Social Security Reform: Implications for Private Pensions (Letter Report,
09/14/2000, GAO/HEHS-00-187).

Pursuant to a congressional request, GAO provided information on the
interactions between Social Security and private pensions, focusing on
the: (1) primary linkages between Social Security and private pensions
and the way they interact to provide retirement income for workers and
families; (2) effects of traditional Social Security reforms on the
structure of employer-sponsored pension plans through changes in the
costs and incentives faced by employers and workers; and (3) effects of
nontraditional reforms, such as individual accounts, on the structure of
the private pension system.

GAO noted that: (1) Social Security and private pensions are key sources
of retirement income that are linked through the employer costs
associated with the compensation provided to workers; (2) because
pension plans serve as a supplement to Socal Security, many plans are
integrated--that is, they explicitly incorporate Social Security
benefits or contributions into their plan design; (3) employers also
implicitly consider Social Security provisions in designing pensions
that complement their human resource and other business strategies; (4)
traditional reforms in the Social Security program, such as changing
benefits or taxes or raising the normal retirement age, may alter the
incentives of workers and employers, which could prompt adjustments in
private pension plans; (5) the effect of any specific reform will depend
on the nature of the change its magnitude, its time horizon for
implementation and its interaction with other provisions that comprise a
comprehensive reform proposal; (6) employers' and workers' responses to
reform will be shaped by a variety of factors, including the firm's
size, the type of pension plan offered, and the economic status of the
worker; (7) employers will respond to reforms that affect compensation
costs or the incentives for sponsoring a plan; (8) the introduction of
individual accounts raises a broad set of issues for private pensions,
depending on how such a reform is structured, its scope--whether it is
voluntary or universal--and its interaction with other reforms as part
of a broader reform proposal; (9) like more traditional reforms, the the
effects of an individual account feature on the pension system will
depend on the explicit and implicit linkages between Social Security and
pensions and employers' and workers' responses to specific reforms; (10)
the nation's retirement income institutions operate in a dynamic
environment where workers, employers, and policymakers interact to
pursue the goal of retirement income security; (11) the complexity of
making policy change suggests that any reform should be taken with
careful deliberation; (12) the complexity of making policy change
suggests that any reform should be taken with careful deliberation; and
(13) at the same time, ensuring retirement income for those who most
need it and encouraging the development of new opportunities to secure
and expand the retirement income of future generations should be
emphasized.

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

 REPORTNUM:  HEHS-00-187
     TITLE:  Social Security Reform: Implications for Private Pensions
      DATE:  09/14/2000
   SUBJECT:  Social security benefits
	     Trust funds
	     Financial management
	     Future budget projections
	     Retirement pensions
	     Retirement benefits
	     Employee retirement plans
IDENTIFIER:  Social Security Trust Fund
	     Social Security Program

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GAO/HEHS-00-187

Report to the Chairman, Committee on Ways and Means, House of
Representatives

September 2000 SOCIAL SECURITY REFORM

Implications for Private Pensions

GAO/ HEHS- 00- 187

Letter 3 References 36 Figures Figure 1: Percentage Share of Aggregate Cash
Income by Retirement

Income Source, Married Couples and Unmarried Individuals, Age 65 and Older,
1998 10 Figure 2: Retirement Income by Source and Income Quintile,

Households Age 65 and Older, 1998 12 Figure 3: Integration With Social
Security in Defined Benefit Plans,

Percentage of Full- Time Participants, 1980- 1997 17

Abbreviations

ERIC Erisa Industry Committee ERISA Employee Retirement Income Security Act
of 1974 IRA individual retirement account OASDI Old- Age and Survivors
Insurance and Disability Insurance OBRA86 1986 Omnibus Budget Reconciliation
Act

Health, Education, and Human Services Division

Lett er

B- 283947 September 14, 2000 The Honorable Bill Archer Chairman Committee on
Ways and Means House of Representatives

Dear Mr. Chairman: The projected insolvency of the Social Security 1 Trust
Funds raises concerns about our nation's ability to ensure adequate
retirement income for current and future generations. While the accompanying
debate focuses on the potential effects of needed reforms on both
beneficiaries and workers, it should also be recognized that Social Security
reforms could affect the income that workers receive from private pensions.
For many workers, the income provided through private employer- sponsored
pensions represents an important pillar of our nation's retirement income
structure. The numerous proposals under consideration for improving the
financial status of Social Security involve a mix of options, including
reducing future benefits, raising the retirement age, 2 raising revenues,
and introducing vehicles for investing payroll taxes in marketable financial
securities such as stocks and bonds. Such reforms, while directly affecting
the retirement income provided through Social Security, will also alter the
environment in which private pensions are sponsored and designed.

To better understand the implications of Social Security reform, you asked
us to study the interactions between Social Security and private pensions.
Specifically, we agreed to examine (1) the primary linkages between Social
Security and private pensions and the way they interact to provide
retirement income for workers and families, (2) the effects of traditional
Social Security reforms on the structure of employer- sponsored pension

1 Social Security refers to the Old- Age and Survivors Insurance and
Disability Insurance (OASDI) programs. 2 When Social Security was
instituted, the age of eligibility for full benefits, or normal retirement
age, was set at age 65. The Congress later enacted an early retirement age
of 62 at which any worker could retire with actuarially reduced benefits.
The normal retirement age is set to gradually rise to 67 by the year 2027
while the age for first eligibility for Social Security retirement benefits
(early retirement age) remains at 62.

plans through changes in the costs and incentives faced by employers and
workers, and (3) the effects of nontraditional reforms, such as individual
accounts, on the structure of the private pension system.

Examining the relationship and interactions between Social Security and
private pensions involves several areas of considerable complexity, and the
conflicting nature of much empirical research complicates any assessment of
the effects of Social Security reforms on private pensions. Our objective in
this study is to provide an overview of the key potential implications that
Social Security reform might have for private pensions. In conducting this
assignment, we surveyed an array of literature relevant to the topic. We
reviewed academic and policy studies of issues relevant to determining the
responses of employers and workers to Social Security reform and changes in
pension law and plan design. We supplemented this research with interviews
of pension experts. Our work was conducted between January and August 2000
in accordance with generally accepted government auditing standards.

Results in Brief Social Security and private pensions are key sources of
retirement income that are linked through the employer costs associated with
the

compensation provided to workers. Because pension plans serve as a
supplement to Social Security, many plans are integrated; that is, they
explicitly incorporate Social Security benefits or contributions into their
plan design. Employers also implicitly consider Social Security provisions
in designing pensions that complement their human resource and other
business strategies. For example, plan provisions may be linked to Social
Security's normal retirement age or provisions for disability benefits.
Because of these linkages, reforms in Social Security may affect worker and
employer behavior, which in turn may have consequences for pension plan
design, coverage, or benefit amounts.

Traditional reforms in the Social Security program, such as changing
benefits or taxes or raising the normal retirement age, may alter the
incentives of workers and employers, which could prompt adjustments in
private pension plans. The effect of any specific reform will depend on the
nature of the change (e. g., increase payroll taxes), its magnitude (e. g.,
cut benefits by 20 percent), its time horizon for implementation (e. g.,
increase payroll taxes in 2002), and its interaction with other provisions
that comprise a comprehensive reform proposal. Employers' and workers'
responses to reform will be shaped by a variety of factors, including the
firm's size, the type of pension plan offered, and the economic status of
the

worker. Employers will respond to reforms that affect compensation costs or
the incentives for sponsoring a plan. For example, a reduction in Social
Security benefits will raise compensation costs for employers with plans
that directly offset the earned pension benefit with a portion of the
worker's Social Security benefit. In response, employers might redesign the
plan feature, absorb the increased cost, or shift the cost to customers
through price increases or to employees through employment or compensation
reductions, among other possible changes. In reaction to increasing the
normal retirement age for Social Security, employers could face added
pension costs for subsidizing early retirement and may redesign their plans
to raise the eligibility age for retirement benefits. Workers may also
respond to Social Security reforms that increase their contributions or
reduce expected benefits by adjusting their savings behavior- for example,
by increasing participation in 401( k) plans or accumulating more savings
through other vehicles. They might also choose to work more, retire later,
or demand higher pension compensation.

The introduction of individual accounts raises a broad set of issues for
private pensions, depending on how such a reform is structured, its scope
(whether it is voluntary or universal), and its interaction with other
reforms as part of a broader reform proposal. Like more traditional reforms,
the effects of an individual account feature on the pension system will
depend on the explicit and implicit linkages between Social Security and
pensions and employers' and workers' responses to specific reforms. For
example, the introduction of individual accounts could affect private
pensions by changing the way employers integrate Social Security and pension
benefits. Depending on the extent to which individual accounts affect
employer costs, workers' reactions to risk, and workers' ability and
propensity to save, private pension coverage and participation could
increase or decrease. The design and implementation of individual accounts
will affect employer costs and could present substantial challenges in
coordinating pension plans with individual accounts within the current
regulatory framework for pensions. At the same time, an individual account
structure could provide an opportunity for many workers to expand their
access to private securities markets and increase their ability and
propensity to save for retirement. This might be possible if, for example, a
voluntary individual account is linked to Social Security. Individual
accounts could also expand the choice and flexibility available to workers
in meeting their income needs during retirement.

Our retirement income institutions operate in a dynamic environment where
workers, employers, and policymakers interact to pursue the goal of

retirement income security. The complexity of making policy change suggests
that any reform should be taken with careful deliberation. At the same time,
ensuring retirement income for those who most need it and encouraging the
development of new opportunities to secure and expand the retirement income
of future generations should be emphasized.

Background Social Security is the largest source of retirement income for
most American workers and their families. Since the program began paying

benefits in 1940, Social Security has served as a publicly provided source
of retirement income for workers. The program also provides benefits for
dependents, survivors, and the disabled and covers about 96 percent of all
workers. Social Security's benefit structure is based on a formula that
replaces specified percentages of lifetime average indexed earnings. The
basic benefit formula is redistributive in that the percentage of lifetime
earnings replaced (replacement rate) is higher for lower earners than it is
for higher earners. Benefits for dependents and survivors are generally
based on the earnings record of the worker from whom benefits are claimed.
When Social Security was instituted, the age of eligibility for full
benefits, or normal retirement age, was set at age 65. The Congress later
enacted an early retirement age of 62 at which any worker could retire with
actuarially reduced benefits. The normal retirement age is set to rise
according to a phased- in schedule to age 67 by the year 2027.

Numerous Proposals Social Security is financed mainly through payroll taxes
paid by workers

Address Social Security's and employers on covered earnings up to a maximum
annual earnings

level. 3 The program is generally financed on a “pay- as- you-
go” basis with Long- Term Solvency

the payroll taxes of current workers used to pay the benefits of current
beneficiaries. Periodic surpluses of revenues over expenditures are credited
to the Social Security Trust Funds, which represent future financial
commitments by the government to the program. Current Trust Fund projections
show that projected future revenues, including the amounts credited to the
Trust Funds, will not be sufficient to finance full benefits in the year
2037 and thereafter.

3 The maximum taxable earnings level in the year 2000 is $76, 200.

The Congress has addressed Social Security's solvency in previous reform
efforts, notably the 1977 and 1983 Amendments to the Social Security Act.
These reforms focused on modifying the program's existing benefit and
financing structures without introducing major changes in the program. The
reforms tended to focus on traditional options such as increasing the
payroll tax rate or covered earnings, altering the benefit formula, and
increasing the age of retirement. For example, the 1977 Amendments made
technical changes to the benefit formula, lowered benefits, and set higher
future payroll tax rates. The 1983 Amendments made a number of changes,
including advancing the payroll tax rate increases enacted in 1977,
increasing the number of workers covered under Social Security, and enacting
a gradual rise in the normal retirement age to 67, which began to be
effective this year. Despite the importance of these earlier reforms, there
is relatively little evidence regarding their effects that is directly
applicable to understanding the implications of current reform efforts on
private pensions. Part of the reason for the lack of evidence is that the
effects of Social Security reforms on pensions are intertwined with broader
economic trends and coincident changes in tax and regulatory policies. 4

4 For example, major reforms of the income tax took place in 1981 and 1986.
In addition, this and other legislation enacted in the 1980s substantially
increased pension regulation.

The nature of the current reform debate changed when the 1994- 1996 Social
Security Advisory Council discussed a broader range of reforms. 5 In
addition to debating traditional reform options, the Advisory Council
considered changing the basis for financing the program to include private
investment. One option would involve government investment of Trust Fund
assets in marketable financial securities. Another option would create an
account for each worker, who could then invest in marketable securities.
While both of these options might reduce the future cost of Social Security
to employers and workers, the individual account option would have greater
potential implications for Social Security's benefit structure. This report
will focus on individual accounts rather than collective investment because
of the implications for the benefit structure and because numerous proposals
incorporating individual accounts with more traditional options have been
put forth to address the program's longterm solvency. 6

Role of Private Pensions Before the creation of Social Security, private
pensions played a modest

Has Evolved Over Time role in providing retirement income. However, from
1940 to 1970, the

percentage of private wage and salary workers participating in private
pension plans increased from 15 to 45 percent due to a variety of factors,
including changes in tax and labor policies. This growth in pension
participation has slowed, however, and has stabilized since 1970 at about
one- half of the workforce. 7 Historically, the pension system developed
with defined benefit pension plans as the predominant form of coverage.
Defined benefit plans generally provide benefits using a specific formula
based on the earnings and tenure of the worker. Typically, defined benefit
plans are funded completely by the employer, who bears the investment risk
of such an arrangement. The other major type of pension plan is the

5 Report of the 1994- 1996 Advisory Council on Social Security, Vols. I and
II (Washington, D. C.: Advisory Council on Social Security, 1997). 6 For
broad discussion of the Social Security reform debate and various proposals
and options, see Social Security: Evaluating Reform Proposals( GAO/ AIMD/
HEHS- 00- 29, Nov. 4, 1999), and Social Security: Different Approaches for
Addressing Program Solvency (GAO/ HEHS- 98- 33, July 22, 1998). For
discussion of the collective investment option, see Social Security
Financing: Implications of Government Stock Investing for the Trust Fund,
the Federal Budget, and the Economy( GAO/ AIMD/ HEHS- 98- 74, Apr. 22,
1998).

7 There are different surveys of pension plan participants and different
ways to measure pension coverage. Using Current Population Survey data,
about 47 percent of the employed labor force is currently covered by a
pension plan. Pension Plans: Characteristics of Persons in the Labor Force
Without Pension Coverage( GAO/ HEHS- 00- 131, Aug. 30, 2000).

defined contribution plan, which generally involves contributions by the
employer to an individual account held for the worker, with the worker
bearing the investment risk. Some defined contribution plans are structured
to allow contributions by the employee. Often, defined contribution plans
are provided by employers as a supplement to defined benefit plans.

The current framework of the private pension system was shaped largely by
the Employee Retirement Income Security Act (ERISA) of 1974. ERISA imposed
specific requirements for vestingï¿½that is, the years of service after which
participants are entitled to benefitsï¿½and set other minimum requirements to
protect pension promises and workers' benefits. It established guidelines
for the operation and funding of pension plans. ERISA also required plan
termination insurance to protect workers' benefits under private sector
defined benefit pension plans. In part to encourage plan sponsorship,
pension plans have long been accorded favorable income tax treatment under
the tax code. Employer contributions to pension funds, up to certain limits,
are deductible expenses, and employee contributions and the contributions'
investment earnings are deferred from taxation. The 1980s saw the
institution of certain employee deferral defined contribution arrangements
under section 401( k) of the Tax Code, which generally allow tax- deferred
worker contributions in addition to employer contributions. 8 The growth of
401( k) plans has been cited by experts as a major factor underlying the
recent trend toward the greater availability of defined contribution plans,
in addition to other factors, such as the increased costs of defined benefit
plans partly associated with increased regulation and changes in income tax
laws, which reduced the tax advantages of pensions.

Social Security and Social Security provides about 38 percent of the
aggregate cash income of

Pensions Are Key Sources the elderly (see fig. 1). Private pensions are a
voluntary, employer- provided

of Retirement Income source of retirement income that comprises about 10
percent of aggregate

elderly income. 9 Also, some pensions are provided by public employers 8 The
Revenue Act of 1978 added Section 401( k) to the Tax Code. However, the
regulations implementing this section were not proposed until 1981 and final
regulations were approved in 1988.

9 This category may include individual annuities and may not include the
liquidation of savings (and interest) that originate as pension lump sums.

such as federal, state, and local governments. These comprise about 8
percent of aggregate elderly income.

Figure 1: Percentage Share of Aggregate Cash Income by Retirement Income
Source, Married Couples and Unmarried Individuals, Age 65 and Older, 1998

Social Security

37.6

Earnings

20.7

Other

3.6

Pensions

18.2

Government Income from

Employee Pensions 8.4

Assets

19.9

Private Pensions or Annuities 9.8

Source: Income of the Population, 55 or Older, 1998, Social Security
Administration, Washington, D. C., Table VII. 3, p. 121.

Pensions generally supplement Social Security benefits. For all but the
lowest and highest income quintiles, pensions are the second most important
source of retirement income (see fig. 2). In contrast, the benefits provided
by Social Security are most important to workers and households in the
middle ranges of the income distribution. Social Security comprises over 80
percent of the retirement income for households in the first (lowest) and
second quintiles of the distribution. For the third (middle) and fourth
quintiles, Social Security still serves as the most important source of
retirement income. For the highest quintile, pensions are a more significant
source of retirement income than is Social Security (20.5 percent compared
with 18. 3 percent), but pensions represent a smaller share for this group
than either personal savings or earnings. One factor underlying these data
is that pensions are not a universal source of retirement income as is
Social Security. As of 1999, about half of the working population was
covered by a pension. Although a larger number of workers may obtain some
pension coverage over an entire career, 10 it is unlikely that pension
coverage will ever match the nearly universal coverage provided by Social
Security.

10 One effort to project future pension recipiency estimated that by 2018
about three- fourths of households would receive some income from pensions.
Employee Benefit Research Institute, EBRI Databook on Employee Benefits, 3rd
ed. (Washington, D. C., EBRI, 1995).

Figure 2: Retirement Income by Source and Income Quintile, Households Age 65
and Older, 1998

Elderly Household Income (Dollars)

60,000 Savings/ Earnings/ Other 50,000

Pensions Social Security

40,000 30,000 20,000 10,000

0 First

Second Third Fourth Fifth Income Level (Quintile)

Note: The data presented here show pension income provided by both public
and private employersponsored pensions. These two sources display largely
the same pattern across income quintiles.

Source: GAO computations based on data in Income of the Population, 55 or
Older, 1998, Social Security Administration, Washington, D. C., Table VII.
5, p. 123.

Linkages Between Social Security and private pensions are key sources of
retirement income

Social Security and that are linked through the employer costs associated
with the

compensation provided to workers. Employers consider Social Security Private
Pensions Are

provisions in designing pensions that complement their human resource
Explicit and Implicit

and other business strategies. Some of the interactions between Social
Security and pensions are explicit, insofar as pension laws and regulations

permit employers to formally “integrate” or take account of
Social Security benefits and contributions in designing their pension plans.
In addition, many pension plans may be indirectly or implicitly linked with
other Social Security features, such as the normal retirement age or
eligibility criteria for disability benefits.

Pensions Are Designed to Many employers choose to offer a pension plan to
further their business

Address Employer Needs strategies or objectives. Although employers are
motivated to offer a

pension plan for many reasons, 11 the most important involve (1) the and
Foster Adequate

employer's need to attract and retain a workforce in a competitive labor
Income Replacement for

market and (2) the tax advantages, or preferences, associated with Workers

pensions. The employer's pension plan decision also will be shaped by the
nature and characteristics of the workforce available to the employer and
the employer's size and type of industry. These factors will enter into the
decision about the type of plan the employer will choose to sponsor and the
benefits it provides to individuals at different income levels.

Employers typically want to attract workers based on their productivity,
motivate them to perform efficiently in pursuit of the firm's goals, and
retain them to reduce the costs associated with turnover. Pensions provide a
tool for accomplishing these objectives. For example, pensions are a means
of providing deferred compensation that may encourage workers to make long-
term commitments to employers. This may have the benefit of reducing
turnover, making for a more stable, productive workforce. 12 At the same
time, employers also want to manage the retirement of their workforce, and
pensions are a means of offering incentives for workers to retire
immediately or sooner or later than they would otherwise.

Employers also choose to sponsor pension plans because of the favorable
federal tax treatment of pension contributions and asset returns. This

11 For a more detailed discussion, see Alan L. Gustman, Olivia S. Mitchell,
and Thomas L. Steinmeier, “The Role of Pensions in the Labor Market: A
Survey of the Literature,” Industrial and Labor Relations Review, Vol.
47, No. 3, Apr. 1994, pp. 417- 38.

12 A related rationale is that pensions provide a higher level of
compensation that encourages workers to exert greater effort on the job. It
may be difficult to monitor employee performance (i. e., detect low effort)
in certain occupations. The higher total compensation offered through a
pension imposes a potentially significant loss or penalty on the worker in
the event that low effort by the worker is detected. Thus, pensions help
overcome monitoring problems and ensure employee effort. This may be
particularly important for professional and managerial occupations.

favorable tax treatment lowers the cost of a dollar of pension compensation
to workers relative to an additional dollar of cash earnings. Business
owners and more highly paid employees find this tax treatment attractive.
Also, the tax advantages of pensions have traditionally played a role in the
financial management of the corporation, allowing firms some flexibility in
minimizing their tax liability and funding plans less expensively. For
example, a firm may contribute, subject to certain conditions and
limitations, more to the plan during profitable years, thus lowering its tax
liability, and less during times when profitability is poor.

In addition to motivations involving the labor market or tax preferences,
workforce characteristics and other business- related factors enter into an
employer's decision to sponsor a plan and the form that plan takes. For
example, the workforce characteristics of a small employer may differ from
those of a large employer. Small employers may tend to employ workers for
whom nonwage compensation is less important than wages. Such workers may be
younger, less experienced, lower paid, and exhibit higher turnover and less
attachment to full- time work than do workers in larger firms. An employer's
industry and occupational structure are also a consideration. Firms that use
highly skilled labor may be more motivated to sponsor pensions than those
using less skilled labor.

After deciding to sponsor a plan, employers must determine the design of the
plan and the benefits to be provided for workers. One of the most basic
decisions is whether the plan is based on a defined benefit or a defined
contribution, a decision that determines whether the employer or the worker
bears the investment risk associated with funding the plan. Employers, in
designing plans and setting benefit levels, will also consider a variety of
factors, including the total retirement income that is considered adequate.
13 One common measure of retirement income adequacy is the replacement rate,
which represents the benefit amount in retirement for a single worker or
household in relation to a measure of pre- retirement earnings, such as
earnings in the year before retirement. Currently, many benefit
professionals consider a 70 to 80 percent replacement rate as adequate to
preserve the pre- retirement living standard. 14 Social Security and
pensions play complementary roles in helping workers attain an adequate
retirement income. Because the Social Security benefit level provides a
proportionately higher benefit for earners at lower levels of the

13 Dan M. McGill, et al., Fundamentals of Private Pensions, 7th ed.(
Philadelphia, Penn.: University of Pennsylvania Press, 1996).

distribution, 15 some employers may balance this feature by designing plans
to provide proportionately higher benefits to middle and higher income
workers. 16

Social Security and Social Security reform could affect the employer's
pension plan decisions

Pensions Are Explicitly in cases where Social Security is explicitly linked
to the pension plan's

Linked Through Integration provisions. One way that Social Security and
pensions are explicitly related

Provisions is through the “integration” or the consideration of
Social Security benefits

or contributions in calculating a private pension benefit. The concept of
integration relates to the employers' responsibility to provide Social
Security contributions on behalf of workers and receive credit for these
contributions in relation to their contributions or the benefits provided
under their pension plans. In defined benefit plans, integration pertains to
the benefits paid to participants; in defined contribution plans, it relates
to the contributions made on behalf of workers by employers. Defined benefit
plans commonly involve two methods of integration:

14 The standard that pension professionals consider an adequate replacement
rate has changed over the years. While a 50 percent replacement rate might
have been considered adequate in the 1930s, when Social Security was
instituted, this standard has risen. See Sylvester J. Schieber, “The
Employee Retirement Income Security Act: Motivations, Provisions, and
Implications for Retirement Income Security,” paper presented at
“ERISA After 25 Years: A Framework for Evaluating Pension
Reform,” Washington, D. C., Sept. 17, 1999, pp. 8- 9. Also note that
the replacement rate considered to be adequate can be computed in a more
sophisticated way, netting out Social Security taxes, other taxes, or
working expenses that will not be paid in retirement. Thus, desired or
target replacement rates can vary significantly by income level and other
factors. See Bruce A. Palmer, “Retirement Income Replacement Ratios:
An Update,” Benefits Quarterly, 2nd Quarter, 1994.

15 Social Security currently provides a replacement rate of 53 percent for a
low earner, 39 percent for an average earner, and 24 percent for a maximum
earner. These figures are based on applying Social Security benefit rules to
hypothetical retired workers who had various specified (steady) earning
levels over their careers and attained age 65 in 2000. The average earner
represents a worker who earned the average of covered workers under Social
Security each year. The low earner earns 45 percent of this average. The
maximum earner has annual earnings equal to the OASDI contribution and
benefit base each year.

16 Pension plan design is influenced by an array of other factors, such as
pension regulation, which may counteract design features that benefit higher
earners. For example, available data suggest that typical pension
replacement rates for a 30- year career worker have been in the 20- to 40-
percent range across the earnings distribution and that lower earners
received slightly higher replacement rates than higher earners. Olivia S.
Mitchell, “New Trends in Pension Benefit and Retirement
Provisions,” Working Paper No. 7381 (Cambridge, Mass.: National Bureau
of Economic Research, Oct. 1999).

In the offset method, the employer designs the plan to provide a given
benefit based on the employee's total compensation. A percentage of any
Social Security benefit received is then deducted from the calculated
pension benefit. In the excess or step- rate method, one layer of benefits
is generally

based on the employee's total compensation, and a second layer is based on
compensation in excess of a specified dollar level termed the
“integration level.” This method is analogous to the way defined
contribution plans are integrated with Social Security on the basis of
contributions. 17

Explicit integration provisions remain a common feature of many pension
plans even though their form has changed over time. The Congress
substantially revised integration provisions in the Tax Reform Act of 1986,
and there was a subsequent decline in the prevalence of integrated plans and
a strong shift toward the use of the excess method. From 1986 to 1997, the
percentage of all defined benefit plan participants in medium to large firms
with an integrated plan declined from 62 to 49 percent. Moreover, the
percentage of participants in defined benefit plans using the offset method
declined from about 43 to 13 percent of all participants, while the
percentage of participants in plans using the excess method increased from
24 to 36 percent (see fig. 3). 18

17 For example, in a defined contribution plan, a “base contribution
percentage” is applied to compensation below the integration level.
For compensation above the integration level, a higher or “excess
contribution percentage” is applied. The difference between these two
contribution percentages is commonly referred to as the “permitted
disparity.” This difference is limited to either 5. 7 percentage
points or the base contribution percentage. In other words, it cannot exceed
5. 7 percent (see McGill, Fundamentals of Private Pensions, Ch. 15). To have
a plan design that relies on permitted disparity under Sec. 401( l) of the
Tax Code, a plan must satisfy certain criteria called “safe
harbors” under nondiscrimination rules, which seek to promote equity
in the provision of pension benefits. In addition, the “integration
level” to which permitted disparity applies is often the maximum
taxable ceiling on covered earning under Social Security. The integration
level may be lower than this ceiling but may not exceed it, and different
permitted disparity rules apply. Pension benefits and contributions can be
integrated with Social Security outside the permitted disparity rules as
long as the plan meets the general nondiscrimination provisions of the Tax
Code.

18 For information on the characteristics of individuals in integrated
pension plans, see Keith A. Bender, “Characteristics of Individuals
with Integrated Pensions,” Social Security Bulletin, Vol. 62, No. 3,
1999, pp. 28- 40.

Figure 3: Integration With Social Security in Defined Benefit Plans,
Percentage of Full- Time Participants, 1980- 1997

Percentage of Full- Time Participants

70

With Integrated Formula

60 50 40

Offset Method

30

Excess Method

20 10

0 1980

1981 1982 1983 1984 1985 1986 1988 1989 1991 1993 1995 1997 Year

Source: U. S. Department of Labor, Bureau of Labor Statistics,
“Employee Benefits in Medium and Large Firms, 1980- 97.”

Pensions Are Implicitly Because Social Security has a central role in
providing retirement income,

Linked in Various Ways With almost all pension plans are implicitly linked
to Social Security, insofar as

Social Security their design takes into account the provisions of and
benefits provided by

Social Security. Because pension designs have evolved over time, they have
incorporated specific features related to Social Security. Examples of such
implicit linkage involve the specification of the age of benefit eligibility
(retirement age) and benefit provisions for survivors and the disabled.

An important implicit linkage with Social Security is pension plans'
specification of a normal retirement age. The retirement ages provided by
Social Security form a basic framework around which plans design their
provisions. Private defined benefit pensions generally include age and
service provisions that determine when an employee becomes eligible for
benefits. While some plans have age- only or service- only retirement
requirements, most plans base retirement benefit eligibility on a
combination of age and service. 19 These age and service provisions allow
employers to structure plans in ways that allow eligible workers to retire
earlier than the ages set by Social Security. However, most plans allow
workers who meet minimum service (vesting) requirements to claim pension
benefits by age 62 or age 65. Another example of an implicit linkage with
Social Security occurs when plans provide “bridge benefits,”
which provide workers who retire from a private pension a supplement until
the worker is eligible for a Social Security benefit at age 62. 20

Social Security and pensions are also implicitly linked through provisions
concerning survivor and disability benefits. Employer- sponsored pension
plans offer benefits for surviving spouses of retired workers, referred to
as joint and survivor benefits. 21 Some pension plans also provide
disability benefits. Joint and survivor benefits are provided in addition to
the survivor benefits received under Social Security. Private disability
benefits often supplement Social Security disability benefits. In 1995, more
than 60 percent of full- time employees were covered under long- term
disability plans. Although not required by law, many plans calculate the
private disability benefit by offsetting the amount received from Social
Security disability benefits in a manner somewhat analogous to the
integration of pension benefits with Social Security old age benefits.

19 Mitchell, “New Trends in Pension Benefit and Retirement
Provisions.” 20 Janice Gregory, “Possible Employer Responses to
Social Security Reform,” in Prospects for Social Security Reform,
edited by O. Mitchell, R. J. Myers, and H. Young (Philadelphia, Penn.:
University of Pennsylvania Press, 1997), pp. 311- 32. 21 Defined benefit
plans are required to provide a 50 percent joint and survivor annuity as a
benefit distribution option to a married employee. Under defined
contribution plans, the surviving spouse inherits the married employee's
account balance. See ERISA Industry Committee (ERIC), The Vital Connection:
An Analysis of the Impact of Social Security Reform on Employer- Sponsored
Retirement Plans( Washington D. C.: ERISA, July 1998).

Traditional Social Traditional reform options, such as reducing benefits or
increasing payroll

Security Reforms taxes, will likely affect the provision of employer-
sponsored pensions. The

effects on pensions will depend on the nature (e. g., benefit cut or payroll
Could Affect Pension

tax increase), magnitude (e. g., cut benefits 10 percent or raise payroll
taxes Plans by Changing the

5 percent), and timing (e. g., raise taxes or the retirement age immediately
Incentives Facing

or in 2015) of the reforms. Effects will also depend on whether Social
Security and pensions are explicitly linked, such as through integration

Employers and provisions, or implicitly linked. For any of the reforms under
consideration,

Workers the ultimate effects on pensions will depend on employers' and
workers'

responses. Employers will likely respond to reforms that change their
compensation costs or reasons for sponsoring plans. For example, Social
Security reforms that reduce benefits could raise plan costs for employers
with “offset” integration features, or employers could redesign
their plans to eliminate that feature, absorb the costs, or take other
actions. Workers will likely respond to reforms that change their Social
Security contributions, their expected benefits, or their incentives to
save, work, or retire. The interactions between workers and employers in
response to Social Security reform will determine the form that pensions
take and may affect other sources of retirement income.

Traditional Social Security Social Security reform proposals that
incorporate traditional options such

Reforms Will Affect as reducing benefits or increasing payroll taxes will
directly affect private

Integrated Pension Plans pension plans that are integrated with Social
Security. Benefit reductions

could raise compensation costs for employers with plans integrated by using
the offset method. Payroll tax increases implemented by changing the maximum
taxable earnings level could affect the incentives present in plans using
the excess method of integration. Such changes could cause employers to
consider redesigning their plans to eliminate integration features, but they
might also consider supplementing benefits to employees at higher earning
levels through nontax- qualified plans.

Reform proposals that reduce benefits will most likely increase employer
costs for plans using the offset integration method. Defined benefit plans
that use the offset integration method generally reduce the accrued pension
benefit by a portion of the benefit earned from Social Security. Thus,
reform proposals that reduce benefits will automatically reduce the offset
amount. As a result, the portion of the total pension benefit that will be
provided by the pension will increase, thus increasing employer plan costs.
A reduction in Social Security benefits only raises the required pension
portion by the amount of the partial offset. For offset plan

participants, a Social Security benefit reduction may still result in a
reduction in the overall retirement income amount because the Social
Security benefit reduction is only partially offset by an increase in the
amount coming from the pension.

Employers may respond to these changes in a variety of ways. For example,
their responses could vary from modifying the offset provision to absorbing
the cost, presumably in reduced profitability, or by shifting the cost
through increased product prices or reduced employment. Alternatively, the
employer could alter other forms of compensation, such as wage rates or
health benefits, in addition to, or in lieu of, changing the pension plan.
One factor that would mitigate the overall effect of higher employer costs
in offset plans is that the prevalence of this method of integration in
defined benefit plans has declined substantially since the Tax Reform Act of
1986 (see fig. 3). However, increasing the costs of using this method could
reduce its prevalence even further.

Social Security reform proposals that increase revenues by increasing the
taxable wage base could affect pension plans that are integrated with Social
Security using the excess method. This could reduce plan costs but could
also erode the effectiveness of the provision. This is because the excess
method permits pension plans to have a higher contribution or accrual rate
for employees above the “integration level,” which in most such
plans is the maximum taxable ceiling on earnings covered by Social Security.
22 As a result, if the level of maximum taxable earnings is raised,
employers might adjust upwards the integration level of plans, thus reducing
the number of covered workers eligible for higher contributions or accruals.
This could reduce employer costs but could make the plan a less attractive
incentive device both for the higher- earning employee and the employer
interested in providing higher compensation for certain employees. 23 Plans
might be restructured with implications for benefit amounts, and some
employers might reevaluate their motivations for plan sponsorship. One
possible scenario is that employers might redesign their

22 In general, the integration level may be less than, but may not exceed,
the maximum taxable earnings level. Bureau of Labor Statistics data show
that for employees of medium and large establishments in defined benefit
plans using the excess method of integration, over 90 percent are in plans
that have a Social Security breakpoint as the integration level.

23 Even nonintegrated plans may use the maximum taxable earnings level as a
basis for the use of permitted disparity in complying with the
nondiscrimination rules of the tax code. Changing the maximum taxable
earnings level might thus alter the balance between groups of workers that
are highly compensated and those that are not.

plans to provide more equal accruals across the earnings distribution and
then supplement the benefits of their highly paid employees through the use
of nontax- qualified plans, which is a current trend in the pension field.
24 Such a development could result in lower benefits for lower and middle
earners and could make higher earners and employers less interested in
maintaining qualified pension plans.

Traditional Social Security Traditional Social Security reforms will also
have implications for private

Reforms Will Also Affect pensions through implicit linkages between Social
Security and pensions.

Pensions Through Other Two implicit linkages involve increases in Social
Security ages for normal

Implicit Linkages and early retirement and increases in payroll tax rates.
Proposals to raise

Social Security's retirement ages and payroll tax rates could increase
employer costs, with employers possibly responding by reevaluating their
plan designs. Although little evidence on the effects of changes in the
retirement age is available, increases in the retirement age would likely
lead employers to review existing early retirement incentives in light of
current labor market conditions and their long- term human resource
objectives.

Many employers have used defined benefit pensions as a tool for workforce
management, especially in reducing turnover or encouraging early retirement.
The ability to offer early retirement incentives through a pension allows
employers to choose when to induce turnover if the firm views this goal as
beneficial. Employers can then hire newer workers at lower compensation
levels, or they can motivate midcareer employees with greater opportunities
for advancement. Data suggest that plans with ageonly retirement provisions
tend to peg these provisions more closely to the Social Security age for
normal retirement (65) and around 55 for early retirement. 25 However, more
typically, plans have age and service requirements; over time these have
tended toward age 62 as the normal

24 Janice Gregory, “Possible Employer Responses to Social Security
Reform,” p. 318; and Christopher Bone, “An Actuarial Perspective
on How Social Security Reform Could Influence Employer- Sponsored
Pensions,” in Prospects for Social Security Reform, edited by O.
Mitchell, R. J. Myers, and H. Young (Philadelphia, Penn.: University of
Pennsylvania Press, 1997), pp. 340- 41. For information on nontax- qualified
deferred compensation arrangements, see Compensation Resource Group, Inc.,
Executive Benefits: A Survey of Current Trends, 1999 Survey Results(
Pasadena, Calif.: CRG, 1999).

25 Mitchell, “New Trends in Pension Benefit and Retirement
Provisions,” p. 12.

retirement age, with provisions allowing earlier retirement, such as at age
55.

If Social Security retirement ages are raised, it is unclear whether or how
employers might adjust retirement ages in private pensions. For example,
while the 1983 Amendments enacted an increase in the retirement age that has
begun to be phased in, little is known about how this has affected the
retirement ages used in pensions. Employers will likely continue to
determine pension retirement ages according to their workforce management
objectives. One factor that may induce employers to adjust the retirement
ages of pensions is when plans offer some form of “bridge
benefit,” which provides a pension benefit supplement to early
retirees until they become eligible for Social Security retirement at early
or normal ages. In such cases, higher Social Security retirement ages with
no compensating adjustment in the plan's retirement age could result in
substantially higher pension costs to the employer. This could create an
incentive to change the plan's provisions for retirement age toward any
higher Social Security retirement ages or to make other plan changes.

Raising Social Security retirement ages could potentially create a larger
gap between Social Security and private pension retirement age provisions
and cause employers to rethink their retirement incentives in the context of
current labor market trends. Some evidence indicates that employers might
respond by seeking to retain the effectiveness of their retirement
incentives. 26 Although some employers will want to continue to use pensions
as a tool to reduce or adjust the composition of their workforces, recent
evidence indicates that some employers may now want to retain

26 One study of pension plans covering 1960 through 1980 reported evidence
of an association between retirement incentives in private pensions and
retirement incentives embedded in the Social Security benefit structure. The
researchers noted that this evidence is consistent with the hypothesis that
employers offset Social Security incentives to retire early by increasing
pension incentives to delay retirement. In spite of the strong relationship
reported, the authors found no statistically significant relationship
between Social Security and changes in pension rewards for deferring
retirement between ages 62 and 65. They found that Social Security
incentives for retiring at or after age 65 were typically reinforced by
similar incentives in private pension plans. See Rebecca A. Luzadis and
Olivia S. Mitchell, “Explaining Pension Dynamics,” The Journal
of Human Resources, Vol. 26, No. 4 (1991), pp. 679- 703.

older workers. 27 For example, some firms have been developing pension
structures in which workers accumulate benefits more evenly over their
careers, in contrast to the “back- loading” typical of
traditional defined benefit plans. 28 The introduction of
“hybrid” arrangements such as “cash balance plans”
29 could have the effect of reducing early retirement subsidies found in
traditional defined benefit plans and could make it more attractive for
firms to retain older workers in the future. 30 Thus, to the extent that
employers are implementing pension plan provisions that encourage workers to
retire later, the potential effects of raising the Social Security
retirement age on private pensions may be mitigated.

In contrast, defined contribution plans do not have the same incentive
properties for early retirement found in many defined benefit plans. 31
Defined contribution plans generally allow workers to withdraw their
accumulations or benefits as a lump- sum, without penalty, beginning at age
59ï¿½. Thus, changing Social Security retirement ages may have implications

27 Mitchell notes an example of a pension requirement that may have
discouraged firms from hiring older workers. Before the 1986 Omnibus
Reconciliation Act (OBRA86), plans could impose participation limits on
(older) workers who joined the firm within 5 years of the plan's normal
retirement age. Such provisions limited the pension accruals for these
workers and made it less expensive for the firm to hire them. OBRA86
eliminated maximum age restrictions on workers, thus making it more
expensive for firms to hire older workers. See Mitchell, “New Trends
in Pension Benefit and Retirement Provisions,” p. 10.

28 Watson Wyatt Worldwide, The Unfolding of a Predictable Surprise: A
Comprehensive Analysis of the Shift From Traditional to Hybrid Plans(
Bethesda, Md.: Watson Wyatt Worldwide, 2000). 29 Hybrid pension plans
combine features of defined benefit and defined contribution plans. For
example, cash balance plans have a benefit structure that looks similar to a
defined contribution plan in that benefits are expressed as a lump- sum
individual account balance. However, cash balance plans (which legally
remain defined benefit plans) operate like defined benefit plans in that the
employer bears the investment risk to meet a given return on the account.

30 Robert L. Clark and Sylvester J. Schieber, “Taking the Subsidy Out
of Early Retirement: The Story Behind the Conversion to Hybrid
Pensions,” paper prepared for the Conference on Financial Innovations
for Retirement Income, The Wharton School, University of Pennsylvania,
Philadelphia, Penn., May 1- 2, 2000.

31 Defined contribution arrangements typically have a more even distribution
of accruals over time than typical defined benefit plans. One expert
suggests that the attractiveness of defined benefit plans as a workforce
management tool may have declined relative to defined contribution
arrangements. Richard A. Ippolito, “The New Pension Economics: Defined
Contribution Plans and Sorting,” The Future of Private Retirement
Plans( Washington, D. C.: EBRI, 2000).

for the age at which individual workers choose to take their benefits. It is
likely that some workers would delay retirement as they try to meet
retirement income goals.

Raising payroll taxes could lead employers to reduce plan benefits or even
terminate some plans, which could reduce worker pension coverage. Higher
payroll taxes would directly raise the compensation costs of employers in
the short term and would likely trigger a series of economic adjustments to
wages, prices, or employment. 32 Pensions or other elements of compensation,
such as health benefits or wages, could be reduced, leaving workers' overall
compensation and the firm's profitability unchanged. Employer responses such
as reducing plan benefits or terminating a plan could depend in part on the
size of the firm. Because smaller employers are generally more sensitive to
changes in their compensation costs, payroll tax increases could make them
more likely to terminate their plans, compared with larger firms. If this is
the case, then overall pension coverage might show a modest decrease, and
the existing disparity in coverage and compensation between large and small
firms might be exacerbated. In general, even though payroll taxes have been
increased in the past, it is difficult to disentangle the effects of payroll
taxes on employers and pensions from other influences.

Workers May Respond to A key element in evaluating the effect of traditional
Social Security reforms

Traditional Social Security on pensions involves workers' responses to such
reforms. While employers

Reforms That Affect play a primary role concerning the decision to sponsor
and design a

Contributions or Future pension plan, worker demands can play a substantive
role in influencing

these decisions. In addition, workers make individual decisions that have
Benefits

implications for their future retirement income. These include decisions
about consumption and saving, how much to work, and when to retire. Social
Security reform could affect the private pension system through its effect
on workers' saving and consumption decisions. Most traditional reforms
involve workers paying more for promised future benefits or accepting lower
benefits. Workers could experience either a reduction in their current
income available for consumptionï¿½if payroll taxes are

32 It has long been argued that employers do not bear any direct burden of
the payroll tax because it is “passed on” to workers through
these economic adjustments. Even if this conclusion is accepted, pensions
might be affected because they constitute a way in which the economic
adjustments could be implemented. There has been examination of the effects
of changes in the Social Security payroll tax generally, but for the most
part, this literature is inconclusive with regard to the effects on
employers and pensions.

increased, for exampleï¿½or a lower anticipated retirement income, which would
occur if benefit levels were reduced.

Workers' response to traditional Social Security reforms could take
different forms. They might act to offset the effect of reforms by saving
more, or working more and retiring later. Alternatively, they might not
change their savings or employment levels but experience a reduced living
standard or draw down other assets. If Social Security reform reduces
anticipated retirement income, many analysts would expect that workers
might, to some degree, want to offset this effect by increasing their saving
outside the Social Security program. Workers could demand higher pension
compensation or save individually by contributing to 401( k) s or individual
retirement accounts (IRAs). 33 Past research has considered whether the
existence of Social Security and workers' anticipation of future benefits
reduced their savings in other assets. While some analysts found evidence of
reduced saving, others disputed such an effect. 34 More recent research has
examined whether the creation of IRAs or 401( k) s has led to a net increase
in individual saving. Some economists contend that the contributions to
these savings vehicles are offset by a reduction in other forms of saving,
while others find that contributions are not completely offset and hence
yield a net increase in savings by workers. 35 The conflicting nature of
these empirical debates illustrates the difficulty in drawing conclusions
about the effects of proposed Social Security reforms on private pensions or
national saving overall.

Another related area in which Social Security reform could have implications
for private pensions concerns workers' decisions about how much to work and
when to retire. Some analysts believe that if workers perceive a current or
future decrease in income due to lower future benefits or higher payroll
taxes, most would work more to make up for lower anticipated income. These
reactions can also apply to their choice of retirement age. Workers
anticipating less retirement income may choose to

33 This could also prompt calls for raising limits on allowable pension
contributions or benefits. 34 For a summary of this empirical debate, see
Henry Aaron, Economic Effects of Social Security( Washington, D. C.: The
Brookings Institution, 1982).

35 For a recent summary and contribution to this debate, see William Gale,
“The Impact of Pensions and 401( k) s on Saving: A Critical Assessment
of the State of the Literature,” paper presented at “ERISA After
25 Years: A Framework for Evaluating Pension Reform,” Washington, D.
C., Sept. 17, 1999.

stay in the workforce longer than they might otherwise. Thus, benefit cuts
or tax increases may create incentives for workers to work more in the
current period or work more years to offset the effect of these changes.
Such effects could imply that over time workers might tend toward higher
labor force participation, more hours of work, or delayed or phased- in
retirement. In turn, employers may redesign pensions to address such worker
preferences. The movement toward defined contribution plan designs, which
tend to reduce early retirement incentives, may be a trend consistent with
these effects.

Structural Reforms to Including individual accounts as a reform feature
raises key issues for the

Social Security Could private pension system. Implications for the private
pension system will

depend on how the individual account is structured (e. g., how it is
financed Have Implications for

and administered), its scope (e. g., whether it has voluntary or universal
the Private Pension

participation), and its interaction with other reform provisions (e. g.,
System

whether other benefits are reduced). Like more traditional reforms, the
effects of an individual account reform feature on the pension system will
occur through explicit and implicit linkages between Social Security and
pensions and employer and worker responses to specific reforms. Because
individual accounts have generally been proposed as a part of more
comprehensive reform packages that include traditional reforms such as
cutting benefits, it is difficult to disentangle their possible effects on
private pensions.

Proposals for Individual The implications of individual accounts for the
private pension system will

Accounts Vary in Form and depend on how the accounts are structured and
administered. 36 These

Raise Many Issues issues include the magnitude and nature of the accounts'
funding, how the

accounts are administered, whether participation is voluntary or universal,
the degree of choice and control accorded to workers in regard to investment
of account funds and the form in which benefits are received, and the
interaction of individual account features with other reform provisions.

The most basic structural issues concern the magnitude of the accounts'
financingï¿½that is, the amount or the percentage of payroll devoted to the

36 Social Security Reform: Implementation Issues for Individual Accounts(
GAO/ HEHS- 99122, June 18, 1999).

accountï¿½and the nature of that financing. While proposals vary, a number of
them focus on creating accounts with a contribution of 2 percent of Social
Security taxable payroll. This feature determines the future role accounts
will play in Social Security financing and whether investment returns might
alleviate the need for traditional reforms. The amount devoted to the
account will also determine workers' retirement income, contingent on
investment performance.

The nature of the individual accounts' financing also has implications for
the private pension system to the extent that it affects the contributions
employers make on behalf of workers. Some proposals implement individual
accounts through a “carve- out,” which generally maintains the
current level of payroll tax rates but devotes a portion of payroll taxes
(e. g., 2 percent) to the individual account. Other proposals implement the
individual accounts by means of an “add- on,” which generally
creates accounts that supplement the current Social Security program and
increases overall contributions to the system. In general, while add- on
accounts would appear more likely to directly increase employers' costs,
assessing the implications of these different structures for private
pensions is complicated because it is necessary to consider the entire
reform package, which may include benefit cuts or other revenue measures
such as general revenue financing or government borrowing. Also, the degree
to which Social Security benefits are reduced or offset against the account
is an important design issue. 37 The accounts can be integrated into the
Social Security benefit structure in a way that preserves all currently
legislated benefits as a floor. This would limit the risk borne by the
worker, while allowing the worker to share in the rewards if the account
exceeds the returns implicit in the current Social Security benefit
structure. This feature will also affect the overall cost of a Social
Security reform package to workers and employers.

Another key issue concerns whether the accounts would be structured to allow
workers to hold the account entirely outside the Social Security program or
whether the accounts would be set up through government institutions that
would play a role in administering and channeling funds to investors.
Employers are concerned about the resources and administrative costs they
would have to devote to managing the accounts and financial flows. Proposals
differ in the degree to which the

37 Proposals that include this feature are discussed in Social Security:
Evaluating Reform Proposals( GAO/ AIMD/ HEHS- 00- 29).

administration of the accounts is either centralized through government
institutions or decentralized through employers and the financial industry.
Some believe that retaining some government role could reduce administrative
burdens on employers and workers, but others emphasize the advantages of
expanded choice that could be made available to workers.

The scope of an individual account reformï¿½that is, whether the account is
mandatory or voluntaryï¿½also could have implications for the private pension
system. Some proposals include mandatory account provisions because they
would appear to be more directly linked to Social Security, and in
particular, to the universal nature of the program. 38 Mandatory accounts
thus provide a degree of certainty about the structure of Social Security
that employers can take into account in responding to reform and in possibly
redesigning their plans. The linkage between voluntary accounts and Social
Security would appear to be more tenuous and more complicated to analyze.
For example, some voluntary account designs are structured to supplement
Social Security and would be hard to distinguish from retirement saving
vehicles such as IRAs. Such similarities could result in low participation
and minimal impact on most workers' retirement income and on pension plans
generally. Alternatively, voluntary accounts could be targeted to specific
groups, such as young workers, lower income workers, or those who are not
currently covered by a private pension. Such designs could address some of
the concerns about the adequacy of benefits and gaps in coverage. 39

Another important individual account design feature concerns the degree of
choice and control that workers would have over their funds and the degree
of flexibility that workers might have in accessing the funds in their
accounts. Providing workers more options in which to invest their funds
allows them to diversify risk and perhaps earn higher returns. However, this
can increase the costs of the system. Allowing greater flexibility in
accessing funds could give workers greater control over the decision to

38 There are different rationales for the mandatory and universal nature of
Social Security. One rationale is that a government program can more easily
deal with adverse selection in providing annuities compared with the private
sector. Another rationale involves protection against those who would
“free ride” on government support unless required to participate
and contribute.

39 Note that, depending on which workers contribute to Social Security
individual accounts and the way in which contributions are treated, the
ability of existing pension plans (such as 401( k) s) to pass
nondiscrimination tests could be affected.

retire. They could also have greater control over the form in which they
receive their retirement income over their lifetime because they could
choose annuities or keep a portion of their funds invested. However,
allowing greater access to funds before retirement and greater choice in the
form in which retirement income is received could complicate administration,
increase costs, and possibly reduce future retirement income. 40

The interaction of an individual account feature with the other provisions
of a comprehensive reform also has consequences for the private pension
system. In this instance, the net effects on the private pension system
would depend on the other provisions included in the reform and the
structure of the individual account feature. Individual accounts could
either moderate or exacerbate these effects, depending on the exact features
of the broader reform.

Individual Accounts Could Structural reforms that create individual accounts
could have an array of

Have Broad Implications for implications for private pensions. Some arise
from the explicit and implicit

Integrated Plans and linkages between Social Security and pensions and will
depend on the

Employer- Worker Decisions responses of employers and workers. For example,
individual accounts

could affect private pensions if the employer chooses to change the type of
integration provisions used. To the extent that individual accounts affect
employer costs or workers' reactions to risk, both employers' incentives to
provide pension coverage and workers' incentives to participate in pensions
could be affected.

One expert suggests that integrated pension plans may be affected through
the definition of the Social Security benefit. 41 The issue could arise
where a portion of the individual's total benefit comes from both the
individual account and from Social Security. Plans currently must estimate
the participant's Social Security benefit to calculate the appropriate
offset. With an individual account, estimating the benefit amount to
determine the appropriate benefit offset could become more complicated and
perhaps costly for the employer. This might compel employers to abandon the

40 Social Security Reform: Implications of Private Annuities for Individual
Accounts (GAO/ HEHS- 99- 160, July 30, 1999); 401( k) Pension Plans: Loan
Provisions Enhance Participation But May Affect Income Security for Some(
GAO/ HEHS- 98- 5, Oct. 1, 1997). 41 Chuck Slusher, “Pension
Integration and Social Security Reform,” Social Security Bulletin,
Vol. 61, No. 3, 1998, pp. 20- 27.

offset method in favor of the excess method of integration. For this method,
they need only satisfy the rules regarding permitted disparity and do not
need to calculate the total Social Security benefit accurately.

Depending on their structure, individual accounts could increase employer
costs by increasing contributions and imposing an administrative burden to
maintain the accounts. Employers may respond to the higher costs associated
with contributions to an add- on account in ways similar to those described
for payroll taxes; worker behavior may also be affected. While large
employers appear to be better able to handle the costs and administrative
demands of an individual account system, smaller employers may face greater
difficulties, such as reduced profitability, that could reduce their
willingness to provide pensions.

Worker reactions to the introduction of individual accounts will be shaped
by the way in which they assess risk in relation to their retirement income.
If individual accounts achieve higher rates of returns than beneficiaries
receive under Social Security, and these returns are captured in a way that
improves program financing, the accounts could reduce or mitigate the
benefit cuts and tax increases otherwise needed to pay promised levels of
Social Security benefits. 42 Therefore, individual accounts might reduce
workers' need to adjust to lower anticipated benefit levels or the higher
taxes included in some reform proposals. However, individual accounts would
also likely increase the level of risk or uncertainty associated with
anticipated retirement income. 43 Under individual account proposals that
provide for a broad range of investment choices, workers might be able to
choose an appropriate level of risk by adjusting investments within the
account, or they might reallocate their pension- related assets to readjust
the level of risk of their overall portfolios. For example, workers could
offset an increase in risk from the individual account by adjusting the
allocation between fixed income assets and equities in their 401( k)

42 Note that depending on the structure of a reform proposal, introducing
individual accounts could increase in the near termthe unfunded costs of
Social Security (sometimes referred to as “transition costs”).
However, proponents of individual accounts argue that in the long term, the
total costs of meeting existing benefit promises under Social Security will
be lower for individual accounts than for traditional reforms. Martin
Feldstein and Andrew Samwick, “The Transition Path in Privatizing
Social Security,” in Privatizing Social Security, Martin Feldstein,
ed. (Chicago: The University of Chicago Press, 1998), pp. 215- 64.

43 The discussion here focuses on investment risk, but workers can face many
other types of risks regarding retirement income such as longevity risk,
inflation risk, and the risks of death and disability.

accounts. Workers might also exhibit increased demand for annuity- type
products or perhaps even defined benefit pension arrangements. 44 The
ability to adjust to the introduction of individual accounts could be more
problematic for workers who have limited knowledge of investment principles
or who have few or no alternative assetsï¿½a sizable portion of the
population. For example, data suggest that about one- quarter of all
families nearing retirement have less than $25, 000 in assets such as
stocks, bonds, home equity, and bank accounts. 45

Implementing Individual Individual accounts raise a broader set of issues
for private pensions

Accounts Presents compared with traditional reforms. The design and
implementation of

Challenges and individual accounts will affect not only employer costs but
could present

Opportunities employers and workers with substantial challenges in
coordinating existing

defined benefit and defined contribution pension plans with individual
accounts under the current regulatory framework for pensions. At the same
time, an individual account structure could provide an opportunity to expand
access to private retirement income while increasing the choice and
flexibility available to workers.

Employers might seek to offset any higher costs arising from individual
accounts by reducing or restructuring their existing pension plans. If the
accounts achieve investment returns that are below historical trends or the
implicit returns to Social Security, the adjustments that employers and
workers may have to make to maintain expected retirement income could be
exacerbated. For example, if accounts perform below expectations, workers
may desire to delay retirement, which could make it more difficult for
employers who may want to offer early retirement incentives to older
workers. A related issue concerns the degree to which employers would

44 Some evidence about change in asset allocation is found in Cori E.
Uccello, “401( k) Investment Decisions and Social Security
Reforms,” Working Paper No. 2000- 04 (Center for Retirement Research,
Mar. 2000). The author finds that when workers have both a defined benefit
(guaranteed) plan and a supplemental 401( k) plan, there is a tendency to
invest more aggressively in the 401( k) account. This suggests that workers
with a guaranteed form of retirement income such as Social Security will
invest more aggressively. Conversely, if the guaranteed portion is
reducedï¿½by substituting an individual account, for exampleï¿½workers might
have a tendency to invest less aggressively. Uccello concludes that the
implication for this is that the return to the individual account might be
lower. As a result, the advantages of moving to an individual account system
might be overstated.

45 Retirement Income: Implications of Demographic Trends for Social Security
and Pension Reform( GAO/ HEHS- 97- 81, July 11, 1997).

want to, or have to, coordinate their existing pensions with individual
accounts. For example, pensions and individual accounts could have very
different rules for distributing benefits. A 401( k) account currently
permits workers to take lump- sum distributions without penalty at age 59ï¿½,
while Social Security individual accounts might restrict distributions until
the age of eligibility for Social Security (62 or later). Existing
regulations for receiving lump sum distributions and the annuity options
available to the worker might also be different for pensions and individual
accounts, complicating administration by the employer. Addressing these
challenges could result in substantial changes in the structure of the
pension system, with possible implications for worker coverage and workers'
overall retirement income.

At the same time, individual accounts could present an opportunity to
improve the nation's retirement income system by providing workers with new
opportunities to save for retirement and by expanding workers' flexibility
in managing their retirement assets. One of the most frequently cited
problems with the private pension system is that it does not cover all
workers. A mandatory, universal system of accounts could provide a defined
contribution account to all workers, which would give them access to private
investment returns. While workers may offset their individual account saving
by saving less elsewhere or borrowing more, the ability to do so may be
limited for some and therefore an increase in total saving is possible. 46
It may be argued that individual accounts could increase workers' awareness
of the need to save for retirement or become more knowledgeable about
investment options. Individual accounts might also increase employers'
incentive to develop new pension vehicles to coordinate with individual
accounts.

While a voluntary system of individual accounts might draw low
participation, the system could be structured to foster the goal of
increased coverage if it is targeted to those groups with low pension
coverage. Such an account design might also affect the ability and
propensity of workers to save if such a voluntary supplemental saving option
were linked with Social Security. While many employers are concerned about
the potential administrative costs of an individual account system, there
may be

46 A recent study found evidence that 401( k) s held by low- earning groups
are more likely to represent an addition to net household wealth compared
with high- earning groups that hold 401( k) s. Eric M. Engen and William G.
Gale, The Effects of 401( k) Plans on Household Wealth: Differences Across
Earnings Groups( Washington, D. C.: The Brookings Institution,

Aug. 2000).

compensating advantages. Some experts have noted that while individual
accounts, either as a supplement to or as a partial substitute for Social
Security, might entail higher administrative costs, these costs might allow
employers to provide workers with greater options and services compared with
Social Security. 47 Given a range of investment options, individual accounts
could also provide workers a means of spreading market risk and perhaps give
them more flexibility in terms of retirement choice later in their careers
by allowing them to phase into retirement.

Concluding While Social Security and private pensions are linked in many
ways, they

Observations remain distinct institutional frameworks for providing
retirement income.

Given that little is known about the effects of changes in either of these
systems alone, determining the possible effects and interactions of Social
Security reform across these very different structures is a difficult task.
Furthermore, with the proposed introduction of individual accounts, the
current Social Security debate has introduced the possibility of a major
structural change in the program. Such accounts, often proposed in
combination with other more traditional reforms, raise an even broader set
of possibilities and questions.

Our retirement income institutions operate in a dynamic environment where
workers, employers, and policymakers interact to pursue the goal of
retirement income security. Numerous concurrent influences, such as changes
in tax and regulatory policies, also affect how these institutions develop
and evolve, and the reform debate should explicitly consider these other
issues. The limited knowledge we have of these influences and the complexity
of instituting policy change suggests that any reform should be taken with
caution and careful deliberation. At the same time, establishing agreement
on the fundamental principles underlying the reform should be emphasized.
These principles should include ensuring retirement income to those who most
need it and encouraging the development of new opportunities to secure and
expand the retirement income of future generations.

47 Olivia S. Mitchell, “Administrative Costs in Public and Private
Retirement System,” in Privatizing Social Security, Martin Feldstein,
ed.

Agency and Other We provided draft copies of this report to the Social
Security

Comments Administration, the Department of Labor's Pension and Welfare
Benefits

Administration, and an external reviewer who is a university- based pension
expert. They provided us with technical comments, which we incorporated
where appropriate. In general, they concurred with our treatment of the
issues as appropriate for an overview of the topic and noted that many
issues discussed in the report could benefit from further research.

We are sending copies of this report to the Honorable Charles B. Rangel,
Ranking Minority Member, House Ways and Means Committee; other interested
congressional committees; the Honorable Alexis M. Herman, Secretary of
Labor; the Honorable Lawrence Summers, Secretary of Treasury; and the
Honorable Kenneth S. Apfel, Commissioner of Social Security. We will also
make copies available to others on request. If you have any questions
concerning this report, please contact me at (202) 512- 5491 or Charles
Jeszeck at (202) 512- 7036. Other major contributors include Kenneth J.
Bombara and Gene Kuehneman.

Sincerely yours, Barbara D. Bovbjerg Associate Director Education, Workforce
and

Income Security Issues

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