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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