Goldman Sachs Rakes In Profit in Credit Crisis - New York Times

For more than three months, as turmoil in the credit market has swept wildly through Wall Street, one mighty investment bank after another has been brought to its knees, leveled by multibillion-dollar blows to their bottom lines.

And then there is Goldman Sachs.

Rarely on Wall Street, where money travels in herds, has one firm gotten it so right when nearly everyone else was getting it so wrong. So far, three banking chief executives have been forced to resign after the debacle, and the pay for nearly all the survivors is expected to be cut deeply.

But for Goldman’s chief executive, Lloyd C. Blankfein, this is turning out to be a very good year. He will surely earn more than the $54.3 million he made last year. If he gets a 20 percent raise — in line with the growth of Goldman’s compensation pool — he will take home at least $65 million. Some expect his pay, which is directly tied to the firm’s performance, to climb as high as $75 million.

Goldman’s good fortune cannot be explained by luck alone. Late last year, as the markets roared along, David A. Viniar, Goldman’s chief financial officer, called a “mortgage risk” meeting in his meticulous 30th-floor office in Lower Manhattan.

At that point, the holdings of Goldman’s mortgage desk were down somewhat, but the notoriously nervous Mr. Viniar was worried about bigger problems. After reviewing the full portfolio with other executives, his message was clear: the bank should reduce its stockpile of mortgages and mortgage-related securities and buy expensive insurance as protection against further losses, a person briefed on the meeting said.

With its mix of swagger and contrary thinking, it was just the kind of bet that has long defined Goldman’s hard-nosed, go-it-alone style.

Most of the firm’s competitors, meanwhile, with the exception of the more specialized Lehman Brothers, appeared to barrel headlong into the mortgage markets. They kept packaging and trading complex securities for high fees without protecting themselves against the positions they were buying.

Even Goldman, which saw the problems coming, continued to package risky mortgages to sell to investors. Some of those investors took losses on those securities, while Goldman’s hedges were profitable.

When the credit markets seized up in late July, Goldman was in the enviable position of having offloaded the toxic products that Merrill Lynch, Citigroup, UBS, Bear Stearns and Morgan Stanley, among others, had kept buying.

“If you look at their profitability through a period of intense credit and mortgage market turmoil,” said Guy Moszkowski, an analyst at Merrill Lynch who covers the investment banks, “you’d have to give them an A-plus.”

This contrast in performance has been hard for competitors to swallow. The bank that seems to have a hand in so many deals and products and regions made more money in the boom and, at least so far, has managed to keep making money through the bust.

In turn, Goldman’s stock has significantly outperformed its peers. At the end of last week it was up about 13 percent for the year, compared with a drop of almost 14 percent for the XBD, the broker-dealer index that includes the leading Wall Street banks. Merrill Lynch, Bear Stearns and Citigroup are down almost 40 percent this year.

Goldman’s secret sauce, say executives, analysts and historians, is high-octane business acumen, tempered with paranoia and institutionally encouraged — though not always observed — humility.

“There is no mystery, or secret handshake,” said Stephen Friedman, a former co-chairman and now a Goldman director. “We did a lot of work to build a culture here in the 1980s, and now people are playing on the balls of their feet. We just have a damn good talent pool.”

That pool has allowed Goldman to extend its reach across Wall Street and beyond.

Last week, John A. Thain, a former Goldman co-president, accepted the top position at Merrill Lynch, while a fellow Goldman alumnus, Duncan L. Niederauer, took Mr. Thain’s job running the New York Stock Exchange. Another fellow veteran trader, Daniel Och, took his $30 billion hedge fund public.

Meanwhile, two Goldman managing directors helped bring Alex Rodriguez back to the Yankees, a deal that could enhance the value of Goldman’s 40 percent stake in the YES cable network — which it is trying to sell — while also pleasing Yankee fans. The symmetry was perfect: like the Yankees, Goldman, more than any other bank on Wall Street, is both hated and revered.

Robert E. Rubin, a former Goldman head, is the new chairman of Citigroup. In Washington, another former chief, Henry M. Paulson Jr., is the Treasury secretary, having been recruited by Joshua B. Bolten, the White House chief of staff and yet another former Goldman executive.

The heads of the Canadian and Italian central banks are Goldman alumni. The World Bank president, Robert B. Zoellick, is another. Jon S. Corzine, once a co-chairman, is the governor of New Jersey. And in academia, Robert S. Kaplan, a former vice chairman, has just been picked as the interim head of Harvard University’s $35 billion endowment.

Since going public in 1999, Goldman has been the No. 1 mergers and acquisitions adviser, globally and in the United States, with two exceptions: in 2005 it came in second in the United States rankings, and in 2000 it lost the top spot globally. In both instances, Morgan Stanley took the lead, according to Dealogic.

Goldman, of course, has made its share of mistakes. It took among the most serious write-downs in the third quarter on loans that were made to private equity firms, totaling $1.5 billion. The firm runs one of the largest hedge fund operations in the world, but its flagship funds — funds whose investors include marquee Goldman clients and employees — have had two years of abysmal performance. Clients are expected to redeem billions of dollars of capital at the end 2007.

But Goldman’s absence from the mortgage debacle and the strong performance of its other businesses made up for the write-down associated with the loans. The firm reported $2.85 billion in profit in the third quarter, up 79 percent. Mr. Moszkowski estimates that investment and commercial banks in the United States have taken $50 billion in write-downs related to mortgages, with more coming; Mr. Blankfein said at a conference last week that he expected to take none.

Goldman’s business is built on taking risks, both for itself and its clients. In recent years, Goldman has established the largest private equity and real estate fund complexes in the world. That has led to natural tensions with private equity clients who sometimes complain, but never publicly, about Goldman’s common insistence to team up with them for a piece of the deal.

“Goldman has done the best job of any firm in the U.S. or world competing with their clients but doing business with them,” said one client who asked not to be named because he does business with the firm. “They’ve managed to get their clients to live with it.”

Still, this bottom-line approach has turned off some Goldman veterans and clients. They see the firm’s desire to advise, finance and invest — a so-called triple play — as antithetical to Goldman’s stated No. 1 business principle of putting clients first.

And there is little question that its success in trading, investment banking and servicing hedge funds — many of the traders come right from Goldman — allows the firm a bird’s-eye view on trends and capital flows in the market.

Numerous Goldman investment bankers, former and current, voice the view that Mr. Blankfein’s approach — using Goldman’s investment banking business to develop principal investment opportunities for the firm — creates a brand intended to feed Goldman’s profits rather than relationships. But this harking back to the firm’s golden days as a pure advisory firm does not find much sympathy at Goldman these days.

“I have little patience for these people who talk of the last days of Camelot,” Mr. Friedman said. “Principal investing has been an important and useful business. If you want to be relevant you have to anticipate where the world is going.”

Mr. Blankfein, at the conference last week, echoed that sentiment. “While the integration of our investment banking operations with our merchant bank was somewhat controversial at the time, we felt these businesses were mutually reinforcing,” he said.

Money soothes a lot of concerns, of course, and Goldman has had plenty to spread around. Through the third quarter, Goldman’s $16.9 billion compensation pool — the money it sets aside to pay its employees — was significantly bigger than the entire $11.4 billion market capitalization of Bear Stearns.

Goldman executives and analysts assign much of their success to smart people and a relatively flat hierarchy that encourages executives to challenge one another. As a result, good ideas can get to the top.

But the differentiator that has become clearest recently is the firm’s ability to manage its risks, a tricky task for any bank. Checks and balances must be in place to turn off a business spigot even as it is still making a lot of money for a lot of people. In a world where power gravitates to the rainmakers, that means only management can empower the party crashers.

At Goldman, the controller’s office — the group responsible for valuing the firm’s huge positions — has 1,100 people, including 20 Ph.D.’s. If there is a dispute, the controller is always deemed right unless the trading desk can make a convincing case for an alternate valuation. The bank says risk managers swap jobs with traders and bankers over a career and can be paid the same multimillion-dollar salaries as investment bankers.

“The risk controllers are taken very seriously,” Mr. Moszkowski said. “They have a level of authority and power that is, on balance, equivalent to the people running the cash registers. It’s not as clear that that happens everywhere.”

For all its success on Wall Street, it is Goldman’s global reach and political heft that inspire a mix of envy and admiration. In the race for president, Goldman Sachs executives are the top contributors to Barack Obama and Mitt Romney, and the second highest contributor to Hillary Rodham Clinton. Mr. Blankfein has held a fund-raiser for Mrs. Clinton in his apartment and has come out publicly in her favor.

Another member of Goldman’s influential diaspora is Philip D. Murphy, a retired executive who is the chief fund-raiser for the Democratic National Committee.

All of which has made Goldman a favorite of conspiracy theorists, columnists and bloggers who see the firm as a Wall Street version of the Trilateral Commission.

One particular obsession is President Bush’s working group on the markets, an informal committee led by Mr. Paulson that includes Ben S. Bernanke, the chairman of the Federal Reserve; Christopher Cox, the chairman of the Securities and Exchange Commission; and Walter Lukken, the acting chairman of the Commodity Futures Trading Commission.

The group meets about once a quarter — privately, with no minutes taken — to ensure that government agencies are briefed on market conditions and issues. The group is currently examining the extent to which the packaging and distribution of mortgage loans contributed to the crisis. It also recently completed a study recommending that hedge funds not be subject to further regulation; the group’s fund committee was led by Eric Mindich, a former Goldman trader who now runs a successful hedge fund.

There is no evidence that the conduct of the group is anything but above board. But to some, the group’s existence adds more color to the view that Goldman is indeed everywhere — much as J. P. Morgan was in the early years of the 20th century.

“Goldman Sachs has as much influence now that the old J. P. Morgan had between 1895 and 1930,” said Charles R. Geisst, a Wall Street historian at Manhattan College. “But, like Morgan, they could be victimized by their own success.”

Mr. Blankfein of Goldman seems aware of all this. When asked at a conference how he hoped to take advantage of his competitors’ weakened position, he said Goldman was focused on making fewer mistakes. But he wryly observed that the firm would surely take it on the chin at some point, too.

“Everybody,” he said, “gets their turn.”

Whose language?

By Michael Skapinker

Published: November 9 2007 02:00 | Last updated: November 9 2007 02:00

Chung Dong-young, a former television anchorman and candidate to be president of South Korea, may be behind in the opinion polls but one of his campaign commitments is eye-catching. If elected, he promises a vast increase in English teaching so that young Koreans do not have to go abroad to learn the language. The country needed to "solve the problem of families separated for English learning", the Korea Times reported him saying.

In China, Yu Minhong has turned New Oriental, the company he founded, into the country's biggest provider of private education, with more than 1m students over the past financial year, the overwhelming majority learning English. In Chile, the government has said it wants its population to be bilingual in English and Spanish within a generation.

No one is certain how many people are learning English. Ten years ago, the British Council thought it was around 1bn. A report, English Next , published by the council last year, forecast that the number of English learners would probably peak at around 2bn in 10-15 years.

How many people already speak English? David Crystal, one of the world's leading experts on the language and author of more than 100 books on the subject, estimates that 1.5bn people - around one-quarter of the world's population - can communicate reasonably well in English.

Latin was once the shared language over a vast area, but that was only in Europe and North Africa. Never in recorded history has a language been as widely spoken as English is today. The reason millions are learning it is simple: it is the language of international business and therefore the key to prosperity. It is not just that Microsoft, Google and Vodafone conduct their business in English; it is the language in which Chinese speak to Brazilians and Germans to Indonesians.

David Graddol, the author of English Next , says it is tempting to view the story of English as a triumph for its native speakers in North America, the British Isles and Australasia - but that would be a mistake. Global English has entered a more complex phase, changing in ways that the older English-speaking countries cannot control and might not like.

Commentators on global English ask three principal questions. First, is English likely to be challenged by other fastgrowing languages such as Mandarin, Spanish or Arabic? Second, as English spreads and is influenced by local languages, could it fragment, as Latin did into Italian and French - or might it survive but spawn new languages, as German did with Dutch and Swedish? Third, if English does retain a standard character that allows it to continue being understood everywhere, will the standard be that of the old English-speaking world or something new and different?

Mr Graddol says the idea of English being supplanted as the world language is not fanciful. About 50 years ago, English had more native speakers than any language except Mandarin. Today both Spanish and Hindi-Urdu have as many native speakers as English does. By the middle of this century, English could fall into fifth place behind Arabic in the numbers who speak it as a first language.

Some believe English will survive because it has a natural advantage: it is easy to learn. Apart from a pesky "s" at the end of the present tense third person singular ("she runs"), verbs remain unchanged no matter who you are talking about. (I run, you run, they run; we ran, he ran, they ran.) Definite and indefinite articles are unaffected by gender (the actor, the actress; a bull, a cow.) There is no need to remember whether a table is masculine or feminine.

There is, however, plenty that is difficult about English. Try explaining its phrasal verbs - the difference, for example, between "I stood up to him" and "I stood him up". Mr Crystal dismisses the idea that English has become the world's language because it is easy. In an essay published last year, he said Latin's grammatical complexity did not hamper its spread. "A language becomes a world language for extrinsic reasons only, and these all relate to the power of the people who speak it," he wrote. The British empire carried English to all those countries on which the sun never set; American economic and cultural clout en-sured English's dominance after the British empire had faded.

So could China's rise see Mandarin becoming the world's language? It may happen. "Thinking back a thousand years, who would have predicted the demise of Latin?" Mr Crystal asks. But at the moment there is little sign of it, he says. The Chinese are rushing to learn English.

Mr Graddol agrees that we are unlikely to see English challenged in our lifetime. Once a lingua franca is established, it takes a long time to shift. Latin may be disappearing but it remained the language of science for generations and was used by the Roman Catholic church well into the 20th century.

As for English fragmenting, Mr Graddol argues it has already happened. "There are many Englishes that you and I wouldn't understand," he says. World Englishes , a recent book by Andy Kirkpatrick, professor at the Hong Kong Institute of Education, gives some examples. An Indian teenager's journal contains this entry: "Two rival groups are out to have fun . . . you know generally indulge in dhamal [a type of dance] and pass time. So, what do they do? Pick on a bechaara bakra [poor goat] who has entered college." Prof Kirkpatrick also provides this sample of Nigerian pidgin English: "Monkey de work, baboon dey chop" (Monkeys work, baboons eat).

It is unlikely, however, that this fragmentation will lead to the disappearance of English as a language understood around the world. It is common for speakers of English to switch from one or other variantto a use of language more appropriate for work, school or international communication. Mr Crystal says modern communication through television, film and the internet means the world is likely to hold on to an English that is widely understood.

The issue is: whose English will it be? Non-native speakers now outnumber native English-speakers by three to one. As hundreds of millions more learn the language, that imbalance will grow. Mr Graddol says the majority of encounters in English today take place between non-native speakers. Indeed, he adds, many business meetings held in English appear to run more smoothly when there are no native English-speakers present.

Native speakers are often poor at ensuring that they are understood in international discussions. They tend to think they need to avoid longer words, when comprehension problems are more often caused by their use of colloquial and metaphorical English.

Barbara Seidlhofer, professor of English and applied linguistics at the University of Vienna, says relief at the absence of native speakers is common. "When we talk to people (often professionals) about international communication, this observation is made very often indeed. We haven't conducted a systematic study of this yet, so what I say is anecdotal for the moment, but there seems to be very widespread agreement about it," she says. She quotes an Austrian banker as saying: "I always find it easier to do business [in English] with partners from Greece or Russia or Denmark. But when the Irish call, it gets complicated and taxing."

On another occasion, at an international student conference in Amsterdam, conducted in English, the lone British representative was asked to be "less English" so that the others could understand her.

Prof Seidlhofer is also founding director of the Vienna-Oxford International Corpus of English (Voice), which is recording and transcribing spoken English interactions between speakers of the language around the world. She says her team has noticed that non-native speakers are varying standard English grammar in several ways. Even the most competent sometimes leave the "s" off the third person singular. It is also common for non-native speakers to use "which" for humans and "who" for non- humans ("things who" and "people which").

Prof Seidlhofer adds that many nonnative speakers leave out definite and indefinite articles where they are required in standard English or put them in where standard English does not use them. Examples are "they have a respect for all" or "he is very good person". Nouns that are not plural in native-speaker English are used as plurals by non-native speakers ("informations", "knowledges", "advices"). Other variations include "make a discussion", "discuss about something" or "phone to somebody".

Many native English speakers will have a ready riposte: these are not variations, they are mistakes. "Knowledges" and "phone to somebody" are plain wrong. Many non-native speakers who teach English around the world would agree. But language changes, and so do notions of grammatical correctness. Mr Crystal points out that plurals such as "informations" were once regarded as correct and were used by Samuel Johnson.

Those who insist on standard English grammar remain in a powerful position. Scientists and academics who want their work published in international journals have to adhere to the grammatical rules followed by the native English-speaking elites.

But spoken English is another matter. Why should non-native speakers bother with what native speakers regard as correct? Their main aim, after all, is to be understood by one another. As Mr Graddol says, in most cases there is no native speaker present.

Prof Seidlhofer says that the English spoken by non-native speakers "is a natural language, and natural languages are difficult to control by 'legislation'.

"I think rather than a new international standard, what we are looking at is the emergence of a new 'international attitude', the recognition and awareness that in many international contexts interlocutors do not need to speak like native speakers, to compare themselves to them and thus always end up 'less good' - a new international assertiveness, so to speak."

When native speakers work in an international organisation, some report their language changing. Mr Crystal has written: "On several occasions, I have encountered English-as-a-first-language politicians, diplomats and civil servants working in Brussels commenting on how they have felt their own English being pulled in the direction of these foreignlanguage patterns . . . These people are not 'talking down' to their colleagues or consciously adopting simpler expressions, for the English of their interlocutors may be as fluent as their own. It is a natural process of accommodation, which in due course could lead to new standardised forms."

Perhaps written English will eventually make these accommodations too. Today, having an article published in the Harvard Business Review or the British Medical Journal represents a substantial professional accomplishment for a business academic from China or a medical researcher from Thailand. But it is possible to imagine a time when a pan-Asian journal, for example, becomes equally, or more, prestigious and imposes its own "Globish" grammatical standards on writers - its editors changing "the patient feels" to "the patient feel".

Native English speakers may wince but are an ever-shrinking minority.

Singapore's graduates leap into work

As the job market becomes more competitive, MBA graduates need to "sell themselves," to clinch top jobs globally.

Michael Melcher, a New York partner with Next Step partners, who has conducted training workshops with a number of Ivy League universities, says focusing on soft skills can add value to a student's appeal.

"I've worked in a lot of top schools in the US and Europe, and most of the MBA students need a fair bit of work. Most of them have made huge investments, time and money to get a MBA degree. But most do not know how to market themselves," adds Mr Melcher.

"So we need to work on their soft skills, to help them tell their story to the employers in a convincing manner. At the end it doesn't matter whether you come from Asia or the US, you need to transcend your local levels, and be able to have a global impact."

This is especially true to the MBA students coming out of Singapore, who are a blend of local and foreign graduates. Even though the buoyant economy coupled with a tight labour market has brought about good employment opportunities, the universities admit it is important for their business schools to find quick job placements for their graduates. As a result a lot of resources are channeled into preparing students to be market-ready.

"MBA is an investment. The opportunity costs are high especially for full-time students who quit their jobs. They are looking for a return on investment (ROI), a career progression or a career switch. Thus, through the career services we equip them with soft skills to assist them," says Ms Tan from the NTU business school.

Ms Tay from NUS agrees: "It is who you are and not what school you come from that matters. What we do at the careers services is create an environment where we can prepare our students to be ready for the market. Whether the economic times are good or bad, every company wants the best candidate for the job. We give the students the grounding to articulate their abilities when they meet an employer."

Housewives and contract workers have little savings

CHANGES to the Central Provident Fund will help CPF members retire with more money - but what about those with little or no CPF savings?

Several MPs raised the plight of this group when debating impending changes to the CPF.

For example, housewives, the self-employed, contract workers and odd-job labourers have little or no CPF funds. These groups need extra help from the Government in their old age, said MPs.

Dr Lim Wee Kiak (Sembawang GRC) said some in this group would not be able to afford longevity insurance, which the Government intends to implement.

The plan is for CPF members to set aside a small sum to buy an annuity plan that pays a modest amount when they reach 85, when their CPF savings are likely to have run out.

Dr Lim suggested the Government help co-fund the premiums of people with little or no CPF savings.

Older odd-job workers who did not make regular CPF contributions are another group to be concerned about, said Mr Inderjit Singh (Ang Mo Kio GRC).

Labour MP Halimah Yacob (Jurong GRC) suggested the Government top up housewives' CPF accounts so they can pay for the scheme. 'There are many without the Minimum Sum and women, as we know, live longer than men,' she said. However, she added, she hoped women would not be charged higher premiums.

Dr Ahmad Magad (Pasir Ris-Punggol GRC) suggested giving bonuses to mothers who work part time, so they can top up their CPF.

S'pore will have world's 4th oldest population by 2050

BY 2050, the population in Singapore could be fourth oldest in the world - after Macau, Japan and Korea.

But Singapore is also one of the very few countries tackling the issues of retirement and an ageing population head-on, said Manpower Minister Ng Eng Hen yesterday.

Singapore is greying, and the signs are showing.

He recounted that it is no longer a novelty to meet residents who are in their 80s and 90s during his constituency visits. Foreigners from younger Asean countries are also quick to note the ageing population.

A recent United Nations study confirmed these impressions. It projected the median age of Singapore's population to be 54 years by 2050, behind Macau (56), Japan (55) and South Korea (55).

Said Dr Ng: 'Singaporeans must come to terms with our longevity, both individually and as a nation. And the quicker we do this, the better.'

This means tackling the ageing problem the same way as other national issues - by thinking long term and acting quickly before a problem becomes unmanageable.

The goal, Dr Ng said, is to put in place a better and sustainable Central Provident Fund system that will help Singaporeans save enough for their full lifespan.

But not all Singaporeans recognise they are living longer. Some even think the higher life expectancy has to do with the elderly being 'farm folk' who were born overseas, and not Singaporeans born here, said Dr Ng.

A fact they have to consider is this: There will be fewer working people to shoulder the burden of supporting the elderly.

In 1960, 23 people aged 15 to 64 supported one person aged 65 and above. Now, it is eight people - and by 2030, it will be four people.

While many countries realise they are ill prepared to deal with a population that is ageing, 'not all have been able to act to avoid the impending crisis'.

Some have debated the issue for a long time. Reform commissions such as in France, Ireland and the United States have spelt out what needs to be done.

But in the case of the Irish, its commission failed to agree on a conclusion; China admits it needs to move faster; and pension reform in Italy has been a major stumbling block for successive governments even after 20 years of deliberations.

Then, there are countries that want to postpone the solution to the next generation. Britain, for instance, intends to move its state pension age to 68 - but only by 2046.

Singapore cannot afford to wait so long, Dr Ng said.

'We should not pass these problems of an ageing population to the next generation... Far better to make adjustments now, while we are able and have time on our side. If we wait and are ill prepared, then the consequences for Singaporeans when they are old and dependent will be more painful.'

How higher interest rates will benefit members

Manpower Minister Ng Eng Hen yesterday sketched out details of the CPF reforms and other measures to help Singaporeans build up their retirement savings.His ministerial statement, focuses on three pillars of retirement support - working longer, increasing CPF returns and making savings last as long as one?s life span

IN 20 years, a Central Provident Fund member with $60,000 in his CPF savings will get $17,900 more.

Manpower Minister Ng Eng Hen cited this example yesterday to show just how much a member will benefit from higher CPF interest rates.

Indeed, seven in 10 of all CPF members and more than half of active CPF members will benefit fully from the higher rate, Dr Ng told Parliament yesterday.

From next January, the Government will pay out an additional percentage point on the first $60,000 on all CPF accounts, up to a cap of $20,000 in the Ordinary Account.

This change was announced by Prime Minister Lee Hsien Loong in his National Day Rally speech last month.

It is aimed at helping Singaporeans, especially low-income workers, build a bigger retirement nest egg.

Yesterday, Dr Ng fleshed out details of the CPF changes, revealing that the higher interest rate will cost the Government at least $700 million a year, equal to its annual grant to the HDB.

At the same time, the Government will float the interest rates of the Special, Medisave and Retirement Accounts (SMRA) and peg them to 10-year Singapore Government Securities (SGS) rates.

Under the current system, the SMRA rate is a guaranteed 4 per cent.

Under the new system, the SMRA rate is pegged to the previous year's 10-year SGS rate plus one percentage point.

The average SGS rate is now 3 per cent. Based on this peg, it means the SMRA interest rate will be 4 per cent - the SGS rate of 3 per cent plus 1 percentage point.

To help members adjust to the floating rate, the Government will still pay out a minimum of 4 per cent on the SMRA for the next two years, said Dr Ng.

This 4 per cent floor will also apply to the first $60,000 in the combined CPF accounts that enjoy a higher interest rate.

Since the 10-year SGS was launched in 1998, the highest daily rate it rose to was 5.69 per cent, while the lowest it hit was 1.79 per cent.

Dr Ng said the decision to peg rates to the 10-year SGS was based on several factors.

Among other considerations, the move had to be financially sound, easily understood and not exposed to fluctuations in currency exchange rates, he said.

The ideal peg, added Dr Ng, would have been a 30-year SGS because that would be the average time members' money stayed in their SMRA.

But there was no such bond and shorter bonds of 20 years were not actively traded, making them unsuitable as a peg.

Said Dr Ng: 'Why plus 1 per cent? Because this will adequately provide for the difference we would expect between the interest on the 10-year SGS, which we are using, and the 30-year SGS, if it existed.'

Addressing worries over fluctuating returns, Dr Ng said the new rates should be viewed from a long-term perspective.

'For members' information, had the new SMRA formula been in place since the first issue of the 10-year SGS in 1998, the SMRA rate would have averaged 4.5 per cent,' he noted.

Likewise, he dismissed fears that the CPF changes will deprive fund managers of investable CPF funds.

Under the new rules, from next April, a CPF member will not be allowed to invest the first $20,000 of his CPF Ordinary and Special accounts savings under the CPF Investment Scheme (CPFIS).

Said Dr Ng: 'Money already invested in CPFIS will not be affected. Even after these restrictions, $42 billion will still be available for use in CPFIS.'

A CPF member will still be able to use Ordinary Account funds for housing, CPF insurance and education schemes, said Dr Ng.

There will also be no change to the HDB concessionary loan rate, which is currently at 2.6 per cent, pegged 0.1 percentage point above the CPF interest rate.

Financial analysts like Mr Leong Sze Hian said the change will make people less negative about the floating SMRA rates.

'With the additional 1 percentage point in the formula, there is a good chance that the rates might exceed 4 per cent over the long term,' said Mr Leong, who is president of the Society of Financial Service Professionals.

Accountant Joe Lim, 28, agreed, saying the new formula struck a balance between risk and reward.

Said Mr Lim: 'There is a potential for slightly higher gains while the extra 1 percentage point acts as a buffer for my savings. Not too bad a deal.'

Singapore’s CPF Retirement Scheme: Delivering More Bang for the Buck

Singapore’s CPF Retirement Scheme: Delivering More Bang for the Buck
From Knowledge@SMU

Singapore’s Central Provident Fund (CPF) is one of Asia’s oldest and best known defined contribution retirement schemes. Established in 1955 as a mandatory savings programme, theCPF now has over 3 million members with balances representing about 15% of Singaporeans’ total wealth. As the country rapidly ages, second only to Japan in terms of low fertility rates and longest life expectancy, government policymakers are paying close attention to whether its citizens and residents are saving enough for retirement.

Singapore Management University finance professor Benedict Koh, and Wharton insurance and risk management professor Olivia Mitchell recently prepared two working papers on Singapore’sCPF Investment Scheme (CPFIS) in which they examine the asset allocation of CPF investors and the cost of investing in unit trusts.

How the CPF Works

CPF member contributions go to three accounts where they earn government-set interest rates: the Ordinary Account (OA), earning 2.5% interest, which could be used to purchase homes and insurance, and support education and other expenses; the Special Account (SA) intended mainly for retirement savings; and the Medisave account for medical and critical illness insurance. Both the SA and Medisave earn 4% interest each, if the funds are invested on members’ behalf by the government. At age 62, SA savings are transferred to a retirement account which can also earn 4% interest and pays an annuity over 20 years up to age 82. Contribution rates to theCPF depend on age and income, and range from 8.5% to 33%, up to an income ceiling of S$4,500 per month. All contributions and withdrawals are tax-free.

The CPF has evolved over 50 years from a “forced savings scheme” to a “wide-ranging social security system”. At the end of 2005, account balances totalled nearly S$120 billion, about three-quarters the size of Singapore’s GDP that year. 49% of members’CPF balances were in the OA, 17% in the SA, 29% in Medisave, with the balance 5% in retirement and other accounts. Since 2003, CPF assets have grown at an average rate of 7%.

“Asset Rich Cash Poor Phenomenon”

According to Koh, Mitchell, Tanuwidjaja, and Fong (“Investment Patterns in Singapore’s Central Provident Fund”), the bulk of cumulativeCPF contributions (44%) have gone to the purchase of residential and investment properties. A sizeable portion (29%) remains in the OA and SA accounts, earning guaranteed interest, while only 10% of the funds were invested in capital market instruments permitted under the CPFIS .

The authors note that the heavy investment in a single property can lead to “an asset rich, cash poor phenomenon” in Singapore. They suggest that policymakers consider restricting the proportion of saving used to purchase property to helpCPF members ensure they have sufficient funds for retirement. Other policy options might include spurring the growth of a reverse mortgage market, and allowing homeowners to freely rent out their apartments for income. Recently, the government has changed rental rules for public housing estates where around 80% of Singaporeans live. Homeowners may now rent out their flats after owning them for 3 years, while those who have taken government funds to purchase their homes can rent after 5 years. The authors feel that such actions by the government may be prudent, so as to enable cash-strapped retirees to transform a consumption good (their residence) into an investment good (rental property) to generate cash for daily expenditures.

Asset Allocation

The authors note that CPF saving “clearly represents a sizeable portion of household’s total wealth…Therefore it is important that CPF holders be proactive in maximising investment returns on CPF saving”. Today, CPF account holders are allowed to invest a portion of their OA and SA funds in a wide range of capital market instruments including fixed deposits, bonds, property funds, equities, annuities, endowment policies, unit trusts, investment-linked insurance policies (ILPs), exchange traded funds and gold. Currently, there are 400 different unit trusts and ILPs on offer. However, the authors’ research shows that “the bulk ofCPF saving today is still held in the government-managed default fund”. As of December 2006, only 10% of funds have been invested while another S$79 billion is retained in the OA and SA accounts.

One reason for the low investment rate, the authors suggest, is that people may prefer to keep their money in the relative safety of aCPF default investment account. Another explanation they offer is that “participants may simply not know what to invest in and how to invest. Being perplexed, members may choose the path of least resistance, which is to simply leave their funds with theCPF and earn the guaranteed return.” Such inertia may be justified by the finding that three-quarters of CPF members in 2006 who enrolled in the CPFIS’s offerings had made losses or earned less return than the 2.5% payable on their CPF ordinary accounts .

Of the funds that were invested (S$27.9 billion), 67% went into insurance policies such as annuities, endowment policies and ILPs, 20% in equity and loan stocks, while only 12% was in unit trusts , collective insurance schemes offered by fund management companies.

The authors also find that men tend to be slightly more proactive in managing their CPF investments as compared to women. Men tend to invest more of their saving in shares, while women tend to put more into insurance products. Contrary to the advice of financial planners,CPF investors tend to take more risk as they age. The more mature (56+) age group commits a higher proportion of saving to stock investments and less to insurance products, compared to younger age-groups. The asset allocation ofCPF investors also differs across income groups. Those in the lower income groups tend to hold less risky investments as compared to the higher income groups.

“Hidden Costs”

In a second paper, “Cost Structures of Investment Offerings in Singapore’s Central Provident Fund”, Koh, Mitchell, and Fong suggest that another possible reason for the low rate of investment ofCPF funds is the “daunting array of fees and charges, minimum initial investments, and other fund features, making it difficult for the unsophisticated investor to know what to elect”. The two largest fund costs are the initial sales charge and the expense ratio. The sales charge ranges from 0% to 6% but has typically been 5%. To address this issue, as of 1^st July 2007, the CPF Board capped initial sales charges at 3%.

The expense ratio ranges from 0% to 7% of the fund’s net asset value. It is important since this is a yearly cost, whereas the sales charge is a one-time cost. The study found that the average expense ratio was 2.1% for actively managed funds allowed under the CPFIS and 1.0% for passively managed funds. There are 164 actively managed equity funds included in the CPFIS and only 3 passively managed ones. Balanced funds (bonds and equity) also had an overall expense ratio of 1.9% while income funds (bonds) showed an average expense ratio of 1.1%.

A third cost becoming more widespread is a “wrap fee” which is charged by financial advisers and insurance companies. It can be as much as 1.5% and is not part of the expense ratio. The authors point out that “unwary or uneducated investors may not be fully appraised of these additional charges.” A fourthcharge is transaction fees and agent bank fees. Bank transaction fees are charged under the OA but not the SA scheme. There is a quarterly service charge of S$2 to S$5 collected by the agent bank for servicing eachCPF investment account. There is also a S$2 to S$2.50 transaction fee per lot of shares purchased unless one works with an Investment Administrator to consolidate purchases. As of the end of 2006, there were threeCPF-approved Investment Administrators.

A fifth charge is hidden expenses, also not included in the expense ratio. This refers to brokerage commissions and the impact of the bid-ask spread on costs. It also includes taxes deducted at source and foreign exchange conversion costs. Although not a cost, investors are also subject to foreign exchange fluctuations. This may be thought of as a hidden risk since it is not easily seen by investors. Marketing and advertising expenses are also excluded from the expense ratio as are interest expenses. ILPs (but not unit trusts) generally include an insurance charge; some ILPs also include a service fee of up to 0.75%. Neither is part of the expense ratio. Less common hidden expenses are a realisation charge (back-end load), redemption fee (for selling in a short time such as 90 days) and switching fees (for switching within a family of funds).

The authors argue that passively-managed funds (regardless of fund type) could be less expensive to manage than actively-managed funds, due to the lower turnover of securities and less monitoring required Passive equity funds have average sales loads that are more than 50% below the sample mean. The same cost difference holds for balanced funds.

The authors also carried out a regression analysis to explain observed cost patterns. They find that (i) ownership, (ii) style of fund management and (iii) type of fund are key factors. Foreign-owned funds are found to charge 42 basis points more in sales load than locally-owned funds, 16 basis points more for management fees, and 53 basis points more in first-year total costs. Actively managed unit trusts charge more than passively managed funds. Equity and balanced funds charge more than income and money market funds. Larger funds are also found to be slightly less expensive than small funds, charging 8 basis points less. According to the authors, “passive funds are often deemed suitable for novice investors who are not sufficiently confident to select their own stocks or unit trust; they may also be suitable for long-term investors seeking growth but who lack the time to actively manage their investments.”

The authors also recommend streamlining and rationalising the many investment choices to include inflation-protected instruments, more index-linked funds, and low-cost life cycle funds. The latter especially are a cost-effective way to diversify and rebalance investments to suit the investor’s life stage. They cite the Chilean experience where investors are defaulted into higher risk funds when younger and automatically transit to more conservative portfolios as they get older, unless they opt for a different investment mix. Other ideas for encouraging investments to enhance investor returns are to aggregate and simplify data on fees and charges, and to provide education and learning aids, such as on-line calculators, that would help investors compare offerings and take decisions on how to optimise their savings for retirement.

“The CPF has taken several measures recently to moderate retail costs for investors. These include setting more stringent criteria for admitting new unit trusts into the CPFIS, continually reviewing existing unit trusts, capping sales charges, and developing investor education programmes that advise its members to make informed decisions,” says Mitchell. “In the longer term, theCPF could continue to fine-tune costs, devise default funds with acceptable risks and returns, and even harness market forces to drive down costs and enhance net returns.”

Published: August 2, 2007

Parliament debate to focus on CPF changes

MPs say compulsory annuity is perceived in negative light

CHANGES to the Central Provident Fund (CPF) system will be the main topic of debate in Parliament from Monday when Manpower Minister Ng Eng Hen gives details of proposed changes.

Wide-ranging amendments to the Penal Code, which governs most criminal offences here, will also be tabled at the sitting, as will a proposed piece of legislation on preventing terrorist bombings.

As these two sets of amendments are only being introduced, or in parliamentary parlance, going through their 'first reading', they will be debated at a later date.

Changes to CPF to prepare for a greying population were first outlined by Prime Minister Lee Hsien Loong in his National Day Rally speech last month.

The CPF measures are meant to ensure people have enough for old age even as lifespans grow longer.

Among other things, CPF members will get higher returns of up to one percentage point more on their savings.

The draw-down age for the Minimum Sum will also be postponed from 62 to 63 in 2012, and gradually raised to 65 by 2018.

The Minimum Sum is the amount members must keep in their Retirement Account after withdrawing their CPF at age 55.CPF members now get a monthly payout from the Minimum Sum at age 62, for up to 20 years.

But the change likely to attract intense scrutiny is some form of compulsory annuity for members now below 50.

MPs say the annuity is perceived negatively at dialogues with residents.

Mr Charles Chong (Pasir Ris-Punggol GRC) said: 'Nobody thinks they are going to live beyond 85. Usually, whatever money goes to the next of kin, so it's hard to say the money goes to others.

'Others also ask, where is the government involvement here? It's getting half the people to subsidise the other half. The minister has to fill in all the blanks,' he added.

On Monday, three MPs will ask the Prime Minister for an update on the public sector's efforts to re-employ older workers beyond the retirement age of 62.

MPs have also tabled questions on the impact of the sub-prime mortgage crisis in the United States on Singapore's economy, banks and property market.

Opposition MP Low Thia Khiang (Hougang) will ask Defence Minister Teo Chee Hean how Dave Teo Ming, an army corporal, managed to slip out of Mandai Hill Camp with arms and ammunition earlier this month. The army corporal was arrested in Orchard Road on Sept 3 after a 20-hour manhunt, and his case is before the courts.

Changes to the Penal Code are likely to include more teeth to deal with crimes committed online and increased sentences for various offences. A draft of the proposed changes was released for the public to give its views last November.

Seven Bills will also be up for debate at the sitting.

They include changes to the Land Titles (Strata) Act to make collective property sales more transparent, and changes to the Building Control Act to improve the quality of construction and safety standards at worksites.

Leave comfort zone to gain cultural versatility

Leave comfort zone to gain cultural versatility I REFER to the report, 'More secondary students to go on overseas stints' (ST, Sept 13). While I am heartened by the move to have more school children go abroad, I believe it requires more than a short stint of overseas experience to instil that 'global thinking' and 'cultural versatility' espoused by Education Minister Tharman Shanmugaratnam.

For students to be truly able to absorb this global mindset, it will take at least three to four years of study abroad. This is because part of this mindset encompasses the need to network and forge deep and meaningful relationships with foreign counterparts, by having common life experiences and growing and developing together. This is not easily achieved by venturing abroad for a few weeks or months.

Sometimes, even pursuing an entire three to four years of tertiary education is no guarantee of this global outlook and mentality.

As pointed out in another article, 'Singaporeans stick together overseas' (ST Life!, Sept 13), there is not much global networking if students stick to their own cliques and associate only with other Singaporeans.

By all means, students should plan for overseas stints or even seriously consider pursuing their higher education abroad. But to think that doing so will naturally instil a global mindset is a misconception.

It requires each individual student to move out of his comfort zone and make a conscientious effort to appreciate each other's cultures and values.

Only then, in the words of Mr Tharman, can students truly 'understand differences around the world and turn them into opportunities'.

Tony Tan Song Huat

WILL NEW BOND PEG END UP 'HURTING THE OLD'?

IT IS designed to enhance the retirement nest egg, but if market conditions have their way, some economists and finance professionals wonder how re-pegging Central Provident Fund (CPF) interest rates to government bonds will help the older generation.

In a recent market weekly report, Citi economist Chua Hak Bin mapped out a scenario in which the younger generation may benefit, but the older generation may get lower returns than now, if their Special, Medisave and Retirement Accounts (SMRA) are pegged to a long-term bond.

The 10-year government bond has a current yield of 2.8 per cent compared to the SMRA's 4-per-cent guaranteed rate, he said. The Ordinary Account (OA) attracts an interest of 2.5 per cent.

Going by this, he calculated that younger individuals with a CPF account of $20,000 in their OA and $40,000 in SMRA would earn an effective interest rate (weighted average) of 3.7 per cent, or $120 more a year, compared to the current 3.5-per-cent effective rate.

The calculation includes the 1-percentage-point additional interest the Government plans to give on the first $60,000 in CPF accounts - up to $20,000 in the OA and the rest in the SMRA.

Still, an older cohort with the Minimum Sum of $99,600 in their SMRA and $20,000 in their OA would earn a lower 3.3 per cent, or $590 less a year, with the bond peg, Dr Chua calculated.

This is because a lower long-term bond yield could dominate the 1-percentage-point interest rate for those with larger sums in their SMRA.

Individuals who previously transferred their savings into the SMRA from the OA would also see the interest rate gap narrow substantially under the new peg.

"Not everybody will benefit. The younger generation benefits as they have only started to save and would most likely put their savings within the first $60,000. But if you are of the older generation who would have a larger proportion of your CPF savings in the SMRA, rates there are actually lower in the long run. Ironically, you are hurting the older generation you are trying to help," Dr Chua told Today.

A recession or financial crisis could also bring down the SMRA interest rate.

Manpower Minister Ng Eng Hen, who will explain in Parliament today how the Government will re-peg the CPF interest rates, said last month that the new SMRA rate will be lower initially, but should do better over time.

Economists have told Today they expect Singapore government bonds to be the reference point, while Society of Financial Service Professionals president Leong Sze Hian expects rates to be pegged to a composite benchmark of two or more indices, such as part Singapore bond index and part global bond index, to give higher returns.

Most, however, are sceptical about the chances of yields crossing the 4-per-cent threshold over time.

"I don't think pegging CPF to a government bond will get high rates above 4 per cent, at least until the end of 2008," said Mr Alvin Liew, former economist at UOB Treasury Research.

With long-term bond yields generally dependent on the outlook of the economy, which grew at 7.9 per cent last year, there are questions about whether Singapore's medium-term economic growth estimate of 4 to 6 per cent can sufficiently bump up yields.

Mr Leong added that bond rates fluctuate and depend on various factors like interest rates, expectations and default risks. "There is no basis for saying that the rate is going to be higher in the future. The fact is, nobody knows," he said.

Besides the impact on older folks, if rates are lower, it might cause a shortfall in Medisave accounts. Said Mr Liew: "In recent months, you have seen healthcare costs going up quite substantially in the Consumer Price Index. The lower-income group will be more affected by lower returns."

Sharing the same concerns, Member of Parliament Ong Kian Min said that, historically, CPF members have enjoyed guaranteed returns regardless of how the economy performs. This move marks a fundamental shift.

"Investing in bonds may subject CPF savings to lower rates. This can only be a good start provided the Government also considers, in future, investments other than bonds that may yield a higher return," he said.

These are some of the questions and suggestions the manpower minister will have to address today.

Nike takes false-advertising case to Supreme Court

By The Associated Press

10.15.02

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PORTLAND, Ore. — Nike Inc. has asked the U.S. Supreme Court to review a free-speech case arising from its advertising campaign to defend working conditions at overseas plants.

The Beaverton-based company, the world's largest athletic shoemaker, filed the appeal yesterday.

Nike is asking for review of a 4-3 ruling by the California Supreme Court in May that an activist can sue Nike for allegedly violating false-advertising laws during a 1996-97 campaign to inform the public about its labor policies. Nike sent letters to the editors of major newspapers, among other things.

The suit claims Nike deceived consumers by falsely stating it guarantees a "living wage" to all workers, and that its workers in Southeast Asia make twice the local minimum wage and are protected from corporal punishment.

Nike says it is taking part in constitutionally protected political debate about worker rights and the global economy.

"Uttering even a word would become far more risky than simply keeping silent, if this ruling stands," said Laurence Tribe, Nike's lead attorney.

The company said yesterday it would not release its annual corporate responsibility report unless a court first wipes out the threat of a suit and big monetary award.

The report discusses the company's labor and environmental policies around the world.

The California Supreme Court ruled Nike's campaign constitutes commercial speech and is subject to California consumer-protection laws that are among the least friendly to business in the country.

The court fight has not yet determined whether Nike made false statements, focusing instead on whether the suit can go forward. San Francisco resident Marc Kasky filed the lawsuit, which had been dismissed by a trial court and a state appeals court before going to the California Supreme Court.

A decision by the U.S. Supreme Court on whether to hear the case, Nike v. Kasky, is expected in December or January.

Activist gets go-ahead to sue Nike over ads

By The Associated Press

05.03.02

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SAN FRANCISCO — California's highest court has ruled Nike Inc. can be sued by an activist alleging the athletic shoe and apparel maker violated false-advertising laws with an ad campaign defending the wages, treatment and safety conditions of workers at overseas factories.

In a 4-3 decision yesterday, the state Supreme Court overturned lower court decisions and ruled Nike's efforts to quell accusations of worker mistreatment constitute commercial speech, which is subject to a California consumer-protection law that is one of the nation's least friendly to businesses.

"Our holding, based on decisions of the United States Supreme Court, in no way prohibits any business enterprise from speaking out on issues of public importance or from vigorously defending its own labor practices," wrote Justice Joyce L. Kennard.

"It means only that when a business enterprise, to promote and defend its sales and profits, makes factual representations about its own products or its own operations, it must speak truthfully."

The court emphasized its ruling does not indicate whether the Beaverton, Ore.-based company made any false representations. Attorney David Brown, who represents Nike, said the company may ask the U.S. Supreme Court to review the case.

"We're greatly disappointed with it because we feel that Nike's position is legally the correct one," Brown said, adding he was happy the court was silent on the case's merits.

The highly publicized suit, which had been dismissed by a trial court and a state appeals court, claims Nike's 1996-1997 campaign in defense of its wages, treatment of workers and health and safety conditions at Asian plants run by contractors was a misleading business practice, not the First Amendment-protected political debate that Nike has argued.

The suit said Nike deceived consumers by falsely stating it guarantees a "living wage" to all workers, that its workers in Southeast Asia make twice the local minimum wage and are protected from corporal punishment, and that it complies with government rules on wages, hours and health and safety conditions.

Those claims were refuted by studies by labor and human rights groups, news media investigations and — most damaging of all — a January 1997 audit by the firm of Ernst & Young, commissioned by Nike, said the suit filed by San Francisco resident Marc Kasky on behalf of California citizens.

Kasky helps manage a foundation that preserves Fort Mason, a former San Francisco military base-turned-recreation area. He said he sued Nike "because it's important they be accountable."

Kasky's attorney, Alan M. Caplan, was excited by the ruling.

"For four years basically we've not litigated the merits of the case. It's all been the one issue of whether Nike's speech was commercial speech," Caplan said. Yesterday's ruling will hold companies "to the standard of telling the truth."

The three dissenting judges wrote it was unfair to deny Nike and other corporations uninhibited speech when defending their reputations against unrestricted public accusations.

"While Nike's critics have taken full advantage of their right to 'uninhibited, robust, and wide-open' debate, the same cannot be said of Nike, the object of their ire," wrote Justice Ming W. Chin. "When Nike tries to defend itself from these attacks, the majority denies it the same First Amendment protection Nike's critics enjoy."

Nike officials said yesterday the company has since improved standards for workers by raising minimum age requirements and using water-based adhesives to assemble products rather than petroleum-based.

Shares of Nike rose 55 cents to close at $54.24 yesterday on the New York Stock Exchange.

The case is Kasky v. Nike Inc.

Social Security Reform: Issues and Values

EXECUTIVE SUMMARY

Few dispute that Social Security faces a long-term financing crisis. The program's true condition, however, is even grimmer than many acknowledge. Beginning around the year 2017, Social Security benefits can be maintained only through higher taxes, cuts in spending or a return to budget deficits. Between 2017 and its "official" insolvency date of 2040, Social Security will require at least $2.5 trillion (in 1998 dollars) of additional revenue to maintain promised levels of benefits. Beyond 2040, deficits grow worse.

Social Security reform is about much more than simply balancing the books, or "quick fix" patches designed to keep a leaky ship afloat for a few additional years. Past reforms have taken that approach and failed, because they did not appreciate the true nature of the problem and because the underlying values the American people hold regarding Social Security had not evolved to a place that would welcome lasting reform.

The task facing reformers is two-fold: first, devise solutions to the structural problems Social Security faces while second, ensuring that these solutions mirror the core public beliefs and opinions that have made Social Security such an admired program. The second task is in many ways more challenging than the first. Therefore, two distinct issues are addressed:

Structural Problems: Social Security was established as a pay-as-you-go social insurance system, in which current taxpayers support current retirees. But pay-as-you-go financing depends upon a) high growth in workers' incomes, and b) a high ratio of workers to retirees. In the future, neither income growth nor growth in the size of the labor force will be sufficient to provide a good rate of return to a growing population of Baby Boomer retirees. The only way to avoid trillions of dollars of tax increases or spending cuts is to improve the rate of return from Social Security by making it a fully-funded pension program.

Public Opinion: As important as the structural problems facing Social Security are, an even more important component of reform is public opinion. In short, there are three core values or opinions around which public opinion revolves on the Social Security debate. They are:

*Security: A guarantee against poverty in retirement. Social Security provided it in the past, but doubts about its solvency mean that it no longer provides peace of mind.

*Return on investment: In Social Security's early years, workers contributed only 2 percent of their wages and the return was good. They now contribute 12.4 percent, and the return is much lower. Workers are not receiving value for their money, and oppose tax increases or benefit cuts that make the return from Social Security even worse.

*Distrust in government/Personal control: Failed reforms of the past caused deep public skepticism that the government can reform Social Security in a way consistent with their values and best interests. Doubts regarding Social Security caused individuals to plan for retirement on their own. The public wishes to shift more of the responsibility for retirement planning away from government and toward them. Proposed reforms should address these key issues and values. Those that do not will likely be unsuccessful.

Proposed reforms should address these key issues and values. Those that do not will likely be unsuccessful.

1. INTRODUCTION

What began as a relatively modest social insurance program to ward off poverty in old age has become the largest and most expensive government program in the world, upon which millions of Americans depend for their retirement incomes.

What began as a tax of only two percent of wages now takes over 12 percent. As a result, Americans have less money to save on their own and expect much more from Social Security than they used to.

A worker putting 12.4 percent of her wages and salary into a stock fund returning the historical average could retire with a nest egg providing an income three times what he had while working. Out of this, she could easily provide for retirement, disability and survivors expenses. The government depicts Social Security as a base for retirement income, as insurance against poverty. But 12.4 percent of wages should provide much more than a base, and workers have demanded more for their money.

As Social Security has changed, Americans' perceptions of it have changed as well. Former Speaker of the House Tip O'Neil called it the "third rail of American politics," which politicians could touch only at their peril. Yet today, the public says they are substantially more likely to vote for a candidate who favors changing the system than one who wants to keep it as it is.

Both political parties place Social Security reform at the top of their agendas. The most difficult challenges are not of high-level finance. It is easy to discuss subtleties of tax rates, salary ceilings, retirement ages and cost of living increases. More difficult is addressing the basic structure of Social Security, the core public values behind it, and the way that these basic values are no longer met.

In many ways, the answers to Social Security reform aren't nearly so hard as the questions:

*Some people count only the employee's payroll tax contribution while others count both employee and employer. This makes a big difference in computing the program's return.

*Some believe the Trust Fund can delay Social Security's insolvency, while others consider it a "polite fiction" filled with "phantom assets." On this question alone hinges whether financing problems are a speck on the horizon or a steam train just around the corner.

*Some see investment in the market as fraught with risk, while others see greater risk in remaining with the current system. The answer to this question can determine the safest route to reform.

Clarifying basic issues like these is essential. If we disagree on how Social Security works, how large a problem it faces, and what risks are included in the alternatives, we can use all the econometric models we want but will never agree on anything.

But Social Security's structure is merely a start. Social Security is as much an American ideal as a government program. Americans feel that Social Security belongs to them as much as to the government. Just as important as the questions above are the public's beliefs, values and opinions about Social Security.

*What do Americans want from Social Security?

*Whom do they trust?

*What risks are they willing to take, and who should take them?

*What tradeoffs will they accept?

Any reform must appreciate Social Security as an American ideal as much as a social insurance or compulsory pension program.

Politicians frequently hear the advice to "speak in terms of values." Here, we must think in terms of values as we consider and evaluate proposals to reform Social Security. Reformers should consider the public's core beliefs and opinions as well as Social Security's structural issues in ensuring that the program continues to protect the things Americans prize about the program.

2. UNDERSTANDING SOCIAL SECURITY

Much of the talk about Social Security — of how much money is in the Trust Fund, how long it will last, what rate is paid on the bonds in the Fund, and so forth — focuses on factors peripheral to its survival and success. It is only by breaking Social Security down to its essential factors — how it is financed, how it pays a return, what return it will be capable of paying in the future — that reformers can avoid past mistakes and ensure a secure future for the program.

Financing: Pay-as-you-go vs. Fully Funded

We must first distinguish between two methods of financing, "pay-as-you-go" and "fully-funded," which are central to understanding how Social Security works, why it faces problems in the future, and how it might be reformed.

Pay-as-you-go is a vertical system, where each working generation supports the generation that preceded it. Under a pay-as-you-go system, there is no saving or investment, merely the continual transfer of wealth from younger generations to older ones.

Pay-as-you-go financing is often dismissed as a "Ponzi scheme." Yet, Americans have long relied on pay-as-you-go without even realizing it. For generations, the elderly lived with their children. Their children would be supported by their own children when the time came. There is nothing inherently wrong or dishonest with this approach; under favorable conditions pay-as-you-go can continue forever, with each generation supporting the one that preceded it and being supported by the one that follows.

But if a family does not have enough children, or if their children do not have very much money, then pay-as-you-go financing becomes problematic. The same conditions apply when pay-as-you-go is applied to a national pension and social insurance plan, as we shall see.

Fully-funded financing is similar to the modern practice of saving for retirement. It is a horizontal system, in which each person or generation saves money while working, then draws upon those funds to cover retirement or other expenses. Unlike pay-as-you-go financing, in which there is an ongoing intergenerational transfer of wealth, in a fully-funded approach each generation saves for its own retirement.

Is Social Security Pay-as-you-go or Fully-Funded?

According to the Social Security Administration, Social Security is a mixed or partially-funded system, with elements of both a pay-as-you-go and a fully-funded approach:

"Since 1983, the program has operated under a "partial reserve" method of funding. The intent is to have the system take in more than it pays out in order to build up the large reserve funds needed to help pay for the benefits of an increasing number of retired workers."

Most payroll taxes immediately pay benefits to current retirees, survivors, or the disabled. In 1998, of an estimated $435 billion that American workers paid in payroll taxes, about $380 billion was spent on benefits.

The government uses the money left over to supplement general tax revenue, and gives the Social Security Trust Fund special Treasury bonds in exchange. Since the Baby Boomers are at the height of their earning years, Social Security is running a surplus and the Trust Fund is growing.

In the future, the Baby Boomers will retire. Social Security will be deprived of Boomers' taxes and will instead have to pay them benefits. Beginning around 2017 Social Security's cash flow will turn negative; it will take in less money in taxes than it pays out in benefits.

To supplement payroll taxes, the bonds in the Trust Fund will be redeemed. This will pay benefits until around 2040, when the Trust Fund will run out. From 2040 onward, payroll taxes will bring in enough money to pay only 75 percent of promised benefits. To maintain full benefits new revenue would have to be found, either through tax increases, spending cuts or new borrowing.

This is a rough synopsis of the "official" view of Social Security. As we will see, there are reasons to take issue with this description, as well as with assurances of the program's stability for the near future. The true prognosis for Social Security's future is decidedly less rosy.

So, What is the Trust Fund, Really?

The American Association of Retired Persons (AARP) claims "even if we just sit back and watch the program, without any kind of change at all, Social Security will be able to pay promised benefits until the year 2029."

The Century Foundation says that, "without the Trust Funds' reserves, the moment when the government would need to find a solution to the gap between payroll tax revenues and obligations to retirees would be moved forward by 19 years, from 2032 to 2013."

Similarly, Social Security Commissioner Kenneth Apfel says that while "demographic changes raise serious long-range solvency issues, Social Security is not a program in crisis. The projected shortfall in the system, while serious, will not happen for almost three decades, by which time the program will be almost 100 years old."

The truth is, the Social Security Trust Fund will neither delay the need for tax increases by a day, nor reduce them by a penny.

This is for a very simple reason: Treasury bonds -- the assets in the Trust Fund -- are nothing more than written promises by the government that at a certain date it will raise revenue sufficient to repay the bond. As the Congressional Research Service has said:

Perhaps the biggest misconception is that the Social Security Trust Funds represent actual resources to be used for future benefit payments, rather than what is in reality a promise by the Government to take steps necessary to secure resources from the economy at that time.

The Trust Fund cannot delay the need for additional revenue, because the bonds in the Fund are themselves promises to provide additional revenue. And ultimately, the only "asset" underlying a government bond is the power to tax.

How much would these taxes be? The projected payroll tax shortfall in 2014 is only $4.2 billion, but grows rapidly as the Baby Boomers retire. Between 2014 and 2030, the Trust Fund will redeem a total $2.49 trillion (in 1999 dollars), an average of $131 billion per year.

The question defenders of the Trust Fund never answer is: where is the government going to get the money to repay those bonds? It's not sitting in Fort Knox, so it has to come from somewhere. The accompanying tables show 1998 Federal spending and revenue by category, along with Social Security's funding shortfall from 2014 to 2031.

Covering the shortfall by raising taxes would require income taxes to increase by 17 percent or payroll taxes by 25 percent. Alternately, we could trim Social Security benefits -- if you consider a one-third reduction a "trim." Or we could reduce other government spending. That is, if cutting National Defense by half or eliminating all funding for energy, agriculture, natural resources, commerce and housing, transportation, and education is your cup of tea.

Of course, we could always borrow, bringing back the days of massive budget deficits. This is what the Trust Fund will bring us, and all of it before Social Security is scheduled to become insolvent.

Both President Clinton and Congressional Republicans state their opposition to increasing taxes to save Social Security. But relying on the Trust Fund burdens the public with $2.5 trillion of additional taxes without notifying them of that fact. In effect, Washington will be telling the public, "We're not raising your taxes to pay for Social Security; we're raising your taxes to pay for the bonds which will pay for Social Security." Given the size of the tax increases that would be necessary, this is a distinction likely be lost on the public.

If the Trust Fund were the backstop against tax increases its defenders claim, then an instant solution to Social Security's problems would be to issue more bonds to the Fund. But as A. Haeworth Robertson, former chief actuary of Social Security stated, "With or without a trust fund, the same amount has to be taken out of the taxpayers' hands."

This is not to say that the Trust Funds are being mismanaged, that money is being "stolen" from the funds, as some accuse. A Federal Trust Fund is different from an ordinary one, but a citizen would need to examine the fine print of the budget to figure that out. Ordinary people, upon realizing that the only assets underlying the Trust Fund are currently residing in their bank accounts, feel a sense of betrayal.

The True Return on Taxes "Invested" in Social Security

A standard approach in articles on Social Security reform is to contrast the return from stocks with that of the bonds issued to the Social Security Trust Fund, then show that over time an individual can earn much more in the market than with Social Security.

A writer to the New York Times recently made a similar point: "if the Government paid more reasonable interest rates for its access to the Social Security reserves, the whole idea of having to go to the stock market would evaporate."

But these comparisons are misleading. Whatever the interest rate on the bonds, the difference between what Social Security collects in taxes and what it pays in benefits will be met using general revenue. Therefore, we need to look closer.

An important first step is to differentiate betweenthe rate of return for individuals and the rate of return for the system as a whole. The chart at right shows the inflation-adjusted rate of return for different categories of beneficiaries retiring in different years. Clearly, those who retired early in Social Security's history received a higher rate of return. Part of the reason is simple: Social Security was founded midway through their working lives, so they received full benefits without paying a full lifetime's taxes.

In addition, different beneficiaries receive different rates of return. Single men, for instance, receive a lower rate of return, because they tend to have shorter life spans than women or married men. One-earner couples receive a higher rate of return because the non-working spouse receives benefits without having to pay taxes.

While important, individual rates of return do not help nearly as much as knowing the structural rate of return for the system as a whole. If the system produces a high rate of return then benefits for everyone can improve, even if some individuals still get a better deal than others.

For that reason, we will define Social Security's rate of return as the annual change in funds available per beneficiary. Three factors determine Social Security's annual rate of return:

*Growth of the labor force

*Growth of productivity

*Growth of the beneficiary population

Growth in the labor force increases the number of workers paying taxes. Growth in productivity increases workers' wages. Both of these factors increase the total pool of money available to pay benefits. Growth in the beneficiary population determines among how many people the pool of money will be divided.

If the labor force and productivity grow faster than the beneficiary population, the amount of money available to each beneficiary will increase. But if the beneficiary population grows too quickly, then there will be less money available per person.

The good news is that these three factors are predictable far in advance. Unlike the stock market, which goes up or down on a daily basis, we can have a fair idea of what the return will be from Social Security decades in advance. The bad news: if they combine to produce a low rate of return, there is little that can be done to change it.

Conclusion

Social Security's ability to continue as a self-financing program for the long term depends on these three factors: growth of the labor force, growth of productivity (which determines growth of workers' wages), and growth of the retiree population.

Looking at the Trust Fund is worse than useless. The bonds in the Trust Fund represent how much payroll tax money has been borrowed for other uses, but they cannot forestall the need for increased revenue in the near future.

Now that we have a general understanding of how Social Security is financed, we can look at how the factors that make for the program's success or failure have changed over time.

3. UNDERLYING PROBLEMS WITH SOCIAL SECURITY

Social Security produces a good rate of return only under certain advantageous economic and demographic conditions. The labor force and the productivity of the economy, which determine the tax base, must grow faster than the population of retirees and other beneficiaries, which forms the benefit base. In the early years of Social Security, these conditions were satisfied. The labor force grew quickly and the economy prospered, while the retiree population increased relatively slowly.

But the factors that made Social Security successful and popular in its early years have turned against it. Social Security is ill-equipped for an environment in which these conditions no longer hold true.

The Baby Boom and Bust

Following World War II, servicemen long separated from their spouses made up for lost time in building families. The "Baby Boom," in which birth rates jumped from 2.2 births per woman in 1940 to 3.6 per woman in 1960, created a demographic wave of new children.

Financing the health and education of the young Baby Boomers was a challenge. But as the Boomers reached working age, the labor force grew by over 2 percent per year and payroll tax revenue increased. As a result, the return from Social Security increased.

Following the Baby Boom, however, birthrates did not simply return to their previous levels. They actually fell as far below normal as they rose above it during the Boom. By the early 1970s, the birth rate had fallen below its 1940 level. It has never recovered since. This created what has been called the "Birth Dearth," the opposite of the Baby Boom.

While the labor force grew by over 2 percent annually in the late 1960s and early 1970s, present growth is only around 1 percent. By the year 2020, growth will be only around 0.1 percent. This means that almost no net additional workers will be paying taxes into Social Security.

As the Baby Boomers begin to retire in the early 21st century, they will stop contributing to Social Security and start collecting benefits. Meanwhile, low birthrates mean there will be fewer workers to take their place, and fewer workers means fewer contributors to the system.

Increased Life Spans

Not only are the Baby Boomers moving toward retirement, but thanks to improved nutrition and healthcare they will spend more years enjoying their retirements than any previous generation of Americans. This is good news for them. It is not so good news for Social Security.

In 1940, only 53.9 percent of males survived to collect benefits. By 1990, over 72 percent of males lived to collect Social Security.

In 1940, people who lived to 65 survived for an average of 12.7 additional years. By 1990, life expectancy at age 65 was 2.5 years longer than in 1940.

The benefit-years liability -- the product of the percentage of the population living to age 65 and life expectancy beyond that age -- nearly doubled between 1940 and 1990, and will continue to increase in the future.

As a result, the money Social Security takes in through payroll taxes must be divided up among a larger pool of beneficiaries. All other things being equal, this means less money available per person.

Lower Productivity Growth

Economist Paul Krugman says that "productivity isn't everything, but in the long run it is almost everything." What he means is that a country cannot reliably raise its standard of living other than by raising the level of output per worker. Employees can work longer hours or more people can enter the labor force, but only for so long. Productivity growth is and will continue to be the linchpin to increased national wealth.

Increased productivity is central to Social Security's rate of return. If productivity increases, wages also increase. If wages increase, workers pay more payroll taxes without having to increase tax rates. Increased payroll tax receipts make for a higher rate of return from Social Security, with more money available for each beneficiary. The U.S. has seen both sides of this equation.

The early post-war period was one of boundless optimism. In the 1960s, real wages per worker subject to payroll taxes rose by an average annual rate of 2.2 percent, and in 1967 Fortune magazine predicted that per capita income would rise by 150 percent by the year 2000.

Quickly, the optimists were proved wrong. In the 1970s, as productivity growth declined, wage growth slipped to 0.5 percent annually. It recovered to only 0.7 percent in the 1980s and 90s, less than one third that of the 1960s. For many lower income workers, wages actually dropped.

Slow productivity growth is serious business: had growth in the last quarter of this century been as high as in the first 75 years, current American living standards would be 25 percent higher than they are today.

High productivity makes it easier to overcome changes in the worker-to-retiree ration. If productivity growth slows, the effects of demographic changes are only exacerbated.

Economists debate the reasons for the slowdown in productivity and wage growth. Part may be that today's economy is based more upon services than upon manufacturing, and productivity increases are harder won in service industries than in manufacturing. As economists joke, we can produce millions more widgets than in days past, but a string quartet needs just as many workers as it did three hundred years ago.

A second reason for slower wage growth may be that a greater share of workers' total compensation is taken up by non-wage benefits, particularly health care. Even to the degree that total compensation is growing, wages subject to Social Security taxes may remain stagnant.

Whatever the reason for the slowdown in growth of productivity and wages, decreased wage growth plays a central role in the nation's ability to provide benefits for future retirees.

The Future Return from Social Security

Declines in labor force and productivity growth combined with increases in the retiree population mean that the future return from Social Security will be far lower than at present. Many individuals may not even get back all the money they put in, much less earn interest.

Social Security is a defined benefit plan, in which a worker is promised a given level of benefits, without regard to the return on the money he has paid in. If the return is insufficient to pay promised benefits, the plan's provider must make up the shortfall. In this case, the provider is the American public. If taxpayers make up the difference, there must be large tax increases or cuts in other programs. If the public chooses not to make up that shortfall, Social Security benefits must be drastically cut.

Since there is little that can be done in the short term to change these conditions, efforts must be concentrated on readying Social Security to weather the coming storm.

5. SOCIAL SECURITY AND QUALITY OF LIFE

Return on investment, security, skepticism about government and a desire for increased personal control all affect public views of the Social Security debate, often in confused, intertwining ways. To some degree, these variables are interrelated. In other ways, they are at odds. The goal is to balance these values in ways that achieve the optimal quality of life.

The selling point behind many reform proposals will no doubt be that they keep Social Security solvent. But we should be asking different questions:

*Does it raise Social Security's return on investment or does it simply pump more money into the system? Will workers have to pay more in while getting less out? In other words, is it reform or is it merely a bailout?

*Does it put Social Security on a sound footing to provide benefits for the future? Or is it a quick fix that will need to be revisited in years to come?

*Does it require blind faith in government, or will workers have real guarantees that their payroll taxes are being invested wisely?

*Does it depend upon optimistic economy and demographic assumptions, or is it built to weather whatever storms the future may bring?

*Does it give workers more control over their retirement planning, or does it maintain Social Security as a one-size-fits-all program?

Social Security is a commitment that covers one's entire adult life, beginning upon entering the labor force and lasting through old age. Reformers should look first to the values, beliefs and opinions that people hold regarding Social Security. No reform of a program as central to the public's quality of life as Social Security can succeed if it does not rest on a foundation of widely held values.

http://www.conginst.org/socialsecurity/issues/index.html