an upside, but toeliminate the downside.”31The supporters of the status quo also proclaim that “Social Securityis the ultimate low-risk retirement program. If a worker lives to be 125, it keeps paying. If theprice level doubles over five years, its benefits are fully indexed for inflation. And social securityis perceived to have no risk of default.”32The arguments of the opponents of privatization do have some validity, for instance, while intheory common stocks provide inflation protection, “a replay of the 17-year period between1965 and 1982 during which the Dow lost more than 68% of its CPI-adjusted real value, [theS&P 500 lost 133% of it CPI-adjusted real value] would bankrupt a retirement plan that30Ryan, Paul. A Roadmap For Americas Future.31Woodhill, Louis. "Why Americans Are Skeptical about Private Social Security." http://www.forbes.com/sites/louiswoodhill/2011/04/13/why-americans-are-skeptical-about-private-social-security-accounts/32Woodhill, Louis. "Why Americans Are Skeptical about Private Social Security." http://www.forbes.com/sites/louiswoodhill/2011/04/13/why-americans-are-skeptical-about-private-social-security-accounts/
20depended upon the stock market. A private retirement plan that aimed to directly replacesocial security could not afford to take such a risk.”33IV. The Dilemma of Investment Choices:1. “To Risk or Not to Risk”The “Great Recession” has caused output to dramatically fall and unemployment levels to riseto unprecedented levels across the entire global economy. Moreover, around the world itravaged stock markets in which private pension funds actively participate. As a result, asindicated by figures provided by the Pensions and the Crisis OECD report, “Private pensionfunds in the United States suffered losses of 26.2% in 2008, worth a heady US$ 5.4 trillion”34.As Graph 3 indicates, investors have been subjected to a significant amount of volatility inequity markets since the turn of this century, and as a result, many future and current retireeshave been left wondering if there is a better path to achieving their retirement goals.33Woodhill, Louis. "Why Americans Are Skeptical about Private Social Security." http://www.forbes.com/sites/louiswoodhill/2011/04/13/why-americans-are-skeptical-about-private-social-security-accounts/34OECD Report. “Pensions and the Crisis.” OECD (2009): 1-8. Print.
21Graph 3: Performance of S&P 500 (1997-2010)35The group most affected by the recent financial crisis is the one that is nearing retirement (45years or older) because of the fact that, in many cases, they have not engaged in the prudentlifecycle investing. Lifecycle investing is a strategy that reduces exposure to risky assets i.e.equities, as investors get closer to retirement. According to the OECD, when the crisismaterialized, “45 percent of 55-65 year olds held more than 70% of their assets inside theirprivate pension in equities.”36To understand the magnitude of the problem that workers are facing, a survey by humanresources consulting firm Towers Watson published in early 2012, indicates that “about 39percent of workers plan to delay retirement, and the majority of those delaying retirementexpect to work another three years. If youre 55 or older, you wont reach the full retirementage for Social Security benefits until age 66 1/2 or 67... By retiring at age 70, youd receive35"Guide to the Markets." J.P Morgan Asset Management36OECD. “Pensions and the Crisis.” OECD (2009): 1-8. Print.
22nearly double the annual Social Security as you have received if you took early retirement atage 62”. 37Moreover, “the concept of a retirement age is becoming irrelevant, at least according to a newstudy of middle-class Americans. Whether it is a desire to reach a certain nest-egg number,dealing with rising health-care costs, or grappling with mortgage debt, more workers aredeciding to delay retirement. A quarter of middle-class Americans, defined as those earningbetween $25,000 and $99,000 annually, say they will ‘need to work until at least age 80.Furthermore, more than a quarter of people in their 20s and 30s expect no income at all fromsocial security during retirement years. On average, people in that age group expect socialsecurity to cover only 20 percent of their retirement funding.”38Also, as a result of population aging, the potential from upside returns from equity investingmight diminish in years to come. This is due to the fact that; “pension funds are expected toreduce their exposures to equities and shift to fixed-income instruments and other low-riskassets to preserve capital and provide guaranteed income streams.”39However, several factors might slow the shift away from equities as investors approachretirement. With longer life spans, “people now face 20 or 30 years of retirement, and the newconcern [of financial advisors] is that clients will exhaust their savings with many years left tolive. Even before the market crash of 2008 reduced portfolio values, members of the babyboom cohort lacked adequate pensions or savings”.40Now they have even greater needs for37Epperson, Sharon. "Delaying Retirement: Why 68 Has Become the New 65." http://www.cnbc.com/id/46572257/38Leigh Parker, Jennifer. "80 Is the New 65 for Many Retirees." http://www.cnbc.com/id/4532207939Mc Kinsey Global Institute, December 2011 “The Emerging Equity Gap: Growth and Stability in the New Investor Landscape.”40Mc Kinsey Global Institute, December 2011 “The Emerging Equity Gap: Growth and Stability in the New Investor Landscape.”
23high returns. A study by the McKinsey Global Institute states that: “if Americans of all agegroups maintain the asset allocations they have today, the rising share of the population over65 will drive down the overall share of household financial assets in equities from 42 percent to40 percent over the next ten years. In 2030, when the last of the baby boomers reachretirement, the US household allocation [in equities] would fall to 38 percent.” 41In the realm of employer sponsored plans such as 401k; 403b and individual retirementaccounts such as Traditional IRA and Roth IRA the problems are numerous because asubstantial part of the contributions to these plans is invested in equities (either in individualstocks, ETFs and or mutual funds), and other volatile asset classes such as gold, industrial andagricultural commodities, high yield bonds and REITs etc. Therefore, all of them are exposed inone way or another to market risk, economic risk, and interest rate risk. Moreover, over the last10 years, traditional theories of portfolio diversification have been undermined due to the factthat, there has been a great degree of correlation for almost all the different asset classes (seeAnnex 2 to see a detailed account about the degree of correlation between different assetclasses).Lastly, for those investors who elect a more conservative approach and are either fully orpredominantly invested in cash or cash equivalent instruments such as liquid money markets orless liquid traditional CDs, they are exposed not only to inflation risk, but to “dollar weaknessrisk”. As Graph 4 indicates, over the last two decades, the U.S dollar index has significantlydeclined vis-a-vis a basket of major currencies.41Mc Kinsey Global Institute, December 2011 “The Emerging Equity Gap: Growth and Stability in the New Investor Landscape.”
24Graph 4: The Rise and Fall of the U.S. Dollar (1992-2011)42In fact, holding U.S. dollars has been one of the worst investments when compared to otherasset classes; as Graph 5 indicates, over the last three decades the dollar has lost 72 percent ofits value.Graph 5: Asset Class Performance 1978-20104342Guide to the Markets." J.P Morgan Asset Management43Franklin Templeton
251. Low Interest Rates: Cash is Not KingRetirees with low exposure to equities have also been negatively affected by the crisis. Forexample, those who were not invested inequities in a significant way, and were instead heavilyinvested in cash and cash equivalent liquid instruments as is recommended for people near orwell into retirement, the crises has also been problematic due to the historically low interestrates in the United States on risk free government bonds and traditional certificates of deposit.While low interest rates may help stimulate private sector borrowing and economic growth,they have made it very costly for retired workers, savers and other risk-averse marketparticipants to generate secure incomes. As Graph 6 indicates, annual income generated on a$100,000 investment in a 6 month CD declined from $5,240 in 2006 to $419 in 2011.Graph 6: The End of Income4444Guide to the Markets." J.P Morgan Asset Management
262. Mutual Funds: Costs and BenefitsMutual funds are the primary vehicle used by individuals to invest in the stock and bondmarkets, and they are the overwhelming choice in retirement plans, Thus, the effectiveness of401 (k), 403 (b), 457, IRAs, and other pension plans depends upon the efficiency and thecompetitiveness of the mutual fund industry.Mutual funds “were introduced in the United States in the mid-1920s, growing from one fundin 1924 to 19 funds in 1929, with approximately $140 million in assets. As of 2007, the industryhas approximately 12 trillion dollars under management distributed among 8,029 funds thatare owned by 55 million U.S. households and 96 million individuals. The most robust growth inmutual funds has been in tax-deferred retirement accounts such as IRAs and 401 (k) where theyrepresent the primary investment vehicle of choice, comprising approximately 50 percent ofthe total U.S. assets in self-directed retirement plans.”45As of 2007, “together, IRAs and definedcontribution plans accounted for 52 percent of the total retirement assets.”46Investing in mutual funds for retirement “expanded after the 1980s when traditional employerdefined benefit plans started to be phased out in favor of defined contribution plans.”47Overthe last few decades, there has been a lot of discussion about excessive fees andanticompetitive practices in the mutual fund industry; nonetheless, “the price elasticity ofdemand for mutual funds (i.e. consumer sensitivity to the fees charged by different mutualfunds) shows that investors are very sensitive to the fees they face, and that price increases45Hubbard, Glenn R., Michael F. Koehn, Stanley I. Ornstein, Marc Van Audenrode, and Jimmy Royer. The Mutual Fund Industry Competition andInvestor Welfare. New York: Columbia Business School, 2010: 3. Print46Hubbard, Glenn R., Michael F. Koehn, Stanley I. Ornstein, Marc Van Audenrode, and Jimmy Royer. The Mutual Fund Industry Competition andInvestor Welfare. New York: Columbia Business School, 2010: 13. Print.47Hubbard, Glenn R., Michael F. Koehn, Stanley I. Ornstein, Marc Van Audenrode, and Jimmy Royer. The Mutual Fund Industry Competition andInvestor Welfare. New York: Columbia Business School, 2010: 3. Print.
27above competitive levels lead investors to switch to lower priced funds. Consequently, there is“no justification for laws…to control monopoly pricing in the mutual fund industry.”48Nonetheless, the biggest issue with mutual funds and actively managed funds are their weakand inconsistent performance, since on average “typically 70 percent of actively managedportfolios fail to do better than the S&P 500”.49Moreover, a study by Dalbar Inc., confirmed that many investors were not participating in long-term mutual fund returns because of frequent switching among funds. Until this and otherstudies were published, “everyone just assumed that whatever the large mutual fund firmsreported as returns were what investors got. However, these studies showed that manyinvestors were chasing hot returns in order to get better returns. In other words, they’d jumpfrom one hot fund to the other in hopes of increasing their return. But just the oppositeoccurred.”50These studies also show that the average investor has only been able to capture ameager 2.6 percent average return over the same period (please see Graph 7). Thisunderperformance could be due to the fact that market volatility creates panic among investorswho tend to jump out of the market when markets perform poorly, thus preventing them inmany cases from capturing the upside of the market.48Hubbard, Glenn R., Michael F. Koehn, Stanley I. Ornstein, Marc Van Audenrode, and Jimmy Royer. The Mutual Fund Industry Competition andInvestor Welfare. New York: Columbia Business School, 2010: xviii. Print.49Larry Light. Book “Taming The Beast”, 8150“Investors Still Lagging the Market.” http://www.investorsinsight.com/blogs/forecasts_trends/archive/2009/11/03/dalbar-update-investors-still-lagging-the-market.aspx.
28Graph 7: Average Return of Equity Portfolios 1994-2010 and the Average Investor51V. The Ryan PlanThe “Ryan Plan” also known as the Roadmap to America’s Future, has been pronounced bymany as the most comprehensive path to reform the current PAYG system.This plan provides workers with the voluntary option of investing a portion of their payroll taxesinto personal savings accounts. By investing in equities and bonds, these accounts would allowworkers to build a significant nest egg for retirement that exceeds what the current socialsecurity program provides. Each account will be the property of the individual, and fullyinheritable, which will allow workers to pass on any remaining balances in their accounts totheir descendants.51Guide to the Markets." J.P Morgan Asset Management
29According to this plan, individuals 55 and older will remain in the current system and will not beaffected by this proposal in any way: they will receive the benefits they have been promised,and have planned for, during their working years. All other workers will have a choice to stay inthe current system or begin contributing to personal accounts.Those who choose the personal account option will have the opportunity to begin investing asignificant portion of their payroll taxes into a series of “life cycle” type mutual funds thatautomatically adjust the portfolio’s risk based on the age of the beneficiary. These portfolioswould be managed by the U.S. government. To administer the savings fund there would be aBoard responsible for paying administrative expenses and regulating investment optionsoffered by nongovernment firms. The Board would consist of five members required to havesubstantial experience, training, and expertise in the management of financial investments andpension benefit plans. These individuals would be appointed by the President, two of whom areappointed after consideration of the recommendations by the House and Senate.Moreover, the expectation is that as these personal accounts continue to accumulate wealth,they will eventually replace the funding that comes through the government’s pay-as-you-go(PAYG) system. This will reduce the demand on government spending, lead to a larger overallbenefit for retired workers, and restore solvency to the Social Security Program.The plan also guarantees the taxpayer’s contributions. Individuals who choose to invest inpersonal accounts will be ensured every dollar they place into an account will be guaranteed,even after inflation. The choice of personal retirement accounts is entirely voluntary. Eventhose under 55 can remain in the current system if they choose. Further, those who choose to
30enter the personal account system, they also have an opportunity to leave the system, andthose who initially opt out of the system of personal accounts can enter into it later on.All individuals in the traditional system who meet certain working requirements will be ensuredthat their minimum benefits are equal to at least 120 percent of the Federal poverty level, animprovement from current law. Those in the personal account system will be guaranteed aminimum of at least 150 percent of the Federal poverty level.Lastly, there would be no taxation of personal account benefits. No tax will be paid on thereceipt of Social Security benefits generated from personal account payments either as a partof an individual’s Federal income tax or estate tax.1. Problems With The Ryan PlanThe problems with the “Ryan Plan” are numerous, and it is politically unfeasible. Firstly, theidea that future retirees can invest in target date funds and just “set it and forget it” is naïve atbest. These funds are very volatile and future pensioners could end up losing a significantportion of their nest-egg even when they are very close to retirement. For example, “the fourlargest target date funds for people who were set to retire in 2010 lost an average of 25percent in 2008, and one of them was down more than 40 percent.”52Moreover, under the Ryan plan, future pensioners that participate in personal accounts areguaranteed a minimum level of benefits of at least 150 percent of the Federal poverty level. Inother words, this plan resembles the PAYG system if the expected performance of the52Tim Garret, “Poor performance raises questions about automatic long-term investment”.
31underlying investments is not achieved. Lastly, given the toxic and divisive political environmentin Washington D.C, it is unlikely that the plan will get any significant support from Democratswho view the plan as too radical, and too similar to the failed plan that the Bush administrationattempted to pass without any success in 2005.VI. Personal Public-Private Social Security Saving Accounts (PPPSSS)PPPSSS accounts are an alternative that transforms the current pay-as-you-go (PAYG) socialsecurity system into a partially privatized system.This plan provides workers with the voluntary choice of investing the portion of the payrolltaxes that currently goes into the Social Security trust fund, into their own personal savingsaccounts. Each account will be the property of the individual, and fully inheritable, which willallow workers to pass on any remaining balances in their accounts to their descendants in theform of a beneficiary PPPSSS account. All inherited PPPSSS accounts would be subject to annualIRS minimum required distribution rules, but these would be based on the inheritor’s own lifeexpectancy. This enables continued investment without the impact of immediate taxes, so thatthose who inherit the account can potentially maximize returns.Under the PPPSSS plan, individuals 50 and older will remain in the current PAYG system. Allother workers will have a choice to stay in the current PAYG Social Security system or begincontributing to personal public-private Social Security saving accounts.The types of investments that would be available in PPPSSS accounts are “point to point”market linked certificates of deposits, these financial instruments combine: FDIC insurance,
32consistent outperformance relative to government bonds, and hedging mechanisms to helppreserve the savings of future pensioners. Moreover, in some instances, these products offer aguaranteed minimum rate of return.Those who choose the personal account option will have the opportunity to invest their payrolltaxes into principal protected market linked certificates of deposit (MLCDs) that range from 2 to10 years in maturity or in U.S. government debt. For instance, savers could invest into longerterm U.S. Treasury-notes that range from 2 to 10 year maturities, and or Treasury inflationprotected bonds (TIPS) of longer maturities that hedge against the risk of cost of livingincreases. For those who prefer to invest in risk free assets such as U.S.T-bills, they will bebetter served by staying in the current PAYG system which ensures them a guaranteed definedbenefit.1. Market Linked CDs: Is Equity Investment without Market Risk Possible?Market linked certificates of deposit (MLCDs), also known as equity linked CDs or index-linkedCDs, are securities with interest rates based on the performance of a specified equity indexsuch as the S&P 500, the Dow Jones, UBS Commodity Index, or the price of an individual assetsuch as gold. The MLCDs may vary by maturity (2 years, 5 years, etc.), and the minimumrequired deposit varies from issue to issue.Resembling traditional CDs, the MLCDs inside PPPSSS accounts provide the safety and securityof an FDIC insured return of principal when held to maturity. Also, MLCDs will provide futureretirees with diversification and a potential hedge against inflation without risking principal.
33Unlike conventional CDs that pay a fixed rate of interest; MLCDs can potentially pay investorsinside PPPSSS accounts a specified fraction of the rate of return of an index; this upsidepotential is known in the industry as a cap, which determines the investor’s upside potential.Market linked CDs have several variants for example, in some instances these products offer aguaranteed minimum rate of return should the market fall if investors are willing to settle for asmaller capped return. Moreover, on the upside, the MLCD may offer, for example, 50 percentof any market increase while protecting its holder from any market downside by guaranteeingat least no loss.Synthetic MLCDs consisting of a zero coupon bond and a stock index call option with the sameexpiration as the time to maturity of the bond,53were first introduced by Chase ManhattanBank of New York in 1987. According to the Structured Products Association, a trade grouprepresenting issuers and vendors, “almost 50 billion of structured products were sold in2005.”54The average buyers of MLCDs are risk-averse investors that still need their assets togrow in order to retire. Banks market MLCDs to investors as hybrid instruments that have thesafety of a traditional CD, with the potential to earn higher returns associated with more riskystock market investments.To understand MLCDs, PPPSSS investors must comprehend their composition. Inside a MLCD,there is a “call option [that] provides the buyer with exposure to the underlying equity. Thezero coupon bond provides the buyer with principal protection. A zero coupon bond allows forprincipal protection since it accretes from its discount value to its par value over a specified53A call option gives the right to purchase an asset for a specified price54Are Structured Products Suitable for Retail Investors
34period of time…The discount from par value of the zero coupon bond can be used to purchasethe call option on the underlying equity”55(see Graph 8 for an illustration of the workings of thestructure on a hypothetical $1000 investment in an MLCD). In other words, “if at maturity, theunderlying index (i.e. S&P 500) has increased, the investor indirectly (a bank operates asintermediary) exercises the call option and earns a return on the capital gains portion of theunderlying index. If the index decreases, the investor does not exercise the option and receivesnothing for it. However, the investor still receives the face value of the bond thereby insuringthe original investment.”56Graph 8: How Does an MLCD Work?5755Lehman Brothers April 4, 2001. Equity Linked Notes An Introduction. http://homepages.math.uic.edu/~tier/Finance/equity-link-notes.pdf56Do equity-linked certificates of deposit have equity-like returns?57Deustche Bank PPT Presentation
35A. Most Popular MLCD StructuresTwo of the most popular MLCD structures are the “point to point” and the “quarterly cap”. Thereturns on a market linked CD using the point to point method is based on the differencebetween two points, or values. The starting point is the value of the index when the CD isissued and the ending point is the value of the index at maturity. The return can be calculatedas the difference between these two points. In other words, the payout can be expressed in thefollowing calculation:Point to Point Structure Return = (Final Closing Value-Initial Closing Value)Initial Closing ValueIt is important to emphasize that in this type of structure, if the indexed interest amount overthe period is greater than the cap, the capped indexed interest amount would apply.On the other hand, a quarterly cap structure has payouts that are based on the sum of thequarterly percentage changes in the underlying investment benchmark from the initialquarterly index value to the final quarterly index value. Each quarterly percentage change iscalculated as follows:Quarterly Cap Structure Return = (Final Quarterly Index Value – Initial Quarterly Index Value)Initial Quarterly Index ValueIt is important to highlight that, in this type of structure, quarterly percentage changes aresubject to a predetermined quarterly cap percentage, meaning that if any quarterly percentage
36changes exceed the quarterly cap, the cap rate will apply as the return for that respectivequarter in the final payout calculation. The cumulative sum of the capped quarterly percentagechanges determines the indexed interest amount due upon maturity. Investors in this type ofMLCD structure must keep in mind that there is no limit, or floor, on the value of any negativequarterly percentage change, and any positive quarterly percentage changes will be subject tothe quarterly cap. As a result, one or a limited number of negative quarterly percentagechanges could potentially eliminate all positive quarters of returns.B. Performance of MLCDs: Historical ResultsTo provide PPPSSS account holders with the best investment options, the historical returns ofthe following two popular MLCD structures were analyzed in a time series analysis:The results show that MLCDs linked to the S&P 500 and gold between 1970 and 2010, and theDow Jones UBS commodity index between 1992 and 2010, under either structure, allunderperform a traditional index investing strategy. In other words, if an investor over thisperiod would have engaged on a “buy and hold” equity or commodity strategy, he or she wouldhave achieved a higher mean total returns than if they had invested in MLCDs provided thatthey were able to withstand the higher volatility (see Graph 9 for a performance comparisonbetween a 2 year “point to point” MLCD vs. investing in gold).2 year (8-quarter holding period) “point to point” MLCD with a 48% upside cap, and a 2 % guaranteedminimum return2 year “quarterly cap” MLCD structure with a 6 percent quarterly upside cap, which also has a 48%potential upside (6% x 8 quarters), and a 2 % guarantee minimum return
37Graph 92 Year Gold vs. 2 Year “Point to Point” MLCD 48% Upside Cap(1970-2010)The results described above, should not be surprising for at least two reasons. To begin with,the most obvious one is that, by investing in an MLCD, whatever the structure, the PPPSSSinvestor is agreeing to give up some potential upside in a bull market in order to protectprincipal during times of weak or negative returns. This potentially represents a hugeopportunity cost in a bull market. The second reason for underperformance is due to the factthat traditional equity and commodity investments carry a bigger risk than investing in MLCDs.Investors expect a higher return by investing in an index or an asset such as gold than byinvesting in an MLCD which has a lower standard deviation.Nonetheless, according to the simulated historical returns between 1970 to 2010 for the threeasset classes, the good news for future PPPSSS investors is that the 2 year (8-quarter holdingperiod) “point to point” MLCD with a 48% upside cap, and a 2 percent guaranteed minimumreturn, linked to the S&P 500 and gold outperformed Treasury-notes of the same maturity (see
38Graph 10 to observe the outperformance of gold over T-notes). Moreover, the 2 year (8-quarterholding period) “point to point” MLCD with a 48% upside cap, and a 2 percent guaranteedminimum return, linked to Dow Jones UBS commodity index between 1992 and 2010, alsooutperformed Treasury-notes of the same maturity. This is possible due to the fact that, “thesynthetic [MLCD] has a 0 beta in a down stock market and a beta close to 1 when there is ahealthy, positive market return.”58The historical returns on the “point to point” structures and 2 year T-notes are as follows:However, it must be emphasized that for the S&P 500, the Dow Jones UBS commodity indexand for gold, the above referenced “quarterly cap” MLCDs underperformed Treasury-notesdespite having a higher standard deviation.58Edwards, Michelle, Do equity-linked certificates of deposit have equity-like returns?MLCD Type & Period (1980-2010) MLCD 2 Year Total Mean Return SD 2 (year period) 2 YEAR T-note SD (2 Year Period)2 Year Point to Point S&P 500 MLCD 12.78% 19.20% 5.72% 7.26%2 Year Point to Point Gold MLCD 9.52% 17.80% 5.72% 7.26%Period 1992-2010 MLCD 2 YEAR TOTAL RETURN SD 2 (year period) 2 YEAR T-note SD (2 Year Period)2 Year Point to Point DJUBS Commodity Index 7.80% 15.90% 3.78% 3.60%
39Graph 10:2 Year Gold “Point to Point” MLCD 48% Upside Cap Outperforms 2 Year T-note(1980-2010)However, despite the superior performance achieved by the “point to point” structures, it mustbe emphasized that these instruments have more volatility than T-notes. Thus, for thosePPPSSS investors that do not feel comfortable with a higher level of volatility inside theiraccounts, government bonds still are an attractive proposition. Nevertheless, features such asprincipal protection and FDIC insurance may entice some investors to ignore the volatility tocapture potential higher returns. The MLCDs inside PPPSSS accounts are FDIC insured becausethey will be sold to future pensioners by commercial banks.The final question then becomes why anyone outside of PPPSSS accounts would invest in afinancial instrument like the “quarterly cap” MLCD given the alternative of the “point to point”MLCD? One probable answer is that investors cannot easily estimate the return distributions ofthe different [2-year] investment strategies (see Graph 11). Thus, in the absence of detailedanalysis, and the types of regulations found in the PPPSSS plan which forbids any MLCD0%10%20%30%40%50%60% 19801982198419861988199019921994199619982000200220042006200820102 year t-note MLCD 2 year gold
40offerings that are not “point to point”, investors interpret the marketing literature that stressesthe safe return of principal with the opportunity to participate in positive market returns as awin-win opportunity.Graph 11:2 Year Gold “Point to Point” MLCD 48% Cap vs. 2 Year Gold “Quarterly Cap” MLCD 48% Cap(1970-2010)In conclusion, in the period analyzed, the descriptive statistics show that although MLCDs cancapture a significant portion of market upside, they underperformed equity and commodityreturns during bull markets. Moreover, it was established that the 2 year “point to pointstructure” in the three different asset classes that were analyzed substantially outperformedTreasury-notes of the same 2 year maturity. On the other hand, the quarterly cap structuresnot only displayed a higher standard deviation than T-notes, as expected, but their mean totalreturn underperformed that of 2 year Treasury-notes. It is however important to emphasizethat prior to purchasing MLCDs inside PPPSSS accounts, investors must understand all of the0.00%10.00%20.00%30.00%40.00%50.00%60.00%19721974197619781980198219841986198819901992199419961998200020022004200620082010MLCD 2 year return Point to Point MLCD 2 year return Quarterly Cap
41terms and conditions; the percentage of the index return that will accrue to the investor’saccount, and the amount to be earned if the underlying index or asset declines in value.C. Drawbacks of MLCDsThere are many considerations that must be taken into account when investing in MLCDs. Forinstance, MLCDs do not provide any assurance of gains unless a minimum return is established.MLCDs are riskier than regular certificates of deposit because there is the possibility of earningnothing if the underlying index or commodity to which it is linked does not perform well. Thus,the PPPSSS account depositor must be aware that when he invests in an MLCD, he or she tradesa sure payment on investing in a traditional in a government bond.Secondly, the hybrid nature of the MLCD (zero coupon bond and call option) may make itdifficult for investors to understand the risk and return characteristics of the financialinstrument. Moreover, these instruments could be very expensive, with fees that could rangebetween 2 and 7 percent.Thirdly, in terms of liquidity, MLCDs are not securities; consequently, they do not trade on asecurities exchange. Moreover, there is no secondary market for them at the moment. Also,PPPSSS investors face penalties if the money is withdrawn before maturity; thus, this presents aliquidity risk that investors must contemplate before investing in an MLCD.Fourthly, unlike long term capital gains that are limited to a 15 percent tax rate, MLCD returnsare considered interest income and taxed at the holder’s ordinary income rate. Thus, these
42instruments are not tax efficient for most consumers when purchased inside non-qualifiedaccounts.Lastly, a PPPSSS investor purchasing an MLCD issued by a bank in excess of the FDIC- insuredamount ($250,000) will have credit exposure to the bank; thus investors could incur in creditrisk.D. Addressing the Drawbacks of MLCDs Inside PPPSSS AccountsIn order to counter these drawbacks, policymakers and PPPSSS investors must consider thefollowing points:Firstly, in order to minimize the complexities of investment selection and choices, under thePPPSSS plan, the government would be in charge of providing information to future pensioners,and the private sector (banks) would offer consumers through a competitive environment, thebest options for growth, diversification, and principal protection.The PPPSSS plan guarantees the taxpayer’s contributions. Individuals who choose to invest inpersonal accounts will be ensured every dollar they contribute into their account (MLCDs areFDIC insured up to $250,000); nonetheless, only those who invest in TIPS will be fully hedgedagainst inflation.Secondly, under the PPPSSS plan, the tax inefficiencies of MLCDs are eradicated since any gainswould accrue in a qualified tax deferred account.
43Thirdly, the PPPSSS system charges no explicit fees to consumers. Under this plan financialinstitutions (banks) would realize profits only after exercising the at the money call option oncethe MLCD matures. Once exercised, banks will keep everything above the MLCD cap level thatwas offered to consumers. Thus, although financial institutions will not realize a profit wheneither markets perform poorly, or when the return of the MLCD is lower or equal to the capthat is paid to consumers; during bull markets, banks will have unlimited upside potential.Moreover, the banks downside potential would be limited to the expenses in which they haveto incur (i.e. labor hours) with those employees dedicated to the construction and managementof these financial instruments.Politically this could represent an attractive proposition for politicians of both major parties. Fordemocrats, the protection of principal and FDIC insurance would be seen as positive features ofthe plan. Moreover, the fee structure of the plan would allow politicians to claim that under thePPPSSS plan “Wall Street does not get paid unless the people get paid”. Republicans willsupport this plan because it reduces the involvement of government to the role of regulatorand provider of information, and potentially reduces the fiscal burden of future unfundedimplicit liabilities.2. How Do PPPSSS Work?The market linked CD offerings that would be available to consumers, would be constructedand managed by domestic (U.S.) commercial banks of the highest credit quality, these bankswould compete with one another in an auction type system that together with economies ofscale would ensure the best available rates for consumers. After the bidding occurs, the bank
44that offers the best rate to consumers would be ranked first; however, with the objective ofsafeguarding consumers from exceeding the FDIC insurance of $250,000, savers would be ableto purchase MLCDs from other institutions that rank lower. (Please see Graph 12 for anexample on the market competition inside PPPSSS)Graph 12: Market Competition between Financial InstitutionsThe role of the social security administration would be to ensure that offerings from bankswhose credit ratings are less than triple AAA are not allowed to compete on daily auctions. Thiscredit rating prerequisite, together with the safety and security of FDIC insurance significantlyminimize credit risks for future retirees. Moreover, under a PPPSSS system, the role of thegovernment would be to ensure that consumers receive the best available information aboutbond and MLCD rates. In order to accomplish this goal, the Social Security Administrationwould place MLCD rankings and issues into a website that could be accessed by consumers andtheir financial advisors 24/7. Moreover, in order to minimize information asymmetries,consumers will have at their disposal a government toll free number that would be open 24hours. Also, consumers could call the issuers of MLCDs (banks) directly, and consult with
45financial advisors regarding maturities, rates, and the type of index that the MLCD is linked to(i.e. S&P 500).The expectation is that as these PPPSSS accounts continue to amass wealth, they will eventuallyreplace the funding that comes through the government’s pay-as-you-go system. This willreduce the demand on government spending, lead to a larger overall benefit for retiredworkers, and restore solvency to the Social Security program.For less risk-averse individuals with liquid or invested assets totaling $250,000 or more outsideor inside qualified accounts, the option of a trustee to trustee qualified non-taxable transfer willbe available. Under this plan, current payers to the Social Security system would be allowed tochannel their contributions into their 401 (k), 403 (b), IRA, or into a long term care insurancepolicy. This transfer could be accomplished by completing a one page suitability analysisprovided by the trustee of the savers’ qualified plan. The private companies that receive theassets transferred by the Social Security administration would be liable in case of loss if thereare irregularities found in the transfer process, or if the person who transferred the assets didnot meet the $250,000 threshold at the time of the transfer. The suitability analysis is notintended as a bureaucratic hurdle, but as a way to ensure that those who completely transferout of the Social Security system have enough means to live during retirement, and do notbecome dependent on the state if they were to lose those funds in more risky investments.(Graph 13 provides a list of choices that will be available to consumers)
46Graph 13: In the Future these will be Your ChoicesLastly for savers that select PPPSSS accounts, they will be eligible for tax free distribution ofbenefits at age 67. On the other hand, for those individuals who select the option of a trusteeto trustee qualified non-taxable transfer, they will be eligible to take distributions at age 59 anda half as it is customary inside these plans. Nonetheless, the portion of the distributions whichaccounts for gains inside 401k, 403 b, IRA would be subject to long term a capital gain whichcurrently stands at 15 percent. It is also important to highlight that the contributions thatderive from payroll taxes would not be subject to double taxation. For accounting purposes, a401 k or a 403 b administrator would have to disclose in quarterly statements the portion of thecontributions that are pre-tax, and those that derive from payroll taxes. Moreover, to simplifymatters further, investment companies would have to denote investments in mutual funds that
47were purchased with contributions from payroll taxes with a new type of share class. This newshare class would be known as a Freedom share or “F share”.VII. Final Remarks and ConclusionReforming social security is one of the biggest challenges that this country confronts in thetwenty first century. The sustainability of the welfare state not only depends on implementingbold reforms, but in bringing together policymakers to design a new social contract with thecitizens of this nation.
48VIII. AnnexesAnnex 1: Description of Retirement Plans in the United StatesTraditional IRA: In a Traditional IRA, you make contributions with money you may be able todeduct on your tax return and any earnings potentially grow tax-deferred until you withdrawthem in retirement.Roth IRA: In a Roth IRA, you make contributions with money youve already paid taxes on (after-tax)and your money may potentially grow tax-free, with tax-free withdrawals in retirement, providedcertain conditions are met.SEP-IRA-Simplified Employee Pension Plan: Simplified Employee Pension Plans (SEP-IRAs) helpself-employed individuals and small-business owners have access to a tax-deferred benefitwhen saving for retirement.Simple IRA: Savings Investment Match Plans for Employees (SIMPLE–IRAs) make it easier forself-employed individuals and small businesses with 100 employees or fewer to offer a tax-advantaged retirement plan, funded by employer contributions and elective employee salarydeferrals.401K Plans: This is a private defined contribution (DC) plan that is available for small and largebusinesses. Employees that participate in a 401(k) plan, tell their employer how much money they wantto go into the account (limits apply). The contributions come out before taxes are calculated.
49403b Plans: A 403b plan is a retirement plan for university, civil government, and not-for-profitemployees. It has the same characteristics and benefits of a 401K plan since it shares many of thewithdrawals, contribution limits, tax rules, and investment choices.457 Plan: A non-qualified, deferred compensation plan established by state and local governments andtax-exempt governments and tax-exempt employers. Eligible employees are allowed to make salarydeferral contributions to the 457 plan. Earnings grow on a tax-deferred basis and contributions are nottaxed until the assets are distributed from the plan. 59Social Security: This is a government sponsored plan in which benefits are based on the amount ofmoney you earned during your lifetime with an emphasis on the 35 years in which contributors earnedthe most.State Pension Plans: Most State pensions are plans are set up as fully funded schemes.Private Defined Benefit Plan: This type of plan promises to pay a specified amount to each person whoretires after a set number of years of service. Such plans pay no taxes on their investments. Employeescontribute to them in some cases; in others, all contributions are made by the employer.59http://www.investopedia.com/terms/1/457plan.asp#axzz1pR3iSDgc
50Annex 2: Correlation amongst different asset classes for the last 10 years
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