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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