Winter 2006

Stable Value & Social Security: What Could the Push for Social Security Privatization Mean for Stable Value?

Author: Chris Tobe, CFA, AEGON Institutional Markets

For many reasons, President Bush appears to be facing an uphill battle in passing Social Security reform legislation that would partially privatize the government-run program. Nevertheless, the President continues to press his case for reform and his political will should not be underestimated. If he succeeds, what might "partial privatization" look like and how might stable value, as an asset class, fit into this paradigm?

To date, the President has not presented a specific and detailed plan; rather, he has proposed reform objectives based on certain principles. The first of these principles is to preserve the current level of benefits for retirees and near-retirees. The second is to maintain current levels of Social Security taxation; i.e., Bush would not increase the payroll tax that currently funds Social Security.

The third principle is where "privatization" comes in. The President proposes to establish voluntary "personal retirement accounts" for younger workers that would prefund a portion of their income during retirement. Individual workers could elect to divert a portion of their payroll taxes into these personal accounts, which would then grow tax-deferred. The balance in these accounts would be available to individuals at retirement, thereby reducing their need for guaranteed benefits from the government.

Critics maintain that such accounts would place retirement funds in jeopardy by shifting market risk to individual investors, while ensuring windfall profits for the Wall Street firms involved in managing these accounts. Wall Street, by and large, has adopted a "wait-and-see" approach to the President's proposals, primarily because it is far from certain yet how these personal accounts would be structured and what types of investments would be permissible.

The most likely scenario at this stage, and one floated by the Bush Administration itself, is that such personal retirement accounts would be modeled after the government Thrift Saving Plan (TSP) available to federal workers and members of Congress. According to a White House statement released on February 10, 2005:

The system of personal retirement accounts would be similar to the Federal employee retirement program, known as the Thrift Savings Plan (TSP). Contributions would be collected and records maintained by a central administrator. Personal retirement accounts would be invested in a mix of conservative bond and stock funds. Workers would be permitted to allocate their personal retirement account contributions among a small number of very broadly diversified index funds patterned after the current TSP funds.i

Based on this information, one could make the reasonable assumption that some form of stable value - possibly amounting to hundreds of billions in total plan assets - would be front and center in a partially privatized Social Security system. Why? Of the $141 billion in total plan assets invested in the TSP, nearly half - $65 to $70 billion - is allocated to a stable value option called the "G Fund,"ii which is invested exclusively in specially issued U.S. Treasury securities. Interestingly, both President Bush and Vice President Cheney have noted the returns available from the G-Fund as a way of touting the Administration's reform proposals. During a Town Hall meeting in Smyrna, Georgia on May 2, 2005, for example, Vice President Cheney had this to say about the TSP funds: "... the most conservative [the stable value G Fund], has gone up about four percent per year. ...Now compare that to the rate of return that you, in effect, get on your Social Security when you pay into the regular Social Security trust fund, that's less than 2 percent." That is essentially the same argument the stable value industry has used for years when comparing stable value returns to money market returns.

What is the G Fund and what makes it a stable value option? The TSP website (www.tsp.gov) describes it this way:

The G Fund consists exclusively of investments in short-term, nonmarketable U.S. Treasury securities specially issued to the TSP. G Fund investments earn interest at a rate that is equal, by law, to the average rate of return on outstanding U.S. Treasury marketable securities with 4 or more years to maturity. Currently, the maturities of the securities in the G Fund range from 1 day (on business days) to 4 days (over holiday weekends). There is no credit risk (that is, risk that principal or interest will not be paid) for the Treasury securities in the G Fund. They are guaranteed by the full faith and credit of the U.S. Government. Because of the Board's current policy of investing only in short-term securities, there is also no market risk in the G Fund. Market risk is the risk of fluctuations in the value of securities due to changes in overall market rates of interest. If you are uncomfortable with market risk, the G Fund may be the most appropriate investment fund for you. However, G Fund rates of return may well be lower than those of the other TSP funds over the long term. As a result of the G Fund rate calculation and the Board's policy of investing exclusively in short-term securities, investors receive a longer-term rate on short-term securities and at the same time avoid the market risk associated with longer-term securities.iii

For federal employees - ranging from park rangers to SEC staff to members of Congress - invested in the option, the G Fund operates as a stable value fund because investors "receive a longer-term rate on short-term securities and at the same time avoid the market risk associated with longer-term securities." This is a concept familiar to 401(k) stable value investors, who have always enjoyed longer term returns with book value liquidity. The major difference is that, unlike 401(k) stable value options, no third-party synthetic GIC provider contractually ensures those benefits in the G Fund; rather, the U.S. Treasury subsidizes the fund by effectively acting as the GIC provider. This subsidy is potentially huge. Consider: a synthetic GIC contract achieves stable returns through a smoothing mechanism that amortizes return volatility over time. If a $70 billion fund used a conventional synthetic GIC contract, the value of the smoothing effect, based on contract fees of five to ten basis points, would be $35 million to $70 million per year. By contrast, the G fund has no such amortizing mechanism; rather, the U.S. Treasury simply guarantees long-term rates on short-term money. In effect, the government subsidy is the difference between short and long-term rates - an enormous benefit that far outstrips the value of conventional synthetic GIC fees.

The table below illustrates the historic GIC-like returns G-fund participants have enjoyed with little volatility:
Year G Fund* Related Securities**
1993 6.14% 6.23%
1994 7.22% 7.29%
1995 7.03% 7.10%
1996 6.76% 6.80%
1997 6.77% 6.80%
1998 5.74% 5.77%
1999 5.99% 6.03%
2000 6.42% 6.42%
2001 5.39% 5.36%
2002 5.00% 4.98%
1993-2002 compound annual rate of return 6.24% 6.27%
* These rates are stated after deducting the administrative expenses of the TSP.
** Rates of return were calculated by the Board. These figures are based on the statutory rate of return and are stated without any reduction for administrative expenses.
Source: http://www.tsp.gov/rates/monthly-history.html

If the TSP model is followed for the Social Security reforms championed by President Bush, the question is: Will the U.S. Treasury similarly subsidize the entire Social Security investor population - up to 148 million participants according to the Employee Benefit Research Institute, compared to 5 million participants currently in the TSP planiv - by acting as the synthetic GIC provider for personal retirement accounts? If so, no private provider could compete head-to-head with the U.S. Treasury. Given the President's focus on costs and privatization, however, it is far more likely that any reform legislation enacted would authorize a competitive bidding process among private providers for stable value funds within the accounts. Assuming this is the case, the closest analogs for how such a process might work for Social Security accounts are probably the Federal Reserve Deferred Compensation plan (for Federal Reserve employees and the only option available at the federal level other than the TSP) and public plans offered at the state and local government levels.

The federal TSP, at $141 billion in total plan assets, is by far the largest public retirement plan - the next largest public plans dip dramatically to around $11 billion, with Texas Municipal Retirement at $11.6 billion and New York City Public & Teachers at $10.8 billion. Total plan assets go down from there with only about ten plans topping $3 billion or more in total plan assets.

Stable value funds in public defined contribution plans consist of a wide range of structures. The oldest model sometimes called an IPG is basically a general account GIC like product usually issued by one insurance company. The larger accounts mentioned in this article use either a diversified portfolio of traditional GICs or synthetic GICs (also called "wraps") or some combination.

Excluding Texas Municipal Retirement fund, at $11.6 billion, which is managed in-house with an internal guarantee like the federal Thrift Savings Plan, many of the remaining largest public plans use stable value extensively:
    • The NYC Public & Teachers, at $10.8 billion in total plan assets, uses a combination of traditional and synthetic GICs, but with a majority in synthetics.
    • The University of California, the next largest public plan at just under $8 billion in total plan assets, uses traditional GICs exclusively.
    • The New York State Deferred Compensation plan, with total plan assets of $6.5 billion, uses a combination of traditional and synthetic GICs, but with a majority in traditional GICs.
    • Washington State Board, at $5.5 billion in total plan assets, primarily uses traditional GICs.
    • California Savings, at $5.1 billion in total plan assets, primarily uses synthetic GICs.
    • Ohio Deferred Compensation, also with $5.1 billion in total plan assets, primarily uses synthetic GICs.
    • Los Angeles County Deferred Compensation, with $4.2 billion in total plan assets, uses both traditional and synthetic GICs.v
    • Almost seventy percent of the Federal Reserve's $3.2 billion deferred compensation plan - $2.3 billion - is invested in that plan's stable value option, comprised entirely of traditional GICs.vi
In summary, a stable value option within an investment platform for Social Security personal accounts is likely to be based on one of two paradigms (assuming the U.S. Treasury does not subsidize the accounts): (1) the Federal Reserve model, in which a portfolio of one-hundred percent traditional GICs are bid out on a continual basis to ensure diversification; or (2) the synthetic GIC model used in many large state/city plans. The older IPG single issuer model would probably not be considered due to credit, diversification, and transparency concerns.

Stable value is the top choice of federal employees in both the federal Thrift Savings Plan and the Federal Reserve Deferred Compensation plan because it provides attractive returns while insulating investors against short-term market swings. For precisely that reason, it is obvious that stable value, regardless of the delivery platform, should be offered as a choice if Social Security is partially privatized.

i http://www.whitehouse.gov/news/releases/2005/02/20050210-1.html
ii http://www.nelsons.com
iii http://www.tsp.gov/features/chapter08.html#sub1
iv http://www.ncpa.org/pub/ba/ba443/
v Pension & Investments January 24, 2005
vi http://www.nelsons.com