During his days as a senior executive at Fidelity Investments, Robert C. Pozen was wary of mutual funds with too few stocks. "Ex-post we are all geniuses, but ex-ante it is pretty hard to figure out which ones are going to go up and which are going to go down," he says. Always a "great believer in diversification," Pozen now teaches at Harvard University's Kennedy School of Government. And, he says, the importance of a broad portfolio has since been highlighted by what happened at Enron, where a heavy concentration of company stock in employee 401(k) plans is causing thousands to lose their life savings.
Diversification may also be a key to Social Security reform, he says. As a member of President George W. Bush's commission to overhaul the system, Pozen, 55, helped design the three options noted in the commission report in January — options allowing participants to divert up to 4 percentage points of the 12.4 percent payroll tax into private investment accounts. The 16-member panel was widely criticized as being stacked with proponents of private accounts, but Pozen insists that Social Security's future solvency depends on a combination of structural reforms and diversified personal accounts.
A former Securities and Exchange Commission official, Pozen is dismayed that Corporate America is "noticeably silent" on the subject. "This is a serious problem, and it is going to impact all CFOs pretty soon," he says, noting, for example, that changing benefit patterns will cause workers to retire later. Social Security reform will reverberate through the 2002 elections, "and business has a choice to be a player or not on this question."
During a 15-year Fidelity career that started as general counsel and ended as vice chairman and president of the management and research unit of the $900 billion asset giant, Pozen was often the public spokesperson for the notoriously secretive firm. While widely credited with orchestrating Fidelity's turnaround in the 1990s, he announced his departure by "mutual decision" from the family-owned firm when Abigail Johnson, daughter of CEO Edward "Ned" Johnson, was tapped to head Fidelity Management last May.
Pozen, who recently published the second edition ofThe Mutual Fund Business, sat down with CFO deputy editor Lori Calabro to discuss the Social Security commission's findings and the current state of retirement benefits.
You were appointed to the Social Security commission last May. What was the commission's specific charge?
There was a lot of ambiguity about the charge. We viewed it as making the system move toward solvency, and using personal accounts as part of that strategy. Obviously, there is a group that hates personal accounts and doesn't want to do them at all. Another group thinks if you only have a personal account, then that will solve everything. The commission said neither side is right. What you need is a combination of structural reforms in the system with a personal account.
The commission came up with three options. Are you partial to any one?
The first option is just a throwaway. It's a personal account without any change in the system, and that's not a serious proposal. Options two and three are both very serious; they help the system get back to solvency and allow people to have personal accounts as a way to get back toward future scheduled benefits. But neither reduces the current levels of benefits.
Option two says we are going to slow the rate of growth of benefits by moving from wage indexing to price indexing, which reduces [the traditional benefit] about 2 percent of payroll. Then it allows individuals to put up to $1,000 in their own account. Because of the higher return [possible], that will get them roughly toward the same scheduled benefit level.
Option three slows the rate of growth in benefits through longevity indexing. That means as people live longer, their benefits will be adjusted. And in particular, it means if people choose to retire early, they are going to take a hit. We've had an incredible trend in the United States — between 1970 and 1990, the number of people retiring early has zoomed, and it's about 60 percent today. That's very difficult for the system. [Longevity indexing] itself is worth about 1.2 percent of payroll. And in this model, because of higher returns from the personal accounts plus new revenues, expected benefits will exceed scheduled benefits.
Did you develop three plans mostly to make the findings politically palatable?
We wanted to show that there are different ways to produce reform. We also imposed on ourselves some very tough [investment] constraints. We were required by the chief actuary to use what most people would think of as a relatively modest return. We used a portfolio of 50 percent stocks and 50 percent bonds, with a 4.6 percent real return. In addition — and this relates to Enron — we [opted] not to allow anyone to put all their money in one stock. You can only put money in a diversified pool.
Still, critics will say that the benefits are not guaranteed the way they are now under Social Security.
There is a misconception that scheduled benefits are guaranteed. They are not. Congress can change them at any time. And while it's impossible to eliminate all risk, what we are talking about is people investing over 30 or 40 years. I have run the numbers for every 20-, 30-, and 40-year period over the past 50 years, eliminating the very puffy years of 1997 through 1999. And in every period, the equity market did better than the Treasury bond rate. But we go further: we propose a Treasury bond pool, so that if people just want to get the Treasury rate, they can. And if they get the Treasury rate, they will be doing better than they would now under Social Security.
You were charged with coming up with plans that wouldn't increase taxes or reduce benefits. Both those things ended up in the results. What happened?
I don't think that's quite correct. First of all, we were charged with not reducing benefits for people in retirement or near retirement. That's why we did not address COLAs [cost-of-living adjustments]. We were not prohibited from slowing down the growth in benefits. Remember, every person will do as well, CPI adjusted, in 2050 as they do now. But they won't grow their benefits as fast.
Second, we all agreed that we would not raise the payroll tax rate, because 12.4 percent is very high. The commission discussed whether the terms of its executive order precluded an increase in the payroll tax base, and, in the end, the White House ruled that it was precluded. In the third plan, there is a proposal to have dedicated revenues to Social Security, but it leaves it up to Congress to decide what type of tax would be used to get that revenue.
What extra burdens will these plans impose on companies?
We were adamant that there be no extra burden on employers; that they'd continue to send in payroll taxes just like they do now. It would be up to the government — through a new Federal Reserve-like entity for pensions — to take those monies and put a certain percentage in a holding investment, like a money market fund or Treasury bond. Then, at the end of the year, that entity would put the money into the investment choices of the individual.
What will it take for business to get behind Social Security reform?
Business doesn't understand what is going to happen if there is no Social Security reform. Look at the budget for this coming year. Assuming we have no new stimulus package, it's roughly about zeroed out. But the accounting is questionable, because implicit in that zero is $189 billion from an annual surplus from Social Security. That surplus, however, is going to dwindle, and ultimately go negative in 2016. Then what are the implications?
Well, first, a lot of CFOs probably want various types of government-funded programs — more money into FDA processing or in developing technologies. Just think of the situation when this $189 billion cushion isn't there. It will be very difficult to get new spending programs.
Second, think about tax reform. Remember when we had big deficits and whenever you went to Congress for tax reform they said you had to "pay for it"? And they didn't mean to "pay for it" by increasing the taxes on someone else's industry. So again, without Social Security reform, there's going to be tremendous difficulty in getting further tax cuts.
Third, there are still many defined benefit plans around, and roughly 50 percent are integrated with Social Security. That is, they calculate what your total benefit is and subtract your Social Security benefit to determine your defined benefit. Now, suppose people become uncertain about whether they will get Social Security. We know that if nothing is done by 2038, Social Security benefits will be cut by roughly 28 percent. This will pose a significant long-term problem for integrated defined-benefit plans.
Were you surprised at criticism leveled at the commission? The president of the AFL-CIO called your report "a radical plan to dismantle Social Security."
The PR at the beginning was terrible. There were pickets at our first meeting, before we even said a word. But it's not a radical plan to dismantle Social Security; it's taking a small portion of Social Security and giving people the choice of getting a better return. His is what I call the "do-nothing plan." What's his suggestion?
I'm afraid Social Security is a very polarizing issue. And my personal belief is that if there is not Social Security reform by 2011, when the baby boom goes into retirement, we won't see it until 2038. The cardinal rule is you can't touch people's benefits once they go into retirement.
How do you think the Enron situation is going to affect Social Security reform?
It should reinforce the commission's conclusions. There is a case where all the money was put in one spot — Enron stock. And we kept saying: diversification, diversification, diversification.
Besides diversification, what should be done to prevent future 401(k) debacles?
Employee participants should be able to sell employer stock that's given as a match. There should be some reasonable waiting period, say a year. But Enron didn't let employees sell until they were 50.
Second, there probably would have to be amendments to ESOPs, KSOPs, and [related] tax provisions. They should state that if some employees sell the stock and the plan goes below a certain amount, the firm doesn't lose the whole tax benefit of the ESOP or KSOP. That shouldn't be the price. The combination of those ideas would go a long way toward solving the problem.
Enron obviously has Congress riled up. They are looking at the percentage of company stock in plans, lockdowns, and the idea of giving financial advice to employees. Does it make you nervous that Congress is getting involved?
It always makes me nervous when Congress responds to a crisis. And if Congress understood that some of these proposals might decrease employer matches, they wouldn't think they were such good ideas.
Do you foresee the uproar over Enron leading Congress to increase senior management's fiduciary responsibilities?
I doubt there will be legislation. The courts will be the ones to decide. But it's the concern corporate officials will have about their [potential] liabilities that will change their attitudes [on fiduciary responsibility].
Any chance 401(k) changes will be a hot issue this proxy season?
Auditor assignments will be a hot issue, and maybe employer stock, but not management of 401(k)s.