Social Security Reform: Administrative Costs for Individual Accounts
Depend on System Design (Letter Report, 06/18/1999, GAO/HEHS-99-131).

Proposals to protect the Social Security program's future solvency and
sustainability include creating a system of individual accounts for
accumulating retirement savings. Available studies of the costs to run a
system of individual accounts do not capture all the likely costs. For
example, the costs of government oversight, enforcement activities, and
public education are generally not included. Designers of a system of
individual accounts must make critical decisions about who would assume
the new administrative and recordkeeping responsibilities, how much
choice individuals would have in selecting and changing their investment
options, and how retired workers would receive their benefits.
Administrative costs would vary, depending on these decisions and the
types and level of customer service offered. They could be higher for
more decentralized systems and for those offering broader investment
choices, more customer service options, or both. In GAO's analysis, a
man who had average annual earnings every year for 45 years would
accumulate $125,430 (in 1998 dollars) in his account under a 0.1-percent
annual administrative cost, as opposed to $75,995 under a two-percent
administrative cost. If individuals bought an annuity, ensuring a steady
stream of income throughout retirement, the average administrative cost
in the current market would be five percent of the amount being
converted into the annuity.

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

 REPORTNUM:  HEHS-99-131
     TITLE:  Social Security Reform: Administrative Costs for
	     Individual Accounts Depend on System Design
      DATE:  06/18/1999
   SUBJECT:  Social security benefits
	     Federal social security programs
	     Retirement benefits
	     Administrative costs
	     Cost control
	     Investment planning
	     Cost analysis
IDENTIFIER:  Social Security Program
	     Federal Thrift Savings Plan
	     SSA Individual Retirement Accounts

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    United States General Accounting Office GAO                Report
    to the Ranking Minority Member, Committee on Ways and Means, House
    of Representatives June 1999          SOCIAL SECURITY REFORM
    Administrative Costs for Individual Accounts Depend on System
    Design GAO/HEHS-99-131 GAO    United States General Accounting
    Office Washington, D.C. 20548 Health, Education, and Human
    Services Division B-282845 June 18, 1999 The Honorable Charles B.
    Rangel Ranking Minority Member Committee on Ways and Means House
    of Representatives Dear Mr. Rangel: The Social Security program
    forms the foundation for America's retirement income system. In
    1998, 31 million individuals and their dependents received
    retirement benefits of $265 billion through this program. In
    addition, 148 million workers currently contribute to the program
    in anticipation of future benefits. However, demographic trends,
    including the aging of the baby boom generation and increased life
    expectancy, threaten the program's future solvency and
    sustainability. In response to this threat, various proposals to
    reform the program are currently under discussion. Proposed
    reforms range from traditional changes, such as reducing benefits
    and raising taxes, to more fundamental changes, such as creating a
    system of individual accounts for accumulating retirement savings.
    Under a system of individual accounts, workers would manage their
    own accounts, and the benefits they received from their accounts
    would generally be more closely linked to the amount of their
    contributions and to the gains or losses their investments
    incurred. Deciding whether and how to implement a system of
    individual accounts presents several difficult issues.
    Policymakers will need to consider how to finance the accounts and
    how they would affect the economy and program solvency, as well as
    how these accounts would affect the current Social Security
    benefit structure. In addition, policymakers will need to consider
    how readily individual accounts can be implemented, administered,
    and explained to the public.1 The cost of administering individual
    accounts is among the key factors to consider. The proposed
    accounts could provide greater individual choice in retirement
    investments and, according to proponents, would carry the
    potential for a higher rate of return on contributions than is
    available 1In testimony earlier this year, we discussed how these
    issues can be used as criteria for evaluating reform proposals.
    See Social Security: Criteria for Evaluating Social Security
    Reform Proposals (GAO/T-HEHS-99-94, Mar. 25, 1999). Page 1
    GAO/HEHS-99-131 Social Security Reform B-282845 under current
    law.2 However, some experts have asserted that the cost of
    administering individual accounts is also likely to be higher than
    the administrative costs of the current Social Security system,
    and this cost could reduce the amount of savings accumulated in
    the retirement accounts. Concerned about administrative costs and
    their effect on account accumulations and benefits, you asked us
    to determine (1) the factors that influence administrative costs,
    (2) the estimates that are available for administrative costs
    associated with individual accounts, and (3) how administrative
    costs might affect the accumulation of savings in individual
    accounts and the retirement benefits they provide. It is important
    to note that this report focuses on only one aspect of individual
    accounts-the administrative costs associated with them. It does
    not attempt to discuss how these individual accounts would be
    financed, how they might affect existing Social Security benefits,
    or other important issues related to implementing individual
    accounts. In addition, this report is designed only to illustrate
    the effects of administrative costs on account accumulations; it
    does not attempt to predict the effects of any specific proposals
    or variation in the rate of return on individual account
    investments. Today we are issuing another report that provides
    additional information on the key decisions to consider relating
    to the design and implementation of a system of individual
    accounts.3 Specific to this report, we conducted our review from
    October 1998 through May 1999 in accordance with generally
    accepted government auditing standards. (See appendix I for
    information on our scope and methodology.) Results in Brief
    When designing a system of individual accounts, the designers must
    make critical decisions about who would assume the new
    administrative and recordkeeping responsibilities, how much choice
    or discretion individuals would have in selecting and changing
    their investment options, and how workers would receive their
    benefits when they retired. The costs of administering a system of
    individual accounts would vary and would depend on these decisions
    and the types and level of customer service offered. Customer
    service features include, for example, how quickly funds are
    allocated to accounts, how frequently investors are informed of
    2Others, however, believe that returns on contributions are not
    the only goal of Social Security and that individual accounts are
    not the only way to increase rates of return. We will address the
    complex rate of return issue in a forthcoming report. 3See Social
    Security Reform: Implementation Issues for Individual Accounts
    (GAO/HEHS-99-122, June 18, 1999). Page 2
    GAO/HEHS-99-131 Social Security Reform B-282845 their account
    balances, and whether services are handled personally or through
    automation. While any system has administrative costs, they could
    be higher for more decentralized systems and for those offering
    broader investment choices, more customer service options, or
    both. Because most Social Security reform proposals that include
    individual accounts do not provide explicit details on how the
    accounts would be implemented and managed, it is difficult to
    accurately assess the costs of administering them. Available cost
    studies have limitations because they do not capture all the
    likely costs associated with a new system. For example, the cost
    of government oversight and enforcement activities needed to
    ensure compliance and the cost of providing public education are
    generally not included. However, the studies can at least provide
    a basis for understanding the possible range of administrative
    costs that individuals might incur under a new system. For
    example, estimates for a centralized system with limited
    investment choices and customer service are as low as 0.1 percent
    of assets per year, while the possible costs for a more
    decentralized system with broader investment choices or a system
    with extensive and flexible customer service are as high as 2 or 3
    percent of assets annually. Although difficult to predict,
    administrative costs can have a significant effect on individual
    account accumulations. Our analysis, which assumed account
    contributions equal to 2 percent of an individual's taxable
    earnings, illustrates this point. In our simulation, for a man who
    had average annual earnings every year for 45 years, a change in
    administrative cost from 0.1 percent to 1 percent reduced
    accumulations in his account by almost 22 percent. A change from
    0.1 percent to 2 percent reduced his account accumulation by
    almost 40 percent. In more practical terms, he would accumulate
    $125,430 (in 1998 dollars) in his account under a 0.1-percent
    annual administrative cost, as opposed to $75,995 under a 2-
    percent administrative cost. The proportionate effect on
    accumulations of these changes in administrative costs was
    approximately the same for all workers in our analysis, regardless
    of whether they had low, average, or high annual earnings.
    Further, individuals may incur additional costs if they are
    required or choose to purchase an annuity, which ensures a steady
    stream of income throughout retirement. In the current market, the
    average administrative cost of purchasing an annuity is 5 percent
    of the amount being converted into the annuity.4 4This 5-percent
    administrative cost does not include the additional cost of
    adverse selection, which is the risk to the annuity provider of
    having to pay benefits to those who live longer than expected.
    Page 3                                                   GAO/HEHS-
    99-131 Social Security Reform B-282845 Background
    A number of proposals have been put forth to establish a national
    system of individual accounts; almost all the proposals would
    affect the Social Security program. Currently, Social Security
    provides retirement benefits to workers as well as benefits to
    disabled workers and the families of disabled, retired, and
    deceased workers. Depending on the reform proposal, individual
    accounts could replace part of the retirement benefits portion of
    the Social Security program, or the accounts could be added to the
    Social Security program. Also, some proposals would mandate worker
    participation in the system of individual accounts, while others
    would make such participation voluntary. In general, if the
    accounts were considered the personal property of individuals, the
    balances would be considered part of their estates when the
    account owners died. However, the proposals for individual
    accounts generally do not clearly delineate how the accounts would
    be structured and administered. Current Social Security    The
    Social Security Administration (SSA) is responsible for the
    Program                    recordkeeping and benefit payment
    activities of the current Social Security program. The program is
    financed largely on a "pay-as-you-go" basis, in which the current
    year's Federal Insurance Contributions Act (FICA) taxes are used
    primarily to pay that year's benefits.5 Employers withhold the
    employee portion of FICA taxes from employees' pay and regularly
    deposit the amount, along with the employer portion, in aggregate,
    in a designated Federal Reserve Bank or another authorized
    depository. At the beginning of the next calendar year, employers
    submit an Internal Revenue Service (IRS) W-2 form to SSA for each
    worker to report his or her earnings for the previous year. SSA
    checks this information and posts it to the earnings record it
    maintains for each individual worker. For tax year 1996, SSA
    received about 235 million W-2s.6 During this process, SSA and the
    IRS work together to verify that earnings are recorded in the
    proper amount in each individual's record. It is important that
    the earnings are recorded correctly because these earnings, rather
    than the FICA amount, form the basis for calculating future
    benefits. A considerable time lag exists-as much as 7 to 22
    months-between the time taxes are deducted from an individual's
    earnings and the time these earnings are credited to the
    individual's record. A worker must contact SSA to apply for
    retirement benefits. SSA calculates the retirement benefit and
    then sends information monthly to the Treasury for issuing a check
    or making an electronic deposit. 5FICA taxes are generally
    composed of equal contributions from both employers and employees.
    6According to SSA, approximately 40 percent of workers receive
    more than one W-2 annually because they work for more than one
    employer during the year. Page 4
    GAO/HEHS-99-131 Social Security Reform B-282845 Administrative
    Structure      Certain key administrative activities must be
    performed under any system Options for Individual        of
    individual accounts, much the same as they would under any defined
    Accounts                      contribution plan.7 These activities
    fall into three main categories: collecting contributions and
    keeping records, investing contributions, and paying benefits: *
    Collecting contributions and keeping records include enrolling
    participants, collecting and recording contributions, gathering
    and updating personal information on each individual (such as
    current address and investment choices), and correcting errors. *
    Investing contributions includes transferring the funds to the
    investment entity, conducting research to support buy and sell
    decisions, buying and selling investments, and recording gains and
    losses. * Paying benefits includes processing claims, handling
    appeals, and, depending on the type of payout option offered,
    issuing regular checks or processing annuities.8 When designing a
    system of individual accounts, the designers must make decisions
    about who would perform each of these administrative activities.9
    Depending on who is chosen to assume these new activities-
    employers, individuals, private sector service providers, or the
    government-each could be affected in varying degrees. Figure 1
    illustrates the three options we identified for the basic
    administrative structure of a system of individual accounts, each
    of which builds on an existing retirement system. A discussion of
    each option follows. 7A defined contribution plan is a pension
    plan in which the contributions are allocated to individual
    accounts by a predetermined formula and benefits vary, depending
    on the contribution level and the return received from the
    investment of these contributions. 8In purchasing an annuity, an
    individual contracts with an annuity provider, who provides a set
    monthly payment, usually over the lifetime of the individual, in
    exchange for an agreed-upon dollar amount. 9In GAO/HEHS-99-122, we
    discuss in more detail the issues to consider when making each of
    these key decisions. Page 5
    GAO/HEHS-99-131 Social Security Reform B-282845 Figure 1: Options
    for Account Administration and Recordkeeping Page 6
    GAO/HEHS-99-131 Social Security Reform B-282845 The first option
    is based on a centralized recordkeeping system. A federal agency,
    such as SSA, could assume administrative and recordkeeping
    responsibilities. This way the structure would build on the
    current payroll reporting and tax collection system.
    Alternatively, a centralized clearinghouse could assume
    recordkeeping responsibilities, similar to how the federal
    government's Thrift Savings Plan (TSP) uses the National Finance
    Center.10 The TSP is a tax-deferred defined contribution
    retirement plan for federal employees that contains features
    typically found in private sector 401(k) plans. The Federal
    Retirement Thrift Investment Board, an independent federal agency,
    manages the TSP. The Board holds the funds in trust, since they
    are owned by the participants, not the government, and thus are to
    be managed independent of political and social considerations.
    Federal employees may contribute each pay period either a
    percentage of their basic pay or a fixed dollar amount. All
    contributions, however, must be made through payroll deductions.11
    Currently, employees can allocate their contributions into three
    TSP funds: the Government Securities Investment Fund (G Fund), the
    Common Stock Index Investment Fund (C Fund), and the Fixed Income
    Index Investment Fund (F Fund).12 Twice a year, employees can
    change their contribution amounts and how future contributions are
    invested. Employees can also transfer their account balances
    between funds monthly. Employees may take from their accounts
    loans that they repay through payroll deductions, using the
    interest rate for the G Fund at the time of the loan. Upon leaving
    the government or retiring, an employee's account balance is paid
    through one of three options: (1) lifetime annuity, (2) lump sum
    payment, or (3) timed withdrawal in the form of monthly payments.
    Throughout this report, we discuss the government-managed and
    independently managed options for a centralized system together
    because they are similar in how information and money would flow
    from the employer through one central entity. Under either
    centralized system, the 10The National Finance Center provides
    recordkeeping and payroll services for the Department of
    Agriculture and other federal agencies. For the TSP, the Center
    provides detailed recordkeeping and software development and
    maintains an office to provide service to participants. 11The
    government automatically contributes 1 percent of basic pay for
    participants in the TSP who are covered by the Federal Employees
    Retirement System, regardless of whether the employees make
    personal contributions. For participants who choose to make
    personal contributions, the government matches the first 3 percent
    of their contributions at 100 percent and the next 2 percent of
    contributions at 50 percent. 12The TSP will add two additional
    funds in May 2000-the Small Capitalization Index Investment Fund
    (S Fund) and the International Stock Index Investment Fund (I
    Fund). Page 7
    GAO/HEHS-99-131 Social Security Reform B-282845 investments could
    be managed centrally by the recordkeeper or contracted out. A
    second option would build on the current decentralized system of
    401(k) plans. A 401(k) plan is an employer-sponsored defined
    contribution plan that allows individuals to contribute, before
    taxes, a portion of their salary to a qualified retirement
    account. Unlike the previous option, under which all funds and
    information would flow through a centralized nationwide structure,
    the employer would collect individuals' contributions and forward
    them directly to the investment manager. In the current system,
    the employer determines which services and investment vehicles the
    plan will provide, and, depending on the plan, individuals may
    choose how the assets are allocated among investment options.
    Under an employer-sponsored option, employers who do not currently
    offer 401(k) plans would bear the responsibility for creating an
    infrastructure to deposit contributions and provide employees with
    links to and choices among investment managers. Alternatively,
    some proposals suggest that a new system could build on the 401(k)
    system and permit individually managed or government-sponsored
    accounts for individuals who do not have access to a plan like a
    401(k) plan through their employers. Finally, the third option
    would build on the decentralized individually managed system of
    individual retirement accounts (IRA). This structure does not
    involve employers in recordkeeping. Individuals send their
    personal funds to a financial service provider who places the
    money in an individual tax-deferred account. Individuals deal
    directly with their providers for services and payment of
    benefits. Under a decentralized individually managed option,
    workers would bear the responsibility for selecting an investment
    manager, or managers, and depositing their contributions.
    Administrative Costs    While any system of individual accounts
    has administrative costs, their Increase With System    level will
    vary depending on the complexity of the system's design. Design
    complexity can be linked to four factors: (1) the administrative
    structure Design Complexity       selected, including who
    maintains the records; (2) the flexibility in selecting and
    changing investments; (3) the level of customer service provided;
    and (4) the variety and type of options offered for paying
    benefits. In general, the more complex the system design and the
    more flexibility offered to individual investors, the higher the
    administrative costs. As a result, implementing a system of
    individual accounts involves Page 8
    GAO/HEHS-99-131 Social Security Reform B-282845 making decisions
    about trade-offs between costs and flexibility. Table 1 summarizes
    the factors that can affect cost. Table 1: Factors That Affect
    Administrative Costs            May decrease costs
    May increase costs Centrally managed recordkeeping
    Decentralized recordkeeping Limited investment choices
    Wide range of investment choices Limited customer services
    Varied and readily available customer services Mandated,
    centralized payout option                Varied or decentralized
    payout options The administrative structure selected for a system
    of individual accounts-beginning with who is responsible for
    recordkeeping-will affect the costs of administering the system. A
    centralized management structure, whether run by SSA or a new
    centralized clearinghouse, could keep administrative costs down by
    taking advantage of economies of scale.13 For example, using one
    centralized system to record data and keep records on individual
    accounts for 148 million workers could minimize the costs per
    individual. Also, investing large sums of pooled contributions
    could lower transaction costs per account. However, centralizing
    these administrative activities would be likely to increase
    government administrative responsibilities and, under some
    proposals, increase government involvement in investment choices.
    Alternatively, a decentralized management structure could decrease
    direct government control over investment choices but could add to
    administrative costs. For example, if recordkeeping and management
    were distributed among a number of private companies,
    administrative costs per participant would likely rise. Moreover,
    depending on the investment options available, decentralizing
    recordkeeping and investments would be likely to increase the need
    for government regulation and oversight and the costs accompanying
    such activities. In general, regardless of the system's structure,
    the principle of economies of scale suggests that as individuals'
    accounts grow over time, the administrative costs per participant
    dollar should decrease. Other design features, such as the
    flexibility in selecting and changing investments, can also affect
    system costs. For example, administrative costs would be lower in
    a system that offered primarily index funds, such as those offered
    to federal employees under the TSP. These funds hold securities in
    proportion to their representation in the stock or bond
    13Centralization does not guarantee low costs from economies of
    scale. Achieving such economies requires planning, management, and
    oversight. Page 9
    GAO/HEHS-99-131 Social Security Reform B-282845 markets and do not
    require significant research on individual companies or
    securities. However, this approach would result in relatively
    limited choices for investors. Conversely, when a wide spectrum of
    investment choices is offered, individual choice is enhanced but
    administrative costs are likely to rise, especially if the choices
    include more actively managed investments. These investments are
    accompanied by higher management fees because the investment
    manager spends more time and money on researching, selecting,
    buying, and selling investments. In addition, systems that offer
    individuals the option to transfer funds from one investment to
    another can have higher administrative costs. When workers
    frequently transfer their account balances from one investment to
    another, they may also incur extra costs to cover the additional
    administrative tasks and costs associated with buying and selling
    investments. A system of individual accounts that allows
    relatively free choice among different investment funds could
    encourage competition and lower costs. However, experiences in
    other countries have demonstrated that, under certain
    circumstances, competition may not achieve lower costs. For
    example, a recent study of the United Kingdom system, which
    includes accounts that are voluntary and decentralized, found
    administrative costs to be as high as 36 percent of an account's
    value.14 The study linked these high costs, in part, to
    competition among providers that resulted in high marketing costs
    and frequent switching between investment providers.15 A
    fundamental decision for paying retirement benefits would be how
    much flexibility to offer individuals in the choice of payout
    options. The options to pay retirement benefits include lump sum
    payments, timed withdrawals, and annuities. Under a lump-sum
    payment option, individuals could liquidate their accounts through
    a single payment at retirement and choose when to spend or save
    that money. In a timed withdrawal, retirees specify a withdrawal
    schedule with the investment manager. Each month, they receive
    their predetermined amount while the balance of the individual
    account remains invested. Annuities can be structured in many ways
    and, therefore, may be more complex to administer and hence more
    costly than the other methods. However, they provide more long-
    term security because they ensure that benefits are available for
    the entire retirement lifetime. Permitting individuals to choose
    among all three 14The 36 percent includes costs attributed to fund
    accumulation (that is, management and administrative costs) and
    costs of switching from one financial provider to another or
    stopping contributions altogether; it does not include
    annuitization costs. 15Mamta Murthi, J. Michael Orszag, and Peter
    R. Orszag, "The Charge Ratio on Individual Accounts: Lessons From
    the U.K. Experience," Birkbeck College Working Paper 99-2,
    University of London, London, Eng., Mar. 1999. Page 10
    GAO/HEHS-99-131 Social Security Reform B-282845 options in the
    current market could further increase overall administrative
    complexity and cost by requiring systems to explain and keep track
    of the various choices. Finally, the types and level of customer
    service provided also affect the costs of a system of individual
    accounts. Customer service includes a range of activities designed
    to accommodate individuals' investment choices or to inform them
    about the system or their accounts. These activities include
    providing statements of account balances, answering questions and
    providing educational material, facilitating transfers of balances
    between different investments, and calculating the gains or losses
    on investments at different intervals. When services are offered
    in greater numbers or with more frequency, the costs and
    administrative complexity of managing the accounts increase. For
    example, contributions can be deposited into the accounts at
    varying intervals, ranging from daily to annually. If
    contributions were made frequently, workers would benefit from
    earlier investment of funds, but the administrative recordkeeping
    costs would be likely to rise. Similarly, the frequency and means
    of providing information about the system or an individual's
    account affect cost. Beginning in fiscal year 2000, SSA will be
    required to provide statements estimating future benefits to
    nearly all U.S. workers annually. Providing these statements will
    cost SSA more than $130 million per year. Some private pension
    plans may provide account statements monthly with higher attendant
    costs. In addition, the more personal the contact offered, the
    more expensive the service. For example, handling a call to a
    toll-free number can cost about five times as much as sending out
    an annual statement. Finally, if contributors are permitted to
    borrow from their accounts, administrative costs could increase
    because loans add a number of administrative tasks, including
    accepting applications, determining eligibility, and monitoring
    repayment. A number of means are used to calculate and report
    administrative costs for defined contribution plans. Some of the
    most common measures include * Expense ratio. This is a ratio that
    reflects total annual operating expenses as a percentage of
    accumulated fund assets. It is expressed either as a percentage of
    assets or in basis points. One basis point equals 0.01 or 1/100 of
    a percent; thus, 100 basis points equals 1 percent of assets. *
    Dollar cost per plan participant. This is usually a flat fee that
    is charged to each participant. It could be an annual assessment
    or a one-time charge. It Page 11
    GAO/HEHS-99-131 Social Security Reform B-282845 may be the only
    fee charged or it may be charged in addition to fees reflected in
    a percentage fee, such as an expense ratio. * Other ratios.
    Administrative costs can also be calculated as a percentage using
    bases other than accumulated assets, including total benefits
    paid, number of workers and retirees covered by the system, income
    per capita, or contributions. More Specifics on            Not all
    Social Security reform proposals that include individual accounts
    System Design Are            provide explicit detail on how the
    accounts would be implemented and managed, and this makes it
    difficult to determine accurately the Needed to Accurately
    administrative costs of a system of individual accounts. Studies
    of the Estimate                     possible costs are available
    but have limitations for a number of reasons. Some are based on
    the reported costs of existing systems, which often fail
    Administrative Costs         to capture the full administrative
    cost of those systems. Further, the studies do not include the
    costs of added responsibilities that could be required under a new
    system, such as the cost to the government for monitoring and
    oversight. Despite their limitations, however, the studies help
    shed light on the possible range of administrative costs. They
    vary in their approaches, but overall, as expected, they predict
    that costs would increase when accompanied by decentralized
    recordkeeping, more and varied investment options, and greater
    levels of customer service. Cost Estimates Increase      To better
    understand the possible costs of administering a system of With
    Design Complexity       individual accounts, we identified a
    number of studies that provide either but May Be Understated
    estimates of these costs or information on the actual costs of
    roughly comparable systems. These studies provide a useful
    starting point for thinking about what the costs might be under
    various system structures and designs. However, in some cases,
    both the estimates and actual costs of current systems may
    understate the full range of costs that may be associated with
    individual accounts. Table 2 provides a range of costs for a
    system of individual accounts under the three basic administrative
    structure options that are currently being discussed. The costs
    are expressed in expense ratios, which identify the percentage of
    fund assets that are deducted from the fund total for
    administrative expenses before gains or losses are posted to
    individual accounts. The estimates vary in how they were
    constructed and in the assumptions they make about the structure
    of the proposed individual account system, in part because there
    is a wide range of possible options for structuring a system of
    individual accounts. Estimates for a centralized Page 12
    GAO/HEHS-99-131 Social Security Reform B-282845 structure
    generally rely on continuing SSA's current centralized
    recordkeeping system rather than creating a new system and assume
    that SSA or some central clearinghouse would contract for a
    limited number of investment options and provide a basic level of
    customer service, similar to the TSP.16 To approximate the
    possible administrative costs for a decentralized employer-
    sponsored system of individual accounts, we used costs of current
    401(k) plans.17 Studies of costs in current 401(k) retirement
    plans can provide useful information because a nationwide system
    of employer-sponsored plans could be similar to 401(k)s, depending
    on the size of the plans and any new requirements that might be
    imposed. The costs of a decentralized individually managed system
    are based largely on the administrative costs of mutual funds,
    because they are the most common retail investment instrument
    individuals use in their IRAs. (For more information on the
    studies and why we chose these estimates, see appendix I.)
    Finally, this section of the report is about the ongoing
    administrative costs associated with building up an account
    balance. Because individuals often do not incur the cost of
    purchasing an annuity until they retire, we discuss the effects of
    annuity costs later in this report. 16Unlike the TSP, most
    estimates do not include the costs associated with permitting
    contributors to borrow from their accounts before retiring. 17Some
    employers, while supporting the individual account concept, have
    expressed reluctance to take on additional administrative
    responsibilities, and there has been less discussion and analysis
    of employer-sponsored individual accounts than of the two other
    options. Page 13
    GAO/HEHS-99-131 Social Security Reform B-282845 Table 2: The Range
    of Administrative Costs Under Discussion Administrative
    Annual cost      Additional information on the source and study
    structure             Sourcea                              as % of
    assets     approach Centralized           Advisory Council on
    0.11     The Report of the 1994-1996 Advisory Council on Social
    Security                                         Social Security
    considered a centralized individual account option. The
    administrative cost estimate was a consensus of the Council
    members' opinions. Employee Benefit                         Low =
    0.10     EBRI, a nonprofit nonpartisan organization dedicated
    Research Institute (EBRI)                 High = 2.0    to public
    policy research on economic security and employee benefits,
    considered two possible systems-one with a low level and one with
    a high level of service features-based on costs of 401(k) plans
    and other investment companies and on discussions with other
    experts. James and others                    Low = 0.14-0.18
    The authors, experts on employee benefit plans, High = 0.49-0.79
    analyzed data on institutional funds to estimate the costs for a
    centralized system with passively managed (low) and actively
    managed (high) funds. They constructed a "total fund expense
    profile," which includes all the costs for mutual funds.b State
    Street Corporation                   0.19-0.34    State Street
    Corporation, a private financial services firm, based its
    estimates on the unit costs of the various administrative
    activities that would be required under a system of individual
    accounts, such as recordkeeping and computer system maintenance.
    The estimates shown here are for year five of the Corporation's
    proposed system. Decentralized         Mitchell
    0.28-1.88    The author, an expert on employee benefit plans,
    employer-sponsored
    published a number of studies of the costs of existing 401(k) and
    other retirement plans. Pension and Welfare
    0.3-3.0    Department of Labor's PWBA is responsible for Benefits
    Administration                                 overseeing and
    regulating the nation's 401(k) plans. (PWBA)
    The cost range reflects the administrative costs of 401(k) plans
    and the opinions of PWBA officials. (continued) Page 14
    GAO/HEHS-99-131 Social Security Reform B-282845 Administrative
    Annual cost      Additional information on the source and study
    structure              Sourcea                                as %
    of assets         approach Decentralized          James and others
    0.32-1.50      The authors used the costs of retail mutual funds
    to individually manged
    estimate the costs for a decentralized system. They constructed a
    "total fund expense profile," which includes all the costs for
    mutual funds.b Investment Company
    0.46-1.49      ICI, the national association of the American
    mutual Institute (ICI) (Rea and
    fund industry, studied trends in costs for equity mutual Reid,
    1998, 1999)                                             funds,
    bond mutual funds, and money market mutual funds. It used a cost
    measure called the "total shareholder cost," which incorporates
    all the costs for a mutual fund.b Advisory Council on
    1.0      The Report of the 1994-1996 Advisory Council on Social
    Security                                               Social
    Security contained a more decentralized option that would permit
    workers considerable flexibility in their investment decisions and
    assumed a contribution of 5 percent of taxable payroll. The
    administrative cost estimate was based on the costs of existing
    similar systems, such as mutual funds. aFull bibliographic data
    for these sources are given in the bibliography. bThe cost to buy
    and hold mutual funds includes two primary categories: shareholder
    transaction fees, which are one-time fees that can be imposed when
    the funds are bought or sold, and annual operating expenses, which
    include the costs of operating the funds on an ongoing basis, such
    as the cost for administrative expenses, compensation for the
    funds investment adviser, and advertising costs. The Costs of a
    Centralized                    As shown in table 2, the estimates
    of administrative costs for centralized Administrative Structure
    systems of individual accounts range from 0.10 percent to 2
    percent of assets. Overall, a centralized system is expected to be
    less expensive than a decentralized system when customer service
    and investment choices are held constant, because of the economies
    of scale that could arise from having centralized contribution
    collections, recordkeeping, and communications with participants.
    However, costs generally increase as the number and type of
    investment options expand. For example, James and others estimated
    that administrative costs would be between 0.14 percent and 0.18
    percent of assets with passively managed index portfolios and
    between 0.49 percent and 0.79 percent with actively managed
    portfolios. Alternatively, costs may rise from variation in the
    customer service features provided. For example, the Employee
    Benefit Research Institute (EBRI), a private nonprofit research
    organization, assumed that providing a higher level of service,
    such as the daily valuation of accounts, allowing loans before
    retirement, investor education, and other services, could raise
    administrative costs from a low of 0.10 percent to a high of 2
    percent of assets. State Street Corporation, a private financial
    services company, provided the most detailed analysis of Page 15
    GAO/HEHS-99-131 Social Security Reform B-282845 costs per
    administrative function based on known costs. Its estimate relied
    on a number of customer service assumptions, including the
    assumptions that participants would have little reason to call and
    that a large percentage of inquiries would be handled through
    means that cost less than person-to-person contact, such as
    automated telephone menus and the Internet. The estimates for a
    centralized system may be understated because they do not take
    into account changes required in the administrative foundation.
    The estimates all rely on the current payroll reporting and
    recordkeeping system as the administrative foundation; however,
    SSA officials told us that depending on the structure and
    expectations of a centralized system of individual accounts, the
    agency might need to make significant and costly changes to its
    recordkeeping system. Under SSA's current recordkeeping system, it
    can take as long as 7 to 22 months from the time FICA taxes are
    withheld to the time earnings are posted to individual records.
    Under a system of individual accounts, this time lag could result
    in lost returns on investments in cases in which the value of an
    individual's chosen investment rises before the individual's
    contribution can be invested.18 Also, SSA currently does not
    follow up with employers for reporting errors under a certain
    dollar threshold, since benefits are not significantly affected by
    these errors. In addition, each year SSA cannot post as many as
    1.5 percent of the earnings reported to any individual record
    because of missing or erroneous identifying information. Under a
    system of individual accounts, in which the benefits would rely on
    the dollar amounts contributed, these errors could be problematic.
    It is not yet clear whether any of these practices would need to
    be revisited or would be acceptable under a new system.19 Finally,
    depending on system design, SSA officials said they could also
    incur significant additional customer service costs, such as an
    increase in calls from individuals inquiring about contributions
    or account balances. Changes in reporting and recordkeeping
    requirements could also affect the IRS and employers. The IRS
    could incur additional administrative costs as it collects and
    reconciles the FICA taxes, especially if a new system required
    tracking individual account contributions separately from these
    taxes. Moreover, employers could be affected if the system
    required changes to 18Some proposals contain alternative measures
    that could mitigate the effect of this time lag. For example,
    contributions could be pooled together and invested in a safe
    investment vehicle, such as a money market fund, until they are
    allocated to individual accounts, at which time the investment
    earnings could also be credited to the individual accounts. 19For
    more detailed information on these and other recordkeeping factors
    to consider when designing individual accounts, see GAO/HEHS-99-
    122. Page 16
    GAO/HEHS-99-131 Social Security Reform B-282845 the current wage-
    reporting documentation and procedures or if employers were
    required to prepare and submit information on individuals more
    frequently than the current annual reporting requirement in order
    to hasten the posting of information to individual accounts. We
    did not find any estimates of these possible additional costs, and
    it is not clear who would bear these costs under a new system.
    Costs to SSA and the IRS could be funded through general revenue,
    or they could be deducted from individual accounts. Costs to
    employers under a centralized system could be included in their
    normal costs of operation. However, these costs could be passed
    along to individuals through other means, such as a reduction in
    other employer-sponsored retirement benefits. Finally, the TSP has
    been cited as a model for a centralized system of individual
    accounts. Administrative costs for the TSP were 0.08 percent of
    assets in 1998.20 However, a former official from the Federal
    Retirement Thrift Investment Board noted that managing the TSP
    differs in important ways from managing a national system of
    individual accounts. The federal workforce and the federal
    government, as a single employer, differ substantially from the
    group that would be covered under a nationwide system. For
    example, the federal workforce experiences less job turnover,
    tends to be older, and has higher average earnings than the
    general workforce. In addition, federal agencies experience
    greater stability and have greater access to automation than the
    employer population at large. Serving a more diverse population of
    investors with a wide variety of employers would likely result in
    higher administrative costs, according to this former official. In
    addition, the administrative costs for the TSP do not include the
    services federal agencies provide on behalf of the plan, such as
    enrolling individuals and working with the recordkeeper. The Costs
    of a Decentralized    Mitchell reported that the costs for 401(k)
    plans holding mutual funds Employer-Sponsored Structure    ranged
    from 0.28 to 1.88 percent of plan assets. These costs include the
    costs of small and mid-sized 401(k) plans, which ranged from 0.28
    to 1.32 percent, and the costs of plans that held mostly mutual
    funds, which ranged from 0.84 to 1.88 percent. These estimates,
    however, do not include all possible expenses. In some cases, they
    exclude money management fees, while in others they exclude
    recordkeeping fees. Mitchell concluded that privatization options
    would be expected to have somewhat higher 20When TSP participants
    leave the federal government before they are entitled to their
    retirement benefits, the accumulated government contributions and
    the earnings on them are used to help offset administrative costs,
    which decreases the gross administrative cost from 0.08 percent of
    assets to a net cost of 0.06 percent. Page 17
    GAO/HEHS-99-131 Social Security Reform B-282845 administrative
    costs than the current system but that these higher costs might be
    offset by economic benefits from a privately managed system.
    Officials from the Department of Labor's Pension and Welfare
    Benefits Administration (PWBA) provided a wider range of
    administrative costs: In 1998, the 401(k) market contained about
    250,000 plans covering approximately 25 million individuals, with
    costs ranging from 0.3 percent to 3 percent of assets. Although
    the costs of existing 401(k) plans provide a basis for
    approximating costs for a decentralized employer-sponsored system
    of individual accounts, the full cost of administering existing
    employer-sponsored plans is difficult to measure. In 401(k) plans,
    for example, employers often contract with a plan administrator to
    provide needed services, which may include keeping records,
    managing investments, or providing information.21 These
    arrangements and the services provided vary widely among plans and
    may result in underreporting of the plans' full costs. For
    example, in some employer plans, much of the payroll collection,
    recordkeeping, and benefit payment activities may be handled by
    the employer in-house and are not necessarily billed to the
    pension plan's accounts. Further, 401(k) costs included in annual
    reports submitted to PWBA do not include investment management
    expenses debited directly from the earnings that accrue in the
    participants' accounts. Under a national system of individual
    accounts, these differences in services and how costs are
    allocated could raise questions of fairness. More uniformity in
    the way plan costs are allocated between the employer and the
    individuals might be called for in order to ensure more equitable
    benefits across plans and to facilitate public understanding and
    oversight of the system. Finally, the demographic characteristics
    of employees covered by 401(k) plans or other employer-sponsored
    retirement plans differ from those of the group of individuals who
    would be covered under a mandatory nationwide system. According to
    EBRI, employees covered by employer-sponsored plans have higher
    earnings and lower job turnover than the general workforce. The
    Costs of a Decentralized      Analysts estimate that the
    administrative costs for a decentralized Individually Managed
    Structure    individually managed system would range from 0.32
    percent to 1.5 percent of assets. Variation in the estimates
    stems, in part, from differences in investment strategy and the
    range of investment choices offered, the level 21Some
    recordkeeping costs faced by 401(k) and other employer-sponsored
    plans, such as costs resulting from compliance with plan
    participation requirements, may not be applicable under a
    mandatory nationwide system. Page 18
    GAO/HEHS-99-131 Social Security Reform B-282845 of service
    provided to the investor, and the level of marketing and
    communication done by investment firms. It is important to note,
    however, that this range of estimates does not reflect the lowest
    or highest cost that an investor could incur. The estimates are
    based on average mutual fund costs. In a system offering a wide
    range of investment choices, some individuals could incur costs
    lower than these averages, while some could incur higher costs
    because some mutual fund companies charge higher administrative
    fees. In our analysis of 1998 data provided by Morningstar, Inc.,
    we found that administrative costs for more than 9,300 mutual
    funds with more than $1 million in assets ranged from as low as
    0.01 percent to as high as 7.34 percent of assets, with an average
    of 1.33 percent of assets.22 Other Costs Are Not    In addition to
    the limitations discussed above, most of the cost estimates
    Included in Reform     do not capture the significant costs
    associated with starting up a new Discussions            system
    and those for the additional responsibilities, including
    government oversight and public education, that would probably
    result from a system of individual accounts. These additional
    costs could be borne by employers, the government, individuals, or
    some combination, depending on the structure and design of the
    account system. Start-Up Costs         Since no current system is
    available to handle a national system of individual accounts, some
    additional costs would be incurred to create such a system,
    regardless of the structure selected. These start-up costs include
    the costs of developing or adapting computer systems, establishing
    electronic links between recordkeepers and investment firms,
    informing and educating the public about the changes and about
    available investment options and their risks and costs, hiring and
    training new staff, and establishing or expanding an
    infrastructure for communicating with and serving the public. Any
    of these services could be provided through contractual
    arrangements. Under a centralized system, the majority of these
    costs would be borne by the government. Alternatively, under a
    decentralized employer-sponsored structure, a significant number
    of employers would incur start-up costs because they do not
    provide pension plans. Currently, about 57 percent of private
    sector workers are not covered by an employer-provided pension
    plan. Their employers would need to develop an infrastructure to
    deposit contributions and convey employees' choices to investment
    managers, unless provisions were made 22We analyzed the data
    Morningstar, Inc., reported as annual expenses and did not include
    those reported as one-time fees. (Morningstar, Inc., is a private
    investment research firm that maintains a proprietary database on
    U.S. mutual funds, stocks, and other financial vehicles.) Page 19
    GAO/HEHS-99-131 Social Security Reform B-282845 to permit the
    uncovered employees to invest through a different vehicle, such as
    an IRA. Finally, under a decentralized individually managed
    structure, financial service providers could incur some start-up
    costs to increase their overall capacity. Little historical
    information is available on start-up costs for very large
    retirement systems. Separate funding was provided for the start-up
    of the TSP, which included costs for hiring and training new
    staff, software development, printing materials, and other initial
    activities. According to EBRI, start-up costs for the TSP averaged
    about $5.00 per participant in the first year and, when translated
    into 1998 dollars, would equate to a start-up cost of $1.08
    billion for a similar system provided on a national scale. In
    addition, these costs could be understated because TSP was able to
    rely on the already established National Finance Center for its
    recordkeeping, which had a computer system in place that included
    records on a portion of the federal workforce. However, a national
    system of individual accounts would be much larger than the TSP
    and could benefit from economies of scale in start-up costs as
    well. The State Street Corporation estimated that costs for the
    first year of operation of a national system of individual
    accounts, including start-up costs, would range from 0.7 to 1.34
    percent of fund assets. The Corporation's cost estimates then
    decrease gradually to 0.27 to 0.51 percent of assets in year three
    and to 0.19 to 0.34 percent in year five. Costs to the Government
    Under a new system of individual accounts, the government would be
    taking on additional management activities, expanding oversight
    and regulatory responsibilities, or both, depending on the
    administrative structure selected. Under a centralized system, the
    full costs of the government's taking on a new role are difficult
    to predict, as stated earlier. In addition, if any kind of
    decentralized structure were adopted, the government would be
    likely to incur additional costs for oversight and enforcement
    activities needed to ensure compliance, and these costs are not
    reflected in any of the estimates. Depending on the structure,
    different agencies would be affected. Under an employer-sponsored
    system, the government would be likely to play a larger role in
    ensuring that employers properly transfer an individual's
    contributions to the investment manager. For example, PWBA
    officials estimated that they would need to dramatically increase
    their investigative staff of 350 if a system of individual
    accounts had a 401(k) structure and if they were responsible for
    oversight. Further, if the structure of a system of individual
    accounts involved more open-market investments, more trading
    activities would occur, thus increasing the need for oversight by
    the Securities and Page 20
    GAO/HEHS-99-131 Social Security Reform B-282845 Exchange
    Commission (SEC) or another government entity. SEC has broad
    responsibility over the securities markets, as well as the market
    intermediaries who provide brokerage services and operate mutual
    funds. SEC officials stated that if an individually managed
    structure were selected, the government would need to enhance its
    oversight efforts to protect new investors.23 Moreover, if the
    individually managed system were mandatory, some federal agency
    would likely be responsible for monitoring individual compliance.
    Finally, how the contributions are collected or distributed could
    create additional government responsibilities. For example, if
    contributions were provided through a tax rebate, new systems for
    providing the rebate and monitoring the process would be required.
    Officials in key federal agencies that could be affected by the
    creation of a system of individual accounts told us that their
    agencies had not yet developed a full estimate of the cost of
    oversight for these possible changes. In addition, depending on
    the design, a new centralized system could require SSA to keep two
    parallel systems running at once-one for tracking and paying
    traditional Social Security benefits and one for tracking and
    paying individual accounts under a new system. Also, if the
    government offered any sort of minimum benefit guarantee, SSA
    would most likely be required to monitor benefits under both
    systems and calculate benefit payments accordingly. The costs of
    these activities are also difficult to estimate, according to SSA
    officials. Costs to Educate the Public    Regardless of the design
    of a new system of individual accounts, changing Social Security
    would require educating the public about the new program's purpose
    and features. The costs of this initial education would most
    likely be borne by the government but could be shared by the
    employers or investment managers. A national system of individual
    accounts would require educating some workers who have never
    invested before.24 According to SSA staff, information on changes
    to the program would most likely be sent to every working
    individual through the mail. They estimate that the minimum
    mailing cost would be $0.50 per letter, which totals more than $70
    million per mailing. Because individual accounts would include new
    types of information, SSA believes that it would also need to
    significantly redesign the personalized annual statement it
    currently sends. In addition, the government would probably 23The
    need for enhanced oversight could vary, depending on the
    investment options available. For example, permitting individuals
    to choose among a few mutual funds would require less government
    oversight than if individuals were given a wide range of choices
    among different investment vehicles. 24In a forthcoming report, we
    will discuss in more detail the need for public education and the
    effect of individual accounts on national savings. Page 21
    GAO/HEHS-99-131 Social Security Reform B-282845 arrange for public
    service announcements on television and radio to heighten people's
    awareness. Furthermore, since most proposals for individual
    accounts provide investment choices, additional education would be
    needed to help individuals understand their investment options and
    their associated risks or costs. In addition, depending on the
    system's design, it would be important for individuals to
    understand how increased customer service and other options, such
    as frequently changing investments, could affect administrative
    costs. The government, employers, and investment managers might
    each have some role and incur some costs for this ongoing
    investment education, depending on system design. The cost of
    public education and who would be responsible for providing it are
    not included in all the cost estimates we reviewed. Costs Affect
    Account          Although the precise cost of a system of
    individual accounts is difficult to Accumulation and
    predict, available information can be used to illustrate the
    effect that different levels of administrative costs could have on
    individual account Retirement Benefits           accumulation and
    retirement benefits. Our analysis shows that the level of
    administrative costs passed on to individuals could have a
    significant effect on the balance of funds that would accumulate
    in their accounts, as well as on the retirement benefits their
    accounts would provide. Account Accumulations         To
    illustrate the effect of different levels of administrative costs,
    we used a Decrease as Costs Increase    model of the Social
    Security system to simulate the balances that would accumulate in
    a system of individual accounts for selected workers, given four
    different annual administrative costs-0.1, 0.25, 1, and 2 percent
    of assets. We selected these costs because they fall within the
    range of possible costs presented in table 2.25 We assumed a
    system of individual accounts that was established beginning in
    2002 and simulated the balances that would accumulate by
    retirement for workers born in 1984, who would participate in the
    new system throughout their careers with low, average, and high
    gender-specific annual earnings. We further assumed that these
    workers made annual contributions of 2 percent of their taxable
    earnings that started at age 22 and ended with retirement at 25We
    did not simulate the effect of a 3-percent cost because this
    amount was notably higher than estimates by others. Page 22
    GAO/HEHS-99-131 Social Security Reform B-282845 age 67.26 We use
    1998 dollars to report our simulation results. (See appendix I for
    further details on our methodology and the model.) Figure 2, which
    illustrates the change in accumulations for a working man with
    average annual earnings throughout a 45-year career, shows that
    the accumulated balances would decrease significantly as the
    annual administrative cost increased. In our simulation, changing
    from an administrative cost of 0.1 percent to 1 percent would
    reduce the account accumulations by more than 22 percent, and
    changing from an administrative cost of 0.1 percent to 2 percent
    would reduce the account accumulation by almost 40 percent. For
    example, a man born in 1984 with average annual earnings who
    worked from age 22 to age 67 would accumulate $125,430 in a system
    with 0.1 percent annual administrative costs and $75,995 if the
    administrative costs were 2 percent annually. The proportionate
    effect on accumulations was approximately the same for all
    workers, regardless of whether they had low, average, or high
    annual earnings. 26We did not attempt to address the financing
    issues related to a system with 2-percent contributions. We
    treated the individual accounts as an addition to the current
    Social Security program. Page 23
    GAO/HEHS-99-131 Social Security Reform B-282845 Figure 2: The
    Effect of Administrative Cost Changes on Accumulated Account
    Balances for a Man With Average Annual Earnings Throughout a 45-
    Year Career It is important to note here, and throughout this
    discussion, that higher administrative costs could be associated
    with more customer service and, potentially, with higher
    investment returns or investment portfolios that more closely
    matched individual needs. However, higher investment returns are
    not consistently correlated with higher administrative costs. Many
    actively managed investment options have not been able to generate
    higher returns than broad market indexes. It should also be noted
    that our simulation made a number of simplifying assumptions,
    which, if changed, would further affect accumulations. For
    instance, we assumed that individuals would have earnings every
    year from age 22 until the normal retirement age of 67, when in
    reality many individuals have discontinuous work histories and
    retire before the normal age. To continue our illustration of a
    man born in 1984 with average annual earnings in a system with a
    2-percent annual administrative cost, he would accumulate $65,214
    by the early retirement age of 62, as opposed to Page 24
    GAO/HEHS-99-131 Social Security Reform B-282845 the $75,995
    balance he would accumulate by the full retirement age of 67. In
    addition, we chose to evaluate the effects on individual accounts
    regardless of the person's marital status. We found, as expected,
    that women's accumulations would be smaller than men's because the
    average annual earnings for women are significantly lower than
    those for men. However, some proposals would allow earnings-
    sharing between married persons, which could help mitigate some of
    the disparity between women and men. Our analysis also assumed
    administrative costs would be withheld from the earnings for each
    account through an annual percentage fee. However, for small
    account holders, the method used to assess administrative costs
    can make a difference. Under a system of individual accounts
    involving contributions of 2 percent of taxable earnings, many
    individuals would have small account balances. For example,
    individuals who earned $30,000 annually would contribute only $600
    into their individual accounts each year. More than 64 percent of
    the working population earned less than $30,000 in 1997. If
    individuals were charged a flat fee per account for administrative
    costs, accumulations in small accounts would be affected to a
    greater extent than if they were charged an annual percentage.
    Other alternatives to mitigate the effects of administrative costs
    on small accounts are available. For example, some analysts have
    suggested pooling the funds of small accounts into one single fund
    until the accounts reach a certain minimum balance, where they
    would be less vulnerable to the effects of administrative costs.
    Additional Payout Costs    When individuals make the decision to
    retire, they may bear all or some of May Affect Retirement
    the costs associated with the payout from a system of individual
    accounts. Benefits                   For our analysis, we assumed
    that each individual would pay a one-time fee to purchase his or
    her retirement annuity. In the current market, the average for the
    costs to cover the administration of an annuity is a one-time
    charge of about 5 percent of the amount being converted into the
    annuity.27 It is important to note that these costs vary widely
    and can be lower or much higher than the average. The
    administrative cost of purchasing annuities includes maintaining
    records, making payments, and providing services to the annuitant
    as well as some profit margin for the 27James M. Poterba and Mark
    J. Warshawsky, "The Cost of Annuitizing Retirement Payouts from
    Individual Accounts." National Bureau of Economic Research,
    Cambridge, Mass., Jan. 1999. Page 25
    GAO/HEHS-99-131 Social Security Reform B-282845 annuity
    provider.28 In addition to these administrative costs, individuals
    who currently purchase annuities in the private market pay
    additional costs because of "adverse selection." In the current
    market, individuals who expect to live a long time are much more
    likely to purchase annuities than are individuals whose life
    expectancies are shorter. As a result, to cover the risk of having
    to pay benefits to those who live longer, annuity providers charge
    more for annuities than they would if every individual purchased
    an annuity at retirement. The cost of insuring against adverse
    selection could cost an individual as much as an additional 12
    percent (above the 5-percent administrative costs) of the amount
    being converted into the annuity.29 If a new system of individual
    accounts were mandatory, the adverse selection cost might be
    somewhat mitigated, but there would still be a cost to administer
    the annuity. Therefore, continuing our example, if the man with
    average annual earnings who accumulated $75,995 in a system with a
    2-percent annual administrative cost were to purchase an annuity
    with a 5-percent fee, he would pay about $3,800 in administrative
    costs to purchase an annuity that would provide an average annual
    benefit of $5,584. Conclusions    Administrative costs are but one
    of many important issues to consider when deciding whether and how
    to create a system of individual accounts as part of Social
    Security reform. However, because they can affect the amount of
    savings individuals are able to accumulate through individual
    accounts, they can be a key element of a reform package that
    includes individual accounts. Because program design affects the
    level of administrative costs and who bears them, policymakers
    will need to assess the possible costs and trade-offs for each of
    the various options under consideration. Individual account
    structures with lower administrative costs are often associated
    with more restricted investment choices and more centralized
    management, while increasing individual choice and decentralizing
    the management structure could result in increased costs. Finding
    the right balance will depend, in part, on the goals of the new
    program. Moreover, steps can be taken under any system to help
    mitigate the effect of administrative costs, especially on small
    account-holders. These include limiting customer service options
    or pooling small accounts. 28In a forthcoming report, we will
    provide a more detailed discussion of the factors that affect the
    costs associated with purchasing an annuity and how these costs
    may factor into a system of individual accounts. 29Poterba and
    Warshawsky, "The Cost of Annuitizing Retirement Payouts from
    Individual Accounts." Page 26
    GAO/HEHS-99-131 Social Security Reform B-282845 Finally, although
    the effect of administrative costs may be offset by higher returns
    on investments, it may not be. If a system of individual accounts
    is implemented, the public will need to fully understand how its
    choices will affect the administrative costs it will incur and how
    these costs affect account accumulations. If a decentralized
    structure is chosen or if diverse investment choices and varied
    customer service options are offered, it will be especially
    important to ensure that the public has access to easy-to-
    understand information on the costs of investment options and on
    the effect the costs can have on its accounts and retirement
    benefits. Agency and Other    We provided a draft of this report
    to SSA, IRS, SEC, PWBA, the Department of Comments and Our    the
    Treasury, and the Federal Retirement Thrift Investment Board, as
    well as to external reviewers who are experts in related areas. In
    commenting Response            on our report, the reviewers
    generally agreed with our characterization of the factors that
    influence administrative costs and the possible range of costs
    under a system of individual accounts. They provided comments to
    us in either oral or written form. These comments were primarily
    technical and clarifying in nature. In addition to submitting
    technical comments, SSA stated that we should expand our
    discussion of the costs of compliance and customer service. We
    expanded our discussion of these issues. Furthermore, SSA and
    others suggested that we provide additional detail on the costs
    associated with annuities. Because this issue is a key focus of a
    forthcoming report, we did not expand on it in this report. The
    written comments are printed in appendix II. As agreed with your
    office, unless you publicly announce its contents earlier, we plan
    no further distribution of this report until 30 days from the date
    of this letter. At that time, we will send copies to the Honorable
    Bill Archer, Chairman of the House Ways and Means Committee; other
    interested congressional committees; the Honorable Kenneth S.
    Apfel, Commissioner of Social Security; the Honorable Alexis M.
    Herman, Secretary of Labor; the Honorable Arthur Levitt, Chairman
    of the Page 27                                    GAO/HEHS-99-131
    Social Security Reform B-282845 Securities and Exchange
    Commission; the Honorable Roger W. Mehle, Executive Director of
    the Federal Retirement Thrift Investment Board; and the Honorable
    Robert E. Rubin, Secretary of the Treasury. Copies will be made
    available to others upon request. GAO contacts and staff
    acknowledgments are listed in appendix III. If you have any
    questions concerning this report, please contact me on (202) 512-
    7215. Sincerely yours, Cynthia M. Fagnoni Director, Education,
    Workforce, and Income Security Issues Page 28
    GAO/HEHS-99-131 Social Security Reform Page 29      GAO/HEHS-99-
    131 Social Security Reform Contents Letter
    1 Appendix I
    32 Objectives, Scope, and Methodology Appendix II
    36 Comments From the Social Security Administration Appendix III
    38 GAO Contacts and Staff Acknowledgments Glossary
    39 Bibliography
    40 Related GAO Products
    44 Tables                  Table 1: Factors That Affect
    Administrative Costs                              9 Table 2: The
    Range of Administrative Costs Under Discussion
    14 Figures                 Figure 1: Options for Account
    Administration and Recordkeeping                 6 Figure 2: The
    Effect of Administrative Cost Changes on                        24
    Accumulated Account Balances for a Man With Average Annual
    Earnings Throughout a 45-Year Career Page 30
    GAO/HEHS-99-131 Social Security Reform Contents Abbreviations EBRI
    Employee Benefit Research Institute FICA         Federal Insurance
    Contributions Act IRA          individual retirement account IRS
    Internal Revenue Service PWBA         Pension and Welfare Benefits
    Administration SEC          Securities and Exchange Commission SSA
    Social Security Administration TSP          Thrift Savings Plan
    Page 31                                       GAO/HEHS-99-131
    Social Security Reform Appendix I Objectives, Scope, and
    Methodology This appendix provides detail about our review and
    analysis of the estimates of administrative costs for individual
    accounts. For this report, we addressed three key questions: 1.
    What factors influence administrative costs? 2. What estimates are
    available for administrative costs associated with a system of
    individual accounts? 3. How might administrative costs affect the
    accumulation of savings in individual accounts and the retirement
    benefits they provide? To address the first two questions, we met
    with officials from the federal agencies that would be affected by
    a system of individual accounts, including the Social Security
    Administration, Internal Revenue Service, Securities and Exchange
    Commission, Department of Labor's Pension and Welfare Benefits
    Administration, Pension Benefit Guarantee Corporation, and the
    Department of the Treasury. In addition, we met with experts in
    the areas of Social Security and pension reform, as well as
    employer representatives, payroll processors, investment managers,
    and annuity providers, to obtain a more detailed understanding of
    the costs involved in managing accounts. We also reviewed the
    experiences of organizations and other countries related to the
    administrative costs of individual accounts. Further, we reviewed
    the actual costs for administrative activities of some defined
    contribution pension plans, and we reviewed several studies of the
    estimated administrative costs of a new system of individual
    accounts. The actual and estimated costs we reviewed, with the
    exception of the estimates of the Advisory Council on Social
    Security, are generally not associated with any particular reform
    proposal but are, rather, an effort to predict the administrative
    costs under a variety of proposals. To address the third question,
    we selected a range of cost estimates from those under discussion
    and, using a Social Security policy simulation model, projected
    their effects on account accumulations and retirement benefits.
    Studies We Reviewed    To identify administrative cost estimates
    and the factors that influence them, we reviewed the literature
    and evaluated estimates from a number of different sources. We
    limited our review to studies that were relatively Page 32
    GAO/HEHS-99-131 Social Security Reform Appendix I Objectives,
    Scope, and Methodology comparable in their assumptions, methods,
    and formats.30 This led us to focus on a set of estimates provided
    by a few specific studies.31 These studies varied in the data that
    they used to calculate their estimates, as well as in the
    assumptions they made about the structure of the proposed
    individual account system. Studies that estimated administrative
    costs for a centralized system of individual accounts included
    work by the Advisory Council on Social Security, work published by
    the Employee Benefit Research Institute, and work by Estelle James
    of the World Bank and others and by State Street Corporation.
    Studies that estimated administrative costs for a decentralized
    individually managed system of individual accounts included work
    by James and others and by the Advisory Council on Social
    Security. We also used work published by the Investment Company
    Institute. We found no studies that estimated administrative costs
    for a decentralized employer-sponsored system of individual
    accounts; however, we reviewed available studies by the Pension
    and Welfare Benefits Administration and Olivia S. Mitchell of the
    Wharton School of the University of Pennsylvania on the costs of
    401(k) pension plans, and we used the administrative costs they
    provided as approximations of the cost of a decentralized
    employer-sponsored system. Each of the costs included in table 2
    covers to some extent the costs incurred for collecting
    contributions, managing records, investing money, and determining
    eligibility. The following list describes the basis of each
    study's cost estimates and other information covered in its
    report: * The Report of the 1994-1996 Advisory Council on Social
    Security based its cost estimate for its decentralized individual-
    managed system on the costs of passively managed index funds and
    mutual funds. The cost estimate for its centralized system was a
    consensus of the Council members' opinions. * The Employee Benefit
    Research Institute report discussed the options and difficulties
    in administering individual accounts and the lack of comparability
    between current retirement savings plans and a system of
    individual accounts. The authors based their discussion of
    administrative costs on the current costs of 401(k) plans and
    other investment companies and their discussions with other
    experts. In addition, the authors used the 30For example, we did
    not use estimates from the Cato Institute because they were based
    on a substantially higher contribution rate. Also, Peter Diamond
    of the Department of Economics at the Massachusetts Institute of
    Technology estimated the cost of a centralized system of
    individual accounts in the form of dollars per worker per year
    rather than as a percentage of assets. While it is possible to
    convert from a dollar estimate to a percentage, it requires making
    other assumptions about account size and rate of return. In
    addition, he provided an estimate for a decentralized system of
    "at least 1% of assets," which lacked the specificity of the other
    cost estimates we selected. 31We also gathered a number of other
    estimates of administrative costs; however, the assumptions they
    were based on were unclear. Nevertheless, most of them fell within
    the range of costs we discuss in this report. Page 33
    GAO/HEHS-99-131 Social Security Reform Appendix I Objectives,
    Scope, and Methodology SSASIM-2 model to simulate the effect of
    administrative costs on individual account benefits. * In the
    report by James and others, data on institutional funds-funds
    limited to institutional investors-were used to estimate
    administrative costs for a centralized system and data on retail
    mutual funds were used to estimate costs for a decentralized
    system. * The State Street Corporation's report constructed a
    model of a market-based individual account system designed to
    ensure reasonable costs and minimize the administrative burden for
    employers. It then calculated an estimate for administrative
    costs, using unit costs from its current operations. As a result,
    its estimated costs depend greatly on the assumptions it made
    about the volume of calls for information and the number of
    transactions that the system would be required to handle. The
    authors structured their proposed system so that individuals would
    have limited investment choices and could change their investments
    only once per year; therefore, they assume that individuals will
    have little need to call, and that a large percentage of calls
    will be handled through voice and Internet technology. * The
    Mitchell report provides an analysis of current administrative
    costs for mutual funds, employer-sponsored defined contribution
    pension plans, and annuities provided by life insurance companies.
* The Investment Company Institute reports analyzed trends in the
    cost of investing in equity mutual funds, bond funds, and money
    market mutual funds from 1980 to 1997. We used the 1997 costs.
    Social Security       In order to answer the question of how
    administrative costs affect account Simulation Model
    accumulations and the retirement benefits they provide, we used a
    Social Security simulation model (SSASIM-2)  that was recently
    developed by the Policy Simulation Group.32 The model has the
    capability of analyzing the implications of adding individual
    defined-contribution accounts to Social Security's existing
    defined-benefit structure. Incorporated into the model is the
    dynamic interaction of the population, the economy, and Social
    Security programs. In our analysis, we made a number of
    assumptions. With respect to population and economic projections,
    including returns on investment and projected wages, we used the
    same assumptions as those used to produce the intermediate-range
    estimates of the 1999 Annual Trustees Report of the Social
    Security Administration. These resulted in a 10.3-percent 32We
    consulted with Martin Holmer of the Policy Simulation Group in
    using the model to run our own simulations. Page 34
    GAO/HEHS-99-131 Social Security Reform Appendix I Objectives,
    Scope, and Methodology nominal rate of return for corporate stocks
    (or about a 7-percent real return) and a 6.3-percent nominal
    return on Treasury bonds (or about a 3-percent real return). With
    respect to the structure of the individual accounts themselves, we
    assumed that the account was funded by a contribution of 2 percent
    of taxable earnings, and we isolated the effect of administrative
    costs on individual accounts from any changes to the Social
    Security program. We assumed that allocations of portfolios were
    based on a lifecycle model of investing and that the accounts
    would be created in 2002.33 Our simulations of account
    accumulations were done for workers born in 1984, who would enter
    the system at the age of 22. We simulated accumulations for two
    groups, those who would retire by the normal retirement age of 67
    and those who would retire by the early retirement age of 62. For
    each group, we ran separate sets of simulations using estimates of
    administrative costs of 0.10, 0.25, 1, and 2 percent of assets per
    year. We picked these estimates because they cover the spectrum of
    most of the cost estimates we identified in table 2. For each set,
    we prepared six simulations segmented by gender and by low,
    average, and high earnings levels. We assumed that individuals
    with low earnings earned 45 percent of the average annual earnings
    each year throughout their careers and that those with high
    earnings earned 160 percent of the average, which is consistent
    with the assumptions used by the Advisory Council on Social
    Security and SSA's Office of the Actuary. We chose to produce our
    results separately for men and women because their earnings
    patterns are significantly different. In addition, to simulate the
    effects of the cost of purchasing annuities, we assumed that
    individuals would pay a one-time fee of 5 percent of the balance
    of their account to purchase a gender-specific, indexed annuity.
    33A lifecycle model of investing assumes that younger individuals
    are able to assume more risk in their investment strategy than
    individuals who are much closer to retirement age. For example,
    individuals in their twenties would invest 100 percent of their
    portfolio in the stock market and their investments in stocks
    would decrease incrementally to 71 percent in their forties and 23
    percent in their sixties. The remainder of their portfolio would
    be invested in Treasury bonds. Page 35
    GAO/HEHS-99-131 Social Security Reform Appendix II Comments From
    the Social Security Administration Page 36      GAO/HEHS-99-131
    Social Security Reform Appendix II Comments From the Social
    Security Administration Page 37
    GAO/HEHS-99-131 Social Security Reform Appendix III GAO Contacts
    and Staff Acknowledgments GAO Contacts       Barbara D. Bovbjerg,
    Associate Director, (202) 512-7215 Kay E. Brown, Assistant
    Director, (202) 512-3674 Staff              In addition to the
    persons named above, the following team members Acknowledgments
    made important contributions to our work and this report: R.
    Elizabeth O'Toole, Alicia Puente Cackley, Abbey Frank, Gerry
    Grant, William McNaught, Deborah Moberly, Valerie Rogers, George
    Scott, Roger J. Thomas, and Rodina Tungol. Page 38
    GAO/HEHS-99-131 Social Security Reform Glossary 401(k) Plan
    An employer-sponsored defined contribution plan that allows
    participants to contribute, before taxes, a portion of their
    salary to a qualified retirement account. Annuity
    A form of contract sold by life insurance companies that
    guarantees a fixed or variable payment made periodically (usually
    monthly) to the annuitant at some future time, usually retirement.
    Basis Point                  The smallest unit of measure for
    administrative costs. One basis point equals 0.01 or 1/100 of a
    percent; thus, 100 basis points equals 1 percent. Charge or Load
    A fee paid by an investor for buying and selling shares in a
    mutual fund or annuity. Defined Contribution Plan    A pension
    plan in which the contributions are allocated to individual
    accounts by a predetermined formula and benefits vary, depending
    on the contribution level and the return from the investment of
    these contributions. Expense Ratio                Expenses as a
    percentage of accumulated fund assets. Commonly used when
    referring to the administrative costs of mutual funds. Individual
    Retirement        A personal, tax-deferred retirement account set
    up by an individual Account                      worker. Page 39
    GAO/HEHS-99-131 Social Security Reform Bibliography Advisory
    Council on Social Security. Report of the 1994-1996 Advisory
    Council on Social Security, Vols. I and II. Washington, D.C.: U.S.
    Government Printing Office, Jan. 1997. Diamond, Peter.
    "Administrative Costs and Equilibrium Charges with Individual
    Accounts." Paper presented at the National Bureau of Economic
    Research Conference, Cambridge, Mass., 1998. Revised Feb. 1999.
    Employee Benefit Research Institute. "Individual Social Security
    Accounts: Issues in Assessing Administrative Feasibility and
    Costs." Special Report SR-34 and Issue Brief 203, prepared by
    Kelly A. Olsen and Dallas L. Salisbury, Washington, D.C., Nov.
    1998. Genetski, Robert. "Administrative Costs and the Relative
    Efficiency of Public and Private Social Security Systems." Social
    Security paper 15. Washington, D.C.: The Cato Institute, Mar. 9,
    1999. James, Estelle; Gary Ferrier; James Smalhout; and Dimitri
    Vittas. "Mutual Funds and Institutional Instruments: What is the
    Most Efficient Way to Set Up Individual Accounts in a Social
    Security System?" Paper presented at the National Bureau of
    Economic Research Conference, Cambridge, Mass., 1998. Mitchell,
    Olivia S. "Administrative Costs in Public and Private Retirement
    Systems." In Privatizing Social Security, ed. Martin Feldstein.
    Chicago, Ill.: University of Chicago Press, 1998. Pp. 403-56.
    Murthi, Mamta, J. Michael Orszag, and Peter R. Orszag. "The Charge
    Ratio on Individual Accounts: Lessons from the U.K. Experience."
    Birkbeck College Working Paper 99-2, University of London, London,
    Eng., Mar. 1999. National Academy of Social Insurance. Report of
    the Panel on Privatization of Social Security. Washington, D.C.:
    Nov. 1998. Pension and Welfare Benefits Administration. Study of
    401(k) Plan Fees and Expenses. Prepared by Economic Systems, Inc.,
    and the Hay Group. Washington, D.C.: Department of Labor, Apr. 13,
    1998. Page 40                                    GAO/HEHS-99-131
    Social Security Reform Bibliography Poterba, James M., and Mark J.
    Warshawsky. "The Cost of Annuitizing Retirement Payouts from
    Individual Accounts." National Bureau of Economic Research,
    Cambridge, Mass., Jan. 1999. Rea, John D., and Brian K. Reid.
    "Trends in the Ownership Cost of Equity Mutual Funds." Investment
    Company Institute Perspective, Vol. 41, No. 3 (Nov. 1998), pp. 1-
    15. Rea, John D., and Brian K. Reid. "Total Shareholder Cost of
    Bond and Money Market Mutual Funds." Investment Company Institute
    Perspective, Vol. 5, No. 3 (Mar. 1999), pp. 1-8. State Street
    Corporation. Administrative Challenges Confronting Social Security
    Reform. Boston, Mass.: 1999. Page 41
    GAO/HEHS-99-131 Social Security Reform Page 42      GAO/HEHS-99-
    131 Social Security Reform Page 43      GAO/HEHS-99-131 Social
    Security Reform Related GAO Products Social Security Reform:
    Implementation Issues for Individual Accounts (GAO/HEHS-99-122,
    June 18, 1999). Social Security: Criteria for Evaluating Social
    Security Reform Proposals (GAO/T-HEHS-99-94, Mar. 25, 1999).
    Social Security: Individual Accounts as an Element of Long-Term
    Financing Reform (GAO/T-HEHS-99-86, Mar. 16, 1999). Social
    Security Reform: Experiences of the Alternative Plans in Texas
    (GAO/HEHS-99-31, Feb. 26, 1999). Social Security and Surpluses:
    GAO's Perspective on the President's Proposals (GAO/T-AIMD/HEHS-
    99-95, Feb. 23, 1999). Social Security and Minorities: Current
    Benefits and Implications of Reform (GAO/T-HEHS-99-60, Feb. 10,
    1999). Social Security: What the President's Proposal Does and
    Does Not Do (GAO/T-AIMD/HEHS-99-76, Feb. 9, 1999). Social Security
    Reform: Implications for Women (GAO/T-HEHS-99-52, Feb. 3, 1999).
    Social Security: Different Approaches for Addressing Program
    Solvency (GAO/HEHS-98-33, July 22, 1998). Social Security Reform:
    Raising Retirement Ages Improves Program Solvency but May Cause
    Hardship for Others (GAO/T-HEHS-98-207, July 15, 1998). Social
    Security Financing: Implications of Government Stock Investing for
    the Trust Fund, the Federal Budget, and the Economy (GAO/HEHS-98-
    74, Apr. 22, 1998). Social Security Financing: Implications of
    Stock Investing for the Trust Fund, the Federal Budget, and the
    Economy (GAO/T-AIMD/HEHS-98-152, Apr. 22, 1998). 401(k) Pension
    Plans: Loan Provisions Enhance Participation but May Affect Income
    Security for Some (GAO/HEHS-98-5, Oct. 1, 1997). (207048)
    Page 44                                      GAO/HEHS-99-131
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