Someday, perhaps soon, Congress will have to make changes to the country’s Social Security program. While it’s safe to assume most venture capitalists won’t rely on the program to ensure the comfort of their own retirements, they might want to keep an eye on the reform process, and not just out of an interest in national politics: A considerable chunk of their future capital stockpile is at stake.
The four key words are “mandatory Social Security coverage,” and if they are incorporated into the Social Security solution the public pension landscape would change dramatically. Over time, this could result in less interest on the part of pensions in long-term, illiquid investments such as venture capital.
Created in 1935, Social Security initially excluded participation by public workers, who instead forked over a percentage of their income to public pension plans. In the 1950s, Congress opened Social Security to public workers, but many pension plans opted not to join the federal system, including state teachers’ pensions in California, Illinois and Ohio, which have operated outside the program. And many of them still do not want in.
Public pension participants not enrolled in Social Security typically contribute about 8% to 9% of their income to their pension programs. The pension participants’ employers on average contribute another 13% to 14% of an individual’s pay, says Jeannine Markoe Raymond, director of federal relations for the National Association of State Retirement Associations.
If mandatory coverage becomes law, statewide plans, municipal systems, police and fire systems and teachers’ plans would have to turn over a huge piece of the money coming from new employees and their employers to the Social Security System. Specifically, Social Security would take 6.2% from the employee and 6.2% from the employer, essentially diverting that 12.4% from the pension plan.
Sen. Daniel Patrick Moynihan (D-N.Y.) is a chief proponent of such “universality.” Fair is fair, says Minority Chief Economist for the Senate Finance Committee David Podoff, who works closely with the retiring senator. Everyone should pay into Social Security and likewise be covered by it, Mr. Podoff says, because the redistributive nature of Social Security is good public policy – and is absent from the public pension systems. He points out that one-third of Social Security’s beneficiaries are not the retirees who contributed but rather widows or widowers, dependents and the disabled who deserve support from everyone. Sen. Moynihan and Sen. Bob Kerrey (D-Neb.) have introduced a bill that includes a mandatory coverage provision.
Pension managers argue that their participants get better benefits from their own retirement plans than they would under Social Security or a combination of Social Security and a reduced pension benefit. Furthermore, opponents of mandatory coverage point to a recent Government Accounting Office study that found the addition of public workers to Social Security would add only two years of solvency to the troubled system. Social Security benefits are doled out to current retirees from contributions by succeeding generations, not from contributions made by retirees and their employers while they were working. With a large generation of Baby Boomers on the cusp of retirement – and a smaller generation entering the workforce to support them – Social Security must be changed to remain viable. Congress could raise the payroll tax, decrease benefits, bring more people into the system for a short-term boost – as mandatory coverage would do – or invest Social Security funds more aggressively to generate additional money for beneficiaries.
Those against mandatory participation argue it is unfair to demand public workers shore up a program from which they were once excluded.
“I personally think [the fairness argument is] bogus,” says Keith Bozarth, executive director of the Illinois State Teachers’ Retirement System. “What’s happened is that retirement systems like ours have been pre-funded. We have … paid the piper as we’ve gone along, and Social Security has operated on a less prudent basis, and so now we’re being asked to come in and help.”
Effect on VCs
What does this mean for venture capitalists? Well, public pensions are big VC investors, including many pensions that would be hard hit by mandatory coverage. This is particularly true for pensions in California, Colorado, Illinois, Louisiana, Massachusetts, Ohio and Texas, states in which about 80% of the individuals potentially affected work, according to Mr. Podoff’s figures. The National Conference of State Legislatures, a Denver-based research group funded by the states, says 5.5 million state and local workers are covered by pensions, but not Social Security.
Unlike Social Security, which is a pay-as-you-go system, pension plans invest the money they collect to pay benefits to future retirees. That’s where VCs come into the picture, benefiting from the desire for a high return on those investments. Indeed, 60% of the capital raised last year by venture partnerships – $14.6 billion – came from public pensions, according to Venture Economics Information Services, a data company owned by the same parent that owns Venture Capital Journal. In recent years, public pensions have typically put up about a third of the money VCs have raised.
Under mandatory coverage proposed by Sen. Moynihan, Social Security would take 12.4% of a public worker’s pay from him and his employer, money that likely would come from the funds currently going to the pension. Public plans now get roughly 21% to 23%, so the introduction of Social Security would halve the intake from new workers. Pensions would be faced with a very different picture than the one their actuaries planned for – and unpalatable options for dealing with the situation.
Diverting half of what otherwise would be pension money to Social Security would leave pensions to pay benefits promised to retirees and soon-to-be-retirees, but with less money coming in from new hires than had been expected.
Mr. Podoff notes that pensions could trim their coverage for new hires in light of the Social Security benefits they will receive. Further, he argues, if pensions have done so well in their investing as to be fully funded, they shouldn’t be too badly hurt by the loss of income.
But while public retirement systems blossomed from the success of the public and private markets during the 1990s, the typical plan contends with at least some unfunded liability. Two years ago, pensions reported an average unfunded liability of 12.6%, according to the 1997 Survey of State and Local Government Employee Retirement Systems conducted by four industry groups collectively known as the Public Pension Coordinating Council, Ms. Markoe Raymond says. She notes, however, that recent years have been good to pensions, and therefore the unfunded liability figure is expected to drop when 1999’s survey is completed.
If and when Social Security coverage becomes mandatory, a pension joining the federal program could adjust to the situation in several ways. A plan could increase the percentage of money taken from employers and covered employees to compensate for the money lost to Social Security. But the pension could expect to face heavy resistance from employers and employees, and the issue likely would become part of the collective bargaining process if a union were involved.
Alternatively, the pension could take its case to the state legislature, asking for funding to compensate for the loss to Social Security. Of course, the plan also could pare down benefits for both existing and future retirees.
Whether a pension chooses one of these options, or some combination, the bottom line is that a plan eventually would have to revisit its asset allocation. With less money coming in than projected and future benefits still to be paid out, the question of liquidity would become key. It is futile to try to predict the precise changes in investment strategy mandatory coverage would prompt, but several pensions have indicated the potential need for more conservative investment approaches if Social Security coverage were required for all new state and local workers. Unfortunately, that shift in strategy would be expected to drive down returns as well.
California State Teachers’ Retirement System lobbyist John Stanton expressed his concerns in a recent report to the pension. “As the plan over time becomes dominated by a closed group of current participants, the potential concern would be that the tail-off in the flow of new contributions could force the plan to restructure its investment portfolio to provide the liquidity – and correspondingly lower investment return – necessary to pay retirement benefits as the majority of the closed group retires,” he wrote. He conceded, however, that the “portfolio effect” had not been clearly established.
The Illinois State Teachers’ Retirement System passed a resolution opposing mandatory coverage late last year. Background materials noted that “diverting revenues from the state and local retirement plans [to Social Security] will reduce investment options and may require TRS and other retirement systems to adjust their investment allocations.”
Jim Miller, State Teachers Retirement System of Ohio’s director of government relations, makes the same point, noting that more conservative investment strategies result in lower yields, thereby “accelerating the negative financial impact.”
Massachusetts State Treasurer Shannon O’Brien also has spoken out against mandatory coverage, noting it could force groups such as the state’s Pension Reserves Investment Management board (PRIM) to refigure asset allocations.
Too Early for Predictions
It is too early to predict whether mandatory coverage will become law – or whether any Social Security reform will claw its way out of a divided Congress – but the issue has made unusual bedfellows of pension managers’ organizations, mayors, public employers and unions, who together oppose the shift to mandatory coverage. The group is approaching legislators who lead committees that would have a hand in Social Security reform, and mandatory-coverage opponents have written a letter to President Bill Clinton expressing their disapproval of the idea.
Mandatory coverage is a relatively minor issue in the overall scheme of Social Security reform, and, accordingly, has received little media attention.
Several politically interested venture capitalists contacted by VCJ were largely unaware of the mandatory coverage issue.
Indeed, no one had brought mandatory coverage to the attention of Mark Heesen, director of legislative, regulatory and entrepreneurial affairs for the National Venture Capital Association. “I have not heard anything,” he says. “Not a word.”
NVCA President M. Kathy Behrens says the group’s principal legislative efforts center on regulatory issues. “Right now, (mandatory Social Security coverage) is not a priority on our agenda, but I can’t tell you it wouldn’t become a priority,” she says.
Political observer and Bessemer Venture Partners General Partner Chris Gabrieli isn’t too worried. Granted, his firm gets its money from one family, but even when Mr. Gabrieli looks beyond his office, he does not think VCs have much to fear. He reasons that as long as returns are good, investors of all types will be drawn to venture capital. Mandatory coverage, he says, might even encourage pensions to stay in VC to generate the additional monies necessary to pay benefits from the reduced capital coming from workers. Further, even if pensions leave the market, other types of investors, such as endowments and foundations, will move in to take bigger pieces of the venture capital pie, Mr. Gabrieli adds.
Social Security proposals are wide-ranging. There’s President Clinton’s proposal to pay down the national debt, issue bonds and invest part of the federal budget surplus in stocks as part of an effort to help bolster Social Security. Then there’s the Republican plan to create individual savings accounts, Sen. Ted Kennedy’s (D-Mass.) suggestion to raise the maximum income taxed by Social Security and Sen. Moynihan’s call for mandatory coverage and curtailed cost-of-living adjustments for Social Security recipients. Indeed, the sheer number of proposals under consideration lowers the likelihood of Congress approving any Social Security reform measure in the near term.
Opponents of mandatory coverage believe they have a strong case, and plenty of poster children in the firefighters, police officers and teachers who would be affected by passage of such a law. At the same time, leaders of the opposition are warning their supporters that the issue is far from dead.
In the last two years, some 18 bills were drafted calling for some form of mandatory Social Security coverage, says Ed Braman, legislative coordinator for the National Conference on Public Employee Retirement Systems, adding that he expects two bills to be introduced in the House this session. At press time he was uncertain whether the measures would call for mandatory coverage.
It was the 1996 government-created Social Security Commission that first brought the idea of mandatory coverage into the current Social Security reform debate. Indeed, mandatory coverage was a key point of agreement among committee members, who otherwise diverged in their suggestions for reforming the Social Security program.
While the Clinton Administration has not proposed mandatory coverage in its budget bill, the President has not removed the provision from the table either, lobbyists say. If a bill gains momentum this year, the influence of Sen. Moynihan, a ranking Democrat on the Senate Finance Committee, on the reform process could be significant, Ms. Markoe Raymond says, in part because he likely would be part of a conference committee to reconcile Social Security reform measures passed by the Senate and House. Sen. Moynihan, however, retires from office in 2000.
“Right now, we are doing our very best to prevent this from happening at all,” says Jim Wood, executive director of the Louisiana State Employees’ Retirement System. “We think a strong offense is our best defense in this situation.”