[Economic Report of the President (2002)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 2

Strengthening Retirement Security


Over the course of the 20th century, longer life expectancies and
increased personal prosperity fostered a virtual revolution in the
way Americans approach work and retirement. At the turn of the last
century, male and female life expectancies at birth were 51.5 years
and 58.3 years, respectively. Today, in contrast, life expectancy at
birth is 79.6 years for males and 84.3 years for females. Because of
these patterns, retirement security was not nearly the important
policy issue in 1900 that it is just over a century later. And this
issue is likely to grow in importance. Thanks to lifestyle
improvements, less dangerous jobs, and advances in medical
technology, among other reasons, the average life expectancy of a
65-year-old is projected to increase by more than 2 years over the
next half century and to continue increasing even after that.

Changes in life expectancy and in fertility--American women are
having fewer children--are among the forces working at the
individual level that have demographic implications at the national
level. These trends, together with the aging of the baby-boom
generation, ensure that the population of the United States will
grow older on average and remain older. Whereas in 1950 only 8
percent of the population were aged 65 or over, today those in that
age group account for more than 12 percent of the population.
Thirty-five years hence, they will represent more than a fifth of
all Americans.

Not only are Americans living longer, but work and living
arrangements have changed as well. In 1900, when fewer than 4 in
10 people reached the age of 65, approximately two-thirds of
these survivors continued to work, the vast majority as farmers
or laborers. In contrast, more than half of all workers today
retire before their 62nd birthday, and only about 12 percent of
the population work past 65. The few elderly Americans at the turn
of the last century who were lucky enough to retire by 65 typically
counted on extended family to support them in their old age: over
72 percent of retired men in 1900 were living with adult children.
Today, fewer than one in five retirees live with extended family.

In addition to longer lives and earlier retirements, increased
personal and national prosperity means that most Americans, including
those in retirement, can now pursue leisure and recreational
activities that were the exclusive privilege of the most affluent
a century ago. To take full advantage of these changes, however,
we must confront issues that previous generations of Americans,
who often labored until life's end, did not have to. Planning
ahead for a comfortable, independent lifestyle during several
decades without earnings from labor has become an important issue
for most of the population. Amassing the resources necessary to
live unsupported by others for an indefinite length of time is a
task that demands forethought and preparation from the time a
worker first enters the labor force. The growing importance of
retirement security demands that, as we enter the 21st century,
we reevaluate the strength of the Nation's many institutions for
supporting workers' retirement planning efforts.

Rationale for a National Retirement System
As a starting point for thinking about retirement security, it is
useful to consider a simplified scenario in which each individual
passes through two distinct phases of adult life, with the length of
each known with certainty. During the ``working'' phase, the individual
uses earnings from work both to purchase goods and services for
current consumption and to accumulate assets for future use. In the
``retirement'' phase, the individual ceases to work and instead
lives on savings accumulated during the first phase. If these
individuals are forward looking, then because they know how many
years they will spend in retirement, they will save enough while
working to ensure that they can maintain through retirement their
previous level of consumption, and perhaps make a bequest to their
heirs as well. Put differently, they will use their savings to
``smooth'' their consumption over their entire lifetime, instead
of living well only while working.

In this highly simplified world, retirement security is not an issue
of national concern. Prudent individuals have the incentives and the
means to successfully plan for their retirement so that they will
always have enough resources in their nonworking years. There is no
need for government involvement in workers' planning and saving
decisions.

Why, then, is retirement security a public policy concern?
Traditionally, the rationale for a public system for retirement
planning derives from three broad sources: insurance against
uncertainty, foresight and planning failures on the part of
individuals, and redistributive goals.

Insurance Against Uncertainty
So far we have deliberately ignored the many sources of uncertainty
an individual faces when planning for the future. But in fact none
of us who are working today knows how long we will be able to work,
how much we will earn along the way, how long we will live, or what
our costs of living in retirement will be. A person may plan to
work for 45 years and may save accordingly, only to discover after
just 40 years that, for health reasons, he or she simply cannot
work any longer. Exactly how long we will live in retirement is
likewise subject to a great deal of uncertainty. Although the
average remaining life expectancy of a 65-year-old today is about
18 years, nearly a quarter of those alive at 65 will live into
their 90s. To guard against the pleasant ``surprise'' of a
longer-than-expected life, an individual needs a larger nest egg
than if he or she were certain of living to the average life expectancy.

Uncertain and unexpected health care costs pose another potential
obstacle to an individual's retirement planning. Out-of-pocket medical
expenses are fairly low for most retirees, but for some they will be
catastrophically high.
Can private insurance markets effectively safeguard individuals
against these contingencies? Although insurance is available
against disability and against large medical costs, not all the
potential shocks to an individual's retirement security can be
insured against. For example, an insured worker may find it
difficult to continue to work, and therefore apply for benefits,
but for various reasons the insurance company may be unable to
verify that the person can indeed no longer work and is therefore
entitled to benefits. This creates what economists call moral
hazard: once a person is insured against running out of money in
retirement, he or she has an incentive to retire earlier than in
the absence of insurance, and this raises the insurer's costs.

It has been argued that the inadequacy of existing insurance
contracts against a long life without work constitutes a market
failure that only a national social insurance system can address.
Some have pointed to the small size of the private U.S. market for
life annuities as evidence of market failure due to adverse
selection: those who expect to live longer than the average will
be more inclined to buy annuities; this self-selection of higher
risk (from the insurers' perspective) individuals raises the cost
to insurers of providing annuities, and thus, ultimately, their
price. The higher price in turn discourages still more potential
annuity purchasers, further shrinking the market. But although there
is evidence of some adverse selection in the U.S. annuity market,
studies have shown that this is not a sufficient explanation of
its small size. Among the leading alternative explanations is the
existence of Social Security, which itself provides a substantial
annuity to most disabled workers and retirees. Thus the seeming
failure of markets for insurance against a long life may not
actually be a sufficient motive for government involvement in
retirement security.


Foresight and Planning
Some have suggested that even if workers could insure against all
uncertainty in planning for retirement, a portion of the population
may nonetheless fail to save adequately for retirement. Why might
this be the case? Some people may simply be shortsighted, failing to
consider fully the long-run implications of their consumption and
saving decisions. Also, some ``free-riders'' might intentionally
neglect to accumulate retirement assets, in the expectation that
they can throw themselves at the mercy of a family or government
safety net that will guarantee them a minimally acceptable living
standard in retirement.
Even a worker who intends to save adequately for retirement may not
fully appreciate the necessity of saving enough, early enough, in
his or her working life. Or that worker may miscalculate the level
of savings necessary to finance a retirement that may span several
decades. Saving for retirement is a continuous, lifelong process,
but inadequate preparation early in life, perhaps due to lack of
experience in saving for large expenditures, may have lifelong
implications. Although some empirical research suggests that most
people do plan and save adequately for retirement, it is ultimately
unclear, given widespread expectations of government support in
old age, how much people would save in the absence of existing
government programs.


Redistributive Goals
For some, a third rationale for a public pension system is as a way
of redistributing resources from higher income to lower income
individuals. There are two reasons why government institutions for
retirement security may be especially well suited for achieving
redistributive goals. The first is that, because retirement benefits
are provided after a person's working years are over, it is
possible to redistribute based on lifetime rather than annual
income. Because income in a given year is not perfectly correlated
with income over a lifetime, redistribution on a lifetime basis
should allow for more accurate targeting of the lifetime needy.
However, as discussed below, evidence suggests that the current
Social Security system accomplishes very little lifetime income
redistribution. Another task for which a social security system
might be uniquely suited is redistribution between generations.
This sort of redistribution might be desirable if each generation
is substantially wealthier than its predecessors. Indeed, in a
continually growing economy this is normally the case, but it was
especially the case for the generation following the Great
Depression. The institution of Social Security transferred a
large amount of resources from those who were younger during the
Depression to those who were older, many of whom had lost much of
their wealth, or were unable to accumulate it, during those years.

Unlike most events against which individuals insure, retirement and
old age are not unforeseen. Accordingly, individual workers can and
should take primary responsibility for their own retirement
preparation. For a variety of reasons, however, retirement planning
in the real world may not reflect the ideal, simplified world in
which each worker can and does optimally provide for his or her
own retirement. To the extent that obstacles to an individual's
ability to save adequately for retirement do exist and cannot be
removed by private markets, or if certain social goals can only be
achieved through government involvement in retirement planning,
retirement security can be a national concern as well as a personal
one. The appropriate public policy in this area depends on the
nature of the impediments to successful retirement planning at the
individual level, and the potential benefits from government
intervention. Given the wide variety of circumstances facing
individuals, however, retirement security must ultimately be the
fruit of government policy that supports and enhances individuals'
efforts to plan for themselves.


Sources of Retirement Security
A traditional metaphor for retirement security is that of the
``three-legged stool,'' where the legs--the principal sources of
income in old age--are Social Security, employer-sponsored pensions,
and individual savings. For elderly households as a group, the
largest share of income today comes from Social Security, providing
38 percent of the total (Chart 2-1). Personal savings, which include
both individual savings and employer pensions, also remain
important, but a fourth income source has taken on increased
salience in recent years, namely, earnings from labor. In fact,
earnings from work are second only to Social Security in their
contribution to the total income of the elderly. Other sources of
income, including Supplemental Security Income (SSI) and other
forms of public assistance, account for only a small fraction of
all income for this group. In the future, the relative importance
of each of these income sources will likely change; for example,
many of today's younger workers will receive a larger share of
income from private pensions upon retirement than did previous
generations.

There are other sources of retirement security as well. Many people
have the advantage of owning a home that they can occupy. Private,
employer-provided health insurance benefits for retirees, as well
as Medicare and Medicaid, also help mitigate the need for income
flows in retirement.

Social Security
Social Security plays a central role in the household budgets of
older Americans as a group. On average, Social Security benefits
account for 58 percent of total income for elderly households
(defined in this chapter as households with at least one member
aged 65 or over). For the poorest elderly, Social Security is
even more important. Those in the lowest income quintile obtain
an average of 77 percent of their money income from Social Security
benefits; for half of that group, Social Security is the sole source
of income.




The importance of Social Security benefits in the retirement
portfolios of most American households does not necessarily mean,
however, that most U.S. households would be poorly prepared for
retirement without it. It is sometimes suggested that, were it
not for Social Security, elderly poverty rates would be much
higher than they are today. But this claim is generally based on
the premise that benefit payments to current Social Security
beneficiaries would suddenly be ended without warning, and that
workers who had contributed to the system their entire lives
would be given nothing in return. That is not the same as saying
that, if Social Security had never existed, the elderly poverty
rate today would necessarily be higher than it is. In the absence
of a national retirement security program, people would have
higher after-tax income and would not expect future retirement
benefits. Therefore it is reasonable to suppose that today's
retirees would have saved more on their own for retirement than
they actually did. Private pension coverage might also have been
dramatically different in the absence of a public pension system.

Consequently, it is important not to conclude, based solely on the
current distribution of retirement income sources, that people
would be poorly prepared for retirement under a different set of
savings institutions.


Employer-Sponsored Pensions
Outside of Social Security, saving for retirement occurs in two
main ways: individuals may save independently, or they may save
through an employer-sponsored pension plan. Savings accumulated
in employer plans have increased dramatically over the past few
decades, growing from $852 billion (in 1997 dollars) in 1978 to
almost $3.6 trillion in 1997. At the same time, there has been a
pronounced trend away from defined-benefit plans, in which employees
are promised specified benefit levels upon retirement, and toward
defined-contribution plans, including 401(k) plans, in which
employers and, often, employees make specific periodic contributions
toward the employees' pension savings. The number of participants
in defined-contribution plans has skyrocketed, from 16.3 million
in 1978 to 54.6 million in 1997, while the number of participants
in defined-benefit plans increased only slightly, from 36.1 million
to 40.4 million (Chart 2-2). The growth in defined-contribution
plans primarily reflects the popularity of 401(k)-type plans;
participation in these had increased to 33.9 million by 1997,
compared with only 7.5 million in 1984. Age-specific trends in
plan participation, as well as a trend toward more companies
offering plans, indicate that the rapid growth of 401(k)-type
plans is likely to continue.




Individual Savings
Income from assets accumulated outside of private pension accounts
is another important component of retirement income, accounting
for about a fifth of all income for elderly households. With more
than half of elderly households reporting income from nonpension
assets in 1998, individual retirement savings are a widespread,
but not yet ubiquitous, phenomenon. At the same time, the
distinction between pension savings and other personal savings
has become increasingly blurred. For example, balances from
401(k) and other pension plans may be rolled over into Individual
Retirement Accounts (IRAs), which are regarded as nonpension
savings. Also, small firms may establish IRAs on behalf of their
workers rather than provide traditional pensions or 401(k)-type
plans; such accounts would be counted as individual savings even
though the employer contributes the funds.


Labor Earnings
Older workers are a vital part of the work force today and will
become even more important in the future, as growth in the work force
slows in response to population trends. Earnings from labor are an
important component of income for a significant minority of older
households. In 1998, 21 percent of elderly households reported
income from labor earnings. Apparently, working is a feasible and
perhaps even a desirable option for those elderly who wish to
supplement income from Social Security and savings. And for those
who determine that they have undersaved, or whose assets decline
in value close to or during retirement, working in the traditional
retirement years can be an important adjustment mechanism. Finally,
today's elderly tend to be in better health than the elderly of 50
years ago, and it is likely that many more than in the past have
valuable skills whose use does not require physical exertion. These
considerations make the choice of continued work even easier.

Public Assistance
Compared with the four primary sources--Social Security, savings in
pension plans, individual savings, and labor earnings--public
assistance programs such as SSI account for an insignificant share
of total income for the elderly. Nevertheless, SSI, as the
retirement security program of last resort, is an important part of
the safety net for a civilized society, guaranteeing a minimum
income for those elderly who have little or no income from other
sources. Five percent of all aged households receive some form of
public assistance, and for a quarter of these it is their sole
income source. Medicare and Medicaid, which provide in-kind
assistance rather than cash benefits and which may have a
substantial insurance value, also are an important form of public
support for the elderly.

Challenges Ahead
At the beginning of the 21st century, America is taking stock of its
institutions for retirement security. A monumental demographic shift
is taking place, in the United States and around the world, with
the result that the elderly, and programs for the elderly, will
consume a growing proportion of the Nation's output. The aging of
the baby-boom generation, whose oldest members will reach the age
of 65 in just 9 years, together with continuing low fertility
rates and increasing life expectancies, will mean that relatively
fewer workers will be available to support a growing elderly
population. Over the next 35 years, the number of workers for every
retiree will fall from 3.3 to just 2.1--a 36 percent drop.

One clear imperative arises from this trend: Americans must take
even greater responsibility for their own retirement security by
increasing their personal saving. Higher personal saving has a
twofold benefit. Not only will it improve personal retirement
security by expanding personal wealth, but it will also have a
salutary effect on the economy as a whole. When individuals save
more, they add to national saving (Box 2-1). Higher national
saving, in turn, means a larger capital stock and, consequently,
an expanded national productive capacity for the future. This
larger economic pie improves the ability of the Nation to ensure
a minimum level of consumption for those members of the growing
elderly population who did not earn enough while working to
accumulate a large base of assets.

Public policy has an important role to play in encouraging personal
saving as the foundation of retirement security. As outlined
earlier, personal saving can take several different forms.
Individuals may save for retirement on their own initiative. This
form of saving can be encouraged through incentives in the tax
system, such as the exemption of capital income from taxation.
These incentives reduce the tax burden that might otherwise inhibit
personal saving; however, they also have a cost in terms of forgone
tax revenue, which can mean that national saving does not increase
by the full amount of the increase in personal saving (see Box 2-4
below). Personal saving may also take place through
employer-sponsored pension plans, which likewise receive favorable
treatment under the tax code. Finally, personal saving may even
take place through a public pension system, if the program allows
individuals to save in accounts that they personally own. The rest
of this chapter examines each of these important retirement
security institutions, beginning with the institution that
dominates the current retirement saving landscape: Social Security.
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Box 2-1. National Saving, Personal Saving, and Growth
National saving is the sum of saving by individuals, businesses, and
all levels of government, Federal, State, and local. Augmented by
saving from abroad, national saving represents the total resources
available for investment: the purchase of factories, equipment,
houses, and inventories. When a country saves more than is necessary
to replace worn-out capital goods with new capital, so that net
national saving is positive, extra resources are available to expand
the country's capital stock. A larger capital stock corresponds
directly to a higher capacity to produce goods and services.
Therefore increasing net national saving today can be an important
step toward expanding the productive capacity of the economy for
tomorrow.

During the 1990s, net national saving averaged about 5 percent of
GDP, down from its 1960s average of nearly 11 percent. Although
net national saving was fairly stable during the 1990s, its
components varied widely across the decade. Net business saving
grew slightly as a fraction of GDP, but there were substantial
changes in the contributions of government and personal saving.
Personal saving dropped sharply, from a peak of 6.5 percent of GDP
in 1992 to just 0.7 percent in 2000. Over the same period, government
accounts flipped from a deficit of 4.8 percent of GDP to a surplus
of 2.5 percent--a total rise in saving of 7.3 percentage points.
Thus, increased government saving roughly offset the decrease in
personal saving. Traditionally, personal saving has been an
important source of net national saving that finances investment.
And because the Federal Government may not be expected to run large,
persistent surpluses as an aging population strains its finances,
it is imperative that the Nation increase personal saving now in
order to expand the economy for the future.

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Social Security: Past and Present


Origins of the Current System
The basic institution for retirement security in the United States
today was established in the midst of the Great Depression, through
the Social Security Act of 1935. Championed by President Franklin
Roosevelt as a means of offering ``some measure of protection to
the average citizen and to his family...against poverty-ridden old
age,'' Social Security was Roosevelt's proposal for a national
system of retirement security. Ultimately, this proposal became a
key part of the Nation's response to the upheaval of traditional
social and economic structures in the early decades of the 20th
century.

The secular decline in agricultural employment, on which many
Americans had depended for their living, worsened the ill effects of
the Great Depression for many of the elderly. The loss of agricultural
jobs over several previous decades had forced a shift of employment
to the cities. But nonfarm workers had always fared worse than
agricultural workers during economic declines, and the pattern
persisted during the 1930s. Unemployment in the work force as a
whole reached a high of 25 percent in 1932, but unemployment among
nonfarm workers peaked at nearly 38 percent. The elderly were hit
particularly hard. In 1930, 54 percent of men aged 65 and over were
unemployed and looking for work, and another quarter were temporarily
laid off without pay.

Aggravating the situation, the stock market crash and subsequent
failure of many financial institutions wiped out the limited
resources that some older workers had managed to accumulate. Without
assets, employment, or traditional support systems, many of the
elderly of the 1930s were in dire need of assistance. President
Roosevelt sought to provide aid for the aged through his plan for
social insurance. Social Security, as envisioned by Roosevelt,
addressed the problem through a system in which workers contributed
a portion of their earnings while working and, in turn, earned the
right to collect benefits upon retirement.
Importantly, Social Security was not implemented as a program for
national saving. Although the authors of the Social Security Act of
1935 intended to create a funded system, one that sets aside revenue
to meet scheduled future benefits, amendments to the act in 1939
made important changes to provide more immediate relief from the
widespread poverty then afflicting the elderly. As a result,
Social Security is not today a fully funded system. Rather it is
primarily a system for the transfer of income from one generation
to the previous one: each generation pays taxes during its working
years to support the current generation of retirees. Such a system
is called an unfunded, or pay-as-you-go, system.

Although the Social Security system as amended in 1939 addressed the
needs of the elderly during the Great Depression, today the United
States faces a different challenge. The role of our retirement
security institutions in enhancing the ability of relatively fewer
workers to support relatively more retirees will be a critical issue
as the 21st century progresses. To that end we must consider the
effect of Social Security on national saving, the essential
ingredient for expanding the economy's productive capacity so that
it can support a vastly larger number of retirees.

Social Security and National Saving
To consider how the presence of Social Security affects national
saving, one must examine the effects of the current program on two
individual components of national saving: government saving and
personal saving.


Government Saving
To the extent that Social Security operates as a pure income
transfer program, in which taxes collected from current workers
are precisely equal to the benefits paid to current retirees, the
system itself has no effect on government saving. Thus the effect
of Social Security on government saving hinges on how any deviation
from annual budget balance in the Social Security program affects
overall government budgetary policy.

When Social Security runs a surplus, so that income from payroll
taxes and taxes on benefits in a given year exceeds total benefit
payments in that year, as is currently the case, the government
essentially has two options for the use of those excess funds.
The surpluses may be spent, or they may be saved. If the surpluses
are used to finance current expenditure beyond the level that would
have prevailed in their absence, they do not contribute to
government saving. If instead those funds are used to pay down
publicly held debt (which represents the accumulation of past
government dissaving), government saving increases dollar for dollar
with the reduction in the debt. However, the government's ability
to save by paying down its publicly held debt is limited by the
amount of such debt. If all publicly held debt were to be retired,
the only way that the government could continue to save through
existing systems would be through investments in non-Federal
securities, such as corporate or municipal bonds, or equities.
This, however, would raise difficult issues about government
interference in equity markets and corporate governance.

Ultimately, the contribution of Social Security to government saving
depends on whether non-Social Security surpluses or deficits are
affected by the annual balances in the Social Security program.
If the presence of Social Security surpluses leads policymakers
to increase spending or reduce taxes in the non-Social Security
budget, the potential contribution of surpluses to government
saving is reduced.

Many discussions of the effect of Social Security surpluses on
national saving are confused by misunderstandings about the
relationship between the Social Security trust fund and national
saving. (Technically, there are separate trust funds for the two
major Social Security programs, that for old-age and survivors
insurance and that for disability insurance, but for purposes of
this discussion we will combine them.) The trust fund is essentially
an accounting device for keeping track of annual surpluses in the
Social Security portion of the Federal budget. The balance of the
trust fund represents the accumulated value of excess revenue,
net of expenses, to the Social Security system in all years that
the system has run a surplus, net of accumulated deficits, as well
as the interest earned on those surpluses. All Social Security
surpluses are credited to the trust fund, regardless of whether
they are used to finance non-Social Security spending or reduce
debt, and regardless of how the existence of those surpluses
affects other government spending. Consequently, the balance in
the trust fund is not a measure of the Social Security program's
accumulated net contribution to government saving. Rather, it
merely represents the upper bound on the saving that could have
happened if all Social Security surpluses had been devoted to
government saving. Although Social Security has run large surpluses
since 1984, these surpluses have in most years been offset by
large non-Social Security deficits, suggesting that actual saving
through Social Security has been far smaller than the value of
the balance of the trust fund.

Personal Saving
To gauge the effect of the current Social Security system on
national saving, one must consider the system's effect not only
on government saving but also on personal saving. It is difficult
to say definitively what personal saving would be, or would have
been in the past, in the absence of Social Security, but reasoning
and empirical evidence can be useful guides. As discussed
previously, careful consideration suggests that Social Security may
act as a substitute for retirement saving. Instead of saving, a
worker pays taxes on his or her wages and, upon retirement, instead
of using past savings to finance consumption, the worker receives
a check from the government. In this way Social Security can
negatively affect personal--and, consequently, national--saving.

For a number of reasons, however, a rational worker might decide to
reduce personal saving less than dollar for dollar with increases
in expected Social Security wealth. A worker may underestimate the
expected value of Social Security benefits or simply not believe
that the scheduled benefits will be forthcoming upon retirement.
This is particularly possible in the current climate, when revenue
has been projected to fall short of projected benefits. Another
possibility is that Social Security affects saving behavior through
an effect on retirement behavior (Box 2-2). If Social Security
makes retirement an attainable goal and thus prompts workers to
plan for an earlier retirement, they may actually save more than
they would have in the absence of the program.

Clearly, economic reasoning alone does not lead to an unambiguous
conclusion regarding the effect of Social Security on personal
saving behavior. Therefore we must rely on empirical analysis to
learn about the actual effect of the program on personal saving and,
ultimately, on national


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Box 2-2. Does Social Security Alter Retirement Behavior?
Careful economic analysis indicates that the current Social Security
system does indeed have the potential to alter workers' retirement
behavior. Incentives that affect retirement could come through a
number of different channels. For some, Social Security provides
more retirement wealth than they would have chosen to provide for
themselves through their own saving; the resulting benefit
windfall in old age could induce their earlier retirement. Also,
Social Security adjusts benefits for those who retire and begin
receiving benefits before or after Social Security's normal
retirement age, currently 65 years and 6 months; if these adjustments
deviate from what is actuarially fair, they may create incentives
favoring retirement at a particular age. If those who work past
65 do not get an actuarially fair increase in benefits, for
example, people might be inclined to retire earlier than otherwise.
People with above- and below-average life expectancies will also
have varying retirement incentives related to the benefit formula.
Social Security may also have affected retirement behavior simply
by establishing the social convention that 65 is the ``normal''
retirement age.
Since rational analysis does not lead to a definite conclusion
about how Social Security affects retirement behavior, we must
examine empirical retirement patterns in order to understand the
ultimate effect of this complex system of incentives. Early
retirement has become more common in the United States, as well
as in other countries, in recent decades. And a considerable amount
of evidence indicates that the relaxation of early retirement rules
and the increased availability of benefits at earlier ages in the
1950s and 1960s resulted in these pronounced trends toward earlier
retirement. Cross-sectional evidence using only U.S. data has been
less clear in establishing a link between Social Security expansions
and declines in the average retirement age. Some research suggests
that changes in pension wealth have had a much stronger effect on
retirement trends than have Social Security changes; this research
finds that any Social Security effect accounts for only about 1
percentage point of the 20-percentage-point decrease in the labor
force participation rate for males aged 55 to 64 between 1950 and 1989.

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saving. Even then the results are less than clear, but in a recent
Congressional Budget Office survey, 24 of 28 cross-sectional studies
found a negative impact of increases in Social Security wealth on
private saving. If Social Security does negatively impact private
saving, as much evidence suggests, it may be inhibiting national
saving and, consequently, economic growth.

The Future of Social Security
In assessing the role of Social Security as a retirement security
institution for the 21st century, two related, yet conceptually
distinct, issues must be addressed. The first is the fundamental
question about the degree to which government transfers should
supplement personal saving for retirement. In the extreme, the
essential choice is between a savings-based program in which
individuals accumulate assets, and a program that simply transfers
income from younger to older generations.

The second issue is that the current Social Security system, which
resembles more the latter system than the former, is on a fiscally
unsustainable course as a result of the demographic changes
discussed earlier: the aging of the population and the consequent
projected decline in the ratio of workers to retirees. These changes
make it impossible to afford the currently projected rate of benefit
growth without large tax increases or other fundamental changes to
the system. The following sections deal with each of these issues in
turn.


Advantages of Personal Accounts
One of the President's principles for strengthening Social Security
is that modernization must include individually controlled,
voluntary personal retirement accounts to augment the Social Security
safety net. Under such a system, a worker could direct a portion of
his or her payroll taxes, or possibly an additional voluntary
contribution, into a personal account that he or she would legally
own. The worker would then choose, from a variety of options, how
the assets in the account are to be invested. Upon retirement, the
worker would have access to the accumulated assets, which could be
used to purchase an annuity, provide a bequest to heirs, or make
withdrawals from as needed. Workers who choose to direct a portion
of their existing payroll taxes into private accounts could expect
a higher combined level of benefits, because an annuity funded by
the personal accounts would have a higher expected value than the
benefits from the traditional system that are being partially
replaced by the account contributions. Personal accounts would thus
represent a voluntary means by which a worker could supplement
benefits from the pay-as-you-go portion of Social Security. As such,
they could provide the foundation for a return to individual-based
retirement security that takes advantage of the safety net aspects
of Social Security and the strengths of individual choice and wealth
accumulation.

Although the introduction of personal accounts within Social Security
would represent the most significant change in the program since
its inception, the idea itself is not new. In President Roosevelt's
message to Congress on Social Security on January 17, 1935, he
stated that one of his three principles for the program was
``voluntary contributory annuities by which individual initiative
can increase the annual amounts received in old age.'' In this light,
a system of personal accounts would appear to be the next step in
the natural evolution of the program. In addition, many other
nations, from the United Kingdom to Australia to former socialist
countries like Kazakhstan, have included personal accounts as an
important part of their national retirement program.

A Social Security system that includes an element of personal
accounts would offer many advantages over the current regime. These
include personal ownership of accounts, bequeathability of account
assets, better diversification of risk, reduced distortion of work
incentives, and the potential for higher national saving. We
discuss each in turn.

Ownership
From the perspective of an individual worker, perhaps the most
striking difference between personal accounts and the current
system is ownership. Under Social Security, a worker's retirement
security depends not on the assets that worker possesses, but on
the hope that future Congresses will raise taxes on the next
generation of workers by a sufficient amount to pay scheduled
benefits. In fact, the Supreme Court ruled in Flemming v. Nestor
(1960) that workers and beneficiaries have no legal ownership claim
to their benefits, even after a lifetime of contributing to the
system. A personal account, on the other hand, would be the legal
property of the worker who contributed to it and whose name it
bears. Regardless of the financial situation of the government, a
worker would be legally entitled to the assets in his or her account
upon retirement.
The security that comes from this ownership, however, is not the
only benefit that ownership offers. Asset ownership and wealth
accumulation could be a positive new experience for many Americans.
In 1998 the median U.S. household owned only $17,400 worth of
financial assets, including sums in retirement accounts. Four out
of every nine households saved nothing at all during the year. For
many families, contributions to individual Social Security accounts
may represent their only chance to build privately held financial
assets and wealth. The experience of selecting investments and
observing the miracle of compound interest at work might help many
workers overcome existing social and informational barriers to
asset ownership. Research has shown, in fact, that the experience
of managing a pension account may actually encourage workers to save
more outside of their pension than they otherwise would. Accordingly,
personal accounts could have an important effect on the personal
saving rate.
Studies have suggested a broad range of other benefits from asset
ownership as well. Owning assets makes people more oriented toward
the future, more likely to take calculated risks, and more likely
to participate in the political process. Financial assets have also
been found to be associated with positive physical and mental health
effects, particularly for those between the ages of 65 and 84.
Married couples with property and financial assets are less likely
to divorce than couples without assets. Finally, a survey of
participants in an experimental program designed to help the poor
save and accumulate assets has yielded important information on the
benefits of asset ownership. Program participants report feeling
more economically secure, are more likely to make education plans
for themselves and their children, and are more likely to plan for
retirement because of their asset accounts. They also reported that
they are more likely to increase their work hours or increase their
income in other ways. They are more confident about the future and
feel more in control of their lives because they are saving.

Bequeathability and Redistribution
Recent research has shown that Social Security is only mildly
progressive and may even be regressive on a lifetime basis, despite
an explicitly progressive benefit formula (Box 2-3). One reason for
this seeming paradox is that people with higher incomes tend to live
longer than those with lower incomes. Because Social Security
retirement benefits cease at the death of the insured individual
(or the individual's surviving spouse), those with shorter lifespans
will earn lower returns on their contributions, all else equal.
Additionally, research has indicated that current Social Security
arrangements may substantially increase the inequality of the wealth
distribution by depressing bequests by low- and moderate-income
households who might have accumulated bequeathable assets in the
absence of the program. Depending on the degree of annuitization of
assets that is required, and on other program design elements, a
system that includes personal accounts has the potential to reduce
some of the regressive tendencies of the current system.
Accountholders who die earlier than the average might be able to
pass on to their heirs a portion of the wealth in their personal
accounts; this would partly correct for the disadvantage many higher
mortality, lower income groups face under Social Security today.
The introduction of personal accounts might also provide an
opportunity for the creation of a more progressive benefit structure
for the pay-as-you-go portion of Social Security.

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Box 2-3. The Effect of Social Security on Income Distribution
One of the traditional justifications for a government role in
retirement security institutions is the potential to use these
institutions as tools for redistribution, especially redistribution
based on lifetime income. It is often argued that Social Security
is redistributive along a number of different dimensions. However,
in large part because of heterogeneity among individuals in
marital status and life expectancy, much less redistribution on a
lifetime basis occurs under the current system than is widely believed.
Progressivity.  The design of the Social Security benefit formula
is explicitly progressive at the individual level. When
redistribution is considered at the family level, however, the
system looks less progressive than the benefit formula seems to
imply. There are two reasons for the potential disparity. First,
many low-income individuals are members of high-income households;
if such a low-income person receives a high return on Social
Security, the system will appear redistributive on an individual,
but not on a household, basis. Second, the ability to collect
benefits on the basis of a spouse's earnings also fosters
redistribution to low- or zero-income individuals with high-income
spouses. Research has shown that the system hardly redistributes
to poor families at all.

Redistribution by marital status. Rates of return are considerably
higher for single-earner couples than for dual earners. For medium
earners (as defined by the Social Security actuaries) retiring in
2000, for example, the 4.75 percent rate of return for a one-earner
couple was very nearly twice that for a two-earner couple. There
is also substantial redistribution from single individuals to
married couples. A man retiring in 2000 with medium earnings and
with a wife who never worked would receive a rate of return on
Social Security that exceeded twice the return obtained by an
identical man who had never married.
Redistribution by race. Largely because of differences in mortality
rates, African Americans receive on average nearly $21,000 less,
on a lifetime basis, from Social Security's retirement program
than whites with similar income and marital status, according to
recent research. Other research finds that rates of return for
African Americans from Social Security are approximately half a
percentage point lower than for whites of the same marital status.
Survivor benefits that pay benefits to the spouse or the children
of deceased workers partly, but not completely, compensate for
the negative effect of mortality on returns. The provision of
disability insurance through Social Security also improves returns
for African Americans, who are more likely than other groups to
collect disability benefits.

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Diversification of Risk
Another important advantage of adding personal accounts to a
pay-as-you-go system is the potential to diversify the risks
inherent in such systems. Under the present Social Security system,
the ultimate rate of return earned by a participant is subject to
political risk. Without structural reform of Social Security,
workers and retirees will face significant uncertainty about how
future policymakers will alter system revenues and outlays to
avoid system insolvency. These actions would directly impact the
rate of return earned by participants in the system.

Although funds invested in equities through a personal account can
be expected to earn a higher rate of return than funds in a
pay-as-you-go system, investment in equities does expose participants
to some degree of financial market volatility. However, as long as
the market risk associated with equity investment is not perfectly
correlated with the demographic and political risks of a
pay-as-you-go system, a mixed system of personal accounts and
pay-as-you-go benefits offers an opportunity for better
diversification than either a pure pay-as-you-go or a pure
investment-based system. This diversification could be especially
important to low-income workers whose sole source of retirement
income is Social Security, and who are consequently less well
diversified than wealthier individuals who are able to hold
private financial assets in addition to expecting scheduled
Social Security benefits.

Labor Supply
A reform of Social Security that includes personal accounts would
reduce the economic inefficiency arising from elements of the
current Social Security system that distort labor supply. For
many workers, including younger workers and secondary earners in
a household, the present structure of the benefit formula means
that the marginal dollar of Social Security payroll taxes that
they pay does nothing to raise their benefits at retirement. When
this is the case, that worker's effective marginal tax rate is
increased by the full amount of the payroll tax (provided the
worker is earning less than the Social Security cap on taxable
earnings, which is $84,900 in 2002). Since a higher marginal tax
rate corresponds to a lower return to work, the Social Security
payroll tax may discourage work by many low- and middle-income
workers. In a system that includes personal accounts, however,
the link between current contributions and future income is
stronger, and there is more incentive to work than under the
current system.
The current Social Security system may also distort labor supply
behavior through its effect on retirement age. Growth of assets in
personal accounts, however, is governed by the rate of return on
those assets rather than by the potentially distortionary rules of
a defined-benefit program. Thus workers with income from personal
accounts may be less influenced in their choice of retirement age
than if their income from Social Security depended entirely on the
particular structure of the Social Security benefit formula.

Higher National Saving
Establishing personal accounts has the potential to raise national
saving, thus expanding the capital stock and increasing productive
capacity, so that a relatively smaller labor force can support a
relatively larger population of beneficiaries. If Social Security
payroll taxes were saved in personal accounts rather than used to
finance an increase in non-Social Security government spending,
national saving would likely be higher. Although it is theoretically
possible, within the current system, for the government to save
those excess payroll tax revenues, the experience of the last 20
years has shown that, even for laudable reasons, it is difficult to
do so. The only truly effective way to preserve a Social Security
surplus is to put it safely beyond the grasp of those who would
spend it for other purposes, by depositing it into personal
accounts. Doing so would also make the rest of the budget more
transparent, because any non-Social Security spending in excess
of non-Social Security revenue would clearly have to be financed
by issuing public debt or increasing non-Social Security revenue.

The degree to which saving in personal accounts would increase
national saving would depend in part on whether households changed
their other personal saving in response to the accounts. Although
ownership of a personal account might dampen other personal saving
to some extent, it is unlikely that the effect would be large
enough to completely offset the expected increase in national
saving. As long as other personal saving were not reduced (and
personal borrowing were not increased) one for one with contributions
to personal accounts, the net effect of the accounts would likely
be to increase national saving (provided that any forgone income
tax revenue is less than the increase in personal saving). Since
many low-income workers today have very little saving to reduce,
overall personal saving should certainly not fall one for one with
increases in personal account saving.

International Experience with Personal Accounts
The United States would by no means be the first country to
incorporate an element of personal accounts into its social
security system. The finances of pay-as-you-go pension systems
around the world have come under pressure, due to unachievable
benefit commitments and an over-60 population that will rise from
9 to 16 percent of the global population over the next three
decades. Finding their pay-as-you-go systems overextended, a growing
number of countries have instituted major structural reforms,
including downsizing traditional defined-benefit public pension
systems and relying increasingly on a personal account-based system
that is fully funded and based on defined contributions. In 1981
Chile became the first country to implement a mandatory, funded
system based on personal accounts. Switzerland, the Netherlands,
and the United Kingdom also instituted major structural reforms
in this direction during the 1980s. After a flurry of reform activity
in the 1990s, at least 22 countries have now added funded systems
or partially privatized part of the old system. Three more European
countries have also advanced proposals. The reformers are a
geographically and economically diverse set of nations, including
6 high-income industrial countries, 10 Latin American countries,
and 5 former socialist countries. China's autonomous province of
Hong Kong has also pursued reform along these lines.

International experience shows that pension reform seems to be one
of the most politically difficult reforms to undertake, but also that
when a pension reform is actually implemented and people are given a
choice, they overwhelmingly choose personal accounts. The case of
Uruguay illustrates the popularity of personal accounts in
countries that have undertaken reforms, despite the political
rhetoric that preceded those changes. In that country, there are
600,000 contributors in the national social security system. Before
reform, a number of surveys showed that only 80,000 people would opt
for personal accounts. When the system was implemented and people
were given a choice, however, more than 400,000 chose personal
accounts.
In evaluating America's reform options in light of the experiences
of other countries, one should keep in mind the important advantages
that this Nation possesses. Indeed, few of the many countries that
have converted to personal account-based public pension systems
were in as favorable a position to do so as the United States.
First and foremost, the United States has the best-developed
financial markets in the world, with a wide variety of investment
vehicles and about 40 percent of world equity market capitalization.
This long and broad experience with financial markets at the
institutional level offers a solid foundation for a system of
personal accounts. Another institutional advantage is the advanced
degree of development of our private pension system. In 2000, 51
percent of all wage and salary workers had some type of private
pension coverage at their current job, and almost 80 percent of
those eligible participated in defined-contribution plans. This
experience with defined-contribution plans means that a sizable
portion of the population is already well grounded in the principles
necessary for understanding and managing personal accounts.
Additionally, the prevalence of these private plans means that much
of the basic financial infrastructure needed for personal accounts
is already in place.


The Financial Sustainability of Social Security
A system of personal accounts based on individual wealth accumulation
has many advantages over alternative methods of financing retirement.
Whether or not personal accounts become part of the solution,
however, Social Security reform is a necessity. The Social Security
system faces a severe, long-term financing shortfall. Put simply,
the system does not have a dedicated income stream sufficient to
pay the benefits scheduled under current law. According to
intermediate projections of the Social Security Administration, by
2016 the system will begin running persistent cash flow deficits;
by 2050 the current benefit structure would cost nearly 18 percent
of the Nation's payroll, whereas program revenue would be just over
13 percent.


Adverse Demographic Trends
The need for reform arises because the structure of the current
system is on a collision course with the changing demographics of
our country. In a funded pension system, the resources available
to pay retirement benefits depend on the assets put into the system
for that purpose and the rate of return those assets earn, not on
demographics. Because Social Security is unfunded, however,
demographic trends can play an important role in system finances
and in determining the rate of return that workers earn on their
Social Security contributions. The ability of an unfunded Social
Security system to pay benefits to retirees in a given year depends
on the size of the taxable wage base in that year. Consequently,
demographic trends that decrease the number of workers available
to support each beneficiary, referred to as the worker-to-beneficiary
ratio, reduce the ability of an unfunded system to pay retirees
without raising taxes or reducing benefits. In the United States,
lagging birthrates and increasing life expectancies, together
with the aging of the baby-boom generation, will put tremendous
pressure on the Social Security system.
The baby-boom generation, defined as those Americans born between
1946 and 1964, was a major demographic boon for the United States.
In particular, the birth of many new workers-to-be during those
years was a major blessing for a pay-as-you-go Social Security
system that operates best with a large number of workers for each
benefit recipient. The total U.S. fertility rate (roughly speaking,
the number of children the average woman would have in her lifetime,
based on current births) climbed steadily through the 1940s and
1950s, from 2.2 children per woman in 1940 to a peak of 3.7 in 1957.
Unfortunately for Social Security, which depends on the younger
generations to finance the retirement of workers in the older
generation, fertility rates subsequently fell to pre-baby boom
rates. By the mid-1970s, the total fertility rate had fallen by half
from its peak, to just 1.8. It presently stands at around 2 children
per woman and is not projected to change substantially in the
foreseeable future.
These lower birthrates are especially problematic given the aging
of the baby-boom generation. Beginning in 2008, the first of the
baby boomers will be eligible for early retirement under Social
Security rules. By 2026 the youngest boomers will have reached age
62, and most of that generation will have retired and begun to
collect Social Security benefits, putting a substantial burden on
the system.

Another significant factor in the aging of the population is the
fact that, as noted previously, Americans are living longer than
ever before. Of the cohort born in 1875--the first to receive
Social Security benefits--only 40 percent survived to age 65, and
those who did lived an average of 12.7 additional years. In
contrast, 69 percent of males born in 1935 lived to age 65, and
those who did could expect to survive an additional 16.2 years on
average. And among males born in 1985, 84 percent are expected to
survive to age 65, and those who do will be able to look forward
to an average of 19.1 years of life in old age.
This trend toward increasing longevity, combined with the low
birthrate, implies an aging of the overall population. The share
of the population over age 65 will increase from 12.4 percent today
to 20.9 percent by the 2050s. Moreover, the ``oldest old,'' those
aged 85 and older, will more than double their share of the
population, from 1.5 percent today to 3.7 percent in 2050.

The combined effect of these fertility and longevity patterns is to
reduce the number of people of working age relative to the number
collecting Social Security benefits. Chart 2-3 displays the
declining ratio of 20- to 64-year-olds to individuals aged 65 and
over. The change in this ratio over time reflects fertility and
longevity trends and, together with changes in labor supply and
Social Security rules, accounts for the change in the
worker-to-beneficiary ratio discussed previously. Today there are
approximately 4.8 people of working age for each person 65 or over;
by 2030 that ratio will have dropped to 2.8, and by 2075 it will
be 2.4. The bottom line is that there will be relatively fewer
people of working age to support a growing elderly population.
Because Social Security is primarily unfunded in its current form,
the declining ratio of young to old foretells serious solvency
problems for Social Security.

Insolvency on the Horizon
Beginning in 2016, as noted previously, payments to Social Security
beneficiaries are projected to exceed revenue to Social Security
from payroll taxes and taxes on benefits. The result will be annual
cash flow deficits for the system, which are projected to
continue indefinitely. Although the trust fund will have a positive
balance at that time, allowing Social Security to continue paying
full benefits, the Federal Government will be forced to find a way
to finance those benefit payments that exceed the revenue generated
by payroll and benefit taxation. In that first year of cash
deficits, the projected shortfall amounts to $17.4 billion in 2001
dollars. Just 4 years later, however, the



annual deficit will have jumped to $99.3 billion. By 2030 Social
Security will face a $270.8 billion annual cash shortfall,
representing over 4 percent of taxable payroll, and deficits will
continue to worsen for the foreseeable future. Until the trust
fund becomes insolvent in 2038, Social Security will finance these
cash deficits by redeeming bonds from the trust fund, but this
will put a large strain on the rest of the Federal Government's
budget. Financing these cash shortfalls, therefore, requires that
the government increase revenue to the system or slow the growth
rate of outlays.

Meanwhile, because of the aging of the population, the non-Social
Security portion of the Federal budget will face increasing pressure
from other sources as well, further complicating the overall fiscal
situation. Medicare will demand an increasing share of the Nation's
resources, reducing the government's flexibility in addressing
Social Security financing issues within the budget. An amount
equivalent to 2.3 percent of GDP goes to Medicare today, and the
program's claim on GDP is projected to rise to 8.5 percent by
2075. Absent structural reforms, Medicare and Social Security
together will consume more than 15 percent of GDP by that year.
By comparison, all personal income taxes paid to the Federal
Government today amount to only about 9 percent of GDP.

Restoring Fiscal Balance
To solve the serious long-term financing shortfall facing Social
Security, some combination of the following two measures is
required:
  Future Social Security resources must be increased
beyond currently legislated levels, or
  Future Social Security spending growth must be reduced
from currently legislated levels.
Every policy proposal to solve the Social Security financing problem,
including those that utilize personal accounts, must follow one or
both of these two approaches. Thus restoration of fiscal balance to
the system will require some combination of a resource increase to
support the benefit structure and a reduction in the rate of
traditional benefit growth to a level that can be paid by currently
legislated tax rates.
Regardless of the path selected, personal accounts would provide
participants with the opportunity to increase their expected benefits
by investing in a diversified portfolio of assets. Historically,
private sector investments have consistently delivered higher
returns than government securities over long time horizons. If the
future is like the past, personal accounts could provide individuals
with higher benefits than in the absence of personal accounts. As
such, personal accounts provide an opportunity to increase the
expected benefits of participants relative to any comparably funded
system that lacks personal accounts, and are therefore an important
component of plans to restore fiscal soundness to the Social
Security system.
Increases in the system's resources could take a number of forms.
One possibility is an increase in the payroll tax, either by an
increase in tax rates or by an expansion of the taxable earnings
base. For perspective, if taxes were increased each year just
enough to cover the contemporaneous benefit shortfall, combined
employer and employee Social Security payroll tax rates would
need to rise from their current level of 12.4 percent to 14.1 percent
by 2020, 16.6 percent by 2030, and 17 percent by 2040. Increasing
payroll taxes on this basis would be detrimental to economic growth
and ultimately unsustainable, and the President, in enunciating
his principles of Social Security reform, has ruled out such an
approach. Alternatively, current law benefits could be paid by
raising general revenue to support the system, but this would
require a comparable income tax increase or a comparable reduction
in non-Social Security spending. Yet another possibility is for
the government to borrow the necessary funds. Any borrowing,
however, would have to be repaid by some future generation
through higher taxes or decreased spending. Debt financing alone
cannot be a permanent solution in any case, because in the absence
of structural reform, the debt could never be repaid, as Social
Security's cash shortfalls are projected to continue indefinitely.

An alternative to increasing revenue to pay for currently legislated
benefit payments is to place the benefit formula on a more
sustainable course. The President has made it clear that benefits
for current retirees, and for persons nearing retirement, should not
be changed. However, under the existing benefit formula, benefits
for future retirees are scheduled to rise substantially above current
levels in real terms. One way to achieve fiscal sustainability is
to restrain the rate of future benefit growth.
Many specific policy changes could be used to slow the rate of
benefit growth. For example, future growth in initial benefits could
be indexed by price growth rather than by wage growth in the economy,
as now. According to intermediate projections of the Social Security
trustees, wage growth is expected to exceed price growth by
approximately 1 percentage point a year. Indexing benefits to price
inflation would keep benefits fixed at their current real level,
significantly reducing future system costs. In fact, according to
the Social Security actuaries, price indexing alone would suffice
to close the entire 75-year actuarial deficit. This approach would
entail no real benefit reductions or tax increases relative to
current tax and benefit levels. Another possible change to reduce
benefit growth would be to adjust benefit levels in accordance
with increases in life expectancy.

Personal Accounts and Fiscal Sustainability
In assessing any reform proposal, it is important to remember that
the need for action to restore fiscal sustainability is independent
of whether personal accounts are implemented. It would be possible
to restore fiscal sustainability without personal accounts, simply
by raising taxes or reducing benefit growth, and it would be
possible to introduce personal accounts in a way that does not
contribute to fiscal sustainability. A well-designed reform package,
however, would provide workers with the opportunity to benefit
from personal accounts and would, simultaneously, help restore
fiscal soundness to the Social Security system.
Many specific design elements in Social Security reform will
determine how personal accounts and fiscal sustainability will
interact. It is possible to design personal accounts that are
wholly separate from the traditional Social Security system; for
example, they could be funded entirely by new contributions or
from general revenue. In that case the accounts would neither
improve nor worsen the underlying fiscal status of the traditional
system. On the other hand, many proposals would integrate the two
systems by allowing for a redirection of current payroll tax
revenue to fund the personal accounts. In this type of proposal,
it is appropriate to construct a ``benefit offset,'' that is, an
amount by which a person can choose to have his or her traditional
benefit reduced in order to have the opportunity to invest in the
personal account. Depending on how this offset is constructed, the
decision to choose a personal account can have implications for
system finances. If, on the one hand, the individual is required
to forgo a portion of benefits that is actuarially equivalent to
the portion that would have been paid with those redirected payroll
taxes, the long-run effect of this choice on system finances will
be neutral. On the other hand, if the benefit offset deviates from
actuarial equivalence, it can have a long-run effect on system finances.

This discussion has focused on the long-run fiscal effects of
specific alternative reforms. During a temporary transition period,
movement to a system of personal accounts would require additional
funds in order to make scheduled payments to current and
near-retirees while simultaneously funding the new personal
accounts. This is sometimes referred to as a transition cost, but
it is more appropriate to think of it as a national economic
investment. These funds would not be spent on consumption, but
rather saved to finance future retirement benefits through the
personal accounts. This prefunding of benefits is the mechanism
by which national saving will be increased. Indeed, ultimately, it
is only by such a reduction in consumption that saving can be increased.

Baselines for Comparison
As the Nation debates plans to reform Social Security and considers
personal accounts as a component of that reform, it is important to
keep in mind the appropriateness of the standards by which any
proposed reform is assessed. It has become clear that the Social
Security system is unsustainable in its present form. As noted
above, options for resolving the system's long-range financing
issues include increasing system revenue and reducing the rate of
growth of system outlays. Because the full benefits scheduled under
current law cannot be paid without taking one or the other of these
steps, or some combination, it is not appropriate to compare a
reformed system with the present, unsustainable system without
specifying how ``current law'' will be brought into fiscal balance.
In other words, one set of options for achieving sustainability
should be compared with other sets of options for doing so; comparing
any set of options for achieving sustainability with the current
unsustainable program is neither meaningful economically nor
informative to the public.

There are many alternative baselines that one could use in this
comparison. One approach is to measure reform proposals against
the benefit levels that could feasibly be paid given current Social
Security payroll tax rates. In 2040, for example, without tax
increases, benefits would have to be 27 percent lower than under
current law. Alternatively, if one wishes to use currently scheduled
benefits as a basis for comparison, it is necessary to specify the
source of the funding required to finance those benefits.

The effectiveness of a particular proposal for reform cannot be
judged solely on the basis of tax rates and benefit levels under
that proposal, however. The change in the total projected future
burden on taxpayers resulting from the reform must also be
considered. This total projected burden is the sum of explicit
national debt and the present value of the benefits scheduled to be
paid under today's primarily pay-as-you-go system. Although the
present value of currently scheduled benefit payments to future
Social Security recipients can be changed through reform of the
system, the value of this implicit burden can be thought of as a
form of implicit ``debt'' on the part of the government. If the
current schedule of future benefit payments were binding and were
feasible, which it is not, the government would find itself in the
situation of paying people alive today about $10 trillion more in
future benefits than it would have collected from them in the form
of future payroll taxes. A complete accounting of a Social Security
reform's effect on national saving and the country's fiscal
situation should recognize the change in this potential burden on
the Federal Government.

It is important to understand how any proposed reform would change
the combined level of the explicit debt and the implicit burden
imposed by scheduled benefits. For example, a change to the current
system could make the country as a whole better off by decreasing
the total national obligation even while increasing explicit,
publicly held debt. This scenario could arise if a transition to
a new system with a lower total projected burden were financed by
converting a portion of future benefit payments into explicit debt.
Under current accounting rules, which document only explicit debt,
the Nation would appear to be worse off after such a transition.
In reality, however, the overall fiscal health of the Nation might
actually have improved. Because of this discrepancy, it is essential
that reform proposals clearly specify not only what benefits and
taxes would be after reform, but also how the total future burden
of the program on future generations would change.

Other Sources of Retirement Security
As the earlier discussion of current sources of retirement income
emphasized, Social Security is not the sole source of support for
the elderly. Nor is it meant to be. The current average Social
Security benefit, for instance, is equal to only about 36 percent
of the average worker's wage. Already today, workers need to
supplement their Social Security benefits with income from other
sources in order to maintain a lifestyle in retirement similar to
what they enjoyed while working. With rising out-of-pocket medical
expenditures, an increasing number of years spent in retirement,
and an unsustainable Social Security system, the need to diversify
retirement wealth is imperative as we move into the future. Personal
saving, undertaken both independently and through employer-sponsored
pension plans, is an increasingly important element of retirement
security.

The role of public policy in ensuring retirement security by no
means ends with Social Security. The government can continue to
adopt tax policies that reward and encourage the efforts of workers
to plan for their own future. Creating a friendly environment for
retirement saving requires an awareness of the ways in which the
tax structure might encourage or discourage people's efforts to
save. The income tax, one of the most basic components of the tax
system, may discourage saving by reducing after-tax returns. This
is particularly true for capital income, which is often taxed
twice: once at the level of the corporation, and once at the
individual level. Recognizing this fact, certain mechanisms that
reduce the burden of the income tax have been built into the tax
system in order to encourage saving for a variety of purposes, but
especially for retirement. IRAs and 401(k) plans are the most
prominent examples of such tax-preferred vehicles, but there are
many less well known arrangements as well.

Employer-Sponsored Pension Plans
One important means by which the government encourages saving for
retirement is through provisions in the tax code that grant special
tax status to profit-sharing and employer-sponsored pension plans.
Generally, contributions made by an employer to a defined-benefit
or a defined-contribution plan, including a 401(k) plan, on behalf
of an employee are not included in the employee's taxable income.
This tax advantage gives employers an incentive to sponsor pension
plans for their employees, thus increasing retirement saving. These
plans also have the advantage that earnings on invested contributions
are not taxed until they are withdrawn, offering participants the
possibility of being subject to a lower tax rate in retirement.
Moreover, even if the owner's tax rate has not declined, there is
an advantage from the deferral of taxes on returns accumulated
within the account, effectively lowering the tax rate on such saving.

Employer-sponsored pensions will continue to increase in importance
as a source of retirement income, as evidenced by the fact that
a substantially larger share of current workers than of current
retirees have pension coverage. As noted earlier, the 401(k) plan
in particular has become increasingly popular in recent years. In
contrast to most other defined-benefit and defined-contribution
plans, in which only the employer contributes to the plan, the
employer, the employee, or both may make contributions to a 401(k)
plan. These plans are expected to account for a growing share of
retirement income. By some estimates, assets in such plans could
rival or even exceed total Social Security wealth by the time
workers currently in their early 30s retire. Provisions of the
Economic Growth and Tax Reform Reconciliation Act (EGTRRA), enacted
in 2001, will further encourage this form of saving by increasing
the limit on individual contributions to 401(k)-type plans, as well
as the limit on an employer's deduction for contributions to certain
types of defined-contribution plans. Additionally, workers aged 50
and over will now be eligible to make ``catch-up'' contributions
to their 401(k)-type plans; this will help workers who might not
have saved in past years.

Although pension assets represent a large and growing share of
retirement wealth, pension coverage remains far from universal. In
recent years almost half of retirees lacked pension income or
annuities, and 49 percent of those employed lacked a pension plan.
With this fact in mind, changes in tax policy and pension law that
further encourage all employers to provide plans for their employees
should continue to be explored.

The government must also work to expand its outreach to employers,
especially small businesses, to encourage retirement plan
sponsorship. It should eliminate artificial barriers to employers
wishing to provide sensible retirement advice to those who
participate in pension plans. Also needed is increased assistance
to employers, plan sponsors, service providers, participants,
and beneficiaries, to better inform these parties of their
responsibilities under the law. This compliance assistance will
ultimately lower the cost of investigations, judicial dispute
resolution, and plan administration. Reducing such burdens should
remain an ongoing Federal goal, because efforts to that end can
yield higher retirement income for working Americans.

Individual Saving
Personal saving independent of profit-sharing plans and
employer-sponsored pensions is the third important component of
retirement security. Public policy has aimed to encourage such
saving as well, most notably through IRAs, which allow individuals
to save for retirement on a tax-preferred basis. Contributions to
traditional IRAs, like those to most employer-sponsored pensions,
are tax-deductible under certain conditions, and earnings on
investments in these accounts are tax-deferred. Contributions to
Roth IRAs are not tax-deductible, but the earnings on these
contributions are generally tax-free. IRAs provide an important
incentive for individuals, some of whom may not be covered by an
employer-sponsored pension plan, to invest for retirement. And
research has shown that IRAs are effective in increasing personal
saving (Box 2-4). EGTRRA greatly expanded the potential for saving
through IRAs by allowing catch-up contributions for those over age
50, raising the annual limit on contributions from $2,000 in 2001
to $5,000 by 2008, and indexing that limit to inflation thereafter.

Congress has appropriated increased resources to several Federal
agencies to promote retirement saving as well as general financial
education. These educational programs should be better coordinated
to leverage best practices and resources aimed at communicating the
importance of savings, both individually and through
employer-sponsored retirement plans. Furthermore, the Federal
Government must remain a committed partner with the private sector,
both for-profit and nonprofit, to educate Americans about the need
and opportunities to save.

Other features of the tax code might also encourage saving for
retirement by relieving some of the burden of the income tax system.
As one example, medical savings accounts may be a useful mechanism
for some people wishing to save in anticipation of possibly large
out-of-pocket medical expenses related to old age.
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Box 2-4.  The Effectiveness of Saving Incentives

How effective are targeted saving incentives such as IRAs and
401(k)s at increasing saving? The answer depends, first, on how
much ``new'' saving these incentives generate, and second, on
the cost of achieving that saving, in terms of tax revenue forgone.
The first question can be addressed by considering two possible
extremes. One is that all saving in IRAs, for example, is new
saving--saving that would not have happened were it not for the
tax incentives associated with saving in an IRA. At the other
extreme, it could be that all saving in IRAs is saving that would
have happened even without the incentive. The question then becomes
where, between these two extremes, the actual fraction of new
saving lies. This question is widely debated, but estimates suggest
that 26 cents of every dollar in IRA contributions represents new saving.
Whatever the amount of new saving is determined to be, is it worth
the cost in terms of forgone tax revenue? A useful measure for
answering that question is the amount of new saving per dollar
of revenue cost. Estimates of this measure have indicated that
IRAs need not generate considerable new saving per dollar of
lost revenue to generate increases in the capital stock that
are ``inexpensive'' relative to the initial revenue loss. This
cost-effectiveness of IRAs results because contributions to IRAs
lead to a larger capital stock and faster growth. This faster
growth translates into higher corporate revenue and, thus, higher
tax revenue that more than makes up for the forgone tax revenue
associated with IRA contributions.

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Fostering Self-Reliance
The key principle underlying all of America's retirement security
institutions should be individual self-reliance in planning for
retirement. Personal Social Security accounts, private pension
plans, and vehicles for individual saving all aim to encourage
and support individuals' efforts to prepare for their own financial
future. Pension plans and saving vehicles allow individuals to save
for retirement on a tax-preferred basis by reducing obstacles to
saving inherent in the income tax system.

In a Social Security system with personal accounts, participants
will take a more active role in exercising direct control over
their retirement wealth, as participants in defined-contribution
pension plans and IRAs already do. Lower income individuals will
find in personal accounts a mechanism by which they can play a
larger role in their own financial destiny. Meanwhile the
defined-benefit element of Social Security will continue to
provide a foundation of retirement income for those for whom
lower resources represent an obstacle to complete self-reliance
in retirement planning.

Meeting the Challenge of Retirement Security
The major challenge facing America's retirement security institutions
in the 21st century is how to enable a relatively smaller work
force to support a growing elderly population. To meet that
challenge, we must fortify all three legs of the retirement
stool: individual saving, employer-provided pensions, and Social
Security. Today the task at hand is to strengthen each of these
institutions to serve our needs tomorrow by encouraging public
policy that focuses on individual self-reliance in retirement
planning.

Social Security is the retirement institution most urgently in need
of rebuilding. Simply put, the system will not take in enough in
payroll taxes over the coming years to pay the scheduled level of
benefits to retirees. Correcting this problem will require some
combination of increasing resources to Social Security and
slowing the growth rate of outlays. However, this difficult
situation also offers an opportunity to build for the future.
Restructuring the current system to include personal accounts
could improve Social Security's fiscal situation while giving
workers a sense of ownership, an element of choice, and the
opportunity to leave something to their heirs. Personal accounts
could also increase national saving, helping to grow the economy
and support a relatively larger elderly population.
A Social Security system made sustainable is just one component
of a complete foundation for retirement security. Personal saving,
undertaken both independently and through employer-sponsored
pension plans, is also essential for ensuring the financial
well-being of future retirees. Employer pensions have seen
considerable growth over the past two decades and should
continue to grow. Individual saving outside of these plans, on
the other hand, has lagged recently. Tax policy should follow
the lead of EGTRRA and continue to develop in ways that encourage,
rather than punish, these forms of saving.

Meeting the needs of a growing retired population with a relatively
smaller work force is a new challenge for the United States, but it
is not by any means an insurmountable one. What lies ahead is clear.
What we must do to prepare is also clear. We must reinforce our
existing retirement security institutions and use them to begin
raising national saving right away. These steps will pave the way
for a secure retirement for Americans and a prosperous future for
the whole country.