Tag: retirement savings

Originally published at Forbes.com on February 24, 2021.

 

What’s a Baby Bond?

The name implies borrowing of some sort or another, as if a parent might borrow money and pay it back later. But the concept is really quite different, a sort of “universal personal account.” There are two different proposals circulating at the moment: one is meant to provide a sort of start-up fund for adult life, and the other, a retirement benefit. But they both are based on the idea of building up an account balance from government contributions while children are young.

The Booker Baby Bonds

Sen. Cory Booker of New Jersey introduced legislation earlier this month to establish what he calls “opportunity accounts.” The bill involves an initial “contribution” of $1,000 for each child at birth, and as much as $2,000 per year afterwards based on household income, with the full amount for families with income of less than 100% of the poverty line, phasing out to $0 at 500% of poverty rate; each of these dollar amounts would increase with the rate of inflation from year to year. These are described as “savings accounts” but there is one large fund, funded by the federal government, with individual account balances tracked nominally within that fund.

And — this makes my head hurt a bit — even though the money for the fund comes from the federal government, and even though, in the year 2021, like pretty much every other bit of government spending, the government would borrow the money to put in this fund (or money-print the money), the money is then “lent” back to the government, in the form of “special interest-bearing obligations of the United States,” with an interest rate equal to the average market yield of all US public debt with a maturity of greater than 10 years. According to Politico, this would be a 3% interest rate, but it’s not clear to me how Politico came up with that rate when a 20 year Treasury is currently 1.63% and even a 30 year Treasury is only 2.19% at the moment. At the same time, the bill implies that there are possibilities of investment losses, but perhaps there were drafting inconsistencies and versions of the proposal that involved equity investments?

So is it “real” money, or is it all a bit of a fiction? Like the Social Security Trust Fund, it’s both, or neither.

And this money could be spent in a limited number of ways: on higher education expenses (including trade school), on the purchase of a home, “any other investment in financial assets or personal capital that provides long-term gains to wages and wealth” (presumably this is meant to allow for investments in starting a small business), or any spending after age 59 1/2. In any case, this is all money that would be available on top of any financial aid rather than taken into account in calculating eligibility for financial aid.

Would this work?

Various proponents have claimed that this would have all manner of beneficial effects, and in particular would “narrow the racial wealth gap,” as the Urban Institute says, because black and Hispanic families are more likely to be poor, and white families are more likely to have inheritances from earlier generations. The cost would work out to $60 billion annually, according to Booker, or $650 billion over a decade according to the Committee for a Responsible Federal Budget, which reports on a prior iteration in which the plan would have been paid for by increasing capital gains taxes and estate taxes. At the time of their analysis, in 2019, 30 year Treasury rates had been level at 3% for two years, so they used this as their assumption to calculate that a child whose family had been in poverty for his/her entire lifetime would have an account of $46,215 at age 18; for a more middle-class family, with income of $56,000 for a family of four, the account balance would be $12,815. (My own math is somewhat different and arrives at an account balance of $38,000 adjusted to strip out the effect of inflation over time, but, eh, you get the picture.)

Would this achieve the goal of the program, helping young adults who had grown up poor get a good start in life? It seems obvious that having this money, over and above what financial aid programs would provide, would increase their financial well-being. But what is the purpose of building up an “account,” especially a notional account, over time? Why create a program which won’t provide any benefits for the next 18 years, when there is no particular rationale except to implement the spending gradually, so that only 18 years from now will the program be operating at full cost? Since all the money is borrowed anyway, what meaningful significance is there to the interest accrual and the lending-back of borrowed money for the purpose of “earning interest”?

And once a recipient leaves young adulthood, the notion of using these accounts as retirement income becomes shaky, because it makes so little sense to require that they continue accruing interest at the very low level of a government bond.

So what is the point of a “Baby Bond” rather than simply beefing up financial aid for education and grants for would-be entrepreneurs? One presumes that there’s a strategy in allocating the funds $2,000 at a time, and with $1,000 for all children regardless of income, to give it the “feel” of a broad-based program and a “savings account” just like the savings accounts we might encourage our children to start for themselves.

The RISE account – a Baby Bond for retirement

There is a second “Baby Bond” proposal which aims much more directly at retirement, because, in this version, the money isn’t accessible at all until retirement age. This proposal comes from financial advisor Ric Edelman, with a description at, among others, the Washington Post.

Here’s how his proposal would work:

The government would issue bonds and use the proceeds to fund accounts for children born in the US, just as with the Booker proposal. However, the bonds would be issued and the funds credited upon a child’s birth, be invested in diversified funds similar to a pension fund. Then, after 20 years, the bonds would be redeemed, but the investment earnings would be greater than the initial bond and interest, so this net earnings would remain in the fund and continue to grow for the next 50 years, at which point the individual would begin to receive retirement benefits in a spend-down using financial planners’ rules of thumb, and any funds remaining upon their death would be used to supplement funds for those who outlive their assets by living past 100.

Edelman does not provide the full details of his plan, and the biggest missing piece is his math around which children would get how much money. Similar to Booker’s plan, babies would be credited with different amounts based on parents’ income, with an average funding of $5,884, which he projects would create an annual payment stream of $26,810, in today’s dollars.

But his two key assumptions are these:

First, he assumes that the government would be able to issue bonds at the low interest rates earned by traditional “savings bonds” (EE bonds), which stands at 0.1%. (It is not clear if he builds into his calculation the one-time adjustment at 20 years which means that savings bonds double the saver’s money, for an annualized rate of 3.5%.) But the program would need to issue bonds of over $23 billion per year, by his own numbers ($5,884 per child and 4 million children born per year); however, the total series EE bond outstanding as of November 19 was $125.8 billion. He assumes that enough investors will choose these savings bonds for the “feel-good” element of the program, but that seems a bit of a stretch over the long term, especially when you’re no longer speaking of helping poor children but funding retirements 70 years in the future for people who may or may not be poor as adults.

Second, he assumes that the program will reliably earn the projected 7.27% in investment earnings. It’s important to note that this is the average assumed rate of return reported by public pension plans in the United States, which is, let’s face it, just about the most aggressive such assumption available — and this isn’t just a matter of the usual accusations of public pensions being to aggressive in order to report lower liabilities and make lower contributions. In the same manner as interest on government bonds is a fraction of what it had been a generation ago, so, too, are expectations for stock market returns declining as the population ages; even before the pandemic or the Trump administration, McKinsey was forecasting long-term declines in U.S. and European equity growth (see this December article on another similar proposal); more recently, Morningstar summarized long-term expectations coming in at anywhere between flat/negative to 5.7%, for U.S. equities, at best. Considering that it would be necessary to beat a 3.5% annualized return, on average, for 20 years, this is not actually a sure thing.

And Edelman acknowledges that the proposal is not truly risk-free, and suggests that “Congress could choose to give the Commission authority to use a surplus from one year’s program to compensate for a deficit incurred by another. Alternatively, Congress could choose to provide funding to eliminate a shortfall experienced by any birth year. Absent these actions, babies from each birth year will simply be limited to receiving only as much income as the program can provide.”

Finally, would it be fair to provide this retirement income only to those children who had been born into poor families? Edelman himself had made an earlier proposal with a flat benefit for all.

Would this proposal work?

My first reaction is that there’s simply no way to implement a plan which would first start to pay out benefits in 70 years, and that Americans further wouldn’t stand for there being differences in payouts by year of birth from what’s nominally a government program for all.

But looking at the core idea, rather than the specifics: this is a proposal for a sovereign wealth fund. Sure, it has a specific objective — providing retirement savings — and yes, unlike the sovereign wealth funds of nations with oil wealth, it would be funded by issuing debt, and its meant to be managed by private-sector investment managers, but in its core concept, functionally, the government would be acting as private-sector investor and earning money with the expectation that it investment revenue would exceed the interest on bonds.

And, in fact, there have been multiple proposals circulating recently. Most recently, in January, in “It’s Past Time for a U.S. Federal Sovereign Wealth Fund” at The National Interest, Richard Caroll proposed that the royalties the U.S. government receives from wealth-extraction on federal lands (with those royalties to be hiked substantially as well), as well as revenues from the Federal Reserve Open Market Operations’ bond purchasing program, should be directed into at U.S. Sovereign Wealth Fund rather than merely the U.S. Treasury, for the purpose of creating investment income as a future income stream given the growing indebtedness of the country. Back in May, Nir Kaissar at Bloomberg argued that instead of bailing out companies, the U.S. should have bought their equity or bonds:

“Like any private investor, the fund would buy the equity or debt of struggling companies at deeply discounted prices, handing the losses to owners or creditors of those companies and imposing the same onerous terms one would encounter in private-sector deals. That would remove questions about whether and which companies deserve to be bailed out because investment would be motivated by profit rather than charity. It would also allow the government, and all Americans by extension, to fully participate in the gains when companies turn around.”

The question of issuing debt to make investments would not be relevant, in this case, because the government would be borrowing to fund the bailouts, in any case, though Kaissar also suggests borrowing additional money to build up the fund even further.

As it happens, we have an example of a retirement-oriented Sovereign Wealth Fund just to the north of us: the Canada Pension Plan has a trust fund which invests in a wide variety of assets. As of 2018, they fully or partially owned Petco, Univision, and Neiman Marcus, for example. But they did not borrow money in order to make these investments; they used the surplus income coming into their Social Security system and are now using the funds generated by a tax hike to build up funds to fully pay for new benefits which will accrue over time. In other words, they are not promising that a plan will “pay for itself” but simply using tax revenues to build up a pension fund.

The long and short of it is this: people want a solution to retirement shortfalls (may I remind you of my Social Security reform proposal?) and to persistent demographic disparities, and this offers the promise of being something new and innovative. But just because something is “innovative” doesn’t necessarily guarantee it’s the right path forward.

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.