Social Security and Ownership

This essay was originally published in the January 2003 issue of Labor and Corporate Governance, The PVS Monthly Review of Multi-employer Plan Proxy Issues. It was a two part essay. The second part has not yet been published due to confusion in the AFL-CIO investment management office as to why these issues are being raised now.

The conventional wisdom among progressives regarding Social Security is that any privatization is to be avoided at all costs. In this month's LCG, the first of a two-part series, author Michael Bindner attempts to challenge the conventional wisdom of the political left surrounding Social Security privatization by highlighting how current reform proposals could in fact be used to advance a progressive ownership agenda for working Americans. The views expressed here are that of the author and do not necessarily reflect the opinion of PVS, its clients, or the AFL-CIO.

Setting the Stage for Political Debate
On December 21st, 2001, the President's Commission to Strengthen Social Security, chaired by former New York Senator Patrick Moynihan, released its recommendations in a report entitled Strengthening Social Security and Creating Personal Wealth for All Americans. The President's Commission called for a yearlong debate on retirement security, with no action until after the 2002 election cycle. During that year, the matter was briefly raised as an election issue, although by and large it was overshadowed by tax policy and the pending war.

In many Congressional races during the last election cycle, Republican candidates shied away from the President's proposals. Although the Republicans now have slim majorities in both chambers of Congress, the majority in the Senate is still less than 60 votes. This means that unilateral action by the Republicans will not be possible on this issue. If the President is serious about bringing private ownership to Social Security, he will have to modify his proposals to make them politically acceptable to labor and other constituencies.

Organized labor has two choices. The first is to stand firm against privatization and assure that nothing passes. The other is to seek modifications in the President's proposal to benefit organized labor. Modifications can be of two types. The first type could improve the workability of any privatization plan, while the second can be considered a poison pill, which would ultimately make any legislation unpalatable for its original supporters. Whether an amendment is perfecting or a poison pill rests in the minds of the privatizers. My aim is to list possible improvements to make the proposal more acceptable to labor, although many on the right may consider them killing amendments. Ultimately, the fate of the recommendations of the President's Commission come down to the President's desire, or lack thereof, to compromise enough with organized labor and to force his own supporters to compromise.

Presidential Commission Recommendation
The commission's chief recommendation in the report was that some portion of Social Security tax revenue should be directed to personal retirement accounts. Funds for these accounts would be collected from employees and employers through the current payroll tax system. A federal Governing Board modeled after the federal Thrift Savings Plan and the Federal Reserve Board would manage the program. This design is meant to duplicate the low administrative costs of the current Social Security program, which it would augment. Part of the Board's charge will be to find ways to speed the reconciliation process between fund collection and the crediting of accounts, which can last well over a year.

Personal accounts would be invested in a two-tier system. Tier I will be managed by the Governing Board, who will contract management to multiple fund managers on a competitive basis. It will include three indexed balanced funds (conservative, medium, and growth) or any combination of five index funds patterned after the federal Thrift Savings Plan, as well as an inflation-protected bond fund. There will be a default standard fund for participants who do not make a fund choice. Private sector account managers will manage Tier II. Participants will be allowed to make Tier II investments after their funds have accumulated to a set amount. The Commission recommends that the private sector fund managers vote equity shares in both tiers, as is the case with the Thrift Savings Plan and private sector mutual funds. Clearly, this could have major implications for proxy voting down the road. Exactly how is too early to say.

If Organized Labor is willing to seek a compromise, a natural proposal would be to insist that the Personal Retirement Accounts created using Social Security funds be managed within the Taft Hartley system, rather than by investment managers operating independently under contract to the Governing Board proposed above. Of course, some may consider such a proposal a poison pill, though it need not be.

Three Models Being Proposed
Model One proposes that 2% of income be diverted to personal accounts, with no other changes to Social Security. Optional within this model is to transfer these funds from the General Fund rather than redirecting the funds from Social Security, or to combine the two approaches. Model Two redirects four percent of income to personal accounts, with a limit on accounts of $1,000 in any given year. For long-term actuarial balance, benefits would be adjusted for price inflation, rather than for wage inflation ? which means that retirees and disabled workers would lose purchasing power relative to workers, but not relative to prices. Model Three requires an additional employee contribution of 1% of income, to be matched by a diversion of 2.5% of income up to $1,000 (which means that higher wage workers can contribute quite a sum, even though the amount diverted from current payroll taxes is capped at a lower level). Because wealthier employees can contribute so much more, the bend point used to calculate benefits would be adjusted so that the benefit payout is less generous than it is currently. Additionally, inflation would be indexed to gains in life expectancy, which will result in annual growth of 0.5% over price inflation. Both Models Two and Three also include a guaranteed minimum benefit, which is linked to the poverty level.

The President's Commission went to great pains to assure that distributional equity is maintained in Models Two and Three. While the sentiment is admirable, organized labor should insist that the outcome be even more progressive than the current program. A starting point in doing so is to recalculate how contributions are credited to American workers. Currently, the employer contribution is credited as a match to the employee contribution. Meanwhile, benefits are linked to average income. This perceived imbalance is a driving force behind the move to create private accounts, because wealthier taxpayers believe they do not receive nearly what they contribute. Changing the way that accounts are credited will change this perception. The key lies in the way the employer match is calculated. Instead of basing the employer contribution on the employee contribution, credit each full-time worker at the firm at the average contribution for such workers in the nation as a whole. Part-time workers would be credited at a separate rate, at some percentage of the full-time rate based on the number of hours worked in the quarter. This result will bring contributions more in line with expected benefits. Even if organized labor opposes all of the President's proposals, advocating this accounting change will be of great benefit to workers, as it will take much of the wind out of the sails of privatization advocates. Of course, my experience debating conservatives on this issue is that their major complaint with Social Security is not the involvement of the government, but the re-distributional nature of the program itself, especially as it impacts the upper middle class. Given this, such a proposal might also be a poison pill.

Alternative Solution: Establish ESOPs!
No provision is made in the Commission's recommendations for Employee Stock Ownership Plans, even voluntarily. Unlike the kind of "trust fund socialism" proposed by the President?s Commission, the inclusion of an ESOP component would encourage employee productivity and may well provide that extra edge needed to overcome a part of the long-long term actuarial deficit in the nation's retirement system.

The Iowa Center for Fiscal Equity proposes that Personal Retirement Accounts include an ESOP option. To incorporate ESOPs, employer and employee contributions should be considered separately in funding personal accounts; with the employee contribution funding diversified personal accounts as proposed by the Commission. Under Model One, 1% of individual income would be transferred to personal accounts or funded from the General Fund. Under Model Two, 2% of income up to $500 could be transferred to personal accounts. Under Model Three, after an additional 0.5% individual contribution, 1.25% of income up to $500 could be transferred to personal accounts.

The employer contribution could be paid to an ESOP, at the option of the employee, rather than to the government. Separate ESOPs should be established for each type of worker (union, professional, management) or each type of worker should be represented on the ESOP board (with union employees represented through the union). The amount contributed to the ESOP reflects the rebasing of the employer contribution on the average wage. Under Model One, the employer would contribute 1% of average income to the ESOP for each employee, regardless of wage, rather than contributing it to FICA. Under Model Two the employer contribution would be 2% of average income. Under Model Three, the employer would contribute an additional 0.5% of average income to the ESOP for each employee, as well as redirecting 1.25% from FICA. The following chart illustrates this breakdown.

If increasing diversification is a goal (although there is nothing more diversified than an economy wide social insurance system), some portion of the employer contribution might be invested with the employee contribution, with the remainder going to the ESOP.

To prevent workers from losing their ESOP savings, some form of insurance for ESOP contributions in the manner that the FDIC insures deposits should be created. Such an insurance plan would provide the safety net required to protect workers against bad actors and might include a regulatory component for added security. Eventually, contributions (not share value) to 401(k) accounts might also be insured.

Average income can be calculated in different ways for the purposes of the employer contribution. Different averages can be credited for full-time and part-time workers. The average can be for the firm or for the economy at-large. If a firm average is used, contract and temporary workers should be included in the average for the client firm. If the national average is used, the amount paid into FICA by the firm should be adjusted so that the total cost to the firm of the employer contribution is the same percentage of payroll as the current obligation.

Employer contributions based on average income would be a change in the way most ESOPs distribute shares to their employees, as the common method is as a percentage of income. In my experience as an ESOP employee-owner, the current practice is demoralizing to lower salaried junior employees, causing retention problems. The effect of longevity should be enough to reward higher salaried employees and to provide them with enough control over the operation of the firm. Adding a differential based on wage is a perceived double hit on equity as seen by these employees. Additionally, the awarding of an equal number of shares each pay period to each employee prevents the kind of incentives found at Enron, especially if the award of additional shares are limited to rewarding results rather than salary level and are distributed to an entire work team. This development will also benefit workers, especially the rank and file.

Investing private account funds in ESOPs provides for a more direct avenue of investment in plant and equipment, rather than encouraging stock speculation and subsidizing mutual fund managers. It gives the employees of the firm an ownership incentive and long-term protection against layoffs, provided that employees also have the appropriate voice in the leadership of the firm, through their elected union representatives where applicable.

Forging Ahead
Labor organizations should seriously consider the President's proposals if doing so means a debate on union representation on corporate and ESOP boards, a long held demand of organized labor. The enactment of such structure might also encourage Union pension funds to convert a portion of their assets from diversified ownership to ESOP participation in the firms at which their members are employed (which I will address in my next article).

The final question addressed here is the shortfall in the Social Security system and how it might be funded. The existence of both private accounts and the ESOP option makes a discussion of raising or abolishing the income cap on contributions more palatable, as such an increase will raise the average income which can be invested in the ESOP trust fund. Higher percentage contributions would also be more acceptable to both employees and employers, provided that a portion of these increases goes to the personal and ESOP retirement accounts.

For progressives, increasing the income cap is more palatable than subsidizing Social Security privatization using the general fund. The President's Commission has recommended in two of its plans that this shortfall be paid out from the General Fund and that benefits be cut by changing the way inflation is calculated (making retirees foot the bill). When the General Fund is tapped for this purpose, either income tax rates must be raised or debt increased. Increases in the debt draw money from the same demographic as income taxes or increased payroll taxes, though the wealthy would much rather lend their money and receive interest than to have it confiscated. If the wealthy must be taxed, most seem to prefer income taxes so that they can attempt to shelter some or all of the money.

No matter how you slice it, however, upper income individuals will fund the difference. Assuring that they do so in a way which does not mortgage our children?s future is one area where organized labor can be effective in exacting concessions, although more than any other provision, insisting on higher payroll taxes may be considered a poison pill. How the White House and the Republican leadership in Congress respond to such proposals will be key to judging how seriously they are pursuing the creation of Personal Retirement Accounts.

Part II in the February issue:
Look for Part Two of this series in the February LCG where Mr. Bindner will detail how Taft-Hartley pension funds, or Personal Retirement Account funds controlled by labor, might be used to leverage expanded ownership and create the workplace of the future.

Social Security ESOP Questions

What provisions of law must be changed and/or what would the impact be on ESOP financing of having OASI contributions flow to ESOPs?

What is preferable, providing survivors insurance for current workers as part of ESOP or to continue this program as social insurance?

What provisions of law would be required to allow ESOPs to serve the function of a credit union to provide home, car, education and line of credit loans (allowing members to borrow against their stock and future incomes without cashing out) and to have the ESOP to receive the home mortgage deduction and student loan deduction directly instead of transferring this to the employee? (note that this approach could bring the Credit Unions into an ESOP privatization coalition).

Can ESOPs hold “diversified shares and assets” or merely be part of a larger 401(k) plan that does so? What provisions of law must be changed, if any, to allow this and retain S Corporation benefits? Might some of these diversified shares be held as public monopoly Customer Stock Ownership Plans (CSOPs) and community development Community Investment Corporations in geographic areas where the firm does business? (this diversified approach might win over Wall Street, which might be a big loser otherwise if ESOPs became the primary focus for OASI privatization).

OASI benefits are currently redistributional. Using the employer contribution to provide flexibility, how could ESOPs duplicate progressivity in making ESOP contributions in lieu of OASI contributions? Might an alternative be to have employee contributions tied to income while the employer contribution is distributed equally – regardless of wage and salary level?
(this approach might win over such organizations as the Center for Budgetary and Policy Priorities, especially if they agreed to run the numbers)

What is better, to have a different ESOP for each “faction” in a firm (labor, management, engineering) or to provide for factional voting and representation for and on the ESOP board? What, if any, provisions of law must be changed in each case? If allowable under current law, how might this be accomplished?

How would a Union convert its pension fund into a series of ESOPs for its members in particular firms? (note that the previous approaches might be useful in bring labor into the coalition)

One possible option to transition from the current Social Security system to an ESOP based system is to allow employers and employees to cease contributing to FICA if past employees and retirees are or have previously been fully capitalized in the firm’s ESOP as if participating under the new provisions their entire tenure with the firm. At what point would it be in the interest of ESOPs to pursue this option and what federal financial incentives might hasten this (i.e., federal securities to capitalize the social security trust fund surplus – or some level over and above a fair distribution of this trust fund)?

Would raising or eliminating the income cap subject to OASI taxation actually help ESOPs by providing more funds for investment under the above scenario? Would such an increase speed the transition? 

Regarding individual contributions to OASI, how would percentage contribution to a 401(k) or ESOP and percentage contribution to FICA be varied by income to both maintain progressivity and finance transition costs? Might ESOPs make these transitional contributions to OASI for employees and then have the employee reimburse the ESOP over time?

The Real Social Security Crisis

Perhaps the most contentious issue in domestic politics is the reform of Social Security. Proponents of change point to forecasts that point to the need for benefit cuts or tax increases to insure program solvency. The Congressional Budget Office points to the increasing share that Social Security, Medicare and Medicaid require in the federal budget of the future. The real driver behind these trends is the aging of the Baby Boom generation. As this generation ages, it demands to use the Social Security benefits it worked for and the medical care to which it is entitled.

Proposed Solutions
Both parties offer various solutions. The President and the “free market” libertarians propose diverting a portion of Social Security payroll taxes to private investment in the stock market in the hopes that returns from the market will, in the long run, outpace the return on government bonds. Of course, this comparison is false, since the payroll tax is related to the performance of the economy as a whole rather than the performance of government financial instruments.

Defenders of Social Security point out that the real objection that the right has to the program is not its return, but its very nature as a redistributive social insurance program. In other words, they allege that the real goal of diverting private assets is to destroy the system, not to save it. Their defense has some merit. In response, progressives propose not only leaving Social Security intact, but increasing the income cap on contributions to capture as much of a share of national income as has been captured in the past (90%). Growing income inequality has left more wealth in far fewer hands, so to capture the same share of income, raising the cap is essential. Defenders of the program also offer their own way to increase national savings, especially among poorer citizens. Instead of redirecting payroll taxes, tax credits to establish savings plans are created so that individuals are forced, or at least encouraged, to save and invest in some form of index fund. In this way, even if no new taxes are raised, everyone has a nest egg to buffet them against the possibility of benefit cuts to Social Security. Investment of Social Security Trust Fund assets in the stock market was also explored for a time, although the tech bust and the return to deficit spending have put that talk to rest.

Similar Impacts
All told, there is not much difference between the solutions offered by the left and the right. The left proposes transfers form general revenues to increase savings while the President’s plan calls for a transfer of general revenues to the Social Security system for the creation of Personal Retirement Accounts (along with a cut in the payroll tax). The effect of this is not unlike raising the income cap on payroll taxes, because higher income individuals pay the lion’s share of the personal income taxes that finance the general fund. The President’s efforts at tax reform not withstanding, his economic advisors must know that cutting taxes further while increasing transfers to the general fund eventually lead a future Democratic president to increase taxes to make up the shortfall. It is simply a question of pay me now versus pay me later.

Likewise, the investment strategies are largely similar, especially if the White House submits Model Three proposed by the President’s Commission to Strengthen Social Security. This model includes an additional savings component, like the plan offered by the left. More importantly, both rely on the use of index funds, with proxy voting decisions left in the hands of fund manager who’s interest is the maximization of profit rather than the strength of the economy or the economic health of the workforce (whether domestic or foreign). Most importantly, both rely on either the performance of the stock market or the tax system to bolster the retirement savings of the Baby Boom. In another essay, I propose a better way to invest public retirement, union pension and supplemental savings funds by including employee ownership I address the difficulty of relying on enhanced savings for the retirement of the Baby Boomers here.

There is little difference between increasing taxes and increasing investment to provide for the increased needs of the Baby Boom generation. Relying on higher taxes by increasing the payroll tax broadly contracts the economy, as children work harder to pay for their parents and grandparents. Simply raising taxes on the wealthy, while attractive because it increases consumption and thus the economy, is likely not adequate to fully meet the enhanced retirement needs of the Baby Boom. Further, any solution that requires raising taxes now for future investment runs into the same problem as increased investment in the market: you can’t eat government bonds or stock certificates.

In the case of increasing stock investment, eventually the securities invested must either produce increased dividends or be sold in such a way that depresses the stock price. In this case, the worker of the future either works harder or has an increasing share of the wealth his or her labor produces go to the redemption of capital, leading to a lower wage. In the end, it matters little to the workers whether they pay higher taxes on a higher wage or lower taxes on a lower wage. The net wage they receive is about the same, and absent productivity gains, this wage is stagnant or decreasing. Of course, if productivity gains are assumed, then there really is no crisis, as the projected output of society meets the demand for goods and services. Let us assume for the moment, that productivity gains or the lack thereof are already part of the model that predicts the Social Security crisis, so productivity is not our answer.

Globalization Effects
Investing in the market does have one advantage that increasing taxes does not, the ability to rely on foreign labor without actually importing it. Globalization, where American firms exploit foreign workers on behalf of consumers, provides enough to the economy in the short run. In the long run, however, overseas workers begin to behave like their American counterparts. They gain a higher standard of living through work, demand more consumer goods and more social services and have smaller families. They eventually refuse to subsidize the American economy and then mimic it.

Addressing the Real Issue
If neither productivity nor globalization is the answer, what is? Simply put, the answer is a larger economy with more workers and more babies. The heart of the demographic crisis in Social Security is that the Baby Boom did not produce a large enough Echo Boom, at least not large enough to fund its own retirement. There are a variety of reasons for this, from the rise of women in the work force to the increasing cost of having a child with economic adolescence stretching into the 20s, to decisions to have less children or to forgo marriage and family entirely. None of this is news to anyone. What is news is that the solution to the Social Security crisis lies not in the financing of retirement but in financing childrearing and education.

The real solution to the demographic crisis lies in altering the tax code to increase the income of families through broadening the earned income tax credit for all families, regardless of income (either high or low) and making it creditable at withholding, essentially enacting a negative income tax. This is paid in one two ways. The first is to do so under personal income taxes. Doing so increases the direct role of government in redistributing wages, and is likely politically unacceptable for that reason. The second way is to end personal income taxation of all but the wealthy and shift the tax burden for wages to the employer under the Business Income Tax. Under this option, the same redistribution occurs, but it is less transparent to the average worker. This option leads to a shifting in how wages and taxes are distributed within companies, but does not change the tax burden for the average company, as the average employer has an average number of children supported by its output.

Finally, to make child rearing more attractive, the economic age of majority must be rolled back to the mid to late teens. At age sixteen or seventeen young people go into either vocational training or follow an academic track, with the key feature being that they are paid to do so and either the government, their school or their future employers bear the costs rather than their parents. Removing this long-term burden takes much of the fear out of bringing a child into the world, leading people to have more children and solving the demographic Social Security crisis once and for all.

The solutions I propose also offer a much better way to decrease abortion services than anything now offered by the pro-life/anti-choice forces. Providing for a higher income for every child and removing the fear of college costs takes away any economic incentive to have an abortion for already established families. Providing for the education and support of young adults also remove the negative impacts of early childbearing, again decreasing or eliminating the incentive for abortion. These impacts are important, because they add members to the coalition to pass these solutions that are not otherwise there. Conservatives think twice about rejecting these reforms if they are also a pro-life vote. Progressives are also hard pressed to stand in the way of proposals to enact a guaranteed income and a wage structure that empowers youth. Solving the demographic crisis takes the vitriol out of the funding crisis, making some form of compromise involving individual stock ownership and increasing taxes to fund the transition possible. Before we continue with Social Security, however, let us further discuss basic structural change to the tax code needed to end the demographic crisis.