United States of America: Selected Issues

This Selected Issues paper analyzes the condition of household, corporate, and bank balance sheets; sustainability of the U.S. external current account deficit; the impact of a slowdown in the growth on the euro area economy; and the implications of the reduction in U.S. treasury securities for monetary policy and financial markets. The study discusses the pros and cons of investing government assets in private securities; the recent changes in agricultural support policy and their impact on other countries; technological innovations and the adoption of new technologies.

Abstract

This Selected Issues paper analyzes the condition of household, corporate, and bank balance sheets; sustainability of the U.S. external current account deficit; the impact of a slowdown in the growth on the euro area economy; and the implications of the reduction in U.S. treasury securities for monetary policy and financial markets. The study discusses the pros and cons of investing government assets in private securities; the recent changes in agricultural support policy and their impact on other countries; technological innovations and the adoption of new technologies.

V. Investing Government Assets in Private Securities: Policy Options and International Experience1

1. In its FY 2002 Budget, the Administration projects that during FY 2002-11 the cumulative unified federal budget surplus after tax cuts and other proposed measures would be $3½ trillion, with $2½ trillion of this amount representing the prospective cumulative surplus in the Social Security trust fund. Net federal government debt owed to the public, however, is estimated to be $3 trillion at the end of FY 2001, and only $2 trillion of this is considered by the Administration to be redeemable over the next decade.2 If at a minimum the Social Security surplus is preserved, then a policy decision has to be made on alternative means of investing the remaining funds (just over $½ trillion). In addition, if the prospective surplus of the Medicare Hospital Insurance (HI) trust fund (another $½ trillion) were also preserved, the total assets that would need to be invested would be just over $1 trillion.3

2. Over the coming decade, the prospect of U.S. budget surpluses that exceed the amount of redeemable outstanding Treasury debt raises the question of alternative uses for the excess funds. The main alternatives are to slow the pace of debt reduction by reducing taxes and/or raising government expenditure or to invest the funds in private assets. A slower pace of debt reduction would preclude the concerns raised by government ownership of private assets, but in view of the coming wave of unfunded liabilities associated with the aging of the population, it would require a sharper increase in future taxes and government debt or larger cuts in benefits and other spending in future decades.

3. The prospect of government investment in private assets has raised several concerns, including the vulnerability of such investment to political pressures and its potentially large size relative to the market, which could distort capital allocation and reduce the efficiency of capital markets.4 This paper lays out the main options and discusses the experience in other instances where government funds have been invested in private securities. It also discusses the pros and cons of the government investing these funds, for example through the Social Security system, compared with the alternative of allowing private individuals to invest them through voluntary personal retirement accounts within Social Security.5

A. Government Investment in Private Assets: Some Key Concerns

4. The prospect of government investment in private assets has raised concerns, primarily relating to the vulnerability of such investments to political pressures and their prospective size relative to the market for financial assets. Also open to question is the mechanism through which such investment should be carried out.

Vulnerability to political pressures

5. The vulnerability of government investment to political pressures could arise from several sources, as noted recently by Federal Reserve Chairman Greenspan (2001c). Since decisions on how to invest government assets would have to be made through the political process, some groups could try to use the process for obtaining funding on terms not available to them in private markets. Furthermore, it may be more difficult to insulate the surplus funds of a defined-benefit program (such as Social Security) from pressure to make politically attractive investments. Since such programs guarantee benefits irrespective of losses, there may be less incentive for prospective beneficiaries to police their investment policies. However, sufficient incentive should remain for beneficiaries and taxpayers to see that the program’s’funds are invested appropriately, since program losses would have to be made up by cuts in benefits or increases in taxes.

6. Several mechanisms have been proposed and tried in other countries to insulate decisions on investing public funds from political pressure. A commonly used mechanism is the creation of an investment board to handle these assets, with the board held publicly accountable by periodic public reporting and review of its operations by public auditors. In addition, the investment board may be required to follow a passive investment strategy, with its asset holdings broadly replicating the composition of key private market indices. Such a strategy might effectively prevent political pressures, but it has been argued that it could have other implications In particular since indexed funds cover only publicly traded securities, smaller non-publicly traded businesses may receive less financing (Greenspan (2001b)) The weight of this concern would be influenced by the potential size of government investment in private assets as well as by the efficiency of the private financial market, particularly the extent to which arbitrage equilibrates the risk-adjusted cost of funds across market segments.

In addition, political pressures could distort the decisions on the domestic/foreign split of investments and could affect decisions when it comes time to run down earlier asset accumulation.6

Capital market disruption

7. Concerns that government investment in private securities could disrupt the functioning of capital markets arise mainly as a result of the potential size of government investment relative to the market (see Office of Management and Budget (2001a)). With a sizeable government share, government decisions to buy and sell securities could cause significant fluctuations in markets and add to market uncertainty.

8. In the United States, the projected size of government funds to be invested (around $1 trillion by 2011) is not unduly large in relation to the size of the overall economy, total stock market capitalization, or assets managed by some of the large institutional investors. In 1999, assets managed by the largest U.S. fund manager, Fidelity Investments, amounted to nearly $1 trillion, which was also roughly equivalent to the combined domestic assets managed by the next two largest fund managers, Barclays and State Street Global Advisers. Under the conservative assumptions that all of the government’s prospective excess funds are invested in domestic equities and that stock market capitalization grows only at the rate of inflation (considerably slower than in recent years), projected government holdings of stocks would be equivalent to 4.7 percent of market capitalization (6.3 percent of GDP) (Figure 1).7 In 1999, domestic equities managed by Fidelity Investments were equivalent to 3.7 percent of capitalization (10 3 percent of GDP) Domestic equities held by state and local government pension plans accounted for 10 percent of the market (Sarney (2001)).8

Figure 1.
Figure 1.

United States: Assets Managed by Selected Private Firms, 1999

(In percent)

Citation: IMF Staff Country Reports 2001, 149; 10.5089/9781451839586.002.A005

Sources: Institutional Investor, Office of Management and Budget; Bloomberg; and staff calculations.1/ NYSE plus Nasdaq.2/ Stock market capitalization is assumed to grow only at the rate of inflation.3/ Excess balance of Social Security trust fund plus Medicare HI surplus (FY 2011).4/ Stock market capitalization is assumed to grow with nominal GDP.

Intergenerational redistribution, risk sharing, and rates of return

9. Some arguments against investing the government’s prospective excess funds in equities have been raised on intergenerational redistribution and risk-sharing grounds, although the literature is inconclusive.9 For example, equity holdings are unevenly distributed across households, partly reflecting differences in risk aversion. But investment of public funds in equities would expose all individuals to equity risk in proportion to their tax liabilities, without regard to their risk preferences. On the other hand, several arguments favor diversifying the government’s holdings. For example, a portfolio comprising only fixed-income securities has higher inflation risk. In addition, the risk-adjusted rate of return of an exclusively fixed-income portfolio may be low relative to that of a more mixed portfolio (Diamond (1997, 1998)) Overall however considerations of intergenerational redistribution and risk sharing do not make a strong case for or against investing trust fund assets in private securities.

10. Rate of return considerations are similarly inconclusive. On the one hand, private securities provide higher rates of return than government bonds. On the other hand, the implications for intergenerational equity need to be considered. It has been argued that in a pay-as-you-go system with defined benefits, the investment of trust fund assets in private securities essentially represents a zero-sum transfer from the current generation of workers to future workers and/or the government sector (Leidy (1997)). This is because, with higher rates of return on trust fund investments, the tax burden on future workers necessary for financing the pay-as-you-go system would be lower. In addition, in the absence of an increase in national saving (as in the case of a pay-as-you-go system), a shift in the trust fund portfolio from low-yielding government bonds toward high-yielding private securities would be mirrored by a shift in private portfolios in the opposite direction The improvement in the trust fund’s longer-term financial position thus would come at the expense of expected returns on the private portfolios of current workers.

Operational mechanism

11. Investment of government assets in private securities might be accomplished through the Social Security system and could be implemented through the use of either a consolidated government account or private individual accounts. It has been argued that private accounts are less susceptible to political tampering (e.g., Gramlich (2001b)), although some mechanisms adopted in other countries and by the U.S. Federal Thrift Investment Board suggest that there are ways to limit political interference in the investment decisions of a consolidated government account.

12. Private individual accounts would entail additional transaction costs, and there is a tradeoff between these costs and the benefits of private accounts. A system would need to be established for administering and supervising private accounts. In the case of Social Security, the potential number of individual accounts is very large (about 150 million), in comparison with, for example, the number of individual retirement accounts (IRAs) that currently have multiple investment options (10 million). The largest number of individual accounts handled by a single U.S. firm is 6 million.10 A system would be needed for ensuring a flow of deposits into these accounts and for investing, reporting, and managing portfolio choices. These administrative and regulatory costs would rise significantly depending on the amount of control individuals have over their accounts. Losses in individual accounts could, in principle, confront the government with significant contingent liabilities, although much would depend on how large a part of the social security pension the losses represented.11 Diamond (1999) estimated that while individual accounts managed through a consolidated government trust fund would cost $40-50 per worker per year on average to administer, fully private accounts would cost twice as much. The extra cost would imply a 20 percent reduction in assets relative to the other accounts. The Congressional Budget Office in a forthcoming study estimates that the costs of a defmed-contribution plan, in which holders have a wide choice of investment options, would be equivalent to about 30 percent of the average value of investments. The cost of a plan similar to the Federal Thrift Savings Plan, with only a few options would be in the 5–8 percent ranee and the costs of a single-option plan, in which private accounts are administered through the already existing Social Security system, would be 1–2 percent.

13. Private individual accounts would entail several additional complicated issues, which remain to be settled. A key question is how to insure against the possibility that some investors may not have sufficient resources for their retirement, either due to an overly rapid consumption of their accumulated funds once they retire or due to losses on their investments leading to an insufficient accumulation of assets. One approach is annuitization, whereby retirees receive a monthly payment stream throughout their retirement instead of a lump-sum payout. However, this in turn raises several issues, including those of equity. As a result of shorter longevity, lower-income people would tend to receive a lower rate of return. Decisions would need to be made regarding the use of excess funds that may accumulate in annuity accounts for example whether to increase payments to existing retirees (which would tend to reinforce the regressive element) or to boost the payout to lower-income retirees (a social policy choice). An additional issue concerns the financial health of annuity companies and the policy response in the event that some companies fail or are otherwise unable to deliver the promised payouts.

B. Experience in Other Countries

14. There is a fair amount of international experience with government assets being invested in private securities, generally through a central fund rather than individually managed accounts (Table 1). In other countries, the size of government funds has been smaller than in the U.S. case, although they have been large in relation to the size of domestic markets. The public assets invested in private securities generally arise from two sources: the assets of partially or fully funded publicly managed pension plans and earnings from a non-renewable resource sector. In either case, the key issue has been how to ensure the security of the assets while providing an acceptable return at a reasonable cost. This has entailed several considerations, including clarity about the objectives of the investment strategy, independence from political interference, public accountability, sound governance, low operating costs, and prudent investment.

Table 1.

Asset Management of Selected Public Sector Funds

article image
Sources: Davis et al. (2001); CPP Annual Report; CDP Annual Report; Arthur Andersen (2000).

End-1999, unless otherwise noted.

In percent of gross state or provincial product.

End-1998.

March 2000.

End-2000.

15. A relevant example for the United States would be the Canada Pension Plan (CPP), even though the CPP started investing in private assets relatively recently and its investments are small in relation to the economy (¼ percent of GDP as of March 2000). 12 The CPP began operation in 1966 as a pay-as-you-go program, but major reforms enacted in 1997 to address its long-term financial shortfall turned it into a partially funded program, as contribution rates were raised substantially above current CPP expenditures. It was also decided to invest a portion of the plan’s funds in private securities in an effort to raise returns.13

16. An independent body, the CPP Investment Board, was set up to manage the CPP’s cash flow in line with sound investment practices. Its statutory provisions require the Board to follow broadly the same investment rules that govern private pension funds. The Board invests the CPP’s assets in domestic equities, bonds, and real estate, and foreign equities and bonds. It is also subject to concentration limits on its investment in the securities of any single entity and in real estate. New flows have been all invested in equities. The share of foreign equities, initially restricted to 20 percent, was raised to 25 percent in 2000 and 30 percent in 2001. The Board originally was required to follow a passive investment strategy, with its domestic equity investment broadly replicating the composition of the Toronto Stock Exchange (TSE) 300 index.14 Since December 1999, it has been authorized to invest actively up to 50 percent of the assets it allocates to domestic equities.

17. The design of the CPP Investment Board paid careful attention to the factors needed for a successful system, including clear objectives and freedom from political influence. The explicit objectives specified in the CPP Investment Board Act—mainly to maximize investment returns without incurring undue risk—provide a benchmark against which the performance of the Board can be measured. Several features of the system attempt to safeguard it from political influence. As noted, investments during the initial period followed a passive strategy. In addition, major policy decisions of the Board require the agreement of the federal government as well as most provinces, which, given the different political parties involved, reduces the risk of partisan pressures. The Directors of the Board are selected through a process that includes consultations between the federal and provincial governments and the private sector.15

18. The legislation that established the CPP Investment Board requires that the Board publishes an annual report which must be submitted to Parliament and made public. The report must contain information on areas such as investment policies, financial statements, and compensation. In addition, the management of the CPP Investment Board includes attention to good governance, low operating costs, and prudent investment. A governance committee oversees operations to prevent conflicts of interest and financial improprieties. Operating costs as of March 2000 were equivalent to 0.3 percent of assets under administration compared with 0.7 percent for private pension plans in Canada and 0.5 percent for large defined-benefit plans in the United States in recent years. Over time however costs could increase as the Board moves toward more active investment strategies.

19. In contrast to the CPP, the administration of the assets of the Quebec Pension Plan (QPP) illustrates some of the problems that can be encountered in investing public funds in private assets. The QPP, like the CPP, began operations in 1966 on a pay-as-you-go basis. An independent fund manager—the Caisse de Dépôt et Placement du Québec (CDP)—was established to manage the QPP’s surplus assets and other public funds in Quebec.16 The CDP invests in a variety of private assets, including bonds, domestic and foreign equities, and real estate. In 2000, total assets managed by the QPP were equivalent to an estimated 8½ percent of provincial GDP. The CDP as a whole is relatively large in relation to Quebec’s and even Canada’s capital markets, with managed assets equivalent to over 50 percent of provincial GDP and 12 percent of Canadian GDP, raising some concerns that its investment decisions can lead to market instability Furthermore the CDP’s objectives include in addition to achieving optimal financial returns, that it contribute to Quebec’s economic vitality, which has sometimes been interpreted as a directive to concentrate investment in local businesses Industrial strategy has also played a role in guiding the investments of the Quebec Pension Plan toward local firms.

20. In some countries, the objectives of public pension plans’ investments in private securities have sometimes also been influenced by factors not directly related to risk-return considerations, including, for example, subjective ethical criteria, stock market stabilization, and industrial policy.17 In the United Kingdom, pension funds are required to disclose whether their portfolio decisions take into account environmental and social effects. In Hong Kong SAR, Japan, and Taiwan Province of China, public funds have been used, or actively considered, for stabilizing the stock market.18

21. Singapore and Hong Kong SAR provide examples of “overfunding” of the government budget, where government bonds are issued in the absence of a financing need in part to provide liquidity in key benchmark assets to facilitate the development of local financial markets.19 As of mid-2000, the Singapore government and the Hong Kong Monetary Authority had built up outstanding balances of US$20 billion and US$14 billion of government and Exchange Fund paper, respectively, partly to serve as benchmarks. The proceeds of this overfunding in both cases have been placed in foreign currency assets.

22. In Norway, the difference between the government’s net oil revenues and the non-oil fiscal deficit (i.e., the surplus on the central government budget) accumulate in the State Petroleum Fund (SPF).20 The assets of the SPF are managed by the central bank under delegation from the ministry of finance. The assets are invested in foreign securities in order to prevent oil exports from leading to excessive exchange rate appreciation (“Dutch disease”). Investing in foreign securities also precludes any political pressure that may arise from investing SPF monies onshore. Formally, the SPF is a local-currency account in the central bank, and the central bank manages a portfolio of foreign assets against this account. The central bank uses a mix between internal and external management of the portfolio. The currency composition of the foreign portfolio is based on a combination of import weights, GDP weights, and market capitalization weights. The portfolio initially comprised only fixed-income securities, but in order to provide more stable long-term returns it has been broadened since 1998 to include equities, which account for 30–50 percent of SPF assets. Equity investments are based on a mix between active and passive management with passive management replicating Thestock indexes in major equity markets.

23. A key operational principle of the Norwegian SPF is transparency. The central bank is required by law to provide information on the fund’s management to the public. Comprehensive accounts and data on the SPF’s operations are regularly available, and quarterly and annual reports provide detailed financial information. The SPF’s accounts are regularly audited, and the reports are made public. Transfers to and from SPF need parliamentary approval, and SPF operations are incorporated into the fiscal accounts.

24. The experience of the Alberta Heritage Savings Fund (AHSF) in Canada, before its reform in 1997, illustrates some of the problems that can arise with public trust fund investments.21 The AHSF was established in 1976 to manage Alberta’s resource-based revenues. Until 1997, its objectives included several social goals in addition to the generation of revenues in preparation for any future decline in resource-based income. A small part of the AHSF was invested in private securities with the expectation of earning a commercial rate of return, but the bulk of the fund was invested in local public and private securities with the objective of strengthening the provincial economy rather than earning a commercial return In addition some assets were lent to provincial governments or government agencies at concessional rates, as well as invested in long-term public works projects of benefit to the local community but without emphasis on financial return. During 1987–97, all income (including capital gains) was transferred to the provincial budget to finance government programs and services, which, together with the investment in public projects, led to a steady erosion in the value of the fund. In 1997, the mandate of the AHSF was streamlined to focus on improving financial returns, and the fund was no longeer used to finance government investment or social projects. Its assets subsequently have been invested in bonds, real estate, domestic and foreign equities, and other financial instruments.22

C. Experience in the United States

25. In the United States, there are examples of public funds being invested in private assets in the form of state resource-based trust funds, state and local pension plans, and a federal employees’ pension plan. The Alaska Permanent Fund (APF) was established in 1976 to manage the government’s oil and gas royalties.23 The objectives were in part to generate income and capital gains to provide for the time when oil revenues diminished and to distribute some of the wealth gains to the people of the state. The APF derives revenue mainly from dedicated oil revenues and legislative appropriations and it distributes dividends each year to Alaskan citizens. The performance benchmarks cover rates of return and risk management, and require public transparency and accountability. Its asset allocation targets cover real estate (9 percent U.S. equities (37 percent) foreign equities (19 percent), and bonds (37 percent). APF is managed by a board of trustees two-thirds of whom are members of the public,’ which is accountable for meeting the fund’s objectives.

26. State and local pension plans in the United States allocate their portfolios across a range of assets, and have a substantial presence in U.S. equity markets. 24 In 1999, two-thirds of their aggregate portfolio of $3 trillion was allocated to equities, with bonds accounting for roughly one quarter, and real estate, cash, and other assets for the remainder. The pattern of the aggregate portfolio is broadly reflected in the asset allocation of the five largest state and local pension plans (Table 2). In 1999 (the latest year for which full information is available), state and local pension plans accounted for 10 percent of U.S. holdings of domestic equities, 24 percent of U. S. foreign equity holdings, and 11 percent of all U.S. equity holdings Domestic and foreign equities represent 80 percent and 20 percent’ respectively, of state and local pension plans’equity holdings.

Table 2.

United States: Asset Allocation of Five Largest State and Local Pension Plans, 1999

(In percent)

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Source: Sarney (2000)
Table 3.

United States: Equity Holdings of all State and Local Pension Plans, 1999

(In billions of dollars)

article image
Source: Sarney (2000).

27. Rates of return in state and local pension plans have been somewhat less than that of private pension plans. However, returns on equity investments have been roughly similar (17 percent) in the two kinds of plans during the past decade, suggesting that the weaker overall performance of state and local plans owes to a smaller equity allocation than to poorer asset management.25 There is some weak statistical evidence that the potential for political interference, as proxied by the number of political appointees on a state pension fund’s investment board, negatively affects investment performance.26

28. The Federal Thrift Savings Plan represents an example of relatively successful private investments by a U.S. federal government entity.27 An investment board, the Federal Retirement Thrift Investment Board, was established in 1986 to manage the funds that federal employees deposited in the savings plan. Plan participants choose their own asset allocations among the various investment possibilities. The board invests the funds in private equities and debt following a passive index strategy in which it does not pick and choose among specific companies or sectors, as well as in government securities. It is financially independent of the government, securing its operating funds from a small charge on the investments it oversees.

List of References

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1

Prepared by Vivek Arora and Steven Dunaway.

2

The roughly $1 trillion in remaining debt would largely consist of marketable bonds that have not matured ($0.8 trillion) and non-marketable debt such as savings bonds and special bonds for state and local governments. Debt reduction could in principle encompass the non-matured marketable debt through buybacks by the Treasury, but this could entail paying a significant premium to bondholders. Such large premiums are viewed as a cost that exceeds the value of retiring the debt before maturity (Greenspan (2001a)). Estimates of the irredeemable debt depend on a number of assumptions including the size of future buybacks and when sales of longer-maturity debt cease. Depending on these assumptions, estimates of the irredeemable debt are typically in the $¾–¼ trillion range.

3

It is appropriate to focus on the excess of the trust fund surpluses, rather than of the whole budget surplus, over the redeemable debt since the non-trust-fund surplus (and perhaps even a part of the HI surplus) is likely to be used to pay for the Administration’s expenditure priorities and possibly for the enacted tax cut.

4

See Greenspan (2001a and 2001b).

5

See Gramlich (2001a) for a discussion of related issues.

6

Leidy (1999) argues that some of the disruptions associated with the drawdown of assets can be overcome by clearly communicating the schedule for the drawdown well in advance of when it actually occurs.

7

If market capitalization is assumed to grow with nominal GDP, projected government investment by 2011 would be 3.4 percent of capitalization.

8

Investments in private securities by the Federal Thrift Retirement Investment Board were just over $60 billion, equivalent to 0.7 percent of GDP or 0.3 percent of market capitalization. See Arthur Andersen (2000).

9

See Bohn (1997) for a summary.

11

In Chile, for example, where the pension system is a defined-contribution scheme based on individual accounts, there is a concern that the contribution rates may be lower than necessary to provide workers, especially those earning the minimum wage, with an adequate pension and that up to two-fifths of contributors may eventually need state assistance, presenting the government with substantial contingent liabilities (Heller and Gillingham (1999)).

12

Tamagno (2000) discusses the CPP investment experience, including international comparisons.

13

Until 1999, the CPP’s surplus funds were entirely invested in non-marketable bonds of the federal and provincial governments.

14

There was no statutory limitation requiring a passive strategy for the board’s investment in foreign equities.

15

Government employees as well as sitting members of the federal or provincial legislatures cannot be appointed to the board.

16

In addition to the QPP, the CDP’s depositors include other public pension plans, such as the Government and Public Employees Retirement Plan for unionized public employees; public insurance plans, such as those covering industrial and traffic accidents; and other depositors, such as the commission that oversees the securities market. See Caisse de Dépôt et Placement du Québec (2000).

17

See, for example, MacLean (2000).

18

MacLean (2000) notes that political pressure to stabilize the stock market may be related to the size of public pension funds invested in equities. However, as noted, this is envisaged to be relatively small in the United States.

20

See Davis et al. (2001).

24

See Sarney (2000).