oversight

Retirement Income: Implications of Demographic Trends for Social Security and Pension Reform

Published by the Government Accountability Office on 1997-07-11.

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

                 United States General Accounting Office

GAO              Report to the Chairman and Ranking
                 Minority Member, Special Committee on
                 Aging, U.S. Senate


July 1997
                 RETIREMENT
                 INCOME
                 Implications of
                 Demographic Trends
                 for Social Security and
                 Pension Reform




GAO/HEHS-97-81
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      Health, Education, and
      Human Services Division

      B-276326

      July 11, 1997

      The Honorable Charles E. Grassley
      Chairman
      The Honorable John B. Breaux
      Ranking Minority Member
      Special Committee on Aging
      United States Senate

      Our nation’s elderly population is growing dramatically. In 1940, when Social Security first paid
      benefits, it was 7 percent of the U.S. population; today it is 13 percent. By 2030, the elderly
      population will be 20 percent of the population. This demographic trend has profound
      implications not just for Social Security but for all sources of retirement income, which also
      include pensions, savings, and earnings. While currently most of our nation’s senior citizens
      enjoy a reasonable standard of living, this trend raises concerns that our society will continue to
      be able to maintain it. This report provides an overview of the trends and key issues relating to
      retirement income.

      We are sending this report to the Commissioner of Social Security and relevant committees and
      subcommittees. The report will be available to others on request.

      This report was prepared under my direction. Please contact Francis P. Mulvey, Assistant
      Director, at (202) 512-3592 if you have questions.




      Jane L. Ross
      Director, Income Security Issues
Executive Summary


             The U.S. elderly population has tripled since 1940 and will more than
Purpose      double by 2050, according to Bureau of the Census projections. The very
             old population (aged 85 and over) will increase fivefold. The elderly are
             expected to make up 20 percent of the U.S. population as early as 2030
             compared with 13 percent today and just 7 percent in 1940. These
             dramatic demographic trends pose serious concerns about the future
             financing, availability, and protection of retirement income for the nation’s
             elderly. Numerous reform proposals under discussion could
             fundamentally change the nation’s retirement system.

             The Chairman and Ranking Minority Member of the Senate Special
             Committee on Aging, concerned about these issues, asked GAO to provide
             information on (1) demographic and economic trends affecting retirement
             income, (2) the status of Social Security’s long-term financing problems
             and proposals to address them, and (3) the extent of pension coverage and
             retirement saving and how to ensure that Americans can count on them
             throughout their retirement years.


             The four major sources of retirement income are Social Security, employer
Background   pensions, income from saved assets, and employment earnings. While
             Social Security provides income to 90 percent of elderly households, it
             provides just 42 percent of their aggregate cash income. Pensions, savings,
             and earnings provide income to considerably fewer households but
             together provide more than 50 percent of the elderly’s aggregate income.
             They largely determine which households have the highest retirement
             incomes.

             As people live longer and if retirement patterns do not change, Social
             Security and employer pensions will cost more or will have to provide
             reduced benefits or both. Personal retirement savings will have to last
             longer, and workers may find themselves needing to work longer. Federal
             policies play a major role in all these sources of retirement income and
             will play a significant role in helping adjust to demographic trends.

             Title II of the Social Security Act established the Old-Age, Survivors, and
             Disability Insurance program, which is generally known as Social Security.
             Initially, it provided old-age benefits to nearly all workers in commerce
             and industry, or about 60 percent of the workforce. Over the years,
             coverage has been expanded to dependents and survivors of insured
             workers, disabled workers, and workers in other types of employment.




             Page 2                                  GAO/HEHS-97-81 Retirement Income Issues
                   Executive Summary




                   With regard to pensions, the federal government has an interest in
                   promoting expanded coverage of workers so they can better meet their
                   retirement income needs. The Employee Retirement Income Security Act
                   (ERISA) of 1974 focused new attention on making pension promises more
                   explicit and benefits more secure. In addition to its minimum funding
                   requirements and other provisions, ERISA established a system of pension
                   insurance, administered by the Pension Benefit Guaranty Corporation
                   (PBGC). PBGC assumes liability for certain types of pensions when they are
                   terminated and pays the pension benefits, subject to certain limits.

                   Federal tax policy also affects how people save for retirement. Since the
                   1970s, federal laws have granted favorable tax treatment to individual
                   retirement accounts (IRA) and the closely related 401(k) pension plans.
                   Nevertheless, personal saving rates are at a historic low. Finally, federal
                   policies also affect postretirement earnings. Most notably, provisions in
                   the Social Security program affect incentives regarding when workers take
                   benefits and how much beneficiaries choose to earn after retirement.


                   As the elderly live longer, they will need retirement income over longer
Results in Brief   periods. Since fertility rates have been declining, the number of the elderly
                   will grow as a share of the population. While the income of the elderly has
                   improved considerably over the past 50 years, demographic trends may
                   potentially slow or reverse such improvements. Economic growth, if
                   strong, could ease some of the pressures these trends create. Still, the
                   nation must confront how the trends will affect the distribution of income
                   between workers and retirees, between the population’s working and
                   retirement years, and between high and low earners.

                   These trends pose long-term financing challenges for both Social Security
                   and the federal budget. Currently, Social Security revenues exceed
                   expenditures. The excess revenues are invested by law in federal
                   government securities and make the total federal deficit lower than it
                   would be otherwise. However, in just 15 years, expenditures are expected
                   to exceed cash revenues, according to Social Security Administration (SSA)
                   projections. At that point, the government’s general fund will have to make
                   up the difference—in effect, repaying funds owed to Social Security. Such
                   repayment will present a significant and growing challenge for the overall
                   federal budget. By 2029, without corrective action, the trust funds will be
                   depleted, and Social Security’s revenues will fund only 70 to 77 percent of
                   benefits.




                   Page 3                                  GAO/HEHS-97-81 Retirement Income Issues
Executive Summary




To restore Social Security’s long-term financial balance, a number of
reform options are available within the current structure of the program,
such as expanding the number of covered workers or further increasing
the retirement age. However, some proposals go beyond restoring
financial balance and call for fundamentally restructuring the Social
Security system. These proposals attempt to shift more of the
responsibility for retirement income from the federal government to
individuals.

Social Security is meant to provide only a foundation for retirement
income. Pensions, savings, and earnings also represent significant sources
of retirement income and largely determine which households have the
highest retirement incomes. Solutions to Social Security’s problems will
inevitably affect these other sources and could give them an even more
significant role. More workers will eventually receive income from
pensions because of legislative changes regarding vesting and spouse
benefits and also because of women’s increasing labor force participation.
Nevertheless, the proportion of workers covered by pensions at a given
moment has not increased substantially since 1970. In addition, the
national saving rate is at a historic low. Moreover, some trends threaten to
diminish retirement income from pensions and savings. For example,
workers increasingly borrow from their pension savings, cash out their
pensions when they change jobs, or, at retirement, take their pensions as
lump-sum payments rather than a guaranteed life annuity.

Ensuring that Americans have enough retirement income in the
twenty-first century to meet their needs will require that the nation and the
Congress make some difficult choices. Social Security has been an
effective agent for ensuring a reliable source of income in retirement and
greatly reducing poverty among the elderly. The effect of changes to the
system on other retirement income sources and their effects on various
groups within the elderly population should be well understood before
decisions are made. Further, the interplay of budget and savings effects
will have to be carefully considered before any reform proposal is
adopted.




Page 4                                  GAO/HEHS-97-81 Retirement Income Issues
                          Executive Summary




Principal Findings

Demographic and           Increasing life expectancy and declining birth rates are responsible for the
Economic Trends Present   substantial growth in the number of the elderly as a share of the total
Serious Challenges        population. The baby-boom generation will simply accelerate this trend.
                          The elderly will need retirement income over longer periods and will
                          consume an increasing share of the national output. By 2030, only two
                          workers are projected to be paying into Social Security for each person
                          receiving benefits, compared with more than three workers today,
                          according to SSA actuaries.

                          Healthy economic growth could ease the pressures of supporting more
                          retirees with fewer workers. Unfortunately, the rate of national saving and
                          the growth in real wages and productivity, factors that relate to economic
                          growth, have slowed notably in the past two decades. Even with strong
                          economic performance, decisions affecting retirement income policies still
                          have to be made and will fundamentally influence how the national output
                          will be divided. They influence how much of total compensation workers
                          consume now and how much they will consume during retirement. They
                          also influence how income is redistributed between current workers and
                          current retirees and between high earners and low earners.

                          Social Security and pension benefits have helped increase the income of
                          the elderly over the past 50 years. For example, the share of the elderly
                          living in poverty has fallen from 35 percent in 1959 to less than 11 percent
                          today. Still, pockets of poverty remain, especially among those aged 75
                          and over and among unmarried women.


Addressing Social         The growth of the elderly population as a share of the total population
Security’s Long-Term      poses serious long-term financing challenges for Social Security. In
Financing Problem         January 1997, the Social Security Advisory Council issued its report on the
                          system’s long-range financial status, but the council members could not
                          reach agreement on a comprehensive solution. Still, five individual reform
                          options enjoyed considerable support and, if enacted, would eliminate
                          about two thirds of the next 75 years’ financing shortfall. These reforms
                          would modify (1) the retirement age, (2) cost-of-living adjustments (COLA),
                          (3) the benefit formula, (4) income taxation of benefits, and (5) which
                          workers are covered under Social Security.




                          Page 5                                  GAO/HEHS-97-81 Retirement Income Issues
                            Executive Summary




                            While these reform options would work within the current structure of the
                            program, “privatization” proposals go further and would significantly
                            restructure Social Security. Such proposals would achieve financial
                            balance by raising revenues or reducing costs while pursuing other goals,
                            such as increasing national saving or giving individuals more responsibility
                            for their retirement income. For example, such proposals would typically
                            increase the role of individual retirement saving while reducing
                            government-provided benefits. For many of these privatization proposals,
                            the transition from the current program to the new system would be quite
                            expensive. The contributions needed to fund both current and future
                            liabilities would clearly be higher than those currently collected.


The Social Security Trust   Solving Social Security’s long-term financing problem would not
Fund Build-Up and the       necessarily address another significant challenge that the program
Federal Deficit             presents for the overall federal budget. Currently, Social Security cash
                            revenues exceed expenditures by roughly $30 billion each year. Under
                            current law, the Department of the Treasury issues interest-bearing
                            government securities to the trust funds for these excess revenues. In
                            effect, Treasury borrows the excess revenues and uses them to help
                            reduce the amount it must borrow from the public. Moreover, the trust
                            funds earned $38 billion in interest last year, which Treasury pays by
                            issuing more securities. If Treasury could not borrow from the trust funds,
                            it would have to borrow more in the private capital market and pay such
                            interest in cash.

                            However, 10 years from now, these excess cash revenues are expected to
                            start falling, and in just 15 years, Social Security’s expenditures are
                            expected to exceed its cash revenues. The government’s general fund will
                            have to make up the difference, in effect repaying Social Security. As a
                            result, the federal deficit will increase, unless offset by spending
                            reductions or revenue increases. In 2028, repayments from the general
                            fund to Social Security are expected to reach about $183 billion in 1997
                            dollars. In that year, this amount would equal 1.4 percent of gross
                            domestic product (GDP), which is the same share of GDP as last year’s
                            deficit for the entire federal government.


Strengthening Employer      Employer pensions and personal retirement savings are also significant
Pensions and Personal       sources of retirement income. About 47 percent of workers had private
Retirement Savings          pension coverage in 1993. Although this coverage rate has changed little
                            since the 1970s, more workers will eventually receive income from



                            Page 6                                  GAO/HEHS-97-81 Retirement Income Issues
                  Executive Summary




                  pensions because of legislative changes in the 1980s regarding vesting and
                  spouse benefits and also because of women’s increasing labor force
                  participation. Still, these changes also imply smaller average pension
                  benefits because they will reflect the shorter job tenures of these workers
                  who would not have received pensions previously. Also, joint-and-survivor
                  annuities yield smaller monthly benefits than worker-only annuities. In
                  addition, complex pension regulations may deter employers from
                  sponsoring pensions. Current proposals to expand pension coverage focus
                  on simplifying some of the regulations.

                  Efforts to increase personal savings outside pension arrangements seem to
                  have had only marginal success. Many households do not save in any
                  systematic way, and personal saving rates have declined by nearly half
                  since 1970. Preferential tax treatment for 401(k) and individual retirement
                  accounts seems to encourage saving, but such saving may substitute, at
                  least partly, for other types of saving.

                  To help meet the nation’s retirement income challenges, pensions and
                  savings must be secure and wisely managed. While tax laws discourage
                  using pension assets for nonretirement purposes, the laws do not strictly
                  prohibit such use. Some workers cash out their pension accounts when
                  they change jobs, despite penalties and tax liabilities. At retirement, most
                  take their pensions as a lump sum, which they must carefully manage to
                  provide income for the rest of their lives. In addition, most plans allow
                  workers to borrow from their accounts for specified purposes. The loan
                  option may encourage workers to contribute more to these accounts and,
                  in some cases, such as borrowing for educational expenses, could result in
                  greater retirement income security. However, if they do borrow, they may
                  reduce the savings available for retirement.

                  In the case of retirement savings and some pension plans, workers control
                  how their savings are invested. However, many workers may lack the
                  information necessary to get higher investment earnings. Research shows
                  that educating employees in how to manage their funds can increase both
                  their retirement contributions and investment returns.


                  GAO   is not making recommendations in this report.
Recommendations
                  GAOobtained comments on this report from SSA and from subject matter
Agency Comments   experts. They did not express any disagreement with the overall message




                  Page 7                                  GAO/HEHS-97-81 Retirement Income Issues
Executive Summary




of the report. They did suggest some technical corrections, which have
been incorporated as appropriate.




Page 8                                 GAO/HEHS-97-81 Retirement Income Issues
Page 9   GAO/HEHS-97-81 Retirement Income Issues
Contents



Executive Summary                                                                                 2


Chapter 1                                                                                        12
                       The Sources of Retirement Income                                          12
Introduction           Objectives, Scope, and Methodology                                        14

Chapter 2                                                                                        15
                       The Elderly Population Is Growing in Number and Proportion                15
Demographic and        Economic Trends Affect Earnings and Future Retirement Income              20
Economic Factors       The Income of the Elderly Has Improved                                    21
Affect Retirement
Income
Chapter 3                                                                                        29
                       Addressing Social Security’s Long-Term Financing Problems                 29
Social Security’s      Social Security Trust Funds and the Federal Deficit                       40
Financing Challenges
Chapter 4                                                                                        42
                       Federal Policies Promote Pension Coverage and Benefit Security            42
Private Pensions and   More Will Receive Pensions Although Coverage Has Not Grown                43
Retirement Saving        Recently
                       Efforts to Increase Personal Retirement Saving Have Not Been              46
Can Help With            Successful
Retirement Income      Will Pensions and Savings Be There for Retirement?                        47
Challenges
Chapter 5                                                                                        50

Concluding
Observations
Appendix               Appendix I: Major Contributors to This Report                             52


Related GAO Products                                                                             56


Table                  Table 2.1: Elderly Households’ Median Income by Types of                  26
                         Income and by Income Distribution, 1994




                       Page 10                               GAO/HEHS-97-81 Retirement Income Issues
          Contents




Figures   Figure 2.1: Population Aged 65 and Over, by Age Group,                    16
            1940-2050
          Figure 2.2: Trends and Projections of Life Expectancy at Age 65,          17
            1940-2060
          Figure 2.3: Historical and Projected Dependency Ratios,                   19
            1960-2040
          Figure 2.4: Median Income Levels and the Poverty Threshold,               22
            Unmarried Persons Aged 65 and Over, 1978-94
          Figure 2.5: Share of Elderly Households Receiving Various Types           23
            of Income, 1994
          Figure 2.6: Share of Elderly Households’ Income by Types of               24
            Income, 1994
          Figure 2.7: Pensions, Savings, and Earnings Determine Who Will            25
            Have Highest Retirement Incomes, 1994
          Figure 2.8: Poverty Rates by Age Group, 1959-94                           27
          Figure 3.1: Social Security’s Revenues Exceed Expenditures Now            41
            but Fall Short Later




          Abbreviations

          AIME       average indexed monthly earnings
          COLA       cost-of-living adjustment
          CPI        Consumer Price Index
          DB         defined benefit
          DC         defined contribution
          DOL        Department of Labor
          ERA        early retirement age
          ERISA      Employee Retirement Income Security Act
          GDP        gross domestic product
          IRA        individual retirement account
          IRS        Internal Revenue Service
          NRA        normal retirement age
          PBGC       Pension Benefit Guaranty Corporation
          PIA        primary insurance amount
          SEP        simplified employee pension
          SIMPLE     savings incentive match plan for employees
          SSA        Social Security Administration
          TSP        Thrift Savings Plan


          Page 11                               GAO/HEHS-97-81 Retirement Income Issues
Chapter 1

Introduction


                    As the U.S. population ages, there will be growing pressures on Social
                    Security and pension programs to provide retirees with the retirement
                    income they need. For more than 60 years, the Social Security program
                    has helped protect America’s elderly from living in poverty, but it now
                    faces a long-term financing problem. Proposals to address the problem are
                    wide-ranging, and many, if adopted, could fundamentally change the
                    nation’s retirement system.


                    When individuals retire from their principal employment, they may receive
The Sources of      income from one or more of several sources, primarily Social Security,
Retirement Income   pensions, personal savings, and earnings from subsequent work. Federal
                    policies play a major role in all these sources of retirement income.
                    Moreover, they affect how income is distributed between workers and
                    retirees, between high and low earners, and between individuals’ working
                    and retirement years.

                    The Social Security Act was signed into law by President Franklin D.
                    Roosevelt in August 1935 in response to the crisis Americans faced during
                    the Great Depression. The retirement component of the act initially
                    provided benefits upon retirement to workers in commerce and industry
                    who had contributed to the program over a portion of their working lives.

                    Social Security was meant to provide a retirement income foundation
                    upon which individuals could build for their retirement years. It was a
                    social insurance program. Over the years, the size and scope of the
                    program has changed. In 1939, coverage was extended to provide benefits
                    for some family members and survivors. In the 1950s, state and local
                    governments were given the option of covering their employees. The
                    Disability Insurance program was added in 1956, providing income for
                    disabled workers. The Medicare program was added in 1965. Beginning in
                    1975, benefits were automatically tied to the Consumer Price Index (CPI) to
                    ensure that the purchasing power of recipients’ income was not eroded by
                    inflation.

                    Because the Social Security program was designed as a pay-as-you-go
                    system with current benefits paid out of current income (primarily from
                    payroll taxes), it experienced periodic financing difficulties as coverage
                    and benefits increased and as the number of retirees increased relative to
                    the number of contributors. Payroll taxes increased from an initial
                    2 percent on the first $3,000 of earnings (1 percent each from employers




                    Page 12                                GAO/HEHS-97-81 Retirement Income Issues
Chapter 1
Introduction




and employees) to 12.4 percent on the first $65,400 of earnings today. For
many Americans, the payroll tax is now the largest tax they pay.

Some of the increases in payroll taxes were always anticipated as a natural
result of the maturing of the Social Security system and its pay-as-you-go
financing. The first benefits were paid only to individuals who had already
made some contributions to the system. In the early years, a very small
share of the elderly qualified for benefits, and larger payroll taxes were not
required. As more and more of the elderly received benefits, higher payroll
taxes were required. While such increases had always been anticipated,
some of the payroll tax increases resulted from benefit increases,
especially cost-of-living adjustments, and eligibility expansion such as
survivor and disability benefits.

Pensions are the second major source of retirement income. Private
pensions grew rapidly in popularity between 1900 and 1920 until about one
worker in six was covered—typically those working in the transportation,
banking, mining, utility, and manufacturing industries. Pension coverage
basically held its own during the Great Depression and again grew rapidly
between 1940 and 1960 and continued to increase into the 1970s when
coverage leveled off at just under half the workforce. Workers nearing
retirement are the most likely to have pension coverage.

The federal government has an interest in promoting expanded pension
coverage of workers so they can better meet their retirement income
needs and because expanded coverage increases national saving. In
addition, the Employee Retirement Income Security Act of 1974 (ERISA)
focused new attention on making pension promises more explicit and
benefits more secure. This act established guidelines for operating pension
funds and set specific requirements for various pension plan provisions.
These new rules and subsequent regulations have raised the costs of
employer-provided defined benefit plans and have affected the growth of
defined contribution plans, including 401(k) plans. Under defined
contribution plans, the benefits are not certain, as they are under defined
benefit plans; they vary depending on the level of contributions made to
the pension and the performance of the investment portfolio.

The rate of personal saving, the third source of retirement income, is at a
historic low. Moreover, the very low rate of national saving has raised
concern among many economists about the long-term effects on national
economic growth because saving helps spur investment, which in turn
contributes to economic growth.



Page 13                                  GAO/HEHS-97-81 Retirement Income Issues
                     Chapter 1
                     Introduction




                     Finally, the last source of retirement income, employment earnings, may
                     become increasingly important if the other sources fail to provide
                     sufficient income to meet the needs of future retirees. Federal policies
                     affect such earnings in that Social Security provisions affect when workers
                     retire and how much they choose to earn after retirement. Also, federal
                     policies regarding health insurance, whether concerning Medicare,
                     Medicaid, or employer-provided retiree health insurance, influence when
                     workers retire.


                     The Chairman and Ranking Minority Member of the Senate Special
Objectives, Scope,   Committee on Aging asked us to review current and emerging issues
and Methodology      relating to retirement income. First, we identified the economic and
                     demographic trends affecting retirement income. Second, we examined
                     the status of Social Security’s long-term financing problems and proposals
                     to address it. Third, we examined the extent of pension coverage and
                     retirement saving and how to ensure that retirees can count on them
                     throughout retirement.

                     In conducting this study, we reviewed the literature and public record
                     relating to retirement income policy. We also examined data on retirement
                     income sources and the demographics of the elderly population. Our data
                     sources included official Social Security data, especially from the 1996
                     Trustees’ Report, Census data, and data from the Health and Retirement
                     Survey, prepared by the University of Michigan Survey Research Center.
                     We looked at relevant legislation and proposals affecting retirement
                     income. We discussed retirement income issues with several experts from
                     government, research institutes, and benefit consulting firms. We
                     conducted our work between March 1996 and May 1997, using generally
                     accepted government auditing standards.




                     Page 14                                GAO/HEHS-97-81 Retirement Income Issues
Chapter 2

Demographic and Economic Factors Affect
Retirement Income

                        The U.S. elderly population has tripled since 1940 and will more than
                        double again by 2050, according to Census projections, and is accounting
                        for a growing share of the total population.1 As people live longer and have
                        fewer children, the number of workers per retiree is declining. Moreover,
                        the elderly will consume an increasing share of the national output. A
                        healthy rate of real economic growth could help ease the pressures
                        created by these challenges, but the prospects for such growth are
                        unclear. Whatever the outcome, federal retirement policies will help
                        determine how national income will be distributed. In fact, the growth in
                        Social Security and private employer pensions since 1940 has contributed
                        substantially to increasing income and reducing poverty among the
                        elderly.


                        In the United States, the elderly population grew from about 9 million in
The Elderly             1940 to about 34 million in 1995, and it is expected to reach 80 million by
Population Is Growing   2050, according to Census projections.2 Moreover, the very old population
in Number and           (those aged 85 and over) is expected to increase fivefold, from about
                        4 million in 1995 to nearly 19 million in 2050. (See fig. 2.1.) As a share of
Proportion              the total U.S. population, the elderly population grew from 7 percent in
                        1940 to 12 percent in 1990; this share is expected to increase to 20 percent
                        by 2050. Other nations, both developed and developing, are experiencing
                        similar and often more pronounced trends.




                        1
                         In this report, we use “elderly” to refer to people aged 65 and over. However, the “retired” population
                        is not so clearly defined; many retire before reaching age 65 and some continue working afterward. We
                        use age 65 primarily because age group data often use age 65 as a break point.
                        2
                         In its population projections, Census uses alternative assumptions of high, middle, and low rates of
                        fertility, mortality, and immigration. These projections reflect the middle assumptions set. Some
                        demographers project even more dramatic growth in the elderly population than Census or Social
                        Security actuaries do. In particular, the 1994-96 Social Security Advisory Council’s Technical Panel on
                        Assumptions and Methods noted that Social Security’s mortality assumptions reflect a lower rate of
                        mortality improvements than may be warranted.



                        Page 15                                                GAO/HEHS-97-81 Retirement Income Issues
                                            Chapter 2
                                            Demographic and Economic Factors Affect
                                            Retirement Income




Figure 2.1: Population Aged 65 and Over, by Age Group, 1940-2050

Population (Millions)

80




60




40




20




  0
  1940                  1960         1980                  2000                  2020                 2040


       85+
       75-84
       65-74


                                            Note: Data for 2000-2050 are midrange Census projections.

                                            Source: U.S. Bureau of the Census, 65+ in the United States (Washington, D.C.: 1996).




                                            Although the baby-boom generation will contribute heavily to the growth
                                            of the elderly population, other demographic trends are also important.
                                            Increasing life expectancy, for example, is another major factor. Figure 2.2
                                            shows that life expectancy has increased continually since the 1930s and
                                            that further improvements are expected. In 1940, the life expectancy of
                                            persons at age 65 was 12 years for men and 13 years for women. By 1995,
                                            life expectancy at aged 65 improved to 15 years for men and 19 for women




                                            Page 16                                             GAO/HEHS-97-81 Retirement Income Issues
                                                 Chapter 2
                                                 Demographic and Economic Factors Affect
                                                 Retirement Income




                                                 and, by 2040, it is projected to be 17 years and 21 years, respectively,
                                                 according to SSA’s intermediate actuarial assumptions.3



Figure 2.2: Trends and Projections of Life Expectancy at Age 65, 1940-2060

Years

25

                                                                                                          21.8
                                                                                           21
                                                                           20.1
20                                                          19.4
                                          18.4                                                      18
                                                                                    17.3
                                                                    16.5
                              15.9                   15.6
15                                   14
                13.4
                       12.9
         11.9

10




 5




 0
           1940          1960         1980             2000           2020            2040            2060


        Men

        Women


                                                 Note: Projections for 2000-2060 are based on the trustees’ intermediate actuarial assumptions.

                                                 Source: 1996 Annual Report of the Board of Trustees of the Federal Old Age and Survivors
                                                 Insurance and Disability Insurance Trust Funds.




                                                 A falling fertility rate is the other principal factor underlying the growth in
                                                 the elderly’s share of the population. Fertility rates rose from about 2.2
                                                 children per woman in 1940 to a peak of about 3.6 children per woman

                                                 3
                                                  For the annual report of the Board of Trustees for the Social Security Trust Funds, SSA actuaries
                                                 project future revenues and benefits. For these projections, they use alternative assumptions regarding
                                                 economic and demographic trends, including average earnings, mortality, fertility, and immigration.
                                                 The intermediate assumptions represent the board’s best estimate of future trends.



                                                 Page 17                                                 GAO/HEHS-97-81 Retirement Income Issues
Chapter 2
Demographic and Economic Factors Affect
Retirement Income




around 1960. Since then, the rate has declined to around 2.0 children per
woman today and is expected to level off at about 1.9 by 2020, according
to SSA’s intermediate assumptions.

The dependency ratio, the number of working-age adults (aged 20 to
64) divided by the number of elderly adults, illustrates the society’s
increasing burden of supporting the elderly. The dependency ratio
declined from 5.8 in 1960 to 4.7 in 1995 and is expected to decline further
to 2.7 in 2040. Looking just at Social Security, there were 3.3 workers for
each aged or disabled beneficiary in 1995, but by 2030, there are expected
to be only 2.0 workers for each beneficiary. (See fig. 2.3.)




Page 18                                   GAO/HEHS-97-81 Retirement Income Issues
                                          Chapter 2
                                          Demographic and Economic Factors Affect
                                          Retirement Income




Figure 2.3: Historical and Projected Dependency Ratios, 1960-2040

Dependency Ratio
6




5




4




3




2




1
1960         1970           1980   1990         2000          2010           2020           2030          2040


          Aged
          Social Security


                                          Note: Here, the “aged” dependency ratio is the number of people aged 20-64 per aged person
                                          (aged 65 and over). The Social Security dependency ratio is the number of workers paying Social
                                          Security taxes per aged or disabled beneficiary. Projections use SSA’s intermediate actuarial
                                          assumptions.

                                          Source: 1996 Annual Report of the Board of Trustees of the Federal Old Age and Survivors
                                          Insurance and Disability Insurance Trust Funds.




                                          In the future, there will be relatively fewer younger persons to work and
                                          support a growing number of aged retirees unless retirement patterns
                                          change. In particular, there will be relatively fewer workers to pay the
                                          Social Security taxes needed to fund benefits.4 At the same time, Social
                                          Security, pensions, and other retirement income will have to provide
                                          income over longer periods as life expectancies rise. As a result,

                                          4
                                           Social Security benefits are expected to increase from 4.7 percent of gross domestic product today to
                                          6.4 percent in 2030, according to SSA’s intermediate projections.



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                      contributions to Social Security and to pension plans must increase or
                      benefits must be reduced or both. Yet increasing payroll taxes or
                      constraining wage growth could make it harder for workers to save for
                      their own future, while cutting benefits will increase their need to save.


                      Our nation’s ability to meet its retirement income challenges depends
Economic Trends       substantially on how well the economy performs. Retirement contribution
Affect Earnings and   rates and benefit levels mostly affect how the nation’s output—its
Future Retirement     economic pie—will be divided. High rates of economic growth would
                      increase the size of the pie. In particular, growth in inflation-adjusted
Income                wages (real wages) affects all types of retirement income. Earnings largely
                      determine Social Security and pension benefit amounts and affect how
                      much workers can or want to save. In addition, real wage growth
                      increases the ability and possibly the willingness of workers to absorb any
                      tax increases or benefit cuts that might be necessary for Social Security’s
                      long-term financial balance.

                      Unfortunately, real wage growth has slowed over the last two decades,
                      largely reflecting slowing productivity growth. This contrasts with the 25
                      years after World War II when the standard of living doubled, helping
                      improve the economic status of today’s elderly relative to that of previous
                      generations. However, various measures of real wage growth exist.
                      Measures that incorporate fringe benefits, such as pensions, and that use
                      different inflation estimates suggest that real compensation has slowed
                      but not necessarily stagnated.5

                      As long as real wage growth is positive, living standards do improve. In
                      fact, a Congressional Budget Office study reports that both the real
                      incomes and wealth of the baby-boom generation are notably better than
                      those of their parents at a similar age.6 Positive real wage growth,
                      increasing labor force participation by women, and changes in ERISA rules
                      in 1986 that increased the number of workers who will ultimately receive a
                      pension all contribute to the prospect of higher inflation-adjusted
                      retirement incomes for the baby-boom generation.

                      Income inequality, which has implications for the distribution of
                      retirement income, has widened in recent years. For example, in 1979, of
                      male workers 25 years old and older, the top tenth earned 3.2 times more

                      5
                       Daniel Sullivan, “Trends in Real Wage Growth,” Chicago Fed Letter, No. 115 (Mar. 1997).
                      6
                       Congressional Budget Office, Baby Boomers in Retirement: An Early Perspective, (Washington, D.C.:
                      Sept. 1993).



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                       than the bottom tenth, but by 1993, the top tenth was earning 4.1 times as
                       much as the bottom tenth. Explanations for this include, among others, an
                       increased demand for a relatively small number of highly skilled workers
                       as a result of technological change. At the same time, the part of the
                       service sector that employs relatively low-skilled workers has also grown.
                       For persons at the low end of the income distribution, their retirement
                       incomes will be lower, and more of them might qualify for means-tested
                       income support and other programs available to the elderly poor.


                       Since 1940, Social Security, pensions, and savings have dramatically
The Income of the      improved the income of the elderly. Accordingly, poverty rates for the
Elderly Has Improved   elderly have declined substantially, but pockets of poverty remain. Social
                       Security provides a strong foundation of retirement income, but pensions,
                       savings, and earnings determine which households will be relatively better
                       off in their retirement years. Figure 2.4 shows the increase in total income
                       and Social Security benefits for the elderly relative to the poverty
                       threshold. Because the threshold varies by household composition, this
                       figure uses unmarried persons aged 65 and over only as an example.7




                       7
                        About 60 percent of elderly households were nonmarried persons. Of these, 77 percent were
                       nonmarried women. In contrast to nonmarried persons, married couples received median Social
                       Security benefits that exceeded the poverty line in each year and by an increasing amount. This
                       reflects the lower poverty rates of married couples.



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Figure 2.4: Median Income Levels and the Poverty Threshold, Unmarried Persons Aged 65 and Over, 1978-94

Income (Dollars)

12,000




10,000




 8,000




 6,000




 4,000




 2,000
     1978          1980       1982    1984         1986         1988         1990        1992         1994



            Total Retirement Income
            Social Security
            Poverty Line


                                             Source: Susan Grad, Income of the Population 55 and Over (Washington, D.C.: SSA, Office of
                                             Research and Statistics, 1981-96).




Sources of Retirement                        In 1994, about 91 percent of all elderly households received Social Security
Income                                       benefits, 67 percent received some income from saved assets, just over
                                             40 percent received pensions, and 21 percent received earned income.
                                             (See fig. 2.5.) The percentage of elderly persons receiving Social Security
                                             benefits has remained stable over the past 20 years while the share
                                             receiving income from assets and pensions has increased by about
                                             10 percentage points each. The percentage receiving income from earnings
                                             has fallen slightly, reflecting the reduced labor force participation of
                                             elderly men.




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Figure 2.5: Share of Elderly Households Receiving Various Types of Income, 1994

Percentage of Elderly Households

100
                   91



 80


                                       67

 60



                                                                     42
 40



                                                                                                 21
 20




  0
             Social Security         Savings                      Pensions                    Earnings

                                            Source: Susan Grad, Income of the Population 55 or Older, 1994 (Washington, D.C.: SSA, Office
                                            of Research and Statistics, 1996).




                                            Social Security benefits contribute the most to the elderly’s aggregate cash
                                            income, accounting for 42 percent. (See fig. 2.6.) The three other sources
                                            contribute about 18 percent each to aggregate elderly income, even though
                                            the share of elderly households receiving each type of income varies
                                            considerably. Their contributions to aggregate income have fluctuated.
                                            For example, savings have ranged between 18 and 28 percent of total
                                            elderly income since 1978.




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Figure 2.6: Share of Elderly
Households’ Income by Types of
Income, 1994                                                           Social Security
                                                                       42%




                                 Savings
                                    18%                                                        Other
                                                                                               4%




                                                                                            Earnings
                                                                                            18%


                                                  Pensions
                                                      19%


                                 Source: Susan Grad, Income of the Population 55 or Older, 1994 (Washington, D.C.: SSA, Office
                                 of Research and Statistics, 1996).




                                 While Social Security provides a strong foundation for retirement income,
                                 it is only a foundation. In 1994, Social Security provided an average of
                                 roughly $9,200 to all elderly households. Figure 2.7 and table 2.1 show the
                                 dollar contributions from each source of elderly income by income level
                                 for 1994. Social Security’s contribution plateaued at roughly $10,000 in the
                                 highest three quintiles. Social Security provided 81 percent of the
                                 aggregate income for each of the bottom two fifths of the income
                                 distribution but just 23 percent for the top fifth. The second largest source
                                 of income for those in the bottom fifth was public assistance, which
                                 provided about 11 percent of their total income. Pensions, savings, and
                                 earnings determine which households have the highest retirement
                                 incomes. They each contributed an average of more than 20 percent of
                                 income to the top fifth of the income distribution but less than 4 percent to
                                 the lowest fifth. Saved assets, for example, provided income to more than
                                 90 percent of elderly households in the top fifth but to only 30 percent in
                                 the lowest fifth.




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Figure 2.7: Pensions, Savings, and Earnings Determine Who Will Have Highest Retirement Incomes, 1994

Elderly Household Income (Dollars)
50,000
                                                                                              45,000


40,000




30,000

                                                                         23,605

20,000
                                                      15,075

                                     9,785
10,000
                 5,665


     0
                 First               Second            Third             Fourth                Fifth
                                              Income Level (Quintile)

          Other
          Earnings
          Pensions
          Savings
          Social Security


                                               Note: Median incomes for each quintile are GAO estimates. Social Security income for the highest
                                               fifth may be lower than for the previous fifth because, among other possible reasons, some
                                               elderly workers or their spouses may not yet be collecting benefits.

                                               Source: GAO analysis of data from Susan Grad, Income of the Population 55 and Older, 1994
                                               (Washington, D.C.: SSA, Office of Research and Statistics, 1996).




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Table 2.1: Elderly Households’ Median
Income by Types of Income and by                                                      Income level (quintile)
Income Distribution, 1994                                           First        Second              Third           Fourth             Fifth
                                        Social Security           $4,600           $7,936           $9,934          $11,401          $10,215
                                        Savings                      153              528            1,553            3,399           10,980
                                        Pensions                     181              724            2,126            5,642            9,495
                                        Earnings                       11             215              935            2,573           12,825
                                        Other                        720              382              528               590           1,485
                                        Total                     $5,665           $9,785          $15,075          $23,605          $45,000
                                        Note: Median incomes for each quintile are estimates. Social Security income for the highest fifth
                                        may be lower than for the previous fifth because, among other possible reasons, some elderly
                                        workers or their spouses may not yet be collecting benefits. Totals may not add because of
                                        rounding.

                                        Source: GAO analysis of data from Susan Grad, Income of the Population 55 and Older, 1994
                                        (Washington, D.C.: SSA, Office of Research and Statistics, 1996).




The Poverty of the Elderly              Poverty rates for the elderly declined dramatically from 35 percent in 1959
Has Declined, but Pockets               to under 11 percent in 1995. (See fig. 2.8) In 1994, 11.7 percent of persons
Remain                                  aged 65 and over were poor compared with 11.9 percent of adults aged
                                        18-64 and 21.2 percent of children under 18.8




                                        8
                                         The poverty threshold in 1994 was $8,967 for a two-person elderly household with no related children.
                                        The poverty index is based solely on money income and does not reflect noncash benefits such as food
                                        stamps, Medicaid, and public housing.



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Figure 2.8: Poverty Rates by Age Group, 1959-94

Percentage of Population

40




30




20




10




 0
 1959           1964          1969            1974            1979             1984              1989              1994


         Adults 65+
         Children <18
         Adults 18-64
         Data Not Available
         1959 Data

                                          Note: Estimates for adults 65+ and adults 18-64 are not available for 1960-65.

                                          Source: U.S. Bureau of the Census.




                                          Social Security has contributed substantially to reducing poverty among
                                          the elderly.9 Excluding Social Security benefits, the incomes of about
                                          54 percent of persons aged 65 or older would have been below the poverty
                                          threshold in 1994.10 Still, even with various government benefits, almost

                                          9
                                           Means-tested public assistance programs such as Supplemental Security Income, Food Stamps,
                                          Medicaid, and housing programs also attempt to alleviate poverty for the elderly and others. While
                                          these programs are beyond the scope of this report, they are an integral part of income support
                                          policies for the poor, including the elderly. Changes in retirement income policy implicitly affect these
                                          programs as well as the poverty of the elderly.
                                          10
                                              However, without Social Security, people might save more or continue working.



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                        30 percent of elderly households are poor or near-poor; here, the
                        “near-poor” are persons with incomes between 100 and 150 percent of the
                        poverty threshold.

                        Poverty tends to affect particular subgroups of the elderly population
                        disproportionately. For persons 75 and older in 1992, 35 percent were poor
                        or near-poor, roughly the same percentage as for children. Poverty status
                        also varies significantly by gender and marital status. Single, widowed, or
                        divorced women are much more likely to live in poverty than couples or
                        unmarried men. About 22 percent of unmarried women aged 65 or older
                        are poor, compared with 15 percent of unmarried men and 5 percent of
                        married couples. Unmarried women make up over 70 percent of poor
                        elderly households.


Health Costs Demand a   Health care costs are substantially greater for the elderly than for others
Growing Share of        and place growing demands on their incomes, even with public and private
Retirement Income       health care insurance. Out-of-pocket health costs consumed 21 percent of
                        elderly household income in 1994, according to an analysis of the 1987
                        National Medical Expenditure Survey and data from other government and
                        insurance industry sources.11 The 1994 values were projected from the
                        1987 survey data, using trend data from other sources. The elderly pay
                        42 percent of their noninstitutional health costs, not including premiums.12
                        Including premiums, the elderly’s out-of-pocket health costs in 1994 were
                        projected to average $2,519 per person, which is nearly four times greater
                        than for the nonelderly. After adjusting for inflation, the elderly spent
                        more than twice as much in 1991 on out-of-pocket costs as they did before
                        Medicare was enacted in 1965.




                        11
                          Out-of-pocket expenses include premiums, deductibles, and copayments as well as costs not covered
                        by insurance at all. However, the data presented here do not include Medicare Part A insurance
                        premium contributions. AARP Public Policy Institute and the Urban Institute, Coming Up Short:
                        Increasing Out-of-Pocket Health Spending by Older Americans, No. 9507 (Washington, D.C.:
                        Apr. 1995).
                        12
                          In the case of long-term care, consumers paid 33 percent of the costs out-of-pocket in 1993.



                        Page 28                                                GAO/HEHS-97-81 Retirement Income Issues
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Social Security’s Financing Challenges


                           Social Security plays a major role in providing retirement income. It pays
                           benefits to more than 90 percent of elderly households and provides more
                           than 40 percent of total elderly income. However, the elderly population is
                           growing in both number and proportion, and as a result, the program faces
                           serious long-term financing problems. Because of previous efforts to
                           address long-term financing issues, the Social Security trust funds are
                           building up substantial reserves to help pay future benefits. These reserves
                           are invested in government securities. However, drawing down the trust
                           funds will have significant implications for the federal budget when the
                           time comes to do so.


                           Although Social Security’s revenues currently exceed its expenditures,
Addressing Social          revenues are expected to be about 14 percent less than total projected
Security’s Long-Term       expenditures over the next 75 years. In 2031, the last members of the
Financing Problems         baby-boom generation will reach age 67, when they can receive full
                           retirement benefits under current law. In 2029, the Social Security trust
                           funds are projected to be depleted. In 2030 and each year thereafter, Social
                           Security revenues are expected to be sufficient to pay only 70 to
                           77 percent of benefits, given current law and SSA’s intermediate
                           assumptions about demographic and economic trends.

                           Restoring Social Security’s long-term financial balance will require some
                           combination of increased revenues and reduced expenditures.13 A variety
                           of options is available within the current structure of the program.
                           However, some proposals would fundamentally alter the structure of the
                           Social Security program. These more dramatic changes go beyond
                           restoring financial balance and attempt to achieve other policy objectives
                           as well.

                           In addition to ensuring program solvency, a variety of policy objectives
                           underlie Social Security’s program structure or proposals to reform it,
                           such as

                       •   helping ensure that the elderly do not live in poverty;
                       •   promoting benefit “equity”—that is, reducing the variation in the implicit
                           rates of return that participants receive on their contributions;
                       •   giving individuals greater control and responsibility for their retirement
                           income;
                       •   increasing personal and national saving; and

                           13
                             Decreasing the administrative costs of the program will not save much money. Current
                           administrative expenditures are less than 1 percent of program expenditures for Old Age and Survivors
                           Insurance.



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                        •   reducing future federal budget deficits.

                            In addition, financing reforms could affect the nation’s economy in various
                            ways. For example, increasing national saving or reducing tax burdens
                            could promote economic growth. Reforms that would invest Social
                            Security revenues in the stock market or require increased federal
                            borrowing could affect stock prices and bond interest rates. Raising the
                            retirement age could affect the labor market for elderly workers.

                            Reforms would have effects on other sources of retirement income and
                            related public policies as well. For example, increasing payroll taxes could
                            affect the ability of workers to save for retirement. Raising Social
                            Security’s retirement age or cutting its benefit amounts could increase
                            costs for private pensions that adjust benefits in relation to Social Security
                            benefits. They would also interact with other income support programs
                            such as Social Security’s disability insurance or the Supplemental Security
                            Income public assistance program.

                            Reforms could have both immediate effects and effects far into the future.
                            For example, bringing newly hired state and local government workers
                            into the Social Security system would immediately increase revenues but
                            would increase benefit payments only when the newly covered workers
                            retire. However, even changes that take effect years from now can affect
                            how workers plan for their retirement now, especially how much they
                            choose to save. Therefore, the sooner solutions are enacted, the more time
                            workers will have to adjust their retirement planning. Acting sooner rather
                            than later also means that the funding shortfall can be addressed over a
                            longer period at a lower annual cost.

                            Finally, any financing reforms would implicitly have distributional effects.
                            For example, increasing Social Security taxes would reduce the disposable
                            income of current workers but would help sustain retirement benefits for
                            current retirees and possibly for themselves when they retire. Cutting
                            benefits instead of increasing payroll taxes would have the opposite
                            distributional effect. Also, Social Security redistributes income from high
                            to low earners to some degree; some reforms would change this
                            redistribution.


Options Within Social       A wide range of options is available for reducing costs or increasing
Security’s Current          revenues within the current structure of the Social Security program.
Structure                   Previously enacted reforms have used many of these in some form.



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                                  Current reform proposals also rely, at least in part, on many of these more
                                  traditional measures, regardless of whether the proposals largely preserve
                                  the current program structure or alter it significantly.

                                  Examples of reducing program expenditures include

                              •   reducing initial benefits by changing the benefit formula for all or some
                                  beneficiaries;
                              •   raising the retirement age, which implicitly reduces initial benefits;
                              •   lowering or eliminating the annual COLAs; and
                              •   means-testing benefits.

                                  Examples of increasing revenues include

                              •   increasing income taxes on Social Security benefits,
                              •   increasing Social Security payroll taxes, and
                              •   investing trust funds in the stock market.

Reducing Initial Benefits         One way to reduce benefits would be to modify the formula used to
Through the Benefit Formula       determine benefit amounts for each retired or disabled recipient.
                                  Determining benefit amounts starts by computing a measure of average
                                  lifetime earnings. For each year, the worker’s covered earnings are
                                  updated, or indexed, to reflect the change in average earnings for the
                                  national economy.14 For retired worker benefits, the average is computed
                                  using the highest 35 years of indexed earnings. Some propose increasing
                                  the computation period to 38 years.15 Because the current formula uses the
                                  years with the highest earnings, additional years would be those with
                                  lower earnings and would thereby lower the average. This change would
                                  likely decrease benefits more for women than for men, because women
                                  usually have more years with zero earnings.




                                  14
                                    Noncovered earnings include any over the maximum taxable earnings ($65,400 per year for 1997) and
                                  any earnings in noncovered employment. Changes in average earnings reflect changes in real wages as
                                  well as wage inflation. Therefore, this indexing captures some of the improvement in the standard of
                                  living.
                                  15
                                   For example, the Ball proposal included in the recent Social Security Advisory Council Report. (See
                                  “Current Proposals Mix Several Elements.)



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                             In addition, the benefit formula provides that benefits are higher for
                             workers with higher lifetime earnings but less than proportionately so.16
                             This “progressive” formula redistributes income from high earners to low
                             earners to help keep low earners out of poverty. At the same time, the
                             formula attempts to maintain some degree of equity for higher earners by
                             providing that benefits increase somewhat with earnings. The specific
                             parameters of the formula implicitly reflect a particular balance between
                             these adequacy and equity concerns.

                             Modifying the formula could include changing the parameters that
                             determine the progressivity of the formula. Such changes could reduce
                             benefits for high earners but leave low earners’ benefits unchanged.
                             However, this could raise equity concerns because high earners would get
                             lower benefits relative to their earnings than they do now. Alternatively,
                             parameter changes could reduce benefits across the board, which could
                             raise concerns that persons with the lowest benefits might not get the
                             retirement income they need.

                             In addition, initial benefits could be reduced by changing the adjustments
                             for early or delayed retirement. Such changes should increase the
                             incentive to postpone retirement and continue working.

Raising the Retirement Age   Raising the retirement age would reduce benefit costs and could involve
                             increasing the normal retirement age (NRA), the early retirement age (ERA),
                             or both. The appropriate age for retirement has arguably changed because
                             life expectancy has increased and the health of the elderly has improved.
                             However, these improvements have been enjoyed primarily by those with
                             higher education and socioeconomic status.

                             Under current law, persons who retire before the NRA receive reduced
                             benefits; those who retire after the NRA receive increased benefits.
                             Therefore, raising the retirement age implicitly has the effect of reducing
                             initial benefits for all retirees. For example, under current law, persons
                             who retire at today’s NRA of 65 would get the basic benefit amount, without
                             adjustments for either early or delayed retirement. As the NRA increases to
                             age 67, persons who still retire at age 65 will have their basic benefits
                             reduced for early retirement. Those in the same age group who retire at


                             16
                               Specifically, the “primary insurance amount” (PIA) is the full monthly benefit payable to retired
                             workers at age 65 or to disabled workers when first entitled. For those entitled to benefits in 1997, the
                             PIA equals (1) 90 percent of the first $455 of average indexed monthly earnings (AIME), plus
                             (2) 32 percent of the next $2,286 of AIME, plus (3) 15 percent of AIME over $2,741. The bend points in
                             this formula (dollar amounts of AIME defining each bracket) are indexed to increases in average
                             national earnings.



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                 other ages would see larger reductions for early retirement or smaller
                 increases for delayed retirement than they would under current law.

                 Raising the ERA as well as the NRA would eliminate retired worker benefits
                 entirely until workers reach the new ERA. More than 50 percent of newly
                 retired workers currently receive benefits at age 62, and more than two
                 thirds retire before age 65. Therefore, the cost savings from increasing the
                 ERA would be substantial. However, some workers who would have retired
                 before age 65 would still qualify for Social Security under the Disability
                 Insurance program.

                 Reforms relating to the retirement age could provide incentives to work
                 longer, but their effects also depend to some degree on the labor market’s
                 response. Having people work longer would help with the demographic
                 problem of the declining ratio of workers to retirees. Working longer could
                 increase workers’ Social Security and pension benefits and allow them to
                 increase their savings rather than spend them. Still, it remains unclear
                 whether workers will want to work longer, whether they will need to
                 because of benefit reductions, and whether employers will provide
                 attractive opportunities to continue working rather than incentives to
                 retire early. In recent years, workers have been retiring earlier, not later,
                 and not always by choice. Less than one sixth of men aged 65 and over are
                 in the labor force today, compared with nearly half in 1950.

Reducing COLAs   Since 1975, Social Security benefits have been automatically increased to
                 keep pace with inflation and maintain their purchasing power. However,
                 some believe that the CPI, which is used to determine COLAs, overstates the
                 true inflation rate. A recent report estimated that the CPI exceeds the true
                 inflation rate by about 1 percentage point.17 If the CPI overstates inflation,
                 then Social Security COLAs increase benefits too much. Moreover, COLAs are
                 costly. Social Security currently pays about $350 billion in benefits;
                 therefore, each 1-percent COLA raises outlays $3.5 billion. COLA increases
                 and any errors in them are cumulative, with each year’s adjustment
                 compounding the previous years’ adjustments. For the same reason,
                 however, COLA reductions would have a compound effect on benefits.
                 Many retirees rely on Social Security COLAs to help keep up with inflation
                 because most pensions have no inflation adjustments or only partial ones.

                 Proposals to modify the COLA include the following: making technical
                 adjustments to the CPI itself; limiting COLAs, for example, by using the CPI

                 17
                  Advisory Commission to Study the Consumer Price Index, “Toward a More Accurate Measure of the
                 Cost of Living,” Final Report to the Senate Finance Committee, Dec. 1996.



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                                minus 1 percentage point or capping the COLA at, say, 2.5 percent; delaying
                                the COLA for a specified number of years or until cumulative inflation
                                reaches, say, 5 percent since the last adjustment; eliminating the COLA; or
                                limiting a full COLA to persons with relatively low benefits.

Means-Testing Benefits          Means-testing Social Security benefits would also reduce program costs
                                and direct benefits to persons who need them most. It would reduce
                                benefits for those with incomes above a certain threshold or from
                                specified sources, such as other pensions. However, persons losing
                                benefits would tend to be those who pay the highest Social Security taxes
                                and already implicitly receive the lowest rates of return on their
                                contributions. Means-testing would further reduce benefit equity for them
                                and could diminish whatever political support they give to the system.
                                Means-testing could raise perceptions of Social Security as a welfare
                                program rather than a program that ensures a basic retirement income to
                                persons who work and contribute to the system their entire working lives.

                                Means-testing could also be applied specifically to dependents’ benefits.18
                                Social Security provides benefits for spouses and children of retired,
                                disabled, and deceased workers. For example, eligible spouses currently
                                receive a benefit based on half the worker’s basic benefit, regardless of the
                                worker’s benefit amount.

Increasing Income Taxes on      In a sense, income taxes on Social Security benefits already provide a
Social Security Benefits        limited means test. Social Security benefits are subject to income taxes if
                                current income exceeds $25,000 for a single person or $32,000 for a
                                married couple. Also, taxes currently apply to only a portion of benefits,
                                up to 85 percent of them, depending on adjusted gross income. Modifying
                                these provisions further, by making 100 percent of benefits subject to
                                income tax above certain income levels, for example, would have an effect
                                similar to a means-tested benefit reduction.

Increasing Revenues From        The Social Security payroll tax provides about 90 percent of the system’s
Social Security Payroll Taxes   revenue, and increasing the payroll tax rate is the most obvious way to
                                increase revenues. However, for many people, the Social Security tax is
                                already the largest tax they pay. According to SSA’s intermediate actuarial
                                assumptions, increasing the payroll tax rate from 12.4 to 14.6 percent for
                                1996 and subsequent years would have restored financial balance for the

                                18
                                 In 1995, about 43 million people were receiving Social Security benefits, of which 3.3 million were
                                spouses, 5.5 million were widows or widowers, and 3.7 million were children. Half of children
                                beneficiaries were children of deceased workers and more than a third were children of disabled
                                workers. About 27 million of the beneficiaries were retired workers, and more than 4 million were
                                disabled workers.



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                               next 75 years.19 Increasing the payroll tax rate would cause all covered
                               workers and their employers to pay more taxes, but workers would
                               receive no increase in benefits from paying these additional taxes. Also, by
                               reducing workers’ disposable income, such tax increases would make it
                               more difficult for some workers to save.

                               Enlarging the Social Security tax base would also increase payroll tax
                               revenues. For example, the maximum earnings subject to the payroll tax
                               are $65,400 per year in 1997.20 Increasing the earnings subject to the
                               payroll tax would increase taxes for a relatively few high earners (about
                               6 percent of all workers). In addition, about 4 percent of the workforce
                               remains uncovered, which mostly includes some state and local
                               government employees and federal employees hired before 1984. Bringing
                               new state and local workers into the Social Security system would expand
                               the payroll tax base. However, expanding the tax base also increases
                               future benefit payments because the newly covered earnings would be
                               included in benefit computations.

Investing Trust Funds in the   Investing some portion of the Social Security trust funds in the stock
Stock Market                   market rather than in government securities might increase system
                               revenues but has potential drawbacks as well. Historically, stock
                               investments have earned higher returns on the average than Treasury
                               securities, but they also carry higher risks. Nevertheless, investing in
                               stocks could increase program revenues without raising taxes. However,
                               Social Security would no longer buy as many Treasury bonds, so Treasury
                               would have to sell more in the private capital market.

                               As a whole, the federal government would be selling lower-yielding
                               government bonds and buying higher-yielding private securities. In turn,
                               such government activity could affect prices of stocks and their expected
                               returns and interest rates. Also, as partial owners of a company,
                               stockholders can vote on company policies, which raises the question of
                               whether and how the government would exercise its voting privileges.
                               While the funds could be invested in “passively managed” portfolios,
                               political pressures could also lead the government to select or omit
                               particular stocks for investment.




                               19
                                However, each year’s actuarial valuation covers a new 75-year period. Therefore, long-term actuarial
                               balance can change from year to year.
                               20
                                The maximum earnings subject to Social Security payroll taxes is updated automatically each year in
                               proportion to increases in the average annual wage.



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Program Restructuring        A variety of proposals would address Social Security’s long-term funding
Serves Other Objectives as   problems by significantly restructuring the program, usually by privatizing
Well as Long-Term Balance    at least a portion of it.21 Such proposals still essentially achieve financial
                             balance by, in effect, raising revenues and reducing costs, but they do so in
                             ways that pursue other objectives as well. Some would reduce the role of
                             Social Security and the federal government in providing retirement income
                             and give individuals greater responsibility and control over their own
                             retirement. Some proposals focus on trying to increase national saving and
                             funding future Social Security benefits in advance.

                             Generally, privatization proposals focus on setting up individual
                             retirement savings accounts and requiring workers to contribute to them.
                             The accounts usually replace a portion of Social Security, whose benefits
                             would be reduced to compensate for revenues diverted to the savings
                             accounts. Some combine new mandatory saving and Social Security
                             benefit cuts, hoping to produce a potential net gain in retirement income.
                             The mandated savings deposits and revised Social Security taxes
                             combined would be greater than current Social Security taxes, in most
                             cases.

                             Virtually all proposals addressing long-term financing issues would
                             increase the proportion of retirement assets invested in the stock market
                             or in other higher-risk, higher-return investments. The common objective
                             is to finance a smaller share of retirement costs with worker contributions
                             and more of the costs with investment returns.

                             The federal government’s Thrift Savings Plan (TSP) for federal workers
                             exemplifies how individually held accounts could be invested in the
                             private sector with a limited government role. Under TSP, vested federal
                             workers own their savings accounts and choose how to invest them in a
                             range of passively managed funds, which include funds invested in stocks,
                             corporate bonds, and government bonds. The government administers
                             these funds through contractors and delegates proxy voting to them.22

                             In the case of individually managed savings accounts, the risk of economic
                             and market performance would be shifted to the worker. Individuals with

                             21
                              Chile is often cited as an example of how privatization can work. Other countries also have planned
                             or are planning to privatize their social security systems. However, their macroeconomic situations
                             and political institutions often differ substantially from ours. For example, Chile is a much less
                             developed economy than the United States, and when it privatized, it had limited capital markets and a
                             budget surplus.
                             22
                              However, the size of such funds under various reform proposals would be far greater than under TSP
                             and, thus, the voting issue would be magnified.



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identical earning histories and retirement contributions could have
notably different retirement incomes because of market fluctuations or
individual investment choices. Some observers have expressed concern
that many workers lack the knowledge necessary to make the best
investment decisions. Many workers, especially women, invest too large a
portion of their savings in relatively safe, fixed-income securities that earn
a relatively low return and shy away from more “risky” equity investments
that generally earn a higher average return. Proponents of privatization
respond that investor education programs can teach workers how to
manage their investment portfolios better. Limited research indicates that
investor education is effective at increasing both workers’ retirement
contributions and their investment returns. Finally, care must be taken to
ensure that retirement savings would last until the retiree dies. Some
proposals would require retirees to purchase a lifetime annuity with their
retirement savings.

To the extent that privatization requires workers to increase their
retirement saving, it could increase national saving. However, workers
might reduce other saving either because they would have less disposable
income from which to save or because they would, in effect, let the new
retirement accounts substitute for their other saving. In cases in which
privatization largely involves redirecting the Social Security trust funds’
balances into the stock market, whether government directs the
investment or not, national saving would probably not increase
significantly. Any increase in private sector investment could be offset, at
least temporarily, by Treasury’s need to borrow money from the private
sector to replace the funds it currently borrows from the trust funds.

Some of the privatization proposals raise the issue of how to make the
transition to a new system. Currently, each year’s Social Security taxes are
used for the most part to pay for that year’s benefits. Financing retirement
through individually owned savings accounts requires “advance funding,”
or saving this year’s contributions to provide future retirement income.
Social Security would still have to have revenues to pay benefits that
retirees and current workers have already earned. The revenues needed to
fund both current and future liabilities would clearly be higher than those
currently collected.

Privatization would also have a significant effect on the distribution of
retirement income between high and low earners, although advocates
claim that all would still be better off. As described above, the Social
Security benefit formula redistributes income from high to low earners



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                            and tries to balance the program’s goals of providing equitable benefits
                            while also meeting basic income needs. To the extent that privatization
                            involves workers’ contributing to their own retirement saving, their
                            contributions are not available for redistribution. Some privatization
                            proposals retain some degree of Social Security coverage or at least a
                            means-tested safety net and therefore permit some redistribution to
                            continue. In effect, such proposals separate the program’s equity and
                            adequacy goals.

                            Privatization proposals also tend to separate retirement benefits from
                            Social Security’s survivors’ and disability benefits. In the cases of death or
                            disability before retirement, individual savings may not have been building
                            long enough to sufficiently replace lost income. Some privatization
                            proposals, therefore, leave these social insurance programs largely as they
                            are now. In the case of death after retirement, the surviving spouse and
                            dependents may still depend on financial support from the retirement
                            savings of the deceased. Therefore, some privatization proposals would
                            require retired workers to purchase a joint and survivor annuity with their
                            retirement savings or obtain spousal consent for the choice of a single life
                            annuity. Joint and survivor annuities provide lower annual benefits but
                            continue to pay benefits to the surviving spouses.


Current Proposals Mix       The 1994-96 Advisory Council on Social Security recently issued a report
Several Elements            in which its members offered three alternative reform proposals. While the
                            council could not achieve majority support in favor of any one proposal, it
                            did appear to reach agreement on certain points. Some individual
                            components appeared in more than one of the three proposals:

                        •   extending mandatory coverage to all state and local government workers
                            hired after 1997;
                        •   assume that revisions to the CPI, which were announced by the Bureau of
                            Labor Statistics in March 1996, will lower the COLAs for future benefits by
                            0.21 percentage points;
                        •   increase the number of years of earnings used in computing benefits from
                            35 to 38;
                        •   subject benefits to income taxes to the extent that workers’ benefits
                            exceed their contributions and deposit the proceeds in the Social Security
                            trust funds;
                        •   accelerate the increase in the retirement age, so that the NRA will reach 67
                            for persons born in 1949 instead of 1960 and increase it after 2011
                            according to increases in longevity.



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According to the National Academy of Social Insurance, these five
measures combined would eliminate more than two thirds of Social
Security’s long-term financial deficit and postpone the exhaustion of the
trust funds from 2030 to 2052.23

Of the three comprehensive reform proposals, the one called the “maintain
benefits” plan, generally associated with former Social Security
Commissioner Robert Ball, would make the fewest changes to the current
system. The Ball proposal would make all the changes above except for
increasing the retirement age. In addition, it calls for studying the
possibility of investing 40 percent of the trust funds in the stock market by
selecting a portfolio that would track some broad market index such as
the Wilshire 5000. The investments would be passively managed by an
independent board. In addition to these and other changes, the Ball
proposal would achieve long-term balance by increasing Social Security
taxes in 2045 by 1.6 percentage points (0.8 percentage points each for
employers and employees.)

A second proposal, called the “individual account” plan and generally
associated with Council Chairman Edward Gramlich, would make all five
of the changes above. In addition, the Gramlich proposal would gradually
reduce benefits by modifying the benefit formula so that eventually all
benefits would be financed by the current Social Security tax rate. After
completely phasing in this change, benefits would be 17-percent lower for
average earners, with larger reductions for high earners and smaller ones
for low earners. Combined with raising the NRA, the average earner’s
benefits would ultimately decline about 30 percent. To offset these benefit
reductions, the Gramlich proposal would add a mandatory individual
savings account financed by new contributions from workers of
1.6 percent of their covered earnings, starting in 1998. Workers would
choose among alternative investment options administered by a
government board, similar to the administration of the TSP. At retirement,
workers would be required to purchase a lifetime annuity with the money
in these accounts.

The third proposal, called the “personal security account” plan and
generally associated with benefits consultant Sylvester Schieber and
economist Carolyn Weaver, would make the most dramatic changes to
Social Security. The Schieber-Weaver proposal would extend coverage,



23
 National Academy of Social Insurance, “Advisory Council on Social Security Plans,” Social Insurance
Update, Vol. 1, no. 3 (December 1996).



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                        assume cost reductions from corrections to the CPI, and accelerate the
                        increase in the retirement age. In addition, it would transform Social
                        Security into a two-tier system. In the first tier, a basic flat benefit amount
                        adjusted for years with covered earnings would be paid to all retirees. The
                        amount would equal about two thirds the current poverty level for a single
                        elderly person, or $410 per month in 1996. The second tier would be a
                        personal security account financed by shifting 5 percentage points of the
                        existing employee tax into those accounts. Workers could invest these
                        funds in a wide range of instruments but could not withdraw them before
                        retirement. At the ERA, they could use the funds freely. The transition to
                        the new system would require new taxes equaling 1.52 percent of covered
                        payroll, starting in 1998 and lasting 72 years. Not insignificantly, it would
                        also require additional government borrowing of nearly $2 trillion in 1995
                        dollars during the first 40 years of the transition.


                        As a result of previous financing reforms, Social Security collects more in
Social Security Trust   revenues than it pays out in benefits each year and builds up substantial
Funds and the Federal   trust fund reserves. This annual excess of revenues over expenditures
Deficit                 lowers the total federal deficit. However, tapping these reserves in the
                        future to help pay benefits would pose a substantial challenge for the
                        overall federal budget.

                        The Social Security trust funds are by law invested in federal government
                        securities and effectively lend money to Treasury. By investing in Treasury
                        securities, Social Security reduces the amount that the federal government
                        must borrow in the private financial markets. Until 2009, Social Security is
                        expected to collect roughly $30 billion more in cash each year than is
                        needed to pay benefits. In addition, the trust funds’ interest earnings were
                        nearly $40 billion last year and will grow as the reserves build up. Treasury
                        credits this interest by issuing more securities. If Treasury had to replace
                        borrowing from the trust funds with borrowing in the private market, it
                        would have to pay this interest in cash. This cash could be borrowed by
                        selling bonds in the private capital market, but such interest payments
                        would further add to the overall federal deficit.

                        Social Security’s excess cash revenues are expected to start falling rapidly
                        in 2009 and to disappear in 2012, under the trustees’ 1996 intermediate
                        actuarial assumptions. (See fig. 3.1.) Expenditures will then exceed cash
                        revenues, and the government’s general fund will have to make up the
                        difference, in effect repaying Social Security. This will increase the budget
                        deficit, unless offset by revenue increases or spending reductions. In 2028,



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                                          this amount is expected to reach about $183 billion in 1997 dollars. In that
                                          year, the budget deficit from Social Security alone would equal 1.4 percent
                                          of GDP, which is the same share of GDP as last year’s deficit for the entire
                                          federal budget. The trust funds are expected to be depleted in 2029.



Figure 3.1: Social Security’s Revenues Exceed Expenditures Now but Fall Short Later

 Excess Revenue (Dollars in Billions)

 50



 25



  0



 -25



 -50



 -75



-100
   1995                    2000              2005                     2010                     2015

                                          Source: 1996 Annual Trustees’ Report and unpublished SSA data.




                                          Solving Social Security’s long-term financing problem will not necessarily
                                          eliminate this budget challenge. Some Social Security reform proposals
                                          would diminish the trust fund build-up and spend-down. However, in any
                                          event, efforts to maintain a stable fiscal policy will depend to some extent
                                          on how this spend-down is addressed.




                                          Page 41                                          GAO/HEHS-97-81 Retirement Income Issues
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Private Pensions and Retirement Saving Can
Help With Retirement Income Challenges

                       While Social Security provides a foundation for retirement income,
                       increasing private pension coverage and individual retirement saving can
                       contribute substantially toward meeting the income needs of the elderly
                       and help increase national saving at the same time. To fulfill their potential
                       as major retirement income sources, both pensions and savings must be
                       secure and carefully managed.

                       The two basic types of pension plans are defined benefit and defined
                       contribution plans. A defined benefit (DB) pension plan promises the
                       worker a benefit based on a specific formula linked to the worker’s
                       earnings and years of employment. The employer, as the plan sponsor, is
                       responsible for funding the promised benefit, investing and managing the
                       funds, and bearing the investment risk. In terms of coverage, DB pensions
                       were the predominant type of employer pension for many years. In 1975,
                       three fourths of workers covered by a private pension had DB plans.

                       Under defined contribution (DC) plans, a percentage of pay is contributed
                       to an account for each worker. While the employer generally makes the
                       contribution, the increasingly popular 401(k) plans also allow
                       contributions by workers. Retirement income from DC plans depends on
                       how much money is deposited and how much the invested funds earn. In
                       DC plans, the worker bears the investment risk and often controls how the
                       funds are invested. Because nearly all DC plan benefits are taken
                       immediately as a lump sum, DC pensions are considered to be more
                       portable than DB plans, which frequently pay a life annuity at retirement.


                       The federal government has an interest in promoting pension coverage to
Federal Policies       ensure greater retirement income security and to help increase national
Promote Pension        saving. Also, the government has assumed the role of helping protect
Coverage and Benefit   workers’ legal rights to pension benefits. The Internal Revenue Code and
                       ERISA define the government’s role, and the Department of Labor (DOL), the
Security               Internal Revenue Service (IRS), and PBGC carry out the laws.

                       The Internal Revenue Code provides preferential income tax treatment for
                       pension contributions and for the capital gains on the funds. These tax
                       preferences have the greatest relevance to employees rather than
                       employers. For employers, all wages are tax deductible just as pension
                       contributions are, but employees do benefit from the deferral of income
                       tax on their pension benefits until they receive them. In particular, the
                       extension of preferential tax treatment to employee contributions to
                       401(k) plans has resulted in the substantial growth of these plans. Even so,



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                    the effect of these tax preferences depends significantly on the structure
                    of income tax rates. Marginal tax rates on high and middle earners have
                    dropped considerably since the 1970s. The tax rate on capital gains also
                    affects these tax preferences because many DB and DC pension assets are
                    invested in equities and other financial instruments that would otherwise
                    be subject to the capital gains tax. Also, tax preferences for pensions
                    result in substantial foregone federal revenues, and the Congress has an
                    interest in limiting these losses and has at times attempted to target who
                    benefits from them and how much. Therefore, changes in tax policy could
                    have a significant effect on pension coverage.

                    To qualify for preferential tax treatment, pension plans must adhere to
                    various standards. For example, in 1942, the Congress enacted
                    “nondiscrimination” provisions to ensure that pension plans did not
                    receive favorable tax treatment if a disproportionate share of the benefits
                    accrued to company officers or other highly paid individuals.

                    In 1974, the Congress enacted ERISA to make pension promises more
                    explicit and workers’ benefits more secure. Among other things, ERISA
                    requires that private DB plan sponsors make contributions according to
                    actuarial standards to help ensure adequate funding. In addition, ERISA
                    requires such sponsors to pay pension insurance premiums to PBGC, which
                    assumes the liability for terminated DB plans and pays the retirement
                    benefits, subject to certain limits. ERISA also requires that plan investments
                    be diversified and that plan fiduciaries adhere to prescribed standards of
                    conduct.


                    Pension coverage for workers in the private sector increased from
More Will Receive   15 percent to 45 percent between 1940 and 1970. This expansion resulted
Pensions Although   from a variety of factors, including tax preferences, healthy economic
Coverage Has Not    expansion, and the growth of labor unions and also from wage and price
                    controls during the 1940s and 1950s. Despite wage controls, employers
Grown Recently      were able to meet union requests for increased compensation by offering
                    pensions and other employee benefits. However, since 1970, the coverage
                    rate has changed very little; it stood at 47 percent in 1993.

                    Nevertheless, in spite of stagnant pension coverage, more workers
                    covered under pension plans and their spouses will eventually receive
                    pensions. ERISA established vesting rules in 1974 and set a 10-year
                    minimum before employees could vest—that is, earn a legal right to their
                    pension benefits. In 1986, the rule was liberalized, allowing either a 5-year



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                          “cliff” or a graded vesting schedule under which participants are
                          20 percent vested after 3 years and receive an additional 20 percent each
                          subsequent year until they are fully vested after 7 years. As a result, more
                          covered employees will meet the vesting requirement, although benefit
                          levels will reflect the shorter job tenures of the employees affected.

                          In addition, more women are working, so more retired couples will have
                          pension income. Also, a larger share of widowed and divorced retirees will
                          receive pension income from their spouse’s employers because of spousal
                          notification laws enacted in 1984.24


Economic Considerations   Employers offer pensions because they help attract and retain valuable
and Regulation Affect     employees, encourage older workers to retire, and give workers an
Pension Coverage          additional incentive to perform well and promote the ongoing success of
                          the employer. Workers accept pension arrangements in place of higher
                          wages and, in fact, unions often seek them because workers benefit from
                          the tax advantages and, with DB pensions, from having employers bear the
                          risk of long-term commitments (unless and until benefits are distributed as
                          a lump sum).

                          However, some factors might make further increases in worker coverage
                          unlikely. About 60 percent of all older (aged 40 to 60) workers are already
                          covered. Moreover, employers are less likely to offer pensions if their
                          workforce tends to be less educated, lower-skilled, or younger or exhibits
                          high turnover. Only 34 percent of those in their twenties are covered by
                          pensions. Also, smaller employers are less likely to offer pensions. For
                          example, only 28 percent of workers at firms with 25-49 employees are
                          covered, while at firms employing more than 1,000, 67 percent are
                          covered. Finally, about 9 percent of the workforce is self-employed, and
                          these workers must, of course, provide for their own retirement income.

                          Structural changes in the economy also influence employers’ decisions to
                          provide pensions. In 1945, 35 percent of the workforce, both private and
                          public, was unionized, compared with 16 percent in 1990, and nearly
                          80 percent of union workers have pension coverage compared with about
                          40 percent of nonunion workers. In addition, the rising cost and demand


                          24
                            The 1984 Retirement Equity Act made the joint-and-survivor benefit the default option for married
                          workers retiring on a pension. Under the joint-and-survivor option, a surviving spouse will continue to
                          receive pension benefits once the pension beneficiary dies. To waive this option, both the retiring
                          worker and his or her spouse must sign a waiver form. Prior to this law, waivers from spouses were
                          not required, and few retiring workers selected the joint-and-survivor option. As a result, many
                          spouses were left without pension benefits when the retiree died first.



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                              for health care has strained the resources that employers have available
                              for other employee benefits.

                              Since ERISA was enacted, legislative and regulatory activity regarding
                              pensions has increased. This activity provided improved benefit security
                              for workers but has affected the structure of pensions. Some of the
                              changes have focused on limiting the federal revenues foregone because
                              of the favorable tax code provisions. However, federal regulations,
                              especially when they change frequently, tend to increase the cost of
                              pensions and reduce employers’ incentive to sponsor pension plans.25


Pension Simplification Is a   In response to concerns about regulatory burdens on employer pension
Focus of Recent               plans, recent federal initiatives have focused on pension simplification.
Legislation                   These efforts seek to encourage expanded coverage by reducing the
                              regulatory requirements for small employers to start pensions. However,
                              this regulatory relief is usually accompanied by a required employer
                              contribution for all employees that might not be attractive to the small
                              employer. Past pension expansion efforts along this line, such as
                              simplified employee pensions (SEP), have not been notably successful in
                              raising pension plan sponsorship rates.26

                              The Small Business Job Protection Act of 1996, created a new “savings
                              incentive match plan for employees” (SIMPLE) for firms with 100 or fewer
                              workers that do not already offer a pension plan. The plan could be based
                              on IRA or 401(k) arrangements and, sponsors would be exempt from
                              certain “nondiscrimination” rules or, under certain conditions, other rules
                              that might otherwise deter plan sponsorship. An employee could
                              contribute up to $6,000 yearly, and the employer would have to meet a
                              matching requirement.27


DC Pension Coverage Has       Although pension coverage on current jobs has been generally stable
Grown                         overall, the number of workers participating in DC plans has grown steadily

                              25
                               Committee for Economic Development, Who Will Pay For Your Retirement?: The Looming Crisis
                              (New York: 1995).
                              26
                               See Private Pensions: Changes Can Produce a Modest Increase in Use of Simplified Employee
                              Pensions (GAO/HRD-92-119, July 1, 1992).
                              27
                                For more detailed information on the provisions in the bill see James R. Storey, Pension Proposals
                              for Simplification and Increased Access (Washington, D.C.: Congressional Research Service, July 16,
                              1996). For another discussion on related proposals advanced by the Clinton administration, see James
                              R. Storey and Ray Schmitt, Pension Reform: President Clinton’s Proposed Retirement Savings and
                              Security Act (Washington, D.C.: Congressional Research Service, July 10, 1996).



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                       over the past 20 years. In 1975, 27 percent of pension plan participants had
                       DC plans; by 1990, 50 percent had them.28 With this trend, more of the risk
                       and responsibility for providing pension income is shifting from the
                       employer to the employee. Recent data and analysis suggest that, rather
                       than representing replacement of DB plans by DC plans, this trend mainly
                       reflects that new or additional pension benefits are often offered as DC
                       plans. Many larger employers supplement their DB plans with DC plans.29

                       In addition, the relatively faster growth of employment at smaller firms
                       may help explain the trend toward DC pensions, which are easier for
                       smaller employers to administer. Between 1980 and 1993, the number of
                       employees in firms with fewer than 100 employees grew 30 percent, twice
                       as fast as for firms with 500 or more employees. In 1993, small firms
                       accounted for 56 percent of all employees. About 25 percent of full-time
                       employees in small firms participate in DC plans, compared with 12 percent
                       participating in DB plans.

                       The 401(k) plan is the fastest growing type of DC pension that allows
                       employees to make tax-deferred contributions that may be augmented by
                       the employer. The growth of these accounts has contributed substantially
                       to the DC trend. Between 1984 and 1990, 401(k) plans’ share of all private
                       plans grew from 3 to 14 percent, and their share of all active pension plan
                       participants grew from 19 to 46 percent.30 This growth appears to be
                       continuing.


                       Personal savings outside pension arrangements can contribute
Efforts to Increase    substantially to retirement income. However, saving patterns vary
Personal Retirement    considerably among families. While most families say they recognize the
Saving Have Not Been   need to save for retirement, many do not save in any systematic way. As
                       with pension coverage, government efforts to encourage more personal
Successful             retirement saving seem to have had only marginal effects.

                       According to our analysis of the University of Michigan’s Health and
                       Retirement Survey, the average net worth of families whose heads are
                       nearing retirement age (from 55 to 61 years of age) is almost $250,000.
                       However, the distribution of wealth is uneven, and many families near

                       28
                        Percentages are not adjusted for double counting of individuals participating in more than one plan.
                       For a more recent analysis of defined contribution plans see Private Pensions: Most Employers That
                       Offer Pensions Use Defined Contribution Plans (GAO/GGD-96-181, Oct. 3, 1996).
                       29
                        Employee Benefits Research Institute, “Pension Evolution in a Changing Economy,” Special Report
                       and Issue Brief No. 141, Washington, D.C., Sept. 1993.
                       30
                         401(k) participants may participate in one or more additional plans.


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                       retirement have relatively few retirement savings. According to our
                       analysis, over half of these families have less than $100,000 in assets, and
                       25 percent have less than $25,000 in assets. Over one quarter of families
                       near retirement in this survey do not own their own home, almost
                       60 percent have no IRA, over 70 percent do not own stocks, 92 percent do
                       not own bonds, and half have less than $5,000 in bank accounts.

                       Tax policy affects how people save for retirement, but its effect on the
                       overall level of personal saving is less clear. Since the 1970s, federal laws
                       have granted favorable tax treatment to IRAs and to the closely related
                       401(k) pension plans. In 1981, most constraints on IRAs were lifted so that
                       nearly all workers and their spouses could participate, making this form of
                       tax-deferred saving very popular. After 1986, tax policy limited the group
                       of workers who could make tax-deductible IRA contributions. Total
                       contributions fell by more than 60 percent, and the percentage of all tax
                       returns claiming an IRA deduction fell from 16 percent in 1985 to 6 percent
                       in 1988. Recent polling evidence suggests that people would save more in
                       IRAs if the tax benefits were increased. The 401(k) plan has many of the
                       same tax advantages as IRAs and is now the fastest growing type of pension
                       plan.

                       Preferential tax treatment for IRAs and 401(k) accounts seems to
                       encourage saving in these vehicles, but they may not necessarily represent
                       totally new saving. Some contributions may merely have been shifted from
                       other forms of saving. Between 1970 and 1994, personal saving rates
                       declined from roughly 8 to 4 percent of disposable personal income, even
                       with these retirement saving incentives. Also, according to available data,
                       most persons responding to these tax preferences are middle- to
                       upper-income, not lower-income, who receive very little income from
                       retirement savings. Low-income families may find it especially difficult to
                       save, and most public assistance programs penalize private saving by
                       requiring low levels of financial assets in order to qualify.


                       To fulfill their potential as retirement income sources, pension assets and
Will Pensions and      savings must be preserved and carefully managed. ERISA sets out
Savings Be There for   requirements regarding how pension assets must be managed, invested,
Retirement?            and preserved for retirement. While tax rules discourage using pension
                       assets for nonretirement purposes, they do not prohibit such use entirely.
                       Also, many pensions allow workers to take a lump sum at retirement
                       rather than receive an annuity. If they elect to take a lump sum, retirees




                       Page 47                                      GAO/HEHS-97-81 Retirement Income Issues
                            Chapter 4
                            Private Pensions and Retirement Saving Can
                            Help With Retirement Income Challenges




                            must then carefully manage these assets along with their other savings to
                            make them last throughout their retirement.


Protecting DB Plan Assets   PBGC insures and guarantees DB pension benefits, and IRS monitors plan
                            funding status. Funding requirements aim not only to protect workers’
                            pensions but also to limit PBGC’s risk of assuming financial responsibility
                            for unfunded benefits when employers go out of business. Premiums for
                            pension guaranty insurance are set so that they increase as the extent to
                            which the plan is underfunded increases. Underfunded plans may also be
                            required to make contributions that gradually reduce the plan’s unfunded
                            liability. Recently, the Retirement Protection Act of 1994 revised rules
                            relating to pension plan underfunding. Along with the healthy investment
                            returns that pension funds have enjoyed, such reforms have substantially
                            improved funding levels and have reduced the financial risk to the pension
                            sponsors that pay the PBGC insurance premiums. Under current law, PBGC
                            may borrow up to $100 million from Treasury, but the federal government
                            has no legal obligation to back up PBGC otherwise.

                            For well-funded plans, boosted by the strong stock market performance of
                            the 1980s and 1990s, the issue arises of how to deal with overfunding.
                            Since firms own the pension assets, they sometimes want to take some of
                            the excess assets back and use them elsewhere. The courts have upheld
                            plan sponsors’ right to “revert” assets, and the practice may be consistent
                            with prudent plan funding. Still, the Congress has been concerned that
                            such reversion may threaten benefit security if the sponsors or their
                            pension funds do poorly in the future. The Congress imposed substantial
                            penalties in response to a wave of reversions in the 1980s, largely stopping
                            the practice. As recently as 1995, proposals were offered to loosen these
                            restrictions.


Investing and Preserving    With DC pensions, as well as with individual retirement saving, workers
DC Plan Assets              generally have responsibility for directing how their assets are invested.
                            Some invest conservatively and earn low returns even though they still
                            have many years before retirement and could arguably bear the risks
                            associated with higher-return investments. To help expand workers’
                            investment choices, DOL recently issued an interpretive bulletin regarding
                            the 404(c) rules to clarify the kinds of investment information firms can
                            give their workers without being professionally liable for giving
                            investment advice.




                            Page 48                                      GAO/HEHS-97-81 Retirement Income Issues
Chapter 4
Private Pensions and Retirement Saving Can
Help With Retirement Income Challenges




Workers also diminish their DC pension savings when they use the funds
for nonretirement purposes. Most plans allow participants to borrow from
their accounts for nonretirement expenditures such as purchasing a home
or paying educational or emergency expenses. Overall, more than
75 percent of workers with DC pensions are able to borrow from their
retirement accounts. Of these workers, almost 8 percent have outstanding
loans, with an average balance of $3,000. A recent Clinton administration
proposal would allow early, penalty-free IRA withdrawals for selected
expenses. This added liquidity may actually encourage more pension
saving. Still, if workers do borrow, they may reduce the savings available
for retirement.

At retirement, IRA and DC pensions do not have to be taken in the form of
an annuity and are generally taken as a lump-sum amount. Moreover,
about 33 percent of DB plan sponsors, who covered more than half of all
participants, provided a lump-sum option for retiring workers. Annuities
help insure retirees against living longer than their retirement funds would
last, but retirees pay insurers for assuming this risk. In contrast, without
an annuity, retirees assume much of the risk for their longevity as well as
responsibility for their wise use of the funds. However, since the federal
and state governments provide public assistance benefits for the
low-income elderly, they also assume some of this risk.




Page 49                                      GAO/HEHS-97-81 Retirement Income Issues
Chapter 5

Concluding Observations


              Dramatic growth in our nation’s elderly population raises issues not just
              for the future of retirement income but also for the federal budget and for
              the economy as a whole. The elderly will consume an increasing share of
              the nation’s output, and unless retirement or work patterns change,
              relatively fewer workers will be supporting more retirees. Our analysis
              leads us to five observations about the future direction of federal
              retirement income policy.

              First, if the dominant purpose in examining Social Security is to restore
              long-term financial balance to the Social Security system, then some
              combination of traditional adjustments —revenue increases or benefit
              reductions —could be sufficient. However, some observers believe that
              the structure of this program should be reevaluated in light of the
              economic, political, and demographic changes of the past 60 years. Even
              though Social Security has become the most important single source of
              retirement income for many people, many believe that now is an
              appropriate time to assess whether the current structure of benefits best
              serves today’s retirement needs.

              Second, giving people greater responsibility for their retirement income
              and greater opportunity to invest their savings to earn potentially higher
              rates of return might raise the general welfare of the nation’s elderly
              retirees. But such potential gains must be weighed against the potential
              problems associated with having individuals bear much more of the risk in
              saving for retirement. Also, if the Social Security program is to continue to
              play an important role in ensuring that the less-well-off have a basic
              retirement income, then care must be taken to ensure that changes in the
              Social Security program do not exacerbate the condition of particular
              groups of elderly poor. Unmarried women are currently much more likely
              to have incomes below the poverty line than other beneficiaries. Changes
              such as increasing the number of years used in computing benefits would
              disproportionately affect women because they more often already have
              several years of zero earnings included in the benefit calculation. Such
              distributional effects will have to be considered in any reform proposal.

              Third, while Social Security’s long-term financing problem and the federal
              budget deficit are different issues, the practice of using the Social Security
              trust funds’ surpluses to partially offset the deficit elsewhere in
              government has substantially intertwined the two issues. The program’s
              annual cash surplus is projected to start falling by 2009 and to disappear
              entirely in 2012, under Social Security’s intermediate assumptions. As
              payments to beneficiaries begin to exceed cash receipts, Social Security



              Page 50                                  GAO/HEHS-97-81 Retirement Income Issues
Chapter 5
Concluding Observations




will have to redeem the Treasury certificates it now holds. Redemptions
will reach nearly $200 billion annually in 2028 (in 1997 dollars) and will
place significant strains on the federal budget. Moreover, some of the
proposals to privatize Social Security involve heavy additional federal
borrowing to finance the transition from a pay-as-you-go to a partially or
fully funded system. All proposals will have to be examined not only for
their effect on Social Security but also for their overall budgetary
consequences.

Fourth, to respond to the nation’s retirement income challenges
effectively, we must also examine pensions and private savings and the
potential effect of Social Security reform proposals on them. For example,
raising Social Security taxes could make it more difficult for people to
save for their retirement or to contribute to their pensions. Proposals to
solve Social Security’s long-term financial problem will have to take into
account the effect on achieving our goals of encouraging greater employee
participation in pensions and increased rates of national saving.

Finally, some of the Social Security privatization proposals focus on
increasing the national rate of saving. If successful, these changes could
help raise our standard of living and help mitigate the strain from dealing
with Social Security’s financing problem. Increased national saving could
lead to higher rates of economic growth, which, in turn, would make it
easier to meet the financial challenges posed by the shortfalls in Social
Security. However, raising the national saving rate may prove to be
difficult. The proposals that aim to increase national saving through
creating individual retirement savings accounts cannot guarantee that
these savings will not simply substitute for other forms of saving. In
addition, some of the proposed changes to the nation’s retirement system
could have significant effects on the nation’s equity and bond markets, and
this will have to be evaluated before such changes are adopted.

Ensuring that Americans have enough retirement income in the
twenty-first century to meet their needs will require that the nation and the
Congress make some difficult choices. Social Security has been an
effective agent for ensuring a reliable source of income in retirement and
greatly reducing poverty among the elderly. The effect of changes to the
system on other retirement income sources and their effects on various
groups within the aged population should be well understood before
decisions are made. Further, the interplay of budget and saving effects will
have to be carefully considered before any reform proposal is adopted.




Page 51                                 GAO/HEHS-97-81 Retirement Income Issues
Appendix I

Major Contributors to This Report


               Francis P. Mulvey, Assistant Director, (202) 512-3592
               Ken Stockbridge, Evaluator-in-Charge
               Michael Packard, Economist
               Ken Bombara, Economist
               Thomas Hungerford, Economist
               Alicia Cackley, Economist




               Page 52                                GAO/HEHS-97-81 Retirement Income Issues
Page 53   GAO/HEHS-97-81 Retirement Income Issues
Page 54   GAO/HEHS-97-81 Retirement Income Issues
Page 55   GAO/HEHS-97-81 Retirement Income Issues
Related GAO Products


              Social Security Reform: Implications for the Financial Well-Being of
              Women (GAO/T-HEHS-97-112, Apr. 10, 1997).

              Private Pensions: Most Employers That Offer Pensions Use Defined
              Contribution Plans (GAO/GGD-97-1, Oct. 3, 1996).

              401(k) Pension Plans: Many Take Advantage of Opportunity to Ensure
              Adequate Retirement Income (GAO/HEHS-96-176, Aug. 2, 1996).

              Public Pensions: Section 457 Plans Pose Greater Risk Than Other
              Supplemental Plans (GAO/HEHS-96-38, Apr. 30, 1996).

              Social Security: Issues Involving Benefit Equity for Working Women
              (GAO/HEHS-96-55, Apr. 10, 1996).

              Public Pensions: State and Local Government Contributions to
              Underfunded Plans (GAO/HEHS-96-56, Mar. 14, 1996).

              Federal Pensions: Thrift Savings Plan Has Key Role in Retirement Benefits
              (GAO/HEHS-96-1, Oct. 19, 1995).

              Private Pension Plans: Efforts to Encourage Infrastructure Investment
              (GAO/HEHS-95-173, Sept. 8, 1995).

              Private Pensions: Funding Rule Change Needed to Reduce PBGC’s
              Multibillion Dollar Exposure (GAO/HEHS-95-5, Oct. 5, 1994).

              Pension Plans: Stronger Labor ERISA Enforcement Should Better Protect
              Plan Participants (GAO/HEHS-94-157, Aug. 8, 1994).

              Private Pensions: Changes Can Produce a Modest Increase in Use of
              Simplified Employee Pensions (GAO/HRD-92-119, July 1, 1992).

              Pension Plans: Survivor Benefit Coverage for Wives Increased After 1984
              Pension Law (GAO/HRD-92-49, Feb. 28, 1992).

              Social Security: Analysis of a Proposal to Privatize Trust Fund Reserves
              (GAO/HRD-91-22, Dec. 12, 1990).

              Social Security: The Trust Fund Reserve Accumulation, the Economy, and
              the Federal Budget (GAO/HRD-89-44, Jan. 19, 1989).




(207444)      Page 56                                GAO/HEHS-97-81 Retirement Income Issues
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