oversight

Social Security: Issues in Comparing Rates of Return With Market Investments

Published by the Government Accountability Office on 1999-08-05.

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

                  United States General Accounting Office

GAO               Report to the Chairman, Special
                  Committee on Aging, and to the
                  Honorable Richard C. Shelby, U.S.
                  Senate

August 1999
                  SOCIAL SECURITY
                  Issues in Comparing
                  Rates of Return With
                  Market Investments




GAO/HEHS-99-110
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      Health, Education, and
      Human Services Division

      B-281321

      August 5, 1999

      The Honorable Charles E. Grassley
      Chairman
      Special Committee on Aging
      United States Senate

      The Honorable Richard C. Shelby
      United States Senate

      As the Congress and the nation have examined how best to restore the long-term solvency of
      the Social Security system, many proposals to restructure the system to include individual
      accounts have been offered. Many who favor individual account proposals point to the low
      rates of return that workers can expect from the current system and the opportunity that
      individual accounts would offer for improving rates of return on retirement contributions.
      Opponents of individual accounts have taken exception to the usefulness and validity of
      focusing on rates of return. This report, entitled Social Security: Issues in Comparing Rates of
      Return With Market Investments, provides a discussion of the key issues to consider in
      comparing Social Security and private market rates of return.

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

      This report was prepared under my direction. Please contact Charles A. Jeszeck, Assistant
      Director, at (202) 512-7036 if you have questions.




      Barbara D. Bovbjerg
      Associate Director, Education, Workforce,
        and Income Security Issues
Executive Summary


             Social Security forms the foundation for our retirement income system,
Purpose      providing crucial benefits to millions of Americans. However, the program
             faces a significant long-term financing shortage, according to government
             projections. In the debate about how to address this problem, some
             proposals would restructure Social Security to include individual
             retirement savings accounts that would either supplement or partially
             replace the current program’s benefits. According to proponents, such
             accounts would substantially improve the rates of return individuals could
             receive on their retirement contributions relative to the current system.
             The proponents assert that rates of return under the current system will be
             near zero and even negative for many future retirees. According to others,
             however, a new system of individual accounts is not the only way to raise
             average rates of return for individuals; investing some portion of the Social
             Security trust funds in the stock market could also help do that. Moreover,
             opponents of individual accounts assert that the rate of return concept
             should not be applied to Social Security because it is a social insurance
             program and should not be viewed strictly as an investment program. Still,
             if rates of return are considered in weighing Social Security reforms, doing
             so raises numerous issues that should be kept in careful perspective.

             In recognition of the role that rate of return comparisons are playing in the
             current reform debate, the Senate Special Committee on Aging and
             Senator Richard Shelby asked GAO to (1) examine estimates of Social
             Security’s implicit rates of return for different birth years, earnings levels,
             household configurations, and other demographic groupings; (2) examine
             rates of return available on private market investments; and (3) discuss the
             issues that arise from comparing Social Security and market investment
             returns.


             In the midst of the Great Depression, Social Security was enacted to help
Background   ensure that the elderly would have adequate retirement incomes and
             would not have to depend on welfare. It would provide benefits that
             workers had earned to some degree because of their contributions and
             those of their employers, and these benefits would be related to the
             earnings on which contributions would be based. Today, less than
             11 percent of the elderly have incomes below the poverty line, compared
             with 35 percent in 1959; for about half of the elderly, incomes excluding
             Social Security benefits are below the poverty line. However, Social
             Security does not only provide benefits to retired workers. In 1939,
             coverage was extended to their dependents and survivors, and, in 1956,
             the Disability Insurance program was added.



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Executive Summary




The current Social Security program is not designed to pay interest on
workers’ contributions the way banks pay interest on a savings account; it
is not a system of individual savings accounts. Rather, Social Security is
financed largely on a “pay-as-you-go” basis, in which each year’s revenues
are primarily used to pay that year’s benefits. Contributions are not
deposited in interest-bearing accounts for individual workers but are
instead credited to the Social Security trust funds. Under current law, the
trust funds must invest any surplus funds in interest-bearing federal
government securities. However, the benefit payments to any given
individual are derived from a formula that does not use interest rates or
the amount of contributions but, rather, uses average lifetime earnings.1

Still, the benefits workers eventually receive reflect an “implicit” rate of
return they receive on their contributions. This implicit rate of return
provides one measure of the relationship between contributions and
benefits. It equals the average interest rate workers would hypothetically
have to earn on their contributions in order to pay for all the benefits they
and their families will receive from Social Security. Note that this implicit
rate of return that individuals receive on their contributions is not the
same as the rate of return (or interest rate) that the Social Security trust
funds earn on their assets. Implicit rates of return for individuals depend
on the relationship between lifetime benefits and contributions, while the
interest earned by the trust funds reflects the prevailing rate of interest in
the market. In part, implicit rates of return for individuals depend on the
interest earned by the trust funds but only because it reduces the
contribution rates required to fund benefits. In addition to depending on
trust fund interest earnings, implicit returns depend on long-term
demographic and economic trends that affect the program’s flows of
contributions and benefits.

To be accurate and consistent, rate of return estimates must reflect all the
contributions and other revenues associated with the benefits that will
eventually be received. For example, they should reflect the employers’
payroll taxes as well as the employees’ taxes. Also, given current law and
actuarial projections, total revenues will not be sufficient to fund all the
benefits anticipated by 2034. Rate of return estimates are misleading if
they reflect a long-term imbalance between revenues and benefits. In


1
 In technical terms, Social Security provides a “defined-benefit” pension, not a
“defined-contribution” pension. A defined-benefit pension provides a benefit based on a specific
formula generally linked to each worker’s earnings and years of employment. In contrast, a
defined-contribution pension resembles an individual savings account; retirement income from this
type of pension depends on the total amount of contributions to the account and any investment
earnings. As an example, 401(k) accounts are a type of defined-contribution pension.



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                   Executive Summary




                   addition, if rate of return estimates include contributions for survivors and
                   dependents or for disability benefits, they should also include these
                   benefits. While disagreement exists concerning the merits of including
                   nonretirement benefits in rate of return calculations, estimates should
                   treat benefits and contributions consistently. This report only presents
                   estimates that satisfy these and similar standards of analytical rigor.
                   Moreover, actual rates of return vary tremendously by individual,
                   particularly because life spans vary; some die early and receive virtually
                   no benefit payments while others live long past the average life
                   expectancy. Therefore, rate of return estimates are used more
                   appropriately for group averages than for individuals.


                   Implicit rates of return that workers receive on their Social Security
Results in Brief   contributions vary significantly across a number of dimensions. The
                   variations mostly reflect several types of income transfers that the
                   program is designed to provide as part of its social insurance function.
                   Implicit returns vary by birth year, reflecting the program’s income
                   transfers to the first generations of retirees from subsequent generations.
                   For example, the inflation-adjusted (or “real”) implicit rate of return
                   averaged more than 25 percent annually for the earliest retirees covered
                   by Social Security and is projected to average roughly 2 percent for baby
                   boomers, according to a Social Security Administration (SSA) study.
                   Implicit returns that workers receive also vary on average by their
                   earnings level, by the number of their dependents and survivors, and by
                   their life expectancies. These characteristics vary by race and gender and
                   therefore rates of return do also.

                   Rates of return on private market assets vary substantially, depending on
                   the investment risks associated with those assets, particularly the risk of
                   asset price volatility and the risk of firms defaulting on obligations. For
                   example, historical inflation-adjusted returns on stock market
                   investments, which have relatively high investment risk, have averaged
                   roughly 7 to 8 percent over the past 60 to 70 years, compared with roughly
                   2 to 3 percent for long-term corporate bonds and roughly 0 to 2 percent for
                   government securities, which have very low investment risk. The choice of
                   assets in a portfolio and the timing of investment decisions ultimately help
                   determine the returns individuals receive and the risk they bear.

                   A simple comparison between the rates of return for the current Social
                   Security program and private market investments would be misleading
                   because of several key issues that such comparisons raise. First, a simple



                   Page 4                             GAO/HEHS-99-110 Social Security Rates of Return
                           Executive Summary




                           comparison between the current Social Security program and market
                           investments would not reflect all the costs associated with a new system
                           with individual accounts. In particular, the returns individuals would
                           effectively enjoy under a new system would depend on how the unfunded
                           liabilities of the current system would be paid off. Also, costs for both
                           managing and annuitizing the new accounts would reduce actual
                           retirement incomes and therefore the effective rates of return workers
                           enjoyed. Second, future rates of return for either market investments or
                           Social Security as it is currently structured could differ from their historic
                           averages. Third, risks differ between the current Social Security program
                           and market investments.

                           Instead of making simple comparisons between Social Security and
                           historical market returns, one should make any rate of return comparisons
                           among comprehensive return estimates for specific reform proposals that
                           include both the individual accounts and the Social Security components
                           of the resulting system. Such return estimates would accurately measure
                           the relationship between all the contributions and benefits implied in each
                           proposal, including both the Social Security and individual account
                           components. In particular, they would reflect the effect of measures taken
                           to ensure the sustainable solvency of the system. However, such rate of
                           return comparisons among reform proposals have some limitations of
                           their own and address only one of several criteria on which to compare
                           proposals. Other criteria include the adequacy and predictability of
                           benefits, the extent of solvency improvement, and the effect on the federal
                           budget and national saving.



Principal Findings

Implicit Rates of Return   Social Security’s implicit rates of return vary significantly by birth year,
Vary Because of Social     earnings level, household composition, and other demographic
Security’s Income          characteristics. Social Security insures workers against the uncertainties
                           associated with various life events and low lifetime earnings. Its income
Transfers                  transfers help ensure that beneficiaries have adequate incomes, and the
                           program has proven effective in reducing poverty. For example, Social
                           Security transfers income to persons who live longer—and therefore need
                           income longer—from those who do not. Those who receive such transfers
                           get higher rates of return than those who do not.




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                                         Executive Summary




                                         In the case of variation by birth year, Social Security’s average implicit
                                         rates of return have fallen continuously since the beginning of the
                                         program. According to an SSA study, inflation-adjusted returns averaged
                                         more than 25 percent annually for Social Security’s first retirees in the
                                         1940s and are estimated to average roughly 4 percent for today’s retirees,
                                         roughly 2 percent for baby boomers, and 1 percent for those who will be
                                         born 40 years from now. (See fig. 1.) These estimates do not include Social
                                         Security disability contributions and benefits but do reflect tax rates that
                                         would maintain actuarial balance on a pay-as-you-go basis.


Figure 1: Social Security’s Implicit
Rates of Return Are Higher for Earlier
Beneficiaries




                                         Note: Inflation-adjusted rates, average for all workers in each birth year. These estimates do not
                                         include Social Security disability contributions and benefits. They do reflect tax rates that would
                                         maintain actuarial balance on a pay-as-you-go basis. They also reflect employer as well as
                                         employee contributions. This is the most complete set of estimates by birth year and one of very
                                         few that compute average rates of return for all workers born in a given year.

                                         Source: Dean R. Leimer, Cohort-Specific Measures of Lifetime Net Social Security Transfers,
                                         working paper 59 (Washington, D.C.: SSA, Office of Research and Statistics, Feb. 1994).




                                         This decline in rates of return is primarily a natural and anticipated
                                         consequence of the maturing of a pay-as-you-go system. Although both




                                         Page 6                                         GAO/HEHS-99-110 Social Security Rates of Return
Executive Summary




Social Security benefits and contributions have always been based on
earnings, early beneficiaries made contributions over a smaller portion of
their careers. Also, from 1937 to 1949, Social Security’s tax rates were
relatively low at 1 percent of payroll each for employees and employers,
compared with 6.2 percent today. Higher rates were not necessary because
only a small share of the elderly had contributed enough to the program to
qualify for benefits. Early beneficiaries as a group received benefits that
were large relative to their contributions, and therefore the implicit rates
of return they enjoyed were very high. As the system matured—that is, as
each year passed and another group of people reaching retirement age
qualified for benefits—benefit costs increased. Tax rates eventually
increased accordingly, and benefits were smaller relative to contributions.
In effect, the start-up phase provided large transfers of income to the first
generations of retirees from subsequent generations.

Now that the system is essentially mature, the lower rates of return for
more recent and future retirees reflect an underlying relationship between
a mature pay-as-you-go system’s long-term average implicit rates and
national trends in total wages covered by the system. While the declines
have been dramatic, future declines should be small because the returns
are now fundamentally tied to the growth of total wages because both
contributions and benefits are based strictly on earnings.

In the case of variation by earnings level, Social Security’s implicit rates of
return are higher on average for workers with low lifetime earnings than
for those with high earnings. For example, for single women born in 1973,
SSA projects that inflation-adjusted implicit rates of return will range from
2.8 percent annually for women with low earnings to 0.4 percent for those
with the maximum earnings on which Social Security taxes are paid. This
pattern reflects the way the benefit formula transfers income from high to
low earners.

Social Security’s average implicit rates of return also differ considerably
for workers if their family situations differ. For example, for workers with
average earnings born in 1973, SSA projects that inflation-adjusted implicit
rates of return will range from 3.7 percent for one-earner couples to
1.3 percent for single men. Workers’ earnings may generate Social Security
benefits for their spouses and dependents as well as themselves, both
while they are receiving benefits and after they have died. Because
workers do not make any additional contributions to receive any of these
auxiliary benefits, workers with families that get them receive a higher
implicit rate of return than workers without such families.



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                            Executive Summary




                            Social Security’s average implicit rates of return also vary by demographic
                            characteristics, such as race and gender, even though Social Security’s
                            benefit and contribution provisions are structurally neutral with respect to
                            these characteristics. These variations in implicit returns arise because
                            different demographic groups have different average earnings levels, life
                            expectancies, and household configurations. Social Security’s income
                            transfers are designed to help ensure adequate incomes for beneficiaries
                            and are not intended to mitigate any inequalities among various
                            demographic groups in income or longevity that exist in our society.


Private Market Rates of     The private market offers a wide variety of investment opportunities with
Return Vary by Risk and     widely varying rates of return that reflect variations in the riskiness of
Portfolio Composition       those investments. Portfolio composition and the performance of the
                            market ultimately determine the return individuals receive and the risks
                            they bear. Over the long term, riskier investments offer higher average
                            rates of return. The risk from volatile asset prices can be managed both by
                            holding riskier investments over longer periods and by managing
                            portfolios so that such risks tend to offset one another. While managing a
                            portfolio’s composition in this manner generally requires sophisticated
                            data analysis and expertise, individual investors can take advantage of
                            such expertise to some degree by investing in widely diversified mutual
                            funds.

                            Social Security reform proposals that create individual accounts vary in
                            the degree of latitude that workers would have in managing their
                            investments. Some proposals would have the government centrally
                            manage the accounts and limit the range of investments workers could
                            choose. Others would have workers manage their own accounts and place
                            few restrictions on their investment options. Such features would
                            significantly determine the range of returns and risks workers would face
                            with their market investments and also the costs of administering their
                            accounts.


Issues in Comparing Rates   A simple comparison between the rates of return for the current Social
of Return Suggest That      Security program and private market investments would be misleading
Comparisons Should Be       because of several key issues that such comparisons raise. First, a simple
                            comparison of rates of return for the current Social Security system and
Made Across Reform          private market investments would be misleading because it would not
Proposals                   capture all the relevant costs that a new system would imply. Most
                            significantly, the transition to a new system would entail costs to pay off



                            Page 8                             GAO/HEHS-99-110 Social Security Rates of Return
Executive Summary




unfunded liabilities of the current system. The amount necessary to pay
the benefits already accrued by current workers and current beneficiaries
is roughly $9 trillion, according to SSA. In a pay-as-you-go system, an
unfunded liability always exists and will be covered by future program
revenues or reduced by benefit cuts or both. However, during the
transition to a restructured system, financing these costs would
significantly reduce returns, and the transition could last for a generation
or longer, depending on how its costs were paid. In addition, costs for
both managing and annuitizing the new accounts would reduce actual
retirement incomes and, therefore, the effective rates of return workers
enjoyed.

Second, future average rates of return on either market investments or
Social Security as it is currently structured could differ significantly from
their historical averages, and the gap between these rates could narrow.
Trends in rates of return on market investments and Social Security are
difficult to predict for many reasons. Still, economic growth fundamentally
drives rates of return for both, and projections for either are misleading if
they are not consistent with economic growth projections. Current SSA
projections suggest that economic growth will be slower in the future than
in the past. They also suggest that labor will become relatively more
scarce. In addition, capital may become more plentiful. Combined, these
trends suggest that market investment returns may be smaller and that
Social Security returns may be relatively larger than they would be without
these trends.

Third, both the level and type of risk differ between the current Social
Security program and private market investments. Some of the risks are
market and economic risks that affect rates of return on either
investments or Social Security or both. Such risks include the volatility of
investment returns and the potential for broad economic downturns.
Other risks are political, relating to uncertainties about what changes the
Congress might make to either the current system or a new one. Estimates
of average rates of return do not measure risk by themselves, and
predicting the statistical variability of those estimates is difficult. In
particular, rates of return do not measure whether retirement incomes will
be adequate, which is a primary risk that Social Security is designed to
help address. In addition, they do not measure the certainty or
predictability of retirement incomes.

In contrast to simple comparisons between the current Social Security
program and market investments, comprehensive rate of return



Page 9                             GAO/HEHS-99-110 Social Security Rates of Return
                  Executive Summary




                  comparisons among specific reform proposals, with all their components,
                  address many of the various issues that arise. Such comparisons among
                  reform proposals reveal that transition costs would reduce rates of return
                  to the extent that many participants would not get significantly higher
                  rates of return than they would under the current system. However, such
                  comparisons also show that once the transition costs are paid off,
                  participants could potentially enjoy significantly higher returns, depending
                  on market performance and economic trends. Comprehensive rate of
                  return comparisons among reform proposals also capture the effects of
                  administrative and annuity costs, which would depend to a large extent on
                  the specific design of the proposals. Such comparisons can reflect the
                  ways that portfolio choices and current economic projections might affect
                  investment earnings.

                  Still, comparing rate of return estimates among specific proposals has
                  some limitations. Some reform provisions are not easily incorporated into
                  rate of return estimates. For example, some proposals would tap general
                  revenues to help finance the system in addition to using payroll taxes, but
                  how return estimates could incorporate such nonpayroll tax revenues is
                  not clear. Moreover, average rate of return estimates do not by themselves
                  reveal the different levels of risk that individuals would face under
                  alternative reform proposals. Examining how total retirement incomes
                  might vary under alternative proposals can suggest to a limited extent how
                  much risk individuals might face in terms of the adequacy and
                  predictability of their incomes. In addition, just as a trade-off exists
                  between risk and return in market investments, the same trade-off exists
                  among alternative approaches to Social Security reform. Some proposals
                  might offer higher rates of return on Social Security contributions but
                  might also increase the risk of inadequate retirement incomes.
                  Alternatively, provisions that attempt to mitigate the risk of market
                  investments, such as guarantees, might create incentives for individuals to
                  take excessive investment risks. Such individuals would enjoy any gains
                  from such excessive risk while the government would incur any losses
                  insured by the guarantees. However, any additional costs resulting from
                  such guarantees would ultimately lower participants’ rates of return.


                  GAO obtained comments on a draft of this report from SSA. SSA generally
Agency Comments   agreed with GAO’s treatment of the issues and offered a number of
                  technical comments, which were incorporated where appropriate.




                  Page 10                           GAO/HEHS-99-110 Social Security Rates of Return
Page 11   GAO/HEHS-99-110 Social Security Rates of Return
Contents



Executive Summary                                                                                       2


Chapter 1                                                                                              14
                         The Current Social Security Program and the Reform Debate                     14
Introduction             Implicit Rates of Return Relate Benefits to Contributions                     16
                         Objectives, Scope, and Methodology                                            21

Chapter 2                                                                                              22
                         Variation by Birth Year Reflects Maturing of System and Wage                  22
Implicit Rates of          Growth
Return Vary Because      Variation by Earnings Level Reflects Income Redistribution                    26
                         Variation by Household Type Reflects the Role of Dependents’                  28
of Social Security’s       Benefits
Income Transfers         Variation by Demographic Group Reflects the Program’s Social                  30
                           Insurance Role

Chapter 3                                                                                              32
                         Riskier Investments Generally Yield Higher Long-Term Average                  32
Private Market Rates       Returns
of Return Vary by Risk   Portfolio Strategies Can Manage Risk                                          33
                         Individuals’ Portfolio Choices Reflect the Extent of Risk Aversion            36
and Portfolio              and Retirement Planning
Composition              Administrative Costs Vary by Investment Strategy                              36
                         Portfolio Management Would Affect Returns on Individual                       37
                           Accounts Under a Restructured Social Security Program

Chapter 4                                                                                              40
                         Additional Costs Need to Be Considered in Comparing Social                    40
Significant Issues in      Security and Market Returns
Comparing Rates of       Future Average Rates Could Differ From Historic Averages                      45
                         Risks Differ Between Social Security and Market Investments                   48
Return                   Comparisons Between Reform Proposals Help Capture Relevant                    50
                           Issues

Chapter 5                                                                                              61

Observations
Appendixes               Appendix I: Comments From the Social Security Administration                  64
                         Appendix II: GAO Contacts and Staff Acknowledgments                           66




                         Page 12                           GAO/HEHS-99-110 Social Security Rates of Return
               Contents




Bibliography                                                                                  67


Table          Table 3.1: Returns on Market Investments Depend on Portfolio                   38
                 Strategies

Figures        Figure 1: Social Security’s Implicit Rates of Return Are Higher for             6
                 Earlier Beneficiaries
               Figure 2.1: Social Security’s Implicit Rates of Return Are Higher              23
                 for Earlier Beneficiaries
               Figure 2.2: Social Security’s Implicit Rates of Return Are Higher              27
                 for Low Than for High Earners
               Figure 2.3: Social Security’s Implicit Rates of Return Are Higher              29
                 for One-Earner Couples
               Figure 3.1: Holding Risky Investments for Long Periods                         34
                 Diminishes Risk
               Figure 4.1: Twenty-Year Average Rates of Return on Market                      48
                 Investments Compared With Growth Rate in Total Covered
                 Wages
               Figure 4.2: Rate of Return Comparisons for Reform Proposals                    54
                 Illustrate Effects on Intergenerational Equity
               Figure 4.3: Rate of Return Comparisons for Reform Proposals                    57
                 Illustrate the Effects of Account Size and Net Returns




               Abbreviations

               AIME       average indexed monthly earnings
               IA         individual accounts
               MB         maintain benefits
               PIA        primary insurance amount
               PSA        personal security accounts
               SSA        Social Security Administration
               TSP        Thrift Savings Plan


               Page 13                            GAO/HEHS-99-110 Social Security Rates of Return
Chapter 1

Introduction


                       Social Security forms the foundation for our retirement income system,
                       providing crucial benefits to millions of Americans. However, the program
                       faces a long-term financing shortage, according to government
                       projections. In the current Social Security reform debate, the rates of
                       return workers implicitly receive on their Social Security contributions
                       have received considerable attention.

                       Some proponents of reform assert that for many future retirees, the
                       inflation-adjusted rates of return on Social Security contributions will be
                       near zero and even negative for some people. However, others believe that
                       the rate of return concept should not be applied to Social Security because
                       it is a social insurance program and should not be viewed strictly as an
                       investment program. Still others view Social Security as a tax-transfer
                       program, in which taxes should not be associated with future benefits but
                       simply considered to be transfers to current beneficiaries, replacing to
                       some degree transfers workers would have otherwise made—for example,
                       to their own parents—in the absence of the program. Nevertheless, if rates
                       of return are considered in weighing Social Security reforms, they should
                       be kept in careful perspective.

                       When applied to Social Security, the rate of return concept fundamentally
                       measures the relationship between benefits and contributions, just as
                       other so-called money’s-worth measures do. Providing a fair return on
                       contributions is just one of Social Security’s objectives. In particular, this
                       objective competes to some degree with the objective of helping ensure
                       adequate incomes, which Social Security’s various income transfers try to
                       achieve.

                       Estimating rates of return involves complex actuarial computations and
                       requires accounting for all contributions and benefits in a correct and
                       consistent manner. Many of the relevant factors are subject to
                       considerable uncertainty, so estimates ideally incorporate the statistical
                       probabilities associated with the uncertainties of those factors. As a result
                       of these uncertainties, actual rates of return for individuals vary
                       tremendously; hence, rate of return estimates are used more appropriately
                       for group averages than for individuals.


                       In the midst of the Great Depression, Social Security was enacted to help
The Current Social     ensure that the elderly would have adequate retirement incomes and
Security Program and   would not have to depend on welfare. It would provide benefits that
the Reform Debate      workers had earned to some degree because of their contributions and



                       Page 14                             GAO/HEHS-99-110 Social Security Rates of Return
Chapter 1
Introduction




those of their employers, and these benefits would be related to the
earnings on which contributions would be based. However, Social Security
does not only provide benefits to retired workers. In 1939, coverage was
extended to their dependents and survivors. In 1956, the Disability
Insurance program was added.

Profound demographic trends are contributing to Social Security’s
long-term financing shortfall. While 3.3 workers support each Social
Security beneficiary today, only 2 workers are expected to be supporting
each beneficiary by 2030. This trend reflects increasing longevity and
declining fertility for all future workers, not just the baby boom
generation. Restoring Social Security’s long-term solvency will require
increased revenues, reduced expenditures, or some combination of both.

A variety of options are available within the current structure of the
program.2 However, some proposals would go beyond restoring long-term
solvency and restructure the program to include individual retirement
savings accounts to either supplement or partially replace the current
program’s benefits. In effect, nontax revenues could be added to the
program if the retirement funds could earn a higher rate of return than
Social Security’s current funds do. According to proponents, a new system
of individual accounts would substantially improve the rates of return
individuals can receive on their retirement contributions. However, others
point out that reforms within the current structure could also improve
rates of return. For example, increasing the build-up of the Social Security
trust funds and having the government invest some of those funds in the
stock market would also draw nontax revenues into the program and raise
rates of return.3

Improving rates of return is just one of many criteria by which to evaluate
alternative reform proposals.4 It is also important to examine the effect of

2
 See Social Security: Different Approaches for Addressing Program Solvency (GAO/HEHS-98-33,
July 22, 1998).
3
 John Geanakoplos, Olivia S. Mitchell, and Stephen P. Zeldes, “Would a Privatized Social Security
System Really Pay a Higher Rate of Return?” in R. Douglas Arnold, Michael Graetz, and Alicia H.
Munnell, eds. Framing the Social Security Debate (Washington, D.C.: Brookings Institution, 1998), pp.
137-56. This paper makes the distinction between three distinct types of reform: privatization,
prefunding, and diversification. Creating a new system of individual accounts would achieve all three,
but only the last two would be necessary to improve rates of return. Privatization would transfer
retirement funds from the government to individuals. Prefunding would build up retirement funds in
advance, in contrast to the current system’s pay-as-you-go financing structure. Diversification would
invest those funds in a wider range of market investments than just government bonds.
4
See Social Security: Criteria for Evaluating Social Security Reform Proposals (GAO/T-HEHS-99-94,
Mar. 25, 1999).



Page 15                                        GAO/HEHS-99-110 Social Security Rates of Return
                    Chapter 1
                    Introduction




                    reforms on the adequacy of retirement incomes, in terms of both the level
                    and the certainty of those incomes. In addition, reforms should restore
                    solvency in a way that is likely to be sustained over time. Moreover,
                    reforms will have effects on the federal budget and the prospects for
                    economic growth. Reforms should also be evaluated for how readily they
                    can be implemented, administered, and explained to the public. Finally,
                    reform proposals should be evaluated as entire packages, weighing all
                    their many effects together.


                    By design, Social Security contributions are not deposited in
Implicit Rates of   interest-bearing accounts for individual workers but are credited to the
Return Relate       Social Security trust funds, which are primarily used to pay current
Benefits to         benefits.5 The trust funds are invested in interest-bearing federal
                    government securities. However, the benefit payments to any given
Contributions       individual are derived from a formula that does not use interest rates or
                    the amount of contributions but rather uses average lifetime earnings.6

                    Even though workers do not earn interest on their contributions as they
                    would on a savings account, the benefits they receive do reflect a rate of
                    return they implicitly receive on their contributions. This implicit rate
                    equals the interest rate that workers would hypothetically have to earn on
                    their contributions in order to pay exactly for all the benefits they and
                    their families will receive over the course of their lives.7 This implicit rate
                    of return provides one measure of the relationship between contributions
                    and benefits. It is important to recognize that this implicit rate of return
                    that individuals receive on their contributions is not the same as the
                    interest that the Social Security trust funds earn on their assets. Implicit
                    rates of return for individuals depend on the relationship between lifetime

                    5
                     The Social Security trust funds are not trust funds in the sense used in the private sector. They are
                    primarily used to keep track of amounts earmarked for a specific purpose. The Department of the
                    Treasury has permanent authority to make Social Security benefit payments as long as there is a fund
                    balance. As a result, benefit payments do not require annual appropriations from the Congress. The
                    trust funds also provide a contingency reserve to help ensure that short-term economic downturns do
                    not result in funding shortfalls. Currently, the trust fund balances equal about 194 percent of annual
                    benefit payments.
                    6
                     In technical terms, Social Security provides a “defined-benefit” pension, not a
                    “defined-contribution” pension. A defined-benefit pension provides a benefit based on a specific
                    formula generally linked to each worker’s earnings and years of employment. In contrast, a
                    defined-contribution pension resembles an individual savings account; retirement income from this
                    type of pension depends on the total amount of contributions to the account and any investment
                    earnings. As an example, 401(k) accounts are a type of defined-contribution pension.
                    7
                     A more technically precise definition of the rate of return for Social Security contributions would be
                    the constant discount rate that equates the present discounted value of contributions with the present
                    discounted value of benefits.



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                           Chapter 1
                           Introduction




                           benefits and contributions, while the interest earned by the trust funds
                           reflects the prevailing rate of interest in the market. In part, implicit rates
                           of return for individuals depend on the interest earned by the trust funds
                           but only because it reduces the contribution rates required to fund
                           benefits. In addition to depending on trust fund interest earnings, implicit
                           returns depend on long-term demographic and economic trends that affect
                           the program’s flows of contributions and benefits.8


Implicit Rates of Return   Implicit rates of return are one type of so-called money’s-worth measure
Are One Type of            and measure the “individual equity” of the program—that is, how benefits
“Money’s-Worth” Measure    compare with contributions. Such measures also reflect how well benefits
                           compare with the income workers would have if they could keep their
                           contributions and invest them elsewhere.

                           Other measures of Social Security’s money’s-worth include payback
                           periods, lifetime benefit/tax ratios, and the dollar value of net lifetime
                           transfers. Such measures begin with an interest rate workers could earn
                           on their contributions. The payback period is how long it takes their
                           benefits to pay back their contributions plus interest. Benefit/tax ratios, or
                           money’s-worth ratios, compare the interest-adjusted value of lifetime
                           benefits with lifetime contributions. In general, these alternative measures
                           yield conclusions similar to the rate of return, but none gives a complete
                           picture. For example, early Social Security beneficiaries enjoyed very high
                           rates of return. However, those returns were on very small contributions,
                           so the absolute dollar value of the income transfer they received was
                           relatively small.

                           Money’s-worth calculations measure only individual equity, which is just
                           one of Social Security’s objectives. The program’s insurance features
                           inherently place greater emphasis on helping ensure that beneficiaries
                           have adequate income; without its built-in income transfers across and
                           within cohorts, Social Security would provide identical rates of return on
                           contributions. In contrast, measures of “income adequacy” include how
                           total retirement income, including benefits, compares with the poverty
                           line. Today, less than 11 percent of the elderly have incomes below the
                           poverty line, compared with 35 percent in 1959. For about half of the
                           elderly, incomes excluding Social Security benefits are below the poverty

                           8
                            Rates of return are most useful when they are adjusted for inflation to reveal how much the
                           purchasing power of an invested sum of money has increased. For example, the yield on a 3-month
                           Treasury bill in 1981, not adjusted for inflation, was 14.0 percent, but inflation was 10.3 percent.
                           Adjusted for inflation, the yield was 3.4 percent. In contrast, the same yield in 1986, not adjusted, was
                           much lower at 6.0 percent although inflation was only 1.9 percent. Adjusted for inflation, the yield in
                           1986 was 4.0 percent, higher than in 1981.



                           Page 17                                          GAO/HEHS-99-110 Social Security Rates of Return
                             Chapter 1
                             Introduction




                             line. Also, “replacement rates,” which equal the initial annual benefit
                             amount divided by the earnings in the worker’s last year of work, show
                             how well benefits compare with or “replace” preretirement income. For
                             example, workers who retired in 1999 at age 65 with a history of average
                             earnings had a replacement rate of 40 percent and an annual benefit of
                             $11,454.


Considerations Relating to   Because rates of return show the relationship between benefits and
Which Benefits and           contributions, rate of return calculations depend critically on which
Contributions Are Included   benefits and contributions are included. To be consistent, calculations
                             must carefully include all the benefits associated with any of the
in Rate of Return            contributions that are included, and vice versa. In particular,
Calculations                 considerations in properly accounting for all benefits and contributions
                             include the treatment of (1) inflation adjustment of benefits,
                             (2) employers’ contributions, (3) any actuarial imbalance in the system,
                             and (4) nonretirement benefits.

Inflation Adjustment of      Rate of return estimates should reflect the automatic annual inflation
Benefits                     adjustment of Social Security benefits, which is a significant part of the
                             benefit package that the payroll tax finances.

Employers’ Contributions     Including the employers’ share of the payroll tax has a significant effect on
                             rate of return calculations since it is half of all payroll taxes. Currently,
                             both the individual and the employer pay a 6.2-percent tax on covered
                             earnings for retirement, survivors, and disability benefits combined.9
                             Although a few studies use only the workers’ contributions to calculate
                             rates of return, most studies use both the employers’ and employees’
                             contributions. Most analysts agree that employees ultimately pay the
                             employers’ share because employers pay lower wages than they would if
                             the employers’ contribution did not exist. Furthermore, estimates that
                             leave out employers’ contributions reflect the full benefits but not the full
                             costs of providing those benefits.

Reflecting an Actuarially    Rate of return calculations that include only contributions and benefits as
Balanced System              defined under current law are misleading, because the system is not in
                             actuarial balance. The returns that workers actually receive will be
                             different from any returns estimated using current contribution and
                             benefit levels, depending on how the financing shortfall is addressed. One
                             approach to resolving this is to use contribution levels that would restore

                             9
                              Self-employed workers pay a contribution rate of 12.4 percent, half of which is tax deductible as a
                             business expense.



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                         Chapter 1
                         Introduction




                         actuarial balance on a pay-as-you-go basis—that is, raising tax rates as the
                         funds are needed to pay benefits. Another is to use reduced benefit levels
                         that would require no tax increases. According to 1996 estimates by the
                         Social Security actuaries, for example, two-earner couples born in 1973
                         with average earnings would receive an inflation-adjusted return of
                         1.9 percent under the tax-increase approach but would receive a return of
                         1.7 percent under the benefit-cut approach. In contrast, their estimated
                         rate of return would be 2.1 percent using contributions and benefits from
                         the current, imbalanced system.10

Nonretirement Benefits   Rate of return calculations must be clear and consistent about whether
                         benefits and contributions are included for survivors, dependents, and
                         disabled workers as well as for retired workers.11 If rate of return
                         calculations included the full range of benefits provided by the Social
                         Security program rather than retirement benefits alone, the calculations
                         would also need to include the full range of contributions made for those
                         benefits. Conversely, if the calculations included only the retirement
                         portion of the benefits, then the contributions would need to be reduced
                         accordingly.

                         Although disagreement exists about whether return estimates should
                         include survivors and disability benefits, either approach can theoretically
                         produce reasonable estimates as long as the contributions and benefits
                         used are comparable. Analysts who prefer to exclude survivors and
                         disability benefits from the computations believe that these benefits are
                         distinct and separable from retirement benefits and that they are more like
                         true insurance. Death and disability can strike at any time, but workers
                         can plan and save for retirement over a known period. So providing for
                         retirement is an issue more of saving than insurance, according to this
                         view. In contrast, analysts preferring return estimates for the whole
                         program point out that returns can vary significantly across retirement,
                         survivors, and disability benefits for various groups of beneficiaries. For
                         example, focusing only on retired worker rates of return for
                         African-Americans, who have shorter life expectancies than whites,




                         10
                          Advisory Council on Social Security, Report of the 1994-1996 Advisory Council on Social Security,
                         Vol. 1 (Washington, D.C.: Jan. 1997), p. 222.
                         11
                           In 1996, retired workers accounted for 61 percent of all Social Security beneficiaries, and they
                         received 68 percent of the benefits.



                         Page 19                                         GAO/HEHS-99-110 Social Security Rates of Return
                         Chapter 1
                         Introduction




                         ignores that African-Americans are considerably more likely to receive
                         disability and survivors benefits.12


Several Factors Are      Several factors that affect rate of return calculations are subject to
Subject to Uncertainty   uncertainty, which makes projections complex and subject to error.
                         Contributions depend on each worker’s earnings level and the tax rate.
                         Workers’ benefits depend on various uncertain life events, such as when
                         they retire, become disabled, or die; whether they have spouses or
                         dependents who are eligible for benefits; and how long benefits are paid.
                         Their benefits also depend on their lifetime earnings histories. Further,
                         their benefits depend on national trends in wage and price levels. Both
                         benefits and contributions depend on any changes in the law that the
                         Congress may make. Rate of return estimates can reflect averages relating
                         to these uncertainties across large groups, such as all average-income
                         workers born in a given year. However, any projections for individual
                         workers would prove to be misleading for many of them because their
                         actual experience can vary so much from the average.13

                         To account for various uncertainties, accurate rate of return estimates
                         require complex actuarial calculations. The most rigorous calculations
                         produce an estimate of what workers can expect to receive from the time
                         they start paying taxes. “Expected values” describe the average return for
                         all possible outcomes, weighted for the probability of each outcome. In the
                         perfect case, this would involve projecting statistical probabilities for each
                         life event, including disability or death at each age, age at retirement,
                         earnings in each year, marital status, number of children, and so on. The
                         return calculations would then use these probabilities in the weighted
                         average of all the benefits received under each of the many different
                         possible scenarios. In contrast, less rigorous calculations estimate a rate of
                         return for a small number of specific illustrative outcomes, such as having
                         a low, average, or high level of lifetime earnings and being single or in a
                         one-earner or two-earner couple. Such “hypothetical worker” calculations
                         are by far the most common type of rate of return estimate. However,
                         while they can be accurate for such specific cases and can be useful for
                         making comparisons across types of individuals, they do not and cannot


                         12
                           In addition, the appropriate contribution rate to attribute to Disability Insurance is not as clear-cut as
                         it may seem. Even though a distinct contribution rate exists for Disability Insurance, the Congress has
                         occasionally adjusted the rates to manage the financial balances of the separate funds. The problems
                         are more complicated for survivors and dependents benefits under the Old-Age and Survivors
                         Insurance program, which does not have a separate contribution rate for each type of benefit.
                         13
                          See SSA Benefit Estimate Statement: Adding Rate of Return Information May Not Be Appropriate
                         (GAO/HEHS-98-228, Sept. 2, 1998).



                         Page 20                                          GAO/HEHS-99-110 Social Security Rates of Return
                     Chapter 1
                     Introduction




                     represent what all workers in a particular group can expect to receive on
                     average. Still, even these simpler, hypothetical worker calculations require
                     proper actuarial methods.


                     In recognition of the role that rate of return comparisons are playing in the
Objectives, Scope,   current reform debate, the Senate Special Committee on Aging and
and Methodology      Senator Richard Shelby asked us to (1) examine estimates of Social
                     Security’s implicit rates of return for different birth years, earnings levels,
                     household configurations, and other demographic groupings; (2) examine
                     rates of return available on private market investments; and (3) discuss the
                     issues that arise from comparing Social Security and market investment
                     returns. To answer these questions, we conducted an extensive review of
                     the growing literature on the subject and interviewed experts familiar with
                     the estimates available. Many estimates of Social Security’s rate of return
                     have been made. Analysts generally agree on which approaches for
                     calculating returns are the most rigorous and which are flawed. We
                     examined estimates from several studies and found that the most rigorous
                     ones produced generally consistent estimates. For example, estimates
                     made by Social Security actuaries for the Report of the 1994-1996 Advisory
                     Council on Social Security were among the most rigorous. In this report,
                     we present only estimates that meet a rigorous standard, and we note any
                     limitations or qualifications. In particular, we present only estimates that
                     include employers’ as well as employees’ contributions and that reflect an
                     actuarially balanced system. We conducted our work between
                     January 1998 and June 1999 in accordance with generally accepted
                     government auditing standards.




                     Page 21                             GAO/HEHS-99-110 Social Security Rates of Return
Chapter 2

Implicit Rates of Return Vary Because of
Social Security’s Income Transfers

                     Social Security’s implicit rates of return vary significantly by birth year,
                     earnings level, household composition, and other demographic
                     characteristics. These variations reflect several types of income transfers
                     that the program provides as part of its social insurance function. Social
                     Security insures workers against the uncertainties associated with various
                     life events and low lifetime earnings. In effect, any type of insurance
                     transfers income to persons who incur losses from those who do not.
                     Similarly, Social Security transfers income, for example, to persons who
                     live longer—and therefore need income longer—from those who do not.
                     Persons who receive such transfers get higher rates of return than those
                     who do not.14


                     Social Security’s implicit rates of return have fallen continuously since the
Variation by Birth   beginning of the program. This decline is primarily a natural and
Year Reflects        anticipated consequence of the maturing of a pay-as-you-go system, in
Maturing of System   which each year’s revenues are primarily used to pay that year’s benefits.
                     When a pay-as-you-go system is started, rates of return are high for earlier
and Wage Growth      retirees because they receive large transfers of income from subsequent
                     generations. While the declines were dramatic initially, they have been
                     much smaller as the system has approached maturity. (See fig. 2.1.)




                     14
                       This chapter summarizes only the basic dimensions by which rates of return vary: birth year,
                     earnings level, and household composition. In addition, interactions exist among these dimensions that
                     present a more complicated picture. For example, a high-earning one-earner couple earns lower
                     returns than average by virtue of its earnings level but higher returns by virtue of its household
                     composition. Rate of return estimates can reveal the net effect for each particular combination of
                     characteristics. However, as noted in chapter 1, rates of return by themselves do not provide a
                     complete picture even then. The dollar value of the income transfer can be relatively low even when
                     the rate of return is relatively high. For a more complete set of rates of return and money’s-worth
                     measures, see Advisory Council on Social Security, Report of the 1994-1996 Advisory Council on Social
                     Security, Vol. 1, pp. 165-230.



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                                         Chapter 2
                                         Implicit Rates of Return Vary Because of
                                         Social Security’s Income Transfers




Figure 2.1: Social Security’s Implicit
Rates of Return Are Higher for Earlier
Beneficiaries




                                         Note: Inflation-adjusted rates, average for all workers in each birth year. These estimates do not
                                         include Social Security disability contributions and benefits. They do reflect tax rates that would
                                         keep the system in actuarial balance on a pay-as-you-go basis. They use the intermediate
                                         assumptions of the 1991 Social Security Trustees’ Report. This is the most complete set of
                                         estimates by birth year and one of very few that compute average rates of return for all workers
                                         born in a given year.

                                         Source: Dean R. Leimer, Cohort-Specific Measures of Lifetime Net Social Security Transfers,
                                         working paper 59 (Washington, D.C.: SSA, Office of Research and Statistics, Feb. 1994).




                                         Figure 2.1 illustrates inflation-adjusted average rates of return for all
                                         workers born in given years—that is, for “birth groups.” These estimates
                                         include all Social Security benefits and contributions except disability, and
                                         they assume that payroll tax rates will increase on a pay-as-you-go basis to
                                         keep the system actuarially balanced. Inflation-adjusted rate of return
                                         estimates were more than 25 percent per year for birth groups born in
                                         1880 or earlier. However, these returns were on relatively small
                                         contributions, so the dollar value of the income transfer they received was
                                         relatively small. Rate of return estimates were more than 10 percent for
                                         birth groups born before 1905. They fell below 6 percent for those born in
                                         1920, below 3 percent for those born in about 1940, and below 2 percent




                                         Page 23                                        GAO/HEHS-99-110 Social Security Rates of Return
Chapter 2
Implicit Rates of Return Vary Because of
Social Security’s Income Transfers




for those born in about 1960. They will reach 1 percent for those who will
be born in about 2040.15

Implicit rates of return declined for successive groups of workers during
the maturing phase of Social Security’s history. From 1937 to 1949, Social
Security’s tax rates were a relatively low 1 percent of payroll each for
employees and employers, compared with 6.2 percent today. Higher rates
were not necessary because only a small share of the elderly had
contributed enough to the program to qualify for benefits.16 In addition,
early beneficiaries made contributions over fewer years in covered
employment than later beneficiaries. As a result, the benefits they received
were very high relative to these smaller contributions, and the implicit
rates of return they enjoyed were very high. As the system matured—that
is, as each year passed and another group of people reaching retirement
age qualified for benefits—benefit costs increased. Tax rates eventually
increased accordingly, newer beneficiaries had made contributions over
more years, and benefits became smaller relative to those contributions.17

In designing Social Security, the Congress chose a pay-as-you-go system
rather than an “advance-funded” one in which tax levels are high enough
to finance future benefit promises.18 In effect, the Congress provided large
income transfers to early generations of beneficiaries. This decision
reflected concern that the government might amass huge reserve funds
and the prospect that this could weaken the economy. It also reflected a
concern about helping improve retirement incomes much sooner than an
advance-funded system would have done. While these early beneficiaries
may have received a substantial income transfer within the Social Security
system, as a group they contributed substantial amounts outside the
system to the retirement incomes of their parents’ generation, which did

15
 Dean R. Leimer, Cohort-Specific Measures of Lifetime Net Social Security Transfers, working paper
59 (Washington, D.C.: SSA, Office of Research and Statistics, Feb. 1994).
16
  In addition, the maximum annual earnings subject to the payroll tax were only $3,000 in 1937.
However, in 1937, 97 percent of all covered workers had total earnings below $3,000, while today
about 94 percent have total earnings below the taxable maximum. Still, the percentage of workers with
total wages under this ceiling was much lower from about 1950 to 1978, when this percentage ranged
between 64 and 85 percent. So this pattern of relatively lower contributions also contributed to higher
rates of return for those who paid taxes during this period.
17
  Technically speaking, more than one generation of retirees benefited from the transfers that resulted
from starting a new system. The Congress increased Social Security benefit levels many times over
several years and expanded coverage to new sets of workers. Each time benefits are added or
coverage is expanded, those incremental changes begin a new maturing process of their own, which
extends the maturing process for the system as a whole. Nevertheless, the current system can now be
considered to be essentially mature since any remaining part of that process is relatively small.
18
 Social Security actually began in 1935 as a partially funded pension plan; however, the 1939
amendments modified it to more of a pay-as-you-go pension plan.



Page 24                                        GAO/HEHS-99-110 Social Security Rates of Return
Chapter 2
Implicit Rates of Return Vary Because of
Social Security’s Income Transfers




not qualify for Social Security benefits. Such contributions included not
only income support that some provided to their own parents but also
taxes and charitable contributions that paid for other forms of support.

In a fully mature pay-as-you-go system, long-term average implicit returns
roughly equal the growth of total wages covered by the system because
both contributions and benefits are based directly on covered wages.19 In
turn, total wage growth depends significantly on the growth of labor
productivity and the growth of the labor force. Since both of these growth
rates have slowed in recent years and are projected to remain low, implicit
Social Security returns have been declining even though the system is now
essentially mature. However, as long as total wage growth remains
positive, long-term average returns on Social Security for birth groups will
also generally remain positive.20 This remains true over the long-term even
with increasing longevity and a declining ratio of workers to beneficiaries.
The estimates in figure 2.1 take these projected demographic changes into
account and also reflect tax rates that would keep the system in actuarial
balance. Under this scenario, tax rates would increase but so would
lifetime benefits as people live longer.




19
  While this fundamental relationship between Social Security’s rate of return and wage growth may
not be immediately obvious, the academic literature has shown it to be true. In short, if demographic
and economic conditions and program provisions were all constant in a mature pay-as-you-go system,
then benefits for one generation of retirees would equal the contributions paid by its children’s
generation. Those contributions would equal the retirees’ contributions plus wage growth, since
contributions are based on wages. If any of the constants were to change, program provisions would
have to change to restore balance. Once balance were restored and all factors became constant again,
this relationship between contributions and benefits would be restored. Of course, in the real world,
returns vary within these long-term averages because contribution and benefit patterns can vary
somewhat and still reflect long-term actuarial balance. For example, the Congress can increase taxes
or cut benefits to achieve actuarial balance, but such policy changes can affect those born earlier more
than those born later or vice versa and still achieve the same level of long-term balance.
20
  This relationship between returns and wage growth helps explain why Social Security is not a “Ponzi”
or pyramid scheme. It is mathematically impossible for a pyramid scheme to continue indefinitely. As
layers are added at the bottom of the pyramid, the number of participants required grows
exponentially and eventually there would never be enough people to complete a full layer. However,
under Social Security, positive rates of return on average can exist indefinitely as long as total wage
growth remains positive.



Page 25                                        GAO/HEHS-99-110 Social Security Rates of Return
                        Chapter 2
                        Implicit Rates of Return Vary Because of
                        Social Security’s Income Transfers




                        Social Security’s implicit rates of return are higher on average for workers
Variation by Earnings   with low lifetime earnings than for those with high earnings. (See fig. 2.2.)
Level Reflects Income   This pattern reflects the way the benefit formula transfers income from
Redistribution          high to low earners.21 To help ensure that beneficiaries with low lifetime
                        earnings have adequate incomes, the benefit formula was designed to be
                        progressive and replace a higher percentage of average lifetime earnings
                        for low earners than for high earners.22




                        21
                          The estimates for figures 2.2 and 2.3 are for illustrative, hypothetical workers. However, a recent
                        study raises questions about whether the “low” and “average” earnings levels reflect earnings that
                        are truly low and average. As a result, rates of return for truly low and average earnings levels would
                        actually be somewhat higher than these estimates suggest. Earnings records for hypothetical workers
                        are assumed to follow a steady, smooth lifetime earnings pattern. In reality, earnings patterns vary
                        considerably, and many workers have some years of zero earnings. Those zero earnings in particular
                        years are not reflected in the average earnings level used for the hypothetical worker cases, but they
                        can affect the Social Security benefit calculation. As a result, the study found that the hypothetical
                        “low” earnings level of $13,000 actually falls between the low and average earnings level. Similarly,
                        the hypothetical “average” earnings level of $29,000 actually falls between the average and high
                        levels. Because rates of return are lower for higher earnings, return estimates for these hypothetical
                        earnings levels may be misleadingly low. Nevertheless, they do illustrate the general pattern by
                        earnings level. See Gary Burtless, Barry Bosworth, and C. Eugene Steuerle. “Changing Patterns of
                        Lifetime Earnings: What Do They Tell Us About Winners and Losers From Privatization?” Paper
                        presented at the First Annual Joint Conference for the Retirement Research Consortium, “New
                        Developments in Retirement Research,” Boston College Center for Retirement Research and Michigan
                        Retirement Research Center, Washington, D.C., May 20-21, 1999.
                        22
                          Specifically, the primary insurance amount (PIA) is the full monthly benefit payable to retired
                        workers at age 65 or to disabled workers when first eligible. Retired workers are first eligible for
                        benefits at age 62 but the monthly benefit is reduced for each month they receive benefits before age
                        65. For those first eligible for benefits in 1998, the PIA equaled (1) 90 percent of the first $477 of
                        average indexed monthly earnings (AIME) plus (2) 32 percent of the next $2,398 of AIME plus
                        (3) 15 percent of AIME over $2,875. The bend points in this formula (dollar amounts of AIME defining
                        each bracket) are indexed to increases in average national earnings.



                        Page 26                                        GAO/HEHS-99-110 Social Security Rates of Return
                                         Chapter 2
                                         Implicit Rates of Return Vary Because of
                                         Social Security’s Income Transfers




Figure 2.2: Social Security’s Implicit
Rates of Return Are Higher for Low
Than for High Earners




                                         Note: Inflation-adjusted rates, single women born in 1973. These estimates include all Social
                                         Security contributions and benefits, including disability, and reflect tax rates that would keep the
                                         system in actuarial balance on a pay-as-you-go basis. These estimates do not reflect the fact that
                                         life expectancy is lower for lower earners. These estimates are for hypothetical workers to
                                         illustrate differences across earnings levels. Each earnings level estimated represents one
                                         earnings amount in each year; the estimates do not represent ranges of earnings. The average
                                         earnings level equals the average Social Security covered earnings in each year, the low
                                         earnings level equals 45 percent of the average, and the high level equals 160 percent of the
                                         average. The maximum taxable earnings level reflects an earnings history in which the workers’
                                         earnings equaled the maximum taxable level in each year. In 1998, the average earnings level
                                         was about $29,000, implying a low earnings level of roughly $13,000 and a high level of roughly
                                         $46,000. The maximum taxable earnings level was $68,400. Returns for single men were roughly
                                         0.5 percentage points lower at each earnings level.

                                         Source: SSA.




                                         However, some analysts have noted that lower earners have lower life
                                         expectancies on average, which reduces their rates of return.23 Various
                                         sets of estimates have attempted to demonstrate the size of the effect on
                                         implicit returns from life expectancy differences across income groups.
                                         While some of these estimates have been flawed, rigorous and reasonably

                                         23
                                           Also, lower earners tend to enter the workforce earlier than higher earners, who tend to have more
                                         years in school. Therefore, lower earners are likely to have more years of nonzero earnings, which
                                         diminishes the benefit formula’s progressivity. However, lower earners more commonly have
                                         interrupted work histories or work outside of covered employment, which strengthens progressivity.



                                         Page 27                                        GAO/HEHS-99-110 Social Security Rates of Return
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                       Implicit Rates of Return Vary Because of
                       Social Security’s Income Transfers




                       accurate estimates have shown that the life expectancy differences
                       between income groups do lower rates of return for low earners and
                       increase them for high earners. However, these effects are not large
                       enough to reverse the overall progressivity of the benefit structure. For
                       example, for workers born between 1917 and 1922, one study estimated
                       that adjusting life expectancy for income differences would decrease the
                       average annual, inflation-adjusted, implicit returns for low-wage men from
                       6.23 to 6.17 percent and would increase such returns for high-wage men
                       from 4.99 to 5.04 percent.24 These estimates did not include disability
                       benefits or contributions.


                       Social Security’s implicit rates of return also vary considerably for
Variation by           workers if their family situations differ. Workers’ earnings generate Social
Household Type         Security benefits for themselves and may also generate benefits for their
Reflects the Role of   spouses and dependents, both while they are receiving benefits and after
                       they have died.25 Because workers do not make any additional
Dependents’ Benefits   contributions for any of these auxiliary benefits, workers with families
                       that get them receive a higher implicit rate of return than workers without
                       such families. Also, one-earner and two-earner couples both receive some
                       combination of retired worker and spouse benefits, but the two-earner
                       couples make contributions based on two earnings records instead of
                       one.26 As a result, one-earner couples receive significantly higher implicit
                       rates of return than two-earner couples or single earners. (See fig. 2.3.) For
                       these estimates, the hypothetical one-earner couples are those in which
                       one spouse works steadily until retirement while the other does not work
                       at all. In reality, a couple could have the second spouse work and make
                       Social Security contributions for some number of years; if that spouse’s
                       average lifetime earnings were low enough, the couple might still receive
                       the same benefit as the hypothetical one-earner couple. Such a couple

                       24
                        James E. Duggan, Robert Gillingham, and John S. Greenlees, Progressive Returns to Social Security?
                       An Answer from Social Security Records, research paper 9501 (Washington, D.C.: U.S. Treasury
                       Department, Nov. 1995), p. 14.
                       25
                         Social Security also pays benefits to divorced spouses. However, most divorced women do not
                       qualify for divorced spouse benefits because most marriages that end in divorce last less than 10 years,
                       the minimum marriage duration needed to qualify for such benefits. In addition, many divorced women
                       who were married at least 10 years do not receive divorced spouse benefits because they either
                       subsequently remarry or have retired worker benefits that exceed their benefit as a divorced spouse.
                       26
                         The spouses with the lower earnings are eligible to receive spouse benefits based on their spouse’s
                       earnings record as well as retired worker benefits based on their own earnings, but they cannot
                       receive both full benefits simultaneously. Essentially, these beneficiaries, who are called “dually
                       entitled,” receive their own retired worker benefit and the difference between that and the spouse
                       benefit if it is higher. Spouse benefits equal 50 percent of the worker’s benefit, which may be higher
                       than the spouse’s own retired worker benefit if the difference in their average lifetime earnings is large
                       enough.



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                                         Chapter 2
                                         Implicit Rates of Return Vary Because of
                                         Social Security’s Income Transfers




                                         would have a lower implicit rate of return than the one-earner case in
                                         which the second spouse makes no contributions. The hypothetical
                                         one-earner case illustrates only one relatively extreme scenario.27


Figure 2.3: Social Security’s Implicit
Rates of Return Are Higher for
One-Earner Couples




                                         Note: Inflation-adjusted rates, average earners born in 1973. These estimates include all Social
                                         Security contributions and benefits, including disability, and reflect tax rates that would keep the
                                         system in actuarial balance on a pay-as-you-go basis. These estimates are for hypothetical
                                         workers with earnings equal to the national average each year; for the one-earner couple, one
                                         spouse does not work at all. In 1998, the average earnings level was about $29,000. The
                                         estimates illustrate differences across household types but they are not averages for all workers
                                         in each type. In addition, they do not reflect any differences in average income that may exist
                                         across these groups.

                                         Source: SSA.




                                         These patterns reflect that Social Security is designed to provide income
                                         transfers from families without dependents to those with them. In
                                         particular, Social Security’s benefit provisions for spouses have the effect
                                         of subsidizing or in some way recognizing the work efforts of spouses who

                                         27
                                           In addition, the hypothetical couple does not capture the effect of the age difference between
                                         spouses; it assumes that spouses are the same age and have two children born when the spouses are in
                                         their mid-20s. Couples with large age differences may get higher rates of return than those with no age
                                         difference because, on average, they may receive benefits for longer periods.



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                         Chapter 2
                         Implicit Rates of Return Vary Because of
                         Social Security’s Income Transfers




                         do not work and earn income outside the home. However, women are
                         increasingly participating in the labor force for greater proportions of their
                         working years, so the role of spousal benefits may be declining in
                         importance for such women but would still be significant for those who do
                         not work outside the home.


                         Social Security’s implicit rates of return also vary by demographic
Variation by             characteristics, such as race and gender, even though Social Security’s
Demographic Group        benefit and contribution provisions are structurally neutral with respect to
Reflects the Program’s   these characteristics. Rather, these variations in implicit returns arise
                         because such demographic groups have different average earnings levels,
Social Insurance Role    life expectancies, and household configurations. These factors
                         significantly affect rates of return as a result of Social Security’s insurance
                         role and income transfers. Its income transfers are designed to help ensure
                         adequate incomes for beneficiaries and are not intended to mitigate any
                         inequalities in income or longevity that exist in our society among various
                         racial, ethnic, or gender groups.

                         For example, figure 2.3 illustrates the difference in returns for hypothetical
                         single men and women both with the same earnings equal to the national
                         average earnings in each year. The difference in implicit returns between
                         single men and women reflects the greater life expectancies of women. At
                         age 65, women today have a life expectancy of about 19 additional years,
                         compared with 16 years for men. However, note that women have lower
                         incomes on average than men, which the estimates in figure 2.3 do not
                         reflect; these estimates are for illustrative households in which all workers
                         have equal earnings. Estimates of average implicit returns for all workers
                         born in the same year would show that the difference between single men
                         and women would be even greater because of the difference in average
                         income.

                         With respect to race differences, nonwhites tend to have lower incomes
                         than whites, which tends to increase the implicit returns of nonwhites.
                         However, African-Americans tend to have shorter life expectancies than
                         whites, which tends to decrease their implicit returns. Still,
                         African-Americans are relatively more likely to be disabled, die before
                         retirement, and have dependents than whites.28 As a result, implicit rates
                         of return are probably higher for African-Americans if the full range of

                         28
                          For example, while African-Americans make up 12 percent of the nation’s population, they make up
                         only 8 percent of Social Security retirement beneficiaries. However, they make up 18 percent of
                         disabled beneficiaries and 23 percent of child beneficiaries. Also, nearly half of all African-American
                         beneficiaries receive disability or survivor benefits compared with 28 percent of white beneficiaries.



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Implicit Rates of Return Vary Because of
Social Security’s Income Transfers




Social Security benefits is included than if only retirement benefits are
included. However, none of the currently available rate of return studies
that examine race differences have included disability benefits. Still,
rigorous and accurate return estimates that do not include disability
benefits generally show that both African-Americans and other nonwhites
have higher average implicit rates of return from Social Security than
whites.29




29
  James E. Duggan, Robert Gillingham, and John S. Greenlees, “Returns Paid to Early Social Security
Cohorts,” Contemporary Policy Issues, Vol. 11 (Oct. 1993), pp. 1-13; Charles Meyer and Nancy Wolff,
“Intercohort and Intracohort Redistribution under Old Age Insurance,” Public Finance Quarterly, Vol.
15, No. 3 (July 1987), pp. 259-81. For a review of the literature on this point, see Dean R. Leimer,
“Guide to Social Security Money’s Worth Issues,” Social Security Bulletin, Vol. 58, No. 2 (summer
1995), p. 13.



Page 31                                       GAO/HEHS-99-110 Social Security Rates of Return
Chapter 3

Private Market Rates of Return Vary by Risk
and Portfolio Composition

                         The private market offers a variety of investment vehicles with widely
                         varying rates of return, reflecting differences in the degree of risk
                         associated with those investments. Portfolio composition and the
                         performance of the market ultimately determine the returns individuals
                         receive. Social Security reform proposals that would create individual
                         accounts vary in the degree of latitude that workers would have in
                         choosing their investments, and the returns they would potentially enjoy
                         would depend on such provisions.


                         Over long periods of time, riskier investments generally yield higher
Riskier Investments      average rates of return. Over the past 60 to 70 years, returns on low-risk
Generally Yield Higher   government securities have been lower over the long term than private
Long-Term Average        securities, with a compound annual average return of roughly 0 to
                         2 percent per year on an inflation-adjusted basis before personal income
Returns                  taxes.30 In contrast, compound annual returns on stocks in Standard &
                         Poor’s composite stock index have averaged roughly 7 to 8 percent per
                         year on an inflation-adjusted basis. On long-term corporate bonds,
                         inflation-adjusted annual returns have averaged roughly 2 to 3 percent.

                         Two specific types of risk are particularly relevant to returns on market
                         investments as they might relate to individual accounts. “Default” or
                         “credit” risk is the risk of borrowers defaulting on their obligations, such
                         as bonds. Bond-rating firms grade borrowers on the risk of default. Highly
                         graded bonds—that is, bonds with low default risk—have consistently
                         been sold at lower interest rates.

                         In contrast, “market” risk relates to the volatility of the price of broad
                         groups of assets, such as stocks, bonds, and other types of investments.
                         The volatility of asset prices is reflected in the volatility of the rates of
                         return on those assets. For example, annual returns on a broad portfolio of
                         stock investments are more volatile than returns on government bonds. On
                         a long-term average basis, the market compensates for this greater market
                         risk by offering higher average returns on riskier investments. For
                         example, the year-to-year variation in rates of return is much greater for
                         stocks than for government securities, and their long-term compound
                         average annual rate of return is higher—roughly 7 to 8 percent per year
                         compared with roughly 0 to 2 percent per year on government securities.



                         30
                          Compound average annual rates of return reflect the total return on an investment over a number of
                         years, figured on a constant annual basis; this is not the same as the arithmetic average of rates for
                         each year.



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                       Chapter 3
                       Private Market Rates of Return Vary by Risk
                       and Portfolio Composition




                       Investors can manage the riskiness of their portfolios by both how long
Portfolio Strategies   they hold specific investments and how they compose their portfolios.
Can Manage Risk        Historical data suggest that over long periods of time, riskier investments
                       have quite reliably offered higher average rates of return than less risky
                       investments. For example, figure 3.1 shows that over any 20-year holding
                       period since 1940, compound average annual returns for the Standard &
                       Poor’s composite stock index have been higher than for U.S. Treasury
                       bills, which have both less default risk and less market risk. However,
                       figure 3.1 also shows that returns can still vary significantly across 20-year
                       holding periods. For example, from 1953 to 1972, inflation-adjusted returns
                       on Standard & Poor’s index averaged 9.1 percent. However, for the 20-year
                       holding period starting just 2 years later in 1955, returns averaged less than
                       half that rate at 4.2 percent. This illustrates a related type of
                       risk—“liquidity risk,” or the risk of having to liquidate investments when
                       market prices are not favorable. In addition, figure 3.1 shows that even
                       conservative investments face the risk of being eroded by inflation. For
                       example, Treasury bills provided negative inflation-adjusted returns for
                       several 20-year holding periods.




                       Page 33                                  GAO/HEHS-99-110 Social Security Rates of Return
                                          Chapter 3
                                          Private Market Rates of Return Vary by Risk
                                          and Portfolio Composition




Figure 3.1: Holding Risky Investments for Long Periods Diminishes Risk




                                          Note: Inflation-adjusted compound annual average rates of return over rolling 20-year holding
                                          periods.

                                          Source: GAO analysis using data from Robert J. Shiller, Market Volatility (Cambridge, Mass.: MIT
                                          Press, 1989), available at www.econ.yale.edu/~shiller/chapt26.html; Council of Economic
                                          Advisers, Economic Report of the President, 1999 (Washington, D.C.: U.S. Government Printing
                                          Office, Feb. 1999).




                                          Diversifying portfolios can also diminish the risks of investment while still
                                          providing relatively higher returns. A properly selected combination of
                                          risky assets can have a lower risk than any of its individual assets, and
                                          such portfolios would still provide higher average returns than an asset
                                          with equal risk over the long term. For example, in the case of market risk,
                                          the risks from different investments can offset one another if their prices
                                          do not fluctuate in a similar pattern, even though they still individually
                                          earn higher average returns. However, such techniques are very
                                          sophisticated, require substantial data analysis, and require the help of
                                          professional advisers for the average investor. Still, investors can also
                                          diversify by investing in mutual funds, which do have professional
                                          managers. Nevertheless, diversifying a stock portfolio does not protect



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Private Market Rates of Return Vary by Risk
and Portfolio Composition




investors against the risk of large swings in the market as a whole;
diversifying the portfolio to include other types of investment assets, such
as bonds, commodities, or real estate, could help manage that risk.31

Measures of investment risk and risk-adjusted rates of return are available
for helping plan portfolios. Estimating a return on an investment without
taking into account its riskiness is likely to overstate the benefit of that
investment. There are different ways to adjust returns for risk, but there is
no clear best way to do so.32 Moreover, these measures have key
limitations that do not permit making generalizations about the
risk-adjusted rates of return that individuals can earn on their portfolios as
a whole. For example, a well-diversified portfolio has a different and often
lower risk than that suggested by the risks of its individual components.33
Also, some techniques for calculating risk-adjusted rates relate only to one
type of risk, such as market risk. In short, the combinations of risk and
return that individual investors face depend fundamentally on how
portfolios are managed.34




31
 For a more complete discussion, see Katerina Simons,“Risk Adjusted Performance of Mutual
Funds,” New England Economic Review (Federal Reserve Bank of Boston), Sept.-Oct. 1998, pp. 33-48.
32
 See Social Security: Capital Markets and Educational Issues Associated With Individual Accounts
(GAO/GGD-99-115, June 28, 1999).
33
  Other limitations include (1) they are primarily useful for investments with normal probability
distributions, which means, for example, that the probability of below-average returns equals the
probability of above-average returns; (2) while many individual investments have such characteristics,
different portfolios may not; and (3) the measures presume that investors are free to borrow and use
leverage in their investment portfolios.
34
  Some controversy surrounds the issue of risk adjustment; there is no one risk-adjusted measure that
everyone agrees is the correct one. For example, some analysts have suggested that the risk-adjusted
rate of return on all assets simply equals the rate on the least risky assets. By holding a particular mix
of assets, they argue, investors demonstrate that they are indifferent to the assets or else they would
change the mix. However, different portfolios can have identical risk levels but different expected
rates of return because portfolios can vary by how well risks are managed. Nevertheless, such analysts
make the point that risk adjustment should reflect investors’ subjective preferences as well as
objective, statistical measures of risk. See John Geanakoplos, Olivia S. Mitchell, and Stephen P. Zeldes,
“Social Security’s Moneysworth,” in Olivia S. Mitchell, Robert J. Myers, and Howard Young, eds.,
Prospects for Social Security Reform (Philadelphia: University of Pennsylvania Press, 1999), pp.
79-151.



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                         Private Market Rates of Return Vary by Risk
                         and Portfolio Composition




                         Investors have varying degrees of aversion to risk that can vary in
Individuals’ Portfolio   particular by income, education, and gender. Low-income and
Choices Reflect the      less-educated individuals and women tend to choose less-risky
Extent of Risk           investments with lower average returns than high-income, highly educated
                         individuals and men.35 This may reflect more than a lack of knowledge of
Aversion and             how to manage investment risk. Those with lower income and wealth have
Retirement Planning      more to lose in relative terms than wealthier individuals. For example, if
                         investors with savings of $5 million each make a risky investment and lose
                         20 percent of the savings, they still have $4 million and can still afford a
                         very generous lifestyle. However, if investors with savings of only $500,000
                         lose 20 percent, the $100,000 they lose can have a significant effect on
                         their lifestyle in retirement. For example, if annuities paid an annual
                         benefit equal to 7 percent of the purchase price, a retiree with $500,000
                         could purchase an annuity that paid $35,000 annually, compared with the
                         $28,000 that $400,000 would buy.

                         In choosing the riskiness of their portfolios, prudent investors also
                         consider how close they are to retirement. Those who are 20 years away
                         from retirement face less risk from investments with higher average
                         returns than those who are only 5 or 10 years away, as fig. 3.1 suggests.
                         Shifting assets gradually to less risky investments as retirement
                         approaches helps guard against a sudden deterioration in savings balances
                         just before retiring or purchasing an annuity.


                         Some investment strategies incur smaller administrative costs than others.
Administrative Costs     For example, some investment funds are “passively managed”—that is, the
Vary by Investment       portfolio is based on a broad market index such as the Standard & Poor
Strategy                 500, and trading activity automatically follows a formula that tries to
                         match the performance of that index. In contrast, some investment funds
                         are “actively managed” by professionals who pick stocks in an attempt to
                         beat the averages. Such funds are more expensive to manage. Moreover,
                         some individual investors use brokers to manage their own portfolios
                         rather than just buy shares in a large fund. Such investors incur
                         transaction costs every time they make a trade.




                         35
                          For example, see Social Security Reform: Implications for Women’s Retirement Income
                         (GAO/HEHS-98-42, Dec. 31, 1997), pp. 9-10.



                         Page 36                                     GAO/HEHS-99-110 Social Security Rates of Return
                       Chapter 3
                       Private Market Rates of Return Vary by Risk
                       and Portfolio Composition




                       Portfolio composition and timing would play a large role in determining
Portfolio Management   the investment returns on individual accounts and, in turn, the retirement
Would Affect Returns   outcomes under Social Security reform proposals that would create
on Individual          individual accounts. However, returns would also depend substantially on
                       the provisions of the proposal, particularly how much latitude it gave
Accounts Under a       workers to choose their investments and annuitize their savings.
Restructured Social
                       For example, the 1994-96 Advisory Council on Social Security offered
Security Program       three alternative reform proposals, two of which created a new system of
                       individual accounts. The “individual accounts” (IA) proposal would restrict
                       investments to a limited number of passively managed index funds, similar
                       to the Thrift Savings Plan (TSP) available to federal employees. It also
                       would require that workers purchase an annuity at retirement with their
                       Social Security retirement accounts. The “personal security accounts”
                       (PSA) proposal would not impose such restrictions.

                       To illustrate the potential investment returns on the individual accounts
                       under alternative proposals, SSA actuaries developed a set of hypothetical
                       portfolio scenarios for the Advisory Council. Table 3.1 presents these
                       scenarios and the resulting investment yields. The scenarios illustrate how
                       the combined effects of investment choices, allocation changes with age,
                       and administrative costs would interact with three sets of assumptions for
                       the returns on stock investments alone. The intermediate return
                       assumption uses an inflation-adjusted stock return of 7 percent per year,
                       which reflects the historical average for the period 1900-95; the high return
                       assumption uses a return of 9.3 percent. In addition to making these return
                       assumptions, the actuaries analyzed a low-return case in which the
                       hypothetical worker’s stock returns are roughly no better than the returns
                       on government bonds. As a result, allocation decisions do not affect the
                       overall yield, although administrative costs still differ between the IA and
                       PSA proposals. The low-return assumption illustrates conservative or
                       poorly timed investments or generally poor returns on stocks. In this case,
                       the PSA proposal has a net yield of 2.0 percent overall for the portfolio, and
                       the IA proposal has a net yield of 2.3 percent at all ages. The estimated net
                       yields in table 3.1 do not project what investment returns would be on
                       average but simply illustrate a range of possible returns for hypothetical
                       workers that fit these particular scenarios. Moreover, they illustrate only
                       returns on the individual accounts themselves, not on all retirement
                       contributions under a new system.




                       Page 37                                  GAO/HEHS-99-110 Social Security Rates of Return
                                          Chapter 3
                                          Private Market Rates of Return Vary by Risk
                                          and Portfolio Composition




Table 3.1: Returns on Market Investments Depend on Portfolio Strategies
                             PSA proposal—401(k)                                          IA proposal—401(k) annuitized
                                         Annual                                                               Annual
                 Percent of       administrative    Portfolio’s net                                    administrative    Portfolio’s net
                   account       expense factor inflation-adjusted                 Percent of         expense factor inflation-adjusted
                 balance in     (percent of fund       annual yield         account balance          (percent of fund       annual yield
Age group     stock market             balance)           (percent)          in stock market                balance)           (percent)
Intermediate returns: Stocks earn 7 percent
Younger
than 40                  55                    1.00               3.885                      55                   0.105                   4.780
40-49                    52                    1.00               3.744                      50                   0.105                   4.545
50-59                    48                    1.00               3.556                      40                   0.105                   4.075
60-69                    43                    1.00               3.321                      20                   0.105                   3.135
High returns: Stocks earn 9.3 percent
Younger
than 40                  55                   0.500               5.650                      55                   0.105                   6.045
40-49                    52                   0.500               5.440                      50                   0.105                   5.695
50-59                    48                   0.500               5.160                      40                   0.105                   4.995
60-69                    43                   0.500               4.810                      20                   0.105                   3.595
                                          Note: Returns are adjusted for inflation. These estimated investment returns do not project what
                                          returns would be on average but simply illustrate a range of possible returns for hypothetical
                                          workers who fit these scenarios. The PSA proposal would have individually held and managed
                                          accounts and would not require that the funds be annuitized at retirement. The IA proposal would
                                          have the federal government hold and manage the accounts with a limited number of passively
                                          managed investment funds. It would also require that funds be annuitized. In addition to these
                                          scenarios, the actuaries analyzed a low-return case in which the hypothetical worker’s stock
                                          returns were roughly no better than the returns on government bonds. This would illustrate
                                          conservative or poorly timed investments or generally poor returns on stocks. In this case, the
                                          PSA proposal has a net yield of 2.0 percent overall for the portfolio and the IA proposal has a net
                                          yield of 2.3 percent at all ages.

                                          Source: Advisory Council on Social Security, Report of the 1994-1996 Advisory Council on Social
                                          Security, Vol. 1 (Washington, D.C.: Jan. 1997).



                                          The share of the hypothetical portfolios invested in stocks is based on
                                          401(k)-plan experience about how workers distribute their 401(k) funds
                                          among types of assets at different ages. Compared with the PSA proposal,
                                          the IA proposal assumptions have a smaller percentage of funds invested in
                                          the stock market as people approach retirement because of the annuity
                                          requirement.

                                          With regard to administrative costs for the individual accounts, the
                                          hypothetical scenarios illustrate ranges as discussed in the reform debate.
                                          Account costs for the IA plan are smaller than for the PSA plan because
                                          accounts and transactions are managed centrally by the government,



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Private Market Rates of Return Vary by Risk
and Portfolio Composition




similar to the TSP plan; they would not vary by individual. In contrast, the
Advisory Council assumed that the account costs for the PSA plan would be
larger than for the IA plan since they would be individually managed.
Moreover, individuals could manage their accounts very differently with
widely ranging administrative costs; some might modify their portfolios
only rarely, incurring very few transaction costs, while others might trade
very actively. The actuaries assumed lower administrative costs for the PSA
high-return case than for the intermediate-return case; this lower cost
assumption helps define a more optimistic, illustrative scenario.

Note that this table presents one limited set of returns illustrating one
hypothetical worker’s investment allocation choices. In fact, as some
critics have contended, allocation choices could and would vary
significantly, especially by income, because low-wage workers tend to
invest more conservatively than high-wage workers.36 Still, despite their
limitations, the Advisory Council’s portfolio scenarios represent one of the
few efforts to illustrate the interaction between portfolio management
choices and overall stock returns. Its scenarios could be interpreted to
reflect variations among individuals as well as variations in market
averages.




36
 Gordon P. Goodfellow and Sylvester J. Schieber, “Simulating Benefit Levels Under Alternative Social
Security Reforms,” in Mitchell, Myers, and Young, eds., Prospects for Social Security Reform, pp.
152-83.



Page 39                                       GAO/HEHS-99-110 Social Security Rates of Return
Chapter 4

Significant Issues in Comparing Rates of
Return

                            A simple comparison between the rates of return for the current Social
                            Security program and private market investments would be misleading
                            because of several key issues that such comparisons raise. First, such
                            comparisons do not capture all the relevant costs that a new system would
                            imply, such as transition, administrative, and annuity costs. Second, future
                            returns on both market investments and Social Security as it is now
                            structured may not be the same as in the past, and the gap between those
                            returns may narrow. Third, risks differ between the current Social Security
                            program and private market investments. In contrast to simply comparing
                            the current Social Security program with market investments, many of
                            these issues can be addressed by estimating rates of return for specific
                            reform proposals and including both the individual account and the Social
                            Security components in those comprehensive estimates. Still, even
                            comparisons of such return estimates among reform proposals have key
                            limitations. For example, rates of return by themselves do not measure the
                            risks workers may face with respect to their retirement incomes.


                            Simple comparisons between returns on market investments and the
Additional Costs Need       current Social Security program do not reflect all the costs that would
to Be Considered in         accompany a new system with individual accounts. Such costs include
Comparing Social
                        •   transition costs: making the transition to the new system would involve
Security and Market         the substantial costs of covering the unfunded liabilities of the current
Returns                     system;
                        •   administrative costs: administering the individual accounts and managing
                            the investment of their funds would incur costs beyond the administrative
                            costs of the current system; and
                        •   annuity costs: converting the account balances at retirement into annuities
                            would also incur costs beyond the current system’s administrative costs.

                            All these costs would affect either the total contributions or the total
                            retirement income benefits or both under the new system. Moreover, the
                            size of these costs and who pays for them would depend on the provisions
                            of a particular proposal. These costs would not necessarily be paid
                            through the payroll taxes of the new system. Whoever pays these costs
                            and how, they should all be reflected in any rate of return estimates made
                            for the new system. Calculating valid, comprehensive rates of return for a
                            new system requires taking into account all the contributions and benefits
                            of the new system, including some new types of contributions and benefits
                            that are not present in the current system. A simple comparison between




                            Page 40                           GAO/HEHS-99-110 Social Security Rates of Return
                   Chapter 4
                   Significant Issues in Comparing Rates of
                   Return




                   the current program and historical market investments would not capture
                   all the contributions and benefits implied by a new system.


Transition Costs   A new system with individual accounts would generally increase the
                   degree to which retirement benefits are funded in advance. Today’s
                   pay-as-you-go system largely funds current benefits from current
                   contributions, but those contributions also entitle workers to future
                   benefits. The amount necessary to pay the benefits already accrued by
                   current workers and current beneficiaries is roughly $9 trillion, according
                   to SSA. In a pay-as-you-go system, an unfunded liability will always exist
                   and will be covered by future revenues or reduced by benefit cuts or
                   both.37 However, any changes that would create individual accounts would
                   require revenues both to deposit in the new accounts for future benefits
                   and to pay for existing accrued benefits. Rate of return estimates for such
                   a system should reflect all the contributions and benefits implied by the
                   whole reform package, including the costs of making the transition.

                   The effect of transition costs on rates of return depends greatly on how
                   those transition costs would be paid. Tax rates could be increased right
                   away or many years later. The costs could also be paid for with benefit
                   cuts, again either sooner or later. Moreover, some proposals would
                   increase federal borrowing for some period of time. If such debt is repaid
                   very slowly by rolling over the debt, transition costs could be paid
                   gradually over several generations. For some reform proposals, the
                   “contributions” to pay transition costs would include general revenues, not
                   payroll taxes or account deposits; general revenues primarily come from
                   individual and corporate income taxes. Workers who pay these transition
                   costs, whoever they are in whichever generation, would receive lower
                   overall returns than those who do not.

                   Some proponents of individual accounts point out that making the
                   transition to increased advanced funding is critical and has implications
                   for comparing rates of return. They observe that rates of return from the
                   individual accounts in an advance-funded system fundamentally differ
                   from Social Security’s implicit rates of return because individual accounts
                   would provide a new source of investment funds and would increase

                   37
                     Note that the unfunded liability of $9 trillion is not the same as the “actuarial imbalance,” which
                   equals roughly $3 trillion, according to SSA. The actuarial imbalance reflects both future revenues and
                   future benefit accruals. In contrast, the unfunded liability reflects neither of these but rather the dollar
                   value of benefits accrued to date but not yet paid. Under any reform proposal that restored long-term
                   solvency—that is, reduced the actuarial imbalance to zero—additional future program revenues would
                   cover some portion of the imbalance while any benefit reductions would eliminate the remaining
                   portion.



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                       Significant Issues in Comparing Rates of
                       Return




                       national saving. This increased pool of investment would produce real
                       increases in economic activity that would make society better off. In
                       contrast, they assert that Social Security only transfers income from
                       taxpayers to beneficiaries, detracts from saving and long-term economic
                       growth, and produces no real economic returns.

                       Other analysts contend that workers paying the transition costs must
                       receive lower returns than they would otherwise in order to improve
                       returns for future generations.38 Moreover, some observe that increasing
                       the advance funding of Social Security would not necessarily increase
                       national saving. Consumers might compensate for their increased savings
                       in their individual accounts by saving less elsewhere or borrowing more.
                       National saving also depends on federal budgets and surpluses, which
                       could be affected by the specific aspects of any changes enacted. For
                       example, any federal borrowing that helps pay for transition costs would
                       offset any corresponding increases in individual account balances to some
                       degree.


Administrative Costs   Market investments entail a variety of transaction and administrative
                       costs, which reduce the rates of return that investors effectively earn.39
                       These costs are not present in the current Social Security system, at least
                       not in the same form or to the same degree. For example, stock brokers
                       charge commissions for making trades, mutual fund managers are
                       compensated for managing the funds, and making deposits into accounts
                       and recordkeeping entail some administrative costs. Reflected in such
                       costs are marketing and advertising expenses, including sales
                       commissions, incurred as money managers and brokers compete for the
                       investors’ business. In some countries that have privatized their social
                       security systems, these costs have been quite high. In contrast, SSA does
                       not maintain actual accounts for each individual but simply keeps records
                       of earnings. Administrative costs for Social Security’s Old-Age and




                       38
                        Geanakoplos, Mitchell, and Zeldes, “Would a Privatized Social Security System Really Pay a Higher
                       Rate of Return?”
                       39
                        See Social Security Reform: Administrative Costs for Individual Accounts Depend on System Design
                       (GAO/HEHS-99-131, June 18, 1999).



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                Survivors Insurance program are less than 1 percent of annual program
                revenues.40

                In a new Social Security system with individual retirement accounts, the
                size and effect of administrative costs would depend significantly on how
                the new system is designed. For example, just as administrative costs vary
                between active and passive investment strategies for individual investors,
                the range of investment strategies permitted under the new system would
                affect its administrative costs. A centrally managed approach, such as that
                envisioned in the IA proposal noted earlier, could minimize costs
                associated with recordkeeping and financial transactions. Limiting the
                range of investment options to a few types of funds available through the
                central system could also avoid substantial marketing costs that might
                arise if individuals had the freedom to switch from one money manager to
                another. Moreover, the effect of administrative costs on rates of return
                could vary across workers, depending on how those costs are paid. If
                individuals were charged a flat fee per account for administrative costs,
                accumulations in small accounts would be affected to a greater extent
                than if they were charged an annual percentage. Therefore, such costs
                would diminish the effective rates of return more for low-income workers
                with smaller balances than for high-income workers. Finally, higher
                administrative costs could be associated with more customer services, and
                some of the additional administrative costs would also provide other,
                nonquantifiable benefits, such as investors’ freedom of choice.


Annuity Costs   In addition to the costs of managing the accounts before retirement, the
                costs of annuitizing the balances at retirement would affect the retirement
                incomes individuals actually enjoy and therefore their effective rates of
                return. Like other investments, annuities purchased in the private market
                entail a variety of transaction and administrative costs.41 However,
                annuities are also a form of insurance, and annuity prices in a free market




                40
                  In addition to direct administrative costs, various indirect costs exist under the current system, such
                as those that Treasury and employers incur for various processing tasks. Indirect costs would also
                exist in a restructured system, including some new costs potentially, such as costs for investor
                education. Because indirect costs may or may not have an effect on individuals’ specific retirement
                contributions and benefits and in many cases are difficult to measure, it is not clear how or whether to
                incorporate them into rate of return estimates. Such costs may also ultimately be paid in the form of
                lower wages to workers or higher prices to consumers, which further complicates how to treat them in
                rate of return estimates.
                41
                 See Social Security Reform: Implications of Annuities for Individual Accounts (GAO/HEHS-99-160,
                July 30, 1999).



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reflect profits that insurers make.42 Moreover, annuity costs could vary
substantially from person to person, depending especially on interest rates
at the time of purchase. Annuity costs greatly depend on interest rates,
with higher interest rates increasing the size of the annuity benefit.43

Annuity costs could also vary considerably across groups of people with
different life expectancies, depending on the ability of annuity providers to
charge different prices to different groups, such as groups defined by
gender or health status. Those groups with longer life expectancies would
receive their annuities longer, and their annuity providers would therefore
incur higher annuity costs for them. Reform provisions might prohibit
annuity providers from charging different prices based on race, gender,
health status, or other factors that reflect differences in life expectancy.44
Such prohibitions would reduce the variation in annuity costs across
groups. However, they would also implicitly transfer income from those
groups with shorter life expectancies—such as men or the poor or
African-Americans—to groups with longer life expectancies—such as
women or the wealthy or whites. Rates of return would vary across such
groups accordingly. Still, such prohibitions might not prevent annuity
providers from using marketing and advertising to appeal to retirees with
shorter life expectancies.

Prohibiting annuity providers from charging different prices to different
groups would probably have a limited effect unless annuities were
mandatory. Otherwise, individuals with shorter life expectancies might
perceive annuity costs to be too high and choose not to buy them. In
effect, they would “self-annuitize” and face the risk that they might outlive
their retirement savings. In the current annuity market, consumers who
expect to live a long time because of health status or family history are
much more likely to purchase annuities than those who do not. As a result,
annuity purchasers as a group have a longer life expectancy at any given
age than the population at large, so annuity prices are higher than they
would be if everyone purchased an annuity. This problem, known as
“adverse selection,” would not be nearly as significant if annuities were
mandatory because people with lower life expectancies would not be able
to opt out of buying an annuity.

42
 In contrast, when the government provides annuities, such as Social Security benefits, it does not
make a profit.
43
  The more money an annuity fund can earn in interest, the more it can pay out in benefits.
44
  Requiring insurers to use unisex annuity rates would be an example of this. Unisex annuity rates are
currently required for employer-provided group annuities, but annuities sold to individuals are usually
based on gender-specific life tables. The current Social Security program, in effect, also provides
unisex annuities, which results in an income transfer from men to women and higher rates of return
for women.


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                        By helping reduce adverse selection, making annuities mandatory in a new
                        system could significantly reduce annuity costs for individuals who would
                        buy annuities anyway while increasing costs for those who otherwise
                        would not. It would implicitly transfer income from those who die earlier
                        to those who die later but help ensure adequate retirement incomes for
                        those who die later.


                        In the future, average rates of return on either market investments or
Future Average Rates    Social Security as it is currently structured could differ significantly from
Could Differ From       their historical averages. Moreover, the gap between these rates could
Historic Averages       narrow. Fundamentally, economic growth drives rates of return for both
                        market investments and Social Security. Rate of return projections for
                        either are misleading if they are not consistent with economic growth
                        projections. More specifically, capital productivity helps determine market
                        rates of return while the growth of labor productivity helps determine
                        Social Security’s long-term average rates of return. Trends in the
                        productivity of both capital and labor are difficult to predict for various
                        reasons, and the markets for capital and labor interact with each other in
                        determining what share of the national income is paid to each.


Returns on Market       For market investments in capital, long-term average rates of return
Investments Depend on   ultimately depend on whether those investments produce more income by
Economic Growth and     producing more goods or services. However, capital comes in many forms,
                        such as land, buildings, technology, machinery, supplies, and product
Market Forces           inventory. Not all these forms of capital are financed through the stock
                        and bond markets, but they all compete with labor for their share of the
                        national income, which determines their rates of return. These rates of
                        return are related to the productivity of each factor of production, but
                        many economic forces work through the markets to determine the rates of
                        return they earn individually.

                        Several issues make it hard to predict returns on capital. Investment in
                        new technology can result in major breakthroughs that change the way we
                        all live or it can go down dead-end paths with little if any result. Moreover,
                        measuring productivity growth from advances in information technology,
                        for example, has proven difficult. Also, the dynamics of the stock market
                        may be changing. For example, the difference, or “spread,” between rates
                        of return on stocks and Treasury securities has been shrinking. Some
                        economists have suggested that this trend reflects that the economy




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                             appears to be less susceptible to recessions, making stock investments
                             less risky.45

                             Still, in the aggregate, returns to capital and labor must fundamentally
                             reflect growth in national income, so projections of future returns depend
                             on assumptions about economic growth. In fact, the growth of the U.S.
                             economy is expected to slow as the population ages. The rate of national
                             saving and the growth in productivity and wages have slowed notably in
                             the past two decades, and these trends relate to economic growth. The
                             Social Security trustees’ projections reflect an assumption that growth will
                             slow as the baby boom generation retires and relatively fewer young
                             people enter the labor force. From 1989 to 1997, the economy grew at an
                             inflation-adjusted average annual rate of 2.2 percent. The trustees’
                             intermediate assumptions use a growth rate of 2.0 percent over the next
                             decade and 1.4 percent by 2020. One analysis estimated that these growth
                             rate assumptions imply that future stock market returns could be as low as
                             4.0 percent.46 If the rate of economic growth turns out to be higher than
                             these projections, returns to capital could be higher, but so could be
                             returns to labor and in turn Social Security’s implicit rates of return and its
                             actuarial balance.


Returns on Social Security   While rates of return on market investments depend on capital’s share of
Depend on Total Wage         income from economic growth, the current Social Security program’s
Growth                       long-term average rates of return depend on labor’s share. As discussed
                             earlier, in a mature pay-as-you-go Social Security system, long-term
                             average implicit returns depend predominantly on the growth rate of all
                             wages covered by Social Security. Growth in total covered wages reflects
                             both average wage increases and growth of the labor force. Wage
                             increases depend on the growth of labor productivity, the growth of the
                             economy as a whole, and the results of other market forces in determining
                             labor’s share of national income. As the baby boom generation retires,
                             labor force growth is expected to slow dramatically but average wages
                             could be bid up in response. As a result, the net effect on total covered
                             wage growth is unclear.




                             45
                              For more discussion of factors that could diminish future stock returns, see Social Security
                             Financing: Implications of Government Stock Investing for the Trust Fund, the Federal Budget, and the
                             Economy (GAO/AIMD/HEHS-98-74, Apr. 22, 1998), pp. 41-44.
                             46
                              Dean Baker, Saving Social Security with Stocks: The Promises Don’t Add Up (New York: Twentieth
                             Century Fund, 1997).



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The Gap Between Market   As a result of anticipated trends, market forces could leave a smaller gap
and Social Security      between the long-term average rates of return on market investments and
Returns May Narrow       Social Security as it is currently structured. Capital and labor compete in
                         the market for their shares of the national income, and they interact with
                         each other. For example, capital investment tends to improve the
                         productivity of labor, which in turn tends to increase wages. As noted
                         earlier, capital is expected to be relatively more plentiful, and labor is
                         expected to be relatively more scarce in the future. Either of these trends
                         could decrease returns to capital and increase returns to labor. In turn, the
                         rates of return available from a new system with individual accounts could
                         be smaller than historical returns on market investments might suggest,
                         and Social Security’s implicit rates of return could be higher than they are
                         expected to be using the current trustees’ assumptions regarding wage
                         growth.

                         Since 1956, the growth rate of total inflation-adjusted wages has averaged
                         roughly 3 percent on a compound annual basis; since 1967, it has averaged
                         2.4 percent. These growth rates are lower than the long-term average
                         annual rate of return of 7 to 8 percent on stocks. However, figure 4.1
                         illustrates that over 20-year periods on a compound annual average basis,
                         stock returns actually dipped below the growth rate of total covered
                         wages during several periods since the 1950s. Still, it remains difficult to
                         say just how narrow the gap will be and how much it may fluctuate.




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Figure 4.1: Twenty-Year Average Rates of Return on Market Investments Compared With Growth Rate in Total Covered
Wages




                                         Note: Inflation-adjusted compound annual averages over rolling 20-year periods. In the early
                                         years of Social Security’s history, total covered wages increased dramatically in some years as
                                         coverage was extended to more workers or the maximum taxable earnings increased.

                                         Source: From GAO analysis of data from SSA; from Robert J. Shiller, Market Volatility (Cambridge,
                                         Mass.: MIT Press, 1989), available at www.econ.yale.edu/~shiller/chapt26.html; and from Council
                                         of Economic Advisers, Economic Report of the President, 1999 (Washington, D.C.: U.S.
                                         Government Printing Office, Feb. 1999).



                                         Simple rate of return comparisons between the current Social Security
Risks Differ Between                     program and market investments do not take into account the differences
Social Security and                      in risk associated with those returns. Economic uncertainty affects the
Market Investments                       risks and returns of private market investments but also, in a different
                                         way, of the Social Security system. In addition, political risks exist for both
                                         the current and any restructured Social Security system. For retirement
                                         incomes, a primary risk is that they may not be adequate. In addition, risks
                                         make retirement income less predictable, which diminishes the ability of
                                         individuals and the society as a whole to set aside a level of resources for
                                         retirement that is neither too high nor too low. By themselves, rate of



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return estimates reflect only the average of the possible retirement
incomes, not their adequacy or the degree to which they could vary. While
some approaches do exist for assessing the risks of alternative reform
proposals, none fully capture the full range of variability in retirement
incomes. Just as a trade-off largely exists between risk and return in
market investments, the same trade-off exists among alternative
approaches to Social Security reform.

As discussed earlier, rates of return in the private market vary
considerably according to various types of investment risk, including
market risk, default risk, and the like, and also according to how well
investors manage those risks. As a result, in a new Social Security system
with individual accounts, average rates of return would vary both by year
of birth and by individual, and this source of variation is not present in the
current system. Different groups of retirees born in different years would
accumulate savings and receive investment earnings over different sets of
years; the returns that the private market offers could vary substantially
between those sets of years, as figure 3.1 illustrated earlier. Moreover,
retirees born within a given year and facing the same investment period
could have very different rates of return, depending on how they allocated
and timed their investments. Even restrictive individual account proposals
would permit workers to invest all their funds conservatively and switch
back and forth between alternative funds with different types of assets. In
contrast, Social Security’s current structure results in rates of return that
vary relatively little from year to year because its rate of return depends on
long-term economic trends, not market fluctuations.

In addition to investment risk, participants face political risk under either
the current system or a new one. That is, the Congress could enact
changes to the system, such as cutting benefits, raising taxes, changing the
tax treatment of retirement benefits, or guaranteeing a minimum
retirement income, that would affect returns on retirement contributions.
Rate of return comparisons should ideally account for differences in both
market and political risk, but political risks are not easily quantified and
both require subjective judgments.

As discussed earlier, a variety of attempts have been made to measure
rates of return on a risk-adjusted basis. While some measures have been
developed for individual investments based on the statistical variation of
their rates of return, these measures adjust only for market risk. Moreover,
risk fundamentally depends on portfolio choice because portfolios can be
designed so that investment risks offset one another to some degree.



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                      One recent study analyzed historical investment returns in various
                      countries and examined how much retirement incomes in an individual
                      account system would vary from workers who retire in one year to those
                      who retire in the next. In the case in which workers with average earnings
                      invested half their portfolio in stocks and received a pension equal to
                      50 percent of average earnings, identical workers in the next year could
                      expect, on average, to get a pension equal to anywhere from 46 to
                      54 percent of average earnings. In some years, this variation could be less,
                      in others more.47

                      Just as a trade-off exists between risk and return in market investments,
                      the same trade-off exists among alternative approaches to Social Security
                      reform. Any Social Security changes enacted will implicitly reflect the
                      relative priorities placed on maximizing returns or minimizing risks for
                      workers and beneficiaries. For example, some individual account
                      proposals would guarantee that workers would have at least as much
                      retirement income as they do under the current system. To some degree,
                      such guarantees provide an incentive to take greater investment risks. If
                      some workers do poorly enough that the government must make up the
                      difference, taxpayers paying the subsidies will have lower rates of return
                      than they would otherwise. Thus, efforts to minimize risk could also
                      reduce returns.


                      As the preceding discussion demonstrates, the rates of return that
Comparisons Between   participants would enjoy under a restructured Social Security program are
Reform Proposals      not equal to the returns they might receive on their market investment
Help Capture          accounts, so a simple rate of return comparison between the current
                      program and market investments would be misleading in assessing the
Relevant Issues       advantages of a new system. All the costs participants pay and all the
                      benefits they receive under the new system should enter into the rate of
                      return calculations. Including both the individual account and Social
                      Security components in one comprehensive rate of return estimate
                      provides the best basis for comparing the individual equity of alternative
                      reform proposals. Still, individual equity is only one of many criteria to use
                      in comparing proposals, and rates of return are only one measure of
                      individual equity.

                      Comparing such comprehensive rates of return for reform proposals can
                      show how transition costs will have different effects on workers born in

                      47
                         Lawrence H. Thompson, Predictability of Individual Pensions, Ageing Working Paper 3.5 (Paris:
                      Organisation for Economic Co-operation and Development, 1997),
                      www.oecd.org/els/pds/socialpolicy/ENG5.PDF.



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                          different years and, hence, can reveal their effects on intergenerational
                          equity. They can show that returns on the entire package of retirement
                          contributions depend on the proportion that is deposited into individual
                          accounts. They can show how returns depend on different provisions
                          relating to administrative costs, annuities, and investment restrictions.
                          They can show how returns depend on the economic assumptions that
                          drive the rates of return on market investments and Social Security
                          benefits generally.

                          However, such comparisons among reform proposals are limited because
                          many of these effects are difficult to predict and model. Moreover, such
                          comparisons should be made only between proposals that achieve
                          comparable levels of long-term actuarial balance. Also, some reform
                          provisions under consideration, such as the use of general revenues, are
                          complicated to incorporate in rate of return calculations. Finally, rates of
                          return alone do not measure the risks that individuals would face in terms
                          of the adequacy and predictability of their retirement incomes.


Advisory Council          While many studies have published rate of return estimates for the current
Estimates Illustrate      Social Security program, very few have published estimates for alternative
Returns for Alternative   reform proposals. The Report of the 1994-1996 Advisory Council on Social
                          Security provides an extensive set of rate of return estimates for reform
Proposals                 proposals.48 These estimates are now somewhat dated, especially since
                          they are based on projections from the 1995 Social Security trustees’
                          report. Since then, the economy has grown faster than projected, and the
                          long-term actuarial balance has improved somewhat. Also, other reform
                          proposals have been introduced that warrant study. Still, the Advisory
                          Council’s rate of return estimates are the best available and are sufficient
                          to illustrate some key points about comparing returns across reform
                          proposals. Moreover, the Council’s three alternative proposals provide a
                          broad range of reform approaches that reflect the essence of key
                          components of more recent proposals.

                          The Advisory Council report provides estimates for three reform proposals
                          and two benchmark cases of particular interest. The IA and PSA plans are
                          individual account proposals, described in chapter 3. The third proposal,
                          the “maintain benefits” (MB) plan, would make changes within the current

                          48
                            One other study has published payback ratios, which are another type of money’s-worth measure, for
                          some stylized, illustrative reform approaches but only for workers from two different birth years. See
                          Kelly A. Olsen and others, How Do Individual Social Security Accounts Stack Up? An Evaluation Using
                          the EBRI-SSASIM2 Policy Simulation Model, issue brief 195 (Washington, D.C.: Employee Benefits
                          Research Institute, Mar. 1998).



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                             program structure to restore solvency. In part, as one alternative, the MB
                             plan would increase revenues by investing up to 40 percent of the trust
                             funds in the stock market. Although it would not create a new system of
                             individual accounts, it would increase advance funding somewhat. The
                             report also provides estimates for two illustrative benchmark cases. The
                             first, known as “present law-PAYGO,” makes no changes except for
                             increasing taxes sufficient to restore solvency on a pay-as-you-go basis.
                             The second, known as “maintain tax rates,” makes no changes except to
                             cut benefits enough to restore solvency with the current tax levels.

                             Among individual account proposals, the IA and PSA plans represent two
                             ends of a spectrum along which most individual account proposals fall.
                             The IA plan would have deposits to the accounts equal to 1.6 percent of
                             workers’ earnings, while the PSA plan would have deposits of 5 percent.
                             Several recent proposals currently under discussion have deposits in the
                             range of 2 to 2.5 percent of earnings, while a few others have deposits as
                             low as 1 percent and as high as 10 percent. The IA plan would have the
                             federal government centrally manage the accounts on workers’ behalf,
                             while the PSA plan would have individuals manage their own accounts. The
                             IA plan would provide a limited selection of investment options, while the
                             PSA plan would place few restrictions on how workers invest their funds.
                             The IA proposal would require workers to purchase an annuity at
                             retirement, while the PSA plan would not. The IA plan would retain the
                             current structure of Social Security benefits but would reduce benefits so
                             that current Social Security payroll tax rates would adequately fund them.
                             The PSA plan would replace the current Social Security benefit with a
                             relatively small flat benefit that would not depend on lifetime earnings.


Reform Proposal              Social Security reforms will have different effects on different generations
Comparisons Illustrate the   depending on their specific provisions. One criterion for evaluating
Effect of Transition Costs   alternative proposals is the “intergenerational equity” they provide, or
                             whether rates of return are fairly consistent across generations. The way
and Intergenerational        proposals would handle the current long-term financing shortfall and the
Equity                       costs of making a transition to a new system would have especially
                             significant effects on intergenerational equity.

                             Figure 4.2 provides the rate of return estimates for one illustrative type of
                             household with average earnings for workers born in different years, as




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calculated by SSA actuaries for the Advisory Council.49 Also, these
estimates illustrate only the intermediate return case in which any stock
market investments in a household’s portfolio earn an inflation-adjusted
average annual return of 7 percent. Rates of return for workers born in
earlier years would not vary significantly among the reform options
because none of them would reduce benefits for those already retired or
nearing retirement. The declining rates of return for persons born earlier
reflect the maturing of the current system and recent declines in total
wage growth, as discussed earlier.




49
  Other types of households, such as single workers or one-earner couples, with different earnings
levels exhibit somewhat similar patterns with regard to intergenerational equity. However, higher
earners have generally lower rates of return, and lower earners have generally higher rates of return.
Also, one-earner couples have generally higher rates of return under the MB plan than under either the
PSA or IA plan. As noted earlier, some interactions exist among the various characteristics—for
example, between household type and earnings level. All the various combinations present a more
complicated picture. For a more extensive set of rates of return and money’s-worth measures, see
Advisory Council on Social Security, Report of the 1994-1996 Advisory Council on Social Security, Vol.
1, pp. 165-230. In addition, these estimates are for hypothetical workers with a steady pattern of
lifetime earnings. As noted in chapter 2, the hypothetical “average” earner may have earnings
somewhat higher than the true average. As a result, workers with earnings closer to the true average
would have higher rates of return on the Social Security component of their retirement income.
Moreover, rates of return will vary for the individual account component by the shape of the earnings
history. For example, for a given lifetime average earnings level, workers who have higher earnings
earlier in their careers would have higher rates of return on their individual accounts than those with
lower early earnings since their account deposits would have more years to earn interest. See Burtless,
Bosworth, and Steuerle, “Changing Patterns of Lifetime Earnings.”



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Figure 4.2: Rate of Return Comparisons for Reform Proposals Illustrate Effects on Intergenerational Equity




                                                                                                             (Figure notes on next page)

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Note: Inflation-adjusted rates, two-earner couples with average earnings. All proposals achieve
comparable actuarial balance over 75 years. These estimates include all Social Security
contributions and benefits, including disability. In 1998, the average earnings level was about
$29,000.The raise taxes only option makes no changes to the current program except to raise
taxes on a pay-as-you-go basis. The cut benefits only option cuts benefits sufficiently to maintain
the current tax rate within the current program structure. The MB (maintain-benefits) proposal,
among other provisions, provides for investing 40 percent of trust fund assets in stocks. The last
two proposals establish individual savings accounts with various provisions, including different
provisions about the range of investment flexibility. The MB and the PSA and IA intermediate
return cases reflect an annual inflation-adjusted rate of return on equities equal to 7 percent.

Source: Advisory Council on Social Security, Report of the 1994-1996 Advisory Council on Social
Security, Vol. 1 (Washington, D.C.: Jan. 1997).




The trough in rates of return for both the IA and PSA intermediate cases
reflects the effect of transition costs, with rates of return depressed while
these costs are paid off.50 As a result, many participants would not get
significantly higher rates of return than they would under the current
system. However, rates of return then improve as the transition costs
diminish. This improvement also reflects that persons born in each
successive year have had more years in which to make individual account
deposits. Each successive group has a larger proportion of retirement
income coming from these accounts and has more to gain from the new
system’s potentially higher investment returns. In contrast, rates of return
are roughly level for the MB plan from the 1943 birth year on. The MB plan
offers higher rates of return than either the raise-taxes-only or
cut-benefits-only cases, largely because it draws new revenue from higher
investment returns.

For the raise-taxes-only case, rates of return decline for the later birth
years because taxes increase only as revenues are needed to pay benefits
in this scenario. Under current projections, no further tax increases would
be needed until 2034, and further increases would be required in later
years. Rates of return therefore diminish for persons working in later years
because they pay more in taxes without any corresponding increases in
benefit levels. In contrast, the effect on rates of return of the
cut-benefits-only approach becomes more level because the tax rate
remains constant from now on. While benefit cuts are necessary to sustain
solvency in this case, rates of return remain fairly constant. In effect, the
cuts in the benefit amounts are compensating for the fact that people are
living longer and collecting benefits longer; but on a total lifetime basis,

50
  Note that the PSA proposal has a higher comprehensive rate of return than the IA proposal, even
though the IA individual account component has a higher yield. This reflects the difference in the size
of each proposal’s account. See below for further discussion.



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                             benefits are roughly constant, as is the tax rate.51 This observation
                             underscores the fact that increasing longevity is one of the root causes of
                             Social Security’s long-term financing problem, since it contributes
                             substantially to the declining ratio of workers to beneficiaries. Current
                             benefit levels cannot be sustained under any scenario without additional
                             revenues of one sort or another, which could include higher investment
                             returns.


Reform Proposal              For individual account proposals, the comprehensive rates of return will
Comparisons Illustrate the   depend primarily on (1) what proportion of retirement contributions can
Effects of Account Size      be invested in the market for potentially higher returns and (2) what net
                             returns those market investments actually earn. In addition to depending
and Costs                    on market outcomes, net returns will depend on administrative and
                             annuitization costs, the effect of annuitization requirements on investment
                             strategies, and the range of permitted investment options. The Advisory
                             Council’s rate of return estimates reflect these various factors to some
                             degree. For example, as discussed earlier and as illustrated in table 3.1,
                             these estimates reflect the administrative and annuity costs implied under
                             the proposals.

                             Figure 4.3 includes two lines each for the IA and PSA proposals, one for low
                             and one for high investment returns, as well as the benchmark case of
                             cutting benefits only. Rates of return for the low-return cases do not vary
                             significantly from each other or from the option of restoring actuarial
                             balance by cutting benefits alone. This largely reflects that the
                             low-investment earnings assumption roughly parallels Social Security’s
                             long-term implicit rate of return. However, these low-return scenarios also
                             illustrate that any improvement in rates of return from individual account
                             proposals depends on actually realizing higher investment returns.
                             Increasing the level of advanced funding alone does not improve returns,
                             even after all transition costs have been paid.




                             51
                               In theory, a scenario in which annual benefit levels are maintained could be sustained by taxes that
                             increase gradually in a way that reflects longevity improvements. Such an approach could also result
                             in relatively level rates of return for different birth years if tax increases were actuarially calculated to
                             reflect longevity trends. The raise-taxes-only scenario illustrated here does not do that because the tax
                             increases reflect the cash flow demands of the program, not the actuarial cost of each year’s newly
                             accrued benefit promises.



                             Page 56                                           GAO/HEHS-99-110 Social Security Rates of Return
                                          Chapter 4
                                          Significant Issues in Comparing Rates of
                                          Return




Figure 4.3: Rate of Return Comparisons for Reform Proposals Illustrate the Effects of Account Size and Net Returns




                                          Note: Inflation-adjusted rates, two-earner couples with average earnings. All proposals achieve
                                          comparable actuarial balance over 75 years. These estimates include all Social Security
                                          contributions and benefits, including disability. In 1998, the average earnings level was about
                                          $29,000.The high-return cases reflect an annual inflation-adjusted rate of return on equities equal
                                          to 9.3 percent. The low-return cases reflect a 2.3-percent rate of return, which is comparable to
                                          returns earned by the Social Security trust funds.

                                          Source: Advisory Council on Social Security, Report of the 1994-1996 Advisory Council on Social
                                          Security, Vol. 1 (Washington, D.C.: Jan. 1997).




                                          In the high-return cases, the PSA proposal yields higher comprehensive
                                          rates of return, largely because a larger proportion of earnings is going
                                          into the individual accounts than with the IA proposal. Since the accounts
                                          are earning a high rate of return, the larger the account the more it raises
                                          the comprehensive rate of return. This also explains why the PSA plan




                                          Page 57                                        GAO/HEHS-99-110 Social Security Rates of Return
                        Chapter 4
                        Significant Issues in Comparing Rates of
                        Return




                        provides higher returns than the IA plan in the intermediate-return case
                        illustrated in figure 4.2. In the intermediate case, the IA accounts yield a
                        higher investment return than the PSA plan in all but the last age range.
                        However, when averaged in with the Social Security component in the
                        comprehensive rate of return, the PSA still yields a higher overall return
                        because the PSA accounts provide a larger share of retirement income. In
                        the high-return cases, the higher returns for the PSA plan also reflect the
                        assumption that workers under the PSA plan would have a larger share of
                        their accounts invested in stocks at later ages, as illustrated in table 3.1.
                        For both plans, stocks are assumed to provide an inflation-adjusted return
                        of 9.3 percent annually in the high-return scenarios. The three alternative
                        return assumptions of 2.3, 7, and 9.3 percent are arbitrary illustrative cases
                        agreed on by the Advisory Council; they do not necessarily reflect the
                        latest assumptions about economic growth or other market projections.


Reform Proposal         Even though comparing rates of return for reform proposals is much more
Comparisons Have Some   valid than simply comparing returns for the current system with those for
Limitations             market investments, limitations and cautions still arise. For example, any
                        reform proposals that are compared should achieve the same degree of
                        long-term solvency. Also, it may not be possible to incorporate the effects
                        of some specific provisions of reform proposals. Moreover, by themselves,
                        rate of return estimates do not measure the risks that workers may face in
                        terms of the predictability or adequacy of their retirement incomes.

                        Some reform provisions make it difficult to generalize exactly what
                        contributions and benefits would be, which complicates rate of return
                        analysis.52 For example, some reform proposals would draw on general
                        revenues of the federal government as well as on Social Security’s own
                        revenues. General revenues come from a wide variety of sources,
                        including both personal and corporate income tax. Shareholders,
                        employees, suppliers, or consumers ultimately end up paying corporate
                        income tax in the form of reduced earnings, reduced wages, reduced
                        supplier prices, or increased consumer prices. Rate of return estimates
                        should include all contributions to the new Social Security system made

                        52
                          In addition, one recent study points out that these estimates do not capture the difference in the tax
                        treatment of Social Security benefits under the alternative proposals. Under the IA and MB plans,
                        Social Security benefits would be subject to income tax to the extent that they exceeded contributions,
                        although the personal account portion of the IA plan would not be taxable. Under the PSA proposal,
                        retirement benefits would not be taxable. More generally, incorporating tax effects vastly complicates
                        rate of return analysis. Because income tax rates depend on all sources of income, not just income
                        from Social Security or the individual accounts, two retirees could have the same retirement benefits
                        from the new system but pay different tax rates on those benefits. One retiree may have income from
                        an employer pension, employment during retirement, or other saved assets, while another retiree may
                        have none of these. See Goodfellow and Schieber, “Simulating Benefit Levels.”



                        Page 58                                        GAO/HEHS-99-110 Social Security Rates of Return
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Significant Issues in Comparing Rates of
Return




by all who benefit from it, regardless of how those contributions are made.
It is not at all clear how to incorporate contributions from general
revenues into return estimates because general revenues come from many
current and future beneficiaries born in various years with various
incomes and household sizes who provide those revenues in varying
proportions. However, to leave any general revenue contributions out of
return estimates would artificially make rates of return look better than
they would actually be.

As discussed earlier, any rate of return is associated with some level of
risk, but the return estimate itself does not measure that risk. For rates of
return under a restructured Social Security system, two distinct types of
risk are of interest. First, how much could actual rates of return vary from
the average projected rate? This variability arises on both the aggregate
and the individual level. A projection that stock investments will earn
7 percent over some future period represents an average for a number of
possible aggregate outcomes with different probabilities. The actual
aggregate outcome could be higher or lower. However, even if the
aggregate outcome actually turns out to be 7 percent, it would represent
an average across many different investors. So the first type of risk,
variability, reflects the risk both that the aggregate projection may be
wrong and that an individual’s return could vary from the average. The
second type of risk is the risk for specific individuals that retirement
outcomes are not adequate. For example, what is the probability for a
given individual of winding up with a retirement income below the poverty
line? Workers value not only being able to predict their retirement income
but also knowing that it will be adequate.

The Advisory Council estimates do not really illustrate the risk of either
variability or inadequacy. They do suggest a range of possible outcomes,
but no probabilities are associated with those outcomes. So these
estimates do not reveal the degree to which actual retirement incomes
could vary from one worker to another or from one birth group to another;
they illustrate only that they could vary using arbitrarily chosen examples.

Some studies have examined the statistical variation of outcomes from
various reform packages, but this analysis still goes only so far.53 In
particular, they examine two types of outcomes. Two studies examine the
variation in dollar retirement incomes under alternative proposals while a

53
 Goodfellow and Schieber, “Simulating Benefit Levels”; Olsen and others, “How Do Individual Social
Security Accounts Stack Up?”; Lee Cohen, Laurel Beedon, and Carlos Figueiredo, A Critical Look at
Equity Investment in the 1994-1996 Advisory Council on Social Security Recommendations, issue brief
30 (Washington, D.C.: American Association of Retired Persons, Public Policy Institute, Apr. 1998).



Page 59                                      GAO/HEHS-99-110 Social Security Rates of Return
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Significant Issues in Comparing Rates of
Return




third examines the variation in rates of return that workers experience.
Such studies make an important contribution, but it is necessary to
appreciate their limitations and how such analysis might be extended.
They do study the aggregate variability risk—that is, how much outcomes
vary because of how much actual aggregate returns could vary from the
projected average. Studies examining retirement incomes address
adequacy somewhat by making comparisons with other reforms that do
not involve individual accounts. However, all these studies assume that all
individuals have identical investments and earn the aggregate rate of
return. This understates an individual’s risk of inadequacy because it does
not reflect individual variation in investment returns. Also, these studies
do not examine the possible variability among persons born in different
years—for example, if there were a dramatic surge or drop in the stock
market or interest rates from one retirement year to the next.

So, while such statistical approaches help describe the minimum extent of
variability, they do not describe the maximum variation possible.
Moreover, they do not capture how individuals subjectively assess and
respond to risk in their own investment choices. Some individuals may be
indifferent to receiving a lower rate of return with less risk and a higher
rate with more risk, and such preferences vary by individual. Risk analysis
based on objective statistical measures is possible and useful, but
ultimately it is limited to some degree in its ability to address individuals’
subjective preferences regarding risk.




Page 60                                    GAO/HEHS-99-110 Social Security Rates of Return
Chapter 5

Observations


               Comparing rates of return on Social Security and private market
               investments has frequently been discussed in evaluating options for
               reform. Social Security’s implicit rate of return provides a measure of
               individual equity—that is, whether workers get a fair level of benefits
               relative to their contributions. Intuitively, it gives a sense of whether
               workers get their money’s worth from Social Security, especially in
               relation to what they could have earned on their contributions elsewhere.
               However, simply comparing the current Social Security program’s implicit
               rate of return with historical returns on market investments reveals little
               about what workers have to gain from alternative reform proposals.
               Rather, if rates of return are to be compared, they should ideally be
               compared among complete reform proposals to capture all the costs that
               the proposals imply and to reflect the latest projections of future
               economic and demographic trends.

               Even such rate of return comparisons among reform proposals must be
               kept in careful perspective. Rates of return address individual equity
               alone, which is just one of many factors that should be used in considering
               Social Security reform alternatives. One of Social Security’s primary
               objectives has always been to help ensure adequate incomes not just for
               the elderly but also for the disabled and for dependents and survivors. The
               current Social Security system attempts to strike a balance between the
               competing goals of income adequacy and individual equity. Social
               Security’s income transfers are a primary means of helping ensure income
               adequacy but implicitly diminish individual equity at the same time.
               Reforms could alter the balance between equity and adequacy, but any
               such change should be a conscious and informed choice.

               In addition to the adequacy-equity balance, several other considerations
               deserve attention in weighing alternatives for reform. Potential effects on
               the federal budget and the national economy are key factors to examine.
               Reforms could have significant implications for the level of national
               saving, which fundamentally affects the prospects for economic growth.
               Such growth can substantially ease the pressures of an aging population in
               which relatively fewer workers will support more retirees.

               Addressing Social Security’s financing issues is similarly essential.
               Reforms clearly must address the long-term actuarial balance of the Social
               Security system and whether that balance is sustainable as time goes on.
               Potentially improving rates of return on workers’ contributions cannot in
               itself restore Social Security’s solvency without additional changes to the
               current system.



               Page 61                           GAO/HEHS-99-110 Social Security Rates of Return
Chapter 5
Observations




Also, proposals should be examined for a number of design and
implementation issues and whether the new system would function
effectively at a reasonable cost. Finally, the public will need to be able to
understand how a reformed Social Security system will be financed and
how benefits will be determined.

Restoring Social Security’s long-term solvency will require making difficult
choices involving many complex and sometimes conflicting objectives.
Given the complexity of the program, its financing, and how it fits in with
the rest of the government and the economy as a whole, the results and
implications of any changes cannot be known with certainty. Improving
rates of return has been one objective that has received much attention in
the Social Security reform debate. However, it is also one of the most
complex and contentious issues, and it is fraught with many key subtleties
and qualifications. Moreover, it is just one of many important
considerations in finding the best approach to restoring Social Security’s
long-term solvency. While rates of return may continue to receive much
attention, they should be kept in careful perspective, acknowledging both
the inherent complexities of rate of return analysis and the larger context
of making trade-offs among several other important objectives.




Page 62                             GAO/HEHS-99-110 Social Security Rates of Return
Page 63   GAO/HEHS-99-110 Social Security Rates of Return
Appendix I

Comments From the Social Security
Administration




              Page 64      GAO/HEHS-99-110 Social Security Rates of Return
Appendix I
Comments From the Social Security
Administration




Page 65                             GAO/HEHS-99-110 Social Security Rates of Return
Appendix II

GAO Contacts and Staff Acknowledgments


                  Barbara D. Bovbjerg, (202) 512-7215
GAO Contacts      Charles A. Jeszeck, (202) 512-7036


                  In addition to the persons named above, Ken Stockbridge, William
Staff             McNaught, and Francis P. Mulvey made key contributions to this report.
Acknowledgments




                  Page 66                          GAO/HEHS-99-110 Social Security Rates of Return
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(207449)   Page 71                            GAO/HEHS-99-110 Social Security Rates of Return
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