Briefing Book

White House Conference

Center on Budget and Policy Priorities 820 First Street, NE, Suite 510 Washington, DC 20002 Tel: 202-408-I 080 Fax: 202-408-I 056 center@center.cbpp.org http://www.cbpp.org The Shortcomings of Individual Accounts Kilolo Kijakazi Senior Policy Analyst Approaching demographic changes and the subsequent long-term shortfall in the Social Security trust funds have prompted a number of policymakers and analysts to propose diverting some part of Social Security payroll taxes into individual accounts. Proponents of this approach typically extol the potential for higher rates of returns on savings in these accounts in comparison to the rate of return to assets in the Social Security trust funds. When the shortcomings of individual accounts are understood, however, it becomes clear that individual accounts are problematic for workers in general and for low-wage workers in particular. Transition Costs. Social Security is largely a "pay-as-you-go" system; the payroll taxes of workers currently in the labor force pay the benefits of current retirees. Thus any payroll taxes that would be diverted into individual accounts would have to be replaced in the Social Security trust funds by raising taxes, increasing the federal debt, or reducing benefits more than would otherwise be necessary. This is illustrated by the depth of the reductions in Social Security benefits required under one of the most painstakingly and thoughtfully designed partial privatization proposals - a bill developed by a private panel known as the National Commission on Retirement Policy and introduced by Senators Gregg and Breaux and Reps. Kolbe and Stenholm. The proposal shifts two percentage points of the Social Security payroll tax from the Social Security trust funds to individual accounts. By removing these payroll tax revenues from the trust funds, the plan deepens the shortfall in the trust funds from 2.19 percent of payroll to about four percent of payroll. To close this gap, the plan necessitates a reduction of 33 percent in the guaranteed Social Security benefit for the average-wage earner by 2025 and a 48 percent reduction by 2070. Risk. Beneficiaries would receive income from their individual accounts to supplement their Social Security benefits. For some beneficiaries, this might offset the Social Security benefit reductions. But that would not be the case for other beneficiaries. How much a beneficiary would receive from his or her individual account would be uncertain. While Social Security provides a "defined" - or guaranteed - benefit, individual accounts are "defined contribution" plans in which the income the accounts generate is not guaranteed and is subject to market risk. How much income an individual would receive from an account would depend on how the markets performed, how lucky or wise the individual was in his or her investments, and on what portion of the account was consumed by administrative costs. Administrative and Annuity Costs and Complexity. These costs cover the expense of managing individual accounts and of converting accounts to annuities when workers retire. Based on data from 401(k) accounts, Henry Aaron of the Brookings Institution and Peter Diamond of M.I.T. have estimated that the administrative costs for retirement accounts that are like IRAs or 401(k)s would reduce the savings in these accounts by about 20 percent. Also, leading research shows an additional 15 to 20 percent of the value of an account is consumed by the cost of converting it to an annuity. Taking all of these costs into consideration, Aaron estimates that at least 30 percent and as much as 50 percent of the accumulated savings in privately managed individual accounts would be consumed. Another problem with individual accounts is that they could be difficult to administer, especially for small businesses. The Employee Benefit Research Institute warned that individual accounts cannot be administered like 401(k) plans, with contributions made each pay period through payroll deductions, without adding significant employer burdens, especially on the small-business sector. Political Sustainability of Social Security with Individual Accounts. Plans that replace part of Social Security with individual accounts risk destabilizing Social Security over time. Under these plans, retired workers generally would receive considerably lower Social Security benefits than under current law. Because people would seem to be paying substantial payroll taxes to Social Security and getting back lower benefits from it, Social Security would likely appear to much of the middle class and more affluent segments of the population to be a bad deal. It would seem to provide them a poor rate of return compared to what their private accounts were paying. These disparate rates of return would, in substantial part reflect the fact that the Social Security trust funds would bear all of the burden of financing the benefits of workers who had already retired or worked for many years when the individual accounts were established. The trust funds also would bear all of the burden of providing more adequate benefits to low-income retirees, low-earning spouses and divorced women, and covering widows, the disabled and the children of disabled and deceased workers. Although not obvious to many workers, a sizeable portion of the Social Security payroll tax is essentially an insurance premium for the disability and life insurance protection that Social Security provides. The private accounts, by contrast, would bear none of these burdens, which would enable them to appear to be a better deal to the average worker. For these reasons, the broad-based support for Social Security would lessen and generate strong pressure to shift more payroll contributions from Social Security to individual accounts. Over time, such pressures would likely prove irresistible. Low-Wage Workers. For several reasons, low-wage workers would be likely to receive lower rates of return from individual accounts than other workers. Some administrative costs are fixed dollar expenses and would consume a greater proportion of small accounts than large ones. Also lower-wage workers generally would not be able to afford as good investment advice, would have less investment experience, and would be more likely to preserve their limited savings by investing conservatively. It appears that claims individual accounts would lead to wealth accumulation for low-wage workers are not well founded. Conclusion. Upon first glance, individual accounts may appear to be a potential solution to the long-term imbalance in the Social Security. A more in-depth understanding of individual accounts, however, brings to light inherent problems that could result in a lessening of retirement security for workers and their families. (See also "The Strengths of Social Security and the Best Course of Action for Preserving this System" by Wendell Primus of the Center on Budget and Policy Priorities.)