oversight

Social Security Reform: Administrative Costs for Individual Accounts Depend on System Design

Published by the Government Accountability Office on 1999-06-18.

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

                  United States General Accounting Office

GAO               Report to the Ranking Minority Member,
                  Committee on Ways and Means, House
                  of Representatives


June 1999
                  SOCIAL SECURITY
                  REFORM
                  Administrative Costs
                  for Individual Accounts
                  Depend on System
                  Design




GAO/HEHS-99-131
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      Health, Education, and
      Human Services Division

      B-282845

      June 18, 1999

      The Honorable Charles B. Rangel
      Ranking Minority Member
      Committee on Ways and Means
      House of Representatives

      Dear Mr. Rangel:

      The Social Security program forms the foundation for America’s
      retirement income system. In 1998, 31 million individuals and their
      dependents received retirement benefits of $265 billion through this
      program. In addition, 148 million workers currently contribute to the
      program in anticipation of future benefits. However, demographic trends,
      including the aging of the baby boom generation and increased life
      expectancy, threaten the program’s future solvency and sustainability. In
      response to this threat, various proposals to reform the program are
      currently under discussion. Proposed reforms range from traditional
      changes, such as reducing benefits and raising taxes, to more fundamental
      changes, such as creating a system of individual accounts for
      accumulating retirement savings. Under a system of individual accounts,
      workers would manage their own accounts, and the benefits they received
      from their accounts would generally be more closely linked to the amount
      of their contributions and to the gains or losses their investments incurred.

      Deciding whether and how to implement a system of individual accounts
      presents several difficult issues. Policymakers will need to consider how
      to finance the accounts and how they would affect the economy and
      program solvency, as well as how these accounts would affect the current
      Social Security benefit structure. In addition, policymakers will need to
      consider how readily individual accounts can be implemented,
      administered, and explained to the public.1

      The cost of administering individual accounts is among the key factors to
      consider. The proposed accounts could provide greater individual choice
      in retirement investments and, according to proponents, would carry the
      potential for a higher rate of return on contributions than is available




      1
       In testimony earlier this year, we discussed how these issues can be used as criteria for evaluating
      reform proposals. See Social Security: Criteria for Evaluating Social Security Reform Proposals
      (GAO/T-HEHS-99-94, Mar. 25, 1999).



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                   under current law.2 However, some experts have asserted that the cost of
                   administering individual accounts is also likely to be higher than the
                   administrative costs of the current Social Security system, and this cost
                   could reduce the amount of savings accumulated in the retirement
                   accounts. Concerned about administrative costs and their effect on
                   account accumulations and benefits, you asked us to determine (1) the
                   factors that influence administrative costs, (2) the estimates that are
                   available for administrative costs associated with individual accounts, and
                   (3) how administrative costs might affect the accumulation of savings in
                   individual accounts and the retirement benefits they provide.

                   It is important to note that this report focuses on only one aspect of
                   individual accounts—the administrative costs associated with them. It
                   does not attempt to discuss how these individual accounts would be
                   financed, how they might affect existing Social Security benefits, or other
                   important issues related to implementing individual accounts. In addition,
                   this report is designed only to illustrate the effects of administrative costs
                   on account accumulations; it does not attempt to predict the effects of any
                   specific proposals or variation in the rate of return on individual account
                   investments.

                   Today we are issuing another report that provides additional information
                   on the key decisions to consider relating to the design and implementation
                   of a system of individual accounts.3 Specific to this report, we conducted
                   our review from October 1998 through May 1999 in accordance with
                   generally accepted government auditing standards. (See appendix I for
                   information on our scope and methodology.)


                   When designing a system of individual accounts, the designers must make
Results in Brief   critical decisions about who would assume the new administrative and
                   recordkeeping responsibilities, how much choice or discretion individuals
                   would have in selecting and changing their investment options, and how
                   workers would receive their benefits when they retired. The costs of
                   administering a system of individual accounts would vary and would
                   depend on these decisions and the types and level of customer service
                   offered. Customer service features include, for example, how quickly
                   funds are allocated to accounts, how frequently investors are informed of

                   2
                    Others, however, believe that returns on contributions are not the only goal of Social Security and
                   that individual accounts are not the only way to increase rates of return. We will address the complex
                   rate of return issue in a forthcoming report.
                   3
                    See Social Security Reform: Implementation Issues for Individual Accounts (GAO/HEHS-99-122, June
                   18, 1999).



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their account balances, and whether services are handled personally or
through automation. While any system has administrative costs, they could
be higher for more decentralized systems and for those offering broader
investment choices, more customer service options, or both.

Because most Social Security reform proposals that include individual
accounts do not provide explicit details on how the accounts would be
implemented and managed, it is difficult to accurately assess the costs of
administering them. Available cost studies have limitations because they
do not capture all the likely costs associated with a new system. For
example, the cost of government oversight and enforcement activities
needed to ensure compliance and the cost of providing public education
are generally not included. However, the studies can at least provide a
basis for understanding the possible range of administrative costs that
individuals might incur under a new system. For example, estimates for a
centralized system with limited investment choices and customer service
are as low as 0.1 percent of assets per year, while the possible costs for a
more decentralized system with broader investment choices or a system
with extensive and flexible customer service are as high as 2 or 3 percent
of assets annually.

Although difficult to predict, administrative costs can have a significant
effect on individual account accumulations. Our analysis, which assumed
account contributions equal to 2 percent of an individual’s taxable
earnings, illustrates this point. In our simulation, for a man who had
average annual earnings every year for 45 years, a change in administrative
cost from 0.1 percent to 1 percent reduced accumulations in his account
by almost 22 percent. A change from 0.1 percent to 2 percent reduced his
account accumulation by almost 40 percent. In more practical terms, he
would accumulate $125,430 (in 1998 dollars) in his account under a
0.1-percent annual administrative cost, as opposed to $75,995 under a
2-percent administrative cost. The proportionate effect on accumulations
of these changes in administrative costs was approximately the same for
all workers in our analysis, regardless of whether they had low, average, or
high annual earnings. Further, individuals may incur additional costs if
they are required or choose to purchase an annuity, which ensures a
steady stream of income throughout retirement. In the current market, the
average administrative cost of purchasing an annuity is 5 percent of the
amount being converted into the annuity.4



4
 This 5-percent administrative cost does not include the additional cost of adverse selection, which is
the risk to the annuity provider of having to pay benefits to those who live longer than expected.



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                          A number of proposals have been put forth to establish a national system
Background                of individual accounts; almost all the proposals would affect the Social
                          Security program. Currently, Social Security provides retirement benefits
                          to workers as well as benefits to disabled workers and the families of
                          disabled, retired, and deceased workers. Depending on the reform
                          proposal, individual accounts could replace part of the retirement benefits
                          portion of the Social Security program, or the accounts could be added to
                          the Social Security program. Also, some proposals would mandate worker
                          participation in the system of individual accounts, while others would
                          make such participation voluntary. In general, if the accounts were
                          considered the personal property of individuals, the balances would be
                          considered part of their estates when the account owners died. However,
                          the proposals for individual accounts generally do not clearly delineate
                          how the accounts would be structured and administered.


Current Social Security   The Social Security Administration (SSA) is responsible for the
Program                   recordkeeping and benefit payment activities of the current Social
                          Security program. The program is financed largely on a “pay-as-you-go”
                          basis, in which the current year’s Federal Insurance Contributions Act
                          (FICA) taxes are used primarily to pay that year’s benefits.5 Employers
                          withhold the employee portion of FICA taxes from employees’ pay and
                          regularly deposit the amount, along with the employer portion, in
                          aggregate, in a designated Federal Reserve Bank or another authorized
                          depository. At the beginning of the next calendar year, employers submit
                          an Internal Revenue Service (IRS) W-2 form to SSA for each worker to
                          report his or her earnings for the previous year. SSA checks this
                          information and posts it to the earnings record it maintains for each
                          individual worker. For tax year 1996, SSA received about 235 million W-2s.6
                          During this process, SSA and the IRS work together to verify that earnings
                          are recorded in the proper amount in each individual’s record. It is
                          important that the earnings are recorded correctly because these earnings,
                          rather than the FICA amount, form the basis for calculating future benefits.
                          A considerable time lag exists—as much as 7 to 22 months—between the
                          time taxes are deducted from an individual’s earnings and the time these
                          earnings are credited to the individual’s record. A worker must contact SSA
                          to apply for retirement benefits. SSA calculates the retirement benefit and
                          then sends information monthly to the Treasury for issuing a check or
                          making an electronic deposit.

                          5
                           FICA taxes are generally composed of equal contributions from both employers and employees.
                          6
                           According to SSA, approximately 40 percent of workers receive more than one W-2 annually because
                          they work for more than one employer during the year.



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Administrative Structure       Certain key administrative activities must be performed under any system
Options for Individual         of individual accounts, much the same as they would under any defined
Accounts                       contribution plan.7 These activities fall into three main categories:
                               collecting contributions and keeping records, investing contributions, and
                               paying benefits:

                           •   Collecting contributions and keeping records include enrolling
                               participants, collecting and recording contributions, gathering and
                               updating personal information on each individual (such as current address
                               and investment choices), and correcting errors.
                           •   Investing contributions includes transferring the funds to the investment
                               entity, conducting research to support buy and sell decisions, buying and
                               selling investments, and recording gains and losses.
                           •   Paying benefits includes processing claims, handling appeals, and,
                               depending on the type of payout option offered, issuing regular checks or
                               processing annuities.8

                               When designing a system of individual accounts, the designers must make
                               decisions about who would perform each of these administrative
                               activities.9 Depending on who is chosen to assume these new
                               activities—employers, individuals, private sector service providers, or the
                               government—each could be affected in varying degrees. Figure 1
                               illustrates the three options we identified for the basic administrative
                               structure of a system of individual accounts, each of which builds on an
                               existing retirement system. A discussion of each option follows.




                               7
                                A defined contribution plan is a pension plan in which the contributions are allocated to individual
                               accounts by a predetermined formula and benefits vary, depending on the contribution level and the
                               return received from the investment of these contributions.
                               8
                                In purchasing an annuity, an individual contracts with an annuity provider, who provides a set
                               monthly payment, usually over the lifetime of the individual, in exchange for an agreed-upon dollar
                               amount.
                               9
                                In GAO/HEHS-99-122, we discuss in more detail the issues to consider when making each of these key
                               decisions.



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Figure 1: Options for Account Administration and Recordkeeping




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The first option is based on a centralized recordkeeping system. A federal
agency, such as SSA, could assume administrative and recordkeeping
responsibilities. This way the structure would build on the current payroll
reporting and tax collection system. Alternatively, a centralized
clearinghouse could assume recordkeeping responsibilities, similar to how
the federal government’s Thrift Savings Plan (TSP) uses the National
Finance Center.10

The TSP is a tax-deferred defined contribution retirement plan for federal
employees that contains features typically found in private sector 401(k)
plans. The Federal Retirement Thrift Investment Board, an independent
federal agency, manages the TSP. The Board holds the funds in trust, since
they are owned by the participants, not the government, and thus are to be
managed independent of political and social considerations. Federal
employees may contribute each pay period either a percentage of their
basic pay or a fixed dollar amount. All contributions, however, must be
made through payroll deductions.11 Currently, employees can allocate
their contributions into three TSP funds: the Government Securities
Investment Fund (G Fund), the Common Stock Index Investment Fund (C
Fund), and the Fixed Income Index Investment Fund (F Fund).12 Twice a
year, employees can change their contribution amounts and how future
contributions are invested. Employees can also transfer their account
balances between funds monthly. Employees may take from their
accounts loans that they repay through payroll deductions, using the
interest rate for the G Fund at the time of the loan. Upon leaving the
government or retiring, an employee’s account balance is paid through one
of three options: (1) lifetime annuity, (2) lump sum payment, or (3) timed
withdrawal in the form of monthly payments.

Throughout this report, we discuss the government-managed and
independently managed options for a centralized system together because
they are similar in how information and money would flow from the
employer through one central entity. Under either centralized system, the


10
 The National Finance Center provides recordkeeping and payroll services for the Department of
Agriculture and other federal agencies. For the TSP, the Center provides detailed recordkeeping and
software development and maintains an office to provide service to participants.
11
 The government automatically contributes 1 percent of basic pay for participants in the TSP who are
covered by the Federal Employees Retirement System, regardless of whether the employees make
personal contributions. For participants who choose to make personal contributions, the government
matches the first 3 percent of their contributions at 100 percent and the next 2 percent of contributions
at 50 percent.
12
 The TSP will add two additional funds in May 2000—the Small Capitalization Index Investment Fund
(S Fund) and the International Stock Index Investment Fund (I Fund).



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                       investments could be managed centrally by the recordkeeper or
                       contracted out.

                       A second option would build on the current decentralized system of 401(k)
                       plans. A 401(k) plan is an employer-sponsored defined contribution plan
                       that allows individuals to contribute, before taxes, a portion of their salary
                       to a qualified retirement account. Unlike the previous option, under which
                       all funds and information would flow through a centralized nationwide
                       structure, the employer would collect individuals’ contributions and
                       forward them directly to the investment manager. In the current system,
                       the employer determines which services and investment vehicles the plan
                       will provide, and, depending on the plan, individuals may choose how the
                       assets are allocated among investment options. Under an
                       employer-sponsored option, employers who do not currently offer 401(k)
                       plans would bear the responsibility for creating an infrastructure to
                       deposit contributions and provide employees with links to and choices
                       among investment managers. Alternatively, some proposals suggest that a
                       new system could build on the 401(k) system and permit individually
                       managed or government-sponsored accounts for individuals who do not
                       have access to a plan like a 401(k) plan through their employers.

                       Finally, the third option would build on the decentralized individually
                       managed system of individual retirement accounts (IRA). This structure
                       does not involve employers in recordkeeping. Individuals send their
                       personal funds to a financial service provider who places the money in an
                       individual tax-deferred account. Individuals deal directly with their
                       providers for services and payment of benefits. Under a decentralized
                       individually managed option, workers would bear the responsibility for
                       selecting an investment manager, or managers, and depositing their
                       contributions.


                       While any system of individual accounts has administrative costs, their
Administrative Costs   level will vary depending on the complexity of the system’s design. Design
Increase With System   complexity can be linked to four factors: (1) the administrative structure
Design Complexity      selected, including who maintains the records; (2) the flexibility in
                       selecting and changing investments; (3) the level of customer service
                       provided; and (4) the variety and type of options offered for paying
                       benefits. In general, the more complex the system design and the more
                       flexibility offered to individual investors, the higher the administrative
                       costs. As a result, implementing a system of individual accounts involves




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                               making decisions about trade-offs between costs and flexibility. Table 1
                               summarizes the factors that can affect cost.

Table 1: Factors That Affect
Administrative Costs           May decrease costs                                 May increase costs
                               Centrally managed recordkeeping                    Decentralized recordkeeping
                               Limited investment choices                         Wide range of investment choices
                               Limited customer services                          Varied and readily available customer
                                                                                  services
                               Mandated, centralized payout option                Varied or decentralized payout options

                               The administrative structure selected for a system of individual
                               accounts—beginning with who is responsible for recordkeeping—will
                               affect the costs of administering the system. A centralized management
                               structure, whether run by SSA or a new centralized clearinghouse, could
                               keep administrative costs down by taking advantage of economies of
                               scale.13 For example, using one centralized system to record data and keep
                               records on individual accounts for 148 million workers could minimize the
                               costs per individual. Also, investing large sums of pooled contributions
                               could lower transaction costs per account. However, centralizing these
                               administrative activities would be likely to increase government
                               administrative responsibilities and, under some proposals, increase
                               government involvement in investment choices. Alternatively, a
                               decentralized management structure could decrease direct government
                               control over investment choices but could add to administrative costs. For
                               example, if recordkeeping and management were distributed among a
                               number of private companies, administrative costs per participant would
                               likely rise. Moreover, depending on the investment options available,
                               decentralizing recordkeeping and investments would be likely to increase
                               the need for government regulation and oversight and the costs
                               accompanying such activities. In general, regardless of the system’s
                               structure, the principle of economies of scale suggests that as individuals’
                               accounts grow over time, the administrative costs per participant dollar
                               should decrease.

                               Other design features, such as the flexibility in selecting and changing
                               investments, can also affect system costs. For example, administrative
                               costs would be lower in a system that offered primarily index funds, such
                               as those offered to federal employees under the TSP. These funds hold
                               securities in proportion to their representation in the stock or bond


                               13
                                 Centralization does not guarantee low costs from economies of scale. Achieving such economies
                               requires planning, management, and oversight.



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markets and do not require significant research on individual companies
or securities. However, this approach would result in relatively limited
choices for investors. Conversely, when a wide spectrum of investment
choices is offered, individual choice is enhanced but administrative costs
are likely to rise, especially if the choices include more actively managed
investments. These investments are accompanied by higher management
fees because the investment manager spends more time and money on
researching, selecting, buying, and selling investments. In addition,
systems that offer individuals the option to transfer funds from one
investment to another can have higher administrative costs. When workers
frequently transfer their account balances from one investment to another,
they may also incur extra costs to cover the additional administrative
tasks and costs associated with buying and selling investments.

A system of individual accounts that allows relatively free choice among
different investment funds could encourage competition and lower costs.
However, experiences in other countries have demonstrated that, under
certain circumstances, competition may not achieve lower costs. For
example, a recent study of the United Kingdom system, which includes
accounts that are voluntary and decentralized, found administrative costs
to be as high as 36 percent of an account’s value.14 The study linked these
high costs, in part, to competition among providers that resulted in high
marketing costs and frequent switching between investment providers.15

A fundamental decision for paying retirement benefits would be how
much flexibility to offer individuals in the choice of payout options. The
options to pay retirement benefits include lump sum payments, timed
withdrawals, and annuities. Under a lump-sum payment option, individuals
could liquidate their accounts through a single payment at retirement and
choose when to spend or save that money. In a timed withdrawal, retirees
specify a withdrawal schedule with the investment manager. Each month,
they receive their predetermined amount while the balance of the
individual account remains invested. Annuities can be structured in many
ways and, therefore, may be more complex to administer and hence more
costly than the other methods. However, they provide more long-term
security because they ensure that benefits are available for the entire
retirement lifetime. Permitting individuals to choose among all three

14
 The 36 percent includes costs attributed to fund accumulation (that is, management and
administrative costs) and costs of switching from one financial provider to another or stopping
contributions altogether; it does not include annuitization costs.
15
 Mamta Murthi, J. Michael Orszag, and Peter R. Orszag, “The Charge Ratio on Individual Accounts:
Lessons From the U.K. Experience,” Birkbeck College Working Paper 99-2, University of London,
London, Eng., Mar. 1999.



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    options in the current market could further increase overall administrative
    complexity and cost by requiring systems to explain and keep track of the
    various choices.

    Finally, the types and level of customer service provided also affect the
    costs of a system of individual accounts. Customer service includes a
    range of activities designed to accommodate individuals’ investment
    choices or to inform them about the system or their accounts. These
    activities include providing statements of account balances, answering
    questions and providing educational material, facilitating transfers of
    balances between different investments, and calculating the gains or
    losses on investments at different intervals. When services are offered in
    greater numbers or with more frequency, the costs and administrative
    complexity of managing the accounts increase. For example, contributions
    can be deposited into the accounts at varying intervals, ranging from daily
    to annually. If contributions were made frequently, workers would benefit
    from earlier investment of funds, but the administrative recordkeeping
    costs would be likely to rise. Similarly, the frequency and means of
    providing information about the system or an individual’s account affect
    cost. Beginning in fiscal year 2000, SSA will be required to provide
    statements estimating future benefits to nearly all U.S. workers annually.
    Providing these statements will cost SSA more than $130 million per year.
    Some private pension plans may provide account statements monthly with
    higher attendant costs. In addition, the more personal the contact offered,
    the more expensive the service. For example, handling a call to a toll-free
    number can cost about five times as much as sending out an annual
    statement. Finally, if contributors are permitted to borrow from their
    accounts, administrative costs could increase because loans add a number
    of administrative tasks, including accepting applications, determining
    eligibility, and monitoring repayment.

    A number of means are used to calculate and report administrative costs
    for defined contribution plans. Some of the most common measures
    include

•   Expense ratio. This is a ratio that reflects total annual operating expenses
    as a percentage of accumulated fund assets. It is expressed either as a
    percentage of assets or in basis points. One basis point equals 0.01 or 1/100
    of a percent; thus, 100 basis points equals 1 percent of assets.
•   Dollar cost per plan participant. This is usually a flat fee that is charged to
    each participant. It could be an annual assessment or a one-time charge. It




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                              may be the only fee charged or it may be charged in addition to fees
                              reflected in a percentage fee, such as an expense ratio.
                          •   Other ratios. Administrative costs can also be calculated as a percentage
                              using bases other than accumulated assets, including total benefits paid,
                              number of workers and retirees covered by the system, income per capita,
                              or contributions.


                              Not all Social Security reform proposals that include individual accounts
More Specifics on             provide explicit detail on how the accounts would be implemented and
System Design Are             managed, and this makes it difficult to determine accurately the
Needed to Accurately          administrative costs of a system of individual accounts. Studies of the
                              possible costs are available but have limitations for a number of reasons.
Estimate                      Some are based on the reported costs of existing systems, which often fail
Administrative Costs          to capture the full administrative cost of those systems. Further, the
                              studies do not include the costs of added responsibilities that could be
                              required under a new system, such as the cost to the government for
                              monitoring and oversight. Despite their limitations, however, the studies
                              help shed light on the possible range of administrative costs. They vary in
                              their approaches, but overall, as expected, they predict that costs would
                              increase when accompanied by decentralized recordkeeping, more and
                              varied investment options, and greater levels of customer service.


Cost Estimates Increase       To better understand the possible costs of administering a system of
With Design Complexity        individual accounts, we identified a number of studies that provide either
but May Be Understated        estimates of these costs or information on the actual costs of roughly
                              comparable systems. These studies provide a useful starting point for
                              thinking about what the costs might be under various system structures
                              and designs. However, in some cases, both the estimates and actual costs
                              of current systems may understate the full range of costs that may be
                              associated with individual accounts.

                              Table 2 provides a range of costs for a system of individual accounts under
                              the three basic administrative structure options that are currently being
                              discussed. The costs are expressed in expense ratios, which identify the
                              percentage of fund assets that are deducted from the fund total for
                              administrative expenses before gains or losses are posted to individual
                              accounts. The estimates vary in how they were constructed and in the
                              assumptions they make about the structure of the proposed individual
                              account system, in part because there is a wide range of possible options
                              for structuring a system of individual accounts. Estimates for a centralized



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structure generally rely on continuing SSA’s current centralized
recordkeeping system rather than creating a new system and assume that
SSA or some central clearinghouse would contract for a limited number of
investment options and provide a basic level of customer service, similar
to the TSP.16 To approximate the possible administrative costs for a
decentralized employer-sponsored system of individual accounts, we used
costs of current 401(k) plans.17 Studies of costs in current 401(k)
retirement plans can provide useful information because a nationwide
system of employer-sponsored plans could be similar to 401(k)s,
depending on the size of the plans and any new requirements that might be
imposed. The costs of a decentralized individually managed system are
based largely on the administrative costs of mutual funds, because they
are the most common retail investment instrument individuals use in their
IRAs. (For more information on the studies and why we chose these
estimates, see appendix I.) Finally, this section of the report is about the
ongoing administrative costs associated with building up an account
balance. Because individuals often do not incur the cost of purchasing an
annuity until they retire, we discuss the effects of annuity costs later in
this report.




16
 Unlike the TSP, most estimates do not include the costs associated with permitting contributors to
borrow from their accounts before retiring.
17
 Some employers, while supporting the individual account concept, have expressed reluctance to take
on additional administrative responsibilities, and there has been less discussion and analysis of
employer-sponsored individual accounts than of the two other options.


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Table 2: The Range of Administrative Costs Under Discussion
Administrative                                           Annual cost      Additional information on the source and study
structure              Sourcea                        as % of assets      approach
Centralized           Advisory Council on                         0.11    The Report of the 1994-1996 Advisory Council on
                      Social Security                                     Social Security considered a centralized individual
                                                                          account option. The administrative cost estimate was a
                                                                          consensus of the Council members’ opinions.
                      Employee Benefit                      Low = 0.10    EBRI, a nonprofit nonpartisan organization dedicated
                      Research Institute (EBRI)              High = 2.0   to public policy research on economic security and
                                                                          employee benefits, considered two possible
                                                                          systems—one with a low level and one with a high
                                                                          level of service features—based on costs of 401(k)
                                                                          plans and other investment companies and on
                                                                          discussions with other experts.
                      James and others                 Low = 0.14-0.18    The authors, experts on employee benefit plans,
                                                       High = 0.49-0.79   analyzed data on institutional funds to estimate the
                                                                          costs for a centralized system with passively managed
                                                                          (low) and actively managed (high) funds. They
                                                                          constructed a “total fund expense profile,” which
                                                                          includes all the costs for mutual funds.b
                      State Street Corporation                0.19-0.34   State Street Corporation, a private financial services
                                                                          firm, based its estimates on the unit costs of the
                                                                          various administrative activities that would be required
                                                                          under a system of individual accounts, such as
                                                                          recordkeeping and computer system maintenance.
                                                                          The estimates shown here are for year five of the
                                                                          Corporation’s proposed system.
Decentralized         Mitchell                                0.28-1.88   The author, an expert on employee benefit plans,
employer-sponsored                                                        published a number of studies of the costs of existing
                                                                          401(k) and other retirement plans.
                      Pension and Welfare                       0.3-3.0   Department of Labor’s PWBA is responsible for
                      Benefits Administration                             overseeing and regulating the nation’s 401(k) plans.
                      (PWBA)                                              The cost range reflects the administrative costs of
                                                                          401(k) plans and the opinions of PWBA officials.
                                                                                                                       (continued)




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Administrative                                               Annual cost          Additional information on the source and study
structure             Sourcea                              as % of assets         approach
Decentralized         James and others                            0.32-1.50       The authors used the costs of retail mutual funds to
individually manged                                                               estimate the costs for a decentralized system. They
                                                                                  constructed a “total fund expense profile,” which
                                                                                  includes all the costs for mutual funds.b
                      Investment Company                          0.46-1.49       ICI, the national association of the American mutual
                      Institute (ICI) (Rea and                                    fund industry, studied trends in costs for equity mutual
                      Reid, 1998, 1999)                                           funds, bond mutual funds, and money market mutual
                                                                                  funds. It used a cost measure called the “total
                                                                                  shareholder cost,” which incorporates all the costs for
                                                                                  a mutual fund.b
                      Advisory Council on                                1.0      The Report of the 1994-1996 Advisory Council on
                      Social Security                                             Social Security contained a more decentralized option
                                                                                  that would permit workers considerable flexibility in
                                                                                  their investment decisions and assumed a contribution
                                                                                  of 5 percent of taxable payroll. The administrative cost
                                                                                  estimate was based on the costs of existing similar
                                                                                  systems, such as mutual funds.

                                            a
                                            Full bibliographic data for these sources are given in the bibliography.
                                            b
                                             The cost to buy and hold mutual funds includes two primary categories: shareholder transaction
                                            fees, which are one-time fees that can be imposed when the funds are bought or sold, and
                                            annual operating expenses, which include the costs of operating the funds on an ongoing basis,
                                            such as the cost for administrative expenses, compensation for the funds investment adviser, and
                                            advertising costs.



The Costs of a Centralized                  As shown in table 2, the estimates of administrative costs for centralized
Administrative Structure                    systems of individual accounts range from 0.10 percent to 2 percent of
                                            assets. Overall, a centralized system is expected to be less expensive than
                                            a decentralized system when customer service and investment choices are
                                            held constant, because of the economies of scale that could arise from
                                            having centralized contribution collections, recordkeeping, and
                                            communications with participants. However, costs generally increase as
                                            the number and type of investment options expand. For example, James
                                            and others estimated that administrative costs would be between
                                            0.14 percent and 0.18 percent of assets with passively managed index
                                            portfolios and between 0.49 percent and 0.79 percent with actively
                                            managed portfolios. Alternatively, costs may rise from variation in the
                                            customer service features provided. For example, the Employee Benefit
                                            Research Institute (EBRI), a private nonprofit research organization,
                                            assumed that providing a higher level of service, such as the daily
                                            valuation of accounts, allowing loans before retirement, investor
                                            education, and other services, could raise administrative costs from a low
                                            of 0.10 percent to a high of 2 percent of assets. State Street Corporation, a
                                            private financial services company, provided the most detailed analysis of



                                            Page 15                                                GAO/HEHS-99-131 Social Security Reform
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costs per administrative function based on known costs. Its estimate relied
on a number of customer service assumptions, including the assumptions
that participants would have little reason to call and that a large
percentage of inquiries would be handled through means that cost less
than person-to-person contact, such as automated telephone menus and
the Internet.

The estimates for a centralized system may be understated because they
do not take into account changes required in the administrative
foundation. The estimates all rely on the current payroll reporting and
recordkeeping system as the administrative foundation; however, SSA
officials told us that depending on the structure and expectations of a
centralized system of individual accounts, the agency might need to make
significant and costly changes to its recordkeeping system. Under SSA’s
current recordkeeping system, it can take as long as 7 to 22 months from
the time FICA taxes are withheld to the time earnings are posted to
individual records. Under a system of individual accounts, this time lag
could result in lost returns on investments in cases in which the value of
an individual’s chosen investment rises before the individual’s
contribution can be invested.18 Also, SSA currently does not follow up with
employers for reporting errors under a certain dollar threshold, since
benefits are not significantly affected by these errors. In addition, each
year SSA cannot post as many as 1.5 percent of the earnings reported to any
individual record because of missing or erroneous identifying information.
Under a system of individual accounts, in which the benefits would rely on
the dollar amounts contributed, these errors could be problematic. It is not
yet clear whether any of these practices would need to be revisited or
would be acceptable under a new system.19 Finally, depending on system
design, SSA officials said they could also incur significant additional
customer service costs, such as an increase in calls from individuals
inquiring about contributions or account balances.

Changes in reporting and recordkeeping requirements could also affect the
IRSand employers. The IRS could incur additional administrative costs as it
collects and reconciles the FICA taxes, especially if a new system required
tracking individual account contributions separately from these taxes.
Moreover, employers could be affected if the system required changes to

18
 Some proposals contain alternative measures that could mitigate the effect of this time lag. For
example, contributions could be pooled together and invested in a safe investment vehicle, such as a
money market fund, until they are allocated to individual accounts, at which time the investment
earnings could also be credited to the individual accounts.
19
  For more detailed information on these and other recordkeeping factors to consider when designing
individual accounts, see GAO/HEHS-99-122.



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                               the current wage-reporting documentation and procedures or if employers
                               were required to prepare and submit information on individuals more
                               frequently than the current annual reporting requirement in order to
                               hasten the posting of information to individual accounts.

                               We did not find any estimates of these possible additional costs, and it is
                               not clear who would bear these costs under a new system. Costs to SSA
                               and the IRS could be funded through general revenue, or they could be
                               deducted from individual accounts. Costs to employers under a
                               centralized system could be included in their normal costs of operation.
                               However, these costs could be passed along to individuals through other
                               means, such as a reduction in other employer-sponsored retirement
                               benefits.

                               Finally, the TSP has been cited as a model for a centralized system of
                               individual accounts. Administrative costs for the TSP were 0.08 percent of
                               assets in 1998.20 However, a former official from the Federal Retirement
                               Thrift Investment Board noted that managing the TSP differs in important
                               ways from managing a national system of individual accounts. The federal
                               workforce and the federal government, as a single employer, differ
                               substantially from the group that would be covered under a nationwide
                               system. For example, the federal workforce experiences less job turnover,
                               tends to be older, and has higher average earnings than the general
                               workforce. In addition, federal agencies experience greater stability and
                               have greater access to automation than the employer population at large.
                               Serving a more diverse population of investors with a wide variety of
                               employers would likely result in higher administrative costs, according to
                               this former official. In addition, the administrative costs for the TSP do not
                               include the services federal agencies provide on behalf of the plan, such as
                               enrolling individuals and working with the recordkeeper.

The Costs of a Decentralized   Mitchell reported that the costs for 401(k) plans holding mutual funds
Employer-Sponsored Structure   ranged from 0.28 to 1.88 percent of plan assets. These costs include the
                               costs of small and mid-sized 401(k) plans, which ranged from 0.28 to 1.32
                               percent, and the costs of plans that held mostly mutual funds, which
                               ranged from 0.84 to 1.88 percent. These estimates, however, do not include
                               all possible expenses. In some cases, they exclude money management
                               fees, while in others they exclude recordkeeping fees. Mitchell concluded
                               that privatization options would be expected to have somewhat higher

                               20
                                When TSP participants leave the federal government before they are entitled to their retirement
                               benefits, the accumulated government contributions and the earnings on them are used to help offset
                               administrative costs, which decreases the gross administrative cost from 0.08 percent of assets to a net
                               cost of 0.06 percent.



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                                 administrative costs than the current system but that these higher costs
                                 might be offset by economic benefits from a privately managed system.
                                 Officials from the Department of Labor’s Pension and Welfare Benefits
                                 Administration (PWBA) provided a wider range of administrative costs: In
                                 1998, the 401(k) market contained about 250,000 plans covering
                                 approximately 25 million individuals, with costs ranging from 0.3 percent
                                 to 3 percent of assets.

                                 Although the costs of existing 401(k) plans provide a basis for
                                 approximating costs for a decentralized employer-sponsored system of
                                 individual accounts, the full cost of administering existing
                                 employer-sponsored plans is difficult to measure. In 401(k) plans, for
                                 example, employers often contract with a plan administrator to provide
                                 needed services, which may include keeping records, managing
                                 investments, or providing information.21 These arrangements and the
                                 services provided vary widely among plans and may result in
                                 underreporting of the plans’ full costs. For example, in some employer
                                 plans, much of the payroll collection, recordkeeping, and benefit payment
                                 activities may be handled by the employer in-house and are not necessarily
                                 billed to the pension plan’s accounts. Further, 401(k) costs included in
                                 annual reports submitted to PWBA do not include investment management
                                 expenses debited directly from the earnings that accrue in the participants’
                                 accounts. Under a national system of individual accounts, these
                                 differences in services and how costs are allocated could raise questions
                                 of fairness. More uniformity in the way plan costs are allocated between
                                 the employer and the individuals might be called for in order to ensure
                                 more equitable benefits across plans and to facilitate public understanding
                                 and oversight of the system.

                                 Finally, the demographic characteristics of employees covered by 401(k)
                                 plans or other employer-sponsored retirement plans differ from those of
                                 the group of individuals who would be covered under a mandatory
                                 nationwide system. According to EBRI, employees covered by
                                 employer-sponsored plans have higher earnings and lower job turnover
                                 than the general workforce.

The Costs of a Decentralized     Analysts estimate that the administrative costs for a decentralized
Individually Managed Structure   individually managed system would range from 0.32 percent to 1.5 percent
                                 of assets. Variation in the estimates stems, in part, from differences in
                                 investment strategy and the range of investment choices offered, the level

                                 21
                                   Some recordkeeping costs faced by 401(k) and other employer-sponsored plans, such as costs
                                 resulting from compliance with plan participation requirements, may not be applicable under a
                                 mandatory nationwide system.



                                 Page 18                                                GAO/HEHS-99-131 Social Security Reform
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                      of service provided to the investor, and the level of marketing and
                      communication done by investment firms.

                      It is important to note, however, that this range of estimates does not
                      reflect the lowest or highest cost that an investor could incur. The
                      estimates are based on average mutual fund costs. In a system offering a
                      wide range of investment choices, some individuals could incur costs
                      lower than these averages, while some could incur higher costs because
                      some mutual fund companies charge higher administrative fees. In our
                      analysis of 1998 data provided by Morningstar, Inc., we found that
                      administrative costs for more than 9,300 mutual funds with more than
                      $1 million in assets ranged from as low as 0.01 percent to as high as
                      7.34 percent of assets, with an average of 1.33 percent of assets.22


Other Costs Are Not   In addition to the limitations discussed above, most of the cost estimates
Included in Reform    do not capture the significant costs associated with starting up a new
Discussions           system and those for the additional responsibilities, including government
                      oversight and public education, that would probably result from a system
                      of individual accounts. These additional costs could be borne by
                      employers, the government, individuals, or some combination, depending
                      on the structure and design of the account system.

Start-Up Costs        Since no current system is available to handle a national system of
                      individual accounts, some additional costs would be incurred to create
                      such a system, regardless of the structure selected. These start-up costs
                      include the costs of developing or adapting computer systems, establishing
                      electronic links between recordkeepers and investment firms, informing
                      and educating the public about the changes and about available
                      investment options and their risks and costs, hiring and training new staff,
                      and establishing or expanding an infrastructure for communicating with
                      and serving the public. Any of these services could be provided through
                      contractual arrangements. Under a centralized system, the majority of
                      these costs would be borne by the government. Alternatively, under a
                      decentralized employer-sponsored structure, a significant number of
                      employers would incur start-up costs because they do not provide pension
                      plans. Currently, about 57 percent of private sector workers are not
                      covered by an employer-provided pension plan. Their employers would
                      need to develop an infrastructure to deposit contributions and convey
                      employees’ choices to investment managers, unless provisions were made

                      22
                        We analyzed the data Morningstar, Inc., reported as annual expenses and did not include those
                      reported as one-time fees. (Morningstar, Inc., is a private investment research firm that maintains a
                      proprietary database on U.S. mutual funds, stocks, and other financial vehicles.)



                      Page 19                                                  GAO/HEHS-99-131 Social Security Reform
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                          to permit the uncovered employees to invest through a different vehicle,
                          such as an IRA. Finally, under a decentralized individually managed
                          structure, financial service providers could incur some start-up costs to
                          increase their overall capacity.

                          Little historical information is available on start-up costs for very large
                          retirement systems. Separate funding was provided for the start-up of the
                          TSP, which included costs for hiring and training new staff, software
                          development, printing materials, and other initial activities. According to
                          EBRI, start-up costs for the TSP averaged about $5.00 per participant in the
                          first year and, when translated into 1998 dollars, would equate to a start-up
                          cost of $1.08 billion for a similar system provided on a national scale. In
                          addition, these costs could be understated because TSP was able to rely on
                          the already established National Finance Center for its recordkeeping,
                          which had a computer system in place that included records on a portion
                          of the federal workforce. However, a national system of individual
                          accounts would be much larger than the TSP and could benefit from
                          economies of scale in start-up costs as well. The State Street Corporation
                          estimated that costs for the first year of operation of a national system of
                          individual accounts, including start-up costs, would range from 0.7 to
                          1.34 percent of fund assets. The Corporation’s cost estimates then
                          decrease gradually to 0.27 to 0.51 percent of assets in year three and to
                          0.19 to 0.34 percent in year five.

Costs to the Government   Under a new system of individual accounts, the government would be
                          taking on additional management activities, expanding oversight and
                          regulatory responsibilities, or both, depending on the administrative
                          structure selected. Under a centralized system, the full costs of the
                          government’s taking on a new role are difficult to predict, as stated earlier.
                          In addition, if any kind of decentralized structure were adopted, the
                          government would be likely to incur additional costs for oversight and
                          enforcement activities needed to ensure compliance, and these costs are
                          not reflected in any of the estimates. Depending on the structure, different
                          agencies would be affected. Under an employer-sponsored system, the
                          government would be likely to play a larger role in ensuring that
                          employers properly transfer an individual’s contributions to the
                          investment manager. For example, PWBA officials estimated that they
                          would need to dramatically increase their investigative staff of 350 if a
                          system of individual accounts had a 401(k) structure and if they were
                          responsible for oversight. Further, if the structure of a system of individual
                          accounts involved more open-market investments, more trading activities
                          would occur, thus increasing the need for oversight by the Securities and



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                              Exchange Commission (SEC) or another government entity. SEC has broad
                              responsibility over the securities markets, as well as the market
                              intermediaries who provide brokerage services and operate mutual funds.
                              SEC officials stated that if an individually managed structure were selected,
                              the government would need to enhance its oversight efforts to protect new
                              investors.23 Moreover, if the individually managed system were mandatory,
                              some federal agency would likely be responsible for monitoring individual
                              compliance. Finally, how the contributions are collected or distributed
                              could create additional government responsibilities. For example, if
                              contributions were provided through a tax rebate, new systems for
                              providing the rebate and monitoring the process would be required.
                              Officials in key federal agencies that could be affected by the creation of a
                              system of individual accounts told us that their agencies had not yet
                              developed a full estimate of the cost of oversight for these possible
                              changes.

                              In addition, depending on the design, a new centralized system could
                              require SSA to keep two parallel systems running at once—one for tracking
                              and paying traditional Social Security benefits and one for tracking and
                              paying individual accounts under a new system. Also, if the government
                              offered any sort of minimum benefit guarantee, SSA would most likely be
                              required to monitor benefits under both systems and calculate benefit
                              payments accordingly. The costs of these activities are also difficult to
                              estimate, according to SSA officials.

Costs to Educate the Public   Regardless of the design of a new system of individual accounts, changing
                              Social Security would require educating the public about the new
                              program’s purpose and features. The costs of this initial education would
                              most likely be borne by the government but could be shared by the
                              employers or investment managers. A national system of individual
                              accounts would require educating some workers who have never invested
                              before.24 According to SSA staff, information on changes to the program
                              would most likely be sent to every working individual through the mail.
                              They estimate that the minimum mailing cost would be $0.50 per letter,
                              which totals more than $70 million per mailing. Because individual
                              accounts would include new types of information, SSA believes that it
                              would also need to significantly redesign the personalized annual
                              statement it currently sends. In addition, the government would probably

                              23
                               The need for enhanced oversight could vary, depending on the investment options available. For
                              example, permitting individuals to choose among a few mutual funds would require less government
                              oversight than if individuals were given a wide range of choices among different investment vehicles.
                              24
                                In a forthcoming report, we will discuss in more detail the need for public education and the effect of
                              individual accounts on national savings.



                              Page 21                                                  GAO/HEHS-99-131 Social Security Reform
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                             arrange for public service announcements on television and radio to
                             heighten people’s awareness.

                             Furthermore, since most proposals for individual accounts provide
                             investment choices, additional education would be needed to help
                             individuals understand their investment options and their associated risks
                             or costs. In addition, depending on the system’s design, it would be
                             important for individuals to understand how increased customer service
                             and other options, such as frequently changing investments, could affect
                             administrative costs. The government, employers, and investment
                             managers might each have some role and incur some costs for this
                             ongoing investment education, depending on system design. The cost of
                             public education and who would be responsible for providing it are not
                             included in all the cost estimates we reviewed.


                             Although the precise cost of a system of individual accounts is difficult to
Costs Affect Account         predict, available information can be used to illustrate the effect that
Accumulation and             different levels of administrative costs could have on individual account
Retirement Benefits          accumulation and retirement benefits. Our analysis shows that the level of
                             administrative costs passed on to individuals could have a significant
                             effect on the balance of funds that would accumulate in their accounts, as
                             well as on the retirement benefits their accounts would provide.


Account Accumulations        To illustrate the effect of different levels of administrative costs, we used a
Decrease as Costs Increase   model of the Social Security system to simulate the balances that would
                             accumulate in a system of individual accounts for selected workers, given
                             four different annual administrative costs—0.1, 0.25, 1, and 2 percent of
                             assets. We selected these costs because they fall within the range of
                             possible costs presented in table 2.25 We assumed a system of individual
                             accounts that was established beginning in 2002 and simulated the
                             balances that would accumulate by retirement for workers born in 1984,
                             who would participate in the new system throughout their careers with
                             low, average, and high gender-specific annual earnings. We further
                             assumed that these workers made annual contributions of 2 percent of
                             their taxable earnings that started at age 22 and ended with retirement at




                             25
                              We did not simulate the effect of a 3-percent cost because this amount was notably higher than
                             estimates by others.



                             Page 22                                                GAO/HEHS-99-131 Social Security Reform
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age 67.26 We use 1998 dollars to report our simulation results. (See
appendix I for further details on our methodology and the model.)

Figure 2, which illustrates the change in accumulations for a working man
with average annual earnings throughout a 45-year career, shows that the
accumulated balances would decrease significantly as the annual
administrative cost increased. In our simulation, changing from an
administrative cost of 0.1 percent to 1 percent would reduce the account
accumulations by more than 22 percent, and changing from an
administrative cost of 0.1 percent to 2 percent would reduce the account
accumulation by almost 40 percent. For example, a man born in 1984 with
average annual earnings who worked from age 22 to age 67 would
accumulate $125,430 in a system with 0.1 percent annual administrative
costs and $75,995 if the administrative costs were 2 percent annually. The
proportionate effect on accumulations was approximately the same for all
workers, regardless of whether they had low, average, or high annual
earnings.




26
 We did not attempt to address the financing issues related to a system with 2-percent contributions.
We treated the individual accounts as an addition to the current Social Security program.



Page 23                                                 GAO/HEHS-99-131 Social Security Reform
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Figure 2: The Effect of Administrative
Cost Changes on Accumulated
Account Balances for a Man With
Average Annual Earnings Throughout
a 45-Year Career




                                         It is important to note here, and throughout this discussion, that higher
                                         administrative costs could be associated with more customer service and,
                                         potentially, with higher investment returns or investment portfolios that
                                         more closely matched individual needs. However, higher investment
                                         returns are not consistently correlated with higher administrative costs.
                                         Many actively managed investment options have not been able to generate
                                         higher returns than broad market indexes.

                                         It should also be noted that our simulation made a number of simplifying
                                         assumptions, which, if changed, would further affect accumulations. For
                                         instance, we assumed that individuals would have earnings every year
                                         from age 22 until the normal retirement age of 67, when in reality many
                                         individuals have discontinuous work histories and retire before the normal
                                         age. To continue our illustration of a man born in 1984 with average
                                         annual earnings in a system with a 2-percent annual administrative cost, he
                                         would accumulate $65,214 by the early retirement age of 62, as opposed to



                                         Page 24                                  GAO/HEHS-99-131 Social Security Reform
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                          the $75,995 balance he would accumulate by the full retirement age of 67.
                          In addition, we chose to evaluate the effects on individual accounts
                          regardless of the person’s marital status. We found, as expected, that
                          women’s accumulations would be smaller than men’s because the average
                          annual earnings for women are significantly lower than those for men.
                          However, some proposals would allow earnings-sharing between married
                          persons, which could help mitigate some of the disparity between women
                          and men.

                          Our analysis also assumed administrative costs would be withheld from
                          the earnings for each account through an annual percentage fee. However,
                          for small account holders, the method used to assess administrative costs
                          can make a difference. Under a system of individual accounts involving
                          contributions of 2 percent of taxable earnings, many individuals would
                          have small account balances. For example, individuals who earned $30,000
                          annually would contribute only $600 into their individual accounts each
                          year. More than 64 percent of the working population earned less than
                          $30,000 in 1997. 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. Other
                          alternatives to mitigate the effects of administrative costs on small
                          accounts are available. For example, some analysts have suggested
                          pooling the funds of small accounts into one single fund until the accounts
                          reach a certain minimum balance, where they would be less vulnerable to
                          the effects of administrative costs.


Additional Payout Costs   When individuals make the decision to retire, they may bear all or some of
May Affect Retirement     the costs associated with the payout from a system of individual accounts.
Benefits                  For our analysis, we assumed that each individual would pay a one-time
                          fee to purchase his or her retirement annuity. In the current market, the
                          average for the costs to cover the administration of an annuity is a
                          one-time charge of about 5 percent of the amount being converted into the
                          annuity.27 It is important to note that these costs vary widely and can be
                          lower or much higher than the average. The administrative cost of
                          purchasing annuities includes maintaining records, making payments, and
                          providing services to the annuitant as well as some profit margin for the




                          27
                            James M. Poterba and Mark J. Warshawsky, “The Cost of Annuitizing Retirement Payouts from
                          Individual Accounts.” National Bureau of Economic Research, Cambridge, Mass., Jan. 1999.



                          Page 25                                              GAO/HEHS-99-131 Social Security Reform
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              annuity provider.28 In addition to these administrative costs, individuals
              who currently purchase annuities in the private market pay additional
              costs because of “adverse selection.” In the current market, individuals
              who expect to live a long time are much more likely to purchase annuities
              than are individuals whose life expectancies are shorter. As a result, to
              cover the risk of having to pay benefits to those who live longer, annuity
              providers charge more for annuities than they would if every individual
              purchased an annuity at retirement. The cost of insuring against adverse
              selection could cost an individual as much as an additional 12 percent
              (above the 5-percent administrative costs) of the amount being converted
              into the annuity.29

              If a new system of individual accounts were mandatory, the adverse
              selection cost might be somewhat mitigated, but there would still be a cost
              to administer the annuity. Therefore, continuing our example, if the man
              with average annual earnings who accumulated $75,995 in a system with a
              2-percent annual administrative cost were to purchase an annuity with a
              5-percent fee, he would pay about $3,800 in administrative costs to
              purchase an annuity that would provide an average annual benefit of
              $5,584.


              Administrative costs are but one of many important issues to consider
Conclusions   when deciding whether and how to create a system of individual accounts
              as part of Social Security reform. However, because they can affect the
              amount of savings individuals are able to accumulate through individual
              accounts, they can be a key element of a reform package that includes
              individual accounts. Because program design affects the level of
              administrative costs and who bears them, policymakers will need to assess
              the possible costs and trade-offs for each of the various options under
              consideration. Individual account structures with lower administrative
              costs are often associated with more restricted investment choices and
              more centralized management, while increasing individual choice and
              decentralizing the management structure could result in increased costs.
              Finding the right balance will depend, in part, on the goals of the new
              program. Moreover, steps can be taken under any system to help mitigate
              the effect of administrative costs, especially on small account-holders.
              These include limiting customer service options or pooling small accounts.


              28
               In a forthcoming report, we will provide a more detailed discussion of the factors that affect the costs
              associated with purchasing an annuity and how these costs may factor into a system of individual
              accounts.
              29
                Poterba and Warshawsky, “The Cost of Annuitizing Retirement Payouts from Individual Accounts.”


              Page 26                                                  GAO/HEHS-99-131 Social Security Reform
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                   Finally, although the effect of administrative costs may be offset by higher
                   returns on investments, it may not be.

                   If a system of individual accounts is implemented, the public will need to
                   fully understand how its choices will affect the administrative costs it will
                   incur and how these costs affect account accumulations. If a decentralized
                   structure is chosen or if diverse investment choices and varied customer
                   service options are offered, it will be especially important to ensure that
                   the public has access to easy-to-understand information on the costs of
                   investment options and on the effect the costs can have on its accounts
                   and retirement benefits.


                   We provided a draft of this report to SSA, IRS, SEC, PWBA, the Department of
Agency and Other   the Treasury, and the Federal Retirement Thrift Investment Board, as well
Comments and Our   as to external reviewers who are experts in related areas. In commenting
Response           on our report, the reviewers generally agreed with our characterization of
                   the factors that influence administrative costs and the possible range of
                   costs under a system of individual accounts. They provided comments to
                   us in either oral or written form. These comments were primarily technical
                   and clarifying in nature. In addition to submitting technical comments, SSA
                   stated that we should expand our discussion of the costs of compliance
                   and customer service. We expanded our discussion of these issues.
                   Furthermore, SSA and others suggested that we provide additional detail on
                   the costs associated with annuities. Because this issue is a key focus of a
                   forthcoming report, we did not expand on it in this report. The written
                   comments are printed in appendix II.


                   As agreed with your office, unless you publicly announce its contents
                   earlier, we plan no further distribution of this report until 30 days from the
                   date of this letter. At that time, we will send copies to the Honorable Bill
                   Archer, Chairman of the House Ways and Means Committee; other
                   interested congressional committees; the Honorable Kenneth S. Apfel,
                   Commissioner of Social Security; the Honorable Alexis M. Herman,
                   Secretary of Labor; the Honorable Arthur Levitt, Chairman of the




                   Page 27                                    GAO/HEHS-99-131 Social Security Reform
B-282845




Securities and Exchange Commission; the Honorable Roger W. Mehle,
Executive Director of the Federal Retirement Thrift Investment Board; and
the Honorable Robert E. Rubin, Secretary of the Treasury. Copies will be
made available to others upon request. GAO contacts and staff
acknowledgments are listed in appendix III. If you have any questions
concerning this report, please contact me on (202) 512-7215.

Sincerely yours,




Cynthia M. Fagnoni
Director, Education, Workforce, and
  Income Security Issues




Page 28                                 GAO/HEHS-99-131 Social Security Reform
Page 29   GAO/HEHS-99-131 Social Security Reform
Contents



Letter                                                                                            1


Appendix I                                                                                       32

Objectives, Scope,
and Methodology
Appendix II                                                                                      36

Comments From the
Social Security
Administration
Appendix III                                                                                     38

GAO Contacts and
Staff
Acknowledgments
Glossary                                                                                         39


Bibliography                                                                                     40


Related GAO Products                                                                             44


Tables                 Table 1: Factors That Affect Administrative Costs                          9
                       Table 2: The Range of Administrative Costs Under Discussion               14

Figures                Figure 1: Options for Account Administration and Recordkeeping             6
                       Figure 2: The Effect of Administrative Cost Changes on                    24
                         Accumulated Account Balances for a Man With Average Annual
                         Earnings Throughout a 45-Year Career




                       Page 30                                GAO/HEHS-99-131 Social Security Reform
Contents




Abbreviations

EBRI       Employee Benefit Research Institute
FICA       Federal Insurance Contributions Act
IRA        individual retirement account
IRS        Internal Revenue Service
PWBA       Pension and Welfare Benefits Administration
SEC        Securities and Exchange Commission
SSA        Social Security Administration
TSP        Thrift Savings Plan


Page 31                                GAO/HEHS-99-131 Social Security Reform
Appendix I

Objectives, Scope, and Methodology


                      This appendix provides detail about our review and analysis of the
                      estimates of administrative costs for individual accounts. For this report,
                      we addressed three key questions:

                      1. What factors influence administrative costs?

                      2. What estimates are available for administrative costs associated with a
                      system of individual accounts?

                      3. How might administrative costs affect the accumulation of savings in
                      individual accounts and the retirement benefits they provide?

                      To address the first two questions, we met with officials from the federal
                      agencies that would be affected by a system of individual accounts,
                      including the Social Security Administration, Internal Revenue Service,
                      Securities and Exchange Commission, Department of Labor’s Pension and
                      Welfare Benefits Administration, Pension Benefit Guarantee Corporation,
                      and the Department of the Treasury. In addition, we met with experts in
                      the areas of Social Security and pension reform, as well as employer
                      representatives, payroll processors, investment managers, and annuity
                      providers, to obtain a more detailed understanding of the costs involved in
                      managing accounts. We also reviewed the experiences of organizations
                      and other countries related to the administrative costs of individual
                      accounts. Further, we reviewed the actual costs for administrative
                      activities of some defined contribution pension plans, and we reviewed
                      several studies of the estimated administrative costs of a new system of
                      individual accounts. The actual and estimated costs we reviewed, with the
                      exception of the estimates of the Advisory Council on Social Security, are
                      generally not associated with any particular reform proposal but are,
                      rather, an effort to predict the administrative costs under a variety of
                      proposals. To address the third question, we selected a range of cost
                      estimates from those under discussion and, using a Social Security policy
                      simulation model, projected their effects on account accumulations and
                      retirement benefits.


                      To identify administrative cost estimates and the factors that influence
Studies We Reviewed   them, we reviewed the literature and evaluated estimates from a number
                      of different sources. We limited our review to studies that were relatively




                      Page 32                                   GAO/HEHS-99-131 Social Security Reform
    Appendix I
    Objectives, Scope, and Methodology




    comparable in their assumptions, methods, and formats.30 This led us to
    focus on a set of estimates provided by a few specific studies.31 These
    studies varied in the data that they used to calculate their estimates, as
    well as in the assumptions they made about the structure of the proposed
    individual account system. Studies that estimated administrative costs for
    a centralized system of individual accounts included work by the Advisory
    Council on Social Security, work published by the Employee Benefit
    Research Institute, and work by Estelle James of the World Bank and
    others and by State Street Corporation. Studies that estimated
    administrative costs for a decentralized individually managed system of
    individual accounts included work by James and others and by the
    Advisory Council on Social Security. We also used work published by the
    Investment Company Institute. We found no studies that estimated
    administrative costs for a decentralized employer-sponsored system of
    individual accounts; however, we reviewed available studies by the
    Pension and Welfare Benefits Administration and Olivia S. Mitchell of the
    Wharton School of the University of Pennsylvania on the costs of 401(k)
    pension plans, and we used the administrative costs they provided as
    approximations of the cost of a decentralized employer-sponsored system.

    Each of the costs included in table 2 covers to some extent the costs
    incurred for collecting contributions, managing records, investing money,
    and determining eligibility. The following list describes the basis of each
    study’s cost estimates and other information covered in its report:

•   The Report of the 1994-1996 Advisory Council on Social Security based its
    cost estimate for its decentralized individual-managed system on the costs
    of passively managed index funds and mutual funds. The cost estimate for
    its centralized system was a consensus of the Council members’ opinions.
•   The Employee Benefit Research Institute report discussed the options and
    difficulties in administering individual accounts and the lack of
    comparability between current retirement savings plans and a system of
    individual accounts. The authors based their discussion of administrative
    costs on the current costs of 401(k) plans and other investment companies
    and their discussions with other experts. In addition, the authors used the

    30
      For example, we did not use estimates from the Cato Institute because they were based on a
    substantially higher contribution rate. Also, Peter Diamond of the Department of Economics at the
    Massachusetts Institute of Technology estimated the cost of a centralized system of individual
    accounts in the form of dollars per worker per year rather than as a percentage of assets. While it is
    possible to convert from a dollar estimate to a percentage, it requires making other assumptions about
    account size and rate of return. In addition, he provided an estimate for a decentralized system of “at
    least 1% of assets,” which lacked the specificity of the other cost estimates we selected.
    31
      We also gathered a number of other estimates of administrative costs; however, the assumptions they
    were based on were unclear. Nevertheless, most of them fell within the range of costs we discuss in
    this report.


    Page 33                                                 GAO/HEHS-99-131 Social Security Reform
                       Appendix I
                       Objectives, Scope, and Methodology




                       SSASIM-2 model to simulate the effect of administrative costs on
                       individual account benefits.
                   •   In the report by James and others, data on institutional funds—funds
                       limited to institutional investors—were used to estimate administrative
                       costs for a centralized system and data on retail mutual funds were used to
                       estimate costs for a decentralized system.
                   •   The State Street Corporation’s report constructed a model of a
                       market-based individual account system designed to ensure reasonable
                       costs and minimize the administrative burden for employers. It then
                       calculated an estimate for administrative costs, using unit costs from its
                       current operations. As a result, its estimated costs depend greatly on the
                       assumptions it made about the volume of calls for information and the
                       number of transactions that the system would be required to handle. The
                       authors structured their proposed system so that individuals would have
                       limited investment choices and could change their investments only once
                       per year; therefore, they assume that individuals will have little need to
                       call, and that a large percentage of calls will be handled through voice and
                       Internet technology.
                   •   The Mitchell report provides an analysis of current administrative costs for
                       mutual funds, employer-sponsored defined contribution pension plans,
                       and annuities provided by life insurance companies.
                   •   The Investment Company Institute reports analyzed trends in the cost of
                       investing in equity mutual funds, bond funds, and money market mutual
                       funds from 1980 to 1997. We used the 1997 costs.


                       In order to answer the question of how administrative costs affect account
Social Security        accumulations and the retirement benefits they provide, we used a Social
Simulation Model       Security simulation model (SSASIM-2) that was recently developed by the
                       Policy Simulation Group.32 The model has the capability of analyzing the
                       implications of adding individual defined-contribution accounts to Social
                       Security’s existing defined-benefit structure. Incorporated into the model
                       is the dynamic interaction of the population, the economy, and Social
                       Security programs.

                       In our analysis, we made a number of assumptions. With respect to
                       population and economic projections, including returns on investment and
                       projected wages, we used the same assumptions as those used to produce
                       the intermediate-range estimates of the 1999 Annual Trustees Report of
                       the Social Security Administration. These resulted in a 10.3-percent

                       32
                         We consulted with Martin Holmer of the Policy Simulation Group in using the model to run our own
                       simulations.



                       Page 34                                               GAO/HEHS-99-131 Social Security Reform
Appendix I
Objectives, Scope, and Methodology




nominal rate of return for corporate stocks (or about a 7-percent real
return) and a 6.3-percent nominal return on Treasury bonds (or about a
3-percent real return). With respect to the structure of the individual
accounts themselves, we assumed that the account was funded by a
contribution of 2 percent of taxable earnings, and we isolated the effect of
administrative costs on individual accounts from any changes to the Social
Security program. We assumed that allocations of portfolios were based
on a lifecycle model of investing and that the accounts would be created in
2002.33 Our simulations of account accumulations were done for workers
born in 1984, who would enter the system at the age of 22.

We simulated accumulations for two groups, those who would retire by
the normal retirement age of 67 and those who would retire by the early
retirement age of 62. For each group, we ran separate sets of simulations
using estimates of administrative costs of 0.10, 0.25, 1, and 2 percent of
assets per year. We picked these estimates because they cover the
spectrum of most of the cost estimates we identified in table 2. For each
set, we prepared six simulations segmented by gender and by low,
average, and high earnings levels. We assumed that individuals with low
earnings earned 45 percent of the average annual earnings each year
throughout their careers and that those with high earnings earned
160 percent of the average, which is consistent with the assumptions used
by the Advisory Council on Social Security and SSA’s Office of the Actuary.
We chose to produce our results separately for men and women because
their earnings patterns are significantly different. In addition, to simulate
the effects of the cost of purchasing annuities, we assumed that
individuals would pay a one-time fee of 5 percent of the balance of their
account to purchase a gender-specific, indexed annuity.




33
  A lifecycle model of investing assumes that younger individuals are able to assume more risk in their
investment strategy than individuals who are much closer to retirement age. For example, individuals
in their twenties would invest 100 percent of their portfolio in the stock market and their investments
in stocks would decrease incrementally to 71 percent in their forties and 23 percent in their sixties.
The remainder of their portfolio would be invested in Treasury bonds.



Page 35                                                  GAO/HEHS-99-131 Social Security Reform
Appendix II

Comments From the Social Security
Administration




              Page 36        GAO/HEHS-99-131 Social Security Reform
Appendix II
Comments From the Social Security
Administration




Page 37                             GAO/HEHS-99-131 Social Security Reform
Appendix III

GAO Contacts and Staff Acknowledgments


                  Barbara D. Bovbjerg, Associate Director, (202) 512-7215
GAO Contacts      Kay E. Brown, Assistant Director, (202) 512-3674


                  In addition to the persons named above, the following team members
Staff             made important contributions to our work and this report: R. Elizabeth
Acknowledgments   O’Toole, Alicia Puente Cackley, Abbey Frank, Gerry Grant, William
                  McNaught, Deborah Moberly, Valerie Rogers, George Scott, Roger J.
                  Thomas, and Rodina Tungol.




                  Page 38                                 GAO/HEHS-99-131 Social Security Reform
Glossary


401(k) Plan                 An employer-sponsored defined contribution plan that allows participants
                            to contribute, before taxes, a portion of their salary to a qualified
                            retirement account.


Annuity                     A form of contract sold by life insurance companies that guarantees a
                            fixed or variable payment made periodically (usually monthly) to the
                            annuitant at some future time, usually retirement.


Basis Point                 The smallest unit of measure for administrative costs. One basis point
                            equals 0.01 or 1/100 of a percent; thus, 100 basis points equals 1 percent.


Charge or Load              A fee paid by an investor for buying and selling shares in a mutual fund or
                            annuity.


Defined Contribution Plan   A pension plan in which the contributions are allocated to individual
                            accounts by a predetermined formula and benefits vary, depending on the
                            contribution level and the return from the investment of these
                            contributions.


Expense Ratio               Expenses as a percentage of accumulated fund assets. Commonly used
                            when referring to the administrative costs of mutual funds.


Individual Retirement       A personal, tax-deferred retirement account set up by an individual
Account                     worker.




                            Page 39                                   GAO/HEHS-99-131 Social Security Reform
Bibliography


               Advisory Council on Social Security. Report of the 1994-1996 Advisory
               Council on Social Security, Vols. I and II. Washington, D.C.: U.S.
               Government Printing Office, Jan. 1997.

               Diamond, Peter. “Administrative Costs and Equilibrium Charges with
               Individual Accounts.” Paper presented at the National Bureau of
               Economic Research Conference, Cambridge, Mass., 1998. Revised
               Feb. 1999.

               Employee Benefit Research Institute. “Individual Social Security Accounts:
               Issues in Assessing Administrative Feasibility and Costs.” Special Report
               SR-34 and Issue Brief 203, prepared by Kelly A. Olsen and Dallas L.
               Salisbury, Washington, D.C., Nov. 1998.

               Genetski, Robert. “Administrative Costs and the Relative Efficiency of
               Public and Private Social Security Systems.” Social Security paper 15.
               Washington, D.C.: The Cato Institute, Mar. 9, 1999.

               James, Estelle; Gary Ferrier; James Smalhout; and Dimitri Vittas. “Mutual
               Funds and Institutional Instruments: What is the Most Efficient Way to Set
               Up Individual Accounts in a Social Security System?” Paper presented at
               the National Bureau of Economic Research Conference, Cambridge,
               Mass., 1998.

               Mitchell, Olivia S. “Administrative Costs in Public and Private Retirement
               Systems.” In Privatizing Social Security, ed. Martin Feldstein. Chicago, Ill.:
               University of Chicago Press, 1998. Pp. 403-56.

               Murthi, Mamta, J. Michael Orszag, and Peter R. Orszag. “The Charge Ratio
               on Individual Accounts: Lessons from the U.K. Experience.” Birkbeck
               College Working Paper 99-2, University of London, London, Eng.,
               Mar. 1999.

               National Academy of Social Insurance. Report of the Panel on
               Privatization of Social Security. Washington, D.C.: Nov. 1998.

               Pension and Welfare Benefits Administration. Study of 401(k) Plan Fees
               and Expenses. Prepared by Economic Systems, Inc., and the Hay Group.
               Washington, D.C.: Department of Labor, Apr. 13, 1998.




               Page 40                                    GAO/HEHS-99-131 Social Security Reform
Bibliography




Poterba, James M., and Mark J. Warshawsky. “The Cost of Annuitizing
Retirement Payouts from Individual Accounts.” National Bureau of
Economic Research, Cambridge, Mass., Jan. 1999.

Rea, John D., and Brian K. Reid. “Trends in the Ownership Cost of Equity
Mutual Funds.” Investment Company Institute Perspective, Vol. 41, No. 3
(Nov. 1998), pp. 1-15.

Rea, John D., and Brian K. Reid. “Total Shareholder Cost of Bond and
Money Market Mutual Funds.” Investment Company Institute Perspective,
Vol. 5, No. 3 (Mar. 1999), pp. 1-8.

State Street Corporation. Administrative Challenges Confronting Social
Security Reform. Boston, Mass.: 1999.




Page 41                                 GAO/HEHS-99-131 Social Security Reform
Page 42   GAO/HEHS-99-131 Social Security Reform
Page 43   GAO/HEHS-99-131 Social Security Reform
Related GAO Products


              Social Security Reform: Implementation Issues for Individual Accounts
              (GAO/HEHS-99-122, June 18, 1999).

              Social Security: Criteria for Evaluating Social Security Reform Proposals
              (GAO/T-HEHS-99-94, Mar. 25, 1999).

              Social Security: Individual Accounts as an Element of Long-Term
              Financing Reform (GAO/T-HEHS-99-86, Mar. 16, 1999).

              Social Security Reform: Experiences of the Alternative Plans in Texas
              (GAO/HEHS-99-31, Feb. 26, 1999).

              Social Security and Surpluses: GAO’s Perspective on the President’s
              Proposals (GAO/T-AIMD/HEHS-99-95, Feb. 23, 1999).

              Social Security and Minorities: Current Benefits and Implications of
              Reform (GAO/T-HEHS-99-60, Feb. 10, 1999).

              Social Security: What the President’s Proposal Does and Does Not Do
              (GAO/T-AIMD/HEHS-99-76, Feb. 9, 1999).

              Social Security Reform: Implications for Women (GAO/T-HEHS-99-52, Feb. 3,
              1999).

              Social Security: Different Approaches for Addressing Program Solvency
              (GAO/HEHS-98-33, July 22, 1998).

              Social Security Reform: Raising Retirement Ages Improves Program
              Solvency but May Cause Hardship for Others (GAO/T-HEHS-98-207, July 15,
              1998).

              Social Security Financing: Implications of Government Stock Investing for
              the Trust Fund, the Federal Budget, and the Economy (GAO/HEHS-98-74,
              Apr. 22, 1998).

              Social Security Financing: Implications of Stock Investing for the Trust
              Fund, the Federal Budget, and the Economy (GAO/T-AIMD/HEHS-98-152, Apr. 22,
              1998).

              401(k) Pension Plans: Loan Provisions Enhance Participation but May
              Affect Income Security for Some (GAO/HEHS-98-5, Oct. 1, 1997).




(207048)      Page 44                                  GAO/HEHS-99-131 Social Security Reform
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