The U.S. Navy Pension Fund, 1800-1842
Recent projections indicate that expenditures on Social Security retirement benefits will begin to exceed payroll-tax revenues and trust-fund earnings before the year 2020, and the Old Age, Survivors, and Disability Insurance (OASDI) trust fund will be depleted within roughly ten years of that date. If substantial changes are not made in the Social Security system, then expenditures are projected to exceed revenues by more than 5 percent of the payroll covered by the Social Security tax. Numerous analysts, commissions, business groups, and labor organizations have studied this situation and made recommendations for changes in the system. One proposal is for changes in the investment strategy of the OASDI trust fund. Presently, tax receipts beyond current outlays are placed into the trust fired, which is permitted to invest only in special-issue U.S. Treasury "bonds," which are essentially accounting entries in the budget of the U.S. government. Many reformers favor some type of private investment of Social Security funds. Proposals include (1) retaining the current structure of Social Security benefits but investing part of the existing trust fund in private equities and bonds, (2) establishing small individual accounts that would be centrally managed with some or all of the funds being invested in private securities, and (3) directing most of an individual's Social Security taxes into private accounts that would have a wide range of private investment opportunities.
Proponents of investing Social Security funds in private securities point to the higher expected returns compared to current investment practices. If the funds were invested in the equity or liabilities of private corporations and if they earned returns similar to the average returns over the past fifty years, then Social Security recipients could enjoy greater retirement benefits at the same cost, or the same benefits with a lower tax burden, or some combination of the two. Depending on the proposal and the investment strategy, such a change in investment practice could partially alleviate the system's long-run financing problems.
Opponents of investing a portion of Social Security funds in private assets highlight the greater risk associated with private securities relative to federal debt. Those risks include greater variation in year-to-year returns, possibilities of large capital losses, and the risk of fraud and malfeasance in the management of the funds specifically and in financial markets more generally. Inevitably, with private investments some retirees may have lower pension benefits than they would have had if all funds had been invested in government bonds, whereas other retirees will have higher benefits.
The debate over permitting the Social Security trust fund to invest in private securities has proceeded without reference to past U.S. experience with the investment of public pension funds in private securities. Indeed, our review of the literature suggests that participants in this debate have assumed, either implicitly or explicitly, that federal pension funds have never been invested in private assets. But they have been. In the first half of the nineteenth century, a substantial proportion of the assets in the U.S. Navy pension fund were used to purchase equity in private companies.
Although the modern Social Security system dwarfs the nineteenth-century navy pension fund in both size and scope, the issues involved in the coverage and funding of the benefits reflect many of the same concerns facing the Social Security system today, and the history of the navy pension fund provides a case study of the potential problems associated with the investment of public pension funds in private equities. Among those problems are the government's inability to credibly shift the risks associated with privatization to those insured by the fund and the government's tendency to increase the benefits as the fund grows.(1) In the case of the naval pension fund the bankruptcy of private firms whose equity composed a substantial proportion of the fund's portfolio ultimately led to taxpayer-funded bailouts. Also, Congress substantially extended the benefits in response to an existing surplus in the pension fund, an action that ultimately resulted in its insolvency. This history has relevance to current debates about the privatization of Social Security.(2)
The Navy Pension Fund
During the earliest years of the republic, Congress decided to provide disability pensions for naval personnel. Although today the term pension is associated with retirement, the navy pension fund was essentially a disability fund.(3) From 1790 through 1797, these pensions were paid to naval (and army) personnel from general appropriations. Legislation enacted in July 1797 provided that officers, marines, and seamen injured in the line of duty were entitled to a disability pension. In the case of officers, the pension was not to exceed half pay, and the benefit for marines and seamen was not to exceed $5 a month. In both cases, the benefit depended on the extent of the disability (Seybert  1969). Additional legislation enacted in 1798, 1799, and 1800 established a separate pension fund for naval personnel, providing a disability benefit with a maximum of half pay for marines and seamen as well as officers. That fund was ultimately to be financed by the sale of prizes, either ships of war or merchantmen of belligerent states or neutral merchantmen carrying contraband.
The laws establishing the navy pension fund also prescribed the fund's administrative structure, its management, and the eligibility conditions for receipt of benefits.(4) The fund was placed under the management of the secretaries of the Navy, Treasury, and War Departments. The 1799 legislation stated that the commissioners of the pension fund should invest all funds in "six percent or other stock [bonds] of the United States, as a majority of them, from time to time, shall determine to be most advantageous." However, the 1800 legislation authorized the commissioners to invest the fund's monies "in any manner which a majority of them might deem most advantageous" (Seybert  1969, 692). The commissioners of the fund took advantage of their broad charge in 1809 by purchasing a large number of shares in a local bank, the Bank of Columbia. Later they invested in two other local banks, Union Bank and Washington Bank. Prior to these purchases of shares, all investments of the fund had been in U.S. bonds. Although the fund's revenue increased during the War of 1812 due to the availability of prizes, the Bank of Columbia failed in 1823-24, causing a loss of income and a temporary loss of capital at a time of increasing obligations to pay benefits. As the pension fund grew, the commissioners found it increasingly difficult to manage through three federal departments. Eventually they requested that Congress place the fund under a single department, and in 1832 the secretary of the navy was made the fund's sole manager. At that time Congress mandated that the Treasurer of the United States hold all fund assets in custody, and directed the secretary of the navy to invest all pension funds in stock of the Bank of the United States (Glasson 1918,102). The reorganization of the fund's management arose from problems associated with the investment in the Bank of Columbia (about which we say more later).
The 1800 act also provided that "every officer, seaman and marine, disabled in the line of his duty, shall be entitled to receive for life, or during his disability, a pension from the United States, according to the nature and degree of his disability, not exceeding one-half of his monthly pay" (American State Papers, Naval Affairs, vol. 4, report no. 529, Jan. 17, 1834, 487).(5) In order to receive a disability pension, a person had to complete an application indicating the circumstances of the injury, when it occurred, the extent of the injury, and the extent of the resulting disability. The application had to be signed by the company surgeon and commanding officer. Injuries could result in a partial or total disability, and the amount of the pension depended on the extent of the disability. Pensions were forfeited if the veteran was convicted of a felony (American State Papers, Naval Affairs, vol. 4, report no. 524, Dec. 23, 1833, 427).
Table 1 lists the value of the interest- and dividend-earning assets of the navy pension fund, the annual returns on its portfolio, the number of beneficiaries, the total amount of annual benefits paid, and the average benefit per recipient for each year between 1800 and 1842.(6) The figures show that the number of beneficiaries, the total cost associated with their pensions, and per capita expenditures generally increased during the life of the fund. The number of pensioners increased from 22 in 1801, receiving annual benefits of $1,605 ($72.95 per recipient), to 946 beneficiaries at an annual cost of $107,129 in 1842 ($113.24 per recipient for "ordinary" benefits and $232.60 per recipient including "extraordinary" payments).(7)
Table 1: Estimated Annual Navy Pension Fund: Amount Invested, Investment Returns, Number of Pensioners, and Annual Outlays of the Fund Paid to Pensioners, 1800-1842
Year Fund(a,b) Annual Number of Annual Investment Returns Pensioners Outlays (dollars) (dollars) (dollars) 1800 26,552 489 -- -- 1801 56,556 4,748 22 1,605 1802 79,056 5,485 -- -- 1803 126,325 8,457 37 3,567 1804 129,712...