Social Security: Individual Accounts as an Element of Long-Term Financing Reform

Published by the Government Accountability Office on 1999-03-16.

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

                          United States General Accounting Office

GAO                       Testimony
                          Before the Committee on Finance, U.S. Senate

For Release on Delivery
Expected at 10:00 a.m.
Tuesday, March 16, 1999
                          SOCIAL SECURITY

                          Individual Accounts as an
                          Element of Long-Term
                          Financing Reform
                          Statement of David M. Walker
                          Comptroller General of the United States

Social Security: Individual Accounts as an
Element of Long-Term Financing Reform

               Mr. Chairman and Members of the Committee:

               Thank you for inviting me here today to continue the ongoing discussion
               on how best to ensure the long-term viability of our nation’s Social
               Security program. Demographic trends threaten the program’s solvency
               such that assets could be depleted by 2032. Numerous proposals to restore
               the Social Security program’s solvency have been put forth; as one
               element of reform, many of these include individual accounts which could
               provide greater individual choice in retirement investment and increased
               rates of return.

               In my remarks today, I will discuss several different approaches to
               restoring the Social Security program’s solvency and sustainability and the
               various factors that must be considered in determining whether individual
               accounts should play a role as an element of Social Security reform. My
               comments are based on several recent GAO reports and testimonies, as well
               as our ongoing work.1

               In summary, Social Security forms the foundation for our retirement
               income structure and, in so doing, provides critical benefits to millions of
               Americans. Yet, problems facing this program pose significant policy
               challenges that we need to address soon in order to lessen the need for
               more dramatic reforms in the future and to demonstrate the federal
               government’s ability to deal with a known major problem before it reaches
               crisis proportions. Some proposals suggest adding individual
               accounts—which are similar to defined contribution plans—to the current
               defined benefit program. These individual accounts offer the potential for
               increased investment returns, but they cannot by themselves restore
               Social Security’s solvency without additional changes to the current
               system. In assessing these proposals, policymakers must consider the
               extent to which the proposals offer sustainable financing for the system.
               Also, they must consider how to balance improvements in individual
               equity (i.e., rates of return on individual contributions) while maintaining
               adequacy (i.e., benefit levels, certainty) of retirement income for those
               individuals who rely on Social Security as their primary or sole source of
               income. And finally, choosing whether to incorporate individual accounts
               into our Social Security system will require careful consideration of a
               number of design and implementation issues to determine if such a system
               would function effectively at a reasonable cost.

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

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                                 Social Security: Individual Accounts as an
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                                 A wide array of reform proposals have introduced the concept of personal
Many Proposals to                or individual retirement accounts into the debate over Social Security’s
Restore Solvency                 future solvency. In evaluating these proposals we must understand
Include Individual
                             •   Social Security’s fundamental role in ensuring the income security of our
Accounts                         nation’s elderly;
                             •   the nature, extent, and timing of Social Security’s financing problem; and
                             •   the differences between the current program and a program that might
                                 include individual accounts.

Social Security Is the           Social Security2 has long served as the foundation of our nation’s
Foundation of Our Nation’s       retirement income system. That system has traditionally comprised three
Retirement Income System         parts: Social Security, employer-sponsored pensions (both public and
                                 private), and personal savings in the form of real and financial assets.3
                                 Social Security is viewed as providing a floor of income protection that the
                                 voluntary forms of employer pensions and individual savings should build
                                 upon to provide a secure retirement. However, private pension plans cover
                                 only about 50 percent of the full-time work force, and a significant portion
                                 of the American public does not have any other significant personal
                                 savings. In addition, Social Security is the sole source of retirement
                                 income for almost a fifth of its beneficiaries. Given Social Security’s
                                 importance as the foundation of retirement income security, it has been a
                                 major contributor to the dramatic reduction in poverty among the elderly
                                 population. Since 1959, poverty rates for the elderly have fallen from
                                 nearly 35 percent to 10.5 percent. (See fig. 1.)

                                  Social Security refers here to the Old-Age, Survivors, and Disability Insurance program, also referred
                                 to as OASDI.
                                  For a discussion of this traditional approach to retirement income, see Retirement Income:
                                 Implications of Demographic Trends for Social Security and Pension Reform (GAO/HEHS-97-81,
                                 July 11, 1997).

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                                          Social Security: Individual Accounts as an
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Figure 1: Poverty Rates for the Elderly
Have Fallen Since 1959

                                          Social Security represents a retirement income insurance program that
                                          helps workers collectively pool the risks associated with loss of earnings
                                          due to old age, disability, and death. It is a mandatory and almost universal
                                          program. As a result, the vast majority of American workers take Social
                                          Security credits with them when they change jobs. Social Security also
                                          provides inflation-protected benefits for the life of the retiree. No matter
                                          how long they live, under the current program design retirees continue to
                                          receive Social Security benefits uneroded by inflation. The program, which
                                          provides benefits not generally available as a package in the private
                                          market, includes benefits for retired workers, their spouses and
                                          dependents, and their survivors as well as for the disabled.

The Financing Problem                     The Social Security system has required changes in the past to ensure
Needs to Be Addressed                     future solvency. Indeed, the Congress has always taken the actions
Now                                       necessary to do this when faced with an immediate solvency crisis.
                                          However, the program faces demographic conditions that require action
                                          now to avoid unfairly burdening future generations with the program’s

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                                rising costs and to give these individuals time to make the necessary
                                adjustments to their retirement planning. Social Security’s financial
                                condition is directly affected by the relative size of the populations of
                                covered workers and beneficiaries. Historically, this relationship has been
                                favorable. Now, however, the covered worker-to-retiree ratio and other
                                demographic factors, such as life expectancy, have changed in ways that
                                threaten the financial solvency and sustainability of this important
                                national program (see fig. 2).

Figure 2: Ratio of Workers to
Beneficiaries Is Declining

                                Thus, although the program was put in 75-year actuarial balance just 15
                                years ago, the Trust Fund balances now are projected to be exhausted in
                                2032 (as estimated in the 1998 Trustees’ Report). In addition, the program
                                will begin to experience a negative cash flow in 2013, which will accelerate
                                with the passage of time. Absent meaningful program reform, this will
                                place increased pressure on the federal budget to raise the resources

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necessary to meet the program’s ongoing costs.4 To restore solvency to the
program today, we would need to immediately increase annual program
revenues by 16 percent or reduce annual benefit payments by 14 percent
across the board.

Even if such actions were taken today, attention would need to be given to
their sustainability. We measure solvency in this program over a 75-year
period. As each year passes, because the system is in temporary surplus, a
year of surplus is dropped from the calculation and a year of deficit is
added into the 75-year average. Hence, changes made today that restore
solvency only for the 75-year period will result in future actuarial
imbalances nearly immediately. For this reason, we must consider what is
needed to put the program on a path toward sustainable solvency so we
will not face these difficult questions on a recurring basis.

Another way to understand the magnitude of the problem is to consider
what the system will cost as a percentage of taxable payroll in the future.
If we did nothing and let the Trust Funds run out in 2032, resources
equivalent to 18 percent of taxable payroll would be needed simply to
finance the system in the following year—more than 37 percent higher
than the revenues projected to be available under the 12.4 percent payroll
tax that currently finances the system (see fig. 3).

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

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Figure 3: Changes Are Needed to
Maintain Solvency

                                  Note: Percentage changes are necessary to maintain solvency for the next year only.

                                  By 2075, the end of the Trustees’ current long-term projection period,
                                  resources equivalent to nearly 20 percent of payroll—or a 48-percent
                                  increase in projected revenues—will be necessary. Alternatively, if we
                                  were to address these gaps through benefit reductions, changes equal to
                                  27 percent of benefits in 2032 and 32 percent in 2075 would be required.
                                  Clearly, these dates are far off and projections are fallible. For example,
                                  stronger economic growth than currently projected would make it
                                  possible to meet the program’s commitments more easily. Health advances
                                  that extend life expectancy beyond current expectations, and other
                                  variables, however, could make things worse. In addition, these revenue or
                                  benefit changes relate only to one year’s financing gap. The percentages
                                  would have to be considerably higher to make the program solvent and
                                  sustainable over an ensuing 75-year period.

                                  If we do not take measures to recognize and address this entire financing
                                  gap, we will have to revisit this difficult debate time and time again. The
                                  program’s future financial situation calls upon us to make prudent

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                           judgments today that will affect those in the future who will be asked to
                           meet these benefit commitments. Importantly, since we can anticipate this
                           situation, and because our economy is strong, we can act now to avoid
                           more painful decisions in the future.

There Are Many             A wide spectrum of Social Security reform proposals has surfaced in this
Differences Between the    debate, and they reflect different perspectives and opinions about how
Current Program and One    best to address the program’s financing problem. Let me describe briefly
                           the two main perspectives on the appropriate benefit structure for Social
That Includes Individual   Security, which are analogous to the distinction between defined benefit
Accounts                   and defined contribution pension plans.

                           The current Social Security system’s benefit structure is designed to
                           address the twin goals of individual equity and retirement income
                           adequacy. Individual equity means that there should be some relationship
                           between contributions made and benefits received (i.e., rates of return on
                           individual contributions). Retirement income adequacy is addressed by
                           providing proportionately larger benefits (redistributive transfers) to
                           lower earners and certain household types, such as those with dependents
                           (i.e., benefit levels and certainty). The current benefit structure combines
                           these twin goals—and the range of benefits Social Security
                           provides—within a single defined benefit formula. Under this defined
                           benefit program, workers’ retirement benefits are based on the lifetime
                           record of earnings, not directly on the payroll tax contributed. Given the
                           current design of the Social Security program and known demographic
                           trends, the rate of return individuals will receive on their contributions is
                           declining. In addition, as noted previously, current promised benefits are
                           not adequately funded over the 75-year projection period.

                           Alternatively, those who propose individual accounts as part of the
                           financing solution emphasize the potential benefits of a defined
                           contribution structure as an element of the Social Security program and/or
                           financing reform. This approach to Social Security focuses on directly
                           linking workers’ contributions to the retirement benefits they will receive.
                           Workers’ contributions are invested in financial assets and earn market
                           returns, and the accumulations in these accounts then provide income in
                           retirement. The advantage of this approach is that individual workers have
                           more control over their accounts and more choice in how the accounts are
                           invested. This control enables individuals to earn a higher rate of return on
                           their contributions than under current law. Of course, these opportunities

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                        for higher returns exist because investors assume some measure of risk
                        that the return expected may not actually be realized.

                        To illustrate the differences between the current Social Security defined
                        benefit structure and a primarily defined contribution structure, we
                        recently studied the experience of three counties in Texas that withdrew
                        from the Social Security system in 1981 and substituted a defined
                        contribution plan for Social Security.5 The Texas plans offer retirement,
                        survivors, and disability benefits. Although contributions are somewhat
                        higher than those of Social Security, they are roughly comparable when
                        Social Security’s financing gap is considered. Benefits are based on
                        contributions and earnings from investments. Under the Texas plans,
                        contributions are invested conservatively in fixed income securities that
                        are readily marketable. We simulated the benefits that typical workers
                        could receive under these plans and compared them with what would have
                        been received under Social Security. We found that for higher income
                        workers the Texas plans provided higher benefits, especially initially.
                        However, because of the Social Security benefit formula “tilt” toward
                        lower earners, many such workers could have done better under Social
                        Security. Other features of Social Security, such as adjustments for
                        inflation, also suggest that many median-wage workers might have done at
                        least as well, if not better, had they stayed under Social Security. However,
                        the Texas plans followed a relatively conservative investment strategy
                        with lower returns than are usually assumed in most individual account
                        proposals. Nonetheless, our analysis does suggest we need to be careful
                        that those most reliant on Social Security are adequately protected.

                        Some reform proposals incorporating individual accounts address the
                        need for such protection by combining defined contribution and defined
                        benefit approaches into a “two-tiered” structure for Social Security. Under
                        such a structure, individuals would receive a base defined benefit amount
                        with a progressive benefit formula and a supplemental defined
                        contribution account benefit. Individuals could be guaranteed a minimum
                        monthly benefit. This approach, however, raises a number of risks and
                        administrative issues which I will discuss later in this statement.

                        Financing a sustainable solution relates to how we bring long-range
Financing Sustainable   program costs and revenues into balance. Addressing the current
Solvency                projected financing imbalance requires either raising revenues or
                        decreasing program costs. Funding future benefit commitments in light of

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

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changing demographics through higher investment returns can help make
the needed measures less severe, and this is one of the reasons many
reform proposals include individual accounts.

Still, creating individual accounts does not by itself address the solvency
problem. Although individual accounts offer the potential to capture
higher investment returns, if the accounts are adopted without the higher
returns being shared within the system or without accompanying benefit
reductions, the solvency problem will not be alleviated.

The extent to which individual accounts affect long-term solvency
depends in part upon whether the accounts are “added on” to the existing
system or “carved out” of it. Some proposals add on individual accounts
as a type of supplementary defined contribution tier. This approach
effectively leaves the entire 12.4 percent payroll tax contribution available
to finance the program while dedicating additional revenues for individual
accounts. These additional revenues might come from a payroll tax
increase or from future unified budget surpluses. However, this approach
does nothing to help Social Security unless incremental investment
income is used to either supplement Social Security revenues or offset
current promised benefits.

The carve out approach involves creating and funding individual accounts
with a portion of the existing payroll tax rate. Thus, from the current
combined payroll tax rate of 12.4 percent, a portion could be carved out
and allocated to individual accounts. The obvious effect is that less
revenue is available to finance the current benefit structure, so the
system’s solvency is further eroded.

Thus, individual accounts represent a way of using higher rates of return
to raise more revenues in the future than does the existing Social Security
program. At the same time, including such accounts as an element of
reform requires that we consider ways to share the increased returns with
Social Security or revise the existing defined benefit structure for future
beneficiaries. In other words, to improve Social Security solvency,
individual accounts and Social Security reform must be considered

In addition, finding the appropriate balance between the defined
contribution and defined benefit approaches also has implications for the
near-term financing of the Social Security program and its payments to
current retirees and those in the near future. If individual accounts reduce

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                       existing program revenues to finance higher returns over the long term,
                       we must still be able to continue to finance ongoing benefits to retirees in
                       the short term. This problem of “transition costs” means that we may have
                       to devote additional resources to the program in the near term. The
                       trade-off is that in the long run individual accounts may, if structured
                       properly, help finance the program in a more sustainable way.

                       Because individual accounts cannot contribute to restoring solvency
Balancing Equity and   without combining with Social Security in some way, it is useful to focus
Adequacy in the        on the implications of individual accounts for Social Security’s defined
Benefit Structure      benefit program. The existing program includes a mix of benefits covering
                       disability, spouses and dependents, and survivors. It also includes
                       transfers to lower earners and families. Some proposals that include
                       individual accounts have been criticized for not fully considering these
                       other benefits when touting the advantages of higher returns on defined
                       contribution accounts. But most proposals address the defined benefit
                       portion by making a number of changes and adjustments to the existing
                       program, and some proposals incorporate a guarantee of current law
                       benefits. I will discuss some elements of these proposals briefly and also
                       address the issue of whether to make the individual accounts mandatory
                       or voluntary.

                       Decisions about the appropriate balance between the defined contribution
                       and defined benefit portions will need to consider the purpose of the
                       original Social Security program. The altered defined benefit portion will
                       still be relied upon to provide a foundation that ensures an adequate and
                       certain retirement income level. Existing proposals attempt to revise this
                       part of the program in a variety of ways, including revising the benefit
                       formula (usually to make it more progressive), changing features of the
                       program (such as lowering the cost-of-living adjustment), raising the age
                       of eligibility for normal and early retirement, or revising ancillary benefits
                       (such as those for spouses). Most of these proposed changes are
                       structured so as to leave current and near-term retirees unaffected. In
                       addition, many would include an individual account element only for
                       workers under a stated age, often around 50.

                       There are also ways to determine offsets to the individual accounts that
                       would raise revenue for the defined benefit program. For example, Social
                       Security could reclaim a portion of the individual account accumulations.
                       This reclaiming, or so-called “claw-back,” could raise significant

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“expectation gap” issues with individuals. These expectation gaps might
be addressed by pooling the investment accounts and other measures.

Another feature of some proposals involves a guarantee of a certain
benefit level. This guarantee could be provided in tandem with other
benefit structure changes such that the worker would be guaranteed a
minimum benefit. One approach would guarantee the current defined
benefit. If the individual account provided less than the current benefit,
then the system would ensure that benefits were provided to fill the gap.
Such an arrangement might be desirable from a benefit adequacy
perspective but would require safeguards against the government
becoming an insurer of excessive risk-taking by individuals.

Clearly, the number of proposals and features make it difficult to sort out
exactly what should be done. We need to study carefully what impacts any
given proposal would have, not only on the overall cost of the system but
also, very importantly, on individuals and families.

One basic feature in this regard concerns whether to make investment in
individual accounts mandatory or voluntary. Insofar as individual accounts
are intended to substitute for a portion of benefits provided under current
law to make it easier to finance the program, most discussion has involved
accounts that are mandatory. This is consistent with the stated goal of
Social Security to ensure a measure of income protection in old age.

The notion of making the accounts voluntary has entered the debate
through proposals that seek to maintain the existing benefit structure of
the program. A voluntary account is an add-on approach that would
supplement Social Security benefits and provide a measure of individual
choice. But under such an approach the overall implications for retirement
income would be uncertain. If the voluntary account was supplementary,
then it might be difficult to determine whether a voluntary account added
to total retirement income; it might merely substitute for other forms of

Another potential result of creating a system of individual accounts would
be the development of an infrastructure that would allow workers to build
up additional savings to meet both income and health care cost needs in
retirement. For example, workers not covered by a private pension could
choose to contribute more to their individual accounts to augment their
retirement savings. Workers could also contribute more to their accounts
as part of any possible premium support plan to help pay health care costs

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                         after they retire. The accounts could thereby contribute to overall
                         retirement security, not just retirement income security.

                         Not all proposals for individual accounts clearly delineate how these
Options Are Available    accounts would be administered, but those that do vary in three key areas:
for Individual Account   (1) who would manage the information and money flow needed to
Design and               maintain a system of individual accounts, (2) how much choice and
                         flexibility would individuals have over investment options and access to
Administration           their accounts, and (3) what mechanisms would be used to pay out
                         benefits upon retirement. Decisions in these areas would have a direct
                         effect on system complexity and who would bear the costs and additional
                         responsibilities of an individual account system as well as on the adequacy
                         and certainty of retirement income for future retirees. Essentially, most of
                         the decisions about the design of a system of individual accounts amount
                         to trade-offs between individual choice and flexibility on the one hand and
                         simplicity and standardization on the other. A full assessment of the
                         implications of these trade-offs will be essential to the debate on whether
                         and how to implement individual accounts. Table 1 summarizes some of
                         the administrative functions that would accompany any system of
                         individual accounts, the critical decisions associated with each function,
                         and a partial list of the options that could be considered.

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Table 1: Snapshot of Design and
Administration Issues             Administrative            Critical
                                  function                  decision/trade-off     Options to consider
                                  Managing the flow of      Centralize or          Build on current Social Security tax and
                                  information and money     decentralize           payroll reporting structure
                                                                                   Build on employer-based 401(k)

                                                                                   Build on individually controlled IRA
                                  Choosing investment       Maximize individual     Offer a small set of indexed funds
                                  options                   choice or minimize risk
                                                                                    Offer a broad range of investment

                                                                                   Combine the two options by requiring a
                                                                                   minimum account balance before a
                                                                                   broader range of options is available
                                  Paying retirement         Maximize individual    Require lifetime annuities
                                  benefits                  choice or ensure
                                                            preservation of        Make annuities voluntary and permit
                                                            retirement benefits    lump-sum and gradual account

                                                                                   Combine the two options by requiring
                                                                                   annuitization to ensure at least a
                                                                                   minimum retirement income, with added
                                                                                   flexibility for remainder of account

Managing the Flow of              When considering the design of a system of individual accounts, the first
Information and                   important decision involves account administration and
Contributions                     management—that is, where and how the information on individuals’
                                  contributions and the accompanying money flow would be recorded and
                                  managed. There are several ways in which this could be done, and the
                                  options span a continuum ranging from a centralized record-keeping
                                  system managed by the government to a completely decentralized system
                                  managed by various entities in the private sector. Each option offers
                                  advantages and challenges.

                                  For example, a new system of individual accounts could build on the
                                  current tax collection and payroll reporting system of the government,
                                  with an agency such as the Social Security Administration assuming
                                  record-keeping responsibilities for individual accounts. Alternatively,
                                  some new centralized government clearinghouse could assume this
                                  responsibility. Managing this information centrally could help keep costs

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                           down by taking advantage of economies of scale. For example,
                           administrative costs for the federal Thrift Savings Plan, which centralizes
                           both the record-keeping and investment functions, are low—averaging
                           about $17.00 per account in 1998. Centralizing these functions by building
                           on the current system would not be without challenges, however. Under
                           the current system, employers report earnings and contributions on an
                           individual basis only once per year; it would take at least 7 to 22 months
                           from the date an individual made a contribution to the date this
                           information could be attributed to an individual’s record. This time lag
                           would likely make it necessary to pursue interim investment alternatives
                           and to educate individuals on the nature and impact of the lag. Options to
                           change the system to enable more timely recording and investing of
                           contributions do exist, but they would require significant changes in the
                           record-keeping systems of the government agencies, additional costs and
                           reporting burdens for employers, or both.

                           If individual accounts were not centralized, they could be built upon a
                           model similar to either the current 401(k) or Individual Retirement
                           Account (IRA) systems.6 While providing a wider range of alternatives for
                           individuals, this approach would be accompanied by additional
                           responsibilities and costs for employers, workers, or both. For example,
                           under a 401(k) model, employers would bear the responsibility for
                           creating an infrastructure to quickly deposit contributions and provide
                           employees with links to and choices among investment managers.
                           Building on an existing employer structure such as this would pose
                           challenges and could prove costly to employers, however, because about
                           50 percent of the private sector workforce is not covered by an
                           employer-provided retirement plan. Under an IRA approach, individual
                           employees would bear the responsibility on their own to select an
                           investment manager or managers and deposit their contributions. Under
                           both of these decentralized options, the appropriate government oversight
                           role would have to be weighed and considered.

Providing Flexibility in   The next critical decision centers around how much choice or discretion
Choosing Investment        individuals would have in selecting who would invest their funds and what
Options                    the range of their investment options would be. Some proposals would
                           allow unlimited investment choices, while others would offer a more
                           limited range of choices. The primary consideration in deciding among the

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

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proposals would be finding the right balance between individual choice
and the related risks and costs to the individual and the government.
These inherent trade-offs should be considered carefully.

Proposals that build upon a centralized system often assume that the
government or some independent oversight entity would select a fund
manager (or managers) through a competitive bidding process. Individuals
would then select from among the investment options offered by a
designated party. Some propose that these options be limited to a small set
of passive or indexed funds similar to those offered under the federal
Thrift Savings Plan, thus minimizing risk to the individual while providing
some degree of choice. Such an approach would also serve to minimize
administrative costs and program complexity. However, a centralized
system of individual accounts also raises the risk that investment
decisions could become politicized, depending on the extent of
government’s role in selecting the funds and fund managers and in other
investment or fund allocation decisions. There are, however, ways in
which these risks could be mitigated (e.g., employing master trust
concepts or creating individual participation pools).

Other proposals would permit individuals more discretion in selecting
their fund manager or managers, either through their employers or directly
in the private market. Under this model, individuals would be able to
select from among a much broader range of investment options, thus
providing individuals with wider latitude to maximize their returns and
enhance their retirement incomes. However, with that wider range of
choices would come the attendant risk to individuals that their retirement
income would not be adequate, as well as risk to the government that
individuals with inadequate retirement income would turn to the
government for support from other programs. In addition, a wider range of
choices could also lead to added administrative complexity and higher
administrative costs, which, if not offset by significantly higher returns,
would further undermine individuals’ retirement income.

Regardless of whether individuals were offered a wide or limited range of
investment choices, there would likely be a need for enhanced public
education, especially if participation in individual accounts was
mandatory. Some educational effort or mechanism would be needed to
provide individuals with information they could use to make informed
investment decisions and to understand the consequences of these
decisions. For example, individuals would need information on basic
investment principles, the risks associated with available choices, and the

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                               effect of choosing among alternatives offered for annuitizing or otherwise
                               withdrawing or borrowing accumulations from the accounts. This would
                               be especially important for individuals who are unfamiliar with making
                               investment choices, for example, low-income and less well-educated
                               individuals who may have limited investing experience. Moreover, the
                               more choices offered, the more extensive the educational effort would
                               need to be. If fewer investment choices were offered, the educational
                               effort could be less costly. Who would provide such information to
                               workers or who would bear the cost is not clear, but it might be possible
                               to draw from experiences in the private pension system.

Preserving Account             The final design element centers around how the accumulated earnings in
Resources for Retirement       individual accounts would be preserved for retirement. Ensuring that
                               retirement income is available for the life of the retiree is a fundamental
                               goal of Social Security. Two important decisions relate to preservation.
                               The first is whether to allow access to the accounts by workers before
                               retirement (e.g., through borrowing). For example, most 401(k) pension
                               plans allow participants to borrow against their pension accounts at
                               relatively low interest rates. In prior work, we reported that relatively few
                               plan participants—less than 8 percent—had one or more loans from their
                               pension accounts at a specific point in time.7 However, those plan
                               participants who borrow from their pension accounts risk having
                               substantially lower pension balances at retirement and, on average, may
                               be less economically secure than nonborrowers. While some may argue
                               that individuals should be allowed the freedom to optimize their lifetime
                               income through borrowing from their accounts before retirement, the
                               added complexity and potential diminution of retirement income need to
                               be given serious consideration.

                               The second important decision is how much flexibility to permit workers
                               when they retire and begin to draw on their accounts. Annuitization of
                               individual accounts is one way to preserve benefits and ensure that
                               benefits are available for the entire life of the retiree—no matter how long
                               he or she lives. However, there are many questions to address in this area.

                           •   Because these accounts would be the personal property of individuals,
                               should annuities be required or should individuals have the option to
                               withdraw their account balances in a lump sum or through gradual

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

                               Page 16                                                                       GAO/T-HEHS-99-86
                              Social Security: Individual Accounts as an
                              Element of Long-Term Financing Reform

                          •   Could the mechanisms that are currently available for purchasing
                              annuities accommodate the significant increase in demand?
                          •   Would new structures and additional oversight be needed?
                          •   How would the various annuity options compare with those of the current
                              system, and would they provide for survivors’ benefits?
                          •   Should annuities offer protection from inflation?

                              Once again, this is not an all-or-nothing proposition. For example, it would
                              be possible to require that individuals annuitize that portion of their
                              accounts which would ensure a minimum retirement income and then
                              provide more flexibility for any funds remaining.

Level of Administrative       Many people have expressed concerns about the administrative costs of
Costs Depends Upon            individual accounts and how these costs would affect accumulations,
System Design                 especially for the small account holder. Each of the decisions discussed
                              above could have a significant effect on the costs of managing and
                              administering individual accounts, and it will be important to consider
                              their effect on the preservation of retirement income. Administrative costs
                              would depend upon the design choices that were made. The more
                              flexibility allowed, the more services provided to the investor, and the
                              more investment options provided, the higher the administrative costs
                              would be. For example, offering investors the option of frequently shifting
                              assets from one investment vehicle to another or offering a toll-free 1-800
                              number for a range of customer investment and education services could
                              significantly increase administrative costs. Moreover, in addition to
                              decisions that affect the level of administrative costs, other factors would
                              need to be carefully considered, such as who would bear the costs and
                              how they would be distributed among large and small accounts.

                              When considering whether and how to include a system of individual
                              accounts as a part of Social Security reform, vital decisions on the optimal
                              design, administrative structure, and implementation schedule will need to
                              be made with great care. A system of accounts that spans the current
                              148 million workers and the 6.5 million employers, regardless of its design,
                              would be significantly larger than any system we have in place today. Such
                              a change would take time and careful deliberation over each of the options
                              and trade-offs mentioned above. In addition, any implementation of
                              individual accounts would need to allow for sufficient lead time to ensure
                              success. The Social Security system is one of our nation’s most important
                              and visible programs. Therefore, we cannot afford to incur major
                              implementation or administration problems. This is especially true

                              Page 17                                                     GAO/T-HEHS-99-86
              Social Security: Individual Accounts as an
              Element of Long-Term Financing Reform

              because individual accounts would be highly visible to individuals and
              would represent “their money.”

              The Congress faces significant challenges in restoring sustainable solvency
Conclusions   to Social Security. We have a historic opportunity to meet these challenges
              because of the strength of our economy and future budget surpluses. We
              also have a historic responsibility—a fiduciary obligation, if you will—to
              leave our nation’s future generations a financially stable system. I believe
              it is possible to craft a solution that will protect the Social Security
              benefits of the nation’s current retirees while ensuring that the system will
              be there for future generations; and perhaps the answer does not lie solely
              in one approach or the other—defined benefit or defined contribution.
              Bridging the gap between these approaches is not beyond our ability. GAO
              and I stand ready to provide the information and analysis that can help the
              Congress meet this challenge in a way that can exceed the expectations of
              all generations of Americans.

(207060)      Page 18                                                     GAO/T-HEHS-99-86
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