[Attachment D]

AVERAGE MARKET-YIELD RATE ON MARKETABLE INTEREST-BEARING OBLIGATIONS OF THE UNITED STATES, AS OF THE BEGINNING OF JUNE OF VARIOUS YEARS

Chairman PICKLE. Thank you, Mr. Myers. I am going to assume you will stay with us?

Mr. MYERS. Yes, Mr. Chairman.

Chairman PICKLE. Now we will be glad to hear from Mr. Mark Stalnecker, the Deputy Assistant Secretary of the Treasury.

STATEMENT OF MARK E. STALNECKER, DEPUTY ASSISTANT SECRETARY OF THE TREASURY (FEDERAL FINANCE), DEPARTMENT OF THE TREASURY

Mr. STALNECKER. Thank you, Mr. Chairman.

Chairman PICKLE. We will be pleased to hear from you.

Mr. STALNECKER. Mr. Chairman, members of the subcommittee, I am pleased to present the views of the Treasury Department on the subject of policies governing the investment of social security trust fund assets.

My comments will be directed only at the investment policies of the trust funds and will not address the more fundamental questions of funding and benefit levels.

The social security trust funds consist of four separate fundsthe Old-Age and Survivors Insurance Trust Fund, the Disability Insurance Trust Fund, the Hospital Insurance Trust Fund, and the Supplementary Medical Insurance Trust Fund.

The invested assets of the funds were $48.6 billion as of September 30, 1981. The investment of the funds is by law the responsibility of the Secretary of the Treasury.

In your letter to Secretary Regan of October 6, 1981, you stated that the subcommittee is interested in learning Treasury's views regarding the continued appropriateness of all current policies and practices concerning the investment of trust fund assets.

Specifically, you requested our views on the following:

(1) the appropriateness of the current statutory interest rate formula in light of both current high interest rates on short-term investments and the fact that many trust fund securities are now held for only short periods before redemption;

(2) the advisability of increasing trust fund purchases of marketable U.S. Government securities in the open market; and

(3) the appropriateness of Treasury's policy of establishing maturities for new special issues given the fact that long-term special issues are often redeemed before maturity when trust fund outgo exceeds income, as is the case with the OASI and the DI trust funds today.

You also expressed your interest in learning whether any changes in policies governing the investment of trust fund assets are advisable given both today's short-term interest rate yields and the financial crisis facing the social security system.

We believe that the long-range investment policies governing the social security trust funds, and other trust funds, should not be dictated by the happenstance of current relationships between short-term and long-term interest rates.

At the time the present law governing the investment of the social security trust funds was enacted in 1960, long-term market rates were higher than short-term rates. For example, 3-month Treasury bill yields were about 2.9 percent on a coupon equivalent basis and yields on 10-year treasuries were about 4.1 percent.

Thus, the statutory requirement that the interest rate on fund investments be based on market yields on Treasury securities with 4 or more years to maturity resulted in a higher return to the funds than would have been realized from a formula based on short-term rates.

Since 1960, long-term rates have generally been higher than short-term rates, but the relationship has fluctuated substantially with changing market conditions, and in recent years there have been prolonged periods when short-term rates were higher than long-term rates.

This relationship has changed dramatically in recent months, as short-term rates declined relative to long-term rates.

The 3-month bill rate is currently about 13.9 percent and the 10year rate is about 14.9 percent, but in May 1981 the 3-month bill rate was as high as 18 percent, while the 10-year rate was 14.7 percent.

Thus, the earnings of the funds will not necessarily be maximized by requiring that future investments be tied to either shortterm or long-term rates.

Nor should the long-range investment policies be dictated by the current status of the much broader problem of social security funding, that is the problem of assuring adequate social security taxes or other sources of funds to meet future benefit payments. The funding problem obviously cannot be resolved by changes in investment policy.

The investment earnings of the funds would of course be increased if the Treasury were to pay a higher interest rate on fund investments than the Treasury is required to pay on comparable maturity borrowings in the market.

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However, this would result in a completely arbitrary subsidy to the funds at the expense of the general taxpayer, and the subsidy thus provided would not be subject to the congressional control and scrutiny inherent in the normal appropriations process.

To assure that Treasury issues to the trust funds are at interest rates consistent with the Treasury's current cost of borrowing in the market the interest rates should be related to the maturities of the issues; that is, a 1-year issue to the trust funds would carry a rate equal to the estimated rate Treasury would pay at that time on a 1-year issue in the market, the rate on a 5-year issue would be based on Treasury's 5-year market rate, and so on.

As to the appropriate maturities of issues to the trust funds, we believe that the selection of maturities should be based on the expected cash needs of the funds. A statutory requirement that the funds be invested in short-term issues and rolled over as they mature would result in excessive dependence on short-term interest rates, which are generally lower than long-term rates, and considerable volatility in fund earnings, because short-term market rates fluctuate much more than long-term rates.

As to the advisability of increasing trust fund purchases of marketable Treasury securities in the open market, we see no advantage to the trust funds from such purchases. So long as Treasury issues of nonmarketable securities to the funds bear interest rates that are tied to market rates, the funds will be assured of current market rates.

Moreover, the maturities and timing of special issues can be tailored more effectively to the needs of the funds, compared to open market purchases.

Given the investment principles suggested above, I would now like to turn to the present specific statutory requirement for the investment of the social security funds in special nommarketable issues. Existing law provides:

Such obligations issued for purchase by the trust funds shall have maturities fixed with due regard for the needs of the trust funds and shall bear interest at a rate equal to the average market yield (computed by the Managing Trustee on the basis of market quotations as of the end of the calendar month next preceding the date of such issue) on all marketable interest bearing obligations of the United States then forming a part of the public debt which are not due or callable until after the expiration of four years from the end of such calendar month. . . . There are three apparent deficiencies in this statutory formula. First, as discussed above, the requirement that the interest rate be based on yields on Treasury marketable issues with 4 or more years to maturity prevents the Treasury from providing interest rates related to the specific maturities of the issues to the trust funds.

Thus, when short-term rates are higher than long-term rates, as has generally been the case this year, the trust funds receive a lower rate of return than they would receive if the statute permitted Treasury to pay interest rates related to the yields on Treasury marketable issues of comparable maturities.

Second, the requirement that the obligations issued to the funds bear interest at a rate equal to the average market yield at the end of the month preceding the date of issue subjects the earnings of the funds to erratic fluctuations which may occur on any one day

in the market, because of market reactions to short-term economic or financial developments or other unsettling news events.

A better approach would be to base the interest rate on an average over a period, which would provide a more equitable rate of return and would help assure more stability in the earnings of the funds.

Third, the requirement that the obligations issued to the funds bear interest rates equal to market yields on all marketable interest bearing obligations of the United States of the prescribed maturities results in a somewhat lower rate of return to the funds than Treasury would be required to pay on new issues in the market; that is, under this statutory formula, Treasury must include in its rate computation the yields on many outstanding issues which were issued many years ago at market rates considerably below current yield levels.

Since such issues are thus traded at deep discounts in the current market, they are especially attractive to purchasers who benefit from the capital gains tax advantage of deep discount issues, as well as to purchasers who gain special tax advantages from the socalled flower bonds which are redeemable at par for the payment of estate taxes.

Consequently, such issues are traded at relatively higher prices, and thus lower nominal yields, than would be required on Treasury new issues.

This inequity to the trust funds could be remedied by permitting the Secretary of the Treasury greater discretion to base his rate determinations on current market yields on selected outstanding issues which are reasonably reflective of Treasury's current borrowing costs.

Also, this administration is currently conducting a comprehensive review of the longstanding statutory requirements and administrative policies and practices governing investments of the social security funds and other trust funds, particularly those funds which are invested under similar statutory formulas.

This review will have to consider the overall levels of trust fund benefits in the future. Upon completion of this review, the Treasury Department will consider appropriate recommendations to Congress to assure an equitable rate of return to the trust funds under changing market conditions.

We look forward to working closely with your subcommittee on this important matter.

Mr. PICKLE. Thank you, Mr. Stalnecker.

As an overall question, I would like to ask you both, if you think that the current manner in which you are investing the trust fund moneys is the best approach?

Are you satisfied with it? Are we getting the best return? Should we invest the trust funds differently?

Mr. MYERS. Mr. Chairman, answering first, I would say that the present method is, in general, the best possible method if it is carried on for a long period of time.

If you jump in and out of investment strategies, it is not the best. at the moment.

I think that it is fair and equitable to everybody that the present general method be continued.

Mr. Stalnecker has pointed out one or two technical elements, such as the possible exclusion of bonds like the "flower bonds" or bonds with deep discounts, that might refine the present method. I think that the general structure of the present method is a fair and equitable one to the Social Security System as a whole and to the General Treasury as well.

Mr. STALNECKER. I would agree with that. I think what has happened over the past 20 years or so since the 1960 amendments were passed has been a financial environment that was totally unanticipated under the statute.

Also, I would point out the long-term nature of these funds, which was anticipated throughout the history of the funds, has meant that the social security funds have been invested in longer term securities over the past 20 years.

As rates have risen, as Mr. Myers mentioned in his testimony, the fact that these longer term rates still exist on the books of the funds has made the comparison to the currently available interest rates look bad relatively speaking.

If you look at the performance of other longer term investment portfolios in the marketplace, which would be analogous to the long-term investment of the social scurity trust funds, the rates of return are very comparable to those earned by the social security trust funds.

I think the problem hasn't been the investment policies of the fund which have been consistently applied regardless of market conditions, but in the general financial conditions which have resulted in ever-increasing interest rates since 1960.

Mr. PICKLE. The assertion by some that we have lost $1 billion in added revenue because of the present policy is a serious one. We have to consider whether there is some way we can actually make much more in the investment of the trust funds, and whether or not that is an appropriate way to go?

Mr. Stalnecker, you indicated there were three different approaches. You listed the one, two, three approaches in your testimony. One you did not mention would be the redeeming of the highest interest special issues before all the lower ones were redeemed. That is another alternative, another option.

Mr. Myers, it seems to me you stated the policy question pretty well that we all face. You said, starting on page 10:

Another strategy is for the Social Security trust funds to roll over their assets into those securities with the highest current yield, but only if such yield exceeded that of current holdings.

Then you say:

Such a strategy would be very advantageous to Social Security, but very disadvantageous to the General Treasury, which would have to pay the higher amounts of interest due from general revenues.

It seems to me that this is the key to the issue. We could redeem the lower interest-bearing bonds and take the higher interest rate now, but if we did it, it would cost the Treasury.

I raise the question, are you trying to protect the trust funds, social security trust funds, or are you trying to protect the General Treasury? It does come down to that.

Whose interests are you looking after?