oversight

Social Security: Capital Markets and Educational Issues Associated With Individual Accounts

Published by the Government Accountability Office on 1999-06-28.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                 United States General Accounting Office

GAO              Report to the Chairman,Committee on
                 Ways and Means
                 House of Representatives


June 1999
                 SOCIAL SECURITY
                 Capital Markets and
                 Educational Issues
                 Associated With
                 Individual Accounts




GAO/GGD-99-115
United States General Accounting Office                                           General Government Division
Washington, D.C. 20548




                 B-281161

                 June 28, 1999

                 The Honorable Bill Archer
                 Chairman, Committee on Ways and Means
                 House of Representatives

                 Dear Mr. Chairman:

                 Proposals have been advanced by various groups calling for individual accounts as a
                 component of Social Security reform. To better understand the potential implications of
                 individual accounts, you asked us to provide you with information on how such accounts
                 could affect private capital and annuities markets as well as national savings, and to
                 determine the potential risk and returns to individuals under such a program. You also asked
                 us to determine the disclosure and educational efforts needed to inform the public about
                 individual accounts. This report responds to your request.

                 We will provide copies of this report to the Honorable Charles B. Rangel, Ranking Minority
                 Member of the House Committee on Ways and Means; the Honorable Kenneth S. Apfel,
                 Chairman of the Social Security Administration; the Honorable Arthur Levitt, Chairman of the
                 Securities and Exchange Commission; the Honorable Alexis M. Herman, the Secretary of the
                 Department of Labor; the Honorable Robert E. Rubin, the Secretary of the Treasury; and
                 other interested committees and organizations. Copies will be made available to others upon
                 request.

                 If you have any questions, please call me (202) 512-8678. Major contributors are
                 acknowledged in appendix II.

                 Sincerely yours,




                 Thomas J. McCool
                 Director, Financial Institutions
                  and Markets Issues




                 Page 1                                     GAO/GGD-99-115 Issues Associated With Individual Accounts
Executive Summary


                   The Social Security program faces a financing challenge primarily due to
Purpose            the aging of the U.S. population. In response, some reform advocates have
                   suggested the use of individual investment accounts as a component of
                   Social Security reform. To better understand the potential implications of
                   individual accounts, the House Committee on Ways and Means asked GAO
                   to determine how such accounts could affect (1) private capital and
                             1                                     2
                   annuities markets as well as national savings, (2) potential returns and
                   risks to individuals, and (3) the disclosure and educational efforts needed
                   to inform the public about such a program.

                   This report addresses certain aspects of the broad issue of the relationship
                   between individual accounts and Social Security’s long-term financing
                   needs. It does not seek to evaluate any specific Social Security reform
                   proposal or seek to address the administrative costs or implementation
                                                              3
                   issues associated with individual accounts. Rather, to identify the
                   potential impact of individual accounts on the capital markets, GAO
                   focused on the potential effect of proposals in which some percentage of
                   taxable payroll or other potential base would be provided to individuals to
                                             4
                   invest in private markets. Some proposals allow individuals wide latitude
                   in investment options; others provide a narrower choice, generally
                   between debt and equity mutual funds, or particular types of mutual
                          5
                   funds.

                   Individual investment accounts could affect the capital markets in several
Results in Brief   ways, depending on how the accounts are funded, how the funds are
                   invested, and how people adjust their own savings behavior in response to
                   individual accounts. As a source of funds for the accounts, most proposals
                   use either the cash collected from Social Security taxes or federal general
                   1
                    Annuities are contracts to provide periodic pay-outs for an agreed-upon span of time in return for a
                   premium. These contracts basically convert savings into income.
                   2
                    National savings includes the savings of individuals, households, and businesses, called private
                   savings; and the net savings of all levels of government.
                   3
                     GAO has issued two other reports that provide additional information on individual accounts as a
                   component of Social Security reform. One report provides information on the implementation issues
                   of individual accounts Social Security Reform: Implementation Issues for Individual Accounts
                   (GAO/HEHS-99-122, June 18, 1999). The other report provides additional detail on administrative
                   costs, which can have a direct effect on how much savings are accumulated in individual accounts over
                   time Social Security Reform: Administrative Costs for Individual Accounts Are Hard to Predict
                   (GAO/HEHS-99-131, June 18, 1999).
                   4
                    We use 2 percent of taxable payroll as an example throughout the report although, depending on the
                   proposal, the percentage or the base could be different.
                   5
                    Mutual funds pool the limited funds of small investors into large amounts, thereby gaining the
                   advantages of large-scale trading. Investors are assigned a prorated share of the total funds according
                   to the size of their investments.




                   Page 2                             GAO/GGD-99-115 Issues Associated With Individual Accounts
Executive Summary




revenues. As a result, the primary capital market effect is a purely
financial one: borrowing in the Treasury debt market (or retiring less debt)
to provide funding for investment in private debt and equity markets.
Although the annual flows are likely to be sizeable (for instance, 2 percent
of payroll would be about $70 billion in 1998), both the private debt and
equity markets should be able to absorb the inflow without significant
long-term disruption. There could eventually be a significant increase in
the amount of new funds flowing into the annuities market. However, the
magnitude of annuity purchases is likely to build gradually over time as
more retirees build larger balances, allowing the market sufficient time to
adjust.

In addition to the financial effect of redirecting funds from the Treasury
debt market to private capital markets, individual account proposals could
also affect the level of financial resources available for private investment
by increasing or decreasing national savings. The extent to which
individual accounts affect national savings will depend on how they are
financed, the structure of the program, and any behavioral responses of
businesses and individuals. National savings is more likely to increase if
(1) the government funds would have been spent but instead are not; (2)
                                                                         6
the program is mandatory and prohibits pre-retirement distributions; and
(3) households do not fully adjust their other retirement saving--that is,
reduce it because of savings involved in individual accounts.

To the extent that households use the opportunities offered by an
individual account program to invest in private equities and debt rather
than Treasury securities, they could increase both the returns they receive
and the risks they face compared to the current Social Security program.
Although asset diversification offers mitigation against certain risks, the
returns that individuals receive would depend on and vary with their
investment choices and the performance of the private debt and equity
markets. On the basis of historical data, most advocates of individual
accounts state that the expected future returns on private investments,
especially equities, would be much higher for individuals than the implicit
return available under the current Social Security program. Others are
skeptical about these claims for higher expected returns on equities. Some
argue that historical returns may not be a good predictor of future returns.
Others suggest that because equity market returns are more volatile than
returns on Treasury securities, a better comparison would be among risk

6
 Pre-retirement distribution refers to distributions other than the those that would occur as a result of
someone’s death. Some proposals allow distributions at death to be paid as a survivor benefit while
others do not.




Page 3                             GAO/GGD-99-115 Issues Associated With Individual Accounts
             Executive Summary




             adjusted returns of various assets. There are numerous ways to adjust
             returns for risk but no clearly best way. In the end, even informed choices
             among potential investments depend upon an individual’s tolerance for
             risk.

             To provide participants with a clear understanding of the purpose and
             structure of an individual account program, an enhanced educational
             program would be necessary. At a minimum, such a program would have
             to provide individuals with information adequate for their decisionmaking,
             as well as protect against misinformation. Existing disclosure and
             antifraud rules provide for the disclosure of information material to
             investors making investment decisions. However, disclosure alone would
             not enable participants in an individual account program to make
             thoughtful and informed investment decisions. An enhanced and broad-
             based educational effort would have to be undertaken in order to provide
             individuals with information they need and can readily understand as well
             as with tools that can help to improve both the decisionmaking process
             and awareness of the consequences of those decisions. Individuals would
             need education on the benefits of saving in general, the relative risk-return
             characteristics of particular investments and how different distribution
             mechanisms can affect their retirement income security. If only a few
             well-diversified investment choices are provided, most of the educational
             effort could be targeted to clarifying the purposes of investing and the
             potential long-term consequences of different investment alternatives.
             However, if a wide variety of choices is offered individuals so that they
             could potentially choose less diversified investments, such as individual
             equities, a more broad-based educational program will be necessary.

             In early 1997, the Advisory Council on Social Security reported on Social
Background   Security’s long-term financing problem of keeping the program solvent.
             Three plans or proposals were advanced by different groups of Council
             members. Two plans called for the creation of mandatory individual
             accounts, and the remaining plan called for having the government invest
                                                     7
             the trust fund in marketable securities. A number of other proposals
             calling for individual accounts have been advanced by various research
             organizations, academics, and Members of Congress. For the most part,
             these other proposals contain provisions similar to those found in the
             Advisory Council’s report.


             7
              See Social Security Financing: Implications of Government Stock Investing for the Trust Fund, the
             Federal Budget, and the Economy (GAO/AIMD/HEHS-98-74, April 1998).




             Page 4                            GAO/GGD-99-115 Issues Associated With Individual Accounts
                     Executive Summary




                     An individual account program requires that some portion of workers’
                     contributions to Social Security be put into individual accounts that they
                                                                    8
                     may invest in private equity or debt markets. The current Social Security
                     program is a pay-as-you-go program whereby each year’s revenue is
                     collected to pay for that year’s benefits. An individual account program
                     would enable individuals to build up and maintain account balances that
                     would provide financing for some part of their Social Security retirement
                     income. As a result, it moves away from a strictly pay-as-you-go system in
                     the direction of an advanced funded system.

                     Individual account proposals are usually framed by three characteristics.
                     The first characteristic pertains to whether to “carve-out” a portion of
                     Social Security’s tax that is to be invested in financial assets, or to “add-on”
                     a percentage to the current tax that is to be invested in financial assets.
                     The second characteristic concerns whether to make investments in
                     individual accounts mandatory or voluntary. Mandatory participation
                     would require that each individual invest some percentage of his or her
                     payroll tax contribution in financial assets. Voluntary individual accounts
                     would allow individuals to opt in or out of investing any portion of their
                     payroll tax contributions into financial assets. The third characteristic
                     pertains to how the accumulated earnings in individual accounts would be
                     paid out upon retirement, i.e., whether annuitization or a lump sum pay-out
                     would be required.


Principal Findings

Market Effects       Funding of individual accounts will come directly or indirectly from
                     increased government borrowing, unless funded by a tax increase or
                     reduced government outlays. In the absence of a tax increase, the
                     government will need to raise resources either by borrowing in the market
                     or by not retiring as much maturing debt as it otherwise would. Some part
                     of funds could be invested in the corporate equity and debt markets. The
                     amounts that would flow into these markets would depend upon the
                     options available to individuals as well as the choices they make. The
                     annual flow resulting from 2 percent of payroll would have been about $70
                     billion in 1998 dollars. Annual net purchases and sales of equities were
                     about $300 billion in 1996 and close to half a trillion dollars in 1997 and
                     1998. Thus, the additional annual flows could represent a 10- to 20-percent

                     8
                      Debt and equities are often the benchmarks used, even though eligible market investments could
                     encompass a wider range of financial assets under certain proposals.




                     Page 5                           GAO/GGD-99-115 Issues Associated With Individual Accounts
                             Executive Summary




                             increase in the annual flow but would still be relatively small compared to
                             the $15 trillion U.S. equity markets as a whole. Funds flowing into
                             individual accounts are more likely to have some short-term effects on the
                             corporate bond market because this market is smaller than the equities
                             market and less liquid—it is not as easy to buy and sell bonds without
                             moving the market. However, it is unlikely that there will be any
                             significant long-term disruptions of either market. Moreover, insurance
                             industry officials said that the annuities markets are likely to be able to
                             absorb the flows from mandatory or voluntary annuitization. They said
                             that the annuities resulting from the liquidation of the individual accounts
                             would generally be phased in over a long period of time and, therefore,
                             could be absorbed by the market without difficulty.

                             The extent to which individual accounts would affect national savings
                             depends on how they would be financed. For instance, funds could come
                             from (1) within the current Social Security system, which would likely
                             reduce government savings; (2) a change in the system resulting from
                             increased payroll taxes or reduced benefits, which would not affect
                             government savings; or (3) outside the system using general revenues,
                             where the effect on government saving would depend on how those funds
                                                               9
                             would otherwise have been used. National saving would also be affected
                             by how households and businesses respond to individual accounts. The
                             extent of these behavioral effects would depend in part on the structure of
                             the individual account program and any limitations placed on the use of
                             funds. For instance, proposals that are mandatory are more likely to
                             increase private saving because such a program would require that all
                             individuals, including those who do not currently save—such as many low-
                             income individuals or families—place some amount in an individual
                             account. Prohibitions or restrictions on borrowing or other forms of
                             preretirement distributions could also limit the ability of some households
                             to reduce their savings in response to individual accounts.

Expected Returns and Risks   Investing in assets through individual accounts involves a trade-off: greater
                             returns are possible, but only if the individual accepts some additional risk,
                             including, but not limited to, more variability in rates of return. Under the
                             current Social Security program, there is little investment risk.
                             Demographic and economic risk are borne collectively by taxpayers and
                             beneficiaries. Moving to an individual account program would mean that

                             9
                               The primary determinant is what would have been done with the revenue if it had not been used to
                             finance individual accounts; would the government have spent it, provided tax cuts, or saved it by
                             buying back outstanding debt? If the government would have spent it or reduced taxes but does not
                             because it funds individual accounts instead, government saving is not affected. If it would have used
                             the funds to buy back debt, government saving is reduced.




                             Page 6                            GAO/GGD-99-115 Issues Associated With Individual Accounts
                     Executive Summary




                     individuals would be able to reap the rewards of their own investments,
                     but they also would incur risk—not only the possibility of lower returns,
                     but also the possibility of losing money. Diversification and other asset
                     allocation approaches could help to improve an individual’s risk/return
                                10
                     trade-off. Holding assets for long periods of time could also improve an
                     individual’s risk/return trade-off because the risk averages out over time,
                     evening out the variations in risk. However, individuals who retire at the
                     same time may receive different pay-outs from individual account
                     investments because of the investment choices they have made. Returns
                     could also vary depending on when an individual retires because of the
                     volatility of the stock market. Thus, market-driven results can produce
                     “winners” and “losers,” depending on when and how individuals invest
                     their accounts and when they liquidate their holdings. As long as
                     individuals are aware of and accept this risk, there may not be calls to fix
                     the “unfair benefits outcomes.” On the other hand, if there are enough
                     “losers,” there could be calls to offset some or all of any losses.

                     Advocates and opponents of individual accounts have estimated what the
                     market rate of return could be for an individual’s investments under an
                     individual account program. Higher returns are possible for individuals
                     investing through individual accounts than are possible under the current
                     Social Security program, but only if individuals take on more risk.
                     Individuals should therefore not only be interested in the returns from
                     their investments, but also in the risks that must be incurred to achieve
                     higher returns. The difficulty is how to measure risk and how to adjust
                     rates of return to compensate for risk and allow for comparability. There
                     are many ways to adjust returns for risk but no clearly best way.

Enhanced Education   Existing Securities and Exchange Commission (SEC) disclosure rules
                     require that material information be provided about a particular
                     investment instrument and its issuer. Separate disclosure rules
                     promulgated by the Department of Labor (DOL) apply to pension plans.
                     Such disclosure would be essential to an individual account program, with
                     some rules having more significance than others, depending on the
                     investment choices offered. For example, if participants were allowed to
                     acquire individual corporate securities such as stocks and bonds, the
                     disclosure and reporting requirements of the Securities Acts of 1933 and
                     1934, such as those applicable to the governance, activities, and financial
                     status of the issuer, would be particularly important. If investment choices

                     10
                       Diversification refers to investing in more than one asset. Asset allocation is the choice of how much
                     to invest in each of the broad asset classes—stocks, bonds, cash, real estate, and possibly others to
                     achieve the best portfolio given the investor’s objectives and constraints.




                     Page 7                             GAO/GGD-99-115 Issues Associated With Individual Accounts
                  Executive Summary




                  were limited to mutual funds, disclosure about the funds would have
                  primary importance, while information about the issuers of the securities
                  owned by the funds would be relatively less significant for participants.

                  Introducing an individual account program would change the nature of the
                  current Social Security program and would require increased education,
                  not only to help people to understand the individual account program, but
                  also what their responsibilities and risk trade-offs would be. The amount
                  of education that would be necessary would depend on the range and type
                  of investment choices and the fees and expenses associated with
                  individual accounts. As a wider variety of choice is offered to individuals,
                  especially under a mandatory program, more education beyond the basics
                  would be necessary because individuals would need to consider broader
                  issues. In addition to understanding the difference between a stock and a
                  bond, investors would need to understand the importance of
                  diversification. Furthermore, being able to understand the rates of return
                  and various risks of different options and pick the appropriate investment
                  vehicle becomes more difficult, as more choice is offered. When choices
                  are limited to a few well-diversified alternatives--such as the case of a few
                                          11
                  indexed mutual funds --many decisions are made by those managing the
                  funds or are made by rules governing the fund (such as what the funds can
                  invest in). Thus, if a few well-diversified choices are offered, the individual
                  would have fewer risk factors to consider, and investor education can be
                  more targeted. Various officials have suggested that a default option be
                  provided for those individuals who, regardless of educational effort, would
                  not make investment choices. Such a default mechanism could provide a
                  very low-risk option based on Treasuries and/or could gear the asset mix
                  to the age of the worker.

                  GAO is not making recommendations in this report.
Recommendations

                  GAO provided drafts of this report to the Department of the Treasury, the
Agency Comments   Social Security Administration, the Securities and Exchange Commission,
                  and the Pension and Welfare Benefits Administration of the Department of
                  Labor (DOL) for review and comment. SSA provided written comments
                  that are included in appendix I. SSA had two major points: (1) that GAO
                  needed to clarify that comparisons between the rate of return implicit in
                  the Social Security system and those of individual accounts were

                  11
                   An indexed mutual fund is a mutual fund that holds shares in proportion to their representation in a
                  market index, such as the Standard & Poors 500.




                  Page 8                            GAO/GGD-99-115 Issues Associated With Individual Accounts
Executive Summary




problematic for many reasons, including the fact that Social Security
provides survivors and disability insurance; and (2) that GAO needed to
discuss the savings implications of the President’s proposal. In response
to the first point, we have further clarified issues regarding the rate of
return comparisons. With regard to the second point, this report was not
intended to comment on specific reform proposals.

In commenting on our report, SSA and the other agencies also provided
technical and clarifying comments. We have incorporated these comments
where appropriate.




Page 9                   GAO/GGD-99-115 Issues Associated With Individual Accounts
Contents



Executive Summary                                                                                      2


Chapter 1                                                                                             12
                        Social Security Has a Financing Problem                                       12
Introduction            Individual Accounts Proposed to Help Solve Social                             13
                          Security’s Financing Problem
                        Objectives, Scope, and Methodology                                            18


Chapter 2                                                                                             20
                        Redirection of Funds Could Affect Composition of                              20
Capital and Annuities     Portfolios
Markets Able to         Current Size of the Private Capital Markets                                   22
                        Effect of Individual Accounts on National Savings                             29
Absorb Individual         Depends on Financing, Structure, and Behavioral
Account Investments       Effects
                        Agency Comments                                                               34


Chapter 3                                                                                             35
                        Instituting an Individual Account Program Means Greater                       36
Return and Risks Are      Risk to Individuals for Potentially Greater Return
Likely to Be Higher     The Expected Market Return for Individual Account                             40
                          Investments
With Individual         Comparing Rate of Return From Social Security to                              48
Accounts                  Expected Return With Individual Accounts Requires
                          Careful Consideration
                        Agency Comments                                                               48


Chapter 4                                                                                             50
                        The Significance of Disclosure Rules Would Depend                             51
Enhanced Education is     Upon Available Investment Choices
Necessary for an        Enhanced Education Is Necessary for an Individual                             55
                          Account Program
Individual Account
Program
Appendixes              Appendix I: Comments From the Social Security                                 64
                          Administration
                        Appendix II: GAO Contacts and Staff Acknowledgments                           66




                        Page 10                 GAO/GGD-99-115 Issues Associated With Individual Accounts
          Contents




Tables    Table 2.1: Amounts of Corporate Equities, Corporate                             23
            Bonds, and U.S. Treasuries Outstanding (Dollars in
            Billions)
          Table 2.2: Annual Holdings of Corporate Equities and                            23
            Bonds by Various Sectors of the Economy (Dollars in
            Billions)
          Table 2.3: Annual Net Purchases and Sales of Corporate                          25
            Equities by Different Sectors (Dollars in Billions)
          Table 2.4: Annual Purchases and Sales of Corporate                              26
            Bonds Equities by Different Sectors (Dollars in
            Billions)
          Table 2.5: Policy Reserves Held for Individual and Group                        28
            Annuities (Dollars in Billions)
          Table 4.1: Investment Choices Under an Individual                               61
            Account Program and the Education Required


Figures   Figure 3.1: Returns of the Standard and Poors 500 Index                         42




          Abbreviations

          DOL           Department of Labor
          FDIC          Federal Deposit Insurance Corporation
          IRA           Individual Retirement Accounts
          OASDI         Old Age Survivor Disabilities Insurance
          OCC           Office of the Comptroller of the Currency
          OTS           Office of Thrift Supervision
          SEC           Securities and Exchange Commission
          SSA           Social Security Administration
          SPD           Summary Plan Description




          Page 11                   GAO/GGD-99-115 Issues Associated With Individual Accounts
Chapter 1




Introduction

                        Social Security forms the foundation for our retirement income system. In
                        1998, it provided approximately $264 billion in annual benefits to 31
                        million workers and their dependents. However, the Social Security
                        program is facing significant future financial challenges as a result of
                        profound demographic changes, including the aging of the baby boom
                        generation and increased life expectancy. In response, different groups
                        and individuals have advanced numerous proposals that have called for
                        the creation of some sort of mandatory or voluntary individual accounts.
                        To better understand the potential implications of individual accounts, the
                        Chairman of the House Committee on Ways and Means asked GAO to
                        determine how individual accounts could affect private capital and
                        annuities markets as well as national savings, the potential risks and
                        returns to individuals, and the disclosure and educational information
                        needed for public understanding and use of an individual account
                        investment program.
                                                              1
                        The Social Security program is not in long-term actuarial balance. That is,
Social Security Has a   Social Security revenues are not expected to be sufficient to pay all benefit
Financing Problem       obligations from 1999 to 2073. Without a change in the current program,
                        excess cash revenues from payroll and income taxes are expected to begin
                        to decline substantially around 2008. Based on the Social Security
                        Trustees latest “best estimate” projections, in 2014 the combined OASDI
                        program will experience a negative cash flow that will accelerate in
                        subsequent years. In addition, the combined OASDI trust funds are
                        expected to be exhausted in 2034, and the estimated annual tax income
                        will be enough to pay approximately 70 percent of benefits.

                        Every year, Social Security’s Board of Trustees estimates the financial
                        status of the program for the next 75 years using three sets of economic
                        and demographic assumptions about the future. According to the
                        Trustees’ intermediate set of these assumptions (or best estimate), the
                        nation’s Social Security program will face both solvency and sustainability
                        problems in the years ahead unless corrective actions are taken. Over the
                        next 75 years, Social Security’s total shortfall is projected to be about $3
                        trillion in 1998 dollars.

                        Social Security’s long-term financing problem is primarily caused by the
                        aging of the U.S. population. As the baby boom generation retires, labor

                        1
                         Social Security consists of two separate trust fund accounts: Old Age and Survivors Insurance
                        (OASI), which funds retirement and survivor benefits, and Disability Insurance (DI), which provides
                        disabled workers and their families. These two accounts are commonly combined in discussing the
                        Social Security program. For the purposes of this report, any reference to the Social Security program
                        refers to the combined Old Age Survivors Disability Insurance (OASDI) program.




                        Page 12                           GAO/GGD-99-115 Issues Associated With Individual Accounts
                          Chapter 1
                          Introduction




                          force growth is expected to slow dramatically. Beyond 2030, the overall
                          population is expected to continue aging due to relatively low birth rates
                          and increasing longevity. These demographic trends will require
                          substantial changes in the Social Security benefits structure and/or
                          revenues (i.e., taxes and/or investment returns). Without such changes,
                          current Social Security tax revenues are expected to be insufficient to
                          cover benefit payments in about 2014, less than 15 years from now. These
                          trends in Social Security’s finances will place a significant burden on
                          future workers and the economy. Without major policy changes, the
                          relatively smaller workforce of tomorrow will bear the brunt of financing
                          Social Security’s cash deficit. In addition, the future workforce also would
                          likely be affected by any reduction in Social Security benefits or increased
                          payroll taxes needed to resolve the program’s long-term financing
                          shortfall. As a result, without timely actions, certain generations could
                          face the twin blows of higher burdens and reduced benefits.

                          Proposals have been advanced by different groups to reform Social
Individual Accounts       Security through individual accounts. Such proposals basically also try to
Proposed to Help          restore the Social Security program’s solvency and conserve its
Solve Social Security’s   sustainability. In its report to the Social Security Commissioner, the 1994-
                          1996 Advisory Council on Social Security offered three alternative reform
Financing Problem         proposals, two of which would create individual accounts. The remaining
                          proposal called for having the government invest the trust fund in financial
                          assets, such as corporate equities. Numerous other proposals, also calling
                          for individual accounts, have since been put forth by various organizations.
                          Currently, therefore, there are a wide array of proposals that rely on some
                          form of individual accounts. These proposals have in common the idea
                          that to varying extents, individuals would manage their own individual
                          accounts. The returns from these accounts would provide some or much
                          of an individual’s future retirement income.
                                                                                                                       2
                          Social Security is currently structured as a defined benefit program. The
                          current Social Security program’s benefit structure is designed to address
                          the twin goals of individual equity and income security—including
                                                         3
                          retirement income adequacy. The basis of the benefit structure is that

                          2
                           A defined benefit plan is one in which the employer determines employees’ retirement benefit amount
                          using specific formulas that consider such factors as age at retirement, years of service, and salary
                          levels. The employer is responsible for ensuring that sufficient funds are available to pay promised
                          benefits.
                          3
                           Individual equity means that there should be some relationship between contributions made and
                          benefits received (i.e., rates of return on individual contributions). Retirement income adequacy is
                          addressed by providing proportionately larger benefits (redistributive transfers) to lower earners and
                          certain household types, such as those with dependents (i.e., benefits levels and certainty).




                          Page 13                            GAO/GGD-99-115 Issues Associated With Individual Accounts
                            Chapter 1
                            Introduction




                            these twin goals, and the range of benefits Social Security provides, are
                            currently combined within a single defined benefit formula. Under this
                            defined benefit program, the worker’s retirement benefits are based on the
                            lifetime record of earnings, not directly on the payroll tax he or she
                            contributed. Alternatively, a number of individual account proposals
                            introduce a defined contribution structure as an element of the Social
                            Security program. A defined contribution approach to Social Security
                            focuses on more directly linking a portion of the worker’s contributions to
                            the retirement benefits that will be received. The worker’s contributions
                            are invested in financial assets and earn market returns, and the
                            accumulations in these accounts can then be used to provide income in
                            retirement and an additional pre-retirement death benefit. One advantage
                            of this approach is that the individual worker has more control over the
                            account and more choice in how the account is invested. In essence, the
                            defined contribution structure is similar to the current 401(k) or IRA
                                     4
                            systems.

                            Some proposals combine defined contribution and defined benefit
                            approaches into a two-tiered structure for Social Security. The aim is to
                            maintain in some form the current existing system as a base tier and add
                            an individual account component as a supplemental tier. Some proposals
                            modify the existing benefit structure; and others propose features that
                            provide guarantees of current law benefits or some other level, such as the
                            poverty line. Other proposals have a more complicated formula including
                            forms of matching. Thus, the relationship between contributions and
                            benefits may be less direct. Under most of these proposals, individuals
                            would receive part of their future benefits from a modified Social Security
                            program and part from the accumulations from their individual account.

Four Main Characteristics   Most of the individual account proposals seek to create investment
                            accounts that to varying extents are managed by the participants
of Individual Account       themselves. However, the actual details of how to structure individual
Proposals                   accounts vary by each proposal. Individual account proposals are usually
                            framed by four characteristics: (1) carve-out versus add-on; (2) mandatory
                            versus voluntary participation; (3) range of investment options offered;
                            and (4) distribution options (e.g., required annuitization or lump-sum pay-
                            out).



                            4
                             A 401(k) pension plan is an employer-sponsored defined contribution plan that allows participants to
                            contribute, before taxes, a portion of their salaries to a qualified retirement account. An IRA is a
                            personal, tax-deferred retirement account. IRA assets can be invested in almost any kind of financial
                            instrument.




                            Page 14                           GAO/GGD-99-115 Issues Associated With Individual Accounts
                                Chapter 1
                                Introduction




Carve-out Versus Add-on         The first characteristic pertains to whether to carve-out a portion of Social
                                Security’s tax that is to be invested in financial assets or to add-on a
                                percentage to the current tax that is to be invested in financial assets.
                                OASDI has a payroll tax of 12.4 percent. A carve-out involves creating and
                                funding individual accounts with a portion of the existing payroll tax.
                                Thus, some portion of the 12.4 percent payroll tax, such as 2 percent,
                                would be carved out of the existing Social Security cash flow and allocated
                                to individual account investments. The resulting impact would be that
                                revenues are taken out of Social Security and less is left to finance current
                                benefits. Other proposals take a different approach and add-on individual
                                accounts as a type of supplementary defined contribution tier. For
                                instance, 2 percent would be added on to the current tax of 12.4 percent.
                                The resulting effect of an add-on leaves the entire 12.4 percent payroll tax
                                contribution available to finance the program while dedicating additional
                                revenues for program financing either from higher payroll taxes and/or
                                from general revenue.

Mandatory Versus Voluntary      The second characteristic of individual account proposals concerns
                                whether to make investments in individual accounts mandatory or
                                voluntary. Mandatory participation in individual accounts would require
                                that each individual invest some percentage of his or her payroll tax
                                contribution in financial assets such as equities. Voluntary participation in
                                individual accounts could allow individuals to opt in or opt out of investing
                                any portion of their payroll tax contributions into financial assets.
                                Individuals would rely on the existing Social Security if they chose to opt
                                out of participating in individual accounts. Other voluntary approaches
                                allow individuals to contribute with or without matching to a retirement
                                account. Additionally, mandatory or voluntary can also refer to the pay-
                                out an individual receives upon retirement, such as a pay-out in the form of
                                a lump sum.

Investment Choices              The third characteristic has to do with the degree of choice and flexibility
                                that individuals would have over investment options. Some proposals
                                would allow unlimited investment choices, such as investments in
                                corporate equities, bonds, or real estate. Other proposals would offer a
                                more limited range of choices, such as equity or bond indexed funds.
                                Thus, individual account investments offer individuals some range of
                                choice over how to accumulate balances for their retirement.

Annuitization Versus Lump-Sum   The final characteristic centers around how the accumulated earnings in
                                individual accounts will be paid out. Preserving individual’s retirement
                                income prior to pay-out by prohibiting pre-retirement distributions or
                                loans is also a requirement of most proposals. However, upon pay-out,



                                Page 15                   GAO/GGD-99-115 Issues Associated With Individual Accounts
                             Chapter 1
                             Introduction




                             some proposals would permit requiring annuities--contracts that convert
                             savings into income and provide periodic pay-outs for an agreed-upon span
                             of time in return for a premium. Other proposals suggest allowing the
                             individual to withdraw the account balance in lumpsum or through gradual
                                       5
                             pay-outs.

Individual Accounts are      Among the changes implementing individual accounts would make to the
                             current Social Security program is to move away from a pay-as-you-go
Different From the Current   system in the direction of an advanced funded system.
Social Security Program


Pay-As-You-Go                Social Security is currently financed largely on a pay-as-you-go basis.
                             Under this type of financing structure, the payroll tax revenues collected
                             from today’s workers are used to pay the benefits of today’s beneficiaries.
                             Under a strict pay-as-you-go financing system, any excess of revenues over
                             expenditures is credited to the program’s trust funds, which function as a
                             contingency reserve.

Advanced Funding Through     Advanced funding refers to building and maintaining total balances for
Individual Accounts          Social Security, whether that is done through individual accounts or some
                                                6
                             other mechanism. Thus, although individual accounts are a form of
                             advanced funding, the two terms are distinct. For instance, building up the
                             balance in the Trust Funds is a form of advanced funding. The creation of
                             individual accounts refers to a defined contribution system of accounts
                             connected to Social Security and held in individuals’ names. Essentially,
                             individual accounts would be advanced funded income arrangements
                             similar to defined contribution plans or 401 (k) plans. Although privately
                             held individual accounts are a widely discussed means to achieve
                             advanced funding, there are other ways to achieve advanced funding.
                             Another approach to advanced funding using private markets would have
                             the government invest directly in private capital markets. Building up the
                             Trust Fund using Treasury securities (marketable or nonmarketable) is
                             another form of advanced funding, although it does not involve
                             diversification gains.

                             Proponents of individual accounts often state that advanced funding and
                             asset diversification are benefits of their proposals. Yet, although

                             5
                              Some other proposals would combine payments from individual accounts with Social Security
                             benefits into a single benefit.
                             6
                              Advanced funding could also occur through a buildup of nonmarketable or marketable Treasury
                             securities or through having the government invest in the private sector.




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                          Chapter 1
                          Introduction




                          advanced funding, individual accounts, and asset diversification are often
                          linked, they are conceptually different. Diversification refers to investing
                          in more than one asset and can be performed by individuals investing in
                          individual accounts or by the government investing the trust fund in
                          corporate equities stocks as well as corporate bonds. Any one of the three
                          categories could change without changing the other. For instance, Social
                          Security’s Trust Funds are currently invested in nonmarketable
                                      7
                          Treasuries. Allowing the Trust Funds to invest in assets other than
                          Treasuries would be diversifying without introducing individual accounts.
                          Alternatively, individual accounts could be introduced whereby individuals
                          are allowed to invest in only one asset--thereby introducing individual
                          accounts without diversifying.

Savings Implications of   Whether advanced funding through individual accounts increases national
Advanced Funding          saving is uncertain. The nation’s saving are composed of the private saving
                          of individuals and businesses and the saving or dissaving of all levels of
                                       8
                          government. Supporters of advanced funding point out that individual
                          accounts offer a way to increase national savings as well as investment
                          and economic growth. Others suggest that the national saving claims of
                          those favoring advanced funding through individual accounts may not be
                          realized. Whether advanced funding through individual accounts increases
                          national saving depends on a number of factors, including how individual
                          accounts are financed (existing payroll tax, general revenues); how private
                                 9
                          saving responds to an individual account system; the structure of the
                          individual account system (mandatory or voluntary), and the limitation or
                          prohibition of pre-retirement distributions and loans to make sure
                          retirement income is preserved.

                          Furthermore, even if national saving increases as a result of individual
                          accounts, individuals may or may not be better off. Saving involves giving
                          up consumption today in exchange for increased consumption in the




                          7
                           The Trust Funds are invested in special issue Treasuries (either bonds or certificates of
                          indebtedness). These special issue Treasuries are redeemable at face value at any time.
                          8
                           In general, government budget deficits reduce from national savings by absorbing funds that
                          otherwise could be used for private investment. Conversely, government budget surpluses add to
                          saving. Surpluses allow the government to pay off some of its maturing debt, thereby reducing the
                          outstanding level of debt held by the public and freeing up additional funds for private investments.
                          9
                              Private saving is the saving of households and businesses.




                          Page 17                              GAO/GGD-99-115 Issues Associated With Individual Accounts
                         Chapter 1
                         Introduction




                         future. Some economists have stated that it is not necessarily the case that
                                                                                             10
                         all increases in saving are worth the cost of foregone consumption.

                         The Chairman of the House Committee on Ways and Means asked us to
Objectives, Scope, and   determine how individual accounts could affect (1) private capital and
Methodology              annuities markets as well as national savings, (2) potential returns and
                         risks to individuals, and (3) the disclosure and educational information
                         needed for public understanding and use of an individual account
                         investment program.

                         To determine the effect of individual accounts on the private capital and
                         annuities markets, as wells as risk and return issues, we interviewed
                         economists and other officials who were both proponents and opponents
                         of individual accounts. These officials included officials from think tanks
                         as well as academicians who have studied Social Security reform. We also
                         reviewed and analyzed several studies relating to the impact of individual
                         accounts on the market as well as studies that had tried to assess the risks
                         and return issues that would arise because of individual accounts. We also
                         analyzed data from the Federal Reserve Flow of Funds as well as data
                         provided by the insurance industry. Additionally, we talked to industry
                         officials from both the insurance and securities industries to obtain their
                         views, and we interviewed government agency officials as.

                         To determine the disclosure and educational requirements needed, we
                         spoke to officials from the Securities and Exchange Commission (SEC),
                         the Department of Labor’s (DOL) Pension and Welfare Benefits
                         Administration (PWBA), the Pension Benefit Guaranty Corporation, and
                         the Social Security Administration (SSA). We also spoke to private sector
                         officials about the educational requirements that would be needed for an
                         individual account program. Additionally, we reviewed various studies
                         that have looked at the best ways to educate people about investment and
                         retirement education.

                         Because of the wide-ranging nature of the numerous proposals being
                         advanced, our report focuses on the common, or generic, elements that
                         underlie various proposals to reform Social Security financing rather than
                         on a complete evaluation of specific proposals.




                         10
                            See Eric M. Engen and William G. Gale, “Effects of Social Security Reform on Private and National
                         Saving,” Social Security Reform Conference Proceedings Federal Reserve Bank of Boston, Conference
                         Series No. 41, June 1997.




                         Page 18                          GAO/GGD-99-115 Issues Associated With Individual Accounts
Chapter 1
Introduction




We did our work in accordance with generally accepted government
auditing standards between October 1998 and June 1999 in Washington,
D.C., and New York, NY.

We requested comments on a draft of this report from SSA, SEC, DOL, the
Department of Treasury, and the Federal Reserve Board. SSA provided
written comments that are included in appendix I. A discussion of these
comments appears at the end of chapters 2 and 3. SSA and the other
agencies also provided technical and clarifying comments, which we
incorporated in this report where appropriate.




Page 19                 GAO/GGD-99-115 Issues Associated With Individual Accounts
Chapter 2

Capital and Annuities Markets Able to Absorb
Individual Account Investments

                       Individual accounts can affect the capital markets in several ways
                       depending on how the accounts are funded, how the funds are invested,
                       how people adjust their own savings behavior in response to having
                       individual accounts, and the restrictions placed on using funds in
                       individual accounts for anything other than retirement income. Most of the
                       proposals use either the Social Security cash flow or federal general
                       revenues as a source of funds. As a result, the primary capital market
                       effect is a purely financial one: borrowing in the Treasury debt market (or
                       retiring less debt) to provide funding for investment in private debt and
                       equity markets. Although the amounts involved are likely to be sizeable,
                       the effect would primarily be one of redirecting funds and readjusting the
                       composition of financial portfolios. There may also be some effect on the
                       difference between the return on Treasury debt and that paid on riskier
                       assets, although the effect is not likely to be large. Although substantial
                       inflows into the private debt market could, in certain circumstances, result
                       in some increased volatility, both the private equity and debt markets
                       should be able to absorb the inflows without significant long-term
                       disruption. There could eventually be a significant increase in the amount
                       of new funds flowing into the annuities market. However, the magnitude of
                       annuity purchases is likely to build gradually over time as more retirees
                       build larger balances, allowing the market sufficient time to adjust.

                       Another potential effect of individual accounts would be an increase or
                       decrease in national savings—the overall level of domestic financial
                       resources available in the economy for the purpose of investing in plant
                       and equipment. Whether individual accounts would increase or decrease
                       national savings depends on how they are financed, how private savings
                       changes as a result of individual accounts, and whether there are
                       restrictions on households’ ability to borrow.

                       Most proposals use either the Social Security cash flow or federal general
Redirection of Funds   revenues as a source of funds for individual accounts. The funds raised are
Could Affect           then to be invested in private equity or debt markets. As a result, there
Composition of         would be an increase in the relative supply of Treasury debt available to
                       the public and an increase in the relative demand for private debt and
Portfolios             equities to be held in individual accounts. This redirection of funds—
                       selling Treasury debt for the cash to invest in private debt and equity—is a
                       purely financial effect. It is likely to result in a change in the composition
                       of private sector holdings as businesses and households absorb the extra
                       government debt and provide new or existing private debt and equity,
                       thereby adjusting their portfolios.




                       Page 20                   GAO/GGD-99-115 Issues Associated With Individual Accounts
                               Chapter 2
                               Capital and Annuities Markets Able to Absorb Individual Account Investments




                               Whether the resources for individual accounts come from Social Security
                               contributions or general revenues, the level of government debt held by
                               the public would increase, or not fall as much as it otherwise would. The
                               only cases in which an increase in debt held by the public would not occur
                               would be those in which the resources come from an additional source of
                               funding—either a tax increase, an expenditure reduction, or the result of
                               some voluntary private saving—that would not otherwise have occurred.
                               Increased government borrowing from the public could put some upward
                               pressure on the interest rate at which the government borrows, if private
                               sector borrowers are to be persuaded to hold the increased supply of
                               government debt. Funds diverted to private equity and debt markets could
                               have the effect of raising the prices and therefore lowering the yields
                               (rates of return) on these higher risk assets. The combined effect could
                               narrow somewhat the difference between the more risky and least risky
                               assets.

Debt Held by the Public Will   Whether resources used to finance individual accounts come from new
                               revenues, additional borrowing, or surpluses, the amounts flowing into
Likely Rise to Provide         private capital markets are likely to be substantial. Funding of individual
Funding                        accounts will come directly or indirectly from increased government
                               borrowing from private markets, unless funded by a tax increase or
                               spending reduction. To fund most individual account proposals, the
                               government would need to raise resources either by borrowing in the
                               market or—under a surplus scenario—by not retiring as much maturing
                               debt as it otherwise would. For certain proposals, changes in borrowing
                               may not arise because these proposals rely on a tax increase or benefit
                               reduction so that current cash flow is not affected. If the source of funding
                               for individual accounts is a carve-out from the current Social Security cash
                               flow, this loss in cash flow would have to be made up from increased
                               borrowing, a reduction in benefits, or some other program change.
                               Alternatively, if the source of funding is general revenues, either additional
                               borrowing from the public or less debt retired will be necessary depending
                                                                                       1
                               on whether the overall budget is in deficit or surplus. Only if the
                               government raises taxes or reduces spending, and uses those revenues to
                               finance individual accounts, is there not likely to be any effect on
                               borrowing because the remaining cash flow would not be affected.




                               1
                                The federal deficit (also called the “unified “ deficit) is the difference between total federal spending
                               and revenue in a given year. To cover this gap, the government borrows from the public by issuing
                               securities, mostly through the Treasury Department. A surplus reduces the need for the federal
                               government to borrow from the public.




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                               Capital and Annuities Markets Able to Absorb Individual Account Investments




Funds Would Be Redirected      The uses of the funding for individual accounts will depend on the options
                               available to investors and the choices they make within those options. To
Into Private Capital Markets   the extent that investors choose to invest in Treasury debt, there is that
                               much less flowing into private capital markets, and any effects on those
                               markets would be reduced. However, investors or their agents are likely to
                               put at least some, if not most, of the funds into the private equity or debt
                               market, and some proposals call for all of the funds to be invested in
                               private markets. The size of this potential flow of funds into the private
                               sector depends on whether individual account investments are mandatory
                               or voluntary as well as the percentage of payroll that forms the basis for
                               the program. The actual amounts allocated to private equity and debt will
                               depend upon individual choice to the extent such choice is allowed, or on
                               selected percentages if those are set by law.

                               The initial annual dollar amount flowing into the capital markets as a
                               result of individual account investments could be about $70 billion (2
                               percent of payroll) in 1998 dollars. According to our analysis of Social
                               Security Administration (SSA) data, the effective taxable payroll for all
                               working individuals will steadily increase well into the future. As a result,
                               the annual dollar amount from individual account investments is likely to
                               increase. For instance, our analysis of SSA data indicates that in the year
                               2020, the effective taxable payroll will be almost $11 trillion. On the basis
                               of that dollar amount, if 2 percent is the designated percentage, the
                               amount flowing into the private equity and debt markets from individual
                               accounts would be about $220 billion in the year 2020.

                               U.S. capital markets are the largest and most liquid in the world. The total
Current Size of the            market value of U.S. equities outstanding at the end of 1998 was about $15
Private Capital                         2                                    3
                               trillion. The total value of corporate bonds outstanding in the United
Markets                        States was about $4 trillion at the end of 1998. The amount of Treasury
                               debt outstanding was also about $4 trillion. As shown in table 2.1, the
                               amounts outstanding for corporate equities and corporate bonds have
                               been increasing. For instance, in 1997 there was about $13 trillion in
                               equities outstanding, up from $10 trillion in 1996. The amounts outstanding
                               for corporate bonds has increased from about $3 billion in 1996 to about $4
                               billion in 1998.



                               2
                                   This amount also includes foreign issues traded in the United States.
                               3
                                 The Flow of Funds data from the Federal Reserve only reports corporate and foreign bonds together.
                               It is difficult, therefore, to separate the corporate bonds from the foreign bonds, and we did not
                               attempt to do so. For the purposes of our discussion, we will refer only to corporate bonds.




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                                          Capital and Annuities Markets Able to Absorb Individual Account Investments




Table 2.1: Amounts of Corporate
Equities, Corporate Bonds, and U.S.       Market                                         1996                    1997                     1998
Treasuries Outstanding (Dollars in        Corporate equities                          $10,062                 $12,776                  $15,438
                                                           a
Billions)                                 Corporate bonds                               3,128                   3,440                    3,894
                                          U.S. Treasuries                               3,755                   3,778                    3,724

                                          Source: Flow of Funds Accounts of the United States, Federal Reserve statistical release for the
                                          fourth quarter 1998, tables L. 209, p. 87, L. 212, p. 89, and L. 213, p. 90.

                                          On the basis of the current size of the corporate equity and bond markets,
                                          the amount representing individual accounts is likely to be a small
                                          percentage of private capital markets, at least for a number of years. For
                                          instance, using a payroll percentage of 2 percent, if $70 billion were to
                                          come from individual accounts, it would represent less than 0.5 percent of
                                          the $15 trillion in equity outstanding in 1998 and less than 2 percent of the
                                          $4 trillion in corporate bonds outstanding in 1998.

                                          Various officials have expressed concern that over time, individual
                                          account investments would represent significant portions of the corporate
                                          equities and bond markets. It is likely that investments from individual
                                          accounts could eventually rival current holdings of other major sectors of
                                          the market and represent a sizeable portion of equity and corporate bond
                                          holdings. For instance, if 2 percent of payroll is placed in individual
                                          accounts annually, SSA estimates that stock holdings in individual
                                          accounts could grow to between $1 trillion and $2 trillion in 1996 dollars
                                          over the next 15 years. The overall market will grow at about the market
                                          rate of return, although individual components may grow faster or slower
                                          depending on strategies and relative demands by mutual funds, pension
                                          plans, and other investors.

Table 2.2: Annual Holdings of Corporate
Equities and Bonds by Various Sectors     Sectors                                       Corporate Equities                  Corporate Bonds
of the Economy (Dollars in Billions)      Year                                      1996    1997     1998            1996      1997     1998
                                          Mutual funds                            $1,470 $2,019 $2,523               $230      $274     $339
                                          Private pension plans                    1,491   1,864    2,232             228       256      301
                                                                    a
                                          State & local governments                  956   1,306    1,593             180       200      245
                                          Life insurance companies                   410     561      746             949     1,026    1,086
                                          a
                                              State and Local Governments refers to their retirement plans.
                                          Source: Flow of Funds Accounts of the United States, Federal Reserve statistical release for the
                                          fourth quarter 1998, tables L. 212, p. 89, and L. 213, p. 90.

                                          For instance, as shown in table 2.2, the total value of equity holdings of
                                          mutual funds was $2.5 trillion in 1998, and the total value of corporate and
                                                                                          4
                                          foreign bond holdings was about $339 billion. The holdings of various

                                          4
                                           Flow of Fund Accounts of the United States, Federal Reserve statistical release for the fourth quarter
                                          of 1998, tables L. 213, p. .90, and L. 212, p. 89.




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                             Chapter 2
                             Capital and Annuities Markets Able to Absorb Individual Account Investments




                             sectors, such as private pension plans, were about $2.2 trillion of equities
                                                                                   5
                             and about $301 billion of corporate bonds in 1998. Thus, although
                             individual account holdings are likely to increase over time, the holdings of
                             many other sectors of the economy are also likely to rise, although certain
                             individual sectors may not. In general, it is difficult to predict how rapidly
                             the sum of these sectors holdings will grow, especially in the presence of
                                                  6
                             individual accounts.

Current Flows Into Private   Even if the annual flows from individual accounts into private capital
                             markets were a small percentage of the total market value of outstanding
Capital Markets              debt and equities, these amounts could still represent a substantial
                             increase in the annual flows into those markets. The actual amounts will
                             depend on the options available to individuals as well as the choices they
                             make. If a large percentage of funds from individual accounts flowed into
                             the equity markets, it could represent an increase of approximately 15 to
                             20 percent in the flow of funds into and out of the equity market, according
                                                                                7
                             to data from the Federal Reserve Flow of Funds. It is not clear that such
                             an increase would have much effect on the pricing, or volatility, of the
                             equity markets. However, the corporate bond market, which is smaller,
                             could be affected, at least in the short term, depending on how much of the
                             funds flow into the market and, to some extent, on the timing of those
                             flows.

Current Stock Market Flows   Most U.S. equities markets are very liquid—it is easy for investors to buy
                                                                        8
                             and sell equities without moving the price. Various sectors of the
                             economy, such as the household sector, mutual funds, private pension
                             plans, and life insurance companies, purchase and sell equities every day.
                             The equities market is a secondary market in which much of the
                             transaction volume and value reflects movement of equities between
                             purchasers and sellers. The annual net purchases can be positive or
                             negative, reflecting the difference between the value of new equities issued
                             and the value of equities repurchased; however, the amounts purchased

                             5
                              Flow of Fund Accounts of the United States, Federal Reserve statistical release for the fourth quarter
                             of 1998, table L. 213, p. 90.
                             6
                              See later section of this chapter for a discussion of possible changes in household savings behavior in
                             response to individual accounts.
                             7
                              This percentage relates approximately $70 billion in individual account funds to the approximately
                             $400 to $500 billion in net purchases and sales of equities over 1997 and 1998.
                             8
                               The equities markets are said to be “liquid” because the markets attract many buyers or sellers. In a
                             liquid market selling or buying can be done with minimal effect on the prevailing competitive
                             established price. The advantage of a liquid market for customers is immediacy or the ability to sell
                             quickly when the customer needs to or buy quickly when there is a chance to make a profit.




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                                           Capital and Annuities Markets Able to Absorb Individual Account Investments




                                           and sold by specific sectors can be quite large. For instance, the annual net
                                           purchases of equities were minus $3 billion in 1996, minus $79 billion in
                                                                                9
                                           1997, and minus $178 billion in 1998. As can be seen in table 2.3, the three
                                           largest purchasers bought in the range of $300 billion in securities each
                                           year from 1996 to 1998. In terms of sellers, the household sector sold
                                           almost $300 billion in 1996 and about a half of a trillion dollars in both 1997
                                           and 1998.

Table 2.3: Annual Net Purchases and
Sales of Corporate Equities by Different   Sector                                              Corporate equities
Sectors (Dollars in Billions)                                                                          1996                1997               1998
                                           Largest net buyers
                                           Mutual funds                                                   $193             $167               $144
                                           Retirement plans of state and local govts.                       52               54                 66
                                           Life insurance companies                                         42               93                 92
                                           Largest net sellers
                                           Household sector                                                -282             -514              -500
                                           Private pension plans                                            -10              -16               -53

                                           Source: Flow of Funds Accounts of the United States, Federal Reserve statistical release for the
                                           fourth quarter 1998, table L. 213, p. 45.

                                           Annual flows within the equities market were in the hundreds of billions of
                                           dollars between 1996 and 1998. Over that period, mutual funds, life
                                           insurance companies, and state and local government retirement plans
                                           were the primary purchasers, and private pension plans and households
                                           were the major sellers of equities. Compared to these annual amounts, an
                                           additional tens of billions of dollars generated by individual accounts is not
                                           likely to cause major disruptions and could potentially be absorbed
                                           without significant price or volatility effects.

                                           There is a greater chance of some possible disruption, however, if all of the
                                           individual account funds were to flow in at once rather than regularly, but
                                           not too predictably, over the course of the year. For instance, $70 billion
                                           distributed evenly over the year would be unlikely to cause much
                                           disruption. However, concentrating that same flow into one quarter of the
                                           year could have some short-term effect on the market because it would
                                           represent a substantial increase in quarterly flows. As a result, to minimize
                                           the likelihood of disruption, it would make sense, to the extent practicable,
                                           to smooth out the inflows so that they do not all come into the market
                                           within a short time period. If the inflows are lumpy and predictable, the
                                           market may be able to anticipate the inflows and adjust prices somewhat,
                                           which could mean that individual account purchases would pay slightly
                                           higher prices than they otherwise would.
                                           9
                                            Flow of Funds Accounts of the United States, Federal Reserve statistical release for the fourth quarter
                                           of 1998, table F. 213, p. 45.




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                                          Capital and Annuities Markets Able to Absorb Individual Account Investments




Corporate Debt Flows                      The corporate debt markets are not as transparent as the corporate
                                          equities markets; for example, there are no central listings for the prices of
                                          the bonds or the volume of corporate bonds sold. They also do not have as
                                          much depth as the equities markets—there are fewer buyers and sellers in
                                          the corporate bond markets. Many corporate bond transactions are done
                                          through private placements; i.e., they are not offered to the corporate debt
                                          market as a whole. The result is a market with less liquidity reflected in a
                                          greater spread between the bid price (what you will pay for the bond) and
                                          the ask price (the price at which you would sell the bond).

                                          As stated previously, the value of outstanding corporate debt is
                                          substantially less than the market value of corporate equities. On an
                                          annual flow basis, corporate debt issues have been running in the
                                          hundreds of billions of dollars over the last decade. However, some
                                          proportion of that is short term (less than 1 year in maturity) so that the
                                          total is not easily comparable to the annual amounts of equities purchased
                                          and sold. As shown in table 2.4, the annual net purchases of corporate
                                          bonds by various sectors ranged from as low as $17 billion for state and
                                          local government retirement plans of in 1996 to as high as $79 billion for
                                          life insurance companies in 1996. On the basis of annual flows, it is
                                          difficult to say what the effect on the bond market is likely to be.

Table 2.4: Annual Purchases and Sales
of Corporate Bonds Equities by            Sector                                             Corporate bonds
Different Sectors (Dollars in Billions)                                                              1996                1997                1998
                                          Large Buyers
                                          Mutual funds                                                   $34              $44                 $65
                                          Retirement plans of state and local govts.                      17               19                  45
                                          Private pension plans                                           21               28                  45
                                          Life insurance companies                                        79               77                  60
                                          Source: Flow of Funds Accounts of the United States, Federal Reserve statistical release for the
                                          fourth quarter 1998, table F. 212, p. 44.

                                          However, if we compare the corporate bond and equity markets, we can
                                          draw some tentative conclusions about the likelihood of individual
                                          accounts having a disruptive effect on either market. The corporate bond
                                          market is relatively smaller and less liquid than the equity market. As a
                                          result, an inflow into the bond market is more likely to affect the market
                                          price and the volatility of the market, compared to an equivalent inflow
                                          into the equity market, especially if it is concentrated in a short period of
                                          time. Any disruption is still likely to be short term in nature and can be
                                          mitigated if the inflow is spread over time, so that other market
                                          participants are less able to predict the inflows and raise prices in
                                          anticipation of the inflow.




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Treasury Debt               Although there are various types of Treasury debt, the overall market for
                            U.S. Treasuries is far more liquid and transparent than the corporate bond
                            market. A large secondary market—in which Treasury securities are
                            bought and sold subsequent to original issuance—exists for Treasuries and
                            helps to make it one of the most liquid markets in the world. Annual net
                            purchases of Treasuries were $23 billion in 1997 and minus $55 billion in
                                 10
                            1998.

                            The effect on the Treasury debt market from a movement to individual
                            accounts will depend not only on the choices available to individuals but
                            also on the extent to which the government borrows from the private
                            capital markets to fund individual accounts. As stated previously, to fund
                            any individual account proposal that does not increase Social Security
                            contributions, the government would need to raise resources either by
                            borrowing in the market or by not retiring as much maturing debt as it
                            otherwise would. The Treasuries market, therefore, could be affected in
                            two ways: (1) by how much the government borrows to fund individual
                            accounts, and (2) by how much individuals choose to invest in Treasuries.
                            However, the depth and liquidity of the Treasury debt market is such that
                            the market is unlikely to be significantly disrupted even by a large flow of
                            funds resulting from individual accounts.

Affect of Individual        Annuities protect against the possibility of outliving one’s financial
                            resources by guaranteeing a stream of income for the remainder of one’s
Accounts on the Annuities   life, regardless of how long that may be. Annuities basically convert
Markets                     savings into income and may be sold individually or as a group product. In
                            a group annuity a pension plan provides annuities at retirement to a group
                            of people under a master contract. It usually is issued by an insurance
                            company to an employer plan for the benefit of employees. The individual
                            members of the group hold certificates as evidence of their annuities.
                            Depending on the structure of individual accounts, individuals may be
                            required to purchase individual annuities or, similar to pension and other
                                                                          11
                            retirement plans, fall under a group annuity.

                            One measure of the size of the annuities market is the level of the
                            insurance industry’s policy reserves—the sum of all insurers’ obligations to
                            their customers arising from annuity contracts outstanding. Each company
                            is required by state insurance regulators to maintain its policy reserves at a

                            10
                              Flow of Funds of the United States, Federal Reserve statistical release for the fourth quarter of 1998,
                            table F. .209, p. 42.
                            11
                             Some approaches call for having the government be responsible for small annuities. Other
                            approaches call for individual account accumu.lations to feed into Social Security benefits.




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                                          level that will ensure payment of all policy obligations as they fall due. As
                                          shown in table 2.5, policy reserves for individual annuities were about $693
                                          billion and for group annuities about $762 billion.

Table 2.5: Policy Reserves Held for
Individual and Group Annuities (Dollars                                                  1995                      1996                       1997
in Billions)                              Annuities
                                          Individual                                     $594                      $622                       $693
                                          Group                                           619                       690                        762
                                          Source: Life Insurance Fact Book, American Council of Life Insurance, 1998, table 7.5, p.119.

                                          Insurance industry officials told us that the annuities industry is likely to
                                          be able to absorb the flows from either mandatory or voluntary
                                          annuitization. Once again, we are talking about a movement of financial
                                          resources from one form to another rather than a new source of funds. The
                                          funds will be moved out of whatever investment instruments (assets)
                                          workers were using for accumulation purposes into a potentially different
                                                                                                            12
                                          combination of assets held by companies supplying annuities. Insurance
                                          industry officials believe that, generally, annuities resulting from the
                                          liquidation of the individual accounts would be phased in gradually and
                                          over a number of decades. In the early years, few if any retirees would
                                          have built up substantial individual account balances. As time passes, both
                                          the number of retirees with individual account balances and the average
                                          size of those balances would gradually increase, allowing the industry and
                                          the market time to adjust without difficulty.

                                          One issue raised by insurance industry officials was that an individual
                                          account proposal that made annuity purchases mandatory at retirement
                                          could result in the demand for a significant number of very small annuities.
                                          For instance, at least initially, there would be many small accounts below
                                          $2,000. Currently, annuity purchases average about $100,000. Although the
                                          industry could absorb a significant number of small accounts, industry
                                          officials said that providing annuities that small could be uneconomical for
                                          the industry because the cost of issuing a monthly check, and other
                                                                                        13
                                          administrative costs, would be prohibitive.




                                          12
                                             Annuities have traditionally been supplied by life insurance companies and financed primarily by
                                          investments in corporate debt and real estate, although there is also likely to be some investment in
                                          corporate equities and Treasury debt.
                                          13
                                             In a forthcoming report, we will provide a more detailed discussion of the factors that affect the costs
                                          associated with purchasing an annuity and how this cost may factor into a system of individual
                                          accounts.




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                         Although the financial effects of individual accounts are an important
Effect of Individual     consideration, a related but somewhat separate issue is the potential for
Accounts on National                                                                   14
                         individual accounts to increase or decrease national saving. Along with
Savings Depends on       borrowing from abroad, national savings provides the resources for private
                         investment in plant and equipment. The primary way in which a movement
Financing, Structure,    to individual accounts could change the overall capacity of the economy to
and Behavioral Effects   produce goods and services would be if individual accounts were to lead
                         to a change in the overall level of national saving. The extent to which
                         individual accounts affect national saving depends on how they are
                         financed (existing payroll tax, general revenues)—the effect on
                         government saving; how private savings—the savings of households and
                         businesses—respond to an individual account system; the structure of the
                         individual account system (mandatory or voluntary); and the limitation or
                         prohibition of the pre-retirement distribution or loans to make sure
                         retirement income is preserved.

Savings Affected by      One important determinant of the effect of individual accounts on national
                         savings is the funding source. There are several possible funding sources,
Funding Source           although most involve a movement of funds from or through the federal
                         government and each has its own effects on the federal government’s
                         portion of national saving. For some funding sources these savings effects
                         are clearer than others. As previously stated, the funds can come from (1)
                         within the current Social Security system, i.e., the surplus or current cash
                         flows; (2) a change in the system resulting from increased payroll taxes or
                                           15
                         reduced benefits; or (3) outside the system using a general fund surplus
                         or general revenues.

                         Using either the Social Security surplus or more generally the current
                         Social Security cash flow is likely to reduce government saving. If part of
                         the cash flow is diverted to individual accounts but there is no change in
                         the benefits paid or the taxes collected, the lost cash flow will either result
                         in a smaller addition to the surplus or be replaced by borrowing. In either
                         case the result is a reduction in the measured government surplus—the
                         sum of the Social Security surplus and the general fund surplus—or an
                         increase in the deficit. From the government’s perspective, its saving has
                         gone down to provide the resources for increased personal savings



                         14
                          National saving includes the saving of individuals, households, and businesses, called private saving;
                         and the net saving of all levels of government.
                         15
                           There are also proposals which allow individuals to voluntarily contribute to individual accounts
                         from their own resources.




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                                      16
through individual accounts. This is a case of a carve-out from Social
Security.

If the resources for individual accounts are financed by additional Social
Security taxes or reduced benefits instead, there will be no direct effect on
government savings. The increased outlays for individual accounts will be
offset by higher government revenues or lower government benefit
payments. In the absence of other changes in Social Security cash flows,
government savings remain constant, and any increase in private saving
would be an increase in national saving. This is a case of an add-on to both
Social Security and to the overall government budget.

The most complicated case involves the use of funds that are outside of
the Social Security system but part of the overall government budget.
There are proposals to use the overall budget surplus or general
government revenues as a source of funds for individual accounts.
Although on its face this appears to reduce government savings by the
amount diverted, the actual effect on government savings depends on what
would have been done with the surplus or revenue if it had not been used
to finance individual accounts.

For example, if the resources would have been used to finance additional
government spending, and the diversion of the funds to individual
accounts means that such spending is not undertaken, government saving
would not be reduced by individual accounts. In this case, any increase in
private saving would be an increase in national saving. Similarly, if the
resources would have been used to finance a tax cut, then diverting funds
to individual accounts does not directly reduce government savings if the
tax cut is not undertaken. In the case of a tax cut, national saving will go
up if individual accounts generate more private saving than the tax cut.

If the funds would have been used to pay down debt, the direct effect of
diverting those resources to individual accounts would be to reduce
government saving. The full effect on national saving depends on the
extent to which individuals adjust their own savings behavior. If they do
not adjust, national saving is on balance unaffected. To the extent
individuals or businesses reduce their saving, national saving will fall.




16
 Because national savings is the sum of government and private saving, the effect of a carve-out
depends on whether private savings goes up by more or less than government savings goes down.




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Behavioral Effects Are      The effects of various individual account proposals on national saving
                            depend not only on how the proposals affect government savings but also
Difficult to Predict        on how private savings behavior will respond to such an approach.
                            Regardless of the financing source, the effect of individual accounts will be
                            to raise, at least to some extent, the level of personal or household saving
                            unless households fully anticipate and offset through a reduction in their
                            own saving. For example, a carve-out from the existing Social Security
                            cash flow would provide funding for individual accounts for everyone
                            (under a mandatory approach) or for those who wished to participate
                            (under a voluntary approach). Such a carve-out is likely to reduce
                            government saving and raise private saving by an equivalent amount in the
                            absence of any behavioral effects. If households are forgoing current
                            consumption by saving for their retirement, then, in response to this
                            potential increase in future retirement benefits, they may reduce, to a
                            greater or lesser extent and in various ways, their own savings, including
                            retirement saving. To the extent that household responses lead to reduced
                            personal saving, national savings as a whole would fall under a carve-out.

                            In general, the result would be similar under any proposal that reduced
                            government saving to fund private saving through individual accounts.
                            This includes proposals that use general revenues that would have been
                            saved by the government; i.e., used to reduce the deficit or retire debt
                            outstanding. The overall level of consumption in the economy is not likely
                            to change as a result of the movement of funds. Any significant change in
                            the level of consumption resulting from such proposals would result from
                            some households reducing their retirement savings to fund consumption
                            because they now had individual accounts.

Behavioral Change Depends   The extent of these behavioral effects will depend on the structure of the
                            program and any limitations that are placed on the use of funds in
on Preferences and          individual accounts, such as restrictions on preretirement withdrawals. If
Opportunities               such a program is mandatory rather than voluntary, it is more likely to
                            affect those households who currently either do not save or do not save as
                            much as the amounts in their individual accounts. A mandatory program
                            would increase savings for those who do not usually save, who are usually
                            low-income people.

                            Household behavior in response to individual accounts will depend on the
                            extent that the household is currently saving for retirement and how the
                            set of options available to households is changed by the presence of
                            individual accounts. One group of households, those that are currently
                            saving as much as they choose for retirement, given their income and
                            wealth, would probably reduce their own saving in the presence of



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Capital and Annuities Markets Able to Absorb Individual Account Investments




individual accounts. For those households for whom individual accounts
closely resemble 401(k)s and IRAs, a shift to individual accounts might
                                                     17
lead them to decrease their use of these accounts. They would have
additional retirement income possibilities available and might choose to
reduce their retirement or other saving to use for consumption in the
present rather than in the future. However, unless they were target savers,
i.e., savers who were trying to reach a specific retirement income goal,
they might not reduce their other savings dollar for dollar with individual
           18
accounts. Therefore, we might expect some reduced saving by a
significant number of households; for certain households, we might expect
a substantial reduction.

Under a voluntary approach, the households that are most likely to
participate are those households that are currently saving but that face
some constraint in terms of the type of retirement saving they can do or
the amount of tax-preferred saving they are allowed. For example,
someone whose employer offered only a defined benefit retirement plan or
a defined contribution plan with very limited options might find that
voluntary individual accounts offered a new opportunity. In addition,
someone who was already contributing as much as he or she was legally
allowed to tax-deferred savings would find a voluntary program attractive
if it allowed an additional amount of tax-deferred saving. These and others
who take advantage of a voluntary program may be more likely to reduce
other forms of saving in response.

Households that are currently not saving, either because they are resource
constrained or because they are not forward-looking, would be forced to
save some amount by a mandatory individual account system. Households
in such situations may welcome the additional resources, especially if they
do not come from a direct reduction in their own consumption. However,
such households may also try to transform some of the additional
resources into consumption if they are able to borrow from the accounts
or otherwise tap into the accounts before retirement. To maintain
retirement income adequacy and to keep savings from being dissipated, it




17
  See National Academy of Social Insurance, Report of the Panel on Privatization of Social Security,
1998 pp. 2-4.
18
   See Eric M. Engen and William G. Gale, “Effects of Social Security Reform on Private and National
Savings” Social Security Reform, Links to Saving, Investment, and Growth, Conference Series No. 41,
June 1997, pp. 103-142.




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may be necessary to prohibit or restrict borrowing or other methods of
                                                       19
drawing down individual accounts prior to retirement.

Even with such restrictions, it may not be possible to completely eliminate
all options that households could use to indirectly increase consumption
from individual accounts. For example, households with little or no
retirement saving or other financial wealth could have wealth in some
other form, such as home equity. It is conceivable that such households
could borrow against that home equity as a way of turning their increased
future consumption into present consumption.

In addition to the effects of individual accounts on household savings there
are also other potential indirect effects on private saving. For example, the
incentives for employers to provide retirement benefits, either through
defined benefit or defined contribution plans, could be affected by
individual accounts. In addition, if less compensated workers in a defined
contribution plan reduce their contributions to the plan, higher
compensated workers may be required to reduce their own contributions
under the antidiscrimination rules.

Offsetting these tendencies to reduce saving, however, there are some
economists who believe that individual accounts might encourage certain
individuals to save more for retirement and thus not reduce their current
        20
savings. Such an effect is more likely to be present if there is some form
of matching by the government as part of the individual account proposal.
Others believe that to the extent that a lack of saving is based on people
not taking a long enough view, the presence of individual accounts and
watching them accumulate could give people a better sense of how saving
small amounts can add up over time. This, plus observing how
               21
compounding works, could induce some to save who otherwise would
not.

National saving is more likely to be increased by some approaches to
individual accounts than by others. Using sources of government funding
that would more likely have resulted in spending rather than saving

19
  While borrowing could potentially allow individuals to reduce retirement income, the option to
borrow can also be an attractive feature under a voluntary program. For discussion of the trade-off see
401(k) Pension Plans: Loan Provisions Enhance Participation But May Affect Income Security
(GAO/HEHS-98-5, October 1, 1998).
20
   Based on James M. Poterba, Steven F. Venti, and David A. Wise, “How Retirement Saving Programs
Increase Savings,” Journal of Economic Perspectives, Volume 10, Number 4, Fall 1996, pp. 91-112.
21
     Interest accrued on a daily, quarterly, semiannual, or annual basis.




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                  decreases the likelihood that government saving would be reduced.
                  Proposals that are mandatory are more likely to increase private saving
                  because a mandatory program would require that all individuals, including
                  those who do not currently save, place some amount in an individual
                  account. Certain prohibitions or restrictions on borrowing or other forms
                  of preretirement distributions would also limit the ability of some
                  households to reduce their savings in response to individual accounts.

                  SSA commented that we needed to discuss the savings implications of the
Agency Comments   President’s proposal. This report was not intended to comment on specific
                  reform proposals.




                  Page 34                      GAO/GGD-99-115 Issues Associated With Individual Accounts
Chapter 3

Return and Risks Are Likely to be Higher With
Individual Accounts

               There is a risk/return trade-off for individuals under an individual account
               program; instituting such a program would likely raise both the risks and
               the returns available to participants compared to the current system. In
               order to receive higher returns, individuals would have to invest in higher
               risk investments. The return that individuals receive would depend on
               both their investment choices and the performance of the market.
               Individuals who earn the same wages and salaries and make the same
               contributions to Social Security could have different retirement incomes
               because of the composition of their portfolios and market fluctuations. As
               with any investment program, diversification and asset allocation could
               reduce the risks while still allowing an individual to earn potentially higher
               returns.

               Most advocates of individual accounts state that the expected return on
               investments under an individual account program would be much higher
               for individuals than the return under the current Social Security program.
               Proponents of individual accounts usually point out that equities have
               historically substantially yielded higher returns than U.S. Treasuries, and
               they expect this trend to continue. Others are skeptical about the claims
               for a continuation of such a high expected return on equities. They state
               that history may not be a good predictor of the future and that the
               expected premium generated by investing in equities has steadily been
               declining. Furthermore, they state that even if expected equity returns are
               higher than other investments, equity returns are risky. Thus, in order to
               determine what returns individuals might expect to receive on their
               individual account investments, the riskiness of the investment should be
               taken into account. Adjusting returns to include risks is important, but
               there are many ways to do this, and no clearly best way.

               Lastly, comparing the implicit rate of return that individuals receive on
               their Social Security contributions to expected rates of return on market
               investments may not be an appropriate comparison for measuring whether
               individuals will fare better under an individual account system. Such
               comparisons do not include all the costs implied by a program of
               individual accounts. In particular, the returns individuals would effectively
               enjoy under individual accounts would depend on how the costs of the
               current system are paid off. Rates of return would also depend on how
                                                                                    1
               administrative and annuity costs affect actual retirement incomes.



               1
                In a forthcoming report, we will provide a more detailed discussion on issues comparing Social
               Security rates of return with those of market investments.




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                        Return and Risks Are Likely to Be Higher With Individual Accounts




                        An individual account program would offer individuals the opportunity to
Instituting an          earn market returns that are higher than the implicit returns to payroll
Individual Account      under the current Social Security program. However, investing in private
Program Means           sector assets through individual accounts involves a clear trade-off--
                        greater return but more risk or more variability in future rates of return.
Greater Risk to         Under the current Social Security program, risks are borne collectively by
Individuals for         the government. Moving to an individual account program would mean
Potentially Greater     that individuals reap the rewards of their own investments, but they also
Return                  incur risk—not only about future returns, but also the possibility of losing
                        money and even having inadequate income for retirement. However,
                        holding assets for the long term, diversification, and the proper asset
                        allocation can mitigate certain risks and improve an individual’s risk/return
                        trade-off.

Risk/Return Trade-Off   A trade-off exists between risk and return in investments. If an individual
                        is willing to consider the possibility of taking on some risk, there is the
                        potential reward of higher expected returns. The capital markets offer a
                        wide variety of investment opportunities with widely varying rates of
                        return, which reflect variations in the riskiness of those investments. For
                        instance, Treasury Bills are considered to be relatively risk free because
                                                                                    2
                        they have almost no default risk and very little price risk. Alternatively,
                        equities are considered to be relatively risky because the rate of return is
                        uncertain.

                        Because debt holders are paid out of company income before
                        stockholders, equity returns are more variable than bonds. Overall, annual
                        returns on equities are more volatile than returns on corporate bonds or
                        Treasuries. On a long-term average basis, the market compensates for this
                        greater risk by offering higher average returns on equities than on less
                        risky investments. Thus, among the three types of investments, corporate
                        equities are the riskiest investments but pay the highest returns, followed
                        by corporate debt and then Treasuries. However, holding riskier
                        investments such as equities over long periods of time can substantially
                        diminish the risk of such investments.

                        The degree of risk and the size of potentially higher returns with individual
                        accounts depend on the equities chosen as well as the performance of the
                        market. A stock’s value is tied to the expected performance of the issuing
                        company. If the company does well, investing in individual equities could
                        be very lucrative for investors. However, if the company does poorly,

                        2
                         Treasury securities are subject to interest rate risk. Treasury bonds and notes are subject to more
                        interest rate risk than Treasury bills, which are basically considered to be risk-free assets.




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                           Return and Risks Are Likely to Be Higher With Individual Accounts




                           investing in individual equities could result in low returns or losses to the
                           investor. Many financial analysts go through intensive research to try and
                           pick the best stocks. Choosing the right stock, however, can be mostly a
                                                       3
                           matter of a “random walk.”

Diversification Improves   Individuals may mitigate the risk of holding equities and bonds by
                           diversifying their portfolios and allocating their investments to adjust their
Risk/Return Trade-Off      risk exposure and to reflect their own risk tolerance and circumstances.
                           Ultimately, the composition of an individual portfolio, along with the
                           performance of the market, determines the return individuals receive and
                           the risk they bear.

                           In constructing a portfolio investors combine equities and bonds and other
                           “securities” in such a way as to meet their preferences and needs,
                           especially their tolerance for risk. Individuals manage their portfolios by
                           monitoring the performance of the portfolios and evaluating them
                           compared to their preferences and needs. Many people have been
                           managing portfolios for years. There are, however, many others who
                           either do not have portfolios or do not consider what they have as a
                           portfolio. With individual accounts, all individuals would eventually have
                           to manage their portfolios as they start to own various investments,
                           especially if they have options over individual securities or types of
                           securities.

                           A well-diversified portfolio could help to diminish risk without lowering
                           the return, thereby improving the risk/return trade-off. For instance, a
                           properly selected combination of risky assets can have a lower risk than
                           any of its individual assets because the risk is spread out among different
                           assets allowing for gains in some assets to offset losses in others. Such
                           portfolios could provide higher average returns over the long term than a
                           single asset with equal risk. Furthermore, diversifying an equity portfolio
                           across companies and industries reduces both default and concentration
                               4
                           risk and reduces the likelihood that a portfolio’s return will vary widely
                           from the expected market return.

                           In order to quantify the diversification of a portfolio, concepts like
                           correlation and covariance are used to measure how much the returns on

                           3
                               That is, choosing the right stock is a random and unpredictable process.
                           4
                            Depending on the composition of an individual’s stock portfolio, an individual could be exposed to
                           “concentration risk,” or the potential loss resulting from a heavy investment in a group of related
                           companies or an industry susceptible to the same economic dynamics. Individuals could also face
                           “default risk,” or the exposure to loss due to an individual company failing.




                           Page 37                              GAO/GGD-99-115 Issues Associated With Individual Accounts
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                               Return and Risks Are Likely to Be Higher With Individual Accounts




                               assets move in tandem with one another. For instance, if annual returns
                               on different investments are not very correlated, their risks can offset each
                               other even though they still individually earn higher average returns. Such
                               techniques, however, are very sophisticated, require substantial data
                               analysis, and would require the help of professional advisors for the
                               average investor. However, there are ways for individuals to take
                               advantage of many of the benefits of diversification without needing to
                               calculate correlation and covariance measures. Indexing is one way to
                               broadly diversify an equity portfolio and to match the approximate market
                                      5
                               return. Typically, investing in broad-based stock indexes such as the
                               Standard & Poor’s 500 index—which represents about two-thirds of the
                               value of the U.S. stock market—diversifies an individual’s portfolio by
                               reducing the likelihood of concentrating investments in specific
                               companies. Such investments also tend to reduce turnover and lower
                               administrative costs because they do not involve as much research or
                               expensive investment advice.

                               A diversified stock portfolio, however, does not protect against the risk of
                               a general stock market downturn. One way to mitigate U.S. stock market
                               risk is to diversify into international markets. An investor can also shield
                               against general stock market risk by diversifying into other types of assets,
                               such as corporate bonds. To minimize exposure to short-term stock
                               market fluctuations, an investor can hold less risky, albeit lower yielding,
                               assets to cover liquidity needs in the short run.

                               Asset allocation can provide an approach to portfolio diversification. For
                               example, percentages can be allocated to equities (including indexes),
                               bonds, and Treasuries. These allocations will generally reflect preferences
                               for risk as well as an individual’s life-cycle phase. Those with a higher
                               tolerance for risk and those who are younger would generally invest more
                               in equities. Those in later life-cycle phases might invest more in bonds or
                               Treasuries.

Individuals Bear Most of the   The primary risk that individuals would face with diversified or indexed
                               individual account investments is “market risk,” the possibility of financial
Risk                           loss caused by adverse market movements. When the stock market drops,
                               prices of some equities fall and can stay depressed for a prolonged period
                               of time. Although a long investment time horizon provides the individual

                               5
                                Indexing reduces risk or exposure to loss associated with an individual company failing and industry-
                               specific downturns. The securities held in a broadly based indexed portfolio would represent many
                               different sectors of the economy and many individual companies. This diversification reduces the risk
                               that any loss related to the performance of an individual security or group of securities would greatly
                               affect the overall performance of the portfolio.




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                              more time to recover from short-term fluctuations, an individual also
                              would have more time to encounter a prolonged stock market downturn.
                              Thus, although long periods of time can help mitigate the effects of market
                              risk, it does not disappear over time.

                              Under most individual account programs, individuals would bear much if
                                                         6
                              not all of the market risk. Although market risk would not increase with
                              the introduction of an individual account program, more people would be
                              exposed to it under an individual account program than are under the
                              current Social Security system. Some individuals would do very well
                              under such an individual account program, but others may not do as well
                              and could experience a significant drop in their expected retirement
                              income compared to others in the same age group or to the current Social
                              Security program. Furthermore, those who are reluctant to invest in the
                              stock market may not benefit from the potentially higher returns of equity
                              investing. Thus, the investment choices individuals make, as well as the
                              performance of the market, would determine the return they would receive
                              under an individual account program.

Individual Returns May Vary   Individuals who retire at the same time may receive different pay-outs
Under an Individual Account   from individual account investments because of the choices they have
Program                       made. Although some individuals could make the same choices,
                              individuals are more likely to make different choices. In part, differences
                              may come about due to luck; other differences may be more systematic.
                              For instance, higher income people may be willing to take on more risk—
                              and possibly earn higher returns—than lower income people. For this
                              reason, higher income individuals could earn higher rates of return than
                              lower income individuals under an individual account program, which is
                              not the case under the current Social Security program.

                              Many programs also provide for a default option for those who do not wish
                              to take an active part in investing in individual accounts. One type of
                              default option would provide investments in Treasuries with very low risk
                              and a low return. Others could provide an asset allocation, possibly age
                              related, with more equities included for younger workers and more
                              Treasuries for older workers.
                                                                                7
                              Returns could vary across cohorts as well under an individual account
                              program. Even if some cohorts made the same choices, given the volatility
                              6
                                  There are some proposals that protect the individual against some or all of the downside risk.
                              7
                               Cohorts pertain to a large group of people with similar characteristics. For example, people of the
                              same age would be in the same age cohort.




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                        Return and Risks Are Likely to Be Higher With Individual Accounts




                        of the stock market, the returns could vary substantially across different
                        time periods and affect cohorts differently. For instance, even if the
                        market experienced no dramatic or long-lasting downturns, the market
                        will create “winners” and “losers” depending on when and how individuals
                        invest their individual account investments and when they liquidate their
                        holdings.

                        As long as workers are aware of and accept the idea that returns may vary
                        across individuals as well as cohorts, there will probably not be calls to fix
                        the “unfair benefits outcomes.” However, if large differences in outcomes
                        become commonplace, many participants could become dissatisfied with
                        the program and demand some payment from the government to make up
                        for any losses they incur or even if substantial differences result. For
                        instance, those that have incurred losses may expect the government to
                        mitigate their losses when they do not receive the return they believe they
                        were led to expect.

                        Furthermore, individual accounts are at least in part an attempt to finance
                        the unfunded liability with the excess returns of equities over
                        nonmarketable Treasuries. To the extent that individuals receive low or
                        even negative returns over time, individual account investments could
                        actually lead to an increase in the unfunded liability of the current Social
                        Security program.

                        The expected return from investments of individual accounts is likely to be
The Expected Market     higher than the average implicit rate of return of the current system, but it
Return for Individual   is unlikely to be as high as many advocates presume. Advocates and
Account Investments     opponents of individual accounts have estimated what the likely market
                        return would be for an individual’s investments under an individual
                        account program. When discussing equity returns, advocates often point
                        to the fact that equities have historically yielded higher returns than
                        Treasuries. They expect returns on equities to continue to be higher than
                        Treasuries and to boost individual returns on individual account
                        investments.

                        Other economists are skeptical that the higher returns presumed under an
                        individual account program will be realized. They state that history may
                        not be a good predictor of the future. Others state that even if expected
                        equity returns are higher than other investments, equity returns are risky.
                        For instance, the average historical return reveals nothing about how
                        variable that return has been from year to year. Thus, in an estimation of
                        an expected return to investments of individual accounts, the riskiness of
                        the investment should be taken into account. Estimating expected returns



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                             Chapter 3
                             Return and Risks Are Likely to Be Higher With Individual Accounts




                             without mention of the risk and costs of the investments will overstate the
                             benefits of investing in marketable securities because the return on
                             marketable securities varies substantially with the riskiness of those
                                           8
                             investments.

Future Returns to Equities   Advocates of individual accounts have stated that individuals would
                             receive higher returns by investing in the stock market than they receive
Uncertain                    under the current Social Security program. Although,comparing
                             investment returns with the rate of return paid by Social Security is always
                             problematic, advocates of individual accounts point out that the rate of
                             return on equities has been significantly higher than other rates of returns.
                             For instance, compounded annual average rates of return on equities have
                             averaged about 7 percent per year since 1900 and 6 percent per year since
                             1957. Alternatively, the compounded annual average return on Treasuries
                             has been between 1 and 2 percent per year on an inflation-adjusted basis,
                             and long-term corporate bonds have averaged 2 percent.

                             The capital markets generally offer higher potential rates of return on
                             riskier investments such as equities. Figure 3.1 shows the annual returns
                             of Standard & Poor’s (S&P) 500 Index, which is a measure of the
                             performance of the stocks of 500 large companies traded on the U.S. stock
                             exchange. Actual nominal (non-inflation-adjusted) returns for large
                             company stocks varied widely from the annualized average return over
                             long periods and have ranged from a low of minus 26.5 percent in 1974 to
                             a high of 52.6 percent in 1954.




                             8
                              For detailed information on how administrative costs can have a direct effect on how much savings
                             are accumulated in individual accounts over time see Social Security Reform: Administrative Costs for
                             Individual Accounts Are Hard to Predict (GAO/HEHS-99-131, June 18, 1999).




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                                          Return and Risks Are Likely to Be Higher With Individual Accounts




Figure 3.1: Returns of the Standard and
Poors 500 Index




                                          Source: Haver Analytics.

                                          As can be seen in figure 3.1, returns are variable. An average return over a
                                          long period of time can obscure the reality that equity returns fluctuate
                                          substantially from year to year. There have also been years in which
                                          equities have yielded negative returns. For instance, over the past 70 years
                                          or so, equity returns were negative in nearly 1 out of every 4 years.

                                          Even taking into account the variability of returns, some analysts have
                                          suggested that historic U.S. returns may overstate future returns. They
                                          state that the equity markets in the United States have tended to
                                          outperform the equity markets in other countries. Thus, when relying on
                                          historical data as the basis for estimates of long-term market growth, if one
                                          looks not just at U.S. data, but also at the historical returns of other
                                          countries, then the high historical returns to equities in the United States
                                                                                        9
                                          could be an exception rather than the rule. Historical returns are the only
                                          empirical basis with which to judge equity returns, but there is no
                                          guarantee that the future will mirror the averages of the past in the United
                                          States as opposed to some subperiod of the U.S. market or, alternatively,
                                                                             10
                                          returns to foreign stock markets.

                                          9
                                           See Philippe Jorion and William N. Goetzmann, A Century of Global Stock Markets, National Bureau
                                          of Economic Research Working Paper 5901, July 1997.
                                          10
                                             See John E. Golob and David G. Bishop, “What Long-Run Returns Can Investors Expect from the
                                          Stock Market?” Federal Reserve Bank of Kansas City Economic Review, vol. 82, No. 3 (Third Quarter
                                          1997), pp. 5-20;and John H. Cochrane, “Where is the Market Going? Uncertain Facts and Novel
                                          Theories,” Economic Perspectives, Vol. XXI, Issue 6 (November/December 1997), pp.3-37.




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Equity Premium Diminishing   In general, investors, tend to be averse to risk and demand a reward for
                             engaging in risky investments. The reward is usually in the form of a risk
                             premium—an expected rate of return higher than that available on
                             alternative risk-free investments. For instance, the historical advantage
                             enjoyed by equity returns over the returns of other assets is what is known
                             as the equity premium. The premium is said to exist because equities have
                             historically earned higher rates of return than those of Treasuries to
                             compensate for the additional risk associated with investing in equities.
                             However, the equity premium has slowly been declining. Studies have
                             shown that the equity premium has declined since the 1950s.

                             A number of studies have attempted to measure the equity premium as
                                                                 11
                             well as explain its size. One study found that the premium appeared to be
                             quite high in the 1930s and 1940s and was caused by the perception of the
                             high volatility in the stock market in the late 1920s and the early 1930s.
                             This led investors to favor less risky securities as opposed to equities,
                             generating a high equity premium. However, as the volatility of stock
                             market declined after the 1929 stock market crash, the appeal of investing
                             in equities began to increase; and although an equity premium continues to
                             exist, it has steadily declined. However, in the 1970s the equity premium
                             increased somewhat from its general downward trend; this was attributed
                                          12
                             to inflation. The study concluded that decreases in the equity premium
                             were the result of increases in expected bond rates and decreases in the
                             expected rates of returns to equities.

                             It has also been suggested that the shrinking premium reflects a structural
                                                                                                 13
                             change in that the economy appears less susceptible to recessions. To
                             the extent that corporate profits fluctuate with general economic
                             conditions, fewer downturns translate into less volatility in corporate
                             earnings. If investors perceive that the outlook for corporate earnings is
                             more certain and that equities may be less risky than they have been


                             11
                              See Oliver J. Blanchard, “Movements in the Equity Premium,” Brookings Papers On Economic
                             Activity, 2:1993, pp. 75-118.


                             12
                                The study noted that inflation causes higher dividend yields, which in turn increases the return to
                             stocks. Alternatively, inflation leads to a decrease in real bond rates, for a few years only. This means
                             that the relationship between inflation and the equity premium is strong in the short run because
                             inflation affects real bond rates, but it is not so strong in the long run because the effect of inflation on
                             bond rates is not as lasting.
                             13
                              Goldman Sachs, “The Equity Risk Premium and the Brave New Business Cycle,” U.S. Economics
                             Analyst, No. 97/8, February 21, 1997.




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                             historically, equity investing might carry a lower premium and, therefore,
                             relatively lower returns. As a result, the equity premium diminishes.

                             It is unclear whether the equity premium will continue to decline.
                             However, if individual accounts affect equity prices in the short run, the
                             equity premium could decrease. For instance, if the demand for equities
                             increases as a result of individual accounts, the prices of equities are likely
                             to increase. This in turn lowers the expected return on equities. As the
                             expected return on equities decreases, the equity premium decreases
                             because the difference between the return on equities and the risk-free
                             asset such as Treasury bills would diminish.

                             The decreasing equity premium could imply that people do not view the
                             stock market to be as risky as they once did. One possible implication is
                             that if people view the stock market as not very risky, and they prove to be
                             right, they will continue to invest in it, and the equity premium is likely to
                             continue decreasing. Alternatively, if the stock market is in fact riskier
                             than investors believe, then investors will be surprised by
                             underperformance and volatility over time and will begin to reduce their
                             equity holdings, which could eventually cause the equity premium to go
                             back to values consistent with past decades.

                             The size of the equity premium has implications for analyzing the benefits
                                                                14
                             of an individual account program. The potential gain from equity
                             investing under an individual account program depends on what future
                             equity returns are and in particular how much return might be expected
                             for taking on additional risk. A significant part of the gain that might be
                             generated from diversifying into equities comes from the equity premium.
                             To the extent that the equity premium continues to decline, individuals are
                             unlikely to receive as high a return from stock investing as they have in the
                             past.

The Returns of Investments   The return that individuals are likely to receive from individual account
                             investments would depend on what they are allowed to invest in, e.g.
                                                                    15
                             stocks, bonds, indexed mutual funds, as well as the risk of the asset being
                             invested in. When estimating expected returns under an individual
                             account program, most proposals have tended to focus on equities.

                             14
                              See Implications of Government Stock Investing for the Trust Fund, the Federal Budget, and the
                             Economy (GAO/AIMD/HEHS-98-74, April 22, 1998).
                             15
                                Mutual funds pool the limited funds of small investors into large amounts, thereby gaining the
                             advantages of large-scale trading. Investors are assigned a prorated share of the total funds according
                             to the size of their investments.




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                        However, other assets may offer different returns. Corporate equities have
                        tended to have higher market returns than other investments because they
                        are riskier. Other investments, such as corporate bonds, have also tended
                        to offer high yields. For instance, corporate bonds offer higher yields than
                        Treasuries to entice investors to buy these securities, which have some
                                        16
                        risk of default. As in the case of corporate equities, investors are offered
                        a higher reward for taking on the additional risk that the company may
                        default. If an individual account system were to provide for mutual funds,
                        depending on the type of mutual fund allowed, individuals would receive
                        various returns. For instance, a government bond mutual fund may yield a
                                                                                       17
                        lower return to investors than an equity indexed mutual fund.

                        Overall, the capital markets offer higher market returns only by having
                        investors take on additional risk. Thus, in estimating expected returns for
                        individual account investments, it is important to not only consider the
                        type of asset invested in but also the riskiness of the investment.

Adjusting the Rate of   Higher returns are possible for individuals investing through individual
                        accounts than under the current Social Security program, but only if
Return for Risk         individuals take on more risk. Individuals should therefore not only be
                        interested in the returns of various assets but also in the risks that have to
                        be incurred to achieve higher returns under an individual account
                        program. The difficulty is how to measure risk and how to adjust rates of
                        return for risk so that investors would be able to compare various returns
                        to investments.

                        Risk is often considered to be the uncertainty of future rates of return,
                        which in turn are equated with variability. In fact, one of the underlying
                        concepts of risk is inherent volatility or variability. For instance, the
                        variability of equity prices is among the key factors that cause investors to
                        consider the stock market risky. The price at which an individual
                        purchases shares of a company early in the morning is not guaranteed
                        even later in the day. Bond prices also vary due to changing interest rates
                        and inflation.




                        16
                          When a bond is purchased, the coupon rate is fixed and known for the life of the bond—this is the
                        rate the purchaser will receive every 6 months for the life of the bond.
                        17
                         An indexed mutual fund is a mutual fund that holds shares in proportion to their representation in a
                        market index such as the S&P 500.




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There are Many Ways to   There are a number of different ways to try to measure variability or risk.
Measure Risk             All such measures give some estimate of the riskiness of investments.
                                                                  18                         19
                         Classic risk measures such as variance or the standard deviation are
                         often used to measure the risk of an asset. However these measures are
                         often considered to be difficult for investors to understand and may not
                         reflect how people perceive risk. For instance, investors do not generally
                         take a symmetrical view of the variability of returns—downward
                         deviations are perceived as economic risks, but upward deviations are
                         regarded positively or as unexpected gains. Furthermore, quantifying
                         uncertainty or risk is usually done using probability distributions. As long
                         as the probability distribution falls symmetrically about the mean or
                         average—what is known as a normal distribution—the variance and
                         standard deviation are adequate measures of risk. However, to the extent
                         that the probability distributions are asymmetrical, as is the case with the
                         returns from a combination of securities, those measures are not as
                         meaningful in terms of measuring risk.

                         Other ways to measure risk include (1) the value at risk (VAR) --how much
                         the value of a portfolio can decline with a given probability in a given time
                         period, or (2) the beta of a security--the tendency of a security’s returns to
                         respond to swings in the broad market. VAR is an approach used by
                         money risk managers to measure the riskiness of their portfolios. It is an
                         estimate of the maximum amount a firm could lose on a particular
                         portfolio a certain percent of the time over a particular period of time. For
                         example, if an investor wanted to put money into a mutual fund and
                         wanted to know the value at risk for the investment of a given time period,
                         the investor could determine the percentage or dollar amount that their
                         investment could lose, e.g., a 2-percent probability that the investor could
                         lose at least $50 of a $1,000 investment over a certain period of time. VAR
                         models construct measures of risk using the volatility of risk factors, such
                         as interest rates or stock indexes, which is helpful for mutual funds that
                         have a wide variety of investments.

                         Measuring the beta is another way to measure risk. In essence, if an
                         investor wanted to know how sensitive a particular asset’s return is to
                         market movements, calculating the beta would do so. Beta measures the
                         amount that investors expect the equity price to change for each additional
                         1-percent change in the market. The lower the beta, the less susceptible
                         the stock’s return is to market movements. The higher the beta, the more
                         18
                            The variance of an asset’s return is the expected value of the squared deviations from the expected
                         return. The variance tries to measure the dispersion of the returns.
                         19
                              The standard deviation is the square root of the variance.




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                     Return and Risks Are Likely to Be Higher With Individual Accounts




                     susceptible the stock’s return is to market movements. Thus, the beta
                     would measure the risk that a particular stock contributes to an
                     individual’s portfolio.

Adjusting for Risk   As previously stated, estimating a return on investments without taking in
                     to account the riskiness of the investment is likely to overstate the benefit
                     of investing in that asset. Adjusting returns to account for risk is
                     important because risk-adjusted returns are likely to be lower than
                     unadjusted returns but more comparable across asset classes.

                     There are different ways to adjust returns for risk, but there is no clear
                     best way to do so. The appropriate risk-adjusted measurements depend on
                     what is being evaluated. For instance, in terms of evaluating the returns of
                                                                                                20
                     mutual funds, various risk-adjusted performance measures could be used.
                                                             21
                     One measure used is the Sharpe Ratio, which basically measures the
                     reward to volatility ratio and is the most commonly used measure for
                     determining the risk-adjusted performance of mutual funds. A high Sharpe
                     ratio means that a mutual fund delivers a high return for the level of
                     volatility of the fund’s investments. Thus, if individuals were trying to
                     determine the mutual fund that had the best combination of return for risk,
                     they would choose the fund that had the highest Sharpe Ratio. An
                     alternative to the Sharpe Ratio is the Modigliani Measure, which measures
                     a fund’s performance relative to the market. The measure uses a broad-
                     based market index, such as the S&P 500, as a benchmark for risk
                     comparison. In essence, the measure is equivalent to the return a mutual
                     fund would achieve if it had the same risk as a market index. Another
                     measure is one calculated by Morningstar, Incorporated. Unlike the
                     Sharpe Ratio, which compares the risk-adjusted performance of any two
                     mutual funds, Morningstar measures the risk-adjusted performance of
                     mutual funds within the same asset class. It usually assigns ratings to
                     mutual funds on the basis of the risk-adjusted return and risk of a mutual
                           22
                     fund. Thus, if individuals wanted to know how various mutual funds did
                     within their asset groups, they would look at the Morningstar rating.

                     20
                      See Katrina Simons, “Risk-Adjusted Performance of Mutual Funds,” New England Economic Review,
                     September/October 1998., pp.34-48.
                     21
                        The Sharpe Ratio measures a mutual fund’s excess return per unit of risk (fund’s average excess
                     return divided by the standard deviation of the fund’s excess return).
                     22
                       Morningstar calculates its risk-adjusted return measure by calculating an excess return measure for
                     each fund by adjusting for sales loads and subtracting the 90-day Treasury bill rate and then dividing
                     the excess return by the average excess return for the fund’s asset class. Morningstar calculates a
                     measure of downside risk by counting the number of months in which the fund’s excess return was
                     negative, summing up all the negative excess returns, and dividing the sum by the total number of
                     months in the measurement period.




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                         There are other risk-adjusted measures that are used. However, there is
                         no clear best way to adjust a return for risk, and there is no one risk-
                         adjusted measure that everyone agrees is the correct measure. Many of
                         the measures are complicated and may require more sophistication to
                         understand than could be expected of individual account investors. It
                         should be noted, however, that although risk-adjusted rates of return are
                         the appropriate measure for individual account investments, an investor’s
                         entire portfolio has a different risk than that of its individual components.
                         Thus, risk-adjusted returns depend fundamentally on how portfolios are
                         managed.

                         Comparing rates of return on Social Security and private market
Comparing Rate of        investments has frequently been discussed in evaluating options for
Return From Social       reforming Social Security, but comparing the two does not capture all the
                                                                                  23
Security to Expected     relevant costs and benefits that reform proposals imply. Such
                         comparisons often do not factor in the costs of disability and survivors
Return With Individual   insurance when determining a rate of return on Social Security
Accounts Requires        contributions for retirement.
Careful Consideration
                         Individual accounts would generally increase the degree to which
                         retirement benefits are funded in advance. Today’s pay-as-you-go Social
                         Security program largely funds current benefits from current
                         contributions, but those contributions also entitle workers to future
                         benefits. The amount necessary to pay the benefits already accrued by
                         current workers and current beneficiaries is roughly $9 trillion. Any
                         changes that would create individual accounts would require revenues
                         both to deposit in the new accounts for future benefits and to pay for
                         existing benefit promises. Rate of return estimates for such a program
                         should reflect all the contributions and benefits implied by the whole
                         reform package, including the costs of making the transition.
                         Administrative and annuity costs could also affect actual retirement
                         incomes.

                         SSA commented that we needed to clarify that comparisons between the
Agency Comments          rate of return implicit in the Social Security system and those of individual
                         accounts were problematic for many reasons including the fact that Social
                         Security provides survivors and disability insurance. We have further
                         clarified issues regarding the rate of return comparisons and have referred
                         to our forthcoming report that provides a more detailed discussion on


                         23
                          In a forthcoming report, we will provide a more detailed discussion on issues comparing Social
                         Security rates of return with those of market investments.




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Return and Risks Are Likely to Be Higher With Individual Accounts




comparing the rate of return implicit in the Social Security system with
those of market investments.




Page 49                       GAO/GGD-99-115 Issues Associated With Individual Accounts
Chapter 4

Enhanced Education is Necessary for an
Individual Account Program

              Under many of the individual account programs that have been proposed,
              individual accounts to varying extents would be managed by participants
              themselves. To operate fairly and efficiently, such a system would have to
              provide participants with information adequate for their decisionmaking as
              well as to protect against misinformation that could impair that process.
              Existing SEC disclosure and antifraud rules and related doctrines provide
                                                                1
              for the disclosure of information that is material to an investment
              decision. However, such disclosure alone would not enable participants in
              an individual account program to understand how best to use such
              information for purposes of their retirement investment decisions.

              To provide participants with a clear understanding of the purpose and
              structure of an individual account program, an enhanced educational
                                             2
              program would be necessary. Such an enhanced and broad-based
              educational effort would have to be undertaken in order to provide
              individuals with information they need and can readily understand, as well
              as with tools that can help both improve the decisionmaking process and
              awareness of the consequences of those decisions. Individuals would need
              education on the benefits of saving in general, the relative risk-return
              characteristics of particular investments, and how different distribution
              options can affect their retirement income stream. If a wide variety of
              choice is offered individuals so that they could potentially choose less
              diversified investments, such as individual equities, a more broad-based
              educational program would be necessary. The wider the variety of
              choices, and thus more potential risks, offered individuals under an
              individual account program, especially a mandatory program, the more
              broad-based the education will need to be. If fewer, well-diversified
              choices are provided under an individual account program, the educational
              effort could be targeted more to the purpose for investing and the potential
              long-term consequences. It is also likely that some sort of provision, such
              as a default option--either a default to the defined benefit part of Social
              Security (staying in the current Social Security program) or to a mandatory
              allocation--may be needed for those individuals who, regardless of the
              education provided, will choose not to make investment choices.




              1
               Under the Securities laws, the term “material information” generally is understood to mean the
              information that a reasonable investor would consider significant in making an investment decision,
              taking into account the circumstances of the particular transaction and the total mix of publicly
              available information.
              2
               Such a program would have to acknowledge that not all participants will speak and read English and,
              thus, educational materials may need to be in a variety of languages.




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                              Enhanced Education is Necessary for an Individual Account Program




                              Existing disclosure rules require that material information be provided
The Significance of           about a particular instrument and its issuer. Such disclosure would be
Disclosure Rules              essential to an individual account program, with some rules having more
Would Depend Upon             significance than others, depending on the investment choices offered.
                              For example, if participants were allowed to acquire corporate securities
Available Investment          such as stocks and bonds, the disclosure and reporting requirements of the
Choices                       Securities Acts of 1933 and 1934, such as those applicable to the
                              governance, activities, and financial status of the issuer, would be
                              particularly important to participants choosing such instruments. If
                              investment choices were limited to mutual funds, disclosure about the
                              funds would have primary importance, and information about the issuers
                              of the securities owned by the funds would be relatively less significant for
                              participants. In addition, the Employee Retirement Income Security Act of
                              1974 (ERISA) requires disclosures in connection with pension funds
                              (covered by Title I of ERISA). If products offered by banks and insurance
                              companies were permitted, special disclosure rules would apply.

Disclosures in Connection     The Securities Acts of 1933 and 1934 generally require disclosure and
                              reporting of detailed information about an issuer of securities, such as its
with Securities and Pension   management, activities, and financial status. The Securities Act of 1933
Plans                         (1933 Act) primarily focuses upon the disclosure of information in
                              connection with a distribution of securities; the Securities and Exchange
                              Act of 1934 (1934 Act) concentrates upon the disclosure of information
                              trading, transactions, and sales involving securities.

                              The 1933 Act requires the disclosure of information intended to afford
                              potential investors an adequate basis upon which to decide whether or not
                              to purchase a new security and to prevent fraudulent conduct in
                              connection with the offering. This disclosure generally takes place
                              through a registration statement filed with SEC (and made available to the
                              public, except for confidential information) and a related prospectus.
                              Both documents contain detailed factual information about the issuer and
                              the offering, including statements about the specifics of the offering as
                              well as detailed information about the management, activities, and
                              financial status of the issuer.

                              The 1934 Act, among other things, contains extensive reporting and
                              disclosure requirements for issuers of securities registered under the act.
                              Issuers must file current, annual, and quarterly reports with SEC, and the
                              annual report must be distributed to security holders. The 1934 Act also
                              governs brokers, dealers, and others involved in selling or purchasing
                              securities. The act contains a broad prohibition against fraud in
                              connection with securities transactions that frequently has served as a



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basis for disclosing to customers an abundance of details about a
particular instrument or transaction.

ERISA and DOL regulations require the administrator of a plan covered by
Title I of ERISA to file certain information about the plan with DOL and
                                                                        3
distribute it to plan participants and beneficiaries receiving benefits. One
of the principal disclosure documents, the summary plan description
(SPD), must include information specified in the regulations, which
includes details about the structure, administration, and operation of the
plan as well as the participant’s or beneficiary’s benefits and rights under
the plan. The SPD must be written in a manner “calculated to be
understood by the average plan participant” and must be “sufficiently
comprehensive to apprise the plan’s participants and beneficiaries of their
rights and obligations under the plan.” Moreover, in fulfilling these
requirements the plan administrator is to take into account “such factors
as the level of comprehension and education of typical participants in the
                                       4
plan and the complexity of the plan.”

In addition to general reporting and disclosure requirements, DOL
regulations contain special disclosure rules for participant-directed
accounts. A participant-directed account plan is one that permits
participants and beneficiaries to direct the investment of assets in their
                     5
individual accounts. The special rules arise in the connection with the
obligations of a fiduciary to a plan that permits such accounts.



3
 ERISA’s regulatory provisions are contained in four parts. Part I covers reporting and disclosure
requirements, which are designed to improve pensions and protect employees by mandating disclosure
of certain plan information to the government, participants, and beneficiaries. Part II establishes
minimum vesting requirements and minimum participation standards, which are intended to lessen
discrimination against lower level employees and broaden the coverage of pension plans. Part III sets
minimum funding standards to improve the stability of certain defined-benefit pension plans. Part IV
defines standards of conduct for pension plan fiduciaries and prohibits certain transactions.
4
 In addition to the SPD, a plan administrator is required to provide each participant with a summary
annual report which, among other things, is to include detailed information regarding the amount of
administrative expenses incurred by the plan, the amount of benefits paid to participants and
beneficiaries, the value of plan assets, income or loss for the year, and the amount of net unrealized
appreciation in plan assets during the plan year.
5
 Regulations for participant-directed accounts specifically require that such accounts provide the
participant or beneficiary the opportunity to choose from a broad range of investment alternatives.
These alternatives must provide a reasonable opportunity for a participant or beneficiary to: (1)
materially affect the potential return on amounts in his or her individual account with respect to which
he or she is permitted to exercise control and the degree of risk to which such amounts are subject; (2)
choose from at least three investment alternatives; and (3) diversify the investment of that portion of
his or her individual account with respect to which he or she is permitted to exercise control so as to
minimize the risk of large losses.




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                           Under DOL regulations, a fiduciary can avoid liability for any loss arising
                           from the participant’s exercise of control over account assets, provided
                           that the participant has the opportunity to exercise control over the
                           account assets and may choose, from a broad range of investment
                           alternatives, the manner in which assets are invested. The regulations
                           further provide that a participant has the opportunity to exercise control
                           only if, among other things, the participant is provided or can obtain
                           information sufficient for him or her to make informed investment
                           decisions. This information includes (a) a description of investment
                           alternatives and associated descriptions of the investment objective, risk
                           and return characteristics of each such alternative; (b) information about
                           designated investment managers; (c) an explanation of when and how to
                           make investment instructions and any restrictions on when a participant
                           can change investments; and (d) a statement of fees that may be charged
                           to an account when a participant changes investment options or buys and
                           sells investments.

Disclosure in Connection   The information that the 1933 and 1934 Acts require issuers to disclose
                           pertains to details about the issuers of securities and the securities
With Mutual Fund Shares    themselves. Such information is significant to a person investing in a
                           specific issuer. For the purchaser of shares in an investment company,
                           such as a mutual fund, which is the vastly prevalent form of investment
                           company, information about the company itself, rather than individual
                           issuers, is most significant. Mutual funds are subject to the Investment
                           Company Act of 1940, which deals with the registration, formation, and
                           operation of investment companies, as well as provisions of the 1933 and
                           1934 Acts governing disclosure and prohibiting fraud. Disclosure about
                           the fund, such as information concerning its investment strategies and its
                           management, is provided in the registration statement filed with SEC; the
                           prospectus or an alternative, less detailed document known as a “profile”;
                           and periodic reports filed with the Commission and distributed to
                                         6
                           shareholders.




                           6
                            As discussed later in the report, SEC recently modified Form N-1 and promulgated the “profile” rule
                           to provide for the disclosure of mutual fund information in a less detailed, more understandable
                           fashion. SEC instituted these changes because the proliferation of mutual funds and products
                           increased the volume and complexity of disclosures, thus leading to the confusion of mutual fund
                           customers.




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Disclosure Concerning         The expansion of products offered by depository institutions (primarily
                              federally insured banks and thrifts and their subsidiaries or affiliates) and
Certain Products Offered by   insurance companies carries with it the potential for confusion about the
Depository Institutions and   nature and risk of investment products offered by such institutions. For
Insurance Companies           example, bank sales of nondeposit instruments, such as mutual fund
                              shares and variable annuities, could lead an investor to conclude that such
                              instruments are federally insured bank products. Investment products
                              sold by insurance companies, such as certain variable annuities and equity-
                              indexed agreements, might be viewed as traditional insurance products,
                              under which the insurer assumes the payment risk. If such products are
                              securities, they are subject to the requirements of federal and state
                              securities laws. The activities of institutions in connection with the
                              products would be subject to regulation under the securities laws as well
                              as regulation by their supervising agencies.
                                                                   7
NonDeposit Bank Products      The federal bank regulators have promulgated rules, guidelines, and
                              policies containing standards for disclosure in connection with a banking
                              institutions’ involvement in sales of nondeposit instruments such as
                              securities. These regulators issued an Interagency Statement on Retail
                              Sales of Non-Deposit Investment Products (“Interagency Statement”)
                              together with subsequent statements that focuses on issues specifically
                              pertaining to the retail sale of investment products to customers on
                              depository institution premises. Among other things, the standards seek to
                              prevent customer confusion over whether such products are FDIC-insured,
                              primarily through disclosure and separation of sales of investment
                              products from other banking activities.

                              New products being offered by insurance companies can also confuse
                              investors about whether such a product is insurance (the insurer accepts
                              the repayment risk) or a security (the purchaser of the product faces some
                              or all repayment risk). States typically regulate disclosure about insurance
                              products by prohibiting unfair, deceptive, or misleading statements about a
                              product. However, to the extent such instruments are securities, their
                              purchase and sale are subject to federal and state securities laws.

Initiatives to Facilitate     To address concerns about the effectiveness of disclosures regarding
                              investing, particularly with respect to mutual funds, SEC and some states
Understanding of              have established programs to provide for disclosing information to
Information                   investors in a more understandable way. SEC’s “plain English” program is

                              7
                               The office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve
                              System, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Thrift Supervision
                              (OTS).




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                        an example. The Commission instituted the program because much of the
                        disclosure provided in prospectuses and other documents often is
                        complex, legalistic, and too specialized for investors to understand. Under
                        this program, the Commission revised its rule for the presentation of
                        information in a prospectus to require that the prospectus comply with
                        plain English writing principles listed in the regulation. SEC also amended
                        its Form N-1A, the registration form used by mutual funds for registration,
                        to provide for the use of plain English principles and simplified
                        descriptions of information essential to an investor’s evaluation of the
                        fund.

                        In March 1998, SEC adopted a rule permitting mutual funds to offer
                        investors a new disclosure called a profile. The document summarizes key
                        information about the fund, including its investment strategies, risks,
                        performances, and fees, in a concise, standardized format. A fund offering
                        a profile can give investors a choice about the amount of information they
                        wish to consider before making a decision about investing in the fund.
                        Investors have the option of purchasing the fund’s shares on the basis of
                        the profile, in which case they are to receive the fund’s prospectus along
                        with the purchase confirmation.

                        Among other things, the new SEC rules are designed to reduce the
                        complexity of information provided to mutual fund customers and the
                        potential for confusion that sometimes accompanies such information.
                        They are an attempt to make the disclosure of material information more
                        useful to those who invest in mutual fund securities.

                        Whether an individual account program is mandatory or voluntary, giving
Enhanced Education Is   millions of working Americans the responsibility for investing part of their
Necessary for an        Social Security payroll taxes on their own requires enhanced education.
Individual Account      Social Security has provided a safety net for millions of people for a long
                        time in that it has been the foundation of the nation’s retirement income
Program                 system, providing income for millions of Americans. Introducing an
                        individual account program would change the nature of the current Social
                        Security program and would require increased education if people are to
                        understand the individual account program and what may be required of
                        them. Although education would be necessary regardless of whether the
                        program was voluntary or mandatory, the government would have a
                        special responsibility under a mandatory program to provide individuals
                        with the basic investment knowledge that they would need in order to
                        make informed investment decisions affecting their retirement.




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                                 The extent to which enhanced education would be necessary would
                                 depend upon the available investment choices and the fees and expenses
                                 associated with an individual account program. An individual account
                                 program that offers many investment choices—especially one that is
                                 mandatory—would likely require a substantial amount of education
                                 because the wider the options provided an individual, the greater the
                                 chances are that the individual could lose money. If fewer well-diversified
                                 options are offered under an individual account program the fewer risk
                                 factors the individual has to consider and the more targeted the education
                                 could be. It would also be important to educate individuals about how to
                                 interpret the fees associated with individual account investments and how
                                 fees would affect their account balances.

Enhanced Education Is            The Social Security program includes workers from all levels of income,
                                 those who currently invest in equity and bond markets and those who do
Important for All                not. It is unlikely that a “one size fits all” educational effort would be
Individuals                      appropriate for an individual account program. Because a mandatory
                                 individual account program would require everyone to participate,
                                 including those who do not currently make investment decisions,
                                 educational efforts would be especially crucial and would need to reach all
                                 individuals.

Enhanced Education Is            Large segments of the working population do not currently make
Important for Those Who Do Not   investment decisions for various reasons. For instance, some people do
Currently Make Investment        not believe that they have enough money to save or at least to save in any
Decisions                        vehicle other than a bank account. Others do not know the benefits of
                                 investing. Lastly, there are those who do not appear to understand the
                                 benefits of saving and investing or the necessity of doing so for retirement.
                                 Whatever the reason, millions of people have never made investment
                                 decisions.

                                 Investor education is especially important for individuals who are
                                 unfamiliar with making investment choices, including low-income and less
                                                                                                        8
                                 well-educated individuals who may have limited investing experience.
                                 Thus, one of the primary areas of enhanced education under an individual
                                 account program would be to educate those who do not know the basics
                                 about savings or diversification, especially if the individual account
                                 program is mandatory. Those individuals and households who do not
                                 currently make investment decisions, but rely on Social Security as their

                                 8
                                  This is especially true for the 21 percent of the adult population with only rudimentary reading and
                                 writing skills (at or below the fifth-grade level) according to the National Center on Education
                                 Statistics).




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                                primary source of retirement income, are likely to be the ones who are
                                most affected by a mandatory individual account program and thus most in
                                need of education.

Current Initiatives Focus on    Congress and various agencies and organizations have instituted programs
Saving, Fraud, and Retirement   to educate people about the benefits of saving and investing. In the
Income                          Savings Are Vital to Everyone’s Retirement Act of 1977, Congress
                                mandated an education and outreach program to promote retirement
                                income savings by the public. The act also required the Secretary of Labor,
                                in consultation with other federal agencies selected by the President, to
                                plan and conduct a National Summit on Retirement Savings. As part of
                                this mandate, the act required the Secretary to bring together retirement
                                and investment professionals, Members of Congress, state and local
                                officials, and others to discuss how to educate the public--employers and
                                individuals--about the importance of saving and about the tools available
                                to enable individuals to retire and remain financially independent.
                                Pursuant to this mandate, DOL sponsored the National Summit in 1998.

                                Other efforts have been made to reach out to investors to educate them
                                about both how to protect themselves against fraud. SEC has realized that
                                an important part of its role in combating fraud is to educate the public
                                about what to be aware of and how to avoid being taken advantage of. If
                                investors are adequately informed about the risks associated with potential
                                securities frauds, then they will be less likely to fall victim to scams.

                                SEC has implemented several programs to advise the investing public
                                about potential frauds. For instance, SEC has issued numerous pamphlets
                                about what types of questions investors should ask about investing and the
                                                                 9
                                people who sell those products. Additionally, SEC has held local “town
                                meetings” across the United States to discuss investment risks. It also
                                coordinates the “Facts on Savings and Investing Campaign” with federal,
                                state, and international securities regulators. SEC officials said that in
                                order to have a successful education program, it is necessary to determine
                                what people do and do not know. This has entailed determining people’s
                                level of literacy and math knowledge in order to design a program that
                                could provide education for individuals with various levels of investment
                                knowledge.




                                9
                                 See pamphlets such as “Ask Questions,” “Cold Calling Alert,” “Invest Wisely: An Introduction to
                                Mutual Funds,” and “Invest Wisely: Advice from Your Securities Industry Regulator,” published by and
                                available from the U.S. Securities and Exchange Commission.




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DOL’s Pension Welfare and Benefits Administration has several
educational outreach efforts for encouraging employers to establish
retirement programs and employees to save for retirement. The basic
program is a joint effort with a wide range of private sector partners,
including the American Savings Education Council, the Employee Benefit
Research Institute, banks, insurance companies, consumer groups, retiree
groups, participant rights’ groups, mutual funds, and other large
companies. This joint effort was designed to provide very basic
information to individuals and employers about the different types of
savings vehicles available under the law and to encourage the private
                                                                 10
sector to provide employees with models of pension programs. The
educational program tries to target special groups whose pension coverage
is low, including such groups as women and minorities as well as small
businesses; only about one-fifth of small businesses offer pension plans to
their employees. DOL has issued numerous pamphlets on what
individuals should know about their pension rights and what businesses
                                                   11
can do to start pension plans for their employees. For instance, they
regularly use the Small Business Administration’s newsletters to
encourage members to establish pension plans and have developed a Web
site for small businesses to give them information on various pension plan
options, depending on how much each business can afford to contribute to
a pension fund.

These current programs have a limited ability to reach the overall
population. One clear constraint is the low level of resources, including
funding directed to investor education. Another limitation is that they are
targeted to circumscribed audiences, such as companies that do not have
retirement programs as opposed to individuals who do not invest.
Furthermore, most efforts are reaching those individuals who choose to
take it upon themselves to find out what they need to do to save more or to
learn how to make better investment decisions. Thus, even as a result of


10
  This joint effort resulted from a concern a few years ago that as baby boomers began to retire and
move away from defined benefit plans into 401(k) plans, there would be a great need for educational
efforts to encourage individuals to save for their retirement. At first, Congress did not support DOL’s
voluntary efforts. However, several years later as 401(k) plans became increasingly popular, Congress
passed the Savers Act, which requires DOL to establish and maintain a retirement education program
for employers and employees.
11
   See pamphlets, “What You Should Know About Your Pension Rights,” “Simple Retirement Solutions
for Small Business,” “Simplified Employee Pensions: What Small Businesses Need to Know,” “Top 10
Ways to Beat the Clock and Prepare for Retirement,” “Reporting and Disclosure Guide for Employee
Plans,” “Protect Your Pension: A Quick Reference Guide,” “A Look at 401(k) Plan Fees’” and “Saving
Incentive Match Plan for Employees of Small Employers,” published by and available from the U.S.
Department of Labor, Pension Welfare and Benefits Association.




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                                  the various targeted efforts undertaken, large segments of the population
                                  are still not being reached.
                                                           12
Education Is Also Important for   Numerous studies have been done that have looked at how well
Those Individuals Who             individuals who are currently investing understand investments and the
Currently Make Investment         markets. On the basis of those studies, it is clear that among those who
Decisions                         save through their company’s retirement programs or on their own, there
                                  are large percentages of the investing population who do not fully
                                  understand what they are doing. For instance, one study found that a little
                                  more than a third of American workers have tried to calculate how much
                                  money they would need to retire comfortably. Another study found that 47
                                  percent of 401 (k) plan participants believe that stocks are components of
                                  a money market fund, and 55 percent of those surveyed thought that they
                                  could not lose money in government bond funds. Another study on the
                                  financial literacy of mutual fund investors found that less than half of all
                                  investors correctly understood the purpose of diversification. Further,
                                  SEC reported that over half of all Americans do not know the difference
                                  between a stock and a bond, and only 16 percent say they have a clear
                                  understanding of what an IRA is.

                                  Although individuals who currently make investment decisions are likely
                                  to have some familiarity with investing, education would also be important
                                  for them because of their increased responsibility under an individual
                                  account program. Furthermore, according to the studies cited above,
                                  there would be a real need for enhanced education about such topics as
                                  investing, risk and return, and diversification. As the Chairman of SEC
                                  has said, there is a wide gap between financial knowledge and financial
                                  responsibilities. Closing that knowledge gap is imperative under an
                                  individual account program.

Enhanced Education Is             Moving to an individual account program is going to require a thorough
                                  education effort for everyone to understand the program and how it is
Important for Individual          different from the current Social Security program. The government has
Accounts Program                  much more responsibility for educating individuals under a mandatory
                                  program because people would effectively be forced by the government to
                                  save and to make decisions about what to do with that saving as well as
                                  bear the consequences of a decision. Even with a default option for those
                                  who do not choose to participate, the government needs to explain why
                                  the option was provided and what are its implications.
                                  12
                                     See studies such as the Securities Industry Association, “1997 Annual SIA Investor Survey: Investors’
                                  Attitudes Towards the Securities Industry, November 1997, and Vanguard Group, “Vanguard/Money
                                  Mutual Fund Literacy Test,” January 1998, and Office of Investor Education and Assistance Securities
                                  and Exchange Commission, “The Facts on Saving and Investing,” February 24, 1998.




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                          Many people do not understand the current Social Security program, how
                          their contributions are measured, and how their benefits are computed,
                          even though the program is over 60 years old. Yet, millions of individuals
                          rely on the program as their sole source of retirement income. In order to
                          increase people’s understanding of Social Security, SSA has implemented
                          various efforts to educate people. Such efforts have included providing a
                          1-800 number for recipients to ask questions, having a public education
                          service campaign, and providing educational packages to individuals.
                          Despite these efforts, SSA officials said that people still have a hard time
                          understanding the program. Implementing an individual account program
                          is likely to require enhanced education not only about individual accounts
                          but also about how an individual account program would change the
                          nature of Social Security and what that means for the individual.

                          At a minimum, under an individual account program, educational efforts
                          would be needed to help people understand how individual accounts
                          would work and how the accounts would affect their retirement income
                          security. Many proposals do not specify what entity would be responsible
                          for the public education program that would be needed for an individual
                                                                                          13
                          account program. On the basis of the type of information experts in
                          employee education say is needed, education about an individual account
                          program could include the following information:

                        • Goals of the program — individuals need to know what the goals of the
                          program are and why they are participating.
                        • Responsibilities — individuals need to know what their responsibilities are
                          under the program.
                        • Retirement Income — individuals need to know what their retirement
                          income needs are and how their retirement needs will be affected under an
                          individual account program.
                        • Materials — individuals need materials that convey the message of the
                          program and what will be required of them.

Amount of Education       The amount of education that would be necessary under an individual
                          account program depends on the range and type of investment choices
Necessary is Directly     offered to individuals. There are basic issues that individuals will need to
Linked to the Choices     be educated about regardless of how the program is structured. Such
Offered                   issues include (1) the choices they have to make; (2) the consequences of
                          those choices; (3) what the investment options are, such as stocks, bonds,
                          13
                             See Richard D. Glass, “Investment Education: Who’s Fooling Whom?” Employee Benefits Journal,
                          March 1999, pp. 3-8; and George Loewenstein, “Costs and Benefits of Health and Retirement Related
                          Choice,” Paper for the Eleventh Annual Conference of the National Academy of Social Insurance,
                          January 8, 1999.




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                                         and indexed mutual funds; (4) rates of return of different investment
                                         vehicles; and (5) the risks of investment vehicles. However, as a wider
                                         variety of choice is offered to individuals, more education beyond the
                                         basics would be necessary because broader issues would need to be
                                         considered. With more variety of choice, investors would need to choose
                                         among various assets, which requires the investor to have certain skills to
                                         evaluate the risks and his or her own preference for risks. If the structure
                                         allows for an even broader variety of choices such as real estate, the
                                         educational requirements would mount. When choices are limited to a few
                                         well-diversified choices (such as a few indexed mutual funds), many
                                         decisions are made by those managing the funds or by rules governing the
                                         fund (such as what an indexed mutual fund can invest in). If the investor
                                         has the option of frequently moving funds from one investment to another,
                                         the educational effort needs to include analytical tools to aid such
                                         decisions and advice about the importance of a long-term horizon. Thus,
                                         the fewer well-diversified choices offered, the less risk to the individual
                                         and the more targeted the education could be.

Table 4.1: Investment Choices Under an
                                         Investment options                          Education needed
Individual Account Program and the
Education Required                       More investment choices offered             More broad-based education that is needed
                                         Fewer investment choices offered            Less education, but more targeted
                                         Source: GAO

More Investment Choices, More            A variety of choices may benefit people in that it offers them a wider
Education                                selection from which to choose, allowing them to choose the option that is
                                         in line with their preferences. However, it also increases their risk in that
                                         they could potentially choose less diversified investments, such as
                                         individual equities, that could result in financial loss. Furthermore, the
                                         wider the variety of choice offered, the greater the need for people to
                                         consider other issues. For instance, because offering a wide variety of
                                         investment options is likely to promote competition among financial
                                         institutions to provide a range of investment vehicles, investors would
                                         need to be educated about fraud and how to avoid it. When Great Britain
                                         went to an individual account program, individuals purchased unsuitable
                                         investments because of high-pressured sales tactics that resulted in
                                         individuals losing billions of dollars. The Chairman of the SEC has stated
                                         that allowing a broad range of investment options under individual
                                         accounts provides opportunities for fraud and sales practice abuses.
                                         Thus, education about fraud becomes important. For example, an investor
                                         would need to know what to look for, what type of questions to ask, what
                                         type of advice is biased, what the investor’s rights are, or what the law
                                         requires. When investment options are limited, the chances of fraud are
                                         reduced.




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                                 Moreover, the wider the variety of choice that is offered individuals, the
                                 more they will need education about understanding the value of
                                 diversification and the possible consequences of not having a diversified
                                 portfolio. If choices are limited to indexed mutual funds, less education
                                 about diversification would be needed because indexed funds are by
                                 nature diversified.

                                 Education is also necessary for understanding risks and the various
                                 returns that are likely with different investment options. With a wider
                                 variety of investment options, understanding risk and being able to manage
                                 the risk become important. It is important to explain to people that
                                 historical returns may not always be good predictors of future returns,
                                 especially when risks are ignored. As stated in chapter 3, measuring risk
                                 and comparing risk-adjusted returns can be a difficult process.
                                 Furthermore, being able to understand the rates of returns of various
                                 options and pick the appropriate investment vehicles become more
                                 difficult, as more variety is offered. Individuals would need more expertise
                                 to understand differences in the rates of return of equities, bonds, equity
                                 mutual funds, indexed funds, and so on.

Fewer Investment Choices, Less   If the program has fewer well-diversified choices, limits would be placed
Education Needed                 on the ways that people could lose money. The educational effort could,
                                 therefore, focus more on getting individuals to be informed participants in
                                 the program. Educational issues that become relevant when individuals
                                 are offered numerous options are of less concern when they are offered
                                 fewer, well-diversified options.

                                 With fewer, well-diversified investment choices, the educational effort
                                 could be more targeted to the purpose of retirement savings, e.g.,
                                 educating people about how much they would need to save and invest for
                                 retirement or determining their goals for retirement. Other issues, such as
                                 compounding—the calculation of interest earned on a daily, quarterly,
                                 semiannual, or annual basis—or the impact of inflation on returns are
                                 issues that individuals need to fundamentally understand. For example,
                                 with compounding interest individuals could earn interest on the money
                                 they save and on the interest that the money earns, e.g., if they invested
                                 $1,000 at 3-percent interest they could double their money in 24 years, but
                                 at 4 percent interest they could double it in 18 years. With inflation, or
                                 rising prices, the money that individuals earn on their investments would
                                 potentially be worth less and less as prices rose. In addition, seemingly
                                 small annual fees can eat away at the accumulated value. Offering fewer,
                                 more well-diversified options enables the education effort to be targeted




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                 on basic issues that would be helpful for individuals to understand in order
                 to save for retirement.

Default Option   Despite current efforts to increase people’s awareness to save more, many
                 people are still not saving and making the retirement choices they need to
                 make, effectively relying on Social Security to be their primary source of
                 retirement income. It is unlikely that moving to individual accounts will
                 result in active participation by all individuals. Thus, various officials have
                 suggested that a default option be provided for those individuals who,
                 regardless of educational effort, will not make investment choices.

                 Default options could include a default to the defined benefit portion of
                 Social Security (staying in the current Social Security program) or to some
                 type of mandatory allocation. One example would be an investment
                 vehicle in which, depending on the age of the individual, certain portions
                 of the investment could be in equities and certain portions in bonds. The
                 portion in bonds would increase with the age of the individual.
                 Alternatively, the default option could be invested totally in Treasuries. As
                 with any option, a default option with less risk is also likely to provide
                 lower returns.




                 Page 63                      GAO/GGD-99-115 Issues Associated With Individual Accounts
Appendix I

Comments From the Social Security
Administration




              Page 64   GAO/GGD-99-115 Issues Associated With Individual Accounts
Appendix I
Comments From the Social Security Administration




Page 65                      GAO/GGD-99-115 Issues Associated With Individual Accounts
Appendix II

GAO Contacts and Staff Acknowledgments


                  Tamara E. Cross, (202) 512-4890
GAO Contact

                  Lawrence D. Cluff, Thomas H. Givens III, Mitchell B. Rachlis, John
Acknowledgments   Schaefer, George Scott, Kenneth Stockbridge, Paul Thompson




                  Page 66                  GAO/GGD-99-115 Issues Associated With Individual Accounts
Page 67   GAO/GGD-99-115 Issues Associated With Individual Accounts
Page 68   GAO/GGD-99-115 Issues Associated With Individual Accounts
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