Social Security Reform: Considerations for Individual Account	 
Design (23-JUN-05, GAO-05-847T).				 
                                                                 
Social Security forms the foundation for our retirement income	 
system, providing critical benefits to millions of Americans.	 
However, the Social Security program is facing significant future
financial challenges as a result of profound demographic changes.
A wide variety of proposals to reform the program are currently  
being discussed, including restructuring the program to 	 
incorporate individual accounts. When designing a system with	 
individual accounts, there are many options and issues to	 
consider. The choices that have to be made will affect not only  
participation in the accounts, but also the amount of savings	 
accumulated in the accounts, and the benefit received from the	 
individual accounts. The Subcommittee asked GAO to discuss	 
options for the administration of individual accounts, including 
the major design issues that are raised within the contribution, 
accumulation, and distribution phases of a retirement savings	 
vehicle.							 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-847T					        
    ACCNO:   A27637						        
  TITLE:     Social Security Reform: Considerations for Individual    
Account Design							 
     DATE:   06/23/2005 
  SUBJECT:   Federal social security programs			 
	     Income statistics					 
	     Pensions						 
	     Program evaluation 				 
	     Program management 				 
	     Retirement 					 
	     Retirement income					 
	     Social security benefits				 
	     Strategic planning 				 
	     Federal Thrift Savings Plan			 
	     Social Security Program				 

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GAO-05-847T

United States Government Accountability Office

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

For Release on Delivery

Expected at 10:00 a.m. EDT SOCIAL SECURITY

Thursday, June 23, 2005

REFORM

                  Considerations for Individual Account Design

Statement of Barbara D. Bovbjerg, Director, Education, Workforce, and Income
Security

GAO-05-847T

[IMG]

June 23, 2005

SOCIAL SECURITY REFORM

Considerations for Individual Account Design

  What GAO Found

Because Social Security is so deeply woven into the fabric of our nation,
any proposed reform should be considered as a package and with respect to
all of the major elements of the Social security program (e.g.,
retirement, disability, and survivors). Individual accounts can be a part
of that reform, and in fact, many proposals include individual accounts.
However, any proposed reform must consider the program in its entirety,
rather than one aspect alone. Likewise, an individual account system must
address key design issues associated with the phases of a retirement
savings vehicle.

Contribution phase: Designing the contributions for individual accounts
requires making choices about the role that contributions play with
respect to the current Social Security system. These choices include
determining the size of the contribution rate, how the contributions are
collected, whether the funds come from existing revenue sources, and
whether participation is voluntary or not.

Accumulation phase: Once contributions have been made, the accumulation
phase requires making decisions about what to do with the funds to make
them grow. These decisions include how much choice individuals would have
in selecting funds, who would invest their funds, and what the range of
their investment choices would be. These decisions, in part, would
determine the cost and complexity of the system and the degree of public
education needed.

Distribution phase: Distributing the accumulated earnings in individual
accounts needs to focus on how these funds would be preserved for
retirement. This includes making choices about when individuals can gain
access to their funds, how much money they receive, and in what form they
receive the funds. Other considerations that arise include the tax
treatment of distributions and whether there will be a guarantee of a
specified level of benefits.

Overall, when designing individual accounts, it is important to keep in
mind that more features tend to increase costs. For example, more
investment choices can result in more administrative fees. Administering
the accounts and educating the public about a system of individual
accounts requires choices and trade-offs. However, any related
administrative, management, and data systems must be developed and tested
before the accounts become available to workers in order to maintain
confidence in the system. Individual accounts could also be designed to
include some progressive features, which would mirror the redistributive
effects of the current Social Security program. However, it is important
to distinguish between progressivity and benefit adequacy. Greater
progressivity is not the same thing as greater adequacy and may result in
less equity.

                 United States Government Accountability Office

Mr. Chairman and Members of the Subcommittee:

I am pleased to be here today to discuss options for designing a system of
individual accounts within the Social Security program. Social Security
forms the foundation for our retirement income system and, in so doing,
provides critical benefits to millions of Americans. However, the Social
Security program is facing significant future financial challenges as a
result of profound demographic changes. A wide variety of proposals to
reform the program are currently being discussed, including restructuring
the program to incorporate individual accounts. When designing a system
with individual accounts, there are many options and issues to consider,
such as whether the accounts should be voluntary or mandatory, the amount
of choice individuals have over their investments, and how and when the
funds are withdrawn from the accounts. The choices that have to be made
will affect not only participation in the accounts, but also the amount of
savings accumulated in the accounts and the benefit received from the
account.

Today I will discuss options for the design of individual accounts
specifically corresponding to the phases of a pension or similar
retirement savings vehicle: the contribution phase, the accumulation
phase, and the distribution phase. GAO has conducted several studies
related to the design, implementation, and administration of individual
accounts. My statement is largely based on that work.1

In summary, the creation of an individual account system faces key design
decisions in each of the phases that comprise the dynamics of a retirement
savings vehicle. For example, regarding contributions, the size of the
contribution and whether the accounts will be mandatory or voluntary must
be decided. This decision will be shaped to some degree by the implicit
relationship of the accounts to the current Social Security program. In
the accumulation phase, individual account design must negotiate a number
of trade-offs in setting, for example, the amount of choice in investment
options and the level of customer service provided. Finally, individual
accounts, like current defined contribution (DC) plans and individual
retirement accounts (IRAs), must distribute accumulated account balances
to individuals. A system of individual accounts covering over 156 million
workers would constitute a fundamental change to Social Security and would
be significantly larger than any existing retirement

1 See the list of related GAO products at the end of this statement.

Background

investment program. Affected individuals need to know about and understand
the features of such a new system to make informed life decisions about
work, savings, and retirement.

According to the Social Security Trustees' 2005 intermediate, or
bestestimate, assumptions, Social Security's cash surplus begins to
decline in 2009, and in 2017 cash flow is expected to turn negative. In
addition, all of the accumulated Treasury obligations held by the trust
funds are expected to be exhausted by 2041. Social Security's long-term
financing shortfall stems primarily from the fact that people are living
longer and having fewer children. As a result, the number of workers
paying into the system for each beneficiary has been falling and is
projected to decline from 3.3 today to about 2 by 2040.

A common feature of many Social Security reform proposals is the creation
of a system of individual accounts. Individual accounts would generally
not by themselves achieve solvency for the Social Security system.
Achieving solvency requires more revenue, lower benefits, or both. Many
proposals that incorporate a system of individual accounts into the
current program would reduce benefits under the current system and make up
for those reductions to some degree with income from the individual
accounts. Individual accounts also try to increase revenues, in effect, by
providing the potential for higher rates of return on account investments
than the trust funds would earn under the current system, but this exposes
workers to a greater degree of risk.

Three key distinctions help to identify the differences between Social
Security's current structure and one that would create individual
accounts.

Insurance versus savings. Social Security is a form of insurance, while
individual accounts would be a form of savings. As social insurance,
Social Security protects workers and their dependents against a variety of
risks such as the inability to earn income due to death, disability, or
old age. In contrast, a savings account provides income only from
individuals' contributions and any interest on them; in effect,
individuals insure themselves under a savings approach.

Defined benefit versus defined contribution. Social Security provides a
defined benefit (DB) pension while individual accounts would provide a
defined contribution (DC) pension. Defined benefit pensions typically
determine benefit amounts using a formula that takes into account
individuals' earnings and years of earnings. The provider assumes the

financial and insurance risk associated with funding those promised
benefit levels. Defined contribution pensions, such as 401(k) plans,
determine benefit amounts based on the contributions made to the accounts
and any earnings on those contributions. As a result, the individual bears
the financial and insurance risks under a defined contribution plan until
retirement.2

Pay-as-you-go versus full funding. Social Security is financed largely on
a pay-as-you-go basis, while individual accounts would be fully funded. In
a pay-as-you-go system, contributions that workers make in a given year
fund the payments to beneficiaries in that same year, and the system's
trust funds are kept to a relatively small contingency reserve.3 In
contrast, in a fully funded system, contributions for a given year are put
aside to pay for future benefits. The investment earnings on these funds
contribute considerable revenues and reduce the size of contributions that
would otherwise be required to pay for the benefits. Defined contribution
pensions and individual retirement savings accounts are fully funded by
definition. Both mandatory and voluntary individual account plans would
reflect all of these distinctions.

In addition to these key distinctions, options for the design of
individual accounts can be grouped in three categories corresponding to
the different phases of a retirement savings vehicle:

o  contribution phase: who should contribute, how much, and with what
funds;

o  accumulation phase: how are funds invested to make them grow; and

o  distribution phase: how much of a benefit is received, when is it
received, and in what form is it received.

2At retirement, individuals have the option of purchasing an annuity with
their defined contribution accounts, which then transfers the financial
and insurance risk to the annuity provider. Before retirement, individuals
may also have the option of purchasing deferred annuities.

3Social Security is now temporarily deviating from pure pay-as-you-go
financing by building up substantial trust fund reserves. Social Security
is collecting more in revenues than it pays in benefits each year partly
because the baby boom generation makes the size of the workforce larger
relative to the beneficiary population. In 2017, shortly after the baby
boomers start to retire, the benefit payments are expected to exceed
revenues, and the trust fund reserves and the interest they earn will help
pay the baby boomers' retirement benefits. For more detail about this
temporary trust fund buildup and how it interacts with the federal budget,
see GAO, Social Security Reform: Demographic Trends Underlie Long-Term
Financing Shortage, GAO/T-HEHS-98-43 (Washington, D.C.: Nov. 20, 1997).

As we have reported previously with respect to Social Security reform as a
whole, as policy makers decide whether and how to create a system of
individual accounts, they must balance a range of difficult concerns.
These concerns include broad macroeconomic issues, such as how to finance
the accounts and how the accounts would affect the economy and program
solvency, as well as program benefit issues, such as how to balance
opportunities for improved individual investment returns with the need to
maintain an adequate income for those who rely on Social Security the
most. No less important is the need to consider how readily individual
accounts could be implemented, administered, and explained to the public.
An essential challenge would be to help people understand the relationship
between their individual accounts and traditional Social Security
benefits, thereby avoiding any gap in expectations about current or future
benefits. Individuals would also need to be informed enough to make
prudent investment decisions, which would require investor education,
especially if individual accounts were mandatory. This would be especially
important for individuals who are unfamiliar with making investment
choices.

Design Determining how contributions to an individual account will be made

requires choices about the role these contributions play vis-`a-vis the
Considerations In the current Social Security system. These choices
include determining the size Contribution Phase and role of contributions,
management of contributions, whether the

account is a substitute or a supplement, and whether participation in the

accounts should be voluntary or mandatory.

Size and Role of An individual account plan can provide for contributions
in a variety of

Contributions ways. For example, a plan might set contributions at a fixed
rate, such as 2 percent of pay, or allow a range of rates with, possibly,
a certain dollar limit. Some proposals provide for greater average
contribution rates for lower earners than for higher earners. Individual
accounts could be designed to include some progressive features, which
could mirror the redistributive effects of the current Social Security
program. For example, contribution rates may go down gradually as earnings
rise, or alternatively, all workers might pay a fixed percentage but have
a dollar cap on contribution amounts.

Ultimately the size of the individual account contribution rate determines
the relative role of the DC aspect of the account versus the DB portion of
the Social Security program. As a result, depending on their design,

individual accounts will have a varying effect on the adequacy of benefits
for certain subgroups of beneficiaries. For instance, disabled
beneficiaries leave the workforce sooner than retired workers. With fewer
years to make contributions (and accrue interest), disabled beneficiaries
will likely have smaller account balances. At the same time, reform
provisions that disfavor subgroups of earners can be offset by other
provisions that favor them. As a result, any evaluations of reform
proposals should not focus solely on individual account proposals but
should consider both the DC and DB aspect of a proposal's provisions as a
whole.

Management of Contributions

In managing individual accounts, contributions might be collected and
deposited by the government in a centralized process or by employers or
account providers in a decentralized process. Under a centralized process,
which would build on the current payroll reporting and tax collection
system, a federal agency, such as the Social Security Administration,
would assume record-keeping responsibilities. Alternatively, a new
centralized government clearinghouse could assume responsibility for
centralized record keeping, similar to the structure for the federal
Thrift Savings Plan. A decentralized structure could build on the system
that has grown up around employer-sponsored 401(k) plans or individually
managed IRAs. Under 401(k) plans, individual records are maintained by
either the employer or a separate entity hired to manage the plan, or
both. Under an IRA, the record-keeping responsibility rests with the
individual investor and the financial institution where the funds are
invested.

    Substitute versus Supplementary Contributions

Individual accounts can either supplement current Social Security
contributions or substitute for all or part of them. With supplemental
accounts, sometimes referred to as add-ons, the individual account and
contributions to it have no effect on existing Social Security benefits.
The supplemental account approach effectively leaves the entire current
12.4 percent payroll tax contribution available to finance the program
while dedicating additional revenues for individual accounts. With
substitute accounts, or carve-outs, the existing Social Security benefit
is reduced (or offset) in some way to account for contributions that have
been diverted

from the program.4 The obvious effect is that less revenue is available to
finance the current benefit structure, which creates a problem of
transition costs. Absent any other reforms, these transition costs
increase in proportion to the individual account contribution rate. This
means that either benefits must be reduced or additional resources must be
devoted to the defined benefit portion of the Social Security program in
the near term. The trade-off to incurring transition costs is that the
expected higher rate of return on the individual accounts may permit
somewhat higher benefits to be paid, although with increased risk.

    Voluntary Contributions Require Additional Considerations

Another important design feature to consider with respect to the
contribution phase is whether the individual account is voluntary or
mandatory. As we have previously reported, voluntary individual accounts
require additional design considerations that mandatory accounts do not.5
For instance a voluntary account could offer participants the ability to
opt in and opt out of the account periodically; most U.S. proposals for
voluntary accounts have not explicitly considered whether people would
face a onetime or a periodic decision to participate. Individuals may
consider the extent of such flexibility in deciding whether to participate
in the accounts. Moreover, the need to track individuals' participation
decisions requires additional administrative tasks and complexity.
Educational efforts would be needed to inform individuals if their
participation in an individual account would be advantageous or not,
especially if the account substitutes for existing Social Security
benefits.

Voluntary individual account plans may also require incentives to induce
participation, while mandatory plans do not. In addition to increasing
participation, incentives generally add to the value of the accounts and,

4In GAO's work to date, we have used the term "add-on" accounts to refer
to accounts that would have no effect on Social Security benefits, would
supplement those benefits, and would draw contributions from new revenue
streams. In contrast, we have used the term "carve-out" accounts to refer
to accounts that would result in some reduction or offset to Social
Security benefits because contributions to those accounts would draw on
existing Social Security revenues. Others have used these terms in
different manners. For example, some have used "add-ons" in connection
with new individual accounts funded from new revenue sources that result
in a reduction or offset to some or all Social Security benefits. In the
final analysis, there are two key dimensions: first, whether individual
accounts are funded from existing or new revenue sources; second, whether
individual accounts result in some reduction or offset to Social Security
benefits.

5 See GAO, Social Security Reform: Information on Using a Voluntary
Approach to Individual Accounts, GAO-03-309, (Washington, D.C.: March 10,
2003).

therefore, ultimately to retirement income. Government contributions and
tax advantages are just a few of the potential incentives for voluntary
individual accounts. The costs of incentives can be difficult to estimate
and can be substantial. Further, in certain circumstances, the net effect
of voluntary individual account incentives may not result in improving
overall retirement income. For example, if the voluntary account was also
supplementary, then it might be difficult to determine whether a voluntary
account adds to total retirement income, as it might merely substitute for
other forms of saving. On the other hand, if the individual accounts truly
add to total retirement income, they allow workers the opportunity and
choice to build up additional savings to meet both income and health care
cost needs in retirement.

Voluntary individual account plans can also affect the total system costs
to the government, providers, employers, or participants, depending on
design. In some cases, offering choice involves additional administrative,
incentive, and educational costs. In particular, tracking individuals'
participation decisions would require administrative processes that do not
arise in mandatory plans. Moreover, the uncertainty of participation rates
in turn creates uncertainty for a variety of costs associated with
voluntary individual account plans. For instance if individuals accurately
perceive any built-in incentive in the benefit offsets, given their
personal circumstances, and make their participation decision accordingly,
then adverse selection could result. This occurs when certain groups of
individuals (for example, those with longer life expectancies) are more
(or less) likely to participate than others and when such participation
patterns result in a net cost to the government.

A system of individual accounts would provide workers with opportunities
to assert greater control over their retirement savings. Therefore, when
designing a system, critical decisions would need to be made about who
will manage and invest funds and what investment choices will be offered.
These decisions, in part, would determine the cost and complexity of the
system and the degree of public education needed. Moreover, offering the
level of customer service found in the private sector, such as frequent
deposits and accessibility of account information, would add costs and
administrative complexity to a system.

  Design Considerations in the Accumulation Phase

Options for Investment Alternatives for designing the investment structure
of a system of

Management individual accounts range from offering the individual a
limited number of preselected funds, such as those offered by the federal
Thrift Savings Plan

(TSP), to offering a broad array of private market choices, such as those
available through IRAs. Options for managing these investment choices
could vary from a centralized, government-managed system to a
decentralized, privately managed system. A centralized system would take
advantage of economies of scale, which is to say that the more accounts
managed by a single entity, the lower the cost for each; thus such an
approach could have lower administrative costs than a decentralized
system. This is especially important when considering that a number of
individuals may initially have small account balances. Depending on how
administrative costs are assessed, administrative costs may eat into the
accumulated savings of all accounts but could have a greater impact on the
smaller accounts.

                    Tradeoffs Between 	Investment Choices 	

There are trade-offs associated with the range of investment choices
offered. When individuals have more investment choices, they have more
opportunity to tailor their financial situation to their own tastes and
preferences and assert greater control over their personal property.
However, with a greater variety of choices comes the possibility that
individuals will not choose a diversified portfolio or will simply make a
bad selection, thus lessening their retirement income from the individual
account. As the range and variety of investment choices grow, so does the
range of possible outcomes for individual account returns. This means that
a number of individual accounts could perform very well, while others will
not perform well at all. This results in increased risk to the government
that individuals with inadequate income will turn to the government for
support through other programs. In addition, a wider range of investment
choices can also lead to higher administrative costs, which, if not offset
by significantly higher returns, could undermine retirement income for
individuals. Limiting investment choice would help to minimize risk and
administrative costs, but doing so could also limit the possible return on
investments. Moreover, limiting choices raises concerns about the role of
government in selecting the investment vehicles and the possibility of
political influence over these selections. Essentially, the challenge
becomes finding the right balance between individual choice and the
related risks and costs to the individual and the government.

Investment decisions become more complicated as the number of choices
increase. If individuals do not make an investment choice, managers would
need to decide how to invest the contributions for those individuals. Some
have proposed placing these contributions in the lowest risk accounts. One
such option would be to place these contributions in a limited number of
funds and then weight individual portfolios differently

depending on the age of the worker, similar to a life-cycle fund, so that
workers increasingly assume less risk as they neared retirement.

Public education about the choices available and the risks associated with
each would be needed under any system. However, the need to educate the
public about the consequences of using different investment strategies
would be less under a system with limited choice than under a system with
a broader range of choice. When the number of choices is limited, the
degree of risk is more defined and the program is less complex. However,
as the number of choices increases, the public would need a greater level
of education to learn about the wider variety of investment options to
understand and use the information disclosed to them, and to fully
appreciate the consequences of investment choices.

    Customer Service Considerations

Frequent statements indicating the actual account value, daily or periodic
valuation of account balances, and the ability to transfer funds between
investment options are some of the different services that could be
available with individual accounts. When more services and more
flexibility are offered, the costs and administrative complexity of
managing the investments increase. Moreover, if individuals consider the
individual accounts as their personal property, they may expect options
and service consistent with those often provided by private sector fund
managers, such as frequent detailed account statements and allowing
frequent interfund transfers.

  Design Considerations in the Distribution Phase

The final design element centers on how the accumulated earnings in
individual accounts would be preserved for retirement. Ensuring that
retirement income is available for the life of the retiree is a
fundamental goal of Social Security. With respect to the distribution
phase, individual account systems could use three basic ways to pay
retirement benefits: annuitization, timed withdrawals, and lump sum
payments. The appropriateness of additional distribution features such as
loans or early withdrawals, which are common in 401(k) plans, would also
need to be considered. While such features would enhance the account
holder's sense of ownership and control, loans or early withdrawals create
a risk for leakage of account income that could diminish adequacy in
retirement. Further, administrative aspects of the distribution must be
considered. These include any guarantees that may be offered as well as
the tax treatment of the distributions.

Annuities 	

Under a system of annuities, retirees would receive monthly payments for
an agreed-upon length of time, and the size of those payments would depend
on the total value of the individual accounts. Under individual account
proposals, annuities would be obtained either through government agencies
or the private market. Further, such annuitization could be mandatory,
voluntary, or some hybrid of both. For example, some individual account
proposals have suggested mandatory annuitization up to an amount necessary
to avoid poverty, and then any remaining account monies could be
distributed at the account holder's discretion.

Mandatory annuitization could help ensure that the accounts provided
retirement income for the entire remaining lifetimes of participants.
Mandatory annuitization of accounts could also minimize adverse selection.
Adverse selection occurs, for example, when only healthy people buy
annuities and on average live longer than nonbuyers, driving up the cost
of annuities. According to one study, annuity prices in a voluntary
environment can be as much as 14 percent higher than they would be if
every retiree were required to purchase an annuity. However, mandatory
annuitization also effectively transfers income from the shorter-lived to
those that are longer-lived.

Additional design considerations for annuities include the type of
annuities that could be offered. For example, monthly income can be a
fixed amount per month (fixed annuity); a steadily increasing amount based
on an index, such as the Consumer Price Index (indexed annuity); or a
variable amount based on returns from investing the premium (variable
annuity). Under a single-life annuity, the annuitant receives a guaranteed
stream of payments that end with the annuitant's death. Under a joint and
survivor annuity, the payments continue to be made, sometimes at a reduced
rate, to a second annuitant, such as a spouse, on the death of the primary
annuitant. For a term-certain annuity, payments are not contingent on the
annuitant's life; instead, they are guaranteed for a specified period of
time, such as 5 or 10 years. With a variable annuity, the annuitant
assumes some of the risk from the investment returns on the annuity.

The current Social Security retirement benefit provides a fixed lifetime
annuity that increases with inflation. In addition, Social Security
provides auxiliary benefits to workers' eligible spouses, children, and
survivors without reducing the size of the worker's own annuity. While
annuity providers could potentially replicate some of the features of
Social Security benefits, some important features would not likely be
replicated.

Adding components such as inflation indexing or a joint and survivor
annuity will require the primary annuitant to accept less monthly income
than under a single-life annuity. Furthermore, individuals with small
account balances at retirement could have difficulty purchasing annuities
in the private sector insurance market. Insurers may find provision of
annuities to be inefficient and costly for individuals with small accounts
because of the relatively high cost of issuing monthly checks and other
administrative costs.

    Timed Withdrawals and Lump Sums

Other options for the payout of accounts include timed withdrawals (also
referred to as self-annuitization) and lump sum payments. In a timed
withdrawal, retirees specify a withdrawal schedule with the investment
manager or record keeper. Each month, they receive their predetermined
amount, while the balance of the individual account remains invested.
Under a lump sum payment option, individuals may liquidate their accounts
through a single payment at retirement and choose to spend or save their
money according to their needs or desires. Both timed withdrawals and lump
sums give the individual the most immediate control of their account. Such
options also underscore that increased personal choice comes with
increased personal responsibility if the retirement income is to be
preserved for the long term.

                                  Guarantees 	

A unique distribution phase design feature of some proposals involves a
guarantee of a certain benefit level at retirement. This guarantee could
be provided in tandem with other benefit structure changes such that the
worker would be guaranteed a minimum benefit. One such approach would
guarantee the current Social Security defined benefit. If the individual
account provided less than the current benefit, then the system would
ensure that benefits were provided to fill the gap. Such an arrangement
might be desirable from a benefit adequacy perspective but would require
safeguards against the government becoming an insurer of excessive risk
taking by individuals. This risk taking could occur if individuals assumed
unwarranted investment risk knowing that the government would still
guarantee a minimum benefit or rate of return.

Preretirement Access While the above design features consider design
options in the distribution phase at retirement, individual account design
may also consider whether to allow preretirement access. For example, most
401(k) pension plans allow participants to borrow against their pension
accounts at relatively low interest rates. In past work we have shown that
preretirement access

improves participation in 401(k) pension plans and might also be an
incentive for participation in a system of voluntary individual accounts.6
However, those plan participants who borrow from their accounts risk
having substantially lower pension balances at retirement and, on average,
may be less economically secure than nonborrowers. While some may argue
that individuals should be allowed the freedom to access income through
borrowing from their accounts before retirement, the added complexity and
potential diminution of retirement income need to be given serious
consideration.

    Tax Treatment

  Conclusions

Any payout option, whether pre-or postretirement, would need to consider
the tax treatment of the individual account distribution. Benefits from
individual accounts could be taxed in a variety of ways. For example,
individual account benefits could be taxed like current Social Security
benefits. Persons who currently receive Social Security benefits and have
income over a certain amount may have to pay taxes on their benefits.7
Generally, the higher one's total income, the greater the taxable part of
one's benefits. Typically, up to 50 percent of one's benefits will be
taxable. However, up to 85 percent can be taxable if, for example, a
person filed a federal tax return and one-half of his or her benefit and
all other income exceeds $34,000. Alternatively, individual accounts could
be taxed similarly to ordinary income. Individual accounts could also be
treated like pension payments (such as DC pensions like 401k plans) or
annuity payments from a qualified employer retirement plan, which may
either be fully or partially taxable, depending on the type of retirement
plan.

Clearly, the wide range of possible options complicates the design of an
individual account system. In general, our work shows that the features
that provide additional flexibility and choice may increase system costs.
Such features would include making participation voluntary, rather than

6 Participants in plans that allow borrowing contribute, on average, 35
percent more to their pension accounts than participants in plans that do
not allow borrowing. See GAO,

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

7Individual income tax filers pay this tax if their adjusted gross income
plus tax-exempt interest income plus one-half their Social Security
benefits exceeds $25,000. A married couple filing jointly will pay the tax
if this income exceeds $32,000. These levels are not adjusted for
inflation, so the percentage of beneficiaries paying tax on Social
security benefits is expected to rise in the future.

mandatory, and expanding the number of investment options.8 Other key
decisions also have cost implications. For example, the contribution
phase, the accumulation phase, and the distribution phase could each be
administered in a centralized or decentralized manner, and at various
levels by the government or by private contractors. In general, costs of
individual accounts will rise with increasing decentralization.

No matter what sort of features individual accounts include, any related
administrative, management, and data systems must be developed and tested
before the individual accounts are made available to American workers. If
reforms are implemented with haste and key administrative functions are
neglected, the ensuing problems have the potential to undermine an
otherwise well-designed accounts system. The federal Thrift Savings Plan
has been suggested as a model for providing a limited amount of options
that reduce risk and administrative costs while still providing some
degree of choice. While using this existing model could mitigate
administrative issues, a system of accounts that spans the entire national
workforce and millions of employers would be significantly larger and more
complex than the TSP.

The choice to include individual accounts as part of broader reform could
fundamentally alter the defined benefit aspect of current Social Security
benefits. Under its current structure, Social Security redistributes
benefits to lower-income workers. Mirroring the redistributive effects of
the current Social Security program, individual accounts could be designed
to include some progressive features. However, it is important to
distinguish between progressivity and benefit adequacy. Greater
progressivity is not the same thing as greater adequacy and may result in
less equity. As a result, any evaluation of a Social Security reform
proposal that includes individual accounts should consider not only the
overall costs to the system but also, very importantly, the impact on
individuals and families. Administering the accounts and educating the
public about a system of individual accounts requires difficult choices
and trade-offs; and these choices will determine the degree and speed of
public acceptance. Ultimately, what matters most is that we maintain a
strong retirement security system for the millions of American workers and
their families.

8 See GAO, Social Security Reform: Information on Using a Voluntary
Approach to Individual Accounts, GAO-03-309 (Washington, D.C.: Mar. 10,
2003), and GAO, Social Security Reform: Implementation Issues for
Individual Accounts, GAO/HEHS-99-122 (Washington, D.C.: June 18, 1999).

Mr. Chairman and Members of the Subcommittee, this concludes my prepared
statement. I would be happy to respond to any questions you or the other
Members of the Subcommittee may have.

GAO Contacts and For further information regarding this testimony, please
contact

Barbara D. Bovbjerg, Director, Education, Workforce, and Income Staff
Security Issues, on (202) 512-7215. Blake Ainsworth, Alicia Cackley,
Acknowledgments Charlie Jeszeck, Michael Collins, and Charles Ford also
contributed to this

statement.

Related Products 	

Social Security Reform: Answers to Key Questions. GAO-05-193SP.
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Options for Social Security Reform. GAO-05-649R. Washington, D.C.: May 6,
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Social Security Reform: Early Action Would Be Prudent. GAO-05-397T.
Washington, D.C.: Mar. 9, 2005.

Social Security: Distribution of Benefits and Taxes Relative to Earnings
Level. GAO-04-747. Washington, D.C.: June 15, 2004.

Social Security Reform: Analysis of a Trust Fund Exhaustion Scenario.
GAO-03-907. Washington, D.C.: July 29, 2003.

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GAO-03-387. Washington, D.C.: Apr. 23, 2003.

Social Security Reform: Analysis of Reform Models Developed by the
President's Commission to Strengthen Social Security. GAO-03-310.
Washington, D.C.: Jan. 15, 2003.

Social Security Reform: Information on Using a Voluntary Approach to
Individual Accounts. GAO-03-309. Washington, D.C.: Mar. 10, 2003.

Social Security: Program's Role in Helping Ensure Income Adequacy.
GAO-02-62. Washington, D.C.: Nov. 30, 2001.

Social Security Reform: Potential Effects on SSA's Disability Programs and
Beneficiaries. GAO-01-35. Washington, D.C.: Jan. 24, 2001.

Social Security Reform: Information on the Archer-Shaw Proposal.
GAO/AIMD/HEHS-00-56. Washington, D.C.: Jan. 18, 2000.

Social Security: Evaluating Reform Proposals. GAO/AIMD/HEHS-00-29.
Washington, D.C.: Nov. 4, 1999.

Social Security: Issues in Comparing Rates of Return with Market
Investments. GAO/HEHS-99-110. Washington, D.C.: Aug. 5, 1999.

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

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

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

Social Security: Restoring Long-Term Solvency Will Require Difficult
Choices. GAO/T-HEHS-98-95. Washington, D.C.: Feb. 10, 1998.

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