Social Security: Capital Markets and Educational Issues Associated With
Individual Accounts (Chapter Report, 06/28/1999, GAO/GGD-99-115).

The aging of the U.S. population poses a financial burden for the Social
Security program. Some have suggested including individual retirements
accounts as an element of Social Security reform. To help Congress
better understand the potential implications of individual accounts,
this report describes how such accounts could affect the (1) private
capital and annuities markets as well as national savings, (2) potential
returns and risks to individuals, and (3) disclosure and education
efforts needed to inform the American people about such a program.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-99-115
     TITLE:  Social Security: Capital Markets and Educational Issues
	     Associated With Individual Accounts
      DATE:  06/28/1999
   SUBJECT:  Information disclosure
	     Economic analysis
	     Stocks (securities)
	     Social security benefits
	     Investments
	     Retirement benefits
	     Financial management
	     Pensions
IDENTIFIER:  Social Security Program
	     SSA Individual Account Program

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    United States General Accounting Office GAO               Report
    to the Chairman,Committee on Ways and Means House of
    Representatives June 1999         SOCIAL SECURITY Capital Markets
    and Educational Issues Associated With Individual Accounts
    GAO/GGD-99-115 United States General Accounting Office
    General Government Division Washington, D.C.  20548 B-281161 June
    28, 1999 The Honorable Bill Archer Chairman, Committee on Ways and
    Means House of Representatives Dear Mr. Chairman: Proposals have
    been advanced by various groups calling for individual accounts as
    a component of Social Security reform.  To better understand the
    potential implications of individual accounts, you asked us to
    provide you with information on how such accounts could affect
    private capital and annuities markets as well as national savings,
    and to determine the potential risk and returns to individuals
    under such a program.  You also asked us to determine the
    disclosure and educational efforts needed to inform the public
    about individual accounts.  This report responds to your request.
    We will provide copies of this report to the Honorable Charles B.
    Rangel, Ranking Minority Member of the House Committee on Ways and
    Means; the Honorable Kenneth S. Apfel, Chairman of the Social
    Security Administration; the Honorable Arthur Levitt, Chairman of
    the Securities and Exchange Commission; the Honorable Alexis M.
    Herman, the Secretary of the Department of Labor; the Honorable
    Robert E. Rubin, the Secretary of the Treasury; and other
    interested committees and organizations.  Copies will be made
    available to others upon request. If you have any questions,
    please call me (202) 512-8678.  Major contributors are
    acknowledged in appendix II. Sincerely yours, Thomas J. McCool
    Director, Financial Institutions and Markets Issues Page 1
    GAO/GGD-99-115 Issues Associated With Individual Accounts
    Executive Summary The Social Security program faces a financing
    challenge primarily due to Purpose             the aging of the
    U.S. population.  In response, some reform advocates have
    suggested the use of individual investment accounts as a component
    of Social Security reform.  To better understand the potential
    implications of individual accounts, the House Committee on Ways
    and Means asked GAO to determine how such accounts could affect
    (1) private capital and annuities1 markets as well as national
    savings,2 (2) potential returns and risks to individuals, and (3)
    the disclosure and educational efforts needed to inform the public
    about such a program. This report addresses certain aspects of the
    broad issue of the relationship between individual accounts and
    Social Security's long-term financing needs.  It does not seek to
    evaluate any specific Social Security reform proposal or seek to
    address the administrative costs or implementation issues
    associated with individual accounts.3  Rather, to identify the
    potential impact of individual accounts on the capital markets,
    GAO focused on the potential effect of proposals in which some
    percentage of taxable payroll or other potential base would be
    provided to individuals to invest in private markets.4  Some
    proposals allow individuals wide latitude in investment options;
    others provide a narrower choice, generally between debt and
    equity mutual funds, or particular types of mutual funds.5
    Individual investment accounts could affect the capital markets in
    several Results in Brief    ways, depending on how the accounts
    are funded, how the funds are invested, and how people adjust
    their own savings behavior in response to individual accounts.  As
    a source of funds for the accounts, most proposals use either the
    cash collected from Social Security taxes or federal general 1
    Annuities are contracts to provide periodic pay-outs for an
    agreed-upon span of time in return for a premium.  These contracts
    basically convert savings into income. 2 National savings includes
    the savings of individuals, households, and businesses, called
    private savings; and the net savings of all levels of government.
    3 GAO has issued two other reports that provide additional
    information on individual accounts as a component of Social
    Security reform.  One report provides information on the
    implementation issues of individual accounts Social Security
    Reform:   Implementation Issues for Individual Accounts (GAO/HEHS-
    99-122, June 18, 1999).  The other report provides additional
    detail on administrative costs, which can have a direct effect on
    how much savings are accumulated in individual accounts over time
    Social Security Reform:   Administrative Costs for Individual
    Accounts Are Hard to Predict (GAO/HEHS-99-131, June 18, 1999). 4
    We use 2 percent of taxable payroll as an example throughout the
    report although, depending on the proposal, the percentage or the
    base could be different. 5 Mutual funds pool the limited funds of
    small investors into large amounts, thereby gaining the advantages
    of large-scale trading.  Investors are assigned a prorated share
    of the total funds according to the size of their investments.
    Page 2                                               GAO/GGD-99-
    115 Issues Associated With Individual Accounts Executive Summary
    revenues.  As a result, the primary capital market effect is a
    purely financial one: borrowing in the Treasury debt market (or
    retiring less debt) to provide funding for investment in private
    debt and equity markets. Although the annual flows are likely to
    be sizeable (for instance, 2 percent of payroll would be about $70
    billion in 1998), both the private debt and equity markets should
    be able to absorb the inflow without significant long-term
    disruption.  There could eventually be a significant increase in
    the amount of new funds flowing into the annuities market.
    However, the magnitude of annuity purchases is likely to build
    gradually over time as more retirees build larger balances,
    allowing the market sufficient time to adjust. In addition to the
    financial effect of redirecting funds from the Treasury debt
    market to private capital markets, individual account proposals
    could also affect the level of financial resources available for
    private investment by increasing or decreasing national savings.
    The extent to which individual accounts affect national savings
    will depend on how they are financed, the structure of the
    program, and any behavioral responses of businesses and
    individuals.  National savings is more likely to increase if (1)
    the government funds would have been spent but instead are not;
    (2) the program is mandatory and prohibits pre-retirement
    distributions;6 and (3) households do not fully adjust their other
    retirement saving--that is, reduce it because of savings involved
    in individual accounts. To the extent that households use the
    opportunities offered by an individual account program to invest
    in private equities and debt rather than Treasury securities, they
    could increase both the returns they receive and the risks they
    face compared to the current Social Security program. Although
    asset diversification offers mitigation against certain risks, the
    returns that individuals receive would depend on and vary with
    their investment choices and the performance of the private debt
    and equity markets.  On the basis of historical data, most
    advocates of individual accounts state that the expected future
    returns on private investments, especially equities, would be much
    higher for individuals than the implicit return available under
    the current Social Security program.  Others are skeptical about
    these claims for higher expected returns on equities.  Some argue
    that historical returns may not be a good predictor of future
    returns. Others suggest that because equity market returns are
    more volatile than returns on Treasury securities, a better
    comparison would be among risk 6 Pre-retirement distribution
    refers to distributions other than the those that would occur as a
    result of someone's death.  Some proposals allow distributions at
    death to be paid as a survivor benefit while others do not. Page 3
    GAO/GGD-99-115 Issues Associated With Individual Accounts
    Executive Summary adjusted returns of various assets.  There are
    numerous ways to adjust returns for risk but no clearly best way.
    In the end, even informed choices among potential investments
    depend upon an individual's tolerance for risk. To provide
    participants with a clear understanding of the purpose and
    structure of an individual account program, an enhanced
    educational program would be necessary.  At a minimum, such a
    program would have to provide individuals with information
    adequate for their decisionmaking, as well as protect against
    misinformation.  Existing disclosure and antifraud rules provide
    for the disclosure of information material to investors making
    investment decisions.  However, disclosure alone would not enable
    participants in an individual account program to make thoughtful
    and informed investment decisions.  An enhanced and broad- based
    educational effort would have to be undertaken in order to provide
    individuals with information they need and can readily understand
    as well as with tools that can help to improve both the
    decisionmaking process and awareness of the consequences of those
    decisions.  Individuals would need education on the benefits of
    saving in general, the relative risk-return characteristics of
    particular investments and how different distribution mechanisms
    can affect their retirement income security.  If only a few well-
    diversified investment choices are provided, most of the
    educational effort could be targeted to clarifying the purposes of
    investing and the potential long-term consequences of different
    investment alternatives. However, if a wide variety of choices is
    offered individuals so that they could potentially choose less
    diversified investments, such as individual equities, a more
    broad-based educational program will be necessary. In early 1997,
    the Advisory Council on Social Security reported on Social
    Background    Security's long-term financing problem of keeping
    the program solvent. Three plans or proposals were advanced by
    different groups of Council members.  Two plans called for the
    creation of mandatory individual accounts, and the remaining plan
    called for having the government invest the trust fund in
    marketable securities.7   A number of other proposals calling for
    individual accounts have been advanced by various research
    organizations, academics, and Members of Congress.  For the most
    part, these other proposals contain provisions similar to those
    found in the Advisory Council's report. 7 See Social Security
    Financing:  Implications of Government Stock Investing for the
    Trust Fund, the Federal Budget, and the Economy (GAO/AIMD/HEHS-98-
    74, April 1998). Page 4
    GAO/GGD-99-115 Issues Associated With Individual Accounts
    Executive Summary An individual account program requires that some
    portion of workers' contributions to Social Security be put into
    individual accounts that they may invest in private equity or debt
    markets.8   The current Social Security program is a pay-as-you-go
    program whereby each year's revenue is collected to pay for that
    year's benefits.  An individual account program would enable
    individuals to build up and maintain account balances that would
    provide financing for some part of their Social Security
    retirement income.  As a result, it moves away from a strictly
    pay-as-you-go system in the direction of an advanced funded
    system. Individual account proposals are usually framed by three
    characteristics. The first characteristic pertains to whether to
    "carve-out" a portion of Social Security's tax that is to be
    invested in financial assets, or to "add-on" a percentage to the
    current tax that is to be invested in financial assets. The second
    characteristic concerns whether to make investments in individual
    accounts mandatory or voluntary.  Mandatory participation would
    require that each individual invest some percentage of his or her
    payroll tax contribution in financial assets.  Voluntary
    individual accounts would allow individuals to opt in or out of
    investing any portion of their payroll tax contributions into
    financial assets.  The third characteristic pertains to how the
    accumulated earnings in individual accounts would be paid out upon
    retirement, i.e., whether annuitization or a lump sum pay-out
    would be required. Principal Findings Funding of individual
    accounts will come directly or indirectly from Market Effects
    increased government borrowing, unless funded by a tax increase or
    reduced government outlays.  In the absence of a tax increase, the
    government will need to raise resources either by borrowing in the
    market or by not retiring as much maturing debt as it otherwise
    would.  Some part of funds could be invested in the corporate
    equity and debt markets.  The amounts that would flow into these
    markets would depend upon the options available to individuals as
    well as the choices they make.    The annual flow resulting from 2
    percent of payroll would have been about $70 billion in 1998
    dollars.   Annual net purchases and sales of equities were about
    $300 billion in 1996 and close to half a trillion dollars in 1997
    and 1998.  Thus, the additional annual flows could represent a 10-
    to 20-percent 8 Debt and equities are often the benchmarks used,
    even though eligible market investments could encompass a wider
    range of financial assets under certain proposals. Page 5
    GAO/GGD-99-115 Issues Associated With Individual Accounts
    Executive Summary increase in the annual flow but would still be
    relatively small compared to the $15 trillion U.S. equity markets
    as a whole.  Funds flowing into individual accounts are more
    likely to have some short-term effects on the corporate bond
    market because this market is smaller than the equities market and
    less liquid-it is not as easy to buy and sell bonds without moving
    the market.  However, it is unlikely that there will be any
    significant long-term disruptions of either market.  Moreover,
    insurance industry officials said that the annuities markets are
    likely to be able to absorb the flows from mandatory or voluntary
    annuitization.  They said that the annuities resulting from the
    liquidation of the individual accounts would generally be phased
    in over a long period of time and, therefore, could be absorbed by
    the market without difficulty. The extent to which individual
    accounts would affect national savings depends on how they would
    be financed.    For instance, funds could come from (1) within the
    current Social Security system, which would likely reduce
    government savings; (2) a change in the system resulting from
    increased payroll taxes or reduced benefits, which would not
    affect government savings; or (3) outside the system using general
    revenues, where the effect on government saving would depend on
    how those funds would otherwise have been used.9  National saving
    would also be affected by how households and businesses respond to
    individual accounts.  The extent of these behavioral effects would
    depend in part on the structure of the individual account program
    and any limitations placed on the use of funds.  For instance,
    proposals that are mandatory are more likely to increase private
    saving because such a program would require that all individuals,
    including those who do not currently save-such as many low- income
    individuals or families-place some amount in an individual
    account.  Prohibitions or restrictions on borrowing or other forms
    of preretirement distributions could also limit the ability of
    some households to reduce their savings in response to individual
    accounts. Investing in assets through individual accounts involves
    a trade-off: greater Expected Returns and Risks returns are
    possible, but only if the individual accepts some additional risk,
    including, but not limited to, more variability in rates of
    return.  Under the current Social Security program, there is
    little investment risk. Demographic and economic risk are borne
    collectively by taxpayers and beneficiaries.  Moving to an
    individual account program would mean that 9 The primary
    determinant is what would have been done with the revenue if it
    had not been used to finance individual accounts; would the
    government have spent it, provided tax cuts, or saved it by buying
    back outstanding debt?  If the government would have spent it or
    reduced taxes but does not because it funds individual accounts
    instead, government saving is not affected.  If it would have used
    the funds to buy back debt, government saving is reduced. Page 6
    GAO/GGD-99-115 Issues Associated With Individual Accounts
    Executive Summary individuals would be able to reap the rewards of
    their own investments, but they also would incur risk-not only the
    possibility of lower returns, but also the possibility of losing
    money.  Diversification and other asset allocation approaches
    could help to improve an individual's risk/return trade-off.10
    Holding assets for long periods of time could also improve an
    individual's risk/return trade-off because the risk averages out
    over time, evening out the variations in risk.  However,
    individuals who retire at the same time may receive different pay-
    outs from individual account investments because of the investment
    choices they have made.  Returns could also vary depending on when
    an individual retires because of the volatility of the stock
    market.  Thus, market-driven results can produce "winners" and
    "losers," depending on when and how individuals invest their
    accounts and when they liquidate their holdings.  As long as
    individuals are aware of and accept this risk, there may not be
    calls to fix the "unfair benefits outcomes."  On the other hand,
    if there are enough "losers," there could be calls to offset some
    or all of any losses. Advocates and opponents of individual
    accounts have estimated what the market rate of return could be
    for an individual's investments under an individual account
    program.  Higher returns are possible for individuals investing
    through individual accounts than are possible under the current
    Social Security program, but only if individuals take on more
    risk. Individuals should therefore not only be interested in the
    returns from their investments, but also in the risks that must be
    incurred to achieve higher returns.  The difficulty is how to
    measure risk and how to adjust rates of return to compensate for
    risk and allow for comparability.  There are many ways to adjust
    returns for risk but no clearly best way. Existing Securities and
    Exchange Commission (SEC) disclosure rules Enhanced Education
    require that material information be provided about a particular
    investment instrument and its issuer.  Separate disclosure rules
    promulgated by the Department of Labor (DOL) apply to pension
    plans. Such disclosure would be essential to an individual account
    program, with some rules having more significance than others,
    depending on the investment choices offered.  For example, if
    participants were allowed to acquire individual corporate
    securities such as stocks and bonds, the disclosure and reporting
    requirements of the Securities Acts of 1933 and 1934, such as
    those applicable to the governance, activities, and financial
    status of the issuer, would be particularly important.  If
    investment choices 10 Diversification refers to investing in more
    than one asset.  Asset allocation is the choice of how much to
    invest in  each of the broad asset classes-stocks, bonds, cash,
    real estate, and possibly others to achieve the best portfolio
    given the investor's objectives and constraints. Page 7
    GAO/GGD-99-115 Issues Associated With Individual Accounts
    Executive Summary were limited to mutual funds, disclosure about
    the funds would have primary importance, while information about
    the issuers of the securities owned by the funds would be
    relatively less significant for participants. Introducing an
    individual account program would change the nature of the current
    Social Security program and would require increased education, not
    only to help people to understand the individual account program,
    but also what their responsibilities and risk trade-offs would be.
    The amount of education that would be necessary would depend on
    the range and type of investment choices and the fees and expenses
    associated with individual accounts.  As a wider variety of choice
    is offered to individuals, especially under a mandatory program,
    more education beyond the basics would be necessary because
    individuals would need to consider broader issues.  In addition to
    understanding the difference between a stock and a bond, investors
    would need to understand the importance of diversification.
    Furthermore, being able to understand the rates of return and
    various risks of different options and pick the appropriate
    investment vehicle becomes more difficult, as more choice is
    offered.  When choices are limited to a few well-diversified
    alternatives--such as the case of a few indexed mutual funds11--
    many decisions are made by those managing the funds or are made by
    rules governing the fund (such as what the funds can invest in).
    Thus, if a few well-diversified choices are offered, the
    individual would have fewer risk factors to consider, and investor
    education can be more targeted.  Various officials have suggested
    that a default option be provided for those individuals who,
    regardless of educational effort, would not make investment
    choices.  Such a default mechanism could provide a very low-risk
    option based on Treasuries and/or could gear the asset mix to the
    age of the worker. GAO is not making recommendations in this
    report. Recommendations GAO provided drafts of this report to the
    Department of the Treasury, the Agency Comments    Social Security
    Administration, the Securities and Exchange Commission, and the
    Pension and Welfare Benefits Administration of the Department of
    Labor (DOL) for review and comment.  SSA provided written comments
    that are included in appendix I.  SSA had two major points: (1)
    that GAO needed to clarify that comparisons between the rate of
    return implicit in the Social Security system and those of
    individual accounts were 11 An indexed mutual fund is a mutual
    fund that holds shares in proportion to their representation in a
    market index, such as the Standard & Poors 500. Page 8
    GAO/GGD-99-115 Issues Associated With Individual Accounts
    Executive Summary problematic for many reasons, including the fact
    that Social Security provides survivors and disability insurance;
    and (2) that GAO needed to discuss the savings implications of the
    President's proposal.  In response to the first point, we have
    further clarified issues regarding the rate of return comparisons.
    With regard to the second point, this report was not intended to
    comment on specific reform proposals. In commenting on our report,
    SSA and the other agencies also provided technical and clarifying
    comments.  We have incorporated these comments where appropriate.
    Page 9                    GAO/GGD-99-115 Issues Associated With
    Individual Accounts Contents 2 Executive Summary 12 Chapter 1
    Social Security Has a Financing Problem
    12 Introduction             Individual Accounts  Proposed to Help
    Solve Social                               13 Security's Financing
    Problem Objectives, Scope, and Methodology
    18 20 Chapter 2                Redirection of Funds Could Affect
    Composition of                                 20 Capital and
    Annuities      Portfolios Current Size of the Private Capital
    Markets                                      22 Markets Able to
    Effect of Individual Accounts on National Savings
    29 Absorb Individual          Depends on Financing, Structure, and
    Behavioral Effects Account Investments      Agency Comments
    34 35 Chapter 3                Instituting an Individual Account
    Program Means Greater                          36 Return and Risks
    Are       Risk to Individuals for Potentially Greater Return The
    Expected Market Return for Individual Account
    40 Likely to Be Higher        Investments With Individual
    Comparing Rate of Return From Social Security to
    48 Expected Return With Individual Accounts Requires Accounts
    Careful Consideration Agency Comments
    48 50 Chapter 4                The Significance of Disclosure
    Rules Would Depend                                51 Enhanced
    Education is      Upon Available Investment Choices Enhanced
    Education Is Necessary for an Individual
    55 Necessary for an           Account Program Individual Account
    Program Appendix I: Comments From the Social Security
    64 Appendixes                 Administration Appendix II: GAO
    Contacts and Staff Acknowledgments                              66
    Page 10                    GAO/GGD-99-115 Issues Associated With
    Individual Accounts Contents Table 2.1: Amounts of Corporate
    Equities, Corporate                              23 Tables
    Bonds, and U.S. Treasuries Outstanding (Dollars in Billions) Table
    2.2: Annual Holdings of Corporate Equities and
    23 Bonds by Various Sectors of the Economy (Dollars in Billions)
    Table 2.3: Annual Net Purchases and Sales of Corporate
    25 Equities by Different Sectors (Dollars in Billions) Table 2.4:
    Annual Purchases and Sales of Corporate
    26 Bonds Equities by Different Sectors (Dollars in Billions) Table
    2.5: Policy Reserves Held for Individual and Group
    28 Annuities (Dollars in Billions) Table 4.1: Investment Choices
    Under an Individual                                61 Account
    Program and the Education Required Figure 3.1: Returns of the
    Standard and Poors 500 Index                          42 Figures
    Abbreviations DOL            Department of Labor FDIC
    Federal Deposit Insurance Corporation IRA            Individual
    Retirement Accounts OASDI          Old Age Survivor Disabilities
    Insurance OCC            Office of the Comptroller of the Currency
    OTS            Office of Thrift Supervision SEC
    Securities and Exchange Commission SSA            Social Security
    Administration SPD            Summary Plan Description Page 11
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    1 Introduction Social Security forms the foundation for our
    retirement income system.  In 1998, it provided approximately $264
    billion in annual benefits to 31 million workers and their
    dependents.  However, the Social Security program is facing
    significant future financial challenges as a result of profound
    demographic changes, including the aging of the baby boom
    generation and increased life expectancy.   In response, different
    groups and individuals have advanced numerous proposals that have
    called for the creation of some sort of mandatory or voluntary
    individual accounts. To better understand the potential
    implications of individual accounts, the Chairman of the House
    Committee on Ways and Means asked GAO to determine how individual
    accounts could affect private capital and annuities markets as
    well as national savings, the potential risks and returns to
    individuals, and the disclosure and educational information needed
    for public understanding and use of an individual account
    investment program. The Social Security program1 is not in long-
    term actuarial balance.  That is, Social Security Has a    Social
    Security revenues are not expected to be sufficient to pay all
    benefit Financing Problem        obligations from 1999 to 2073.
    Without a change in the current program, excess cash revenues from
    payroll and income taxes are expected to begin to decline
    substantially around 2008.  Based on the Social Security Trustees
    latest "best estimate" projections, in 2014 the combined OASDI
    program will experience a negative cash flow that will accelerate
    in subsequent years.  In addition, the combined OASDI trust funds
    are expected to be exhausted in 2034, and the estimated annual tax
    income will be enough to pay approximately 70 percent of benefits.
    Every year, Social Security's Board of Trustees estimates the
    financial status of the program for the next 75 years using three
    sets of economic and demographic assumptions about the future.
    According to the Trustees'  intermediate set of these assumptions
    (or best estimate), the nation's Social Security program will face
    both solvency and sustainability problems in the years ahead
    unless corrective actions are taken.  Over the next 75 years,
    Social Security's total shortfall is projected to be about $3
    trillion in 1998 dollars. Social Security's long-term financing
    problem is primarily caused by the aging of the U.S. population.
    As the baby boom generation retires, labor 1 Social Security
    consists of two separate trust fund accounts:  Old Age and
    Survivors Insurance (OASI), which funds retirement and survivor
    benefits, and Disability Insurance (DI), which provides disabled
    workers and their families.  These two accounts are commonly
    combined in discussing the Social Security program.   For the
    purposes of this report, any reference to the Social Security
    program refers to the combined Old Age Survivors Disability
    Insurance (OASDI) program. Page 12
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    1 Introduction force growth is expected to slow dramatically.
    Beyond 2030, the overall population is expected to continue aging
    due to relatively low birth rates and increasing longevity.  These
    demographic trends will require substantial changes in the Social
    Security benefits structure and/or revenues (i.e., taxes and/or
    investment returns).  Without such changes, current Social
    Security tax revenues are expected to be insufficient to cover
    benefit payments in about 2014, less than 15 years from now.
    These trends in Social Security's finances will place a
    significant burden on future workers and the economy.  Without
    major policy changes, the relatively smaller workforce of tomorrow
    will bear the brunt of financing Social Security's cash deficit.
    In addition, the future workforce also would likely be affected by
    any reduction in Social Security benefits or increased payroll
    taxes needed to resolve the program's long-term financing
    shortfall.  As a result, without timely actions, certain
    generations could face the twin blows of higher burdens and
    reduced benefits. Proposals have been advanced by different groups
    to reform Social Individual Accounts              Security through
    individual accounts.   Such proposals basically also try to
    Proposed to Help                 restore the Social Security
    program's solvency and conserve its sustainability.  In its report
    to the Social Security Commissioner, the 1994- Solve Social
    Security's 1996 Advisory Council on Social Security offered three
    alternative reform Financing Problem                proposals, two
    of which would create individual accounts.  The remaining proposal
    called for having the government invest the trust fund in
    financial assets, such as corporate equities.  Numerous other
    proposals, also calling for individual accounts, have since been
    put forth by various organizations. Currently, therefore, there
    are a wide array of proposals that rely on some form of individual
    accounts.   These proposals have in common the idea that to
    varying extents, individuals would manage their own individual
    accounts.  The returns from these accounts would provide some or
    much of an individual's future retirement income. Social Security
    is currently structured as a defined benefit program.2   The
    current Social Security program's benefit structure is designed to
    address the twin goals of individual equity and income security-
    including retirement income adequacy.3  The basis of the benefit
    structure is that 2 A defined benefit plan is one in which the
    employer determines employees' retirement benefit amount using
    specific formulas that consider such factors as age at retirement,
    years of service, and salary levels.  The employer is responsible
    for ensuring that sufficient funds are available to pay promised
    benefits. 3 Individual equity means that there should be some
    relationship between contributions made and benefits received
    (i.e., rates of return on individual contributions).  Retirement
    income adequacy is addressed by providing proportionately larger
    benefits (redistributive transfers) to lower earners and certain
    household types, such as those with dependents (i.e., benefits
    levels and certainty). Page 13
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    1 Introduction these twin goals, and the range of benefits Social
    Security provides, are currently combined within a single defined
    benefit formula.  Under this defined benefit program, the worker's
    retirement benefits are based on the lifetime record of earnings,
    not directly on the payroll tax he or she contributed.
    Alternatively, a number of individual account proposals introduce
    a defined contribution structure as an element of the Social
    Security program.  A defined contribution approach to Social
    Security focuses on more directly linking a portion of the
    worker's contributions to the retirement benefits that will be
    received.  The worker's contributions are invested in financial
    assets and earn market returns, and the accumulations in these
    accounts can then be used to provide income in retirement and an
    additional pre-retirement death benefit.  One advantage of this
    approach is that the individual worker has more control over the
    account and more choice in how the account is invested.   In
    essence, the defined contribution structure is similar to the
    current 401(k) or IRA systems.4 Some proposals combine defined
    contribution and defined benefit approaches into a two-tiered
    structure for Social Security.  The aim is to maintain in some
    form the current existing system as a base tier and add an
    individual account component as a supplemental tier.   Some
    proposals modify the existing benefit structure; and others
    propose features that provide guarantees of current law benefits
    or some other level, such as the poverty line.   Other proposals
    have a more complicated formula including forms of matching.
    Thus, the relationship between contributions and benefits may be
    less direct.  Under most of these proposals, individuals would
    receive part of their future benefits from a modified Social
    Security program and part from the accumulations from their
    individual account. Most of the individual account proposals seek
    to create investment Four Main Characteristics    accounts that to
    varying extents are managed by the participants of Individual
    Account        themselves.  However, the actual details of how to
    structure individual Proposals                    accounts vary by
    each proposal.  Individual account proposals are usually framed by
    four characteristics: (1) carve-out versus add-on; (2) mandatory
    versus voluntary participation; (3) range of investment options
    offered; and (4) distribution options (e.g., required
    annuitization or lump-sum pay- out). 4 A 401(k) pension plan is an
    employer-sponsored defined contribution plan that allows
    participants to contribute, before taxes, a portion of their
    salaries to a qualified retirement account.  An IRA is a personal,
    tax-deferred retirement account.  IRA assets can be invested in
    almost any kind of financial instrument. Page 14
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    1 Introduction Carve-out Versus Add-on          The first
    characteristic pertains to whether to carve-out a portion of
    Social Security's tax that is to be invested in financial assets
    or to add-on a percentage to the current tax that is to be
    invested in financial assets. OASDI has a payroll tax of 12.4
    percent.  A carve-out involves creating and funding individual
    accounts with a portion of the existing payroll tax. Thus, some
    portion of the 12.4 percent payroll tax, such as 2 percent, would
    be carved out of the existing Social Security cash flow and
    allocated to individual account investments.   The resulting
    impact would be that revenues are taken out of Social Security and
    less is left to finance current benefits.  Other proposals take a
    different approach and add-on individual accounts as a type of
    supplementary defined contribution tier.  For instance, 2 percent
    would be added on to the current tax of 12.4 percent. The
    resulting effect of an add-on leaves the entire 12.4 percent
    payroll tax contribution available to finance the program while
    dedicating additional revenues for program financing either from
    higher payroll taxes and/or from general revenue. Mandatory Versus
    Voluntary       The second characteristic of individual account
    proposals concerns whether to make investments in individual
    accounts mandatory or voluntary.  Mandatory participation in
    individual accounts would require that each individual invest some
    percentage of his or her payroll tax contribution in financial
    assets such as equities.  Voluntary participation in individual
    accounts could allow individuals to opt in or opt out of investing
    any portion of their payroll tax contributions into financial
    assets. Individuals would rely on the existing Social Security if
    they chose to opt out of participating in individual accounts.
    Other voluntary approaches allow individuals to contribute with or
    without matching to a retirement account.  Additionally, mandatory
    or voluntary can also refer to the pay- out an individual receives
    upon retirement, such as a pay-out in the form of a lump sum.
    Investment Choices               The third characteristic has to
    do with the degree of choice and flexibility that individuals
    would have over investment options.   Some proposals would allow
    unlimited investment choices, such as investments in corporate
    equities, bonds, or  real estate.  Other proposals would offer a
    more limited range of choices, such as equity or bond indexed
    funds. Thus, individual account investments offer individuals some
    range of choice over how to accumulate balances for their
    retirement. Annuitization Versus Lump-Sum    The final
    characteristic centers around how the accumulated earnings in
    individual accounts will be paid out.  Preserving individual's
    retirement income prior to pay-out by prohibiting pre-retirement
    distributions or loans is also a requirement of most proposals.
    However, upon pay-out, Page 15                   GAO/GGD-99-115
    Issues Associated With Individual Accounts Chapter 1 Introduction
    some proposals would permit requiring annuities--contracts that
    convert savings into income and provide periodic pay-outs for an
    agreed-upon span of time in return for a premium.   Other
    proposals suggest allowing the individual to withdraw the account
    balance in lumpsum or through gradual pay-outs. 5 Among the
    changes implementing individual accounts would make to the
    Individual Accounts are       current Social Security program is
    to move away from a pay-as-you-go Different From the Current
    system in the direction of an advanced funded system. Social
    Security Program Pay-As-You-Go                 Social Security is
    currently financed largely on a pay-as-you-go basis. Under this
    type of financing structure, the payroll tax revenues collected
    from today's workers are used to pay the benefits of today's
    beneficiaries. Under a strict pay-as-you-go financing system, any
    excess of revenues over expenditures is credited to the program's
    trust funds, which function as a contingency reserve. Advanced
    Funding Through      Advanced funding refers to building and
    maintaining total balances for Individual Accounts
    Social Security, whether that is done through individual accounts
    or some other mechanism.6  Thus, although individual accounts are
    a form of advanced funding, the two terms are distinct.  For
    instance, building up the balance in the Trust Funds is a form of
    advanced funding.  The creation of individual accounts refers to a
    defined contribution system of accounts connected to Social
    Security and held in individuals' names.  Essentially, individual
    accounts would be advanced funded income arrangements similar to
    defined contribution plans or 401 (k) plans.  Although privately
    held individual accounts are a widely discussed means to achieve
    advanced funding, there are other ways to achieve advanced
    funding. Another approach to advanced funding using private
    markets would have the government invest directly in private
    capital markets.  Building up the Trust Fund using Treasury
    securities (marketable or nonmarketable) is another form of
    advanced funding, although it does not involve diversification
    gains. Proponents of individual accounts often state that advanced
    funding and asset diversification are benefits of their proposals.
    Yet, although 5 Some other proposals would combine payments from
    individual accounts with Social Security benefits into a single
    benefit. 6 Advanced funding could also occur through a buildup of
    nonmarketable or marketable Treasury securities or through having
    the government invest in the private sector. Page 16
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    1 Introduction advanced funding, individual accounts, and asset
    diversification are often linked, they are conceptually different.
    Diversification refers to investing in more than one asset and can
    be performed by individuals investing in individual accounts or by
    the government investing the trust fund in corporate equities
    stocks as well as corporate bonds.  Any one of the three
    categories could change without changing the other.  For instance,
    Social Security's Trust Funds are currently invested in
    nonmarketable Treasuries.7  Allowing the Trust Funds to invest in
    assets other than Treasuries would be diversifying without
    introducing individual accounts. Alternatively, individual
    accounts could be introduced whereby individuals are allowed to
    invest in only one asset--thereby introducing individual accounts
    without diversifying. Savings Implications of    Whether advanced
    funding through individual accounts increases national Advanced
    Funding           saving is uncertain.  The nation's saving are
    composed of the private saving of individuals and businesses and
    the saving or dissaving of all levels of government.8   Supporters
    of advanced funding point out that individual accounts offer a way
    to increase national savings as well as investment and economic
    growth.  Others suggest that the national saving claims of those
    favoring advanced funding through individual accounts may not be
    realized.  Whether advanced funding through individual accounts
    increases national saving depends on a number of factors,
    including how individual accounts are financed (existing payroll
    tax, general revenues); how private saving9 responds to an
    individual account system; the structure of the individual account
    system (mandatory or voluntary), and the limitation or prohibition
    of pre-retirement distributions and loans to make sure retirement
    income is preserved. Furthermore, even if national saving
    increases as a result of individual accounts, individuals may or
    may not be better off.  Saving involves giving up consumption
    today in exchange for increased consumption in the 7 The Trust
    Funds are invested in special issue Treasuries (either bonds or
    certificates of indebtedness).  These special issue Treasuries are
    redeemable at face value at any time. 8 In general, government
    budget deficits reduce from national savings by absorbing funds
    that otherwise could be used for private investment.  Conversely,
    government budget surpluses add to saving.  Surpluses allow the
    government to pay off some of its maturing debt, thereby reducing
    the outstanding level of debt held by the public and freeing up
    additional funds for private investments. 9 Private saving is the
    saving of households and businesses. Page 17
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    1 Introduction future.  Some economists have stated that it is not
    necessarily the case that all increases in saving are worth the
    cost of foregone consumption. 10 The Chairman of the House
    Committee on Ways and Means asked us to Objectives, Scope, and
    determine how individual accounts could affect (1) private capital
    and Methodology                      annuities markets as well as
    national savings, (2) potential returns and risks to individuals,
    and (3) the disclosure and educational information needed for
    public understanding and use of an individual account investment
    program. To determine the effect of individual accounts on the
    private capital and annuities markets, as wells as risk and return
    issues, we interviewed economists and other officials who were
    both proponents and opponents of individual accounts.  These
    officials included officials from think tanks as well as
    academicians who have studied Social Security reform.  We also
    reviewed and analyzed several studies relating to the impact of
    individual accounts on the market as well as studies that had
    tried to assess the risks and return issues that would arise
    because of individual accounts.  We also analyzed data from the
    Federal Reserve Flow of Funds as well as data provided by the
    insurance industry.   Additionally, we talked to industry
    officials from both the insurance and securities industries to
    obtain their views, and we interviewed government agency officials
    as. To determine the disclosure and educational requirements
    needed, we spoke to officials from the Securities and Exchange
    Commission (SEC), the Department of Labor's (DOL) Pension and
    Welfare Benefits Administration (PWBA), the Pension Benefit
    Guaranty Corporation, and the Social Security Administration
    (SSA).  We also spoke to private sector officials about the
    educational requirements that would be needed for an individual
    account program.  Additionally, we reviewed various studies that
    have looked at the best ways to educate people about investment
    and retirement education. Because of the wide-ranging nature of
    the numerous proposals being advanced, our report focuses on the
    common, or generic, elements that underlie various proposals to
    reform Social Security financing rather than on a complete
    evaluation of specific proposals. 10 See Eric M. Engen and William
    G. Gale, "Effects of Social Security Reform on Private and
    National Saving," Social Security Reform  Conference Proceedings
    Federal Reserve Bank of Boston, Conference Series No. 41, June
    1997. Page 18
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    1 Introduction We did our work in accordance with generally
    accepted government auditing standards between October 1998 and
    June 1999 in Washington, D.C., and New York, NY. We requested
    comments on a draft of this report from SSA, SEC, DOL, the
    Department of Treasury, and the Federal Reserve Board.  SSA
    provided written comments that are included in appendix I.  A
    discussion of these comments appears at the end of chapters 2 and
    3.  SSA and the other agencies also provided technical and
    clarifying comments, which we incorporated in this report where
    appropriate. Page 19                    GAO/GGD-99-115 Issues
    Associated With Individual Accounts Chapter 2 Capital and
    Annuities Markets Able to Absorb Individual Account Investments
    Individual accounts can affect the capital markets in several ways
    depending on how the accounts are funded, how the funds are
    invested, how people adjust their own savings behavior in response
    to having individual accounts, and the restrictions placed on
    using funds in individual accounts for anything other than
    retirement income. Most of the proposals use either the Social
    Security cash flow or federal general revenues as a source of
    funds. As a result, the primary capital market effect is a purely
    financial one: borrowing in the Treasury debt market (or retiring
    less debt) to provide funding for investment in private debt and
    equity markets. Although the amounts involved are likely to be
    sizeable, the effect would primarily be one of redirecting funds
    and readjusting the composition of financial portfolios. There may
    also be some effect on the difference between the return on
    Treasury debt and that paid on riskier assets, although the effect
    is not likely to be large. Although substantial inflows into the
    private debt market could, in certain circumstances, result in
    some increased volatility, both the private equity and debt
    markets should be able to absorb the inflows without significant
    long-term disruption. There could eventually be a significant
    increase in the amount of new funds flowing into the annuities
    market. However, the magnitude of annuity purchases is likely to
    build gradually over time as more retirees build larger balances,
    allowing the market sufficient time to adjust. Another potential
    effect of individual accounts would be an increase or decrease in
    national savings-the overall level of domestic financial resources
    available in the economy for the purpose of investing in plant and
    equipment. Whether individual accounts would increase or decrease
    national savings depends on how they are financed, how private
    savings changes as a result of individual accounts, and whether
    there are restrictions on households' ability to borrow. Most
    proposals use either the Social Security cash flow or federal
    general Redirection of Funds    revenues as a source of funds for
    individual accounts. The funds raised are Could Affect
    then to be invested in private equity or debt markets. As a
    result, there would be an increase in the relative supply of
    Treasury debt available to Composition of          the public and
    an increase in the relative demand for private debt and Portfolios
    equities to be held in individual accounts. This redirection of
    funds- selling Treasury debt for the cash to invest in private
    debt and equity-is a purely financial effect. It is likely to
    result in a change in the composition of private sector holdings
    as businesses and households absorb the extra government debt and
    provide new or existing private debt and equity, thereby adjusting
    their portfolios. Page 20                   GAO/GGD-99-115 Issues
    Associated With Individual Accounts Chapter 2 Capital and
    Annuities Markets Able to Absorb Individual Account Investments
    Whether the resources for individual accounts come from Social
    Security contributions or general revenues, the level of
    government debt held by the public would increase, or not fall as
    much as it otherwise would. The only cases in which an increase in
    debt held by the public would not occur would be those in which
    the resources come from an additional source of funding-either a
    tax increase, an expenditure reduction, or the result of some
    voluntary private saving-that would not otherwise have occurred.
    Increased government borrowing from the public could put some
    upward pressure on the interest rate at which the government
    borrows, if private sector borrowers are to be persuaded to hold
    the increased supply of government debt. Funds diverted to private
    equity and debt markets could have the effect of raising the
    prices and therefore lowering the yields (rates of return) on
    these higher risk assets. The combined effect could narrow
    somewhat the difference between the more risky and least risky
    assets. Whether resources used to finance individual accounts come
    from new Debt Held by the Public Will revenues, additional
    borrowing, or surpluses, the amounts flowing into Likely Rise to
    Provide            private capital markets are likely to be
    substantial. Funding of individual Funding
    accounts will come directly or indirectly from increased
    government borrowing from private markets, unless funded by a tax
    increase or spending reduction. To fund most individual account
    proposals, the government would need to raise resources either by
    borrowing in the market or-under a surplus scenario-by not
    retiring as much maturing debt as it otherwise would. For certain
    proposals, changes in borrowing may not arise because these
    proposals rely on a tax increase or benefit reduction so that
    current cash flow is not affected. If the source of funding for
    individual accounts is a carve-out from the current Social
    Security cash flow, this loss in cash flow would have to be made
    up from increased borrowing, a reduction in benefits, or some
    other program change. Alternatively, if the source of funding is
    general revenues, either additional borrowing from the public or
    less debt retired will be necessary depending on whether the
    overall budget is in deficit or surplus.1 Only if the government
    raises taxes or reduces spending, and uses those revenues to
    finance individual accounts, is there not likely to be any effect
    on borrowing because the remaining cash flow would not be
    affected. 1 The federal deficit (also called the "unified "
    deficit) is the difference between total federal spending and
    revenue in a given year. To cover this gap, the government borrows
    from the public by issuing securities, mostly through the Treasury
    Department. A surplus reduces the need for the federal government
    to borrow from the public. Page 21
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    2 Capital and Annuities Markets Able to Absorb Individual Account
    Investments The uses of the funding for individual accounts will
    depend on the options Funds Would Be Redirected available to
    investors and the choices they make within those options. To Into
    Private Capital Markets the extent that investors choose to invest
    in Treasury debt, there is that much less flowing into private
    capital markets, and any effects on those markets would be
    reduced. However, investors or their agents are likely to put at
    least some, if not most, of the funds into the private equity or
    debt market, and some proposals call for all of the funds to be
    invested in private markets. The size of this potential flow of
    funds into the private sector depends on whether individual
    account investments are mandatory or voluntary as well as the
    percentage of payroll that forms the basis for the program. The
    actual amounts allocated to private equity and debt will depend
    upon individual choice to the extent such choice is allowed, or on
    selected percentages if those are set by law. The initial annual
    dollar amount flowing into the capital markets as a result of
    individual account investments could be about $70 billion (2
    percent of payroll) in 1998 dollars. According to our analysis of
    Social Security Administration (SSA) data, the effective taxable
    payroll for all working individuals will steadily increase well
    into the future. As a result, the annual dollar amount from
    individual account investments is likely to increase. For
    instance, our analysis of SSA data indicates that in the year
    2020, the effective taxable payroll will be almost $11 trillion.
    On the basis of that dollar amount, if 2 percent is the designated
    percentage, the amount flowing into the private equity and debt
    markets from individual accounts would be about $220 billion in
    the year 2020. U.S. capital markets are the largest and most
    liquid in the world. The total Current Size of the
    market value of U.S. equities outstanding at the end of 1998 was
    about $15 Private Capital                     trillion.2  The
    total value of corporate bonds3 outstanding in the United States
    was about $4 trillion at the end of 1998. The amount of Treasury
    Markets                             debt outstanding was also
    about $4 trillion. As shown in table 2.1, the amounts outstanding
    for corporate equities and corporate bonds have been increasing.
    For instance, in 1997 there was about $13 trillion in equities
    outstanding, up from $10 trillion in 1996. The amounts outstanding
    for corporate bonds has increased from about $3 billion in 1996 to
    about $4 billion in 1998. 2 This amount also includes foreign
    issues traded in the United States. 3 The Flow of Funds data from
    the Federal Reserve only reports corporate and foreign bonds
    together. It is difficult, therefore, to separate the corporate
    bonds from the foreign bonds, and we did not attempt to do so. For
    the purposes of our discussion, we will refer only to corporate
    bonds. Page 22
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    2 Capital and Annuities Markets Able to Absorb Individual Account
    Investments Table 2.1: Amounts of Corporate            Market
    1996                                   1997
    1998 Equities, Corporate Bonds, and U.S.        Corporate equities
    $10,062                                $12,776
    $15,438 Treasuries Outstanding (Dollars in         Corporate
    bondsa                                                    3,128
    3,440                                  3,894 Billions)
    U.S. Treasuries
    3,755                                  3,778
    3,724 Source: Flow of Funds Accounts of the United States, Federal
    Reserve statistical release for the fourth quarter 1998, tables L.
    209, p. 87, L. 212, p. 89, and L. 213, p. 90. On the basis of the
    current size of the corporate equity and bond markets, the amount
    representing individual accounts is likely to be a small
    percentage of private capital markets, at least for a number of
    years. For instance, using a payroll percentage of 2 percent, if
    $70 billion were to come from individual accounts, it would
    represent less than 0.5 percent of the $15 trillion in equity
    outstanding in 1998 and less than 2 percent of the $4 trillion in
    corporate bonds outstanding in 1998. Various officials have
    expressed concern that over time, individual account investments
    would represent significant portions of the corporate equities and
    bond markets. It is likely that investments from individual
    accounts could eventually rival current holdings of other major
    sectors of the market and represent a sizeable portion of equity
    and corporate bond holdings. For instance, if 2 percent of payroll
    is placed in individual accounts annually, SSA estimates that
    stock holdings in individual accounts could grow to between $1
    trillion and $2 trillion in 1996 dollars over the next 15 years.
    The overall market will grow at about the market rate of return,
    although individual components may grow faster or slower depending
    on strategies and relative demands by mutual funds, pension plans,
    and other investors. Table 2.2: Annual Holdings of Corporate
    Sectors
    Corporate Equities                                     Corporate
    Bonds Equities and Bonds by Various Sectors      Year
    1996             1997              1998              1996
    1997              1998 of the Economy (Dollars in Billions)
    Mutual funds                                              $1,470
    $2,019            $2,523               $230             $274
    $339 Private pension plans
    1,491            1,864             2,232                228
    256               301 State & local governmentsa
    956           1,306             1,593                180
    200               245 Life insurance companies
    410               561              746               949
    1,026             1,086 aState and Local Governments refers to
    their retirement plans. Source: Flow of Funds Accounts of the
    United States, Federal Reserve statistical release for the fourth
    quarter 1998, tables L. 212, p. 89, and L. 213, p. 90. For
    instance, as shown in table 2.2, the total value of equity
    holdings of mutual funds was $2.5 trillion in 1998, and the total
    value of corporate and foreign bond holdings was about $339
    billion.4 The holdings of various 4 Flow of Fund Accounts of the
    United States, Federal Reserve statistical release for the fourth
    quarter of 1998, tables L. 213, p. .90, and L. 212, p. 89. Page 23
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    2 Capital and Annuities Markets Able to Absorb Individual Account
    Investments sectors, such as private pension plans, were about
    $2.2 trillion of equities and about $301 billion of corporate
    bonds in 1998.5 Thus, although individual account holdings are
    likely to increase over time, the holdings of many other sectors
    of the economy are also likely to rise, although certain
    individual sectors may not. In general, it is difficult to predict
    how rapidly the sum of these sectors holdings will grow,
    especially in the presence of individual accounts.6 Even if the
    annual flows from individual accounts into private capital Current
    Flows Into Private    markets were a small percentage of the total
    market value of outstanding Capital Markets               debt and
    equities, these amounts could still represent a substantial
    increase in the annual flows into those markets. The actual
    amounts will depend on the options available to individuals as
    well as the choices they make. If a large percentage of funds from
    individual accounts flowed into the equity markets, it could
    represent an increase of approximately 15 to 20 percent in the
    flow of funds into and out of the equity market, according to data
    from the Federal Reserve Flow of Funds.7 It is not clear that such
    an increase would have much effect on the pricing, or volatility,
    of the equity markets. However, the corporate bond market, which
    is smaller, could be affected, at least in the short term,
    depending on how much of the funds flow into the market and, to
    some extent, on the timing of those flows. Current Stock Market
    Flows    Most U.S. equities markets are very liquid-it is easy for
    investors to buy and sell equities without moving the price.8
    Various sectors of the economy, such as the household sector,
    mutual funds, private pension plans, and life insurance companies,
    purchase and sell equities every day. The equities market is a
    secondary market in which much of the transaction volume and value
    reflects movement of equities between purchasers and sellers. The
    annual net purchases can be positive or negative, reflecting the
    difference between the value of new equities issued and the value
    of equities repurchased; however, the amounts purchased 5 Flow of
    Fund Accounts of the United States, Federal Reserve statistical
    release for the fourth quarter of 1998, table L. 213, p. 90. 6 See
    later section of this chapter for a discussion of possible changes
    in household savings behavior in response to individual accounts.
    7 This percentage relates approximately $70 billion in individual
    account funds to the approximately $400 to $500 billion in net
    purchases and sales of equities over 1997 and 1998. 8 The equities
    markets are said to be "liquid" because the markets attract many
    buyers or sellers. In a liquid market selling or buying can be
    done with minimal effect on the prevailing competitive established
    price. The advantage of a liquid market for customers is immediacy
    or the ability to sell quickly when the customer needs to or buy
    quickly when there is a chance to make a profit. Page 24
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    2 Capital and Annuities Markets Able to Absorb Individual Account
    Investments and sold by specific sectors can be quite large. For
    instance, the annual net purchases of equities were minus $3
    billion in 1996, minus $79 billion in 1997, and minus $178 billion
    in 1998.9 As can be seen in table 2.3, the three largest
    purchasers bought in the range of $300 billion in securities each
    year from 1996 to 1998. In terms of sellers, the household sector
    sold almost $300 billion in 1996 and about a half of a trillion
    dollars in both 1997 and 1998. Table 2.3: Annual Net Purchases and
    Sector
    Corporate equities Sales of Corporate Equities by Different
    1996                      1997                       1998 Sectors
    (Dollars in Billions)               Largest net buyers Mutual
    funds
    $193                      $167                       $144
    Retirement plans of state and local govts.
    52                         54                        66 Life
    insurance companies
    42                         93                        92 Largest
    net sellers Household sector
    -282                      -514                       -500 Private
    pension plans
    -10                        -16                       -53 Source:
    Flow of Funds Accounts of the United States, Federal Reserve
    statistical release for the fourth quarter 1998, table L. 213, p.
    45. Annual flows within the equities market were in the hundreds
    of billions of dollars between 1996 and 1998. Over that period,
    mutual funds, life insurance companies, and state and local
    government retirement plans were the primary purchasers, and
    private pension plans and households were the major sellers of
    equities. Compared to these annual amounts, an additional tens of
    billions of dollars generated by individual accounts is not likely
    to cause major disruptions and could potentially be absorbed
    without significant price or volatility effects. There is a
    greater chance of some possible disruption, however, if all of the
    individual account funds were to flow in at once rather than
    regularly, but not too predictably, over the course of the year.
    For instance, $70 billion distributed evenly over the year would
    be unlikely to cause much disruption. However, concentrating that
    same flow into one quarter of the year could have some short-term
    effect on the market because it would represent a substantial
    increase in quarterly flows. As a result, to minimize the
    likelihood of disruption, it would make sense, to the extent
    practicable, to smooth out the inflows so that they do not all
    come into the market within a short time period. If the inflows
    are lumpy and predictable, the market may be able to anticipate
    the inflows and adjust prices somewhat, which could mean that
    individual account purchases would pay slightly higher prices than
    they otherwise would. 9 Flow of Funds Accounts of the United
    States, Federal Reserve statistical release for the fourth quarter
    of 1998, table F. 213, p. 45. Page 25
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    2 Capital and Annuities Markets Able to Absorb Individual Account
    Investments Corporate Debt Flows                       The
    corporate debt markets are not as transparent as the corporate
    equities markets; for example, there are no central listings for
    the prices of the bonds or the volume of corporate bonds sold.
    They also do not have as much depth as the equities markets-there
    are fewer buyers and sellers in the corporate bond markets. Many
    corporate bond transactions are done through private placements;
    i.e., they are not offered to the corporate debt market as a
    whole. The result is a market with less liquidity reflected in a
    greater spread between the bid price (what you will pay for the
    bond) and the ask price (the price at which you would sell the
    bond). As stated previously, the value of outstanding corporate
    debt is substantially less than the market value of corporate
    equities. On an annual flow basis, corporate debt issues have been
    running in the hundreds of billions of dollars over the last
    decade. However, some proportion of that is short term (less than
    1 year in maturity) so that the total is not easily comparable to
    the annual amounts of equities purchased and sold. As shown in
    table 2.4, the annual net purchases of corporate bonds by various
    sectors ranged from as low as $17 billion for state and local
    government retirement plans of in 1996 to as high as $79 billion
    for life insurance companies in 1996. On the basis of annual
    flows, it is difficult to say what the effect on the bond market
    is likely to be. Table 2.4: Annual Purchases and Sales      Sector
    Corporate bonds of Corporate Bonds Equities by
    1996             1997                 1998 Different Sectors
    (Dollars in Billions)    Large Buyers Mutual funds
    $34              $44                  $65 Retirement plans of
    state and local govts.                      17               19
    45 Private pension plans
    21               28                  45 Life insurance companies
    79               77                  60 Source: Flow of Funds
    Accounts of the United States, Federal Reserve statistical release
    for the fourth quarter 1998, table F. 212, p. 44. However, if we
    compare the corporate bond and equity markets, we can draw some
    tentative conclusions about the likelihood of individual accounts
    having a disruptive effect on either market. The corporate bond
    market is relatively smaller and less liquid than the equity
    market. As a result, an inflow into the bond market is more likely
    to affect the market price and the volatility of the market,
    compared to an equivalent inflow into the equity market,
    especially if it is concentrated in a short period of time. Any
    disruption is still likely to be short term in nature and can be
    mitigated if the inflow is spread over time, so that other market
    participants are less able to predict the inflows and raise prices
    in anticipation of the inflow. Page 26
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    2 Capital and Annuities Markets Able to Absorb Individual Account
    Investments Treasury Debt                Although there are
    various types of Treasury debt, the overall market for U.S.
    Treasuries is far more liquid and transparent than the corporate
    bond market. A large secondary market-in which Treasury securities
    are bought and sold subsequent to original issuance-exists for
    Treasuries and helps to make it one of the most liquid markets in
    the world. Annual net purchases of Treasuries were $23 billion in
    1997 and minus $55 billion in 1998.10 The effect on the Treasury
    debt market from a movement to individual accounts will depend not
    only on the choices available to individuals but also on the
    extent to which the government borrows from the private capital
    markets to fund individual accounts. As stated previously, to fund
    any individual account proposal that does not increase Social
    Security contributions, the government would need to raise
    resources either by borrowing in the market or by not retiring as
    much maturing debt as it otherwise would. The Treasuries market,
    therefore, could be affected in two ways: (1) by how much the
    government borrows to fund individual accounts, and (2) by how
    much individuals choose to invest in Treasuries. However, the
    depth and liquidity of the Treasury debt market is such that the
    market is unlikely to be significantly disrupted even by a large
    flow of funds resulting from individual accounts. Annuities
    protect against the possibility of outliving one's financial
    Affect of Individual         resources by guaranteeing a stream of
    income for the remainder of one's Accounts on the Annuities
    life, regardless of how long that may be. Annuities basically
    convert Markets                      savings into income and may
    be sold individually or as a group product. In a group annuity a
    pension plan provides annuities at retirement to a group of people
    under a master contract. It usually is issued by an insurance
    company to an employer plan for the benefit of employees. The
    individual members of the group hold certificates as evidence of
    their annuities. Depending on the structure of individual
    accounts, individuals may be required to purchase individual
    annuities or, similar to pension and other retirement plans, fall
    under a group annuity.11 One measure of the size of the annuities
    market is the level of the insurance industry's policy reserves-
    the sum of all insurers' obligations to their customers arising
    from annuity contracts outstanding. Each company is required by
    state insurance regulators to maintain its policy reserves at a 10
    Flow of Funds of the United States, Federal Reserve statistical
    release for the fourth quarter of 1998, table F. .209, p. 42. 11
    Some approaches call for having the government be responsible for
    small annuities.  Other approaches call for individual account
    accumu.lations to feed into Social Security benefits. Page 27
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    2 Capital and Annuities Markets Able to Absorb Individual Account
    Investments level that will ensure payment of all policy
    obligations as they fall due. As shown in table 2.5, policy
    reserves for individual annuities were about $693 billion and for
    group annuities about $762 billion. Table 2.5: Policy Reserves
    Held for
    1995                                   1996
    1997 Individual and Group Annuities (Dollars    Annuities in
    Billions)                                Individual
    $594                                   $622
    $693 Group
    619                                    690
    762 Source: Life Insurance Fact Book, American Council of Life
    Insurance, 1998, table 7.5, p.119. Insurance industry officials
    told us that the annuities industry is likely to be able to absorb
    the flows from either mandatory or voluntary annuitization. Once
    again, we are talking about a movement of financial resources from
    one form to another rather than a new source of funds. The funds
    will be moved out of whatever investment instruments (assets)
    workers were using for accumulation purposes into a potentially
    different combination of assets held by companies supplying
    annuities.12 Insurance industry officials believe that, generally,
    annuities resulting from the liquidation of the individual
    accounts would be phased in gradually and over a number of
    decades. In the early years, few if any retirees would have built
    up substantial individual account balances. As time passes, both
    the number of retirees with individual account balances and the
    average size of those balances would gradually increase, allowing
    the industry and the market time to adjust without difficulty. One
    issue raised by insurance industry officials was that an
    individual account proposal that made annuity purchases mandatory
    at retirement could result in the demand for a significant number
    of very small annuities. For instance, at least initially, there
    would be many small accounts below $2,000. Currently, annuity
    purchases average about $100,000. Although the industry could
    absorb a significant number of small accounts, industry officials
    said that providing annuities that small could be uneconomical for
    the industry because the cost of issuing a monthly check, and
    other administrative costs, would be prohibitive.13 12 Annuities
    have traditionally been supplied by life insurance companies and
    financed primarily by investments in corporate debt and real
    estate, although there is also likely to be some investment in
    corporate equities and Treasury debt. 13 In a forthcoming report,
    we will provide a more detailed discussion of the factors that
    affect the costs associated with purchasing an annuity and how
    this cost may factor into a system of individual accounts. Page 28
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    2 Capital and Annuities Markets Able to Absorb Individual Account
    Investments Although the financial effects of individual accounts
    are an important Effect of Individual            consideration, a
    related but somewhat separate issue is the potential for Accounts
    on National            individual accounts to increase or decrease
    national saving. 14 Along with borrowing from abroad, national
    savings provides the resources for private Savings Depends on
    investment in plant and equipment. The primary way in which a
    movement Financing, Structure,           to individual accounts
    could change the overall capacity of the economy to and Behavioral
    Effects produce goods and services would be if individual accounts
    were to lead to a change in the overall level of national saving.
    The extent to which individual accounts affect national saving
    depends on how they are financed (existing payroll tax, general
    revenues)-the effect on government saving; how private savings-the
    savings of households and businesses-respond to an individual
    account system; the structure of the individual account system
    (mandatory or voluntary); and the limitation or prohibition of the
    pre-retirement distribution or loans to make sure retirement
    income is preserved. One important determinant of the effect of
    individual accounts on national Savings Affected by
    savings is the funding source. There are several possible funding
    sources, Funding Source                  although most involve a
    movement of funds from or through the federal government and each
    has its own effects on the federal government's portion of
    national saving. For some funding sources these savings effects
    are clearer than others. As previously stated, the funds can come
    from (1) within the current Social Security system, i.e., the
    surplus or current cash flows; (2) a change in the system
    resulting from increased payroll taxes or reduced benefits;15 or
    (3) outside the system using a general fund surplus or general
    revenues. Using either the Social Security surplus or more
    generally the current Social Security cash flow is likely to
    reduce government saving. If part of the cash flow is diverted to
    individual accounts but there is no change in the benefits paid or
    the taxes collected, the lost cash flow will either result in a
    smaller addition to the surplus or be replaced by borrowing. In
    either case the result is a reduction in the measured government
    surplus-the sum of the Social Security surplus and the general
    fund surplus-or an increase in the deficit. From the government's
    perspective, its saving has gone down to provide the resources for
    increased personal savings 14 National saving includes the saving
    of individuals, households, and businesses, called private saving;
    and the net saving of all levels of government. 15 There are also
    proposals which allow individuals to voluntarily contribute to
    individual accounts from their own resources. Page 29
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    2 Capital and Annuities Markets Able to Absorb Individual Account
    Investments through individual accounts.16 This is a case of a
    carve-out from Social Security. If the resources for individual
    accounts are financed by additional Social Security taxes or
    reduced benefits instead, there will be no direct effect on
    government savings. The increased outlays for individual accounts
    will be offset by higher government revenues or lower government
    benefit payments. In the absence of other changes in Social
    Security cash flows, government savings remain constant, and any
    increase in private saving would be an increase in national
    saving. This is a case of an add-on to both Social Security and to
    the overall government budget. The most complicated case involves
    the use of funds that are outside of the Social Security system
    but part of the overall government budget. There are proposals to
    use the overall budget surplus or general government revenues as a
    source of funds for individual accounts. Although on its face this
    appears to reduce government savings by the amount diverted, the
    actual effect on government savings depends on what would have
    been done with the surplus or revenue if it had not been used to
    finance individual accounts. For example, if the resources would
    have been used to finance additional government spending, and the
    diversion of the funds to individual accounts means that such
    spending is not undertaken, government saving would not be reduced
    by individual accounts. In this case, any increase in private
    saving would be an increase in national saving.  Similarly, if the
    resources would have been used to finance a tax cut, then
    diverting funds to individual accounts does not directly reduce
    government savings if the tax cut is not undertaken. In the case
    of a tax cut, national saving will go up if individual accounts
    generate more private saving than the tax cut. If the funds would
    have been used to pay down debt, the direct effect of diverting
    those resources to individual accounts would be to reduce
    government saving. The full effect on national saving depends on
    the extent to which individuals adjust their own savings behavior.
    If they do not adjust, national saving is on balance unaffected.
    To the extent individuals or businesses reduce their saving,
    national saving will fall. 16 Because national savings is the sum
    of government and private saving, the effect of a carve-out
    depends on whether private savings goes up by more or less than
    government savings goes down. Page 30
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    2 Capital and Annuities Markets Able to Absorb Individual Account
    Investments The effects of various individual account proposals on
    national saving Behavioral Effects Are            depend not only
    on how the proposals affect government savings but also Difficult
    to Predict              on how private savings behavior will
    respond to such an approach. Regardless of the financing source,
    the effect of individual accounts will be to raise, at least to
    some extent, the level of personal or household saving unless
    households fully anticipate and offset through a reduction in
    their own saving. For example, a carve-out from the existing
    Social Security cash flow would provide funding for individual
    accounts for everyone (under a mandatory approach) or for those
    who wished to participate (under a voluntary approach). Such a
    carve-out is likely to reduce government saving and raise private
    saving by an equivalent amount in the absence of any behavioral
    effects. If households are forgoing current consumption by saving
    for their retirement, then, in response to this potential increase
    in future retirement benefits, they may reduce, to a greater or
    lesser extent and in various ways, their own savings, including
    retirement saving. To the extent that household responses lead to
    reduced personal saving, national savings as a whole would fall
    under a carve-out. In general, the result would be similar under
    any proposal that reduced government saving to fund private saving
    through individual accounts. This includes proposals that use
    general revenues that would have been saved by the government;
    i.e., used to reduce the deficit or retire debt outstanding. The
    overall level of consumption in the economy is not likely to
    change as a result of the movement of funds. Any significant
    change in the level of consumption resulting from such proposals
    would result from some households reducing their retirement
    savings to fund consumption because they now had individual
    accounts. The extent of these behavioral effects will depend on
    the structure of the Behavioral Change Depends program and any
    limitations that are placed on the use of funds in on Preferences
    and                individual accounts, such as restrictions on
    preretirement withdrawals. If Opportunities
    such a program is mandatory rather than voluntary, it is more
    likely to affect those households who currently either do not save
    or do not save as much as the amounts in their individual
    accounts. A mandatory program would increase savings for those who
    do not usually save, who are usually low-income people. Household
    behavior in response to individual accounts will depend on the
    extent that the household is currently saving for retirement and
    how the set of options available to households is changed by the
    presence of individual accounts. One group of households, those
    that are currently saving as much as they choose for retirement,
    given their income and wealth, would probably reduce their own
    saving in the presence of Page 31                      GAO/GGD-99-
    115 Issues Associated With Individual Accounts Chapter 2 Capital
    and Annuities Markets Able to Absorb Individual Account
    Investments individual accounts. For those households for whom
    individual accounts closely resemble 401(k)s and IRAs, a shift to
    individual accounts might lead them to decrease their use of these
    accounts.17 They would have additional retirement income
    possibilities available and might choose to reduce their
    retirement or other saving to use for consumption in the present
    rather than in the future. However, unless they were target
    savers, i.e., savers who were trying to reach a specific
    retirement income goal, they might not reduce their other savings
    dollar for dollar with individual accounts.18 Therefore, we might
    expect some reduced saving by a significant number of households;
    for certain households, we might expect a substantial reduction.
    Under a voluntary approach, the households that are most likely to
    participate are those households that are currently saving but
    that face some constraint in terms of the type of retirement
    saving they can do or the amount of tax-preferred saving they are
    allowed. For example, someone whose employer offered only a
    defined benefit retirement plan or a defined contribution plan
    with very limited options might find that voluntary individual
    accounts offered a new opportunity. In addition, someone who was
    already contributing as much as he or she was legally allowed to
    tax-deferred savings would find a voluntary program attractive if
    it allowed an additional amount of tax-deferred saving. These and
    others who take advantage of a voluntary program may be more
    likely to reduce other forms of saving in response. Households
    that are currently not saving, either because they are resource
    constrained or because they are not forward-looking, would be
    forced to save some amount by a mandatory individual account
    system. Households in such situations may welcome the additional
    resources, especially if they do not come from a direct reduction
    in their own consumption. However, such households may also try to
    transform some of the additional resources into consumption if
    they are able to borrow from the accounts or otherwise tap into
    the accounts before retirement. To maintain retirement income
    adequacy and to keep savings from being dissipated, it 17 See
    National Academy of Social Insurance, Report of the Panel on
    Privatization of Social Security, 1998 pp. 2-4. 18 See Eric M.
    Engen and William G. Gale, "Effects of Social Security Reform on
    Private and National Savings" Social Security Reform, Links to
    Saving, Investment, and Growth, Conference Series No. 41, June
    1997, pp. 103-142. Page 32
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    2 Capital and Annuities Markets Able to Absorb Individual Account
    Investments may be necessary to prohibit or restrict borrowing or
    other methods of drawing down individual accounts prior to
    retirement. 19 Even with such restrictions, it may not be possible
    to completely eliminate all options that households could use to
    indirectly increase consumption from individual accounts. For
    example, households with little or no retirement saving or other
    financial wealth could have wealth in some other form, such as
    home equity. It is conceivable that such households could borrow
    against that home equity as a way of turning their increased
    future consumption into present consumption. In addition to the
    effects of individual accounts on household savings there are also
    other potential indirect effects on private saving. For example,
    the incentives for employers to provide retirement benefits,
    either through defined benefit or defined contribution plans,
    could be affected by individual accounts. In addition, if less
    compensated workers in a defined contribution plan reduce their
    contributions to the plan, higher compensated workers may be
    required to reduce their own contributions under the
    antidiscrimination rules. Offsetting these tendencies to reduce
    saving, however, there are some economists who believe that
    individual accounts might encourage certain individuals to save
    more for retirement and thus not reduce their current savings.20
    Such an effect is more likely to be present if there is some form
    of matching by the government as part of the individual account
    proposal. Others believe that to the extent that a lack of saving
    is based on people not taking a long enough view, the presence of
    individual accounts and watching them accumulate could give people
    a better sense of how saving small amounts can add up over time.
    This, plus observing how compounding21 works, could induce some to
    save who otherwise would not. National saving is more likely to be
    increased by some approaches to individual accounts than by
    others. Using sources of government funding that would more likely
    have resulted in spending rather than saving 19 While borrowing
    could potentially allow individuals to reduce retirement income,
    the option to borrow can also be an attractive feature under a
    voluntary program.  For discussion of the trade-off see 401(k)
    Pension Plans:  Loan Provisions Enhance Participation But May
    Affect Income Security (GAO/HEHS-98-5, October 1, 1998). 20 Based
    on James M. Poterba, Steven F. Venti, and David A. Wise, "How
    Retirement Saving Programs Increase Savings," Journal of Economic
    Perspectives, Volume 10, Number 4, Fall 1996, pp. 91-112. 21
    Interest accrued on a daily, quarterly, semiannual, or annual
    basis. Page 33
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    2 Capital and Annuities Markets Able to Absorb Individual Account
    Investments decreases the likelihood that government saving would
    be reduced. Proposals that are mandatory are more likely to
    increase private saving because a mandatory program would require
    that all individuals, including those who do not currently save,
    place some amount in an individual account. Certain prohibitions
    or restrictions on borrowing or other forms of preretirement
    distributions would also limit the ability of some households to
    reduce their savings in response to individual accounts. SSA
    commented that we needed to discuss the savings implications of
    the Agency Comments    President's proposal.  This report was not
    intended to comment on specific reform proposals. Page 34
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    3 Return and Risks Are Likely to be Higher With Individual
    Accounts There is a risk/return trade-off for individuals under an
    individual account program; instituting such a program would
    likely raise both the risks and the returns available to
    participants compared to the current system.  In order to receive
    higher returns, individuals would have to invest in higher risk
    investments.  The return that individuals receive would depend on
    both their investment choices and the performance of the market.
    Individuals who earn the same wages and salaries and make the same
    contributions to Social Security could have different retirement
    incomes because of the composition of their portfolios and market
    fluctuations.  As with any investment program, diversification and
    asset allocation could reduce the risks while still allowing an
    individual to earn potentially higher returns. Most advocates of
    individual accounts state that the expected return on investments
    under an individual account program would be much higher for
    individuals than the return under the current Social Security
    program. Proponents of individual accounts usually point out that
    equities have historically substantially yielded higher returns
    than U.S. Treasuries, and they expect this trend to continue.
    Others are skeptical about the claims for a continuation of such a
    high expected return on equities.  They state that history may not
    be a good predictor of the future and that the expected premium
    generated by investing in equities has steadily been declining.
    Furthermore, they state that even if expected equity returns are
    higher than other investments, equity returns are risky.  Thus, in
    order to determine what returns individuals might expect to
    receive on their individual account investments, the riskiness of
    the investment should be taken into account. Adjusting returns to
    include risks is important, but there are many ways to do this,
    and no clearly best way. Lastly, comparing the implicit rate of
    return that individuals receive on their Social Security
    contributions to expected rates of return on market investments
    may not be an appropriate comparison for measuring whether
    individuals will fare better under an individual account system.
    Such comparisons do not include all the costs implied by a program
    of individual accounts.  In particular, the returns individuals
    would effectively enjoy under individual accounts would depend on
    how the costs of the current system are paid off.  Rates of return
    would also depend on how administrative and annuity costs affect
    actual retirement incomes.1 1 In a forthcoming report, we will
    provide a more detailed discussion on issues comparing Social
    Security rates of return with those of market investments. Page 35
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    3 Return and Risks Are Likely to Be Higher With Individual
    Accounts An individual account program would offer individuals the
    opportunity to Instituting an           earn market returns that
    are higher than the implicit returns to payroll Individual Account
    under the current Social Security program.  However, investing in
    private sector assets through individual accounts involves a clear
    trade-off-- Program Means            greater return but more risk
    or more variability in future rates of return. Greater Risk to
    Under the current Social Security program, risks are borne
    collectively by Individuals for          the government.   Moving
    to an individual account program would mean Potentially Greater
    that individuals reap the rewards of their own investments, but
    they also Return                   incur risk-not only about
    future returns, but also the possibility of losing money and even
    having inadequate income for retirement.  However, holding assets
    for the  long term, diversification, and the proper asset
    allocation can mitigate certain risks and improve an individual's
    risk/return trade-off. A trade-off exists between risk and return
    in investments.  If an individual Risk/Return Trade-Off    is
    willing to consider the possibility of taking on some risk, there
    is the potential reward of higher expected returns.  The capital
    markets offer a wide variety of investment opportunities with
    widely varying rates of return, which reflect variations in the
    riskiness of those investments.  For instance, Treasury Bills are
    considered to be relatively risk free because they have almost no
    default risk and very little price risk.2  Alternatively, equities
    are considered to be relatively risky because the rate of return
    is uncertain. Because debt holders are paid out of company income
    before stockholders, equity returns are more variable than bonds.
    Overall, annual returns on equities are more volatile than returns
    on corporate bonds or Treasuries.  On a long-term average basis,
    the market compensates for this greater risk by offering higher
    average returns on equities than on less risky investments.  Thus,
    among the three types of investments, corporate equities are the
    riskiest investments but pay the highest returns, followed by
    corporate debt and then Treasuries.  However, holding riskier
    investments such as equities over long periods of time can
    substantially diminish the risk of such investments. The degree of
    risk and the size of potentially higher returns with individual
    accounts depend on the equities chosen as well as the performance
    of the market.  A stock's value is tied to the expected
    performance of the issuing company.  If the company does well,
    investing in individual equities could be very lucrative for
    investors.  However, if the company does poorly, 2 Treasury
    securities are subject to interest rate risk.  Treasury bonds and
    notes are subject to more interest rate risk than Treasury bills,
    which are basically considered to be risk-free assets. Page 36
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    3 Return and Risks Are Likely to Be Higher With Individual
    Accounts investing in individual equities could result in low
    returns or losses to the investor.  Many financial analysts go
    through intensive research to try and pick the best stocks.
    Choosing the right stock, however, can be mostly a matter of a
    "random walk."3 Individuals may mitigate the risk of holding
    equities and bonds by Diversification Improves    diversifying
    their portfolios and allocating their investments to adjust their
    Risk/Return Trade-Off       risk exposure and to reflect their own
    risk tolerance and circumstances. Ultimately, the composition of
    an individual portfolio, along with the performance of the market,
    determines the return individuals receive and the risk they bear.
    In constructing a portfolio investors combine equities and bonds
    and other "securities" in such a way as to meet their preferences
    and needs, especially their tolerance for risk.   Individuals
    manage their portfolios by monitoring the performance of the
    portfolios and evaluating them compared to their preferences and
    needs.  Many people have been managing portfolios for years.
    There are, however, many others who either do not have portfolios
    or do not consider what they have as a portfolio.  With individual
    accounts, all individuals would eventually have to manage their
    portfolios as they start to own various investments, especially if
    they have options over individual securities or types of
    securities. A well-diversified portfolio could help to diminish
    risk without lowering the return, thereby improving the
    risk/return trade-off.  For instance, a properly selected
    combination of risky assets can have a lower risk than any of its
    individual assets because the risk is spread out among different
    assets allowing for gains in some assets to offset losses in
    others.   Such portfolios could provide higher average returns
    over the long term than a single asset with equal risk.
    Furthermore, diversifying an equity portfolio across companies and
    industries reduces both default and concentration risk4 and
    reduces the likelihood that a portfolio's return will vary widely
    from the expected market return. In order to quantify the
    diversification of a portfolio, concepts like correlation and
    covariance are used to measure how much the returns on 3 That is,
    choosing the right stock is a random and unpredictable process. 4
    Depending on the composition of an individual's stock portfolio,
    an individual could be exposed to "concentration risk," or the
    potential loss resulting from a heavy investment in a group of
    related companies or an industry susceptible to the same economic
    dynamics.  Individuals could also face "default risk," or the
    exposure to loss due to an individual company failing. Page 37
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    3 Return and Risks Are Likely to Be Higher With Individual
    Accounts assets move in tandem with one another.  For instance, if
    annual returns on different investments are not very correlated,
    their risks can offset each other even though they still
    individually earn higher average returns.   Such techniques,
    however, are very sophisticated, require substantial data
    analysis, and would require the help of professional advisors for
    the average investor.  However, there are ways for individuals to
    take advantage of many of the benefits of diversification without
    needing to calculate correlation and covariance measures.
    Indexing is one way to broadly diversify an equity portfolio and
    to match the approximate market return.5  Typically, investing in
    broad-based stock indexes such as the Standard & Poor's 500 index-
    which represents about two-thirds of the value of the U.S. stock
    market-diversifies an individual's portfolio by reducing the
    likelihood of concentrating investments in specific companies.
    Such investments also tend to reduce turnover and lower
    administrative costs because they do not involve as much research
    or expensive investment advice. A diversified stock portfolio,
    however, does not protect against the risk of a general stock
    market downturn.  One way to mitigate U.S. stock market risk is to
    diversify into international markets.  An investor can also shield
    against general stock market risk by diversifying into other types
    of assets, such as corporate bonds.  To minimize exposure to
    short-term stock market fluctuations, an investor can hold less
    risky, albeit lower yielding, assets to cover liquidity needs in
    the short run. Asset allocation can provide an approach to
    portfolio diversification.  For example, percentages can be
    allocated to equities (including indexes), bonds, and Treasuries.
    These allocations will generally reflect preferences for risk as
    well as an individual's life-cycle phase.  Those with a higher
    tolerance for risk and those who are younger would generally
    invest more in equities.  Those in later life-cycle phases might
    invest more in bonds or Treasuries. The primary risk that
    individuals would face with diversified or indexed Individuals
    Bear Most of the individual account investments is "market risk,"
    the possibility of financial Risk
    loss caused by adverse market movements.  When the stock market
    drops, prices of some equities fall and can stay depressed for a
    prolonged period of time.  Although a long investment time horizon
    provides the individual 5 Indexing reduces risk or exposure to
    loss associated with an individual company failing and industry-
    specific downturns.  The securities held in a broadly based
    indexed portfolio would represent many different sectors of the
    economy and many individual companies.  This diversification
    reduces the risk that any loss related to the performance of an
    individual security or group of securities would greatly affect
    the overall performance of the portfolio. Page 38
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    3 Return and Risks Are Likely to Be Higher With Individual
    Accounts more time to recover from short-term fluctuations, an
    individual also would have more time to encounter a prolonged
    stock market downturn. Thus, although long periods of time can
    help mitigate the effects of market risk, it does not disappear
    over time. Under most individual account programs, individuals
    would bear much if not all of the market risk.6  Although market
    risk would not increase with the introduction of an individual
    account program, more people would be exposed to it under an
    individual account program than are under the current Social
    Security system.  Some individuals would do very well under such
    an individual account program, but others may not do as well and
    could experience a significant drop in their expected retirement
    income compared to others in the same age group or to the current
    Social Security program.  Furthermore, those who are reluctant to
    invest in the stock market may not benefit from the potentially
    higher returns of equity investing.  Thus, the investment choices
    individuals make, as well as the performance of the market, would
    determine the return they would receive under an individual
    account program. Individual Returns May Vary    Individuals who
    retire at the same time may receive different pay-outs Under an
    Individual Account    from individual account investments because
    of the choices they have Program                        made.
    Although some individuals could make the same choices, individuals
    are more likely to make different choices.   In part, differences
    may come about due to luck; other differences may be more
    systematic. For instance, higher income people may be willing to
    take on more risk- and possibly earn higher returns-than lower
    income people.  For this reason, higher income individuals could
    earn higher rates of return than lower income individuals under an
    individual account program, which is not the case under the
    current Social Security program. Many programs also provide for a
    default option for those who do not wish to take an active part in
    investing in individual accounts.  One type of default option
    would provide investments in Treasuries with very low risk and a
    low return.  Others could provide an asset allocation, possibly
    age related, with more equities included for younger workers and
    more Treasuries for older workers. Returns could vary across
    cohorts7 as well under an individual account program.  Even if
    some cohorts made the same choices, given the volatility 6 There
    are some proposals that protect the individual against some or all
    of the downside risk. 7 Cohorts pertain to a large group of people
    with similar characteristics.  For example, people of the same age
    would be in the same age cohort. Page 39
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    3 Return and Risks Are Likely to Be Higher With Individual
    Accounts of the stock market, the returns could vary substantially
    across different time periods and affect cohorts differently.  For
    instance, even if the market experienced no dramatic or long-
    lasting downturns, the market will create "winners" and "losers"
    depending on when and how individuals invest their individual
    account investments and when they liquidate their holdings. As
    long as workers are aware of and accept the idea that returns may
    vary across individuals as well as cohorts, there will probably
    not be calls to fix the "unfair benefits outcomes."  However, if
    large differences in outcomes become commonplace, many
    participants could become dissatisfied with the program and demand
    some payment from the government to make up for any losses they
    incur or even if substantial differences result.   For instance,
    those that have incurred losses may expect the government to
    mitigate their losses when they do not receive the return they
    believe they were led to expect. Furthermore, individual accounts
    are at least in part an attempt to finance the unfunded liability
    with the excess returns of equities over nonmarketable Treasuries.
    To the extent that individuals receive low or even negative
    returns over time, individual account investments could actually
    lead to an increase in the unfunded liability of the current
    Social Security program. The expected return from investments of
    individual accounts is likely to be The Expected Market
    higher than the average implicit rate of return of the current
    system, but it Return for Individual    is unlikely to be as high
    as many advocates presume.  Advocates and opponents of individual
    accounts have estimated what the likely market Account Investments
    return would be for an individual's investments under an
    individual account program.   When discussing equity returns,
    advocates often point to the fact that equities have historically
    yielded higher returns than Treasuries.  They expect returns on
    equities to continue to be higher than Treasuries and to boost
    individual returns on individual account investments. Other
    economists are skeptical that the higher returns presumed under an
    individual account program will be realized.  They state that
    history may not be a good predictor of the future.  Others state
    that even if expected equity returns are higher than other
    investments, equity returns are risky. For instance, the average
    historical return reveals nothing about how variable that return
    has been from year to year.  Thus, in an estimation of an expected
    return to investments of individual accounts, the riskiness of the
    investment should be taken into account.  Estimating expected
    returns Page 40                       GAO/GGD-99-115 Issues
    Associated With Individual Accounts Chapter 3 Return and Risks Are
    Likely to Be Higher With Individual Accounts without mention of
    the risk and costs of the investments will overstate the benefits
    of investing in marketable securities because the return on
    marketable securities varies substantially with the riskiness of
    those investments.8 Advocates of individual accounts have stated
    that individuals would Future Returns to Equities    receive
    higher returns by investing in the stock market than they receive
    Uncertain                     under the current Social Security
    program. Although,comparing investment returns with the rate of
    return paid by Social Security is always problematic, advocates of
    individual accounts point out that the rate of return on equities
    has been significantly higher than other rates of returns. For
    instance, compounded annual average rates of return on equities
    have averaged about 7 percent per year since 1900 and 6 percent
    per year since 1957.  Alternatively, the compounded annual average
    return on Treasuries has been between 1 and 2 percent per year on
    an inflation-adjusted basis, and long-term corporate bonds have
    averaged 2 percent. The capital markets generally offer higher
    potential rates of return on riskier investments such as equities.
    Figure 3.1 shows the annual returns of Standard & Poor's (S&P) 500
    Index, which is a measure of the performance of the stocks of 500
    large companies traded on the U.S. stock exchange. Actual nominal
    (non-inflation-adjusted) returns for large company stocks varied
    widely from the annualized average return over long periods and
    have ranged from a low of  minus 26.5 percent in 1974 to a high of
    52.6 percent in 1954. 8 For detailed information on how
    administrative costs can have a direct effect on how much savings
    are accumulated in individual accounts over time see Social
    Security Reform:  Administrative Costs for Individual Accounts Are
    Hard to Predict (GAO/HEHS-99-131, June 18, 1999). Page 41
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    3 Return and Risks Are Likely to Be Higher With Individual
    Accounts Figure 3.1: Returns of the Standard and Poors 500 Index
    Source:  Haver Analytics. As can be seen in figure 3.1, returns
    are variable.  An average return over a long period of time can
    obscure the reality that equity returns fluctuate substantially
    from year to year.  There have also been years in which equities
    have yielded negative returns.  For instance, over the past 70
    years or so, equity returns were negative in nearly 1 out of every
    4 years. Even taking into account the variability of returns, some
    analysts have suggested that historic U.S. returns may overstate
    future returns.  They state that the equity markets in the United
    States have tended to outperform the equity markets in other
    countries.  Thus, when relying on historical data as the basis for
    estimates of long-term market growth, if one looks not just at
    U.S. data, but also at the historical returns of other countries,
    then the high historical returns to equities in the United States
    could be an exception rather than the rule.9   Historical returns
    are the only empirical basis with which to judge equity returns,
    but there is no guarantee that the future will mirror the averages
    of the past in the United States as opposed to some subperiod of
    the U.S. market or, alternatively, returns to foreign stock
    markets.10 9 See Philippe Jorion and William N. Goetzmann,  A
    Century of Global Stock Markets, National Bureau of Economic
    Research Working Paper 5901, July 1997. 10 See John E. Golob and
    David G. Bishop, "What Long-Run Returns Can Investors Expect from
    the Stock Market?"  Federal Reserve Bank of Kansas City Economic
    Review, vol. 82, No. 3 (Third Quarter 1997), pp. 5-20;and John H.
    Cochrane, "Where is the Market Going? Uncertain Facts and Novel
    Theories," Economic Perspectives, Vol. XXI, Issue 6
    (November/December 1997), pp.3-37. Page 42
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    3 Return and Risks Are Likely to Be Higher With Individual
    Accounts Equity Premium Diminishing    In general, investors, tend
    to be averse to risk and demand a reward for engaging in risky
    investments.  The reward is usually in the form of a risk premium-
    an expected rate of return higher than that available on
    alternative risk-free investments.  For instance, the historical
    advantage enjoyed by equity returns over the returns of other
    assets is what is known as the equity premium.  The premium is
    said to exist because equities have historically earned higher
    rates of return than those of Treasuries to compensate for the
    additional risk associated with investing in equities. However,
    the equity premium has slowly been declining.  Studies have shown
    that the equity premium has declined since the 1950s. A number of
    studies have attempted to measure the equity premium as well as
    explain its size.  One study11 found that the premium appeared to
    be quite high in the 1930s and 1940s and was caused by the
    perception of the high volatility in the stock market in the late
    1920s and the early 1930s. This led investors to favor less risky
    securities as opposed to equities, generating a high equity
    premium.   However, as the volatility of stock market declined
    after the 1929 stock market crash, the appeal of investing in
    equities began to increase; and although an equity premium
    continues to exist, it has steadily declined.  However, in the
    1970s the equity premium increased somewhat from its general
    downward trend; this was attributed to inflation.12  The study
    concluded that decreases in the equity premium were the result of
    increases in expected bond rates and decreases in the expected
    rates of returns to equities. It has also been suggested that the
    shrinking premium reflects a structural change in that the economy
    appears less susceptible to recessions.13  To the extent that
    corporate profits fluctuate with general economic conditions,
    fewer downturns translate into less volatility in corporate
    earnings.  If investors perceive that the outlook for corporate
    earnings is more certain and that equities may be less risky than
    they have been 11 See Oliver J. Blanchard, "Movements in the
    Equity Premium," Brookings Papers On Economic Activity, 2:1993,
    pp. 75-118. 12 The study noted that inflation causes higher
    dividend yields, which in turn increases the return to stocks.
    Alternatively, inflation leads to a decrease in real bond rates,
    for a few years only.  This means that the relationship between
    inflation and the equity premium is strong in the short run
    because inflation affects real bond rates, but it is not so strong
    in the long run because the effect of inflation on bond rates is
    not as lasting. 13 Goldman Sachs, "The Equity Risk Premium and the
    Brave New Business Cycle," U.S. Economics Analyst, No. 97/8,
    February 21, 1997. Page 43
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    3 Return and Risks Are Likely to Be Higher With Individual
    Accounts historically, equity investing might carry a lower
    premium and, therefore, relatively lower returns.  As a result,
    the equity premium diminishes. It is unclear whether the equity
    premium will continue to decline. However, if individual accounts
    affect equity prices in the short run, the equity premium could
    decrease.  For instance, if the demand for equities increases as a
    result of individual accounts, the prices of equities are likely
    to increase.  This in turn lowers the expected return on equities.
    As the expected return on equities decreases, the equity premium
    decreases because the difference between the return on equities
    and the risk-free asset such as Treasury bills would diminish. The
    decreasing equity premium could imply that people do not view the
    stock market to be as risky as they once did.  One possible
    implication is that if people view the stock market as not very
    risky, and they prove to be right, they will continue to invest in
    it, and the equity premium is likely to continue decreasing.
    Alternatively, if the stock market is in fact riskier than
    investors believe, then investors will be surprised by
    underperformance and volatility over time and will begin to reduce
    their equity holdings, which could eventually cause the equity
    premium to go back to values consistent with past decades. The
    size of the equity premium has implications for analyzing the
    benefits of an individual account program.14  The potential gain
    from equity investing under an individual account program depends
    on what future equity returns are and in particular how much
    return might be expected for taking on additional risk.  A
    significant part of the gain that might be generated from
    diversifying into equities comes from the equity premium. To the
    extent that the equity premium continues to decline, individuals
    are unlikely to receive as high a return from stock investing as
    they have in the past. The return that individuals are likely to
    receive from individual account The Returns of Investments
    investments would depend on what they are allowed to invest in,
    e.g. stocks, bonds, indexed mutual funds,15 as well as the risk of
    the asset being invested in.   When estimating expected returns
    under an individual account program, most proposals have tended to
    focus on equities. 14 See Implications of Government Stock
    Investing for the Trust Fund, the Federal Budget, and the Economy
    (GAO/AIMD/HEHS-98-74, April 22, 1998). 15 Mutual funds pool the
    limited funds of small investors into large amounts, thereby
    gaining the advantages of large-scale trading.  Investors are
    assigned a prorated share of the total funds according to the size
    of their investments. Page 44
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    3 Return and Risks Are Likely to Be Higher With Individual
    Accounts However, other assets may offer different returns.
    Corporate equities have tended to have higher market returns than
    other investments because they are riskier.  Other investments,
    such as corporate bonds, have also tended to offer high yields.
    For instance, corporate bonds offer higher yields than Treasuries
    to entice investors to buy these securities, which have some risk
    of default.16  As in the case of corporate equities, investors are
    offered a higher reward for taking on the additional risk that the
    company may default.  If an individual account system were to
    provide for mutual funds, depending on the type of mutual fund
    allowed, individuals would receive various returns.  For instance,
    a government bond mutual fund may yield a lower return to
    investors than an equity indexed mutual fund.17 Overall, the
    capital markets offer higher market returns only by having
    investors take on additional risk.  Thus, in estimating expected
    returns for individual account investments, it is important to not
    only consider the type of asset invested in but also the riskiness
    of the investment. Higher returns are possible for individuals
    investing through individual Adjusting the Rate of    accounts
    than under the current Social Security program, but only if Return
    for Risk          individuals take on more risk.  Individuals
    should therefore not only be interested in the returns of various
    assets but also in the risks that have to be incurred to achieve
    higher returns under an individual account program.  The
    difficulty is how to measure risk and how to adjust rates of
    return for risk so that investors would be able to compare various
    returns to investments. Risk is often considered to be the
    uncertainty of future rates of return, which in turn are equated
    with variability.  In fact, one of the underlying concepts of risk
    is inherent volatility or variability.  For instance, the
    variability of equity prices is among the key factors that cause
    investors to consider the stock market risky.  The price at which
    an individual purchases shares of a company early in the morning
    is not guaranteed even later in the day.  Bond prices also vary
    due to changing interest rates and inflation. 16 When  a bond is
    purchased, the coupon rate is fixed and known for the life of the
    bond-this is the rate the purchaser will receive every 6 months
    for the life of the bond. 17 An indexed mutual fund is a mutual
    fund that holds shares in proportion to their representation in a
    market index such as the S&P 500. Page 45
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    3 Return and Risks Are Likely to Be Higher With Individual
    Accounts There are Many Ways to    There are a number of different
    ways to try to measure variability or risk. Measure Risk
    All such measures give some estimate of the riskiness of
    investments. Classic risk measures such as variance18 or the
    standard deviation19 are often used to measure the risk of an
    asset. However these measures are often considered to be difficult
    for investors to understand and may not reflect how people
    perceive risk.  For instance, investors do not generally take a
    symmetrical view of the variability of returns-downward deviations
    are perceived as economic risks, but upward deviations are
    regarded positively or as unexpected gains.  Furthermore,
    quantifying uncertainty or risk is usually done using probability
    distributions.  As long as the probability distribution falls
    symmetrically about the mean or average-what is known as a normal
    distribution-the variance and standard deviation are adequate
    measures of risk.  However, to the extent that the probability
    distributions are asymmetrical, as is the case with the returns
    from a combination of securities, those measures are not as
    meaningful in terms of measuring risk. Other ways to measure risk
    include (1) the value at risk (VAR) --how much the value of a
    portfolio can decline with a given probability in a given time
    period, or (2) the beta of a security--the tendency of a
    security's returns to respond to swings in the broad market.  VAR
    is an approach used by money risk managers to measure the
    riskiness of their portfolios.  It is an estimate of the maximum
    amount a firm could lose on a particular portfolio a certain
    percent of the time over a particular period of time.  For
    example, if an investor wanted to put money into a mutual fund and
    wanted to know the value at risk for the investment of a given
    time period, the investor could determine the percentage or dollar
    amount that their investment could lose, e.g., a 2-percent
    probability that the investor could lose at least $50 of a $1,000
    investment over a certain period of time.   VAR models construct
    measures of risk using the volatility of risk factors, such as
    interest rates or stock indexes, which is helpful for mutual funds
    that have a wide variety of investments. Measuring the beta is
    another way to measure risk.  In essence, if an investor wanted to
    know how sensitive a particular asset's return is to market
    movements, calculating the beta would do so.  Beta measures the
    amount that investors expect the equity price to change for each
    additional 1-percent change in the market.  The lower the beta,
    the less susceptible the stock's return is to market movements.
    The higher the beta, the more 18 The variance of an asset's return
    is the expected value of the squared deviations from the expected
    return.  The variance tries to measure the dispersion of the
    returns. 19 The standard deviation is the square root of the
    variance. Page 46
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    3 Return and Risks Are Likely to Be Higher With Individual
    Accounts susceptible the stock's return is to market movements.
    Thus, the beta would measure the risk that a particular stock
    contributes to an individual's portfolio. Adjusting for Risk    As
    previously stated, estimating a return on investments without
    taking in to account the riskiness of the investment is likely to
    overstate the benefit of investing in that asset.  Adjusting
    returns to account for risk is important because risk-adjusted
    returns are likely to be lower than unadjusted returns but more
    comparable across asset classes. There are different ways to
    adjust returns for risk, but there is no clear best way to do so.
    The appropriate risk-adjusted measurements depend on what is being
    evaluated.  For instance, in terms of evaluating the returns of
    mutual funds, various risk-adjusted performance measures could be
    used.20 One measure used is the Sharpe Ratio,21 which basically
    measures the reward to volatility ratio and is the most commonly
    used measure for determining the risk-adjusted performance of
    mutual funds.  A high Sharpe ratio means that a mutual fund
    delivers a high return for the level of volatility of the fund's
    investments.  Thus, if individuals were trying to determine the
    mutual fund that had the best combination of return for risk, they
    would choose the fund that had the highest Sharpe Ratio.   An
    alternative to the Sharpe Ratio is the Modigliani Measure, which
    measures a fund's performance relative to the market.   The
    measure uses a broad- based market index, such as the S&P 500, as
    a benchmark for risk comparison.  In essence, the measure is
    equivalent to the return a mutual fund would achieve if it had the
    same risk as a market index.   Another measure is one calculated
    by Morningstar, Incorporated.  Unlike the Sharpe Ratio, which
    compares the risk-adjusted performance of any two mutual funds,
    Morningstar measures the risk-adjusted performance of mutual funds
    within the same asset class.  It usually assigns ratings to mutual
    funds on the basis of the risk-adjusted return and risk of a
    mutual fund.22  Thus, if individuals wanted to know how various
    mutual funds did within their asset groups, they would look at the
    Morningstar rating. 20 See Katrina Simons, "Risk-Adjusted
    Performance of Mutual Funds," New England Economic Review,
    September/October 1998., pp.34-48. 21 The Sharpe Ratio measures a
    mutual fund's excess return per unit of risk (fund's average
    excess return divided by the standard deviation of the fund's
    excess return). 22 Morningstar calculates its risk-adjusted return
    measure by calculating an excess return measure for each fund by
    adjusting for sales loads and subtracting the 90-day Treasury bill
    rate and then dividing the excess return by the average excess
    return for the fund's asset class.  Morningstar calculates a
    measure of downside risk by counting the number of months in which
    the fund's excess return was negative, summing up all the negative
    excess returns, and dividing the sum by the total number of months
    in the measurement period. Page 47
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    3 Return and Risks Are Likely to Be Higher With Individual
    Accounts There are other risk-adjusted measures that are used.
    However, there is no clear best way to adjust a return for risk,
    and there is no one risk- adjusted measure that everyone agrees is
    the correct measure.  Many of the measures are complicated and may
    require more sophistication to understand than could be expected
    of individual account investors.  It should be noted, however,
    that although risk-adjusted rates of return are the appropriate
    measure for individual account investments, an investor's entire
    portfolio has a different risk than that of its individual
    components. Thus, risk-adjusted returns depend fundamentally on
    how portfolios are managed. Comparing rates of return on Social
    Security and private market Comparing Rate of
    investments has frequently been discussed in evaluating options
    for Return From Social              reforming Social Security, but
    comparing the two does not capture all the relevant costs and
    benefits that reform proposals imply.23   Such Security to
    Expected            comparisons often do not factor in the costs
    of disability and survivors Return With Individual insurance when
    determining a rate of return on Social Security Accounts Requires
    contributions for retirement. Careful Consideration Individual
    accounts would generally increase the degree to which retirement
    benefits are funded in advance.   Today's pay-as-you-go Social
    Security program largely funds current benefits from current
    contributions, but those contributions also entitle workers to
    future benefits.  The amount necessary to pay the benefits already
    accrued by current workers and current beneficiaries is roughly $9
    trillion.   Any changes that would create individual accounts
    would require revenues both to deposit in the new accounts for
    future benefits and to pay for existing benefit promises.  Rate of
    return estimates for such a program should reflect all the
    contributions and benefits implied by the whole reform package,
    including the costs of making the transition. Administrative and
    annuity costs could also affect actual retirement incomes. SSA
    commented that we needed to clarify that comparisons between the
    Agency Comments                 rate of return implicit in the
    Social Security system and those of individual accounts were
    problematic for many reasons including the fact that Social
    Security provides survivors and disability insurance.  We have
    further clarified issues regarding the rate of return comparisons
    and have referred to our forthcoming report that provides a more
    detailed discussion on 23 In a forthcoming report, we will provide
    a more detailed discussion on issues comparing Social Security
    rates of return with those of market investments. Page 48
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    3 Return and Risks Are Likely to Be Higher With Individual
    Accounts comparing the rate of return implicit in the Social
    Security system with those of market investments. Page 49
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    4 Enhanced Education is Necessary for an Individual Account
    Program Under many of the individual account programs that have
    been proposed, individual accounts to varying extents would be
    managed by participants themselves.  To operate fairly and
    efficiently, such a system would have to provide participants with
    information adequate for their decisionmaking as well as to
    protect against misinformation that could impair that process.
    Existing SEC disclosure and antifraud rules and related doctrines
    provide for the disclosure of information that is material1 to an
    investment decision.  However, such disclosure alone would not
    enable participants in an individual account program to understand
    how best to use such information for purposes of their retirement
    investment decisions. To provide participants with a clear
    understanding of the purpose and structure of an individual
    account program, an enhanced educational program would be
    necessary.2  Such an enhanced and broad-based educational effort
    would have to be undertaken in order to provide individuals with
    information they need and can readily understand, as well as with
    tools that can help both improve the decisionmaking process and
    awareness of the consequences of those decisions.  Individuals
    would need education on the benefits of saving in general, the
    relative risk-return characteristics of particular investments,
    and how different distribution options can affect their retirement
    income stream.   If a wide variety of choice is offered
    individuals so that they could potentially choose less diversified
    investments, such as individual equities, a more broad-based
    educational program would be necessary.  The wider the variety of
    choices, and thus more potential risks, offered individuals under
    an individual account program, especially a mandatory program, the
    more broad-based the education will need to be.  If fewer, well-
    diversified choices are provided under an individual account
    program, the educational effort could be targeted more to the
    purpose for investing and the potential long-term consequences.
    It is also likely that some sort of provision, such as a default
    option--either a default to the defined benefit part of Social
    Security (staying in the current Social Security program) or to a
    mandatory allocation--may be needed for those individuals who,
    regardless of the education provided, will choose not to make
    investment choices. 1 Under the Securities laws, the term
    "material information" generally is understood to mean the
    information that a reasonable investor would consider significant
    in making an investment decision, taking into account the
    circumstances of the particular transaction and the total mix of
    publicly available information. 2 Such a program would have to
    acknowledge that not all participants will speak and read English
    and, thus, educational materials may need to be in a variety of
    languages. Page 50
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    4 Enhanced Education is Necessary for an Individual Account
    Program Existing disclosure rules require that material
    information be provided The Significance of                about a
    particular instrument and its issuer.  Such disclosure would be
    Disclosure Rules                   essential to an individual
    account program, with some rules having more significance than
    others, depending on the investment choices offered. Would Depend
    Upon                  For example, if participants were allowed to
    acquire corporate securities Available Investment
    such as stocks and bonds, the disclosure and reporting
    requirements of the Choices                            Securities
    Acts of 1933 and 1934, such as those applicable to the governance,
    activities, and financial status of the issuer, would be
    particularly important to participants choosing such instruments.
    If investment choices were limited to mutual funds, disclosure
    about the funds would have primary importance, and information
    about the issuers of the securities owned by the funds would be
    relatively less significant for participants.  In addition, the
    Employee Retirement Income Security Act of 1974 (ERISA) requires
    disclosures in connection with pension funds (covered by Title I
    of ERISA). If products offered by banks and insurance companies
    were permitted, special disclosure rules would apply. The
    Securities Acts of 1933 and 1934 generally require disclosure and
    Disclosures in Connection          reporting of detailed
    information about an issuer of securities, such as its with
    Securities and Pension management, activities, and financial
    status.  The Securities Act of 1933 Plans
    (1933 Act) primarily focuses upon the disclosure of information in
    connection with a distribution of securities; the Securities and
    Exchange Act of 1934 (1934 Act) concentrates upon the disclosure
    of information trading, transactions, and sales involving
    securities. The 1933 Act requires the disclosure of information
    intended to afford potential investors an adequate basis upon
    which to decide whether or not to purchase a new security and to
    prevent fraudulent conduct in connection with the offering.  This
    disclosure generally takes place through a registration statement
    filed with SEC (and made available to the public, except for
    confidential information) and a related prospectus. Both documents
    contain detailed factual information about the issuer and the
    offering, including statements about the specifics of the offering
    as well as detailed information about the management, activities,
    and financial status of the issuer. The 1934 Act, among other
    things, contains extensive reporting and disclosure requirements
    for issuers of securities registered under the act. Issuers must
    file current, annual, and quarterly reports with SEC, and the
    annual report must be distributed to security holders.  The 1934
    Act also governs brokers, dealers, and others involved in selling
    or purchasing securities.  The act contains a broad prohibition
    against fraud in connection with securities transactions that
    frequently has served as a Page 51                      GAO/GGD-
    99-115 Issues Associated With Individual Accounts Chapter 4
    Enhanced Education is Necessary for an Individual Account Program
    basis for disclosing to customers an abundance of details about a
    particular instrument or transaction. ERISA and DOL regulations
    require the administrator of a plan covered by Title I of ERISA to
    file certain information about the plan with DOL and distribute it
    to plan participants and beneficiaries receiving benefits.3  One
    of the principal disclosure documents, the summary plan
    description (SPD), must include information specified in the
    regulations, which includes details about the structure,
    administration, and operation of the plan as well as the
    participant's or beneficiary's benefits and rights under the plan.
    The SPD must be written in a manner "calculated to be understood
    by the average plan participant" and must be "sufficiently
    comprehensive to apprise the plan's participants and beneficiaries
    of their rights and obligations under the plan."  Moreover, in
    fulfilling these requirements the plan administrator is to take
    into account "such factors as the level of comprehension and
    education of typical participants in the plan and the complexity
    of the plan."4 In addition to general reporting and disclosure
    requirements, DOL regulations contain special disclosure rules for
    participant-directed accounts.  A participant-directed account
    plan is one that permits participants and beneficiaries to direct
    the investment of assets in their individual accounts. 5   The
    special rules arise in the connection with the obligations of a
    fiduciary to a plan that permits such accounts. 3 ERISA's
    regulatory provisions are contained in four parts.  Part I covers
    reporting and disclosure requirements, which are designed to
    improve pensions and protect employees by mandating disclosure of
    certain plan information to the government, participants, and
    beneficiaries.  Part II establishes minimum vesting requirements
    and minimum participation standards, which  are intended to lessen
    discrimination against lower level employees and broaden the
    coverage of pension plans.  Part III sets minimum funding
    standards to improve the stability of certain  defined-benefit
    pension plans. Part IV defines standards of conduct for pension
    plan fiduciaries and prohibits certain transactions. 4 In addition
    to the SPD, a plan administrator is required to provide each
    participant with a summary annual report which, among other
    things, is to include detailed information regarding the amount of
    administrative expenses incurred by the plan, the amount of
    benefits paid to participants and beneficiaries, the value of plan
    assets, income or loss for the year, and the amount of net
    unrealized appreciation in plan assets during the plan year. 5
    Regulations for participant-directed accounts specifically require
    that such accounts provide the participant or beneficiary the
    opportunity to choose from a broad range of investment
    alternatives. These alternatives must provide a reasonable
    opportunity for a participant or beneficiary to:  (1) materially
    affect the potential return on amounts in his or her individual
    account with respect to which he or she is permitted to exercise
    control and the degree of risk to which such amounts are subject;
    (2) choose from at least three investment alternatives; and (3)
    diversify the investment of that portion of his or her individual
    account with respect to which he or she is permitted to exercise
    control so as to minimize the risk of large losses. Page 52
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    4 Enhanced Education is Necessary for an Individual Account
    Program Under DOL regulations, a fiduciary can avoid liability for
    any loss arising from the participant's exercise of control over
    account assets, provided that the participant has the opportunity
    to exercise control over the account assets and may choose, from a
    broad range of investment alternatives, the manner in which assets
    are invested.  The regulations further provide that a participant
    has the opportunity to exercise control only if, among other
    things, the participant is provided or can obtain information
    sufficient for him or her to make informed investment decisions.
    This information includes (a) a description of investment
    alternatives and associated descriptions of the investment
    objective, risk and return characteristics of each such
    alternative; (b) information about designated investment managers;
    (c) an explanation of when and how to make investment instructions
    and any restrictions on when a participant can change investments;
    and (d) a statement of fees that may be charged to an account when
    a participant changes investment options or buys and sells
    investments. The information that the 1933 and 1934 Acts require
    issuers to disclose Disclosure in Connection    pertains to
    details about the issuers of securities and the securities With
    Mutual Fund Shares     themselves.  Such information is
    significant to a person investing in a specific issuer.  For the
    purchaser of shares in an investment company, such as a mutual
    fund, which is the vastly prevalent form of  investment company,
    information about the company itself, rather than individual
    issuers, is most significant.  Mutual funds are subject to the
    Investment Company Act of 1940, which deals with the registration,
    formation, and operation of investment companies, as well as
    provisions of the 1933 and 1934 Acts governing disclosure and
    prohibiting fraud.  Disclosure about the fund, such as information
    concerning its investment strategies and its management, is
    provided in the registration statement filed with SEC; the
    prospectus or an alternative, less detailed document known as a
    "profile"; and periodic reports filed with the Commission and
    distributed to shareholders.6 6 As discussed later in the report,
    SEC recently modified Form N-1 and promulgated the "profile" rule
    to provide for the disclosure of mutual fund information in a less
    detailed, more understandable fashion.  SEC instituted these
    changes because the proliferation of mutual funds and products
    increased the volume and complexity of disclosures, thus leading
    to the confusion of mutual fund customers. Page 53
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    4 Enhanced Education is Necessary for an Individual Account
    Program The expansion of products offered by depository
    institutions (primarily Disclosure Concerning
    federally insured banks and thrifts and their subsidiaries or
    affiliates) and Certain Products Offered by insurance companies
    carries with it the potential for confusion about the Depository
    Institutions and        nature and risk of investment products
    offered by such institutions.  For Insurance Companies
    example, bank sales of nondeposit instruments, such as mutual fund
    shares and variable annuities, could lead an investor to conclude
    that such instruments are federally insured bank products.
    Investment products sold by insurance companies, such as certain
    variable annuities and equity- indexed agreements, might be viewed
    as traditional insurance products, under which the insurer assumes
    the payment risk.  If such products are securities, they are
    subject to the requirements of federal and state securities laws.
    The activities of institutions in connection with the products
    would be subject to regulation under the securities laws as well
    as regulation by their supervising agencies. NonDeposit Bank
    Products           The federal bank regulators 7 have promulgated
    rules, guidelines, and policies containing standards for
    disclosure in connection with a banking institutions' involvement
    in sales of nondeposit instruments such as securities.  These
    regulators issued an Interagency Statement on Retail Sales of Non-
    Deposit Investment Products ("Interagency Statement") together
    with subsequent statements that focuses on issues specifically
    pertaining to the retail sale of investment products to customers
    on depository institution premises.  Among other things, the
    standards seek to prevent customer confusion over whether such
    products are FDIC-insured, primarily through disclosure and
    separation of sales of investment products from other banking
    activities. New products being offered by insurance companies can
    also confuse investors about whether such a product is insurance
    (the insurer accepts the repayment risk) or a security (the
    purchaser of the product faces some or all repayment risk).
    States typically regulate disclosure about insurance products by
    prohibiting unfair, deceptive, or misleading statements about a
    product.  However, to the extent such instruments are securities,
    their purchase and sale are  subject to federal and state
    securities laws. To address concerns about the effectiveness of
    disclosures regarding Initiatives to Facilitate
    investing, particularly with respect to mutual funds, SEC and some
    states Understanding of                   have established
    programs to provide for disclosing information to Information
    investors in a more understandable way.  SEC's "plain English"
    program is 7 The office of the Comptroller of the Currency (OCC),
    the Board of Governors of the Federal Reserve System, the Federal
    Deposit Insurance Corporation (FDIC), and the Office of the Thrift
    Supervision (OTS). Page 54
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    4 Enhanced Education is Necessary for an Individual Account
    Program an example.  The Commission instituted the program because
    much of the disclosure provided in prospectuses and other
    documents often is complex, legalistic, and too specialized for
    investors to understand.  Under this program, the Commission
    revised its rule for the presentation of information in a
    prospectus to require that the prospectus comply with plain
    English writing principles listed in the regulation.  SEC also
    amended its Form N-1A, the registration form used by mutual funds
    for registration, to provide for the use of plain English
    principles and simplified descriptions of information essential to
    an investor's evaluation of the fund. In March 1998, SEC adopted a
    rule permitting mutual funds to offer investors a new disclosure
    called a profile.  The document summarizes key information about
    the fund, including its investment strategies, risks,
    performances, and fees, in a concise, standardized format.  A fund
    offering a profile can give investors a choice about the amount of
    information they wish to consider before making a decision about
    investing in the fund. Investors have the option of purchasing the
    fund's shares on the basis of the profile, in which case they are
    to receive the fund's prospectus along with the purchase
    confirmation. Among other things, the new SEC rules are designed
    to reduce the complexity of information provided to mutual fund
    customers and the potential for confusion that sometimes
    accompanies such information. They are an attempt to make the
    disclosure of material information more useful to those who invest
    in mutual fund securities. Whether an individual account program
    is mandatory or voluntary, giving Enhanced Education Is millions
    of working Americans the responsibility for investing part of
    their Necessary for an                 Social Security payroll
    taxes on their own requires enhanced education. Social Security
    has provided a safety net for millions of people for a long
    Individual Account               time in that it has been the
    foundation of the nation's retirement income Program
    system, providing income for millions of Americans.  Introducing
    an individual account program would change the nature of the
    current Social Security program and would require increased
    education if people are to understand the individual account
    program and what may be required of them.  Although education
    would be necessary regardless of whether the program was voluntary
    or mandatory, the government would have a special responsibility
    under a mandatory program to provide individuals with the basic
    investment knowledge that they would need in order to make
    informed investment decisions affecting their retirement. Page 55
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    4 Enhanced Education is Necessary for an Individual Account
    Program The extent to which enhanced education would be necessary
    would depend upon the available investment choices and the fees
    and expenses associated with an individual account program.  An
    individual account program that offers many investment choices-
    especially one that is mandatory-would likely require a
    substantial amount of education because the wider the options
    provided an individual, the greater the chances are that the
    individual could lose money.  If fewer well-diversified options
    are offered under an individual account program the fewer risk
    factors the individual has to consider and the more targeted the
    education could be.  It would also be important to educate
    individuals about how to interpret the fees associated with
    individual account investments and how fees would affect their
    account balances. The Social Security program includes workers
    from all levels of income, Enhanced Education Is
    those who currently invest in equity and bond markets and those
    who do Important for All                  not.  It is unlikely
    that a "one size fits all" educational effort would be Individuals
    appropriate for an individual account program.  Because a
    mandatory individual account program would require everyone to
    participate, including those who do not currently make investment
    decisions, educational efforts would be especially crucial and
    would need to reach all individuals. Enhanced Education Is
    Large segments of the working population do not currently make
    Important for Those Who Do Not investment decisions for various
    reasons.  For instance, some people do Currently Make Investment
    not believe that they have enough money to save or at least to
    save in any Decisions                          vehicle other than
    a bank account.  Others do not know the benefits of investing.
    Lastly, there are those who do not appear to understand the
    benefits of saving and investing or the necessity of doing so for
    retirement. Whatever the reason, millions of people have never
    made investment decisions. Investor education is especially
    important for individuals who are unfamiliar with making
    investment choices, including low-income and less well-educated
    individuals who may have limited investing experience.8 Thus, one
    of the primary areas of enhanced education under an individual
    account program would be to educate those who do not know the
    basics about savings or diversification, especially if the
    individual account program is mandatory.   Those individuals and
    households who do not currently make investment decisions, but
    rely on Social Security as their 8 This is especially true for the
    21 percent of the adult population with only rudimentary reading
    and writing skills (at or below the fifth-grade level) according
    to the National Center on Education Statistics). Page 56
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    4 Enhanced Education is Necessary for an Individual Account
    Program primary source of retirement income, are likely to be the
    ones who are most affected by a mandatory individual account
    program and thus most in need of education. Current Initiatives
    Focus on     Congress and various agencies and organizations have
    instituted programs Saving, Fraud, and Retirement    to educate
    people about the benefits of saving and investing.  In the Income
    Savings Are Vital to Everyone's Retirement Act of 1977, Congress
    mandated an education and outreach program to promote retirement
    income savings by the public.  The act also required the Secretary
    of Labor, in consultation with other federal agencies selected by
    the President, to plan and conduct a National Summit on Retirement
    Savings.  As part of this mandate, the act required the Secretary
    to bring together retirement and investment professionals, Members
    of Congress, state and local officials, and others to discuss how
    to educate the public--employers and individuals--about the
    importance of saving and about the tools available to enable
    individuals to retire and remain financially independent. Pursuant
    to this mandate, DOL sponsored the National Summit in 1998. Other
    efforts have been made to reach out to investors to educate them
    about both how to protect themselves against fraud.  SEC has
    realized that an important part of its role in combating fraud is
    to educate the public about what to be aware of and how to avoid
    being taken advantage of.  If investors are adequately informed
    about the risks associated with potential securities frauds, then
    they will be less likely to fall victim to scams. SEC has
    implemented several programs to advise the investing public about
    potential frauds.  For instance, SEC has issued numerous pamphlets
    about what types of questions investors should ask about investing
    and the people who sell those products.9  Additionally, SEC has
    held local "town meetings" across the United States to discuss
    investment risks.  It also coordinates the "Facts on Savings and
    Investing Campaign" with federal, state, and international
    securities regulators.   SEC officials said that in order to have
    a successful education program, it is necessary to determine what
    people do and do not know.   This has entailed determining
    people's level of literacy and math knowledge in order to design a
    program that could provide education for individuals with various
    levels of investment knowledge. 9 See pamphlets such as "Ask
    Questions,"  "Cold Calling Alert,"  "Invest Wisely: An
    Introduction to Mutual Funds," and "Invest Wisely:  Advice from
    Your Securities Industry Regulator,"  published by and available
    from the U.S. Securities  and Exchange Commission. Page 57
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    4 Enhanced Education is Necessary for an Individual Account
    Program DOL's Pension Welfare and Benefits Administration has
    several educational outreach efforts for encouraging employers to
    establish retirement programs and employees to save for
    retirement.  The basic program is a joint effort with a wide range
    of private sector partners, including the American Savings
    Education Council, the Employee Benefit Research Institute, banks,
    insurance companies, consumer groups, retiree groups, participant
    rights' groups, mutual funds, and other large companies.  This
    joint effort was designed to provide very basic information to
    individuals and employers about the different types of savings
    vehicles available under the law and to encourage the private
    sector to provide employees with models of pension programs.10
    The educational program tries to target special groups whose
    pension coverage is low, including such groups as women and
    minorities as well as small businesses; only about one-fifth of
    small businesses offer pension plans to their employees.  DOL  has
    issued numerous pamphlets on what individuals should know about
    their pension rights and what businesses can do to start pension
    plans for their employees.11  For instance, they regularly use the
    Small Business Administration's newsletters to encourage members
    to establish pension plans and have developed a Web site for small
    businesses to give them information on various pension plan
    options, depending on how much each business can afford to
    contribute to a pension fund. These current programs have a
    limited ability to reach the overall population.  One clear
    constraint is the low level of resources, including funding
    directed to investor education.  Another limitation is that they
    are targeted to circumscribed audiences, such as companies that do
    not have retirement programs as opposed to individuals who do not
    invest. Furthermore, most efforts are reaching those individuals
    who choose to take it upon themselves to find out what they need
    to do to save more or to learn how to make better investment
    decisions.  Thus, even as a result of 10 This joint effort
    resulted from a concern a few years ago that as baby boomers began
    to retire and move away from defined benefit plans into 401(k)
    plans, there would be a great need for educational efforts to
    encourage individuals to save for their retirement.  At first,
    Congress did not support DOL's voluntary efforts.  However,
    several years later as 401(k) plans became increasingly popular,
    Congress passed the Savers Act, which requires  DOL to establish
    and maintain a retirement education program for employers and
    employees. 11 See pamphlets, "What You Should Know About Your
    Pension Rights," "Simple Retirement Solutions for Small Business,"
    "Simplified Employee Pensions:  What Small Businesses Need to
    Know," "Top 10 Ways to Beat the Clock and Prepare for Retirement,"
    "Reporting and Disclosure Guide for Employee Plans," "Protect Your
    Pension:  A Quick Reference Guide," "A Look at 401(k) Plan Fees'"
    and  "Saving Incentive Match Plan for Employees of Small
    Employers," published by and available from the U.S. Department of
    Labor, Pension Welfare and Benefits Association. Page 58
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    4 Enhanced Education is Necessary for an Individual Account
    Program the various targeted efforts undertaken, large segments of
    the population are still not being reached. Education Is Also
    Important for    Numerous studies12 have been done that have
    looked at how well Those Individuals Who              individuals
    who are currently investing understand investments and the
    Currently Make Investment          markets.  On the basis of those
    studies, it is clear that among those who Decisions
    save through their company's retirement programs or on their own,
    there are large percentages of the investing population who do not
    fully understand what they are doing.  For instance, one study
    found that a little more than a third of American workers have
    tried to calculate how much money they would need to retire
    comfortably.  Another study found that 47 percent of 401 (k) plan
    participants believe that stocks are components of a money market
    fund, and 55 percent of those surveyed thought that they could not
    lose money in government bond funds.  Another study on the
    financial literacy of mutual fund investors found that less than
    half of all investors correctly understood the purpose of
    diversification.  Further, SEC reported that over half of all
    Americans do not know the difference between a stock and a bond,
    and only 16 percent say they have a clear understanding of what an
    IRA is. Although individuals who currently make investment
    decisions are likely to have some familiarity with investing,
    education would also be important for them because of their
    increased responsibility under an individual account program.
    Furthermore, according to the studies cited above, there would  be
    a real need for enhanced education about such topics as investing,
    risk and return, and diversification.  As the Chairman of SEC has
    said, there is a wide gap between financial knowledge and
    financial responsibilities.  Closing that knowledge gap is
    imperative under an individual account program. Moving to an
    individual account program is going to require a thorough Enhanced
    Education Is              education effort for everyone to
    understand the program and how it is Important for Individual
    different from the current Social Security program.   The
    government has Accounts Program                   much more
    responsibility for educating individuals under a mandatory program
    because people would effectively be forced by the government to
    save and to make decisions about what to do with that saving as
    well as bear the consequences of a decision.  Even with a default
    option for those who do not choose to participate, the government
    needs to explain why the option was provided and what are its
    implications. 12 See studies such as the Securities Industry
    Association, "1997 Annual SIA Investor Survey:  Investors'
    Attitudes Towards the Securities Industry, November 1997, and
    Vanguard Group, "Vanguard/Money Mutual Fund Literacy Test,"
    January 1998, and Office of Investor Education and Assistance
    Securities and Exchange Commission, "The Facts on Saving and
    Investing," February 24, 1998. Page 59
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    4 Enhanced Education is Necessary for an Individual Account
    Program Many people do not understand the current Social Security
    program, how their contributions are measured, and how their
    benefits are computed, even though the program is over 60 years
    old.  Yet, millions of individuals rely on the program as their
    sole source of retirement income.  In order to increase people's
    understanding of Social Security, SSA has implemented various
    efforts to educate people.   Such efforts have included providing
    a 1-800 number for recipients to ask questions, having a public
    education service campaign, and providing educational packages to
    individuals. Despite these efforts, SSA officials said that people
    still have a hard time understanding the program.   Implementing
    an individual account program is likely to require enhanced
    education not only about individual accounts but also about how an
    individual account program would change the nature of Social
    Security and what that means for the individual. At a minimum,
    under an individual account program, educational efforts would be
    needed to help people understand how individual accounts would
    work and how the accounts would affect their retirement income
    security.  Many proposals do not specify what entity would be
    responsible for the public education program that would be needed
    for an individual account program.  On the basis of the type of
    information experts13 in employee education say is needed,
    education about an individual account program could include the
    following information: *  Goals of the program - individuals need
    to know what the goals of the program are and why they are
    participating. *  Responsibilities - individuals need to know what
    their responsibilities are under the program. *  Retirement Income
    - individuals need to know what their retirement income needs are
    and how their retirement needs will be affected under an
    individual account program. *  Materials - individuals need
    materials that convey the message of the program and what will be
    required of them. The amount of education that would be necessary
    under an individual Amount of Education        account program
    depends on the range and type of investment choices Necessary is
    Directly      offered to individuals.  There are basic issues that
    individuals will need to Linked to the Choices      be educated
    about regardless of how the program is structured.  Such Offered
    issues include (1) the choices they have to make; (2) the
    consequences of those choices; (3) what the investment options
    are, such as stocks, bonds, 13 See Richard D. Glass, "Investment
    Education:  Who's Fooling Whom?" Employee Benefits Journal, March
    1999, pp. 3-8; and George Loewenstein, "Costs and Benefits of
    Health and Retirement Related Choice," Paper for the Eleventh
    Annual  Conference of the National Academy of Social Insurance,
    January 8, 1999. Page 60
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    4 Enhanced Education is Necessary for an Individual Account
    Program and indexed mutual funds; (4) rates of return of different
    investment vehicles; and (5) the risks of investment vehicles.
    However, as a wider variety of choice is offered to individuals,
    more education beyond the basics would be necessary because
    broader issues would need to be considered.  With more variety of
    choice, investors would need to choose among various assets, which
    requires the investor to have certain skills to evaluate the risks
    and his or her own preference for risks.  If the structure allows
    for an even broader variety of choices such as real estate, the
    educational requirements would mount.  When choices are limited to
    a few well-diversified choices (such as a few indexed mutual
    funds), many decisions are made by those managing the funds or by
    rules governing the fund (such as what an indexed mutual fund can
    invest in).  If the investor has the option of frequently moving
    funds from one investment to another, the educational effort needs
    to include analytical tools to aid such decisions and advice about
    the importance of a long-term horizon.  Thus, the fewer well-
    diversified choices offered, the less risk to the individual and
    the more targeted the education could be. Table 4.1: Investment
    Choices Under an    Investment options
    Education needed Individual Account Program and the        More
    investment choices offered             More broad-based education
    that is needed Education Required                        Fewer
    investment choices offered            Less education, but more
    targeted Source:  GAO More Investment Choices, More             A
    variety of choices may benefit people in that it offers them a
    wider Education                                 selection from
    which to choose, allowing them to choose the option that is in
    line with their preferences.  However, it also increases their
    risk in that they could potentially choose less diversified
    investments, such as individual equities, that could result in
    financial loss.  Furthermore, the wider the variety of choice
    offered, the greater the need for people to consider other issues.
    For instance, because offering a wide variety of investment
    options is likely to promote competition among financial
    institutions to provide a range of investment vehicles, investors
    would need to be educated about fraud and how to avoid it.  When
    Great Britain went to an individual account program, individuals
    purchased unsuitable investments because of high-pressured sales
    tactics that resulted in individuals losing billions of dollars.
    The Chairman of the SEC has stated that allowing a broad range of
    investment options under individual accounts provides
    opportunities for fraud and sales practice abuses. Thus, education
    about fraud becomes important.  For example, an investor would
    need to know what to look for, what type of questions to ask, what
    type of advice is biased, what the investor's rights are, or what
    the law requires.  When investment options are limited, the
    chances of fraud are reduced. Page 61
    GAO/GGD-99-115 Issues Associated With Individual Accounts Chapter
    4 Enhanced Education is Necessary for an Individual Account
    Program Moreover, the wider the variety of choice that is offered
    individuals, the more they will need education about understanding
    the value of diversification and the possible consequences of not
    having a diversified portfolio.   If choices are limited to
    indexed mutual funds, less education about diversification would
    be needed because indexed funds are by nature diversified.
    Education is also necessary for understanding risks and the
    various returns that are likely with different investment options.
    With a wider variety of investment options, understanding risk and
    being able to manage the risk become important.  It is important
    to explain to people that historical returns may not always be
    good predictors of future returns, especially when risks are
    ignored.  As stated in chapter 3, measuring risk and comparing
    risk-adjusted returns can be a difficult process. Furthermore,
    being able to understand the rates of returns of various options
    and pick the appropriate investment vehicles become more
    difficult, as more variety is offered.  Individuals would need
    more expertise to understand differences in the rates of return of
    equities, bonds, equity mutual funds, indexed funds, and so on.
    Fewer Investment Choices, Less    If the program has fewer well-
    diversified choices, limits would be placed Education Needed
    on the ways that people could lose money.  The educational effort
    could, therefore, focus more on getting individuals to be informed
    participants in the program.  Educational issues that become
    relevant when individuals are offered numerous options are of less
    concern when they are offered fewer, well-diversified options.
    With fewer, well-diversified investment choices, the educational
    effort could be more targeted to the purpose of retirement
    savings, e.g., educating people about how much they would need to
    save and invest for retirement or determining their goals for
    retirement.   Other issues, such as compounding-the calculation of
    interest earned on a daily, quarterly, semiannual, or annual
    basis-or the impact of inflation on returns are issues that
    individuals need to fundamentally understand.  For example, with
    compounding interest individuals could earn interest on the money
    they save and on the interest that the money earns, e.g., if they
    invested $1,000 at 3-percent interest they could double their
    money in 24 years, but at 4 percent interest they could double it
    in 18 years.  With inflation, or rising prices, the money that
    individuals earn on their investments would potentially be worth
    less and less as prices rose.  In addition, seemingly small annual
    fees can eat away at the accumulated value. Offering fewer, more
    well-diversified options enables the education effort to be
    targeted Page 62                      GAO/GGD-99-115 Issues
    Associated With Individual Accounts Chapter 4 Enhanced Education
    is Necessary for an Individual Account Program on basic issues
    that would be helpful for individuals to understand in order to
    save for retirement. Despite current efforts to increase people's
    awareness to save more, many Default Option    people are still
    not saving and making the retirement choices they need to make,
    effectively relying on Social Security to be their primary source
    of retirement income.  It is unlikely that moving to individual
    accounts will result in active participation by all individuals.
    Thus, various officials have suggested that a default option be
    provided for those individuals who, regardless of educational
    effort, will not make investment choices. Default options could
    include a default to the defined benefit portion of Social
    Security (staying in the current Social Security program) or to
    some type of mandatory allocation.  One example would be an
    investment vehicle in which, depending on the age of the
    individual, certain portions of the investment could be in
    equities and certain portions in bonds.  The portion in bonds
    would increase with the age of the individual. Alternatively, the
    default option could be invested totally in Treasuries.  As with
    any option, a default option with less risk is also likely to
    provide lower returns. Page 63                      GAO/GGD-99-115
    Issues Associated With Individual Accounts Appendix I Comments
    From the Social Security Administration Page 64    GAO/GGD-99-115
    Issues Associated With Individual Accounts Appendix I Comments
    From the Social Security Administration Page 65
    GAO/GGD-99-115 Issues Associated With Individual Accounts Appendix
    II GAO Contacts and Staff Acknowledgments Tamara E. Cross, (202)
    512-4890 GAO Contact Lawrence D. Cluff, Thomas H. Givens III,
    Mitchell B. Rachlis, John Acknowledgments    Schaefer, George
    Scott, Kenneth Stockbridge, Paul Thompson Page 66
    GAO/GGD-99-115 Issues Associated With Individual Accounts Page 67
    GAO/GGD-99-115 Issues Associated With Individual Accounts Page 68
    GAO/GGD-99-115 Issues Associated With Individual Accounts Ordering
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