oversight

Social Security: Criteria for Evaluating Social Security Reform Proposals

Published by the Government Accountability Office on 1999-03-25.

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

                           United States General Accounting Office

GAO                        Testimony
                           Before the Subcommittee on Social Security, Committee
                           on Ways and Means, House of Representatives




For Release on Delivery
Expected at 10:00 a.m.
Thursday, March 25, 1999
                           SOCIAL SECURITY

                           Criteria for Evaluating
                           Social Security Reform
                           Proposals
                           Statement of David M. Walker
                           Comptroller General of the United States




GAO/T-HEHS-99-94
Social Security: Criteria for Evaluating
Social Security Reform Proposals

                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.1 According to the OASDI Trustees’ 1998 mid-range
                estimates, the program’s cash flow is projected to turn negative in 2013. In
                addition, all of the accumulated Treasury obligations held by the Trust
                Funds are projected to be exhausted by 2032. The financing problems
                facing Social Security pose significant policy challenges that should be
                addressed soon in order to lessen the need for more dramatic reforms
                later.

                Social Security forms the foundation for our retirement income system
                and, in so doing, provides benefits that are critical to the well-being of
                millions of Americans. A wide array of proposals have been put forth to
                restore this program’s solvency, and the Congress will need to determine
                which proposals best reflect our country’s goals for a retirement income
                program. Today, I would like to provide an analytic framework for
                assessing these proposals. I would like to begin by discussing the purpose
                of the Social Security system. The role that we envision for the program
                will be vital in deciding which proposals to adopt. Next, in response to
                your invitation to me to appear at this hearing, I would like to offer what I
                believe are the basic criteria for assessing reform proposals. I would then
                like to stress that the Congress needs to compare reform proposal
                packages. If we focus on the pros and cons of each element of reform, we
                will get mired in the details and lose sight of important interactive effects.
                It will also be more difficult to build the bridges necessary to achieve
                consensus. Finally, I want to point out the importance of establishing the
                proper benchmarks against which reforms must be measured. Often
                reform proposals are compared to current promised benefits, but this
                benchmark, while in some ways valid, has some drawbacks. Currently
                promised benefits are not fully financed, and so it might be necessary to
                use a benchmark of a fully financed system to fairly evaluate reform
                proposals.

                My comments today are based largely on a body of work we have
                published as well as on ongoing work for this Committee. It is not my
                intention to take a position for or against any individual reform proposal
                or elements. Rather, my testimony is designed to help clarify the debate on
                various proposals to help the Congress move forward in addressing this


                1
                 Social Security refers here to the Old-Age, Survivors, and Disability Insurance program, or OASDI.



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                            important national debate. In choosing among proposals, policymakers
                            should consider three basic criteria:

                        •   the extent to which the proposal achieves sustainable solvency and how
                            the proposal would affect the economy and the federal budget;
                        •   the balance struck between the twin goals of individual equity (rates of
                            return on individual contributions) and income adequacy (level and
                            certainty of benefits); and
                        •   how readily such changes could be implemented, administered, and
                            explained to the public.

                            While there are many reform proposals with a wide range of features and
                            options, all proposals to restore long-term solvency involve some
                            combination of cutting benefits, raising revenues, or capturing increased
                            returns from investing contributions. We will face many difficult choices in
                            making Social Security a sustainable program. But our strong economy
                            gives us an historic opportunity to address this problem. Focusing on
                            comprehensive packages of reforms that protect the benefits of current
                            retirees while achieving the right balance of equity and adequacy for future
                            beneficiaries will help us to foster credibility and acceptance. This is the
                            best way to meet our obligations and achieve overarching goal that we all
                            seek—that is, ensuring the retirement income security of current and
                            future generations.


                            In the past few years, as attention has focused on Social Security’s future
Difficult Choices Are       financial situation, a wide array of proposals have been put forth. Some
Necessary to Restore        reduce benefits, some raise revenues; most propose some combination to
Social Security’s           restore financial solvency. The more traditional reforms seek to preserve
                            the program’s structure, restoring solvency through adjusting benefit and
Solvency                    revenue provisions; others would restructure the system by allowing
                            workers to fund at least some portion of their benefits through individual
                            accounts. Regardless of structure, many proposals rely on capturing
                            increased returns from market investments. In evaluating these proposals,
                            it is important to understand Social Security’s fundamental role in
                            ensuring the income security of our nation’s elderly and the nature, timing,
                            and extent of the financing problem.2




                            2
                             For a discussion, see Social Security: Different Approaches for Addressing Program Solvency
                            (GAO/HEHS-98-33, July 22, 1998).



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Social Security Is the                    Social Security has long served as the foundation of our nation’s
Foundation of Our Nation’s                retirement income system, which has traditionally been comprised of
Retirement Income System                  three parts: Social Security, employer-sponsored pensions (both public
                                          and private), and personal savings.3 Social Security provides a floor of
                                          income protection that the voluntary forms of employer pensions and
                                          individual savings can build on to provide a secure retirement. However,
                                          private pension plans only cover about one-half of the full-time workforce,
                                          and a significant portion of the American public does not have significant
                                          personal savings. In addition, Social Security is the sole source of
                                          retirement income for almost a fifth of recipients. (See fig. 1.)


Figure 1: Social Security Benefits as a
Percentage of Income


                                                        17%


                                              11%                            39%




                                                           33%




                                                   Less Than 50% of Income

                                                   50-89% of Income

                                                   90-99% of Income

                                                   100% of Income




                                          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. 2.)

                                          3
                                           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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Figure 2: Poverty Rates for the Elderly,
1959 to 1996                               40    Percentage




                                           30




                                           20




                                           10




                                            0

                                                1960          1965     1970           1975   1980   1985    1990      1995




                                           Social Security’s benefit structure represents a retirement income
                                           insurance program whereby workers pool the risks associated with the
                                           loss of earnings due to old age, disability, or death. It is a mandatory and
                                           almost universal program. As a result, the vast majority of American
                                           workers take Social Security credits with them whenever they change
                                           jobs. Social Security also provides inflation-protected benefits for the life
                                           of the retiree. No matter how long they live, retirees will 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 those who are disabled.


The Financing Problem                      The Congress has always taken the actions necessary to ensure Social
Needs to Be Addressed                      Security’s future solvency when faced with an immediate solvency crisis.
Now                                        These actions have generally been adjustments to the benefit and revenue
                                           provisions of the program. Today, the program does not face an immediate
                                           crisis; rather, it faces a long-range and more fundamental financing
                                           problem due to demographic trends. While the crisis is not immediate, it is
                                           important to act soon if we are to avoid having to unfairly burden future
                                           generations with the program’s rising costs and give these individuals time
                                           to make necessary adjustments to their retirement planning.



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                                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, but a major reason we are debating Social
                                Security’s financing today is that the covered worker-to-retiree ratio and
                                other demographic factors—in particular, life expectancy—have changed
                                in ways that threaten the financial solvency and sustainability of this
                                important national program. (See fig. 3.)


Figure 3: Ratio of Workers to
Beneficiaries                   10        Workers per Beneficiary




                                 8




                                 6




                                 4




                                 2




                                 0
                                     55
                                            60
                                                 65
                                                      70
                                                           75
                                                                80
                                                                     85
                                                                             90
                                                                             95
                                                                             00
                                                                             05
                                                                             10
                                                                             15
                                                                             20
                                                                             25
                                                                             30
                                                                             35
                                                                             40
                                                                             45
                                                                             50
                                                                             55
                                                                             60
                                                                             65
                                                                             70
                                                                             75
                                     19
                                           19
                                                 19
                                                      19
                                                           19
                                                                19
                                                                     19
                                                                          19
                                                                          19
                                                                          20
                                                                          20
                                                                          20
                                                                          20
                                                                          20
                                                                          20
                                                                          20
                                                                          20
                                                                          20
                                                                          20
                                                                          20
                                                                          20
                                                                          20
                                                                          20
                                                                          20
                                                                          20
                                Thus, while the program was put in 75-year actuarial balance just 15 years
                                ago, Trust Fund balances now are projected to be exhausted in 2032. In
                                addition, the program will begin to experience a negative cash flow in
                                2013, which will accelerate over time. (See fig. 4.) Absent meaningful
                                program reform, this will place increased pressure on the federal budget
                                to raise the resources necessary to meet the program’s ongoing costs. To
                                restore the 75-year actuarial balance 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.




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Figure 4: Social Security Income and Cost Rates

20    Percent of Payroll
                                                                                                                                          19.8
                                                    18.0



15

                           12.9



10




 5




 0
 00




                     10




                                  20




                                              30




                                                                40




                                                                                  50




                                                                                                    60




                                                                                                                       70




                                                                                                                                           80
20




                    20




                                  20




                                             20




                                                               20




                                                                                 20




                                                                                                   20




                                                                                                                      20




                                                                                                                                          20
            Cost Rate
            Income Rate


                                          Note: Includes revenues from income taxation of Social Security benefits. By 2075, the amount
                                          would be 13.4 percent of payroll.




                                          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.
                                          Consider what would happen if we did nothing and let the Trust Funds be
                                          exhausted in 2032, as estimated in the 1998 Trustees’ report. It would then
                                          be necessary to find resources in the following year that would be 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. 5.)
                                          Alternatively, we would have to reduce benefits in the year following Trust
                                          Fund exhaustion by 27 percent. Clearly, we must act soon in order to
                                          minimize the needed changes and maximize the fairness to future
                                          generations.




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Figure 5: Percentage Changes Needed
to Maintain Solvency                  60   Percentage



                                                                                                 48%

                                      45

                                                                          37%

                                                                                        32%
                                      30
                                                                   27%



                                                     16.3%
                                      15    14%




                                       0


                                                     1998-2075                  2032                   2075



                                               Benefit Reduction

                                               Tax Increase



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




Proposals Rely on                     A variety of proposals have been offered to address Social Security’s
Different Benefit                     financial problems. Some would reduce benefits by modifying the benefit
Adjustments and Financing             formula (such as increasing the number of years used to calculate
                                      benefits), reducing cost-of-living adjustments (COLA), raising the normal
Arrangements                          and/or early retirement ages, or revising dependent benefits. Others have
                                      proposed revenue increases, including raising the payroll tax that finances
                                      the system; increasing the taxation of benefits; or covering those few
                                      remaining workers not currently required to participate in Social Security,
                                      such as older state and local government employees. A number of
                                      proposals would incorporate investment returns to increase revenues and
                                      to reduce benefit cuts, or tax increases that would otherwise be required,
                                      or both.

                                      In fact, almost all proposals combine benefit reductions and changes
                                      designed to gain increased investment returns. The proposals differ not
                                      only with regard to specific benefit changes but also in how investment
                                      returns are captured. Some would change the Trust Fund’s investment



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                   policy so that the government could purchase equities or other
                   instruments besides Treasury securities; others would restructure the
                   Social Security system so that participants could invest at least part of
                   their own contributions. The latter approach creates individual accounts
                   as a means to finance and accumulate future benefits, rather than relying
                   entirely on payroll tax financing through a centrally managed government
                   trust fund account.

                   These proposals also differ in how such increased returns would be
                   financed. Some would use a portion of current payroll tax collections—a
                   “carve-out” from the Trust Fund—while others would “add-on” federal
                   budget surpluses (that is, general revenues) or additional payroll taxes as
                   a means to finance either current benefits or individual accounts. These
                   choices carry with them implications for individual beneficiaries, the
                   Social Security program, the federal budget, and the national economy.
                   Such implications should be well understood before a policy choice is
                   made.


                   Proposals that restore solvency to Social Security necessarily combine
Choosing Among     several or even a multitude of changes to the program. Although these
Reform Proposals   changes are presented in a comprehensive package, debate often focuses
                   on individual aspects that, on their own, are undesirable. For example,
                   many criticize proposals to raise the normal retirement age without
                   considering the other, potentially offsetting elements of the proposals of
                   which this change would be a part. Although such criticisms are legitimate
                   and can contribute to the public debate, it is critically important to
                   evaluate the effects of an entire package before considering whether these
                   proposed changes add up to acceptable program reform. If a
                   comprehensive package of reforms meets policymakers’ most important
                   goals for Social Security, individual elements of the package may be more
                   acceptable. After all, individual reform elements can drive interactive
                   effects that can tend to smooth the rough edges of the individual elements.
                   In addition, it’s important to look at a complete puzzle before rendering
                   final judgments and understand how it would stand up against relevant
                   reform criteria. For example, phasing in an increased normal retirement
                   age coupled with adding individual accounts could result in more
                   flexibility and benefit levels for baby boomers and generation Xers
                   compared with the current system.

                   Evaluating such packages can be complex, however. What factors or
                   elements should such evaluation measure? What weight should be placed



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                         upon particular factors? I would not presume to tell policymakers which
                         factors or elements should prove decisive for them in choosing among
                         proposed reform packages. I am, however, in a position to suggest what
                         factors to consider in making these choices.

                         Over the course of the last several years, various reform proposals have
                         been crafted with specific goals in mind—articulated in terms of solvency,
                         the economy, individual equity, and income adequacy. Two primary
                         criteria can be used to evaluate these proposals: (1) the extent to which
                         they achieve sustainable solvency and their effect on the economy and the
                         federal budget and (2) the balance they strike between the twin goals of
                         individual equity and income adequacy. I would also add a third criterion,
                         which, although not addressing a goal of Social Security reform, focuses
                         on the important practical aspects of reform—that is, how readily such
                         changes could be implemented, administered, and explained to the public.
                         These elements provide a basis to address a range of more detailed
                         questions (see attachment 1) that help describe and measure the potential
                         effects of various proposals on important policy and operational aspects
                         of public concern. Measuring proposals against these three criteria can
                         help shed light on the important choices we face; I will discuss each in
                         turn.


Criterion 1: Financing   Crafting a sustainable solution to Social Security’s financing problem
Sustainable Solvency     involves more than ensuring long-range actuarial balance, although
                         actuarial balance is also a goal to be achieved. Simply taking the actions
                         necessary to put the Social Security system back into an exact 75-year
                         actuarial balance could result in having to revisit these difficult issues
                         again in the not-too-distant future. For example, if we were to raise payroll
                         taxes 2.19 percent—which, according to the 1998 Trustees’ annual report,
                         is the amount necessary to achieve 75-year balance—the system would be
                         out of balance almost immediately and the 2013 cash problem I cited
                         earlier would move forward only to the year 2020.

                         Historically, the program’s solvency has generally been measured over a
                         75-year projection period. If projected revenues equal projected outlays
                         over the 75-year time horizon, then the system is declared in actuarial
                         balance. Unfortunately, this measure of solvency is highly transient and
                         involves what could be called a “cliff effect.” (See fig. 6.) Each year, the
                         75-year actuarial period changes and a year with a surplus is replaced by a
                         new 75th year that has a significant deficit. As a result, changes made to




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                                                  restore solvency only for the 75-year period will result in future actuarial
                                                  imbalances almost immediately.



Figure 6: Social Security Trust Fund Financial Outlook

2200 Billions of 1998 Dollars

1800

1400

1000

 600

 200

 -200

 -600

-1000

-1400

-1800

-2200

-2600
        2000     2005        2010   2015   2020     2025     2030    2035     2040     2045   2050   2055   2060   2065   2070   2075

           Trust Fund Balance

           Surplus/Deficit




                                                  Moreover, the problem is not one that is 74 years away because the
                                                  program will begin running annual cash deficits long before the trust funds
                                                  actually deplete their assets. Add to this the possibility that adverse
                                                  economic or demographic conditions could accelerate the depletion of the
                                                  trust funds, and the time when the Congress would need to address the
                                                  problem moves even closer. Therefore, simply restoring 75-year actuarial
                                                  balance today could mean that the Congress would have to visit these
                                                  issues again in just 15 or 20 years. In fact, today’s debate is a testimony to
                                                  this fact. About 16 years ago, the President and the Congress thought they
                                                  had saved Social Security for current and future generations. That reform
                                                  package did save us from the brink of bankruptcy, but it did not address
                                                  the cliff effect.

                                                  Solutions that lead to sustainable solvency are those that avoid the need to
                                                  periodically revisit this difficult issue, but they have implications for the



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risk borne by individuals. To the extent that a worker’s future retirement
benefits are funded in advance—in that they will depend on contributions
and the earnings (rates of return) on those contributions—the system is at
less risk of insolvency from unfavorable demographic or economic trends.
While pre-funding benefits has obvious advantages with respect to
sustainability over the largely pay-as-you-go system currently in place,
individuals bear more risk under such an approach, and the social
insurance aspects of the program could be weakened.

Reforms that provide sustainable solvency could also have positive effects
for the economy at large. To the extent that pre-funding worker retirement
results in increased savings and investment, the overall future economy
would be larger, making it easier for the nation to support a larger elderly
population. Simply put, if the dollar that the worker contributes today is
invested in private assets (stocks and bonds), there is a reasonable chance
that the dollar will contribute to a growing economy. The dollar invested
will grow in value and provide a return to the owner of the asset. Thus,
investment returns will, in general, help us finance a given benefit in the
future more cheaply (that is, with less expenditure today) than the way we
currently finance Social Security.

How the measures to achieve solvency are financed can have important
implications for the federal budget and the national economy. In addition,
federal fiscal policy itself can be an important element in fostering
economic growth. Our work on the long-term fiscal outlook shows that
replacing deficits with surpluses increases national income over the next
50 years, thereby making it easier for the nation to meet future needs and
commitments. Thus, it is important to consider the interaction of federal
fiscal policy with measures to restore program solvency in laying a
foundation for a sustainable Social Security program. For example,
proposals using budget surpluses to fund individual accounts, to purchase
private stocks or bonds for the trust fund, or reduce publicly held debt
would all have some positive effects on national saving and economic
growth. Yet, considerable debate exists over the relative extent of the
economic benefits under these different alternatives. Using the projected
budget surpluses to reduce publicly held debt alone would indirectly make
the Social Security system more sustainable but would not reform or
restructure the existing program. I discussed this at greater length before
this Committee several weeks ago in the context of the President’s budget
proposals.4

4
 See Social Security and Surpluses: GAO’s Perspective on the President’s Proposals
(GAO/T-AIMD/HEHS-99-96, Feb. 23, 1999).



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                                 Furthermore, some proposals must finance what most analysts call
                                 “transition costs,” and how these are financed matters as well. When
                                 proposals incorporate some degree of pre-funding—either via individual
                                 accounts or through the current program structure—current workers
                                 would, in effect, contribute both to their own accounts and pay for the
                                 benefits of current retirees under the existing defined benefit program.
                                 The resulting incremental transition costs must be financed. If transition
                                 costs are financed by borrowing or with projected budget surpluses, the
                                 effects on Social Security participants would be mitigated, but the positive
                                 effects of pre-funding on national saving could be neutralized in the near
                                 term by additional public borrowing.

                                 Sustainable solvency is an important criterion in assessing reform
                                 proposals but may require trade-offs between short-run and long-run
                                 gains. Further, it is not the only criterion by which to evaluate reform
                                 proposals. The economic and financing considerations that achieve
                                 sustainable solvency should be measured against equity and adequacy
                                 concerns as well.


Criterion 2: Balancing           The current Social Security system’s benefit structure is designed to
Equity and Adequacy in the       address the twin goals of individual equity and retirement income
Benefit Structure                adequacy. Individual equity means that there should be some relationship
                                 between contributions made and benefits received (that is, rates of return
                                 on individual contributions). Retirement income adequacy is addressed by
                                 providing proportionately larger benefits to lower earners and certain
                                 household types, such as those with dependents (that is, a progressive and
                                 targeted benefit structure). Virtually all reform proposals address the
                                 concept of income adequacy, but some place a different emphasis on it
                                 relative to the goal of individual equity. Differences in how various
                                 proposals balance these competing goals will help determine which
                                 proposals will be acceptable to policymakers and the public.

                                 Policymakers could assess this balance by considering the extent to which
                                 proposals address the following concerns:

                             •   Adequacy: (1) adequate benefit levels to protect the elderly from poverty
                                 and (2) higher replacement rates for low-income workers.
                             •   Equity: (1) reasonable returns on contributions, (2) improved
                                 intergenerational equity, and (3) increased individual choice and control.




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The weight individual policymakers may place on different concerns
would vary, depending on how they value different attributes. For
example, if offering individual choice and control is less important than
maintaining replacement rates for low-income workers, then reform
proposals emphasizing adequacy considerations might be preferred.

Each proposal for reform will have an impact on individuals and families,
whether limited to changes within the current program’s structure or
whether some portion of the program’s financial gap is to be closed
through access to equity markets. To restore solvency only via changes to
current benefits or current payroll tax revenues reduces the implicit rate
of return that future cohorts of beneficiaries will receive on their
contributions. (See fig. 7.) This serves to reduce individual equity and,
depending on what exact measures are taken, could compromise
adequacy as well. To preserve the existing protections and income
adequacy for certain types of beneficiaries under this approach, it could be
necessary to reduce the benefits of other types of beneficiaries. To avoid
such a result, payroll taxes (or the maximum taxable ceiling) might be
raised, but this could make current or future workers worse off. Adding
the prospect of additional earnings to the system, either from market
investment returns or from some other external source, could boost
individual equity while reducing the necessity for other changes to the
program, depending on how the investment returns or other revenues are
shared.




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Figure 7: Social Security’s Implicit
Rates of Return                        25    Percent of Implicit Return on Contributions




                                       20




                                       15




                                       10




                                        5




                                        0
                                        80

                                              90

                                                    00

                                                          10

                                                                20

                                                                      30

                                                                            40

                                                                                  50

                                                                                           60

                                                                                                70

                                                                                                     80

                                                                                                          90

                                                                                                               00

                                                                                                                    10

                                                                                                                         20

                                                                                                                              30

                                                                                                                                    40

                                                                                                                                         50
                                       18

                                             18

                                                    19

                                                         19

                                                               19

                                                                     19

                                                                           19

                                                                                 19

                                                                                       19

                                                                                                19

                                                                                                     19

                                                                                                          19

                                                                                                               20

                                                                                                                    20

                                                                                                                         20

                                                                                                                              20

                                                                                                                                   20

                                                                                                                                         20
                                       Birth Year



                                       Note: These estimates do not include all Social Security disability contributions and benefits. They
                                       do reflect tax rates that would keep the system in actuarial balance on a pay-as-you-go basis.
                                       They use the intermediate assumptions of the 1991 Social Security Trustees’ Report.




                                       In considering this balance, it helps to understand that Social Security is
                                       currently structured as a defined benefit program and that restructuring
                                       this program to include individual accounts would add, in effect, a defined
                                       contribution element to the system. Under Social Security, workers’
                                       retirement benefits are based on lifetime records of earnings, not directly
                                       on the payroll taxes they contributed. Based on the current design of the
                                       Social Security program and known demographic trends, the rate of return
                                       most 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 or
                                       financing reform. This approach to Social Security focuses on directly
                                       linking a portion of worker contributions to the retirement benefits that




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                            will be received. Worker contributions are invested in financial assets and
                            earn market returns; the accumulations in these accounts can then be used
                            to provide income in retirement. Under this approach, individual workers
                            have more control over the account and more choice in how the account is
                            invested. This control might enable individuals to earn a higher rate of
                            return on their contributions than under current law. But, of course, these
                            opportunities for higher returns exist because the investor assumes some
                            measure of risk that the return expected may not actually be realized.

                            Some reform proposals incorporating individual accounts address the
                            need for protecting individuals and ensuring income adequacy by
                            combining the 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. The benefit that would be earned through individual
                            account accumulations would either be added to a restructured defined
                            benefit amount (that is, supplement) or subtracted, in whole or in part,
                            from the benefits that would otherwise be provided through Social
                            Security’s defined benefit structure (that is, offset). Either approach could
                            require redesigning the benefit structure to ensure the types of protections
                            currently provided by Social Security. Such a structure could include a
                            modified version of the current defined benefit program or could
                            incorporate various types of guarantees based on the current or some
                            alternative benefit structure. Such guarantees would, however, create
                            contingent liabilities and incremental costs for the government.

                            Clearly, the number of proposals and features can make it difficult to sort
                            out exactly what should be done and what effects various actions would
                            have on individuals and families, although such effects may represent the
                            most important considerations in evaluating reform. It is critical,
                            therefore, that the extent to which proposals achieve solvency—
                            admittedly an easier criterion to measure—not overshadow the balance of
                            equity and adequacy.


Criterion 3: Implementing   Implementation, administration, and public understanding form a third
and Administering           important area to consider. Although some consider these issues merely
Proposed Reforms            technical or routine compared with macroeconomic considerations or
                            concerns about benefit adequacy, implementation and administration
                            issues are important because they have the potential to delay—if not
                            derail—reform if they are not considered early enough for planning



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                                purposes. Moreover, such issues can influence policy choices—feasibility
                                and cost should be integral factors in the ultimate decisions regarding the
                                Social Security program. In addition, potential transparency and public
                                education needs associated with various proposals should be considered.
                                Reforms that are not well understood could face difficulties in achieving
                                broad public acceptance and support.

Feasibility of Implementation   Degrees of implementation and administrative complexity arise in virtually
and Administration              all proposed reforms to Social Security. The extent to which these issues
                                present true challenges varies with the degree to which reform proposals
                                step away from current practices. Hence, proposals that would make
                                changes to revenues or to benefits without restructuring the current
                                defined benefit structure of the program are less difficult to implement
                                and less costly to administer than those that would create new tiers of
                                benefits or of beneficiaries. For example, reducing COLAs, either by
                                improving the accuracy of the calculation or by limiting COLA increases
                                directly (such as by capping, delaying, or eliminating the COLA) would not
                                require significant administrative change. Similarly, raising the retirement
                                age, in effect a recalculation of benefits, would not represent a large
                                increase in ongoing administrative costs, although some implementation
                                costs would accrue and would include the costs of educating the public
                                about the changing rules. Both these changes, however, would have a
                                ripple effect on certain private sector pension and saving plans that are
                                integrated with the benefits provided under Social Security. If the private
                                sector plan formulas are not adjusted, these changes would result in
                                additional benefit costs under the private sector plans. Alternatively, to the
                                extent that private sector employers act to adapt their pensions to an
                                altered Social Security benefit, these actions represent private
                                administrative costs as yet unmeasured.

                                Allowing the government to invest surplus Social Security funds would
                                raise certain implementation issues, the most significant of which are
                                investment vehicle and security selection and shareholder voting rights;
                                relatively less significant concerns regarding cost or complexity would
                                also be raised. However, these issues could prove controversial to resolve
                                because critics have expressed concern about increased government
                                involvement in financial markets and corporate affairs.5

                                But there may be ways that we can alleviate some of the concerns about
                                government investing. One way would be to introduce master trust

                                5
                                Social Security Financing: Implications of Government Stock Investing for the Trust Fund, the Federal
                                Budget, and the Economy (GAO/AIMD/HEHS-98-74, Apr. 1998).



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    principles for collective investment of base defined-benefit or individual
    account funds, which would be separate from other government funds. In
    this regard, we might be able to replicate or piggyback on a model that
    seems to be working well for federal workers—the Federal Thrift Savings
    Plan. These existing vehicles might help us limit concerns about the
    potential for political manipulation of investment decisions and thus foster
    the credibility needed to build bridges to consensus on reforms.

    The greatest potential implementation and administrative challenges are
    associated with proposals that would create individual accounts. Not all
    proposals for individual accounts clearly delineate how these accounts
    would be administered, but those that do vary in three key areas:

•   the management of the information and money flow needed to maintain a
    system of individual accounts,
•   the degree of choice and flexibility individuals would have over
    investment options and access to their accounts, and
•   the mechanisms that would be used to pay out benefits upon retirement.

    Decisions in these areas could 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. Table 1 provides a snapshot of 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: Design and Administration
Issues                               Administrative         Critical decision
                                     function               or trade-off          Options to consider
                                     Managing the flow      Centralized or        — Build on current Social Security tax and
                                     of information and     decentralized         payroll reporting structure.
                                     money                  recordkeeping         — Build on employer-based 401(k) structure.
                                                                                  — Build on individually controlled IRA
                                                                                  structure.
                                     Choosing               Maximizing            — Offer a small set of indexed funds.
                                     investment options     individual choice     — Offer a broad range of investment options.
                                                            or minimizing risk    — Combine the two options by requiring a
                                                                                  minimum account balance before a broader
                                                                                  range of options is available.
                                     Paying retirement      Maximizing            — Require lifetime annuities.
                                     benefits               individual choice     — Make annuities voluntary, and permit lump
                                                            or ensuring           sum and gradual account withdrawals.
                                                            preservation of       — Combine the two options by requiring
                                                            retirement benefits   annuitization to ensure at least a minimum
                                                                                  retirement income, with added flexibility for
                                                                                  remainder of account.

                                     Essentially, most decisions about the design of a system of individual
                                     accounts amounts to trade-offs between individual choice and flexibility
                                     and simplicity and standardization. For example, a centralized
                                     recordkeeping system, managed by government, could take advantage of
                                     existing systems and economies of scale but would not offer the wider
                                     range of alternatives for individuals that a decentralized system would. A
                                     system of individual accounts that permitted participants full and
                                     unfettered choice of investments would offer an ability to maximize
                                     returns but with attendant risk that incomes would not be adequate.
                                     Alternatively, a more centralized investment program, with fewer available
                                     choices, would be less administratively complex and would protect
                                     participants from poor investment selection; but it would also raise the
                                     risk that investment decisions could become politicized, depending on the
                                     extent of the government’s role in selecting investment funds and fund
                                     managers. Flexibility in how funds are withdrawn could allow individuals
                                     choice in how to manage their own funds but creates administrative
                                     complexity and risks leaving diminished capital to support an adequate
                                     income throughout retirement. A full assessment of the implications of
                                     these trade-offs will be essential to the debate on whether and how to
                                     implement individual accounts.

Costs of Implementation and          Although there are costs associated with most Social Security reform
Administration                       proposals, debate has focused largely and correctly on the costs of
                                     proposals that involve restructuring for two reasons. First, administrative




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                       Social Security Reform Proposals




                       costs of changes within Social Security’s current structure could be
                       relatively insignificant, and adding individual accounts to the structure
                       creates the potential for much higher implementation and administrative
                       costs. For example, there could be substantial start-up costs associated
                       with an individual account system. Second, the risk of higher
                       administrative costs of individual accounts would be borne by individual
                       account holders, directly affecting their benefits. Many have expressed
                       concerns about the administrative costs of individual accounts and how
                       these costs would affect accumulations, especially for the small-account
                       holder. Each of the reform decisions discussed here today can 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 on the design choices that were made.
                       The more flexibility allowed, the more services provided to the investor;
                       the more investment options provided, the higher the administrative costs
                       would be. For example, offering investors the option to shift assets
                       frequently from one investment vehicle to another or offering a toll-free
                       number for a range of customer investment and education services could
                       significantly increase administrative costs. 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.

                       To some extent, however, the creation of individual accounts could help
                       ease administrative burdens in the future. They would represent an
                       infrastructure that could allow workers to build up additional savings to
                       meet future retirement income and health care cost needs without
                       significant additional implementation and administrative costs. For
                       example, workers not covered by a private pension could choose to
                       contribute more to their individual accounts to augment their retirement
                       savings. Workers might also contribute more to their accounts to help pay
                       health care costs after they retire. The accounts could thereby contribute
                       to overall retirement security, not just retirement income security.

Public Understanding   Regardless of the reform proposal being considered, there will be a need
                       for enhanced public education and information. This effort would not
                       focus on educating the public about choices for Social Security reform;
                       that process began some time ago under congressional and presidential
                       leadership and has raised public consciousness not only regarding Social
                       Security’s financing problems but also of the choices we face. Instead,



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              enhanced education and information would serve to explain what changes
              have been adopted so that participants can adjust their retirement
              planning accordingly. Retirement planning is, in its nature, a long-term
              process, and we must give Americans not only the time to adapt their
              plans to a reformed Social Security program but also the information
              necessary to do so.

              While any change to the Social Security program must be explained to the
              public, the need would be especially acute if individual accounts were a
              feature of the chosen reform package. Not only would participants need to
              be informed of this change, they would also require investor education,
              especially if individual accounts were mandatory. For example, individuals
              would need information on basic investment principles, the risks
              associated with available choices, and the 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, including
              those with lower incomes and less education, who may have limited
              investing experience.

              Public understanding may not necessarily bring about public acceptance
              of Social Security reform. But the credibility of any reform package will be
              enhanced to the extent that the American public understands the changes
              being made and the impact these changes have on their personal
              retirement planning.


              Restoring solvency to the Social Security system is a formidable challenge.
Conclusions   Addressing it in a sustainable fashion today could help us avoid similar
              challenges in the future rather than leaving difficult choices for our
              children. The health of our economy and projected budget surpluses offer
              an historic opportunity to meet these challenges from a position of
              financial and economic strength. Such good fortune can indeed help us
              meet our historic responsibility—a fiduciary obligation, if you will—to
              leave our nation’s future generations a financially stable system. We must
              also move forward to address Social Security because we have other,
              equally serious obligations before us—compared to addressing the
              health-care financing problem, reforming Social Security is easy lifting.

              Today, I have offered three basic criteria against which Social Security
              reform proposals may be measured. These may not be the same criteria
              every analyst would suggest, and certainly how policymakers weight the



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various elements may vary. But if comprehensive proposals are evaluated
as to (1) their financing and economic effects, (2) their effects on
individuals, and (3) their feasibility, we will have a good foundation for
devising agreeable solutions, perhaps not in every detail, but as an overall
reform package that will meet the most important of our objectives.

I believe it is possible to reform Social Security in a way that will exceed
the expectations of all generations of Americans. The reports about Social
Security’s long-term solvency problem and the challenges it represents
have caused many Americans to have decidedly low expectations about
the future of their Social Security benefits. Many current retirees and those
nearing retirement believe that their benefits will need to be cut to restore
solvency, while some baby boomers and many generation Xers are
doubtful that the program will be there for them when they retire. We
believe it is possible to craft a solution that will protect Social Security
benefits for the nation’s current retirees, while ensuring that the system
will be there for future generations. Perhaps the answer is not solely one
approach or another—such as defined benefit versus defined contribution.
Bridging the gap between these approaches is not beyond our ability.
Doing so would represent a major accomplishment that would benefit
future generations. It would also help to restore the public’s respect for
and confidence in its government. 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.

Mr. Chairman, this concludes my remarks. I would be happy to answer any
questions you or other Members of the Committee may have.




Page 21                                                      GAO/T-HEHS-99-94
Appendix

Elements for Evaluating Social Security
Reforms

Financing Sustainable        To what extent does the proposal
Solvency
                         •   restore 75-year actuarial balance?
                         •   create a stable system beyond the 75-year period?
                         •   increase national saving?
                         •   reduce debt held by the public?
                         •   draw on general revenues to finance changes?
                         •   use Social Security trust fund surpluses to finance changes?
                         •   result in a future budget deficit?
                         •   require an increase in taxes?
                         •   create contingent liabilities?


Balancing Adequacy and       To what extent does the proposal
Equity
                         •   provide reasonable minimum benefits to minimize poverty among the
                             elderly?
                         •   provide adequate support for the disabled, dependents, and survivors?
                         •   provide higher replacement rates for low-income workers?
                         •   ensure that those who contribute receive benefits?
                         •   provide a reasonable return on investment?
                         •   expand individual choice and control?
                         •   improve intergenerational equity?
                         •   provide an opportunity to enhance individual wealth?
                         •   set reasonable targets as to the percentage of the current and projected
                             economy and the federal budget, represented by these costs?
                         •   provide safety valves to control future program growth?


Implementing and             To what extent does the proposal
Administering Reforms
                         •   provide a reasonable amount of time and adequate funding for
                             implementation?
                         •   result in reasonable ongoing administrative costs?
                         •   allow the general public to readily understand its financing structure,
                             thereby increasing public confidence?
                         •   allow the general public to readily understand the benefit structure,
                             thereby avoiding expectation gaps?
                         •   limit the potential for politically motivated investment decisions?




(207045)                     Page 22                                                     GAO/T-HEHS-99-94
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