Outside of perhaps the Iraq War and same-sex marriages, no topic is currently more polarizing than Social Security reform. Partisan rhetoric is mounting on both sides of a debate about privatizing the 70-year-old government entitlement program. Under the plan getting a great deal of attention by the Bush Administration, Social Security beneficiaries could invest a portion of their retirement savings in private savings accounts (PSAs), which resemble 401(k)s and other defined-contribution plans.
To be sure, the Social Security debate centers on the financial fate of current and future retirees. But privatization would certainly spawn side effects in finance and business circles. At the very least, PSAs would send a huge amount of money Wall Street’s way. Less well discussed are the big potential effects that privatization could have on corporations and their ability to raise capital.
Much depends on which reform plan, if any, is enacted and on how much money beneficiaries choose to sock away in the accounts, economic experts say. But even if the most moderate privatization plan would produce two stunning results in the capital markets. First, hundreds of billions of PSA dollars would flow into stocks and bonds, possibly during a short period. Second, the federal government would be forced to borrow up to $2 trillion over the next few decades to ensure that the current Social Security Trust Fund is solvent during the transition to a privatized system.
The privatization plan with the most political momentum (dubbed Reform Model 2 by the President’s Commission to Strengthen Social Security) would divert between 2 percent and 4 percent of wages from the Social Security Trust Fund into PSAs. Depending on the investment choices that account holders make, the plan would likely pump between $70 billion and $140 billion annually into the capital markets, according to most estimates, including one from the Government Accountability Office.
Further, the government would have to issue between $900 billion and $2 trillion worth of Treasury bonds to raise enough money to fund the transition. That would enable current retirees to get their benefits while new income is diverted into PSAs. Under Model 2, the proceeds from Treasury bonds — rather than those from tax hikes or a boost in payroll deductions — would be used to bridge the gap during the transition. The President’s Commission calculates that transition payments would last about 20 years.
Based on past trends of the investment of defined-contribution plans and other vehicles, PSA account holders would funnel 50 percent of the $70 billion to $140 billion into equities via index and active mutual funds, says Brad Thompson, an investment strategist with Frost National Bank in San Antonio. The other half would go into corporate bonds (30 percent) and Treasury bonds (20 percent)
Thompson points out that the $30 billion of PSA investments he estimates would be placed in corporate bonds — largely through mutual funds — would be a boost for companies, given that last year about $12 billion worth of corporate debt was issued.
In the short term, demand would outstrip supply. “The increased demand [for corporate debt] should push bond prices up, and the cost of capital down,” he said. What’s more, lower costs of capital would entice some CFOs to swap older, more expensive debt for lower-yielding new debt, Thompson believes. In the longer run, corporations would respond to the signal of cheaper debt by increasing supply. “Eventually, marginal borrowers will have their bonds priced according to their specific credit risk, rather than the effects of a partially privatized Social Security,” he said.